Monday, May 16, 2016

Ottawa Taps Pensions For Infrastructure?

Andy Blatchford of the Canadian Press reports, Will big pension funds and Ottawa partner to build tomorrow's infrastructure?:
The Trudeau government's newfound enthusiasm about a big Montreal transit proposal has given Canadians a glimpse at one way Ottawa could fund billions in public infrastructure, like roads, bridges and rail, over the long haul.

In recent days, senior Liberals have been talking up an unusual funding model for the $5.5-billion light-rail plan for Montreal, calling for a partnership that includes Ottawa and a public pension fund.

The idea was put forward by Quebec's massive public pension fund manager, which recently announced its proposal to build a large electric rail network connecting Montreal to its suburbs.

The fund, the Caisse de depot et placement du Quebec, is prepared to pump $3 billion into the project -- and it wants the provincial and federal governments to kick in the rest.

A subsidiary of the Caisse would operate the rail network and gradually recoup the pension plan's investment through user fees. Eventual profits would be funnelled into Quebecers' public nest egg -- the Quebec Pension Plan -- which is managed by the Caisse.

The idea was made public after the Liberal government signalled in its March budget that it would like to engage deep-pocketed pension funds and other "innovative sources of funding" to help raise much-needed cash for long-term infrastructure projects -- when it's in the public interest.

So far, this first example of a potential federal partnership with a major pension plan appears to have stoked excitement among senior Liberal cabinet ministers.

"I salute the innovative efforts of the Caisse de depot et placement du Quebec, which, through its metropolitan electric network, is proposing a new business model to implement major infrastructure projects," Finance Minister Bill Morneau told a business crowd late last week in Montreal.

"We have the chance in Canada to count on pension funds that have developed an expertise in infrastructure that is recognized around the world."

Morneau added that Ottawa is studying the Caisse's plan with "lots of interest."

His inaugural budget followed through on a Liberal election pledge to double infrastructure spending over the next 10 years, raising the overall federal investment to $120 billion.

The party has argued boosting infrastructure spending will increase productivity, generate more long-term growth and create jobs.

The plan, however, comes at a cost.

Infrastructure spending is expected to contribute to a string of five-straight budgetary deficits that could add more than $110 billion to Canada's public debt.

Seeking out other sources of cash for infrastructure could increase the number of new investments while helping prevent the country from sliding even deeper into the red.

The first phase of the Liberal plan calls for $11.9 billion of spending over five years. It's focused on projects such as repairing aging water and public transit infrastructure as well as providing cash for smaller projects that can be completed by 2019.

There's also money available for planning larger, more-ambitious projects that would be part of the program's second phase, the details of which have yet to be unveiled.

That's where the Caisse's light-rail plan comes in -- it features a type of funding model the government could increasingly tap into.

Infrastructure Minister Amarjeet Sohi told the Senate's question period last week that the timing of the government's second phase aligns with the Montreal proposal. He added that the government is working "very closely" with the Caisse.

"This is one of the most innovative and creative projects that I have seen in my short while in this portfolio, and it will be transformative for the region of Montreal," Sohi said.

"I see this as a great opportunity for us to support innovation in delivery of infrastructure, because we do need to engage public sector pension funds, as well as private sector funds, to make sure the amount of infrastructure that we build across the country engages other stakeholders and partners."

In their remarks last week, both Sohi and Morneau complimented Caisse CEO Michael Sabia, whom Morneau has named to his economic advisory council.

The council, tasked with helping the government map out a long-term growth plan, also features another head of a powerful public pension plan: Mark Wiseman, president and CEO of the Canada Pension Plan Investment Board.

The groups will meet for the first time Monday north of Ottawa. Morneau and Sohi will both be among several cabinet ministers present at the meeting.

Large Canadian pension plans, such as the Caisse and CPPIB, have invested billions in infrastructure projects abroad. Funds like these covet access to the reliable, predictable returns that infrastructure offers through revenue streams such as user fees, like tolls.

In its budget, the Liberals also mentioned something called "asset recycling," a system that could see governments in Canada lease or sell stakes in existing major public assets such as highways, rail lines, and ports.

Wiseman has praised asset recycling as a model Canada could use to attract long-term capital as it deals with its growing infrastructure deficit.

Sabia has argued that opening the door to pension plans to make more infrastructure investments in Canada would create a win-win scenario.

"Every time you take the train, every time you buy a ticket, obviously it is a contribution to your retirement fund," Sabia said last month after he announced the Montreal rail proposal.
I agree with Michael Sabia, Ottawa's push to court Canada's large pensions on infrastructure is a win-win for everyone. I expect to see more projects where Canada's Top Ten pensions are called to bankroll infrastructure and help manage existing (mature) infrastructure assets like bridges, rail lines, airports, highways, and ports or to develop new (greenfield) infrastructure projects.

In order to understand why this push for "asset recycling"  makes so much sense for the federal government, pensions and the economy, you need to think like a large Canadian pension fund, meaning you need to take a very long-term view of things:
  • Governments around the world are cash-strapped at a time when the world is in a serious economic rut. From where I'm standing, the deflation dog is barking very loudly and Harvard economist Larry Summers is right, monetary policy alone isn't going to pull the global economy out of its rut. We need more fiscal stimulus in the form of massive infrastructure spending. 
  • Summers has warned that pushing off repairs of America's crumbling infrastructure to future generations creates the "worst and most toxic" debts. He's absolutely right. America will fall $1.44 trillion short of what it needs to spend on infrastructure through the next decade, a gap that could strip 2.5 million jobs and $4 trillion of gross domestic product from the economy, a report from a society of professional engineers said last week.
  • In Canada, the situation isn't any better. The 2016 Infrastructure Report Card shows that Canada’s critical infrastructure is in dire straits with over a third of municipal infrastructure in either fair, poor or very poor condition.
  • Spending on infrastructure is desperately needed not only to modernize it but also to boost the economy, making the country much more competitive for future growth. Investing in infrastructure means investing in good jobs that pay decent wages (good multiplier effect) but also investing in the future prosperity of the country to meet the challenges of an increasingly more competitive global economy.
  • Where do Canada's large pension funds come into the picture? It turns out Canada's Top Ten pensions know a thing or two about investing in infrastructure. They own prize infrastructure assets in Australia, Britain, Europe, and around the world and unlike private equity or hedge funds, they invest huge sums directly in infrastructure, making this the asset class of choice in terms of finding stable, recurring cash flows and decent yield at a time when most public and private assets are over-valued. 
  • Investing in domestic infrastructure carries the added benefit of not taking any foreign exchange risk and not dealing with regulatory risks that can come if a foreign government changes the rules of the game. Canadian pensions have Canadian dollar denominated liabilities, so it makes much more sense for them to invest in domestic infrastructure
  • But why infrastructure? Why not stocks, bonds, private equity, real estate, and hedge funds? Again, think like a large Canadian pension fund, which means take a total portfolio approach to allocate risk in the best, most cost efficient manner to maximize returns without taking undue risk
  • In a world where ultra low and negative rates are here to stay and where the Governor of the Bank of Canada is warning pensions to brace for lower rates, where are Canada's large pensions going to obtain the yield to meet their long-dated liabilities which go out 75+ years? Stocks and corporate bonds are over-valued and very volatile and government bonds offer historic low yields. Hedge funds and private equity funds? Turns out those investments have run their course and overwhelmingly enrich hedge fund and private equity gurus, not so much pension beneficiaries. Sure, if you select the right funds, you'll make money but you'll pay big fees for those returns and you won't be able to invest large sums directly like you can with infrastructure (and to a lesser extent real estate). In terms of scalability, costs and stable and predictable returns over a very long horizon, investing large sums in infrastructure makes perfect long-term sense for Canada's large pensions
  • The key difference between Canada's large pensions and their US counterparts is a world class governance model which allows them to attract and retain talented pension fund managers that can invest directly across public and private markets all around the world, foregoing external manager fees. Canada's large pensions are world renowned infrastructure investors who have the expertise required to invest and develop domestic infrastructure assets much better than any government organization can. Unlike government bureaucrats, Canada's large pension fund managers are compensated based on their long-term returns so it's in their best interests to see these investments flourish over a long period. In other words, their alignment of interests are better than civil servants managing infrastructure projects
Now, after going through all this, if you're still not convinced that "asset recycling" makes sense for all stakeholders, including Canadian taxpayers, then I don't know what to tell you.

I don't want to make it sound like investing in infrastructure is the end all and be all of economic policy (it isn't going to make a huge dent, especially if Canada's real estate bubble bursts), but it makes really good sense and if it's done properly using the expertise of Canada's large public pensions, it will pay long-term dividends to the economy and help fund these large pensions over many years.

What about smaller Canadian pension plans that can't invest directly in infrastructure? Well, they can seek advice from experts like David Rogers and Stephen Dowd at Caledon Capital Management or invest in private infrastructure funds like the one at Fiera Infrastructure or invest in shares of publicly traded Brookfield Infrastructure Partners (BIP). Or they can talk to OMERS to provide them with solutions to meet their infrastructure needs.

But it's going to be hard to compete with the big boys when it comes to infrastructure. They have the funds and the expertise to invest large sums directly into domestic and international infrastructure. 

By the way, if your kid wants enter finance, steer him or her toward a career in infrastructure. Ideally, they will obtain a degree in civil or mechanical engineering and then go on to do an MBA and go work at some private infrastructure company like SNC-Lavalin Group or at a European giant like Vinci, Hochtief or Ferrovial. I would recommend anyone looking for a career in infrastructure to gain operational, not just financial transaction experience in this asset class.

However, it's not just engineers with MBAs that are needed. Law firms need to develop in-house expertise in infrastructure investments as they too can benefit from this secular push into infrastructure. Start planning and start thinking long-term when it comes to how more infrastructure investing is going to change our economy

Finally, the rumor mills in Montreal are that Michael Sabia, who went from outsider to rainmaker, is preparing for a career in politics after he leaves the Caisse. He has publicly denied any speculation that he's preparing for a career in politics but you never know, Premier Sabia or Minister Sabia has a nice ring to it (we need more qualified people entering public office). 

Last week in Montreal, Michael Sabia and Ron Mock gave a presentation on Best Practices in Fund Management: Lessons from the Canadian Public Pension Model at the 69th CFA Institute Annual Conference. My former Caisse colleague Miville Tremblay who now works at the Bank of Canada moderated this panel discussion which also featured University of Michigan law professor Dana Muir and he told me it was a success and well attended by participants from all over the world.

Unfortunately, this discussion is not publicly available as of now. Miville told me that is entirely up to the CFA Institute. Below, you can watch a panel discussion on The Changing Global Bond Market and its Implications featuring Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada.

I also embedded a short clip from CDPQ Infra, the infrastructure group led by Macky Tall which the Caisse recently spun off as an independent subsidiary (just like they did for real estate which is Ivanhoé Cambridge). The clip shows you the benefits of the new Réseau électrique métropolitain (our city desperately needs it and more initiatives like it!).

The Caisse recently changed its organizational model to face anticipated volatility, modest returns and ‘anemic growth’, consolidating investments in public and private companies under chief investment officer Roland Lescure, who had held the no. 2 position since 2009.

It is also creating a new division, Depositors and Total Portfolio Construction, which will be led by Jean Michel (former head of Air Canada Pension Fund), who was appointed as VP of Advisory Services to Depositors and Strategic Analysis just over a month ago.

All these are great moves which Sabia initiated. Jean Michel brings a wealth of experience from Air Canada Pension Fund where he and his small team performed miracles to bring that pension plan back to fully funded status (using the same strategies that HOOPP and OTPP use) and Roland Lescure is a class act who should be CIO of Public and Private investments like his counterparts at Teachers and elsewhere.


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