Wednesday, November 22, 2017

The Evolution of Canadian Pensions?

OPTrust put out a press release, World Bank report shines spotlight on Canadian pension model:
Canadian public pension funds and pension plans are regarded as among the best in the world, but they underwent an evolution of changes to get to where they are today. Because of their success, the World Bank Group partnered with four Canadian pension funds, Alberta Investment Management Corporation (AIMCo), Caisse de dépôt et placement du Québec (CDPQ), Healthcare of Ontario Pension Plan (HOOPP), and OPTrust, as well as the Government of Ontario on a report that studies the evolution of these plans.

The World Bank Group will use the report, authored by Toronto-based firm Common Wealth, to inform its work to strengthen retirement security in emerging economies and increase dialogue on successful pension models in Canada.

World Bank CFO Joaquim Levy attended the launch of the report "The Evolution of the Canadian Pension Model" today at The Omni King Edward Hotel. Hosted by the Canadian Club Toronto, a panel discussion showcased the evolution and endeavours of the pension funds and offered lessons for emerging economies seeking to improve their retirement systems and public pension institutions.

Based on in-depth interviews with some of Canada's top pension leaders and case studies of four funds (AIMCo, CDPQ, HOOPP, and OPTrust), the detailed World Bank report covers the essential components of pension plan organizations – governance, people and organization, investments, administration, plan design and funding, and regulation and public policy – and presents a four-phase framework for the evolution of pension organizations. It outlines 14 key lessons and draws out several success factors including:
  • Strong collaboration between diverse stakeholders – labour, government, business, and finance – and a sustained relationship built on trust
  • Strong, independent governance
  • Singularity of purpose – to run the organization like a business and focus on delivering retirement security for plan members
  • Presence of strong, ethical leadership at the top and throughout the organization
  • Recruitment and retention of top global talent with a competitive and performance-based compensation framework
  • Critical "founding" stage of a new or reformed pension organization
  • Governments creating the right regulatory environment
  • Investments managed in-house rather than outsourced to third-party fund managers
The report also highlights seven challenges that will shape the future of the Canadian pension model.

Download the Report (PDF):

Remarks were given by:
  • Joaquim Levy, Managing Director and Chief Financial Officer, World Bank Group
  • Christine Hogan, Executive Director for Canada, Ireland and the Caribbean, World Bank Group
Panelists included:
The panel discussion was moderated by Terrie O'Leary (EVP, Business Strategy and Operations, Toronto Global).

World Bank Group – Managing Director and Chief Financial Officer, Joaquim Levy

"The responsibilities in designing and managing pension funds are immense and long-lasting. Learning from successful experiences is thus extremely valuable for those setting up new systems, as we see in many developing countries that the World Bank is working with. In designing its system, Canada has tackled many of these crucial issues. I am pleased that some of the Canadian funds are among those looking to partner with pension funds in developing countries and help them invest their assets efficiently, productively, and for the long term."

AIMCo – CEO, Kevin Uebelein

"AIMCo is pleased that the World Bank is acknowledging the important advantages the Canadian Model of investment management offers pension plans in its latest research, and that it has chosen to include AIMCo among the leaders in this space. Canadian pension plans, as evidenced by those represented in this paper, offer several unique advantages to meet the long-term objectives of clients. The progress these plans have made in the last 10 years is remarkable, and AIMCo looks forward to continuing the important role we play in ensuring the long-term sustainability of our clients' investments."

CDPQ – Executive Vice-President, Legal Affairs and Secretariat, Kim Thomassin

"The report helpfully documents and explains the stages in the evolution of Canadian pension fund investors who, despite their differences, all fit within the Canadian pension model. The narrative resonates with particular saliency for CDPQ, where the evolution continues to this day with our innovative model for infrastructure investments and our expansion into emerging markets."

HOOPP – President and CEO, Jim Keohane

"HOOPP is honoured to be recognized by the World Bank for our role in the evolution of the Canadian Pension Model. We are strong proponents of the importance of independent governance, scale and in-house investing as well as a balance of risk management, investment success and low administrative costs. This allows us to deliver 80 cents of every pension dollar from investments while achieving a 122% fully funded status that ensures HOOPP delivers on its pension promise."

OPTrust – President and CEO, Hugh O'Reilly

"The Canadian pension model has much to offer the ongoing international discussion on pension funding, governance and management. As good pension citizens, OPTrust is pleased to be recognized by the World Bank and to be part of this effort to enhance retirement income security for all."

Ontario Ministry of Finance - Minister of Finance, Charles Sousa

"Canada's pension plans are world leaders in ensuring strong retirement security, and Ontario's pension plans are at the forefront of this evolution. It is no mistake that the World Bank has recognized the strength of our framework, identifying our plans as models for global retirement security."

Common Wealth – Founding Partners, Alex Mazer and Jonathan Weisstub

"Our collaboration on this World Bank report aligns with our mission to expand access to high-quality retirement security. We believe that making the principles and lessons from the best Canadian pension organizations available to stakeholders around the world will have a material impact on retirement security across continents."


The World Bank Group is one of the world's largest sources of funding and knowledge for developing countries. It comprises five closely associated institutions: the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA), which together form the World Bank; the International Finance Corporation (IFC); the Multilateral Investment Guarantee Agency (MIGA); and the International Centre for Settlement of Investment Disputes (ICSID). Each institution plays a distinct role in the mission to fight poverty and improve living standards for people in the developing world. For more information, please visit,,


Founded in 2015, Common Wealth is a Toronto-based firm focused on expanding access to retirement security. It has advised pension organizations with collective assets exceeding $800 billion, as well as unions, associations, and governments, on issues of strategy, governance, regulation, and the design and implementation of retirement plans, products, and institutions. In partnership with the Service Employees International Union, Common Wealth recently created the first retirement plan in Canada for lower- and moderate-income earners. The firm is currently working with a variety of partners to create portable, value-for-money, community-based retirement plans within sectors where most workers lack pension coverage.


Alberta Investment Management Corporation (AIMCo) is one of Canada's largest and most diversified institutional investment fund managers. The Corporation manages more than $95.7 billion for Alberta pensions, endowments and government funds and is governed by an experienced Board of Directors. AIMCo's goal is to inspire the confidence of Albertans by achieving superior risk-adjusted investment returns. The Corporation was established as a Crown corporation on January 1, 2008. The sole shareholder is the Province of Alberta. Our assets were previously managed by a division of Alberta Treasury Board and Finance.


Caisse de dépôt et placement du Québec (CDPQ) is a long-term institutional investor that manages funds primarily for public and parapublic pension and insurance plans. As at December 31, 2016, it held C$270.7 billion in net assets. As one of Canada's leading institutional fund managers, CDPQ invests globally in major financial markets, private equity, infrastructure and real estate.


Created in 1960, HOOPP is the pension plan of choice for Ontario's hospital and community-based healthcare sector more than 321,000 members and retired members and 500 employers. With more than $70 billion in assets, HOOPP is one of the largest DB pension plans in Ontario, and in Canada. HOOPP is governed by a Board of Trustees with representation from the Ontario Hospital Association (OHA) and four unions.


With net assets of $19 billion, OPTrust invests and manages one of Canada's largest pension funds and administers the OPSEU Pension Plan, a defined benefit plan with almost 90,000 members and retirees. OPTrust was established to give plan members and the Government of Ontario an equal voice in the administration of the Plan and the investment of its assets through joint trusteeship. OPTrust is governed by a 10-member Board of Trustees, five of whom are appointed by OPSEU and five by the Government of Ontario.

Media invited to attend
Event Details:

The Evolution of Canadian Pensions - "Lessons Learned: The Emergence and Evolution of the Canadian Pension Model"
Date: Wednesday, November 22, 2017
Time: 7:10am
Location: The Omni King Edward Hotel, 37 King St. East, Toronto, Ontario
Event website:

Summary/Backgrounder on the World Bank Report on the Evolution of the Canadian Pension Model  November 22, 2017


  • Canadian public pension funds and pension plans are regarded as among the best in the world today. They also play a significant role in the Canadian financial system, accounting for $1.2T in assets under management with more than 20 million contributors and beneficiaries.
  • It is a reputation that has been built over many years. Just 20 to 30 years ago, many of the pension plans were funded on a pay-as-you-go basis or had funding deficits. They were largely or entirely invested in domestic government bonds, lacked independent governance, and were administered in an outdated and error-prone fashion.
  • A report commissioned by the World Bank – working in collaboration with four participating Canadian pension funds (AIMCo, CDPQ, HOOPP and OPtrust), the Government of Ontario, and Toronto-based retirement security firm Common Wealth – examines the evolution of the Canadian pension model. The purpose of the report was to identify practical lessons learned that could benefit a range of stakeholders in emerging economies looking to design and deliver retirement security systems in a more efficient and sustainable manner.
  • The detailed report covers the essential components of pension plan organizations – governance, people and organization, investments, administration, plan design and funding and regulation and public policy – and presents a four-phase framework for the evolution of pension organizations. It outlines 14 key lessons and draws out several success factors including:
    • Strong collaboration between diverse stakeholders – labour, government, business, and finance – and a sustained relationship built on trust
    • Strong independent governance (possibly the most important element)
    • Singularity of purpose – to run the organization like a business and focus on delivering retirement security for plan members
    • Presence of strong, ethical leadership at the top and throughout the organization
    • Recruitment and retention of top global talent with a competitive and performance-based compensation framework
    • Critical "founding" stage of a new or reformed pension organization
    • Governments creating the right regulatory environment
  • The report highlights that the Canadian pension funds did not take an identical path in their development. A number of them encountered significant missteps, but were able to overcome them over a period of time.
  • Despite the success of the Canadian public pension plans to date, virtually all of them understand and are seized with the challenges and risks that lie ahead and are actively developing and deploying strategies to address these issues. The following are of particular concern:
    • A "low for longer" environment
    • Maturity of plans and ensuring intergenerational equity
    • "Pension envy" sentiments
    • Complexity and competitiveness for good investment opportunities
    • Increasing demands for accountability, transparency and ethical measures
    • Reforms in the regulatory environment
    • Preparation for the next market downturn or financial crisis
  • The report defines the "Canadian model" of public pension as a Canadian public pension plan or public pension asset manager that is typically defined-benefit, has a public-sector sponsor or sponsors, and has the following characteristics:
    • Governance – the funds operate at arm's length of governments and sponsors and are overseen by independent boards with strong accountability and transparency frameworks
    • Scale – assets under management exceed $10 billion and are often significantly higher
    • In-house management by professionals – a significant portion of investment management and/or pension administration is performed by in-house professionals who receive competitive compensation
    • Diversification – the funds' investments are highly diversified by both geography and asset class, including a significant allocation to alternative asset classes such as real estate, private equity, and/or infrastructure, and significant direct investments in such asset classes
    • Talent – the ability to attract and retain top talent at both the board and management level
    • Long time horizon – long-term investors are able to withstand short-term market volatility
SOURCE OPSEU Pension Trust (OPTrust)
Take the time to read the entire press release on OPTrust's site here.

Also, take the time to read the World Bank's report, The Evolution of the Canadian Pension Model : Practical Lessons for Building World-Class Pension Organizations, which is available here.

Below, you will read a summary of this report:
Canada is home to some of the world's most admired and successful public pension organizations. This was not always the case. As recently as the mid-1980s, many Canadian public pensions were invested largely or entirely in domestic government bonds, were funded primarily on a pay-as-you go basis, lacked independent governance, and were administered in an outdated and error-prone fashion. Over the past three decades, a Canadian model of public pension has emerged that combines independent governance, professional in-house investment management, scale, and extensive geographic and asset-class diversification. This report aims to document the emergence and evolution of this Canadian model, distilling practical lessons for stakeholders in emerging economies working to improve their pension arrangements and retirement systems. Although a growing body of literature exists on the Canadian model of pension organization, this report is unique in two respects: its emphasis on the evolutionary journey of Canadian pension organizations (as opposed to their current state) and its in-depth focus on Canadian pension funds that have received less attention than some of their peers.
I encourage you to download the entire report here and read it carefully, it's well worth it. You will gain an appreciation for the history that led up to what is now widely recognized as the Canadian pension model.

The report focuses on four large Canadian pensions -- AIMCo, OPTrust, la Caisse and HOOPP -- but it also discusses other large Canadian pensions too. I was hoping all of Canada's top ten would participate but it's fine, you will still learn a lot by reading this report.

The key elements underlying the success of Canada's large pensions can be seen in the figure below (click on image):

The report disusses each element in detail and provides four excellent fund case studies which I encourage you to read carefully. I enjoyed reading all of them.

Now, being a pension expert, I read this report and thought it was excellent but there are some things that were missing to make it more complete:
  • OTPP: A full discussion on the evolution of the Canadian pension model cannot take place without a case study of the Ontario Teachers' Pension Plan (OTPP). I suggest the authors of this report look into my conversation with Jim Leech to get some more historical context.
  • Compensation: There is a discussion on competitive compensation at Canada's large pensions but little in the way of details (see my discussion here). 
  • Leverage: Canada's large pensions are piling on the leverage, which is a benefit they have over their global peers. There is a reason why they're able to lever up, namely, they run great operations with a tight focus on risk management and enjoy triple A credit ratings. 
  • Shared-risk model: When it comes to fully-funded pensions, it's worth focusing on why some of Canada's successful defined-benefit plans like OTPP, HOOPP and CAATT are jointly sponsored and fully funded plans because there is risk sharing going on, meaning when the plans run into trouble, contribution rates are increased, benefits cut, or both. HOOPP and OTPP have fully or partially removed inflation protection in the past to restore their respective plan's funded status. OPTrust and OMERS are fully-funded or close to it but unlike HOOPP and OTPP, they don't have the capability to cut benefits when their plans run into trouble. I wish there was a detailed discussion on the shared-risk model and its importance in keeping these plans fully funded.
Anyway, apart from these minor quips, I'm glad the World Bank is finally shining a light on the Canadian pension model. Again, take the time to read the entire report here, it is excellent.

I couldn't attend this morning's event in Toronto but truth be told, I wasn't invited and besides, I wake up at 7 a.m. and breakfast meetings are just not my thing (I don't want to see anyone in the morning except for Joe, Becky and Andrew, and sometimes not even them!).

OPTrust posted some pictures from this morning's event on LinkedIn (click on images):

Below, take the time to watch the event which was posted on YouTube by Media Events. Like I said yesterday when I debunked some myths on CPP-CPPIB, Canadians don't know how lucky they are to have world class defined-benefit pensions which are the envy of the world.

Tuesday, November 21, 2017

CPPIB's CEO Exposes CPP Myth?

Lisa Wright of the Toronto Star reports, Canada Pension Plan is safe for generations, says CEO of investment board:
In his travels to every province and one territory over the last 17 months, British-born Mark Machin was struck most by one thing about Canadians.

“There’s still this myth that’s circulating that the Canada Pension Plan won’t be there when you retire,” said the CEO of the CPP Investment Board, the largest pension fund in the country that manages a $328-billion investment portfolio on behalf of 20 million Canadian workers and retirees.

“You ask the average person — stop anyone on the street — and they’ll say the CPP won’t be there . . . . It’s amazing,” Machin said.

“Overall it’s the envy of the world.”

So the first person from outside of Canada to head up the independent investment arm of the Canada Pension Plan is now on a mission to reassure Canadians that the fund is safe and healthy for generations to come, even in the face of inevitable economic and stock market fluctuations.

Don’t just take the former Goldman Sachs executive’s word for it. The chief actuary of Canada regularly reviews the financial state of the fund and measures its sustainability, and last year estimated the fund is sustainable for 75 years — until 2091 — with an average rate of return of 3.9 per cent.

The CPPIB says its 10-year annual rate of return after accounting for expenses and inflation was 5.2 per cent, and was 10.5 per cent over each of the last five years — well above the threshold set by the chief actuary.

The widely diversified portfolio is invested across 50 countries, including ownership stakes in a slew of assets few Canadians are aware of, from First Canadian Place and Highway 407 to Viking Cruises and the entertainment conglomerate that owns the Ultimate Fighter Championship (Machin pointed out the UFC is very popular with millennials).

He said that in financial circles around the world, the CPP is renowned as “a smart, sophisticated global investor. So I come to Canada and it really surprised me that people around the country who are contributing their hard-earned money into the CPP don’t know what’s going on,” said Machin, who took over the post in June 2016 after running the board’s international division in Hong Kong.

“We have delegations coming from all over the world here to figure out how we do it, what are the elements that make this so successful in Canada.”

Machin said that’s mainly due to “some really brave and far-sighted things” the Canadian government did in the 1990s to fix the then-faultering pension system, which was formed in 1966 (coincidentally the year Machin was born in Cheshire, England.)

Back then there were 6.5 workers for every Canadian retiree. But by 1993, amid falling birth rates and longer life expectancy, benefits paid out started to be higher than contributions and investment income coming in. Projections showed that by 2055, there would also only be two workers per retiree.

So in 1997, Ottawa did two things: raised contribution rates and created the CPPIB as an arm’s-length organization investing the assets of the CPP outside of what was needed for benefit payments to ensure its financial viability into the future.

“Our job is to grow that pot of money so that there’s more than enough to pay the benefits whenever they’re needed,” said Machin.

Though the chief actuary warned in 1995 that there would be nothing left in the fund by 2015 if the status quo continued, it took up until 2015, coincidentally, before investment income exceeded cumulative net contributions, the board said. That year the fund returned 18.7-per-cent interest and had climbed to approximately $265 billion.

As of Sept. 30, the fund reported assets of $328.2 billion. The fund has about $3 billion extra coming in from contributions than is needed to pay the benefits in any year.

Starting in 2021 however, the CPP is expected to begin using a small portion of CPPIB investment earnings to supplement the contributions that constitute the primary means of funding benefits.

Last year the government also announced an “enhanced” CPP that will increase benefits paid out — although many years down the road — through an increase in contributions over five years starting in 2019.

Another reason for the CPP’s success, Machin notes, is that the investment board is free of political interference so that government can’t dip into the fund to take money out when times are bad or good.

“We are protected by an act of Parliament. To change that act of Parliament is a higher bar than to change the Constitution of Canada. That’s part of the secret sauce,” he said.

Though the investment mix has shifted in recent years from roughly 70 per cent equity “equivalent” (since it includes public and private investments) and 30 per cent fixed income to a more aggressive 85-15 ratio, Machin said he is comfortable with the investment strategy, despite fears of an impending market correction after years of bull markets.

“We think it’s an appropriate level of risk for a long-term investor like us,” he said, adding their experts put the investment model through rigorous stress tests. “You can’t make returns without taking some risks,” he added.

The fund is also invested 82 per cent outside Canada. Though Machin said that might seem like a lot to some, Canada represents less than 3 per cent of world financial markets so given that, the investment on home turf is quite substantial.

“We have a really simple mandate: to maximize returns without undue risk of loss,” noted Machin, who began spreading his upbeat outlook at the Economic Club of Canada in Toronto on Monday and will appear later this week in Ottawa and Vancouver.

“The system is sustainable and we’ve got a group of people here in Toronto to make sure the money’s there and is invested wisely both in Canada and around the world on their behalf.”
It doesn't surprise me how clueless Canadians are when it comes to the CPP and CPPIB. I even have well-educated friends of mine who believe CPP won't be around in 20 or 30 years when they retire or worse still, that the federal government will raid it to pay off the debt in the future.

I tell them bluntly: "you're all idiots and clueless about how lucky we are to have CPP assets managed by CPPIB. Please don't propagate these myths and for god's sake, read my blog and educate yourselves!". (I know, lack some diplomatic tact but that's how we talk amongst friends and I can't stand when smart people say stupid things).

Why are Canadians lucky to have CPPIB, PSP Investments, la Caisse, Ontario Teachers', HOOPP, AIMCo, bcIMC, OMERS and other large, well-governed pensions? In short, because it means a meaningful subset of the population can retire with dignity and security and avoid pension poverty.

Early this morning, a buddy of mine who is a radiologist gave me a lift to the hospital so I can avoid the hassle of finding parking and hurry up to grab a number for my blood tests before the herd.

We were talking pensions, which is odd since it's a topic that doesn't particularly interest him. He told me: "I need to amass $2 million in my RRSP to collect a $60,000 annual pension, assuming a rate of 3%. I wish I had a pension when I retire."

Now, I'm not crying for my buddy and neither should you. Radiologists get paid extremely well and barring a catastrophe, I'm sure he will eventually amass over $2 million in his RRSP, but the point I'm making is he is willing to pay a lot more now into CPP to gain later in terms of pension benefits.

Smart people know the value of a defined-benefit pension. Period. They want to work 30 or more years and eventually be able to retire knowing they have a safe, secure pension they can count on for the rest of their living years.

All Canadians have that in the form of CPP where assets are managed at arm's length at CPPIB, which effectively means assets are managed in the best interests of all Canadians, not in the best interests of the federal and provincial governments who oversee the Canada Pension Plan (but not CPPIB which operates independently and has an independent board overseeing its operations).

Briefly, the key advantages to this structure:
  • CPPIB can pool assets to lower costs internally and with its external managers. It can invest a huge portion of the assets internally and use its clout to lower fees with external managers (through co-investments in private equity or through direct negotiations with public market funds).
  • CPP pools investment and longevity risk which means Canadians won't outlive their CPP pension. 
  • CPPIB invests in both public and private markets allowing it to add significant value-added over its Reference Portfolio over the long run.  
That last point is critical. Canadians don't understand how collectively their national pension plan owns the very best hedge funds and private equity funds, and top commercial real estate and infrastructure assets all over the world.

CPPIB is invested 82% outside Canada. If it were up to me, the Fund would be invested 95% outside Canada except if the new Canada Infrastructure Bank takes off in a huge way.

By the way, members of the board for the new Canada Infrastructure Bank were announced and I was glad to see Bruno Guilmette, the former head of Infrastructure at PSP Investments, was among those selected. Bruno's investment expertise will be indispensable to this board. You can view a list of the board members here.

As far as CPPIB, I've said it before and I'll say it again, clueless Canadians have no idea how lucky we are to have this Fund manage CPP assets at arm's length from all governments.

And we're also very lucky we have Mark Machin at the helm and other experts at all levels of this beast of an organization, running it like a business. Do they get paid well for what they do? You bet but it's in our best interests to pay those that manage billions for the Canada Pension Plan very well.

So, the next time you hear someone say the Canada Pension Plan is doomed, please refer them to this comment, tell them to relax and that the CPP-CPPIB is the envy of the world.

Below, Carolyn Wilkins, Senior Deputy Governor at the Bank of Canada discusses why cryptocurrencies aren't currencies. Mark Machin, the head of Canada Pension Plan Investment Board, said he doesn’t think the bitcoin and blockchain space is “investible” yet, but the country’s largest pension fund is monitoring it with interest.

I personally hope CPPIB finds a way to go long and SHORT cryptocurrencies and profit off the frenzy and inevitable collapse. In the meantime, keep shorting that loonie of ours! -:)

Monday, November 20, 2017

Private Equity's New Competition?

PE Hub posted a Reuters article, Private equity to face competition from investors, says Carlyle Co-CEO:
Private equity firms are awash in cash, with nearly US$1trn of available capital, but the industry is facing internal competition as limited partner (LP) investors seek to play a more active role in buyouts, according to David Rubenstein, co-founder and co-CEO of the Carlyle Group.

The structure and composition of private equity funds will change significantly as LPs that would previously have invested in the funds increasingly branch out into arranging buyouts themselves, Rubenstein said.

Rubenstein was giving his views on the future development of private equity firms, based on his 30-plus year career in the industry, at the SuperInvestor Conference in Amsterdam this week.

“I expect we’ll see longer duration funds become more prevalent, with consequently lower fees for LPs and carried interest for general partners [private equity firms].” Rubenstein said.

Many LPs are looking for longer-term investments with lower return targets, which will ripple through the conventional buyout community, Rubenstein said, adding that more permanent capital will also be sought to match longer investment duration needs.

Several LPs that would have previously invested in private equity funds, including Canadian pension funds PSP Investments and the Canadian Pension Plan Investment Board, have built their own operations to buy assets in recent years and some European firms are also looking at co-investment buyouts.


Rubenstein predicted that sovereign wealth funds will replace US public pension funds as the largest source of capital for buyout firms, and said that retail investors will also play a more significant role going forward.

“Individual retail investors will be the biggest new entry as regulations relax on investing in private equity,” he added.

He also highlighted private debt as a significant growth area and predicted that it could grow to rival private equity. Private debt, which includes direct lending that targets small and medium-sized companies, currently has US$600bn of assets under management, according to Preqin.

While the global private equity industry currently has nearly US$1trn of ‘dry powder’ available to spend, the breakneck development of the shadow banking market means that sponsors now form a smaller part of the investment world, other delegates said.

Rubenstein is expecting public and political opinion, which has been highly critical of private equity’s role in turning around underperforming companies via debt-financed buyouts, to relax as knowledge of how the industry works develops.

“A lot of people still don’t really understand what private equity does,” Rubenstein said.
Private equity firms are gearing up to lobby hard against proposed US tax reforms that could curb the private equity industry’s profitability and make buying and selling companies more difficult.

Rubenstein said that a proposed cap on the tax deductibility of interest payments exceeding 30% of income is unlikely to have a significant impact on private equity firms, as debt forms a smaller proportion of buyouts than in the industry’s early days.

The bill also includes a tightening of the carried interest loophole, which allows private equity managers to have their profits taxed at a lower capital gains rate than income tax rate if they hold a company for more than one year.

“I think we can expect some effect there,” he said.
Ed Ballard and William Louch of Financial News also report, David Rubenstein’s five predictions for the future of private equity:
“God looks favourably on the founders of private equity firms.” That was the conclusion of David Rubenstein as the Carlyle Group co-founder reflected on his generation's staying power, reports FN's sister publication Private Equity News.

Over the past three decades, Rubenstein has been an enduring presence as the business of buying and selling companies has transformed from a niche Wall Street practice into a gigantic industry commanding hundreds of billions of dollars and spanning asset classes.

The late phase of his career—and those of his peers such as Stephen Schwarzman, Henry Kravis and David Bonderman—is now coinciding with sweeping realignments in the industry. Addressing the SuperInvestor conference in Amsterdam, he made five predictions for the future of the buyout business.

US public pensions will lose the top spot…

Saudi Arabia’s pledge to commit $20bn to a Blackstone Group infrastructure fund may show the way the wind is blowing. “The US public pension funds … have been the biggest source of capital for PE firms for much have the past 30 years. I don’t think they will be for the next 30 years,” Rubenstein said. “I think the sovereign wealth funds and the national pension funds will replace the US public pension funds as the biggest source of equity capital.”

...and so will the US

“The biggest source of capital is from the US, the biggest deals are done in the US and more capital is invested in the US than in any other part of the world,” Rubenstein said. “This will change dramatically.” He predicted that the private equity investment will become much more balanced between developed and emerging economies.

Private credit will equal private equity

Private equity funds raised £347bn last year, far surpassing the $97bn raised by debt funds, according to Preqin. But, as Rubenstein said, “private credit is something that more or less started with the great recession...It will become as big as PE over the next 10 years in terms of dollars committed.”

Private equity firms will consolidate

Although the industry is awash with capital, there is never enough to go around. A Preqin survey published in August found four in five private equity fund managers say there is more competition for capital than there had been a year earlier, while just 1% reported a decrease. Ultimately that dynamic will force many small independent firms out of the market, Rubenstein said: “I think you’ll see some of the larger firms increase their market share due to their increased capabilities to raise capital. You’ll see more acquisitions of smaller firms and more consolidation within the industry.”

Long-term funds will become commonplace

“The business model hasn’t changed that dramatically over 30 years, PE still uses the same basic model with a few variations," Rubenstein said. "We’ll see more and more longer term funds where people hold onto capital which is invested over 10 or 15 years where they’ll take lower carry and pay no fee on committed capital.” Like several rivals including Blackstone Group and CVC Capital Partners, Carlyle has recently raised a longer-life fund as buyout firms look for ways to compete with patient investors such as pension funds. Meanwhile, specialists have sprung up such as Castik Capital and Core Equity Holdings.

Last month saw Carlyle pass the leadership torch over to a new generation when the Washington, DC-based firm announced that Rubenstein and his co-founder William Conway will become the firm's joint executive chairmen. They are being replaced as joint CEOs by Carlyle veteran Glenn Youngkin and Kewsong Lee, who joined the firm in 2013 from Warburg Pincus.

Looking back on his career, Rubenstein also recalled some notable investing mis-steps — including passing up an opportunity to invest in Facebook.
And Javier Espinoza of the Financial Times also reports, Private equity model ‘starting to look like spent force’:
The private equity model “is starting to look like a spent force” because more competition and record cash available is leading to lower returns as operators are forced to take on more risk, an adviser to the industry has said.

Professor John Colley, associate dean at Warwick Business School, said the recent collapse of British carrier Monarch Airlines and the potential surrender of UK care homes operator Four Seasons to lenders exposed a weak model of ownership.

In a recent article, Prof Colley argued that private equity’s modus operandi may have run its course, likely to hit managers but also large pension funds, which have increasingly raised their allocation to the asset class.

In the US alone the average US pension fund had 7 per cent of its asset allocation in private equity as of last year.

However, industry insiders have argued that private equity has and will continue to deliver the goods for its investors.

In Prof Colley’s article, published by The Conversation website, he wrote: “The sector is known for turning round companies, slashing costs, increasing cash flow and using debt to reduce tax and mitigate risk, but the model is now looking fragile.”

He added: “An oversupply of rival funds and investor money looking for opportunities is forcing investment in higher-risk business and the acceptance of more marginal returns.”

Prof Colley, who advises various private businesses at board level, said private equity groups were putting up with higher costs in the companies they bought partly because of high valuations in the stock market.

Because of these dynamics, he argued, “it may well be that the model has run its course and is ready to be replaced by something else”.

His comments were in stark contrast with some of the industry’s most ferocious defenders.

Speaking at a trade conference in Amsterdam, David Rubenstein, the billionaire co-founder of the Carlyle Group, said the model of private equity had worked “pretty well” for both managers and investors and that was likely to continue for the next three decades, with minor adjustments.

Mr Rubenstein said: “The basic model of [private equity] has worked. Very few business models have survived for forty years or so. The private equity model is unique in the history of money management.”

The model of asset management charged no carried interest — the cut managers share with investors — for 200 years, he said, but private equity in the 1960s changed it because “money would be committed but not actually invested and more or less 20 per cent of the profits would go to the [manager]”.

He added: “That basic business model with permutations and changes is still the model we use today. Carried interest when it is earned and realised has produced enormous amounts of profits for managers but also has led to large profits for [investors].”

Mr Rubenstein said if carried interest were to disappear the industry would not attract the talent or capital and the returns would not be as good.

“The model has worked pretty well,” he said.
Indeed, the private equity model has worked exceptionally well, allowing Mr. Rubenstein and his co-founders and other private equity titans to amass a fortune over the last three decades.

Not surprisingly, Mr. Rubenstein is defending the industry that has been so good to him (and to investors but mostly to GPs). Others are equally vocal in defense of private equity as they willfully ignore the industry's leveraged asset-stripping boom.

For those of you who don't understand how the fee structure works in private equity, it's similar to hedge funds, meaning 2% management fee and 20% carry (performance fee) with the big difference that the 2% managagement fee in private equity is typically charged on committed, not called capital, and typically declines over the life the fund (see here for more details).

Another big difference between private equity funds and hedge funds is the former charge a 20% performance fee only after clearing a hurdle rate (typically 7-8%) which is why it's a popular asset class at endowment funds like Yale and at large public pensions like CalPERS.

All those fees add up, however, which is why many large Canadian pensions have developed an extensive co-investment program where they invest in top PE funds but also co-invest with them on larger transactions to lower overall fees.

In order to do this properly, Canada's large pensions have hired experienced professionals which they pay extremely well to be able to quickly analyze co-investments and invest alongside their GPs when nice opportunities arise. This is one form of direct investing which lowers overall fees (there are no fees on co-investments but to gain access to them LPs have to invest in funds first where they pay big fees).

Another form is when the life of a PE fund comes to an end and instead of a traditional exit (ie. selling to strategic or via public markets), one or more portfolio companies are auctioned off to the highest LP bidder which can keep that company on its books for a lot longer. This too is a form of direct investing where once the company is bought by a pension, it pays no fees to the GP.

All this may sound complicated but it's also important to note private equity's J-curve effect, meaning private equity fund investments initially have negative returns and accumulated negative net cash flows for a relatively long time period, which investors have to bear in mind when setting up a new program or approving new investments.

Now, will Canada's large pensions bypass private equity funds? No, I've already explained that Canada's large pensions can never compete head-on with private equity in the best deals because the first phone call bankers and business CEOs make is to Blackstone, KKR, Carlyle, TPG and a handful of elite funds, not to CPPIB, PSP or Ontario Teachers'.

However, Canada's large pensions are increasingly sourcing some deals on their own, bypassing fees to PE funds. For example, the Ontario Teachers Pension Plan announced Friday that it has purchased the P.E.I. company Atlantic Aqua Farms, the largest grower and processor of live mussels in North America.

Now, the purchase of Atlantic Aqua Farms marks Ontario Teachers' first venture into the realm of aquaculture, and falls under its natural resources mandate to invest in the global food basket, with an eye on sustainable sources of food production, so technically it's not a private equity deal but it's still a private market deal where they're not paying any fees to a GP.

The key advantage Canada's large pensions have over private equity funds is they have a much longer investment horizon and can keep private companies generating excellent cash flows on their books for well over ten years (after 3 years of a fund's life, PE GPs are already looking to raise money for their next fund, which sometimes brings about a misalignment of interests).

And in private debt, both CPPIB and PSP Investments can compete with top private equity funds as they have hired exceptional teams working on a credit platform (so they get paid exceptionally well) which only focuses in this area.

Now, KKR, Blackstone and other large private equity shops are finding ways to lock up client money for longer, but Carlyle doesn’t seem to be in a rush to do the same:
The private equity behemoth, where co-founder Rubenstein is the chief fundraiser, can revisit investor wallets with relative ease, he said Tuesday.

“We have a pretty good ability to get capital when we need it and we really haven’t struggled to raise capital in any recent time,” Rubenstein told investors and analysts while discussing third-quarter results. “We are always looking at different permutations of how you can raise capital, but I’d say right now the model that we have is one that we’re reasonably comfortable with.”

Long-dated and permanent-capital vehicles can reduce the frequency of fundraising, permit longer investments in assets worth holding on to, and generate more predictable fees. Carlyle does have a longer-life private equity fund, championed by co-CEO designate Kewsong Lee. The pool is doing “quite well” and will likely have a larger successor fund, Rubenstein said.

But the appeal to Carlyle doesn’t seem to be as great as, say, at KKR, where a new pair of long-term investor agreements was the centerpiece of the firm’s earnings call last week. The partnerships secured $7 billion in fresh capital.

“When you have a reputation as we do, and as other peers that we compete with do, and you go out and raise a successor buyout fund, while you have to go out and raise it, it’s -- I won’t call it permanent capital -- but it’s very likely you can raise these funds for quite some time into the future,” said Rubenstein.
The appeal of permanent capital to investors is they can commit more for longer and obtain lower fees and Carlyle might not be in a rush but it will follow suit (see above, second article).

Anyway, Mr. Rubestein, Mr. Conway and Mr. D'Aniello are passing the torch now so they aren't going to be running the day-to-day operations at the world's most connected private equity fund.

Carlyle will hand its incoming co-chief executive officers bonuses and stock that will add several million dollars to their annual base salary of $275,000 (now you know why Mark Jenkins left CPPIB to join Carlyle and why one senior infrastructure officer at OMERS is joining Blackstone to help them with their new infrastructure fund which will be headed up by ex-General Electric exec Steve Bolze).

So maybe there is some truth, private equity has some big competitors in the pension space, but let's not forget who the real kingpins are and who has the deep pockets to attract top talent to their shops (remember what Mark Wiseman once told me: "If I could hire and pay David Bonderman, I would, but I can't, so in private equity, we will always pay fees and co-invest with top funds").

David Rubenstein, co-CEO of Carlyle Group, recently discussed the company's succession plan, on "Bloomberg Markets: Middle East" from the Saudi Future Investment Initiative in Riyadh. Watch this interview here.

Below, CNBC's Joe Kernen reports Carlyle Group announces a significant change in leadership as both David Rubenstein and William Conway are giving up their roles effective January. Read more about this succession plan here.

Friday, November 17, 2017

A Conversation with David Swensen?

Janet Lorin and Christine Harper of Bloomberg report, Yale's Swensen Sees Low Volatility as `Profoundly Troubling':
David Swensen, Yale University’s longtime chief investment officer, said the lack of market volatility in the current geopolitical environment is a major concern and warned that another crash is possible.

“When you compare the fundamental risks that we see all around the globe with the lack of volatility in our securities markets, it’s profoundly troubling,” Swensen, 63, said Tuesday during remarks at the Council on Foreign Relations in New York. That “makes me wonder if we’re not setting ourselves up for an ’87, or a ’98 or a 2008-2009,” he said, referring to previous market crises.

“The defining moments for portfolio management” came in those years, “and if you ignore that you’re not going to be able to manage your portfolio,” Swensen said.

The investment chief, who was interviewed by former U.S. Treasury Secretary Robert Rubin, also said he’s expecting lower returns for the university’s endowment, which he’s run for 32 years with a 13.5 percent average annual rate of return.

For the past 12 to 18 months, Swensen said he has been warning university officials to expect much lower returns in the future, as little as 5 percent annually, which would be down from previous assumptions of 8.25 percent.

“It’s not a very popular change,” he said. “We’re victims of our own success.”

‘Strategic Positions’

Swensen’s widely copied strategy of shifting away from U.S. stocks to alternatives including private equity has generated billions of dollars in gains for the school in New Haven, Connecticut. The fund reached a record of $27.2 billion as of midyear.

“We have to take strategic positions in the portfolio,” Swensen told an overflow crowd. “One of the most important metrics that we look at is the percentage of the portfolio that’s in what we call uncorrelated assets, and that’s a combination of absolute return, cash and short-term bonds. Those are the assets that would protect the endowment in the event of a market crisis.”

Asked why Yale’s uncorrelated assets are higher now than in 2008, he said, "I’m not worried about the economy so much, what I’m concerned about is valuation."
Janet Lorin of Bloomberg also reports that Mr. Swensen talked about China, quants, and manager selection:
Yale University chief investment officer David Swensen, in a rare public appearance, spoke Tuesday to former U.S. Treasury Secretary Robert Rubin at the Council on Foreign Relations.

During the hour-long session, Swensen, 63, disclosed that annualized returns over his 32-year tenure have been 13.5 percent, higher than the endowment’s assumption of 8.25 percent a year.

Swensen said he favors private equity and doesn’t like quants, and talked about his efforts to get university officials to lower expectations for future returns. The endowment has swelled to a record $27.2 billion, the second-largest in U.S. higher education.

During the interview, Swensen shared thoughts about investing and opportunities:
  • On where to invest: “The types of questions that you need to ask with respect to where you are investing are the bedrock for putting together your asset allocation. When I look around the world, there are places that we just won’t invest. Russia. If the rule of law does not follow, then do you know whether or not you own anything? And if you don’t know whether or not you own it, then why would you put your funds there? As we look around the world in spite of the problems we face in the United States, this is one of the best environments in which to invest. I think that the breadth of emerging markets that we were interested in 20 years ago has narrowed dramatically.”
  • On China: His level of concern about China has been “pretty constant” over the past 12 or 18 months. “China is an area that makes me incredibly nervous, but at the same time, we’re heavily committed there. I’ve had great relationships with a handful of managers in China that have produced extraordinary returns. The party commitment to capitalism doesn’t seem as steadfast as I might have thought five or ten years ago.”
  • On private and public markets: Private equity “where you buy the company, you make the company better and then you sell the company is as a superior form of capitalism. I’m really concerned about what’s going on in our public markets. The short-termism is incredibly damaging. There’s this focus on quarter-to-quarter earnings. There’s this focus whether you are a penny short or a penny above the estimate. There’s this activist mentality that permeates the markets.”
  • On quants: “I’ve never been a big fan of quantitative approaches to investing and the fundamental reason is that I can’t understand what’s in the black box. And if don’t know what’s in the black box and there’s under-performance, I don’t know if the black box is broken or if it’s out of favor. If it’s broken you want to stop and if it’s out of favor, we want to increase exposure. And so, I’m an old-fashioned guy that wants to sit across the table from somebody who’s done the analysis and understand why they own the position.”
  • On manager selection: Swensen has long attributed much of his success to the selection of managers for their character and the quality of investment principles. The test for character is “subjective, a gut feeling.” He tries to spend time with prospective managers in a social setting when making evaluations. “Track records are really overrated,” Swensen said. “We would miss out on some incredible investment opportunities if we required three or five years of audited returns before backing somebody.”
I love that last part on manager selection, he's so right. David Swensen is a god in the endowment fund world, and for good reason. He holds the longest, most enviable track record among his peers and he has literally authored the book on pioneering portfolio management.

So when Swensen speaks, you'd better listen and listen carefully. Do I agree with everything he says? Of course not, my name is Leo Kolivakis and I've got my own opinions on markets and the economy but I agree with a lot of the points he raises:
  • On low volatility: Since the summer, I've been warning you the silence of the VIX won't last forever, and when vol picks up, many traders jumping on the short global vol trade are going to be screaming like lambs to the slaughter. When volatility spikes and stays high, it will crush many unsuspecting fools who keep buying exchange-trade products betting that volatility will sink lower. Now is not the time to be picking up dimes in front of a steamroller. 
  • On public versus private markets: Swensen loves private equity and I don't blame him. It has been a great asset class for Yale and other institutional investors but I'm much more tempered in my enthusiasm and have taken on those who defend the industry at all cost, stating much of the outperformance in private equity is due to leveraged asset-stripping. In public markets, I share Swensen's concerns on short-termism but I'm also concerned on valuations as euphoria keeps creeping into these markets, no thanks to the universal shift into passive investing and global central banks who refuse to let markets go down. I've been warning my readers that markets are on the edge of a cliff, it's as good as it gets for stocks and if credit markets keep deteriorating and a crisis develops, we are going to experience the worst bear market ever. This won't bode well for public or private markets.
  • On China: Unlike Swensen, I'm very worried about deflation headed for the US and what will happen when the bubble economy bursts. Importantly, I don't see any "baffling" inflation-deflation mystery, think deflation remains the clear and present danger, and I'm dismayed at smart people who think a major reversal in inflation is upon us. As such, I'm short emerging market stocks (EEM) and Chinese shares (FXI). Because of deflation, I'm also short oil (USO), energy (XLE), metals and mining (XME) and financials (XLF) and remain long and strong good old boring US bonds (TLT), the ultimate diversifier in these insane markets. 
  • On quants and manager selection: I understand Swensen's healthy skepticism on quants taking over the world but there's no denying this trend has been going on for a while and will likely persist. Just because you can't understand the black box, it doesn't mean you can't invest in it. Maybe put them on a managed account platform and monitor and control the risk more carefully. As far as manager selection, he's spot on, you need to look way past track record, get a gut feeling for a potential manager and run with it. You won't always be right but so what, it's an art, not science.
Speaking of art, I had to chuckle this week when I learned Leonardo Da Vinci's Salvator Mundi smashed an auction record, selling for $450 million (click on image):

Too much money, with too few brains chasing too few deals. I didn't say it first, Trump's friend did when he sold his real estate holdings way before the 2008 meltdown. He might have gotten out too early but he had the sense to get out.

And that's the moral of the story. Markets can keep setting records and they can stay irrational longer than you or I can stay solvent, but at one point the music will stop and it will hurt a generation of investors.

Are there intelligent risks to take? Sure, you can track what top funds are buying and selling but that's not going to guarantee you great returns because the more risk you take, the more volatility you will need to endure and it's fun when liquidity is plentiful but not so much when it dries up.

Nevertheless, it's Friday and US Thanksgiving is next week, so let me share with you some stocks that moved up nicely on my watch list today, and they're not just biotechs (click on image):

You can track more of my investment ideas on StockTwits here but to be honest, I don't have the time to post every stock I'm looking at.

I also want to let my readers know that I updated my comment on CalPERS doubling its bond allocation to include Monday's Investment Committee clips and earlier today, I spoke with OPTrust's President and CEO, Hugh O'Reilly, on that pension's decision to divest from big tobacco. You can read his comments at the end of that comment in an update here.

As a reminder, I don't get paid for sharing my wisdom on pensions and investments. In fact, I'm grossly underpaid for all the work that goes into this blog so I kindly remind everyone regularly reading my comments to please take the time to donate via PayPal on the top right-hand side under my picture (view web version on your smartphone).

I want to sincerely thank all of you who financially support my efforts, it's truly appreciated.

Below, a conversation with David Swensen. Take the time to listen to him, Yale and Harvard weren't the top-performing endowment funds last fiscal year but he's a very wise man who had one of my favorite economists, James Tobin, as his mentor.

I particularly like his bleak assessment of America’s looming retirement crisis around minute 40 and how he then slams US public pensions who justify a discount rate of 7.5 percent when he thinks they should be using the 10-year bond yield plus 50 basis points (roughly 3 percent).

I guess he's unaware the Mother of all US pension bailouts is in the works right now which makes the debate on discount rates obsolete.

Thursday, November 16, 2017

Norway's Fund Jolts Energy and FX Markets?