Wednesday, May 8, 2013

Brazilian Pension Funds Go Global?

Joseph Leahy of the Financial Times reports, Brazilian pension funds go global:
As little as a year ago, Brazil’s greatest concern was the currency war – a tsunami of international funds that it believed was threatening to inundate its financial markets and those of other emerging countries.

Now, Brazilian real interest rates have fallen so low that, in a dramatic reversal, the country’s own pension funds are looking abroad. While their initial offshore investments will not amount to anything like a tsunami, it marks the start of what may prove to be an important step in the maturing of Brazil’s financial industry.

Global asset managers, investments banks and international private equity funds are flocking to the country’s pension funds to try to win a share of the potential outward flows, which are estimated to be between $25bn and $45bn.

“Pension funds are very interested in doing this kind of diversification as they have very tough actuarial targets,” says Carlos Massaru Takahashi, chief executive of Brazilian fund manager BB Gestão de Recursos DTVM, which has more than R$400bn in assets under management. “Probably this investment will happen this semester.”

Not only are Brazilian pension funds looking for higher returns potentially offered by developed markets such as the US but they are also seeking to broaden portfolios centred on Brazilian government bonds and local equities.

“There is a part of this that is a search for returns and that will continue to be our objective, but there is also a part that is about global diversification from the perspective of risk management,” says Mauricio Wanderley, director of investments and finances at Valia, the pension fund of the world’s largest iron ore exporter Vale.

The sudden move towards diversification marks a turning point for a country that until now has been batting away foreign fund inflows by implementing currency controls and other defensive measures.

Brazil’s government was worried that hot money inflows, fuelled by loose monetary policy in developed markets, were driving up its exchange rate against the US dollar and weakening the ability of domestic industry to compete.

But then followed a historic fall in Brazil’s benchmark interest rate, the Selic, from 12.5 per cent in mid-2011 to an all-time low of 7.25 per cent. At the same time, inflation has crept up, reducing the real interest rate sharply.

For Brazilian investors, addicted to the easy pickings offered by the country’s high interest rates – a legacy of its earlier period of runaway inflation – the sudden decline has come as a shock. Rather than keeping most of their money in liquid government treasuries or other fixed income instruments, they now must look for alternatives if they are to meet their targets for returns.

Brazil’s pension fund industry body, Abrapp, said the country’s funds had 61.7 per cent of their money in fixed income as of December 31 last year and the remainder in shares and mixed funds.

With interest rates low and the local market underperforming – the Bovespa index is down 9 per cent this year compared with a 14 per cent gain in the S&P 500 – the incentive to begin investing abroad is compelling.

“What we are seeing is these big pension funds are going global,” says André Laport, partner at Goldman Sachs in São Paulo.

The tentative moves by the industry to begin looking overseas are provoking a feeding frenzy among foreign asset managers, pension funds and investment banks looking for a share of this new and unexpected source of money.

With assets estimated by JPMorgan at up to about $450bn, there is potential under the present law for 10 per cent of this, or up to $45bn, to flow into overseas markets.

“There is a lot of interest here in the US from private equity players,” says Sanjiv Kapur, a lawyer at Jones Day. He says he will be organising a seminar for private equity groups and pension funds in the US alongside a Brazilian law firm.

However, fund managers in Brazil caution the process will be gradual. Not only does the law require fund managers to form groups of four or more institutions, which would then invest in one Brazilian fund that in turn places that money abroad, they also need to familiarise themselves with offshore investment strategies.

Bankers believe these will at first be conservative, such as investing in the S&P 500, before they begin to pursue more aggressive strategies. Cassio Calil, president of JPMorgan Asset Management in Brazil, says pension fund managers in the country will need to analyse an array of considerations, from currency risk to the fact that investing in multinationals in developed countries would see some of their money returning to Brazil through these companies.

Then there is the fact that, though Brazilian benchmark interest rates have fallen, many pension funds are still making good returns at home. The concern is whether these will be sustainable in the future as Brazilian interest rates continue to move lower.
Brazilian pension funds are facing the same conundrum as other global pensions, namely, how to meet their tough actuarial targets by diversifying risk properly.

The problem is that in a world of low interest rates, it's becoming exceedingly difficult to properly diversify risk. Still, sophisticated pensions are doing so by allocating across public and private markets. Some are making sizable allocations to private equity, real estate and infrastructure.

In my last comment, I wrote about PSP Investments buying Hochtief's airports unit for $1.4 billion USD. This is a huge deal, one that will likely pay off handsomely in the future. But investing in private markets takes specialized resources and these investments carry their own risks. Pensions cannot underestimate the risk of illiqudity (not an issue for PSP Investments because it has positive cash flows for many more years).

The push toward global assets will be good for Brazilian pension funds. They need to find the right partners in public and private markets, make sure alignment of interests are right, and proceed cautiously following a solid strategic plan that will minimize risks and make this transition smoother (for example, diversify vintage year risk in private equity and diversify properly in sectors, regions, funds, strategies, etc.).

One thing is for sure, Brazil has some of the smartest investment professionals in the world and they are up for the challenge. There is a reason why the Canada Pension Plan Investment Board invested in BTG Pactual, a global powerhouse and one of the better known Brazilian success stories. CPPIB, the Caisse and other large Canadian pensions are also heavily invested in Brazilian real estate, effectively betting on a continuation of Brazil's boom.

Still, Brazil faces serious challenges in their public pension system. Mark Hussein, Global Head of Commercial Insurance & Investments, HSBC Seguros, discussed the the global pension crisis a year ago, stating the pension problem in Brazil is magnified by an unsustainable public pensions system and a population which is not taking sufficient steps to prepare for retirement. You can watch the clip on World Finance TV by clicking here (from January, 2012).

Below, Arminio Fraga, former president of Brazil's central bank, talks about the Brazilian economy and monetary policy. He spoke at a Brazilian-American Chamber of Commerce event in New York on April 22. Very good speech, worth listening to as he discusses some of the structural problems impacting their economy.