Thursday, July 17, 2014

CalSTRS Takes CPPIB to School?

Mark McQueen of the Wellington Financial blog wrote a comment yesterday, CalSTRS exec gives a frank assessment of CPP Private Equity portfolio (added emphasis is mine):
Stupid as it has been for me to turn a critical eye onto the CPP Investment Board over the past seven years, there been some third party validation of late of much of the analysis and commentary that has me in the doghouse in certain quarters.

First, we had the Globe and Mail finally bearing down last month on some of the many topics and issues you’ve read about over the course of seven long years. Today’s validation comes via the Director of Private Equity at California State Teachers’ Retirement System as she weighs in, too; albeit indirectly. CalSTRS, with $189 billion under management, describes itself as “the largest educator-only pension fund in the world” and is very much a peer of Canada’s CPP in terms of size and asset allocation strategy.

CalSTRS has US$21 billion of private equity exposure; a smaller allocation than CPPIB’s $41 billion, but still chunky enough to give CalSTRS every reason to be transparent with its stakeholders about how that investment is doing, and where it is headed over the coming years.

Courtesy of a forthright interview with Buyouts Magazine, we can glean a frank assessment of how CPP’s (ie. our) mega buyout portfolio is doing too, since we share many of the same “2005-2008″ private equity fund commitments that CalSTRS invested in.

I know it’s not from our own fund managers, but here’s the news nonetheless, from Margot Wirth of CalSTRS (H/T again to Reuters):
- CalSTRS has a “very high exposure to those types of funds”, and will be reducing them going forward
- “Those vintages are not going to end up terrible” in terms of financial returns
- “2005 to 2008 account for 65 percent of the portfolio’s estimated $21 billion private-equity exposure”
- “many of those funds have performed poorly relative to benchmarks”
- CalSTRS “plans to put more emphasis on small and mid-market buyout, debt-related and emerging market funds”
- “Room for the pivot will be made by reducing the size of commitments to large buyout funds”
- CalSTRS “already has exposure to emerging managers and niche strategies through its $818 million Private Equity Proactive Portfolio. That program had been managed by a dedicated staff operating independently of the rest of the private equity team for most of the last decade. CalSTRS has spent the last year integrating that staff into its main private equity team, moving Proactive opportunities through the same due diligence process used for larger, more established managers.”

There you have it. As detailed and clear a discussion as a stakeholder could hope for about the state of the allocation and the plans for the near term. Via the media. Imagine what we’d learn if the Canadian scribes did a little less cheerleading and a bit more analysis about one of the largest buckets of investment capital the world over.

What we can deduce, according to CalSTRS, is that many of CPPIB’s 2005-2008 mega private equity commitments “have performed poorly relative to benchmarks.” Funds that Ms. Wirth is referring to likely include many of the big names, as these are PE vehicles that both CPP and CalSTRS are currently invested in (based upon public disclosure):
Apax Europe VII (2007), Apollo VI (2005), Apollo VII (2007), Blackstone Capital Partners V (2005), Blackstone Capital Partners VI (2008), CVC European Equity Partners V (2008), First Reserve Fund XI (2006), First Reserve Fund XII (2008), FountainVest China Growth Fund (2008), Hellman & Friedman Capital Partners VI (2006), Hellman & Friedman Capital Partners VII (2009), Hony Capital Fund 2008 (2008), Onex Partners III (2008):, Providence Equity Partners VI (2006), TPG Partners V (2006), TPG VI (2008), and Welsh, Carson, Anderson & Stowe X (2005).
We have billions and billions in these funds. Not that this is news to you, since you were well apprised as we went from allocating $1-$2 billion to external private equity funds to $8 billion per annum around the time that Mark Wiseman took over as SVP and Head of CPP Private Investments (see representative prior posts “Doubling Down on Private Equity at CPP Investment Board” Feb 20-09 and “61% of CPPIB Private Equity Commitments sampled are currently below solvency threshold” May 21-13). CalSTRS wasn’t the first big pension plan to make the point that we’d bought a bad batch, but they are definitely the first that I’ve seen who are actually investors in these particular funds. AIMCO’s CEO beat them to the punch, but CalSTRS deserves full credit for not mincing words (see prior post “AIMCo’s take on PE marks stark contrast to CPPIB” Aug 24-11).

Some will say that it isn’t Mr. Wiseman’s fault that 2005-08 turned out to be substandard vintage years for the mega buyout world. I agree, but the CPPIB’s team did dramatically increase our allocation — in both relative and absolute terms — to this asset class at absolutely the wrong time. Again, who knew? But the management and Board of Directors continue to refuse to provide clear disclosure about the true IRR financial performance of these funds, unlike CalSTRS, CalPERS, Oregon, WSIB and so forth (see prior representative post “CPPIB should take a page from Oregon’s book” Sept. 12-10). That can’t be blamed on back luck or third party LBO managers.

As for putting more of a focus on smaller and more diverse fund strategies, which is clearly underway at CalSTRS, CPPIB has been going the opposite way for as long as I can remember. This has always been a key concern of mine, as longstanding readers may recall. From 2007:
I cannot accept the argument that they are now “too big” to directly back Canadian VC funds. It takes just a few hours a year to monitor a fund once you’ve done the initial due diligence and made the commitment.
CalSTRS is making changes in how it interacts with smaller funds too, as they have taken steps to directly manage the “emerging manager”, small cap PE or VC universe, rather than outsource that to a Fund-of-Fund manager, ala CPPIB.

Most fascinating of all perhaps, is that CalSTRS is admitting to these concerns, and making immediate adjustments, despite turning in a return of 18.7% in its most recent fiscal year. Well ahead of CPPIB’s 16.5% number. Over a 10 year basis, CalSTRS’ return is 60 basis points higher than CPPIB’s (7.7% versus 7.1%); with that kind of enhanced performance, CPP could reduce payroll taxes for Canadian employers and workers, for example.

Sixty bps is quite the incremental value-add over an extended period. I can’t be sure if the premium performance directly leads to more transparency around how the assets are doing, but Canadians definitely benefit from the U.S. culture of complete disclosure from many of their pension stewards (see representative prior post “12 questions CPP Investment Board won’t be answering on BNN today” Jan. 17-13).

And for that we are grateful.
Wow! Where do I begin? I read this last night and emailed the link to Mark Wiseman asking him if he read it and has comments. He replied "Nope x2." I told him I am going to tackle it and he told me "enjoy."

So let me take the time to critically examine this blog comment. In the interest of full disclosure, CPPIB is one of the large Canadian pension funds that subscribes to my blog (HOOPP is the other). And just because they subscribe, it doesn't mean that I'm going to send flowers their way. Just like everyone, I praise the good things they do and criticize the bad things (go back to read my recent comment on CPPIB's struggle with big, bold investment bets).

Back to Mark McQueen's blog comment. He obviously has an axe to grind with CPPIB and it comes out when he states the following:
I cannot accept the argument that they are now “too big” to directly back Canadian VC funds. It takes just a few hours a year to monitor a fund once you’ve done the initial due diligence and made the commitment.
When I read this, I understood his agenda. Interestingly, Bison, a firm that specializes in private equity data, put out a blog comment recently on how public pensions' appetite for VC jumped in 2013.

My take on venture capital? Most public pension funds are going to lose their shirts investing in VC. In my lengthy and personal comment on why Gordon Fyfe left PSP to join bcIMC, I forgot to mention the famous meeting with Doug Leone of Sequoia Capital, one of the best VC funds in the world. I discussed it in my comment on CalPERS revamping its PE portfolio:
... I remember when I was working at PSP helping Derek Murphy set up private equity, I got him and Gordon Fyfe to meet Doug Leone, one of the founders of Sequoia Capital. In the VC world, Sequoia Capital are gods. They are part of a handful of elite VC funds and they command respect because they seeded Apple, Google, Oracle and many other successful technology powerhouses.

Anyways, I don't know where I got Doug Leone's name, probably from one of the many books I bought, but I just called him up and asked him if he would meet with Derek and Gordon. At first, he refused and told me straight out: "Don't bother investing in venture capital funds unless you want to lose all your money. We're not interested in meeting PSP or any public pension fund. Our last $500 million fund was oversubscribed by $4.5 billion. We're fighting amongst partners as to whether to allocate more money between Yale or Harvard's endowment fund. "

I kept pleading with him to meet Derek and Gordon. I even called him three times in one day until he finally gave in: "Ok kid, I like your persistence, tell them they got thirty minutes." Gordon and Derek loved that meeting and realized venture capital isn't a space PSP will ever invest in. They both told me "we never felt so poor in our lives." Of course, wealth is all relative as they're both doing just fine at PSP, collecting millions in comp beating their bogus benchmarks (they finally got the PE benchmark right!).
Admittedly, this is a bit of a self-serving answer on Doug Leone's part but for the most part he's absolutely right, investing in VC is a money losing proposition and only the best of the best make money in this space.

My two year stint replacing a senior economist at the Business Development Bank of Canada (BDC) confirmed this. BDC was hemorrhaging money in their VC portfolio and had to completely revamp it. The guy who hired me, Jérôme Nycz, was appointed executive vice president, BDC Capital in 2013 and is now in charge of this portfolio (I heard it's better but it's still a very risky portfolio).

Anyways, all this to say that while McQueen wants CPPIB to invest directly in VC funds, I think he's nuts and the evidence doesn't support his case. Even if CPPIB did invest directly in VC and made money (a big IF), it would be peanuts in terms of the overall portfolio and wouldn't make a big difference in terms of value add. Given its huge size, scale is a huge issue for CPPIB which is why they look to be part of big deals around the world (this is hard when everyone is piling into PE, fueling a big bubble).

And unlike other large Canadian pension funds, CPPIB doesn't invest directly in private equity or real estate (only in infrastructure). They typically co-invest with their partners, which are all listed on their website, and they want first dibs on big transactions but they are very cognizant of the environment and are not willing to participate in deals at any price.

McQueen raises other issues in his comment. He's right that CPPIB "doubled down" on buyout funds at the worst possible time but that's because assets under management were ballooning at the time so they had to invest more in private equity. And I got news for him, they weren't alone. When I was helping Derek Murphy set up private equity at PSP, we knew the timing was all wrong and there was huge vintage year risk so we proceeded cautiously at first. But once the asset class is approved and you have to invest, you need to put that money to work. CPPIB had way more assets under management at the time, so they invested correspondingly more in private equity funds.

Now, let's pretend for a second that CPPIB or PSP didn't invest in vintage years 2005-2007 and left that money in public markets. They still would have gotten clobbered during financial crisis but with less liquidity risk and less fees. The thing is, unlike other more mature pension funds, CPPIB and PSP are young funds and they are cashflow positive for many more years so they can afford to take on illiquidity risk that others can't. And they typically do so when there is a crisis and everyone else is selling.

Mark Wiseman isn't a dummy, far from it.  He knows the challenges CPPIB is facing trying to find private market deals in this environment. And he also knows CPPIB will underperform its benchmark portfolio when public markets are soaring. He explained this in detail when he went over CPPIB's FY2014 results.

Importantly, in markets where public equities roar, CPPIB will typically underperform 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. Also, by definition, private market assets are not as efficiently priced as public market assets and the right partners will lead them to the right deals and unlock value in these private assets. So, 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.

Cynics will snivel: "Leo, you know it's all bullshit, these are all accounting/ valuation gimmicks  that Canada's large pension funds use to add fictitious value on any given year to beat their bogus benchmarks in private markets and collect millions in compensation." They are right for any given year but performance and comp is measured and based over a four-year period, not just one year. So if CPPIB's strategy is to invest a large chunk of assets in private markets, taking on huge illiquidity risk, their performance should be measured over a ten year period. And their Reference Portfolio is arguably one of the hardest to beat among all of Canada's large public pension funds.

In this regard, McQueen is comparing apples to oranges when he compares CalSTRS to CPPIB. They are two different funds with different maturities, different liabilities, and different objectives. CPP is a partially funded (not fully funded) plan and it is meeting its actuarial target. CalSTRS is a fully funded plan and in April, its pension shortfall stood at $74 billion, meaning it's about 70 percent funded for the long term and expects to run out of cash by 2046. To be fair to CalSTRS, there are a lot of reasons behind that shortfall and it's not due to their investment performance, which consistently ranks among the best of the very large U.S. public pension funds.

McQueen also compares performances between CPPIB and CalSTRS, neglecting to mention they have different fiscal years (CPPIB's is March 31st while CalSTRS 's end at the end of June) and they have different risk profiles (because they are completely different funds!). He writes:
Most fascinating of all perhaps, is that CalSTRS is admitting to these concerns, and making immediate adjustments, despite turning in a return of 18.7% in its most recent fiscal year. Well ahead of CPPIB’s 16.5% number. Over a 10 year basis, CalSTRS’ return is 60 basis points higher than CPPIB’s (7.7% versus 7.1%); with that kind of enhanced performance, CPP could reduce payroll taxes for Canadian employers and workers, for example.
Huh?? Forget the fact that they have different fiscal years. One fund is based in the U.S., has more exposure to U.S. stocks and reports its performance in U.S. dollars.

And what the hell is he talking about when he says "with that kind of enhanced performance, CPP could reduce payroll taxes for Canadian employers and workers."? This is pure rubbish! I actually want to see payroll taxes go up so that we enhance the CPP and bolster Canada's retirement system which is failing our citizens and condemning them to pension poverty.

But let me tell you one area where I agree with McQueen. I wrote about it when I went over CPPIB's struggle with big, bold investment bets:
One other thing everyone does is talk up their successes in private markets but hide their miserable failures. I don't particularly like Mark McQueen, the guy who runs Wellington Financial mentioned in the article above, and think he has an agenda against CPPIB. But he's right that these large pension funds have had some serious flops in private markets and they all hide the bad news.

Why do they do it? It's all part of image and public relations. They want to get paid big bucks for managing billions from captive clients, even if in some cases this comp is totally unjustified, so they focus on highlighting their successes and hide their failures. The problem is these are public pension funds and they need to be a lot more transparent about their successes and failures in public and private markets (publish net IRRs of every single internal and external investment portfolio).
Back in the summer of 2007, when I wrote my governance study for the Treasury Board and pissed off PSP to the point where they were sending me silly legal letters by bailiff early in the morning (unfrigging believable the crap I had to put up with back then), I wrote about the need to enhance disclosure of reference benchmarks and performance across public and private portfolios and specifically referred to CalSTRS, Ohio and a few other U.S. state pension funds. CalSTRS does a wonderful job disclosing the performance IRRs of all its external managers by fund and vintage year (I would love it if they added the total fees they paid out to each fund). Canada's large public pension funds should all follow their lead in this regard.

If you have any comments, feel free to email me or post them below. I don't have a monopoly on wisdom when it comes to pensions and investments but I think I do a decent job presenting a balanced view which is why many institutions read me every day. Please remember to donate and/or subscribe at the top right-hand side to show your appreciation.

Below, Chris Ailman, CalSTRS chief investment officer, discusses market opportunities amid global geopolitical concerns. And Mark Wiseman discusses their approach and what it takes to be successful at CPPIB. I take all this stuff on hiring "the best and brightest" with a grain of salt. As I wrote in my last comment on CPPIB, there is still a lot of work that needs to be done in this regard.

In particular, I encourage all of Canada's public pension funds, especially CPPIB which leads by example, to do a lot more to diversify their workplace and hire people from diverse backgrounds, including persons with disabilities, and put an end to reversion to mediocrity. Get to work and make Canadians from all backgrounds proud!

Postscript: You can read Mark McQueen's response to my blog post here. Apart from trying to discredit me and my "style" of blogging, he really fails to understand the concerns I raise above. In particular, VC is very risky which is why it will always remain a very small percentage of any pension's private equity portfolio. For the most part, pensions are better off avoiding this space altogether.

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