Wednesday, February 10, 2016

OTPP Steps on a German Land Mine?

Barbara Shecter of the National Post reports, National Bank to write off $165-million investment after Germany shuts down Maple Bank:
National Bank of Canada will take a writedown of $165 million, which represents the full carrying value of its investment in Canadian trading and securities lending firm Maple Financial Group, after authorities in Germany shut down Maple’s business activities there over the weekend.

On Monday, a spokesperson for the Ontario Teachers’ Pension Plan, another minority investor in Maple, said the pension manager is “assessing the current situation,” which stems from an investigation launched last fall into alleged trading-related tax fraud at Maple’s German subsidiary.

Both Teachers’ and National Bank have pledged to repay dividends they received if the allegations are proven.

Montreal-based National Bank has a 24.9 per cent equity interest in Maple Financial Group, a private firm.

“National Bank has advised the German authorities that if it is determined portions of dividends received from Maple Financial Group Inc. could be reasonably attributable to tax fraud by Maple Bank, arrangements will be made to repay those amounts to the relevant authority,” National Bank said in a statement.

Deborah Allen, vice-president of communications at Teachers, said the pension manager “entered into a dialogue with the relevant authorities and gave assurances” about potential dividend repayments “immediately upon becoming aware of the allegations against employees of Maple Bank last fall.”

According to National Bank, which raised $300 million through an equity issue in October and signaled it would be taking action regarding the value of its holding in Maple, the investigation involves “selected trading activities by Maple Bank, and some of its current and former employees” during the 2006 to 2010 tax years.

“The German authorities have alleged that these trading activities violated German tax laws,” National Bank said in a statement, adding that neither National Bank nor its employees were involved in the trading activities, nor are they understood to be the subjects of the investigation.

Rob Sedran, an analyst at CIBC World Markets Inc., said National Bank’s equity raise last fall suggested the write down of its Maple holding “would be required at some point.”

In a note to clients Monday, Sedran said the impact on National Bank after the first-quarter charge should be “immaterial as Maple Financial was contributing less than one per cent to the bank’s earnings.”

According to Sedran, Maple’s businesses include collateralized asset-based lending, credit derivatives, and proprietary trading.

Maple Financial Group is unrelated to Maple Acquisition Group, which bought the TMX in 2012.
Doug Alexander of Bloomberg also reports, National Bank Takes $119 Million Writedown on Maple Bank:
National Bank of Canada said it will write off the full C$165 million ($119 million) carrying value of its stake in Maple Financial Group Inc. after that company’s operations in Germany were limited by regulators amid a tax probe.

The writedown will be included in fiscal first-quarter results reported on Feb. 23, cutting National Bank’s common equity Tier 1 ratio by about 13 basis points, the Montreal-based lender said Sunday in a statement. National Bank, which signaled in October that such a reduction was possible, owns 24.9 percent of Maple Financial, parent of Maple Bank GmbH.

“Beyond the charge this quarter, the earnings impact should be immaterial as Maple Financial was contributing less than 1 percent to the bank’s earnings," Robert Sedran, an analyst with CIBC World Markets, said in a note to clients. “With no lasting earnings impact, there should be no lasting valuation impact either."

Shares of National Bank fell 2.5 percent to C$38.83 at 9:54 a.m. in Toronto, the worst performance in the eight-company Standard & Poor’s/TSX Banks Index. The shares have slid 3.7 percent this year.
Tax Probe

Germany’s BaFin financial-services regulator said earlier Sunday that it’s limiting Maple Bank GmbH’s activities on concern the business faces over-indebtedness in the midst of the tax probe. Barbara Fuchs, a spokeswoman for Maple Bank in Frankfurt, said the company can’t comment on investigations.

“These events result from ongoing investigations launched by German authorities in September 2015 focusing on selected trading activities by Maple Bank, and certain of its current and former employees,” National Bank said Sunday. “None of National Bank of Canada and its employees were involved in these trading activities, nor to our knowledge is National Bank of Canada or any of our employees the subject of these investigations.”

Maple Financial is a closely held company based in Canada, whose shareholders
also include Ontario Teachers’ Pension Plan, with a 28 percent stake, according to its website. The firm, which was formed in 1986, has more than 260 employees in Toronto, Frankfurt, London and Jersey City, New Jersey, among other locations. Its units include a German bank with branches in Canada and the Netherlands, and broker-dealers in Canada, the U.S. and U.K.
Deborah Allan, a spokeswoman for Toronto-based Ontario Teachers’, said the pension fund has discussed the allegations against Maple Financial with officials, and is “continuing to assess the current situation.”

Maple Bank GmbH has been in business since 1994 and deals in equity and fixed-income trading, repos and securities lending, as well as structured products and institutional sales, according to its website.
Arno Schuetze and Alexander Hübner of Reuters also report, Financial watchdog closes German unit of Canada's Maple Financial:
German financial watchdog Bafin on Sunday closed the German operations of Canada's Maple Financial on impending financial over-indebtedness related to tax evasion investigations.

In September, German prosecutors searched offices and residences linked to Maple Bank in a probe of serious tax evasion and money laundering connected to so called dividend stripping trades.

The trades involve buying a stock just before losing rights to a dividend, then selling it, taking advantage of a now-closed legal loophole that allowed both buyer and seller to reclaim capital gains tax.

Bafin said in a statement that once Maple Bank made some necessary tax provisions, over-indebtedness loomed.

Maple Bank said in a separate statement that the requested tax provisions are connected to the ongoing investigations into dividend stripping trades carried out between in 2006 to 2010.

A Maple Bank spokeswoman declined to comment on the amount of the necessary provisions.

German daily Sueddeutsche Zeitung reported on Sunday that Frankfurt prosecutors allege that Maple Bank and its business partners have bilked the taxpayer of some 450 million euros.

The bank has an equity capital of just 300 million euros.

Bafin said in a statement that the lender with 5 billion euros ($5.58 billion) in assets posed no threat to the financial stability of the country.

Despite its small size, Maple Bank shot to fame in Germany in 2008, when the lender helped Porsche in its takeover attempt of Volkswagen, which eventually led to the acquisition of the sports car maker by Europe's leading car manufacturer.

Maple Bank specialises in equities and derivatives trading and as of Feb. 4 had 2.6 billion euros in liabilities mainly with institutional clients.

Bafin said it has barred Maple Bank from continuing its business to safeguard its assets.

While deposits of up to 100,000 euros are safeguarded by Germany's deposits protection scheme, up to 60 million euros per client will be covered by Germany's banking association's guarantee fund if Bafin declares the bank an indemnification case, a spokesman for the bank lobby group said on Sunday.

Maple Bank is owned among others by the National Bank of Canada and the Ontario Teachers' Pension Plan.
There were warnings that something was brewing with Maple Financial's German subsidiary in October last year when Ross Marowits of the Canadian Press reported, Teachers' Pension Plan, National Bank watching legal problems facing Maple investment:
Legal problems facing the European subsidiary of Maple Financial Group is creating uncertainty for two of its largest investors -- the Ontario Teachers' Pension Plan and the National Bank of Canada.

National Bank (TSX:NA) says its investment -- which had a carrying value of $165 million as of Aug. 31 -- was at risk for big losses because of allegations of tax irregularities between 2006 and 2010 in Germany against Maple Bank GmbH.

"Given the seriousness of the reported allegations and the actions which may be taken by German regulatory authorities . . . National Bank considers its investment at risk of substantial loss," Canada's sixth-largest bank said in a news release.

The bank holds a 24.9 per cent interest in Toronto-based Maple, just behind the 28 per cent state held by Teachers', the country's third-largest pension fund manager.

Vancouver's Chan family owns 29 per cent, while Maple management and employees hold 13 per cent, with the remaining five per cent scattered among a number of investors, according to Maple's financial report.

Teachers spokeswoman Deborah Allan said the fund manager was "closely monitoring any developments, but (we) are not commenting on the investment."

Maple Financial Group is unrelated to Maple Acquisition Group, which bought the TMX in 2012.

Founded in 1986, Maple Financial changed its name in 1997 from Financial Products Group of First Marathon Inc. It had 3.75 billion euro of net assets as of Sept. 30, 2014.

The Office of the Superintendent of Financial Institutions (OSFI), which regulates federally registered banks, trusts and private pension plans, said it was aware of Maple's situation but was not permitted by legislation to say if it was investigating.

National added Maple in 1999 as part of its $712-million acquisition of brokerage firm First Marathon. It was merged with National subsidiary Levesque Beaubien Geoffrion Inc. to form National Bank Financial.

The bank issued the warning about its Maple investment Thursday afternoon as it announced a restructuring that will see the elimination of several hundred jobs, mainly in Quebec.

It also announced that it expects to raise $300 million in gross proceeds after issuing 7.16 million shares to a syndicate of underwriters led by National Bank Financial.

"In an environment of low economic growth and high technological transformation, we feel that additional efforts to improve efficiency and processes, as well as adding to our excess capital cushion, are the right steps to take," said CEO Louis Vachon.

The bank said Maple contributed less than one per cent to its annual profits in each of the last two years. A full writedown would reduce its Tier 1 capital ratio by about 13 basis points.
What are my thoughts on all this? First, this isn't something that looks good for the National Bank or Ontario Teachers' Pension Plan. Both these organizations pride themselves on "cutting edge due diligence" on external hedge funds but they obviously weren't monitoring the operations at this German subsidiary very closely.

Second, the National Bank says none of their Canadian employees were involved with these trading activities but if they had any knowledge of what was going on, there could be legal ramifications (ie., heavy fines) in the future. Right now, it's an $165 million write down and 13 basis points off its Tier 1 capital, which is a hit but nothing the bank can't handle. However, if Bafin proves that the National Bank was aware of these trading activities and turned a blind eye to these trades, it could impose additional fines.

Third, this is the type of stuff that keeps the board of Ontario Teachers' up at night. OTPP's chairman of the board, Jean Turmel, was previously  president of Financial Markets, Treasury and Investment Bank at the National Bank and he knows its CEO Louis Vachon extremely well (they're friends). I can guarantee you there are a lot of tough questions being asked at Teachers' and the National Bank in regards to this screw-up.

Fourth, Ontario Teachers' CEO Ron Mock knows all about harsh hedge fund lessons due to operational blowups. The last thing he needed was to find out news of shady tax evasion going on at the German subsidiary of a company Ontario Teachers' owns a 28% stake in. That $185 million write down is going to hurt Teachers' value added in 2016 and that is a huge sum to lose in a brutal environment where every basis point counts.

Now, it's entirely possible and very likely that Louis Vachon, Ron Mock, Jean Turmel and the rest of the employees at the National Bank and Ontario Teachers' had no idea of what was going on at Maple Financial's German subsidiary. This beckons the question: What did Maple Financial's senior managers in Toronto know and how did they not discover this illegal trading earlier? This is a huge operational screw-up on their part.

I met with representatives of Maple Financial a long time ago in Toronto. I thought very highly of them but it goes to show you even the most sophisticated shops drop the ball at times and this certainly doesn't look good for them, the National Bank or Ontario Teachers.

And just to be clear, every major bank in Canada has had issues in the past. Some of them we hear about, others are brushed under the carpet. It took me less than 30 minutes to figure out Norshield Financial was a Ponzi scheme back in 2002 and yet the Royal Bank was allowing brokers to invest in this laughable "fund of funds" back then. What a joke!

This case should serve as a wake-up call to all the banks and Canadian pension funds investing in businesses. When you invest in businesses, you invest in people and you better make sure their operations are kosher because if they're not, you're in for a nasty surprise down the road.

Another thing that crossed my mind as I was writing this comment was whether German tax authorities wanted to stick it to Canadian banks and pension funds following PSP's skirting of foreign taxes which embarrassed the Canadian federal government and German tax authorities. Trust me, I'm sure that had something to do with all this even though Germany's Bafin will deny it.

Lastly, please note apart from naming Graven Larsen as its new CIO, Ontario Teachers' recently made some important changes to its senior managers. You can read about these changes here.

Also, Ron Mock appointed Barbara Zvan to Senior Vice-President, Strategy & Risk and Chief Investment Risk Officer. Ms. Zvan reports to the CEO and leads the Strategy & Risk team in supporting the Plan Sponsors in plan design decisions and the Board in determining appropriate benchmarks and risk appetite. In addition, Ms. Zvan drives the responsible investing and climate change risk management and strategy for the Plan.

Teachers' even posted a nice picture of Barbara Zvan, all smiles:

I've never met her (just spoke to her once) but have heard nothing but good things about her and Wayne Kozun from Leo de Bever. This also shows that just like CPPIB, OTPP is taking gender diversity seriously, but it too needs to do a lot more in terms of workplace diversity at all levels of the organization, and start hiring disadvantaged groups like people with disabilities.

Trust me, despite what Jean Turmel told me once, people with disabilities work just as hard, if not harder to overcome prejudices, and they can handle the stress of trading these crazy schizoid markets! (Still, Turmel was right about one thing, always manage your downside risk!!).

Was Barbara Zvan responsible for knowing what was going on at Maple Bank in Germany? Of course not but somebody somewhere dropped the ball and I'm blaming Maple's Toronto office more than anyone else.

But one thing is for sure, this is the last thing Ontario Teachers' or the National Bank needed to deal with at a time when markets are brutal and every gain or loss has an impact on the bottom line.

Below, BNN's Paul Bagnell reports on how the National Bank will write down the entire value or $165-million of its investment in Maple Financial Group, which operates Maple Bank in Germany. Nothing was mentioned on Ontario Teachers' $185 million write down.

Tuesday, February 9, 2016

What's Behind The Market Turmoil?

Matt Philips of Quartz reports, China’s crisis, Europe’s debt, and the US oil bust have become one big worldwide mess:
It’s finally happened. The Chinese economic slump, the global energy bust, the European debt crisis, and the increasingly uncertain American economy have finally fused into one very large, unpleasant economic story.

The latest economic data out of China show Chinese authorities continue to buy up yuan with the country’s foreign exchange reserves in an effort to prop up the currency.

In part because of sluggish demand from China—the world’s largest consumer of commodities—stock prices of commodities producers have slid sharply, pushing markets in the US closer to a bear market.

In the US, investors dumped shares of Chesapeake Energy, the second-largest US producer of natural gas, after news reports that the company hired restructuring attorneys. Chesapeake stressed that it has no plans to pursue bankruptcy.

The stock market selloff has helped push investors into government securities, pushing yields on bonds to their lowest levels in a year. (Bond yields fall as prices rise.)

Those lower long-term bond yields—along with potential exposure to the slumping energy sector and China—are weighing on bank shares. (When long term bond yields fall it hurts banks because it effectively lowers interest rates that they can charge borrowers, squeezing profits.)

Deutsche Bank, a bank that has gotten attention for its exposure to energy over the last few days, got clobbered today after a credit analyst brought up the prospect that it wouldn’t be able to make a payment on an obscure set of its bonds. (Deutsche has vigorously contested that notion.)

On top of all those concerns, banks in Europe are getting burned by a fresh flare-up of the European debt crisis.

In short, the markets are about as messy right now as they’ve been at any time over the last couple years. So when Janet Yellen appears before the US Congress on Wednesday as part of her semiannual testimony, everyone is going to be waiting to hear some soothing words.

If she doesn’t sing the market’s tune, look out below.
Watch out below is right, these markets are brutal. And the hits keep on coming:
  • Bloomberg reports American International Group Inc. (AIG) plans to exit at least half the hedge funds in which the insurer is invested. According to people familiar with the company’s portfolio, the insurer has holdings in more than 100 funds and plans to cut that number to 50 or fewer. I guess they are tired of seeing their hedge funds getting crushed in this market and paying them 2 & 20 for leveraged beta. As hedge funds underperform, redemptions will rise, forcing a wave of liquidations at the worst possible time (this is already happening).
  • Perhaps sensing this, Perry Capital, a $10 billion New York-based multistrategy hedge fund led by Goldman Sachs alum Richard Perry, is making a $1 billion bet against investment-grade corporate bonds, according to The Wall Street Journal. The report didn't specify which companies, but it said the fund's short bet included owners of commercial real estate and telecom companies. 
  • Another well-known hedge fund manager, Kyle Bass who runs Dallas-based Hayman Capital, recently revealed he is shorting shares of a real estate investment trust (REIT) operated by United Development Funding (UDF), accusing it of orchestrating a $1 billion “Ponzi-like scheme.” Shares tanked by more than 30% recently.
  • Wolf Richter wrote a comment on Naked Capitalism, What the Heck is Going on in The Stock Market?, looking at several recent blow-ups. I would add that shares of Tesla (TSLA) are down close to 40% this year.
  • In a post on Monday, Mark Dow at Behavioral Macro outlined the simple, but elegant and persuasive theory about why oil prices have been driven so low and why they remain there today. According to Dow, the supply pressures won’t stop until debt-financed production becomes equity-financed production
  • Yields on Japan's benchmark 10-year government bond fell below zero for the first time, as investors clamored for safe-haven assets in the wake of a global market rout. Meanwhile Bloomberg reports that the probability of negative U.S. rates is on the rise.
  • The new negative normal and the increasing likelihood that ultra low rates are here to stay spell big trouble for big banks. Moreover, President Obama just signed a bill to double the budget for Wall Street regulators, which will effectively turn banks into highly regulated utilities incapable of taking any risks. Add to this the risk of contagion from European banks because of Deutsche's big unknowns (shares of this bank are now trading below 2008 lows), and you have the recipe for a full-blown global banking crisis
  • Worse still, central banks are the only game in town, and they've been eerily quiet. Some claptraps on CNBC (like Steve Liesman) think the Fed should take Friday's jobs report as a good sign to keep raising rates. Meanwhile, the Dow has lost more than 600 points since Friday, signalling a pronounced slowdown in U.S. economic activity ahead (economists like Liesman should learn that stocks are a leading, not lagging, indicator of economic activity).
But it's not all doom and gloom in these scaredy cat markets:
  • According to Bespoke Investment Group, when investors get this scared, stocks rally. As of Monday's close the S&P 500 dividend yield was 2.38 percent, which was 0.63 percentage point higher than the 10-year U.S. Teasury note yield at 1.75 percent. This was the widest spread between the two instruments since July 2012. "In other words, treasuries, which offer no upside from their face value, paid an investor less to own them than an asset class that has historically generated capital appreciation at an annualized high single-digit percentage rate. For this to happen, either investor expectations for long-term equity returns must have changed, or investors were really scared." — Bespoke Investment Group wrote in a note to clients Tuesday.
  • Share buyback might save this market. Early indications are that 2016 buybacks are "on pace to be one of the fastest starts on record," David Kostin, chief U.S. equity strategist at Goldman Sachs, said in a note his team sent to clients over the weekend. Announcements so far have totaled $63 billion barely a month into the year, and Kostin thinks that's just the beginning." Companies have generally expressed a continued commitment to buybacks, holding the view that market weakness is a reason to increase, rather than taper, their repurchases," he said. Of course, the downside is companies have lost billions buying back their own stock.
  • Former long-term bear Mike Mayo, research analyst at CLSA Americas, turned bull recently after 17 years. He told CNBC on Monday that U.S. banks are more resilient than they were before. The analyst claims that while bank earnings were soft, they have strong balance sheets. Mayo said that even if investors were to charge off loans from energy companies and emerging markets debt, the balance sheets would remain strong. He added that concerns that have spilled over from European banks are overdone. 
  • What else? Keep you eye on the mighty greenback. The dollar index slipped to a 4-month low today, which tells you traders are betting the Fed will sit tight and save China in the nick of time. As the greenback weakens, it loosens financial conditions and firms up commodity prices which will help ease the pricking of the global debt bubble.
  • According to Bloomberg, wagers on the price of crude climbed to the highest since the U.S. Commodity Futures Trading Commission began tracking the data in 2006. Speculators’ combined short and long positions in West Texas Intermediate crude, the U.S. benchmark, rose to 497,280 futures and options contracts in the week ended Feb. 2. “This is a reflection of a lot of conviction on both sides,” said John Kilduff, a partner at Again Capital LLC, a New York-based hedge fund that focuses on energy. “We’re seeing a battle royal between those who think a bottom has been put in and those who think we have lower to go.”
I don't know if oil prices are at an interim low or if they will drift lower, but there is a "battle royal" going on there and in the stock market where high beta stocks are getting flushed for safe, dividend stocks (a classic RISK OFF flight to safety).

But I agree with GMO's Jeremy Grantham who recently stated while the stock market sell-off makes him nervous, he fears the big crash is coming later:
Jeremy Grantham is surprisingly bullish!

In his latest quarterly outlook, Grantham, cofounder and chief investment officer at GMO, outlines his views on the markets and the economy.

And in somewhat of a contrast to his recent commentary, sees the oil crash as a big tailwind for the economy and doesn't think the stock market, though it is expensive and potentially heading into a bear market, is going to crash.

"Looking to 2016, we can agree that uncertainties are above average," Grantham writes.

"But I think the global economy and the U.S. in particular will do better than the bears believe it will because they appear to underestimate the slow-burning but huge positive of much-reduced resource prices in the U.S. and the availability of capacity both in labor and machinery."

Grantham adds (emphasis ours):
As always, though, prudent investors should ignore historical niceties like these and invest according to GMO’s rather depressing 7-year forecast. The U.S. equity market, although not in bubble territory, is very overpriced (+50% to 60%) and the outlook for fixed income is dismal.

At current asset prices no pension fund requirements can be met. Thus, we should welcome a major market break that will leave us with more reasonable investment growth potential for the longer term, but I suspect that we will have to wait patiently for such a major decline.

The ability of the market to hurt eager bears some more is probably not exhausted. I still believe that, with the help of the Fed and its allies, the U.S. market will rally once again to become a fully-fledged bubble before it breaks. That is, after all, the logical outcome of a Fed policy that stimulates and overestimates some more until, finally, some strut in the complicated economic structure snaps. Good luck in 2016.
OK, so maybe not bullish, per se, but Grantham is definitely sounding the alarm on not sounding the alarm on a stock market bubble and resulting crash.

Over the last 18 months, stocks are basically flat in what has been by far the most difficult period for investors since the financial crisis.

And this period has really been defined by three things: a crash in oil prices, a continued and relentless slowing of the Chinese economy, and a change in Federal Reserve policy.

On top of all this is the decline in profit margins, which Grantham has called the "most mean-reverting series in finance," implying that the long period of elevated margins we've seen from American corporations is most certainly going to come an end. And soon.

Profit margins are near record highs, and Grantham expects them to fall.

In Grantham's view the Fed holding off on raising rates all the way until December 2015 staved off what could have been a really disastrous year for stocks given the weakness in oil prices and anxiety over China's economy.

And continued assistance from the Fed is likely to send stocks higher, or at least stabilize them somewhat.

The question, then, is whether this sends stocks into a "blow-off-top" where, as Grantham outlines, you'd expect to see a two-standard-deviation event with stocks rocketing higher and the S&P 500 heading to 2,300 before the big crash.

"I must admit to feeling nervous for this year’s equity outlook in the U.S," Grantham writes. "But I am not entirely convinced. Sure, we can have a regular bear market. That is always the case. But the BIG ONE? I doubt it."

In addition to not being (overly) concerned with the prospects of a new stock market crash, Grantham also thinks we're about to see the good side of the oil crash that has been a long-awaited part of the US economic narrative in the last year.

"The largest hits from the major oil company responses are behind us, although at $30/barrel (and maybe less) there will be some further retrenchment," Grantham writes.

He adds: "And now comes the matching response from us, the consumers. Everything we buy has cheaper input costs. The major item of gasoline purchases is a steady jolt of encouragement. Heating bills are also much lower. Could there be a better financial input than this to the group that has been hurting for 30 years — the median wage earner? Not easily."

This is good!

Everything, it seems, is getting cheaper, and according to the latest data out of the BLS released Friday, our paychecks are getting bigger as average hourly wages grew 2.5% over last year in January, roughly matching the largest increase of the current economic cycle (December's gains were revised higher to show annual growth of 2.7%.)

But Grantham goes a step beyond the standard, "Low oil means more spending for consumers" line of thinking (which is why he's one our favorite market thinkers to track).

Grantham further argues that increasing commodity prices, as much as anything else, have been and will be factors ahead of recessions.

Because while 2008 was all about the crash in housing and the stress at major banks, the rapid rise in oil prices and other commodities stressed consumers as much as anything else, in Grantham's view.

And just as this rise was overlooked eight years ago, the crash in prices and the delayed — but positive — feedback to consumers and the economy has been forgotten by the market.

But the benefits are coming. Now.

"Market opinion now, though, impressed with the early negatives that it should have expected and because the offsetting stimulus effect is delayed and weakened initially by some understandable increases in savings, is doing the opposite," Grantham writes.

"[The market] is underrating what will very likely become an important economic tailwind for the next several quarters. Reflecting current opinion, Luke Kawa, a writer for Bloomberg reviewing the oil situation claims, 'One of the biggest surprises in economics has been how the world responded to a period of lower energy prices.' Well, the economic world is easily surprised."

Read Grantham 's full note here »
Is Jeremy Grantham right? Is the market underestimating the stimulative effects of lower energy prices? Maybe or maybe the market is rightfully worried that lower energy prices reflect the coming deflation tsunami.

But I agree with Grantham, the Big Crash that everyone is fretting about isn't coming anytime soon. This is all nonsense that blogs like Zero Hedge love propagating. Sure, some sectors like energy (XLE), Metals & Mining (XME) have crashed and will remain in a bear market for a very long time.

And other high-flyers like small (XBI) and large (IBB) biotechs are getting massacred in these RISK OFF markets but once things calm down, biotech shares will resume their secular bull market and make new highs.

That's what I'm trading on. Maybe I'll be wrong, maybe I'll be right, but either way I'm putting my money where my mouth is and will trade these gut wrenching biotech swings.

Apart from biotech, however, I think investors can seize opportunities in other sectors and have written on this here. The bloodbath in stocks may not be over because of the factors I discussed above, least of which are hedge fund redemptions, but the algos can switch gears in a millisecond and in these markets, so you better be very careful managing your risk whether you're long or short.

Below, while everyone is trying to figure out "who’s to blame for the market turmoil?", Grant Peterkin, senior fixed income portfolio manager at Lombard Odier Investment Managers, discusses what he thinks is setting off “alarm bells” in global markets right now.

Second, Larry McDonald, Societe Generale, weighs in on comments made by Deutsche Bank CEO as he disputed financial stability worries and states his bet on banks.

Lastly, former OMB Director David Stockman talks commodities with his view of long-term cheap oil from the economic slowdown in China and a monetary collapse due to negative interest rates. He speaks on "Bloomberg ‹GO›." I agree with some things, like oil prices will stay low for a long time as demand from China slows, but his call of a "monetary collapse" is too dark and basically means the end of capitalism as we know it.

As always, please remember to donate and/ or subscribe to my blog on the right-hand side under my picture and support my efforts in bringing you daily comments on pensions and investments. Thank you!

Monday, February 8, 2016

Hedge Funds Getting Crushed?

Kaja Whitehouse of USA Today reports, Hedge funds keep getting crushed:
After a rough 2015, "smart money" hedge fund investors are getting crushed again this year as some of their favorite stocks get walloped.

The average hedge fund that invests in stocks — as opposed to debt or currencies — dropped 3.66% in the first month of the year, according to data from Hedge Fund Research.

Some of the biggest names to get trounced include:

►Pershing Square Capital Management, the publicly traded investment vehicle of billionaire hedgie Bill Ackman, fell 11% last month following a 20% decline last year, data from the web site shows.

►Larry Robbins' Glenview Capital, famous for picking stocks that could benefit from Obamacare, dropped 13.65% in January following a decline of 18% last year, according to data from HSBC's Hedge Weekly report, a copy of which was obtained by USA TODAY.

►Marcato International, a well-known activist fund run by Ackman protege Mick McGuire, fell 12.1% last month following a 9% loss last year, according to HSBC.

Even last year's winners had a tough time of it in January:

►Trian Partners, whose Nelson Peltz made headlines fighting with DuPont last year, lost 7% in January,HSBC data showed. Last year, Trian posted gains of more than 4%.

►Tiger Global Management — run by Chase Coleman, a descendant of Peter Stuyvesant, one of New York's earliest movers and shakers — lost 14% last month, according to Reuters. Last year, the tech focused fund posted gains of 6.8%.

►Maverick Capital, run by Texas billionaire Lee Ainslie, fell 2% in January, HSBC data showed. The hedge fund firm stunned with a 16% gain last year.

The decline follows big losses in some of the hedge fund industry's top stocks. Shares of Inc. (AMZN), for example, are down 25% this year. Apple Inc. (AAPL), another hedge fund favorite, is down 10% this year, while Netflix Inc. (NFLX) has dropped 27%.

Pharmaceutical stocks, which hedge funds poured into last year due to the heavy merger activity, are also taking a licking amid concerns about drug prices.

Valeant Pharmaceuticals (VRX), a hedge fund favorite that hurt Ackman's Pershing especially hard, is down 5% this year, following double-digit declines last year.

Chemical giant DuPont (DD), meanwhile, is down 12% this year. Energy companies and financial stocks are also getting crushed on fears that they will get hurt by falling oil prices.

One minor exception to the January doldrums appears to be Greenlight Capital, a hedge fund run by famed short-seller David Einhorn. The fund eked out a 1.3% return following a 20% decline last year, HSBC data showed.
If you think that's bad, check out Carl Icahn, he's having a terrible day. A few weeks ago I questioned whether hedge funds are escaping the market carnage and this just confirms that even the best of them are getting crushed in these brutal markets. When it comes to hedge funds, it's all about leveraged beta!

How brutal are markets? When you see hedge fund darlings getting deFANGed as well as shares of LinkedIn (LNKD) and Tableau Software (DATA) being sliced in half or more, you know there's a whole lot of pain in Hedgeland right now.

Speaking of pain, Rob Copeland and Bradley Hope of the Wall Street Journal report, Schism Atop Bridgewater, the World’s Largest Hedge Fund:
Employees at the world’s largest hedge fund carry around iPads with an app called “Pain Button.” It tracks negative feelings like “angry,” “frustrated” and “sad” with the twist of on-screen dials.

Pain is part of the “complete honesty” philosophy at Bridgewater Associates LP, which has made more money for investors than any other hedge fund in history. But those same principles have led to an unprecedented showdown atop the Westport, Conn., firm, which manages $154 billion.

Bridgewater founder Ray Dalio and his presumed heir apparent, Greg Jensen, have called for votes on each other’s conduct.

The 66-year-old Mr. Dalio has asked the firm’s management and stakeholders committees if they believe Mr. Jensen, 42, has “integrity.” The term is defined in a 123-page treatise written by Mr. Dalio as never saying something about a person that you wouldn’t tell the person directly.

Mr. Jensen, one of two co-chief executives at Bridgewater, asked the same group to decide if Mr. Dalio is fulfilling the succession plan he began in 2011.

Bridgewater is known as much for its idiosyncratic culture as its investment prowess, and Mr. Dalio has long espoused that conflict is essential and helps the firm perform at its best. Employees are told to air disputes openly and then try to resolve them, which sometimes escalates into a vote.

The tumult between Messrs. Dalio and Jensen is an extreme example even for Bridgewater. They have never confronted each other so intensely before, according to current and former employees.

In the past, employees have been fired, or “sorted out,” for repeatedly violating the firm’s core principles, according to people familiar with the matter. Bridgewater is run on a set of 210 principles that have been downloaded from its website more than two million times.

Principle No. 72 applies even to the billionaires who lead Bridgewater: “Hold people accountable and appreciate them holding you accountable.”

The potential impact of the disagreement is unclear. The fact that the votes were called at all has unleashed employee anxiety about Bridgewater’s future leadership, people familiar with the matter say.

Messrs. Dalio and Jensen declined to comment in detail about their dispute.

“The question here about Greg is whether he said things about me on tape in our meetings that he did not discuss with me before,” Mr. Dalio said in a written statement to The Wall Street Journal.

Mr. Dalio, Bridgewater’s chairman and co-chief investment officer, said the issue isn’t about “a traditional definition of integrity.” He said he believes Mr. Jensen has “incredible integrity by any traditional definition.”

Mr. Jensen, one of the firm’s two other co-chief investment officers, said in his own statement that the disagreements have been “healthy.”

“It’s the way that they can be resolved that keeps us all here and resulted in the incredible working relationships that have made Bridgewater so successful,” he added. “I can’t imagine working in any other place.”

As of Friday morning, the votes hadn’t been completed, according to a person familiar with the matter. In a statement Friday evening after this article was published online, Mr. Dalio said “this particular dispute has already been resolved via our process.”

A spokesman declined to comment further, including on the status of the votes.

Mr. Dalio has produced an estimated $45 billion in net gains since launching Bridgewater in 1975 from his two-bedroom Manhattan apartment. The gains top all other hedge-fund managers, according to LCH Investments NV.

The firm was born as a research shop that offered global macroeconomic opinions and veered into investing when Mr. Dalio got $5 million from the World Bank’s pension fund in 1985 to trade bonds. Bridgewater has since grown to 1,500 employees.

Because of Bridgewater’s impressive long-term performance, its investors include many of the largest pensions in the U.S., such as the Pennsylvania Public School Employees’ Retirement System, and sovereign-wealth funds.

Bridgewater’s main hedge fund, called Pure Alpha, has an average annual return of about 13% after fees since its start in 1991.

Bridgewater has stumbled a bit lately. For the first time in more than a decade, the firm manages fewer assets than it did a year earlier. A widely mimicked fund that uses passive, automated programs to shift investments among asset classes like currencies and bonds fell 7% last year.

Pure Alpha, which makes more traditional hedge-fund investments posted a gain of nearly 5%, outperforming peers.

The principles created by Mr. Dalio aim to remove human emotions such as fear and greed from decision-making and maximize profits. He said Bridgewater’s “evidence-based meritocracy” is “not easy for outsiders to make sense of, but it is the secret to our success.”

Shortly after organizing the principles in a written list about 12 years ago, Mr. Dalio had them printed, and some employees began carrying the principles at all times.

“Firing people is not a big deal—certainly nowhere near as big a deal as keeping badly performing people,” he writes in Principle No. 130. Any manager who talks about subordinates who aren’t in the room is “a slimy weasel,” according to Principle No. 5.

While discord is encouraged, Mr. Dalio’s words often are taken as gospel. One former Bridgewater employee recalls debating with other employees for as long as an hour whether a misused apostrophe in one of Mr. Dalio’s research reports was intentional or not.

Mr. Dalio says most employees “are in fact rewarded” for challenging him. About 20% of the feedback he got in the past two years was negative, he adds.

About 25% of new hires leave Bridgewater within the first 18 months, but the turnover rate declines after that, according to the firm. Bridgewater is a major recruiter of recent graduates from elite colleges such as Harvard University, Dartmouth College and the Massachusetts Institute of Technology.

Those who stick around embrace Bridgewater’s philosophy. That includes Mr. Jensen, who started at Bridgewater as an intern about 20 years ago. He became the likely successor to Mr. Dalio after the Bridgewater founder began in 2011 to cede some of his control and ownership.

Bridgewater requires employees to watch professionally edited training videos that use case studies to show how the investment firm’s principles should be used in day-to-day work. Tens of thousands of hours of videos and transcripts are stockpiled in the “Transparency Library.”

One video shows Mr. Dalio standing at a dry-erase board and demonstrating how the marker ink won’t fully rub out with an eraser, according to people familiar with the video. Mr. Dalio prods Bridgewater employees at length about why they bought the dry-erase board, why it doesn’t work and how the bad decision could have been avoided, those people say.

Other videos feature disputes involving high-level executives. A video that Bridgewater titled “Eileen Lies” details the handling of accusations several years ago against Eileen Murray, a management committee member.

Bridgewater won’t comment on the accusations, but people familiar with the video say it describes the discovery that a prospective employee’s resume contained a falsehood.

Ms. Murray, who is co-CEO with Mr. Jensen, wouldn’t comment. “I can assure you that if Eileen was assessed to be a liar she wouldn’t be here today,” Mr. Dalio said. “We and she couldn’t imagine her working anywhere else.”

Technology is helping Bridgewater gather ever more employee data. The firm has hired former officials from the National Security Agency and Central Intelligence Agency, as well as the International Business Machines Corp. scientist who led the development of its Watson artificial-intelligence platform.

Data-mining company Palantir Technologies Inc., one of the most valuable private companies, helps Bridgewater analyze employees’ internal ratings.

While at work, Bridgewater employees constantly rate each other on more than 60 attributes, including “willingness to touch the nerve,” “conceptual thinking” and “reliability,” people familiar with the matter say.

The system feeds data into an ever-growing set of benchmarks, comparable to a stock index, that flag low scores and can eventually lead to a smaller bonus for an employee or even being let go.

In an iPad app called “Dot Collector,” employees weigh in on the direction of conversations while they are happening. Employees also are quizzed about the outcome of meetings. Any meeting of at least three people is expected to hold at least one poll, according to people familiar with the matter.

The average employee accumulates more than 2,000 “dots,” or individual ratings from other employees, a year, a person familiar with the matter says.

Those ratings are distilled into a “Baseball Card” that shows every employee’s average rating for various attributes. The card also includes each employee’s overall “Believability Index,” which reflects how much weight the employee’s opinion has in debates and polls.

The “Pain Button” serves as a kind of diary of unpleasant experiences. It can be used to spot negative patterns, track progress in dealing with conflict and potentially avoid similar experiences in the future.

The app reflects another core tenet at Bridgewater: “Pain + Reflection = Progress.” Employees are frequently encouraged to “get in synch” and hash out their disagreements, current and former employees say.

Bridgewater is working on a new app called “Dispute Resolver.” When it is finished, the app will suggest ways to handle disputes between disagreeing employees, help escalate the dispute to a mediator or even begin the process of forming a tribunal where both sides submit evidence, according to a person familiar with the matter.

The focus on decision-making is related to Mr. Dalio’s belief that “emotional hijackings” can impair decision-making in investments and life.

After honing ideas through debate and discussion, Bridgewater employees write trading algorithms that buy and sell investments automatically, with some oversight.

Those algorithms can be triggered by outside data. For instance, data showing an increase in global shipping might set in motion an algorithm that boosts a particular Bridgewater fund’s exposure to capture profits from the change.

A decade ago, employees rated each other as little as once a year, recalls Mike Kane, who spent his first year out of college as an associate at the firm.

“It’s difficult to have a strong company culture as you get larger,” says Mr. Kane, adding that he appreciated Mr. Dalio’s willingness to let young employees take on major responsibility and speak their minds so openly.

After Messrs. Dalio and Jensen called for the votes, about a dozen top employees and stakeholders at Bridgewater began reviewing video recordings of meetings, transcripts and other material to prepare, according to people familiar with the matter.

Voters were told to keep quiet. After the Journal asked Bridgewater about the dispute, the firm warned employees in an email that it would find anyone responsible for leaking information, people familiar with the matter say.

Under Bridgewater’s policies, vote results and each person’s individual votes are made available to the rest of the firm. “All employees see what would be hidden in most companies,” Mr. Dalio said.
So Ray Dalio's no. 2 is trying to impeach him and according to the FT, Greg Jensen has been asked to take a step back from his current role as co-chief executive:
Mr Jensen will shift his responsibilities away from his role as co-chief executive, a post he shares with Eileen Murray. He will focus more on serving as co-chief investment officer, alongside Mr Dalio and Bob Prince.

Bridgewater had started the process of conducting a search for a new co-chief executive before this particular disagreement.

Mr Dalio said that he and Mr Jensen “both expect to work together, probably for the rest of our careers”.

Mr Jensen echoed the sentiment in an email on Friday: “Both Ray and I are committed to Bridgewater. Ray and I have had [and will have] many disagreements. We have a process for handling them and both of us believe that process is working well. It is through this unique culture of open disagreement that we have produced the meaningful work and meaningful relationships that those who work here and our clients have come to expect.”

Bridgewater said on Sunday: “No decisions have been made. We are still trying to determine the proper mix of responsibilities among our executive team. Greg is incredibly capable, we are working to find the proper balance for him between managing the business as CEO and managing the investments as CIO. Fortunately, we have a great process and culture for working through this as part of our transition.”

Mr Dalio had praised Mr Jensen in a 2006 speech, citing him among the “extraordinary people” who had helped build the company’s success. He described Mr Jensen — who, at 31, had already spent a decade at Bridgewater — as being “in possession of the best package of character attributes I have seen in any human being”.

At a certain point of seniority at Bridgewater, employees must invest a large percentage of their net worth into the company, so that their incentives are aligned with that of the firm’s growth, and effectively making a departure economically impractical. Bridgewater also enforces strict non-compete agreements on those who have had access to its intellectual property.

Westport, Connecticut-based Bridgewater oversees $154bn and has generated the most money for investors since launching in 1975, according to an annual list compiled by LCH Investments. It has notched up $45bn in net gains since inception, including $3.3bn last year, according to LCH data.

The management turmoil had worsened amid weaker performance and scrutiny of Bridgewater’s flagship $80bn “All Weather” fund, which invests according to a “risk parity” strategy that passively buys and sells based on the mathematical volatility of assets.

The actively managed Pure Alpha fund, run since 1991, returned 4.7 per cent after fees last year. The HFRI Fund Weighted Composite index fell 0.9 per cent, according to Hedge Fund Research.
As I recently noted in my review of the best and worst hedge funds of 2015, Bridgewater's Pure Alpha's performance while positive was unimpressive in a year full of macro events. And most pensions are heavily invested in the All Weather Fund and they're losing money in the last three years, especially last year when mad money wreaked havoc on risk parity strategies.

Three years ago, I openly worried that the world's biggest hedge fund was in trouble but nobody was paying attention. When you see public disagreements like this being aired out in the media, it's not a good sign no matter what Ray Dalio and Greg Jensen state.

Let me take it a step further and openly question whether Bridgewater's obsessive focus on "radical transparency" is diverting its attention away from much more pressing cultural and performance issues at the fund. There's something going on at Bridgewater and I don't like it one bit.

Dalio may be warning of asymmetric downside risks in the global economy but he should think long and hard of the asymmetric power structure at his fund which gives the impression that he likes to be openly challenged but in reality, what he says goes.

How do I know? I met the man, think very highly of him and his fund, was among the first pension fund managers in Canada to invest in Bridgewater back in 2002, but he's very imposing and intimidating and I get the sense that a lot of employees there fear him. And when you live in a constant state of fear and have to constantly rate each other (which breeds paranoia, not cooperation, and stifles creativity), a lot of internal angst and animosity which has been bottled up for years is bound to seethe through at a time when the fund is losing money. I think this is what's happening now.

I could be wrong but I think Ray Dalio needs to focus less on "radical transparency" and more on radically transforming the culture of his shop. And no matter what he says, it's still his shop and anyone who challenges that in any way, shape or form will be led to the guillotine.

[Note to Ray Dalio: I'd be more than happy to fly in and give all of Bridgewater's employees a talk on why I think Bridgewater's radical transparency has reached a point of diminishing returns. Also, stop hiring data geeks from Harvard and MIT and start hiring real people who overcome real challenges in their life. If you ask me, Bridgewater needs more diversity in its shop, including people with disabilities. Talk about radical transparency and dealing with adversity is cheap, let your employees see what that means on a daily basis so they can gain real and much needed perspective on life.]

Let me get back on track with the topic of this comment. While many hedge funds are getting crushed, some top performing muti-strategy funds are doing just fine. Citadel is buying the NYSE market making business, giving it more of power to enter an exit trades in a flash crash millisecond.

And then there's Yale secretive hedge fund, Nancy Zimmerman’s Bracebridge Capital which has gone from $5.8 billion in assets four years ago to $10.3 billion today with a return of about 10 percent a year since its inception:
That makes it the largest hedge fund in the world run by a woman. Zimmerman, who survived a 1990s scandal involving Russia, her husband and Harvard University, is so successful at avoiding the limelight that Leda Braga’s $9.5 billion Systematica Investments Ltd. is often cited as the top woman-led firm by assets.

Swensen, who runs Yale University’s $25.6 billion endowment, and Thomas Steyer of Farallon Capital Management originally staked Zimmerman in 1994 with about $50 million. Yale’s investment now is valued at around $1 billion, making it one of the endowment’s most profitable.

“She’s employing this leveraged strategy to exploit pricing differentials in the fixed-income world with an obsessive focus on risk,” Swensen said in an interview.

Boston-based Bracebridge has had only eight losing months since 2009. The fund’s 2 percent gain last year eclipsed the industry, which was up 0.6 percent on average, according to data compiled by Bloomberg. Hedge funds had trouble navigating unexpected market events, including a devaluation in the Chinese currency in August, a rally in European government bonds and a steep drop in oil prices.
When you get seeded by David Swensen and Thomas Steyer and post these type of risk-adjusted returns, you're just as impressive, if not more impressive than those who are trying to one up Soros.

But I caution you, even though ultra low rates are here to stay, beware of large hedge funds taking massively leveraged bets in fixed income markets. It typically ends badly when genius fails!!

What else? I find it very interesting that small and nimble Canadian hedge funds are outperforming the market while their much larger U.S. counterparts are getting crushed. Perhaps many U.S. institutional allocators should take advantage of the cheap loonie and come invest in small Canadian hedge funds (for a fee, I can assist them finding people like Martin Lalonde at Rivermont).

I know, investing in Canadian hedge funds isn't sexy and it's certainly not risk free, but global allocators need to expand their platform and start looking for gems all around the world, not just focus on the "biggest and brightest" hot U.S. hedge funds. Playing that game is fraught with risks too.

Below, as markets keep plunging lower on Monday, longtime stock bull Jeremy Siegel said Monday he expects short-term volatility to linger until oil prices and China's currency stabilize. "There is a double threat of deflation, which is very scary for the market," Siegel told CNBC's "Squawk Box."

I've been warning my readers to prepare for global deflation for years. I even told Ray Dalio this back in 2004 when we met and he fired back: "Son, what's your track record?". Not bad on my macro calls, less so on my micro calls but I'm still plugging away in these crazy, schizoid markets.

In the second clip below, watch Dalio discuss meaningful work and meaningful relationships through radical truth and radical transparency. Listen to his comments carefully but take this stuff with a shaker of salt because there's a lot of marketing behind his comments and I think there's a radical problem at Bridgewater which has yet to be properly addressed (Ray, take my offer above seriously and you can tape me all you want!).

Lastly, while offense wins games in football, it's defense that wins Super Bowls. Sunday's Super Bowl 50 proved that once again. I suggest all hedge funds getting crushed in these markets listen to Al Pacino's great speech below from the movie Any Given Sunday.

Love this clip, Dalio should show it at the next Bridgewater assembly. "Life is a game of inches" and in any fight, it's the guy or gal willing to "fight and die" for that inch who will come out ahead. Now get out there and fight for that inch (or basis point) and remember to subscribe to this radically truthful blog which says it is like it is even if it pisses off some pension plutocrats and hedge fund gods!

Friday, February 5, 2016

Canadian Pensions Cooling on Infrastructure?

Matt Scuffham of Reuters reports, Canada pension funds pull back on infrastructure as prices climb:
Canada’s biggest pension funds say they are walking away from more and more global infrastructure deals, citing concerns that intense competition for assets has driven valuations too far.

The shift could help cool global prices for tunnels, airports, toll roads, energy networks and other infrastructure as Canadian pension plans are among the world’s biggest and most active buyers.

Pension funds’ investment in infrastructure has risen since the 2008 financial crisis, as plunging interest rates and bond yields drove these players to seek steady returns elsewhere. Global equity and commodity turmoil has done little to dampen that interest and intense competition for a limited number of assets has been reflected in recent valuations.

Some investors, particularly in private equity circles, complain that the Canadian funds – dubbed “maple revolutionaries” because of the strategy of direct equity investments they pioneered in the 1990s – have a tendency to overpay.

Senior executives at the leading Canadian funds defend the merits of past infrastructure deals, but say they are worried prices no longer reflect the illiquidity of the assets, which cannot be sold quickly like stocks or bonds.

“The market is overheated. We have stepped out of the bidding for a lot of assets over the last two or three years,” a senior executive at one of Canada’s biggest public pension funds, who declined to be named, told Reuters.

Among recent deals with no Canadian participation, British rail rolling-stock owner Eversholt Rail Group was sold for $3.8-billion (U.S.) to Hong Kong’s Cheung Kong Infrastructure Holdings (CKI).

Canadian funds still expect infrastructure to grow as a proportion of their overall investments because most plans have money rolling in and view infrastructure as a good match for long-term liabilities. But they say want to be more selective.

Canada’s biggest 10 public pension funds have more than trebled in size since 2003 to more than $1.1-trillion (Canadian) in assets. A third of that is now held in alternative assets such as infrastructure, real estate and private equity.


Four Canadian pension funds now rank among the world’s top 10 infrastructure investors, according to Boston Consulting Group. At the end of 2014 the four funds had $36.8-billion (U.S.) infrastructure assets under management, equivalent to 41 per cent of the total infrastructure assets held by the top 10.

One New York-based investment banker, speaking on condition of anonymity, said private equity firms that have lost an infrastructure auction to a Canadian pension fund often grumble they paid too much, referring to rival bids as “dumb money”.

For example, last year’s acquisition by Canada’s CPPIB and Hermes Infrastructure of a 30 per cent stake in Associated British Ports for about $2.4-billion valued the business at around 20 times earnings compared with multiples of 10 to 12 that investors say are typical for the sector.

But recent prices do not necessarily mean buyers are paying too much said Dougal Macdonald, the head of Morgan Stanley Canada, which has advised on a number of deals involving Canadian pension funds.

“In a low rate environment, target returns across virtually all asset classes have come down. It is simply a resetting of returns for the right assets,” he said.

Canadian pension funds typically look for nominal returns of 6 to 8 per cent from infrastructure, a few percentage points above what they would expect from fixed-income investments. Bankers note that private equity funds often seek returns of 20 per cent or higher, meaning pension funds can afford to pay more.


Still, Canadian executives said their funds should avoid being drawn into bidding wars as part of competing consortia.

“You’ve got to try and avoid auctions because they can get crazy. If you’re just walking around with an open cheque book in these markets you’re going to pay too much,” said another executive with one of Canada’s three largest pension funds, who declined to be named because of the sensitivity of the issue.

The executive said Canada’s largest funds should co-operate more frequently. However, such “club deals” remained rare for the top three – the CPPIB, the Caisse de dépôt et placement du Québec and the Ontario Teachers’ Pension Plan.

In the past they often found themselves competing against each other as well as foreign rivals that include South Korea’s National Pension Service, Dutch pension fund APG, Australia’s Future Fund, private equity and some sovereign wealth funds.

Among recent deals, New South Wales Premier Mike Baird hailed a “stunning result” for the Australian province after a consortium including the Caisse agreed to pay $7.5-billion for an electricity network last year, significantly more than analysts expected.

The group had seen off competition from other investors including the CPPIB and a unit of another Canadian pension fund. The Caisse said at the time it was confident the acquisition met its investment objectives.

Canadian funds are also involved in a takeover battle for Australian port and rail giant Asciano AIO.AX, with Brookfield Asset Management BAMa.TO bidding against a consortium that includes the CPPIB.

Asciano’s shares are trading below both groups’ offers but at 34 times their earnings still look expensive compared with its nearest rival Aurizon, valued at 13 times its earnings.

“There’s a lot of money chasing assets,” an executive at an Ontario-based fund said. “The important thing is to maintain our discipline”.
None of this surprises me. Three years ago, I openly asked whether pensions are taking on too much illiquidity risk and whether their collective search for yield is inflating an infrastructure bubble.

In April of last year, Ontario Teachers' CEO Ron Mock sounded the alarm on alternative investments stating: “There’s a lot of money crowded into the broadly defined alternatives space. We find it too expensive. It’s time for us to step back.”

I want you to all remember my rule of thumb, when everyone is doing the same thing, paying outrageous prices for liquid or illiquid investments, or investing in the hottest hedge funds or whatever hot new strategy or theme investment banks are peddling, it typically means lower returns ahead.

Call it the law of unintended consequences. When I was working at PSP back in 2005, I sent a Fortune article to the president and senior management which discussed why Tom Barrack, the king of real estate was cashing out. I specifically highlighted this quote, which remains my favorite investment quote of all-time: "There's too much money chasing too few good deals, with too much debt and too few brains."

That didn't exactly win me any friends over in the Real Estate department where the then head of Real Estate at PSP, André Collin, was fuming but I couldn't care less as my job wasn't to coddle people, it was to warn them about risks lurking ahead (something Gordon Fyfe never fully appreciated and ended up regretting).

That same year, I flew over to London to attend some Barclays conference on commodities and came right back to Montreal to work on a board presentation arguing against commodities as an asset class (too many investment banking cheerleaders peddling BRICS and commodities at that conference) .

The investment bankers didn't like me a lot as I made them do a lot of grunt work and finally decided against recommending commodities in PSP's portfolio. Mihail Garchev who is still at PSP helped me look at the numbers and it just didn't make sense. That decision alone saved PSP billions in losses.

Unfortunately, at the time, PSP was taking all sorts of stupid risks in its credit portfolio, including selling CDS and buying ABCP. In the summer of 2006, I looked at the issuance of CDOs and CDO-squared and cubed products, and warned PSP's senior managers of the bursting of the U.S. housing bubble and how it will wreak havoc on credit markets, but nobody took my dire warnings seriously (to be fair, some were worried too and nobody had any idea how bad things would get).

In fact, I remember calling people at Goldman to discuss ways we can short ABX (an index of subprime debt) and this made them somewhat nervous: "Why would you want to do that? The U.S. housing market is great. " (felt like saying "because I don't trust you guys and I don't want you to question me, just tell me if you can do it and how much it will cost us!". But nothing came out of this because PSP's management decided not to hedge our credit risk back then).

I wrote about that experience here and how it cost me my job here. Anyways, that's all ancient history now but all this to say when everyone is doing the same thing, following the crowd, listening to their trusted investment bankers peddling them hot investment ideas, it typically doesn't end well.

There are booms and busts in everything. That goes for public markets and private markets. You'll have cycles and typically dumb money is on a feeding frenzy when you're at the top of the cycle.

Now, as far as infrastructure, there's no question it's an important asset class. I know, I worked with Bruno Guilmette, PSP's former head of infrastructure, on the board presentation to introduce that asset class at PSP back in 2005.

The best way to think of infrastructure is as an investment similar to real estate but with a much longer investment horizon, providing steady cash flows (yield) over a very, very long time. Typically infrastructure investments yield returns in between stocks and bonds over a very long period.

Why do pensions love infrastructure? Because pensions need to match assets with liabilities and with rates at record lows and likely staying ultra low for years, they need to find a relatively safe, secure and scalable substitute to long bonds which aren't yielding enough to match their long dated liabilities which go out 75+ years (there's a duration mismatch with long bonds and yields are too low).

And when you're a big Canadian pension fund, you're not going to invest in an infrastructure fund, you're going to invest huge sums directly. Unlike private equity which is almost exclusively, if not exclusively, done via fund investments and co-investments, all of Canada's Top Ten invest in infrastructure directly (same with real estate but there are also a lot of fund partnerships in that asset class).

The problem is when everyone is looking to find prize infrastructure assets, things get expensive because everyone is playing the bidding game. This is what the article above discusses. Note how many "senior executives" are complaining publicly to that reporter, off the record of course.

Still, there have been some interesting deals lately. For example, Borealis Infrastructure, an investment arm of OMERS and arguably one of the best infrastructure investors in the world, just bought a 24.15% stake in Spain’s largest operator of oil storage facilities and pipelines:
Borealis Infrastructure – part of the OMERS pension system – is acquiring a 9.15% stake in Compania Logistica de Hidrocarburos, or CLH, from Cepsa and a 15 stake from Global Infrastructure Partners.

Financial terms of the two deals were not immediately available.

CLH, Borealis Infrastructure’s first investment in Spain, expands the pension fund manager’s European infrastructure portfolio which already includes investments in the United Kingdom, Germany, Sweden, Finland and the Czech Republic.

CLH has 40 storage facilities and 4,000 kilometres of pipelines in Spain. The company also has 16 storage facilities and more than 2,000 km of pipelines in the United Kingdom.
Back in November, CPPIB, OMERS and Ontario Teachers’ bought a stake in a Chicago toll road:
Three Canadian pension funds have signed a deal to buy the company that operates the Chicago Skyway toll road for US$2.8 billion.

The Canada Pension Plan Investment Board, Ontario Municipal Employees Retirement System and Ontario Teachers’ Pension Plan will each hold a one-third stake in Skyway Concession Co. LLC, which runs the toll road under a concession agreement that lasts until 2104.

The Skyway runs 12.5 kilometres and connects the Dan Ryan Expressway to the Indiana Toll Road.

Skyway Concession, owned by Cintra Concesiones de Infraestructuras de Transporte S.A. and Macquarie Atlas Roads and Macquarie Infrastructure Partners, took over operations of the toll road in 2005 under a 99-year deal for US$1.83 billion.

The company is responsible for all operating and maintenance costs of the Skyway, but has the right to all toll and concession revenue.

The deal is subject to regulatory approvals and customary closing conditions.
As you can see, there of plenty of deals going on but things might be getting frothy and with risks of deflation and a global slowdown looming, I guess a lot of infrastructure investors are scrutinizing the multiples they pay on these investments a lot more closely.

And while many are cooling off on infrastructure, some are even selling assets. AIMCo just announced the sale of Autopista central toll road in Chile:
Alberta Investment Management Corporation ("AIMCo") is pleased to announce the successful divestment of its 50% interest in Autopista Central de Chile, a Santiago-based toll road infrastructure asset, on behalf of certain of its clients, to Abertis Infraestructuras SA ("Abertis") for € 948 million (approximately CAD 1.5 billion).

The sale of Autopista Central represents the culmination of a very successful private investment for AIMCo and a demonstration of its ability to manage this unique asset through the investment life cycle. This mutually beneficial transaction further provides a unique opportunity for Abertis to consolidate its interests under its Chilean Road Portfolio, furthering its current strategy.

Autopista Central is a 61-kilometer, six-lane highway in Santiago that went into operation in 2007. AIMCo acquired a 50% stake in Autopista Central de Chile in December 2010, on behalf of certain of its clients, joining a consortium of companies with 100% ownership of Autopista Central SA unit, a Santiago-based provider of toll roads operations services. The consortium, now solely-owned by Abertis, holds the concession until 2031.

"AIMCo has enjoyed working with the strong management team of Autopista Central and our partner Abertis over the last five years," says Ben Hawkins, Senior Vice President, Infrastructure & Timberlands at AIMCo. "Autopista Central has one of the best management teams in the industry, and the acquisition will allow Abertis to achieve further synergies and benefits to its portfolio. We are happy to have been an owner of this important piece of infrastructure to Santiago, and remain committed to investing further in Chile given the right opportunities."

AIMCo Chief Executive Officer, Kevin Uebelein, states further, "Today's transaction realizes excellent gains for AIMCo's clients. Our talented and capable team of Infrastructure investment professionals maximized the value of this asset through each stage of the investment lifecycle as evidenced by this outcome."
I will leave you with something AIMCo's former CEO Leo de Bever shared with me via email earlier today on this topic:
When I was at Ontario Teachers, we were one of the first Canadian funds to start investing in infrastructure. The market was inefficient, and we probably made more money than we should have because as others followed suit, prices started to rise.

With the rapid growth of pension and sovereign wealth funds, the money is piling into this asset class faster than the supply of good investments. Some of the new investors are seeking top line yield without factoring in risk. The biggest risk of infrastructure is political and contractual: whenever there is a dispute between a few investors and a lot of taxpayers or users, the investors are in danger of losing out. With publicly owned infrastructure, that cost is just quietly absorbed.

Reliability of contracts and concession provisions are key to attracting capital on good financial terms. With interest rates low, target returns of 6% to 8% may look like a king's ransom, but pricing infrastructure as a risk free bond makes little sense, because it ignores efficiency of capital use and operating risks. The unit cost of capital on many publicly financed projects may be low, but in many cases they end up having to raise a lot more dollars. Some of the best projects I never financed ended up badly for that reason.

Most government owned social infrastructure has been underpriced for decades because of the political pressure to keep user rates low, resulting in a lot of deferred maintenance and no provision for capital replacement. It seems that we need bridges falling down and water pipes bursting before we make that connection.

There should be a growing opportunity for pension funds to fund new infrastructure, as governments look for more efficient ways to deal with these issues. I have been surprised that this is not happening faster.

The main reason seems to be that no one is held accountable for the social opportunity cost of deficient infrastructure caused by congestion, grid failure, and water pollution from poor sewage treatment capacity planning. I see this as one of the factors holding down future GDP growth potential.

Canada's federal government is embarking on a big infrastructure build program. That could be great, and is long overdue, assuming it targets the right investments. We should think carefully about not just building more of what we already have. The future may need different facilities, reflecting, for example, what I see as a trend to more distributed production of energy, and more emphasis on decentralized ways to improve efficiency of water use and treatment.
Smart guy that Leo de Bever and you'll recall the 'godfather of infrastructure' was warning investors of how expensive infrastructure was getting back in July 2010 when he stated the following:
"I did a fair bit of the early infrastructure stuff among Canadian pension funds," he said. "And in the beginning you could get an honest 14 per cent return on equity because the market was very inefficient." To do the same thing these days, with a number of players competing for deals, would take a whole pile of leverage, he suggested.
But ended with this comment:
"In most places, water and sewage are going to take an enormous amount of capital because everything is starting to leak," he said. "Given that the fiscal positions of a lot of these governments is pretty weak, private capital has to come in at some point, and that's when I think infrastructure will become attractive again."
So while Canada's big pensions are cooling on infrastructure, it doesn't mean they've written this asset class off entirely. Quite the opposite, they still invest heavily in infrastructure but are scrutinizing deals a lot more carefully.

It's also worth noting that some funds, like the Caisse, are taking on greenfield infrastructure projects in Quebec. While some are questioning whether it can make money on these projects, I'm very confident it will do just fine (the Caisse hired the right people to oversee these greenfield projects).

Below, an investment in infrastructure panel at Global Investment Conference 2013 featuring Neil Petroff, former CIO of Ontario Teachers' Pension Plan and other experts. This was three years ago but take the time to listen to Neil's comments as well as those of others.

Also, André Bourbonnais, CEO of the Public Sector Pension Investment Board, Winston Wenyan Ma, managing director and head of the North America Office at China Investment Corporation, Ron Mock, CEO  of Ontario Teachers Pension Plan, and Michael Sabia, CEO of Caisse de dépôt et placement du Québec, participated in a panel discussion about Canadian pension plans and investment strategy. Bloomberg's Scott Deveau moderated the panel last April at the Bloomberg Canada Economic Series in Toronto. Even though this panel took place almost a year ago, listen to their comments very carefully as they're still highly relevant.

Lastly, I embedded a long History channel documentary on America's crumbling infrastructure. While Ted Cruz, Donald Trump, Marco Rubio, Hillary Clinton and Bernie Sanders debate each other to be America's next leader, the country's infrastructure is falling apart.

Given Friday's lackluster U.S. jobs report, I think it's time for America's leaders to take advantage of ultra low rates for years and start investing massively in the nation's infrastructure. Unlike minimum wage retail and restaurant jobs, infrastructure jobs pay decent wages and help grow the economy.