Friday, July 31, 2015

Risk On, Risk Off?

Svea Herbst-Bayliss and Lawrence Delevingne of Reuters report, Hedge fund Elliott eyes fresh market turbulence:
Paul Singer's $27 billion hedge fund Elliott Associates is worried about Europe's prospects and is bracing for fresh market turbulence.

In a letter to investors dated July 23 and seen by Reuters on Thursday, the New York-based firm told clients that it has returned 2.8 percent in its Elliott Associates, L.P. and 2.2 percent in its Elliott International Limited.

While both funds beat the Standard & Poor's 500 Stock Index's 1.2 percent gain, the fund spent pages explaining its more cautious approach and warning that even after a six-year bull market in stocks, there is "no such thing as a permanent trend in the markets."

It worries about central bankers' easy money policy noting that governments that have "abused the power to create 'money' have always, eventually, paid a huge price for their profligacy."

"We are not bragging about our record, nor do we feel defensive about not keeping up with the S&P 500 in the last few years," adding that it invests carefully especially at a time it sees more chance for severe market turmoil.

It also expressed concern about Europe even after the region found a solution to Greece's debt problem and worries that long-term problems have not been adequately addressed, possibly causing "the breakup of the euro."

"The bottom line in our view is that Europe is in a very difficult situation," the fund wrote.

Still Elliott sees what it calls "attractive opportunities in the activist equity area and a few interesting situations in event arbitrage." The firm recently lost a campaign to block the merger of two Samsung affiliates in Korea.

It also said it is cooling on real estate investments, noting "the balance in our real estate securities trading has turned to the sell side."

The firm recently raised $2.5 billion in new capital, calling it "dry powder."

But it also warned investors in the normally secretive hedge fund world to stop sending its closely followed letters to journalists and others.

"We have learned the identities of certain individuals who breached their confidentiality obligations by disclosing the contents of Elliott's quarterly reports," the firm wrote adding "We are taking action and seeking monetary damages from violators."

The Wall Street Journal first reported on Elliott's tough stance to keep its letters private.
I would ask Paul Singer and all other "elite hedge fund gurus" to make their quarterly or monthly letters to investors public as most of the money they manage comes from public pension funds.

Singer is an outspoken critic of central banks engaging in quantitative easing and has recently stated that bonds are the bigger short. I disagree with him on that call as I see the return of deflation -- or more precisely, the continuation of deflation -- wreaking havoc on the global economy for a prolonged period, which basically means we haven't seen the secular low in Treasury bond yields.

But I agree with Singer that the latest deal to save Greece and Europe is effectively a sham and that European leaders have failed to address deep structural issues that threaten the eurozone's future. In fact, despite massive QE from the ECB, I'm convinced the euro deflation crisis will rage on, wreaking havoc on unsustainable debts of periphery economies but also on core eurozone economies.

I also agree with Singer's call to shed real estate assets and raise cash to have "dry powder" at hand for opportunities. And in these volatile markets, there will be plenty of opportunities at hand but you need to pick your spots carefully or risk getting slaughtered.

Singer's Elliott Associates is doing relatively well, beating the S&P 500. Most hedge funds are struggling to remain open. The rout in commodities has annihilated many commodity hedge funds. The Wall Street Journal reports that Cargill's Black River Asset Management plans to shut down four of its hedge funds and return more than $1 billion to investors over the next several months.

Fortress Investment Group (FIG) on Thursday said its liquid hedge funds posted a $6million pre-tax loss for the second quarter as a result of turmoil at its flagship hedge fund portfolio that bets on global economic trends, sending its shares down.

Earlier this week, Laurence Fletcher of the Wall Street Journal reported, Hedge Fund’s Assets Fall by 95%:
One of the big hedge fund winners of the credit crisis has become a major loser in the era of easy money.

London-based bond-trader Mako Investment Managers LLP was a star performer in 2008 and investors poured money into its flagship Pelagus Capital Fund. But assets under management have fallen 95% since the end of 2012 due to weak returns and because investors have yanked their money.

Pelagus’s assets stood at $1.14 billion at the end of 2012, according to a person familiar with the matter, and have fallen to just $59 million at the end of June, according to an investor letter reviewed by The Wall Street Journal.

The decline highlights the difficulties faced by bond funds that have struggled to generate performance as huge quantitative easing programs by major central banks have suppressed volatility in the market.

On average, hedge funds that trade sovereign bonds are up 2.1% in the first half of this year, according to Hedge Fund Research, having gained just 1.2% in both 2013 and 2014—those results significantly lag the average return from hedge funds as a whole.

“QE has almost killed these strategies,” said one major European investor in hedge funds.

Among funds to have struggled trading interest rates in recent years is Brevan Howard’s $21.7 billion flagship macro fund, which last year posted its first-ever down year, according to a letter to investors. The BlueCrest Capital International fund, another major macro fund, made just 0.1% last year, according to regulatory filings. Macro funds bet on stocks, currencies, bonds and other assets.

Mako’s chief investment officer, Bruno Usai, said “near-zero interest rates and low market volatility” mean it is tough for funds such as Pelagus to make the double-digit returns of previous years.

In 2008, Pelagus made a return of 33.1%, according to an investor letter reviewed by The Wall Street Journal, while hedge funds on average lost 19% that year, according to data group Hedge Fund Research.

But recent performance has seen the fund lose money in each of the past 12 months, according to the letter. The fund is down 3.4% so far this year to the end of June and lost 4.1% last year, having made only small gains in each of the previous three calendar years.

According to the letter, the fund underestimated how Greece’s debt crisis would hit European bond markets—European sovereign bond yields rose as the crisis escalated—meaning the fund put on some trades too early. It didn’t specify the trades it put on.

Mr. Usai said the firm plans to launch a new fund before the end of September. He said it was an “irony” that investors are leaving funds such as his “just as fixed income volatility is starting to pick up and the Fed is on course to raise official rates this year.”
I keep warning my institutional readers to ignore your useless investment consultants and stop chasing after the hottest hedge funds. Most of the time, you'll get burned.

And while quantitative easing has made it tougher to make money trading sovereign bonds, I'm sick and tired of these excuses. Either your fund can adapt and deliver alpha, or simply bow out and return the money back to your investors.

We all know about quantitative easing and the pending liquidity time bomb, but institutions are paying big fees to hedge funds to navigate through this difficult environment. If they can't deliver alpha, they should get out and return the money to their investors way before losing 95% of their assets (investors should have pulled the plug on Mako years ago!).

All this talk on hedge funds struggling to deliver alpha led me to go back to reading the wonderful letters from Absolute Return Partners. Niels Jensen and his team offer investors some great food for thought. In June, Niels asked whether bond investors are crying wolf, concluding this is NOT the beginning of something much bigger and that economic growth will stay low for many years to come, and central banks have no intentions of suddenly flooding the bond market with sell orders.

In his July comment, A Return to Fundamentals?, Jensen notes that financial markets have in many ways behaved oddly since the near meltdown in 2008 and looks at whether we are finally beginning to see some sort of normalisation – as in a return to the conditions we had prior to 2008 – and what that would mean in practice.

He concludes:
"Overall, I don’t see any clear signs that the risk on, risk off mentality, which has ruled since 2008, is finally coming to an end. Yes, correlations have begun to recede a little bit here and there; however, if it is indeed a sign of bigger things to come, it is still very early days."
I highly recommend you make a habit of reading the letters from Absolute Return Partners. There is obviously some self-promotion but they will provide you with a lot of great insights on markets and alternative investments.

What do I think? I think Risk On/ Risk Off markets are here to stay. This is all a product of the liquidity tsunami from central banks around the world to counter the threat of global deflation, and illiquidity in fixed income markets.

In terms of equities, I've already told you we could be setting up for some nice countertrend rallies in Chinese (FXI), emerging markets (EEM), energy (XLE), commodities (GSG), metals and mining (XME), and gold (GLD) shares in the next few months, especially if global growth improves, but I would steer clear of these sectors. There will be violent short covering rallies but the trend is inexorably down.

My long-term forecast of global deflation remains intact which is why even though I might be tempted to trade countertrend rallies in energy and commodities, I keep steering clear of these sectors in favor of tech (QQQ) and biotech (IBB and XBI). Here too, it's very volatile, but I continue to buy the dips in biotechs I track as I think the long secular bull market in this sector is still in the early innings.

By the way, here is a small list of small biotechs I track and trade (click on image):

Some have performed better than others but they're all volatile and if you have no experience trading biotechs, stick to the indexes (IBB and XBI) or avoid this sector altogether. You literally have to stomach insane volatility and be very patient at times in order to make big profits.

Hope you enjoyed reading my weekend comment. As always, please remember to click on my ads and more importantly to donate or subscribe to this blog via PayPal at the top right-hand side. I sincerely thank all of you who have supported my efforts to bring you the latest insights on pensions and investments.

Below, that famous "Wax On, Wax Off" scene from the Karate Kid. I suggest hedge funds struggling in these "Risk On, Risk Off" markets take the time to listen to Mr. Miyagi. "Don't forget to breathe!".

Thursday, July 30, 2015

The End of Private Equity Superheroes?

Devin Banerjee of Bloomberg reports, Rubenstein Says Private Equity’s Fees, Investors Have Changed:
The private equity industry has changed the most in decades as its investor base evolves and clients demand more fee concessions, Carlyle Group LP’s David Rubenstein said.

“The industry has changed more in the four or five years since the crisis than in the previous 45 years,” Rubenstein, Carlyle’s co-founder and co-chief executive officer, said Sunday on the television program “Wall Street Week.”

From the 1970s to early 2000s, public pension plans were the biggest investors in the industry, said Rubenstein, who started Washington-based Carlyle in 1987 and has expanded it to manage $193 billion. Private equity firms use the money they collect to buy companies and later sell them for a profit. Today, sovereign-wealth funds are overtaking pensions in allocating money to the firms, of which Carlyle is the second-biggest, he said.

Large investors and those who commit early to funds are also able to extract discounts on the fees they pay the buyout firms, Rubenstein said, whereas in the past all clients were charged the same percentage on their committed money.

In addition, big clients are increasingly seeking separately managed funds with the firms, rather than solely committing to commingled funds with other investors, he said.
Retirement Money

Rubenstein, 65, said the “great revolution” coming to the industry will be the ability to add non-accredited investors, or those with a net worth lower than $1 million or those earning less than $200,000 a year. Regulations of fund structures should change to allow such people to put some of their retirement savings in private equity vehicles, said Rubenstein.

“Wall Street Week” is produced by SkyBridge Media, an affiliate of SkyBridge Capital, the fund-of-funds business founded by Anthony Scaramucci. SkyBridge, which sometimes has other business relationships with the show’s participants, advertisers and sponsors, pays Fox stations in key markets to broadcast the show and also streams it online every Sunday at 11 a.m. in New York.
I'm not sure about the "great revolution" Rubenstein is talking about in terms of non-accredited retail investors being able to invest in private equity. In my opinion, retail investors are better off investing in the shares of PE giants and staying liquid, but the three biggest private equity firms posted lower second-quarter profit after U.S. stocks slipped for the first time since 2012, a harbinger of things to come.

I do however agree with Rubenstein on the changing landscape in terms of large institutions and fee compression.

In fact, large pensions and sovereign wealth funds are increasingly trying to avoid private equity fees altogether. Last week, the Wall Street Journal reported that Dutch pension-fund manager PGGM teamed up with investors including sovereign-wealth funds for the €3.7 billion ($4.06 billion) takeover of a car leasing company to help its drive to reduce the hefty fees it pays to private-equity firms:
The acquisition of LeasePlan Corporation NV from German car maker Volkswagen AG and Fleet Investments is PGGM’s largest direct private-equity transaction, according to PGGM spokesman Maurice Wilbrink.

The Dutch fund has been building its in-house team to invest in companies directly, alongside private-equity firms and other investors, after selling its private-equity investment unit in 2011. Investors from the Canada Pension Plan Investment Board to Singaporean sovereign-wealth fund GIC are increasingly seeking to buy assets directly, rather than just through private-equity firms. Several pension funds have publicly voiced their concerns over the level of fees charged by the private-equity industry.

By acquiring companies directly, PGGM avoids paying private-equity firms annual fees of between 1% and 2% of the money invested. It also avoids the 20% fee known as carry that private-equity firms keep from the sale of profitable assets.

Most of the money that PGGM manages is on behalf of PFZW, a pension fund for Dutch nurses and social workers. In 2014, PFZW paid €445 million of fees to private-equity firms—more than half of its €811 million fee bill to money managers. Yet private equity only accounts for €9 billion, or 5.6% of PFZW’s €161.2 billion of assets, according to its annual report.

“We are looking at all kinds of ways to lower management fees and also performance fees,” Mr. Wilbrink said. “We think the private-equity sector should lower its fees and should accept that more money should go to the beneficiaries because they are the capital providers and it’s their money.”

PGGM also makes its own infrastructure investments to avoid paying fees to infrastructure funds.

PGGM is buying LeasePlan in partnership with Singaporean sovereign-wealth fund GIC; the Abu Dhabi Investment Authority, or ADIA, also a sovereign-wealth fund; ATP, Denmark’s largest pension fund; the merchant-banking unit of Goldman Sachs ; and London-based private-equity firm TDR Capital LLP.

GIC, ADIA and ATP are also part of the trend among traditional investors in private-equity firms to increasingly invest directly in takeovers of companies.

The investors will pay for the acquisition with an equity investment equal to about half of the purchase price, a convertible bond of €480 million and a loan of €1.55 billion, LeasePlan said in a statement. Unlike in a traditional private-equity-backed leveraged buyout, the debt won't be secured on the company that is being acquired.

“None of the debt raised by the Investors would be borrowed by LeasePlan and the company would not be responsible for the repayment of such debt,” LeasePlan said.

LeasePlan reported net income of €372 million in 2014, operates in 32 countries and has a workforce of more than 6,800 people.
Talk about a great deal and unlike private equity funds, large global pensions and sovereign wealth funds which invest directly in private equity have a much longer investment horizon and aren't looking to load their acquiring companies with debt so they can profit from dividend recapitalizations.

No wonder private equity funds are worried. They know they're cooked, which is one reason why they're trying to emulate the Oracle of Omaha to garner ever more "long term" assets and continue to steal from clients now that times are still relatively good.

What else? Amy Or of the Wall Street Journal reports that in what may be a sign of intensifying competition for assets, several private equity firms are dipping back into old investments:
"More and more sponsors are paying up where they think they have a material informational advantage,” said Justin Abelow , a managing director of financial sponsor coverage at investment bank Houlihan Lokey Inc.

Private equity firms, armed with $1.2 trillion in uncalled capital, need to fend off peers and strategic buyers in the fierce pursuit of assets. Standard & Poor’s Capital IQ Leveraged Commentary and Data said that as of the first half of the year, the average private equity purchase price multiple crept up to 10.1 times the target company’s trailing earnings before interest, taxes, depreciation and amortization, topping a historical high of 9.7 times in 2007.

As we report in the July issue of Private Equity Analyst, some firms looking for an edge in deals are taking a trip down memory lane.

Cleveland’s Riverside Co., for example, in May bought for a second time Health & Safety Institute, a provider of training materials and cardiopulmonary resuscitation courses. It previously owned the business between 2006 and 2012.

Partner Karen Pajarillo said her firm “didn’t have as much of a learning curve as others who are new to the business,” though HSI’s mix of revenue has changed over the years to include more online learning material.

Advent International is donning yoga pants once again, acquiring nearly 14% of yoga-gear maker Lululemon Athletica Inc for $845 million last year. The New York firm invested growth capital in the Canadian apparel company in 2005 at an enterprise value of 225 million Canadian dollars, taking the company public two years later in a $327.6 million offering. Lululemon share prices have risen by about 55% since Advent’s second investment in the company.

Revisiting old investments has proved profitable in the past for some firms.

San Francisco firm Friedman Fleischer & Lowe made a 10-times return on foam-mattress company Tempur-Pedic International Inc . in 2006 when it exited the $350 million investment it made in 2002. The firm reinvested in the company in 2008, re-exiting in 2011 at a 3.3-times return.

But second time isn’t always a charm, and firms must stay mindful that times change and the formula used previously may not work again, private equity executives said. Charterhouse Capital Partners lost control of U.K. washroom services provider PHS Group after the company was taken over by lenders. Charterhouse took PHS public in 2001, before taking it private again in 2005.
The second time around is definitely not always a charm. The market is a lot more competitive now as strategics are flush with cash and overvalued shares.

Lastly, I agree with Becky Pritchard of Financial News, it's the end of the private equity superheroes:
Quiz time. Who runs BC Partners? Who is the chairman of the British Private Equity & Venture Capital Association? And who is the top dog at Cinven?

If you drew a blank with any of those questions, you are not alone. The private equity industry, once the domain of larger-than-life characters, is full of curiously understated individuals these days.

Most of the buyout pioneers that founded Europe’s private equity industry have retired over the past decade. Men like Apax Partners’ Sir Ronald Cohen, CVC Capital Partners’ Michael Smith, Charterhouse Capital Partners’ Gordon Bonnyman, Permira’s Damon Buffini and Terra Firma’s Guy Hands got outsized returns for their investors and often had outsized personalities – charismatic, bombastic or just plain mouthy.

But, for the most part, they have stepped back to be replaced by committees and a generation of top executives with a lower profile. This new generation are more bureaucrats than entrepreneurs.

Industry roots

Thomas Kubr, managing director of investor Capital Dynamics, said he “absolutely” thought that Europe’s private equity leaders had changed in style over the past decade. Part of that was down to the early roots of private equity, he said: “The industry was started by people who never in their life thought they would be doing private equity because they had no clue what that was. Now you have entire career paths structured around the industry.”

Many of Europe’s biggest private equity firms began life in the banks. They were staffed by smart people that the banks were not sure what to do with, according to Ian Simpson, founder of placement agent Amala Partners, who has worked in the industry for 27 years.

The first industry leaders were the ones deemed by the banks to be “too dangerous to lend money but too bright to stick in HR”, he said.

Those years were a heady time for private equity: it was still almost a cottage industry and deal-doers were able to score blockbuster returns. Guy Hands made around £3 billion profit working for Nomura in the 1990s, for instance. Under Bonnyman’s leadership, Charterhouse invested €73 million in UK government leasing company Porterbrook in 1996, eventually getting a $481 million profit when it flipped it a year later.

In 1996, under Cohen’s leadership, Apax built up a 33% stake in Cambridge-based software company Autonomy, later selling its holding during the technology bubble of 2001 for a capital gain of more than £1 billion.

After pioneering the techniques used on buyouts at the banks, many of these trail-blazers decided to spin out and start their own firms. Buffini led the management buyout of Permira from Schroders Ventures Europe in 2001, Bonnyman led the spin out of Charterhouse Capital Partners from HSBC in 2001 and Hands left Nomura’s principal finance arm to set up Terra Firma in 2001.

New leadership style

Over the early 2000s, those new firms grew rapidly from small operations into huge asset managers with money pouring in from investors. Returns also began to slide as more players entered the market and the business became more institutionalised.

In the years around the financial crisis, many of the founders handed the reins over to the next generation of leaders or even groups of leaders, many of whom had lower public profiles than their predecessors. Cohen stepped back from running Apax in 2004, handing over to Martin Halusa; Buffini handed control of the firm to Kurt Björklund and Tom Lister in 2007; and Smith retired as chairman of CVC in 2012, handing control to Rolly van Rappard, Donald Mackenzie and Steve Koltes.

Antoon Schneider, a senior partner at The Boston Consulting Group, said the new generation were more managers than entrepreneurs but that a different financial environment called for a fresh style of leadership.

He said: “The great deal guys became the founding partners of the industry. The best dealmakers got to the top but now, with the second generation, it’s less about that. They are less entrepreneurs than they are managers. These are now larger, more complex organisations and the fact that you aren’t necessarily in a high-growth environment, you could argue that calls for a different kind of leader.”

A focus on the institution rather than on the individual is now reflected in the agreements made between investors and the buyout firms, known as limited partner agreements. These documents traditionally named one or two “key men” – if these named individuals left or died, investors could put investment from the fund on hold. These days there are usually a large group of key men mentioned in fund documents, reflecting how much more institutionalised and less focused on individuals the asset class has become.

Is the industry missing out on the entrepreneurialism of the early mavericks? Simpson said investors now want consistency from their managers rather than the bursts of genius that became the mark of the old guard.

He said: “They were a bit more entrepreneurial. The people in private equity come from a much more consistent background now. Everyone is a lot more interested in process and repeatability. Investors push that way.”

Jim Strang, a managing director at Hamilton Lane, thinks this change in leadership style has been a positive step for investors and has made the industry more professional. He said: “As PE firms have evolved, they have become large, complex businesses in their own right. The tools that you need to be a great business manager are different to being a great deals professional. So the fact that you have a different look and feel is probably a good thing.”

Minimising risks

He added that the new generation of leaders were more focused on how to run their firms and grow their businesses than their traditional deal-doing forefathers. He said: “The industry is way more competitive, way more sophisticated and developed than it was back in the day. They have got much better thinking about how to institutionalise their business to make it less risky.”

Perhaps the change was inevitable. As the industry has matured, it is natural for the focus to shift from the individual to the institution. But it does mean that many of the largest firms have become faceless behemoths that are tricky to tell apart.

Kubr summed it up: “You’ll find it in any industry. You get the true pioneers who develop a lot of the structures – but what comes afterwards is that you have to get professionalised. I guess I would say it’s neutral. It’s just a different style.”
The institutionalization of private equity, hedge funds, real estate, infrastructure is changing the landscape for the large alternative shops and placing ever more pressure on funds to tighten compliance and align their interests with investors.

Moreover, markets are changing faster than ever and private equity firms that fail to adapt to this new environment are going to be left behind. What I see happening in the future is a bifurcation in the private equity industry where the giants get bigger by collecting more assets from large pensions and sovereign wealth funds but their returns start sagging as competition heats up in the large cap space and deflation takes hold.

The smaller private equity firms which are typically more focused on performance will continue doing well by focusing on smaller deals and they will collect their assets from family offices and small endowment and pension funds. Also, the CalPERS of this world will continue to focus some of their capital in emerging manager programs to transition them to their mature manager portfolio (watch the latest CalPERS' board meeting at the end of my last comment).

Hope you enjoyed reading this comment. As always, please remember to click on my ads and more importantly to donate or subscribe to this blog via PayPal at the top right-hand side.

I am off to my appointment at the Montreal Neurological Institute where I am taking part in an Opexa study for progressive Multiple Sclerosis using my own T-cells (hard to know whether you're on the placebo). Whether you have or haven't contributed to my blog, please donate to the MNI as it's truly an incredible hospital and research center, conducting clinical and basic research and providing extraordinary care to thousands of patients with neurological diseases.

Below, Carlyle Group co-founder, co-CEO David Rubenstein, discusses private equity, technology, energy, politics philanthropy and more on Wall Street Week.

Great episode and my favorite passage was what he said about his parents and how to raise your kids when they are brought up in an advantageous background.

Listen to his comments, many of which I agree with and some of which I don't. Along with Blackstone's Stephen Schwarzman and a handful of elite managers, he is the last of the remaining PE superheroes.

Update: Just after writing this comment, the New York Times reported that Jerome Kohlberg Jr., a veteran financier who pioneered the $2.6 trillion leveraged-buyout industry but later rejected its hunger for huge and aggressive deals, died at his home in Martha's Vineyard. He was 90. Mr. Kolhberg was another private equity luminary who will be sorely missed.

Wednesday, July 29, 2015

California Dreamin'?

Dan Walters of the Sacramento Bee reports, California pension funds saw $100 billion gain in 2013-14:
California’s state and local government pension systems saw their assets climb by more than $100 billion during the 2013-14 fiscal year, outpacing the national trend by several percentage points, according to a new Census Bureau report.

Although payouts from the systems to retirees rose by $3 billion, additional contributions from government employers and their employees and a sharp increase in investment earnings contributed to the asset gain.

By the close of the fiscal year, California fund assets had risen to $751.8 billion, a gain of 15.5 percent from the previous year, the Census Bureau reported. Nationwide, state and local pension funds saw a 12.8 percent increase.

The major reason for the gain was a 46.3 percent increase in earnings to $115.8 billion. Another $30.1 billion in contributions – 70 percent of it from employers – added to the total revenue stream, offset by $46.1 billion in payouts to 1.2 million retirees.

State pension funds, led by the California Public Employees Retirement System, held 72.4 percent of total assets, with the remainder scattered among local pension systems.

But the state funds’ $544.8 billion in assets fell short of their reported $661.2 billion in calculated pension obligations, with the gap constituting an “unfunded liability.”

Overall, the state’s funds had 82 percent of what they needed to cover obligations, up from 77 percent the previous year. CalPERS has pegged its level most recently at 77 percent. The Census Bureau report did not delve into local pension funds’ unfunded liabilities.

Generally, pension fund analysts believe that they need to have at least 80 percent of liabilities covered by current assets to be considered healthy.

Despite the 2013-14 earnings increase, it’s likely that the next annual report will show more modest pension fund gains. CalPERS recently reported that its 2014-15 earnings were just 2.4 percent, less than a third of its 7.5 percent assumption, and other pension funds have reported less-than-stellar investment gains as well.
Indeed, choppy markets weren't good for CalPERS in fiscal 2014-2015. Dale Kasler of the Sacramento Bee recently reported, CalPERS reports 2.4 percent investment gain:
CalPERS reported a 2.4 percent profit Monday on its investments for the just-ended fiscal year, its lowest return in three years.

The performance is significantly below the pension fund’s official investment forecast of 7.5 percent, and could lead to another round of rate hikes for the state and the hundreds of local governments and school districts that belong to the California Public Employees’ Retirement System.

CalPERS officials, though, said a decision on rate increases is a ways off. They added that despite the low results for fiscal 2014-15, they’ve earned an average return of nearly 11 percent over the past five years and the pension fund isn’t in any immediate trouble because of one difficult year.

“We are a long-term investor,” said Ted Eliopoulos, the fund’s chief investment officer, in a conference call with reporters.

Choppy returns in the stock market held back the performance of CalPERS’ portfolio. CalPERS gained just 1 percent on its stocks, which make up 54 percent of the total portfolio of $300.1 billion.

Eliopoulos said the sparse returns on CalPERS’ stock portfolio were not a surprise in light of a strong run-up in prices the past several years. “We’re going on six years on a bull run in equity markets in the United States,” he said. “The prospects for returns are moderating.”

CalPERS’ investment performance has an enormous impact on the contribution rates charged to the state and local governments and school districts. CalPERS has been hiking those contributions by hundreds of millions of dollars annually in recent years to compensate for huge investment losses in 2008 and 2009, and to reflect larger government payrolls and predictions of longer life spans for current and future retirees.

Read more here:

Eliopoulos wouldn’t say if the latest investment results would bring more rate increases. “We have a whole other (rate-setting) process that will now take into account these returns,” he said. That process “will take some time.”

The 2.4 percent gain for the year that ended June 30 pales in comparison to the 18 percent profit earned a year earlier. While the stock holdings eked out minimal gains, the real estate portfolio earned a 13.5 percent return and private-equity investments earned 8.9 percent.

Read more here:

The pension fund was 77 percent funded as of a year ago, the latest data available. While CalPERS has plenty of money to pay retirees for now and the foreseeable future, the funding ratio means it has 77 cents in assets for every $1 in long-term obligations. Some experts say 80 percent is an adequate funding level, while others say pension systems should be 100 percent funded.
I've said it before and I'll say it again, CalPERS' investment results are all about beta. As long as U.S. and global stock markets surge higher, they're fine, but if a long bear market develops, their beneficiaries and contributors are pretty much screwed.

The same goes on all over the United States which why the trillion dollar state funding gap keeps getting bigger and risks toppling many state plans over if another financial crisis hits global markets.

Now, CalPERS has done some smart moves, like nuke its hedge fund program which it never really took seriously to begin with, paying outrageous fees for leveraged beta. In private equity, it recently announced that it's consolidating its external managers to reduce fees and have more control over investments.

But the giant California public pension fund isn't without its critics. Even I questioned whether failure to disclose all private equity fees isn't a serious breach of their fiduciary duty. And by the way, that fellow sitting there at the top of this comment is Joseph John Jelincic Jr. who according to the first article I cited above, is an investment officer at CalPERS Global Real Estate and also member of CalPERS' Board of Directors.

When I read that under his picture, I almost fell out of my chair. Talk about a serious conflict of interest. To be fair, Jelincic asks tough questions but it's simply unacceptable to have someone who works as at a public pension fund, especially in investments, to sit on its board. That's a total governance faux pas!

[Update: JJ Jelincic sent me this after he read this comment:
"Just so you know, my salary is set by negotiations between SEIU and the State of California. CalPERS is bound by that contract but doesn't negotiate it. (For the record I'm an Investment Officer III and at the top of the range.)

Because of the time I spend on the Board I do not participate in the IO III incentive program even through it is in the contract. (I estimate that costs me 10-15K a year.). So you can see I really don't have an economic conflict. Being on the Board has no impact (at least positively) on my income. It may make management uncomfortable but that is a different issue.

BTW the Sacramento Bee has a database that shows the salaries and bonuses for all the Investment Officers."
I thank him for clarifying this situation.]

Apart from the lack of independent, qualified board of directors, another governance problem at CalPERS and other U.S. state pension funds is the compensation is too low to attract qualified pension fund managers who can bring assets internally and add value at a fraction of the cost of going external. Sure, some big U.S. pensions are now opening their wallet to attract talent, but I remain very skeptical as the governance is all wrong (too much political interference).

I ran a search on CalPERS' website to view their latest comprehensive annual report and couldn't find it. The 2014 Annual Report is available for investment results as of June 30th, 2014 (fiscal year) but the latest one isn't available yet. I did however find a news release, CalPERS Reports Preliminary 2014-15 Fiscal Year Investment Returns:
The California Public Employees' Retirement System (CalPERS) today reported a preliminary 2.4 percent net return on investments for the 12-months that ended June 30, 2015. CalPERS assets at the end of the fiscal year stood at more than $301 billion.

Over the past three and five years, the Fund has earned returns of 10.9 and 10.7 percent, respectively. Both longer term performance figures exceed the Fund's assumed investment return of 7.5 percent, and are more appropriate indicators of the overall health of the investment portfolio. Importantly, the three- and five-year returns exceeded policy benchmarks by 59 and 34 basis points, respectively. A basis point is one one-hundredth of a percentage point.

"It's important to remember that CalPERS is a long-term investor, and our focus is the success and sustainability of our system over multiple generations," said Henry Jones, Chair of CalPERS Investment Committee.

It marks the first time since 2007 that the CalPERS portfolio has performed better than the benchmarks for the three- and five-year time periods, and is an important milestone for the System and its Investment Office. CalPERS 20-year investment return stands at 7.76 percent.

"Despite the impact of slow global economic growth and increased short-term market volatility on our fiscal year return, the strength of our long-term numbers gives us confidence that our strategic plan is working," said Ted Eliopoulos, CalPERS Chief Investment Officer. "CalPERS continues to focus on our mission of managing the CalPERS investment portfolio in a cost-effective, transparent and risk-aware manner in order to generate returns to pay long-term benefits."

The modest gain for the fiscal year - despite challenging world markets and economies - was helped by the strong performance of CalPERS real estate investments, approximately ten percent of the fund as of June 30, 2015. Investments in income-generating properties like office, industrial and retail assets returned approximately 13.5 percent, outperforming the Pension Fund's real estate benchmark by more than 114 basis points.

Overall fund returns and risks continue to be driven primarily by the large allocation to global equity, approximately 54 percent of the fund as of June 30, 2015. The Global Equity portfolio returned one percent against its benchmark returns of 1.3 percent. Key factors over the past twelve months include the strengthening of the US dollar versus most foreign currencies, as well as challenging emerging market local returns. Fixed Income is the second largest asset class in the fund, approximately 18 percent as of June 30, 2015, and returned 1.3 percent, outperforming its benchmark returns by 93 basis points.

Private Equity, approximately nine percent of the fund as of June 30, 2015, recorded strong absolute returns for the fiscal year, earning 8.9 percent, while underperforming its benchmark by 221 basis points (click on image).

Returns for real estate, private equity and some components of the inflation assets reflect market values through March 31, 2015.

CalPERS 2014-15 Fiscal Year investment performance will be calculated based on audited figures and will be reflected in contribution levels for the State of California and school districts in Fiscal Year 2016-17, and for contracting cities, counties and special districts in Fiscal Year 2017-18.
Now, a few points here. First, like so many other delusional U.S. public pension funds, CalPERS is wrong to cling to its 7.5% discount rate based on the pension rate-of-return fantasy. That works fine as long as stocks are in a bull market, but with rates at historic lows, when stocks turn south, those rosy investment projections will come back to haunt them.

Second, even though their fiscal years are off by a quarter, CalPERS seriously underperformed CPPIB, bcIMC, and PSP Investments in fiscal 2015. Admittedly, this isn't a fair comparison as one bad quarter in stocks can hurt overall performance and one is a large U.S. pension fund whereas the others are Canadian, but still over a one, five and ten year period, Canada's large pensions are significantly outperforming their U.S. counterparts, especially on a risk-adjusted basis.

Third, the investment results for CalPERS' Real Estate and Private equity are as of the end of March, so we can make some comparisons there with the results of these asset classes in fiscal 2015. I have PSP's fiscal 2015 results fresh in mind, so here are some quick observations:
  • In CalPERS' Private Equity returned 8.9% in fiscal 2015, underperforming its benchmark by 221 basis points. PSP's Private Equity gained 9.4% in fiscal 2015 versus its benchmark return of 11.6%, an underperformance of 220 basis points. In other words, in private equity, both programs performed similarly except that PSP's Private Equity program invests a lot more directly than CalPERS' and pays out significantly fewer fees to external PE managers (they do invest in funds for co-investment opportunities).
  • In Real Estate, CalPERS returned 13.5% in fiscal 2015, outperforming its real estate benchmark by 114 basis points. PSP's Real Estate significantly outperformed its benchmark by 790 basis points (12.8% vs 4.9%) in fiscal 2015. Again PSP invests directly in real estate, paying fewer fees than CalPERS, but clearly the benchmark PSP uses to gauge the performance of its real estate portfolio does not reflect the risks and beta of the underlying investments.
  • The same can be said about PSP's Natural Resources which far surpassed its benchmark return (12.2% vs 3.6%) while CalPERS' Forestland significantly underperformed its benchmark in fiscal 2015 by a whopping 1094 basis points (not exactly the same as forestland is a part of natural resources but you catch my drift). I think this is why CalPERS is divesting from these investments.
  • Only in Infrastructure did CalPERS significantly outperform its benchmark by 932 basis points, gaining 13.2% in fiscal 2015. By comparison, PSP's Infrastructure gained 10.4% vs 6.1% for its benchmark, an outperformance of 430 basis points. Again, I don't have issues with PSP's Infrastructure benchmark, only their Real Estate and Natural Resources ones, and just like CPPIB, the Caisse and other large Canadian pensions, PSP invests directly in infrastructure, not through funds, avoiding paying fees to external managers.
  • It goes without saying that no investment officer at CalPERS is getting compensated anywhere near the amount of PSP's senior managers or other senior managers at Canada's large public pension funds (Canadian fund managers enjoy much higher compensation because of a better governance model but some think this compensation is extreme).
I better stop there as I can ramble on and on about comparing pension funds and the benchmarks they use to gauge the performance of their public and private investments. 

I'm still waiting to hear about that other large California public pension fund, CalSTRS, but their annual report for fiscal 2015 isn't available yet. I don't expect the results to be significantly different from those of CalPERS and it too is embroiled in its own private equity carry fee reporting scandal

Hope you enjoyed reading this comment. As always, please remember to click on my ads and more importantly to donate or subscribe to this blog via PayPal at the top right-hand side. Below, I embedded the latest CalPERS' investment committee board meeting on June 15th, 2015.

For a pension and investment junkie like me, I love listening to these board meetings. I think you should all take the time to listen to this meeting, it's boring at parts but there are some great segments here and I applaud CalPERS for making these board meetings public (good governance).

I also embedded the video of the classic song, California Dreamin', featuring The Mamas and The Papas. Keep dreaming California but when markets turn south, you're in for a very rude awakening.

Tuesday, July 28, 2015

The Return Of Deflation?

Jamie McGeever of Reuters reports, Deflation threat returns to stalk investors and policymakers:
Fear of falling prices in a debt-laden world has returned to unnerve investors and central banks alike, as the slide on oil and commodity markets that set off a deflation scare last year has resumed with a vengeance.

This summer's Shanghai stock market shock is also deepening anxiety that a cooling of the Chinese economy will lead to sharply lower global growth, while weak consumer prices are undermining assumptions that U.S. interest rates will soon rise.

By this spring, the deflation scare had been fading, with investors confident the plunge in oil prices was over. They moved out of the safety of government bonds, pushing up yields in the hope that easy central bank money would gradually reflate the world economy. Victory over deflation could then be declared.

However, the Thomson Reuters Commodity Research Bureau index has plummeted 10 percent in July to its lowest level since the nadir of the global recession in early 2009.

Crucially, this benchmark index has breached the lows it hit in March, casting doubt on expectations that raw materials costs would soon cease to drag down annual consumer inflation rates.

"We're worried that the recent weakness in commodity prices could signal a loss of momentum in global growth that we're not projecting," said Bruce Kasman, global chief economist at JP Morgan in New York.

JP Morgan has yet to adjust its official projections, but Kasman said global growth in the second quarter is estimated at only 2 percent, a percentage point below his forecast at the start of the quarter.

Prolonged deflation is damaging, especially for the developed economies where household, corporate and government debt remains so high. If consumer prices fall, the real value of this debt rises, making it increasingly difficult to repay.

Consumer inflation is already near zero across the world. Even the recoveries underway in the United States, Britain and continental Europe do not seem strong enough to generate significant price pressures as economies in the emerging world, led by China, slow sharply.

This complicates - and possibly delays - interest rate rises planned by the U.S. Federal Reserve and Bank of England, which markets had assumed would happen by early 2016.

The dollar and sterling have risen in anticipation of higher rates, moves that are themselves deflationary as they lower the price of imports. "Lower goods prices and a stronger dollar could slow the Fed's path. The dollar matters," said Kasman.


Global inflation was just 1.6 percent in the second quarter, according to JP Morgan, down from 2.0 percent at the end of last year. While it is forecast to rise throughout 2015, this assumes commodity prices and economic growth don't weaken further.

Investors are left wondering where to put their money. Like commodities, emerging markets are suffering heavy selling and rising volatility; growing caution among investors could also hurt stocks, and bonds are near their most expensive in decades.

Latest fund flow data from Bank of America Merrill Lynch shows investors are starting to play "deflation trades". In the week ending July 22 they dumped billions of dollars' worth of gold, commodities and emerging market assets, BAML said.

Much of the attention is on China, the world's second largest economy which kept commodity prices high during its boom years that now seem to be fading.

Shanghai stocks lost a third of their value in the three weeks to July 9 before staging a government-inspired recovery. That was shattered by an 8.5 percent plunge on Monday, the biggest one-day loss since February 2007.

Capital is flooding out of China. Net outflows totalled as much as $220 billion in the second quarter, Goldman Sachs estimates, bringing the total in the past year to as much as $761 billion.

Bridgewater Associates, the world's largest hedge fund, reckons the impact of the financial sector on Chinese economic growth will flip from a positive 2 percent over the past year to zero or negative in the third quarter.

Last week, it issued a gloomy note on China, saying: "We are now at the point of maximum uncertainty. There are now no safe places to invest and the environment looks riskier."

This creates problems for both China's central bank and counterparts in the developed world which target inflation, such as the Fed, BoE and European Central Bank.

British inflation is zero, well short of the BoE's 2 percent target. The U.S. rate on the Fed's favoured measure is 1.2 percent, under its 2 percent target over three years. All this undermines the case for higher interest rates.

Last year's deflation scare was most acute in the euro zone, prompting the ECB to start pumping 1 trillion euros into the economy in March. In a new paper on Monday, the ECB warned that the war on deflation was not yet over.

"It remains too early to identify a turning point in underlying inflation from a statistical point of view. More data are required for the signal for such a turning point to become strong enough," the paper said.
Regular readers of my blog know my thoughts on global deflation. It was never dead to begin with. It's still there, lurking in the background, except the center of global deflation has shifted from the eurozone to China:
In spite of aggressive monetary easing by major central banks around the world, since 2008/09 financial crisis, inflation is yet to reach sustainable level. Some economies like countries in Euro zone, Japan still struggling to beat deflationary threat.

What might be fueling global deflation?

Relentless rout in Commodity prices adding downside pressure to global inflation. Bloomberg commodity index has reached 13 year low and commodity sell off is quite broad based, covering all sectors - energy, agricultural, industrial, precious metals.
  • Oil is trading near its lowest since financial crisis.
  • Gold is trading close to its lowest level in five years.
  • Sugar has fallen to seven year low.
  • Milk prices have dropped 65% in last 12 months.
  • Copper is reeling to its lowest, since financial crisis, down close to 28% in last 1 year.
And China is the culprit behind this major commodity rout.

Before the financial crisis, ships loaded with commodities were heading to China, as the giant was consuming more than half of global production in some.

In 2012, China was consuming about more than 50% of global iron ore, aluminum and nickel. Copper and zinc consumption was about 50% of global production.

This has led to some serious investments and capacity increase in commodity segment, which is leading to today's excess capacity.

China was able to maintain some growth prospects even after the crisis till 2011/13, after which its economy have started to crumble at sharp pace.

It now turns out that in 2015, Chinese economic activities have slowed to multi decade low and indicators are pointing to even lower.

Last Friday, preliminary reading for July in HSBC PMI came at 48.2, lowest in 15 months, suggesting further slowdown.

World's is likely to keep feeling the chill of a deflationary threat as world's second largest economy slows down further.
Indeed, if China heads into a prolonged bout of deflation, the world will keep feeling the chill of a deflationary threat. It will pretty much export deflation everywhere, including the United States.

No wonder Treasuries are becoming the stars of the financial markets as tumbling commodities and stocks raise concern inflation will turn to deflation.

The bursting of the China bubble is wreaking havoc on energy and commodity shares as well as commodity currencies.  I wrote about it on Friday in my comment on an ominous sign from commodities.

But I also warned my readers:
[...] go back to carefully read my comments on Bridgewater turning bearish on China and a tale of two markets. We could be setting up for some nice countertrend rallies in Chinese (FXI), emerging markets (EEM), energy (XLE), commodities (GSG), metals and mining (XME), and gold (GLD) shares in the next few months.

How is this possible? First, if markets deteriorate further, the Fed won't hike rates this year. Second, real rates in emerging markets remain too high relative to real rates in the developed world, so expect more central bank easing in emerging markets in the near future. Third, the reflationistas may be temporarily right,  global growth will likely come in stronger than anticipated in the next few quarters, which will help boost energy and commodity shares.

But make no mistake, my long-term forecast of global deflation remains intact which is why even though I might be tempted to trade countertrend rallies in energy and commodities, I keep steering clear of these sectors in favor of tech (QQQ) and biotech (IBB and XBI).
Keep all this in mind as the Fed meets on Tuesday and Wednesday to discuss any changes to its monetary policy. I still maintain the Fed won't make a monumental mistake of raising rates this year because it will risk a crisis in emerging markets and send the mighty greenback soaring higher, putting further pressure on commodities and raising the risks of global deflation.

Also, keep in mind, there is no inflation and no need for the Fed to raise rates. In fact, with rates at historic lows and commodities tanking because of weakness out of China, the Fed prefers to err on the side caution and inflation than risk another global financial crisis and a prolonged period of global deflation.

Markets are already starting to look ahead and pricing in better global growth from all this monetary stimulus. On Tuesday, you're seeing some big moves in shares of the Metals and Mining ETF (XME), led by Freeport-McMoRan (FCX).

Again, these are violent countertrend moves that are a combination of short covering and buying activity from investors and traders who felt the recent rout in these shares was way overdone. You can trade these countertrend rallies, especially if global indicators start turning up in the weeks ahead, but be careful not to overstay your welcome. This is the last leg up before markets turn south.

Below, global bond manager Robert Kessler recently appeared on WealthTrack with Consuelo Mack to discuss why he is sticking with his decade long, bullish view on Treasuries and says the Federal Reserve is in “no position to raise interest rates.”

I agree with Mr. Kessler as well as with Van Hoisington and Lacy Hunt of Hoisington Investment Management who in their latest quarterly economic outlook end by stating:
"While Treasury bond yields have repeatedly shown the ability to rise in response to a multitude of short-run concerns that fade in and out of the bond market on a regular basis, the secular low in Treasury bond yields is not likely to occur until inflation troughs and real yields are well below long-run mean values. We therefore continue to comfortably hold our long-held position in long-term Treasury securities." 
Keep this in mind when Wall Street talking heads tell you deflation is dead. Deflation isn't dead, it never was dead. It's there, ongoing, and central banks around the world are petrified, trying hard to stimulate the global economy before it becomes entrenched.

Monday, July 27, 2015

PSP Investments Gains 14.5% in Fiscal 2015

The Canada News Wire reports, PSP Investments Reports Fiscal Year 2015 Results:
The Public Sector Pension Investment Board (PSP Investments) announced today a gross total portfolio return of 14.5% for the fiscal year ended March 31, 2015 (fiscal year 2015). For the 10-year period ended March 31, 2015, PSP Investments' net annualized investment return reached 7.6% or 5.8% after inflation, significantly above the net long-term rate of return objective used by the Chief Actuary of Canada for the public sector pension plans, which averaged 6.0% or 4.2% after inflation for the period.

The investment return for the year exceeded the Policy Portfolio Benchmark rate of return of 13.1%, representing $1.5 billion of value added. In Fiscal 2015, all portfolios achieved solid performances, the majority generating double digit investment returns.

"We are pleased with these strong returns in a year that saw the appointment of a new Chair in November 2014 and the arrival of André Bourbonnais, our new President and CEO, at the end of March 2015," said Michael P. Mueller, Chair of the Board of PSP Investments. "This performance attests to the strength and depth of the organization and its senior management team and to the quality of its corporate governance."

"I wish to highlight the contribution of two of our key people whose efforts were crucial to keeping us on course to record these strong results; namely, John Valentini, who led us with great poise during his tenure as Interim President and CEO, and Cheryl Barker, who stepped up solidly in her role as Interim Chair during a large part of the year," added Mr. Mueller.

Solid Foundation from which to Grow
"I wholeheartedly embrace PSP Investments' important social mission of contributing to the long-term sustainability of the public sector pension plans for the ultimate benefit of the contributors and beneficiaries," said André Bourbonnais, President and CEO of PSP Investments. "I intend to build on the strength and depth of our organization to deliver on that mission. With the projected growth in assets -, this will undoubtedly involve expanding into still more asset classes, transforming PSP Investments into a truly global pension investment manager with a local presence in select international markets and supplementing the organizational structure to better capture opportunities at the total fund level."

Surpassing Targets and Financial Thresholds

In fiscal 2015, PSP Investments' net assets increased by $18.3 billion or 20%. These gains were attributable to a combination of strong investment performance and net contributions. Net assets at the end of fiscal 2015 exceeded the $100-billion threshold to a record $112.0 billion. PSP Investments generated profit and other comprehensive income of $13.7 billion in the latest fiscal year. Over the past five-year period, PSP Investments recorded a gross compound annualized investment return of 11.7% and generated $43.3 billion in investment income.

Public Markets Equities, Fixed Income and Private Markets Post Solid Returns

For fiscal 2015, Public Markets Equities returns ranged from 7.2% for the Canadian Equity portfolio to 29.5% for the US Large Cap Equity portfolio. The Fixed Income portfolio generated a return of 9.4% while the return for the World Inflation-Linked Bonds portfolio was 16.9%.

In 2015, all Private Markets asset classes achieved strong investment returns. Real Estate and Natural Resources1 led the way with returns of 12.8% and 12.2%, respectively. Infrastructure posted a 10.4% investment return while the Private Equity portfolio investment return was 9.4%.

The asset mix as at March 31, 2015, was as follows: Public Markets Equities 50.2%, Fixed Income and World Inflation-Linked Bonds 17.9%, Real Estate 12.8%, Private Equity 9.0%; Infrastructure 6.3%; Cash and Cash Equivalents 2.4% and Natural Resources 1.4%.
Ben Dummett of the Wall Street Journal also reports, PSP Investments Generates 14.5% Return in Fiscal 2015:
Public Sector Pension Investment Board, one of Canada’s biggest pension funds, said Thursday it generated a 14.5% return in fiscal 2015, beating its internal benchmark on strong gains across public and private asset classes.

PSP Investments had 112 billion Canadian dollars ($86 billion) in assets under management for the year ended March 31, surpassing the C$100 billion mark for the first time. The latest result is up from $93.7 billion a year earlier and reflects a combination of investment returns and pension contributions.

Gains in large-cap U.S. stockholdings, inflation-linked bonds and private investments—including real estate, natural resources and infrastructure—helped the Montreal-based pension fund exceed its internal benchmark return of 13.1%.

The strong performance was consistent with benchmark-beating gains by several of Canada’s biggest pension funds in their latest annual periods, including Canada Pension Plan Investment Board, Caisse de dépôt et placement du Québec and Ontario Teachers’ Pension Plan.

But a combination of high valuations across public and private asset classes, lower crude prices, China’s slowing economic growth and uncertainty over any fallout from Greece’s debt woes increases the risks to these strong returns continuing.

André Bourbonnais, PSP Investments’ newly appointed chief executive, acknowledges some assets are relatively expensive, but that challenge won’t put the fund on the sidelines.

“Prices are way up there, but there are still pockets of value…and the worst thing we can do is stand still and be paralyzed by this market,” Mr. Bourbonnais said in an interview. The pension fund executive took over the top job at the end of March, joining from CPPIB where he headed private investments.

To protect against a potential downturn, for example in private assets, PSP Investments is investing in convertible debt and structuring investments in ways that reduce potential returns but also offer some protection, he said.

Since joining PSP Investments, Mr. Bourbonnais has worked to foster greater cooperation among investment groups and has created a chief investment officer position to help identify investment themes.“One of the big themes we are thinking about is innovation and how do we play innovation: do we buy public stock; do we try to find private companies; do we buy (real estate) in Palo Alto?” he said.

PSP Investments plans to open new offices in New York and London in the coming months to establish investment teams specializing in illiquid credits and private equity, respectively.

“Developing an international footprint in key markets will help us benefit from local knowledge…and allow us to be closer to our partners,” Mr. Bourbonnais said.
Indeed, as Scott Deveau of Bloomberg reports, PSP Builds Credit Office in New York in Global Expansion:
Public Sector Pension Investment Board will open offices in New York and London and is eyeing Asia as part of the Canadian fund’s plan to double its C$112 billion ($86 billion) in assets over the next decade.

PSP plans to build a loan-origination business in New York and private-equity operations in London this year, Andre Bourbonnais, chief executive officer of PSP, said in a phone interview Thursday.

“We’re going to stick to the markets we know better, which is essentially the Western world,” he said. Within 24 months PSP will look at getting an office in Asia, he said. “Having a foot on the ground there is going to be key for local knowledge, local human capital and being closer to our partners.”

PSP, which oversees the retirement savings of federal public servants, including the Royal Canadian Mounted Police, follows other domestic pension funds bulking up operations overseas.

The U.S. and Europe are presenting the greatest opportunity for investment in challenging markets where many investors are chasing deals, he said.

The fund returned 15 percent on its investments in the year ended March 31, 2015, and increased the value of its assets under management by 20 percent over the year, according to a statement Thursday.

Break Silos

Bourbonnais took over as chief executive of PSP in March after serving as global head of private investment at Canada Pension Plan Investment Board. He said he has already implemented measures within the organization aimed at breaking down barriers between the pension plan’s various departments so it can compete more effectively.

“This place has been built pretty much bottom up, with each investment class doing their own thing,” he said. “We need to break the silos and try to get as much synergies from the group as possible.”

PSP has also created a new chief investment officer position, and has reorganized its debt and credit functions under one roof and its private investment arms under another, he said.
Mr. Bourbonnais is right, PSP was mostly built from the bottom up and his predecessor, Gordon Fyfe, didn't have the foresight to hire a chief investment officer, preferring instead to wear both hats of CEO and CIO (which he is now doing at bcIMC).

To be fair, Gordon did create an Office of the CIO and had the brains to hire my former colleague Mihail Garchev and a few other analysts, but it was woefully under-staffed and desperately needed new direction and more "synergies" between public and private markets.

The person now responsible for leading this group is Daniel Garant who came to PSP back in 2008 from Hydro-Québec where he was their CFO to head PSP's Public Markets. According to PSP's website, Mr. Garant was just appointed CIO this July.

Apart from appointing Mr. Garant CIO, Mr. Boubonnais also recently promoted Anik Lanthier to the position of  Senior Vice President, Public Equities and Absolute Return. She is now part of senior management at PSP.

Also worth noting that Derek Murphy, the former head of Private Equity, is no longer with PSP. He left the organization soon after Mr. Bourbonnais got to PSP in early April after being appointed in late January. Neil Cunningham, the Senior Vice President and Global Head of Real Estate Investments is now acting as the Interim Senior Vice President, Global Head of Private Investments.

Now that we got those HR issues out of the way, it's time to go over PSP's fiscal 2015 results. I urge you all to take the time to read PSP's 2015 Annual Report. It is extremely well written and provides a lot of useful information on investments and other activities at PSP during fiscal 2015.

Let's begin by looking at PSP's portfolio and benchmark returns which are available on page 21 of the Annual Report (click on image):

As you can see, there were strong returns across Public and Private Markets in fiscal 2015. Returns of global public equities were particularly strong, especially in the U.S. (+29.5%) where the boost from the USD also helped bolster the Public Equity portfolio (PSP indexes its large cap U.S. equity exposure). 

In terms of Public Markets, it's worth reading the passage below taken from page 22 of the Annual Report (click on image): 

The key points to remember on Public Markets are the following:

  • U.S. Large Cap Equity, which is indexed, delivered solid gains (+29.5%) and were boosted by the surging U.S. dollar.
  • Emerging Markets Equity, which are also indexed, delivered solid gains of 15.2% in FY 2015.
  • EFEA Large Cap Equity which isn't indexed and managed internally, underperformed its benchmark by 80 basis points in fiscal 2015 (12.9% vs 13.7%).  Over a five-year period, however, this portfolio is on par with its benchmark (11.1% vs 11%).
  • Canadian Equity portfolio slightly outperformed its benchmark by 30 basis points (7.2% vs 6.9%) as did the Small Cap Equity portfolio, gaining 20 basis points over its benchmark (25% vs 24.8%).
  • Fixed Income underperformed its benchmark by 70 basis points in fiscal 2015 (11.7% vs 12.4%) as strong gains in World Inflation-Linked Bonds (+16.9%), which are indexed, were offset by weak performance elsewhere. On page 23 of the Annual Report, it states that the "underperformance can be explained by the positioning of the Fixed Income portfolio to take advantage of rising US and global rates" (good luck with that call, especially if global deflation hits the world economy). 
  • There was a good balance between internal and external absolute return mandates, with the former adding $115 million of relative value and the latter adding $193 million of relative value. Good positioning on the USD vs the euro, geographic and sector calls (like underweighting energy) and fixed income relative value trading all added to absolute returns in fiscal 2015.
  • The internal Value Opportunity portfolio gained 30.1% in fiscal 2015, contributing $35 million in relative value. The positive added value was partially offset by the underperformance of PSP's Active Fixed Income portfolio.
  • Asset-backed term notes contributed $29 million in relative value, as PSP continued to benefit from a reduction of risk on the underlying assets as they approach maturity.
In terms of Private Markets, here are some of my observations:

  • Real Estate, where the bulk of the private assets are concentrated, significantly outperformed its benchmark by 790 basis points (12.8% vs 4.9%) in fiscal 2015. Net assets of the Real Estate portfolio totalled $14.4 billion at the end of fiscal year 2015, an increase of $3.8 billion from the prior fiscal year.
  • Over the last five fiscal years, Real Estate has gained 12.6%, far outpacing its benchmark return of 5.7%. These gains relative to the RE benchmark accounted for the bulk of the value added at PSP over this period.
  • There were also strong gains in Infrastructure (10.4% vs 6.1%) and Natural Resources (12.2% vs 3.6%) relative to their respective benchmarks.
  • The only private market asset class that underperformed its benchmark was Private Equity, gaining 9.4% in fiscal 2015 versus its benchmark return of 11.6%. Still, over the last five fiscal years, Private Equity has managed to gain 220 basis points above its benchmark (15.4% vs 13.2%).
Once again, there were spectacular gains in private markets -- especially in Real Estate, Infrastructure and Natural Resources -- relative to their respective benchmarks.

So what are the benchmarks of the portfolios? Below, I provide you with the benchmarks of each portfolio taken from page 20 of the Annual Report (click on image):

I will tell you right away the benchmarks for Real Estate, Natural Resources and to a much lesser extent Infrastructure (respective cost of capital), do not reflect the risks of the underlying portfolio, especially in Real Estate. At least Private Equity cleaned up its benchmark to now include Private Equity Fund Universe plus its cost of capital. 

The benchmark for PSP's Real Estate portfolio is particularly egregious given that it's gotten easier to beat since my time at PSP and since I wrote my second blog comment back in June 2008 on alternative investments and bogus benchmarks.

Read the passages below taken from page 24 and 25 of the Annual Report (click on image):

No doubt, there were strong gains in core markets like the United States, but PSP is taking quite a bit of real estate risk in emerging markets and it's also taking a lot of opportunistic real estate risk. Even risks in developed markets like New Zealand and Australia can whack PSP as their currencies are plunging in the latest rout in commodities.

This just proves my point that the Auditor General of Canada really dropped the ball in its Special Examination of PSP Investments back in 2011. It's abundantly clear to me that the Office of the Auditor General lacks the resources to perform an in-depth performance, risk and operational due diligence on PSP or any other large Canadian public pension fund (that is a huge and increasingly worrisome governance gap that remains unaddressed).

As I've stated plenty of times on my blog, when it comes to gauging performance, it's all about benchmarks, stupid! You can can have a monkey taking all sorts of opportunistic real estate risk, handily beating his or her bogus "cost of capital" benchmark over any given year, especially over a four or five year period.

And let me be clear here, I'm not taking personal swipes at Neil Cunningham, the head of PSP's real estate portfolio. Neil is a hell of real estate manager and a good person. Unlike his predecessor, which I didn't particularly like, I actually like him on a professional and personal basis (he taught me how to implement my Yahoo stock portfolio and always had time to chat real estate with me).

But when I see the shenanigans that are still going on at PSP in terms of some of their private market benchmarks, I'm dumfounded and wonder why the Board of Directors are still letting this farce go on. 

And why are benchmarks important? Because they determine compensation at PSP and other large Canadian public pension funds. Period. If the Board doesn't get the benchmarks in all portfolios right, it allows pension fund managers to game their respective benchmark and handily beat it, making off like bandits.

Have a look at the compensation of PSP's senior managers during fiscal 2015 taken from page 69 of the Annual Report (click on image):

As you can see, the senior managers at PSP are compensated extremely well, far better than their counterparts at the Caisse and many other large Canadian public pension funds. 

No doubt, compensation is based on four-year rolling returns and PSP has delivered on this front, adding significant value but you have to wonder if they got the Real Estate and other private market benchmarks right from the get-go, would it have impacted the added-value and compensation of PSP's senior managers? (the answer is most definitely yes).

By the way, you will also notice Mr. Bourbonnais made roughly $3 million in total compensation in fiscal 2015, which was a signing bonus, and in a footnote it says he was given a guarantee that his total direct compensation over the next three fiscal years will be no less than $2.5 million a year.

It's important however to keep in mind that Mr. Bourbonnais walked away from a big position at CPPIB where he was head of private markets and pretty much had that amount guaranteed in terms of total compensation over the next three fiscal years, so even though this seems outrageous, it's not. It's only fair given what he walked away from.

Also, John Valentini deserved his total compensation in fiscal 2015 given he was the interim president for a long time before André Bourbonnais got there. Daniel Garant's total compensation will rise significantly over the next three fiscal years too given the increased responsibility he has (although I'm not sure if he is CIO of Public and Private Markets like Neil Petroff was or CIO of Public Markets like Roland Lescure at the Caisse).

In any case, PSP's fiscal 2015 results were excellent and there's no question that apart from criticism of some of their private market benchmarks, they're doing a great job managing assets on behalf of their contributors and beneficiaries. 

I would just add that PSP needs to do a lot more work in terms of diversifying its workplace at all levels of the organization, and do a lot more to hire minorities, especially persons with disabilities (that is another HR audit that should take place at every single large Canadian public pension fund, not just PSP).

Once again, please take the time to carefully read PSP's 2015 Annual Report, it's excellent and covers a lot of topics that I forgot to cover or don't have time to cover. For example, over 73% of PSP's assets are now managed internally and the cost of managing these assets is significantly lower than any mutual fund.

Back in May, André Bourbonnais, president and chief executive officer of the Public Sector Pension Investment Board, Winston Wenyan Ma, managing director and head of the North America Office at China Investment Corporation, Ron Mock, president and chief executive officer of Ontario Teachers Pension Plan, and Michael Sabia, president and chief executive officer of Caisse de dépôt et placement du Québec, participated in a panel discussion about Canadian pension plans and investment strategy. Bloomberg's Scott Deveau moderated the panel at the Bloomberg Canada Economic Series in Toronto (May 21, 2015). Please take the time to listen to this discussion here.

Below, an older discussion with André Bourbonnais at a Thompson Reuters conference where he discussed CPPIB's approach to investing in private markets (October, 2014). Very interesting discussion, listen to his comments and answers to some excellent questions.