CPPIB's CEO Sounds Alarm on Illiquid Assets

Paula Sambo of Bloomberg News reports that CPPIB's Mark Machin warns on global rush into illiquid assets:
The biggest global funds should all be monitoring their investments in illiquid assets, according to the head of Canada’s largest pension fund.

“I do ring the alarm bell on not to be too invested in illiquid assets,” Mark Machin, chief executive officer of the Canada Pension Plan Investment Board, said in a Bloomberg Television interview Monday at the World Economic Forum in Davos. “We are very comfortable with our risk models and what we would do in various lurches down markets, but I do worry about the expansion of a lot of funds like us around the world into private illiquid assets.”

Lower-for-longer interest rates have pushed pension funds and asset managers to cast their nets far and wide in search for returns amid a slew of geopolitical risks and trade tensions. Investors looking to diversify their portfolios are seeking shelter in low volatility assets that tend to be illiquid like infrastructure investments.

But the rapid dash to alternative assets by the stewards of retirement cash comes with risks, and it’s caught the attention of regulators. One major worry is that a downturn in funds would struggle to pull cash out of illiquid assets. While pension funds typically hold debt until maturity it doesn’t mean they can’t be hurt by mark-to-market losses.

The head of CPPIB said that while there’s little to worry about in the near-term, investors should be very careful about the huge shift of assets from public to private markets which could trigger steeper selloffs and exacerbate a crisis.

Trade Tensions

“You have to be very careful to make sure that you truly understand the liquidity positions, that you truly understand if that thing turns out to not be liquid you can still cope, and if you can still pay the university, the pensioners,” he said.

The Toronto-based pension fund manages $409.5 billion in assets for about 20 million Canadian pensioners. Half of that is in illiquid assets, Machin said. CPPIB reported a 2.3-per-cent return on investments for the quarter ended Sept. 30. Its ten and five-year annualized net nominal returns were 10.2 per cent and 10.3 per cent respectively.

“Our view is that these global trade tensions will continue and create some weight on global trading and supply chains and technology. There is nowhere to hide from that so you need to diversify,” he said. “If you sell, you have to hold something. For us, you’d have to invest in something else either its cash or some physical commodities.”

CPPIB, which currently holds about 85 per cent of its assets outside of Canada, plans to boost exposure to better-yielding emerging markets, lifting that allocation to one-third of its portfolio in the next five years. The pension fund still sees private equity as a good asset class from a risk return point of view and is relying on venture capital to participate early in the next market trends.
I suggest you watch the entire interview here (and below) and listen to it at least three times.

Here are my notes:
  • On a slowing economy: There are "mixed views out there about slowing growth". One view from general economists on Wall Street is that a pause in the escalation of tensions between the US and China is a platform for renewed growth. "Our view is that on the surface that may be a little bit of a rapprochement but probably these tensions will continue and therefore will create some weight on global trading, global supply chains, and technology and many other things which will probably keep a damper on growth." Given their view, "there's nowhere really to hide from that, all you can do is diversify in many different markets, sectors and strategies."
  • On selling private equity investments:If you sell, you have to hold something. For us, we’d have to invest in something else either its cash or some physical commodity or something. We have a portfolio designed for long-term investing. We want to be generally deployed but we want to be invested in a broad range of assets. Some may perform well in a slower market, some less well but we want a diversified portfolio.”
  • On private equity trends: "I think the trend towards private equity is pretty robust. When we look out at expected returns in different asset classes, even on a risk-adjusted basis, private equity is very robust. North American private equity, European and Asian PE is still a decent asset class to be invested in."
  • On the risks of illiquid assets: “The thing I continuously ring the alarm bell on is not to be too invested in illiquid assets. We have half our portfolio is in illiquid assets and we are very comfortable with our risk models and what we would do in various lurches down markets, but I do worry about the expansion of a lot of funds like us around the world into private illiquid assets. What you could see if there is a lurch down in markets and people are relying on liquid investments to sell but if everyone is selling the same liquid things at the same time and it's not liquid, then it triggers the risk models, etc. You have to be very careful to make sure that you truly understand the liquidity positions, that you truly understand if that thing turns out to not be liquid you can still cope, and if you can still pay their pensioners, their university, or whatever it is they need to be paying” he said.
  • On systemic risk: Machin was careful not to sound the alarm but he stressed this is one of those things people should pay attention to because "it can exacerbate the lurch down" and "it's one of those things that could create a systemic issue down the road."
  • On private equity fees: "Well, it's one of the remarkable things, name something else in finance that over the last 40 years has maintained its fees yet grown in massive volume. The argument is though that it continues to create value for investors. We are one of the biggest private equity fund investors in the world. We also do a lot of direct investing alongside those funds, the funds that we have great relationships with, and that's one way of reducing the fee drag for us. There's continued inflows, more asset owners like us are putting more capital in private equity so maybe fee compression but it's not on the horizon right now."
  • On getting into venture capital: "We decided to go into it at this time because we want insight into all those companies staying private for longer...and the disruption that's happening. Everybody is talking about the accelerating speed of disruption in the world, we find that by not being in those earlier companies, we are a little less clear eyed on those changes than we'd like to be. I wouldn't say we're blind, we have a thematic investment strategy that goes deep in some areas but getting into venture cap is one way we hope we can partner with them to get insight on those earlier trends."
  • On sustainability and climate change: "This is a huge issue, we identified it a major issue 11 years ago for a long-term investor. It's a complex issue. Our job is to identify all the possible risks in the investments we make and the overall portfolio whether that's physical changes, whether they're regulatory changes, consumer preference changes...all these changes that will spill through the portfolio and create risks. For every major investment, the teams identify all those risks and make sure we are compensated for them or we are not going to make the investment."
Great interview. The focal point in the media is on Mark Machin's warning on illiquid assets but it's not the first time he warned about this.

Last February, Machin openly worried about the fallout if investors lose their appetite for private assets and need to raise money quickly just like in the 2008-09 crisis. That can create an avalanche of selling and many investors are ill-prepared because they haven't stress tested their portfolios for liquidity risks.

As he notes, if it gets really bad, many liquid investments will turn out to be illiquid and this will exacerbate the downturn.

For example, in October 2008, CalPERS sold stocks during the rout to meet its capital calls to private equity funds. It was obviously the wrong time to sell stocks but CalPERS didn't have a choice, it had commitments to meet and those private equity funds wanted the money to make investments.

This is why CalPERS is now looking to introduce leverage in its portfolio not be caught in the same predicament when markets head south.

Leverage is an important strategy which all of Canada's large pensions use judiciously for all sorts of reasons. In fact, some think it's at the core of the Canada model (it's not, good governance is but with that comes the intelligent use of leverage).

More interesting to me is what Machin said about private equity. CPPIB has 24% of its portfolio invested in private equity, far exceeding what its large Canadian peers have invested in this asset class (typically 12-15%).

But unlike OMERS which prides itself on its purely direct investment approach, CPPIB has gained its massive exposure in this important asset class by investing in top funds and co-investing alongside them on large transactions to lower the fee drag (pay no fees on co-investments but to gain access to them, you need the right partners and you need to pay fees to top funds).

I remember Mark Wiseman, the former CEO of CPPIB, telling me: "If I can pay David Bonderman to work for us, I would, but I can't afford him. So unlike infrastructure where we invest directly, in private equity, we will always invest in top funds and reduce our fees through co-investments."

I prefer this approach over OMERS's purely direct investing approach for a lot of reasons, the main one being it's easier to scale into the asset class while delivering great long-term returns.

I'll get back to that in a subsequent comment but the key thing Mark Machin said is that private equity is the most important asset class and one they believe will continue to add value over the long run.

Finally, Mark Machin wrote a great comment on what matters when investing for generations which you should all take the time to read here.

Below, Mark Machin, chief executive officer of the Canada Pension Plan Investment Board, discusses portfolio diversification and the outlook for private equity and venture capital markets. He also comments on ESG investing in an interview with Sonali Basak on "Bloomberg Markets" at the World Economic Forum's annual meeting in Davos, Switzerland.

And Ray Dalio, founder of Bridgewater Associates, joins "Squawk Box" at the World Economic Forum in Davos to discuss what he's watching in the markets for 2020.

Lastly, Paul Tudor Jones, chairman of JUST Capital and chief investment officer of Tudor Investment Corporation, joins "Squawk Box" to discuss the markets, interest rates, the world economy and more.