Author: Leo Kolivakis

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

Jonathan Rochford, portfolio manager at Narrow Road Capital, wrote a guest comment for ValueWalk, The Dallas Pension Fiasco Is Just the Beginning (h/t, Jim Leech):

The recent blow-up of the Dallas Police and Fire Pension System was entirely predictable. Whilst it is tempting to blame unusual circumstances for the recent lock-up of redemptions and likely substantial reductions to pensions for those still in the fund, many other American pension funds are heading down the same road. The combination of overpriced financial markets, inadequate contributions and overly generous pension promises mean dozens of US local and state government pension plans will end up in the same situation. The simple maths and political factors at play mean what happened at GM, Chrysler, Detroit and now Dallas will happen nationwide in the coming decade. So, what’s happened in Dallas and why will it happen elsewhere?

The Dallas pension scheme has been underfunded for many years with the situation accelerating recently. As the table below shows, as at 1 January 2016 the pension plan had $2.68 billion of assets (AVA) against $5.95 billion of liabilities (AAL), making the funding ratio (AVA/AAL) a mere 45.1%. Despite equity markets recovering strongly over the last seven years, the value of the assets has fallen at the same time as the value of the liabilities has grown rapidly. The story of how such a seemingly odd outcome could occur dates back to decisions made long before the financial crisis (click on image).

Source: Dallas Police and Fire Pension System

In the late 1990’s, returns in financial markets had been strong for years leading many to believe that exceptional returns would continue. In this environment, the board that ran the Dallas plan decided that more generous pension terms could be offered to employees and that these could be funded by the higher expected returns without needing greater contributions from the Dallas municipality and its taxpayers. Exceptionally generous terms were introduced including the now notorious DROP accounts and inflated assumptions for cost of living adjustments (COLA). These changes meant that pension liabilities were guaranteed to skyrocket in future years, whilst there was no guarantee that investment returns and inflation levels would also be high. Dallas police and fire personnel were being offered the equivalent of a free lunch and they took full advantage.

In the 2000’s the pension plan made some unusual investment decisions. A disproportionate amount of plan assets were invested in illiquid and exotic alternative investments. When the financial crisis struck these assets didn’t decline as much as the assets of other pension plans. However, this was merely a deferral of the inevitable write downs which came in the last two years after a change in management.

Dallas Pension – Recent Events

Throughout 2016 the pension board, the municipality and the State government bickered over who was responsible and who should pay to fix the mess. The State government blamed the municipality for the poor investment decisions. The municipality blamed the State government for creating a system that it could not control but was supposed to be responsible for. It also blamed the pension board for the overly generous changes they implemented. The pension board recognised the huge problem but offered only minor concessions arguing that plan participants were entitled to be paid in full in all circumstances. They asked the municipality for a one-off addition of $1.1 billion, equivalent to almost one year’s general fund revenue for the municipality.

As the funding ratio plummeted during 2016, plan participants became concerned that their generous pension entitlements might not be met. In other pension plans the employer might increase its contributions when these circumstances occurred, but in Dallas the municipality was already paying close to the legislative maximum. Police officers with high balances retired in record numbers, pulling out $500 million in four months in late 2016. Those who withdrew received 100% of what was owed, with those remaining seeing their position as measured by the funding ratio deteriorate further.

In November, when faced with $154 million of redemption requests and dwindling liquid assets, the pension board suspended redemptions. The funding ratio is now estimated to be around 36% with assets forecast to be exhausted in a decade. Litigation has begun with some plan participants suing to see their redemption requests honoured. The municipality has indicated it wants to claw back some of the generous benefits accrued since the changes in the 1990’s, though this is likely to only impact those who didn’t redeemed. The State has begun a criminal investigation. Everyone is looking to blame someone else, but not everyone has accepted that drastic pension cuts are inevitable.

Dallas Pension – The Interplay of Political Decisions and Financial Reality

The factors that led to Dallas pension fiasco are all too common. Politicians and their administrations often make decisions that are politically beneficial without taking into account financial reality. A generous pension scheme keeps workers and their unions onside, helping the politicians win re-election. However, the bill for the generosity is deferred beyond the current political generation, with unrealistic assumptions of future returns enabling the problem to be obscured. As financial markets tend to go up the escalator and down the elevator it is not until a market crash that the unrealistic return assumptions are exposed and the funding ratio collapses.

This is when a second political reality kicks in. In the case of Dallas, there are just under 10,000 participants in the pension plan compared to 1.258 million residents in the municipality. Plan participants therefore make up less than 1% of the population. If the Dallas municipality chose to fully fund the Dallas pension plan it would be require an enormous increase in taxes from the entire population in order to fund overly generous pensions for a very small minority of the population. For current politicians, it is far easier to blame the previous politicians and the pension board for the mess and see pensions for a select group cut by half or more than it is to sell a massive tax increase.

The legal position remains murky and it will take some time to clear up. The municipality is paying 37.5% of employee benefits into the pension plan, the maximum amount required by state law. Without a change in state legislation, it seems likely that the Dallas pension plan will have to bear almost all of the financial pain through pension reductions. If state legislation was changed to increase the burden on the municipality years of litigation could ensue with the potential for the municipality to declare bankruptcy as a strategic response. The appointment of an administrator during bankruptcy could see services reduced and/or taxes increased, but pension cuts would be all but a certainty.

Dallas Pension Isn’t the First and Won’t be the Last

It’s tempting to see the generous pension structure and bad investment decisions in Dallas as making it a special case. Detroit was seen by many as a special case when it went into bankruptcy in 2013 as it had seen its population fall by 25% in a decade. This depopulation left a smaller population base trying to fund the debt and pensions obligations incurred when the population was much larger. Growing debt and pension obligations are signs of what is to come for many local and state governments who have been living beyond their means for decades.

As well as building up pension obligations many US governments have been accruing explicit debt. The two are intertwined, with some governments issuing debt to make payments into their pension plans, often to close the underfunding gap. This is very much a short-term measure, as whether it is pension contributions or debt repayments both will either require high taxes and/or lower spending on government services in the future in order for these payments to be met.

Pew Charitable Trusts research estimates a $1.5 trillion pension funding gap for the states alone, with Kentucky, New Jersey, Illinois, Pennsylvania and California going backwards at a rapid rate. Using a wider range of fiscal health measures the Mercatus Center has the five worst states as Kentucky, Illinois, New Jersey, Massachusetts and Connecticut. The table below shows the five state pension plans in Illinois, with an average funded ratio of just 37.6% (click on image).

Dallas Pension Source: Illinois Commission on Government Forecasting and Accountability

For cities, Chicago is likely to be the next Detroit with the city and its school system both showing signs of financial distress. Chicago is trying to stem the bleeding with a grab bag of tax and other revenue increases but in the long term this makes the overall position worse.

Default is Almost Inevitable as the Weak get Weaker

The problem for Chicago and others trying to pay their debt and pension obligations by raising taxes is that this makes them unattractive destinations for businesses and workers. Growth covers many sins, as growth creates more jobs and drags more people into the area. This increases the tax base and lessens the burden from previous commitments on those already there. Well managed, low tax jurisdictions benefit from a positive feedback loop.

For states and municipalities in decline, their best taxpayers are the first to leave when the tax burden increases. Young college educated workers with professional jobs generate substantial income and sales tax revenue but require little in the way of education and healthcare expenditure. This cohort has many options for work elsewhere and can easily relocate. Chicago and Illinois are bleeding people, with the flight of millionaires particularly detrimental on revenues.

Those who own property are caught in a catch 22; property taxes and declining population have pushed property prices down, potentially creating negative equity. But staying means a bigger drain on the household budget as property taxes are the most efficient way to raise revenue and therefore become the tax increased the most. If too many people leave property prices plummet as they have in Detroit, making it even more difficult to collect property taxes as these are typically calculated as a percentage of the property valuation. Bankruptcy becomes inevitable as a poorer and older population base that remains simply cannot support the debt and pension obligations incurred when the population base was larger and wealthier.

Dallas Pension – Will be Reduced, but Bondholders Will Fare Worst

The playbook from the Detroit bankruptcy is likely to be used repeatedly in the coming decade. When a bankruptcy occurs and an administrator is appointed a very clear order of priority emerges. Firstly, services must be provided otherwise voters/taxpayers will leave or revolt. There may need to be cuts to balance the budget but if there is no police force, water or waste collection the city will cease to function.

Secondly, pensions will be reduced to match the available assets quarantined to meet pension obligations and the ability of the budget to provide some contribution. If the budget doesn’t have capacity or the legal obligation to contribute more to pension funding, pensioners should expect their payments to be cut to something like the funding percentage. For Dallas and the Dallas pension plans in Illinois this means payments cut by more than half.

Third in line are financial debtors. Bondholders and lenders don’t vote and they are seen as a bunch of faceless wealthy individuals and institutions who mostly reside out of state. They effectively rank behind pensioners, who are people who predominantly reside in the state and who vote, even though the two groups technically might rank equally. This makes state and local government debt a great candidate for a CDS short as the recovery rate for unsecured debt is usually awful in the event of default.

Dallas Pension Canary In Coal Mine? The Next Crisis Will Trigger an Avalanche

At the risk of being labelled a Meredith Whitney style boy who cried wolf I expect that the next financial crisis will trigger a wholesale revaluation of the creditworthiness of US state and local government debt. I have no crystal ball for when this will happen, but it is almost certain that the next decade will contain another substantial decline in asset prices. This will impact state and local governments and their pension obligations in two major ways.

Firstly, asset prices will fall causing underfunded pensions to become even more obviously insolvent. Most US defined benefit pension funds are using 7.50% – 8.00% as their future return assumption. Using a 7.50% return assumption for a 60/40 stock/bond portfolio, with ten year US treasuries at 2.50%, implies equities will return 10.8% every year going forward. In a low growth, low inflation environment this might be achievable for several years, but an eventual market crash will destroy any outperformance from the good years. The continued use of such high return assumptions is unrealistic and is being used to kick the can further down the road. The largest US public pension fund, Calpers, has recognised this and is reducing its return expectations from 7.50% to 7.00% over three years. This still implies a 10% return on equities for a 60/40 portfolio.

Secondly, downturns cause a reassessment of all types of debt with the highest risk and most unsustainable debt unable to be renewed. State and local governments with a history of increasing indebtedness and no realistic plan for reducing their debts may become unable to borrow at any price. This will force them to seek bankruptcy or an equivalent restructuring process. Once this happens for one mainland state (Illinois looks likely to be the first) lenders will dramatically reprice the possibility that it could happen elsewhere. Those who think states cannot file for bankruptcy should watch the process occurring in Puerto Rico, it will be repeated elsewhere. Barring a federal bailout, an overly indebted state or territory has no alternative other than to default on its debts. Raising taxes or cutting services will see the city or state depopulated. Politicians and voters are strongly incentivised to default.

Dallas Pension – Conclusion

Chronic budget deficits, growing indebtedness, excessive pension return assumptions and pension underfunding all set the stage for a wave of state and local government pension and debt defaults in the coming decade. As Detroit has shown this century, once an area loses its competitiveness its financial viability spirals downward. As taxes increase and services are cut the wealthiest and highest income earners leave slashing government revenues and increasing the burden on the older and poorer population that remains.

The next substantial fall in asset prices will sharpen the focus on budget deficits and pension underfunding, with the most indebted and underfunded states likely to find they are unable to rollover their debts at any price. Remaining residents will be negatively impacted, pensioners will see their payments slashed and bondholders will recover little, if any, of their debt. As there is virtually no political will to take action to avoid these problems investors should position their portfolios in expectation that these events will happen.

Written by Jonathan Rochford for Narrow Road Capital on January 17, 2017. Comments and criticisms are welcomed and can be sent to info@narrowroadcapital.com

Disclosure

This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice. It contains information derived and sourced from a broad list of third parties, and has been prepared on the basis that this third party information is accurate. This article expresses the views of the author at a point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including securities linked to the performance of various companies and financial institutions.

This is an excellent comment on why all roads lead to Dallas when it comes to chronically underfunded US public pensions with poor governance. I thank Jim leech for bringing it to my attention.

US state and local public pension plans need a miracle to get out of the hole they are in. Detroit was a basket case but Dallas and Chicago are not far behind. This particular case of the Dallas Police and Fire Pension once again demonstrates how public plans with little or no governance are a disaster waiting to happen.

The key passage from above is this one:

The combination of overpriced financial markets, inadequate contributions and overly generous pension promises mean dozens of US local and state government pension plans will end up in the same situation. The simple maths and political factors at play mean what happened at GM, Chrysler, Detroit and now Dallas will happen nationwide in the coming decade. So, what’s happened in Dallas and why will it happen elsewhere?

The simple math just doesn’t add up when you combine chronically underfunded public pensions with overly generous pension promises. You can promise pensioners the world but when the money runs out and you’re unable to raise property or sales taxes to fund gross incompetence and negligence, the only option left is to drastically reduce pension benefits.

If you don’t believe me, ask Greek pensioners. For years they were living under the delusion that their public pensions are well managed and that their pension payments are sacred, untouchable, good as gold. When the money ran out, they got a rude awakening as their pension benefits were slashed by 50, 60, 70% or more.

Pensions are all about managing assets and liabilities. If liabilities soar while assets plummet, there simply is no choice but to raise contributions and/or cut benefits. This is especially true if pensions are chronically underfunded. The math is simple and any rational person looking at the situation objectively would come to the same conclusion.

In response to dire pension calculus, state and local governments are trying to raise taxes and emit pension obligation bonds. These are feeble attempts to solve deep structural problems that can only be addressed properly through major reforms on pension governance and introducing some form of a shared risk model to make sure these pensions are sustainable over the long run.

Do all roads lead to Dallas? You bet, to Dallas, Chicago, Detroit and Greece, but so many people are living in Bubble Land that they simply can’t see the global pension storm is gathering steam and will soon threaten public finances everywhere, especially in areas where chronic pension deficits abound.

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

Jacqueline Nelson of the Globe and Mail reports, Teachers eyes new tack after 25 years:

Ontario Teachers’ Pension Plan first began to lead the Canadian pension funds’ shift from sleepy, passive investors to globe-trotting deal makers 25 years ago.

What Teachers started in 1991 with a few million dollars and its first direct private equity investment has grown into a multibillion-dollar private-capital group active around the world. Others have followed, with new funds specializing in buyouts and turnarounds emerging and more institutional investors seeking to boost their exposure to alternative investments.

Now wrapping up a landmark year, Teachers Private Capital is giving more thought to selling some investments into the hot market.

“We’ve probably been more focused on taking advantage of where prices are today and lightening up on some of our holdings than we have been on adding new companies to our portfolio,” says Jane Rowe, head of Teachers Private Capital division, from headquarters perched in northern Toronto.

Ms. Rowe is taking stock of a private-equity portfolio representing 16 per cent of Teachers’ total assets – $28.4-billion as of the end of 2015, the most recent figure available. When the Ontario Teachers’ Pension Plan was made independent in 1990, it was just a pile of non-marketable Province of Ontario debentures. Over time, Teachers Private Capital bought up a quirky range of international businesses such as a British lottery, seniors’ housing facilities, mattress companies and snack foods. In its next act, Ms. Rowe says Teachers Private Capital will further refine how it sets itself apart from – and partners with – its global competitiors.

It has been a profitable run for the country’s largest single-profession pension plan. After factoring in asset management, internal and carried interest costs, the group has generated a 20.2-per-cent internal rate of return for the schoolteachers of Ontario since its inception.

Over time, Teachers Private Capital has sent less money to private-equity firms to invest on its behalf, building a team that can do more direct investments that now make up about three-quarters of its holdings. In many cases, the private equity funds that it does invest in have also become co-investment partners on other deals.

There were some hard lessons along the way. A massive $35-billion leveraged buyout bid for Bell Canada Enterprises (now BCE Inc.) that Teachers led in 2007 might have been the world’s largest at the time, but instead fizzled out 18 months later. And the group’s very first private-equity investment of a 25-per-cent stake in the White Rose Crafts and Nursery Sales Ltd. store chain was a major bust.

“We lost all our money within six months – that’s the folklore,” says Ms. Rowe of that investment. “But shortly thereafter – about two years later – we did our investment into Maple Leaf Sports & Entertainment. And that’s one we held for 17 years,” she says. Teachers’ sold its stake to Canadian telecom giants in 2012 for $1.32-billion.

Twenty years ago, Teachers was already being recognized as a potentially significant source of capital for Canadian mergers and takeovers. But the then-$35-billion pension fund was limited in its investments by the depth of Canada’s capital markets, because federal pension laws capped foreign investments at no more than 20 per cent of the total fund.

While finding its footing in the Canadian private-investment world, Teachers private-capital team encountered criticisms that it didn’t have the knowledge and experience needed to influence corporate management and boards when it took large stakes in companies, or led hostile bids.

Two decades later, Teachers Private Capital has proven its ability to turn companies around at home and abroad – it built up investments in North America, Europe, Asia, Africa and South America and now has about 70 investment professionals. But the group is being tested in other ways. Keeping the international team focused, engaged and committed to Teachers is the challenge Ms. Rowe thinks about most. “I’m always worried somebody’s going to poach them or steal them,” she says.

There’s also a lot more competition out there for Teachers, not only from other Canadian pension funds that have developed their own robust private-equity investment arms, but from investors around the world. The amount of available money piling up with private equity fund managers, called dry powder by industry insiders, hit a record $839-billion (U.S.) globally in September, 2016, according to research firm Preqin. That has grown from a little more than $500-billion a decade ago.

Teachers’ private equity team feels the pressure to prove they can outperform stock indexes that can be bought and managed without the same expense. “You can do that in part through leverage, but really what we kind of say is fundamentally you need to find sectors that you hope are going to outperform GDP over an extended period of time,” Ms. Rowe said.

That’s why Teachers toasted its quarter-century with a $1.03-billion (Canadian) deal for wine-producer Constellation Brands Inc. this fall, giving the pension plan a cellar full of top wine brands such as Kim Crawford and Jackson-Triggs. Teachers’ estimates that Canadian wine consumption is growing at about 4 per cent to 5 per cent annually, compared to a couple of per cent for Canadian GDP.

This deal also recalls Teachers’ earlier investments. In the 1990s, the pension plan took a 23-per-cent stake in wine producer Vincor International Inc. for $13-million – a much smaller cheque size than would turn its head today. Teachers later helped the business leap to the public markets. Vincor was then acquired by Constellation Brands about 10 years ago. Now, it’s returning to the Teachers stable.

The fund does more direct investing than it used to, which has made its relationships with other private-equity investors more important.

“The further you go in geography from home, the more you should probably have a smart friend at the table as you are doing those transactions,” Ms. Rowe said. “If an opportunity came in, for argument’s sake, for Colombia or Korea, you know, I’d be kind of saying what makes a Teachers’ here at Yonge and Finch the go-to provider of capital there?”

As Teachers built its reputation as an investor among other international private equity heavyweights, it has also relied on its wholesome brand. Everyone has been to school and can relate to paying the pensions of hard-working teachers. It’s a tougher sell for private equity firms, which are perceived as making money purely to fatten the pockets of their top brass, Ms. Rowe says. “It’s easier to make why we do our investing resonate.”

Ontario Teachers’ Private Capital is a success story. Under the watch of Jim Leech, the former CEO, it really took off and blossomed. Jim was the person who hired Mark Wiseman to develop Teachers’ private equity fund and co-investment program before he moved on to head CPPIB.

And under the watch of Jane Rowe, the current head of Teachers’ Private Capital and likely next president of Ontario Teachers’, direct investments have continued to be the focus as they try to contain costs and get more bang out of their private equity buck.

But these are treacherous times for private equity, there are serious and legitimate concerns about diminishing returns and misalignment of interests.

Against this backdrop, Canada’s new masters of the universe are focusing their attention on other asset classes, like infrastructure where they can invest huge sums directly, foregoing any fees whatsoever to third party funds.

Still, private equity is an important asset class and will remain an important asset class as Canada’s large pensions push further into private markets in their constant search for alpha. What this means is that all these large pensions will continue to develop their fund and co-investment programs to try to gain access to larger deals where they effectively pay no fees.

Go back to read my recent comment on whether size matters for PE fund performance. There I discuss the push from OMERS and others to invest more directly in private equity but I also tempered my enthusiasm on direct PE investments noting the following:

While I welcome OPE’s success in going direct, OMERS still needs to invest in private equity funds. And some of Canada’s largest pensions, like CPPIB, will never go direct in private equity because they don’t feel like they can compete with top funds in this space.

[Note: It might help if OPE reports the IRR of their direct operations, net of all expenses relative to the IRR of their fund investments, net of all fees so their stakeholders can understand the pros and cons of going direct in private equity. Here you need to look at a long period.]

There is a lot of misinformation when it comes to Canadian pensions ‘going direct’ in private equity. Yes, they have a much longer investment horizon than traditional funds which is a competitive advantage, but PE funds are adapting and going longer too and in the end, it will be very hard, if not impossible, for any Canadian pension to compete with top PE funds.

I am not saying there aren’t qualified people doing wonderful work investing directly in PE at Canada’s large pensions, but the fact is it will be hard for them to match the performance of top PE funds, even after fees and expenses are taken into account.

Who knows, maybe OPE will prove me wrong, but this is a tough environment for private equity and I’m not sure going direct in this asset class is a wise long-term strategy (unlike infrastructure, where most of Canada’s large pensions are investing directly).

When I talk about direct investments above, it’s purely direct, which means the teams source their own deals and help transform operations at a private company they acquired. I think this is a hard space to compete against giants like Apax, Blackstone, Carlyle, KKR, TPG  and others.

It’s much easier for Canada’s large pensions to invest in funds and then invest directly through co-investments (where they pay no fees) on bigger deals or when a large private equity fund sells them a big stake in a private company, like the Apax-CPPIB deal on GlobalLogic I covered in my last comment.

The key point is this, Ontario Teachers, CPPIB, OMERS, PSP, bcIMC, AIMCo, the Caisse and other large Canadian pensions will never be able to compete head on with premiere global private equity funds for two reasons. First, they can’t compete on compensation and second they will never get the first phone call from investment bankers or strategics (companies looking to sell a business unit) when there is a great deal on the table.

It’s just never going to happen, ever. This doesn’t mean that Jane Rowe, Mark Redman, Jim Pittman, Ryan Selwood or other private equity professionals at Canada’s large pensions aren’t good at what they do. They are damn good at what they do but even they will tell you what I’m telling you is 100% accurate, not in their wildest dreams can they effectively compete with PE giants, even over a very long investment horizon.

When it comes to private equity, there is a symbiotic relationship between Canada’s large pensions and large private equity global funds. They need each other to thrive and make the necessary returns they require to justify a 10 or 15% allocation to private equity. Sure, Canada’s large pensions are doing more and more direct investments, mostly through co-investments with large PE funds they invest in and pay big fees to. But this notion that Ontario Teachers’ Private Capital or any other private equity group at Canada’s large pensions will move entirely into direct investments effectively competing with top private equity funds on big deals is pure fantasy. And it’s a dangerous notion because it’s not in the best interests of their beneficiaries and stakeholders.

Just to underscore this point, Ontario Teachers’ recently announced a great deal with Redbird Partners to invest in Dallas-based Compass Datacenters:

RedBird Capital Partners (“RedBird”) and Ontario Teachers’ Pension Plan (“Ontario Teachers’”) today announced an investment in Compass Datacenters, LLC (“Compass” or the “Company”) in partnership with the Company’s management team, which includes Founder and CEO Chris Crosby. The existing management team will continue to lead the business and execute the Company’s growth strategy, which is supported by long-term, flexible capital from Compass’s new investment partners. Financial terms of the transaction were not disclosed.

“The next major wave of growth in the data center industry will be driven by the need for dedicated data centers that address technology trends including large-scale Internet of Things deployments, edge computing strategies that reduce latency, rapid delivery of new applications, and more,” said Chris Crosby. “I couldn’t be happier about welcoming RedBird and Ontario Teachers’ to our team, as it provides Compass with the financial resources to fund the next phase of our growth with partners who have deep domain expertise in the industry. We will continue serving as a trusted, behind-the-scenes provider to large-scale users in this multi-billion market which is experiencing impressive double-digit growth.”

Based in Dallas, Texas, Compass is a leading wholesale data center developer, specializing in customized build-to-order solutions for enterprise, cloud computing, and service provider customers. Compass focuses on solving customer needs through its patented architecture, scalable design, low cost of ownership model, and overall speed to market. Compass’s solutions also enable customers to locate their dedicated facilities anywhere. This functionality provides customers with the degree of geographic flexibility necessary as the Internet of Things (IoT) and large rich packet applications (such as video and augmented reality) require data centers to be located closer to end users. Compass CEO Chris Crosby was a founding member of the second-largest data center company in the world and leads a team that has collectively built over $3 billion of data centers globally and operated more than six million square feet of space.

“Compass’s unique solutions align perfectly with the way data center needs are evolving for large cloud/SaaS providers, corporate customers and service providers, and this investment gives Compass significant resources to take advantage of market opportunities,” said Robert Covington, Partner of RedBird Capital. “Compass now has the ability to develop larger, multi-phase projects for customers, as well as to invest in the acquisition of real estate in markets that support customer needs. Compass is one of the great stories in the data center industry, and we are proud to be part of the team’s growth strategy.”

“This investment enables Compass to significantly advance its growth plan, maintain its focus on innovative customer solutions and continue to leverage the experience and knowledge of its talented management team,” said Jane Rowe, Senior Managing Director, Private Capital, Ontario Teachers’. “We recognized that Compass is a leader in its market segment and, through this partnership, is very well positioned to serve as the trusted data center partner for even more customers whose evolving technology needs can be met by the facilities that Compass designs and builds.”

DH Capital served as exclusive financial advisor to Compass Datacenters on the transaction.

The recent deals of Ontario Teachers’ investing in Compass Datacenters and CPPIB buying a big stake in GlobalLogic underscore the need to have great private equity partners all around the world. They also show you where these two mega pensions see growth in the IT sector going forward.

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

Indulai PM and Jochelle Mendonca of India’s Economic Times report, Apax Partners sells 48% of GlobalLogic to CPPIB in $1.5 billion deal:

Apax Partners has sold half its 96% stake in GlobalLogic, an IT outsourcing firm founded by four IT Titans, to Canada’s CPP Investment Board.

The financial terms weren’t disclosed, but people in the know said the transaction valued the digital products development company at $1.5 billion (Rs 10,235 crore). That means a big payday for Apax, as the private equity firm will end up making more than three times money on a four-year-old investment.

Apax acquired GlobalLogic in 2013 for $420 million from a clutch of financial investors, including a PE fund managed by Goldman Sachs, Westbridge, New Atlantic Ventures and Sequoia. It will continue to own 48% of the US-based firm, with the management team holding the rest, the people said. Both CPPIB and Apax will become co owners of the company.

The transaction would be one of the biggest private equity exits in the technology sector post Capgemini’s $4 billion acquisition of Nadasdaq-listed iGate, which was also backed by Apax Partners.

Ryan Selwood, managing director and head of direct private equity at CPPIB, called it a “compelling opportunity” for the Canadian pension fund. “GlobalLogic’s market-leading position, exceptional track record and deep customer relationships will enable it to continue capitalising on technology megatrends,” he said.

“GlobalLogic has seen significant returns from early investments in customer focus and in building differentiated capabilities to drive digital transformation for a number of large customers,” said Rohan Haldea, partner at Apax Partners.

Founded by Rajul Garg, Sanjay Singh, Manoj Agarwala and Tarun Upadhyay, San Jose, California-based GlobalLogic has its core operations in India. The company was initially founded as Induslogic in 2000, with headquarters in Vienna, Virginia and had a delivery centre in Noida.

It provides product development services, including experience design, product engineering, content engineering, and labs. It specializes in big data and analytics, cloud, design, DevOps, embedded, Internet of Things, mobile, and security practices.

“In the past three years with Apax, we’ve enjoyed a 20%+ compound annual growth rate, consistently outperforming the broader product engineering services market,” said GlobalLogic Chief Executive Shashank Samant.

GlobalLogic is one of the larger players in the outsourced engineering research and development industry. The company is forecast to post around $450 million in fiscal 2017 revenue, with a 20% operating margin. It has more than 11,000 employees and delivery centres, called ToyFactories, in India, the US, Eastern Europe and Argentina.

Engineering R&D services have been growing faster than regular IT services, though over a smaller base. The sector has seen some consolidation, with over 15 niche players having been acquired over the last two years.

GlobalLogic was also looking at potential acquisitions, and could consider at bolting niche consulting firms in the future. India’s technology sector has matured and has more challenges to face, but analysts believe growth can still be achieved with the right business mix and people.

“Despite having a cautious outlook on growth/margins and the overall Indian IT space currently, we still maintain our view that if the business mix is right, the proposition is right and execution is right — the IT services industry still has growth left,” Nomura Securities analysts Ashwin Mehta and Rishit Parikh wrote in a note in September.

Apax, which started investing in India 10 years ago, has invested $1.5 billion across half a dozen companies, but has already returned $2.3 billion cash to its investors, even though it has yet to exit some of its portfolio companies. The performance makes it one of the most successful global private equity funds in India. The UK-based investment firm, which manages $20 billion globally, has invested predominantly in the technology space. Apax backed iGate to acquire India’s Patni Computer Systems in 2011 for roughly $1 billion and sold it off to Capegemini four years, making a nearly fourfold return.

It also made bets in the healthcare and financial services space in the country. It acquired an 11% stake in Apollo Hospitals in 2007 for $100 million, which it sold off in 2013 making a 3.5-time return. The PE fund has a Rs 500 crore exposure to the Murugappa Group’s Cholamandalam Investment & Finance Co.

Someone from the Street.com contacted me on Friday to give my thoughts on this deal. I said it was a great deal for all parties involved and referred her to Mark Machin and Ryan Selwood at CPPIB.

First, Apax the private equity giant which acquired GlobalLogic in 2013 for $420 million made more than three times its money in a little over three years. That is a great return for Apax and its private equity clients which are pretty much the who’s who in the pension and sovereign wealth fund world.

Second, CPPIB through its fund and co-investment program just got a big stake in one of the fastest growing companies in a very hot industry. The way it works is like this. CPPIB invests billions in private equity, exclusively through funds like Apax which it pays hefty fees to. But it also gets to co-invest alongside them in some big deals (paying no fees) or gets first dibs when these private equity funds sell part of their stakes in their portfolio of companies. It wasn’t by accident that Apax approached CPPIB to sell them half their stake in GlobalLogic.

On co-investments, CPPIB pays no fees but when it acquires a stake in a private company which is part of the private equity portfolio through its fund investments, it pays a premium to the general partner, in this case, Apax. Now, if GlobalLogic continues to grow at a healthy clip, CPPIB will turn around in three years and exit this investment via an IPO in public markets and make multiples on its investments, boosting its returns in private equity (Apax will also make a killing in the process).

What does GlobalLogic gain? In addition to Apax, it gains a strategic long-term partner/ owner with tentacles around the world that will provide solid long-term strategic advice to its management and if needed, patient capital to fund new projects.

It’s through co-investments and private equity deals like this that CPPIB and other large Canadian pensions are able to juice their private equity returns. These gains benefit their beneficiaries but it also allows senior pension fund managers to reap big gains relative to their private equity benchmarks to collect big bonuses in their own personal compensation.

I had a discussion with someone in public markets yesterday who told me flat out “they should strip away these co-investments and big deals from CPPIB’s private equity returns”, adding “it’s not like they sourced them, they get them just because they are big and are able to invest huge sums in private equity giants like Apax.”

True but if you are Ryan Selwood at CPPIB, you can argue that you work hard to invest in Apax and cut deals like GlobalLogic so you deserve to reap the rewards of such deals. Nobody forced Apax to sell its stake to CPPIB, negotiations happened at the highest levels and it is an excellent deal all around.

The Globe and Mail had a big report on CPPIB’s appetite for risk, which isn’t anything new. CPPIB has comparative advantages over many other large investors and it will use these advantages to make strategic long-term investments at the right time (click on image):

It’s not about taking on more risk, it’s about taking on smarter risk. What CPPIB is doing makes great sense and you don’t need a PhD in finance to understand it.

The key thing to understand is that in a raging bull market, CPPIB will typically underperform its peers and many other public funds but when a bear market develops, it will use its competitive advantages to get to work and make strategic long-term acquisitions across public and private markets all over the world, and these investments will benefit the CPP Fund over the long run.

Again, it’s not rocket science, it’s understanding their long-term competitive advantages and capitalizing on them at the right time by taking very smart long-term risks.

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

Bruce Einhorn and Heejin Kim of Bloomberg report, A Scandal at Korea’s Retirement Giant:

With 546 trillion won ($456.5 billion) in assets, South Korea’s public National Pension Service is the world’s third-largest pension fund, behind Japan’s and Norway’s. It’s also become a part of the widening scandal surrounding impeached President Park Geun-hye.

On Dec. 31, a Seoul court issued a warrant for the arrest of Moon Hyung-pyo, chairman of the NPS. He was suspected of having pressured the fund, when he was a government minister, to support the controversial merger of two Samsung Group-affiliated companies. Moon’s lawyer said the chairman denied the allegations, according to reports in Korean media. Authorities also want to know whether Samsung made donations to benefit a confidante of the president in exchange for help getting NPS support. Jay Y. Lee, Samsung’s heir apparent and de facto leader, was summoned to be questioned as a suspect on Jan. 12. Both Samsung and Lee have denied wrongdoing. The NPS has said it supported the deal based on investment considerations.

Established in 1988, the NPS is Korea’s main public retirement plan and a major investor in the country’s blue-chip companies, owning 9 percent of Samsung Electronics, 8 percent of Hyundai Motor, 10.3 percent of LG Display, and large stakes in other prominent companies. Its potential influence as a shareholder makes it a natural target for pressure from politicians seeking favors from the corporations in its portfolio. The scandal has “created huge risks to the integrity and legitimacy of the NPS,” says Katharine Moon, a political science professor at Wellesley College.

As the fallout from Park’s impeachment spreads, some lawmakers are looking into reforming the pension service. The alleged use of the fund’s investment clout to advance politicians’ agendas “can bring doubts on Korea’s capital markets overall,” says Chae Yibai, a National Assembly member from the opposition People’s Party. “We need to discuss the matter of the independence of the investment management unit from the control of the government, like overseas pension funds,” he says.

Despite its size, the NPS often takes a passive approach in its relations with the chaebol, the family-run conglomerates that dominate Korea’s economy and have close ties with local politicians, says Woojin Kim, an associate professor of finance at Seoul National University. The fund’s management structure contributes to its low-key approach. The NPS has three decision-making bodies to provide public input into investment decisions, but “none of them is formed of members with knowledge of asset management or pension funds,” says Kim Sang-Jo, a professor of international trade at Hansung University in Seoul. Instead, officials from business lobbies, labor unions, and civic groups dominate the committees, and “they have little power or interest in decision-making on important issues at NPS,” says Kim.

The NPS has occasionally taken a more active role, particularly when the government has the lead on an issue. In early 2016 the fund announced plans to blacklist companies that didn’t follow Park’s directive to raise their dividend payouts, part of her effort to get chaebol to reduce their cash hoards and return money to shareholders through dividends or to workers via wage increases.

The NPS has recently felt some pain from a government-dictated relocation of its headquarters to Jeonju, a sleepy provincial capital about 125 miles south of Seoul. During her campaign for president in 2012, Park pledged to help redevelop the southwestern city. More than 30 fund managers, including about 20 in charge of overseas investment, have left the fund rather than relocate, according to the NPS.

By focusing public attention on the tangled relationships among the government, the fund, and business, the turmoil may ultimately help the NPS achieve one stated goal: to invest more outside Korea. “The Korean stock market is going to be too small for them,” says Michael Na, a Korea strategist with Nomura. “More and more of the money will go overseas.” Foreign investments account for less than 150 trillion won, about 27 percent of its total assets, but the NPS wants to expand its foreign portfolio to more than 300 trillion won by 2021. This year it plans to increase international holdings by about 25 trillion won, of which 10 trillion will go to alternative investments such as private equity or bank loans. The NPS in July picked BlackRock and Grosvenor Capital Management to manage as much as $1 billion in hedge fund investments. As for local stocks, the fund “will cautiously approach investing in domestic markets for this year,” spokeswoman Chi Young Hye says.

Moving beyond Korean equities wouldn’t only reduce the risk of political meddling but would also potentially improve investment performance, says Moon of Wellesley. That will be essential as NPS fund managers face the task of supporting Korea’s aging population. “They know the math,” she says. “There will have to be a push to diversify and decrease the overinvesting in a small number of companies.”

The bottom line: Korea’s public retirement plan is a major shareholder in the country’s most important companies, and its chairman has been arrested.

So, what else is new, a scandal at a large national pension fund with paltry governance? How shocking!

Sorry, I’m still in a crabby mood and recovering from the flu with off and on low grade fever but I decided to write on this because it’s just another example of a large pension fund — in this case, the third largest in the world — where lack of proper governance leads to political interference and corruption.

South Korea’s National Pension Service should first and foremost get its governance right. It should relocate its headquarters back to Seoul (nobody worth anything will want to live in Jeonju) and hire a top-notch consulting firm like McKinsey or Boston Consulting Group to make a series of recommendations on how it can bolster its governance, adopting Canadian pension governance standards.

In Canada, there is is a clear separation of pension investments and governments. Instead, most have an independent qualified board overseeing the operations at these pensions where decisions of where and how to invest are made solely by senior pension fund managers that are paid extremely well to run these organizations.

Is it perfect? No, it isn’t and there is always room to improve on governance, but it’s a lot better than having your national pension fund run by a bunch of corrupt cronies who are looking to line their pockets.

The thing that gets me is the part of Korea’s NPS allocating a billion dollars to hedge funds and picking BlackRock and Grosvenor Capital Management.

On Wednesday, Bloomberg reported that BlackRock’s main quantitative hedge-fund strategies were on track to post big losses:

At least three of the quant strategies used by BlackRock’s global hedge fund platform have suffered losses greater than 10 percent in the year through November, according to the client update, a copy of which was seen by Bloomberg. That compares with an average return of 3.6 percent for quant funds, Hedge Fund Research Inc.’s directional quant index shows.

In September, Mark Wiseman, the former head of the Canada Pension Plan Investment Board, was brought in to run the group and no doubt use his huge Rolodex to garner new assets.

But things aren’t going well for this group. I don’t know what exactly is going on at Blackrock’s SAE team but it’s losing top talent and investors. Larry Fink, BlackRock’s CEO, is right to feel frustrated with the group’s poor showing.

[Note: Too many quants with PhDs all doing factor-based models are getting killed. BlackRock needs to really understand why these strategies are unable to perform and if it can’t get to the bottom of it, shut these operations down until it has clear answers to explain their poor performance to investors.]

As far as Grosvenor Capital, it’s a well known fund of funds which invests across hedge funds and other alternative funds. It has a solid reputation but again, why is NPS investing in any hedge funds before it gets its governance right? That just doesn’t make sense to me.

I think Korea’s NPS should be revamped and the first order of business is to drastically improve its governance. Forget hedge funds, private equity funds, infrastructure, real estate or foreign investments. Get the governance right first, implement fraud detection and whistleblower policies, use top-notch consultants and forensic accounting firms to beef up internal compliance and then worry about investing in hedge funds!

By the way, those of you looking to invest in a great macro hedge fund, Bloomberg reports Chris Rokos’s hedge fund rose about 20 percent in 2016, its first full year of trading, to become one of the world’s best-performing money pools betting on economic trends, according to people with knowledge of the matter.

In my opinion, Rokos is a superstar macro manager, one of the very best in the world. Brevan Howard has never been the same without him and he really performed exceptionally well last year which wasn’t an easy year for most hedge funds in general and macro funds in particular (just ask Mr. Soros who lost a cool billion after Trump was elected; Rokos one-upped him last year).

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

Gillian Tan of Bloomberg View reports, Pension Funds Should Look North For Inspiration:

When it comes to at least one type of investing, U.S. pension funds should take a (maple) leaf out of their Canadian counterparts’ playbook.

Despite being among the largest private equity investors, U.S. pension funds such as the California Public Employees’ Retirement System and the California State Teachers’ Retirement System have been slow to transition from a hands-off approach to one that involves actively participating in select deals, a feature known in the industry as direct investing.

A More Direct Approach

The benefits of direct investing are lower (or sometimes no) fees and the potential to enhance returns, and that makes it an attractive proposition. But so far, U.S. pension funds have been pretty content as passive investors for the most part, writing checks in exchange for indirect ownership of a roster of companies but without outsize exposure to any (click on image).

State of the States

State pension funds are comfortable writing checks to private equity firms but could bolster their returns by investing directly in some of those firms’ deals (click on image).

Not so Canadian funds. A quick glance at the list of the private equity investors — commonly referred to as limited partners — that have been either participating in deals alongside funds managed by firms such as KKR & Co. or doing deals on their own since 2006 shows that these funds have had a resounding head start over those in the U.S.

Notably Absent

Large U.S. pension funds are nowhere to be seen among private equity fund investors that participate directly in deals, a strategy used to amplify their returns (click on image).

Canadian funds’ willingness to pursue direct investing is driven in part by tax considerations: they can avoid most U.S. levies thanks to a tax treaty between the two North American nations, while they are exempt from taxes in their own homeland. But U.S. pensions would still benefit from better returns, so it’s curious that they haven’t been more active in this area.

There’s plenty of opportunity for direct investing. Private equity firms are generally willing to let their most sophisticated investors bet on specific deals in order to solidify the relationship (which can hasten the raising of future funds). It also gives them access to additional capital.

Rattling the Can

Private equity firms recognize that offering fund investors the right to participate directly in their deals bolsters their general fundraising efforts (click on image),

The latter point has been a crucial ingredient that has enabled larger transactions and filled the gap caused by the death of the so-called “club” deals (those involving a team of private equity firms) since the crisis.

Seal the Deal

U.S. private equity deals which are partly funded by direct investments from so-called limited partners reached their highest combined total since 2007 (click on image).

There are some added complications. Because some of the deals involve heated auction processes, limited partners must do their own diligence and deliver a verdict fairly quickly. That could prove tricky for U.S. pension funds, which would need to hire a handful of qualified executives and may find it tough to match the compensation offered elsewhere in the industry. Still, the potential for greater investment gains may make it worth the effort — even for funds like Calpers that are reportedly considering lowering their overall return targets.

With 2017 around the corner, one of the resolutions of chief investment officers at U.S. pension funds should be to evolve their approach to private equity investing. They’ve got retired teachers, public servants and other beneficiaries to think about.

This article basically talks about how Canada’s large pensions leverage off their relationships with private equity general partners to co-invest alongside them on bigger deals.

It even cites one recent example in the footnotes where the  Caisse de dépôt et placement du Québec, or CDPQ, in September announced a $500 million investment in Sedgwick Claims Management Services Inc., joining existing shareholders KKR and Stone Point Capital LLC.

Let me cut to the chase and explain all this. An equity co-investment (or co-investment) is a minority investment, made directly into an operating company, alongside a financial sponsor or other private equity investor, in a leveraged buyout, recapitalization or growth capital transaction.

Unlike infrastructure where they invest almost exclusively directly, in private equity, Canada’s top pensions invest in funds and co-invest alongside them to lower fees (typically pay no fees on large co-investments which they get access to once invested in funds where they do pay fees). In order to do this properly, they need to hire qualified people who can analyze a co-investment quickly and have minimum turnaround time.

Unlike US pensions, Canada’s large pensions are able to attract, hire and retain very qualified candidates for positions that require a special skill set because they got the governance and compensation right. This is why they engage in a lot more co-investments than US pension funds which focus exclusively on fund investments, paying comparatively more in fees.

[Note: You can read an older (November 2015) Prequin Special Report on the Outlook For Private Equity Co-Investments here.]

On top of this, some of Canada’s large pensions are increasingly going direct in private equity, foregoing any fees whatsoever to PE funds. The article above talks about Ontario Teachers. In a recent comment of mine looking at whether size matters for PE fund performance, I brought up what OMERS is doing:

In Canada, there is a big push by pensions to go direct in private equity, foregoing funds altogether. Dasha Afanasieva of Reuters reports, Canada’s OMERS private equity arm makes first European sale:

Ontario’s municipal workers pension fund has sold a majority stake in marine-services company V.Group to buyout firm Advent International in the first sale by the Canadian fund’s private equity arm in Europe.

Pension funds and other institutional investors are a growing force in direct private investment as they seek to bypass investing in traditional buyout funds and boost returns against a backdrop of low global interest rates.

As part of the shift to more direct investment, the Ontario Municipal Employees Retirement System (OMERS) set up a private equity team (OPE) and now has about $10-billion invested.

It started a London operation in 2009 and two years later it bought V.Group, which manages more than 1,000 vessels and employs more than 3,000 people, from Exponent Private Equity for an enterprise value of $520-million (U.S.).

Mark Redman, global head of private equity at OMERS Private Markets, said the V.Group sale was its fourth successful exit worldwide this year and vindicated the fund’s strategy. He said no more private equity sales were in the works for now.

“I am delighted that we have demonstrated ultimate proof of concept with this exit and am confident the global team shall continue to generate the long-term, stable returns necessary to meet the OMERS pension promise,” he said.

OMERS, which has about $80-billion (Canadian) of assets under management, still allocates some $2-billion Canadian dollars through private equity funds, but OPE expects this to decline further as it focuses more on direct investments.

OPE declined to disclose how much Advent paid for 51 per cent of V.Group. OPE will remain a minority investor.

OPE targets investments in companies with enterprise values of $200-million to $1.5-billion with a geographical focus is on Canada, the United States and Europe, with a particular emphasis on Britain.

As pension funds increasingly focus on direct private investments, traditional private equity houses are in turn setting up funds which hold onto companies for longer and target potentially lower returns.

Bankers say this broad trend in the private equity industry has led to higher valuations as the fundraising pool has grown bigger than ever.

Advent has a $13-billion (U.S.) fund for equity investments outside Latin America of between $100-million and $1-billion.

The sale announced on Monday followed bolt on acquisitions of Bibby Ship Management and Selandia Ship Management Group by V.Group.

Goldman Sachs acted as financial advisers to the shipping services company; Weil acted as legal counsel and EY as financial diligence advisers.

Now, a couple of comments. While I welcome OPE’s success in going direct, OMERS still needs to invest in private equity funds. And some of Canada’s largest pensions, like CPPIB, will never go direct in private equity because they don’t feel like they can compete with top funds in this space (they will invest and co-invest with top PE funds but never go purely direct on their own).

[Note: It might help if OPE reports the IRR of their direct operations, net of all expenses relative to the IRR of their fund investments, net of all fees so their stakeholders can understand the pros and cons of going direct in private equity. Here you need to look at a long period.]

There is a lot of misinformation when it comes to Canadian pensions ‘going direct’ in private equity. Yes, they have a much longer investment horizon than traditional funds which is a competitive advantage, but PE funds are adapting and going longer too and in the end, it will be very hard, if not impossible, for any Canadian pension to compete with top PE funds.

I am not saying there aren’t qualified people doing wonderful work investing directly in PE at Canada’s large pensions, but the fact is it will be hard for them to match the performance of top PE funds, even after fees and expenses are taken into account.

Who knows, maybe OPE will prove me wrong, but this is a tough environment for private equity and I’m not sure going direct in this asset class is a wise long-term strategy (unlike infrastructure, where most of Canada’s large pensions are investing directly).

When it comes to private equity, Mark Wiseman once uttered this to me in a private meeting: “Unlike infrastructure where we invest directly, in private equity it will always be a mixture of fund investments and co-investments.” When I asked him why, he bluntly stated: “Because I can’t afford to hire David Bonderman. If I could afford to, I would, but I can’t.”

Keep in mind these are treacherous times for private equity and investors are increasingly scrutinizing any misalignment of interests, but when it comes to the king deal makers, there is no way Canada’s top ten pensions are going to compete with the Blackstones, Carlyles and KKRs of this world who will get the first phone call when a nice juicy private deal becomes available.

Again, this is not to say that Canada’s large pensions don’t have experienced and very qualified private equity professionals working for them but let’s be honest, Jane Rowe of Ontario Teachers won’t get a call before Steve Schwarzman of Blackstone on a major deal (it just won’t happen).

Still, despite this, Canada’s large pensions are engaging in more direct private equity deals, sourcing them on their own, and using their competitive advantages (like much longer investment horizon) to make money on these direct deals. They don’t always turn out right but when they do, they give even the big PE funds a run for their money.

And yes, US pensions need to do a lot more co-investments to lower fees but to do this properly, they need to hire qualified PE professionals and their compensation system doesn’t allow them to do so.

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

Heather Gillers of the Wall Street Journal reports, America’s Largest Pension Fund: A 7.5% Annual Return Is No Longer Realistic:

Top officers of the largest U.S. pension fund want to lower their investment targets, a move that would trigger more pain for cash-strapped cities across California and set an increasingly cautious tone for those who manage retirement assets around the country.

Chief Investment Officer Ted Eliopoulos and two other executives with the California Public Employees’ Retirement System plan to propose next Tuesday that their board abandon a long-held goal of 7.5% annually, according to system spokesman Brad Pacheco. Reductions to 7.25% and 7% have been studied, according to new documents posted Tuesday.

The last time the California system lowered its investment expectation was in 2012, when the rate was dropped to 7.5% from 7.75%.

The new recommendation comes just 13 months after the fund known by its acronym Calpers agreed to a plan that would slowly scale back its target by as much as a quarter percentage point annually—and only in years of positive investment performance. Now Mr. Eliopoulos and other officials are concerned that plan may not be fast enough because of a mounting cash crunch and declining estimates of future earnings.

“There’s no doubt Calpers needs to start aligning its rate of return expectations with reality,” California Gov. Jerry Brown said in a statement provided to the Journal.

The accounting maneuver would have real-life consequences for taxpayers and cities. It would likely trigger a painful increase in yearly pension bills for the towns, counties and school districts that participate in California’s state pension plan. Any loss in expected investment earnings must be made up with significantly higher annual contributions from public employers as well as the state.

“Lowering the rate of return sooner is undoubtedly going to make it more difficult for cities that are teetering on the edge financially,” said Bruce Channing, chair of the city managers’ pensions committee for the California League of Cities.

Nearly three quarters of school districts said in a survey conducted by Calpers that the impact of dropping the rate would be “high” or “extremely high.”

A drop in Calpers’s rate of return assumptions could also put pressure on other funds to be more aggressive about their reductions and concede that investment gains alone won’t be enough to fund hundreds of billions in liabilities. Because of its size, Calpers typically acts as a bellwether for the rest of the pension world. It manages nearly $300 billion in assets for 1.8 million members.

Pensions have long been criticized for using unrealistic investment assumptions, which proved costly during the last financial crisis. More than two-thirds of state retirement systems have trimmed their assumptions since 2008, according to an analysis of plans by the National Association of State Retirement Administrators.

The Illinois Teachers Retirement System in August dropped its target rate to 7% from 7.5% in August, the third drop in four years, and the fund’s executive director has said the rate will likely be reduced further next year. The $184 billion New York State and Local Retirement System lowered its assumed rate from 7.5% to 7% in 2015.

Amit Sinha of The Thought Factory blog also wrote an opinion piece for MarketWatch, What Calpers decides about its investment-returns forecast matters for pension plans (and taxpayers) across the U.S.:

The investment team at Calpers has been signaling that the current assumption of 7.5% long-term investment returns may be too high, and it would probably peg it around 6% instead.

The 7.5% rate is hardly unusual among government pension funds. But as the $300 billion gorilla in the pension world, any change — likely to be discussed at its Dec. 19 board meeting — will be watched by other pension plans that could then have a harder time justifying their own targeted returns.

This chart of expected-return assumptions of some of the larger pension plans shows that while about 40% of the largest corporate plans assume returns 7% and below, only 9% of public pensions assume returns 7% and below (click on image).

There is an element of subjectivity in estimating future returns, and the decision comes loaded with behavioral and political implications. The number determines how well-funded a pension plan is, which in turn determines the amount a state or municipality needs to pay into their pension system. A higher number can make the pension plan appear healthier, requiring lower contributions today.

If the funded status appears artificially high, one risk is that officials can promise a level of benefits that they may be unable to maintain. In the future that can lead to higher taxes, fewer services and even a cut in actual pension benefits.

The flip side is that reducing the expected return to 6% may double the immediate contributions of some municipalities, according to Pension & Investments, adding to local budget stresses.

Look at what has been happening in Dallas over the past month. The troubled $2.1 billion Dallas Police and Fire System suspended lump-sum withdrawals and has asked the city for a one-time infusion of $1.1 billion, an amount roughly equal to Dallas’ entire general fund (but nowhere close to what the pension fund needs to be fully funded).

This case highlights two negative behavioral implications of using artificially high future investment assumptions to value pension benefits. First, the impression of being well funded can lead to making promises you cannot keep. In 1993 Dallas provided generous benefits without appropriately accounting for how it might be able to meet them. Second, expecting higher returns can drive money into riskier investments with the promise of higher returns. In the case of Dallas, the pension system invested in real-estate deals that didn’t deliver as expected.

My friend and author Ben Carlson has collated a few more examples of troubled pension plans here.

Widening out across the nation, the extent of underfunding is likely not $1 trillion across states — but $6 trillion.

Why is this?

The financially accurate approach to valuing future liabilities is using a discount rate that you are relatively certain of earning, such as a Treasury or high quality bond rate. Private pensions are required to account for their liabilities using high-quality bond rates. As the chart below shows, the rates that public pensions are required to use to account for their liabilities are significantly higher than the rates used by corporate pensions. This results in understating public pension liabilities, and creates an incentive to make expected returns as high as possible (click on image).

The investment consultant Callan Associates created this series of pie charts to highlight the increased complexity that pension plans need to take on in order to meet a 7.5% return assumption today. In January 1995, the 10-year Treasury yield was around 7.75%, allowing you to earn 7.5% returns over 10 years with relative certainty; currently it is just under 2.5%, thereby pushing investors into assets such as equities and alternatives that might provide higher returns, but come with greater risk. The S&P 500 for example, returned an annualized return of 10% since 1995, but came with higher volatility, including a 50% decline in value during the financial crisis (click on image).

Calpers has a relatively well-balanced asset allocation, as this table shows, and shooting for higher returns would mean increasing the risk profile of the fund, which may not be prudent (click on image).

Critics of moving to a more financially accurate method of pension accounting rightly point to the immediate pain that would cause. If municipalities in California have to double their contributions by reducing discount rates from 7.5% to 6%, then it would be a disaster for them if they used a discount rate similar to that of corporate pensions.

However, there is something flawed in this logic. Instead of acknowledging the problem and then finding a solution, the critics would rather pretend the problem doesn’t exist. It’s the difference between “you owe $6 trillion, let’s work out a way for you to pay it off over time” and “you only owe $1 trillion, no big deal”.

Unless the true extent of underfunding is brought to light, we may be providing beneficiaries with a false hope that their promised benefits are secure. If taxpayers reach the limit of what they are willing to contribute, and state and federal governments are unable or unwilling to step in, then a cut in benefits may end up on the cards.

Even if over the next few years we see stellar investment returns (and I hope we do!), this conversation needs to happen. Instead of increasing benefits or reducing contributions, excess investment returns should be used to fill the widening hole. And the first step toward that is recognizing the size of that hole.

What Calpers decides to do with its expected-return assumption is likely to be a political decision, driven by compromise. The hope is that it can open up a much-needed debate that leads taxpayers, beneficiaries, pension committees and governments down the path of better understanding who is going to bear the risk of things not going as planned.

But if we hide the numbers, it’s hard to make the right decisions.

Amit Sinha has worked in the investment industry for over 16 years and in his spare time writes about bringing financial concepts, technology, design and behavior together. You can follow him on his blog The Thought Factory.

I’ve already covered why CalPERS needs to get real on future returns, stating the following:

The main reason why US public pensions don’t like lowering their return assumptions is because it effectively means public sector workers and state and local governments will need to contribute more to shore up these pensions. And this isn’t always feasible, which means property taxes might need to rise too to shore up these public pensions.

This is why I keep stating the pension crisis is deflationary. The shift from defined-benefit to defined-contribution plans shifts the retirement risk entirely on to employees which will eventually succumb to pension poverty once they outlive their meager savings (forcing higher social welfare costs for governments) and public sector pension deficits will only be met by lowering return assumptions, hiking the contributions, cutting benefits or raising property taxes, all of which take money out of the system and impact aggregate demand in a negative way.

This is why it’s a huge deal if CalPERS goes ahead and lowers its investment return assumptions. The ripple effects will be felt throughout the economy especially if other US public pensions follow suit.

Unfortunately, CalPERS doesn’t have much of choice because if it doesn’t lower its return target and its pension deficit grows, it will be forced to take more drastic actions down the road. And it’s not about being conservative, it’s about being realistic and getting real on future returns, especially now that California’s pensions are underfunded to the tune of one trillion dollars or $93K per household.

It’s not just CalPERS. From Illinois to Kentucky, US public pensions need to get real on future return assumptions or pray for a miracle that will never happen.

And the Dow 20,000 won’t save them or other pensions which are chronically underfunded. This too is a pipe dream which ignores the simple fact that no matter how good investment teams are at US public pensions, investment gains alone will never be enough to shore up public pensions over the long run.

Why? Because pensions are all about managing assets and liabilities. Those liabilities are long-dated (go out 75+ years) so for any decline in interest rates, the increase in liabilities is disproportionately larger than the gain in assets (in finance parlance, the duration of liabilities is much larger than the duration of assets, so any decline in rates will impact liabilities negatively more than it impacts assets in a positive way).

Now, a lot of people are getting excited about rates going up at the same time as assets going up. After the Fed raised rates on Wednesday, I was shocked to see how many industry professionals were parading in front of CNBC cameras claiming that “inflation concerns are on the rise” and the “Fed will surprise markets by raising rates a lot more aggressively in 2017″.

Total nonsense! Keep dreaming! I stand by everything I wrote last Friday when I went over the unleashing of animal spirits and think a lot of people aren’t paying attention to the surging greenback making a 14-year high (and going higher) and how it will tighten US financial conditions, lower US inflation expectations (via lower import prices) and hurt the domestic economy and possibly spur another Asian financial crisis, starting in China.

I know, president-elect Donald Trump and his powerhouse administration will “make America great again” allowing US public pensions to get back to the good old days when they were using 8%+ investment return assumptions to discount their future liabilities.

Like I said, keep dreaming, these markets seem so easy when they quietly keep rising but that’s when you need to be paying the most attention because the trend is your friend until it isn’t and when things shift, they shift very abruptly, especially when expectations are priced for perfection in terms of fiscal and monetary policy.

All this to say that 7.5% annualized return over the next ten years is a big pipe dream and no matter how much US public pensions allocate to illiquid or liquid alternatives, they will never attain this bogey without taking huge risks which will likely set them back further in terms of funded status.

I am open to all criticisms, suggestions, counterpoints, but I pretty much stand by everything I’ve written above and think that the day of reckoning for many US public pensions is right around the corner. Better to be safe than sorry which is why CalPERS is right to lower its future return assumptions. Others will necessarily have to follow or risk a much worse outcome down the road.

Let me repeat, I don’t care if you’re CalPERS, CalSTRS, Ontario Teachers’, HOOPP or if you have George Soros, Ken Griffin, Jim Simons, Steve Schwarzman and Ray Dalio all sitting on your investment committee, investment gains alone are not going to shore up your pension when times are tough, especially if it’s already chronically underfunded.

At one point, pension plans need to adjust benefits too or shore up public pensions via more taxpayer dollars. That’s when the real fun begins.

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

Vipal Monga and Heather Gillers of the Wall Street Journal report, Dow 20000 Won’t Wipe Away Pension Problems:

The 2016 surge in stocks and bond yields is a rare positive for U.S. company and public pensions. But it doesn’t solve their problems.

In November large corporate retirement plans gained back $116 billion needed to pay out future benefits largely because of dramatic market movements following Donald Trump’s Nov. 8 election win, according to consulting firm Mercer Investment Consulting LLC.

The S&P 500 soared and long-term interest rates rose, boosting asset values and lowering liabilities for pensions at 1,500 of the largest U.S. companies. The present-day value of future obligations owed by companies falls when interest rates rise.

Even with November’s gains, corporate pensions were left with a $414 billion funding deficit, $10 billion larger than it was at the end of last year, according to Mercer. Funding deficits occur when the value of assets in pension plans don’t equal the projected future payments to retirees.

“It’s been good, but not great,” said Michael Moran, pension strategist at Goldman Sachs Asset Management. “Things are better than where we were a month ago, but it’s still too early to declare victory.”

That tempered reaction indicates the magnitude of the funding gap faced by managers of retirement assets across the U.S. Pensions still haven’t recovered from the chronic deficits created by the financial crisis and perpetuated by low interest rates.

The largest corporate-pension funds lost more than $300 billion during the 2008 downturn, according to consulting firm Milliman Inc., and that loss wiped out the previous five years of gains.

Pension deficits are a big deal for companies, because firms must close funding gaps with cash they could use for other purposes. Companies such as General Motors Co., International Paper Co., and CSX Corp. have all borrowed money this year to pump funds into their pension plans.

Companies in the S&P 1500 have contributed $550 billion into their pension plans between 2008 and Nov. 30 of this year, according to Mercer. Even with those contributions, their funded status was 81.3% as of Nov. 30.

Although pension-funding levels fluctuate during the year, most companies lock in their pension obligations at the end of the year for accounting purposes. November’s run-up, if it continues into December, could help lessen the burden of what had earlier been shaping up to be a big drag on 2016 financial results.

Funding holes are a trickier problem for funds that manage the pension assets of public workers because market rallies don’t automatically help close the gap.

Public-pension liabilities have grown significantly over the past decade, with the 30 largest plans tracked by the Public Plans Database showing a net pension debt of $585 billion in 2014, compared with $186 billion in 2005.

Almost all public retirement systems engage in an accounting practice known as “smoothing” returns, meaning it takes time to fully recognize investment earnings that exceed expectations. That approach limits how much the funding status will improve this year even if strong stock markets help the plans earn a return above their targets.

“All we know is that interest rates have popped up a little bit and equity prices have run up over the last three weeks,” said Alan Perry, an actuary with Milliman. “How that’s going to filter into the ingredients that go into forecasting long-term returns, it’s too early to tell.”

The largest public pension in the U.S., California Public Employees’ Retirement System, is debating whether to lower its expected rate of return—currently 7.5%.

The fund, known by its acronym Calpers, absorbed substantial losses during the last recession and currently has just 68% of assets needed to pay for future obligations. It earned 0.6% on its investments in the fiscal year ended June 30, well short of its annual goal.

“It’s too early to tell whether this [recent improvement] is something that’s going to be sustained,” said California State Controller Betty T. Yee, who serves on Calpers’s board.

This is a good article which explains why big gains in the stock market and the backup in yields aren’t going to make a dent in America’s ongoing pension crisis.

First, let me split US private pensions apart from US public pensions. Unlike the latter, the former aren’t delusional when it comes to discounting their future liabilities. In particular, they don’t use rosy investment assumptions to discount future liabilities but actual AAA corporate bond yields which have declined a lot as government bond yields hit record lows.

Some think using market rates artificially inflates pension deficits at America’s corporate defined-benefit plans and there is some truth to this argument. But one thing is for sure, if reported corporate pension deficits are higher than they should be at private corporations, US public pension deficits are woefully under-reported using a silly and delusional approach which discounts future liabilities using a pension rate-of-return fantasy.

Now, it’s in US corporations’ best interests to over-report their pension deficits just like it’s in the best interests of US public plans to under-report them. How so? Aren’t pension deficits a noose around the neck of US corporations?

Yes, they are which is why they are trying to offload the risk onto employees and get rid of defined-benefit plans altogether for any new employees. What concerns me is that they are shifting everyone into defined-contribution plans which will only ensure more pension poverty down the road. That is the brutal truth on DC pensions, they aren’t real pensions employees can count on.

Interestingly, in an email exchange, Jim Leech, the former president of the Ontario Teachers’ Pension Plan, agreed with Bob Baldwin’s comments on Canada’s great pension debate and added this:

“My recollection is that the Tories were lobbied hard for this after New Brunswick succeeded in its reform and reluctantly introduced the TB concept. I say reluctantly because they were more interested in promoting their group DC plan – forget the name (it was PRPPs).

So drafting was in works by civil servants before Liberals won. The Canada Post labour strife put back on front burner as TB is most helpful answer there but unions are fighting tooth and nail. Liberals likely thought there would be no outcry as there was none when Tories announced originally.

Still amazed that GM/Unifor went straight to DC instead of adopting TB.”

What Jim is referring to is that sponsors are shifting employees into defined-contribution plans without first assessing the merits of target or variable-benefit plans.

Of course, TB plans are not DB plans and this is something that employees should be made aware of and something Bob Baldwin explained further when I asked him where he considers various plans (like OTPP, HOOPP, OMERS, etc.) fall in the spectrum:

“I would reserve the term Target Benefit for plans in which all accrued benefits (i.e. accrued benefits of active members, retirees and deferred vested benefits) are subject to adjustment based on the financial status of the plan. Aside from the New Brunswick’s shared risk plans, the best examples of this type of plan are the union initiated multi-employer plans. I would describe OTPP and HOOPP as plans that are largely but not purely DB. They are not purely DB because they have shifted some financial risk from the contribution rate to the benefits.

The fact that you asked the question is important to me. It speaks to the reality that pension design is more like a spectrum of choice rather than a binary choice between DB and DC or even a three way choice among DB, DC and TB. There are any number of ways that financial risk can be allocated. Unfortunately, when the reality that confronts us is a spectrum, the language we will choose to describe it will almost always be more categorical than the reality itself. That’s why in my earlier email urged paying more attention to how risk is allocated and less to the labels we use.”

I agree with Bob Baldwin and might add that even though OTPP and HOOPP are fully or even over-funded, not every public pension plan can do what they’re doing either because they don’t have the governance or because their investment policies don’t allow them to take the leverage that these two venerable Canadian pension plans take.

Also, while I like their use of adjusting inflation protection partially or fully to get their respective  plans back to fully-funded status, former actuary Malcolm Hamilton made a good point to me yesterday that in a low inflation world, adjusting for inflation protection becomes a lot harder and less effective (God forbid we go into deflation, then there will be no choice but to raise contributions, cut benefits or increase taxes).

As far as US public plans, they truly need a miracle. Every day I read articles about horror stories at Dallas, Chicago, San Diego, and elsewhere in the United States.

I highly recommend every state plan follows CalPERS and gets real on future returns but I recognize this will have ripple effects on the US economy and deter from growth over a long period.

The problem is ignoring the elephant in the room and waiting for disaster to strike (another financial crisis) will only make the problem that much worse in the future and really deter from US growth.

President-elect Trump is meeting with tech executives today. I think that is great as America needs to tackle its productivity problem, but something tells me he should also meet with leaders of US pension plans to discuss how pensions can make America great again.

One thing is for sure, Dow 20,000 or even 50,000 under Trump isn’t going to solve America’s pension ills or make a dent in America’s ongoing retirement crisis. And if we get another financial crisis, deflation, Dow 5,000 and zero or negative rates for a very long time, all pensions are screwed, especially US public pensions.

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

Richard Ferguson of the Australian reports, CPPIB acquires 50pc stake in AMP Capital-managed NZ portfolio:

North American investor Canada Pension Plan Investment Board has acquired a half-stake in an AMP Capital-managed portfolio of New Zealand properties for $NZ580 million ($557m).

CPPIB bought the 50 per cent interest in the New Zealand properties from another ­Canadian fund investor, PSP ­Investments, which will keep a half-stake in the suite of prime office and retail assets.

The portfolio of 13 buildings is worth $NZ1.1 billion in total and is located primarily in Wellington and Auckland.

Yesterday’s move was CPPIB’s first investment in New Zealand and saw the fund expand its $C38.4bn ($39bn) worth of global real estate investments.

CPPIB head of Asian real estate investments Jimmy Phua said the Canadian pension fund was attracted to New Zealand’s strong population growth and buoyant tourism sector.

“With this acquisition, we are able to gain a meaningful presence in the New Zealand commercial real estate market, partnering alongside PSP Investments, who is a like-minded, long-term partner,” he said.

CPPIB is partnered with AMP Capital in several Australian ventures and said the firm would continue to manage the New Zealand portfolio. “This is a rare opportunity to acquire a ­diversified portfolio that includes top-tier office and retail properties in New Zealand,” he said.

The AMP-managed property portfolio includes the Botany Town Centre and the Manukau Supa Centre in Auckland.

It also holds the 13-level St Pauls Square office building in Wellington, which is undergoing a $38 million refurbishment, ­before the New Zealand government moves in after signing a 15-year lease.

AMP Capital head of real estate investments Chris Judd said there had been talks about the expansion of the New Zealand property portfolio.

“Ultimately we will be looking at more acquisitions in the near future but right now I’m ­focused on investment performance,” he said.

CPPIB put out this press release going over the deal:

Canada Pension Plan Investment Board (CPPIB) announced today that it has signed an agreement to acquire a 50% interest in a diversified portfolio of prime office and retail properties in New Zealand from the Public Sector Pension Investment Board (PSP Investments). The 50% interest is valued at NZ$580 million (C$545 million) with an equity investment of NZ$230 million (C$216 million) subject to customary closing adjustments. PSP Investments will continue to hold the remaining 50% interest. The portfolio will continue to be managed by AMP Capital, an existing partner of CPPIB in Australia.‎

The portfolio comprises a mix of 13 well-located office properties and high-quality shopping centres totalling approximately 268,000 square metres (2.9 million square feet). Located primarily in Auckland and Wellington, the properties are situated within the central business districts and growing metropolitan markets.

“This is a rare opportunity to acquire a diversified portfolio that includes top-tier office and retail properties in New Zealand, a market with continuing population and tourism growth,” said ‎Jimmy Phua, Managing Director, Head of Real Estate Investments – Asia, CPPIB. “With this acquisition, we are able to gain a meaningful presence in the New Zealand commercial real estate market, partnering alongside PSP Investments, who is a like-minded, long-term partner and extending our relationship with AMP Capital.”

The transaction is expected to close following customary closing conditions and regulatory approvals.

At September 30, 2016, CPPIB’s investments in global real estate totalled C$38.4 billion.

I don’t know much about New Zealand except that it’s a beautiful country and boasts the best rugby team in the world, the All Blacks.

From what I’ve read, New Zealand’s political stability is in stark contrast to Australia’s shakes and shifts and the country’s economy is being labeled “the miracle economy“.

Why did CPPIB buy this real estate portfolio? To diversify its real estate holdings in Asia and New Zealand, just like Australia, is a stable country with a strong economy which will benefit over the long term as Asian emerging markets grow.

It is also worth noting that the Kiwi-CAD cross rate is fairly stable and one Canadian dollar equals about 1.06 New Zealand dollars, so currency risk isn’t as big of a deal here (unless you get a Brexit type of event in New Zealand which seems highly unlikely).

Why is PSP selling part of its real estate holdings in New Zealand? Why not? It wants to lock in profits and focus its attention elsewhere. It’s not selling out, still has a big stake, and now has a great long-term investor alongside it to manage these assets.

Don’t forget, in Canada, it’s all a big giant pension club. Everyone knows each other. André Bourbonnais, PSP’s CEO, used to work at CPPIB and knows Mark Machin, CPPIB’s CEO, very well. Neil Cunningham, PSP’s Senior Vice President and Global Head of Real Estate Investments, knows Graeme Eadie, CPPIB’s Senior Managing Director & Global Head of Real Assets.

There is a lot of communication between the senior managers of Canada’s large pensions so if someone is looking to unload something or buy something, they will talk to each other first to see if they can strike a deal. It could be that CPPIB’s real estate partner in Australia, AMP Capital, approached them with this particular deal but I am certain there were high level discussions between senior representatives at these funds.

Anyway, that isn’t a bad thing, especially between PSP and CPPIB, two of the largest Canadian Crown corporations with very similar liquidity profiles and a lot of money to invest across public and private markets all around the world. In my opinion, they should be partnering up on more deals.

[Note: One area where they are not similar is in the way they benchmark their respective policy portfolios and in particular, the way they benchmark real estate assets. This is a deficiency on PSP’s part which I’ve discussed plenty of times on this blog, like when I covered PSP’s fiscal 2016 results. Neil Cunningham and his team are doing an outstanding job managing PSP’s real estate portfolio, but it sure helps that their benchmark doesn’t reflect the risks they take and is easy to beat.]

In other real estate news, Pooja Sarkar of India’s Economic Times reports, CPPIB to invest in India’s largest realty deal:

In the largest deal brewing up in the commercial real estate space in India, Canada Pension Plan Investment Board ( CPPIB) is leading the negotiation to acquire private equity firm Everstone Group’s industrial and logistics real estate development platform, IndoSpace, as part of private real estate investment (REIT), said two people familiar with the development.

The entire deal is pegged at Rs 15,000 crore making it the largest commercial real estate transaction in the country, they added.

“The deal has been structured in two parts, in the first phase, CPPIB will acquire the ready development space of nearly 10 million sft for nearly Rs 4000 crore,” said the first person mentioned above.

“Indospace is developing another 30 million sft across the country which will be developed and added to this portfolio and the payouts will be linked to that. Everstone will continue to manage these assets even after the full sale process,” the second person added.

IndoSpace is a joint venture between Everstone Group and US-based Realterm. Everstone is a private equity and real estate firm that focuses on India and South-East Asia, with over $3.3 billion of assets under management. Realterm is an industrial real estate firm that manages approximately $2.5 billion of assets across 300 operating and development properties in North America, Europe and India.

Sources add that Everstone has hired Citi bank to run the sale process.

Reits are entities that own rent-generating real estate assets and offer investors regular income streams and long-term capital appreciation.

With this sale, this would be the first successful Reit offering from the Indian subcontinent.

“The talks were on with three serious contender but final negotiations are underway with CPPIB and it would be the largest investment by Canadian pension fund in India to date,” the first person added.

CPPIB and Everstone both declined to comment for the story.

The deal is expected to be signed by January end with CPPIB head expected to visit India two weeks late and discuss the transaction, said another person involved in the matter.

This is a good deal as India is one of the emerging markets that many analysts feel has great prospects ahead even if there will be problems along the way, like its unprecedented assault on cash.

The point with all these private market deals is that CPPIB, PSP and other large Canadian pensions are setting up teams in these regions and finding the right partners to make these long-term strategic investments which will benefit their funds and their beneficiaries.

Below, Canada Pension Plan Investment Board Chief Executive Officer Mark Machin says he was among the minority of investors who accurately foresaw Donald Trump’s march to the White House:

In an interview on BNN, Machin said his doubts in the polls indicating a Hillary Clinton victory began growing in late 2015.

“I had personally predicted a Trump win for the past year; I thought the margin of error was very, very tight in the polls … and it could quite easily swing in Trump’s direction,” he said.

Machin said investors can easily assess scheduled political events like the U.S. election and the U.K. referendum, but are no better at accurately predicting the outcome than the polls.

“Markets are not great at judging the outcomes because market participants don’t really have any better insight than anybody else on what the politics and public opinion is going to be,” he said. “They’re also not that great at judging what the reaction will be after the event as well, and that was classically the case in … the U.S. election.”

Watch the entire interview below or click here if it doesn’t load below. He discusses CPPIB’s investments and how they are positioning their portfolio to achieve the long-term actuarial target rate-of-return. He also discusses why CPPIB’s governance is the key to its long-term success.

I met Mark Machin a few months ago when he was in Montreal and think he’s very nice, very smart and a very capable leader.

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

Frank McGuire of Newsmax Finance reports, Former Fed Adviser: ‘Some Miracle’ Needed to Defuse $1.3 Trillion Pensions Time Bomb:

America will need “some miracle” to survive the looming economic disaster of $1.3 trillion worth of underfunded government pensions, a former Federal Reserve adviser has warned.

“The average state pension in the last fiscal year returned something south of 1%. You cannot fill that gap with a bulldozer, impossible,” Danielle DiMartino Booth told Real Vision TV.

The median state pension had 74.5 percent of assets needed to meet promised benefits, down from 75.6 percent the prior year. The decline followed two years of gains. The shortfall for states overall was $1.1 trillion in 2015 and has continued to grow.

“Anyone who knows their compounding tables knows you don’t make that up. You don’t get that back unless you get some miracle,” Business Insider quoted the president of Money Strong as saying.

“The baby boomers are no longer an actuarial theory,” she said. “They’re a reality. The checks are being written.”

Pressure on governments to increase pension contributions has mounted because of investment losses during the recession that ended in 2009, benefit increases, rising retirements and flat or declining public payrolls that have cut the number of workers paying in. U.S. state and local government pensions logged median increases of 3.4 percent for the 12 months ended June 30, 2015, according to data from Wilshire Associates.

State and local pensions count on annual gains of 7 percent to 8 percent to pay retirement benefits for teachers, police officers and other civil employees. The funds are being forced to re-evaluate projected investment gains that determine how much money taxpayers need to put into them, given the recent run of lackluster returns.

And while many aging Americans have accepted the “new reality” that they would be retiring at 70 instead of 65, any additional extension won’t be welcome. “They’re turning 71. And the physiological decision to stay in the workforce won’t work for much longer. And that means that these pensions are going to come under tremendous amounts of pressure,” she said.

“And the idea that we can escape what’s to come, given demographically what we’re staring at is naive at best. And it’s reckless at worst,” DiMartino Booth said. “And when you throw private equity and all of the dry powder that they have — that they’re sitting on — still waiting to deploy on pensions’ behalf, at really egregious valuations, yeah, it’s hard to sleep at night,” she said.

DiMartino Booth cited Dallas as an example of the pensions crisis, where returns for the $2.27 billion Police and Fire Pension System have suffered due to risky investments in real estate.

“We’re seeing this surge of people trying to retire early and take the money. Because they see it’s not going to be there. And if that dynamic and that belief spreads– forget all the other problems,” DiMartino Booth said. “The pension fund — underfunding is Ground Zero.”

DiMartino Booth warned of public violence if her pensions predictions come to fruition. Large pension shortfalls may lead to cuts in services as governments face pressure to pump more cash into the retirement systems.

“This is where the smile comes off my face. We are an angry country. We’re an angry world. The wealth effect is dead. The inequality divide is unlike anything we’ve seen since the years that preceded the Great Depression,” she said.

To be sure, New Jersey became the state with the worst-funded public pension system in the U.S. in 2015, followed closely by Kentucky and Illinois, Bloomberg recently reported.

The Garden State had $135.7 billion less than it needs to cover all the benefits that have been promised, a $22.6 billion increase over the prior year, according to data compiled by Bloomberg. Illinois’s unfunded pension liabilities rose to $119.1 billion from $111.5 billion.

The two were among states whose retirement systems slipped further behind as rock-bottom bond yields and lackluster stock-market gains caused investment returns to fall short of targets.

Danielle DiMartino Booth, president of Money Strong, is one smart lady. I’ve heard her speak a few times on CNBC and she understands Fed policy and the economy.

In this interview, she highlights a lot of the issues I’ve been warning of for years, namely, state pensions are delusional, reality will hit them all hard which effectively means higher contributions, lower benefits, higher property taxes and a slower economy as baby boomers retire with little to no savings.

I’ve also been warning my readers that the global pension crisis isn’t getting better, it’s deflationary and it will exacerbate rising inequality which is itself very deflationary.

I discussed all this in my recent comment on CalPERS getting real on future returns:

So, CalPERS is getting real on future returns? It’s about time. I’ve long argued that US public pensions are delusional when it comes to their investment return assumptions and that if they used the discount rates most Canadian public pensions use, they’d be insolvent.

And J.J. Jelincic is right, taking too little risk in public equities is walking away from upside but he’s not being completely honest because when a mature pension plan with negative cash flows the size of CalPERS is underfunded, taking more risk in public equities can also spell doom because it introduces a lot more volatility in the asset mix (ie. downside risk).

When it comes to pensions, it’s not just about taking more risk, it’s about taking smarter risks, it’s about delivering high risk-adjusted returns over the long run to minimize the volatility in contribution risk.

Sure, CalPERS can allocate 60% of its portfolio to MSCI global stocks and hope for the best but can it then live through the volatility or worse still, a prolonged recession and bear market?

This too has huge implications because pension plans are path dependent which means the starting point matters and if the plan is underfunded or severely underfunded, taking more risk can put it in a deeper hole, one that it might never get out of.

…

The main reason why US public pensions don’t like lowering their return assumptions is because it effectively means public sector workers and state and local governments will need to contribute more to shore up these pensions. And this isn’t always feasible, which means property taxes might need to rise too to shore up these public pensions.

This is why I keep stating the pension crisis is deflationary. The shift from defined-benefit to defined-contribution plans shifts the retirement risk entirely on to employees which will eventually succumb to pension poverty once they outlive their meager savings (forcing higher social welfare costs for governments) and public sector pension deficits will only be met by lowering return assumptions, hiking the contributions, cutting benefits or raising property taxes, all of which take money out of the system and impact aggregate demand in a negative way.

This is why it’s a huge deal if CalPERS goes ahead and lowers its investment return assumptions. The ripple effects will be felt throughout the economy especially if other US public pensions follow suit.

The point is CalPERS is a mature plan with negative cash flows and it’s underfunded so it needs to get real on its return assumptions as do plenty of other US state pensions that are in the same or much worse situation (most are far worse).

Now, to be fair, the situation isn’t dire as the article above states the median state pension has had 74.5 percent of assets needed to meet promised benefits, down from 75.6 percent the prior year. Typically any figure close to 80% is considered fine to pension actuaries who smooth things out over a long period.

But as DiMartino Booth correctly points out, the structural headwinds pensions face, driven primarily by demographics but other factors too, are unlike anything in the past and looking ahead, the environment is very grim for US state pensions.

Maybe the Trump reflation rally will continue for the next four years and interest rates will normalize at 5-6% — the best scenario for pensions. But if I were advising US state pensions, I’d say this is a pipe dream scenario and they are all better off getting real on future returns, just like CalPERS is currently doing.

Defusing America’s pensions time bomb will require some serious structural reforms to the governance of these plans and adopting a shared-risk model so that the risk of these plans doesn’t just fall on sponsors and taxpayers. Beneficiaries need to accept that when times are tough, their benefits will necessarily be lower until these plans get back to fully funded status.

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

Dylan Cox of Pitchbook reports, Size doesn’t matter in PE fund performance over the long term:

Despite the dueling claims that smaller PE fund managers lack sophistication or sufficient scale, or that larger fund managers lack the nimbleness, operational focus and expertise necessary to improve portfolio companies, returns across different fund sizes are relatively uniform in the long term. 10-year horizon IRRs for PE funds of any size bucket are all between 10% and 11%.

When comparing returns on a horizon basis, it’s important to remember that the data is indicative of market conditions over time, and not the returns of any one vintage. For example, a lower IRR across the industry between the five- and 10-year horizon is not indicative of a loss of alpha-generating capacity after the five-year mark, but rather a reflection of the stretched hold periods and asset write-offs that plagued many PE portfolios during the recession. Similarly, the three-year horizon IRR is the highest we observe, due to the fact that these investments were made before the recent run-up in valuations and have been subsequently marked as such—even though many of these returns have yet to be fully realized through an exit.

Interestingly, funds with less than $250 million in AUM have underperformed the rest of the asset class on a one- and three-year horizon. This is at least partially due to the aforementioned run-up in valuations which stemmed from cash-heavy corporate balance sheets that went looking for inorganic growth through strategic acquisitions—a strategy that often doesn’t reach the lower middle market (LMM) of PE. Only in the last few months have valuations started to rise in the LMM and below, as PE firms of all stripes increasingly look for value plays through add-ons and smaller portfolio companies.

Note: This column was previously published in The Lead Left.

For more data and analysis into PE fund performance, download our new Benchmarking Report.

Let me first thank Ken Akoundi of Investor DNA for bringing this up to my attention. You can subscribe to Ken’s distribution list where he sends a daily email with links to various articles covering industry news here.

As far as this study, I would be careful interpreting aggregate data on PE funds and note that previous studies have shown that there is performance persistence in the private equity industry.

Yesterday I covered why big hedge funds are getting bigger or risk going home. You should read that comment because a lot of what I wrote there is driving the same bifurcation between small and large PE funds in the industry.

Importantly, big institutions looking for scale are not going to waste their time performing due diligence on several small PE funds which may or may not perform better than their larger rivals. They will go to the large brand name private equity funds that everybody knows well because they will be able to invest and co-invest (where they pay no fees) large sums with them.

And just like big hedge funds are dropping their fees, big PE funds are dropping their fees but locking in their investors for a longer period, effectively emulating Warren Buffet’s approach. I discussed why they are doing this last year in this comment.

These are treacherous times for private equity and big institutional investors are taking note, demanding a lot more from their PE partners and making sure private equity’s diminishing returns and misalignment of interests don’t impact their long-term performance.

Still, large PE funds are generating huge returns, embracing the quick flip and reorienting their internal strategies to adapt to a tough environment.

In Canada, there is a big push by pensions to go direct in private equity, foregoing funds altogether. Dasha Afanasieva of Reuters reports, Canada’s OMERS private equity arm makes first European sale:

Ontario’s municipal workers pension fund has sold a majority stake in marine-services company V.Group to buyout firm Advent International in the first sale by the Canadian fund’s private equity arm in Europe.

Pension funds and other institutional investors are a growing force in direct private investment as they seek to bypass investing in traditional buyout funds and boost returns against a backdrop of low global interest rates.

As part of the shift to more direct investment, the Ontario Municipal Employees Retirement System (OMERS) set up a private equity team (OPE) and now has about $10-billion invested.

It started a London operation in 2009 and two years later it bought V.Group, which manages more than 1,000 vessels and employs more than 3,000 people, from Exponent Private Equity for an enterprise value of $520-million (U.S.).

Mark Redman, global head of private equity at OMERS Private Markets, said the V.Group sale was its fourth successful exit worldwide this year and vindicated the fund’s strategy. He said no more private equity sales were in the works for now.

“I am delighted that we have demonstrated ultimate proof of concept with this exit and am confident the global team shall continue to generate the long-term, stable returns necessary to meet the OMERS pension promise,” he said.

OMERS, which has about $80-billion (Canadian) of assets under management, still allocates some $2-billion Canadian dollars through private equity funds, but OPE expects this to decline further as it focuses more on direct investments.

OPE declined to disclose how much Advent paid for 51 per cent of V.Group. OPE will remain a minority investor.

OPE targets investments in companies with enterprise values of $200-million to $1.5-billion with a geographical focus is on Canada, the United States and Europe, with a particular emphasis on Britain.

As pension funds increasingly focus on direct private investments, traditional private equity houses are in turn setting up funds which hold onto companies for longer and target potentially lower returns.

Bankers say this broad trend in the private equity industry has led to higher valuations as the fundraising pool has grown bigger than ever.

Advent has a $13-billion (U.S.) fund for equity investments outside Latin America of between $100-million and $1-billion.

The sale announced on Monday followed bolt on acquisitions of Bibby Ship Management and Selandia Ship Management Group by V.Group.

Goldman Sachs acted as financial advisers to the shipping services company; Weil acted as legal counsel and EY as financial diligence advisers.

Now, a couple of comments. While I welcome OPE’s success in going direct, OMERS still needs to invest in private equity funds. And some of Canada’s largest pensions, like CPPIB, will never go direct in private equity because they don’t feel like they can compete with top funds in this space.

[Note: It might help if OPE reports the IRR of their direct operations, net of all expenses relative to the IRR of their fund investments, net of all fees so their stakeholders can understand the pros and cons of going direct in private equity. Here you need to look at a long period.]

There is a lot of misinformation when it comes to Canadian pensions ‘going direct’ in private equity. Yes, they have a much longer investment horizon than traditional funds which is a competitive advantage, but PE funds are adapting and going longer too and in the end, it will be very hard, if not impossible, for any Canadian pension to compete with top PE funds.

I am not saying there aren’t qualified people doing wonderful work investing directly in PE at Canada’s large pensions, but the fact is it will be hard for them to match the performance of top PE funds, even after fees and expenses are taken into account.

Who knows, maybe OPE will prove me wrong, but this is a tough environment for private equity and I’m not sure going direct in this asset class is a wise long-term strategy (unlike infrastructure, where most of Canada’s large pensions are investing directly).

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