Thursday, January 31, 2013

Pensions Taking On Too Much Illiquidity Risk?

My last comment on the Caisse focusing on illiquid asset classes generated a few excellent responses, so I decided to follow-up on this topic. Let me begin with what a former pension fund manager shared with me after reading my comment:
Excellent article. I am always impressed to see that some investors still think that illiquid assets are less volatile. Most investors know that illiquid assets have their traditional risk measures (standard deviation, covariance, correlation and beta) underestimated due to stale pricing and infrequent “third-party” valuations. Of course, one can use relatively simple statistical adjustments to estimate the true underlying risk but many investors still prefer to stick with the underestimated risk measures.

Private equities generally use more leverage than the average public market investment. It is therefore not surprising to observe a statistically adjusted Beta higher than one. A leading edge Canadian investment organization assumes an average beta of 1.3 for its Private Equity portfolio.

If you don’t risk-adjust your returns, investing in levered strategies, high beta strategies, and private equities may look like a winning strategy. This will outperform when the public market goes up, and it will underperform in down markets. In the long run, assuming the markets go up, the strategy will work but with much more real volatility than its benchmark.

I have done some statistical analysis of a large investment organization using such approach and conclude that its departure from its benchmark in investing into levered strategies, high beta strategies, and private equities is statistically significant. I also find that its residual alpha is significant too but negative. Thus, if one has a negative investment skill (in the sense of stock picking, bond picking, etc), one can try to hide it by leveraging its Beta…

At the end of 2011, the Caisse’s benchmark had 24.4% exposure to private equity, infrastructure and Real Estate. The actual portfolio was slightly overexposed at 25.0% (down from 25.4% in 2010). The planned increases from 25% to 30% will significantly increase the active risk of the portfolio. The unadjusted (apparent) total risk may go down but the true (adjusted) total risk will significantly go up. The Caisse with the largest risk department in Canada (and one of the largest in the world) should know better.

As you mentioned, benchmarking is a major issue in private equities. And one should always be skeptical of changes in those benchmarks. Many such benchmarks are non-public and many suffer from survivorship bias. I have observed one major investor outperforming its benchmark by more than 20% in the first half of the year, then matching its new benchmark in the second half. Was the benchmark changed to lock-in an outperformance obtained by improper risk taking?

I also agree with your observation that the herd behavior of investors out of public equities, into private equities is changing the supply/demand relationship of these assets and therefore affecting their future return potential – something to keep in mind. If too many investors are chasing the same private equity deals, the higher pricing of these investments can only make future returns lower.
There are many excellent points in this comment. First, if you don't adjust returns for risk, private equity (and other illiquid asset classes like real estate and infrastructure) always outperform traditional stocks and bonds. This is why left unconstrained, asset allocation "optimization" models will allocate as much as possible into these illiquid asset classes because they underestimate the true risk of these investments (pension risk managers know this and adjust accordingly).

Moreover, academic studies have shown that there is substantial heterogeneity across private equity funds and that median returns underperform the S&P500. And unlike mutual funds, there is performance persistence among top funds, although lately there seems to be a changing of the old private equity guard.

Other studies using a select sample of funds have found private equity outperforms public markets net of fees but is highly correlated with public market conditions:
On average, our sample funds have outperformed the S&P 500 on a net-of-fee basis by about 15%, or about 1.5% per year. Performance and cash flows over time are highly correlated with public market conditions. Consequently, funds raised in hot markets underperform in absolute terms (IRR) but not relative to the S&P 500 (PME). Both capital calls and distributions are  more likely and larger when public equity valuations rise, but distributions are more sensitive  than calls, implying that net cash flows are procyclical and private equity funds are liquidity providers (sinks) when valuations are high (low). Controlling for public equity valuations, there is little evidence for the common view that private equity is a liquidity sink, except during the financial crisis and ensuing recession of 2007-2009, when unexplained calls spiked and distributions plummeted.
I won't get into the pros and cons of academic studies on private equity and hedge funds. Suffice to note that most of these studies are fraught with pitfalls, survivorship bias being one of the biggest (lots of hedge funds and PE funds don't survive, biasing performance data).

But the comment above from the former pension fund manager also elicited this detailed response from a private equity expert defending the asset class:
Lots of strongly felt assumptions going on here, many reflect familiar biases and presumptions that have plenty room for debate.

For example, valuations of companies do not in fact fluctuate as widely as values of minority bits and pieces of stocks in listed companies (why would they?). The only public company value that is comparable is a takeover bid, which is always at a premium, often significant (30 to 50 %) to the trading value implied market cap. The public market bias in those who evaluate private equity presume the way public markets are evaluated is sacrosanct. Stale pricing, or perhaps correct but simply necessarily subjective and therefore impossible to truly validate? Try unloading 100 % of the a listed company stock on the public market at the end of the trading day, and then you can mark to market.

Many private equity strategies are structured with much more downside protection than a trading common stock, and can mute valuation changes quite legitimately. Sure some firms have higher than public leverage, but the presumption is the public leverage is optimal in the first instance, it rarely is. In private equity, a company is worth what one can finance, a pretty good capitalistic indicator of value, not indicative of "excessive" leverage other than in hindsight.

Most mainstream private equity returns come from acquisition add-ons, or transformative mergers, which are challenging for staff and industries but otherwise have proven productivity enhancing outcomes, or stretch out the life of otherwise dying or fading businesses. Many also use growth capital, debt and equity to enhance existing businesses, and all employ management incentive structures that are far more focused than in most public companies.

To say alpha is negative is fine but presumes alpha makes any sense, that beta is always a rational known, and the time horizons for measuring (a quarter, a year? 10 years?) lead one to rethinking this and regress to old ideas, like seeking absolute returns (used to be called profits) like any other commercial enterprise, which simply makes more intellectual sense. Why should asset managers allocate capital so differently than commercial enterprise allocate their capital, ie. old style payback, hurdle rates and other types of project finance time tested ideas - that's what privately equity is actually structured around as an industry business model, for good reason. The whole alpha beta split is responsible for epic misallocation of capital. Parsing return attribution over short periods is a fools game, really one of compensation, and one that management's at institutions and their comp consultants exploit well.

The fact is that many private equity investment programs don't deliver, but a small but significant number do. All the analysis shows you is being median is a waste of time, while in the public markets median might still be ok. Rather than homogenize the whole industry and force an asset class definition, the portfolio objective is to diversify away from the public market culture and ecosystem, which is quite arguably very polluted, maybe even broken or at least has moved too far away from serving its business aims.

Private equity at its best goes back to old time business rather than investment values, and rewards risks in a way that is much more clearly aligned with investors ie. most comp is paid when cash is returned to investors - why do institutions not require this for hedge funds? Why do institutions say infrastructure is not really equity, because bond and risk guys say so, when it actually is (equity means massive ownership responsibility, not just a different stream of the cash flow), and is often even more levered than private equity? And traders get libor cost of funds, yet that cost of capital is not made available to other traditional investments when evaluating alpha? Why not?

Too many issues and biases for me to even address here. The point is, the reference point the commenter makes assume all other areas of investment and risk have been perfected, and private equity is driving a truck through the framework. Good to think through the potential dysfunctions, but it is far from uniquely in private equity.

You know I am a major sceptic of private equity and those that mislead their audiences and institutions, and I am far from being a shill for the industry. But the challenge is to do the task well, and keep the public market and asset management pollution out of the picture.
I think the Caisse is in its own way trying to escape the dysfunctions of our times, and trying to find a better way. Private equity and illiquids may not be the solution, but what is? They should be applauded for taking a view, however flawed or simplistic it may be.
I don't know if the Caisse is trying to "escape the dysfunctions of our times," but they have taken a clear view that bonds and stocks won't suffice to meet the target rate of returns set by their depositors and are thus allocating more into illiquid private markets.

And they're not alone. Following my last comment, another pension fund manager sent me a Bloomberg article discussing how Norway's plan to cut tariffs to ship gas through its pipelines by 90 percent will deal a blow to funds that have spent more than $5 billion since 2010 buying stakes in the infrastructure of western Europe’s largest gas producer.

The article specifically mentions the Canada Pension Plan Investment Board (CPPIB) and the Public Sector Pension Investment Board (PSPIB) as two of the major investors in these pipelines:
Statoil ASA (STL), which is 67 percent owned by the Norwegian state, sold a 24 percent stake in Gassled in 2011 for 17.35 billion kroner, bringing its holding down to 5 percent. The stake was bought by Solveig, a company owned by Canada Pension Plan Investment Board, Allianz Capital Partners, a subsidiary of Allianz, and Infinity Investments SA, a unit of the Abu Dhabi Investment Authority.

Total AS and Royal Dutch Shell Plc (RDSA) also sold stakes in Gassled in 2011.

Shell in September 2011 agreed to sell its 5 percent stake for 3.9 billion kroner to Infragas Norge AS, a unit of Canada’s Public Sector Pension Investment Board. Total in June 2011 agreed to sell its 6.4 percent stake for 4.6 billion kroner to Silex Gas Norway AS, owned by Allianz.

The pension fund manager who sent me the article noted "how do you model this risk?". And he's right, there are many regulatory risks and other risks in infrastructure that are difficult if not impossible to model.

One of the best comments on the risks of illiquid asset classes I received yesterday came from Jim Keohane, president and CEO of the Healthcare of Ontario Pension Plan (HOOPP). Jim notes the following after reading my last comment:
I find this whole discussion quite interesting. I agree with the commentary of the former pension fund manager. Private assets are just as volatile as public assets. When private assets are sold the main valuation methodology for determining the appropriate price is public market comparables, so you would be kidding yourself if you thought that private market valuations are materially different than their public market comparables. Just because you don’t mark private assets to market every day doesn’t make them less volatile, it just gives you the illusion of lack of volatility.

Another important element which seems to get missed in these discussions is the value of liquidity. At different points in time having liquidity in your portfolio can be extremely valuable. One only needs to look back to 2008 to see the benefits of having liquidity. If you had the liquidity to position yourself on the buy side of some of the distressed selling which happened in 2008 and early 2009, you were able to pick up some unbelievable bargains.
Moving into illiquid assets increases the risk of the portfolio and causes you to forgo opportunities that arise from time to time when distressed selling occurs - in fact it may cause you to be the distressed seller! Liquidity is a very valuable part of your portfolio both from a risk management point of view and from a return seeking point of view. You should not give up liquidity unless you are being well compensated to do so. Current private market valuations do not compensate you for accepting illiquidity, so in my view there is not a very compelling case to move out of public markets and into private markets at this time.
Got that folks? Current private market valuations do not compensate you for accepting illiquididty risk. Lots of pensions learned the value of liquidity the hard way during the 2008 crisis. When they needed it the most, they didn't have it and were forced to sell public market assets at distressed levels to shore up their liquidity.

Jim Keohane also shared his thoughts on Norway's proposed cut in tariffs:
The pipeline example illustrates the point. By investing in private assets you assume all the same risks that you assume when investing in public companies. In the case of infrastructure assets, you also face regulatory risks such as this. Generally speaking, local governments will take actions that favor their stakeholders – the voters in their country and don’t care whether it disadvantages a foreign pension plan. You would be naïve to think otherwise. Canadian governments and regulators act the same way.

I am sure that CPPIB and PSP are well aware that these types of political risks exist within these types of investments. Valuations are the critical factor. As long as you receive a high enough risk premium to compensate you for taking on these risks then it is an appropriate investment. I think that the point that this brings out is that investing in infrastructure is not a free ride. It has all of the risks contained in any other equity investment, so you need to go in with your eyes wide open!
Finally, a pension policy expert from British Columbia sent me this note:
Leo, I’m always impressed by the quality of the comments by the folks who comment on your postings. Shows you are becoming the most prominent commentator on pensions in Canada – and I suspect broader as well.

I’ve always been nervous about this whole private equity thing – not to mention real estate, as I’m not sure how accurate the valuation is. My suspicion has been that changes in value would generally lag the market, especially on the down side – that is just human nature – to think your assets are worth more than they really are, and I suspect the trend to upgrade valuations is most likely when the tide is rising.

Learning more about how the benchmarks are set for private equity and real estate make me even more cautious – especially when bonuses are related to benchmark outperformance. I suspect most boards do not have the expertise to assess the validity of the benchmarks their investment people are recommending them to approve. It seems a whole industry has build up around benchmarks.
The entire pension industry is indeed built around benchmarks which is why I've spent a lot of time in the past demystifying pension fund benchmarks. It's not an easy topic and it doesn't win me support from many senior pension fund managers in Canada who think they're being properly compensated for the risks they're taking.

But this blog is unique and has done more to increase the dialogue on tricky issues in pensions than most other financial news outlets, including specialized pension magazines and sites. The contributions you read here are simply not found anywhere else.

This is why I will ask all of you -- friends and foes -- to show your support by donating any amount or better yet, subscribing on a monthly basis to this blog by clicking on the PayPal button on the right hand side just above my profile picture. I realize that the blog comments are free but I put a lot of  time and effort in these comments. I thank those of you who have donated or have subscribed to a monthly donation.

Below, Mark Weisdorf, chief executive officer of infrastructure investing for JPMorgan Asset Management (formerly head of private markets at CPPIB), talks about strategy for private investment in infrastructure. He speaks with Deirdre Bolton on Bloomberg Television's "Money Moves."