Thursday, September 20, 2012

Canadian Pensions Enriching the New Tycoons?

Janet McFarland of the Globe and Mail reports, Pension plans see investing opportunities in alternative assets:
A soaring number of Canadian pension plans are shifting their investment strategies this year to embrace real estate and other alternative assets as they struggle to cope with the challenges of a world with entrenched low interest rates.

A survey of pension plans by RBC Investor Services Ltd. suggests a majority of plans have given up waiting for higher interest rates – which would boost returns and reduce their long-term funding liabilities – and are making structural changes to their investment approach.

The poll of 56 pension plans, titled Navigating Low Growth, found 71 per cent believe the low interest rate environment is “the biggest challenge” facing them over the next year. In last year’s poll, just 27 per cent cited interest rates as their biggest challenge.

The survey found 48 per cent of pension plans expect to increase their holdings in the next year of so-called “alternative” assets, which refers to assets other than stocks and bonds. Alternatives include real estate and infrastructure holdings such as utility companies, mass transit or road infrastructure.

In the same survey a year ago, 21 per cent of pension plans said they were planning to boost their alternative asset holdings.

Scott MacDonald, head of pensions at RBC Investor Services, says there are “no obvious signs of rescue coming any time soon” in the form of higher interest rates, so many funds have finally concluded it is time to change their investing approach. “When you see zero, and it’s not moving off of zero, there just isn’t an external force that’s going to change your fortunes materially without intervention on your part.”

Of those funds looking at boosting alternative asset holdings, 45 per cent said they planned to increase their real estate holdings, 34 per cent are looking at infrastructure, 14 per cent are planning private equity investments and 7 per cent are planning more hedge fund investments.

Mr. MacDonald said large public sector pension plans have had better performance in recent years due to their investments in alternative assets, and smaller plans increasingly want to emulate that success.

The Canada Pension Plan Investment Board – one of the country’s largest pension fund managers – has increasingly shifted into alternative asset investments, reducing its holdings of public company stocks from 45.7 per cent of its portfolio in June, 2009, to 34 per cent as of June this year. It has boosted its weightings of private equity investments, real estate and infrastructure assets over the same period.

CPPIB chief executive officer Mark Wiseman said alternative investments fit the fund’s long-term investment nature and have the right risk-versus-reward profile. “We believe that private equity assets can produce risk-weighted returns that will outperform public equities in the long run,” he said Wednesday.

He added, however, that it takes “significant capabilities” to invest in these asset classes, and many smaller pension funds “don’t have the scale to develop these capabilities in-house.”

Many smaller pension funds have been slower to make the shift because it is harder to invest in alternative assets. The RBC survey found smaller funds cited their lack of expertise and insufficient scale as their main hurdles in shifting to alternative assets. Despite the barriers, just 17 per cent of funds said they had no plans to expand into the sector.

Mr. MacDonald said there are ways for smaller funds to get into alternative assets through investment pools, but noted costs rise when plans have to invest indirectly through other intermediaries.

The survey also found pension plans saw further worsening of their funded status in 2012. On a solvency basis, 70 per cent of pension funds said their funding level is below 90 per cent, which means their assets are equal to less than 90 per cent of their long-term liability for funding pensions. In the 2011 survey, 51 per cent had a funding level under 90 per cent.

The good news for pension plan members is that 61 per cent of survey respondents say they are committed to maintaining their traditional defined-benefit plans, which RBC says means “the pension promise lives on.”

The survey also found 27 per cent of respondents have closed traditional defined-benefit plans to new hires, who must instead join defined-contribution plans that do not pay a guaranteed level of income in retirement. A further 12 per cent said they intend to close their plans to new hires in the next two to five years.
In other words, the good news is that DB lives on for existing members but it's on life support. Many smaller plans are struggling to maintain the pension promise.

The most important takeaway from the article above is what Mark Wiseman, President and CEO at CPPIB, said about investing in alternatives, namely, it takes “significant capabilities” to invest in these asset classes, and many smaller pension funds “don’t have the scale to develop these capabilities in-house.”

What typically happens in these smaller plans is they listen to the 'expert advice' of their brainless pension consultants who shove them into some real estate, private equity, infrastructure and hedge fund of funds so they gain exposure to alternatives.

In other words, just like many US state pensions, they'll end up paying high fees, getting low profits in return. This is great news for the alternatives industry, further enriching the "New Tycoons," but I'm convinced the end result for all these smaller plans is that they will get squeezed on fees and get poor results shifting into alternatives.

The same goes for most US pensions running out of alternatives, taking the wrong approach as they buy the hogwash of the new asset allocation tipping point. Ask South Carolina how the massive shift into alternatives worked out for them. After moving 50% of their assets into alternatives, paying huge fees and getting low returns, they decided to throw in the towel on alts. This is one of many examples of Fast Times in Pensionland throughout the United States.

Am I against 'alternative' investments? Not at all but have some serious concerns as most pension funds have adopted the wrong strategy with these investments, getting raped on fees and nowhere near the returns they expected. 

Go back to read the speech by the former President & CEO at CPPIB, David Denison, on Canadian pension funds as “Maple Revolutionaries” ‐ lessons from our success.  He cites four key reasons why Canadian public pension funds have enjoyed such success: scale, governance, internal capabilities, and investment horizon.

Many small and large plans don't have all four critical elements to tackle alternative investments properly. For example, OMERS is beefing up its private equity team in London to take advantage of opportunities in Europe. Like Ontario Teachers', they prefer direct investments into private equity and infrastructure. CPPIB co-invests with top PE managers and goes direct in infrastructure (I agree with CPPIB's approach).

The point is they're not paying fees upon fees to some fund of funds, they're either going direct or (more likely in private equity) co-investing alongside the best managers in the world. To do this properly, they need to attract and retain talent with a specific skill set to build significant capabilities in-house, something which smaller plans cannot do.

Does this mean smaller plans are permanently disadvantaged when it comes to investing in alternatives? Not necessarily. First of all, I don't buy the hype of alternatives, never did. Most PE and hedge fund managers are terrible and underperform public market indexes. Moreover, there is a changing of the old private equity guard as many pension funds realize alignment of interests, and more importantly performance, just isn't there any longer.

In this environment, smaller plans have to think 'outside the box' when adopting an investment strategy into alternatives. They need to reconsider their approach with fund of funds, focusing on seeding mandates in hedge funds and private equity, looking to find smart, hungry emerging managers who will offer them lower fees, better performance and an equity stake where they can really prosper. Smaller plans can do this alone or in a group with other smaller plans looking to get into alternatives.

Smart money is focusing on seeding talented managers. It's not an easy game but the payoff can be huge and alignment of interests are much better as emerging managers are much more focused on performance, not asset gathering. Any pension fund looking to take such an approach should contact me directly at LKolivakis@gmail.com. I will grill fund of funds managers for you and set it up right.

Finally, read a few interesting stories in private equity. Bloomberg reports that Apollo is gaining a bigger share of the collateralized loan obligation market, managing about $9 billion in assets since the start of last year, and raising more than $1.4 billion of such funds in the same period.

And Reuters reports that CVC Capital Partners, one of the world's largest private equity groups with investments in Formula One and theme parks group Merlin Entertainment, has sold a 10 percent stake of the firm to a group of investors as it looks to strengthen ties with its influential backers:
The names of the investors and the value of the stake were kept confidential, the person added.

The deal comes as leading private equity firms look to deepen relationships with their largest and wealthiest investors to ensure long term backing for their funds.

Rival buyouts firm Apax has already sold a similar stake of itself to sovereign wealth funds eager to earn better returns from their private equity investments.

By buying into the management company alongside the private equity partners, investors can get first refusal on investments alongside funds in deals and earn a slice of the lucrative performance fees, also known as carried interest.

CVC is expected to start raising its latest fund next year and is targeting about 10 billion euros for deals, one of the largest funds since the financial crisis, people familiar with the situation have previously said.

CVC declined to comment.
I get very nervous when I see established alternatives funds selling stakes to sovereign wealth and pension funds. I've already expressed my concerns when Texas Teachers lost its Bridgewater mind, striking a similar deal. When you take an equity stake in an established fund, yes, you lower performance fees, but you also expose yourself to all sorts of liability issues. Large Canadian pension funds do not opt for this approach and rightfully so (it's better done when seeding a fund).

Below, Bloomberg's Jason Kelly looks into Blackstone Group's move beyond private equity as it leads the industry into non-traditional investments. He speaks on Bloomberg Television's "Money Moves."

And eFront COO of North America Eric Bernstein discusses his leading software provider of financial solutions. He speaks with Scarlet Fu on Bloomberg Television's "Money Moves."