On CPP Investments' Insanely Large Allocation to Private Equity

Amir Barnea wrote another op-ed for the Toronto Star slamming CPP Investments for investing a third of its assets in private equity when Warren Buffet shuns it:

When Canada’s national pension plan reported financial results in May, one fact really stood out for me: a full third of its assets — about $190 billion — are invested in private equity.

Stocks make up 24 per cent of its investments, bonds make up 13 per cent, and real estate just nine per cent. Private equity is by far CPP Investments biggest bet.

But what is private equity exactly?

Different from public equity, where investors buy a stake in a publicly listed company, private equity refers to the private ownership of non-listed firms or of those that were once public and have been since taken private. CPP Investments invests in private equity in two ways. The first is via direct investments, where it holds ownership stakes that vary from passive, minority positions, up to 100% control of private companies. The second is through private equity funds run by private equity firms, such as KKR and Blackstone. In this type of investment, CPP commits an amount (typically, a few hundred million dollars) alongside other big (mostly institutional) investors.

On the face of it, this investment approach seems reasonable — struggling businesses could always use fresh cash injections and new leadership. But some feel private equity has a tendency to put profits ahead of ethics.

Pulitzer Prize winner Gretchen Morgenson and co-author Joshua Rosner argue in their book “These are the Plunderers: How Private Equity Runs — and Wrecks — America” that private equity firms are “a relatively small group of financiers whose unrelenting pursuit of profits extracts wealth from the many to enrich the few.”

In the U.S., Democratic Sen. Elizabeth Warren also has negative views on private equity: “Private equity funds often operate under a model where they purchase controlling interests in companies for a short time, load them up with debt, strip them of their assets, extract exorbitant fees, and sell them at a profit — implementing drastic cost-cutting measures at the expense of consumers, workers, communities, and taxpayers.”

“This leads to a practice of extraction rather than investment and of destruction, rather than creation,” author Brendan Ballou summarizes in a second book that came out recently, “Plunder: Private Equity’s Plan to Pillage America.”

But despite increasing concern about private equity tactics, over the past decade CPP Investments has shifted more and more of its assets into that investing category in search of high returns. Private equity now accounts for 33 per cent of their portfolio. For comparison, CalPERS, the largest U.S. pension fund, has only about 11% of its assets invested in private equity, while Norway’s oil fund, one of the world’s largest wealth funds, has no investments in private equity at all.

Private equity partners under attack over ethics

Many of CPP Investments’s long-term private equity partners have come under attack from American lawmakers due to poor ethical standards.

For example, Sen. Warren and her colleagues questioned The Carlyle Group (in which CPP has invested $1.3 billion since 2015) and Warburg Pincus ($300 million since 2016) about their investments in nursing homes and long-term care after it was found that the quality of service significantly declined following a private equity take over.

TPG Capital (CPP’s investments are $2.9 billion since 2006) was criticized for its ownership of for-profit hospice companies; Apax Partners ($2.5 billion invested) was grilled over child labour issues in Takko, a fashion brand it owns; Thoma Bravo ($1.8 billion) was questioned about whether RealPage’s software is contributing to rising rents across the U.S.; and Apollo Global Management, Blackstone, The Carlyle Group, and TPG Capital were accused of “preying on rural and lower-income communities to turn a profit.

When asked whether the ethical standards of the private equity industry are a source of concern, Michel Leduc, CPP Investments’s global head of public affairs and communications, chose not to address the question. Rather, he highlighted that “our private asset investments have contributed positively to the Fund’s value-added.”

Ethical questions are not the only concern when it comes to CPP’s investments in private equity. There is also the lack of transparency. While CPP regularly commits hundreds of millions of dollars to private equity funds, contributors and beneficiaries often have no idea how the money is really invested.

Take for example a reported investment of $750 million in Apollo Investment Fund IX, which was made in 2019. The only information that CPP shares on its website with respect to this investment is its current estimated value and the distributions (dividends) that have been received. But which businesses were acquired by the Apollo fund? In which industries? How leveraged are the investments? These questions are all left unanswered for Canadians.

Extensive research in private equity databases — which are difficult to access by the public — reveals that CPP Investments is the largest investor in the Apollo IX fund and that it is domiciled in three different tax havens. It also appears that 21.5 per cent of the fund’s $25 billion in assets are invested in firms operating in the “Casinos and Gaming” industry. These facts are not made available to Canadians, and are therefore not subject to scrutiny or debate.

A third concern deals with private equity fund valuation.

Can private equity valuations always be trusted?

Private equity investments cannot be marked-to-market in the same way that public equities are, since these are stakes in private companies. This could create ambiguities with respect to the true value of some private equity holdings. Since the “market value” of a private equity fund is reported by the private equity firm that runs it, some question whether reported values can always be trusted.

Additionally, since usually there is a gap (of months, or in some cases years) between the time at which an institution (such as CPP Investments) commits funds to a private equity investment and the time at which the money is actually transferred, there is some ambiguity in the method used for calculating returns.

In an interview earlier this year, legendary investor Warren Buffett echoed these concerns.

“We’ve seen a number of proposals from private equity funds, where the returns are not calculated in a manner that I would regard as honest,” Buffett said. “If I were running a pension fund, I would be very careful about what was being offered to me. It’s not as good as it looks,” the Oracle of Omaha warned.

Lukas Schmid, professor of finance at the Marshall School of Business, University of Southern California, is also skeptical. In a recent research project (with Niklas Hüther and Roberto Steri) he shows that private equity (PE) investments are riskier, and don’t offer superior returns compared to publicly listed stocks.

“PEs are a great way to hide volatility,” he said in an interview. “That’s why asset managers like them. But there’s a lot of hidden risk in these investments, and they’re getting into trouble now when interest rates are higher.”

The CPP Investments’s heavy reliance on returns generated by private equity requires a serious debate.

Some of its investing partners have been accused of poor ethical standards, there is a lack of transparency in holdings, and it’s impossible to mark such investments to market, as you can with public investments. We should be asking why CPP Investments decided to bet a full third of its portfolio on private equity, more than most other major pension funds.

Michel Leduc says that since the Canada Pension Plan has very predictable cash inflows (compulsory contributions) and cash outflows (payments to beneficiaries), it is well positioned to invest in private equity. “We can prudently seek less liquid, more complex assets, and be well compensated for it. Private assets play an important role in pursuing additional sources of value-add beyond passive alternatives available in public market,” he wrote to me.

But if fresh academic research shows that there is no added value in private equity, and Warren Buffett — arguably the most successful investor in the world — is highly skeptical about private equity, I think Canadians should be concerned.

Amir Barnea is an associate professor of finance at HEC Montréal and a freelance contributing columnist for the Star. Follow him on Twitter: @abarnea1

Oh boy, where do I begin?

This is a terrible column from Amir Barnea which doesn't take into account so many important points.

Instead, he sloppily points to some books and politicians criticizing private equity (nothing new there, goes back to Barbarians at the Gate) and then criticizes valuations on private investments and sprinkles on top something the Oracle of Omaha stated which is hypocritical since Buffett invests a large portion of his vast wealth in private companies.

First, let's start with basics. A pension plan exists to meet future liabilities. 

The starting point is always on those future liabilities and then you work your way back to create a well diversified asset mix to increase the probability of meeting those future liabilities.

From an actuarial standpoint, it gets a little more complicated because some pension plans are fully funded, meaning their plan is more sensitive to investment returns, some like base CPP are partially funded which means the asset manager (CPP Investments) can take on more risk  to cover their future liabilities:

Note, additional CPP as opposed to base CPP is a fully funded plan so it cannot take on as much risk in its asset mix to meet future liabilities (in essence, additional CPP's asset mix  is more like those at CDPQ, BCI, OTPP, OMERS, HOOPP, PSP Investments and AIMCo).

This is all explained transparently on CPP Investments' website here:

Federal and provincial governments decided in 2016 to expand the Canada Pension Plan (CPP) to provide enhanced future benefits for workers. The increased contributions and associated benefits are referred to as additional CPP, whereas the historic contributions and associated benefits are referred to as the base CPP. In coming decades, this means that CPP benefits in retirement could replace approximately one-third of a person’s income compared to the current level of approximately one-quarter, up to a certain limit.

CPP Investments received the first additional CPP contribution amounts in January 2019. As a result, there are now two accounts – one for the base CPP and another for the additional CPP contributions. Both accounts have the full advantage of CPP Investments’ global network, expertise, investment strategies and risk governance framework. Our strategy is to build a single, resilient CPP Fund with a view to the strong performance of, and fairness between, both accounts.

Additional CPP and base CPP rely on the importance of investment income in the program’s total revenues over time.

The additional CPP is required to be a “fully funded” pension plan. As such, assets are targeted to equal or exceed the present value of benefits. This includes payments to retirees as well as benefits that contributors have earned to date. When fully mature, investment income is expected to represent about 70% of the additional CPP’s total revenues (investment income plus contributions).

As a result, a fully funded plan is directly sensitive to:

  • any changes in the assumed rate of return on investments; and
  • any difference in the returns achieved, compared to those expected.

The base CPP is a “partially funded” plan. To maintain a stable contribution rate, the Chief Actuary estimates that income earned from investments will represent about 40% of the base CPP’s total revenues when it is in its mature state.

The base CPP is sensitive to demographic factors like life expectancy, birth rate and immigration rates. It can also be affected by economic changes, including the level of employment and rate of real (i.e., after inflation) wage growth.

Most important, a partially funded plan is less sensitive to investment returns than a fully funded plan.

Contribution rates

For both the base CPP and the additional CPP, contributions are set such that current investments plus future contributions are expected to fully pay for all benefits today and in the future. At the same time, we seek to maintain a stable contribution rate for current and future contributors.

The 30th Actuarial Report on the Canada Pension Plan – based on the status of the Fund as at Dec. 31, 2018 – details return-on-investment assumptions over the 75-year period from 2018:

  • the base CPP account will earn an average annual net real rate of return of 3.95%; and
  • the more conservatively invested additional CPP account will earn an average annual net real rate of return of 3.38%.

Both assumed rates of return are over and above the rate of Canadian consumer price inflation, after all investment costs.

None of these intricate points are explained by Amir Barnea who is an associate professor of finance at HEC but really lacks intimate knowledge of CPP Investments' liabilities and asset mix.

Now, since the bulk of the assets in the Canada Pension Plan still remain in base CPP (over 95% but additional CPP assets are growing fast), you bet they're taking on more equity risk to meet those future liabilities, they can afford to without jeopardizing their funded status.

In all, 57% of CPP Investments' assets are in public (24%) and private equities (33%) and this is the right amount of risk to take given their liability profile and that base CPP is a partially funded plan.

The big point of contention here is why invest 33% in private equity, paying big fees, when CPP Investments can just index these assets into the MSCI World Index.

Here again, the devil is in the details.

Unlike other large pension funds, mostly in the US, Canada's large pension investment managers operate independently from the government and can properly compensate their employees to manage more assets internally to lower fees and costs.

CPP Investments is a perfect example of this and it goes back to the Mark Wiseman days when he was CEO after setting up their private equity fund and co-investment program.

Back then, I remember meeting Mark and asking him why they opted for this approach and he bluntly replied: "Easy, because I can't afford to hire David Bonderman, if I could, I would, so we invest with TPG and co-invest with them."

Mark's successor, Mark Machin opted for the exact same approach telling me: "We invest with top private equity funds and co-invest alongside them on bigger transactions to lower fee drag."

John Graham is also taking this view and Suyi Kim and her team are in charge of making sure this massive private equity portfolio is run like a tight ship, investing with top funds and co-investing alongside them to reduce fee drag.

I'll let you and Amir Barnea in a on something, the secret to a top private equity program at any large pension fund or sovereign wealth fund isn't in fund investments (fees eat away at returns over time), it's in the ability to run a great co-investment program to lower fees and maintain a high allocation to private equity.

And here is something else, if I hazard to guess, I'd say over half of the massive private equity assets at CPP Investments are in co-investments, a form of direct investing where they pay no fees.

But to do co-investments properly, you need to attract and retain top talent in finance, or else they will leave and go to private equity funds (if they can).

CPP Investments' Private Equity team has been able to attract top talent but the war for talent is ferocious and even CPP Investments loses good people from time to time (they have a strong bench to replace them).

Again, Amir Barnea doesn't discuss this approach and its clear benefits over the long run.

And when I say clear, the value add of private equity, infrastructure and real estate along with private credit which is also huge at CPP Investments is significant over the long run, adding billions in net dollar value add over a tough benchmark for its Reference Portfolio made up of 85% global equity/15% nominal bonds issued by Canadian governments (for the additional CPP account, CPP Investments has adopted a Reference Portfolio of 50% global equity/50% nominal bonds issued by Canadian governments).

Stated differently, if CPP Investments never adopted its active management approach back in 2006 and only indexed its holdings in equities to some public market index, it would have had a lot less assets and with higher, not lower risk and volatility (making setting the contribution rate a nightmare).

What about Warren Buffett's criticism, after all he's the Oracle of Omaha and everyone knows who he is.

Well, when it comes to private equity and hedge funds, old man Buffett doesn't really impress me so I ignore him on that front.

Not saying he's totally clueless or that he doesn't raise good points, just think he and Charlie Munger like adding a lot of sauce and tend to generalize a lot on alternative investments.

When I look at Blackstone, Apollo, Ares, Apax, BC Partners, Permira, KKR, TPG, and a bunch of other top private equity funds CPP Investments' invests in (see their PE partners here), I see great long-term franchises that have been there over many cycles.

Private equity is by far the most important asset class at all the large pension funds and sovereign wealth funds because that is where the returns came from over the long run, especially if they got the approach right and co-invested alongside their partners on bigger transactions.

Capiche? Never mind what Buffett and Elizabeth Warren state, look at where the world's largest asset managers all over the world are investing and ask yourself why.

And yes, valuations are somewhat stale but they are rigorous in private markets and a large fund like CPP Investments doesn't mess around with valuations, taking writedowns in private markets when warranted.

Is private equity perfect? Hell no! And it has its own unique risks but when it's done well like at CPP Investments, there's no question it's worth it over the long run.

Lastly, lots of chatter last week on CPP Investments seeding hedge funds at $50 to $100 million or more a pop.

This is actually a smart strategy from Priti Singh and her team but it's not easy and you need the right relationships, approach and follow-up to do this properly.

If I had to bet on anyone doing this right, it's CPP Investments but again, it's not an easy game (far from it, bulk of startup hedge funds do not make it to three year mark).

Below, Warren Buffett is well-known for promoting the clear success of value investing, but one lesser known attitude he holds is his disdain for private equity firms.

Again, he raises some good points but tends to generalize and fails to paint a more accurate picture of the PE industry. He should also be honest on how much he invests in private markets where he makes incredible returns holding over the long run (he sounds grumpy and irritated because he is competing with PE funds on deals).

Also, I embedded a great panel discussion on private equity in the real economy which took place at Davos earlier this year featuring Suyi Kim, Senior Managing Director; Global Head, Private Equity at CPP Investments. Take the time to watch this and listen to Suyi's comments.