Pension360

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Devin Banerjee of Bloomberg reports, Rubenstein Says Private Equity’s Fees, Investors Have Changed:

The private equity industry has changed the most in decades as its investor base evolves and clients demand more fee concessions, Carlyle Group LP’s David Rubenstein said.

“The industry has changed more in the four or five years since the crisis than in the previous 45 years,” Rubenstein, Carlyle’s co-founder and co-chief executive officer, said Sunday on the television program “Wall Street Week.”

From the 1970s to early 2000s, public pension plans were the biggest investors in the industry, said Rubenstein, who started Washington-based Carlyle in 1987 and has expanded it to manage $193 billion. Private equity firms use the money they collect to buy companies and later sell them for a profit. Today, sovereign-wealth funds are overtaking pensions in allocating money to the firms, of which Carlyle is the second-biggest, he said.

Large investors and those who commit early to funds are also able to extract discounts on the fees they pay the buyout firms, Rubenstein said, whereas in the past all clients were charged the same percentage on their committed money.

In addition, big clients are increasingly seeking separately managed funds with the firms, rather than solely committing to commingled funds with other investors, he said.

Retirement Money

Rubenstein, 65, said the “great revolution” coming to the industry will be the ability to add non-accredited investors, or those with a net worth lower than $1 million or those earning less than $200,000 a year. Regulations of fund structures should change to allow such people to put some of their retirement savings in private equity vehicles, said Rubenstein.

“Wall Street Week” is produced by SkyBridge Media, an affiliate of SkyBridge Capital, the fund-of-funds business founded by Anthony Scaramucci. SkyBridge, which sometimes has other business relationships with the show’s participants, advertisers and sponsors, pays Fox stations in key markets to broadcast the show and also streams it online every Sunday at 11 a.m. in New York.

I’m not sure about the “great revolution” Rubenstein is talking about in terms of non-accredited retail investors being able to invest in private equity. In my opinion, retail investors are better off investing in the shares of PE giants and staying liquid, but the three biggest private equity firms posted lower second-quarter profit after U.S. stocks slipped for the first time since 2012, a harbinger of things to come.

I do however agree with Rubenstein on the changing landscape in terms of large institutions and fee compression.

In fact, large pensions and sovereign wealth funds are increasingly trying to avoid private equity fees altogether. Last week, the Wall Street Journal reported that Dutch pension-fund manager PGGM teamed up with investors including sovereign-wealth funds for the €3.7 billion ($4.06 billion) takeover of a car leasing company to help its drive to reduce the hefty fees it pays to private-equity firms:

The acquisition of LeasePlan Corporation NV from German car maker Volkswagen AG and Fleet Investments is PGGM’s largest direct private-equity transaction, according to PGGM spokesman Maurice Wilbrink.

The Dutch fund has been building its in-house team to invest in companies directly, alongside private-equity firms and other investors, after selling its private-equity investment unit in 2011. Investors from the Canada Pension Plan Investment Board to Singaporean sovereign-wealth fund GIC are increasingly seeking to buy assets directly, rather than just through private-equity firms. Several pension funds have publicly voiced their concerns over the level of fees charged by the private-equity industry.

By acquiring companies directly, PGGM avoids paying private-equity firms annual fees of between 1% and 2% of the money invested. It also avoids the 20% fee known as carry that private-equity firms keep from the sale of profitable assets.

Most of the money that PGGM manages is on behalf of PFZW, a pension fund for Dutch nurses and social workers. In 2014, PFZW paid €445 million of fees to private-equity firms—more than half of its €811 million fee bill to money managers. Yet private equity only accounts for €9 billion, or 5.6% of PFZW’s €161.2 billion of assets, according to its annual report.

“We are looking at all kinds of ways to lower management fees and also performance fees,” Mr. Wilbrink said. “We think the private-equity sector should lower its fees and should accept that more money should go to the beneficiaries because they are the capital providers and it’s their money.”

PGGM also makes its own infrastructure investments to avoid paying fees to infrastructure funds.

PGGM is buying LeasePlan in partnership with Singaporean sovereign-wealth fund GIC; the Abu Dhabi Investment Authority, or ADIA, also a sovereign-wealth fund; ATP, Denmark’s largest pension fund; the merchant-banking unit of Goldman Sachs ; and London-based private-equity firm TDR Capital LLP.

GIC, ADIA and ATP are also part of the trend among traditional investors in private-equity firms to increasingly invest directly in takeovers of companies.

The investors will pay for the acquisition with an equity investment equal to about half of the purchase price, a convertible bond of €480 million and a loan of €1.55 billion, LeasePlan said in a statement. Unlike in a traditional private-equity-backed leveraged buyout, the debt won’t be secured on the company that is being acquired.

“None of the debt raised by the Investors would be borrowed by LeasePlan and the company would not be responsible for the repayment of such debt,” LeasePlan said.

LeasePlan reported net income of €372 million in 2014, operates in 32 countries and has a workforce of more than 6,800 people.

Talk about a great deal and unlike private equity funds, large global pensions and sovereign wealth funds which invest directly in private equity have a much longer investment horizon and aren’t looking to load their acquiring companies with debt so they can profit from dividend recapitalizations.

No wonder private equity funds are worried. They know they’re cooked, which is one reason why they’re trying to emulate the Oracle of Omaha to garner ever more “long term” assets and continue to steal from clients now that times are still relatively good.

What else? Amy Or of the Wall Street Journal reports that in what may be a sign of intensifying competition for assets, several private equity firms are dipping back into old investments:

“More and more sponsors are paying up where they think they have a material informational advantage,” said Justin Abelow , a managing director of financial sponsor coverage at investment bank Houlihan Lokey Inc.

Private equity firms, armed with $1.2 trillion in uncalled capital, need to fend off peers and strategic buyers in the fierce pursuit of assets. Standard & Poor’s Capital IQ Leveraged Commentary and Data said that as of the first half of the year, the average private equity purchase price multiple crept up to 10.1 times the target company’s trailing earnings before interest, taxes, depreciation and amortization, topping a historical high of 9.7 times in 2007.

As we report in the July issue of Private Equity Analyst, some firms looking for an edge in deals are taking a trip down memory lane.

Cleveland’s Riverside Co., for example, in May bought for a second time Health & Safety Institute, a provider of training materials and cardiopulmonary resuscitation courses. It previously owned the business between 2006 and 2012.

Partner Karen Pajarillo said her firm “didn’t have as much of a learning curve as others who are new to the business,” though HSI’s mix of revenue has changed over the years to include more online learning material.

Advent International is donning yoga pants once again, acquiring nearly 14% of yoga-gear maker Lululemon Athletica Inc for $845 million last year. The New York firm invested growth capital in the Canadian apparel company in 2005 at an enterprise value of 225 million Canadian dollars, taking the company public two years later in a $327.6 million offering. Lululemon share prices have risen by about 55% since Advent’s second investment in the company.

Revisiting old investments has proved profitable in the past for some firms.

San Francisco firm Friedman Fleischer & Lowe made a 10-times return on foam-mattress company Tempur-Pedic International Inc . in 2006 when it exited the $350 million investment it made in 2002. The firm reinvested in the company in 2008, re-exiting in 2011 at a 3.3-times return.

But second time isn’t always a charm, and firms must stay mindful that times change and the formula used previously may not work again, private equity executives said. Charterhouse Capital Partners lost control of U.K. washroom services provider PHS Group after the company was taken over by lenders. Charterhouse took PHS public in 2001, before taking it private again in 2005.

The second time around is definitely not always a charm. The market is a lot more competitive now as strategics are flush with cash and overvalued shares.

Lastly, I agree with Becky Pritchard of Financial News, it’s the end of the private equity superheroes:

Quiz time. Who runs BC Partners? Who is the chairman of the British Private Equity & Venture Capital Association? And who is the top dog at Cinven?

If you drew a blank with any of those questions, you are not alone. The private equity industry, once the domain of larger-than-life characters, is full of curiously understated individuals these days.

Most of the buyout pioneers that founded Europe’s private equity industry have retired over the past decade. Men like Apax Partners’ Sir Ronald Cohen, CVC Capital Partners’ Michael Smith, Charterhouse Capital Partners’ Gordon Bonnyman, Permira’s Damon Buffini and Terra Firma’s Guy Hands got outsized returns for their investors and often had outsized personalities – charismatic, bombastic or just plain mouthy.

But, for the most part, they have stepped back to be replaced by committees and a generation of top executives with a lower profile. This new generation are more bureaucrats than entrepreneurs.

Industry roots

Thomas Kubr, managing director of investor Capital Dynamics, said he “absolutely” thought that Europe’s private equity leaders had changed in style over the past decade. Part of that was down to the early roots of private equity, he said: “The industry was started by people who never in their life thought they would be doing private equity because they had no clue what that was. Now you have entire career paths structured around the industry.”

Many of Europe’s biggest private equity firms began life in the banks. They were staffed by smart people that the banks were not sure what to do with, according to Ian Simpson, founder of placement agent Amala Partners, who has worked in the industry for 27 years.

The first industry leaders were the ones deemed by the banks to be “too dangerous to lend money but too bright to stick in HR”, he said.

Those years were a heady time for private equity: it was still almost a cottage industry and deal-doers were able to score blockbuster returns. Guy Hands made around £3 billion profit working for Nomura in the 1990s, for instance. Under Bonnyman’s leadership, Charterhouse invested €73 million in UK government leasing company Porterbrook in 1996, eventually getting a $481 million profit when it flipped it a year later.

In 1996, under Cohen’s leadership, Apax built up a 33% stake in Cambridge-based software company Autonomy, later selling its holding during the technology bubble of 2001 for a capital gain of more than £1 billion.

After pioneering the techniques used on buyouts at the banks, many of these trail-blazers decided to spin out and start their own firms. Buffini led the management buyout of Permira from Schroders Ventures Europe in 2001, Bonnyman led the spin out of Charterhouse Capital Partners from HSBC in 2001 and Hands left Nomura’s principal finance arm to set up Terra Firma in 2001.

New leadership style

Over the early 2000s, those new firms grew rapidly from small operations into huge asset managers with money pouring in from investors. Returns also began to slide as more players entered the market and the business became more institutionalised.

In the years around the financial crisis, many of the founders handed the reins over to the next generation of leaders or even groups of leaders, many of whom had lower public profiles than their predecessors. Cohen stepped back from running Apax in 2004, handing over to Martin Halusa; Buffini handed control of the firm to Kurt Björklund and Tom Lister in 2007; and Smith retired as chairman of CVC in 2012, handing control to Rolly van Rappard, Donald Mackenzie and Steve Koltes.

Antoon Schneider, a senior partner at The Boston Consulting Group, said the new generation were more managers than entrepreneurs but that a different financial environment called for a fresh style of leadership.

He said: “The great deal guys became the founding partners of the industry. The best dealmakers got to the top but now, with the second generation, it’s less about that. They are less entrepreneurs than they are managers. These are now larger, more complex organisations and the fact that you aren’t necessarily in a high-growth environment, you could argue that calls for a different kind of leader.”

A focus on the institution rather than on the individual is now reflected in the agreements made between investors and the buyout firms, known as limited partner agreements. These documents traditionally named one or two “key men” – if these named individuals left or died, investors could put investment from the fund on hold. These days there are usually a large group of key men mentioned in fund documents, reflecting how much more institutionalised and less focused on individuals the asset class has become.

Is the industry missing out on the entrepreneurialism of the early mavericks? Simpson said investors now want consistency from their managers rather than the bursts of genius that became the mark of the old guard.

He said: “They were a bit more entrepreneurial. The people in private equity come from a much more consistent background now. Everyone is a lot more interested in process and repeatability. Investors push that way.”

Jim Strang, a managing director at Hamilton Lane, thinks this change in leadership style has been a positive step for investors and has made the industry more professional. He said: “As PE firms have evolved, they have become large, complex businesses in their own right. The tools that you need to be a great business manager are different to being a great deals professional. So the fact that you have a different look and feel is probably a good thing.”

Minimising risks

He added that the new generation of leaders were more focused on how to run their firms and grow their businesses than their traditional deal-doing forefathers. He said: “The industry is way more competitive, way more sophisticated and developed than it was back in the day. They have got much better thinking about how to institutionalise their business to make it less risky.”

Perhaps the change was inevitable. As the industry has matured, it is natural for the focus to shift from the individual to the institution. But it does mean that many of the largest firms have become faceless behemoths that are tricky to tell apart.

Kubr summed it up: “You’ll find it in any industry. You get the true pioneers who develop a lot of the structures – but what comes afterwards is that you have to get professionalised. I guess I would say it’s neutral. It’s just a different style.”

The institutionalization of private equity, hedge funds, real estate, infrastructure is changing the landscape for the large alternative shops and placing ever more pressure on funds to tighten compliance and align their interests with investors.

Moreover, markets are changing faster than ever and private equity firms that fail to adapt to this new environment are going to be left behind. What I see happening in the future is a bifurcation in the private equity industry where the giants get bigger by collecting more assets from large pensions and sovereign wealth funds but their returns start sagging as competition heats up in the large cap space and deflation takes hold.

The smaller private equity firms which are typically more focused on performance will continue doing well by focusing on smaller deals and they will collect their assets from family offices and small endowment and pension funds. Also, the CalPERS of this world will continue to focus some of their capital in emerging manager programs to transition them to their mature manager portfolio (watch the latest CalPERS’ board meeting at the end of my last comment).

Hope you enjoyed reading this comment. As always, please remember to click on my ads and more importantly to donate or subscribe to this blog via PayPal at the top right-hand side.

I am off to my appointment at the Montreal Neurological Institute where I am taking part in an Opexa study for progressive Multiple Sclerosis using my own T-cells (hard to know whether you’re on the placebo). Whether you have or haven’t contributed to my blog, please donate to the MNI as it’s truly an incredible hospital and research center, conducting clinical and basic research and providing extraordinary care to thousands of patients with neurological diseases.

Photo  jjMustang_79 via Flickr CC License

New Jersey Senate President Stephen Sweeney on Wednesday took another stab at paying down the state’s pension debt: he proposed restructuring the state’s pension debt by creating a federal loan program.

Democratic lawmakers in recent months have come out with a laundry list of different pension proposals; they are trying to offer countermeasures to Chris Christie’s plan, which involves cutting benefits.

More from NJ.com:

The government aid program — which Sweeney stressed would not be a bailout — would allow financially strapped New Jersey to shed its $50 billion unfunded liability and cut the state’s required annual pension contribution in half.

[…]

States would be eligible to borrow about $50 billion from the Federal Reserve at 1 percent interest over 30 years under the plan.

Based on its current funding levels, New Jersey will soon be on the hook for $6 billion a year, but paying off the unfunded liability up front and investing the money from the reserve, would save the state $3 billion a year, Sweeney estimated.

“This is not a bailout or a handout,” he emphasized. “It’s a loan program.”

Sweeney’s proposal assumes the investments’ yields beat the 1 percent loan interest.

For a state to sign on, it would have to get approval from the voters and pass a constitutional amendment promising to make the full payment recommended by actuaries. Pay less, and the state would simply slide back into debt.

Sweeney said he is already talking to unions and lawmakers across the country to gauge interest and “build support”.

Photo credit: “New Jersey State House” by Marion Touvel – http://en.wikipedia.org/wiki/Image:New_Jersey_State_House.jpg. Licensed under Public domain via Wikimedia Commons

On August 22-25, Phoenix voters will get a chance to approve or throw out a ballot measure that would overhaul the city’s pension system.

Residents are getting used to this routine: it’s the third consecutive year a major pension reform proposal has been on the ballot.

The measure, Prop. 103, would funnel new, highly paid hires into a defined contribution/hybrid system and cut them off from the current defined benefit system.

More from the Arizona Republic:

Phoenix voters may be discouraged over how annual pension payments are squeezing out city services. Some worry that the pension fund is on shaky ground. But the mega-pay-outs to those big-shots? Oh, how that has frosted people.

Proposition 103 addresses that frost-laden issue squarely. By creating a hybrid pension/defined contribution system for highly paid new hires, it assures few retiring municipal executives will ever again see six-figure pensions, much less the stratospheric featherbeds we have seen in recent years.

The measure, the third pension issue before Phoenix voters in as many years, is far from a pension “solution.” It will save Phoenix an estimated $38 million over 20 years. So, it is not exactly a life preserver for pension-strained city budgets.

[…]

For new Phoenix employees, the pension-padding practice of “spiking” will be more limited. The percentage of their pay dedicated to the retirement fund will cap out at no more than 11 percent, [as opposed to] 18 percent.

Proposition 103 is outlined on page 5 of this document.

Photo credit: “Entering Arizona on I-10 Westbound” by Wing-Chi Poon – Own work. Licensed under CC BY-SA 2.5 via Wikimedia Commons – http://commons.wikimedia.org/wiki/File:Entering_Arizona_on_I-10_Westbound.jpg#mediaviewer/File:Entering_Arizona_on_I-10_Westbound.jpg

The New York City Employee Retirement System (NYCERS) on Tuesday approved a measure that ordered staff to study the financial impact of divesting from gun retailers, like Cabela’s, Dick’s – and even Walmart.

From the New York Daily News:

The city’s largest pension fund voted Tuesday to move forward with possible divestment from gun sellers.

[…]

[Leticia] James, a trustee of the New York City Employee Retirement System, or NYCERS, has especially targeted Walmart as the country’s largest gun retailer. But she also wants to study ditching stock from other merchants, like Dick’s Sporting Goods, Big 5 Sporting Goods, Cabelas and Kroger supermarkets.

“Our nation continues to bleed from mass shootings, and we have to get guns off our streets and off department store shelves,” James said.

She said owning stock in gun sellers — including $109 million in Walmart alone — also puts shareholders at risk from possible lawsuits.

The board “must take note of these potential risks inherent in holding securities related to the gun industry. These current and future incidents of gun violence continually contribute to headline, reputational, regulatory, litigation, and business risk factors for firms associated with firearms and ammunition sales,” the resolution to order a study on companies with at least $50 million in gun sales says.

[…]

A consultant will now conduct an analysis of the costs and benefits to the city of getting rid of the stock. The pension fund has already divested from gun manufacturers.

The measure was sponsored by trustee Letitia James and passed the board almost unanimously, with only one “no” vote.

Photo by  Jim Wrigley Photography via Flickr CC License

The Vermont Pension Investment Committee (VPIC), the entity that manages the state’s pension assets, on Tuesday voted not to consider divesting from fossil fuel companies.

Two elements drove the decision: the Board was told divestment could cost $9 million and wasn’t a sound financial decision; additionally, the state Treasurer urged the Board to act as fiduciaries, not as agents of social change.

More from the Vermont Digger:

VPIC Chairman Stephen Rauh stressed the board’s fiduciary duty to beneficiaries of the retirement system.

“We were not created as an agent of social change,” Rauh said.

[…]

Douglas Moseley of NEPC LLC, a fiduciary adviser for the state, recommended against divesting from fossil fuels. He said there would be transaction fees associated with moving pension fund investments, and eliminating fossil fuel companies from the portfolio “would change the overall risk balance” of the fund.

Matt Considine, director of investments for the State of Vermont, said divestment would be a $9 million hit annually to the pension fund.

[…]

State Treasurer Beth Pearce spoke at length about the committee’s first duty: Vermont retirees.

“Our first and foremost responsibility [is] to the 48,000 active and retired members,” of the state’s retirement system, she said. “We are fiduciaries; our job is to get enough income in the fund to support the retirement security of those 48,000 people and I take that very seriously. At the same time I believe that climate risk is real.”

Fossil fuel-related assets make up $263 million of the state’s $4 billion pension portfolio.

Photo by  Paul Falardeau via Flickr CC License

The state of Montana and its public retirees agreed to a settlement last week over a cost-of-living adjustment cut originally enacted in 2013.

In 2013, lawmakers passed a law to reduce retirees’ annual COLA from 3 percent to 1 percent. The law has been stuck in the court system ever since.

But last week, the state settled with retirees: all employees hired before July 1, 2013 will get to keep their 3 percent COLA.

From the Helena Independent Record:

A 2013 legislative attempt to cut the annual benefits increase for retired state and local employees died after a recent settlement between the retiree association and the state of Montana.

The potential cut has been in limbo for nearly two years, and was bound for a decision in front of the Montana Supreme Court. Chief Justice Mike McGrath dismissed the case last Thursday after both parties agreed to drop their appeals.

The settlement maintains the 3 percent Guaranteed Annual Benefit Adjustment for employees hired prior to July 1, 2013. It also requires both parties to pay their own attorney fees.

Cathy Kendall, president of the retiree association, touted the settlement as a victory that provides stability for 20,000 Montana retirees.

“Because the GABA is the only method that retirees have to adjust their lifestyle to the cost of living, and to the increased cost for health insurance and medical care, it’s critical to retirees to know that they have some constancy,” she said.

[…]

A spokesperson for the Montana Attorney General’s Office said the settlement was made with the support of legislative leaders and is in the best interest of all Montanans.

“It preserves flexibility for the Legislature and governor to craft other lawful pension reforms in the future, and Montana taxpayers will not be paying the Association of Montana Retired Public Employees’ attorney fees,” spokesman John Barnes wrote in an email.

The suing retiree group had argued that the COLA cut would cost “median” retiree around $135,000 over the course of 20 years.

Photo by Joe Gratz via Flickr CC License

In the midst of Western sanctions, Russia is looking to stimulate its economy from within: the country is forcefully urging its pension funds to invest in bonds of domestic corporations.

Pension funds, however, are understandably reluctant; Russia’s sturdiest companies aren’t issuing bonds, which means many pension funds are scooping up bonds that are considered “junk”, and below the minimum standard set by the funds’ investment policy.

More from Bloomberg:

President Vladimir Putin’s government is pushing pension funds to buy more corporate bonds whether they like it or not. And many don’t.

In an effort to replace the foreign investment sapped by sanctions, Russia is guiding pension assets into companies’ bonds by halving the amount the funds can hold in banks. The reason managers say they’re stashing money in deposits is corporate bonds are just too risky for their retirement savers.

“We’re sure the state would save banks in case of emergency but we understand that it won’t be able to protect us from facing corporate defaults if the economic situation worsens,” Natalya Chuykova, who helps manage the equivalent of $1.3 billion of pension assets as a vice president at OAO Elektroenergetiki in Moscow, said by phone on Friday.

The reluctance from pension managers underscores wider caution about investing even in Russian companies untouched by U.S.-led sanctions as lower crude prices send the oil-export dependent economy into recession. Corporate yields soared as much as 9 percentage points amid the ruble’s collapse last year through January, before dropping by an average 5 percentage points this year, according to a bond index compiled by Uralsib Financial Corp. in Moscow.

[…]

One problem with the corporate-bond market, say pension-fund managers, is that the best quality companies aren’t issuing. Most of the 323 billion rubles of bonds sold in May and June were from companies with junk credit ratings below the minimum required level for pension funds of BB-. About half of the bonds were issued by banks, according to Denis Poryvay, an analyst at AO Raiffeisenbank in Moscow.

Russia is changing a key part of pension funds’ investment policy; last year, funds were permitted to put up to 80 percent of their money in banks – and many funds did put their money there because they were uncomfortable with other domestic investments.

But starting in 2016, that 80 percent limit will drop to 40 percent. The change will force pension funds to get active with their money – with likely destinations being corporate bonds.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

The Canada News Wire reports, PSP Investments Reports Fiscal Year 2015 Results:

The Public Sector Pension Investment Board (PSP Investments) announced today a gross total portfolio return of 14.5% for the fiscal year ended March 31, 2015 (fiscal year 2015). For the 10-year period ended March 31, 2015, PSP Investments’ net annualized investment return reached 7.6% or 5.8% after inflation, significantly above the net long-term rate of return objective used by the Chief Actuary of Canada for the public sector pension plans, which averaged 6.0% or 4.2% after inflation for the period.

The investment return for the year exceeded the Policy Portfolio Benchmark rate of return of 13.1%, representing $1.5 billion of value added. In Fiscal 2015, all portfolios achieved solid performances, the majority generating double digit investment returns.

“We are pleased with these strong returns in a year that saw the appointment of a new Chair in November 2014 and the arrival of André Bourbonnais, our new President and CEO, at the end of March 2015,” said Michael P. Mueller, Chair of the Board of PSP Investments. “This performance attests to the strength and depth of the organization and its senior management team and to the quality of its corporate governance.”

“I wish to highlight the contribution of two of our key people whose efforts were crucial to keeping us on course to record these strong results; namely, John Valentini, who led us with great poise during his tenure as Interim President and CEO, and Cheryl Barker, who stepped up solidly in her role as Interim Chair during a large part of the year,” added Mr. Mueller.

Solid Foundation from which to Grow

“I wholeheartedly embrace PSP Investments’ important social mission of contributing to the long-term sustainability of the public sector pension plans for the ultimate benefit of the contributors and beneficiaries,” said André Bourbonnais, President and CEO of PSP Investments. “I intend to build on the strength and depth of our organization to deliver on that mission. With the projected growth in assets -, this will undoubtedly involve expanding into still more asset classes, transforming PSP Investments into a truly global pension investment manager with a local presence in select international markets and supplementing the organizational structure to better capture opportunities at the total fund level.”

Surpassing Targets and Financial Thresholds

In fiscal 2015, PSP Investments’ net assets increased by $18.3 billion or 20%. These gains were attributable to a combination of strong investment performance and net contributions. Net assets at the end of fiscal 2015 exceeded the $100-billion threshold to a record $112.0 billion. PSP Investments generated profit and other comprehensive income of $13.7 billion in the latest fiscal year. Over the past five-year period, PSP Investments recorded a gross compound annualized investment return of 11.7% and generated $43.3 billion in investment income.

Public Markets Equities, Fixed Income and Private Markets Post Solid Returns

For fiscal 2015, Public Markets Equities returns ranged from 7.2% for the Canadian Equity portfolio to 29.5% for the US Large Cap Equity portfolio. The Fixed Income portfolio generated a return of 9.4% while the return for the World Inflation-Linked Bonds portfolio was 16.9%.

In 2015, all Private Markets asset classes achieved strong investment returns. Real Estate and Natural Resources1 led the way with returns of 12.8% and 12.2%, respectively. Infrastructure posted a 10.4% investment return while the Private Equity portfolio investment return was 9.4%.

The asset mix as at March 31, 2015, was as follows: Public Markets Equities 50.2%, Fixed Income and World Inflation-Linked Bonds 17.9%, Real Estate 12.8%, Private Equity 9.0%; Infrastructure 6.3%; Cash and Cash Equivalents 2.4% and Natural Resources 1.4%.

As Scott Deveau of Bloomberg reports, PSP Builds Credit Office in New York in Global Expansion:

Public Sector Pension Investment Board will open offices in New York and London and is eyeing Asia as part of the Canadian fund’s plan to double its C$112 billion ($86 billion) in assets over the next decade.

PSP plans to build a loan-origination business in New York and private-equity operations in London this year, Andre Bourbonnais, chief executive officer of PSP, said in a phone interview Thursday.

“We’re going to stick to the markets we know better, which is essentially the Western world,” he said. Within 24 months PSP will look at getting an office in Asia, he said. “Having a foot on the ground there is going to be key for local knowledge, local human capital and being closer to our partners.”

PSP, which oversees the retirement savings of federal public servants, including the Royal Canadian Mounted Police, follows other domestic pension funds bulking up operations overseas.

The U.S. and Europe are presenting the greatest opportunity for investment in challenging markets where many investors are chasing deals, he said.

The fund returned 15 percent on its investments in the year ended March 31, 2015, and increased the value of its assets under management by 20 percent over the year, according to a statement Thursday.

Break Silos

Bourbonnais took over as chief executive of PSP in March after serving as global head of private investment at Canada Pension Plan Investment Board. He said he has already implemented measures within the organization aimed at breaking down barriers between the pension plan’s various departments so it can compete more effectively.

“This place has been built pretty much bottom up, with each investment class doing their own thing,” he said. “We need to break the silos and try to get as much synergies from the group as possible.”

PSP has also created a new chief investment officer position, and has reorganized its debt and credit functions under one roof and its private investment arms under another, he said.

Mr. Bourbonnais is right, PSP was mostly built from the bottom up and his predecessor, Gordon Fyfe, didn’t have the foresight to hire a chief investment officer, preferring instead to wear both hats of CEO and CIO (which he is now doing at bcIMC).

To be fair, Gordon did create an Office of the CIO and had the brains to hire my former colleague Mihail Garchev and a few other analysts, but it was woefully under-staffed and desperately needed new direction and more “synergies” between public and private markets.

The person now responsible for leading this group is Daniel Garant who came to PSP back in 2008 from Hydro-Québec where he was their CFO to head PSP’s Public Markets. According to PSP’s website, Mr. Garant was just appointed CIO this July.

Apart from appointing Mr. Garant CIO, Mr. Boubonnais also recently promoted Anik Lanthier to the position of  Senior Vice President, Public Equities and Absolute Return. She is now part of senior management at PSP.

Also worth noting that Derek Murphy, the former head of Private Equity, is no longer with PSP. He left the organization soon after Mr. Bourbonnais got to PSP in early April after being appointed in late January. Neil Cunningham, the Senior Vice President and Global Head of Real Estate Investments is now acting as the Interim Senior Vice President, Global Head of Private Investments.

Now that we got those HR issues out of the way, it’s time to go over PSP’s fiscal 2015 results. I urge you all to take the time to read PSP’s 2015 Annual Report. It is extremely well written and provides a lot of useful information on investments and other activities at PSP during fiscal 2015.

Let’s begin by looking at PSP’s portfolio and benchmark returns which are available on page 21 of the Annual Report (click on image):

As you can see, there were strong returns across Public and Private Markets in fiscal 2015. Returns of global public equities were particularly strong, especially in the U.S. (+29.5%) where the boost from the USD also helped bolster the Public Equity portfolio (PSP indexes its large cap U.S. equity exposure).

In terms of Public Markets, it’s worth reading the passage below taken from page 22 of the Annual Report (click on image):

The key points to remember on Public Markets are the following:

• U.S. Large Cap Equity, which is indexed, delivered solid gains (+29.5%) and were boosted by the surging U.S. dollar.

• Emerging Markets Equity, which are also indexed, delivered solid gains of 15.2% in FY 2015.
• EFEA Large Cap Equity which isn’t indexed and managed internally, underperformed its benchmark by 80 basis points in fiscal 2015 (12.9% vs 13.7%).  Over a five-year period, however, this portfolio is on par with its benchmark (11.1% vs 11%).
• Canadian Equity portfolio slightly outperformed its benchmark by 30 basis points (7.2% vs 6.9%) as did the Small Cap Equity portfolio, gaining 20 basis points over its benchmark (25% vs 24.8%).
• Fixed Income underperformed its benchmark by 70 basis points in fiscal 2015 (11.7% vs 12.4%) as strong gains in World Inflation-Linked Bonds (+16.9%), which are indexed, were offset by weak performance elsewhere. On page 23 of the Annual Report, it states that the “underperformance can be explained by the positioning of the Fixed Income portfolio to take advantage of rising US and global rates” (good luck with that call, especially if global deflation hits the world economy).
• There was a good balance between internal and external absolute return mandates, with the former adding $115 million of relative value and the latter adding $193 million of relative value. Good positioning on the USD vs the euro, geographic and sector calls (like underweighting energy) and fixed income relative value trading all added to absolute returns in fiscal 2015.
• The internal Value Opportunity portfolio gained 30.1% in fiscal 2015, contributing $35 million in relative value. The positive added value was partially offset by the underperformance of PSP’s Active Fixed Income portfolio.
• Asset-backed term notes contributed $29 million in relative value, as PSP continued to benefit from a reduction of risk on the underlying assets as they approach maturity.

In terms of Private Markets, here are some of my observations:

• Real Estate, where the bulk of the private assets are concentrated, significantly outperformed its benchmark by 790 basis points (12.8% vs 4.9%) in fiscal 2015. Net assets of the Real Estate portfolio totalled $14.4 billion at the end of fiscal year 2015, an increase of $3.8 billion from the prior fiscal year.
• Over the last five fiscal years, Real Estate has gained 12.6%, far outpacing its benchmark return of 5.7%. These gains relative to the RE benchmark accounted for the bulk of the value added at PSP over this period.
• There were also strong gains in Infrastructure (10.4% vs 6.1%) and Natural Resources (12.2% vs 3.6%) relative to their respective benchmarks.
• The only private market asset class that underperformed its benchmark was Private Equity, gaining 9.4% in fiscal 2015 versus its benchmark return of 11.6%. Still, over the last five fiscal years, Private Equity has managed to gain 220 basis points above its benchmark (15.4% vs 13.2%).

Once again, there were spectacular gains in private markets — especially in Real Estate, Infrastructure and Natural Resources — relative to their respective benchmarks.

So what are the benchmarks of the portfolios? Below, I provide you with the benchmarks of each portfolio taken from page 20 of the Annual Report (click on image):

I will tell you right away the benchmarks for Real Estate, Natural Resources and to a much lesser extent Infrastructure (respective cost of capital), do not reflect the risks of the underlying portfolio, especially in Real Estate. At least Private Equity cleaned up its benchmark to now include Private Equity Fund Universe plus its cost of capital. 

The benchmark for PSP’s Real Estate portfolio is particularly egregious given that it’s gotten easier to beat since my time at PSP and since I wrote my second blog comment back in June 2008 on alternative investments and bogus benchmarks.

Read the passages below taken from page 24 and 25 of the Annual Report (click on image):

No doubt, there were strong gains in core markets like the United States, but PSP is taking quite a bit of real estate risk in emerging markets and it’s also taking a lot of opportunistic real estate risk. Even risks in developed markets like New Zealand and Australia can whack PSP as their currencies are plunging in the latest rout in commodities.

This just proves my point that the Auditor General of Canada really dropped the ball in its Special Examination of PSP Investments back in 2011. It’s abundantly clear to me that the Office of the Auditor General lacks the resources to perform an in-depth performance, risk and operational due diligence on PSP or any other large Canadian public pension fund (that is a huge and increasingly worrisome governance gap that remains unaddressed).

As I’ve stated plenty of times on my blog, when it comes to gauging performance, it’s all about benchmarks, stupid! You can can have a monkey taking all sorts of opportunistic real estate risk, handily beating his or her bogus “cost of capital” benchmark over any given year, especially over a four or five year period.

And let me be clear here, I’m not taking personal swipes at Neil Cunningham, the head of PSP’s real estate portfolio. Neil is a hell of real estate manager and a good person. Unlike his predecessor, which I didn’t particularly like, I actually like him on a professional and personal basis (he taught me how to implement my Yahoo stock portfolio and always had time to chat real estate with me).

But when I see the shenanigans that are still going on at PSP in terms of some of their private market benchmarks, I’m dumfounded and wonder why the Board of Directors are still letting this farce go on. 

And why are benchmarks important? Because they determine compensation at PSP and other large Canadian public pension funds. Period. If the Board doesn’t get the benchmarks in all portfolios right, it allows pension fund managers to game their respective benchmark and handily beat it, making off like bandits.

Have a look at the compensation of PSP’s senior managers during fiscal 2015 taken from page 69 of the Annual Report (click on image):

As you can see, the senior managers at PSP are compensated extremely well, far better than their counterparts at the Caisse and many other large Canadian public pension funds. 

No doubt, compensation is based on four-year rolling returns and PSP has delivered on this front, adding significant value but you have to wonder if they got the Real Estate and other private market benchmarks right from the get-go, would it have impacted the added-value and compensation of PSP’s senior managers? (the answer is most definitely yes).

By the way, you will also notice Mr. Bourbonnais made roughly $3 million in total compensation in fiscal 2015, which was a signing bonus, and in a footnote it says he was given a guarantee that his total direct compensation over the next three fiscal years will be no less than $2.5 million a year.

It’s important however to keep in mind that Mr. Bourbonnais walked away from a big position at CPPIB where he was head of private markets and pretty much had that amount guaranteed in terms of total compensation over the next three fiscal years, so even though this seems outrageous, it’s not. It’s only fair given what he walked away from.

Also, John Valentini deserved his total compensation in fiscal 2015 given he was the interim president for a long time before André Bourbonnais got there. Daniel Garant’s total compensation will rise significantly over the next three fiscal years too given the increased responsibility he has (although I’m not sure if he is CIO of Public and Private Markets like Neil Petroff was or CIO of Public Markets like Roland Lescure at the Caisse).

In any case, PSP’s fiscal 2015 results were excellent and there’s no question that apart from criticism of some of their private market benchmarks, they’re doing a great job managing assets on behalf of their contributors and beneficiaries. 

I would just add that PSP needs to do a lot more work in terms of diversifying its workplace at all levels of the organization, and do a lot more to hire minorities, especially persons with disabilities (that is another HR audit that should take place at every single large Canadian public pension fund, not just PSP).

Finally, while Canada’s pension plutocrats enjoy millions in total compensation, I kindly remind them and others that I work very hard trading and blogging to get by and the least they should do is show their support for the tremendous work I do in providing them and others with the latest insights on pensions and investments. Remember, it takes a special guy to battle progressive MS and do what I’m doing.

Once again, please take the time to carefully read PSP’s 2015 Annual Report, it’s excellent and covers a lot of topics that I forgot to cover or don’t have time to cover. For example, over 73% of PSP’s assets are now managed internally and the cost of managing these assets is significantly lower than any mutual fund.

Back in May, André Bourbonnais, president and chief executive officer of the Public Sector Pension Investment Board, Winston Wenyan Ma, managing director and head of the North America Office at China Investment Corporation, Ron Mock, president and chief executive officer of Ontario Teachers Pension Plan, and Michael Sabia, president and chief executive officer of Caisse de dépôt et placement du Québec, participated in a panel discussion about Canadian pension plans and investment strategy. Bloomberg’s Scott Deveau moderated the panel at the Bloomberg Canada Economic Series in Toronto (May 21, 2015). Please take the time to listen to this discussion here.

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