Thursday, May 31, 2018

Will Canada's Pensions Buy Kinder Pipeline?

Reuters reports that Canadian pension funds may be long-term buyers of Kinder pipeline:
Canada’s biggest public pension funds could be long-term buyers of Kinder Morgan Canada Ltd’s Trans Mountain pipeline but are unlikely to invest until the $7.4 billion project has been built, several pension fund sources said on Tuesday.

The Canadian government said on Tuesday it will buy the Trans Mountain assets for $4.5 billion, hoping to salvage a project that faces formidable political and environmental opposition. The pipeline is intended to move Canadian crude to ports in the Vancouver area for shipment to foreign markets.

Although the federal government has taken stakes in other struggling energy projects, Tuesday’s announcement marked the first time it is being an entire pipeline, and Ottawa said it does not want to hold the asset for the long term.

Frank McKenna, Toronto-Dominion Bank’s deputy chairman and a former New Brunswick premier, said he expected pension funds and private equity players to be interested in the asset as well as other pipeline or infrastructure players.

“I think there will be a lot of private sector interest in this project once the political risk is taken out of it. These are very desirable assets. They pay good economic rents and they’re long-life assets,” he said. TD is the biggest lender to the project.

The Canada Pension Plan Investment Board, Canada’s biggest public pension plan, said on Tuesday it was “not actively assessing an investment in the extension opportunity.”

The Canadian government could bring in partners to help finance the expansion, according to pension fund sources. However, it is unlikely to do so through its Infrastructure Bank, set up last year to facilitate public-private partnerships but not yet operational, they said.

Canadian pension funds have a long-held preference for buying assets that are already built rather than those with construction risks, and the reputational risk associated with the project could also be a turnoff.

With that in mind, pension fund sources said the federal government may have to hold the asset for a number of years to eventually attract the best price and give it the best chance to recover money for taxpayers, or even make a profit.

Caisse de depot et placement du Quebec, Canada’s second biggest public pension and Kinder Morgan Canada’s biggest independent shareholder, has shown the most appetite for financing the construction of new infrastructure among Canada’s biggest pension plans. It declined to comment.

Ontario Teachers Pension Plan, Canada’s third biggest public pension fund, did not immediately comment.
And Scott Deveau, Kevin Orland and Josh Wingrove of Bloomberg News report, Trans Mountain seen drawing pension funds or returning to Kinder Morgan:
So now Justin Trudeau owns a pipeline. Who will take it off his hands remains an open question.

Canada said Tuesday it would buy Kinder Morgan Inc.’s Trans Mountain pipeline, with its expansion project and shipping terminal, for $3.5 billion before eventually selling the project to a new buyer. Finance Minister Bill Morneau, speaking Tuesday in Ottawa, said it was too soon to say if Canada would sell in the short or medium term, but didn’t want to hold the project in the long term.

Finding a buyer for Trans Mountain could be tricky amid ardent opposition from British Columbia, the Pacific Coast province it crosses, along with environmental and some indigenous groups. That opposition was enough to make Kinder throw up its hands and halt construction last month. Even as Morneau struck an upbeat tone on the potential pool of buyers, he didn’t give a specific time frame for a deal.

“Many investors have already expressed interest in the project, including Indigenous groups, Canadian pension funds, and others,” he said.

One analyst floated another potential home: Kinder Morgan itself.

Canada’s purchase may “‘be a vehicle to indemnify the project against regulatory risk,” Katie Bays, an analyst with Height Securities LLC in Washington, said in a telephone interview. “Once the construction is complete or once regulatory risk evaporates, whichever comes first, the project could be repurchased by Kinder Morgan.”

Kinder Morgan Canada, the unit that raised C$1.75 billion (US$1.3 billion) for the project in an initial public offering last year, declined to comment on the speculation.


If Kinder doesn’t want it back, some investors have shown interest in the project in the past.

Before deciding on taking the Canadian unit public, Houston-based Kinder Morgan ran a dual-track process that also entailed exploring a joint venture of the pipeline project. That possibility attracted interest from U.S. private equity firm ArcLight Capital Partners and Australia’s IFM Investors Pty Ltd., people familiar with the matter said at the time.

Brookfield Asset Management Inc., which was said to be another bidder on the joint venture and eventually became one of Kinder Morgan Canada’s largest investors, could be a potential partner in Trans Mountain now. The Toronto-based alternative-asset manager already has a joint venture with Kinder Morgan, Natural Gas Pipeline Company of America, through its publicly traded Brookfield Infrastructure Partners. A representative declined to comment.

Among pension funds, the Ontario Municipal Employees Retirement System and the Alberta Investment Management Corp. could also be interested in the project. OMERS’ infrastructure arm is invested in several pipeline assets, including the Czech Republic’s NET4GAS sro, CLH Pipeline System in the U.K. and Spain, as well as the U.K.’s Scotia Gas Networks.


OMERS also appointed Michael Ryder as the senior managing director of its infrastructure unit, OMERS Infrastructure. Ryder joined in January from U.S. private equity giant Blackstone Group LP, where he was responsible for leading the firm’s midstream energy and oilfield services investment strategy. A representative for the fund declined to comment.

AIMCo, as the Alberta fund is known, is supportive of measures to boost investor confidence and address market uncertainty, Denes Nemeth, a spokesman for the fund, said in an email, while declining to comment on whether AIMCo would be interested in investing in the project.

Canada Pension Plan Investment Board, the country’s largest pension fund, said in an emailed statement it was not “actively assessing an investment in the extension opportunity."


Meanwhile, Caisse de Depot et Placement du Quebec, Canada’s second-largest pension fund, last month disclosed holdings of 10.2 million shares in Kinder Morgan Canada, making it the largest investor outside of its parent company. A spokesman declined to comment on whether the Caisse would consider an investment in the Trans Mountain pipeline Tuesday.

Caisse Chief Executive Officer Michael Sabia told reporters last week in Montreal that the Kinder Morgan investment was made prior to the pension fund announcing a new strategy in October to reduce its holdings in carbon-intensive industries in favor of renewable energy. He said last week that the Kinder Morgan Canada investment, along with all future investments, would be reviewed in light of the new policy.

After Kinder said it was halting work on the project until it had more certainty, the province of Alberta was named as a potential buyer for all or part of the project. Premier Rachel Notley said at the time that the province would consider all options for ensuring the project was built. “At this point, we don’t think that’s necessary,” she said Tuesday.


Canada’s other major pipeline operators are not seen as likely to enter the fray, either. Enbridge Inc. and TransCanada Corp., both based in Calgary, already operate major pipelines that carry oil-sands crude, and both are enmeshed in their own major projects. TransCanada’s proposed Keystone XL pipeline has battled delays for roughly a decade, and Enbridge’s Line 3 replacement and expansion still hinges on a critical regulatory ruling in Minnesota.

TransCanada spokesman Grady Semmens said in an e-mailed statement that the company isn’t involved in discussions about the Trans Mountain pipeline, and that it won’t comment further about speculation on the project. Suzanne Wilton, a spokeswoman for Enbridge, said the company is focused on its C$22 billion growth program and would not speculate on the project.


The time is not right for either company to take on a project like Trans Mountain, said Laura Lau, who helps manage C$1.5 billion in assets, including shares of TransCanada and Enbridge, at Brompton Corp. in Toronto. Enbridge has been selling assets to help whittle down debt it took on in last year’s purchase of Spectra Energy Corp. TransCanada would be more able to buy it, but the company had its credit rating cut by Standard & Poor’s earlier this month, she said.

The purchase also would distract and draw resources away from their current projects, which Lau said she’s optimistic will go through.

“If they buy Trans Mountain, they have to not do something else,” Lau said in an interview. “There’s only so much money to go around.”
You read these articles and you can tell there definitely is a lot of interest in this project from Canada's large pensions.

But before they invest one cent, they need to know the project is up an running which means there won't be any construction or regulatory risks.

The good news is that even though the Canada Infrastructure Bank isn't operational yet, this week,  Pierre Lavallée was appointed as the organization’s incoming President and Chief Executive Officer:
On behalf of the Board of Directors, Janice Fukakusa, Chair of Canada Infrastructure Bank, today welcomed Pierre Lavallée as the organization’s incoming President and Chief Executive Officer (CEO), effective June 18, 2018.

As CEO, Mr. Lavallée will lead Canada Infrastructure Bank’s strategy and day-to-day operations, and report to the board.

Over the last six years, he has held various roles at Canada Pension Plan Investment Board (CPPIB), most recently Senior Managing Director & Global Head of Investment Partnerships, where he led a team managing approximately $94 billion of assets. Prior to joining CPPIB, Mr. Lavallée was Executive Vice-President at Montreal-based Reitmans (Canada) Limited and a Partner with Bain & Co., where he worked for more than 18 years, including several years as Managing Partner for Canada. In addition, he has previous international trade experience in Ottawa and Japan.

“With an exceptional combination of investment and public-sector expertise, Pierre is well placed to set the strategic course and direction of Canada Infrastructure Bank and develop a high-performing management team,” said Ms. Fukakusa.

“I am excited to build a team and start working with the board, private and institutional investors and public-sector proponents on innovative transactions to develop new infrastructure projects for Canadians,” said Mr. Lavallée.

As announced earlier, Canada Infrastructure Bank appointed Annie Ropar to the position of Chief Financial Officer and Chief Administrative Officer, effective June 1, 2018.

With the appointment of these key leaders, Canada Infrastructure Bank is building the expert team, systems and processes needed to make investments, advise governments across Canada on revenue-generating infrastructure projects, and collect and share infrastructure data to enable more effective decision-making.

Bruno Guilmette, who has been serving as interim Chief Investment Officer, will return to the board on June 1, 2018 and will continue working with the incoming Chief Executive Officer during the leadership transition. Mr. Guilmette was appointed to the board of directors in November 2017 and stepped down temporarily while serving as interim CIO.

“I wish to sincerely thank Bruno for his leadership in building up the investment and advisory capabilities of Canada Infrastructure Bank,” said Ms. Fukakusa. “He has set a solid foundation for further advancing the bank’s internal capacity for its investing, advisory and data roles.”

About Canada Infrastructure Bank

Canada Infrastructure Bank uses federal support to attract private sector and institutional investment to new revenue-generating infrastructure projects that are in the public interest. By engaging the expertise and capital of the private sector, the Bank will help provide more infrastructure for Canadians.
This is very good news. Mr. Lavallée has tremendous experience and he will hit the ground running. It might be too soon for the Trans Mountain deal but they will eventually look at it and probably begin by financing the Caisse's REM project first since commitments were already made by the federal government.

It's also good news that Bruno Guilmette is returning to stay on as the interim CIO. I worked with Bruno at PSP when he was head of Infrastructure. He really knows his stuff and will be instrumental in helping this organization ramp up.

Now, my hunch is the two main Canadian pensions interested in this project are AIMCo and OMERS and they can very well partner up to invest in it. AIMCo is independent of Alberta's government but it must want first dibs on a prized pipeline which will be the economic lifeblood of that province.

OMERS has a lot of experience managing pipelines so it would be a great partner to AIMCo on this deal if they were to buy it (the dollar amount would be too much for either pension to go it alone).

I thought the Caisse would be interested because let's face it, it has a great team in place to take over the construction of this pipeline but given that it wants to reduce its carbon footprint, I'm not sure it wants to get involved (but it's too bad since this is a great project for the Caisse's REM team to consider, minus all the political and regulatory hurdles).

I'm pretty sure CPPIB and OTPP aren't interested in this project, not at this time as there are too many risks. They prefer investing in brownfield projects (CPPIB) and will only invest in greenfield if they have a specialized team in place to help them manage the asset (OTPP).

All this to say, there is a lot of chatter on Canada's pensions investing in the Trans Mountain pipeline deal but I think we need to wait before jumping to any conclusions.

I guarantee you no Canadian pension will invest in this project unless they get the right terms to fulfill their fiduciary duty and achieve the return objective. Moreover, as you can read above, competition is intense because Brookfield Asset Management also expressed an interest and that firm is a global leader in infrastructure.

Below, AIMCo's former CEO and Chairman of Nauticol Energy,  Leo de Bever, discusses the pipeline deal and why the Government of Canada did the right thing by intervening to save it. He speaks with Bloomberg's Amanda Lang on "Bloomberg Markets".

Wednesday, May 30, 2018

Caisse and OTPP Invest in Energy Service?

Benefits Canada reports, Caisse, Teachers’ acquire Germany-based energy service provider:
The Caisse de dépôt et placement du Québec and the Ontario Teachers’ Pension Plan are part of a consortium of investors acquiring global energy service provider Techem GmbH.

Joined by private equity firm Partners Group and Techem’s management team, the consortium is buying the Germany-based company from Macquarie European Infrastructure Fund 2, which acquired it in 2008. The transaction, which is expected to close in the third quarter of 2018, values Techem at 4.6 billion euros, according to a press release.

“Energy efficiency, which is at the centre of Techem’s offering, is key to building a sustainable future,” said Stéphane Etroy, executive vice-president and head of private equity at the Caisse, in the release. “Given CDPQ’s desire to support the transition to a low-carbon economy, investing in Techem is a very attractive opportunity for us. Techem’s business model positions it to benefit from growing urbanization and demand for housing energy efficiency over the long term. We are confident that together with Techem’s solid management team, Partners Group and Ontario Teachers’, the company will continue on its path of success.”

Techem’s energy business provides services and devices for the metering and billing of energy and water, plus device sales, rental and maintenance. In addition, it delivers heat, cooling, flow energy and light, as well as the planning, set-up, financing and operation of energy systems and energy monitoring and controlling services.

Following the acquisition’s close, the consortium will work with Techem’s management team to support the company’s development in existing markets and expand its presence geographically.

“Techem is a well-positioned business that looks set for continued domestic and international growth,” said Jo Taylor, senior managing director, international at Ontario Teachers’. “It serves the growing, global need for energy conservation and empowers users in multi-occupancy properties to have greater control over their own energy consumption by providing accurate billing.

“Ontario Teachers’ has a strong track record in the energy and infrastructure sectors, as well as significant experience in the sub-metering space and we are delighted to partner with Techem’s innovative management team and with Partners Group and CDPQ.”
The Caisse and Ontario Teachers' put out a press release on Friday, Partners Group to lead consortium including CDPQ and Ontario Teachers' in acquisition of Techem, a global market leader in energy sub-metering services:
Partners Group, the global private markets investment manager, is leading a consortium of investors in the acquisition of Techem GmbH ("Techem" or "the Company"), a global market leader in the provision of heat and water sub-metering services. Partners Group, which will invest on behalf of its private equity and infrastructure clients, will be joined in the acquisition by Caisse de dépôt et placement du Québec ("CDPQ") and Ontario Teachers' Pension Plan ("Ontario Teachers'") as well as Techem's management team. The consortium is acquiring Techem from Macquarie European Infrastructure Fund 2, which acquired 100% of the Company in 2008. The transaction, which is expected to close in the third quarter of 2018, values Techem at an enterprise value of EUR 4.6 billion.

Founded in 1952 and headquartered in Eschborn, Germany, Techem caters to a global client base of real estate operators and private home owners from its 150 branches in more than 20 countries. Its principal Energy Services business provides services and devices for the metering and billing of energy and water, plus device sales, hire and maintenance. In addition, its Energy Contracting business delivers heat, cooling, flow energy and light, as well as the planning, set-up, financing and operation of energy systems and energy monitoring and controlling services. Techem is the market leader in Germany, the largest sub-metering market in the world, as well as in an additional 13 European markets. Techem solutions today account for 6.9 million tons of emission savings in CO2 per year, thus contributing to the ambitious global climate protection objectives. In the 2016/17 financial year, Techem's 3,640 employees serviced 11 million apartments worldwide, recording sales of EUR 782.7 million.

Following the close of the acquisition, Partners Group together with CDPQ and Ontario Teachers' will work with Techem's management team, led by Frank Hyldmar, to support the development of the Company in existing markets and expand the Company’s presence geographically. One value creation initiative will focus on the introduction of new technologies to Techem's strong, existing platform and installed base to enhance the customer experience. There will also be a continued focus on customer services and quality excellence programs as the Company grows.

Frank Hyldmar, CEO of Techem, comments: "A decade after delisting from the Frankfurt Stock Exchange, Techem can show a solid track record of growth. However, even with our market-leading position today, we believe there is plenty of future growth potential for our Company and look forward to working with Partners Group, an experienced private equity and infrastructure investor, as well as its strategic partners CDPQ and Ontario Teachers', to realize our ambitions and deliver an exceptional service to our customers around the world."

Jürgen Diegruber, Partner, Private Equity Europe, Partners Group, adds: "Techem is a market leader in a highly-regulated industry with high barriers to entry and strong tailwinds. With increasing global awareness of energy usage, Techem's products and services are a key element of the fight against energy waste, enabling heating and energy supplies to be managed in a more precise and sustainable manner. We look forward to working with Frank Hyldmar and his talented team, as well as with our partners CDPQ and Ontario Teachers', to expand Techem's market-leading position."

Stéphane Etroy, Executive Vice-President and Head of Private Equity, CDPQ, says: "Energy efficiency, which is at the center of Techem's offering, is key to building a sustainable future. Given CDPQ's desire to support the transition to a low-carbon economy, investing in Techem is a very attractive opportunity for us. Techem’s business model positions it to benefit from growing urbanization and demand for housing energy efficiency, over the long term. We are confident that together with Techem's solid management team, Partners Group, and Ontario Teachers', the company will continue on its path of success."

Jo Taylor, Senior Managing Director International, Ontario Teachers', comments: "Techem is a well-positioned business that looks set for continued domestic and international growth. It serves the growing, global need for energy conservation and empowers users in multi-occupancy properties to have greater control over their own energy consumption by providing accurate billing. Ontario Teachers' has a strong track record in the energy and infrastructure sectors, as well as significant experience in the sub-metering space and we are delighted to partner with Techem’s innovative management team and with Partners Group and CDPQ."

About Partners Group

Partners Group is a global private markets investment management firm with over EUR 62 billion (USD 74 billion) in investment programs under management in private equity, private real estate, private infrastructure and private debt. The firm manages a broad range of customized portfolios for an international clientele of institutional investors. Partners Group is headquartered in Zug, Switzerland and has offices in Denver, Houston, New York, São Paulo, London, Guernsey, Paris, Luxembourg, Milan, Munich, Dubai, Mumbai, Singapore, Manila, Shanghai, Seoul, Tokyo and Sydney. The firm employs over 1,000 people and is listed on the SIX Swiss Exchange (symbol: PGHN) with a major ownership by its partners and employees.

About Caisse de dépôt et placement du Québec

Caisse de dépôt et placement du Québec (CDPQ) is a long-term institutional investor that manages funds primarily for public and parapublic pension and insurance plans. As at December 31, 2017, it held $298.5 billion in net assets. As one of Canada's leading institutional fund managers, CDPQ invests globally in major financial markets, private equity, infrastructure, real estate and private debt. For more information, visit, follow us on Twitter @LaCDPQ or consult our Facebook or LinkedIn pages.

About Ontario Teachers'

The Ontario Teachers' Pension Plan (Ontario Teachers') is Canada's largest single-profession pension plan, with $189.5 billion in net assets at December 31, 2017. It holds a diverse global portfolio of assets, approximately 80% of which is managed in-house, and has earned an average annualized rate of return of 9.9% since the plan's founding in 1990. Ontario Teachers' is an independent organization headquartered in Toronto. Its Asia-Pacific region office is located in Hong Kong and its Europe, Middle East & Africa region office is in London. The defined-benefit plan, which is fully funded, invests and administers the pensions of the province of Ontario's 323,000 active and retired teachers. For more information, visit and follow us on Twitter @OtppInfo.
So what is this deal all about? In my last comment, I discussed how PSP is ramping up direct private equity deals by leveraging off its external partners to gain access to large co-investment deals.

I even mentioned Stephane Etroy and the Caisse's private equity group are also going direct in PE, looking at doing more co-investments to lower fees as they scale up the private equity portfolio.

This is a perfect example of a beautiful co-investment with Partners Group, one of Europe's leading asset managers in private markets (remember, on co-investments, pensions pay no fees and they're large, scalable deals but to have access to them, they need to invest in the funds of their partners which in this case is Partners Group and there, they pay big fees).

Back in 2002, when I was allocating to external directional hedge funds at the Caisse, Partners Group was running a managed account platform of hedge funds offering investors full liquidity and transparency.

Along the way, they figured out that the big money (big fees) isn't in hedge funds but private equity, real estate and infrastructure and wisely decided to shift their attention to private markets.

Now they're the Blackstone of Europe. They serve over 1,000 institutional investors worldwide "who seek superior investment performance through private markets for their more than 100 million beneficiaries". They have USD 74 billion in assets under management and more than 1,000 professionals across 19 offices worldwide.

Both Ontario Teachers' and the Caisse have a long relationship with Partners Group so when this co-investment opportunity came up to partner up with them and Techem's management team for this deal, they jumped on it.

The deal facilates a management buy-in which ensures alignment of interests and the expertise to grow this company to the next level are there.

I personally love these type of deals in private equity. You have a great partner in Partners Group, the Caisse and Ontario Teachers' know each other very well, and you have a management buy-in in a company set to grow nicely over many years.

It just doesn't get any sweeter than this.

Of course, the devil is in the details. The deal values the German metering company at an enterprise value of 4.6 billion euros ($5.4 billion) which is no small chunk of change (hence why it's a consortium buying it) but the Caisse, OTPP and its partners surely have a value creation plan to unlock more value over the coming decade (this isn't a quick flip).

Also, keep in mind both the Caisse and OTPP take ESG investing very seriously and this deal is another step in the right direction to support the transition into a low-carbon economy while they make the requisite long-term returns to fulfill their fiduciary duty.

Go back to read my comment on Canada's pensions betting on industrial innovation where I discuss Ontario Teachers' financing deal in Stem, Inc., an artificial intelligence-powered energy storage company headquartered in California.

There too, Teachers' teamed up with Activate Capital Ltd. and Temasek Holdings.

That deal fell under the mandate of the infrastructure group whereas this deal falls under private equity (it doesn't really matter, it's a private market deal with  a long investment horizon).

Below, the heating cost allocation according to Techem. You have to watch this clip on Vimeo here if it doesn't load below.

By the way, this is the future of energy service and there is growing competition. For example, check out the other clip below from ista international but from my understanding, Techem is still the world leader in this space.

If you have anything to add, contact me at and I'll be glad to share your comments.

Tuesday, May 29, 2018

PSP Ramping Up Direct Private Equity?

Kirk Falconer of PE Hub Network reports, PSP Investments ramps up direct deals to half of PE portfolio assets:
Public Sector Pension Investment Board, one of Canada’s largest and fastest growing pension systems, is doing more direct deals as part of a strategy intended to transform its approach to private equity and infrastructure investing.

Over two-plus years, PSP Investments has deployed billions of dollars to a series of global transactions, shining a light on the characteristically low-profile institution.

One result has been growth in PE co-sponsorships and co-investments to “slightly above” half of portfolio assets today from 40 percent in 2015, Guthrie Stewart, PSP senior vice president and global head of private investments, told PE Hub Canada.

PE investing set a new record in PSP’s fiscal 2017, when outlays totalled $4.8 billion, more than half of them earmarked for direct deals. Stewart says activity in fiscal 2018, about which PSP will report in June, will show the “momentum has continued.”

PSP has been just as aggressive on the infrastructure side, investing $2.6 billion in fiscal 2017, nearly 70 percent of it on a direct basis.

Combined deployments in this period lifted PE and infrastructure assets to more than $27 billion, up 57 percent from two years earlier.

Stewart says these statistics mark a “dramatic shift” since 2015, when he came onboard to overhaul the private-markets operation.

At the time, both asset classes were underallocated. PSP’s goal was to turn things around by “broadening the strategy, taking a more disciplined approach, and achieving more diversification,” Stewart said.

Initiatives included scaling the talent and capabilities of internal personnel, split between PSP’s Montréal headquarters and London office opened last year. Focus was also given to building more external relationships that could add value and “drive direct investments,” Stewart said.

External partners are mostly select PE firms. PSP commits capital to more than 30 general partner teams, a “foundational number” that will likely continue to expand, Stewart said. About a dozen infrastructure firms also secure commitments.

Examples include American Securities, which in March supported PSP’s investment in early childhood educator Learning Care, and Ardian, which in December sold stakes to PSP and Caisse de dépôt et placement du Québec in industrial engineering group Fives, reportedly for US$1.8 billion.

Two others are BC Partners, which in October teamed up with PSP and Ontario Teachers’ Pension Plan in the US$3.1 billion buy of ceramic products supplier CeramTec, and Blackstone, which early last year partnered with PSP and CDPQ in the US$6.1 billion buy of hospital staffing provider Team Health.

Other disclosed examples are Apax Partners, Apollo, Lightyear Capital, MBK, New Mountain Capital, Partners Group and TPG.

Stewart says a linchpin of the new strategy is the ability of PSP’s in-house investment pros — led by Simon Marc, head of private equity, and Patrick Samson, head of infrastructure — to “exercise strong judgement and execute rapidly” when picking partners and opportunities.

“We strive to be as non-institutional as possible, to move at the same speed as our GPs,” he said.

Getting bigger

Doing more direct deals is essential to returns and “rounding out diversification,” as well as being “more deliberate about the assets we add to the portfolio,” Stewart said.

It is also key to generating investment volumes that facilitate PSP’s rapid growth.

PSP is the youngest of Canada’s four largest pension systems, overseeing $139 billion in retirement savings on behalf of federal public employees, including defence and police forces. Its capital pool, fueled both by contribution flows and investment returns, is projected to exceed $200 billion by 2026 and $250 billion by 2029.

Stewart, 61, was recruited to PSP by André Bourbonnais, who was appointed president and CEO in 2015 after running private investments at Canada Pension Plan Investment Board.

Earlier this year, Bourbonnais departed PSP for BlackRock. He was replaced by Neil Cunningham, previously global head of real estate and natural resources.

Stewart’s prior career included serving as a partner at EdgeStone Capital Partners. He also spent 15 years in executive roles in the telecom industry, including as president and CEO of Teleglobe Canada.
Guthrie Stewart was also André Bourbonnais's boss at Teleglobe Canada and that's how he landed this job at PSP Investments.

Anyway, the article focuses on how PSP is ramping up its co-investments in private equity, a group led by Simon Marc.

Nothing new to me. Last February, I attended a CFA lunch with André Bourbonnais where he explicitly stated the organization was ramping up private equity co-investments:
[...] in private equity, PSP invests with top funds and pays hefty fees ("2 and 20 is very costly so you need to choose your partners well"), however, they also do a lot of co-investments (where they pay no fees or marginal fees), lowering the overall fees they pay. André said "private equity is very labor intensive" which is why he's not comfortable with purely direct investments, owning 100% of a company (said "it's too many headaches") and prefers investing in top funds where they also co-invest alongside them on larger transactions to lower overall fees (I totally agree with this approach in private equity for all of Canada's mighty PE investors). But he said to do a lot of co-investments to lower overall fees, you need to hire the right people who monitor external PE funds and can analyze co-investment deals quickly to see if they are worth investing in (sometimes they're not). He gave the example of a $300 million investment with BC Partners which led to $700 million in co-investments, lowering the overall fees (that is fantastic and exactly the right approach).
I remember André also saying PSP was playing catch up to CPPIB in private debt and other areas and I'm pretty sure he meant co-investments.

The key thing to note is in order for PSP or any large institution to get invited to co-invest alongside a general partner (GP) on a much bigger transaction, it first needs to develop a strong relationship with that GP or fund. And that means first investing in their private equity funds where they pay big fees.

What are the advantages of co-investments? Scale and fees. The transactions are typically larger and there are no fees paid to the GP for co-investing alongside them (which is why it's called direct investing). Larger transactions allow PSP or another large pension to allocate more to private equity quickly and efficiently.

But as the article above states, you need to hire smart and capable people internally to evaluate large co-investments quickly and thoroughly because when the GPs come to you with large deals, you'd better be ready or else they'll move on to the next investor.

Now, PSP isn't the only large pension ramping up co-investments to lower private equity fees. The Caisse's private equity group led by Stephane Etroy is also going direct in PE.

Last week, I discussed how CalPERS is bringing private equity in-house to do more co-investments but unlike PSP and the Caisse, CalPERS isn't paying its private equity team properly to evaluate these deals so it needs to outsource these activities to BlackRock where Mark Wiseman and André Bourbonnais now work, helping Larry Fink beef up his private market operations.

Again, it's confusing but let me explain three forms of direct investing in private equity:
  1. Purely direct: This is where the pension sources its own deal and invests 100% in a private company, taking it over to improve its operations over time and selling it for multiples of what it bought it for. These purely direct deals are extremely rare because most pensions don't want the headaches that come with owning 100% of a company. Also, pensions can’t compete with private equity giants on the very best deals all over the world.
  2. Co-investments: This is a form of direct investing because pensions pay no fees to co-invest alongside GPs on larger transactions but in order to gain access to these co-investments, the pension needs to pay fees to the GP's traditional private equity funds (typically 2% management fee on committed capital which declines as the fund's life progresses and 20% carry or performance fee). The GPs are happy because they still get their juicy fees and the LPs (limited partners or investors) are happy because they get to co-invest with their GPs on large transactions to lower overall fees and scale up their private equity portfolio.
  3. Bids on companies when fund's life ends: Yet another form of direct investing is an auction that can take place when a PE fund's life nears its end and the GP wants to auction off some portfolio companies. If the LP is interested in carrying this company longer in its books (remember, pensions have a longer investment horizon than PE funds), then it is invited to bid on a portfolio company.
Either way, the bulk of direct private equity deals at Canada's large pensions and elsewhere comes through co-investments and in order to gain access to these large direct transactions where they pay no fees they first need to pay fees to traditional funds and hire capable people to quickly evaluate these large deals.

Basically, it's all about building solid long-term relationships with partners all over the world and having the right staff to quickly evaluate and execute on these large co-investments.

Below, a discussion on the challenges of co-investing, special accounts & the divergence in the returns that LPs will earn from private equity featuring Guthrie Stewart, Global Head of Private Investments, PSP Investments (clip is from last year but still worth watching).

Monday, May 28, 2018

The Italian Job?

Joumanna Bercetche of CNBC reports, Traders are worried this could be the 'big unwinding' of Italian bond markets:
Italian bonds have witnessed one of their worst trading weeks since the euro zone sovereign debt crisis, with many traders getting a stark reminder of the volatility that once characterized markets in the region.

On Friday, two-year Italian bond yields rose 35 basis points in one day — almost equivalent to the entire range of the year for U.S. 10-year Treasurys. This was the weakest session in five years and continued a month that's seen these yields rise 70 basis points in total.

Yields move inversely to a bond's price and a spike higher is seen as investors feeling more concerned about lending to Italy's government. More specifically, traders usually sell short-maturity paper when there are growing credit risk concerns at a sovereign level.

The original catalyst for the selling came from the populist parties hoping to take control of Italy after inconclusive elections in March. Lega and the Five Star Movement (M5S) plan to issue short-term bills to finance state activity in their economic policy proposals. Market participants were taken aback and many have interpreted that initiative as laying the foundation for a potential parallel currency in the future, further amplifying the potential new government's collision course with the rest of Europe.

But the fear has not been limited to short-dated paper. Ten-year Italian bonds have also came under pressure with yields topping 2.5 percent and are now trading at their widest gap with German paper in over four years.

There is palpable anxiety in the market as Italy's political future remains uncertain. Over the weekend, M5S and Lega looked to have failed in their bid to form a government after President Sergio Mattarella rejected their pick for economy minister due to his euroskeptic credentials. This has raised the prospect of a caretaker government to lead the country into yet another round of elections later this year.

In Monday's trading session, and with liquidity in markets thin due to the U.S. Memorial Day, Italian two-year yields briefly snapped back 15 basis points tighter before paring all the gains of the day. Traders have pointed to short covering in the market.

However, the relief rally may be short lived. One head of trading at a large fund manager, who preferred to remain anonymous due to the sensitive nature of the situation, told CNBC that a "big unwinding" is beginning for Italian bonds and Monday's pullback would not last long.

Ratings agencies are also beginning to raise alarm bells. On Friday, Moody's hinted that it may look to review Italy's debt rating, citing concerns over the two anti-establishment parties' fiscal plans that could ratchet up spending by as much as 100 billion euros ($117 billion), according to some analysts.

With outstanding debt of more than 2.3 trillion euros and one of the highest levels of debt-to-gross domestic product in the advanced world, Italy's public finances will come under scrutiny again if spending ramps up.

Gene Frieda, a global strategist at Pimco, told CNBC via email that the immediate concern for investors is that another round of elections and the prospect of a right-wing anti-European populist government undermines the economic recovery in Italy.

"(It) threatens further rating downgrades. In that context, even after the recent sell-off, BTPs (Italian bonds) do not look particularly cheap," he said.

On Monday, Matteo Salvini, the leader of the right-wing Lega party, further added to market concerns saying that there is no point staying in the EU if the rules don't change. This has prompted some analysts to believe that if there is another election on the horizon, one that would effectively be a referendum on the euro.

According to Goldman Sachs analysis, the European Central Bank owns around 20 percent of outstanding Italian bonds due to years of quantitative easing, but foreign investors also own about 37 percent.

The question is then, will investors still want to own that risk into what could be a binary event?
Maybe the same hedge funds that ventured into Greek debt will buy Italian bonds as spreads blow up.

It's Memorial Day in the United States so markets are quiet on Monday.

But markets are open in Europe and things are going from bad to worse in Italy as bonds and stocks are crashing after an initial reversal.

Adding to angst, calls to impeach the president after a candidate was vetoed only poured gasoline on a popular uprising which views the Eurozone as anti-democratic.

Welcome to the European debt boomerang. Every few years, we are reminded of just how fragile things are in Euroland and why investing there is fraught with risks.

And as Zero Hedge pointed out this morning, contagion risks remain the biggest worry in the periphery:
While most investors are focused on Italian politics - the parallel currency 'mini-BoT' fears and potential for a constitutional crisis - Spain is now facing its own political crisis amid calls for a no-confidence vote against Rajoy. However, 'Spaxit' remains a distant concern for investors as another member of the PIIGS peripheral problems is starting to signal concerns about 'Portugone'?

As Statista's Brigitte van de Pas notes, on average, European Union countries had a gross government debt of roughly 81 percent of GDP in 2018.

This average disguises real differences between EU countries. Whereas Greece had a government debt of 177.8 percent in 2018, Estonia had a debt of only 8.8 percent - the lowest in the entire EU zone.

You will find more infographics at Statista

While the high Greek debt is well-known, a number of other countries however also have a debt that is higher than their own GDP. The Italian debt, for example, is lower than the Greek but still significant, at over 130 percent of GDP.

Portugal, in third place, had a debt of 122.5 percent.

One small positive note though: all three countries had even higher debts in 2017, and the European Commission forecasted a slow, but a further decrease of their government debt in 2019. Whether this holds true for Italy, with their newly-elected government of Movimento 5 Stelle and Lega remains to be seen.
And let's not forget Spain where Prime Minister Mariano Rajoy will face a vote of confidence in his leadership on Friday.

So, here we are, barely a week away from June and more drama is headed our way via the latest political and market blow-up in Italy.

I've long held the view that Grexit and even Brexit are a joke compared to Italexit.

Why? Because Italy's economy is much bigger than that of Greece's and if Italians hold a referendum to leave the Eurozone and actually vote in favor, it pretty much spells the end of the Eurozone and the euro.

I reckon tomorrow morning (and even today), global central banks are all on the phone with each other trying to play damage control.

No doubt, the ECB will continue backstopping Italian debt but other central banks including the Fed might intervene too.

So, hold on to your volatility hats because the summer has barely begun and we might be in for another European drama session.

All this trouble back in the ancestral home has really riled up CNBC's Rick Santelli. Below, he discusses the fragile banks and sovereign debt situation with Praxis Trading's Yra Harris.

All I can say is forget the wave of US coporate bond defaults headed our way, fresh troubles in Euroland are going to roil global financial markets unless central banks come to the rescue.

In this environment, stay long US long bonds (TLT) and the US dollar (UUP) and hope the Italian job won't clobber your portfolio.

Friday, May 25, 2018

Get Set For a Wave of Defaults?

Jeff Cox of CNBC reports, Moody's warns of 'particularly large' wave of junk bond defaults ahead:
With corporate debt hitting its highest levels since before the financial crisis, Moody's is warning that substantial trouble is ahead for junk bonds when the next downturn hits.

The ratings agency said low interest rates and investor appetite for yield has pushed companies into issuing mounds of debt that offer comparatively low levels of protection for investors. While the near-term outlook for credit is "benign," that won't be the case when economic conditions worsen.

The "prolonged environment of low growth and low interest rates has been a catalyst for striking changes in nonfinancial corporate credit quality," Mariarosa Verde, Moody's senior credit officer, said in a report. "The record number of highly leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives."

Though the current default rate is just 3 percent for speculative-grade credit, that has been predicated on favorable conditions that may not last.

Since 2009, the level of global nonfinancial companies rated as speculative, or junk, has surged by 58 percent, to the highest ever, with 40 percent rated B1 or lower, the point that Moody's considers "highly speculative," as opposed to "non-investment grade speculative."

In dollar terms, that translates to $3.7 trillion in total junk debt outstanding, $2 trillion of which is in the B1 or lower category.

"Strong investor demand for higher yields continues to allow all but the weakest issuers to avoid default by refinancing maturing debt," Verde wrote. "A number of very weak issuers are living on borrowed time while benign conditions last."

The level of speculative-grade issuance peaked in the U.S. in 2013, at $334.5 billion, according to the Securities Industry and Financial Markets Association. American companies have $8.8 trillion in total outstanding debt, a 49 percent increase since the Great Recession ended in 2009.

During that time, there's been a strong divergence in debt issuance, with investment-grade firms (shown below in the green line) pulling back as a share of total debt issuance, while speculative grade debt (the blue line) has increased.

Credit conditions have been conducive to lower-rated companies going to market, as global central banks have kept rates low and helped keep liquidity flowing through the system.

That's had some positive impacts, as smaller firms with greater access to capital have been able to implement game-changing technologies into multiple industries, particularly energy.

At the same time, higher-rated companies have been issuing debt and using it to reward shareholders with buybacks and dividends. As a result, their debt, while still investment grade, often has fallen a few notches, with the very top of the ladder shrinking from 21 percent pre-crisis to 14 percent currently.

Moody's warned that the trend could result in more "fallen angels," or companies that see their pristine ratings dinged as they continue to roll up debt.

Overall, median debt when compared with EBITDA has risen 30 percent for investment-grade companies and 10 percent for speculative.

"For many speculative-grade issuers, debt capacity may have reached its limit but structural protections continue to weaken," Verde said. "Many of these highly leveraged borrowers have more latitude than at any other time in the past to engage in potentially credit-eroding activities such as asset sales or debt-accretive transactions without needing to get lender consent."

Lower-rated companies have managed to keep their defaults below the historical average even though their credit metrics are "deeply stretched," Verde added.

"This extended period of benign credit conditions has helped many weak, highly leveraged companies to avoid default," she wrote. "These companies are poised to default when credit conditions eventually become more difficult."
By the way, you might be interested in knowing who owns all this US corporate debt:

Welcome to the zombie economy, central banks kept rates ultra-low for so long that companies went on a massive borrowing binge and investors keep pumping billions into high yield debt.

Large companies borrowed to reward shareholders via share buybacks and increases in dividends, but they're mostly rewarding themselves as they manipulate earnings per share to artificially inflate their numbers and reap rewards through their bloated executive compensation scheme (based on EPS).

Smaller companies are borrowing because they need to in order to survive as many would be out of business if they couldn't borrow to run their operations.

Don't you just love modern day financial capitalism? If Marx were alive today, he would be fascinated (but not shocked) with the gross subsidization of the financial sector through "radical" monetary policy and of course direct government lending, like the famous TARP program which admittedly was paid back in full no thanks to record amount of financial and non-financial borrowing.

Anyway, as I keep repeating, pay attention to high-yield, aka junk bonds (HYG, JNK) because this remains the canary in the coal mine (click on images):

As shown above, both junk bond ETFs are hovering around  their 50-week moving average so there is no imminent threat right now but if prices continue to decline or plunge (ie, spreads blow up), you should definitely take note because it could signal big trouble ahead.

When people ask me why I'm so bullish on US long bonds (TLT), I tell them it's not so much that I'm bullish on Treasuries because I hate stocks and other risk assets but it's because the global economy is slowing, risks are rising and you need to hedge downside risks. And I have yet to find a better hedge than Treasuries which remain the ultimate diversifier.

Don't get me wrong, I still risk my own capital and sometimes I take big risks. Today, I was looking at shares of Mirati Therapeutics (MRTX) and wanted to kill myself because at one point, I owned 5000 shares at $5 and dumped them 50 cents higher right before the stock got slammed and hit a 52-week low of $2.70. The rest, as they say, is history (click on images):

Admittedly, this is like winning a lottery but believe it or not, trading biotechs, I've seen this movie a few times!!

Oh well, c'est la vie, just goes to show you sometimes you need to stop trading and just stay put (easier said than done when you're losing money as a position swings like a yo-yo but that's the nature of the biotech beast).

However, I've also witnessed plenty of biotech horror shows and counted my lucky stars I wasn't invested in them (click on images):

Like I said, it's the binary nature of the biotech beast, if you get caught in a big position, you can easily face the risk of ruin.

But it's not just biotech, I've seen plenty of big dips in my trading career and some really nasty ones in stocks like Macy's (M), Kroger (KR), General Electric (GE) and more recently Symantec (SYMC):

When people ask me "Why BONDS??", I tell them: "Because you never know what nasty surprises are lurking around the corner. Never."

Right now, things are perking up in Europe, emerging markets and those are risks we are aware of. By definition, you can measure risk, you can't measure uncertainty.

If you get caught in a brutal sell-off, you have two choices: 1) cut your losses and eat them or 2) add to your position to average down HOPING the shares will recover. Both options are painful, trust me.

Earlier this week, my father and I were talking about how it's been a while since we had a financial crisis. He was grumbling about how "Nortel was a scam and John Dunn was the only one who made money" and I told him "It was Frank Dunn and there was plenty of blame to go around".

[Note: I'll never forget a senior VP meeting at the Caisse when then CIO (Pierre something, I forget his name) was pounding the table to buy more shares of Nortel as they declined and most people agreed but if I remember correctly, Adel Sarwat wasn't too gung-ho about it but reluctantly said yes.]

My dad also asked me: "What ever happened to Lehman Brothers?" I replied: "Finito caputo!"

"You see, they're all crooks like that Dunn guy!", he said.

Why am I sharing all this with you? Because if you've been around long enough, you know one thing about markets, trends don't last forever and when the trend changes, it could be violent and it could take a very long time before things get back to normal.

In my opinion, the longer we go without a crisis and recession, the worse it will be when it strikes, both in terms of magnitude and duration.

So enjoy riding the wave in junk bonds, stocks and other risk assets, because when the tsunami strikes, it won't be pretty.

Below, Erik Townsend and Patrick Ceresna welcome Dr. Lacy Hunt to MacroVoices. I want you all to take the time to listen carefully to Lacy Hunt as he explains why the (Treasury) bond bull market isn't over and why we cannot get out of the current predicament through more debt and why it will take a long time to recover after the next crisis hits. You can also download the podcast transcript here.

I end by wishing my US readers a nice long Memorial Day weekend and by thanking my loyal subscribers and donators. If you haven't donated to this blog, please do so through Paypal on the right-hand side, under my picture. Thank you and enjoy your weekend!

Thursday, May 24, 2018

Canada's Public Service Pension Problem?

Frederick Vettese, partner of Morneau Shepell and author of “Retirement Income for Life: Getting More without Saving More”, wrote a special for the Globe and Mail, When it comes to pensions, don’t follow Ottawa’s example:
It is a sad fact that only 20 per cent of private-sector workers are covered by pension plans in their workplace. In stark contrast, nearly 100 per cent of public-sector workers are covered. Of course, none of this is news; pension envy among private-sector workers is as Canadian as hockey and Timbits.

What is perhaps more interesting and less well understood is the garbled message the government is sending with the pension programs it provides to its own employees. I will single out the federal Public Service Pension Plan (PSPP), not only because it has more than half a million members, or because it is generous even by public-sector standards, but also because the federal government has the power to effect change in a way that would benefit millions of Canadians.

The classic defence of plans such as the PSPP is that everyone benefits when civil servants can retire in dignity. Besides the obvious advantages for the participants themselves, good government-sponsored pension plans create a benchmark for other employers to emulate.

In the case of the federal government, however, this rationale contains a fatal flaw. The last thing the federal government would ever want is for all private-sector employers to adopt pension plans like the PSPP. The consequences would be disastrous for both the Canadian labour force and for tax revenues.

Consider the labour force first. At present, we have about four workers for every retiree. Fifty years ago, that ratio was 6.6 to 1 and in another 20 years it is forecast to dwindle to just 2.3 to 1. Barring a robotic revolution, we will probably not have enough workers to keep the economy running.

Don’t count on immigration to make up for the looming shortage of workers. It is already running at the highest rate in a century (with the exception of 1956, when the Hungarian refugee crisis occurred); the general public is unlikely to want to see immigration rise much more, even if we had the infrastructure to support it.

A higher birth rate is another possible way to change the worker-to-retiree ratio, but it is not clear what, if anything, would cause the birth rate to rise any time soon. Besides, the impact on the worker-to-retiree ratio would be negligible for at least 30 years.

The inescapable conclusion is that the only viable way to ensure there will be enough workers in the future is to encourage people to keep working longer. Alas, the federal PSPP does just the opposite. The plan’s retirement rules incentivize long-term civil servants to retire as early as age 50. If private-sector employers had maintained similar pension plans all along, the labour force today would have roughly one million fewer workers.

The effect on income-tax revenues if everyone had a PSPP-like pension plan would be equally damaging. A C.D. Howe paper by Malcolm Hamilton estimates that the average Canadian worker contributes about 14.1 per cent of pay toward retirement. (This includes employee and employer contributions to registered retirement savings plans and pension plans but not tax-free savings accounts.) In the case of federal public-sector workers, the contribution rate could exceed 25 per cent in a year when the PSSP has a big deficit. If private-sector workers (and their employers) made tax-deductible contributions at that rate, overall tax revenues would drop by more than $15-billion a year. Clearly, the federal government would never allow this to happen.

The time has, therefore, come to change the federal PSPP to better reflect the public interest. (Or actually, to change it further. Some amendments were made during the Harper era though they did not go nearly far enough.) The plan is a relic from an era during which the country had more potential workers than the economy could absorb but this is no longer the case.

So what should the federal government do to set a good example for private-sector employers? First, it should remove all incentives within the PSPP to retire early. Employees could still retire early, of course, but with the same penalty that applies to all participants in the Canada Pension Plan. Retiring early in comfort may require them to save a little extra in an RRSP and/or a TFSA, the same as what most other Canadians already do.

Second, it should reduce total employee and employer contributions under the PSPP to 18 per cent of pay, including any deficit payments that may have to be made in the future. Even at 18 per cent, the amounts being contributed by, and on behalf of, federal civil servants would still be at the high end of the spectrum.

Of course, these recommendations will not go over well with all stakeholders. No doubt the public-sector unions would strenuously defend the status quo on the basis that PSPP members contribute a high percentage of pay and should be entitled to a generous pension benefit in return. On this point, I would note that over the 12-year period from 2006 to 2017, PSPP contributions by members constituted barely one-third of total contributions (37 per cent to be exact). In most large public-sector plans, member contributions fund 50 per cent of the total pension cost and that includes the cost of paying off any plan deficits that may arise. It is time the federal PSPP fell into line.

The effect of the suggested changes would not be felt immediately since new retirement rules can be applied only to future service. They are, nevertheless, important if the federal government truly wants to set a good pension example for the rest of the country.
I shared this article with two of Canada's best actuaries, Bernard Dussault, Canada's former Chief Actuary, and Malcolm Hamilton, a retired actuary who worked many years as a partner at Mercer and now writes policy papers for the C.D. Howe Institute.

Not surprisingly, Malcolm agreed with the author:
I agree that the federal PSPP is, from the taxpayers' perspective, a disgrace and that something should be done about it.

My description of the problem, and how best to solve it, is quite different.
Bernard provided a little more analysis and questioned the author's claims:
This article fails to point out that the federal government already took measures a few years ago to address the unduly rising cost of the Pension Plan for the Public Service of Canada (PPPSC) mainly by increasing the pensionable age from 60 to 65 for members hired after 2012.

As can be seen in Table 4 on page 9 of the actuarial report on the Pension Plan for the Public Service of Canada (PPPSC) as at March 31, 2014 (, its current service cost is about 17.5% of payroll for the post-2012 hires, shared equally by the members and the government (employer), which is appreciably lower that the about 20.7% cost for pre-2013 hires. This favourably happens to fall below the prescribed fiscal 18% limit above which pension contributions are immediately subject to income taxes.

In other words, the government pays less than 9% of payroll for the post-2012 hires' pensions, which in my view is reasonable considering the important role that pension plans play for the alleviation of seniors' poverty.
Malcolm then followed up to state the following:
I think that you need to add a couple of things.

First, Bernard's description of the changes to the PSPP is quite misleading. Many members hired after 2012, specifically those hired under the age of 30, will be able to retire at the age of 60, not 65 as Bernard contends.

More importantly, only 50% of the cost of the PSPP is covered by contributions. The other 50% is covered by risk-taking. Since taxpayers bear all of this risk, they end up paying much more than Bernard suggests. For this, we can thank defective public sector accounting standards, which allow governments to claim, as does Bernard, that pension plans costing 40% of pay really cost 20% of pay.

In private sector financial statements, this would simply not be tolerated.
I thank Malcolm and Bernard for sharing their insights with me on this article.

I actually agree with both of them to a certain extent but let me explain. Like the author, Fred Vettese, Malcolm paints an overly dire portrait of the federal Public Service Pension Plan (PSPP).

For his part, Bernard points out facts which contradict the author's claims but he too doesn't address some issues which the author is right to point out and as such, is overly optimistic in his assessment.

In my opinion, the most important point that Fred Vettese addresses is the demographic shift going on in Canada (and elsewhere) where in a few years, we will have more retirees than active workers.

You know where I'm getting at with this? That's right, I want to see the federal Public Service Pension Plan (PSPP) adopt a shared-risk model which forces intergenerational equity.

In particular, I want to see conditional inflation protection adopted so if the plan experiences a deficit, retired members will experience a cut in inflation protection for some time until the plan is fully funded again.

In fact, conditional inflation protection is a critical factor behind HOOPP and OTPP's success and that of other fully funded plans in Canada.

It's mind-boggling that in 2018 we still have public sector unions demanding guaranteed inflation protection as if the rest of society owes it to them no matter what.

I'm sorry, I'm an ardent defender of defined-benefit plans but I absolutely need to see two key elements: 1) world-class governance and 2) a shared-risk model where if needed, contributions are raised, benefits cut (typically for a short time using conditional inflation protection) and/ or both.

We need to defend DB pensions but we also need to make them fairer and more sustainable over the long run.

One thing the article above doesn't address because it's a bit confusing is PSP Investments was incorporated as a Crown corporation under the Public Sector Pension Investment Board Act in 1999 to fund retirement benefits under the Plans for service after April 1, 2000, for the Public Service, Canadian Armed Forces, Royal Canadian Mounted Police, and after March 1, 2007, for the Reserve Force.

Notice it's focused on the funding needs of the Plans for service after April 1, 2000, and doing a great job providing an annualized return well above the required actuarial return set by the Chief Actuary of Canada. You can see PSP's fast facts on the Public Service Pension Plan here.

What about the funding needs of the Plans before April 1, 2000? Thus far, PSP hasn't had to worry about those, they are debt which is funded from the federal government's General Account but if they were all of a sudden responsible to fund those retirement benefits, it would be a big deal for the organization and put additional pressure on it because those Plans are in a deficit.

In my opinion, PSP should be responsible for funding pre-April 2000 Plans as well and this too would be fairer for taxpayers, not to mention better for all stakeholders.

I don't want to get into too much detail here but it's a big issue which is currently being discussed in Ottawa (it's been discussed for what seems far too long).

Lastly, I remind all of you that municipal and provincial debt isn't factored into total debt in Canada much like state and local debt are not included in the US federal balance sheet:

I mention this because I had a conversation with a friend of mine in Ontario who was asking me if the Ontario Government uses the pension surpluses to pad that province's balance sheet and I said: "of course it does". He then asked me if the Ontario Government can use those surpluses to spend on programs and I said: "of course not".

He also asked me why they're not amalgamating all these provincial public pensions (including HOOPP which is private) so the province can save costs. I told him it's never going to happen and there would be huge pushback if it did.

I leave you on this note, Canada's pension problems are a joke compared to what is going on in the United States.

Below, Thad Calabrese, NYU, and Kuyler Crocker, Tulare County Board of Supervisors, discuss why cities are investing in the market through the issuance of pension bonds.

Listen carefully to this discussion and especially listen to what professor Calabrese states on these pension bonds, he's spot on but he too neglects mention the real problem behind state and local pension deficits: years of neglect/ mismanagement, poor governance and no shared risk model.

Wednesday, May 23, 2018

Are Smaller Hedge Funds Worth It?

Thomas Franck of CNBC reports, If you want to run a hedge fund that beats the market, keep it small:
Successful hedge fund managers should do something unusual if they want to stay that way: Say no to new investors.

The bigger a hedge fund gets, the worst it tends to perform, according to a new academic study.

Holding other features constant, a 10 percent increase in fund size results­­­ in a decrease of 13 basis points per month (or 1.53 percent per year) in raw returns on average and a decrease of 10 basis points per month (or 1.21 percent per year) in style-adjusted returns, according to the paper from Purdue University.

"A key implication of our findings for investors is that performance persistence is achievable when funds maintain a small size," researchers Chao Gao, Tim Haight and Chengdong Yin wrote. "Fund performance declines with fund age and that declining performance is not significantly related to a variety of fund and family-level characteristics, nor is it significantly related to young funds assuming higher downside risk."

The paper clarifies prior literature that found that hedge fund performance peaks during the first few years of a fund's life, but declines thereafter at an average rate of 42 basis points per year.

The decline in performance, according to the Purdue researchers, appears to be due to managers taking their eye of the ball and focusing more on asset gathering (and the steady fees that come with them) rather than investing.

Other studies hold that historical compensation contracts in the hedge fund industry, such as 2 percent management and 20 percent performance fees, is not effective at aligning managers' incentives with investors' interests.

Yin's 2016 study, for example, demonstrates that the management fee comprises a larger portion of total compensation when funds grow large and thus a fund's optimal size, from a compensation perspective, exceeds the size that is optimal for performance.

The research comes amid an ongoing move by funds to offer more competitive fee structures amid lackluster performance, declining revenues and rapidly evaporating investor patience.

"When funds grow large, fund managers may have less incentive to improve fund performance because most of their compensation comes from the asset-based management fee," the researchers concluded. "Thus, investing in small funds, regardless of age, may provide for superior and sustainable returns."
Ah, the old large versus small hedge fund debate. A few years ago, Barron's had a similar comment on how small hedge funds outperform bigger rivals but CNBC then responded by stating bigger is better.

Let me cut to the chase and give you my quick takeaways:
  • No doubt, smaller hedge funds that survive their first year in operation are by definition hungrier for performance and much more focused on performance. Why? Because in order to survive, they need to perform and raise their assets under management to a decent level over the first three years.
  • What is the critical threshold for assets under management? It depends on the strategy but some say it's $300 million, some $500 million and some over $1 billion to survive and deal with all the regulatory, compliance and institutional demands.
  • Large hedge funds are able to address all these demands. They also have a lot of money to pay their people well which allows them to attract the best talent. So, it's not true that all large hedge funds are lazy asset gatherers who stopped focusing on performance. Many are but there are plenty very much still focused on performance and if they weren't, they'd be out of business
  • I can also tell you there are A LOT of crappy small funds which is why most investors don't bother with them, preferring to focus on the 'best of breed' large funds which are scalable and offer them peace of mind (if they blow up, less career risk since other large institutions also invested in them).  
Anyway, I had lunch with Andrew Claerhout, the former head of Infrastructure and Natural Resources at Ontario Teachers' Pension Plan and Greg Doyle, Vice-President of Pension Investments at Kruger.

It was actually the second day in a row I met up with Andrew for lunch and it was a pleasure meeting him in person in Montreal where he was visiting for a couple of days.

I've said this before and I'll say it again, Teachers' screwed up big time letting go of such outstanding talent. Andrew should have been the next CEO of Ontario Teachers', he's very intelligent, super nice and an outstanding leader (following his departure, the CIO "resigned" and there were a couple of senior managing directors that left Teachers' Private Capital to start their own PE fund).

Anyway, Andrew, Greg and I had a great lunch, we enjoyed the nice weather and I enjoyed listening to them talk private equity, infrastructure, renewable energy and more. Greg was especially chatty and he's a bright guy, reminds me a lot of Mike Keenan over at Bimcor (BCE's pension plan).

Andrew really knows his stuff too, said there was a value creation plan behind every investment and "no investment was made unless we figured out a way to improve operations and unlock value".

Honestly, the guy should write a book or a guest blog comment because he spent 13 years at Ontario Teachers' first working in private equity (Mark Wiseman hired him) and then heading up infrastructure and natural resources over the last four years. He's seen a lot and he's no passive investor, he enjoys getting into the operational weeds.

We talked about the climate for fundraising. Earlier today, I sent Andrew a Bloomberg article on how Carlyle's co-founder David Rubenstein sees more money flowing into private equity than at any time in his three-decade career.

Rubenstein is a master at raising funds. Greg Doyle has met him (and plenty of other big shots) but he remembers him saying: "It takes six months to launch an IPO and 18 months on average to raise money and close a private equity fund."

You see, even in private equity, the fundraising might be great for the large, well-known funds, but it's no cake walk and it's brutal for smaller funds, many of which are struggling to survive.

Still, just like in hedge funds, there are some excellent small or medium-sized private equity funds (I can think of one excellent medium-sized PE fund in Canada, Searchlight Capital, founded by Erol Uzumeri who used to work at Teachers' Private Capital, Eric Zinderhofer from Apollo and Oliver Harmann from KKR).

Many institutional investors love private equity, it's their best asset class and they like it even if it's illiquid because the alignment of interests are there and so is long-term performance.

My last comment was all about how CalPERS is bringing private equity in-house, trying to emulate what Canada's large pensions are doing through fund investments and co-investments on larger transactions (a form of direct investing which lowers overall fees but it’s not pure direct investing).

Anyway, today I wanted to talk about hedge funds, especially smaller hedge funds.

There are some talented absolute return managers in Canada that are run by excellent managers but for one reason or another, they don't make it on consultants' lists of funds to invest in.

I hate the cookie-cutter approach where you need to check off all the boxes and think it's really worth  meeting managers one by one to understand their strategy, performance and people.

For example, in Montreal, I've already referred to the folks at Crystalline Management, one of the oldest hedge funds in the country which will soon celebrate its 20-year anniversary. Marc Amirault and his team have done a great job running a couple of arbitrage strategies and they have grown their assets very carefully (I think they're way too conservative and have told them so but it's what they're comfortable with).

But there are other emerging managers, some that received mandates from PGEQ. Quite frankly, the biggest problem in Quebec and rest of Canada is we lack a billionaire Bass family like they have in Texas to fund new private equity and hedge funds on a much larger scale.

We desperately need big billionaires with big cojones writing big seed tickets. I'm dead serious about this. The PGEQ is fine but we need something much, much bigger, preferably backed by large family offices since big pension funds aren't into taking big seed risks.

[Note: In March, CPPIB announced it made initial investments of as much as $250 million each in five startups and young hedge funds under its Emerging Managers Program in the past two years. None of these fledgling hedge funds are Canadian. Read details here.]

I see guys like Karl Gauvin and Paul Turcotte at OpenMind Capital trying to get assets under management and offering institutional quality volatility funds. Go see them, kick the tires, talk to them and you'll see they know what they're talking about.

But there are other less well-known players, slowly gathering assets under management, people I've worked with in the past. One of them is Francois Laplante who runs Folco Strategy Partners and is posting outstanding absolute return numbers.

I know Francois from my days at the National Bank going back almost 20 years. He and Philippe Couture were the only traders who survived and are still trading for a living (Philippe trades his own money and doesn't want to manage outside money).

Francois runs a segregated account using Interactive Brokers platform and charges low fees (1.25% management fee and 10% carry) because his costs are low. It's fully transparent, the client owns the account and can get out at any time, and he can run all the trades pari passu through this structure (by the way, OpenMind uses the same IB structure and also charges low fees).

I had lunch with him a couple of weeks ago and asked him to give me a brief description of his strategy/ edge:
Folco Strategy Partners equity long/short seeks to generate annual returns of 10% (net of fees) with a risk target lower than equity markets. We have a contrarian approach and we
focus on REITs and other defensive real asset industries such as renewable energy, rails, energy infrastructures, independent power producers, pipelines, utilities and telcos. The strategy offers a very low correlation to the equity market.

Our unique proprietary top-down and bottom-up investment process uses a combination of fundamental and technical analysis.

We focus on our sectors of expertise and remain disciplined at all times. We believe publicly-traded real asset sectors are occasionally mispriced, and we use these opportunities to our advantage.

We may invest or short securities in other sectors to seize opportunities or minimize downside risk (maximum 20% of AUM). We establish our geographic and segment exposures based on regional growth perspectives, currency impact and supply/demand dynamics The manager has a significant personal investment in the strategy. I am the biggest investor.
I highly suggest you contact him at  Folco Strategy Partners and do your own due diligence. A guy who has traded this long and in size (he ran big ALM desk at Desjardins) really knows his stuff and he's posting incredible numbers (a couple of investors I brought to him didn't believe it but one was so impressed, he already invested with him after visiting his office and kicking the tires).

All this to say, everyone loves big hedge funds, I too track what top funds are buying and selling every quarter, but it's worth keeping your eyes and ears open for smaller hedge funds that aren't brand names but often (not always) offer much better returns and alignment of interests.

In my humble opinion, the best investors positioned to invest in smaller hedge funds are large family offices who aren't afraid to take some smart risks.

Large pension funds can also seed smaller hedge funds through a fund of funds structure or some other structure (like PGEQ) but they move at a very slow pace and there just not interested in allocating risk to such a venture and when they do, it moves at glacial speed.

Let's face it, big pensions looking for scale want to write big tickets to a few big players. That will never change but maybe they need to rethink their approach and allocate some risk to smaller hedge funds.

Below, CNBC's Leslie Picker reports that hedge funds are raking in the money. The big hedge funds are getting bigger but this leads to crowded trades which is why returns are dwindling over time.

Update: Charles Lemay, Vice-President Business Development at Landry Investment Management, shared this with me after reading this comment (added emphasis is mine):
Great article Leo, 100% agree. When interests are aligned and the PM/employees have skin in the game...motivation to perform and succeed is much higher. You find this much more often in smaller shops vs larger ones who have “made it” and can afford to pay the bigger salaries so the PMs/employees get complacent. It’s not always true but like Vital Proulx said at the EMB event a couple weeks ago...graduating from being an emerging manager to above a billion is one have a sustainable business now...but keeping that drive and motivation to keep performing and growing to your “sweet spot” AUM for you strategy is very important. We need more stories like Hexavest (like your billionaire Bass family) who made it from nothing to $20B and have kept the engine going. Vital doesn’t need to work...but his passion is there, he loves what he does and wants to keep going. And yes PGEQ needs to get bigger...much bigger.
I thank Charles for sending me this and agree with Vital Proulx's wise advice, no matter how big you get, you need to keep the drive and motivation alive and that's been the secret behind Hexavest's success.

And just so you know, Hexavest recently announced it hired Vincent Deslisle as the co-CIO to help Vital and Jean-Pierre Couture, the Chief Economist. Good move, Vincent has a lot of passion for investment research and he's a very nice guy too.