Wednesday, October 31, 2012

Straight Outta Compton?

Dale Kasler of the Sacramento Bee reports, CalPERS sues Compton over missed payments:
A second California city has fallen behind on its payments to CalPERS, prompting a lawsuit by the big pension fund.

Compton owes $2.7 million to the California Public Employees' Retirement System, the pension fund said Monday.

CalPERS sued the city in Sacramento Superior Court after Compton failed to make its required payments for September.

Harold Duffey, the city manager, said Monday that Compton is experiencing a short-term cash-flow problem and expects to clear up the debt before the end of the year.

Compton has been facing significant financial problems and publicly flirted with a bankruptcy filing over the summer.

Still, Compton's troubles represent yet another challenge to CalPERS and the durability of public pensions in general, as cities cope with severe revenue shortfalls.

San Bernardino, which filed for bankruptcy protection in August, is $5.2 million behind on its payments to CalPERS.

The fund has tried to get the bankruptcy case tossed out, saying the city is using the bankruptcy law unfairly to get out of paying its bills.

In Stockton, another city in bankruptcy protection, two creditors are trying to keep the city from paying its CalPERS bills. The creditors, a pair of bond-insurance companies which are owed millions, say their claim shouldn't take a back seat to CalPERS.

Skipping payments to CalPERS, the nation's largest public pension fund, was once considered unthinkable. Vallejo considered scaling back its pension benefits after its bankruptcy filing in 2008 but backed off after getting a warning from CalPERS.

Duffey said Compton submitted a payment plan to CalPERS, promising to "catch up in December." But the pension fund filed the court case anyway.

"Contributions are required by law and if they're not paid, we do intend to pursue all obligations," said CalPERS spokeswoman Amy Norris.

The unpaid bills include payments for pensions and health insurance, she said.
Last week, I discussed the San Bernardino pension showdown and stated:
Keep an eye on this case because it could mark an important turning point for all US public pension plans. As the private sector looks to offload pension risk to insurers or offer lump-sum payouts to thousands of retirees, municipal bankruptcy might be used as a tool to 'restructure' all debts, including pension debt.
As creditors and public pension funds fight for what is due to them, this could get very messy, forcing courts to decide if stressed cities can scrap obligations to retirement plans:
So what happens if California cities facing fiscal emergencies stop paying into their employees' pension funds? We all could find out soon.

CalPensions.com, an online news site, reported that "CalPERS filed court actions against two financially troubled cities, San Bernardino and Compton, after they stopped making legally required payments to the big pension fund, a rare default not made in the Stockton and Vallejo bankruptcies." CalPERS is the California Public Employees Retirement System, the nation's largest public pension program.

The city of San Bernardino filed for bankruptcy protection Aug. 1 and has skipped $5.3 million in pension payments to CalPERS. Compton, in Los Angeles County, has been considering bankruptcy. It made partial payments to CalPERS, but was left owing about $2.7 million. Stockton, which sought bankruptcy protection in June, and Vallejo, which exited bankruptcy last year, made their pension payments.

Most pension experts cite California court decisions mandating that pension contracts with public employees must be honored. "But you can't pay if you don't have any money," Mark Cabaniss told us; he's an attorney from Kelseyville who has written on pensions for the CalWatchdog.com journalism site. "In theory, a judge can order [cities] to pay. But what happens after that? I don't know."

He said that the question really isn't one of contracts. "These aren't really legal questions; they're political," he said. "When things go belly-up, the cases will go to the California Supreme Court. Will the court then say the cities can cut the pensions? Or will the cities have to fire every single employee? Obviously, you will have to keep enough police on to keep the peace in the cities, as well as some other employees."

But how many police and other employees? Mr. Cabaniss said the problem then could become having the courts micromanaging city budgets. Courts have taken similar steps, for example, with prison conditions in California. And courts even sometimes have ordered tax increases.

According to a summary in the Claremont Review of Books, "Between 1985 and 2003, federal judges ordered more than $2 billion in new spending by the [Kansas City, Mo.] school district to encourage desegregation. Not only did they double property taxes to pay this huge bill, but they imposed an income tax surcharge on everyone who lived or worked in the city. ... [The] judicial effort to improve Kansas City schools was a dismal failure."

The Kansas City case is infamous because judges were shown, if they didn't know it already, that they don't do well acting as legislators.

Mr. Cabaniss pointed out that California's constitutional tax limitation measures, which require two-thirds approval of local voters for tax increases, might preclude such a state court decision. We would add, on the other hand, that judges in the California court system receive state pensions and might not want to set a precedent that could reduce their own retirement benefits.

Yet another consideration is that, unlike federal judges, such as those overseeing the California prisons and Kansas City schools, who enjoy lifetime positions, California Supreme Court justices are subject to periodic approval by voters, and can be recalled. Most famously, in 1986, Chief Justice Rose Elizabeth Bird and two associate justices were removed by voters for obstructing the implementation of the death penalty.

Mr. Cabaniss also pointed us to a recent article by Amy B. Monahan, a professor at the University of Minnesota Law School, in the Iowa Law Review. As the article abstract put it, "This Article demonstrates that by holding that benefits not yet earned are contractually protected, without explaining the basis for finding that such a contract exists, California courts have improperly infringed on legislative power and have fashioned a rule that is inconsistent with both contract and economic theory."

We have been warning for a dozen years that a public pension crisis would strike California because the public employee unions prevailed upon the state Legislature and local governments to substantially boost retirement benefits. Now, the crisis is upon us.
The crisis is upon us and like a malignant cancer, it will spread throughout the United States, pitting public pension funds against cities and municipalities and their creditors, which include bond insurers.

And it's not the gangsters in Compton but the banksters on Wall Street that worry me. They're back at it today after markets closed for two days because of severe weather. Cleaning up the mess from Hurricane Sandy will take weeks and months in some neighborhoods. Cleaning up the pension mess will take years and might never be cleaned up, leaving cash-strapped cities like Compton and San Bernardino in dire straights.

Tuesday, October 30, 2012

Exposing the Magnitude of the Catastrophe?

Frank Keegan, editor of StateBudgetSolutions.org, a project of sunshinereview.org, recently wrote a comment, Milliman government pension report exposes magnitude of catastrophe:
When a "premier global consulting and actuarial" firm proves in its first Public Pension Funding study that those government pensions are doomed, it is past time for action. Milliman's study showing a 33 percent increase in pension debt over official numbers from a minute change in accounting should be enough to spur reform.

However, this hidden fiscal cancer threatening to consume the American economy and sabotage essential state and local government services gets even worse when you look at pension performance since the Jan. 1, 2012 cutoff date for the Milliman data.

Those latest numbers show a system collapsing faster than the experts can calculate.

While Milliman's 2012 Public Pension Funding Survey calculates pension debt for the biggest 100 funds at almost $1.2 trillion instead of the official estimate of $895 billion as of the first of this year, performance through June 30 reported to U.S. Census shows it spiraling out of control.

From the quarter ending June 30, 2011, through the same quarter this year, taxpayers and government workers pumped $154 billion into Census' Top 100 government pension funds. Yet value of holdings declined $57.6 billion from the same quarter in 2011.

Worst of all, over that time pension funds paid out $149 billion more than they earned, devouring contributions instead of investing them to pay future benefits as promised.

The Census Quarterly Survey of Public Pensions collects data from state and municipal pension funds representing 89.4 percent of "financial activity." Census estimates there are 3,418 state and municipal pension funds in the U.S.

Worst news of all is that Q2 earnings on investments were negative $14.2 billion, a $66 billion decline from the same quarter last year.

In the course of one year, for every $1 taxpayers and workers put in, pension fund managers lost and paid out $2. How long can that go on?

Every year pensions must invest all contributions to pay future benefits. Investments must grow enough and earn enough income every year to pay benefits and expenses. If they do not, eventually the pension fund must run out of money. Every year they fall behind, the fiscal abyss gets deeper until it reaches a point of no return.

This totally blows away Milliman's attempt to offer "... an aggregate analysis of these 100 public pensions and their funded status."

In an effort to counter widespread criticism that politicians and pension fund managers cook the books to hide the true debt taxpayers must pay in coming decades for no government services of any kind, the Milliman study made minor changes to two current government pension accounting techniques.

Even though government pension accounting techniques are illegal for private sector pensions, politicians routinely use them to secretly evade balanced budget laws.

What Milliman found was that by just changing the assumed "discount rate" public pensions use to determine long-term value of investment assets from 8 percent to 7.65 percent and calculating that value on a market basis instead of actuarial basis, the debt increased almost $300 billion, 33 percent.

But that fails to show pension funds should have grown to the equivalent of $4.1 trillion instead of the actual $2.7 trillion reported as of June 30, putting the long-term debt at more than $5 trillion based on realistic calculations.

Milliman acknowledges, "Most pension plans suffered significant asset losses in the 2007-2009 time frame. While these losses were generally followed by sizeable gains during 2009-2011, those gains were typically not as large as the losses that preceded them, leading to plans generally having reported actuarial asset values larger than market values."

They do that by loading up portfolios with risky investments hoping returns will justify delusional assumptions.

According to Milliman, more than 70 percent of their 100 plans' investments are in stocks, real estate, private equity, hedge funds and commodities, which almost guarantees future gains will not make up future losses.

The small accounting changes in the study also cut pension funding level from the official 75 cents for every dollar owed to less than 68 cents.

Even that number is optimistic compared to a study for State Budget Solutions by Andrew Biggs -- using accounting standards universally accepted by economists - that proved as of 2011 state and municipal pensions could only pay 41 cents of every dollar they owe workers.

Actuaries who calculate pension funding levels say 80 cents on the dollar is the point at which a pension should be considered in crisis under most circumstances.

Politicians expect private sector workers and businesses to make up the difference.

Milliman points out that aggregate numbers in the study do not necessarily apply to individual pension systems, and results can vary widely.

So, take a look at Wisconsin Retirement System, rated as 100 percent funded by Milliman and a "Solid Performer" by the Pew Center on the States.

In a study updated this year, economists Robert Novy-Marx and Joshua Rauh calculated the average Wisconsin household will have to pay more than $1,500 in additional taxes every year for 30 years just for pensions.

That is on top of all other rate hikes, new taxes and additional revenue from economic growth. Citizens will receive no governmental services of any kind in exchange for the extraordinary taxes.

If that is what fully funded means, taxpayers in other states might as well just turn their homes and businesses over to state and municipal workers now.

Far from being reassuring, the first Milliman pension report must be one more call to action.

Numerous recent studies by a wide array of economists determined that under current policy and as presently operated, public pension funds eventually will run out of money. Employees and retirees covered by some plans will not get full benefits.

Links to those studies can be found here.
Similar concerns are being raised throughout the United States. According to the Pioneer Institute, it's time that Massachusetts gets real about pension liabilities:
Can we ensure that public pensions are solvent, fair to employees, and capable of attracting high-quality individuals to public service? Pioneer has long known that reaching these goals will require a fundamental rethinking of our public pension system. We’ve produced numerous reports, gained several good reforms, and recognized courageous legislators like State Senator Will Brownsberger for serious reform proposals.

But we must do more – and now. This week, we begin releasing the first of a 10-part series on public pensions, focusing on the real unfunded liability for the state and localities.

In The Fiscal Implications of Massachusetts Retirement Boards' Investment Returns, Pioneer Senior Fellow on Finance Iliya Atanasov presents the projected costs for three scenarios to retire the state’s unfunded pension liability. The study shows that even minor fluctuations in investment returns can have dramatic impacts on the annual outlays governments will have to make to fund public pensions. That means short-changing other priorities like education, health care, and core government services.

Currently most every public pension fund assumes at least an 8% return. State Treasurer Steve Grossman deserves credit for recommending that we lower the annual rate of return (ARR) in Massachusetts from 8.25% to 8%, but with private firms working from 4.5 to 5% ARR and the state of Rhode Island moving to a 7.5% ARR, we need to look reality in the face. We’ve avoided the truly hard questions by papering over the real unfunded liability we face, doing things like extending the schedule for retiring the unfunded pension liability from 2025 to 2040. It’s time to get real.
Atanasov is right, it's high time all states get real about projected investment returns and lower their annual rate of return assumptions. If US public pension funds used the same discount rate as the Oracle of Ontario (5.4%), they'd be insolvent, forcing taxpayers to foot the bill.

Nonetheless, the main problem behind public pension deficits is not the high discount rate. In his Bloomberg comment, Peter Orszag, vice chairman of corporate and investment banking at Citigroup Inc. and a former director of the Office of Management and Budget in the Obama administration, writes, Pension Funding Scare Won’t Frighten All States:
State and local governments, struggling to emerge from the aftermath of the financial crisis, face another looming funding gap: in their public pensions. These plans hold almost $3 trillion in assets and cover more than 10 percent of U.S. workers, so they’re an important force in the economy.

Even under existing accounting rules, which make the pension math look good by allowing states to apply an artificially high discount rate to future liabilities, the average state pension plan holds assets equal to only about three-quarters of projected liabilities. The difference amounts to about a half-trillion dollars.

Under a lower discount rate that has been approved by the Government Accounting Standards Board and will have to be used by mid-2014 by states that are not meeting their annual required contributions, the difference is greater.

Using an even lower discount rate, one that many economists prefer, the gap would be as much as $2 trillion. Any way you do the calculation, clearly there’s a big problem.

Yet discussions about how to address it are based on flawed assumptions. The dominant view is that large state and local pension gaps are universal across the country, that they are caused largely by assuming too high a discount rate in assessing future liabilities, and that intransigent unions are to blame for the biggest gaps.
Myth Busting

Alicia Munnell, the director of the Center for Retirement Research at Boston College, takes on each of these myths in her new book, “State and Local Pensions: What Now?” Munnell, with whom I served in President Bill Clinton’s administration, has devoted most of her career to pension issues.

First, she computes a funding ratio -- that is, the ratio of assets to liabilities -- for each state plan. She finds substantial variation: Five percent of public pension plans, for example, were fully funded in 2010, and 35 percent had a funding ratio of at least 80 percent. On the other hand, 12 percent of plans had severe problems: Their assets were less than 60 percent of their projected liabilities.

The New York state teachers’ fund had assets fully equal to liabilities, whereas the New York City teachers’ fund had assets equal to 63 percent of its projected costs. Illinois, Kentucky and Pennsylvania face enormous gaps, while Delaware, Florida, North Carolina and Tennessee have managed their pension plans relatively well.

Why were some plans so badly underfunded and others not? Munnell’s answer is the biggest surprise in her analysis. She argues that neither the artificially high discount rate nor unions can explain the variation. As she concludes, “The poorly funded plans did not come close to surmounting the lower hurdle associated with a high discount rate; raising the hurdle is unlikely to have improved their behavior. And union strength simply did not show up as a statistically significant factor in any of the empirical analysis.”

The worst-funded plans were not especially generous in their benefits, Munnell found, which is consistent with her argument that union strength isn’t what matters. These plans, though, did tend to share two characteristics: They were disproportionately teachers’ plans, and they used a funding method (called the projected unit credit cost method) that is less stringent than those used by other plans.

The states with huge funding gaps have “behaved badly,” Munnell concludes. “They have either not made the required contributions or used inaccurate assumptions so that their contribution requirements are not meaningful.” She added, “Fiscal discipline simply appeared not to be part of the state’s culture.”
Growing Burden

In pensions, as in life, what goes around comes around. In states that have behaved well in the past -- such as Delaware -- the burden of pension plans will increase in future years only modestly if at all. In contrast, a state such as Illinois, which has perhaps the worst record of avoiding necessary funding even while expanding benefits, will have to increase its pension contributions sharply if it is to meet its obligations.

To get a sense of what looms, assume that, over the next three decades, the plans will earn an average nominal return of 6 percent on their assets. In that case, Illinois will have to raise contributions from less than 8 percent of total state revenue in 2009 to an average of 14 percent between 2014 and 2044. Delaware, in contrast, would need to raise its contribution by only 2 percent of state revenue. The required adjustments in the states with problems need not, and should not, be made overnight, but they will be a drag on state resources for a long time.

The revelation that problems exist mainly in states that have failed to adhere to a credible long-term funding strategy contains a lesson for policy makers in Washington: It is essential to behave responsibly.

Simply hoping our long-term fiscal problems will magically disappear is not a credible strategy. As part of the negotiations over how to address the fiscal cliff -- the federal spending cuts and tax increases scheduled to take effect in January -- policy makers should combine more support for the economy in 2013 (in the form of tax cuts and infrastructure spending) with a specific and credible deficit reduction plan that rolls out gradually over the next several decades.
Interestingly, Bloomberg reports that debt sold by Illinois issuers is rallying the most in 20 months in the face of a warning that the state’s pensions may run out of money and drain funding from education, infrastructure and local aid.Guess municipal bond investors aren't overly concerned about Illinois' pension deficits.

As I've written in the seven simple truths about public employee pensions, public pension deficits are the result of a decade of states taking pension holidays and raising benefits without paying for them, not the Great Recession. It only exposed the magnitude of the problem.

Moreover, Orszag is right, hoping long-term fiscal problems will magically disappear is not a credible strategy. To tackle public pension deficits, states need to implement much needed reforms, including sweeping governance reforms, bolstering defined-benefit plans and ensuring their long-term sustainability.

The dumbest measure promotes a shift out of defined-benefit into defined-contribution plans, placing the retirement onus entirely onto workers. As I've stated many times, the shift out of DB into DC plans is a shortsighted measure that will only exacerbate pension poverty, adding to America's 401(k) nightmare and long-term debt.

Speaking of nightmares, watch clip below as Bloomberg's Tom Keene and Sara Eisen talk through the destruction caused on the East Coast by Hurricane Sandy. They speak on Bloomberg Surveillance.

And former MTA Chairman Peter Kalikow talks about Hurricane Sandy's devastating impact on New York City's subway system. He speaks on Bloomberg Television's "Superstorm: State of Emergency."


Monday, October 29, 2012

Preparing For The Ultimate Disaster?

Before I proceed to my comment, wanted to bring to your attention a new blog that Jean-Pierre Desloges, a former fixed income trader at the Caisse de dépôt et placement du Québec, recently created. It's called Financial Iceberg and it's mainly geared toward institutional traders looking for quick and in-depth market information often ignored in mainstream media. All you need is to create a password and log in for free.

Jean-Pierre trades bond, currency and equity futures. In his blog, he covers charts, markets, technicals, top news and even posts short blog comments. Today he posted a link to a BNN article stating that Moody’s could cut the credit ratings of six Canadian banks and an analysis of Spanish retail sales from the Instituto Nacional de Estadistica (report in English).

A few weeks ago, Jean-Pierre contacted me to work together on a blog. Told him that I'm a lone wolf, fiercely independent, and warned him that a blog requires a lot of unpaid work, but promised to support him in his venture. Enjoy our conversations as he often brings to my attention stories that I overlook, like how companies like Coca-Cola are announcing record buybacks to boost shares, a trend that other cash-rich companies are following during these uncertain times.

Of course, as the title of his blog suggests, Jean-Pierre is highly skeptical that global policymakers will be able to navigate through uncharted terrain, but he's a trader who uses technical and fundamental analysis to trade around the news. He knows that being married to any one view is the road to ruin.

That brings me to my topic, preparing for disaster. Most logical people are hunkering down as Hurricane Sandy nears the eastern United States. Unfortunately, there are plenty of idiots ignoring the dire warnings, putting their lives and the lives of first responders at risk.

As the US deals with the 'storm of the century', over in Europe, they are adding fuel to the flames of another storm, the endless debt crisis. Any logical analyst looking at the situation in Greece, Spain, Portugal and Italy would conclude that austerity has been a colossal failure, exacerbating the debt crisis, threatening global peace and prosperity.

Elite hedge funds are navigating around this storm, but few are hitting home runs and some are suffering massive redemptions as losses pile on. It's an insanely tough environment for all active managers trying to work through the deflationary forces of the European debt crisis and the inflationary forces of unprecedented quantitative easing from global central banks.

My views haven't changed much in the last couple of years. I still maintain the 'power elite' will do whatever it takes to prop up the global financial system, reflate risk assets in an attempt to raise inflation expectations and squelch a Japanese-style deflation scenario, or even worse, a prolonged and dangerous debt deflation spiral.

Will central banks succeed or are they sewing the seeds of the next crisis? That remains to be seen but many hedge funds preparing for disaster are quickly realizing that the most powerful hedge funds in the world are run by Ben Bernanke and his global counterparts, and fighting them, betting on disaster, can lead to the road to ruin.

In fact, right now, think pension funds have a leg up on hedge funds, mutual funds and private equity funds. Why? Because they have a much longer investment horizon and can sit through this global storm, waiting for a recovery to realize gains on their public and private investments.

That's why pension funds are betting big on global real estate. The Canada Pension Plan Investment Board recently paid $445 million to acquire stakes in two major shopping malls in Australia that are undergoing transformations.

The manager of Canada Pension Plan’s investment portfolio also unveiled two deals on Friday – a 39-per cent-stake in Dorna, a Madrid-based marketer of motorbike racing, and a $400-million financing for Formula One Group, the company behind F1 auto racing.

Obviously, CPPIB isn't worried about Grexit, the end of Europe, a hard landing in China, or the US fiscal cliff.  They are investing huge sums in these private investments because they are confident that these deals will benefit their members over the long-term.

Are there reasons to be concerned? You bet. As the Fed basically handcuffs itself to a zero-rate policy until employment picks up significantly, I'm seeing the hunt for yield  lead to the resurgence of structured credit hedge funds and soaring dividend recapitalizations in private equity. All this leverage is creating systemic risk and if central banks don't pay attention, another financial disaster will strike, ensuring decades of deflation.

That's why it's crucial that European policymakers stop dithering and realize that their policies have hitherto been a total failure. Below, leave you with an RT interview with William Engdahl, who says all the measures the EU leaders are imposing are failing to address the core problems on the continent, paving the way to the Third Reich.

Also embedded a clip from a Guardian article discussing how in austerity-ravaged Greece, the neo-Nazi party Golden Dawn is on the rise. Think this is gross sensationalism, far from depicting reality in Greece where most people despise neo-Nazis and what they stand for, but the clip below shows the ugly side of austerity.

Finally, Hurricane Sandy barreled toward southern New Jersey after bringing a region with 60 million residents to virtual standstill and upending the US presidential race eight days before Election Day. For anyone who thinks this storm isn't serious, watch the clip below.


Sunday, October 28, 2012

The Paulson Disadvantage Minus Fund?

Kate Kelly of CNBC reports, Paulson Fund Losses Prompt Some Investors to Pull Out:
Last January, when investors in one of Paulson & Co.’s best-known hedge funds saw the value of their investments had been slashed in half, some wondered how much worse it could get.

Then by Sept. 30, there was an additional drop of 15 percentage points—with three months left to go in the year.

As a result, some Paulson investors—who gave the firm a pass last year when the riskier version of the firm’s umbrella fund, Paulson Advantage Plus, saw enormous losses—are now throwing in the towel.

Fed up with lagging returns at the hedge-fund management company, a number of investors large and small are opting to either reduce their capital at risk or yank it entirely by year’s end. 

It's the latest blow to fund manager John Paulson, who became famous in the investing world after he bet correctly on the collapse of housing prices in 2008.

"We expected, based on the way [Paulson] does things, that we're going to have periods of time where he's out of favor," said Craig Husting, the chief investment officer of the Public School and Education Employee Retirement Systems of Missouri, a pair of pension funds that have trimmed their investments in Paulson's Advantage Plus to a third of the original size over the past year and a half. "But just the beta - the volatility of his bets - is why we pared back."

With just days to go before an Oct. 31 deadline for investors who want to redeem their capital to notify Paulson, Husting may well be joined by a panoply of others.

They range from the private bank of of Citigroup (C), which revealed in August that it would claw back its funds (a process starting in 2013), to the 92nd Street Y, which people familiar with the matter said pulled its capital this year because of concerns about future potential losses and its investment mix.

Other significant players, including the brokerage arm of Morgan Stanley (MS), are considering pulling funds, but haven't yet made a final decision, people familiar with the matter said. (A spokeswoman for the 92nd Street Y didn't return calls for comment, and a Morgan Stanley spokesman declined to comment.)

Paulson, which is known for its aggressive, 25-person investor-relations team, isn't taking the reversals lying down.

"Recent performance in our Advantage Fund is disappointing and we understand investor frustration," said the firm in a written statement.

The firm noted that over the lifetime of the Advantage Funds, which were opened in 2004, Paulson had "far exceeded" both the event-driven hedge fund index and the Standard & Poor's 500-stock index (^GSPC), returning more than 10 percent annually.

It also noted that the vast majority of its current Advantage fund participants - 89 percent - have invested in it using gold as a currency, rather than dollars, an option Paulson offers to all its investors. In gold-share terms, the Advantage fund is flat for the year, the firm added, not down.

During the past year, Paulson has worked to appease worried investors.

Last winter, the company invited unhappy Advantage fund participants to move their capital into other Paulson funds while preserving their high-water marks. That meant that the former Advantage investors had the chance to participate in 100 percent of their new funds' profits, rather than the standard 80 percent, with the remaining 20 percent reverting back to Paulson management.

At the same time, Paulson set up a new risk-management structure that gathered for biweekly meetings and set new trading and leverage limits.

Ironically, though, it was some of the resultant hedges against a further credit crisis in Europe, as well as battered performances in Paulson's gold-miner portfolio, that have given the firm's Advantage funds trouble since.

Through Sept. 30, people familiar with the matter said, the Advantage Plus fund has fallen 15 percent, meaning that a dollar invested in it on Jan. 1, 2011, would be worth about 41 cents today. In the Advantage fund, the drop was roughly 10 percent, meaning that that dollar would be worth 57 cents today.

That fall has been equally pronounced in the firm's total assets under management.

Once $38 billion, the figure has fallen to nearly half that since early 2011, and now sits at nearly $20 billion, people familiar with the matter said.

Of that, about $12 billion belongs to John Paulson and his employees, creating what the firm described in its statement as "a very sticky capital base."

The firm also points out that on a capital-weighted basis, its funds are up an average of 2 percent this year.

Heartened by Paulson's tremendous wins during the recession and hoping 2011 was a one-off, many investors hung tight over the past year.

But an August announcement that Citigroup would remove Paulson from its internal hedge-fund platform, which initiated a $410 million redemption process, crystallized the doubts among some of the fund company's more patient investors.

"In my 20-plus years, I have never seen someone go from so high to so low in such a time period," said Brad Alford, who runs the Atlanta investment firm Alpha Capital Management and had originally invested about $10 million of his high net worth clients' money in Paulson. That figure, Alford estimated, is now closer to $3 million.

His frustration with Paulson is such that he's pulling out of a broader fund-of-funds platform entirely just to remove his capital from Paulson - even though the platform contains other funds he likes, such as DE Shaw's Oculus Fund, which is up by double digits so far this year.

"You just get so frustrated that you are done with the name, you are done with the manager, he's done something you can never go back from," Alford added. He's had better luck with mutual funds that employ hedge fund-type strategies with much more liquidity and a fraction of the fees, he said.
On Friday, I praised Paulson for hitting one of the few hedge fund home runs of the year, donating $100 million to the Central Park Conservancy. If you ever visited NYC, you'd understand why this park is so beautiful and must be conserved for future generations.

But Paulson's track record has been abysmal since making his extraordinary call betting big against subprime debt right before the crisis hit. As I've already discussed in the rise and fall of hedge fund titans, think the media played a big part in hyping up Mr. Paulson as being some sort of hedge fund 'god'.

He's clearly not as great as the media portrayed him to be and I've seen a lot of other managers who rose to prominence following a year of stellar (outlier) performance, only to fall back to earth as their performance lagged behind markets and their peers.

If I were to give Mr. Paulson some unsolicited advice, I'd tell him to get rid of his "aggressive, 25-person investor-relations team," and focus 100% of his effort on performance and where he's gone wrong. Like too many other hedge funds, waiting for disaster to strike again, he's been getting crushed. He has to step back and ask himself where his analysis is flawed. If all investors redeem and he is left with only employees' capital to manage, then so be it. Retrench, focus solely on performance and forget about marketing.

I'd give the same advice to other hedge funds suffering a similar fate but unlike Paulson, they don't have the deep pockets to survive the drawdowns and redemptions.  Most other hedge funds that are underperforming are going to close shop. A few of these managers will re-open new funds, most will not.

I look at Paulson's portfolio every quarter, along with those of other top funds. Think he's made some excellent moves (homebuilders, financials, insurance) but others (gold miners) leave me scratching my head. His big bet on Nexen might pan out but it's very risky (Alcan deal, or 'steal', left a bitter taste in Canada and many are skeptical that this deal will go through). Also, Paulson is a stock picker, not a global macro guy and the sooner he accepts this, the better off he'll be. He should focus on his core competency, not global macro calls.

As far as investors who are increasingly frustrated and looking to redeem from Paulson now, it's very late in the game. The time to have redeemed from Paulson was after his "stellar year," less so now. These funds of funds managing high net worth money are ridiculous, covering their asses because they were unable to determine the return drivers in Paulson's fund beforehand and protect their clients' gains.

Below, CNBC's Kate Kelly reports on how a wrong bet on Europe burned Paulson badly last year, so he shored up his risk controls and hedges. Moreover, a combination of hedging costs and battered gold-mining stocks have given his funds another bruising this year.

Saturday, October 27, 2012

The Vilification of the 1%?

Billionaire financier and Home Depot co-founder Ken Langone told Bloomberg Television's Trish Regan on "Street Smart" that he is "proudly part of the 1%":
Langone on his past:

"As a little boy, my first job was delivering newspapers and then I had a variety of different jobs. I worked in a butcher shop, I worked in a supermarket, I worked in construction. I dug ditches on the Long Island expressway in 1954, 1955, 1956. During my summers off from Bucknell, I was a day laborer and they were building the section of the expressway from the city line to Shelter Rock Road. That was the way that I was able to augment my needs for college. My parents did what they could do but I still had to work to help because it was only about $2,500 a year to go to Bucknell. Today it is $53,000 a year, which is kind of sad."

On whether it's frustrating to hear politicians talk about working Americans vs. the 1%:

"Let me say this loud and clear. I am proudly part of the 1%. I worked like hell to become part of the 1%. I don't want anything back for what about to say, but it also happened. By my virtue of Bernie, Arthur and I getting into the 1%, we bought 330,000 people along with us, the great Home Depot, great paying jobs to wonderful bright careers and futures. I was once part of the 99%. The goal of being in the 99% was to get not from the standpoint of the money, but the standpoint of the accomplishment, the standpoint of the satisfaction. The thing that I find tragic today--I don't know what the hell a conditional mortgage obligation is, I don't know what subprime debt is. I have never owned any of it. I have invested in companies, I have worked in companies, we have built companies, we have created jobs."

"I have been in Wall Street all of my life. I love it. It has been good to me. I know many wonderful, decent, honorable, ethical hard-working people that were in Wall Street with me. This vilification of what is going on in America today is disgusting. We're upside-down right now. Sure, things were done that were wrong. Sure, excesses happen. But there's plenty of blame to go around. There is Barney Frank, the Congress, who pushed the American dream that everyone should on a home. Now, everyone should not own a home. There is a lot of people that can't afford it. There are a lot of people who don't have a responsibility to own a home. The point of the notion that this is going to be the American dream, everyone was in the pool swimming and all of a sudden when it blew up, then you look around for scapegoats."

On whether it's more difficult for young people right now:

"I wish I was their age because the opportunities that are out there now are as good as they were as I've ever seen in all my life. They might be harder to identify, but they are there. But once you identify them and once you figure out what the human want is and you address that human want with the supply of whatever they need, you can do well. I don't buy into this notion. We will get through this period of experimentation with socialism. Do not buy into this notion. We will get through this time of experimentation. What would you call it? Take from the rich because the rich are bad? That's how I feel."

"Let me really play with a liberal's head. I don't know whether other people should or shouldn't pay taxes. I know I can, and I am willing, to pay more taxes. I know I should not get social security. I don't need it. I won, so don't give it to me. But if you want to do that to me, do it in a constructive way that what you take from me beyond you already get is sequestered to reduce this humongous debt that we have so these kids that have not been born yet aren't burdened by our lavish lifestyles."
Ken Langone raises some good points but fails to acknowledge other equally important ones. First, there are many good and ethical people on Wall Street. Problem is that the incentives are all screwed up and the relentless and myopic focus on short-term gain often leads to dangerous herding behavior which culminates in financial crises, wreaking havoc on the real economy.

Second, while I have nothing against the 1%, I worry about economic inequality and the decimation of America's middle class. There is no question that the ultra-wealthy pay a lot of taxes but they too have to do their part in bringing down the debt in a meaningful way. To be sure, the best way to bring down debt is by creating good jobs, expanding the middle class, but extending tax breaks on the 1% is simply irresponsible and will only exacerbate economic inequality which has already reached dangerous levels.

Third, while billionaires like Ken Langone don't need Social Security, millions of Americans rely on it to get by in their senior years. This is particularly true after the 2008 crisis which slaughtered 401(k) savings plans. Moreover, as more and more companies dismantle defined-benefit pension plans and offload pension risk to insurers, millions more will be facing pension poverty in retirement. This too will add to an already stretched social-welfare system.

Fourth, every generation has its struggles, but I worry about students graduating in this economy. To say that they have the same or better opportunities than the previous generation is utter rubbish. American students are graduating from college with record debt and are struggling to find jobs commensurate with their skill set.

Fifth, using the term "socialism" to describe the US economic system is laughable. Over $1 billion was spent on political ads in this election. Washington is all about money, power, Wall Street and disability. In fact, many argue that the system has become nothing but corporate welfarism as bailouts go to big banks and other large corporations, leaving the poor, unemployed and underemployed out to dry.

Finally, while I concede that the majority of the 1% worked extremely hard to get there, wish all these billionaires would acknowledge how damn lucky they are. From Bill Gates, to Warren Buffett, to Ray Dalio, to Ken Langone and whoever else enjoys the spoils of great wealth, never overlook the 'luck factor' in their lives. There are millions of others in the 99% who work just as hard, if not harder, and will never amass anything close to their wealth.

Below, Geeknet CEO Ken Langone talks about his life and career on Bloomberg Television's "Street Smart." Also embedded a Moyers & Company show where Bill Moyers is joined by Matt Taibbi and Chrystia Freeland to discuss the rise of plutocracy and how the super-rich have willfully confused their self-interest with America's interest.


Friday, October 26, 2012

Hedge Funds Belt Few Home Runs?

Gregory Zuckerman and Juliet Chung of the WSJ report, Hedge Funds Belt Few Home Runs:
They are the few. The proud. The hedge-fund managers making a killing this year.

David Tepper's firm was up about 25% through Friday, partly from a bet Europe will avoid a meltdown. Steve Mandel's firm gained nearly as much from soaring consumer and technology stocks. Pine River Capital Management rose 30% thanks in part to subprime mortgages, as did Josh Birnbaum's Tilden Park. And the Barnegat Fund has climbed over 39% with a debt strategy that the manager concedes isn't for the faint of heart.

The big gains, as reported by fund investors and people familiar with the firms, come as most hedge funds struggle for the fourth year a row, the longest period of underperformance since 1995 to 1998. Hedge funds on average gained 4.7% through September, according to industry tracker HFR, while stock-trading funds were up on average 5.5%. By comparison, the Standard & Poor's 500 index scored gains of 14%, including dividends, through Friday.

Many hedge funds have kept some money out of the market, concerned that "potential disaster scenarios" for the global economy "still lurk," says Greg Brousseau, founder of Central Park Group, which invests in hedge funds. This reticence hurt returns when the market rallied.

Driving the impressive gains at some of the year's big winners are a few distinctive—if sometimes risky—strategies.

Mr. Tepper's nearly $15 billion Appaloosa Management LP, based in Short Hills, N.J., is known for an expertise in distressed debt, and racked up over $7 billion in 2009 with bullish picks. This year, Mr. Tepper has scored approximately $3 billion of gains trading in and out of various stock, bond and stock-futures positions, according to an investor.

The firm began the year with a bullish stance, but sold positions when Greek elections raised questions about the future of the euro. Appaloosa bought again in late July after European Central Bank President Mario Draghi promised to "preserve the euro."

Technology and airline stocks, along with European company shares, also have helped Mr. Tepper's firm. According to the investor, Appaloosa remains bullish on global markets but wary of whether the Continent can keep its footing.

Mr. Mandel runs Lone Pine Capital LLC, of Greenwich, Conn., where he has made his mark betting on consumer-related companies. Since 2008, rivals have spent more time studying—and trading on—macroeconomic trends. But Mr. Mandel has stuck with traditional stock picking, according to an investor. This year, he's benefited from holdings of Apple Inc., AAPL up 51% in 2012; Gap Inc., up 91%; and Priceline.com, which has climbed 22%.

Some of this year's largest gains are coming from investors who bet on a housing recovery. Pine River was one of the first to make a huge wager on subprime mortgages, a trade placed about a year ago.

"It felt very lonely at the time, like we were the only ones doing it," recalls Colin Teichholtz a senior portfolio manager at the firm, which manages a total of $10.3 billion. Pine River continues to invest in subprime mortgages.

Tilden Park Capital Management LP is a New York hedge-fund started in 2008 by Mr. Birnbaum, former co-head of trading in the structured products arm of Goldman Sachs Group Inc. He was among those at the firm to become bearish on housing in early 2007, in time to place winning trades ahead of the housing collapse.

In a twist, Mr. Birnbaum turned optimistic on housing early this year, zeroing in on residential markets likely to recover markedly, according to people familiar with the firm. Tilden bought bonds backed by distressed home loans that stood to rise in a recovery and, in some cases, even a dip.

The firm, which managed about $1.1 billion through September, also was one of a handful that profited by taking the other side of J.P. Morgan Chase & Co.'s ill-fated "London whale" trades, which cost the bank more than $6 billion earlier this year.

London-based CQS LLP is also up, gaining 27.3% in its flagship fund through September, according to a person familiar with the $11.8 billion firm.

Bob Treue, founder of Hoboken, N.J.-based Barnegat Fund, is scoring gains trading Italian debt and other investments. His "relative value" strategy has capitalized on investors dumping holdings in recent times of panic.

Barnegat, which manages $617 million, uses heavy dollops of borrowed money, or leverage, in hopes of boosting returns—a similar approach to that used by Long-Term Capital Management, a hedge fund that famously collapsed in 1998, though Mr. Treue holds onto cash to prepare for any market downturn.

Mr. Treue is honest about his strategy's potential downside, which is one reason he hasn't seen a rush of investors to his fund. He recently sent a letter to potential investors listing 11 reasons not to invest with Barnegat, including the fact that it only has six employees. Mr. Treue says "99% of investors pass" after they read his warning.
Mr. Treue is a true trooper, no pun intended. He's one of the few who is not only outperforming but being 100% honest with potential investors about the downside risk of investing in his fund (watch interview below).

While there are exceptional hedge funds, most have lost the magic and are struggling to survive. What strikes me is how so many hedge funds have clamped down on risk worried about Europe, China, the US fiscal cliff, and whatever else the rest of the herd is looking at. On Wall Street, selling fear is good for business.

I remain bullish and view this latest pullback as another  buying opportunity. I'm particularly bullish on US coal stocks right now, adding to positions as people fret over tech results and what will happen with Europe and the US fiscal cliff. No matter who wins the elections, I remain bullish on coal companies.

But I'm not a big, swinging hedge fund manager charging clients 2 & 20 for beta or sub-beta performance. I'm just a blogger who calls it like he sees it. Most hedgies are overpaid asset gatherers who couldn't manage their way out of a paper bag. Same with private equity managers who are back at their old game of loading companies up with debt. They too are large asset gatherers delivering paltry returns.

Nonetheless, pension funds remain undeterred, increasing their hedge fund allocation despite the recent poor performance. This is good news for Igor, Yuri and Tatiana over at MCM Capital Management, hard at work preparing for the First Russian Hedge Funds Forum taking place in early December. You can be sure a lots of institutional investors horny for hedge funds will be attending that event looking for "Russian alpha."

All kidding aside, when will institutional investors and politicians finally get their collective heads out of their asses when it comes to hedge funds and private equity? As one NYT reporter laments, if primary-care doctors were taxed like hedge fund and private equity managers, there wouldn't be such an acute shortage of primary-care physicians in the United States.

As far as 'hedge fund homers', here are some of my favorites for 2012:
  • Reuters reports that Blackstone is preparing to launch a multibillion-dollar fund that will buy stakes in hedge fund managers in the secondary market, as traditional buyers such as banks pull back amid disappointing fund performance and regulation. Smart money is seeding hungry and talented alpha managers!
  • Forbes reports that billionaire hedge fund manager John Paulson has announced a pledge of $100 million to the Central Park Conservancy. When the pledge is fulfilled, the donation will be the biggest gift ever made to a public park. The gift will also be the largest made by Paulson in his second career as a philanthropist (blowhards like Donald Trump should take note).
And my favorite hedge fund homer of the year:
  • Reuters reports that Tom Steyer the billionaire founder of Farallon Capital, one of the world's biggest and best hedge funds, told investors on Monday that he plans to step down by year's end and become increasingly involved in philanthropy and politics.
Very smart man, he sees a future beyond hedge funds and knows the meaning of enough. I can assure you he won't be attending that Russian hedge fund conference or any other bogus hedge fund conference for the rest of his life (not that he ever went to these silly conferences).

Below, leave you with a long clip from the Economist Buttonwood Gathering 2012, featuring hedge fund managers Hugh Hendry and David Einhorn. While Tyler Turden and the rest of the turds over at Zero Edge couldn't stop praising Mr. Hendry and Mr. Einhorn for their "deep insights," I was hardly impressed (like David Einhorn but he's clueless on QE and Hendry comes off as a smug, arrogant gold shill who's full of it when he proclaims he's an agnostic existentialist).

Second, embedded a Bloomberg interview with Julian Robertson, founder and chief executive officer of Tiger Management LLC, talking about the hedge-fund industry, investment strategy and the outlook for the U.S. presidential election. Robertson, speaking with Tom Keene and Sara Eisen on Bloomberg Television's "Surveillance,"says hedge funds are 'scared'.

Third, embedded an interview with Bob Treue, founder and portfolio manager at Barnegat Fund Management, talking about the performance of his hedge fund, fixed-income arbitrage and investment strategy.  He speaks with Erik Schatzker and Sara Eisen on Bloomberg Television’s “Market Makers.”

Finally, Michael Platt, founder of hedge fund BlueCrest Capital Management LLP, talks about the sovereign debt market, investment strategy and global economic challenges. Platt speaks with Stephanie Ruhle on Bloomberg Television's "Market Makers."




Thursday, October 25, 2012

Ontario Downsizes Proposed Super Fund?

Mark Browlee of the Ottawa Citizen reports, Provincial Liberals announce 3 new pension agreements:
The Ontario Liberals say they have taken another step toward reducing their multi-billion-dollar deficit, this time by negotiating new public sector pension plans that freeze contribution rates for three unions.

The five-year rate freeze applies to both employers and employees of the Healthcare of Ontario Pension Plan, the Ontario Public Service Employees Union Pension Plan and the Colleges of Applied Arts and Technology Pension Plan.

They will save the province $1.5 billion over the next three years the government would have otherwise had to pay, said Bob Chiarelli, member of provincial parliament for Ottawa West-Nepean and the minister of Infrastructure, in a news release issued Wednesday.

It is the Liberals’ latest attempt at reining in a $14.8-billion deficit that has steadily grown since they took power nine years ago.

They imposed a wage freeze on teachers across the province at the end of the summer, while at the same time limiting their ability to strike. However, four of the unions representing affected employees have announced plans to challenge the legislation in court.

More recently the Liberals announced a pay freeze for about 500,000 workers, including civil service employees and those at hospitals, hydro companies and colleges.

Both opposition parties, the Progressive Conservatives and the NDP, have said they won’t be supporting the plan. The PCs have called the bill “weak” because it doesn’t apply to municipal workers such as firefighters and paramedics.

The impasse was Premier Dalton McGuinty’s stated reason for hitting the reset button on the provincial legislature last week through by announcing a controversial measure called prorogation.
In her article, Karen Howlett of the Globe and Mail reports, Ontario downsizes proposed super pension fund for public workers:
The Ontario government is considerably downsizing a proposed super pension fund that would manage the retirement savings of public-sector workers.

The government was planning to create a pooled fund to manage the pension plans for employees in community colleges, many universities and the province's largest public sector union. But under a new accord with the government, two of the pension plans have been exempted from becoming part of the proposed fund.

The super fund was to rank as the third-largest public sector pension plan in Ontario, with assets of $46-billion. But with two pension plans now out of the mix, its assets would shrink to just under $27-billion.

Finance Minister Dwight Duncan announced on Tuesday that the Ontario Public Service Employees Union Pension Plan and the Colleges of Applied Arts and Technology Pension Plan have each agreed to freeze their contribution rates for five years.

If there is a funding shortfall during that period, the pension plans would be required to reduce future benefits before increasing employer contributions. The two plans have combined assets of $19.3-billion.

The agreements demonstrate that the government can get work done even when the legislature is not in session, said Mr. Duncan, who vigorously defended Premier Dalton McGuinty’s decision to prorogue parliament indefinitely and derail committee hearings into two cancelled power plants.

“To listen to the opposition, you would think that MPPs only work when the house is in session,” Mr. Duncan said.

The pension plan accords, reached at a meeting on Monday evening, are part of the austerity measures Mr. Duncan unveiled in the budget last March to help the province tackle a projected deficit of $14.4-billion for this year. He said public-sector employees in Ontario will have to make higher contributions to their pension plans, have their benefits cut or work longer before they can collect retirement pay.

The Healthcare of Ontario Pension Plan, with assets of $40.3-billion, has also agreed to freeze contribution rates for five years. HOOPP, which was not to be part of the proposed super fund, got its own quid pro quo for agreeing to freeze contributions.

Currently, employees in HOOPP contribute 45 cents to the plan for every 55 cents from their employer. The government had planned to make employees subject to a 50-50 funding arrangement, HOOPP chief executive officer Jim Keohane said in an interview.

“They backed off on that,” he said.

Pooling pension would create economies of scale and reduce administration costs. But there has been considerable pushback from labour groups amid concerns that they would have less say in how their funds were managed. Officials at OPSEU and CAAT both expressed relief that they will no longer be forced to pool their assets.

“The agreement is a major victory over what was sure to be an all-out attack on retirement security for thousands of public sector workers,” OPSEU President Warren (Smokey) Thomas said on Tuesday.

However, the Canadian Union of Public Employees, another labour group, said the agreement with HOOPP is premature.

“Unanimous consent of all [the participants in the pension plan] is required and CUPE is not in agreement,” it said in a statement.

A spokeswoman for Mr. Duncan said the government still plans to create a pooled fund to manage university employees’ pensions as well as the $12-billion fund set aside to safely store decommissioned nuclear reactors. The government is also looking at creating a pooled pension fund with assets of just under $15-billion for employees of the province’s four electricity utilities, including Hydro One and Ontario Power Generation.

Mr. Duncan said the agreements with the three funds to freeze contribution rates will generate savings of $1.5-billion over three years for the province, but they will not show up in this year’s budget.

The agreements do not address “the real and pressing need” for a public sector wage freeze,” said Progressive Conservative MPP Peter Shurman in calling on the government to restart the legislature.
And Jonathan Jenkins of the Toronto Sun reports, Ontario eyes freezing its pension plan contributions:
Ontario could avoid costs of up to $1.5 billion within three years by freezing the amount it will contribute to three pension funds, Finance Minister Dwight Duncan said Tuesday.

“If you remember in the budget, I said the default for pension shortfalls would no longer be increases in contributions but decreases in benefits — if needed,” Duncan said. “This will allow us to avoid up to $1.5 billion in costs over the life of the agreement.”

The three pensions include the Healthcare of Ontario Pension Plan (HOOPP), the Ontario Public Service Employee Union Pension Plan, and the College of Applied Arts and Technology Pension Plan — although the Canadian Union of Public Employees said an agreement on HOOPP is not yet finalized.

“This is a very strange way of doing business,” Michael Hurley, the president of CUPE’s hospital union council, said, adding Duncan was moving with “unseemly haste” to announce a deal.

CUPE, though, has no objection to freezing employer contribution rates and it’s unlikely to derail the agreement.

Duncan said the HOOPP board had signed off on the agreement and getting CUPE to accept the deal was an “internal” matter.

Finance officials said the three pensions together are worth about $70 billion and have 240,000 active pensioners. It doesn’t extend yet to the Ontario Teachers Pension Plan, worth $117 billion and with 170,000 pensioners, although Duncan said if an agreement can’t be reached with the plan’s board, legislation is an option.

The need to make the changes was laid out by economist Don Drummond in his February report on how Ontario could reform its public services, Duncan said.

“Drummond said the fastest growing line item in our budget is pension costs and it’s expected to rise quite considerably over the next five years,” Duncan said. “This allows us to avoid that. It will allow for the continued sustainability of these plans.”

Progressive Conservative finance critic Peter Shurman said the $1.5 billion in costs “avoided” doesn’t affect Ontario’s deficit as it stands.

“The fact of the matter is that $1.5 billion does not impact the people of Ontario in any meaningful or near-term way,” Shurman said.
I agree with Peter Shurman, these proposed changes won't make a material impact on Ontario's ballooning deficit in the near-term but faced with soaring deficits, the government decided to act and go after pensions.

These austerity measures mean public sector employees in Ontario will have to make higher contributions to their pension plans, have their benefits cut or work longer before they can collect retirement pay.

As far as downsizing the proposed super fund, few details were provided in the Globe article above as to why officials at OPSEU and CAAT both expressed 'relief' that they will no longer be forced to pool their assets except to say that there was 'pushback' from labour groups amid concerns that they would have less say in how their funds were managed.

I am of the view that pooling assets isn't easy but it creates economies of scales and reduces administrative costs. Those labor groups might want to seek solid independent advice on the pros and cons of pooling assets because longer-term, I'm of the view their plan members would be much better off being part of a large, well-governed plan.

As far as HOOPP, these new measures won't impact their plan. They led their peers in Canada, up 12.2% in 2011, and enjoy the enviable position of being fully funded. If they can maintain this fully funded status by properly matching their assets and liabilities, they will not need to raise the contributions for HOOPP employees to a 50-50 funding arrangement.

That leaves the Ontario Teachers' Pension Plan, another world class plan that also delivered stellar results in 2011. In a recent comment on the Oracle of Ontario, I discussed how OTPP uses the lowest discount rate in the industry, 5.4%, reflecting the older demographics of its plan. Some experts have told me this low discount rate is "too conservative" and "overstates" the true liabilities of that plan. If the board doesn't  reach an agreement with Ontario's teachers, legislation will likely be enacted, and tensions will mount.

Finally, I was struck by a letter published in the Chronicle Journal by Louise Fisher, OPSEU retiree, who states the following on leaving pensions alone:
I understand that prior to proroguing parliament, the Ontario government was moving toward pension reforms that would ultimately see control of our public service pensions turned over to corporations, despite the fact that they are very well-managed and quite stable as is.
It’s no secret that governments at all levels are vigorously seeking new and creative ways to save money and to pay down ballooning deficits. But this has led to a disturbing trend in which it is becoming increasingly popular to mess with the very lifeblood of ordinary citizens.
To take such unnecessary risks with something that’s taken an individual a lifetime to build, and is essential to the very survival of many senior Canadians, is unconscionable. It is not only morally and ethically wrong, in my opinion, but amounts to nothing less than theft.
I have had to work well over 30 years for my modest income, and like so many other public- and private-sector employees I paid dearly into that pension believing that it would be there to sustain me in my senior years.
Clearly, Ontario’s governments over the past 50 years have ignored, and failed to plan for the “grey tsunami” that they knew would eventually come and is now hitting Canada in a big way. Instead, our elected officials squandered or mismanaged many of the tax dollars seniors paid out over the past half-century that should have gone into affordable senior public housing, long-term care facilities, and many other health-related and socially relevant services that are shamefully lacking in Ontario today.
That being the case, it is even more imperative that seniors retain what pension funds we currently receive in order to help us stay as healthy as possible, and in our own homes for as long as possible (those of us who are fortunate enough to have one, that is).
I therefore implore you and your colleagues to leave our pensions alone, and not to take action that could exacerbate an already dire situation. To do otherwise is to risk the anger of all seniors who vote in much larger numbers than ever before!
Whether or not you agree with Louise Fisher, she eloquently states the point that she and millions of other workers with modest incomes have contributed 'dearly' into their pension believing it will be there to sustain them in their senior years. When we mess with pensions, we break a sacred promise.

More worrisome, if governments and corporations continue cutting defined-benefit pensions, they will be condemning millions to pension poverty. That's when you will really see deficits ballooning out of control.

Below, leave you with Yanis Varoufakis's latest interview on Australian television on how the middle class in Greece is being decimated by austerity programs. Don't agree with everything Varoufakis states but this interview is a must watch for Canadians who take far too many things, including education, healthcare and pensions, for granted.

Wednesday, October 24, 2012

Private Equity Eyes Dividend Recaps?

Michael Stothard and Dan McCrum of the FT report, Private equity eyes dividend ‘recaps’:
Private equity firms are looking to cash in on the latest rally in the European corporate debt markets by borrowing at low cost against their investments to pay themselves dividends.

So-called “dividend recapitalisations” by private equity groups, which were a prominent feature of the pre-crisis boom years, are showing signs of returning on the back of increased demand from investors for riskier forms of corporate debt.

RAC, the UK car breakdown service, on Tuesday closed the books on a £260m term loan intended to help pay a special dividend to Carlyle, which bought the company in June for £1bn. Also expected is a similar €250m deal by Birds Eye Iglo, the frozen foods business owned by Permira.

Bankers say there are about 10 more European deals being discussed that might come to market in the coming months. “Interest in dividend recaps has grown very quickly post the summer as market conditions continue to be strong,” said Jason Bruhl, head of European high-yield syndicate at Citi.

The market for dividend recaps has already seen strong growth in the US in recent months, with 14 debt-financed dividend recapitalisations worth a total of more than $5.5bn in the third quarter. In just a few weeks since the start of October there have been a further nine bond-based deals worth $6.6bn.
Dividend recapitalisation deals now represent about 25 per cent of the total US leveraged loan and high yield bond market by volume, according to data from Standard & Poor’s LCD, with private equity firms including Leonard Green, Bain Capital and CVC Capital coming into the market.

“If there is a business that is relatively unlevered, dividend recaps make sense today given where the debt markets are,” said Lionel Assant, senior managing director and European head of private equity for Blackstone.

The rise in the number of dividend recaps round the world comes as buyout groups face a tough market to sell their investments. Strategic buyers remain wary, while initial public offerings from private equity-backed companies are running at about a third of the amount raised in 2011.

“You can’t exit, you can’t do a public offering, it’s a way to take the pressure off,” said one private equity executive, adding that as long as investor flows continue to favour fixed income over equities, raising money in the debt markets to fund distributions is likely to continue.

The market for dividend recapitalisations in Europe is now growing, although is unlikely to reach the same heights as in the US. “Traditionally, European investors have been a little more cautious in their approach to these deals,” said Mathew Cestar, head of leveraged finance in Europe at Credit Suisse.

But Europe is still on course to record the highest number of dividend recap loans since the crisis, with $4.4bn-worth done in the first three quarters compared with $4.8bn in the whole of last year, according to Dealogic. This is short of the nearly $40bn in 2007, however.

Waves of dividend recapitalisations have proved controversial, with buyout groups accused of loading portfolio companies with debt to pay themselves big profits. Investors say this time round sponsors are being more cautious.

“The recaps you see today are generally at more reasonable credit multiples than we saw in 2007, but they are still more aggressive and more numerous than any other time in the past few years,” said Jonathan Butler, European head of leveraged finance at Pramerica Investment Management.
The WSJ also reported on how debt is fueling a dividend boom as private equity firms are adding debt to the companies they own in order to fund payouts to themselves, a controversial practice now reaching a record pace:
Leonard Green & Partners LP, Bain Capital LLC and Carlyle Group LP are among the firms using the tactic, which rose in popularity before the financial crisis.

In these deals, known as "dividend recapitalizations," private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups.

The resurgence has been helped by investors' appetite for high-yielding debt at a time of historically low interest rates.
While this practice is controversial, private equity managers argue that dividend recaps make sense in a flat economy. Matthew Bristow, Managing Director of ClearRidge Capital, wrote an article a couple of years ago on how dividend recapitalizations act as cash alternatives for private equity:
For those Private Equity Groups (PEGs) that own a strong portfolio company with high earnings and relatively low debt, they are increasingly turning towards dividend recapitalizations rather than selling ownership in their portfolio company in the short-term.

Before we go any further, let’s clear up the definition of a dividend recapitalization (recap). It occurs when the owner of a company, typically a PEG, as a preferred stock holder, issues new debt to pay a special dividend to their limited partners who provided the cash to fund the initial acquisition of the portfolio company.
A dividend recap is an alternative to way of realizing cash, other than selling the company or trying an IPO. For example, a PEG that invested $10 million cash in acquiring a company, may choose today to pull out $10 million cash in a dividend recap.

In the simplest terms, this is a bonus for the preferred stock holders who backed the acquisition, but it also increases the debt load on the company, and hence increases default risk for creditors and common shareholders, but as with many financial tools, we need to understand more to determine the advantages and disadvantages for all parties.

One thing is certain, however – the dividend recap is becoming an increasingly popular tool for PEGs in a flat economy.

Some of the motivations for a dividend recap:

1) Sell – Alternative A: Selling the company today may not yield the highest price and desired return on investment – if the business has a real opportunity to grow sales and earnings in the coming year or so, many PEGs and common shareholders would rather wait and sell for more money in 2011 or 2012, while focusing on growth initiatives in the meantime.

2) IPO – Alternative B: In the current market, an IPO is often risky and unpredictable, so fewer PEGs are choosing this route as the ideal exit.

3) A dividend recap allows the PEG to pull out money they initially invested while retaining the same ownership in the Company. If this seems confusing, you could consider the example of pulling $100k cash out and remortgaging your home after it went up in value. You are still the 100% common shareholder (owner) of your house, but you now owe the bank a higher principal amount. And just to confuse matters, it is possible that the loan to current value could be lower than when you bought your house, because of an increase in the home’s value, so it does not necessarily increase the leverage on the home from when you originally bought it.

4) There may be tax advantages for the PEG’s limited partners compared to a sale of the company, which is partly dependent on changes in the qualified dividend rate and changes in rules on taxing carried interest.

5) High yield bond financing is historically cheap for those firms that qualify, so interest payments are relatively low. If, however, principal and interest payments increase significantly, the CFO is going to have a tougher time, as there will be less cash available for capital expenditures to grow the company. Tighter cash flow also reduces the margin for error in financial projections, budgeting and planning.

Good news for companies that were acquired by a PEG that is considering a dividend recap:

i) A dividend recap is only available to higher quality, stronger performing companies, so if you’re in this group, you’re company’s performing well;

ii) the default rate for companies that underwent a dividend recap was only 6%, compared to 11% on average for the original LBO that funded the acquisition in the first place*;

iii) the PEG would not attempt a dividend recap unless they were confident that the company would result in a higher sale price in the future, which benefits all shareholders;

*according to a 11/19/10 CFO.com article for deals in the late 1990s and early 2000s.
But not everyone is convinced that dividend recaps are the way to go and some limited partners are dead set against this practice. Back in April, Fortune published an article by Dan Primack, Obama and private equity: Friends or foes?:
Many private equity investors are convinced that President Obama is their enemy, not only because he wants to defeat former Bain Capital boss Mitt Romney in November, but also because of a new corporate tax reform proposal that could make private equity deals more difficult to finance.
The industry's most dangerous enemy, however, is not in the White House. It's in the mirror, due to private equity's pervasive use of dividend recapitalization -- a noxious financial strategy that perverts the industry's mission and threatens its future ability to raise capital.

Here's how it works: When a private equity firm buys a company in a traditional leveraged buyout, it typically uses bank loans to finance much of the purchase price. Since the company being acquired takes out the bank loans, it's the one on the hook for future interest payments -- not the private equity owner. The extra twist comes when, often years later, private equity owners instruct the company to take out even more bank loans. Those proceeds are then funneled to private equity investors in the form of a "dividend," rather than being used for corporate purposes like buying new equipment or hiring new employees.

In most cases, companies can handle the extra debt load. But sometimes the interest payments become unbearable and the company folds, as in the case of Bain's investment in medical diagnostics specialist Dade International. Not only did private equity not increase the company's value, but its actions actually helped destroy value.

Even when the company survives, it's difficult to argue that the added debt has contributed to anything other than private equity's bank balance. And calling it a "dividend" is just plain deceitful, since dividends are supposed to come from legitimate earnings.

According to Standard & Poor's, there was more than $28 billion in dividend recap activity last year and nearly $7 billion during the first two months of 2012 (has since soared to $54 billion). That's just a small fraction of overall private equity activity, but it still represents an unacceptable burden on companies whose only crime was to be acquired by firms that talked a big game about "value added."

So what can be done to stem the tide? The best solution would be self-policing. Unfortunately, that would be like asking kids to choose apples over miniature candy bars while trick-or-treating. That leaves government intervention -- not a prohibition against dividend recaps, but tax policy that would discourage their use.

Last month President Obama proposed a corporate tax reform package that would, in part, stop encouraging corporations "to finance themselves with debt rather than with equity." Among the proposed fixes was an unspecified reduction in the amount of interest that companies are allowed to claim as a tax deduction (now 100%). Depending on the specifics -- and possible exceptions, such as for small-business loans -- such a move could make private equity firms much less likely to engage in dividend recaps by increasing the cost of such capital.

Obama's proposal may sound like an attack on private equity, but it's not quite that simple. While dividend recaps are quick and easy money for the industry, they're bad for business in the long term. Investors in private equity funds -- including public pension systems -- have begun talking a lot about "sustainable" investments, rather than just buy, sell, and move on. These investors also have large public equity portfolios and don't like the idea of private equity removing value from companies that may be taken public, or killing a company, which contributes to unemployment and helps trigger larger macroeconomic troubles. These influential investors could reduce their private equity allocations if they see it happening too much.

So if President Obama's primary goal was to destroy private equity, he might try to encourage even more dividend recaps. Luckily, for all involved, he's doing the opposite.
Influential investors, including large endowments and large public pension funds, have been scaling back on private equity allocations, not because of dividend recaps, but because of poor performance.

In fact, the University of Oxford's investment chief, Sandra Robertson, recently startled the audience at the British Private Equity and Venture Capital Association’s annual summit, accusing managers of failing their clients by charging excessive fees and delivering lacklustre returns:
“Why on earth as a rational investor would I allocate blindly to private equity?” she asked, in a speech calculated to provoke debate among quiescent private equity investors as much as those handling their money.

“We need proof that the time and resources required to invest in private equity is worthwhile. You need to earn your place in our portfolios,” she told the audience at London’s Landmark hotel.

As chief executive of the Oxford Endowment, one of Britain’s more discreet investors, she oversees £1.5bn of assets, including £200m in private equity funds, which have been among the university’s most successful investments. The endowment’s private equity holdings rose 10 per cent in value last year.

Before taking over the endowment five years ago, Ms Robertson was co-head of portfolio management at the Wellcome Trust, another of the UK’s largest institutional investors.

Speaking after some of the industry’s most prominent figures, Ms Robertson said that it had in recent years changed significantly and become a “pain” to invest in. “There is no longer an alignment of interests,” she said. “Entrepreneurs have been replaced by brands and partnerships by organisations.

“It is a battle to get in: fundraising, the legal documents with pages and pages of legal jargon designed by lawyers only to be interpreted by lawyers, the endless legal extensions. And that’s before you’ve even tried to begin calculating carried interest.

“And even once you’re in the partnership you have to deal with GPs falling out, when they stop talking to each other, the endless legal extensions, the fund extensions and figuring out all the fees.”

In one particularly pointed remark, Ms Robertson asked a rhetorical question of William Conway, the co-founder of the Carlyle Group, who spoke before her at the summit.

“Bill, if you’re in the room, I can understand why Carlyle kept the preferred return at 8 per cent,” she said. “Where is the economic generator in Carlyle? It’s not in the carried interest, it’s in the fees.”

Ms Robertson declined to comment further on her speech.
Ms. Robertson is a smart lady, one that clearly understands that big 'brand name' private equity funds have become a big pain in the ass. They have ceased being hungry entrepreneurs looking to unlock value in companies and have instead become large asset gatherers, collecting huge fees, delivering paltry returns. I can say the same thing about hedge funds that have long lost the magic.

Of course, the industry was quick to respond to Ms. Robertson's allegations. Mark Florman, Chief Executive at the British Private Equity and Venture Capital Association, sent a response to the FT stating that private equity is not judged on fees:
Sir, While your reporting (October 19) of the University of Oxford investment chief’s remarks at the British Private Equity and Venture Capital Association’s recent summit was an accurate reflection of what was said, it failed to identify why investors choose to put their money into private equity: the returns private equity investments generate are a more important factor than the management fees earned by private equity firms.
Private equity firms are judged by, and grow as a consequence of, the profit they deliver to investors, and not on their management fees as suggested by Sandra Robertson. The alignment of interests arising from carried interest being a share of realised capital gains is one of the critical reasons that the private equity model has endured so successfully.

Figures published in the UK by the BVCA show both the average since-inception and 10-year rates of return generated across the industry were 14.3 per cent. These figures are based on our annual survey covering 97 per cent of our eligible membership, and provide the most comprehensive picture available of performance within the UK industry. In comparable terms over the past decade, total pension fund assets have returned 5.9 per cent (as measured by the WM Company), while the FTSE All-Share has returned just 4.8 per cent.

It is this outperformance that is the defining characteristic of private equity in the UK, and the prime contributor to the growth of the industry both in the UK and globally: as a simple measure of why so many limited partners invest in the sector, the BVCA’s membership now accounts for more than £200bn of investors’ assets under management in the UK. The robust nature of the private equity model may explain why it has been the outstanding element in the annual reports of so many investors, including, not least, Oxford university itself.
I'm not terribly impressed by this response and doubt it impressed most of the sharp institutional investors I know in private equity. True, private equity has a high hurdle rate, much higher than hedge funds, but it also carries all sorts of risks that accompany illiquid investments, and institutional investors are right to question their private equity investments, scrutinizing their returns and fees.

Below, Bloomberg's Cristina Alesci talks about companies working with private equity taking on more debt. She speaks on Bloomberg Television's "Money Moves." Ms. Alesci also spoke with Pimm Fox on Bloomberg Television's "Taking Stock," explaining why private equity is under pressure to show value.