Monday, December 2, 2013

Canada's Global Buyout Kings?

Katia Dmitrieva and Matthew Campbell of Bloomberg report, How Canada’s pension funds changed their conservative ways to become global buyout kings:
Mark Wiseman, the chief executive of Canada Pension Plan Investment Board, walked into the high-end New York department store Bergdorf Goodman in the mid-1990s looking for a suit. He left empty-handed.

“I couldn’t afford anything there — I probably still can’t,” said Wiseman, sitting in the $192.8 billion fund’s headquarters in Toronto last month. “Is that where I shop? No, thanks. But there are a lot of people who do.”

Instead of a suit, Wiseman bought the store. Canada Pension, the country’s largest pension manager, in October helped lead a $6.3 billion buyout of Bergdorf owner Neiman Marcus Group, a change in style for a fund more familiar with port operators than Prada purses.

“It’s the biggest mistake that you can make in investing: don’t assume that the rest of the world is like you,” Wiseman said.

The deal shows how Canada’s pension funds have changed their conservative investing ways, becoming private-equity deal makers to acquire companies worldwide in industries ranging from luxury retail to entertainment and health care. The strategy, aimed at boosting returns, sometimes puts them in direct competition with their usual partners — buyout firms such as KKR & Co. and Blackstone Group LP. It has also meant riskier deals, as when the funds said they would consider joining a bid to buy money-losing smartphone manufacturer BlackBerry Ltd.

Active Year

The funds have been especially active this year. In the first 10 months, the six largest participated in $18.4 billion of mergers and acquisitions, according to data compiled by Bloomberg. That was more than double the $7.4 billion of the three biggest U.S. buyout shops, Blackstone, Carlyle Group LP and Apollo Global Management LLC — the first time since 2009 the Canadian pensions have surpassed the private-equity firms, the data show.

The Canadian public funds, which collectively manage more than $685 billion, have long invested in private-equity firms as passive limited partners.

Their shift into direct private-equity transactions, which began on a small scale in the early 1990s, comes as they look to sidestep fees charged by the buyout firms and to meet pension obligations for Canada’s aging population as interest rates remain stagnant.

“It’s important that the pension plans earn the returns to fulfill a promise that has been made,” said Jim Leech, CEO of Ontario Teachers’ Pension Plan, the country’s third-largest pension fund with $122.8 billion in assets as of Dec. 31. “Diversification is the only free lunch in investing where you can protect yourself.”

Direct Investing

Unlike in Canada, many U.S. public pension plans are barred from participating in direct acquisitions, preventing them from making the same shift. They invest instead in the buyout firms’ funds, which charge limited partners a typical fee of 2% of assets and 20% of gains.

While the Canadian pensions do most of their direct private investing alongside buyout firms, usually entering bids jointly, they have become rivals in other transactions. Ontario Teachers’ bought a majority stake in Heartland Dental Care Inc. last year, outbidding buyout shops including KKR and Madison Dearborn Partners LLC, a person with knowledge of the matter said at the time. The transaction valued the company at about $1.3 billion.

Earlier this year, U.K. cinema chain Vue Entertainment Ltd. was bought by Canadian pension funds Ontario Municipal Employees Retirement System, known as Omers, and Alberta Investment Management Corp. for 935 million pounds ($1.51 billion). The deal — put together without an auction — was executed in six weeks and froze out other potentially interested buyers, including London buyout firm BC Partners Holdings Ltd., a person familiar with the situation said.

More Buyouts

“We’re competing against every other investor in the world,” said Gordon Fyfe, CEO of Public Service Pension Investments, the fourth-largest fund manager in Canada. “There’s a limited amount of returns and if you’re going to win and you’re going to earn returns, you’re taking them from someone else.”

More buyouts are on the way. Borealis, the infrastructure arm of Omers, is among bidders for Fortum Oyj’s Finnish gas network, according to people familiar with the situation.

It’s difficult to compare the private-equity performance of the Canadian funds to big buyout shops as they don’t break out returns in the same way. However, the private investing arms of the four largest Canadian pension funds returned an average 12% in 2012, including both direct and passive investments, according to data compiled by Bloomberg from the funds’ annual reports.

Predictable Stream

The five largest publicly-traded buyout firms in North America that report annual private-equity performance figures — Blackstone, KKR, Fortress Investment Group LLC, Carlyle and Oaktree Capital Group LLC — had an average gain of 19%.

The Canadian funds don’t face the same pressure as buyout firms to sell their companies to return money to investors. Flush with a predictable stream of capital thanks to employee contributions, they can hold assets longer and ride out downturns, said Fyfe. Private-equity shops typically sell companies after five to seven years and need to raise new money every couple of years.

“When any of the top 10 pension plans decides to buy something, they think more in terms of decades than quarters,” said Scott MacDonald, head of pension segment development at Royal Bank of Canada’s investor services unit.

Total Assets

They’re steadily dedicating more of their resources to takeovers. Last year the four biggest Canadian funds on average had about 11% of their total assets allocated to private equity, both direct and as limited partners, up from 3.6% in 2005, their reports show.

“As returns from big fixed-income portfolios come down, you have to find sources of replacement returns that come at reasonable risk levels,” said Michael Sabia, chief executive officer of Caisse de Depot et Placement du Quebec, the country’s second-largest fund.

That’s not always achieved. Ontario Teachers’ was forced to write off its entire investment in New Zealand’s Yellow Pages directory business, which it acquired with Unitas Capital for $1.6 billion in 2007, after lenders took control of the business.

In the BlackBerry talks, Canadian funds including CPP and Alberta Investment said they would consider joining with insurance company Fairfax Financial Holdings Ltd. to take the phone maker private. BlackBerry’s hunt for a buyer was scrapped in November in favor of a capital injection from Fairfax and partners. The funds did not contribute.

Expensive Battles

The competition between the pension plans and buyout shops can result in expensive takeover battles.

Canada Pension and partner Dexus Property Group this month found themselves in a bidding war with Australia’s GPT Group to take over Commonwealth Bank of Australia’s listed property trust. GPT on Nov. 19 made an A$3 billion ($2.74 billion) offer that trumped CPP and Dexus’s A$2.83 billion offer, which they had already increased.

“There’s 10 times as much money flowing into private equity than 20 years ago,” Leo de Bever, CEO of Alberta Investment, said in a telephone interview. “But it doesn’t mean there are 10 times as many opportunities. You have to be pickier and find unusual opportunities, dig a little deeper.”
I recently discussed why CPPIB has reached an investment impasse. The CPP Fund's assets under management are mushrooming but as global pensions and sovereign wealth funds all compete for scarce private equity deals, the opportunity set is shrinking and that's not good for large funds like CPPIB.

In fact, this is a terrible environment for private equity. Top PE funds are feeling the pressure as fundraising volume surges and deal activity plummets. Among limited partners, everyone is worried about bubbles in all asset classes, including private equity.

With interest rates at historic lows, everyone is playing the same game, bidding up prices of risk assets across public and private markets. This makes the job of pension fund managers that much more difficult. Mark Wiseman and Leo de Bever have both raised concerns over the pricing of private equity deals and have stated flat out that they will walk away if the price isn't right. 

But they are in the minority. Most pension funds are plowing into private equity. It's not 2007 all over again but if the current trend continues, it has the potential to become much worse. There is a virtual feeding frenzy among global investors chasing yields in all asset classes, and people are getting very nervous.

However, I will tell you that we're still in the early innings of the mother of all liquidity rallies. Even if the Fed tapers in the near future, which I highly doubt after the Septaper surprise, it won't fundamentally change the upward direction of risk assets. Big money will keep on buying the pullbacks and I suspect this bubble will last longer than all previous ones.

Now, getting back to the article above, I take all the financial articles praising the dealmaking prowess of large Canadian pension funds with a grain of salt. Some Canadian pension funds are flying solo in private equity but all of them primarily rely on their relationships with top private equity funds to keep delivering the results they require to attain their actuarial rate of return.

Mark Wiseman, President and CEO of CPPIB, shared this with me:
My general view, as we have discussed in the past, is that the solo approach works well for some (ie OTPP) and is a viable approach when you have a relatively large and experienced team and relatively little capital to deploy. We, as you know, continue to follow a co-sponsorship approach, which suits us well and, as Neiman Marcus demonstrates, leads to high quality deal flow and execution.
I agree but also know that OTPP still primarily co-invests with top funds and that's where it generates the bulk of its private equity returns. It has had some success in direct deals and some major flops too (Yellow Pages being one of those major flops).

One private equity expert bemoans that Canadian funds are way too secretive when it comes to their direct private equity deals. They should publish the internal rate of return (IRR) net of all costs including foreign exchange costs, for direct deals and fund deals. Even if it's not as good as their fund investments and co-investments, they should publish these figures in their annual report. This way, stakeholders can gauge whether their hefty payouts are truly warranted.

CPPIB does direct investments in infrastructure but in private equity, it co-invests with top global funds. Given its mammoth size, this is the right course of action but it creates other headaches. In particular, the deals have to be large enough to make a difference (scale is an issue) and  they have to be attractively priced, which isn't the case when everyone is bidding for the same large deals.

The $6 billion Neiman Marcus deal is a perfect example. If you read this Reuters article, TPG Capital and Warburg Pincus took the luxury retailer private in 2005 for $5.1 billion. CPPIB and Ares are buying it for $6 billion eight years later. That's a nice premium but not outrageous given the success and growth potential of Neiman Marcus. I actually think this is a better deal than OTPP's purchase of Saks.

Interestingly, the main theme CPPIB and top private equity funds are really investing in is inequality. I discussed how capitalists and pensions can't afford recovery but it's even more perverse than this, they're betting that inequality will continue and profiting off investments in luxury retailers and dollar stores. Just check out the share price of Tiffany & Co. (TIF), Sotheby's (BID), Dollar Tree (DLTR) and Dollar General (DG) over the past year. Top hedge funds have also profited off the inequality theme, which is why some are betting big on a turnaround of J.C. Penny (JCP) (despite recent run-up, I remain skeptical on JCP).

Finally, some advice for Mark Wiseman. The next time you're shopping for a nice suit, don't bother going to Bergdorf Goodman, Harry Rosen, or other high end retailers which mark up prices like crazy to cover their expensive rent. Just come to Montreal and ask Gordon Fyfe to take you to Samuelsohn on Avenue du Parc where we once went to buy suits and sport jackets (by appointment only). You won't find the latest collection, tailor made suits, or be served like the high end boutiques but if you're patient, you'll find great suits at exceptional prices (just bring cash). If you prefer being served, go to Italmoda on St-Hubert where you'll find competitive prices on BOSS, Armani and my favorite, Canali suits (it's a family owned business and they have the best and nicest salespeople in Montreal).

Below, Jim Leech discusses how Teachers' Private Capital built its private equity expertise with INSEAD. Listen to his comments but keep in mind what I wrote above.

Second, Carlyle Group LP (CG), the world’s second-largest manager of alternative assets such as private equity and real estate, said third-quarter profit decreased 21 percent as it earned less for investment performance and sold fewer assets than a year ago. Devin Banerjee reports on Bloomberg Television's "Money Moves."

Finally, Pantheon Ventures Partner Kevin Albert discusses the evolution of the private equity industry with Deirdre Bolton on Bloomberg Television's "Money Moves."

Very interesting conversation but I'm skeptical of the so-called "democratization" of private equity and think this is just more evidence of fresh signs of a bubble in this asset class.

Postscript on the great fashion debate: Mark Wiseman, a die-hard Maple Leafs fan, shared this with me: "I buy my suits at Tom’s Place in Kensington market. I’ll put Tom up against the best the Montreal has to offer!" Sorry Mark, in fashion, restaurants and hockey, Montreal still rules!!!