Friday, February 27, 2015

Private Equity Discovers Warren Buffett?

Simon Clark of the Wall Street Journal's MarketWatch reports, Blackstone wants to invest like Warren Buffett:
Blackstone Group is talking to its biggest investors to create a “coalition of the willing” that can buy control of large companies outside of its existing funds, according to Joe Baratta, head of private equity at the New York-based firm.

Blackstone (BX) usually buys control of companies through its main private-equity fund. It is talking to a select group of large investors who may want to own a company for longer than the usual term of private-equity ownership of five to 10 years and target lower returns.

Baratta likened the potential new approach to the style of Warren Buffett, whose Berkshire Hathaway Inc. doesn’t have a time limit on its investments because it doesn’t buy assets through a fund.

“I don’t know why Warren Buffett should be the only person who can have a 15-year, 14% sort of return horizon,” Baratta said at the Super Return private equity conference in Berlin.

Several large private equity groups recently started exploring ways to buy big companies in partnership with large investors outside their existing funds. The potential new approach comes as major institutional investors, such as pension funds and sovereign-wealth funds, which are clients of the big private-equity groups, look for steady returns in an environment of persistently low global interest rates.

An expanded version of this report appears at
William Alden of the New York Times also reports, Blackstone Considers a Lower-Return, Longer-Term Approach to Private Equity:
Private Equity firms have always offered a high-octane investing experience, attempting to multiply investors’ capital over a period as long as a decade.

But some of the largest firms are now considering taking a more sedate approach with some of their biggest clients in the latest sign that the industry is moving away from its former free-wheeling spirit.

Joseph Baratta, the head of private equity at the Blackstone Group, the biggest alternative investment firm, said at a conference in Berlin on Tuesday that the firm was speaking with large investors about a new investment structure that would aim for lower returns over a longer period of time.

Mr. Baratta, whose remarks were reported by The Wall Street Journal, said the investments would be made outside of Blackstone’s traditional funds, which impose time limits on the investing cycle. Invoking Warren E. Buffett’s Berkshire Hathaway, Mr. Baratta said he wanted to own companies for more than 10 years.

”I don’t know why Warren Buffett should be the only person who can have a 15-year, 14 percent sort of return horizon,” Mr. Baratta said, according to The Journal.

His remarks, at the SuperReturn International conference, were only the latest example of chatter about this sort of structure in private equity circles.

News reports last fall said that Blackstone and the Carlyle Group, the private equity giant based in Washington, were both considering making investments outside their existing funds. Such moves would let the firms buy companies they might otherwise pass on — big, established corporations that don’t need significant restructuring but could benefit from private ownership.

Another private equity giant, Kohlberg Kravis Roberts, has increasingly been making investments from its own balance sheet in addition to its funds. While this differs from the approach Mr. Baratta discussed, it similarly allows for new types of investments and provides a more stable source of capital. K.K.R., for example, has used its balance sheet to make minority investments in fast-growing companies like Arago, a German software maker, and Magic Leap, an augmented-reality start-up.

The holy grail that these private equity firms are chasing is what they call “permanent capital,” exemplified by Berkshire.

Blackstone, which has not yet deployed such a strategy, might gather a “coalition of the willing” investors to buy individual companies, Mr. Baratta said. This approach could be attractive to some of the world’s biggest investors, including sovereign wealth funds and big pension funds, which, though they want market-beating returns, also want to avoid taking too much risk.

Mr. Baratta said Blackstone and the coalition of investors could buy consumer goods companies like H.J. Heinz, which Berkshire Hathaway bought with the Brazilian investment firm 3G Capital, or infrastructure assets, according to The Journal.

”It opens up a whole universe of opportunities that we’re not currently accessing,” he said.
I must admit, when I read these articles earlier this week, I started chuckling and getting all cynical. Why? Because I was thinking to myself that in a low-return world awash in liquidity where it's getting harder for these private equity giants to compete with each other and with strategics (ie. corporations with record profits and inflated shares), all of a sudden they're discovering the virtues of the Oracle of Omaha's approach and the long, long view that Canadian pensions have been touting for a very long time!

But don't kid yourself, this "new shift" among private equity giants is nothing more than a clever ruse to garner ever more assets so they can keep collecting that all important management fee, which they collect no matter what (on multibillions, it really adds up!). The New York Times article above talks about "permanent capital" but I prefer an expression Derek Murphy, the head of PSP's Private Equity group, once cynically quipped to me: "The only reason these guys want to talk to us is that they view us as a source of perpetual funding" (he used more colorful language but I'll spare you the details).

"Murph" is absolutely right, PSP Investments, CPPIB, and other mega large global pensions and sovereign wealth funds are nothing more than a source of perpetual funding to these private equity giants. Facing pressure from investors and more regulatory scrutiny, they are lowering fees but looking to make it up by shifting focus on the longer term to collect increasingly more assets from their biggest clients.

This gives new meaning to the term "glorified asset gathers," which is why I've long argued the large hedge funds, private equity funds, real estate funds and mega alternative investment firms managing multibillions need to slash fees, especially their management fee (it should be a nominal fee, 25 basis points or less).

In other words, just like overpaid hedge fund gurus, realizing they had to do something to respond to increasing regulatory scrutiny and pressure from investors, overpaid private equity titans came up with this "ingenious" new way to garner more assets from the "coalition of the willing" to keep adding to their obscene wealth, which by the way, they amassed through the blood, sweat and tears of public sector workers contributing to their pensions (Piketty needs to revise his treatise on inequality).

Alright, let me be more open minded and stop being such a hopeless cynic. The truth is unlike hedge funds, private equity funds provide a better alignment of interests with pension funds and other investors focusing on a long period. So perhaps these private equity firms are shifting focus, aiming for lower returns over a longer period, because they're responding better to the needs of their biggest clients.

Also, I don't mean to take swipes at Blackstone's co-founder and CEO Steve Schwartzman. He has assembled a great investment team. Their success is well earned as they're printing money over there. I would invest with a David Blitzer or a Jonathan Gray any time because these guys are truly the cream of the crop and unlike other shops, Blackstone has a better governance structure and real succession planning, which is why they're the global leaders in alternative investments and why their shares are finally surging higher (click on image):

But I agree with TPG's co-founder, Jim Coulter, there are 'titanic shifts' going on in private equity:
The structure of the traditional private equity fund is under threat as investors seek new ways to buy and own companies without paying high fees to buyout firms, according to TPG co-founder Jim Coulter.

“I’ve never seen a period of time when we’ve had the extent of titanic shifts in the industry that we are seeing right now,” Mr. Coulter said at the Super Return private equity conference in Berlin. “The first is really the shift from funds.”

Investors usually commit to private equity funds for 10 years. They typically pay fees on undrawn commitments to private equity firms as well as lower fees on commitments that have been drawn to buy assets. Undrawn is money committed to a fund but not yet used. Drawn is money committed and used to buy a company.

The fees that private equity firms charge investors on capital that has been committed but not used are likely to decrease, Mr. Coulter said.

Investors such as sovereign wealth funds are increasingly demanding to invest money alongside private equity firms or through separate managed accounts to reduce the fees they pay.

Mr. Coulter said he expects the share of companies acquired through traditional private equity fund structures to decrease as new models emerge. Blackstone Group and CVC Capital Partners are among firms experimenting with new models,  people familiar with the firms have said.

One reason for the change is the fees on undrawn commitments usually cause private equity funds to show poor performance in their first years.

“That fee drag in the early years of a fund actually becomes difficult,” Mr. Coulter said.
As I stated above, facing pressure from investors and heightened scrutiny from federal regulators, some of the largest private equity firms are giving up their claim to fees that generated hundreds of millions of dollars for them over the years. But the private equity giants are adapting and looking to make up any drag on fees by increasing the assets they manage over a longer period.

Maybe these private equity giants are concerned that we're heading into a protracted period of global deflation, and they're thinking it's a wise business decision to shift focus to generate more modest returns over a longer period. I don't know but there are certainly 'titanic shifts' going on in the industry right now.

On the last point, Chad Bray of CNBC reports, Private Equity Executives Offer Differing Views on Industry’s Future:
Guy Hands and David M. Rubenstein gave vastly different views on Wednesday about the future of the private equity industry. But that may be a result of where they are perched.

Mr. Rubenstein is co-chief executive of one of the world's largest private equity firms, the Carlyle Group, and Mr. Hands is the founder of Terra Firma Capital Partners, a smaller, privately held firm.

Speaking at the SuperReturn International conference in Berlin, Mr. Hands said he believed the industry, outside the large, publicly traded firms like Carlyle, would go back to its roots and focus on smaller fund-raising and on being more closely tied to its clients.

Most important, he said, they will go back to being "more genuinely private," while the large firms will continue to move beyond traditional private equity to become generalist asset managers.

"It means being more aligned with your investors, putting much more of your own skin in the game, giving them what they really want, minimizing their fees, maximizing their returns," Mr. Hands said.

"That way private equity will go 'back to the future,'  " he said. "To take advantage of these opportunities and create alpha, the future for private equity lies in its past."

Mr. Rubenstein offered a bit of a different view on a separate panel at the conference.

He sees private equity opening up to a much larger client base in the next decade, including individuals managing their 401(k) investments in the United States. He also sees sovereign wealth funds playing a larger role than they ever have.

And, he predicted, the industry will discuss its returns and its operations in a more standardized and public fashion.

"People will actually know what a top quartile fund is," Mr. Rubenstein said. "There will be a standard definition and a standard organization — government or nongovernment — that will certify someone is a top quartile. People will not be able to say they are top quartile, when they are not."

He also thinks the industry will go by a new name: Private equity does not fully describe what the industry does today, if not tomorrow, he believes.

"Everything will be known to the public," Mr. Rubenstein said. "Everybody's performance will be known. Everybody's valuation will be known."

"Everyone will feel the industry is as transparent as the public equity industry is," he said.
I actually agree with both Guy Hands and David Rubenstein. There is a bifurcation going on in private equity. I see smaller private equity and venture capital funds with much better alignment of interests sprouting up and they will be courted by family offices, smaller pensions and endowments who are looking to build strong, long lasting relationships with excellent smaller funds.

But Rubenstein is absolutely right, the mega pension and sovereign wealth funds, the so-called "coalition of the willing" that write huge tickets in the hundreds of millions are looking for scale across global private markets which is why they'll be focusing their attention on truly top quartile alternative investment firms that offer investments in private equity, real estate, hedge funds and anything in between. Some are even venturing into infrastructure, although there the CPPIBs of this world invest directly just like in farmland.

The problem with the generalist alternative investment model is how will the Blackstones, Carlyles and KKRs keep delivering exceptional results to these big investors and keep alignment of interests? Importantly, as they grow their assets, they will increasingly be perceived as asset gatherers, and some will really start scrutinizing their performance and fees, questioning whether this is the right approach (Canadian funds are already going more direct, bypassing PE firms as much as possible).

As far as opening up private equity to the masses investing in their retirement accounts, I'm a lot less sanguine or enthusiastic as Mr. Rubenstein. I prefer to see enhanced CPP or an enhanced Social Security where well-governed, large public DB pensions invest in private equity for the masses instead of introducing private equity as an option for retirement accounts. This would be in everyone's best interest.

If you want to invest in these private equity giants, just buy shares of Blackstone (BX), The Carlyle Group (CG), KKR & Co. (KKR), Oaktree Capital Group (OAK), or Apollo Global Management (APO). They offer great dividends and some will see substantial capital appreciation but keep in mind the discussion above and realize there are 'titanic shifts' going on in the industry right now and if global deflation strikes, it will hurt everyone, including private equity giants.

If you have any comments you want to share on this topic, feel free to send me an email ( I'm taking a week off to recharge my batteries but will have access to my emails. Please remember to show your appreciation for this blog and donate and/or subscribe via PayPal at the top right-hand side. The information you read here and the way I tie it all together to the bigger macro picture is truly unique. Please show your appreciation through your financial support.

One final note. I read a lot of nonsense in other blogs on the "Greek crisis," especially on Zero Hedge but also in more reputable blogs like Naked Capitalism which just posted something silly on the alternative in Greece. If you really want to understand why Greece is in such a mess, take the time to read an op-ed the New York Times published by Aristos Doxiadis, What Greece Needs. It is truly superb and he explains it all in that short comment (another great article you should all read is Ambrose Evans-Pritchard's latest, Humiliated Greece eyes Byzantine pivot as crisis deepens).

Below, David Rubenstein, co-chief executive of the Carlyle Group, discusses trends in private equity, where bubbles are forming and where he sees the best global investment opportunities. Take the time to listen to his comments, he's one of the smartest private equity gurus in the world and a tireless philanthropist, just like Blackstone's Jonathan Gray.

More hedge fund and private equity gurus should follow their lead and ignore Forbes' silly list of the world's richest. Sitting on vast wealth is pointless, just ask Buffett, Gates and other billionaires, including Blackstone's co-founder, Pete Peterson, who understand the meaning of enough (see the 60 Minutes clip below).

Update: Warren Buffett released his annual letter to Berkshire Hathaway shareholders on Saturday, written with his usual mix of business facts, common-sense advice and showmanship. This year marks the 50th anniversary of Buffett's time heading the sprawling conglomerate. You can read highlights here.

The Oracle of Omaha provides advice that could make you rich. My favorite is #3: don't listen to experts. "Anything can happen anytime in markets," writes Buffett. "And no advisor, economist, or TV commentator -- and definitely not Charlie nor I -- can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet."

Lastly, Buffett has a message for public pensions, colleges and the like: Stop pouring money into expensive, high-end money managers:
"The commission of the investment sins listed above is not limited to 'the little guy.' Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades," Buffett wrote in his latest letter to Berkshire Hathaway shareholders.

Buffett has long been a critic of so-called alternative investing, a category that includes hedge and private equity funds, among others. The reason is the cut they take for their services, which can make billions of dollars for the managers but far less for clients, according to the man sometimes called "The Oracle of Omaha."

"A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool's game," Buffett wrote on underperformance.
When Warren Buffett and George Soros are on the same page, you know they're on to something and it's high time U.S. public pensions scrutinize the fees they're paying to external managers.

Thursday, February 26, 2015

Caisse Gains 12% in 2014

Ross Marowits of the Canadian Press reports, Caisse de dépôt sees softer stock market ahead after generating 12% return in 2014:
The years-long bull run on equity markets that helped the Caisse de dépôt et placement du Québec generate a 12% return in 2014 is running out of steam and will require careful watching going forward, CEO Michael Sabia said Wednesday.

“We’re certainly not calling for a big correction…but it’s going to be increasingly difficult to replicate the kind of returns that we’ve seen everywhere basically since 2009,” Sabia told reporters in discussing the Quebec pension fund manager’s 2014 results.

That means the Caisse must continue to invest defensively in high quality assets, including real estate and infrastructure that have generated strong returns, he said.

Chief investment officer Roland Lescure said the double-digit returns of the past four to five years will end.

“In the next five years we should expect single-digit returns with double-digit volatility and that requires quality, quality, quality, but also the ability to be opportunistic.”

The large institutional investor said its assets as of Dec. 31, 2014, were $225.9 billion, even though investment return slowed slightly from 13.1% in 2013.

All three of the Caisse’s major asset classes experienced gains, led by equities which had a nearly 14% return as assets rose to $106.9 billion. Inflation-sensitive investments had an 11 per cent return, while fixed-income investments increased 8.4%.

Sabia described the Caisse’s performance as “solid,” considering currency fluctuations, low interest rates and falling oil prices near year-end.

“Despite the volatility, we showed our resilience. We have stayed the course and that’s what counts.”

Its real estate division, Ivanhoe Cambridge, completed a record number of transactions in 2014 as shifted focused from hotels to multi-residential and logistics properties. It made acquisitions valued at $5.1 billion and sold properties worth $8.6 billion, including 21 hotels.

The division generated $2.1 billion of net investments in 2014 as its assets grew to $22.9 billion.

The Caisse’s infrastructure portfolio has more than doubled in four years to $10.1 billion, including $1.3 billion invested in 2014, when it enjoyed a 13.2% annual return.

Sabia expects new investments will more than double the infrastructure portfolio again in the next few years as the Caisse creates a new subsidiary that will fund and build projects in Quebec and chase opportunities in the United States and elsewhere abroad.

“It is probably fair to say our No. 1 global priority is to substantially expand our infrastructure presence in the United States, where we think the needs are great,” he said.

The Caisse invested $2.5 billion in Quebec companies last year and more than $11 billion over four years, pushing its assets in the province to $60 billion.

However, it shifted five per cent of its Canadian exposure to other markets to capitalize on global growth. More than 47% of its investments are outside the country.

Meanwhile, Sabia said the Caisse continues to have faith in two troubled Quebec companies — SNC-Lavalin (TSX:SNC) which faces bribery and corruption charges, and Bombardier (TSX:BBD.B) which is seeking new liquidity.

Sabia said SNC-Lavalin has made big ethics changes and is not the same company it was a few years ago. The Caisse has maintained its level of investment in the embattled engineering firm at about 10%.

The Caisse also took advantage of Bombardier’s recent nearly $1-billion equity offering to increase its $271-million stake in the airplane and rail equipment manufacturer, but didn’t say by how much.
Nicolas Van Praet of the Globe and Mail also reports, Caisse eyes ‘substantial infrastructure opportunities’ in the U.S.:
Caisse de dépôt et placement du Québec has already helped Canadian investors become the single largest foreign buyer of U.S. commercial real estate since 2010.

Now, the Caisse has its eye on another big bet south of the border: infrastructure, from airports to bridges.

Canada’s second-largest pension fund is aiming to double its current $10-billion infrastructure portfolio over four years and believes a significant portion of that growth will come from the United States.

“We think there are very, very substantial infrastructure opportunities in the United States,” chief executive Michael Sabia told reporters in discussing the pension fund’s 12-per-cent return for 2014. “In geographic terms, this would be priority one.”

As part of a transformative deal announced last month with Quebec giving the Caisse new powers to develop major infrastructure projects in the province, the pension fund is carving out a new subsidiary to handle such investments. It hopes to parlay the Quebec model, based on easing the financial load on government, to other parts of the world.

The Caisse has slowly been ramping up its infrastructure exposure in the U.S. Recent investments include a $600-million commitment for a roughly 30-per-cent stake in electricity supplier Indianopolis Power & Light Co. It also holds a 16-per-cent interest in U.S. petroleum pipeline Colonial and is said to be among a group being solicited to bid for natural gas pipeline operator Southern Star Central Corp.

But, ever searching for investments that generate long-term stable cash-flow, it wants more.

“There is a significant demand and need for infrastructure investment in the U.S., in particular in the transport sector,” said Macky Tall, who leads the Caisse’s infrastructure business. “Many roads and bridges are in need of being repaired and renewed.”

Despite the historic reluctance of the U.S. government to open up the country’s physical assets to private investors such as the Caisse, President Barack Obama’s administration has recently shown more openness in light of the strained finances of many state governments. As U.S. Transportation Secretary Anthony Fox said last year in announcing the Build America Investment Initiative: “The reality is we have trillions of dollars internationally on the sidelines that are not being put to work.”

Mr. Sabia has been executing a strategy of boosting investments in tangible assets such as real estate and infrastructure while focusing on public equities it sees as high-quality and less risk. The aim is to generate even and predictable results at a time when equity markets remain erratic and low yields are expected to continue in bond markets.

Last year’s 12-per-cent return was powered by strong gains in U.S. stock holdings. The Caisse’s global equity portfolio in particular, which invests in large-cap companies, returned 18.5 per cent as those multinationals tapped into growth in the U.S. consumer market and the economy in general.

Asked if public equity markets are overheated, Mr. Sabia noted that efforts companies have made on cost-cutting have fuelled an improvement in corporate profits of late. He said that can’t continue forever and that companies will need to generate revenue growth eventually.

“We’re not calling for a big correction in the markets,” Mr. Sabia said. “Our sense of this is, yeah the elastic is stretched pretty tight. And we’re very conscious of that. That doesn’t lead us to believe things are going to snap tomorrow. But we’re very vigilant about it.”

With a stake of about 10 per cent, the Caisse remains a major investor in SNC-Lavalin Group Inc. Mr. Sabia said the pension fund continues to back the engineering company’s efforts to win new business and put its ethics scandal behind it, even in light of new corruption charges laid by the RCMP last week.

“The fact that we haven’t changed our position, I think, speaks clearly about what we think about the current situation,” Mr. Sabia said.

Returns over the past four years under Mr. Sabia’s watch have totalled 9.6 per cent. His five-year term as CEO was extended in 2013.
Third, Ben Dummett of the Wall Street Journal reports gains in U.S. stocks helped the Caisse generate a 12% return:
Canada’s second-largest pension fund said it generated a 12% return last year, led by gains in U.S. stocks, eclipsing the fund’s internal benchmark by a small margin.

But Caisse de dépôt et placement du Québec isn’t convinced the strong run in U.S. equities will continue this year, citing stretched valuations.

The Quebec pension fund said net assets totaled 225.9 billion Canadian dollars ($180.8 billion) at the end of December, up from about C$200 billion at the end of 2013. That placed the fund, which manages pension money for much of Quebec’s workforce, behind CPP Investment Board, which had C$238.8 billion of assets under management at the end of December.

Caisse’s 12% return also edged out a 11.4% gain in the fund’s benchmark. Canadian pension funds typically measure themselves against an in-house index to reflect the diversity of public and private asset classes in which they invest.

The latest results come as the fund has moved away from investments that mirror benchmark indexes in favor of focusing more on concentrated portfolios of public and private holdings that are meant to generate steady returns. The goal is to reduce the fund’s exposure to market volatility while take better advantage of global economic growth.

“A big part of the strategy…is to be able to outperform on the downside,” something Caisse hasn’t managed well historically, Chief Executive Michael Sabia said in a phone interview.

Caisse’s public and private-equity holdings generated the biggest return among its investments, gaining 13.9% compared with 12% for the benchmark. Within that group, U.S. equities fared the best, posting a 24% return as major U.S. stock indexes rose amid growing confidence in the U.S. economy.

The weaker Canadian dollar measured against its U.S. counterpart would have also helped boost the pension fund’s U.S. equity returns after converting the U.S. dollar gains back into Canadian currency.

But the fund is more leery of the outlook for U.S. equities since stock valuations relative to corporate earnings growth are near record highs.

“The market is suddenly more vulnerable than it has been,” Roland Lescure, the fund’s chief investment officer, said in the same phone interview.

Caisse also splits its assets among fixed income and so-called inflation-sensitive investments, including real estate, infrastructure and real return bonds. The fixed-income portfolio performed largely in line with its index, but inflation-sensitive investments led by infrastructure holdings underperformed.

Infrastructure holdings, which appeal to pension funds because of the steady income they generate, also lagged behind Caisse’s benchmark over the last four years.

Caisse said its infrastructure return for 2014 exceeded its long-term target. The pension fund measures its infrastructure holdings against a benchmark of 60 public securities even though many of its infrastructure holdings aren’t listed on a stock exchange, making an accurate comparison more difficult.

According to the fund, 75% of the index’s four-year return stemmed from rising equity markets, while dividend income generated by the index-member companies accounted for 25% of the benchmark’s return.

“The Caisse will continue to make significant investments in infrastructure, particularly in Québec, the United States and in growth markets,” the pension fund said in a statement. “This asset class is central to its investment strategy, especially in an environment of low interest rates and greater volatility in the equity markets.”
Finally, Scott Deveau of Bloomberg reports, Caisse's Sabia Says Stock Markets Will `Run Out of Gas':
The double-digit gains global stock markets have experienced in the past few years can’t continue much longer, and more modest gains are in store, said Michael Sabia, the head of Canada’s second-largest pension fund.

“It’s going to run out of gas,” said Sabia, chief executive of the Caisse de Depot et placement du Quebec, in an interview in Montreal.

The Caisse has benefited from the run-up in stock prices, in particular in the U.S., coming out of the recession. The Montreal-based pension fund posted an overall return of 12 percent in 2014 on its investments, fueled by an increase in its equities portfolio. Over the past five years, its overall return on its investments has averaged 10.4 percent annually.

Sabia said a more realistic annual return would be in the single digits once the public equity markets cool, although he cautioned he didn’t know when that will be.

The bulk of gains in corporate profitability, in particular among U.S. multinationals, have come from cost cuts, he said. Companies will have to boost sales too, for the Standard & Poor’s 500 Index to continue rising.

The Caisse isn’t forecasting a massive correction. Instead, single-digit returns are a more likely scenario, he said. The fund had C$225.9 billion ($182 billion) in total assets at the end of 2014, compared with C$200 billion a year earlier.

Quebec Retirement

The pension fund, which oversees the retirement savings of those living in Quebec, is a prominent investor in infrastructure, real estate, public and private equity worldwide. The fund is looking to diversify its portfolio globally and will pursue opportunities in the U.S., Australia, and Mexico, Sabia said. It will also be exploring some opportunities in India and Europe.

The Caisse has shifted about 5 percent of its exposure in Canada to other markets in the past four years and currently has about about C$117 billion, or 47 percent of its investments, outside of the country. That’s up from C$72 billion in 2010.

Sabia also took the opportunity to defend two embattled Quebec companies the Caisse is currently invested in: SNC-Lavalin Group Inc. and Bombardier Inc.

The Caisse is SNC-Lavalin’s largest shareholder with about 10 percent of its outstanding common shares. SNC-Lavalin was charged last week with attempted bribery and fraud related to construction projects in Libya and said it would vigorously defend itself against the charges, which it said involved employees who left “long ago.”

Governance Changes

SNC-Lavalin has made great strides in corporate governance as it moves to distance itself from a scandal over improper payments that led to the departure of its former CEO Pierre Duhaime three years ago, Sabia said. The Caisse has not altered its investment in SNC-Lavalin after the last charges and supports the board’s efforts to improve its governance.

“The SNC-Lavalin today is not the SNC-Lavalin of five or six years ago,” he said.

Bombardier issued C$938 million in new equity last week to help cover the cost overruns of its CSeries jet program. The Caisse participated nominally in the raise, just a “top up” of its existing investment, Sabia said.

It will also consider investing in whatever debt offering the company might consider, he said.

“They managed to do a pretty big equity offering. Given that and whatever debt they’re going to do, they’re going to come out of this period with a dramatically changed balance sheet,” Sabia said. “I think the runway is there for them.”
You can gain more insights on the Caisse's 2014 results by going directly on their website here. In particular, the Caisse provides fact sheets on the following broad asset classes:
Keep in mind that unlike other major Canadian pension funds, the Caisse has a dual mandate to promote economic activity in Quebec as well as maximizing returns for its depositors.

In fact, the recent deal to handle Quebec's infrastructure needs is part of this dual mandate. Some have criticized the deal, questioning whether the Caisse can make money on public transit, but this very well might be a model they can export elsewhere, especially in the United States where CBS 60 Minutes reports infrastructure is falling apart.

Whether or not the Caisse will be successful in exporting this infrastructure model to the United States remains to be seen but if you follow the wise advice of Nobel laureate Michael Spence on why the world needs better public investments, public pensions investing in infrastructure could very well be the answer to a growing and disturbing jobs crisis plaguing the developed world.

As far as the overall results, they were definitely solid, with all portfolios contributing to the overall net investment of $23.77 billion (click on image below):

Of course, what really matters is value-added over benchmarks. After all, this is why we pay Canadian pension fund managers big bucks (some a lot more than others). 

In fact, in its press release, the Caisse states in no uncertain terms:
"[its] investment strategy centers on an absolute return approach in which investment portfolios are built on strong convictions, irrespective of benchmark indices. These indices are only used ex post, to measure the portfolios’ performance. The approach is based on active management and rigorous, fundamental analysis of potential investments."
I've already discussed life after benchmarks at the Caisse. So how did their active management stack up? For the overall portfolio, the 12% return edged out the fund's benchmark which delivered an 11.4% gain, adding 60 basis points of value-added last year (do not know the four year figure).

Below, I provide you with the highlights of the three main broad asset classes with a breakdown of individual portfolios (click on each image to read the highlights):

Fixed Income:



Some quick points to consider just looking at these highlights:
  • Declining rates helped the Fixed Income group generate strong returns in 2014 but clearly the value-added is waning. In 2014, Fixed Income returned 8.4%, 10 basis points under its benchmark which gained 8.5%. Over the past four years, the results are better, with Fixed Income gaining 5.6%, 70 basis points over its benchmark which gained 4.9%. Real estate debt was the best performing portfolio in Fixed Income over the last year and four years but on a dollar basis, its not significant enough to add to the overall gains in Fixed Income.
  • There were solid gains in Inflation-Sensitive assets but notice that both Real Estate and Infrastructure underperformed their respective benchmarks in 2014 and the last four years, which means there was no value-added from these asset classes. The returns of Infrastructure are particularly bad relative to its benchmark but in my opinion, this reflects a problem with the benchmark of Infrastructure as there is way too much beta and perhaps too high of an additional spread to reflect the illiquid nature and leverage used in these assets. More details on the Caisse's benchmarks are available on page 20 of the 2013 Annual Report (the 2014 Annual Report will be available in April).
  • In Equities, Private Equity also slightly underperformed its benchmark over the last year and last four years, but again this reflects strong gains in public equities and perhaps the spread to adjust for leverage and illiquidity. U.S Equity led the gains in Equities in 2014 but the Caisse indexes this portfolio (following the 2008 crisis) so there was no value-added there, it's strictly beta. However, there were strong gains in the Global Quality Equity as well as Canadian Equity portfolios relative to their benchmarks in 2014 and over the last four years, contributing to the overall value-added.
If you read this, you might be confused. The Caisse's strategy is to shift more of its assets into real estate, private equity and infrastructure and yet there is no value-added there, which is troubling if you just read the headline figures without digging deeper into what makes up the benchmarks of these private market asset classes.

The irony, of course, is that the Caisse is increasingly shifting assets in private markets but most of the value-added over its benchmarks is coming from public markets, especially public equities.

But this is to be expected when stock markets are surging higher. And as a friend of mine reminded me: "It about time they produced value-added in Public Equities. For years, they were underperforming and so they came up with this Global Quality Equity portfolio to create value."

Also, keep in mind private markets are generating solid returns and as I recently noted in my comment on why Canadian pensions are snapping up real estate:
... in my opinion the Caisse's real estate division, Ivanhoé Cambridge, is by far the best real estate investment management outfit in Canada. There are excellent teams elsewhere too, like PSP Investments, but Ivanhoe has done a tremendous job investing directly in real estate and they have been very selective, even in the United States where they really scrutinize their deals carefully and aren't shy of walking away if the deal is too pricey.
There is something else, the Caisse's strategy might pay off when we hit a real bear market and pubic equities tank. Maybe that's why they're not too concerned about all the beta and high spread to adjust for leverage and illiquidity in these private market benchmarks.

But there are skeptics out there. One of them is Dominic Clermont, formerly of Clermont Alpha, who sent me a study he did 2 years ago showing the Caisse's alpha was negative between 1998 and 2012. Dominic hasn't updated that study (he told me he will) but he shared this:
I had done a study two years ago that showed that the Caisse's alpha was close to -1% and close to statistically significantly different from zero and negative. Part of that regular value lost is compensated by taking a lot more risk than its benchmark by being levered. That leverage means doing better than the benchmark when the markets do perform well, and being in a crisis when the market tanks...
I asked him to clarify this statement and noted something a pension fund manager shared with me in my post on the highest paid pension fund CEOs:
Also, it's not easy comparing payouts among Canada's large DB plans. Why? One senior portfolio manager shared this with me:
"First and foremost, various funds use more leverage than others. This is the most differentiating factor in explaining performance across DB plans. In Canada, F/X policy will also impact performance of past 3 years. ‎It's very hard to compare returns because of vastly different invest policies; case in point is PSP's huge equity weighting (need to include all real estate, private equity and infrastructure) that has a huge beta."
Dominic came back to me with some additional thoughts:
I would love to do proper performance attribution, but I had limited access to data. But we can infer a lot with published data. We do have historical performance for all major funds like the Caisse, CPP, Teachers, PSP, etc. in their financial statements. They also publish the performance of their benchmark.

I agree that because of different investment policies, it is difficult to compare one plan to the next. But we can compare any plan to itself, i.e. its benchmark.

Again, I like to do proper performance attribution in a multivariate framework and that is one area of expertise to me. To do it on a huge plan like the Caisse would require a lot of data which I do not have access to. But a simple CAPM type of attribution would give some insight. In this case, the benchmark is not an equity market as in the base case of CAPM, but the strategy mix of the Caisse.

Thus if we regress the returns (or the excess returns over risk free rate) of a plan, over its benchmark return (or excess over RF rate), we would obtain a Beta of the regression to be close to one if the plan is properly managed with proper risk controls. That is what I obtain when I do this exercise with the returns of a well-known plan – well known for its quality of management, and its constant outperformance.

When I do this for the Caisse, I get a Beta of the regression significantly greater than 1 – close to 1.25. It looks like the leverage of the Caisse over the 15 years of the regression was on average close to 25% above its benchmark! Now part of that as you mentioned and as I explain in my study could come from:
  • Investment in high Beta stocks,
  • Investment in levered Private equity
  • Investment in levered Real Estate and Infrastructure
  • Investment in longer duration bonds
  • Leveraging the balance sheet of the plan: Check Graphic 1 on the link:
It shows the leverage of the Caisse going from 18% in 1998 to 36% in 2008! So my average of 25% excess Beta is in line with this documented leverage.

The chart also shows Ontario Teachers' and OMERS' leverage. The difference is that Teachers' leverage is IN its benchmark, while the Caisse is NOT. Thus the Caisse is taking 25% more risk than its clients' policy mix! You would think that all these clients risk monitoring would be complaining… They are not. 

Of course, that leverage is good when markets return positively and you can see that on the colored chart. But that leverage is terrible when the markets drop 2008, 2002, 2001. When that happen, it is time to fire the management, restart with a new one and blame the previous management for the big loss. Some of those big losses were also exaggerated by forced liquidation accounting (we all remember the ABCP $6 billion loss reserve which was almost fully recovered in the following years inflating the returns under the new administration).

By not doing proper attribution, we are not aware of the continuous loss (negative alpha) hidden by the excess returns not obtained by skilled alpha, but by higher risk through leverage. The risk-adjusted remains negative… And we are not focusing our energies into building an alpha generating organisation with optimal risk budgeting. Why bother, the leverage will give us the extra returns! But that is not true alpha, not true value added.

Which brings me to the alpha of the regression. I told you that this other great institution which does proper risk controls, gets a Beta close to one. They also get a positive alpha of the regression which is statistically significant (t stat close to 2). Not surprising, they master the risk budgeting exercise, and they understand risk controls.

For the Caisse, the Alpha of the regression is close to -1% per year and it is statistically significant. Nobody in the private market could sustain such long period of negative alpha. Nobody could manage a portfolio with 25% more risk than what is requested by the client.

In my report, I also talk about the QPP contribution rate. When Canada created the CPP in the mid-60s, Quebec said "Hey, we want to better manage our own fund." That led to the creation of the Caisse de Depot and it was an excellent decision as the returns of the QPP were much better because they were managed professionally in a diversified portfolio (vs provincial bonds for the CPP). Unnoticed by everyone in Quebec, the contribution rate started to increase in 2012 and will continue to increase up until 2017 at which time Quebecers will pay 9% more than the rest of Canadians for basically the same pension plan (some tiny differences). And the explanation is this negative alpha.

I also explained that with proper risk budgeting techniques at all levels, the Caisse could deliver an extra $5 billion with 20% less risk! Instead of increasing the contribution rate of all CDPQ clients QPP, REGOP, etc., we could have kept them at the same level or lower. And part of that extra $5B return every year would find its way into the Quebec government coffer through reduced contributions and higher taxes (the higher contributions to QPP, Regop, etc. that Quebecers pay are tax deductible…)

For how long are we going to avoid looking at proper attribution? For how long are we going to forfeit this extra $5B per year in extra returns?
I shared Dominic's study with Roland Lescure, the CIO of the Caisse, who shared this with me:
You are right, we have significantly lowered leverage at the Caisse since 2009. Leverage is now solely used to fund part of our real estate portfolio and the (in)famous ABCP portfolio which will be gone by 2016. As you rightly point out, most Canadian pension funds use leverage to different degrees. Further, we also have significantly reduced risk by focusing our investments on quality companies and projects, which are less risky than the usual benchmark-driven investments. And those investments happen to have served us well as they did outperform the benchmarks significantly in 2014. You probably have all the details for each of our portfolios but I would point out that our Canadian equity portfolio outperformed the TSX by close to 300 bps. And the global quality equity portfolio did even better.
I thank Dominic Clermont and Roland Lescure for sharing their insights. Dominic raises several excellent points, some of which are politically sensitive and to be honest, hard to verify without experts really digging into the results of each and every large Canadian pension. Also, that increase in the contribution rate for public sector workers is part of tackling Quebec's pension deficits, slowly introducing more risk-sharing in these plans.

Again, this is why even though I'm against an omnipotent regulator looking at systemic risks at pensions, I believe all of Canada's large pensions need to provide details of their public and private investments to the Bank of Canada and we need to introduce uniform comprehensive performance, operational and risk audits at all of Canada's major pensions.

These audits need to be conducted by independent and qualified third parties that are properly staffed to conduct them. The current auditing by agencies such as the Auditor General of Canada is simply too flimsy as far as I'm concerned, which is why we need better, more comprehensive audits across the board and the findings should be made public for all of Canada's large pensions.

And let me say while the Caisse has clearly reduced leverage since the ABCP scandal which the media keeps covering up, it is increasingly shifting into private markets, introducing more illiquidity risk that can come back to haunt them if global deflation takes hold.

As far as stocks are concerned, I see a melt-up occurring in tech and biotech even if the Fed makes a monumental mistake and raises rates this year (read the latest comment by Sober Look to understand why market expectations of Fed rate hikes are unrealistic). It will be a rough and tumble year but my advice to the Caisse is to stay long U.S. equities (especially small caps) and start nibbling at European equities like Warren Buffett. And stick a fork in Canadian equities, they're cooked!

Will the liquidity and share buyback party end one day? You bet it will but that is a topic for another day where I will introduce you to a very sharp emerging manager and his team working on an amazing and truly unique tail risk strategy.

As far as U.S. equities, I think the Caisse needs to stop indexing and start looking at ways to take opportunistic large bets using some of the information I discussed when I covered top funds' Q4 activity. This would be above and beyond the information they receive from their external fund managers.

By the way, if you compare the Caisse's top holdings to those of the Bill and Melinda Gates Foundation, you'll notice they are both long shares of Waste Management (WM), one of the top-performing stocks in the S&P 500 over the last year.

I'll share another interesting fact with you, something CNBC's Dominic Chu discussed a few days ago. Five stocks -- Apple (AAPL), Amazon (AMZN), Biogen Idec (BIIB), Gilead (GILD), and Netflix (NFLX) -- account for all of the gains in the Nasdaq this year. If that's not herd behavior, I don't know what is!!

Lastly, it takes a lot of time to write these in-depth comments and you won't read this stuff in traditional media outlets which get hung up on headline figures and hardly ever dig deeper. Please take the time to contribute to my blog on the top right-hand side, or better yet, stop discriminating against me and hire the best damn pension and investment analyst in the world who just happens to live in la belle province!

Below, Michael Sabia, CEO of the Caisse, discusses the Caisse's 2014 results with TVA's Pierre Bruneau (in French). Michael also appeared on RDI Économie last night where he was interviewed by Gérald Filion. You can view that interview here and you can read Filion's blog comment here (in French).

Also, some food for thought for the Caisse's real estate team. A new report from Zillow shows that rents across the U.S. are increasing, and not just in the expected regions of New York City, San Francisco and Boston. Overall, rents increased 3.3% year-over-year as of January. But many cities outpaced that, including Kansas City, which saw rent grow more than double the national average, jumping 8.5% year-over-year. St. Louis saw rent increase by 4.5% over the same period. Rents in Detroit grew by 5.0% and rents in Cleveland grew by 4.2%.

Zillow CEO Spencer Rascoff explains the U.S. rental market following the housing crisis: "All of a sudden, there were 5 million new renters and the rental stock didn't increase." People can't afford new homes so pensions should be focusing on multi-family commercial real estate and not just in prime markets. The Caisse is already betting big on multi-family real estate.

Wednesday, February 25, 2015

Overhauling New Jersey's Pensions?

Josh Dawsey of the Wall Street Journal reports, Gov. Chris Christie Panel Proposes Overhaul of New Jersey’s Pension System:
Gov. Chris Christie’s committee to study New Jersey’s troubled pension system wants to overhaul the retirement program for public employees, freezing the current setup and replacing it with a “cash balance” plan.

The plan would spread out the current pension system’s unfunded liability over many years, and would more closely reflect benefits in the private sector, according to members of the commission. Mr. Christie endorsed the report conclusions Tuesday in a speech to the Legislature.

The commission is also calling for a state constitutional amendment to require governors to make payments to the new plan.

“Although the proposed plans are likely to be less generous to long-tenured employees as compared with the current plans, a less generous plan that is funded is preferable to a more-generous plan that isn’t,” the report says.

Benefits in the new plan could swing based on fluctuations in the stock and bond markets, introducing an element of risk.

Workers in the system would have their current plan frozen, according to Tom Healey, the commission chairman, and new workers would be entered into the new plan. Employees would have individual accounts, he said.

“You can do lots of different things with a total mess,” Mr. Healey said in an interview. “You can either say, let’s try to fix it or you can move to Wisconsin. We’re at the edge of the cliff here.”

The proposal received pushback from some unions and Democrats. Mr. Healey said he had met with the state’s main teachers union, and said its leaders were cooperative. Other meetings are scheduled in coming weeks.

Wendell Steinhauer, president of the New Jersey Education Association, said the union supports the proposal’s recommendations to freeze benefits of the current pension system, create a newly managed one and adopt a guarantee of state funding in the state constitution.

But Mr. Steinhauer said that some of the pension proposal “unfairly burdens” workers and wouldn’t be feasible.

“There will be many things that NJEA disagrees with, some of them very strongly,” Mr. Steinhauer said in a statement. “This is a report. It is not a law, and it is not the final word on what will or must happen.”

Other states such as Kentucky and Louisiana have recently introduced cash benefit plans, though Louisiana’s plan was ruled unconstitutional.

Joshua Franzel, a vice president for research at the Center for State and Local Government Excellence, said cash benefit plans are a way for states to provide more predictability in their pension systems.

The plans tend to guarantee a certain rate of investment return, but unlike a defined benefit pension system the hybrid ones don’t lock in a fixed allowance based just on the worker’s salary. It shifts some of the risk of market fluctuations to the employee without fully doing so, Mr. Franzel said.

“It’s a middle approach for managing risk and trying to control costs and control liabilities,” said Mr. Franzel, whose center studies pensions. “We are seeing a trend to more states beginning to consider and implement hybrid plans.”

New Jersey’s pension system is underfunded by about $37 billion.

The commission’s report said parts of its approach are likely to be unpopular at first but that “in time they will be viewed as the best way to move forward.”
A little over a month ago, I wrote a comment on taming New Jersey's insatiable beast, explaining why New Jersey's pensions are grossly underfunded and criticizing Gov. Christie's approach to handling their "pension crisis."

On Monday, a judge ruled that Gov. Chris Christie and the state's Democrat-controlled Legislature must find $1.57 billion to put into pension funds for retired public workers. 

And how did New Jersey's feisty governor respond? In a sad attempt to chalk up political points by trying to emulate Wisconsin's popular governor Scott Walker, he responded with a "fiscally responsible" plan to reform his state's pension system (a last ditch attempt to run as a GOP candidate in 2016?).

But New Jersey isn't Wisconsin in any way, shape or form. State of Wisconsin Investment Board is one of the best state pensions in the United States because they got the governance right and are following Canadian funds in managing more of their assets in-house.

By contrast, New Jersey's Division of Investment outsources most of their pension assets and doles out huge fees to private equity funds and hedge funds, one of which employs Gov. Christie's wife. Also, just like elsewhere, there's way too much political interference in their state pension, which virtually ensures mediocre performance over a long period (don't look at the last four years, a monkey could have outperformed in this environment just over-weighting equities).

More worrisome, I'm against these so-called "hybrid" plans because they are nothing more than defined-contribution (DC) plans in disguise placing the onus of risk entirely on members of these plans. And the brutal truth on DC plans is they're far less secure and much worse than DB plans.

Also, while I believe in shared-risk plans if they're done right, the sad truth is converting more public sector workers from DB into DC or hybrid plans is bad economic policy which will only ensure more Americans will retire in poverty.

Importantly, this isn't a conservative or liberal issue. Good pension policy that bolsters defined-benefit plans is good economic policy. The benefits of DB plans are grossly under-appreciated, especially well-governed ones which operate at arms-length from the government.

This is why I'm happy to see New York City is contemplating setting up a pension plan for private workers. As Bloomberg's Megan McArdle notes, details are still sketchy as to whether it will be a DC or DB plan but it will mean people will have to save more now to enjoy a safe retirement later (I disagree with her facile dismissal that "each type has its benefits and drawbacks,' because she doesn't understand the the brutal truth on DC plans).

All around the United States, we're witnessing major problems in public pensions. Last week, I discussed why Chicago and Tampa are the next Detroit. On Tuesday, I read a Bloomberg article on how Kansas and Kentucky may borrow billions to invest in cash-strapped pension funds, undeterred by warnings the practice risks driving up taxpayers’ bills to retirees. Keep in mind, Kentucky is in an even bigger pension mess than Illinois, which speaks volumes on just how dire their situation is.

And how are politicians responding to their pension mess? They're basically ignoring the problem or coming up with dumb solutions which will exacerbate pension poverty down the road and weaken the economy of the United States. This is certainly the case in New Jersey, Illinois,  Kentucky, Kansas and other states struggling to slay their pension demon.

Below, NJTV News provides coverage of Gov. Chris Christie’s 2016 Budget Address. The coverage includes the duration of the remarks and expert analysis (fast forward to minute 25 to listen to Gov. Christie's comments on pensions).

He's right, New Jersey desperately needs to reform its pension system because they can't tax or grow their way out of this problem. But the reforms his administration is proposing are not going to make the problem go away. In fact, these reforms are going to exacerbate pension poverty in New Jersey and weaken their economy, making their public debt much worse over the long run.

To his credit, however, Gov. Christie is calling for a state constitutional amendment to require governors to make payments to the new plan. I think every state should adopt a similar constitutional amendment to top up their existing public pensions every year, not some new hybrid plan New Jersey is proposing.

Tuesday, February 24, 2015

Is Farmland a Good Fit For Pensions?

Michel Leduc, senior managing director of public affairs at CPPIB, wrote a comment for the Leader-Post, Saskatchewan farmland a good fit for CPP (h/t, Pension360):
A little more than a year ago the Canada Pension Plan Investment Board (CPPIB) bought 115,000 acres of Saskatchewan farmland from Assiniboia Farmland LP. Some misinformation has been circulating about this and I want to set the record straight.

CPPIB exists to help provide a foundation upon which Canadians build their financial security in retirement. The assets we manage belong to over 18 million contributors and beneficiaries who participate in the Canada Pension Plan (CPP), including more than 700,000 Saskatchewanians.

CPPIB believes farmland is a good investment because well-run farms that have been properly maintained provide stable returns over the long term and add diversity to our investment portfolio.

CPPIB has the ability to spend money on improvements to the farms, and to own the land for decades. During that time many emerging countries will see rapid increases in population and wealth, increasing the demand for food. Saskatchewan has the potential to be a big beneficiary of this global trend.

We spent a long time studying farming dynamics before we bought this land. And we're proud to own it.

Assiniboia Farmland is an agriculture investment company founded and based in Regina. It had previously bought the 115,000 acres, much of which grows wheat, barley and canola, and we liked its business model, which supports family farms in Saskatchewan.

It helps farmers to cash in on their land while still allowing them to run, and even expand, their farms if they choose. Assiniboia is now doing that on CPPIB's behalf and with our financial backing. It's playing an important role in a market where many young farmers don't have the money to buy their parents' farms, and loans can be hard to secure.

For a long time now roughly 40 per cent of Saskatchewan's farmland has been rented, rather than owned, by the farmers who farm it.

Within about six months of owning the land we ensured that 18 abandoned buildings were demolished, seven old storage and fuel tanks were removed, and three yard sites were cleared up.

In addition, two ponds that were being used to dump waste were cleaned out. An abandoned water well was capped. We are working on improvements to irrigation, storage and drainage.

We want to partner with local farmers to improve production techniques - and the livelihoods of those working in the sector.

Premier Brad Wall's government has made clear its desire to foster a competitive, strong and vibrant economy. The long-term vision that he laid out in 2012 included increasing crop production by 10-million tonnes by 2020 and boosting exports of agriculture and food products to $15-billion. We want to contribute to those goals through our investment.

CPPIB is a patient, responsible, long-term investor. We do not plan to amass huge individual holdings of farmland, or to squeeze out returns. We will make reasonable investments to improve farms and help those farmers who choose to partner with us to compete.

CPPIB paid Assiniboia about $120 million for the land. If we bring our investments in Saskatchewan farmland up to $500 million over the next five or six years, we would still constitute less than one per cent of the market. Large investors make up a tiny sliver of Saskatchewan farmland transactions.

We did this deal in full daylight, following all the rules, trusting in Saskatchewan's stable regulatory environment and its desire to foster a thriving economy.

Contrary to what's been alleged, CPPIB did not make use of any loophole. The Saskatchewan Farmland Security Act (SFSA) allows CPPIB to buy farmland because we're Canadian. CPPIB was created for Canadians by an Act of Parliament, the Canada Pension Plan Investment Board Act. Any changes to that Act require approval from twothirds of the provinces representing two-thirds of the country's population.

The SFSA was updated in 2002 to allow both Canadian individuals and Canadian entities to own farmland. It says that foreigners and publicly-traded companies are restricted.

CPPIB is quintessentially Canadian. We work for the millions of Canadians who have contributed hard-earned dollars to the CPP and want to see that money put to work in investments like Saskatchewan farmland.

Other than the traditional family farm, it is hard to imagine another owner that better represents both the interests of Saskatchewan residents and the province's own goals.
That article elicited a critical response from Dan Patterson who ranches south of Moose Jaw and was general manager of the Farm Land Security Board for 20 years. He wrote an article, Valid concerns about CPP land venture:
Two recent articles regarding Saskatchewan's farm land ownership legislation ("Leduc: Saskatchewan farmland a good fit for CPP" and Bruce Johnstone's "Gov't eyes farmland Act changes") contribute some confusion to the issues involved.

Firstly, is the assertion by Michel Leduc of the Canada Pension Plan Investment Board (CPPIB), and by the minister of agriculture as quoted by Johnstone, that the farmland purchases by the CPPIB are beyond the regulatory scope of the Farm Land Security Board.

For complex regulatory reasons, the special status claimed by the CPPIB can be legitimately questioned. Clearly, though, the existing situation creates untenable inequity among Canada's largest pension plans, which have similar aspirations to invest billions of dollars in Saskatchewan farmland.

Examples are the BC Public Service Pension Plan, the Quebec Pension Plan, the Federal Public Employees Pension Plan and the Ontario Teacher's Pension Plan.

Leduc describes the CPPIB in terms that depict his organization as a developmental institution motivated to improve the prospects of young Saskatchewan farmers. This is entirely contradictory to the CPPIB Act. It explicitly requires the board to maximize its return on investments.

Similarly, Assiniboia Farmland LLP claimed its establishment would also foster and support young farmers by encouraging farm parents to liquidate their land holdings to an investment firm leaving their children as tenants.

Meanwhile its private advice to prospective investors was that the land would be managed to extract maximum rental income and would be blocked into "efficiently managed units".

Managing 500,000 acres of farmland with the objective of maximizing profits both for itself and for its client will logically lead over time to a reduction of renters to achieve management efficiencies. This result will be contrary to the benevolent assertions of Mr. Leduc.

As to the question of who will ultimately profit most from this transfer of land ownership from farmers to investors, recent history has shown the significant increase in value of farmland over the last decade would have been better left with multi-generational farmers to enhance their financial capacity to invest in new technology and the risk management benefit that growing equity creates.

The proposition put by the CPPIB is that its planned acquisition of 500,000 acres is such a low percentage of Saskatchewan's total farm land that it will have little effect on individual farmers or their communities.

This is facile. All farmers, whether established or beginning, know that competing in the land market with a $200-billion pension plan is an uneven competition.

Furthermore, its intended acquisitions will not be spread evenly over the province, but will create serious local impacts. Land values will be artificially inflated by such funds, which are external to the normal agricultural economy. The historic pattern where land that comes on the market is distributed to farmers within target communities will be destroyed.

The farmland ownership rules of Canada's three Prairie provinces are actually very similar. Instead of depicting this common regulatory environment as the world's most restrictive, the message should be that they are the most forward-looking.

The majority of the world's farmers wish their legislators had the same foresight.
I have to admit, Mr. Patterson raises some excellent points that need to be properly addressed by CPPIB. In particular, how is CPPIB going to "maximize returns" without hurting the livelihood of local farmers and squeezing them out of owning farmland?

Let me discuss some other concerns I have with pensions investing in farmland. Jesse Newman of the Wall Street Journal recently reported, Farmland Values in Parts of Midwest Fall for First Time in Decades:
Farmland values declined in parts of the Midwest for the first time in decades last year, reflecting a cooling in the market driven by two years of bumper crops and sharply lower grain prices, according to Federal Reserve reports on Thursday.

The average price of farmland in the Federal Reserve Bank of Chicago’s district, which includes Illinois, Iowa and other big farm states, fell 3% in 2014, marking the first annual decline since 1986, the Chicago Fed said. Prices for cropland during the fourth quarter remained steady compared with the previous quarter, according to the bank’s survey of agricultural lenders, though half of all respondents said they expect farmland values to decline further in the current quarter.

In the St. Louis Fed’s district, which includes parts of Illinois, Kentucky and Arkansas, prices for “quality” farmland gained 0.8% in the fourth quarter compared with year-ago levels, despite lower crop prices and farm incomes in the region. A majority of lenders in the district expect values to cool in the current quarter compared with the first quarter of last year, reflecting reduced demand for land amid tighter profit margins for farmers.

The reports spotlight an overall slowdown in the U.S. farm economy and in the appreciation of farmland prices. Crop prices had soared for much of the past decade, fueled by drought and rising demand for corn from ethanol processors and foreign importers. The gains pushed agricultural land values so high that some analysts warned of a bubble.

On Tuesday, the U.S. Department of Agriculture projected net U.S. farm income this year would fall to $73.6 billion, the lowest since 2009, from $108 billion in 2014.

Prices for corn, the biggest U.S. crop by value, have tumbled more than 50% since the summer of 2012, when they soared to record highs amid a severe U.S. drought. Growers produced the nation’s largest corn and soybeans harvests ever last autumn, helped by nearly flawless weather over much of the growing season.

In the Chicago Fed district, farmland values in the latest quarter dropped in major corn-producing states like Illinois, Iowa and Indiana compared with year-ago levels, while land values in Wisconsin increased slightly and were unchanged in Michigan. The fourth quarter of 2014 marked the first time since the third quarter of 2009 that cropland values in the district dropped overall compared with a year earlier.

“Lower corn and soybean prices have been primary factors contributing to the drop in farmland values,” David Oppedahl, senior business economist at the Chicago Fed, wrote in Thursday’s report, adding that for 2015, “district farmland values seem to be headed lower.”

While exceptional returns for livestock producers in 2014 helped blunt the impact of falling crop prices on land values, Mr. Oppedahl said, the trend may come to a halt if prices for animal feed grains stabilize somewhat this year.

Meanwhile, the St. Louis Fed said farm income, household spending by farms and expenditures on farm equipment declined in its region. Midwestern bankers expect a continued slowdown in the current quarter in those three categories.

“It is very difficult for farmers to buy farmland and new equipment with corn prices in the $3.50 range,” said one Missouri lender in the St. Louis Fed report.

Bankers in the Midwest also noted a rise in financial strain for crop farmers in the latest quarter. Lenders in the Chicago region reported a dramatic increase in demand for farm loans compared with year-ago levels, with an index of loan-demand reaching the highest level since 1994. Farm loan repayment rates also were “much weaker,” in the fourth quarter of 2014 compared with the same period a year earlier, the bank said, with an index of loan-repayment falling to the lowest level since 2002.
As if that's not bad enough, just yesterday, Joe Winterbottom and P.J. Huffstutter of Reuters reported, Rent walkouts point to strains in U.S. farm economy:
Across the U.S. Midwest, the plunge in grain prices to near four-year lows is pitting landowners determined to sustain rental incomes against farmer tenants worried about making rent payments because their revenues are squeezed.

Some grain farmers already see the burden as too big. They are taking an extreme step, one not widely seen since the 1980s: breaching lease contracts, reducing how much land they will sow this spring and risking years-long legal battles with landlords.

The tensions add to other signs the agricultural boom that the U.S. grain farming sector has enjoyed for a decade is over. On Friday, tractor maker John Deere cut its profit forecast citing falling sales caused by lower farm income and grain prices.

Many rent payments – which vary from a few thousand dollars for a tiny farm to millions for a major operation – are due on March 1, just weeks after the U.S. Department of Agriculture (USDA) estimated net farm income, which peaked at $129 billion in 2013, could slide by almost a third this year to $74 billion.

The costs of inputs, such as fertilizer and seeds, are remaining stubbornly high, the strong dollar is souring exports and grain prices are expected to stay low.

How many people are walking away from leases they had committed to is not known. In Iowa, the nation's top corn and soybean producer, one real estate expert says that out of the estimated 100,000 farmland leases in the state, 1,000 or more could be breached by this spring.

The stakes are high because huge swaths of agricultural land are leased: As of 2012, in the majority of counties in the Midwest Corn Belt and the grain-growing Plains, at least 40 percent of farmland was leased or rented out, USDA data shows.

"It's hard to know where the bottom is on this," said David Miller, Iowa Farm Bureau's director of research and commodity services.


Grain production is, however, unlikely to be affected in any major way yet as landowners will rather have someone working their land, even at reduced rates, than let it lie fallow.

But prolonged weakness in the farm economy could send ripples far and wide: as farms consolidate, "there would be fewer machinery dealers, fewer elevators, and so-on through the rural economy," said Craig Dobbins, professor of agricultural economics at Purdue University.

Possibly also fewer new farmers.

Jon Sparks farms about 1,400 acres of family land and rented ground in Indiana. His nephew wants to return to work on the farm but margins are tight and land rents high. Sparks cannot make it work financially.

"We can't grow without overextending ourselves," Sparks said. "I don't know what to do."

Landowners are reluctant to cut rents. Some are retirees who partly rely on the rental income from the land they once farmed, and the rising number of realty investors want to maintain returns. Landlords have also seen tenants spend on new machinery and buildings during the boom and feel renters should still be able to afford lease payments.

"As cash rent collections start this spring, I expect to see more farm operators who have had difficulty acquiring adequate financing either let leases go or try and renegotiate terms," said Jim Farrell, president of Farmers National Co, which manages about 4,900 farms across 24 states for land-owners.

Take an 80-acre (32 hectare) farm in Madison County, Iowa, owned by a client of Peoples Company, a farmland manager. The farmer who rented the land at $375 an acre last year offered $315 for this year, said Steve Bruere, president of the company. The owner turned him down, and rented it to a neighbor for $325 -- plus a hefty bonus if gross income tops $750.

There are growing numbers of other examples. Miller, of the Iowa Farm Bureau, said he learned about a farmer near Marshalltown, in central Iowa, who had walked away from 650 acres (263 hectares) of crop ground because he could not pay the rent. Just days later, he was told a north-central Iowa farmer breached his lease on 6,500 acres.


Concern about broken leases has some landlords reviewing legal options, according to Roger A. McEowen, director of the Iowa State University Center for Agricultural Law and Taxation. His staff began fielding phone calls from nervous landowners last autumn.

One catch is that many landlords never thought to file the paperwork to put a lien on their tenants' assets. That means landowners "can't go grab anything off the farm if the tenant doesn't pay," McEowen said. "It also means that they're going to be behind the bank."

Still, farmers could have a tough time walking away from their leases, said Kelvin Leibold, a farm management specialist at Iowa State University extension.

"People want their money. They want to get paid. I expect we will see some cases going to court over this," he added.

To avoid such a scenario, farmers have begun turning to banks for loans that will help fund operations and conserve their cash. Operating loans for farmers jumped 37 percent in the fourth quarter of 2014 over a year ago to $54 billion, according to survey-based estimates in the Kansas City Federal Reserve bank's latest Agricultural Finance Databook.

Loans with an undefined purpose -- which might be used for rents, according to the bank's assistant vice-president Nathan Kauffman -- nearly doubled in the fourth quarter of 2014 from a year earlier to $25 billion.

Total non-real estate farm loan volumes jumped more than 50 percent for the quarter, to $112 billion.

"It's all about working capital and bankers are stressing working capital," said Sam Miller, managing director of agricultural banking at BMO Harris Bank. "Liquidity has tightened up considerably in the last year."
These articles highlight two things: First, the bubble in farmland is bursting and second, when it bursts and farmers walk away from their leases, it could potentially mean costly and lengthy court battles pitting landowners (ie. endowment funds and public pension funds like CPPIB and PSPIB which also invests in farmland) against farmers. That doesn't look good at all for pensions.

All this to say, while it's really cool following Harvard's mighty endowment into timberland and farmland, when you come down to it, managing and operating farmland is a lot harder than it seems on paper and the risks are greatly under-appreciated. Add the potential of global deflation wreaking havoc on all private market investments and you understand why I'm skeptical that farmland is a good fit for pensions, even if they invest for the long, long run.

Below, economist Ernie Goss says the steep rise in agricultural land prices in a short period of time has created a bubble, and there's no doubt that land price growth is coming down. He says it won't be like the farm crisis of the 1980s, because a lot of farmers have paid cash for purchases (December 2013). It wasn't just the Fed that led to the farmland bubble, endowments and pensions also contributed to it.

Also, an older WKBT TV report (March, 2013) where some agriculture experts warned the market for farmland could be headed toward a similar fate as the housing market bubble. I agree with Vance Haugen, farmers and investors should be very concerned about the bubble in farmland popping. It's going to get a lot worse.