Monday, September 24, 2012

The Oracle of Ontario?

Julie Segal of Institutional Investor reports, The Oracle of Ontario:
Jim Leech, the 65-year old CEO of the C$117 billion ($118.2 billion) Ontario Teachers’ Pension Plan, is hard to rattle. He comes from a family of generals, attended the Royal Military College of Canada and became a captain in the Canadian Army before going into business. True to a childhood steeped in military discipline, Leech is a hard-core believer that emotion should have nothing to do with investing. But the sale last month of Toronto-based Ontario Teachers’ majority stake in Maple Leaf Sports + Entertainment, which owns the Toronto Maple Leafs hockey team as well as the arena where they play, might have stung. After all, the Leafs are to Toronto what baseball’s Yankees are to New York.

Except the Yankees have won 27 World Series championships; the Leafs haven’t captured hockey’s Stanley Cup since 1967 and haven’t made the playoffs since 2004.

Leech might have felt the Leafs were experiencing one more painful loss when the pension fund sold its stake. But the Ontario Teachers’ CEO, and his predecessors who made the investment 18 years ago, have long recognized that the pension plan could make a good profit from the Leafs whether the team won or lost. The Leafs sell out every home game, and their die-hard fans spend a lot of money following them. Ontario Teachers pocketed about C$1 billion in profit from its investment to help pay the 300,000 teachers who are covered by the fund.

The success of the MLSE deal — and, more important, of Ontario Teachers’ portfolio overall — hinges on the unique governance structure that was set up at the plan’s founding in 1990. Teachers in Ontario have been earning pensions since 1917, but the fund itself was going broke by the late 1980s. The government and the Ontario Teachers’ Federation named Gerald Bouey, former governor of the Bank of Canada, to lead the initiative to replace the sleepy government agency that had managed the fund with a nonprofit private corporation. Ontario Teachers was set up with an independent board that delegates all investment decisions to its CEO. The laid-back Leech gets passionate when he talks about how elected officials, bureaucracy and, certainly, emotion shouldn’t touch Ontario Teachers’ investment decisions, even when they concern unionized teachers and the politicized rhetoric surrounding pensions.

“It’s run like a business,” says Leech during an interview at his office in the North York section of Toronto, Canada’s financial capital. “There is subtlety in that: The board has the power to delegate through the CEO,” Leech says emphatically, meaning the trustees do not get involved in investment decisions.

Running Ontario Teachers like a business might seem like a no-brainer, but that’s not the way most public pension funds operate. They’re often managed more like creaky political machines, whose boards have to approve investments and asset allocation changes, and whose chief investment officers come and go at the whim of elected officials. And, like the Maple Leafs, many of them are on a losing streak as they face meager future returns, falling tax revenue, dramatically rising life expectancies for their beneficiaries and political pressure, particularly in the U.S., to significantly pare benefits.

What Leech oversees, and what Ontario has built over the past two decades, is an in-house asset manager that primarily depends on its own well-paid professionals to make direct investments, rather than hiring expensive consultants and outside firms to do the job. Other Canadian plan sponsors, such as the Canada Pension Plan Investment Board and Caisse de dépôt et placement du Québec, which each manage more than C$165 billion in pension assets, also employ a direct approach.

It’s a model hard to argue with. Since the beginning Ontario Teachers has earned an average of 10 percent annually. Even APG Asset Management, which runs the biggest Dutch pension fund and has been lauded for its cutting-edge investing, has returned only 7 percent a year since 1993. According to Santa Monica, California–­based Wilshire Associates, the median annualized return for U.S. public pension funds was 6.32 percent for the ten years ended June 30, 2012. Ontario Teachers earned 8 percent a year over the decade ended December 31, 2011 (the most recent time period available). No wonder its approach is being emulated, if not downright copied, by investors around the globe. Sovereign wealth funds and pension funds have been flying to Canada and knocking on Leech’s door to learn how the Oracle of Ontario does it.

“It’s corporate governance 101,” says Lawrence Schloss, who visited Leech in July 2010, shortly after being named deputy comptroller for pensions and CIO of the $120 billion New York City Retirement System. “Everyone has to agree that this is the job of the trustee, this is the job of management, then figure out what’s the mission statement, what risk do we want to take, our return objectives, how to execute. It’s the Constitution. In Ontario that’s black-and-white.”

Ontario Teachers is Canada’s largest single-profession pension plan and was set up as an independent organization by the Ontario government and the Ontario Teachers’ Federation. Each appoints four board members and agrees on a chairman: now Eileen Mercier, former CFO of Canadian forest products company Abitibi-Price. To take the business of investing out of the political sphere, the board delegates authority to invest wholly to the CEO, and Leech delegates to his team.

Leech’s right-hand man is chief investment officer Neil Petroff, who joined Ontario Teachers in 1993, one of the plan’s first 25 employees and only its second CIO. Wayne Kozun oversees C$51.7 billion in public equities, including a separate group for relationship investments — essentially, a quiet activist team. Ronald Mock runs a C$55.8 billion fixed-income portfolio. Jane Rowe was hired in 2010 to take over Teachers’ Private Capital after her predecessor Erol Uzumeri left to form his own firm. TPC was created in 1991, invests directly in private companies as well as funds and is one of the largest private equity groups in the world. The unit has generated an internal rate of return of 19.3 percent; if it were on its own, it would rank in the top quartile against peers in the private equity world.

Stephen Dowd runs the C$8.7 billion direct infrastructure group, launched in 2001 to invest in airports, electrical power generation, water and natural-gas distribution, among other systems. Pension funds around the world are just now trying to increase their infrastructure investments as an alternative to bonds and to protect against inflation. The team at Ontario Teachers is pragmatic: It supplements its direct investing with outside funds when it doesn’t believe it can develop its own talent in a particular sector or country cost-effectively.

Ontario Teachers, which has 838 employees, took its time in creating the approach now known as the Canadian model. It single-handedly developed the equity derivatives market in Canada as a way to swap out of government debentures, which were its only asset when it was founded. Another milestone came in 1996, when Ontario Teachers made a huge bet that active management would be the path to outsize returns. Its value approach protected against much of the damage others suffered from the 2000 bear market. In 2000 it made a bold move, acquiring all of Cadillac Fairview Corp., a real estate company that operates as a wholly owned subsidiary, after Goldman Sachs Asset Management backed out of a restructuring deal at the last minute. The purchase made Ontario Teachers the first pension plan to own an operating real estate development management company. Now Cadillac CEO John Sullivan runs C$15 billion in real estate for Ontario Teachers.

In 2004, Ontario Teachers sent its senior management team to South Africa, the first of two trips to gather information on emerging markets, in a project dubbed Atlantis. In 2006 the team visited Brazil. It was then that the plan consummated a deal to work with Brazilian mogul Eike Batista. Recently, it teamed up with activist hedge fund Jana Partners and successfully pushed media conglomerate McGraw-Hill Cos. to restructure. The only other pension plan to do something similar is Alberta Investment Management Co., run by Leo de Bever, an émigré from Ontario Teachers who is trying to build a direct model in Edmonton (see sidebar, right).

“Ontario Teachers stands out for its commitment to shareholder value creation and its entrepreneurial and commercial mind-set,” Jana founder Barry Rosenstein says. “That’s what made them a great partner in our McGraw-Hill campaign.”

Public pension funds, which control $3 trillion of assets in the U.S. alone, have been playing a more active role in capital markets, and that role is set to expand exponentially in the coming years. Direct investing is real-world economics. When a pension fund hires a firm like Blackstone Group, it typically pays a 2 percent management fee plus 20 percent of any profits. Public pension funds have the scale to hire talent and can save on the huge costs associated with investing through an intermediary. With the prospect of skimpy returns and interest rates at historic lows, funds need all the help they can get to minimize the amount taxpayers will have to shoulder to make up for any shortfalls. But it’s not just about the fees; it’s also about control. By investing directly, TPC head Rowe gets calls from banks and CEOs about every potential deal in Canada.

Power is shifting toward investors, not just because of the tantalizing allure of the Canadian model. Public pension funds are displacing Wall Street as the new power brokers simply because they have the capital: the ability to fund new businesses, bridges and corporate expansion. In an effort to save the world from another financial crisis, regulators have forced banks to increase capital, reduce leverage and risk exposure, and — as former Citigroup head Sanford Weill now proposes — possibly even prepare to break up. Pension funds and other asset owners are eagerly jumping into the void. Plan sponsors are going directly to organizations that need capital and making deals. Wall Street will have to adapt to the newfound power of asset owners — not easy when profits from deal making, bond trading and IPOs are already under pressure.

Public funds are rightly salivating over Ontario Teachers’ returns and independent approach. Exceptional investing can help mitigate the pension crisis. Since inception Ontario Teachers has added C$53 billion to the plan’s size through its active management. “People ask what that means to them,” says CIO Petroff, explaining that pensioners often believe their contributions are funding their retirement incomes. “But 75 percent of the fund is made up of investments. Only 25 percent is from contributions.”

That’s not to say that governments and unions can simply invest their way out of their problems. Ontario Teachers itself still has a C$9.6 billion shortfall. But by delivering great investment returns, Leech has gained credibility with his beneficiaries and has argued for changes that stand in stark contrast to other plans. In fact, the plan uses a discount rate, which determines the value of future liabilities, that is among the lowest in the world. At just 5.40 percent, the rate makes Ontario Teachers’ promises for the future appear more onerous than others’, preventing the plan from kicking any problems into the future. It also helps that the government and the union are equal partners in this. Last year, for instance, teachers agreed to increase their contributions by 1.1 percent by 2014, and pensioners who retired after 2009 will receive slightly smaller cost-of-living increases for the next three years.

The Canadian model won’t work for everyone. Funds need to be large enough to throw their weight around the investing world, investment professionals have to be compensated in line with what they would make in the private sector— even if that generates some combative headlines in the local press — and trustees, the media, unions and the public need to understand that there will be good years and bad ones. What’s more, Ontario Teachers developed its model over 20 years and has benefited from being an early investor in asset classes that others are now chasing. “It’s a long-term journey,” says Uzumeri, the former head of TPC who left to co-found private equity fund Searchlight Capital Partners, which operates out of London, New York and Toronto. “You need the right governance, the delegation of authority to the investment managers, the tolerance for risk and the right compensation. Without that, the four-legged stool tips over.”

Some public pension funds in the U.S. have done direct investments, but they have been the exception, not the rule. The California Public Employees’ Retirement System and the California State Teachers’ Retirement System both do direct investing in areas such as real estate, private equity co-investments and, more recently, infrastructure. These direct investments are cyclical, however. During bull markets, when all investment values are rising, boards will endorse these approaches. During stressed markets, such as 2008, trustees often have retrenched, reasoning that specialized money managers are a better bet. Sometimes it just comes down to paychecks.

“If you can’t offer compensation to attract and retain experienced people it’s very difficult to compete,” says Mark Weisdorf, CEO of Infrastructure Investments for J.P. Morgan Asset Management and former head of Private Markets at the Canada Pension Plan Investment Board.

THE DIRECT-INVESTING MODEL ISN'T NEW. ENDOWMENTS and foundations, particularly in the U.S., have been among the most sophisticated investors, setting up independent asset management companies and investing early in private equity, real estate, infrastructure and hedge funds. In 1985, Yale University hired David Swensen, a former Ph.D. student of Nobel Prize–winning Yale economist James Tobin, to take over its endowment. Swensen quickly identified hedge funds and private equity as opportunities and moved the portfolio into them. By the 1990s one fifth of the portfolio was in hedge funds.

Then came Harvard University. Jack Meyer, hired to manage the endowment in 1990, built a similar portfolio during his years as CEO of Harvard Management Co. before leaving in 2005 to start a hedge fund. Swensen and Meyer did things differently, however: Swensen used the best outside managers, while Harvard at one time ran as much as 85 percent of its assets in-house, prompting criticism from professors and others about the risk the university was taking and the outsize paychecks being handed to in-house investment staffers. Great returns couldn’t overcome the negative spotlight, and Harvard partly retrenched.

Public pension funds have long existed in the government sphere, subject to politics, the vagaries of state finances and the agendas of unions. Larry Cary, an attorney representing Transport Workers Union Local 100 and a former trustee for NYCERS, has advised against adopting a model like Canada’s, saying the move would hand assets over to Wall Street types, a not-so-popular group in the aftermath of the financial crisis. Cary was unswayed by arguments that New York City already pays $400 million in fees to intermediaries and that managing investments in-house could redirect some of those fees from Wall Street back to the fund. Most pension plans need that kind of help. According to the Center for Retirement Research at Boston College, public pension funds in the U.S. are 24 percent underfunded. That’s money that will ultimately have to come from somewhere. If taxpayers don’t cover the shortfall, employees will have to contribute more or investments will have to generate better returns.

Leech joined Ontario Teachers as head of private equity and infrastructure in 2001 after 25 years in business. He had been CEO of Unicorp Canada Corp., one of Canada’s first public merchant banks, and Union Energy, then one of North America’s largest energy and pipeline companies. He had led two start-up technology companies in the 1990s. Leech was ready to retire, but Claude Lamoureux, Ontario Teachers’ first CEO, and Robert Bertram, its first CIO, called and offered him the opportunity to expand the fund’s still-nascent private investing platform. They wanted his experience in M&A and business-building. Leech grew the group from eight to 50 people and from about C$1.75 billion to C$20 billion in assets.

Ontario Teachers launched its Atlantis program in 2004. It wanted to expand into emerging markets, but it also wanted to do its own research. In 2006 the investment management team went to Brazil and met as many people as possible. Ontario Teachers partnered with Batista and provided money for several of his public ventures, including a C$1.1 billion stake in oil company OGX Petróleo e Gas Participações. The plan also took a position in what public equity head Kozun calls the Goldman Sachs of Brazil: BTG Pactual.

Leech became CEO of Ontario Teachers in 2007, a year before the financial crisis. Not even Ontario Teachers was able to escape the carnage, losing 18 percent in 2008, the fund’s worst year. But other public pension plans lost far more, including CalPERS, which shed 26 percent. Ontario Teachers’ direct investments helped mitigate the damage. TPC lost 13 percent, just half the loss of the average buyout firm. Bertram retired as CIO at the end of 2008, and Petroff succeeded him on January 1, 2009. That year Petroff and his team drafted a blueprint for the future, called Strategy 2020. The details of Strategy 2020 are under wraps. “Innovation is alive and well here,” says Leech. “It used to be that we could do something innovatively, and it would take six years before anybody else would catch on. Now it’s a lot shorter, so we don’t talk about it.”

Leech says going direct rather than through funds has meant that the private capital portfolio earns an extra billion dollars annually. “That’s enough to pay 25,000 pensions,” he adds. In 2010 the infrastructure portfolio earned 13 percent — generating C$600 million more than the industry benchmark, which was up 4 percent — because of Ontario Teachers’ direct-investment approach.

The plan has unique access to investments because of its reputation and capabilities. In November 2010 it partnered with Canada’s Omers Worldwide pension plan to buy the U.K.’s High Speed 1 railway, which runs from London to Paris and Brussels. The U.K. government in part chose the two Canadian pension plans because it wanted to close the deal quickly. They did so in 18 days. “And that was a £2 billion [$3.2 billion] deal. My home took three months to close, and we’re closing high-speed rail in under a month,” quips Petroff.

The infrastructure portfolio has matured, and Dowd is now working on building a team that is responsible for managing the assets in addition to accumulating them. He says that since 2008 the team has looked only at private infrastructure; public infrastructure companies didn’t fare well during the crisis. “Northumbrian Water [one of the plan’s holdings during the crisis] was a fantastic fundamental asset, but there was too much volatility for a pension fund,” Dowd explains.

Two years ago Ontario Teachers launched a long-term equity portfolio, which invests in private and public companies, and looks for companies that it can hold for a minimum of ten years. That might seem like the wrong dogma when investing legends like Pacific Investment Management Co.’s William Gross are publicly proclaiming the death of equities and others say the concept of buy-and-hold is dead. Ontario Teachers, though, has forged ahead for more than 20 years by being different. In 2010 it bought Camelot Group, a global lottery operator that holds the exclusive license to operate the U.K. National Lottery, for the long-term equity portfolio. In July 2011, Ontario Teachers also bought Imperial Parking Corp., the largest parking company in Canada, for its long-term equity portfolio. Because the pension plan will keep a property for as long as it generates good returns, Allan Copping, CEO of Impark, which had been bought and sold three times in the preceding ten years, has said he can finally strategize about the parking business.

Ontario Teachers wants to build its brand in Europe, especially in private equity. Jo Taylor, who joined the plan in January and is a 25-year veteran of private equity, including a stint running a business line for 3i Group, the U.K.’s biggest private equity shop, says: “In Europe there’s more familiarity with us as a fund investor than as an investor in companies. We’re going to be investing often enough that they see us as committed, and we’ll invest in brands and management teams that will get us recognition.”

Ontario Teachers’ recent foray with Jana to push McGraw-Hill to restructure is worth watching for a clue to the pension plan’s future. Though McGraw-Hill quickly said it would implement the majority of Ontario Teachers and Jana’s recommendations, the move raises the issue of how public a fight the plan would have been willing to wage. Leech has emphasized repeatedly that future equity returns will be meager and alternatives such as private equity and infrastructure won’t provide quite the feast they once did. Activist investing is another way to achieve outsize returns. It’s not always pretty, but it can be effective. Ontario Teachers’ model ensures that the pension plan can shift methods and strategies as markets change.

One of the plan’s biggest challenges is keeping ahead of all those people looking to copy its model, even if Leech is at the same time an evangelist about the benefits of direct investing. Ontario Teachers took an early interest in infrastructure, but now the copycats have bid up prices. “We want to go into places where other people aren’t,” says Leech.

As much as the plan’s CEO worries about copycats, they will have a hard time, at least in the U.S. , where pensions are governed by ERISA rules that prescribe what a plan can and can’t do to meet its fiduciary obligations. Canadian pension plans operate by “prudent man” rules, which set down best practices and provide more leeway and judgment.

But plans like NYCERS, which counts 300,000 municipal employees as members, may have no choice but to develop a new model for investing. New York City contributes $8 billion a year for pension costs, about 10 percent of its total budget, up from $1.5 billion, or 3 percent, ten years ago. Schloss, who is CIO of the entire New York City retirement system, says everybody with a stake in the pension fund will have to agree that getting the best returns at the lowest costs should be the plan’s mission. “Don’t blame public employees,” he says. “Go fix the governance and set up an asset management firm that makes independent, nonpolitical investment decisions and works.”

Leech intends to retire at the end of 2013. Although his successor has not been named, Ontario Teachers has built a structure and organization that will outlast his tenure: a professional, independent asset management firm that can attract the best and brightest investors in the world. Governments are bending under the weight of their liabilities to retirees; they need investors on their side who can find the next Microsoft Corp. or Google to save the pension system. The Maple Leafs are a lousy hockey team that actually made for a good investment. That’s not true of pension funds. Their investments need to be managed by a winning team.

“You can’t do it with B players,” says Leech.
Great article highlighting why Ontario Teachers' is one of the best pension plans in the world. And Jim Leech is lucky, he has a great team backing him up. He's also a very decent guy. Crossed paths with him last year when I was there with a commodity arbitrage manager from Montreal. I introduced myself, he asked us who we are waiting to see and he personally went to get them (you won't see that from many presidents of large pension funds).

Leech has been an ardent defender of the defined-benefit plan, responding to critics like Bill Tufts who think that costs  are unsustainable. In 2011, Ontario Teachers' returned 11.2%, stellar results beating out all its Canadian peers except HOOPP, which delivered 12.2% in 2011.

HOOPP and Teachers use different approaches. HOOPP does almost everything internally while Teachers' will often use external managers for investment activities they can't replicate internally. Both funds use repos extensively, leveraging up their stock and bond portfolios, saving millions in the process (instead of having some custodian do it off balance sheet, charging them insane fees).

The big difference, however, is Ontario Teachers' takes directional leverage whereas HOOPP doesn't (repos are matched by money market instruments, not invested in hedge funds, private equity and real estate). I have heard figures that Teachers' is leveraged up to 50%, which works well in good years, but goes against them in bad years like 2008, when they crashed and burned.

One thing that did surprise me from the article above is that Ontario Teachers'  uses a discount rate of 5.4% to determine the value of future liabilities. This is indeed among the lowest in the world for public plans. Most US public plans still use 7.5% to 8% and most Canadian public plans, including HOOPP which is private, use a discount rate closer to 6.3%.

Given the different demographic profile of Ontario Teachers' Pension Plan (older members), it would be appropriate for them to use a lower discount rate than most other Canadian and US plans, but some experts have told me the discount rate they use is extremely conservative, overstating their liabilities and understating their funded status.

Finally, let me clarify a myth about going direct in private equity. You can do some directs, but the reality is Teachers' cannot compete with the David Bondermans of this world. In private equity, it makes more sense to do what CPPIB does, ie. co-invest along with top managers. Of course, these days, even brand name PE funds are struggling to deliver results.

[Deborah Allen, Director, Communications and Media Relations at Teachers, shared this with me: "Just FYI, we do have a major co-investment program in our Teachers' Private Capital Division, which has about $12 billion in assets - In that group we do direct investments, co-investments and funds. TPC has had a 19% IRR over the past 10 years."]

Finally, in late February, nearly four hundred guests dined at the Pierre for FPA's annual Financial Services Dinner. The event honored financial and insurance leaders noted for their outstanding social responsibility initiatives. Below, Jim Leech's remarks from that dinner.