Thursday, January 31, 2019

Caisse, OMERS Buy US Logistics Developer?

Benefits Canada reports, Ivanhoé Cambridge, Oxford Properties team up to buy U.S. logistics real estate developer:
The real estate investing arms of the Caisse de dépôt et placement du Québec and the Ontario Municipal Employees Retirement System are teaming up to invest in the U.S.-based IDI Logistics.

“We are delighted to be working with Oxford on this venture for the future success of IDI Logistics, a company which consistently builds, operates and leases some of the best bulk-and-big-box logistics real estate in the United States,” said Mario Morroni, executive vice-president of industrial for North America at Ivanhoé Cambridge, in a press release. “This transaction perfectly illustrates our plan to capture the growth in demand for logistics globally, which includes a meaningful increase of our investments in that sector across four continents.”

In just over two years, Ivanhoé Cambridge has grown its investments in the industrial and logistics sector by about seven billion dollars, according to Morroni.

IDI Logistics is based in Atlanta and specifically deals with developing and managing logistics real estate assets. Besides the company itself, the joint venture is taking on its portfolio of 111 operating assets, 35 development projects and 33 parcels of land.

“This acquisition represents Oxford’s first logistics acquisition in the United States, is complementary to our Canadian industrial portfolio and is consistent with our investment strategy to establish and grow a portfolio of best-in-class logistics assets across the globe,” said Kevin Egan, head of New York and U.S. investments at Oxford Properties.

“Furthermore, it highlights the evolution and growth of our U.S. business, which now actively invests and manages across the office, retail, multi-family, logistics and credit sectors with approximately US$15.1 billion of assets under management. We’re excited to partner with Ivanhoé Cambridge and look forward to driving the next phase of success for IDI Logistics.”
Natalie Wong of Bloomberg also reports, Oxford Joins Caisse in $3.5 Billion Deal for Brookfield’s IDI:
Two of Canada’s biggest pension funds will jointly own Atlanta-based warehouse developer IDI Logistics after Ivanhoe Cambridge Inc. sold half of its stake in the company to Oxford Properties Group.

Ivanhoe, which bought IDI in November from a unit of Canada’s Brookfield Asset Management Inc., for about $3.5 billion, sold 50 percent of it to Oxford for about $1.7 billion in December, according to people with knowledge of the transactions who asked not to be named.

IDI has more than 70 employees across six offices in the U.S. and a portfolio of 111 assets, 35 development projects and 33 land parcels, the companies said in a statement Wednesday. Together, the new owners say they can more effectively develop IDI’s business.

“It would take us years to piece together a portfolio this size and quality on an asset-by-asset basis, so IDI was an opportunity to own, together with Ivanhoe Cambridge, a 47 million square feet portfolio plus a very large development pipeline,” said Kevin Egan, head of New York and U.S. investments at Oxford, the property unit of pension fund OMERS.

Industrial real estate deals are attracting institutional capital in North America as the rise of e-commerce continues to drive up rents and lower vacancy rates for warehouses and distribution centers. Blackstone Group LP closed its $7.6 billion purchase of Gramercy Property Trust in October and bought Canada’s Pure Industrial REIT last January in a joint venture with Ivanhoe, which has also singled out warehouses as a target for its growing global business.

In just over two years, Ivanhoe has increased its overall committed investments in the industrial sector from more than C$2 billion ($1.5 billion) to more than C$9 billion, Mario Morroni, executive vice president of industrial in North America for Ivanhoe, a unit of Caisse de Depot et Placement du Quebec, said in a statement.

The IDI acquisition will help Montreal-based Ivanhoe “to accelerate deployment probably by about 3 or 4 years and given where we were at market pricing right now, we felt that it was important for us to be able to keep on developing the support of the development of this team,” Morroni said in an interview.

‘Perfect Partner’

Oxford “was for us the perfect partner to know that going over the next couple of years, where there may be a slowdown, we’re going to have two sources of capital with people who understand the risk of development and make IDI even better than it has been for the past 30 years,” Morroni said.

The investment is part of Oxford’s continued expansion of its global industrial portfolio: the Toronto-based firm has a C$1.9 billion portfolio in Canada and made its first foray last year into Europe’s logistics sector with a 200 million pound ($261 million) investment in GLP’s development fund, Egan said. In the U.S., Oxford has been expanding its presence with plans to spend about $2 billion to develop New York’s Hudson Square. It already has about $15.1 billion of assets under management in the U.S.
The key passage in the Bloomberg article is this:
Industrial real estate deals are attracting institutional capital in North America as the rise of e-commerce continues to drive up rents and lower vacancy rates for warehouses and distribution centers. Blackstone Group LP closed its $7.6 billion purchase of Gramercy Property Trust in October and bought Canada’s Pure Industrial REIT last January in a joint venture with Ivanhoe, which has also singled out warehouses as a target for its growing global business.
Logistics real estate is a very hot area all over the world (not just North America) as e-commerce explodes.

The Caisse and CPPIB have already invested in logistics facilities in Asia and this deal is one of many and more to come in North America. It's basically investing in a long-term secular trend, the rise of e-commerce all over the world.

The Caisse's real estate subsidiary, Ivanhoé Cambridge, bought IDI Logistics from Brookfield Asset Management for $3.5 billion and sold half its stake to OMERS's real estate subsidiary, Oxford Properties, for $1.7 billion in December.

It's a great deal for Oxford as it ramps up its logistics exposure and partners up with one of the best real estate outfits in the world (Ivanhoé Cambridge). And for Ivanhoé, Oxford is a great partner, one I'm sure they will team up with again for future real estate ventures.

I don't cover real estate as much as I should but make no mistake, it's one of the most important asset classes at these large pensions because it's a long duration asset which offers steady returns (long-term leases and capital appreciation) and fits well in terms of a liability hedging as well as inflation hedging (real assets) portfolio.

The long-term returns of real estate are anywhere between the returns of bonds and equities with less risk than stocks, especially when talking about prized real estate assets. Sure, there are some opportunistic deals which are much riskier (and offer higher returns) but these deals are not what makes up the bulk of pension fund portfolios (they typically invest in external managers who take these risks).

Anyway, there isn't much more I can add on this deal. Take the time to read the Ivanhoé Cambridge press release here, Mario D. Morroni, Executive Vice President, Industrial, North America at Ivanhoé Cambridge explains it very clearly.

Are there risks with logistics and commercial real estate? Of course, the biggest risk is a pronounced economic downturn. For example, when the oil slump hit Alberta hard, commercial real estate in Calgary and Edmonton also slumped, vacancy rates surged and rents declined.

But again, logistics is a long-term secular theme, these pensions aren't buying these facilities for a quick flip and they can ride out any downturn in the US and global economy, waiting for a recovery.

Below, IDI Logistics is one of the world's leading investors and developers of logistics warehouses and distribution parks with 33 million square feet of premier assets under management and additional prime land sites to develop another 20 million square feet of distribution facilities near major markets and transport routes throughout North America.

Second, my favorite real estate investor, Blackstone President and Chief Operating Officer Jonathan Gray talks with Bloomberg’s Jason Kelly at Bloomberg’s The Year Ahead summit in New York (November 28, 2018). Listen carefully to his insights on real estate, he makes great points.

In fact, listen carefully to the entire interview with Jon Gray, he covers all of Blackstone's four main activities -- real estate, private equity, credit and hedge funds -- extremely well and also discusses how his firm is trying to improve data among the units to improve its returns.

Lastly, Howard Marks, co-chairman of OakTree Capital, sat down with CNBC's Brian Sullivan earlier today to discuss his market outlook and the Fed's decision to hold rates. Great interview, listen to what he says about what happens if the Fed cuts rates later this year (he gets into it around minute 4:30 when Brian Sullivan asks him: "What happens if the Fed cuts rates?").

Update: Alexandra Faciu, a real estate expert, shared this comment on LinkedIn after reading this post (added emphasis is mine):
Transactions like this where a pension fund sells interest to another one shortly after acquisition are very reassuring, the premise being that if one pension fund gets it wrong it’s highly unlikely that a second one would do the same. Moreover, we are talking about top Canadian pension funds. We can be certain that any dispositions by Brookfield would be at the peak of the market i.e expensive, but at the same time, as you said, this is a long term hold in a platform that has been successful in an asset class market that will continue to grow. The only comment I will make is that given logistics is dependent on retail, both funds will have to proactively stay on top of the trends in consumer behavior: Millenials are buying on-line and Gen Z in stores, with the rest of us doing a bit of both. The question is: which trend will have more influence? However, like anything else in real estate, time will tell.
I thank Alexandra for her excellent insights on this deal.

And on Friday, I read that the CEO of the biggest mall owner in the US says he’s nervous about more retail bankruptcies this year:
The biggest mall owner in the U.S. is warning of more store closures and even bankruptcies to rattle the retail industry in 2019.

“There are some retailers out there that we’re nervous about,” Simon Property Group CEO David Simon said Friday during a call with analysts after the company reported earnings, though he didn’t name those companies. “We are concerned about a few [retail bankruptcies] that should shake out in the first quarter.”

Simon, the largest mall owner in the U.S., has like its peers been grappling with how to deal with an onslaught of store closures from tenants big and small, ranging from Sears to Starbucks’ Teavana. The real estate investment trust finds itself in an especially unique position with Sears’ bankruptcy in that it’s also a member of an unsecured creditors committee now arguing Sears can’t be saved, as Sears Chairman Eddie Lampert is still trying to salvage some 400 stores.
Gives you an idea on why logistics is better than owning retail malls right now.

Wednesday, January 30, 2019

CalSTRS, CalPERS Beefing Up Private Equity?

Randy Diamond of ai-CIO reports, CalSTRS Wants to Double Co-Investments:
The investment staff of the California State Teachers’ Retirement System (CalSTRS) wants to double the number of co-investments in the system’s approximate $18 billion private equity program in the next two to five years, adding 15 new staffers and possibly opening an office in San Francisco to handle the additional investments.

The West Sacramento-based pension’s plan to build its private equity program is contained in agenda material for its January 30 investment committee meeting. The investment committee is being asked to approve CalSTRS’s strategic direction in efforts to expand the private equity program, the pension system’s best-producing asset class over the short and long term.

CalSTRS’s overall private equity returns for the one-year period ending March 31 totaled 15.5%, the largest return of any asset class.

CalSTRS currently has 8.1% of its overall portfolio devoted to private equity, but its long-term target is 13%.

CalSTRS investment officials see co-investments as a way to get to that target. Co-investments only account for a small part of the plan’s private equity portfolio, around 5%, said a September report from the Meketa Investment Group, which serves as a CalSTRS investment consultant.

The new January 30 plan said that over the last two calendar years, the CalSTRS private equity program has made new commitments of approximately $6 billion to $7 billion a year with co-investments representing approximately 8% to 9% of total new commitments.

The plan says private equity’s current team of 23 professionals, 18 who specialize in investments and five operational personnel, are at capacity for the current investment pace and that an additional 15 hires are needed to at least double co-investments.

CalSTRS paid more than $500 million in management and profit-sharing fees to its private equity general managers in calendar year 2017, the most recent data available. The CalSTRS plan says that “increasing co-invest represents the most immediate, largest, and greatest opportunity to reduce costs and increase investment returns.”

Under co-investments, CalSTRS and other pension plans are offered additional stakes in portfolio companies acquired by private equity firms, often at little or no additional fees. This is usually in addition to the pension plan’s investment as a limited partner in a co-mingled fund with a general partner.

Officials of the $214.9 billion CalSTRS see co-investments as a possible entry point to make direct investments in private equity at a later point without external managers.

CalSTRS’s approach contrasts with that of its larger Sacramento neighbor, the California Public Employees’ Retirement System (CalPERS), which is proposing to invest $20 billion in additional private equity funds through two direct-style investment vehicles. One vehicle, called Innovation, would take stakes in late-stage companies in the venture capital cycle. The other vehicle, known as Horizon, would take buy-and-hold stakes in established companies. CalPERS currently has around $28 billion invested in private equity.

The CalSTRS plan says the competition for high-quality co-investment professionals “makes it advisable to budget for a higher average salary for such professionals” than existing personnel. It does not state, however, what the new staffers should be paid.

The plan also says that private equity investment staff to be hired for the expanded co-investment program “would be significantly enhanced by being located in a major financial center.”

It says that while public asset classes are largely research-oriented, private asset classes are more relationship-oriented.

“In major financial centers, investment professionals have more opportunities to interact and form relationships with other investors, lenders, investment bankers, consultants, advisors, regulators, lawyers, and operating company executives,” the plan says. “Such an ecosystem is more efficient and is likely to result in a higher level of knowledge, competitiveness, and overall flow of opportunity.”

The plan says San Francisco is an “obvious choice to consider” for the co-investment expansion because there are many general partners located in the Bay Area, including KKR, TPG, and GI. It also said that other major institutional investors, including Singapore’s GIC sovereign wealth fund and the Queensland Investment Corp., have placed private equity professionals in the Bay Area.

CalSTRS is the second-largest US fund by assets, surpassed only by the $345.6 billion CalPERS, which is No. 1.
I saw this article last week and it caught my attention.

Let me begin by stating there's no question in my mind that both CalSTRS and CalPERS need to increase their co-ivestments in private equity to increase their allocation to this asset class which has been a top-performer for both pension funds and to lower overall fees paid to general partners even though they're increasing their allocation to private equity.

This is exactly what Canada's large pensions have done over the last five years, namely, increased their direct private equity investments and their allocation to private equity predominantly through more co-investments alongside their GPs (which they still invest with through traditional comingled funds).

The big difference, however, is in Canada, the governance is set in a way where there's zero government interference in the day-to-day operations of these large public pensions and that includes in their compensation scheme. Canada's large pensions pay their private equity and other private market senior managers extremely well to do more direct investing (via more co-investments).

US public pensions cannot compensate their private equity staff as well but in the case of CalSTRS, they seem to recognize this deficiency and are saying "we need to open up an office in San Francisco and pay our private equity staff market rates to handle this co-investment activity."

Last year, CalPERS was planning to outsource this activity to an external manager but all that changed in November when it apparently scrapped this proposal:
The California Public Employees’ Retirement System (CalPERS) has ended its consideration of a plan that would have seen a strategic partner play a key role in running its existing $27 billion plus private equity program.

BlackRock, Goldman Sachs Asset Management, Neuberger Berman, AlpInvest Partners, Hamilton Lane, and HarbourVest Partners had all submitted plans to CalPERS early this year detailing the role they would play in managing the largest private equity portfolio in the US.

John Cole, a CalPERS senior investment officer, told the investment committee at its meeting on November 13 that the plan is now off the table.

“A year ago, we thought maybe it would be best to find the large partner in a discretionary role to help us identify good funds and to expand our relationships to include more co-investing and access to secondary transactions,” he said.

Cole said the six investment organizations that applied to help CalPERS were all outstanding. “But we have come to the realization after a lot of analysis and discussion that the structure is unlikely to meaningfully strengthen our organization,” he said.

Cole did not go into detail and CalPERS never specified whether the chosen firm would have run all or part of the private equity program, which is mostly invested in co-mingled funds with general partners.

CalPERS had been in exclusive talks with the world’s largest asset manager, BlackRock, before announcing that it was seeking proposals from a wider set of managers to be a strategic partner in the administration of the private equity program.

Cole did not rule out the firms helping CalPERS in an advisory capacity but said no decision would be made until CalPERS appoints a new private equity director in early 2019.

The pension plan has been without a private equity director since Real Desrochers left in April 2017 to join a private equity firm.

In another major announcement, Cole also disclosed that CalPERS is scaling back a program announced in 2015 by outgoing Chief Investment Officer Ted Eliopoulos to reduce the number of private equity managers from several hundred to 30.

The reduction was designed to allow CalPERS to focus its private equity commitments on top-tier private equity managers with the best returns. It was also supposed to simplify administration and allow CalPERS to get better fees by concentrating commitments in a smaller number of managers.

Cole said at the Nov. 13 meeting that the pension system had reduced the number of general partner relationships from several hundred to currently around 90 with a target of between 40 and 45.. “We think that makes sense in order not to dilute our impact and, as a result, the returns from the entire private equity portfolio,” he said.

CalPERS’s private equity consultant, Meketa Investment Group, questioned the wisdom last year of CalPERS cutting its private equity managers to 30, expressing concerns about missed investment opportunities.

In a November 2018 report, Meketa says that investment staff has sought to expand the list of managers with a continued focus on high-quality general partners. “The expansion of the manager set provides opportunity, not only to increase scale, but also pursue strategies beyond the mega and large buyouts in order to add portfolio diversification,” it said.

More than 60% of the CalPERS private equity portfolio is in buyout funds.

The private equity asset class is CalPERS’s largest-producing asset group in both the short- and long-term. The $361.1 billion pension plan is only 71% funded.

The private equity asset class provided CalPERS with a 16.1% net return in the fiscal year ending June 30, 9% over the 10-year period, and 10.5% over the 20-year period, shows CalPERS data.

CalPERS is also pursuing an expansion of its private equity program, pending board approval, creating its own $20 billion direct investment program that would invest in later-stage companies in the venture cycle and take buy and hold stakes in established companies.

The expansion would be managed by a separate organization, funded by CalPERS, that would have the power to make investments without the approval of the CalPERS board.

Cole did not give any indication when the CalPERS Investment Committee, made up of board members, would consider the plan. CalPERS officials had said they hoped to start the program by early next year.
I question the wisdom of Meketa, the private equity investment consultant, in advising CalPERS not to reduce the number of its private equity relationships down to 30 at most  because I remember Réal Desrochers telling me there were too many relationships at one point and it was negatively impacting the performance of Private Equity.

But Meketa's recommendation might reflect the fact that CalPERS can't find enough private equity commitments:
A consultant’s review of the California Public Employees’ Retirement System’s $27.6 billion private equity portfolio has found that the current investment pace is not likely to be sufficient to maintain the pension system’s 8% target to the asset class.

The $361.1 billion CalPERS is below the 8% allocation right now; 7.7% of its portfolio is invested in private equity as of August 31. CalPERS is the largest private equity investor in the US.

The review by the Meketa Investment Group, scheduled to be presented at the CalPERS Investment Committee meeting on November 13, says CalPERS made $5.3 billion of commitments during the 12-month fiscal year ending June 30, slightly below its $6 billion target.

However, the problem goes beyond a $700 million shortfall for CalPERS to reach its target allocation. The pension plan so far has not been able to reach its private equity allocation because it is receiving more distributions as funds end than it can reinvest. Private equity funds normally end after a seven- to 10-year cycle and redistribute profits.

The problem for CalPERS is it can’t find enough new private equity investments in any given year, as Meketa notes. Distributions have exceeded contributions for eight years in a row, including the latest fiscal year, the review noted.

In the June 30 fiscal year, Meketa found that cash distributions to CalPERS from private equity funds totaled $7.4 billion compared to $4.5 billion in new contributions. While CalPERS made a larger $5.3 billion in new commitments to private equity, not all the money was called by private equity general partners because they did not find suitable investments.

Meketa found that CalPERS’s commitments on a calendar year basis have dropped dramatically since 2008, when the pension system allocated more than $14 billion to new private equity funds. Since then, CalPERS has not allocated more than $4 billion in any single calendar year to the asset class, the consultant’s review shows.

CalPERS’s own data shows that the pension system has received more than $80 billion in private equity distributions combined for the 11 fiscal years between June 30, 2007, and June 30, 2018, but commitments to new investments in that time period are less than half of that figure.

CalPERS’s own investment staff has concluded that the retirement plan would need to make $10 billion in commitments each year for the pension plan to maintain its 8% allocation to private equity, the Meketa review notes.

Pension system investment officials have not detailed extensively in public how they plan to get up to that $10 billion number in their top-returning asset class. They have described an environment at investment committee meetings that pits CalPERS against other institutional investors, as they vie to be part of over-subscribed top-tier private equity funds.

What’s clear is the importance of the asset class to overall returns.

The private equity asset class provided CalPERS with a 16.1% net return in the fiscal year ending June 30, 9% over the 10-year period, and 10.5% over the 20-year period, shows CalPERS data.

In contrast, the CalPERS overall fund produced an 8.6% return in the latest fiscal year, a 5.6% return for the 10-year period, and a 6.1% return for the 20-year period. CalPERS is only 71% funded.
Anyway, it's clear that maintaining an allocation to private equity and increasing it requires a much more concerted effort in increasing co-investments, especially if you want to keep the fees as a percentage of total assets as low as possible.

In December, ai-CIO reported that CalPERS planned private equity program could grow quickly:
A California Public Employees’ Retirement System (CalPERS) official says the system’s planned private equity direct investment organization could easily commit $10 billion of capital within five years and could also take on several additional investment partners.

The comments of John Cole, a CalPERS senior investment official, offer detail about the efforts by the largest US public pension plan to launch an up to $20 billion investment organization that would take investment stakes in late-stage companies in the venture capital cycle as well as buy-and-hold stakes in established companies, a la Warren Buffett.

The CalPERS Investment Committee has not yet approved the plan, but most of the 13 members are generally supportive of the concept, though questions clearly remain.

The committee is expected to formally vote on the plan within the next several months.

Cole said at the committee’s meeting on Dec. 17 that time is of the essence. CalPERS has been negotiating with investment teams to run the new private equity organization but can’t hire anyone until the organization is approved.

“The kind of talent we need always has options,” Cole said, noting the competitive nature of hiring top investment teams.

He also said the private equity plan has the full support of incoming Chief Investment Officer Ben Meng, who is expected to start next month.

Cole said the organization, once approved, could make its first investments within six to 18 months. He then sees a rapid infusion of cash into the two CalPERS-backed organizations: Innovation, which will invest in late-stage companies like the Ubers of the world, and Horizon, which will take buy-and-hold stakes in established companies.

Asked by investment committee member Margaret Brown how long it would take for the two entities to reach the $10 billion investment level, Cole replied: “In these two entities, we’re projecting easily within five years.”

CalPERS ultimately expects to commit $20 billion to Innovation and Horizon, but that could take up to a decade.

In response to another question from Brown, Cole said initially CalPERS would be the sole investor in Innovation and Horizon, but said additional investors were possible in future years. “What we’ve done is to enter into this with a belief that we must be the sole investor in order to set this up and to make sure that it meets our needs, first and foremost,” he said.

Cole then said CalPERS could be open to one or two additional partners that could add capital and share expenses for the planned private equity organization, dubbed “CalPERS Direct.” He did not lay out a timetable for additional investment partners.

The investment officer also defended the “CalPERS Direct” concept, which has been met by some criticism, including that of former committee member and system portfolio manager, J.J. Jelincic.

The criticism is that “CalPERS Direct” isn’t really direct at all, like the way the Canadian pension plans operate, because the pension plan is proposing a limited partner (CalPERS) and two yet-to-be-announced general partners that would make the investments for Innovation and Horizon. This contrasts with major Canadian pension plans who have in some cases cut out the middleman and do private equity investments directly.

“For us, what it means is that we will have an exclusive relationship,” Cole said. “We will be the only investor and therefore define specifically the entire investment agreement with an outside team of the investment managers acting solely on our behalf.”

CalPERS officials have never fully explained why they have rejected the Canadian model, except to say that the general partner-limited partner arrangement would allow CalPERS to pay the multimillion-dollar salaries that are necessary to attract top investment staff.

Jelincic attended the December 17 committee meeting, arguing that the new private equity investment program would be risky investment-wise. He said that if the investment committee was intent on a new private equity program, it should run the program internally without an external general partner. Jelincic said that would give CalPERS full control managing the program.

Jelincic has also made comments previously that the new private equity organization would not save CalPERS any money on fees. The expense of CalPERS’s existing $28 billion private equity program, which would run alongside the new private equity organization, has been a long-term controversy.

In the existing program, CalPERS pays management fees of up to 2% to the general partners who manage the funds that CalPERS participates in as a limited partner. The general partners take 20% of the profits from managing the investments, even though they put up little or no money.

Acting investment committee member Steve Juarez, representing State Treasurer John Chiang, brought up Jelincic by name, and questioned Cole about the fees that would be paid to the general partners and their investment staff in the new private equity organization.

Cole responded that CalPERS will be saving management fees as assets increase in the planned organization. He said at first, CalPERS will pay the two management teams for Innovation and Horizon that act as the general partners a 2% management fee and a 20% profit sharing but “as you get closer to $10 [billion], [the management fee] will be closer to half a percent, you don’t have to wait until 10 to get there.”

Cole also said the 20% profit sharing received by the general investment partners would also decrease over time as investment organizations become larger and increase their asset base. He didn’t offer specifics.

Another area of controversy is the limited disclosure that would be made to the public about investments by the new private equity organizations.

The investment organizations would disclose investment results, but much of their activities would operate in secret. Advisory boards formed to monitor the Innovation and Horizon investment teams would not have public meetings and the overall investment organizations would not be subject to public record requests. Also, the investment staff of new organizations would not be required to fill out state disclosure forms on their investment holdings.

Brown said she and other unnamed investment committee members remain concerned about the lack of transparency.

“This board has a fiduciary responsibility to 1.9 million members and thousands of employers,” she said at the Dec. 17 meeting. “And so, with that in mind, I wanted to let you know that I have a lot of concerns that we are putting this program together, I think in part to avoid transparency.”

CalPERS general counsel Matthew Jacobs responded that “would defeat the entire purpose of the endeavor that the Investment Office is undertaking, [because] these are private investments and they’re private for a reason, which is that the financial information needs to be private and the people running them have these types of preferences.”

Cole also jumped in. “I think Matt put it succinctly, private investing means private,” he said. “And an attempt to take private investing and make it public is, runs the risk of undercutting its very purpose.”
I agree with John Cole and Matthew Jacobs, CalPERS' board of directors doesn't need to have full transparency on what is going on in these investment vehicles, it needs a level of transparency to feel comfortable and to monitor the progress.

Last week, CalPERS's new CIO, Ben Meng, said the pension fund must expand its private equity activity:
Ben Meng, the new chief investment officer of the California Public Employees’ Retirement System (CalPERS), says a planned expansion of its private equity program to a more direct approach will allow the pension system to increase returns in its best-producing asset class, helping CalPERS meet its 7% average yearly return expectations.

“In order to achieve 7%, our required rate of return, there is no option but to do more in private equity,” Meng said in a press briefing with reporters Tuesday afternoon at a CalPERS retreat meeting in Rohnert Park, California.

CalPERS investment officials plan to keep the plan’s existing $27.8 billion private equity program, which is mostly made up of CalPERS participating as a limited partner alongside other institutional investors in funds run by private equity firms. The program would coexist alongside the planned direct-style private equity expansion initative.

CalPERS’s traditional private equity program has been shrinking. It made up just 8.1% of the pension plan’s $345.6 billion portfolio as of Oct. 31, 2018, down from 9.5% four years earlier. As competition heats up between institutional investors for limited spots in what are expected to be top-producing funds, CalPERS is increasingly being shut out.

CalPERS investment officials see a way around the shrinkage of the asset class by creating an up to $20 billion investment organization that would shun private equity firms. Instead, CalPERS would create and fund two private equity investment vehicles: Innovation, which would invest in late-stage companies in the venture capital cycle in healthcare, life sciences, and technology. and Horizon, which would take buy-and-hold stakes in established companies.

It’s clear why CalPERS wants to expand private equity, given attractive returns for the asset class. CalPERS produced an 8.6% overall return for the fiscal year ended June 30, 2018, but private equity results topped 16%. Over the 10-year period, CalPERS private equity returns have been 10% compared to 5.6% for the overall fund.

The new private equity plan is not without controversy because CalPERS would provide funds for Innovation and Horizon, but investments would be controlled by private equity general partners. CalPERS would be the sole limited partner initially in the relationship.

The CalPERS private equity plan differs from the Canadian model, in which Canadian pension make some of their private equity investments directly without general partners.

Meng said someday CalPERS might be able to adopt a Canadian-style private equity model but said there are obstacles in the near-term because new rules and regulations would be required to create the program.

“We can do direct maybe in the future, but today I don’t think we are ready because of a number of limitations,” said Meng.

He said those obstacles included not only a revamp of CalPERS’s governing rules, but the difficulty of attracting top-notch investment professionals to CalPERS’s headquarters city of Sacramento, as it is not a global financial center.

CalPERS officials have previously disclosed that if CalPERS runs the private equity organization directly, it would have to disclose expected multi-million-dollar compensation for investment team leaders running Innovation and Horizon, creating potential public outrage.

Under the current plan for Innovation and Horizon, that wouldn’t be an issue, because the two investment organizations would be shielded from public disclosure laws as they would not be directly part of CalPERS, even though the pension plan would fund them.

Meng said the Innovation and Horizon investment team approach, with the investment team in charge of each organization acting as general partner and CalPERS acting as a limited partner, is much easier to implement and could be done, “sooner rather than later.”

CalPERS officials had said previously they expected to present the Horizon and Innovation plan to the system’s investment committee by February or March, but Meng said there is no specific timetable to get the plan approved. He did say that CalPERS is moving as fast as possible to get the plan to the investment committee.

CalPERS Chief Executive Officer Marcie Frost, who joined the interview with Meng, said the pension system is conducting detailed checks on potential investment team leaders that would act as general partners for Horizon and Innovation.

“We are still doing due diligence,” she said. “This is the No. 1 responsibility that we have for the fund is that we have to conduct a very thorough due diligence on anyone this organization would partner with,” she said.

Meng said CalPERS is talking to a number of candidates to lead the investment teams, but he would not disclose how many. Pension system officials have previously disclosed that they include David Roux, a co-founder of Silicon Valley-based private equity firm Silver Lake, and Adam Grosser, who oversaw Silver Lake’s Kraftwerk fund. Silver Lake is best known for its investments in technology companies.
I'd be surprised if Silver Lake isn't chosen as a GP since it's one of the best technology private equity funds in the world.

What is clear is Ben Meng understands very clearly the constraints he's operating under. He previously worked at CalPERS before moving back so he knows the terrain and politics extremely well.

He also ordered a full review of CalPERS's investment activities over the next 180 days, one that will include an investment performance attribution analysis to uncover the drivers of CalPERS returns.

I'll give him one recommendation, apart from increasing co-investments (a form of direct investments) through these new private equity vehicles, it may make sense for CalPERS to get back into certain highly scalable hedge fund strategies and develop long-term relationships with top alpha managers.

In other words, don't just focus all your attention on illiquid alternatives (private markets), focus some of it on liquid ones and the key here is to hire the right team to help you set up operations (experienced people like Daniel MacDonald, the Head of Advisory and Pensions at Middlemark Partners can advise CalPERS).

Lastly, naked capitalism is back at it, going after CalPERS any chance it gets, like its recent comment how private equity expert Dr. Ashby Monk repudiates CalPERS CEO Marcie Frost's private equity scheme. I can only take these comments in doses, they're so slanted and sloppy, I leave it up to my readers to review.

Below, John Cole speaks at the CalPERS investment committee on November 13, 2008. I also embedded the CalPERS investment committee meeting which took place on December 17, 2018 (fast forward to 2:48 to get to private equity section).

Lastly, I embedded a clip on private equity from the CalSTRS's investment committee which took place in mid November. All three clips from this investment committee are available here.

I will post today's board meeting once it is publicly available here.

Update: Former committee member and system portfolio manager, J.J. Jelincic, shared this with me after reading this comment:
There is a difference between CAN'T and WON'T  (when it comes to setting compensation):
California Government Code


(a) The board shall appoint and, notwithstanding Sections 19825, 19826, 19829, and 19832, shall fix the compensation of an executive officer, a general counsel, a chief actuary, a chief investment officer, a chief financial officer, a chief operating officer, a chief health director, and other investment officers and portfolio managers whose positions are designated managerial pursuant to Section 18801.1.
I thank J.J. for sharing this with me and find it odd that CalPERS Board doesn't set higher compensation to attract and retain qualified staff in private equity and other activities.

Tuesday, January 29, 2019

Are US Public Pensions Cooked?

Eric Boehm of Reason reports, Can Public Pensions Survive the Next Recession?:
A decade of consistent economic growth lifted the major stock market indices to all-time highs in 2018. But even before the recent dip, many state pension plans were struggling to get back to where they were before the last recession. Unfunded pension debt across the 50 states totals a staggering $1.6 trillion, even by the plans' own (often overly rosy) accounting.

If a decade of positive investment returns can't fix what's wrong with America's public pension systems, how much worse could things get in the event of another downturn? That's what Greg Mennis, Susan Banta, and David Draine, three researchers at the Harvard Kennedy School, set out to determine. They subjected state pension plans to a series of stress tests meant to simulate the consequences of a variety of adverse economic climates over the next two decades, including everything from another major recession to merely lower-than-expected investment growth.

What they found isn't pretty.

"Public pension systems may be more vulnerable to an economic downturn than they have ever been," the trio of researchers concluded in a paper published by the Pew Charitable Trusts in 2018. Deeply indebted pension plans in places such as Kentucky and New Jersey face insolvency if annual returns average 5 percent for the foreseeable future rather than the higher (usually around 7 percent) rates the plans assume. In other words, it won't take much to tip those systems into bankruptcy.

If a major downturn does come, states such as Colorado, Ohio, and Pennsylvania—which are closer to the national average in terms of how well-funded their pensions are—could require "contributions that may be unaffordable" to avoid insolvency.

One of the only states that seems ready to survive fiscal troubles is Wisconsin, where the combination of low existing debt and a 401(k)-style defined benefit plan means unexpected costs would be manageable and shared between employees and taxpayers.

Mennis, Banta, and Draine argue convincingly that stress tests provide a better snapshot of the health of a state pension system than more traditional methods, such as looking at aggregate unfunded liabilities or the funding ratio—that is, the percentage of future liabilities projected to be covered by a combination of future contributions, taxes, and investment earnings. Those metrics can be gamed by making unreasonable assumptions of future investment growth, but stress testing is a reminder that the good times won't keep rolling forever.

Connecticut, Hawaii, New Jersey, and Virginia have passed legislation or adopted policy changes mandating annual stress-testing of public pension plans, while California and Washington have created informal guidelines establishing similar processes. More states should do the same.
Last June, I discussed the great pension train wreck where John Mauldin alluded to the Harvard study funded by Pew Charitable Trusts using “stress test” analysis, similar to what the Federal Reserve does for large banks.

Between you, me and the lamppost, things are going to get worse -- much, much worse -- for many chronically and not-so-chronically underfunded US public pensions when the next recession hits and you don't need fancy stress tests conducted by Harvard researchers to understand why, all you need is to think clearly about the facts.

First, when will the next recession hit? Earlier today, Jeff Cox of CNBC reported, Bond King Jeffrey Gundlach says we just got ‘the most recessionary signal’ yet:
Drooping consumer sentiment is pointing the way to a substantial economic slowdown, if history is any guide.

In particular, the gap between current sentiment and future expectations has blown out wider, according to the Conference Board’s Consumer Confidence Index released Tuesday.

While confidence in the broader confidence index remains strong, falling just slightly month over month, the Expectations Index tumbled from 97.7 to 87.3 from December. Since October, the expectations reading has plunged 24 percent. Conversely, the Present Situation Index is at 169.6, a nudge lower from December’s reading.

Such wide gaps have portended sharp declines in economic activity, as pointed out by several market observers, including DoubleLine Capital’s Jeffrey Gundlach, the so-called Bond King.

“The most recessionary signal at present is consumer future expectations relative to current conditions. It’s one of the worst readings ever,” he said in a tweet.

The difference between the two readings has only been wider three times in the survey’s history going back to 1967, according to Bespoke Investment Group. Those came in January through March of 2001, the final month being the beginning of a recession.

Moreover, when the gap between the Present Situation and Expectations indexes has exceeded 50 — it is currently at 82.3 — “recessions weren’t far behind,” wrote Bespoke’s Paul Hickey (click on image).

The partial government shutdown, which ended this week, was the longest in history and likely dented sentiment.

“Shock events such as government shutdowns (i.e. 2013) tend to have sharp, but temporary, impacts on consumer confidence,” Lynn Franco, senior director of economic indicators at The Conference Board, said in a statement. “Thus, it appears that this month’s decline is more the result of a temporary shock than a precursor to a significant slowdown in the coming months.”

But Hickey said investors would be wise to watch what appears to be a fragile economy closely. He said such disparities in present and future sentiment are the last indicators of growth that is in its latter stages.

“The stock market decline in December followed by the government shutdown undoubtedly had a negative impact on consumer sentiment in January, so the big gap in sentiment towards the present and future doesn’t guarantee that the US economy is on the cusp of a recession, but it does serve as a reminder that the economy is a lot slower now than it was a year ago,” he said in a note. “Therefore, the cushion to absorb any further weakness has worn thinner.”
No doubt, the US government shutdown did hit consumer confidence and this is a temporary shock (for now unless it closes again on February 15th). And some aren't convinced this is a good indicator to gauge whether a recession is coming:

Still, I'd heed the warning from Bespoke's Paul Hickey because the US economy is slowing and a lot more fragile going forward. The cumulative effects of nine rate hikes is taking its toll on the economy and anyone who tells you otherwise is living a fairy tale.

What else do you need to be looking at to know for sure if a major US recession is headed our way? Look for a curve steepening which will happen when the Fed begins cutting rates, sending the yield curve sharply higher (ht, Zero Hedge which didn't bother crediting Francois Trahan for these charts):

Last week, I had my annual lunch with Montreal's best bond trader, a fellow who runs his own hedge fund using his own capital and doesn't want to manage outside money. He treated me to a lunch at Milos which we both thoroughly enjoyed (best lunch special in the city by far).

Anyway, he was telling me how he was up 30% at one point last year but ended up 10%, which is still excellent but he told me flat out: "In order to make money in these markets, you need to swing trade bonds." I said the same goes for stocks (I was up 50%+ at one point last year swing trading and ended up 10% because I got greedy and didn't book my profits in September!).

He's neither bearish nor bullish on US bonds, still sees the 10-year note trading between 2% and 4% but he told me that right now his conviction trade is to go long the 5-year US bond and to short the 10-year Canadian bond. I cannot give you more details as to why but he's a sharp cookie so I'm not going to argue with him (one thing we agreed on is the Bank of Canada missed its chance to hike rates two years ago when it should have).

I told him I'm still bearish on Canada and so by extension, I'm long Canadian bonds and US bonds as I see a slowdown unfolding down south, one that will hit us hard in a year.

Anyway, I'm getting off course. Back to the topic at hand, the next US recession might hit us sooner than we think and that means rates will decline over the next two years.

By how much is anyone's guess but if the next crisis is bad, we might see a new secular low on the 10-year US Treasury note yield and that alone will hit many chronically and not-so-chronically underfunded US public pensions very hard. And if stocks and other risk assets get clobbered too, it will be a perfect storm for all pensions.

But remember, the decline in rates is much more of a factor when it comes to pension deficits for the simple reason that the duration of liabilities is a lot bigger than the duration of assets.

So, if you're going to "stress test" the funded status of US public pensions or any pension for that matter, you need to look at various scenarios where interest rates decline marginally or precipitously over the next two or three years.

I guarantee you a lot of US public pensions have not done this or if they have, they're not sharing their results because it will scare the bejesus out of their members.

What else haven't they done? Stress tests to gauge their liquidity risk if a major dislocation happens in public markets and they're forced to sell public and private market assets at the wrong time (echos of 2008!!). CPPIB's Mark Machin warned investors about this last week in Davos and he was absolutely right.

All this to say, I have serious doubts many chronically underfunded US public pensions will survive the next recession but it all depends on how bad it gets and how long it lasts.

To be sure, no pension will escape the effects of a bad recession but some are a lot more vulnerable than others because their funded status is well below the 80% that most experts consider sustainable.

In Canada, most of our large public pensions are either fully funded or close to it but they too will be hit if a bad recession strikes the US.

The big difference is Canada's large public pensions have the right governance and most have adopted the shared risk model (ex., adopted conditional inflation protection) to weather a really bad storm.

I wrote all about this last week when I went over the pros and cons of Canada's retirement system.

Malcolm Hamilton shared this with me after reading that comment:
I have one important clarification.

I did not advocate that the federal government issue 6% bonds to RRSPs, TFSAs and RPPs. I said that this is something that it could do if it wanted all Canadians to enjoy the treatment now reserved for federal public servants... i.e everyone earns a guaranteed 6% return made possible by huge risks borne by Canadian taxpayers. As you point out, this is irresponsible and unwise and the federal government should not seriously consider it. My point is that it is no more irresponsible or unwise than the DB pension plan that the federal government currently offers its employees.

DB plans are not the answer to our pension problems. Remember, a pension plan ceases to be a DB plan the minute that pensions or pension indexing depend on investment returns or funding positions.

Risk "sharing" is another dead end. Taxpayers should not be expected to share risks without sharing rewards, and employees will need to pay much more for their pensions if taxpayers are appropriately rewarded for the risks they bear.

The answer is to prospectively convert public sector DB plans and JSPPs (jointly sponsored pension plans) to Target Benefit Plans, where members bear all of the risks, including the risks that taxpayers now bear for free. The pension boards and pension managers can then sit down with unions and plan members and decide how much investment risk the plan should take now that members bear all of the risks as adjustments to their contributions and/or to their pensions. No more free lunch. Public sector employees and public sector pension plans would then enter the real world... the one where you can't solve all your problems by punting them to taxpayers.
I obviously disagree with him on target benefit plans as the way forward because I see them as glorified defined-contribution plans which I'm not fond of and stick to my proposal of  'more well-governed DB plans'.

Malcolm kept insisting:
So here's the problem with your position. You compare Target Benefit Plans to Defined Benefit Plans that cost twice as much. It's like comparing a Pontiac to a Porsche (I'm dating myself).

Properly priced, a public sector DB plan costs 40% of pay. By changing the guaranteed benefit to a target benefit that will be adjusted as circumstances require (by changing the level of the benefit or the indexing), we reduce the cost of the pension plan to 20% of pay. So yes, the DB pension is much more valuable. But it is much more valuable because it is much more expensive, not because it is a better plan design. I see no evidence that members will voluntarily pay the extra 20% of pay. I believe that most public sector employees would rather pay 20% of pay for the Target Benefit Plan than pay 40% of pay for the Defined Benefit Plan. In other words, the Target Benefit Plan is better value.

In support of my position, I draw your attention to the behavior of employees in DC plans that allow them to choose between safe investments (long term government bonds) and more risky ones. Virtually no retirement saver voluntarily invests all of their money, or even half of their money, in government bonds. When employees retire, few decide to buy annuities. They prefer to take investment risk and, by so doing, to strive for higher returns and, eventually, higher incomes. They could save twice as much and take less risk, but they choose not to do so.

I believe that the same will happen in Target Benefit Plans. The plans will invest in balanced portfolios that will typically deliver good returns and good pensions, but with no guarantees. The plans will take less risk than today's public sector DB plans because employees will no longer be able to pocket the reward for risks borne by the public - hence risk-taking will be less advantageous to plan members.

You may not understand this. You may not want to understand it. But this is how things work. If you feel differently, explain how the public is now rewarded for the investment risks it bears. Or perhaps you think that public employees deserve a free ride? As I wrote earlier, the federal government's DB plan is no different than telling federal employees that they can use 20% of their compensation to buy long term RRBs with 4% real interest rate while offering other Canadians a 1% real interest rate on the bonds they buy.
It's not that I 'don't understand or want to understand' but I can easily accuse Malcolm of the same, he doesn't want to understand my proposal of creating new, well-governed public DB plans with a shared-risk model so that private-sector workers can enjoy the same defined-benefit pension as the public sector employees.

Also, I sent Malcolm's comments to Jim Keohane, President and CEO of HOOPP, who shared this with me:
This is a bit of a “glass half empty “ view. You could also view it that prudent risk-taking, scale, good governance and good management allow Canadian model plans to provide good pensions for 20% of pay which would otherwise cost 40% of pay thus saving taxpayers 20% of pay.

The Federal Public service plan is unique in Canada in that the employer assumes all of the downside risk. Virtually every other public sector plan is a shared risk plan with contingent benefits. In the case of HOOPP, neither the employers or the province guarantee the pension. The only obligation the employer has is to pay their share of the annual contributions as long as they remain members of the plan (which is voluntary). When you consider that COLA (cost-of-living) is not guaranteed and can be reduced or eliminated should plan funding be insufficient, employees accept most of the risk of underfunding. The notion that taxpayers are taking all the risk and that plan members are getting all the benefit is simply not true.

What we should be focusing on is the efficiency of the conversion of pension savings into pension payments. Our recent research paper “The Value of a Good Pension” shows the efficiency of moving from individual savings plans to collective plans. If more Canadians were fortunate enough to be members of Canada model plans there would be a much larger pool of savings to pay pensions which would benefit all of Canadian society and taxpayers.
I completely agree with Jim on the value of a good pension and opening up the Canada model to more Canadians (ergo my proposal!) and I think his rebuttal to Malcolm is legitimate and very succinct.

Anyway, one thing is for sure, and both Malcolm and Jim will agree with me on this, Canada's large public pensions are in much better shape to weather the next storm relative to their US counterparts. I don't think that's up for debate.

Below, once again, CPPIB's CEO Mark Machin in Davos last week discussing where he thinks the institutional investor belongs in the Davos conversation, company sustainability, investment themes and his investment strategy with Bloomberg's Erik Schatzker.

Mark ends by expressing his concerns about what happens the next time there's a major dislocation in public markets and investors who hold too much private markets are forced to sell at the wrong time to meet their obligations (ie. Mind your liquidity risk!! Truth be told, this will present excellent opportunities for CPPIB if it happens).

Monday, January 28, 2019

Ray Dalio on the Limits of Capitalism?

Catherine Clifford of CNBC reports, Hedge fund billionaire Ray Dalio: ‘Capitalism basically is not working for the majority of people’:
With just over $18 billion to his name, capitalism has been good to Ray Dalio: He started his hedge fund, Bridgewater Associates, out of a two-bedroom New York City apartment in 1975 and it now manages $160 billion in assets and is the largest hedge fund in the world, according to Forbes.

Quite literally, Dalio has built a fortune thanks to capitalism. But he’s also keenly aware that it is a deeply flawed system.

“Capitalism basically is not working for the majority of people. That’s just the reality,” Dalio said at the 2018 Summit conference in Los Angeles in November. Monday, Dalio tweeted a video of his Summit talk.

Dalio made the comment about capitalism during a discussion about wealth inequality.

“Today, the top one-tenth of 1 percent of the population’s net worth is equal to the bottom 90 percent combined. In other words, a big giant wealth gap. That was the same — last time that happened was the late ’30s,” Dalio said. (Indeed, research from Emmanuel Saez and Gabriel Zucman of the National Bureau of Economic Research of wealth inequality throughout the 20th century, covered by The Guardian, bears this out.)

Further, Dalio points to a survey by the Federal Reserve showing that 40 percent of adults can’t come up with $400 in the case of an emergency. “It gives you an idea of what the polarity is,” Dalio said. “That’s a real world. That’s an issue.”

And Dalio says the income gap will only get worse.

“We’re in a situation when the economy is at a peak, we still have this very big tension. That’s where we are today,” he said in November. “We’re in a situation where, if you have a downturn, and we will have a downturn, I believe that — I worry that that polarity will become greater.”

In fact, Dalio said that the President of the United States should declare the current wealth gap a national emergency.

“If I was doing it, I think that you have to call that a national emergency,” said Dalio. Then, reasoned Dalio, the President could ”[take] responsibility for changing those metrics. I think there’s a lot that can be done in private-public partnerships and so on to be able to change it, but I fear that that probably will not be done by the next time we have a downturn, and I fear for what that conflict is going to be like that.”

Dalio is not the only billionaire to speak out about the problems with modern capitalism.

Berkshire Hathaway CEO Warren Buffett, who is worth $81 billion according to Forbes, has said the problem with the economy is the extreme wealth of people like him.

“The real problem, in my view, is — this has been — the prosperity has been unbelievable for the extremely rich people,” Warren Buffett, who is currently worth $81 billion, told PBS Newshour in June 2017. “This has been a prosperity that’s been disproportionately rewarding to the people on top.”

The evolving economy “doesn’t benefit the steelworker maybe in Ohio,” Buffett said on Newshour. “And that’s the problem that has to be addressed, because when you have something that’s good for society, but terribly harmful for given individuals, we have got to make sure those individuals are taken care of.”

That’s not what’s currently happening according to the billionaires, and it worries Dalio.

“I’m concerned because we’re not working together around our common principles,” Dalio said in a Summit follow-up interview, published on Jan. 8. “The amount of tolerance there is for the differences, the amount of empathy, the desire to work it out and find the common solutions, is diminished.”
Ray Dalio and Warren Buffett are absolutely right, extreme wealth inequality represents the dark side of capitalism and unless it's addressed and treated as a national emergency, it will get worse and bring about more populism, cynicism and outrage from the restless masses.

And Dalio is right, there are no common principles to tackle this pressing issue.

In fact, over the weekend, Heather Long of The Washington Post reported, ‘The aristocrats are out of touch’: Davos elites believe the answer to inequality is ‘upskilling’:
DAVOS, Switzerland — Leaders of the world’s largest and most powerful companies are on edge. A decade after the financial crisis, their businesses are thriving and their pocketbooks are overflowing, but they worry about populism and the threat it poses to the global order they helped build.

Many executives gathered at the exclusive World Economic Forum this week acknowledged that inequality is a major problem fueling populist backlash, and that some middle-class jobs in the West are being lost to trade and automation (even though more jobs overall are being created around the world).

A few business leaders in Davos went so far as compare today’s situation to the late 19th century, an era when tycoons like Andrew Carnegie, Andrew W. Mellon, and John D. Rockefeller amassed huge fortunes while most in the working class toiled under harsh conditions.

“We’re living in a Gilded Age,” said Scott Minerd, chief investment officer of Guggenheim Partners, which manages more than $265 billion in assets. “I think, in America, the aristocrats are out of touch. They don’t understand the issues around the common man.”

The solution to inequality, many in Davos said, is “upskilling” people so that they can obtain better jobs in the digital economy.

“The lack of education in those areas in digital is absolutely shocking. That has to be changed,” Stephen A. Schwarzman, chief executive of Blackstone, told a panel. “That will very much lessen the inequalities that people have in terms of job opportunities.”

Schwarzman, whose net worth is estimated at $13 billion, said it is “up to the grown-ups” to make digital upskilling happen in K-12 schools.

His calls were echoed by others, including Ruth Porat, chief financial officer at Alphabet, Google’s parent company; Keith Block, co-chief executive of Salesforce; C Vijayakumar, chief executive of HCL Technologies; and Michael Dell, founder of Dell Technologies.

“All of us collectively can do quite a lot to create opportunities so that everybody is included in this growth,” said Dell, who is worth an estimated $28 billion. “It’s going to require lots of new skills, capabilities.”

Dell said the issue goes beyond K-12 education and that companies need to train workers continuously. His own company struggles with finding enough skilled workers, and poaching them from other companies doesn’t work, Dell added. “You need to hire and train and grow them from within.”

At a meeting of the International Business Council on the sidelines of Davos, chief executives pledged their companies would train “more than 17 million people globally.”

Salesforce and PwC championed in-house training platforms in which employees can earn rewards for taking online courses in coding and acquiring other digital skills.

However, the World Economic Forum acknowledged that private-sector efforts would probably fall short. In a report released earlier this month, the forum estimated it would cost the United States $34 billion to reskill the 1.37 million workers expected to lose their jobs to automation in the next decade. The forum said 86 percent of the cost “would likely fall on the government."

“Upskilling is not going to alter the insecurities and inequalities,” said Guy Standing, author of “The Precariat: The New Dangerous Class,” who spoke on four panels at Davos this year. He said most executives still don’t understand what is needed.

Standing said calls for more education and training were a “cop-out,” and that the result would undoubtedly help only a small number of people, which in turn could bring down wages and status in whatever new jobs they went on to obtain.

A study in 2015 by economists Brad J. Hershbein, Melissa S. Kearney and Lawrence H. Summers postulated what would happen if 10 percent of American men, ages 25 to 64, who did not have a bachelor’s degree suddenly obtained one. They found that it would improve pay and job prospects for the men who earned the degrees, but would do little to reduce the inequality gap because the richest Americans have so much more income and wealth.

There’s also the question of who would pay for education and re-skilling. Democrats like Rep. Alexandria Ocasio-Cortez (D-N.Y.) have proposed higher income taxes on the rich, while Sen. Elizabeth Warren (D-Mass.) is set to unveil a proposal for a new tax on wealth.

But millionaires and billionaires in Davos panned the idea of higher taxes, arguing that the private sector does a better job than the government of spending money wisely.

“No, I am not supportive of that, and I don’t think it would help the growth of the U.S. economy,” Dell responded when asked about his views of Ocasio-Cortez’s proposal for a 70 percent marginal income tax on earnings above $10 million.

Dell noted that he and his wife contribute most of their wealth to a foundation. “I feel much more comfortable with our ability as a private foundation to allocate those funds than I do giving them to the government.”

Others argued that their tax rate is already high and that raising tax rates could push people to move abroad or not invest.

“If I look at my tax rate now, it’s probably well into the 60s,” said AECOM chief executive Michael S. Burke, adding that he pays federal taxes, California income taxes, sales tax and a significant property tax. “I think we ought to have a competitive tax rate.”

When asked whether corporations should pay higher taxes, executives again criticized the idea. In 2017, President Trump and the Republicans in Congress passed a sweeping tax bill with the largest corporate tax cut in U.S. history.

“It’s an easy fix, I think, for many people to say, ‘Well, let’s just tax,’” Block said during a panel.

By contrast, leaders from academia and the nonprofit world were quick to call for higher taxes and a redistribution of income.

“Extreme economic inequality is out of control,” Winnie Byanyima, the executive director of Oxfam International, told a panel. “We’re in a world where governments do not tax wealth enough, do not tax the rich enough.”

An Oxfam report this week found that the share of wealth held by billionaires was increasing by $2.5 billion a day, while the share of wealth among the 3.8 billion of the world’s poorest was decreasing by $500 million dollars a day. While some quibble with the methodology of the Oxfam report, there’s widespread consensus that inequality is getting worse in many parts of the world.

Standing, a professor at the School of Oriental and African Studies at the University of London, called for a “new income distribution system,” where governments commit to assuring a universal basic income that would be enough to keep its citizens out of poverty.

A Gallup poll last year showed that only 56 percent of Americans overall — and less than half of Democrats — have a positive view of capitalism, a decline in sentiment in one of the best years for the economy since at least 2000. More Democrats now think more favorably of socialism than capitalism.

Some executives said the business community needs to do a better job of helping people see how much they benefit from a free, capitalist economy.

“We’re not helping people really understand what capitalism and socialism really means. And we’re not educating them enough to train them for the new jobs,” said Burke.

Critics were quick to pounce on the executives as out of touch, and their proposed remedy of upskilling as naive, if not insulting.

“Davos is always in favor of reducing inequality and poverty: locally, nationally and globally — but not if they have to pay for it,” tweeted economist Branko Milanovic who studies inequality at the City University of New York (CUNY).

However, others said it was not practical to look for solutions to the problems of the common man from the top echelons of society.

“There’s an uncomfortable awareness that things are not right, the ecological crisis, the angst out there, the Brexit vote, the Trump vote, but then they come up with these bromide platitudes,” said Standing. “But in a sense, we can’t expect them to provide the answers. They are part of the problem.”
I love the way she ends her article because it's common sense that asking people who are part of the problem to find solutions to the problem isn't going to get you anywhere.

The exchange below captured at Davos last week exemplifies exactly what I mean by this:

I like Michael Dell, think he's an incredible entrepreneur but I wouldn't rely on him or any other billionaire to come up with sensible economic policies which are in the best interests of the masses and the overall economy.

Last week, I hooked up with Geoffrey Briant, President & CEO of G2 Alternatives Advisory Corp., and Gordon Power, CEO of Earth Capital Partners, as they are in the process of fundraising for the new sustainable investing fund.

We chatted about Davos and it's Gordon who sent me the second article above this weekend. I raised the point that companies are always complaining they can't find skilled workers but very few are investing in training and retraining new and existing workers which defies all logic.

On LinkedIn, Geoff said Gordon was adding training and retraining to Earth Capital's dividend calculations and in my opinion, this should be part of a comprehensive ESG score that pensions and other large institutional investors use to measure the progress of public and private companies in their portfolios.

Ask them flat out: "What are you doing to reduce inequality in general? And then more specifically, gender inequality, inequality among visible minorities, people with disabilities, etc.?"

CBS News recently had a great segment on hiring people with autism which is one example of what I mean. It requires companies who look beyond mental and physical disabilities and focus on people's capabilities.

If we are going to tackle rising and extreme inequality, however, we need a more comprehensive approach and we really need to understand its causes and its pervasive effects on our democracy.

Go back to the first article above where she states: "Quite literally, Dalio has built a fortune thanks to capitalism."

Really? Dalio and a few other elite hedge fund managers have built a fortune charging heavy duty fees to US and global public pensions, it has nothing to do with capitalism per se.

Let me further explain. Hedge fund capitalism, especially for eltite funds, isn't really capitalism, a point professor Ludovic Phalippou recently illustrated on LinkedIn:

Now, I don't agree with Phalippou's negative sentiments on hedge funds because he generalizes but if it was real capitalism, all of these guys wouldn't just close up shop to open a family office or restart under a different name, they'd have to first pay back their management fees and a portion of their losses to clients and then play the casino with whatever is left over.

At the very least, on top of a high water mark, hedge funds should have a hurdle rate before they charge a penny of management fees, especially the big behemoths.

The point I'm getting at is there are structural reasons as to why inequality is a growing problem and hedge fund capitalism is part of a larger problem of financial capitalism. The financialization of our economy has led to widespread and unsustainable inequality.

Last week, I went for a follow up routine visit to my endocrinologist who cured my hyperthyroidism. We discussed Davos and Trump's tax cuts as he checked my vital signs and blood results and shared this with me: "The problem with today's billionaires and corporate multi-millionaires is if you give them tax cuts, all they're going to do is invest more in their hedge funds to earn returns on that money. The billionaire industrialists of the past used to invest in factories after receiving a tax cut and actually created jobs."

It's not that simple but he made an excellent point, tax cuts which only exacerbate income and wealth inequality aren't worth it as they blow up the debt and deficit and ultimately weaken the long-term prospects of the economy.

So, is the solution to rising inequality Elizabeth Warren's proposed ‘wealth tax’ on Americans with more than $50 million in assets?

Maybe but as a friend of mine pointed out, this misses the larger point:
I hate stupidity. These people don't understand the problem, therefore, the solutions they propose are placing band-aids on a flesh wound.

Leo, this is like someone telling you that your proposal for pensions is wrong. What we should do is cut the expenses for the dispersed pension plans by 7%. That will solve the issue in their eyes.

Of course, this is proposed because the IMF has suggested it.

The current system is unsustainable. No one wants to address the structural issues. Ergo, at one point in the not-too-distant future, it will collapse, as it always has.
He added this:
I am amazed by the elite and their schemes. They know that in the next crisis, they can't bail out the banks again because the public won't stand for it. Instead, they tell everyone there will be universal income for people. That is a scam.

As you know Leo, the average person is so indebted that the universal income would go right back to the banks. The banks LOVE this proposal because it bails them out without the pitchforks.

Your endocrinologist is absolutely correct. Now, why do hedge funds pay a different tax rate than everyone else? Why are assets taxed differently and have all kinds of tax incentives when compared to income. Because the 1% and the large corporations have BRIBED government to pass these laws in their favor. THAT is the problem.

The larger focus has to be on the STRUCTURE of the economy. Historically, most nations have collapsed under their own weight of deflation, as the population loses faith in their leaders, hoard money (so they don't invest), and either move somewhere else, or if they are not capable of doing so, buy hard assets.

This is what is happening to us. Now a few years ago, this would have sounded crazy. Today, you can see these trends evolving right in front of your eyes, and they are getting worse by the day.

I could go on for pages, but I'll simply reiterate that Glass-Steagall must be reinstated. Banks must be returned to their function of funneling savings into PRODUCTIVE investment in the economy. Investing must be SEPARATED from banks so bank deposits CANNOT be used for investment. The investment houses cannot be allowed to rehypothecate 100 times (the problem today is DEBT is used as collateral to borrow money. Only in finance. Would you lend me money if I said I can back the loan with my car loan?).

Government must have people with EXPERIENCE in the REAL economy to pass laws and make decisions. They are allowed one term (three years tops) and then OUT. The corruption must be stopped. Period.

Government cannot be allowed to run continual deficits. PERIOD. For the last 60 years, the running deficits is equivalent to robbing people of their purchasing power. Wages stagnant and everything rising in cost because of government has led to the destruction of the middle class and threatens the fabric of the current society as we know it.

I could go on to expound on these points but the email would be much, much longer. I'll stop there and leave you with this. One person I learned a great deal from, who's been a banker all his life, that was there when derivatives were born, and that has since retired and written some fantastic books is Satyajit Das.

He explained to an audience how the next crisis was assured, it was only a question of when. Of course, one audience member asked him how he could be so sure that there would be another crisis. He took a long pause and said:

"When I'm alone at night and contemplate the current financial system that has been fabricated, I come to the realization that it is the greatest fiction ever created in the history of mankind."
I don't share my friend's doomsday views or his views on reinstating Glass-Steagall or running deficits is bad (ever heard of MMT economics?) but he raises many good points on understanding the structure of the economy before trying to tackle inequality with dumb proposals.

Another contact of mine in Florida who is a cynical historian shared this with me after I sent him the article on the elites at Davos not getting it: “The US is a war economy and has been ever since WWII. Although the Military/Industrial Complex lobby would fight you tooth and nail, if you could take an ax to the defense budget and redeploy those funds towards health, education and welfare, you'd ultimately put a noticeable dent in income/wealth inequality in the US.”

Interestingly, Ray Dalio posted another comment on LinkedIn today on this topic, Populism + Weakening Economy + Limited Central Bank Power to Ease + Elections = Risky Markets and Risky Economies:
Recently, 1) the Fed wisely rolled back its plans to hike interest rates and to shrink its balance sheet and 2) Chinese negotiators made clear that they are willing to do a trade deal. These are good things that the markets reacted well to. At the same time, a) the wealth/opportunity gap is increasingly becoming manifest in b) increased populism of both the left and the right, which is leading to c) greater conflict both within and between countries and d) more extreme and worse decision making, which is especially risky when e) economic growth is weakening and f) central banks have limited capacity to ease, g) important elections are approaching, and h) the big geopolitical tensions arising from China emerging as a power that is challenging the US as the existing leading world power are intensifying. Over the next 2-3 years, this confluence of forces will come to a head and have big influences on markets, economies, societies, and world affairs (much as they did in the late 1930s).

Greater Polarity and Upcoming Elections

One of my economic/political principles is: “If there is a big gap in the economic conditions of people who share a budget and there is an economic downturn, there is a high chance of bad conflict. If there isn’t a big gap (e.g., most people are poor or most people are rich), there is much less risk of a conflict. Disparity in wealth, especially when accompanied by disparity in values, leads to increasing conflict and, in the government, that manifests itself in the form of populism of the left and populism of the right. As a rule, populists of the right (who are usually capitalists) don’t know how to divide the pie well, while populists of the left (who are usually socialists) don’t know how to grow the pie. While one would hope that when such polarity exists leaders would reform the system both to divide the pie and make it grow better (which is doable and certainly the best path), unfortunately leaders who know how to bring people together behind policies that both grow and divide the pie well are both rare and unappreciated. So the problem of the gap in wealth and opportunity is unlikely to be resolved well and peacefully.”

In my study of populism from March 2017 (located on, it became clear to me that populism and populist leaders typically follow a pretty standard path of steadily increasing conflict both within and between countries; for that reason, conflict was the thing that I wanted to monitor most closely to help us see what is likely to transpire. That’s why my great research assistants and I created “conflict gauges,” which I will share with you at another time.

With this perspective in mind, it is important to keep in mind that the big questions of a) whether populists of the right (i.e., capitalists) or populists of the left (i.e., socialists) end up in control and b) whether or not their conflicts will adversely affect the operations of government, the economy, and international relations will largely be answered over the next 2-3 years because during that period the US, the UK, Italy, Spain, France, Germany, and the European Parliament either will or probably will have elections that will answer these questions.

In the US, the roster of Democratic candidates and their policies are now beginning to emerge. We can now begin to see that the wealth gap issue will probably be the biggest issue of the election, and we can begin to see where the emerging candidates are on the spectrum of populism of the left (socialism) and populism of the right (capitalism). For example, we have recently seen the proposal for a 70% top marginal tax rate on incomes over $10 million floated by the 29-year-old new Rep. Alexandria Ocasio-Cortez, who represents parts of the Bronx and Queens in New York City, and we can see that the majority of Americans polled are in favor of it. We have also recently seen the proposal for a wealth tax of 2% on assets over $50 million and 3% on fortunes over $1 billion come from Sen. Elizabeth Warren, who represents Massachusetts; we don’t yet have polling results for this proposal, but my guess is that it will receive a similar reception. While we haven’t yet seen markets react to such news, because it is way too early to handicap the odds of who will be in control and what they will do, we know this will become increasingly apparent and then will be determined over the next two years, and we know these things will have big implications for capital flows, market valuations, economic conditions, and domestic and international relations.

The same will be true in Europe, as the internal and external populist conflicts are intensifying at the same time as Europe is being economically held together by the thin thread of a central bank and a single currency, which is facing increased stress from some seemingly irreconcilable differences. More specifically, at the same time as wealth and ideological polarities within and between countries are intensifying due to the monetary union leaving some countries stuck in stagnation while others are getting richer, the ECB’s region-wide debt-buying program that held the currency together is becoming untenable because the mix of debt that the ECB has to buy in order to provide support for the euro is becoming of lower quality. That makes buying the debt increasingly objectionable to “Northern European” countries. This is happening at the same time as the Brexit precipice is approaching and important elections and political appointments will occur.

The US-China Geopolitical Conflict

While the US-China trade war appears to be negotiable, a geopolitical war over IP and how either to divide the world into agreed-upon spheres of influence (or to coexist in overlapping areas) is emerging with greater strength. This dispute is most immediately over where and how each country’s companies compete—especially the most important new technology companies (especially those in 5G, artificial intelligence chips, information/data management, and quantum computing). Rather than that being resolved soon, these economic and geopolitical disputes (e.g., over Taiwan’s reunification with mainland China) will be with us for decades to come. Still, it is hoped that enough can be agreed on so that a “trade deal” can be reached and the markets can celebrate at the end of the 90-day negotiating period. Time is on China’s side because they are growing and improving at a faster pace and because those in the US and Europe are their own worst enemies, so I would expect China to be relatively non-confrontational. If I had one wish for the Americans and Europeans, it would be for them to manage themselves well.
In other words, China can sit and wait out Trump's term and deal with the next president, whoever he or she may be. Of course, if Trump gets re-elected, China will need to negotiate from a position of weakness as it's already feeling the pain of tariffs.

Go back to read last week's comment on rising systemic fear at Davos where I ended it on this note:
I leave you with a paper Jonathan Nitzan and Shimshon Bichler published earlier this week, The Harder They Fall. The full PDF file is available here. It's the section on systemic fear and capitalized power that I want you to pay particular attention to (click on image):

Coupled with the dialectics of power and fear, this leads the authors to conclude "the road for another major bear market and roller-coaster consequences for the subjects of global capitalism, is now wide open" and the "only missing hard fall is the reversal of US earnings"  (click on image):

Before you dismiss this analysis as Marxist nonsense (that would be very silly), I remind you that before returning to academia, Jonathan Nitzan worked for many years at BCA Research and he is extremely familiar with markets but he and Shimshon are looking at markets from a much deeper perspective.

You won't hear about them at Davos, they don't have the fame and fortune to attend this conference but their work on systemic fear and capitalized power shouldn't be dismissed, quite the opposite, intelligent investors like George Soros have embraced it.
Lastly,  make sure you read Noah Smith's Bloomberg article, Too Many Americans Will Never Be Able to Retire. I won't go over it here but it's part of the structural factors that lead to more inequality and a long period of debt deflation in my opinion.

The same thing is going on in other developed countries but not to the same extent. Still, even in Canada, a poll found the majority of baby boomers would opt for semi-retirement if employers only allowed it, which goes to show you there's quite a bit of retirement angst in our country where wealth disparities aren't as pronounced as in the US.

Below, Ray Dalio, founder of Bridgewater Associates, joined CNBC's "Squawk Box" at the World Economic Forum at Davos to discuss the state of the world economy, the role of the central bank, and the the upcoming 2020 election's impact on the economy.

I also embedded an older (2017) clip where Ray discussed tax reform, the US economy and why the wealth gap is the issue of our time with FOX Business News's Maria Bartiromo.

Ray's co-CIO, Greg Jensen, also discussed the current market structure and the firm's economic outlook, monetary policy, and earnings expectations. He spoke with Bloomberg's Erik Schatzker at the World Economic Forum's annual meeting in Davos, Switzerland, on "Bloomberg Surveillance."

Lastly, in an interview that aired on CBS' "60 Minutes," former Starbucks CEO Howard Schultz said he was considering mounting an independent bid for president. Here's what three experts say about his chances. Watch the entire interview here. I think he's going to surprise a lot of people if he runs.

Update: After reading this comment, Jonathan Nitzan shared this with me:
Leo, I think your focus in this piece is misguided.

Conventional economics associates income -- and therefore its distribution -- with factor productivity. This theory, formulated by J.B. Clark in 1899, remains dominant. Its main claim is that if the Dalios of this world earn 25,000 times the salary of their workers, it is only because they are 25,000 times more productive, and if society wants to reduce this inequality gap, it can do so only by making workers more productive.

The problem with this 'modest proposal' is threefold.

First, their claims to the contrary notwithstanding, economists do not know how to measure factor productivity, and therefore have no proof whatsoever that that this "productivity" correlates with income.

Second, income does correlate, and rather tightly, with measured hierarchical power -- see the 2018 article of Blair Fix on 'The Trouble with Human Capital Theory' (

Third and finally, calls by "enlightened investors" to do something about growing inequality betray their built-in schizophrenia: on the one hand, their very quest for power forces them to increase income inequality without end, while, on the other hand, they realize that ultimately, this very process is bound to spell their own demise.
I thank Jonathan for his wise insights on this topic and direct my readers to the Nitzan & Bichler archives here to read their latest research and previous research.