Monday, September 30, 2013

Blackstone Sees Epic Credit Bubble?

Lawrence Delevingne of CNBC reports, Blackstone: We're in an 'epic credit bubble':
One of the world's largest investment firms believes the financial system is overly leveraged.

"We are in the middle of an epic credit bubble, in my opinion, the likes of which I haven't seen in my career in private equity," Joseph Baratta, The Blackstone Group's global head of private equity, said Thursday night at the Dow Jones Private Equity Analyst Conference in New York City. "The cost of a high yield bond on an absolute coupon basis is as low as it's ever been."

Baratta said Blackstone is "bullish" on the U.S. economy, but the "valuations we have to pay relative to the growth prospects are out of whack right now."

Baratta said the U.S. still has "clear headwinds" and is "range bound" between 1 percent and 3 percent economic growth.

Blackstone, which manages $53 billion in private equity assets and $230 billion overall, is pursuing select investment opportunities in energy, transportation infrastructure, consumer finance, housing and construction, according to Baratta.

"We're not just levering up U.S. GDP into multiples today," Baratta said. "I do expect mean reversion to happen at some point on interest rates, on credit spreads, on the cost of some investment grade corporate credit."

The high valuation of many companies today makes it harder for them to grow. "The biggest risk to returns of this vintage is that exit multiples are depressed," Baratta said.
Baratta's comments serve as a warning to institutional investors piling into private equity. As I've previously discussed, the pressure is on private equity funds to find attractive deals in this environment and while investors are maintaining their allocations, they are turning lukewarm on the asset class and see lower returns ahead. Moreover, the move toward Asia hasn't delivered the returns PE funds are accustomed to and big investors are sounding caution in that region.

In terms of credit markets, Cullen Roche of Pragmatic Capitalist sees the logic in Baratta's bubble theory:
Yes, while everyone focuses on the stock market, the real disequilibrium that has been potentially built up over the years has been in credit markets where the portfolio rebalancing effect has forced investors out of risk free US government bonds and into assets that serve a similar purpose in a much riskier credit structure. We’ve taken another safe asset class and forced this massive rebalancing of portfolios that has resulted in investors chasing yield to the point of actually making the market potentially more unstable than it otherwise would be.

Of course, this all works fine so long as the income is there to support the credit structure. But the big risk is a recession or a big profit recession where companies are no longer seeing the cash flows. That’s when the big risks present themselves. And if that were to occur we’d see a mass exodus out of many of these private credit markets in search of the true safe assets – US government debt. And if the Fed is still siphoning the risk free asset out of the private sector when investors most want it this could actually exacerbate the problems in other markets as the exodus into cash and cash like instruments ensues. Think 2008 style US T-bond rally all over again.
But not everyone buys the bubble theory in credit markets. Ben Eisen of MarketWatch reports on how the junk bond credit clock is moving slower this time around:
Cries of a credit bubble appear to be coming back into vogue.

Take, for instance, Joseph Baratta, The Blackstone Group‘s global head of private equity, who reportedly said at a conference on Thursday: “We are in the middle of an epic credit bubble, in my opinion, the likes of which I haven’t seen in my career in private equity.”

But in the high yield bond market at least, if there is a bubble, the chug toward any sort of pop appears to have been slowed down by a lethargic economy and a responsive Federal Reserve.

High yield, or junk, bonds tend to move in a cycle characterized by fits and starts, as the balance sheets of these lowest-rated companies strengthen and weaken. While the means of labeling it vary, Wesley Sparks, head of taxable fixed income at Schroders, categorizes the so-called “clock” of high yield credit quality into four categories.

It starts with “repair” in which balance sheets improve and cash generation efforts increase; then comes “recovery “efforts to boost cash flow and expand margins; “expansion” follows, defined by falling margins and rising leverage; “downturn” comes after that, as the economy slows down and defaults rise, prompting companies to begin the “repair” phase all over again.

The repair-to-downturn cycle went all the way through between 2002 and the beginning of 2009. This time around, Sparks pegs the junk bond market in the middle of the “expansion” phase (right around 7 o’clock), nearly five years after the cycle ended (click on chart below).

The slower pace comes from the sluggishness of the economic recovery, he says. Companies tend to increase their leverage as the economy picks up steam, while credit standards tend to drop. To slow down the time before defaults inevitably rise is a good thing for the junk bond markets.

“This credit cycle has been slowed down because of the slow-growth environment, but it’s been stabilized by an accommodative Fed,” Sparks said in an interview Tuesday. “In the current environment, credit is quite constructive.”

But not all high-yield sectors move around the clock at the same speed. The slow pace creates some differentiation. For example, in the expansion phase we are currently in, cyclicals like consumer and chemical companies are tending to do well, he said. Once the downtrend hits and defaults rise, other sectors like food and beverage and healthcare may become more attractive.
Finally, it's worth noting that Baratta's comments stand in contrast to the bullish tone of Blackstone President Tony James who told Bloomberg last week the good times in the buyout market are just starting:
Blackstone Group LP President Tony James said the “good times” are just starting for private-equity firms because the U.S. economic recovery is still in its early stages, Europe has stabilized and China is rebounding.

“I don’t see the good times coming to an end for quite a while, absent some global shock,” James said in an interview airing today with Bloomberg Television’s Erik Schatzker at the Clinton Global Initiative in New York. “I’m not sure the stock market doesn’t have a long way to run still, and the economy certainly still has a long way to run.”

Profit at New York-based Blackstone more than tripled in the second quarter from a year earlier as the firm, led by James and Chief Executive Officer Stephen Schwarzman, took advantage of rising stock markets to sell holdings and take portfolio companies public. Now is a better time to sell than to buy as interest rates kept low by the U.S. Federal Reserve allow buyers to finance acquisitions at high prices, Schwarzman said at the Sept. 24 Bloomberg Markets 50 Summit in New York.

‘Recovery Thesis’

Private-equity firms depend on both selling and buying companies to make money for investors, who expect to earn their money back with a return five to six years after it’s put into a deal. Bill Conway, Carlyle Group LP’s co-chief executive officer, said on Aug. 7 that the investment environment has grown more challenging, sending shares of Washington-based Carlyle down 1.2 percent.

Even in a competitive climate, Carlyle has raised more than $10 billion for its newest buyout fund, Carlyle Partners VI, exceeding its target.

James’s comments were echoed today by Alex Navab, co-head of private equity for the Americas at KKR & Co. (KKR), who said the U.S. economy will continue to grow over the next three to four years. The U.S. private sector is growing at a healthy pace despite obstacles such as the federal debt and lack of action in Congress.

“Our view is that the private sector has grown three-plus percent and what’s really been a drag to GDP has been the government issues,” Navab said at the Dow Jones Private Equity Analyst Conference in New York. “We think the economy has further to go, through 2016 or 2017. Today is actually a good time to be investing, particularly in a recovery thesis in the U.S.”

European Deals

Higher interest rates would create “turmoil,” giving Blackstone (BX) and its private-equity peers opportunities to buy assets at low prices, James said in the interview at the Clinton Global Initiative. The benchmark 10-year U.S. Treasury yield rose to 2.64 percent as of yesterday from as low as 1.63 percent in early May, before the Fed began stoking speculation that its asset purchases may be nearing an end.

Blackstone has shifted its focus for new deals to Europe and Asia from the U.S., said James, as Europe stabilizes and China finds its economic footing.

Deal making in the U.S. has slowed. The number of private-equity transactions announced this year through yesterday dropped 16 percent compared to the same period last year, according to data compiled by Bloomberg.

“There’s just not much out there to buy,” James said. “There aren’t many corporate sellers -- why that is, we can speculate -- but there just aren’t.”

James said he’s disturbed that markets haven’t reacted more negatively to the impending breach of the U.S. debt ceiling. Investor “complacency” allows Congress and President Barack Obama to delay deciding whether to raise the ceiling until the last minute, he said.

“That’s one of the most dangerous things about this cycle,” James said. “If you can push it to the limit, there’s a high possibility of miscalculation.”
We shall see what surprises Washington has in store for us. I've already warned my readers of nasty surprises that lurk ahead and think that investors are starting to fear the worst, and rightfully so.

Below, Blackstone Group LP President Tony James talks about the outlook for the company, financial markets and the private equity industry. He spoke with Bloomberg Television's "Market Makers" host Erik Schatzker at the Clinton Global Initiative in New York.

Friday, September 27, 2013

Looting the Pension Funds?

Matt Taibbi of Rolling Stone wrote a controversial piece, Looting the Pension Funds:
In the final months of 2011, almost two years before the city of Detroit would shock America by declaring bankruptcy in the face of what it claimed were insurmountable pension costs, the state of Rhode Island took bold action to avert what it called its own looming pension crisis. Led by its newly elected treasurer, Gina Raimondo – an ostentatiously ambitious 42-year-old Rhodes scholar and former venture capitalist – the state declared war on public pensions, ramming through an ingenious new law slashing benefits of state employees with a speed and ferocity seldom before seen by any local government.

Called the Rhode Island Retirement Security Act of 2011, her plan would later be hailed as the most comprehensive pension reform ever implemented. The rap was so convincing at first that the overwhelmed local burghers of her little petri-dish state didn't even know how to react. "She's Yale, Harvard, Oxford – she worked on Wall Street," says Paul Doughty, the current president of the Providence firefighters union. "Nobody wanted to be the first to raise his hand and admit he didn't know what the fuck she was talking about."

Soon she was being talked about as a probable candidate for Rhode Island's 2014 gubernatorial race. By 2013, Raimondo had raised more than $2 million, a staggering sum for a still-undeclared candidate in a thimble-size state. Donors from Wall Street firms like Goldman Sachs, Bain Capital and JPMorgan Chase showered her with money, with more than $247,000 coming from New York contributors alone. A shadowy organization called EngageRI, a public-advocacy group of the 501(c)4 type whose donors were shielded from public scrutiny by the infamous Citizens United decision, spent $740,000 promoting Raimondo's ideas. Within Rhode Island, there began to be whispers that Raimondo had her sights on the presidency. Even former Obama right hand and Chicago mayor Rahm Emanuel pointed to Rhode Island as an example to be followed in curing pension woes.

What few people knew at the time was that Raimondo's "tool kit" wasn't just meant for local consumption. The dynamic young Rhodes scholar was allowing her state to be used as a test case for the rest of the country, at the behest of powerful out-of-state financiers with dreams of pushing pension reform down the throats of taxpayers and public workers from coast to coast. One of her key supporters was billionaire former Enron executive John Arnold – a dickishly ubiquitous young right-wing kingmaker with clear designs on becoming the next generation's Koch brothers, and who for years had been funding a nationwide campaign to slash benefits for public workers.

Nor did anyone know that part of Raimondo's strategy for saving money involved handing more than $1 billion – 14 percent of the state fund – to hedge funds, including a trio of well-known New York-based funds: Dan Loeb's Third Point Capital was given $66 million, Ken Garschina's Mason Capital got $64 million and $70 million went to Paul Singer's Elliott Management. The funds now stood collectively to be paid tens of millions in fees every single year by the already overburdened taxpayers of her ostensibly flat-broke state. Felicitously, Loeb, Garschina and Singer serve on the board of the Manhattan Institute, a prominent conservative think tank with a history of supporting benefit-slashing reforms. The institute named Raimondo its 2011 "Urban Innovator" of the year.

The state's workers, in other words, were being forced to subsidize their own political disenfranchisement, coughing up at least $200 million to members of a group that had supported anti-labor laws. Later, when Edward Siedle, a former SEC lawyer, asked Raimondo in a column for how much the state was paying in fees to these hedge funds, she first claimed she didn't know. Raimondo later told the Providence Journal she was contractually obliged to defer to hedge funds on the release of "proprietary" information, which immediately prompted a letter in protest from a series of freaked-out interest groups. Under pressure, the state later released some fee information, but the information was originally kept hidden, even from the workers themselves. "When I asked, I was basically hammered," says Marcia Reback, a former sixth-grade schoolteacher and retired Providence Teachers Union president who serves as the lone union rep on Rhode Island's nine-member State Investment Commission. "I couldn't get any information about the actual costs."

This is the third act in an improbable triple-fucking of ordinary people that Wall Street is seeking to pull off as a shocker epilogue to the crisis era. Five years ago this fall, an epidemic of fraud and thievery in the financial-services industry triggered the collapse of our economy. The resultant loss of tax revenue plunged states everywhere into spiraling fiscal crises, and local governments suffered huge losses in their retirement portfolios – remember, these public pension funds were some of the most frequently targeted suckers upon whom Wall Street dumped its fraud-riddled mortgage-backed securities in the pre-crash years.

Today, the same Wall Street crowd that caused the crash is not merely rolling in money again but aggressively counterattacking on the public-relations front. The battle increasingly centers around public funds like state and municipal pensions. This war isn't just about money. Crucially, in ways invisible to most Americans, it's also about blame. In state after state, politicians are following the Rhode Island playbook, using scare tactics and lavishly funded PR campaigns to cast teachers, firefighters and cops – not bankers – as the budget-devouring boogeymen responsible for the mounting fiscal problems of America's states and cities.

Not only did these middle-class workers already lose huge chunks of retirement money to huckster financiers in the crash, and not only are they now being asked to take the long-term hit for those years of greed and speculative excess, but in many cases they're also being forced to sit by and watch helplessly as Gordon Gekko wanna-be's like Loeb or scorched-earth takeover artists like Bain Capital are put in charge of their retirement savings.

It's a scam of almost unmatchable balls and cruelty, accomplished with the aid of some singularly spineless politicians. And it hasn't happened overnight. This has been in the works for decades, and the fighting has been dirty all the way.

There's $2.6 trillion in state pension money under management in America, and there are a lot of fingers in that pie. Any attempt to make a neat Aesop narrative about what's wrong with the system would inevitably be an oversimplification. But in this hugely contentious, often overheated national controversy – which at times has pitted private-sector workers who've mostly lost their benefits already against public-sector workers who are merely about to lose them – two key angles have gone largely unreported. Namely: who got us into this mess, and who's now being paid to get us out of it.
I encourage my readers to take the time to read the rest of Matt Taibbi's entire piece here. The language is raw and even though I disagree with many assertions and accusations, it's worth reading because he tackles an issue that rarely receives proper media coverage, namely, the pathetic state of U.S. public pension funds, how they got into this mess and who is being paid to get them out of it.

Over the years, I've written many critical comments on fast times in Pensionland. I've seen it all, the good, the bad and the downright ugly. Public pensions are big business and they feed the Wall Street machine. From asset managers, to hedge funds, to private equity funds, to pension consultants, to accountants, lawyers, brokers, advisors, vendors, and everyone else that wants a piece of the public pension pie.

Taibbi brings up excellent points but he fails to delve deeper into a topic that is far more complex than his article leads you to believe. He points fingers at "ambitious" politicians who fund "greedy" hedge fund and private equity managers in exchange for political contributions, but fails to see the bigger problem is the lack of proper pension governance which has literally crushed the U.S. public pension system over the last 30 years.

And when you focus on governance, you will quickly see that everyone is to blame for the great retirement heist: governments, unions, pension funds, corporations, and all the financial intermediaries in between. No doubt, it's a scandal that states failed to top up their pensions for many years, but it's equally abhorrent that many unions and governments cling to the pension rate of return fantasy in order to keep contribution rates as low as possible or that they fight any attempts to increase the compensation of their public pension fund managers.

Earlier this week, I discussed how U.S. public pension assets hit a record high and mentioned how hedge funds and private equity funds are thriving no thanks to these public pension funds, noting the following:
So long as these pension plans offer their beneficiaries gold-plated retirement benefits, money will need to earn high rates of return in order to fund these payments. And despite the ample criticism that has been lobbed at hedge funds and private equity funds since 2008, there has been little traction in attacks on the premise that the best funds really don't deliver high returns. Certainly not all funds are able to deliver the jaw-dropping returns, but enough are to maintain the momentum of investor allocations necessary to keep the industry afloat.

If there is to be a day of reckoning for hedge funds and private equity funds, it will necessarily only spring from a crisis in confidence in the minds of those individuals in California, New York, Texas and many other states who have as their main priority ensuring that retirement checks get sent to former public workers when there are due.

Until then, checks will continue to be written by investors eager to earn 20-30% on their money, and managers of alternative funds will still eagerly cash those checks and then promptly look for opportunities in the market that they can pounce on to quickly double and triple their money.
In that comment, I also discussed how low compensation of U.S. public pension fund managers and lack of independent investment boards continue to plague the performance of these funds.

I explained that there is a symbiotic relationship between Wall Street and public pension funds and that there are ingrained interests fighting the overhaul of the governance system because it will affect their pockets. As large Canadian and international funds move to dodge Wall Street, in the U.S., the opposite is happening. Everyone is embracing the new asset allocation tipping point, shoving billions into hedge funds and private equity funds to make their ridiculous 8% bogey, with little or no regard for the outrageous fees being doled out.

Of course, it's not that cut and dry. In some cases, the fees are justified, but in many cases, they're not and the big guys are getting bigger while smaller funds who are often outperforming them are struggling to survive. But again, why pay fees to external managers if you can replicate many strategies in-house for a fraction of the cost? Of course, to do this, you need to PAY public pension fund managers properly and get rid of political interference once and for all.

The points I raise above only scratch the surface of the problem. My biggest concern is how income inequality is growing and far too many people in the U.S. and elsewhere who are not properly covered will succumb to the new pension poverty. Pointing fingers at opportunistic politicians and greedy hedge fund managers will increase your magazine's sales but it does nothing to rectify the structural issues underlying America's retirement crisis. Now more than ever, we need new thinking to tackle this crisis.

Below, Matt Taibbi discusses how Wall Street firms are now making millions in profits off of public pension funds nationwide. "Essentially it is a wealth transfer from teachers, cops and firemen to billionaire hedge funders," Taibbi says. "Pension funds are one of the last great, unguarded piles of money in this country and there are going to be all sort of operators that are trying to get their hands on that money."

Thursday, September 26, 2013

Grayken's Big Bet On European Real Estate?

Hui-yong Yu of Bloomberg reports, Grayken to Invest $330 Million in Lone Star Property Fund:
Lone Star Funds founder and Chairman John Grayken is investing $330 million of his own money in the company’s new $6.6 billion commercial real estate fund, a bet on strong returns for property.

The capital commitment was disclosed during a meeting yesterday of the Oregon Investment Council, which voted to invest $300 million in the new fund. Grayken’s pledge is the most the billionaire has put into one of his Dallas-based firm’s funds by both dollar and percentage.

Lone Star’s new fund is the biggest global pool being raised for real estate private equity, according to Preqin, a London-based research firm for alternative assets. The target was increased from the original $6 billion in response to investor demand. The first capital pledges are scheduled to be completed on Sept. 27, according to yesterday’s Oregon meeting.

About half of the new fund will be invested in Europe, Nick Beevers, head of investor relations for Lone Star, told the Oregon pension trustees. About 30 percent to 40 percent will be in the U.S. and the remainder in Japan, he said.

“We see the investment opportunities being extremely heavy” in Europe, he said during the meeting in Tigard, Oregon. “We expect continued substantial investment in the United States.”

Lone Star expected to close yesterday on the purchase of 265 loans backed by 313 properties, said Andre Collin, head of North American commercial real estate acquisitions for Lone Star and a member of the firm’s investment committee.

Hudson Employees

Grayken’s investment represents 5 percent of the fund, higher than normal for a general partner. The firm’s partners will make a 1 percent combined investment in addition to Grayken’s personal pledge, Beevers said. Employees of Hudson Advisors, Lone Star’s asset-management arm, are contributing 1.5 percent through a co-investment vehicle, Beevers said.

“The pipeline that we are looking at right now in Japan, in Europe, especially in Europe, and in America is very, very strong” for distressed real estate investments over the next three years, Collin said. “In Europe, the market is way bigger than America right now in terms of that pipeline.”

Excluding 2011, when Lone Star won the bidding for about half of Anglo Irish Bank Corp.’s $9.65 billion of U.S. real estate loans, the portion that was mainly subperforming or nonperforming, “it's been by far our best year in all the regions,” Collin said.

In the U.S., Lone Star is focused on distressed debt, with more than $1 trillion of commercial real estate debt maturing in the next three to four years -- or more than 30 percent of the country’s total supply of commercial-property loans, Collin said. More than half that debt is subperforming or nonperforming, he said.

Secondary Markets

In the U.S., ``our focus right now is mainly on the secondary markets,” Collin said. “We're not the primary market guys right now because that cycle, that market, has passed for us,'' with more competition and easier financing having driven up prices, he said. In secondary markets, there are fewer lenders and ``we benefit from very strong relationships with a lot of these lenders.''

In Europe, aside from Lone Star deal makers, Hudson Advisors has about 300 people competing with Blackstone Group LP (BX), Apollo Global Management LLC, Cerberus Capital Management LP, Fortress Investment Group LLC (FIG) and Kennedy Wilson for workouts of distressed-property investments. U.S. investment banks, once Lone Star’s biggest rivals, have largely exited the market, Collin said.

“What our colleagues in Europe are working on is north of $25 billion of files,” he said. “It’s very significant.”

In addition to stepping up purchases, Lone Star and other real estate private-equity managers have been paying out more proceeds to investors this year as they take advantage of a strong market to sell assets, said Anthony Breault, Oregon’s interim senior investment officer for real estate. Lone Star represents about 8 percent of Oregon’s real estate portfolio.
John Grayken is a force to be reckoned with. If he is putting $330 million of his own money in Lone Star's new $6.6 billion commercial real estate fund, representing 5 percent of the fund, you know he is extremely bullish on Europe (roughly half the assets will be invested there).

André Collin, the former head of real estate at PSP Investments who now heads Lone Star's North American operations, highlighted the strong pipeline in Japan and especially in Europe. The focus on Europe is particularly noteworthy given that many large investors, including the Caisse, expressed serious reservations on European properties.

But some of the best real estate managers are honing their attention on Europe. Bloomberg reports Blackstone raised $2 billion in the first phase of fundraising for its fourth European real estate fund:
Blackstone is targeting 5 billion euros ($6.8 billion) for the fund, called Blackstone Real Estate Partners Europe IV, said the person, who asked not to be identified because the process is private.

Peter Rose, a spokesman for New York-based Blackstone, declined to comment. The fundraising progress was reported earlier today by PEI Media’s PERE, a publication focused on private real estate investing.

Blackstone is preparing for a “growing series” of real estate sales through 2014, taking advantage of rebounding value in hotels and commercial property following the global recession, Tony James, the firm’s president, said in July. The firm is working on public offerings of Hilton Worldwide Holdings Inc. and Extended Stay America Inc., and last month agreed to sell its stake in London’s Broadgate office complex to Singapore’s sovereign-wealth fund for more than 1.7 billion pounds ($2.7 billion).

Blackstone’s real estate unit spent $3.5 billion of its funds’ money in Europe last year “because the distress there is creating very interesting opportunities,” Jonathan Gray, global head of real estate, said earlier this year. The firm’s third European property fund, which raised more than 3.1 billion euros in 2009, has returned 18 percent a year after fees as of June 30, according to Blackstone’s second-quarter earnings report.

Blackstone is also raising its first Asia real estate fund and held an initial close in June with $1.5 billion. That pool is targeting $4 billion, according to the firm.
When it comes to commercial real estate, I wouldn't bet against John Grayken, Tom Barrack, or Jonathan Gray, the three best real estate investors in the world. And when investors see Grayken make such a significant personal investment in his new fund, it reassures them that alignment of interests are more than adequately covered.

One thing that worries investors, however, is the lack of succession planning at Lone Star, an issue which was raised in another discussion for the state of Oregon’s pension trustees back in May:
John Grayken, founder of Lone Star Funds, has a record of generating more than 20 percent returns over two decades as the world’s biggest buyer of delinquent mortgages. What he doesn’t have is a designated successor.

That deficiency became a focus of discussion for the state of Oregon’s pension trustees as Grayken, 56, pitched his latest investment, a $5 billion fund he finished raising last week to buy soured residential loans from Europe’s banking crisis.

“I want to have a succession strategy in place,” State Treasurer Ted Wheeler said. “That’s important to me.”

While the issue didn’t impede Lone Star’s ability to raise the new fund, with Oregon voting to invest as much as $400 million, Grayken has faced the question of an heir apparent since the 2007 resignation of his longtime right-hand man, former Vice Chairman Ellis Short. Short left the firm just as the global credit crisis caused investors to shun risk, hampering Grayken when he set out to raise the predecessor fund to the $5 billion one he closed last week.

Succession issues are particularly important for pension funds, which invest with a horizon of decades. Private-equity funds, including Lone Star’s, typically contain a provision known as the key-man clause to protect investors in the event of senior-management departures that could affect the running or performance of their investments.
‘John Show’

“John has no intention -- you can ask him -- of building an institution,” said Nori Gerardo Lietz, founder of Arete Capital and an early champion of Grayken’s in her prior role as a pension-fund consultant. “Unlike some of these other organizations that are trying to really build an ongoing entity that will survive the founders, it is the John show,” Gerardo Lietz said at the May 1 meeting of Oregon’s pension trustees.

Grayken, through spokesman Jed Repko of the public relations firm Joele Frank, Wilkinson Brimmer Katcher, declined to comment on succession.

Grayken, who turns 57 on June 1, has already committed 20 percent of the new fund to buy assets from failed Belgian lender Fortis, and is about to raise another pool for commercial assets this summer. He also has set his sights on acquiring mortgage-servicing rights from U.S. banks. The current fund was $1 billion oversubscribed.

Since Grayken founded Lone Star in 1995, the firm has bought distressed mortgage-related assets valued at more than $85 billion, helping banks in Canada, South Korea, Japan, Taiwan, Germany, Ireland and elsewhere rid themselves of bad loans following economic declines. Now the action is in Europe, where Boston-area native Grayken has been based since 1997, having given up his U.S. citizenship in 1999 for an Irish passport and married a British woman.
Critical Planning

The company has senior executives in each of the regions in which it operates.

“Succession planning is critical,” said Theresa Whitmarsh, executive director of the Washington State Investment Board, which oversees about $89 billion in pension and related assets. “We’re buying people and we’re buying the strategy and we have to make sure it’s sustainable.”

Whitmarsh declined to comment on Lone Star. Washington has been an investor, or limited partner, with Lone Star, a general partner, in the past. “The LP community has been pushing the issue a lot more,” she said. “I don’t think any GP can ignore the issue.”
Doubled Money

Oregon has invested about $1.87 billion in 10 prior Lone Star funds and the firm has roughly doubled the state’s money, for a net annual internal rate of return after fees of about 18 percent, according to figures cited at the May 1 meeting by Anthony Breault, acting senior investment officer for real estate at Oregon’s pension fund.

“These guys have done a great job for us, they’ve delivered outstanding returns, but no succession strategy for me is really problematic,” Wheeler said. “This is a long-term investment and it’s a pension plan.”

Whereas the previous fund invested mainly in U.S. residential debt, including whole loans and securities, “our expectation now is that the percent of the capital, of the collateral that is in Europe will grow substantially,” to more than 60 percent, Grayken told the Oregon pension overseers on May 1. The predecessor fund was $4.6 billion.

“There are still opportunities in U.S. residential,” Grayken said. “It was a very, very aggressively financed asset class prior to the crisis and despite the fact that we see appreciation in housing prices today, there’s still a lot of debt that is underwater and has to get cleaned up by the banks.”
Global Buying

The firm ran another fund at the same time, the $5.5 billion Real Estate Fund II, which bought distressed commercial mortgage debt around the world, including in Europe, the U.S. and Japan, Grayken said. That fund, Lone Star Real Estate Fund II, is approaching 70 percent invested or committed, Grayken said. “The market’s been very good for us. This part of the cycle, that is the best part for an investment strategy like ours, and we are at this time projecting that we are comfortably going to exceed return targets for those two funds.”

Grayken said the firm expects to start raising Lone Star Real Estate Fund III this summer.

Lone Star made its name buying distressed loan portfolios and lenders in Asia starting in the late 1990s. In some cases, it bought financial institutions to get at the underlying assets and work them out, reviving the lender and taking it public for a profit. In 2005, Lone Star reaped a sevenfold return on its investment in Tokyo Star Bank Ltd. That same year, the firm sold a third of Japan’s biggest golf-course operator, Pacific Golf Management KK, in the first initial public offering of such an asset.
Asian Investments

As the most senior executive after Grayken, Short helped lead the firm’s move into Asia in the late 1990s. Besides buying billions of dollars of delinquent mortgages from Japanese and South Korean banks, golf courses in Japan and consumer lenders, it bought office towers in both countries. Short oversaw the firm’s Asian operations from Tokyo and later supervised European deals as well.

Short, a native of Independence, Missouri, teamed up with Grayken at Colony Advisors, the Los Angeles-based real estate company that Texas billionaire Robert Bass started in 1991. Short then was working at GE Capital, General Electric Co. (GE)’s finance unit, which had bought bad loans with Colony.

When Grayken formed Lone Star in 1995, he brought in Short and relied on him to help run the firm.
Kildare Partners

Short recently formed a new firm called Kildare Partners and aims to raise about $1 billion to invest in distressed real estate and related debt in Europe, PERE, a publication of London-based PEI Media, reported May 13.

Short didn’t immediately respond to an e-mail and call placed after regular business hours.

In 2008, Lone Star bought $30.6 billion of collateralized debt obligations from Merrill Lynch & Co. for about 22 cents on the dollar in one of the first and largest distressed deals of the financial crisis. It also acquired San Diego-based subprime lender Accredited Home Lenders Holding Co., and a mortgage unit of Bear Stearns Cos.

Lone Star has an approximately 800-worker back office in Hudson Advisors, which takes loans that Lone Star buys and collects on each.

“I’ve asked him, over the years, ‘Why do you keep doing this?’” Gerardo Lietz said at the Oregon Investment Council meeting May 1. You have “more money than Croesus, you know. He said, ‘As long as I can get up, have that thrill, the jazz of doing it, I’m going to keep doing it,’ and I said, ‘What happens that day you don’t?’ And he said, ‘Then I shut it down,’” she said he told her.
Succession Plan

Grayken’s lack of a succession plan, and lack of interest in institutionalizing his business, veers from the path espoused by KKR & Co. and Blackstone Group LP (BX), whose founders have taken the firms public.

Lone Star Fund VIII, which closed last week (in May), was the largest of the private-equity real estate funds being marketed, according to Preqin, a London-based researcher. It’s the third-largest fund of its kind raised since the beginning of 2009.

“If he gets hit by the proverbial bus, which is sort of the worst-case scenario, the investments that have been made will go into their machine,” Gerardo Lietz said, referring to Hudson Advisors, the asset-management arm of Lone Star. “Just sort of work themselves through the investment and the asset-management process. Hudson can certainly do that.”
I wouldn't worry too much about succession planning at Lone Star because they have experienced real estate professionals backing up Grayken. However, this is an issue that needs to be addressed down the road because Grayken won't be around forever.

Below, Nouriel Roubini, chairman at Roubini Global Economics, discusses the global economic recovery with a focus on Europe and the impact of continued central bank easing. He speaks on Bloomberg Television’s “Bloomberg Surveillance.”

And Italian Prime Minister Enrico Letta talks about the risk of a U.K. exit from the European Union and the future of the eurozone. He spoke in an interview with Bloomberg’s Erik Schatzker yesterday. Angie Lau reports on Bloomberg Television's "Asia Edge."

Lastly, Bloomberg's Scarlet Fu displays the difference in overall deleveraging by the United States and Europe following the financial crisis of 2008. She speaks on Bloomberg Television's "Bloomberg Surveillance."

But for all the gloom & doom on Europe, shares are up significantly over the past year and top real estate investors like Grayken don't seem too concerned about any crisis in the region. He's betting big on a European recovery and investing a significant amount of his personal fortune in his new fund. If that doesn't reassure investors, don't know what will.

Wednesday, September 25, 2013

Risks to PBGC Worse Than Thought?

Phil Ciciora of Phys Org reports, Risks to government pension insurer worse than thought, research finds:
A study co-written by a University of Illinois pension policy expert warns that the financial risks facing the government-sponsored corporation that insures all private-sector pension plans in the U.S. are much greater than commonly thought.

University of Illinois finance professor Jeffrey R. Brown says that the Pension Benefit Guaranty Corp. is facing a very large financial shortfall and ultimately may need to be bailed out by taxpayers.

"Our in-depth review of the PBGC's models indicates that they are likely to underestimate how bad things can get when the economy is weak," said Brown, the William G. Karnes Professor of Finance and the director of the Center for Business and Public Policy in the U. of I. College of Business. "The implication is that the financial risks facing the system are much greater than widely believed."

Brown co-wrote the paper with Douglas J. Elliott, Tracy Gordon and Ross Hammond, all of The Brookings Institution. The team of researchers conducted an independent review of the Pension Insurance Modeling System, the complex simulation model that is used for assessing the long-term health of the financially troubled PBGC insurance program.

"There is a lot of debate in the plan sponsor and policy community about whether PBGC's long-term financial projections are excessively optimistic or pessimistic," he said. "This is important because these projections frame the discussion about what steps, if any, Congress should take to strengthen the pension insurance program. Some interest groups believe that PBGC's models overstate the program's exposure, whereas many economists are concerned that the problem may be worse than it appears."

Brown, a former member of the bipartisan Social Security Advisory Board and a senior economist with the President's Council of Economic Advisers in 2001-2002, says that the federal pension insurance agency's model is "likely to substantially understate the degree of fiscal risk to PBGC's insurance programs."

"During a financial crisis or recession, you tend to have clusters of corporate bankruptcies," he said.

According to Brown, these clusters also tend to happen around the same time that the typical plan's funding status is worsening as a result of investment losses that accompany an economic downturn.

"The PBGC's model does not adequately account for these macroeconomic shocks that lead to correlated losses," he said.

Brown says the PBGC is supposed to be self-financing and not receive taxpayer funding – but notes that the same was once true of beleaguered mortgage giants Fannie Mae and Freddie Mac.

"Taxpayers are probably going to have to foot the bill in the same way we bailed out savings and loans in the 1980s and the mortgage agencies during the 2008 financial crisis," he said. "Nearly everyone believes that Congress is ultimately going to have to backstop the PBGC because it's insuring the pensions of tens of millions of people. No one believes they're going to just let it fail."

The paper is titled "A Review of the Pension Benefit Guaranty Corporation Pension Insurance Modeling System."
Readers can download an executive summary and the entire paper on Brookings' site here. I note the following:
A key finding of our review is that the limited treatment of correlated risk factors arising from the macroeconomic environment is likely to substantially understate the degree of fiscal risk to PBGC’s insurance programs. This may be one reason that actual PBGC results have come out much below PIMS’ median projections. In the PIMS model, there are very few avenues through which broader macroeconomic factors can operate directly on the distribution of potential future losses.
In reality, however, macroeconomic factors directly affect many of the key drivers of PBGC’s finances: for example, during an economic downturn, it is reasonable to expect more plan sponsors to experience financial distress and more plans to be underfunded. Consequently, the distribution of possible loss exposure has much “fatter tails” (that is, the probability of extreme losses is much greater) than is currently captured by the PIMS model. This matters because PBGC and other insurers have an asymmetric exposure to fat tails, being hurt more by the negative extremes than they are aided by the positive extremes.

Although our analysis focuses narrowly on the PIMS model, rather than broader policy questions about the pension insurance program, it is worth stressing that these extreme negative events are most likely to occur in states of the world in which the broader U.S. economy is relatively weak, which means that it would be a particularly economically painful time for the nation to have to address an underfunded pension insurance program.
Recognizing the true economic costs of these correlated risks and how they affect the broader fiscal position of the U.S. government, therefore, has potentially important implications for program design, the average level of premiums, the question of whether to risk‐adjust premiums, and other important policy parameters which are well beyond the scope of this narrow technical review of the PIMS model.
Our review provides a number of specific observations about the model that could be used to guide future revisions to the model in this respect, particularly with regard to the modeling of the bankruptcy and financial market processes.
A few thoughts on this paper and its broader implications. First, it hardly surprises me that the authors found a " limited treatment of correlated risk factors arising from the macroeconomic environment is likely to substantially understate the degree of fiscal risk to PBGC’s insurance programs." I don't think this problem is unique to PBGC but because it is a government insurer, it receives a lot more scrutiny than other organizations, and rightfully so.

Second, the authors are right to point out that risks to a corporate pension plan increase significantly during a recession, placing more pressure on PBGC's insurance programs as it deals with "clusters of corporate bankruptcies." Unlike U.S. public pension funds, corporate plans use market rates (typically AA or higher corporate bonds) to determine their future liabilities. So when a recession occurs, they experience investment losses and soaring liabilities.What made matters worse after the 2008 crisis is that public and private pension funds were piling into corporate bonds, driving rates to historic lows and pension liabilities to historic highs. No wonder corporations are now racing to de-risk pensions.

Third, while corporate America's pension time bomb has been defused for now, many corporate plans remain vulnerable to a substantial macroeconomic shock. It would make more sense to raise premiums during good economic times and decrease them during bad times to cushion the blow of a severe downturn. Of course, any suggestion of raising premiums will be met with fierce protests from corporations looking to cut pension costs.

Finally, from a broader policy perspective, I keep bringing up the point that pensions should be treated like a public good and corporations shouldn't be in the pension business at all. They should focus on their core business and pensions should be managed by well-governed public pension funds that operate at arms length from the government. This way, we can scrap defined-contribution plans and address the issue of pension portability, giving people the peace of mind that their pensions are properly managed no matter where they work, allowing them to retire in dignity and security.

Importantly, it's high time America and the rest of the world gets serious about pension policy. We can tinker at the edges but the reality is once the tsunami hits, millions of people will resort to flipping burgers to scrape by during their golden years (watch below). And they will be among the lucky ones. Most will resort to eating cat food to survive.

Tuesday, September 24, 2013

U.S. Public Pension Assets Hit Record High

Lisa Lambert of Reuters reports, U.S. public pension investments jump, costs surge too:
Asset values at U.S. public pension funds rose 8.4 percent in the latest fiscal year to the highest level in more than 40 years, but their costs also rose, the U.S. Census reported on Monday.

Most retirement systems ended fiscal 2013 on June 30. In the final quarter of that fiscal year the cash and securities holdings of the 100 largest public-employee pensions were $2.944 trillion, up 8.4 percent from a year earlier and the highest level since the Census began collecting pension data in 1968.

Still, quarterly growth in their investments has been slowing at the same time they are having to pay more to retirees. Benefits and withdrawals also reached record highs in the quarter, jumping 16.8 percent from a year earlier to $62.2 billion.

"It looks like we're stabilizing instead of growing," said Erika Becker-Medina, chief of statistics in the Census governments division. She noted that on a quarter-to-quarter basis, the assets level was up just 0.4 percent.

Investments provide the lion's share of retirement system revenues, with employers and employees also pitching in funds. During the 2007-09 recession, the financial crisis caused those investments to crumble just as states confronting collapsing revenues cut their pension contributions and also laid off employees.

Pensions have slowly marched back to health since holdings reached a low of $2.1 trillion in 2009. In fiscal 2013, investments finally surpassed the peak they reached in 2007 before the recession began.

Governments across the country have reformed pension policies in the aftermath of the funding crisis. Some began making the full contributions that their actuaries suggest. Others have had employees pitch in more, raised retirement ages, and cut annual cost of living adjustments to benefits.

The Census data showed that governments and employees both are now pitching in greater amounts of money.

Government contributions increased over the year by 2.3 percent to $22.8 billion, while employee contributions rose 11.2 percent to $11.4 billion. Government contributions have been creeping up over the last few years, Becker-Medina noted, pointing out that in the quarter that ended on June 30, 2008, government contributions were $18.39 billion.

"This data confirms what we've been seeing, which is that strong equity markets and increasing contributions from both employers and employees are driving higher public pension asset values," said Keith Brainard, research director at the National Association of State Retirement Administrators. "While quarterly and annual changes in contributions tend to be steady, investment earnings typically are lumpy and more volatile."

Over the year, corporate stock holdings of pension plans increased 7.4 percent to $1.01 trillion and their international securities rose 16.8 percent to $592.6 billion. U.S. government securities rose over the year by 6.9 percent to $267.1 billion. Corporate bond holdings fell 9 percent to $330.8 billion.

Retirement systems' earnings on investments were $38.28 billion in the quarter, down from earnings of $115.49 billion the previous quarter but better than $16.3 billion in losses they had in the same period in 2012.

Public pensions "have stood out in returns versus other institutional peers for the primary reason that one of the assets classes that held up well in the second quarter was U.S. equities," said Steve Foresti, managing director and head of the Investment Research Group at Wilshire Consulting in Los Angeles.

Wilshire recently found that for the year ended June 30, public pensions had a median investment return of 12.4 percent. Most pensions plan for returns of between 7 and 8 percent.

During the quarter, the Dow Jones industrial average rose 2.3 percent, the Standard & Poor's 500 2.4 percent, and the Nasdaq 4.2 percent.

The S&P 500 had the strongest first half of any year since 1998, as well. The final two quarters of most pensions' fiscal years represent the first half of calendar 2013.

The retirement systems' financial reports for fiscal 2013 will not be released for a while. Looking at the financial reports for fiscal 2012, Wilshire found that the median funding level for 134 state pensions was 71 percent, meaning they have enough assets to cover 71 percent of their costs.

"With their asset allocation and how markets have performed, I expect to see improvement," said Foresti about the funding level for fiscal 2013. "I'd estimate they will be 75 percent."
You can read a summary of the Quarterly Survey of Public Pensions here. The report is encouraging and provides more evidence that rising returns are bolstering U.S. public pensions. And if assets keep rising along with interest rates, the funded status of these state plans will improve further.

Nevertheless, even as assets hit a record high, there are reasons to be concerned. First, costs are rising and both employees and employers are paying more into these state plans. Second, benefits and  withdrawals also reached record highs in the quarter, jumping 16.8 percent from a year earlier to $62.2 billion. Third, even though the funded status has improved in the last few years, many state plans are still in terrible shape and reforms are needed to bolster them and ensure their long-term sustainability. The new GASB rules, which will slash projected rates of return for public pension funds' unfunded portions from roughly 7.5 percent to a much lower market level, will hit many public pensions hard.

One of the reforms I keep harping on is improving the compensation for U.S. pension fund managers. In his parting interview to the FT, Larry Schloss, the understated private equity expert who safeguards the pension money for New York City’s police officers, firefighters and teachers, discussed some of the problems he encountered during his tenure:
New York’s pension system seems archaic compared with more advanced peers in the field. First, there are five distinct funds: one for teachers ($50bn); another for firefighters ($9bn); a third for police officers ($30bn); a fourth for city workers ($48bn); and, lastly, one for people who work at schools but are not educators ($3bn).

Each union employs its own trustees, even though the groups share about 90 per cent of investments. Much to Mr Schloss’s chagrin, a proposal to merge the five investment committees into a single one to cut costs failed, thanks to political undercurrents.

Another pitfall is that, unlike peers such as Calpers and Calstrs, California’s two big pension funds, the city’s pension group outsources all its investments to BlackRock and 324 other financial managers. It thus invests only in funds. “Consequently, we pay fees to everyone ... It’s a bit odd that New York City, the world’s financial capital, outsources all of its investment management to money managers,” laments Mr Schloss. “You’ll save money on the margin if you do it in-house. The key is not to give up the returns.”

He adds: “We have $140bn in assets and we don’t own one property because it’s all in funds ... I think we should own some buildings and save on fees and do joint ventures with people.”

Bringing people on board to manage money is also a tedious process, due in part to rules brought in years ago after a corruption scandal. While the time it takes to hire a manager has been shortened to nine months from about 17, the rules are the same ones the city uses to “buy school buses and pencils,” notes Mr Schloss.

Mr Schloss laments that he does not pay his staff well. The average person who works in New York’s bureau of investment management makes $100,000 and must live in one of the five boroughs. “It’s not enough,” says Mr Schloss. “If you come out of Harvard Business School and get a starting job at a bank, you get a couple of hundred thousand dollars.”

Mr Schloss’s departure from the job seems bittersweet as he got such a kick out of it. He is not lobbying for a second act at the municipal building, but he makes the case that the unspoken rule that the new comptroller brings his own chief investment officer works against investors’ interests. “It’s not the right way to manage money,” he concludes. “If you look at some of the other public pension funds, you’ll see that the chief investment officer is more of a staff job, and the group in the investment office stays, no matter who the elected officials are.”
Mr. Schloss raises excellent points that need to be addressed by many U.S. public pension plans. In particular, an inadequate compensation scheme is a huge obstacle for leaders trying to attract and retain talent to their public pension fund to lower costs by managing assets internally.

Importantly, this is the primary reason U.S. public pension funds are trailing their Canadian peers and unfortunately, there is no political will to change compensation and set up independent investment boards that operate at arms-length from the government.

Finally, while the state of U.S. public pension plans is improving, hedge funds and private equity funds are thanks to them:
The reason for the continued success of hedge funds and private equity funds is actually quite simple – investors love them!

Of course, there were doubts and recriminations that surfaced again and again at the end of 2008 and the beginning of 2009. Of course, there were investors that suffered eye-watering losses on their fund investments who would require some coaxing (and a little TLC) before their would allocate money again.

But when fund after fund continued to post high investment returns, and the rest of the financial markets seemed to oscillate between pessimism and indifference, investors began writing checks again. With replenished war chests, hedge funds and private equity funds were back in business.

So long as these funds can credibly promise high returns, there will be a steady flow of investors willing to back them. Once accumulated, the money is deployed wherever the men and women running them feel there is an opportunity to profit. This industry is driven, first and foremost, by the confidence level of these investors.

Despite the vitriol that is on occasion directed and the mangers that profit from their funds successes, surprisingly little attention is given to those institutions that are their lifeblood.

Critics expecting to see money flowing from the trust funds and the personal estates of the 1% are often surprised to learn that most of the money in private equity funds and most of the new money going into hedge funds actually comes from US public pension plans, both big and small, that provide retirement benefits to teachers, firemen, police and other government workers across the country, as well as the generous endowments of many leading colleges and universities. Not wealthy plutocrats dressed like the man from the Monopoly board game, with a cane and top hat the accessorize his formal morning suit.

So long as these pension plans offer their beneficiaries gold-plated retirement benefits, money will need to earn high rates of return in order to fund these payments. And despite the ample criticism that has been lobbed at hedge funds and private equity funds since 2008, there has been little traction in attacks on the premise that the best funds really don't deliver high returns. Certainly not all funds are able to deliver the jaw-dropping returns, but enough are to maintain the momentum of investor allocations necessary to keep the industry afloat.

If there is to be a day of reckoning for hedge funds and private equity funds, it will necessarily only spring from a crisis in confidence in the minds of those individuals in California, New York, Texas and many other states who have as their main priority ensuring that retirement checks get sent to former public workers when there are due.

Until then, checks will continue to be written by investors eager to earn 20-30% on their money, and managers of alternative funds will still eagerly cash those checks and then promptly look for opportunities in the market that they can pounce on to quickly double and triple their money.
The symbiotic relationship between U.S. public pension funds and the alternatives industry is an interesting topic which is a lot more complicated than this article leads you to believe. It's not just about chasing yield, there are governance issues and political reasons that explain why assets of the top alternative asset managers have soared to record levels after the crisis. But there is no doubt U.S. public pension funds are fueling this growth, paying high fees and not always getting the returns they expect.

Below,  Lawrence Schloss, New York City's chief investment officer and deputy comptroller for pensions, talks about the city's pension fund returns and investment strategy. He speaks with Scarlet Fu on Bloomberg Television's "Money Moves," and raises the issue of how low compensation is plaguing U.S. public pension funds.

Monday, September 23, 2013

Ontario Teachers Cautious on China?

Isabella Steger of the Wall Street Journal reports, Ontario Teachers' Pension Plan Cautious About Investing in China:
The Ontario Teachers' Pension Plan, one of the world's biggest pension funds, opened its Hong Kong office with a note of caution about investing in China, saying lack of clear information could make it difficult to invest there.

"I think we have to proceed with caution" in China, said chief executive Jim Leech, who is due to retire at the end of the year after six years in the top job.

The fund, which has about 129.5 billion Canadian dollars ($125.9 billion) in assets under management on behalf of about 300,000 teachers in Canada's most populous province, officially opened its Hong Kong office on Monday, its second major international office after London. The fund currently has about C$1.5 billion invested in the Asian-Pacific region, but faces rising competition from other investors including private-equity funds and sovereign-wealth funds that are flush with cash and rival pension funds, all of which have had footholds in the region for years.

In China, the fund's most high-profile holding is a $300 million investment in Jingdong Century Trading Co., which runs online shopping site, according to S&P Capital IQ data. The company isn't listed.

Chief investment officer Neil Petroff said that conducting due diligence in China was a big hurdle to getting deals done. "If we don't have the right information and we can't get it, it is a non-starter," he said.

In Asia-Pacific, the fund biggest deal to date is a $2.3 billion co-investment with Hastings Funds Management in a New South Wales desalination plant in May 2012, according to Dealogic data. In March, it struck a deal to buy a majority stake in the telecommunication assets of Australia's largest construction company, Leighton Holdings Ltd., for 619.5 million Australian dollars ($579.5 million).

Competition is heating up in the Asia-Pacific region for quality infrastructure assets, particularly in mature and well-regulated markets like Australia. The Ontario fund lost out on a deal to buy Port Botany and Port Kembla in New South Wales earlier this year to a consortium including Abu Dhabi Investment Authority and Industry Funds Management, which bought the assets for $5.3 billion. The Ontario fund competed against other Canadian pension funds in the process, including Alberta Investment Management Corp. and Canadian Pension Plan Investment Board. Caisse de depot et placement du Quebec has also been active in Australia.

Mr. Petroff said the fund "missed a great deal" in Port Botany and Port Kembla, with its offer price falling just $12 million short of the final sum paid.

The Ontario Teachers' Hong Kong office is also opening at a time its competitors at home are escalating their interest in the region. Canada Pension Plan Investment Board, which has had a Hong Kong office for a few years, appointed former Goldman Sachs Group Inc.'s vice chairman in Asia-Pacific excluding Japan, Mark Machin, as its Asia president last year. In China, CPPIB recently raised its investment in a logistics joint venture with Australia's Goodman Group by $400 million.

Mr. Leech said the fund sees opportunities with wealthy families in Asia. Unlike private-equity firms, who typically have a three- to five-year investment horizon, his fund "could play very well with some families in Asia" who prefer longer-term investors, he added.

"In any market that is emerging, [wealthy families] are a source of investments" when they tackle inter-generational succession issues. "We see it over and over whether in Latin America, India or Turkey," said Mr. Leech.

The fund posted a return of 13% for 2012 compared with its internal benchmark of 11%. Mr. Leech will be succeeded by Ron Mock, currently the head of fixed income and alternative investments at the pension fund.
Investing in China is not easy. There is tremendous growth but the market lacks key characteristics that are required for funds to invest properly. In particular, lack of transparency and an underdeveloped legal and regulatory system are major deterrents for Canadian pension funds that invest billions in public and private markets. That is why the focus has been in Australia which benefits from China's growth but also has the key elements found in mature, well-regulated markets.

There is another problem investing in Asia. A recent article in Asian Investor discusses how CPPIB and Singapore's Northstar Group are having a hard time sourcing private equity expertise in the region to staff their offices. The lack of private equity expertise in Asia presents serious challenges to Canadian pension funds investing in the region.

Still, Canada's largest pension funds remain undeterred and are forging ahead. Peter Guy of Investments & Pensions Asia reports, Ontario Teachers’ Pension eyes opportunities in Asia:
The Ontario Teachers’ Pension Plan (OTPP) has opened an office in Hong Kong, reflecting its proactive investment approach and the growth of Asia.

OTPP, the largest single profession pension plan in Canada with CAD130bn ($126bn) in AUM, says its presence in Hong Kong should enhance its ability to operate in the entire region. Wayne Kozun, Senior Vice President, Public Equities, says: “Today, with our Hong Kong office we can execute relationship deals in Asia.”

Working closely with external asset managers in Asia remains an important objective. According to Jane Rowe, Senior Vice-President, Teacher’s Private Capital and Infrastructure, “We take a long term view on Asia and China and intend to ride out short term cycles. We look for teams of GPs whose investment philosophy and methods are consistent with OTPP’s beliefs. Talented GPs with a sound track record also provide us with future deal flow sources and co-investment opportunities.”

Since OTPP’s inception in 1990, more than three quarters of the plan’s income has come from investments. When the plan started investing in financial markets, the fund stood at $19bn. Since then its investments have earned an average annual return of 10.1%.

Kozun adds: “Our style of relationship investing, where we become the second or third largest shareholder, is one of the ways we operate and add value. It also means that we may have a board seat and work closely with management. But, we are not an activist style, public investor. We are cooperative and supportive like our relationship with our investment in Hitachi.”

Presently, OTPP has deployed about $12bn allocated to private capital or private equity, of which $1.5bn is in Asian, regional private equity funds specialising in geographical or industrial sectors. Another $1bn is still available and committed to be drawn down by mandated PE funds. “A GP that truly adds value is paramount to us beyond financial engineering, rising multiples or access to IPO markets,” says Rowe about their standards for GPs.

OTPP has two Asian private equity mandates left for this year, Rowe adds. “We are looking for other managers with good, value adding strategies. In PE, we are looking for co-investment opportunities. OTPP adds value through its six industry specialty teams to work with Asian GPs on due diligence, governance - all to add value.”

OTPP is looking for pan-Asian opportunities, including India, but excluding frontier markets. Kozun says: “We are surprised at the abrupt sell off in emerging markets due to tapering and opportunities are out there. Our $300m QFII allocation, will be applied to A-Shares. The quota will also be used with external managers so that’s one of the reasons we have located to Asia.”

OTPP’s minimum investment size is usually $75m and aims for generating top quartile returns on its investments. They aren’t involved in fund of funds strategies; rather, they are proactive. Rowe currently favours Asia consumer themes. “This year we are focused on value creation in our investees working with them rather than putting new capital to work.”
Finding the right general partners is the key to long-term success in Asia. If Canadian funds fly solo in this region, they will get killed. As I've previously discussed, Asia is a hot market for private equity giants but even they are struggling with China's slowdown and are now pushing banks to offer more leverage:
China’s economic slowdown is prompting private equity firms to change their tactics to maintain returns in the country, with one suggestion being to push banks to provide more leverage and finance recapitalisations of portfolio companies.

“With the slowdown in economic growth, being a passive minority investor in an unlevered company is a pretty hard way to make private equity level returns,” said Stephen Peel, co-head in Asia for US private equity firm TPG, at the SuperReturn Asian 2013 conference in Hong Kong last week.

There have been very few leveraged buyouts in China and private equity firms have made most of their money taking small stakes in companies and piggybacking off economic growth spurring revenue growth. That model is now looking increasingly flawed.

“We need to find deals where we can get greater control than we have historically and where we can use more leverage to drive down the cost of capital and push up equity returns,” said Peel.

The challenge private equity firms face is that, in China, onshore acquisition finance is not permitted. Instead, funds have to find financing offshore, which is tricky when most of the companies' assets that can be used as collateral are on the mainland.

“It’s a long way off the efficient buyouts you see in North America or Europe,” said Peel.

Another method is to find a company that is already levered. TPG invested in Shenzhen Development Bank, which as a bank already has a highly geared balance sheet because it makes loans as a business. TPG still owns a leasing company called Unitrust, which is levered about 8:1 said Peel.

“We are looking more and more for businesses that inherently have leverage,” said Peel.

Carlyle’s co-head in Asia, X.D. Yang, who started in the private equity business in 1995, sees the Chinese buyout market evolving rapidly, spurred by the Chinese banks.

“I see evolution happening quickly in the next three to five years,” said Yang during the conference. “Once one or two of model deals get done then the rest of the market will follow.”

Yang was speaking after Carlyle recently completed China’s largest ever leveraged buyout, the $3.7 billion privatisation of US-listed Focus Media Holding.

Carlyle Group and China-based FountainVest Partners helped the display advertising company’s chairman Jason Jiang take the firm private and own 19.7% each.

“Lining up financing for the deal took quite a while,” said Carlyle’s Yang.

It was complicated by the fact that the financing vehicle was offshore and the cashflow from the business was onshore in China. “That took some education.”

“In the end the Chinese banks provided the majority of the financing,” said Carlyle’s Yang.

The banks providing the $1.5 billion loan included China Minsheng Bank, Industrial & Commercial Bank of China and China Development Bank, alongside Western banks. They then parceled out $1.08 billion of the loan to other banks.

“The Chinese banks clearly viewed leverage finance as a business that they have been studying for years and this was a test case,” he said.

“The next step is to educate the Chinese banks how to do a dividend recap,” said Carlyle’s Yang. “It’s a tried and true model in other markets, but Chinese banks need to be convinced that the shareholder can take capital out of the company while the banks stay put.”

A dividend recap adds more debt onto the company in order to pay its shareholders a dividend.

Ming Lu, regional head for Southeast Asia, KKR agreed that private equity’s minority investment model in China is looking increasingly flawed due to the economic slowdown. However, much as KKR would like to take control of top-tier businesses in China and lever them up, it is not always possible.

“High-quality businesses are not for sale in China, particularly for control,” said Lu.

Therefore he thinks: “Minority growth equity investment will remain the mainstay for the forseeable future .”
I agree with KKR's Lu, minority growth equity investment will remain the mainstay for the forseeable future and private equity firms looking for more leverage or eying dividend recaps to generate returns in a slowing economic environment will be disappointed.

And I'm not so sure this is a bad thing. The last thing the world needs is a leveraged buyout frenzy developing in China, exposing their banks to serious downside risks. True, Focus Media was a success and leverage finance can benefit growth, but I have a more tempered view believing China isn't ready for Western-style leveraged buyouts (eventually it will be but not now).

All this to say that Jim Leech and Neil Petroff are right to be cautious on China. There are incredible opportunities but many structural challenges that are not easily addressed.

Below,  Pantheon Private Equity's Kevin Albert and Palico CEO Antoine Drean discuss the private equity market with Pimm Fox on Bloomberg Television's "Taking Stock." And Andy Xie, a former chief Asia economist at Morgan Stanley, talks about India and China's economic outlook. He speaks in Hong Kong with Angie Lau on Bloomberg Television's "Asia Edge."

Friday, September 20, 2013

Credit Risk in Provincial Pensions?

CBC reports, Moody's highlights unfunded pension risk in Quebec, N.L.:
Quebec and Newfoundland and Labrador have the largest unfunded pension liabilities among the Canadian provinces, according to Moody’s.

In a wide-ranging report on pension liabilities, the ratings agency found that Canadian provinces achieve good transparency in their pension plan reporting.

But underfunding of defined benefit pension plans for public-sector workers is a credit problem throughout the developed world, it said.

Alberta announced new rules earlier this week that will help it meet its pension obligations, including increased contributions from civil servants and less early retirement.

In Quebec and Newfoundland and Labrador “relatively large unfunded pension liabilities pose a challenge as they are likely to rise for multiple reasons,” Moody’s said in its report.
N.L. suffered after financial crisis

It estimates N.L.‘s ratio of funded liabilities to assets at 54 per cent in 2009, down from 77 per cent a year earlier. The province, rated Aa2 stable, took a substantial loss due to the 2008 financial crisis, Moody’s added and pointed out that deficits are forecast through 2014-15.

“Rising pension costs will add another challenge as the province tries to balance its budget. Newfoundland and Labrador has included pension reform as part of its 10-year sustainability plan, and has committed one-third of its annual surpluses, once achieved, toward the unfunded pension liability,” the report said.

Quebec’s ratio of funded liabilities to assets is 49.2 per cent and the province is rated Aa2 stable.

“Over the next few years, the province will face pressure to reduce both its relatively high debt burden and unfunded pension liability, within a context of having little room to increase new revenue given its status as a highly taxed Canadian jurisdiction,” Moody’s wrote.
Saskatchewan urged to pay more

It also urged Saskatchewan, which has a “pay-as-you-go” approach, to fully pay its annual pension requirement.

"Saskatchewan is in an unusual situation among Canadian provinces because it began to close all of its defined-benefit pension plans and transition to defined-contribution plans in the 1970s. Enough time has passed since these plans were closed to new members that Saskatchewan can reasonably forecast the required annual payments to members,” Moody’s said.

Provinces with the greatest unfunded pension liabilities should enact reforms to bring their costs down, the report said.

In 2012, Ontario had a small surplus in its pension funds and New Brunswick had the smallest burden, at 8.3 per cent.

The report also highlights the higher risk from pension liabilities among U.S. states. Unfunded pension liabilities are a major issue in settling Detroit's bankruptcy claims.
CTV also reports, Quebec, Newfoundland and Labrador face pension risk, says Moody's:
Quebec and Newfoundland and Labrador face the biggest pension risk among Canadian provinces due to large shortfalls in their pension funds, ratings agency Moody's says.

Moody's said Thursday that Saskatchewan also has a large pension deficit, but noted it has closed its defined-benefit plans and takes a pay-as-you-go approach to funding them.

"In both Quebec and in Newfoundland and Labrador, relatively large unfunded pension liabilities pose a challenge as they are likely to continue to rise for multiple reasons," Moody's analyst Michael Yake wrote in a report.

The report said average asset returns have been lower since 2008-09, while the discount rates which are used to calculate liabilities have fallen and the average life expectancy of pensioners is rising.

Saskatchewan and Newfoundland and Labrador had the highest ratio of unfunded liabilities to revenues at 55 per cent, while Quebec stood at 49 per cent, it said.

Ontario was the best positioned as the only province with a small surplus.

"We believe that credit risk tied to pensions is manageable because of the relatively small size of unfunded liabilities as a share of revenue and because we expect the provinces that are facing the highest liabilities to enact reforms," Yake wrote.

"If they do not, then credit risk could rise."

The provinces are not alone in facing the problem of underfunded pensions in the wake of the financial crisis.

Several of the biggest names in corporate Canada also face deficits in their employee pension plans, forcing them to put millions into the plans.

Canadian Pacific Railway (TSX:CP), Canadian National Railway (TSX:CNR), Bell Canada (TSX:BCE), MTS Allstream (TSX:MBT), Canada Post and NAV Canada have all lobbied Ottawa in hopes of gaining some measure of funding relief for their pension plans.

Air Canada struck a deal earlier this year to give it some help, but the relief came with rules that set limits on executive pay and prevent it from paying dividends to shareholders and buying back stock.
Earlier this week I discussed Alberta's sweeping pension reforms, stating that even though there is no crisis on the horizon, the demographic of their public sector work force requires the government to implement changes to lower pension costs.

There is no crisis in provincial pension plans but this report from Moody's serves as a warning that if pension costs are not brought under control, credit ratings of provinces will suffer a hit.

In the U.S., Moody's has cut ratings of states and cities over pensions and has highlighted that local governments have little control over pensions:
Many U.S. local governments have large pension liabilities, but few control the management, reforms and investments of their retirement plans, according to a report by Moody's Investors Service released on Monday.

Altogether, an estimated 75 percent of U.S. local government pensions are run through centrally administered plans, such as state "cost-sharing" systems, the ratings agency found in a sweeping survey of the public pension landscape that analyzed 8,000 local governments.

School districts in particular have little pension independence, it added, as all but a handful of school district pensions are run by cost-sharing plans. In addition, more than a dozen states pay part or all of school districts' annual pension contributions.

"The unfunded liabilities of U.S. municipal defined benefit pensions are significant, whether expressed in terms of balance sheet or annual budget," Moody's said in its report.

The aggregate net pension liabilities for the thousands of governments it studied are equivalent to 150 percent of their outstanding direct debt, Moody's found.

In budgetary terms, the approximate median pension liability for the governments is equivalent to 100 percent of annual operations.

State governments have generally received more scrutiny during the heated battles over public employees' retirement benefits.

But the Pew Center on the States at the beginning of the year found the most populous 61 U.S. cities are short by a collective $99 billion for pensions. The shortfall grew to $217 billion when other retiree promises, such as healthcare, were added.

Moody's noted "taxpayers can be responsible for the pension obligations of multiple levels of government," which in turn can cloud large aggregate pension exposure. For example, a resident of the city of Chicago could support 16 different pension plans.

Local pensions face other risks, as well, it said, such as exposure to changes in financial markets. Centrally administered plans have been moving out of fixed-income investments and into equities in the search for higher returns.

"In half of the states, many local governments of all types are directly linked to the asset performance of one or two large pension plans," Moody's said. "Management of this market risk is beyond the control of most local governments in cost-sharing plans, where they typically have little if any influence over investment policy or decisions."

As for the subsidies, states frequently pay at least part of pension contributions on behalf of school districts - New Jersey districts do not have to bear any pension costs or liabilities for their schools. The states may cut these payments as they grapple with their own budget and pension problems, Moody's said.

"How likely is the risk that on-behalf payments would be terminated? For many states, it may not be a matter of if but when," Moody's said, noting Maryland recently approved shifting pension costs to local schools.

Without a subsidy, Illinois school districts' unfunded pension liability would rise to more than 30 percent of their budgets compared to 2 percent currently, Moody's found.

However, Pennsylvania school districts' pension burden would double.

Moody's also said there are advantages to centralized plans, mainly in the form of lower administration costs.

Altogether, it found pension contributions may have more bearing on credit quality than local government control.

"A strong history of funding based on conservative financial assumptions confers low risk even if plan types are not conducive to local control of benefits or funding, or if state law constrains the ability to alter benefits," the report said.
The message is clear, provincial, state and local governments can no longer ignore their pension woes. If they do, their credit ratings will suffer and they will pay more to borrow.

In Canada, it's obvious that Ontario is in excellent shape when it comes to managing its public sector pension plans. Other provinces should follow its lead and look into how they can address their public pension deficits.

Below, Pierre Gattaz, chairman of Medef, France's biggest business lobby, discusses investor confidence, taxation and the French pension system. He speaks in Paris with Caroline Connan on Bloomberg Television's "The Pulse."