Friday, May 30, 2014

Get Ready for Life After Benchmarks?

Melissa Shin of Benefits Canada reports, Get ready for a life after benchmarks:
Benchmark-oriented active managers will fall behind.

That’s what Yariv Itah, managing partner at Casey Quirk, argued at an Alternative Investment Management Association event in Toronto on Wednesday.

A paper he co-wrote, Life After Benchmarks, says clients will soon care more about outcomes, such as specific cash-flow needs, than outperforming a benchmark.

But “to get away from the benchmark, you need a lot of courage,” says Jean-Luc Gravel, executive vice-president of global equity markets at Caisse de dépôt et placement du Québec. That’s particularly the case in Canada, where we have fewer names to choose from.

Even though clients will compare your performance to the benchmark over the long term, it can be dangerous to try beating it over the short term. For instance, when Nortel comprised 35% of the TSE 300 (now the S&P/TSX Composite Index), many managers Gravel spoke to knew it was overpriced. But they refused to sell, because they’d lose their jobs if clients didn’t see the stock in the portfolio.

Gravel says the Caisse has moved away from benchmark-oriented investing globally. “You don’t want to be down 48% even if the benchmark is down 50%,” he says. “In terms of risk-adjusted returns, it’s a better approach.”

Success without benchmarks
Managers may feel lost if they can’t compare their performance to the S&P 500 or S&P/TSX 60. The solution, says Gravel, is to create your own comparisons.

His team does 10-year forecasts to determine expected returns for their chosen allocations – for equities, he’s aiming for 7.5%, but with less risk than a typical manager. Then, they tell clients, so managers are kept accountable.

Ray Carroll, CIO of Breton Hill Capital, agrees that setting expectations will calm clients clamouring for comparisons. At the outset, walk them through scenarios where your approach should perform well, and explain which risk management tools you’ll use in down times.

Carroll says running and explaining simulations is time-intensive, but worth it. For instance, one of his largest investors gave him more money during a period of underperformance thanks to such explanations. “We see you’re down,” the investor said, “but it’s in a scenario where you said you’d be down. And, we’re impressed with how you’ve applied your risk management tools.”

Prepare for the future
In a non-benchmark world, static asset allocation isn’t enough, says Itah. Managers should start allocating portfolios by risks: cash, duration, credit, equity and correlation. And instead of setting an allocation to run for three years, for instance, managers should be taking advantage of opportunities as they arise, subject to that predefined risk profile.

They should also move away from narrow mandates (e.g., large-cap value equities) and broaden their asset classes. He predicts between 2013 and 2016, Canadian plan sponsors will increase their non-benchmark strategies by 23.1% at the expense of active equity, passive and cash allocations.

To prepare, every active manager should be comfortable with derivatives, short-selling, quant modelling, FX and commodities, Itah adds. “In the future, alternative investing will be the default method of active management. Hedge funds will be mainstream.”
You can read the Casey Quirk paper, Life After Benchmarks, by clicking here. I ended up going to the Montreal luncheon yesterday which discussed the same topic. The featured speakers were:
  • Mario Therrien, Senior VP External Mandate, Caisse de dépôt et placement du Québec (moderator)
  • Yariv Itah, Managing Partner, Casey Quirk (presenter of findings)
  • Jean-Luc Gravel, Executive VP Global Equity Markets, Caisse de dépôt et placement du Québec (panelist)
  • Jacques Lussier, President, IPSOL Capital (panelist)
  • Mihail Garchev, Senior Director, PSP Investments (panelist)
The room was packed (a bit too tight when eating) and I got to see a lot of my former colleagues from the Caisse and PSP as well as other people who I was glad to catch up with. The discussion was somewhat interesting but to be frank, I wasn't particularly impressed and think there is a lot of intellectual masturbation that goes on when discussing "life after benchmarks."

Anik Lanthier, Vice-President at PSP in charge of allocating to external funds, said it best to me after the lunch: "It's all nice to talk about being benchmark agnostic but at the end of the day, the board is going to want to measure your performance relative to a benchmark. And even if they shift away from benchmarks, when a new board comes in, they will push for performance relative to benchmarks." She's bang on and still a breath of fresh air (she hasn't changed a bit in 10 years).

I also had a chance to talk to Jean-Luc Gravel after the lunch. He's a very nice and sharp guy. We talked about the importance of long-term investing. I asked him if he read Larry Fink's comments sounding the alarm on how activist investors are way too focused on short-term investing. He told me he did and agrees with most of those comments.

Jean-Luc and I also discussed CPPIB's long-term focus. I told him it's funny how the private markets group wants their performance to be evaluated over the long-run but public markets have to beat the TSX and S&P 500 every year. He told me the Caisse has moved away from short-term investing and that public markets are also evaluated over a longer investment horizon. "But if everyone starts doing this, it will arbitrage away opportunities that come our way."

Jacques Lussier talked about the importance of process over performance, a topic which far too many institutional investors ignore. In fact, at my table sitting next to me was Francois Magny of RDA Capital and Yves Martin of Akira Capital. Yves is winding down his commodity arbitrage fund and learned firsthand how hard it is to start a hedge fund in this environment. We talked about low volatility and the dumb risks pensions and bank prop desks are taking selling options.

"Volatility keeps falling because traders keep selling it to collect yield. But as vol falls, you have to sell more vol to keep collecting the same yield," Yves said. Francois Magny agreed stating that a lot of players are taking huge risks selling vol in this environment. "At one point, the big money will be made buying vol."

I told them there is too much liquidity in these markets and that point hasn't come yet. It increasingly looks like the big unwind in Q1 was just another big buying opportunity. Stocks keep surging to record highs and even though more corrections are coming, we won't see a major bear market in the near future.

Back to life after benchmarks. My former PSP colleague, Mihail Garchev, spoke eloquently about two benchmarks, one based on opportunity cost and one based on "value creation." He rightly noted that private market benchmarks are not easy to construct but most pensions funds evaluate them relative to public market benchmarks because the opportunity cost of tying up your money in an illiquid investment is investing in some equity index. But he added private equity managers are not focused on benchmarks, they are focused on value creation, which means they look at deals that make sense and try to extract value from them.

Mihail is right but he knows full well that pension fund managers take all sorts of dumb risks to beat their benchmarks, something which we both witnessed at PSP (we were working side by side) and which wasn't addressed in the Auditor General's Special Examination. Importantly, benchmarks matter because they determine compensation and thus influence investment decisions.

Go back to read my January comment on CalPERS revamping its PE portfolio, where I wrote:
Ah benchmarks, one of my favorite subjects and the one topic that makes Canada's pension aristocrats extremely nervous. It's all about the benchmarks, stupid! If you don't get the benchmarks right in private equity, real estate, infrastructure, hedge funds, stocks, bonds, commodities or whatever, then you run the risk of over-compensating pension fund managers who are gaming their benchmark to collect a big fat bonus. And as we saw with the scandal at the Caisse that the media is covering up, things don't always turn out well when pension fund managers take stupid risks, like investing in structured crap banks are dumping on them.

A few months ago, Réal Desrochers called me to work on fixing CalPERS private equity benchmark. I can't consult CalPERS or any U.S. public pension fund because I'm not a registered investment advisor with the SEC and they got all these rules down there which make it impossible for a Canadian to work for them.

Anyways, I remember telling Réal their PE benchmark is too tough to beat, the opposite problem that many Canadian funds encounter. I told him I like a spread over the S&P 500 and even though it's not perfect, over the long-run this is the way to benchmark the PE portfolio.

Andy Moysiuk, the former head of HOOPP Capital Partners and now partner at Alignvest  has his own views on benchmarks in private equity. He basically thinks they're useless and they incentivize pension fund managers to take stupid risks. He raises many excellent points but at the end of the day, I like to keep things simple which is why I like a spread over the S&P 500 or MSCI World (if the portfolio is more global).

Should the spread be 300 or 500 basis points? In a deflationary world, I would argue that many public pension funds praying for an alternatives miracle that is unlikely to happen will be lucky to get 300 basis points over the S&P 500 in their private equity portfolio over the next ten years. To their credit, CalPERS has updated their statement of investment policy for benchmarks, something all public pension funds, especially the ones in Canada should be doing (don't hold your breath!).
Finally, I saw my good friend Nicolas Papageorgiou, at the lunch yesterday. Nicolas is one smart cookie. He's a professor of finance at HEC, an expert of smart beta, and is now running a $70 million fund at HR Strategies. He asked a question where he basically expressed his skepticism on life after benchmarks, stating that it's just using different factor models but in the end, "it's basically doing the same thing that we've done in the last 30 years."

After the lunch, Nicolas told me "it's all about marketing." I couldn't agree more and it's all part of the nonsense consultants feed institutional investors so they keep shoving more money into hedge funds, private equity, real estate and infrastructure.

I don't want to be too critical. I think Yariv Itah, Managing Partner, Casey Quirk, is a very smart guy and you should all definitely read his paper, Life After Benchmarks, as it is interesting even if it's heavily biased toward hedge funds and other alternatives. It's just that you have to take all these discussions on "life after benchmarks" with a grain of salt and remember that despite what this paper claims, at the end of the day, benchmarks matter a lot!

On a closing note, most of these conferences and lunches are a total waste of time and money. I would have much preferred having lunch with Fred Lecoq on Bernard st., enjoying the beautiful weather and talking stocks, but I decided to get out of my comfort zone, put on a suit and tie and head over there. I also got to talk to Anik Lanthier, Jean-Luc Gravelle, and see many more people like Marc Amirault, Mario Therrien, Claude Perron, Eric Martin, Simon Lapierre, Ron Chesire, Bernard Augustin, Catalin Zimbresteanu, Johnny Quigley, and Denis Parisien (who is now at Razorbill Advisors). So, in the end, even though I am publicly whining, I am glad I went and thank Claude Perron for organizing it.

Once again, please take the time to subscribe and/or donate to my blog via the PayPal buttons on the top right-hand side. You can also contact me ( if you want to send me a cheque or if you're looking for a top notch investment analyst who isn't afraid to stick his neck out and tell it to you like it really is. Remember the wise words Gordon Fyfe once told me: "Leo, you're the best investment analyst I've ever worked with." Damn right I am!

Below, an old tribute to the Montreal Canadiens, made by a Habs fan for their 100th anniversary (December, 2009). The Habs got eliminated last night by the New York Rangers. It was painful to watch and I now have to adjust to life after the Habs, which totally sucks! Good show les boys, can't wait till next year. Go Habs Go!!!

Thursday, May 29, 2014

AIMCo Scores Huge on Timberland?

Darcy Henton of the Calgary Herald reports, Investment in Australian woodlots pays off for Alberta:
An Alberta Heritage Savings Trust Fund investment into private woodlots in Australia is paying huge dividends since more than 2,500 square kilometres of land was purchased out of bankruptcy following the 2008 global recession, says AIMCo chief executive Leo de Bever.

De Bever said the $400-million investment in 2011 paid a nearly $100-million return this year after the bankruptcy issues were resolved and the Great Southern Plantations started to produce forestry products.

“This is a perfect example of why it pays to be a long-term investor,” he told an all-party legislature Heritage Fund committee meeting Tuesday.

“We were the only investor that could come in and say: ‘Ok, this is a royal mess . . . but we can provide cash now to the receiver and you will be through with this problem, and we’ll work it out over time.’ In this particular year, that strategy came to fruition.”

Most investors can’t wait two or three years for a return on their investment, but the Heritage Savings Trust Fund is an investment for future generations and doesn’t have to post quarterly profits for clients, he said.

The investment’s staggering 27 per cent return last year helped boost the fund’s overall annual rate of return on investments to 11.6 per cent by the end of December 2013 and pushed its net value to $17.3 billion.

More than $1.4 billion will be transferred to the provincial treasury and $178 million will be retained in the fund for inflation-proofing. The PC government stopped putting non-renewable resource revenue into the fund in 1987.

Alberta Investment Management Corp., investment managers for 26 provincial government funds with assets of more than $70 billion, has also invested recently in the Chinese e-commerce giant Alibaba, the committee heard.

“This was an opportunity where one of the founders of Alibaba needed some liquidity and AIMCo was able to close very quickly on that kind of deal and pick up a very interesting asset that’s now getting ready to IPO (initial public offering) hopefully by the end of this year,” said AIMCo’s executive vice-president David Goerz.

De Bever said in an interview following his presentation that the Australian woodlot investment is “a picture deal” that will likely generate another $50 million to $100 million in profit.

Other deals may produce significant returns, but this one captures people’s imaginations, he said.

“People can visualize what we did,” he added. “In fact, you’re going to see it featured in our annual report. We’re highlighting this transaction as one where we could use our expertise to get a better result.”

The opportunity to purchase 640 properties in a half-dozen Australian states occurred after a government program to induce Australians to invest in timber to address a nationwide shortage of wood fibre went off the rails during the world economic crisis, he explained.

De Bever, who has announced his retirement from AIMCo but has committed to stay until a replacement can be found, said the organization could beat out smaller competitors because it has the internal expertise and resources to handle such a huge deal without having to hire expensive consultants.

The committee heard the province, through AIMCo, owns a piece of virtually every public company on the continent and that 60 to 70 per cent of its assets are foreign.

Committee member David Eggen, an Edmonton-Calder NDP MLA, questioned why more investments aren’t made into Alberta companies to help diversify the economy.

“I just think that in the interests of diversifying our economy, increased investment would be prudent,” Eggen said.

De Bever said AIMCo has been directed to invest in innovative Alberta technologies with an objective to make a 10 to 15 per cent return commercializing that technology.
I've already covered AIMCo's 2013 results here. In aggregate, AIMCo earned 12.5% net in 2013 led by a strong performance in public markets but there were significant gains in private markets too.

AIMCo's annual report isn't available yet, but we see from the article above just how well their investments in timberland have done. I like the article because it demonstrates the advantage of a well governed, well staffed pension fund has over other investment managers.

In particular, Canada's large pension funds have a long investment horizon and the expertise to enter into complex private market transactions that other players, including private equity funds, wouldn't touch. The typical investment horizon of a private equity fund is 4 to 6 years, but with pensions, it's much longer. And forget mutual funds, they invest in public markets and are basically closet indexers whose returns are determined by the vagaries of markets.

And you'll notice that because AIMCo has the internal expertise and resources to handle such a deal, they don't have to pay huge fees to some useless investment consultant peddling garbage or some overpaid hedge fund guru who has become a large, lazy asset gatherer charging outrageous alpha fees for leveraged beta.

In three years, AIMCo earned $100 million on a $400 million investment, and the beauty is that they did so at a fraction of the cost that it would have cost if they farmed it out to an external manager who would have charged them a huge fee and not returned anything close to what they delivered. That is what I call smart investing and this is the type of value-added that deserves to be well compensated.

Now, timberland is a hot asset class. In September 2012, I wrote about how Harvard is betting big on timberland. In June 2011, I told you all the Timberwest transaction involving PSP and bcIMC. Timberland investments have a nice fit in an institutional portfolio but you need expertise and resources to manage the evolving risks of these investments which are often underestimated.

There is another problem, as everyone starts jumping on the timberland bandwagon, pricing pressure will put downward pressure on future returns. But if you have the right team in place to evaluate deals and jump on opportunities like the one in Australia that AIMCo did, you will make excellent risk-adjusted returns.

Finally, I had a chance to chat with Leo de Bever following my recent comment on why he is stepping down. Leo told me he was somewhat disappointed that I quoted the aiCIO article which was "factually wrong" and he told me that he will be focusing his attention on this new fund looking to help innovative Alberta companies commercialize their technology, which is what he always wanted to do.

I wished Leo much success in this new venture and invited him to write guest commentaries on my blog. We also talked about how difficult it is to monetize a blog and asked him to subscribe to my blog.

Below, Bank of America Private Wealth Management's Doug Donnell discusses investing in timberland with Deirdre Bolton on Bloomberg Television's "Money Moves" (December, 2013).

Wednesday, May 28, 2014

The Euro Deflation Crisis?

Peter Polak of Foreign Affairs reports, The Euro Deflation Crisis:
A specter is haunting Europe -- the specter of deflation. Countries throughout the European Union have been struggling for the past several years with stagnant or falling prices. In Hungary, inflation has fallen to its lowest level since 1974. In Bulgaria, Cyprus, Greece, Ireland, and Latvia, consumer prices fell on a year-over-year basis in 2013. Over the same period, consumer prices remained static in Portugal and Spain, and they rose by the statistically insignificant rate of 0.5 percent in Denmark, Lithuania, Slovakia, and Sweden. Aggregate inflation in the EU has declined to a five-year low of 0.5 percent, well below the target of two percent set by the European Central Bank (ECB).

As long as incomes remain stable, deflation has a positive impact on consumers’ purchasing power; they can buy more goods and services as prices fall. Their savings also increase in value as prices decline, unless banks begin to charge negative interest rates -- basically, a fee for holding money. But deflation can be devastating for citizens with loans: as the value of their money remains stagnant or even decreases, they must continue to meet their debt obligations, the nominal value of which does not change. At the same time, whatever assets they have pledged as loan collateral decline in price, prompting lenders to demand further security against default. Deflation is also bad news for individuals and companies who do business across borders. Imports may become more expensive, and exports can generate lower revenues. Deflation also threatens citizens and companies with loans and other credit facilities.

For evidence of the ill effects of deflation, look to Japan in the 1990s, which closely resembles Europe today. There, too, the financial sector struggled under a large burden of bad loans. Like Europe, Japan also faced an aging population that consumed less. Another disquieting similarity is that the ECB, like its Japanese counterpart, seems unwilling to dramatically counteract these ominous monetary trends. The ECB has some reasons for its reticence -- but they aren't good enough.


The ECB has already missed its best opportunity to effectively ease Europe’s money supply to counteract deflation. Two years ago, inflation in Europe dipped below the central bank’s two-percent target, and the European economy was at the lowest point of its four-year downturn. But the ECB was strongly influenced by Germany’s Bundesbank, which has historically been much more concerned about inflation than deflation. Now that the economy has started to revive and inflation has likely reached its lowest point, monetary expansion would not have much of a positive impact, at least not for Europe's leading economies.

For Europe's smaller economies, monetary expansion might still facilitate a recovery. If the ECB adopted a quantitative easing program involving the direct purchase of national bonds and collateralized loans, Spain, which has a huge stock of such debt, might come out ahead. But the implementation of such a strategy would be far more challenging in Europe than in the United States or Japan because of structural problems within Europe’s banking sector. Financial institutions within Europe’s fragmented banking sector still hold savings within the confines of their national borders.

It is also unclear whether quantitative easing is likely to have a significant impact across Europe right now. In the United States, quantitative easing seemed to help the most during and immediately after the financial crisis, because it brought stability to asset prices and to the financial sector generally. Beyond immediate damage control, though, quantative easing has had a relatively small effect in the United States. Japan’s recent policy of quantitative easing, which was much more ambitious than that of the United States had its greatest impact last year, stimulating GDP growth, at least temporarily, and boosting inflation to 1.5 percent per year, its highest level in years. Yet despite these achievements, quantitative easing has not been sufficient to bring an end to Japan’s long-term stagnation.

The ECB, furthermore, has already pursued a type of quantitative easing, which might have accomplished all the EU can hope to achieve through such policies. The ECB’s most effective measure to date was its program of long-term refinancing operations, which greatly improved the liquidity of the banking sectors in Europe’s smaller economies while decreasing the risk associated with their government bonds. For these effects alone, the policy was a success. But it had only a minor impact on inflation and GDP growth. Further rounds of quantitative easing, then, would likely lead to effects similar to those in the United States and Japan. It might contribute a few percentage points to GDP growth and the inflation rate, but it would not have any lasting effects on Europe’s economic recovery.


Nonetheless, further quantitative easing by the ECB would be worth the effort. First, for Europe's weakest economies, an increase in economic growth by even a few tenths of one percent would make a tremendous difference. Second, further quantitative easing would allow the ECB to refine its use of extraordinary monetary measures. It could identify which assets are the most effective to buy and at what quantity. If the ECB is ever called on again for quantitative easing, that information would prove to be very useful.

But the ECB should be cautious. Unlike the U.S. Federal Reserve, the ECB does not have the legal authority to buy broad asset types, such as federal bonds and mortgage-backed securities. Instead, it would likely have to focus on more defined instruments, such as corporate bonds. And that would raise the political pressure on the central bank to choose assets based on political expediency, rather than sound financial and economic reasoning.

Moreover, European governments will have a hard time rallying citizens around deflationary policies. Over the last two decades or more, Europeans have been told by their governments that inflation leads to negative consequences, such as rising prices, the devaluation of savings, and a slowdown in social and economic development. Now, governments will have to convince them that, rather than fight inflation, the EU should hope for it.


The ECB continually emphasizes the differences between Japan and the eurozone. Yet it shouldn't deny the very clear similarities. Demographically, Europe and Japan both have aging populations that are consuming less, which produces slower economic growth. Europe and Japan are both heavily indebted as well, which increases the negative effects of deflation.

Although the ECB did not mention deflation in its 2013 economic report, current conditions make it a real possibility. European countries, especially the Baltic States, already see the reduction of wages and prices as an unavoidable form of internal devaluation necessary to correct economic imbalances with other EU countries. Meanwhile, Europe’s banking sector remains fragile. Once inflation reaches zero percent -- which may happen soon -- the ECB would be forced to acknowledge the risk of deflation. By then, however, it may be too late.

That's why the ECB must take steps now to counter the possibility of deflation. It should start by putting downward pressure on interest rates until they fall slightly below zero. This would encourage consumers to spend rather than save their money, which would lead to higher economic growth and lower unemployment. The ECB should also continue purchasing government bonds under the Securities Markets Programme (SMP), without “sterilizing” those purchases by removing an equal amount from banks of those countries. But since these measures alone will not reverse the slide toward deflation, the ECB should also proceed directly to another round of quantitative easing.
Nobel Prize-winning economist Paul Krugman yesterday challenged the ECB to act to stop the eurozone slipping into Japan-style deflation and being "persistently depressed":
Speaking at the ECB's inaugural Forum on Central Banking, Krugman suggested the eurozone could sleep walk into Japan-style deflation.

It would be easy to convince oneself there is no problem, Prof Krugman said, adding: "There is not that explosive downward dynamics in the euro area, or in the United States.

"But then there has never been explosive downward dynamics in Japan either, and yet we do think that Japan has had a persistent deflation problem."

Opening the ECB's Sintra Forum, billed as the European version of the Federal Reserve's renowned Jackson Hole conference, Mr Draghi warned on Monday that there was a risk of disinflationary expectations taking hold.
The ECB has no choice, the longer it procrastinates, the higher the risks of a severe deflationary spiral which might last decades. And if Europe slides into deflation, it will have global ramifications and expose a lot of naked swimmers in these markets.

This is why I laugh at articles warning us how not to get soaked when the bond bubble bursts. Really? The bond bubble is about to go "poof!" and interest rates will soar to 1980 levels? Somebody should warn the bond market which remains more concerned of deflation than whiffs of inflation. The 10-year U.S. bond yield keeps falling and now stands at 2.45%.

Go back to read my outlook 2014, where I stated:
I must admit, I'm a high beta junkie and love trading stocks that move. Bonds just don't do it for me, never did. In fact, I don't understand why anyone would invest in bonds given the historic low rates we're seeing. Nonetheless, I think the bond panic of 2013 was way overdone and given the risks of deflation, investors would be wise to invest in high quality bonds and carefully choose high dividend stocks of companies with low debt and strong cash flows (the backup in yields is presenting good opportunities on some interest rate sensitive sectors, like utilities and REITs).
And it so happens that utilities (XLU) and high dividend stocks are the top performing sectors so far this year. The big unwind hurt biotechs (IBB), internet (FDN) and other momentum stocks (QQQ) but I believe the second half of the year you will see massive RISK ON and all the sectors that got clobbered in Q1 will come roaring back.

Back to the ECB, in my outlook 2014, I also stated the following:
Gold won't shine again until ECB moves: In my last comment on hot stocks of 2013 and 2014, I discussed why gold shares (GLD) are way oversold and it's a good time to start accumulating at these levels. And as I stated in my comment from tapering to deflation, the ECB will have to crank up its quantitative easing, and when it does, gold shares will rally hard.

But be careful with gold. Just like other commodity shares, you'll see plenty of false breakouts due mostly to short covering. These counter-trend rallies are great to trade but don't be fooled, gold will not take off until the ECB starts cranking up its quantitative easing (short the euro, it's overvalued).

When will the ECB move? I don't know but I will tell you this, there will be another Greek haircut and it may come sooner than you think now that Greece has achieved a primary surplus by ramming through troika's insanely deflationary policies. Periphery Europe remains a huge concern for the global recovery and there is no doubt in my mind the ECB will have to crank up its quantitative easing. This is bearish for the euro but bullish for gold.
I am not sure the Germans will swallow another Greek haircut but the elections this past weekend saw big gains for the anti-austerity party SYRIZA, which is asking for debt forgiveness. I personally can't stand SYRIZA's leader, Alexis Tsipras, and basically think he's a demagogue and a complete buffoon. But Greeks are tired of living with sky high unemployment and when the masses are hungry and desperate, they vote in idiots who promise them the world. The same thing is going on elsewhere in Europe where voters are revolting.

You'll notice I talk a lot about inflation and deflation. The macro backdrop is key and I think too many players are underestimating the possibility of a protracted period of deflation. US private equity funds rushing to invest in Europe don't have a clue of what they're getting into. Many of them will get clobbered and lose their investors' money.

Of course, there are some pretty smart market strategists who disagree with me. Below, two of my favorites. Jim Bianco, Bianco Research president, and David Rosenberg, Gluskin Sheff chief economist, discuss the rise of inflation and provide analysis where the markets may be headed.

And Michael Hudson discusses why EU voters are voting against austerity. Take the time to listen to this interview below, it is excellent.

Please remember to subscribe and/or donate to my blog on the top right-hand side. If you're taking the time to read my comments, you should take the time to contribute. Thank you!

Tuesday, May 27, 2014

Private Equity Returns to Australia and Europe?

Ross Kelly and Cynthia Koons of the Wall Street Journal report, Private Equity Returns to Australia:
When it comes to investing in Australia, private-equity firms are back.

After a lull in activity Down Under in the wake of the 2008 financial crisis, global firms such as KKR & Co. and TPG Group are on the hunt again, having recently raised large amounts of capital to deploy in the Asia-Pacific region. That has inspired a renaissance of buyout activity in Australia, one of the few markets in the region where private-equity firms can do full takeovers.

In the first five months of the year, announced private-equity takeover deals in the country hit US$5.5 billion, according to Dealogic, higher than the amount for any full year since 2006.

“Many of the large local and global private-equity firms have recently raised new funds, so they have significant war chests,” said John Knox, Credit Suisse’s co-head of investment banking in Australia.

He added that “debt markets are very strong, probably the strongest they have been since 2007,” allowing private-equity firms to take on more leverage at a lower cost.

Asian and Australian banks have been eager to lend to deals in recent months, while the U.S. debt markets have become a source of funding for Australian deals, giving firms a number of options when it comes to securing debt.

Meanwhile, fundraising in Asia has picked up steam in recent months, with KKR last year raising a US$6 billion Asia fund, the biggest-ever for the region and TPG closing a US$3.3 billion fund last week. Australian private-equity firm Pacific Equity Partners, or PEP, meanwhile, is currently raising capital for its fifth fund, potentially targeting around three billion Australian dollars (US$2.8 billion), a person familiar with the raising said. It will be competing for capital with Carlyle Group, which is also looking to raise a US$3.5 billion fund for Asia.

That has led to a spurt of jumbo deals in Australia. Compliance services provider SAI Global Ltd. said Monday that PEP bid A$1.1 billion (US$1 billion) for it. Last week, KKR bid A$3.05 billion for Treasury Wine Estates Ltd., the world’s second-biggest listed vintner. Also, TPG bid for the DTZ property services unit of Australian engineering company UGL Ltd., a person familiar with the matter said earlier this month, in a deal that could be valued at more than A$1 billion. Treasury Wine rejected KKR’s offer but said it is open to others, while UGL said it is still assessing the merits of any offers for DTZ.

“Many companies have been waiting for an opportunity to restructure their operations by unloading units that are deemed to be noncore to some of their strategic objectives, and private-equity funds tend to pick up those types of businesses,” said Yasser El-Ansary, chief executive of the Australian Private Equity & Venture Capital Association.

UGL considers DTZ to be a noncore asset, while other companies across myriad sectors have indicated, too, that they could part with business units to help bolster their balance sheets.

National airline Qantas Airways Ltd., for example, is considering a sale of its frequent-flier business, while mining company BHP Billiton Ltd. is shopping assets considered marginal to its operations. Australia’s slowing mining boom has also thrown up potential companies private-equity firms can set their sights on.

“The economic environment in Australia has been relatively tough, and many believe the outlook is better,” Mr. Knox said. “Some companies haven’t been able to grow so they are natural targets.”

Meanwhile, Australia’s stock market is up 11% in the past 12 months, after the central bank relaxed interest rates to help spur growth. The Reserve Bank of Australia has cut interest rates eight times over the past two years to a record-low 2.5%, helping to drive activity in the country’s housing market and potentially reigniting the retail sector.

With the stock market hovering near six-year highs, private-equity firms can now exit from investments through initial public offerings. That option hasn’t been readily available over the past few years. TPG’s disappointing float of department store Myer in late 2009 left investors wary of new offerings.

The IPO market, however, is starting to show signs of life again. PEP partially exited from cleaning-and-catering company Spotless Group Ltd. through an IPO last week and TPG and Carlyle are considering a float of hospital operator Healthscope in a deal that could raise around A$5 billion for its private-equity owners.

New floats help free up capital for private-equity firms to invest. Moelis & Co. analyst Adam Michell said SAI Global, for example, might receive rival offers from other private-equity firms in need of investment opportunities after recent IPOs.

These dynamics should keep private-equity buyouts of Australian companies robust in the next year.

“It’s very likely that in the coming 12 months or so we’ll continue to see a heightened level of deal activity,” Mr. El-Ansary said. “There are a range of industry sectors that have a strong outlook over the coming years—look, for example, at the level of deal activity in the health-care and aged-care space.”
Another region seeing a significant pickup in private equity activity is Europe Ayesha Javed, Dan Dunkley and Matt Turner of Financial News report, US private equity firms increase buying in Europe:
Private equity firms and trade players in the US are increasingly looking to buy European mid-market businesses as they face a saturated deal market at home and seek value elsewhere.
Alan Giddins, co-head of private equity at 3i Group, said: “We have undoubtedly seen an increased number of US private equity houses, who don’t have offices in Europe, competing in European auction processes.”

Rod Richards, managing partner of mid-market firm Graphite Capital, noted that five of the nine businesses the firm has sold in the past three years have been to US bidders.

Three of them went to financial buyers, with interest from unexpected sources such as New Mountain Capital and AEA Investors, which bought recruitment outsourcing company Alexander Mann in October and NES Global Talent in 2012 respectively.

Advisers often cite the acquisition of UK consumer data company Callcredit by GTCR, a Chicago-based private equity fund, as evidence of the trend. The US firm does not have a European office.

Thierry Monjauze, who heads the European operations at US mid-market investment bank Harris Williams & Co, said: “There is no doubt that there has been a significant increase in activity level from US private equity firms into Europe. Many US firms are spending more time in Europe pursuing acquisitions and indeed a few have opened up offices internationally.”

Richards at Graphite Capital said that some US buyers were seeing UK companies as a platform for expansion into Europe, partly because the US market had become more competitive and Europe was seen to have more opportunities for value, while others were providing a route for the acquired company to expand into the US.

US private equity firms also tend to make their investment decisions quickly, agreeing a price early and completing the deal, according to Richards.

So far this year there have been 13 acquisitions of European targets by US private equity firms, worth $8.7 billion, according to data provider Dealogic.

This is already 37% higher than the total of such deals done in the whole of 2013, but down on the $30.9 billion-worth completed in 2012.

Monjauze said: “A few years ago, it was not commonplace to consistently see US PE firms show strong interest in European sale processes, whereas now sellers expect significant US interest. This phenomenon has created a dynamic where local PE firms are having to compete and pay more for assets.”

US advisers are also gearing up in Europe. US-based financial services firm Stephens, which has private equity, investment banking and wealth management arms, is looking to establish a presence in London, Financial News reported last week.
I bring these articles to your attention for several reasons. First, cheap debt is the primary factor fuelling private equity activity everywhere, not just Australia.Second, while there are opportunities to restructure companies, I'm worried about the leverage PE funds are using to enter these deals and their exit strategy. The IPO market is showing signs of life but for how long?

Third, and more importantly, I worry about local and global funds with "significant war chests" bidding on deals, raising the valuations to ridiculous levels. This morning I had an email exchange with Mark Wiseman, congratulating him on CPPIB's fiscal 2014 results, but told him I'm worried about public and private markets going forward and I don't envy him. He told me flat out: "indeed...tough times to invest in."

Put yourself in Mark Wiseman and André Bourbonnais' shoes. You have billions to allocate in private equity and you worry about cheap debt and bidding wars raising prices on deals. You try to navigate as responsibly and as prudently as possible but in this environment, you're going to get caught up in the private market frenzy. I just hope rates stay low for a very long time because if they unexpectedly start rising, it will get very, very ugly out there.

Of course, I'm more worried about deflation, especially in the eurozone, so I don't see any reason to worry about a significant rise in interest rates anytime soon. In fact, I predict the ECB will finally start engaging in massive quantitative easing which will spur gold shares and gold prices, at least in the short run. I would stay short the euro, the CAD and Aussie dollar in this environment.

Finally, according to Economic Times, Ontario Teachers is part of TPG's $1 billion consortium bid on real estate services company DTZ, teaming up with PAG, helmed by its former senior executive Weijian Shan.

Below, Laurence Tosi, chief financial officer at Blackstone Group LP, talks about his role as CFO, the private-equity industry, and Blackstone's performance. He speaks with Jason Kelly at the Bloomberg Link CFO Conference in New York.

And Adena Friedman, chief financial officer of Carlyle Group LP, talks about the evolving role of the CFO, the private-equity industry and public investors' understanding of the firms. She speaks with Jason Kelly at the Bloomberg Link CFO Conference in New York.

Monday, May 26, 2014

CPPIB Gains 16.5% Gross in FY 2014

Janet McFarland of the Globe and Mail reports, CPPIB’s active investment plan scores big with 16.5% rate of return:
The Canada Pension Plan fund saw its assets swell by $36-billion over the past fiscal year after recording its highest annual rate of return on investments in the past decade, but warns that good investment deals are harder to come by as more large investors flood into acquisition markets.

The Canada Pension Plan Investment Board (CPPIB), which manages Canada’s largest pool of pension assets, said total assets hit $219-billion as of March 31, up from $183-billion a year earlier, which is the highest annual gain in dollar terms that the fund has ever earned.

“At the end of the day, the reason we’re most pleased about that is that it’s really what pays pensions,” chief executive officer Mark Wiseman told reporters Friday. “Those returns will help pay pensions for the next 75 years and beyond. ... It continues to enhance the overall sustainability of the Canada Pension Plan.”

CPPIB says its long-term rate of return is on track to cover all anticipated CPP payments for at least the next 75 years, which is the time frame measured by Canada’s chief actuary. The fund needs to earn a 4-per-cent annualized rate of return above the rate of inflation to be sustainable for the long term, and currently has a 10-year rate of return of 5.1 per cent, which is ahead of the required level but a decline from 5.5 per cent at the end of 2013.

The 16.5-per-cent rate of return on investments in fiscal 2014, ended March 31, is the second-highest annual return earned by CPPIB in its 15-year history, outpacing all annual performance results except 2004, when the fund earned a 17.6-per-cent rate of return.

A major part of the return last year came from a $9.7-billion gain from converting foreign holdings into Canadian dollars for reporting purposes.

CPPIB said its 2014 return almost exactly matched the rate of return that would have been earned by a passive “reference portfolio” that simply invested in public stock indexes and government bonds. CPPIB earned $62-million less than a passive investment strategy would have produced after including operating costs.

The performance measure is closely watched because CPPIB decided eight years ago to begin actively investing its assets instead of passively investing in investments that matched indexes.

Mr. Wiseman said public stock markets earned “exceptional gains” during CPPIB’s fiscal year, ended March 31, so it was a difficult year to outperform public market benchmarks in the reference portfolio.

He said returns are typically expected to lag the passive benchmark over the short term when public markets perform strongly because there is a a valuation lag for private market holdings – including private equity and real estate – that are difficult to revalue on an annual basis. CPPIB has about 40 per cent of its portfolio in private investments.

Mr. Wiseman said he remains committed to a strategy of increasing investments in private markets, which reduces risk by adding diversity to the portfolio. He said private investments have a lot of “embedded” value that is not easily measured until they are sold.

“We believe it’s an extraordinary result to keep up with the reference portfolio in a period of time where there is extremely bullish equity markets,” he said. “We would have expected generally in market conditions like these that we would have underperformed the reference portfolio, and we were quite pleased we were able to keep up with it.”

In the eight years since CPPIB created its reference portfolio, the fund said it has earned $3-billion of additional returns above the passive benchmark after excluding operating costs.

Mr. Wiseman said Friday that the fund is seeing increasing competition for investment deals as more investment funds look to invest in alternative assets such as private equity and real estate, especially while interest rates remain low and credit is plentiful.

As a result, he said the fund is in a period of “patient” investing, selling some assets that are highly valued and being careful about new investments.

“In my career as an investor, this is probably the toughest market today to operate in as a value investor,” Mr. Wiseman said.

He said most assets are “fairly priced,” and better deals are often more complex or involve emerging markets like China and India that require time and expertise to handle well.

The fund said its $35.8-billion increase in assets last year included $5.7-billion from worker and employer contributions, and $30.1-billion from investment returns earned on the portfolio.

CPPIB also published its executive compensation report Friday, showing Mr. Wiseman earned a total of $3.6-million last year, up from $2.8-million in fiscal 2013. Most of the increase came from incentive programs based on CPPIB’s four-year investment return. André Bourbonnais, senior vice-president of private investments, earned $3.5-million, an increase from $2.6-million last year.
The Canadian Press reports, How your pension is doing: a 16.5% annual return:
The 2013-14 financial year was an unusually strong one for the Canada Pension Plan Investment Board, which earned a 16.5 per cent annual return on the billions of dollars in assets it manages for the national retirement system, but its CEO cautions that level of growth likely won't soon be repeated.

"Although we are pleased with these annual results, this relatively short-term performance is far less meaningful than our long-term results as financial markets can move sharply in either direction over shorter time horizons," CPPIB chief executive Mark Wiseman said Friday as the fund manager released its annual report for the year ended March 31.

Wiseman said all of CPPIB's investment teams made material contributions last year, producing CPPIB's largest level of annual investment income since inception, but noted the Canada Pension Plan isn't expected to need to draw money from the fund until at least 2023 and, even then, at a relatively small amount for several years.
$219B in assets

For the financial year ended March 31, CPPIB had $219.1 billion of assets under management, up from $183.3 billion a year earlier, with the vast majority of the increase coming from investments.

About $30 billion of the increase was due to investments and $5.7 billion came from excess contributions paid to the pension plan by working Canadians and their employers outside of Quebec. By comparison, investments provided only $16.2 billion of net contributions in fiscal 2013 and only $9.5 billion in fiscal 2012.

The CPPIB, one of Canada's biggest pension funds, invests money not currently needed by the Canada Pension Plan to pay benefits. The plan receives its funds equally from payroll contributions from the people who work in Canada — outside of Quebec which has a separate plan — and matching contributions from their employers.

The board has been dealing with the volatility of publicly traded stocks and low returns from government bonds by diversifying into other forms of assets, including equity in private companies and investments in infrastructure such as highways and real estate.

There has been a public debate about whether Canadians will have sufficient income in retirement given that generally people live longer, that there are more people of retirement age and that savings rates are low debt levels high.
Public or private pension savings?

In Ontario, for instance, Liberal Premier Kathleen Wynne has included a separate provincial pension counterpart as one of her party's key election promises ahead of the province's June 12 election. On a federal level, the Harper government has steered clear of calls for increasing mandatory employee-employer contributions to the CPP in favour of a policy that enables voluntary contributions under professional management.

Wiseman says the CPPIB takes no position on whether the Canada Pension Plan is sufficient given overall retirement needs or what changes may be required, but says it has the organization has a "platform" of people, relationships and assets that can be expanded if policy-makers decide that's necessary.
"We are built for scale," Wiseman said. "We know that the fund today is going to grow by 2050 to something like a trillion dollars and we are designing our platform to be able to invest in scale."

Wiseman cautioned that the CPPIB — despite its large size in Canadian terms — competes against much bigger investors in the global market such as private equity funds, sovereign wealth funds and other public pension plans that are also on the hunt for similar types of investments.

He said that makes it difficult to find new investments at a price that provide the returns that are required so the Canada Pension Plan can deliver on its commitments.

"My view is that, at least in my career as an investor, this is probably the toughest market today to operate in as a value investor," Wiseman told reporters in a briefing Friday.
Looking for opportunity

"When you look around the world, you don't see assets are grossly overpriced and you don't see assets that are grossly under-priced."

"In areas where there is opportunity, it tends to be complex and hard to transact."

Wiseman said there may be opportunities in China but there's a limit on what foreign investors can do there and while there may be opportunities in India, they can be complex to execute.

Earlier this year, the fund partnered with residential developer China Vanke Co. Ltd. to invest US$250 million in the Chinese residential market.

CPPIB also recently launched a couple of strategic alliances in India, one focused on office buildings and another on financing for residential projects.
Ben Dummett of the Wall Street Journal also reports, Canada Pension Fund CPPIB Posts 16.5% Return:
Canada's biggest pension fund on Friday posted a 16.5% return for its latest fiscal year, led by gains in its public and private equity holdings in developed and emerging markets.

CPP Investment Board had 219.1 billion Canadian dollars ($201.1 billion) of assets under management at the end of its fiscal year on March 31, up C$35.8 billion from a year ago. The increase included C$30.1 billion in investment income, after subtracting costs to operate the fund, which is the largest level of annual investment income since the fund's inception, CPPIB said. The remaining C$5.7 billion reflects pension contributions.

The fund's performance, despite the big gain, was largely in line with CPPIB's internal benchmark return of 16.4%.

Mark Wiseman, CPPIB's chief executive, said the fund's relative performance isn't surprising, and was actually better than it might seem, when the greater diversity of the fund's holdings compared with its benchmark is taken into account.

CPPIB's internal benchmark comprises a passive portfolio of about 65% publicly traded equities and 35% publicly traded bonds. By comparison, it only has about 60% of the fund in publicly traded securities and the rest in private assets. That means CPPIB couldn't reap the full benefit of equities that soared in 2013 in the U.S., Europe and Japan amid growing investor confidence over the global economic recovery. The fund's private assets include real estate, infrastructure, farmland and equities in private companies.

CPPIB's more diversified portfolio "ought not to keep up in a bull market" in public equities, but in a bear market, "we should outperform" because of the fund's relatively lower exposure to public markets, Mr. Wiseman said at a news conference. In addition, the value of private assets typically declines at a slower rate than public securities in a bear-market environment. But the fund actually outperformed on that basis, since the return was in line with the benchmark, Mr. Wiseman said.

Increasingly, Canada's pension funds are investing more of their money in private assets. That diversification strategy guards against overexposure to any one particular asset. Historically, private assets have also proven to generate bigger relative returns, in part because private markets tend to be less efficient. While public-market gains typically average in the mid- to high-single digits, private assets are expected in some cases to generate gains close to 15% to 20% on average.

Over the last five years, the value of CPPIB's private-asset holdings have more than tripled to C$89.1 billion from C$25.6 billion, and now represent about 40.6% of the fund's holdings.

In the latest year, some of CPPIB's private-equity investments included the acquisition of U.S. life insurance and reinsurance provider Wilton Re Holdings Ltd. for $1.8 billion, giving it a platform to expand into that sector. It also closed the $6.0 billion acquisition with U.S. private-equity firm Ares Management of luxury retailer Neiman Marcus Group Ltd. In the real-estate sector, it formed a new venture with China Vanka Co., China's biggest residential developer, and new real-estate ventures in India.

CPPIB's large size and its long-term investment horizon that it measures over decades, can give it an advantage over other institutional investors in scouring and bidding for investments. But Mr. Wiseman says the current investment climate "is probably the toughest" he has seen in his career for a value investor like CPPIB.

That is because assets are "by and large fairly priced," making it difficult to find investments the fund believes the market is mispricing or undervaluing, he said.

Some opportunities exist in China and India, but the complexity of operating in those countries makes investing there difficult, Mr. Wiseman noted.
Finally, Andrea Hopkins of Reuters reports, CPPIB notches 16.5 percent return, eyes developing markets for deals:
The Canada Pension Plan Investment Board, one of the world's biggest dealmakers, said it is hard to find good deals because most assets are fully priced, but it will be patient and focus on emerging markets to find deals that offer long-term value.

CPPIB, which manages Canada's national pension fund, said on Thursday its assets rose to a record C$219.1 billion ($201.39 billion) at the end of fiscal 2014, as its investment portfolio returned 16.5 percent for the year ended March 31.

Chief Executive Mark Wiseman said CPPIB will put a disproportionate amount of effort into finding deals in developing markets because its long-term investment horizon allows it more time than many competitors to reap the benefits.

"We are continuing to try and develop our portfolio in growth markets, places like India, Brazil, China - we see those markets providing good long-term value for the fund over all," Wiseman told Reuters following the release of the fund manager's results.

CPPIB opened an office in Sao Paulo in April to access Latin American markets including Brazil, Peru, Chile, Colombia and Mexico.

Wiseman said the flow of acquisitions will likely remain subdued in 2015 because competitors have come back into the market after stepping back in the wake of the financial crisis, and there are lots of capital chasing investment opportunities.

"In my career as a investor this is probably the tightest market to operate in as a value investor," he told reporters. "Assets are by and large fully priced ... and if I had to use one word to describe the mentality around here it is 'patient.'"

The fund manager struck 103 global deals in fiscal 2014, 45 of which were over C$200 million.

Wiseman said CPPIB will focus on assets like infrastructure, real estate and private equity, and build out its public market capabilities in those developing markets.

The eighth year of active management of the fund has boosted foreign assets to 69 percent of the portfolio, while Canadian assets make up 31 percent of the book.

The 16.5 percent 2014 investment gain was up from 10.1 percent a year earlier and its fifth straight gain after the fund manager suffered losses in 2008 and 2009.

Investment returns were led by a 36.8 percent gain in private emerging market equities, a 35.1 percent rise in private foreign developed market equities, a 30.1 percent gain in Canadian private equities, a 26.3 percent gain in public foreign developed market equities, a 20.0 percent gain in "other debt," an 18.0 percent gain in real estate and a 16.6 percent gain in infrastructure.

Weaker parts of the portfolio included investments in Canadian public equities, which returned 15.6 percent, public emerging market equities, which returned 5.8 percent, bonds and money market securities, which returned 0.3 percent, and non-marketable bonds, which notched a negative 0.1 percent return.
You can read more on CPPIB's FY 2014 results on their website here. The 2014 Annual Report is available here. I will provide my general thoughts on these results and refer to the table below (click on image):

Here are my general thoughts:
  • Except for bonds, these results are very strong across the board. If you look at the table above, you will see exceptional returns in both public and private markets except for bonds which were basically flat in fiscal 2014.
  • Almost $10 billion of the gain came from foreign exchange as the Canadian dollar slid in FY 2014 (I warned all of you to short Canada back in December). And it could have been better if CPPIB didn't hedge F/X. Footnote #4 in the table above explicitly states that the total fund return in fiscal 2014 includes a loss of $543 million from currency hedging activities and a $1 billion gain from absolute return strategies which are not attributed to any asset class.
  • CPPIB should follow AIMCo and others and report net returns in their headlines. Their press release, however, does state the following: "In fiscal 2014, the CPP Fund’s strong total portfolio return of 16.5% closely corresponded to the CPP Reference Portfolio with $514 million in gross dollar value-added (DVA) above the CPP Reference Portfolio’s return. Despite the strong CPP Reference Portfolio return, we outperformed the benchmark due to strong income and valuation gains from our privately-held assets. Net of all operating costs, the investment portfolio essentially matched the CPP Reference Portfolio’s return, producing negative $62 million in dollar value-added."
  • The press release, however, emphasizes long-term results: "Given our long-term view and risk/return accountability framework, we track cumulative value-added returns since the April 1, 2006 inception of the CPP Reference Portfolio. Cumulative gross value-added over the past eight years considerably outperformed the benchmark totalling $5.5 billion. Over this period cumulative costs to operate CPPIB were $2.5 billion, resulting in net dollar value-added of $3.0 billion. "
  • I realize CPPIB is running a mammoth operation and is being "built for scale" but operating costs matter and they include fees being doled out to external public and private managers. This is why I'm a stickler for transparency on all costs, fees and foreign exchange fees. At the end of the day, whether you are running a pension fund, hedge fund, mutual fund, or private equity fund, what matters is the internal rate of return (IRR) net of all fees and costs, including foreign exchange transactions.
  • Mark Wiseman is a very smart and nice guy. I've spoken to him on several occasions and he knows his stuff. He's absolutely right, in markets where public equities roar, CPPIB will typically under-perform its Reference Portfolio but in a bear market for stocks, it will typically outperform its Reference Portfolio. Why? Because private market investments are not marked-to-market, so the valuation lag will boost CPPIB's return in markets where public equities decline. Over the long-run, the shift in private markets should offer considerable added value over the Reference Portfolio which is made up of stocks and bonds.
  • But while I understand the diversification benefits of shifting a considerable chunk of CPPIB's assets into private markets, this shift presents a whole host of operational and investment risks which need to taken into account. My biggest fear is that too many pensions and sovereign wealth funds are chasing big deals around the world, enriching private equity and real estate gurus, and bidding up the price of assets. Lest we all forget the wise words of Tom Barrack, the king of real estate who cashed out right before the financial crisis in 2005, stating back then: "There's too much money chasing too few good deals, with too much debt and too few brains."
  •  Shifting more and more assets into private markets has become the new religion at Canadian public pension funds. It goes back to the days of Claude Lamoureux, Ontario Teachers' former  CEO, who started this trend, made the requisite governance changes and started hiring and compensating people properly to attract and retain talented individuals who know what they're doing in private markets. But I agree with Jim Keohane, CEO of HOOPP, a lot of pensions are taking on too much illiquidity risk, and they will get crushed when the next crisis hits.
  • Of course, CPPIB and PSP investments have a huge liquidity advantage over their counterparts in that their cash flow is positive for many more years, which means they can take on a lot of liquidity risk, especially when markets tank.
  • But right now, the environment isn't conducive to making  a lot of deals in private markets which is why Mark Wiseman and André Bourbonnais, CPPIB's senior vice-president of private investments, are going to sit tight and be very selective with the deals they enter. CPPIB's size is more of a hindrance in this environment because they need to get into bigger and bigger deals which are full of risks when other players are bidding up prices to extreme valuations.
  • As far as India, China and other BRICs, there are tremendous opportunities but huge risks in these countries. Hot money flows wreak havoc in their public markets and if you don't pick your partners carefully, good luck making money investing in their private markets.
  • In terms of compensation, I note that both Mark Wiseman and Mr. Bourbonnais both made almost the same amount in fiscal 2014 ($3.6 million and $3.5 million). I contrast this to PSP's hefty payouts for fiscal 2013 where Gordon Fyfe, PSP's CEO, made considerably more than other senior executives (all part of PSP's tricky balancing act). This shows me that CPPIB's compensation, while generous, is a lot fairer than that of PSP which has the same fiscal year. PSP is outperforming CPPIB over a four-year period but still, the difference in comp is ridiculous considering the outperformance (value added over a four year period) isn't that much better and the fact is that PSP is based in Montreal which is way cheaper than Toronto in terms of cost of living (I have to give credit to Gordon, however, he sure knows how to ensure he and his senior managers get paid extremely well. He's a master at charming his board of directors).
  • Finally, one area where CPPIB is killing PSP Investments is in plain old communication (you can even follow CPPIB on Twitter now). I embedded four articles from Canadian and U.S. sources in this comment (there are more). The pathetic coverage of PSP's results isn't just because its results come out in July when Parliament approves the annual report, it's because PSP's public relations and website stink when it comes to communication. Again, that's all Gordon's doing, he doesn't like being discussed in the media, keeps everything hush, and basically thinks the annual report suffices.
Those are my general thoughts on CPPIB's fiscal 2014 results. If you have any comments, feel free to reach out to me  at

Below, Mark Wiseman, CEO of CPPIB, talks about the FCLT initiative and the importance of  long-term investing. Very wise man, Canadians are lucky he's running their pension plan and the federal government is wrong not to enhance the CPP for all Canadians.

Thursday, May 22, 2014

Hedge Funds Won't Make You Rich?

Noah Smith, an assistant professor of finance at Stony Brook University, wrote a comment for Bloomberg View, Hedge Funds Won't Make You Rich:
The recent release of Institutional Investor Alpha’s hedge-fund survey has everyone asking how the fund managers continue to make so much money. Academics and journalists alike point out that hedge funds, as a class, haven’t delivered above-market after-fee returns for quite some time. Hedge funds, of course, get paid whether the market goes up or down, so the real question is why hedge funds continue to receive large inflows of capital from pension funds and other investors. The New Yorker magazine’s John Cassidy has a good roundup of the most prominent theories. He includes some good links to research on the question of whether hedge funds deliver superior risk-adjusted returns, or offer significant diversification potential.

But the real question is: Why would people expect hedge funds to deliver superior returns in the first place?

People often seem to treat the term “hedge fund” as if it’s a shorthand for “money manager of unusual skill.” At the Skybridge Alternatives Conference (SALT) last year, host Anthony Scaramucci told attendees that “Mutual funds are the propeller planes…while hedge funds are the fighter jets.” And of course we’ve all heard of those famous world-beating billionaire hedge-fund managers like John Paulson, Ken Griffin or Cliff Asness.

But is there any fundamental characteristic common to all or most hedge funds that makes them “fighter jets”? “Hedge fund,” after all, is just a legal category. There are regulations governing what kind of assets a fund is allowed to trade, and what kinds of clients the fund can service. Hedge funds are only allowed to sell to certain types of investors -- rich people, large institutions and those who qualify as so-called sophisticated investors. In exchange for this limitation on who can invest in them, they are exempt from most restrictions on what kinds of assets they can trade and how much leverage they can take on.

Theoretically, this exemption should mean that hedge funds offer the potential for diversification. Since they can invest in things other funds can’t, buying into hedge funds can theoretically give an investor access to a wider universe of assets.

But beyond that, there is little reason to believe that hedge funds as a group offer anything special. After all, any Tom, Dick or Harry can start a hedge fund. That’s right -- all you need is a business license. You can start a hedge fund without ever having managed a dime of money in your life. That’s called “free entry.” In economics, free entry means that average profits in an industry (net of opportunity cost) should be competed away to zero. Why should hedge funds be any different?

In other words, if a pension-fund manager or rich investor hurls his money at a fund just because it's called a “hedge fund,” he isn't making a sophisticated, market-beating choice; he is paying through the nose to take a lot of risk and get a bit of diversification. Thus, it’s no surprise that during the past couple of decades, even as money has continued to flow into hedge funds, their return hasn't impressed. Free entry has competed away the ability of the hedge-fund class to beat the market.

So how did hedge funds get such a good reputation? Well, it’s possible that their eye-catching early performance was a kind of loss leader. In the beginning, investors probably shied away from this scary new asset class, so higher after-fee returns were necessary to convince them that hedge funds were for real. After the word got out about the high returns and hedge funds became known as “fighter jets,” hedge funds were free to charge higher fees and a huge flood of scrubs entered the profession. The net result was that after-fee returns to the hedge fund class as a whole collapsed.

Now, this doesn’t mean there aren’t hedge-fund managers who can beat the market. As in the venture-capital industry, there seem to be a few superstars who really can deliver superb performance, year in and year out. You already know many of their names. The catch is, these superstars are unlikely to need your money. By the time we discover them, they already have a lot of capital, and taking on more would make it hard for them to keep generating market-beating returns. In other words, the only way to find a hedge-fund who can reliably beat the market for you is to pick one who’s not yet a star, but is destined to become one.

So here’s the real question: Do you, as a pension-fund manager, or rich individual investor, think that you have an above-average ability to pick out the non-superstar hedge funds that will outperform in the future? And if so, why? Also, is your superior fund-picking ability worth the average hedge-fund fee?
If you decide the answer is “no,” then you should consider investing in an index that tracks average hedge-fund returns (like the HFRX Global Hedge Fund Index), in order to get that bit of diversification without paying the big hedge-fund fees.
I like this comment until that last paragraph. I wouldn't touch the HFRX Global Hedge Fund Index for the same reason that I wouldn't touch any private equity index. If you're not invested in top decile funds, it's not worth investing in any hedge fund or private equity index. You are better off investing in S&P 500 over the long-run.

I've already covered some of my thoughts on the great hedge fund mystery and ended that comment by stating:
...any guy who would surgically implant fat cells in his penis needs to get his head examined. And any pension fund that needs to be invested in the "biggest" hedge funds no matter what the fees and performance needs a reality check. When it comes to penises and hedge funds, bigger isn't always better! 
I wasn't kidding around. People are stupid. In fact, the older I get, the more cynical I've become on the collective stupidity of the masses. Millions of people are led into believing all sorts of garbage and their insecurities translate into big dollars for many industries, including the alternatives industry.

The same thing goes on in the pension fund world. "Oh, Joe just wrote a $200 million ticket to hedge fund X and a $500 million ticket to private equity fund Y, he must have a big penis but I will show him!" Unfortunately, the only thing you're showing Joe is how much shit for brains you've both got!

Go back to read my comments on Ron Mock's thoughts on hedge funds here and here. I don't want to make Ron sound like the guru of hedge fund investing. He's not, he's made plenty of mistakes and got clobbered in 2008 investing in all sorts of illiquid and funky hedge funds which I wouldn't have touched with a ten foot pole.

But Ron knows all about alpha and he learned from his mistakes, including mistakes from managing his own sizable fixed income arbitrage fund which blew up because of a rogue trader. He also knows how important it is to make sure alignment of interests are there. Teachers has a hedge fund bogey of T-bills+5% and they invest mostly in market neutral strategies. When it comes to assets under management, their sweet spot for hedge funds managing between $1 and $3 billion, big but not too big that they have become large and lazy asset gatherers collecting that 2% management fee, focusing more on marketing than performance. Also, after the 2008 debacle, Teachers was forced to tighten up liquidity risk, so they moved most of their hedge funds on to a managed account platform (managed by Innocap) but still invest in illiquid strategies (which are not conducive to managed account platforms!).

Back to the comment above. The only people getting rich on hedge funds are overpaid hedge fund gurus, brokers recommending the new asset allocation tipping point (so they can generate more fees), and useless investment consultants who are now competing with funds of funds, investing in hedge funds. The name of the game is fees and asset gathering.

But the alternatives gig is up. When you see CalPERS chopping its allocation to hedge funds, you know something is up. Also, pension funds are focusing a lot more on fees and I think the era of fee compression has just begun.

One little mistake I made in some recent comments was mixing up the hurdle rate with the high water mark. I challenged the Bridgewaters and Blackstones of this world to do away with management fees completely, share the pain of deflation, and set a hurdle rate of T-bills + 5% before they charge performance fees (PE funds all use a hurdle before they charge performance fees). Of course, no mega fund will ever accept my challenge and why should they? Dumb public pension funds are more than happy to feed these alternative powerhouses and keep paying them outrageous fees.

This is one area which Thomas Piketty needs  to examine. The ability of the financial elite to bamboozle pensions into investing in high fee funds has led to enormous wealth. But while the media loves glorifying hedge fund "gods", I remain very skeptical on pensions praying for an alternatives miracle. Also, as I wrote in the hedge fund curse, even the big boys lose money, and lots of it, so don't blindly follow their 13-F moves.

Finally, remember the wise words of Leo de Bever, who is stepping down from AIMCo. Leo once told me "if I can find the next Warren Buffett, I'd invest with him, but I can't, so I'd rather bring assets internally and cut the fees I pay external managers." Smart man which is why you won't see him get all giddy on hedge funds.

Below, Anthony Scaramucci of Skybridge Capital on the sovereign debt market and other major themes of the conference in Las Vegas. Who would have thought Greek bonds would have been the best asset class last year? Dan Loeb and yours truly, that's who!

Wednesday, May 21, 2014

The Era of Fee Compression?

Mark Cobley of Financial News reports, Public pension funds add to pressure on fees:
Investment officers at the UK’s £180 billion Local Government Pension Scheme today added their voices to a growing chorus calling for better disclosure of asset managers’ “hidden” costs and fees.

Executives responsible for running the council workers’ pension scheme, which consists of 100 sub-funds administered by local authorities across the UK, gathered in the Cotswolds Tuesday for the annual NAPF Local Authority conference.

Investment fees were top of the agenda. Jonathan Hunt, head of treasury and pensions at the Tri-Borough, a co-operative venture between Westminster, Hammersmith & Fulham and Kensington & Chelsea councils in London, told delegates: “As a user of fund managers, we are very aware that many costs are ‘hidden’.

“I don’t mean this in a malignant sense. I only mean there are many costs – transaction costs, taxes, trading costs, third-party brokerage fees – that I don’t get an invoice for, and so it’s difficult to challenge them.”

Hunt – who said he was quite happy for asset managers to receive fair compensation – said it was arguably more important for the investment industry to convince “regulators and legislators” that these costs were reasonable, as well as the pension funds themselves.

The UK national government has heaped pressure on council pension funds to reduce costs in the past year. Earlier this month, the local government minister, Brandon Lewis, set out plans for forcing or encouraging the funds to shift billions out of actively managed mandates and into index-tracking funds, saying this would save £190 million a year in transaction costs.

This has proved controversial in the sector. Joanne Segars, chief executive of the National Association of Pension Funds, which is organising the conference, said she had spoken to many delegates who argued that public funds already have low running costs, and many had successfully used active managers to beat their investment targets. Segars argued the government should allow funds "flexibility" on the question.

Lewis will address the conference on his reform plans later today.

Rodney Barton, director of the West Yorkshire Pension Fund, said he had pressed for, and got, full disclosure of transaction costs from managers through “contract notes”.

He said: “These identified all the costs, including stamp duty and commissions paid, because in certain markets, we found that managers were not supposed to be paying these away and they were.”

But Hunt said that many smaller local government schemes might not have adequate in-house staff resource to pore through all the investment information in such notes.

The debate at the LGPS conference comes against a wider backdrop of pressure on asset managers' costs. Two weeks ago, the Financial Conduct Authority said most managers were not disclosing enough about their charges on £131 billion of funds in the retail market.

The Investment Management Association has responded with a plan for “all-in”, “pounds and pence” fee disclosure, and a consultation with its members on how they should disclose portfolio turnover.
It's about time global public pension funds had a real discussion on fees. In a deflationary world with paltry returns, fee compression will be on top of the agenda.

In recent weeks, I've discussed private equity's hidden fees and explained in detail Wall Street's secret pension swindle and how it's enriching the 1%, which now includes a bunch of overpaid hedge fund gurus charging 2 & 20 on multi billions. I also explained the great hedge fund mystery and why the alternatives gig is up as large pension funds like CalPERS start chopping their allocation to hedge funds.

Moreover, I explained why institutional investors and the financial media need to stop worshiping so-called hedge fund "gods" and get on to discussing what pension funds are paying all their external managers, brokers and useless investment consultants.

Many elite hedge funds and top institutional investors read my blog. They know my thoughts on why despite whiffs of inflation, the main threat to the global economy remains deflation. George Soros knows it too which is why he wants Japan's mammoth pension fund to crank up the risk.

But in a deflationary world investors worry about costs and fees. With the 10-year bond yield hovering around 2.5%, it will be much harder for investors to obtain their actuarial rate of return. This is why Bridgewater recently sounded the alarm on public pensions. Ray Dalio and Bob Prince aren't stupid. They too read my blog.

But I have a huge problem with the Bridgewaters and Blackstones of this world. It basically centers around alignment of interests. Let's do the math, shall we? When a hedge fund or private equity juggernaut receives 2% management fee on $100 billion+, that's a huge chunk of dough. Even 1% on these astronomical amounts is ridiculous for turning on the lights.

I recently challenged both Bridgewater and Blackstone to do away with management fees completely, share the pain of deflation, and set a hurdle rate of T-bills + 5% before they charge performance fees (PE funds all use a hurdle before they charge performance fees). Of course, neither of these mega funds will ever accept my challenge and why should they? Dumb public pension funds are more than happy to feed these alternative powerhouses and keep paying them outrageous fees.

The entire hedge fund and private equity model needs to be revisited. Nobody has the guts to say it but I think 2 & 20 is insane, especially for the large shops because it promotes lazy asset gathering and diverts attention away from performance. 2 & 20 is fine for hedge funds starting off but once they pass a threshold of assets under management, that management fee should be drastically reduced to 50 basis points or completely cut.

I know, it's so much easier collecting that 2% management fee, especially when managing billions, but the economics of such deals aren't in the best interests of pensions or their beneficiaries. Importantly, the institutionalization of the hedge fund and private equity industry has mostly benefited the large shops but at the expense of pensions which pay out astronomical fees.

I would love to take part in a panel to discuss fees and benchmarks of alternative investments. Speaking of which, AIMA Canada is going to be holding events discussing life after benchmarks in Toronto and Montreal. I was approached to find people for the Montreal event taking place next Thursday and suggested a few names as well as inviting me to be part of the expert panel (that didn't fly over too well because people know my thoughts on benchmarks).

My former boss, Mario Therrien, and former colleague, Mihail Garchev, will be speaking. I might attend but to be honest, the topic bores me to death and I will revisit it again when I delve deeply into the annual reports of Canada's public pension funds. Mihail will do a great job researching the topic but he needs to polish up his presentation skills. Mario is an excellent speaker but he will be defending his benchmark fiercely, which isn't really representative of his underlying portfolio.

Anyways, enough of that, the focus of this comment is fees or more precisely, why in an era of deflation and severe underperformance from active managers, fees must come down drastically, especially at the large shops managing billions. To all of you gurus managing several billions, take my challenge and see how rough it is when you do away with that all-important management fee which you receive no matter how poorly you perform.

Finally, let me take a moment to thank institutional investors who recently contributed to my blog. I am waiting for many more to subscribe and/or donate via the PayPal buttons at the top of this page. Also, I am done accepting meetings with hedge funds and private equity funds. If you want something from me, the minimum donation is $500 and if you want me to help you open doors (only if you're good and pass my due diligence), the minimum is $1000. The $5000 a year option is for special clients who need consulting services.

I am also open to steady work but it will be on my terms and you better get ready to pay up. I know my worth, my contacts alone are incredible. I'm not lowering my standards for anyone and I am not in a position to relocate, so if you have anything interesting to discuss for a job where I can remain in Montreal, contact me directly at Don't mistake this as arrogance or desperation, it's called self confidence and I am not going to jump on anything even if it pays well.

Below, CNBC reporter Lawrence Delevingne explains why hedge fund managers usually make much more money than their mutual fund counterparts -- and how that could change if enough switch over.

Delevigne focuses on the 20% performance fee but as I state above, the 2% management fee is the real problem, especially for the large shops managing billions. Many of them have become large, lazy asset gatherers who focus more on marketing than performance. Things are slowly changing but the era of fee compression has just begun and in a deflationary world, fees will keep falling hard.