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The Harvard Management Co. announced this week that it’ll be sending half its employees home for good and outsourcing most of its money management.

It’s a big change for an endowment that for many years was the best money manager in the business; but since 2005, the fund’s fortunes have changed.

HMC lost money in FY2016, returning -2% even as its benchmark portfolio returned 1% and broader markets grew even more.

Are there any lessons to learn from HMC? Barry Ritholtz think so. He writes at Bloomberg:

No. 1. When a money manager is outperforming the benchmarks, leave them alone: Under Meyer, HMC had captured lightning in a bottle. Messing with that rare and delicate thing is simply foolish. Harvard had to learn that the hard way.

No. 2. Simpler and cheaper beats complicated and expensive: Investing luminaries such as Charles Ellis, Jack Bogle and Burton Malkiel have long argued that the simpler and cheaper a portfolio is, the better its long-term performance. This is true even for a $37 billion endowment like Harvard’s.

No. 3. Opining about things you know nothing about is an expensive self-indulgence: The second-guessing of outsiders who thought they knew better is a perfect example of this. The Harvard professors and alums who deemed themselves more insightful about the mysteries of investing than the professionals is just the sort of hubris that the trading gods love to punish. This 2004 New York Times article about how much higher Jack Meyer’s pay was than that of Yale Chief Investment Officer David Swensen sums up the critics’ complaints — and naivete. What the critics accomplished was saving millions of dollars in management compensation while forsaking billions of dollars in returns. That was a dumb trade.

No. 4. Costly, underperforming alternative investments are on notice: This is part of a broader trend that was first thrust into view in 2014, when the giant California Public Employees Retirement System (CalPERS) pension fund said it was dumping its hedge fund investments, and reducing other so-called alternative investments. But pension funds and endowments move slowly; Harvard has had six different endowment managers before reaching the same conclusion as CalPERS. Other pension funds and endowments are likely to find religion as well. (Are you listening, New York?) It’s inevitable that pensions and endowments will also cool on venture capital and private equity.

Read the rest of the lessons at the link.

Trustees for the California State Teachers’ Retirement System next month will discuss whether to lower the pension fund’s assumed rate of return from 7.5 percent to 7.25 percent.

CalSTRS’ current rate is right at the nationwide median; but many public plans — including CalPERS — are continuing to lower their assumptions.

More from Reuters:

The California State Teachers’ Retirement System will consider lowering its expected return rate to 7.25 percent from 7.5 percent, based on economic factors and improvements to beneficiaries’ life expectancies.

CalSTRS Board is scheduled to consider the move during its February meeting. The recommendation was published late on Wednesday on the public pension fund’s website.

The changes are based on new lower assumptions for price inflation and general wage growth, which reduced the probability that CalSTRS would achieve its 7.5 percent return to 50 percent over the long-term, according to the report.

[…]

CalSTRS must also take into account improvements in beneficiaries’ life expectancies, the report noted.

Under the proposed changes, CalSTRS’s funding ratio would drop to 63.9 percent from 67.2 percent, and contribution rates would rise.

CalSTRS estimates that under a 7.25 percent expected return, the state contribution rate would increase by 0.5 percent of payroll for each of the next five years. Currently, the state contribution rate is 8.8 percent of payroll.

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

Tawfik Hammoud and Vinay Shandal of BCG recently wrote an op-ed for the Globe and Mail, Canada needs to work on its private-equity game:

When you look at who attended last week’s World Economic Forum in Davos, it’s striking how many are global investors or work for large funds – and in particular, private-equity firms.

The question Canadians should be asking themselves is, how do we ensure that Canada receives its fair share of the trillions of dollars deployed by global investment funds, including real estate, infrastructure, venture capital and private equity? How can our entrepreneurs and company owners benefit from this growth capital and the opportunities that come with it?

How can we create an investment ecosystem that gives rise to more Canadian investment firms led by top professionals?

The global investors who gathered in Davos, Switzerland, have much to be thankful for. Business is thriving and the various private asset classes’ performance keeps pumping up demand, especially relative to fixed income and public equities. Take private equity, for example: 94 per cent of investors in a recent survey count themselves satisfied with the returns, and more than 85 per cent say they intend to commit more or the same amount of capital to private equity next year. As a result, the capital flowing into private equity is unprecedented, established firms are raising record amounts of money and fund oversubscription is common.

More than 600 new private-equity funds were created last year alone and the industry is holding $1.3-trillion (U.S.) of “dry powder,” or uninvested capital, that is sitting on the sidelines waiting to be invested. While the merits and operating model of private equity can and should be debated (as they were when former private-equity man Mitt Romney ran for president in the 2012 U.S. election), there is no denying its growing importance in many economies. Carlyle Group and Kohlberg Kravis Roberts & Co. (and their portfolio companies) employ more people than any other U.S. public company outside of Wal-Mart Stores Inc.

The sector’s roaring success might also be the biggest risk to its future. There might be such a thing as too much money, after all.

A swath of new entrants is pouring into private assets, searching for yield in a world of low interest rates. Chinese, Middle Eastern and other emerging markets investors are on the rise and have quadrupled their outbound investment over the past few years. Sovereign wealth funds, pension plans, insurance companies and even some mutual funds are allocating money to the private markets and borrowing from their playbooks. So much money chasing a limited number of opportunities has pushed prices up: historically high multiples combined with lower levels of leverage are putting pressure on returns. Private-equity deal multiples, for example, have exceeded the peaks last seen in 2006-07 for larger transactions (deals above $500-million) and deals above $250-million are also flirting with these highs. But most indicators still point to a favourable outlook as long as the credit markets remain fluid and fund managers continue to create value during their ownership period.

Canadian pension funds, many of which were present at Davos, are increasingly active in this crowded field. They have invested time and money to develop direct capabilities and increasingly stronger investment teams. In many regards, they are years ahead of their peers around the world. However, outside of our pension funds and a few select local firms, Canada tends to punch under its weight. We lack the kind of developed investment ecosystems that are thriving in other countries. As an example, the United States has 24 times more private-equity funds than Canada and has raised nearly 40 times more capital over the past 10 years.

The point is broader: Canada should be attracting more foreign direct investment, including money from global investment firms. FDI in Canada has grown by just 2 per cent a year since 2005, compared with an average of 7 per cent for all OECD countries and 8 per cent for Australia. As a percentage of GDP, Canada still sits in the middle of pack of OECD countries, but 30 per cent of that investment is driven by mining and oil and gas and is heavily skewed to M&A as opposed to greenfield investment (relative to other countries).

Something doesn’t add up. Canada is a great place to put money to work. We are a country with low political risk, competitive corporate taxes, an educated and diverse labour force, liquid public markets and a real need for infrastructure investments. Yet, we are net exporters of capital: foreign investors are often not finding Canadian opportunities as attractive as they should.

For all the criticism the investment industry sometimes faces, it would be a real miss if we failed to show long-term, growth-minded investors that Canada is an attractive place to put their money to work. We want global investors writing cheques for stakes in Canadian companies, so they can help improve their productivity, invest in technology, create new jobs, and grow global champions in many industries. If investors don’t hear our compelling story, Canada and many of its companies could be left on the sidelines as they watch all this dry powder get deployed in other markets.

This is an excellent op-ed, one that I want all of you to read carefully and share with your industry contacts. The last time I saw Tawfik Hammoud of BCG is when we worked together on a consulting mandate for the Caisse on sovereign debt risks (back in 2011). He is now the global head of BCG’s Principal Investors & Private Equity practice and is based in Toronto (all of BCG’s team are very nice and bright people, enjoyed working with them).

So, what’s this article all about and why is it important enough to cover on my blog?  Well, I’ve been short Canada and the loonie since December 2013, moved all my money to the US and never looked back. I know, Canadian banks did well last year but investing in the Canadian stock market is a joke, it’s basically composed of three sectors: financials, telecoms and energy.

Ok, now we’re in January 2017, the Bank of Canada recently “surprised” markets (no surprise to me or my buddy running a currency hedge fund in Toronto) by stating they are on guard and ready to lower rates if the economic outlook deteriorates, sending the loonie tumbling to about 75 cents US (it now stands at 76 cents US).

You would think global investors, especially large US investors, would be taking advantage of our relatively cheap currency to pounce on Canadian public and private assets.

Unfortunately, it doesn’t work that way. Canada isn’t exactly a hotbed of private equity activity. Yes, our large Canadian public pensions invest in private equity, mostly through funds and co-investments and a bit of purely direct investments, but the geographic focus remains primarily in the United States, the UK, Europe and increasingly in Asia and Latin America.

Sure, we have great private equity companies in Canada like Brookfield Asset Management (BAM), our answer to Blackstone (BX), the US private equity powerhouse, but even Brookfield focuses mostly outside Canada for its largest private equity transactions.

So why? Why is Canada’s private equity industry under-developed and why are global and domestic private equity powerhouses basically shunning our economy, especially now that the loonie is much cheaper than it was a few years ago?

The article above cites Canada’s stable political climate, competitive corporate tax rate and diverse and highly educated workforce but I think when it comes to real entrepreneurial opportunities, Canada lags far behind the United States and other countries.

Now, we can argue that maybe Canada’s large pensions should do more to invest in and even incubate more domestic private equity funds (they already do some) but the job of Canada’s pension fund managers isn’t to incubate domestic private equity funds or hedge funds, it’s to maximize returns taking the least risk possible by investing across global public and private markets.

Only the Caisse has a dual mandate of investing part of its assets in Quebec’s public and private markets and we can argue whether this is in the best interests of its beneficiaries over the long run (the Caisse will talk up its successes but I’m highly skeptical and think Quebec pensioners would have been better off if that money was invested across global markets, not Quebec).

In my opinion, the biggest problem in Canada is the culture of defeatism and government over-taxation (on individuals) and over-regulation of industries. At the risk of sounding crazy to some of you tree hugging left-wing liberals, Canada needs a Donald Trump which will cut out huge government waste and insane regulations across the financial and other industries, many of which are nothing more than a government backed oligopoly charging Canadians insane fees (look at banks, mutual funds and telcom fees and tell me we don’t need a lot more competition here).

My close buddies reading this will laugh as they recently blasted me for voting Liberal in the last election. Yes, I too voted for “boy wonder” mostly because I was sick and tired of Harper’s arrogance but Trudeau junior’s ineptitude, inexperience and recent comments on Alberta’s tar sands and ridiculous and needless cross country tour just pissed me off enough so I will be returning to my conservative economic roots during the next election even if O’Leary wins that party’s leadership race (love him on Shark Tank, not so sure how he would be as our PM).

Politics aside, we need to ask ourselves very tough questions in Canada and across all provinces because it’s been my contention all along that far too many Canadians are living in a Northern bubble, erroneously believing that we can afford generous social programs forever. Canadians are in for one rude awakening in the not too distant future.

What else pisses me off about Canada? Unlike the United States where the best of the best rise to the top regardless of the color their skin, gender, sexual orientation, religious beliefs and disabilities, there is a pervasive institutionalized racism that is seriously setting this country back years, if not decades (you can disagree with me but I’m not going to be politically correct to assuage your hurt feelings, Canada lacks real diversity at all levels of major public and private organizations).

So, before Canada can rightfully argue that it deserves a bigger chunk of the global private equity pie, we need to reexamine a lot of things in this country on the social, cultural and economic front, because the way I see it, we’re not headed in the right direction and have not created the right conditions to attract foreign investment from top global private equity funds.

As always, these are my opinions, you have every right to disagree with me but I’m not budging one iota and I can back up everything I’ve written above with concrete facts, not fake news.

Rising interest rates and a potentially shrinking corporate income tax could lead to a higher percentage of companies closing their defined-benefit plans in 2017, according to Willis Towers Watson.

From Employee Benefits Advisor:

Michael Archer, leader of the Client Solutions Group at Willis Towers Watson’s North American retirement practice, says that an expected drop in the corporate income tax and an expected rise in interest rates will make it easier for defined benefit plan sponsors to terminate their retirement plans in 2017.

[…]

“If we get tax legislation that reduces corporate income taxes and is retroactive to the beginning of the year, we will see many plan sponsors make contributions in advance and fund their plan balance. They will do it because they are faced with PBGC premiums, which are increasing at a rapid rate, and those increases affect the cost of debt in retirement plans,” he says. “Now there are two incentives to fund and fund now because of the bigger deduction and they get out of paying the variable premium.”

The report also has some words for 401k plan sponsors. From EBA:

Archer encourages 401(k) plan sponsors to pay attention to the fees that are charged and the investment options they offer and also keep abreast of general compliance issues in the new year.

Regulatory bodies like the IRS and Department of Labor have increased the number of audits they are doing and the amount of attention they are paying to retirement plans.

“The focus on compliance is really important,” he says.

Archer pointed out that the Department of Labor has been sending letters to plan participants who are over the plan’s normal retirement age reminding them they can start their benefits.

“That kind of outreach hasn’t been seen before,” he says.

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

Lawrence Delevingne of Reuters reports, Struggling hedge funds still expense bonuses, bar tabs:

Investors are starting to sour on the idea of reimbursing hedge funds for multi-million dollar trader bonuses, lavish marketing dinners and trophy office space.

Powerful firms such as Citadel LLC and Millennium Management LLC charge clients for such costs through so-called “pass-through” fees, which can include everything from a new hire’s deferred compensation to travel to high-end technology.

It all adds up: investors often end up paying more than double the industry’s standard fees of 2 percent of assets and 20 percent of investment gains, which many already consider too high.

Investors have for years tolerated pass-through charges because of high net returns, but weak performance lately is testing their patience.

Clients of losing funds last year, including those managed by Blackstone Group LP’s (BX.N) Senfina Advisors LLC, Folger Hill Asset Management LP and Balyasny Asset Management LP, likely still paid fees far higher than 2 percent of assets.

Clients of shops that made money, including Paloma Partners and Hutchin Hill Capital LP, were left with returns of less than 5 percent partly because of a draining combination of pass-through and performance fees.

For a graphic on the hedge funds that passed through low returns, click on image below:

Millennium, the $34 billion New York firm led by billionaire Israel Englander, charged clients its usual fees of 5 or 6 percent of assets and 20 percent of gains in 2016, according to a person familiar with the situation. The charges left investors in Millennium’s flagship fund with a net return of just 3.3 percent.

Citadel, the $26 billion Chicago firm led by billionaire Kenneth Griffin, charged pass-through fees that added up to about 5.3 percent in 2015 and 6.3 percent in 2014, according to another person familiar with the situation. Charges for 2016 were not finalized, but the costs typically add up to between 5 and 10 percent of assets, separate from the 20 percent performance fee Citadel typically charges.

Citadel’s flagship fund returned 5 percent in 2016, far below its 19.5 percent annual average since 1990, according to the source who, like others, spoke on the condition of anonymity because the information is private.

All firms mentioned declined to comment or did not respond to requests for comment.

In 2014, consulting firm Cambridge Associates studied fees charged by multi-manager funds, which deploy various investment strategies using small teams and often include pass-throughs. Their clients lose 33 percent of profits to fees, on average, Cambridge found.

The report by research consultant Tomas Kmetko noted such funds would need to generate gross returns of roughly 19 percent to deliver a 10 percent net profit to clients.

‘STUNNING TO ME’

Defenders of pass-throughs said the fees were necessary to keep elite talent and provide traders with top technology. They said that firm executives were often among the largest investors in their funds and pay the same fees as clients.

But frustration is starting to show.

A 2016 survey by consulting firm EY found that 95 percent of investors prefer no pass-through expense. The report also said fewer investors support various types of pass-through fees than in the past.

“It’s stunning to me to think you would pay more than 2 percent,” said Marc Levine, chairman of the Illinois State Board of Investment, which has reduced its use of hedge funds. “That creates a huge hurdle to have the right alignment of interests.”

Investors pulled $11.5 billion from multi-strategy funds in 2016 after three consecutive years of net additions, according to data tracker eVestment. Redemptions for firms that use pass-through fees were not available.

Even with pass-through fees, firms like Citadel, Millennium and Paloma have produced double-digit net returns over the long-term. The Cambridge study also found that multi-manager funds generally performed better and with lower volatility than a global stock index.

“High fees and expenses are hard to stomach, particularly in a low-return environment, but it’s all about the net,” said Michael Hennessy, co-founder of hedge fund investment firm Morgan Creek Capital Management.

INTELLECTUAL PROPERTY

Citadel has used pass-through fees for an unusual purpose: developing intellectual property.

The firm relied partly on client fees to build an internal administration business starting in 2007. But only Citadel’s owners, including Griffin, benefited from the 2011 sale of the unit, Omnium LLC, to Northern Trust Corp for $100 million, plus $60 million or so in subsequent profit-sharing, two people familiar with the situation said.

Citadel noted in a 2016 U.S. Securities and Exchange Commission filing that some pass-through expenses are still used to develop intellectual property, the extent of which was unclear. Besides hedge funds, Citadel’s other business lines include Citadel Securities LLC, the powerful market-maker, and Citadel Technology LLC, a small portfolio management software provider.

Some Citadel hedge fund investors and advisers to them told Reuters they were unhappy about the firm charging clients to build technology whose profits Citadel alone will enjoy. “It’s really against the spirit of a partnership,” said one.

A spokesman for Citadel declined to comment.

A person familiar with the situation noted that Citadel put tens of millions of dollars into the businesses and disclosed to clients that only Citadel would benefit from related revenues. The person also noted Citadel’s high marks from an investor survey by industry publication Alpha for alignment of interests and independent oversight.

Gordon Barnes, global head of due diligence at Cambridge, said few hedge fund managers charge their investors for services provided by affiliates because of various problems it can cause.

“Even with the right legal disclosures, it rarely passes a basic fairness test,” Barnes said, declining to comment on any individual firm. “These arrangements tend to favor the manager’s interests.”

Interestingly, Zero Hedge recently reported that Citadel just paid a $22 million settlement for front-running its clients (great alignment of interests!). Chump change for Ken Griffin, one of the richest hedge fund managers alive and part of a handful of elite hedge fund managers in the world who are highly regarded among institutional investors.

But the good fat hedge fund years are coming to an abrupt end. Fed up with mediocre returns and outrageous fees, institutional investors are finally starting to drill down on performance and fees and asking themselves whether hedge funds — even “elite hedge funds” — are worth the trouble.

I know, everybody invests in a handful of hedge funds and Citadel, Millennium, Paloma and other ‘elite’ multi-strategy hedge funds figure prominently in the hedge fund portfolios of big pensions and sovereign wealth funds. All the more reason to cut this nonsense on fees and finally put and end to outrageous gouging, especially in a low return, low interest rate world.

“Yeah but Leo, it’s Ken Griffin and Izzy Englander, two of the best hedge fund managers alive!” So what? I don’t care if it’s Ken Griffin, Izzy Englander, Ray Dalio, Steve Cohen, Jim Simons, or even if George Soros started taking money from institutional investors, nonsense is nonsense and I will call it out each and every time!

Because trust me, smart pensions and sovereign wealth funds aren’t stupid. They see this nonsense and are hotly debating their allocations to hedge funds and whether they want to be part of the herd getting gouged on pass-through and other creative fees.

Listen to Michael Sabia’s interview in Davos at the end of my last comment. Notice how he deliberately avoided a discussion on hedge funds when asked about investing in them? All he said was “not hedge funds”. The Caisse has significantly curtailed its investments in external hedge funds. Why? Because, as Sabia states, they prefer focusing their attention on long-term illiquid alternatives, primarily infrastructure and real estate, which can provide them with stable yields over the long run without all the headline risk of hedge funds that quite frankly aren’t delivering what they are suppose to deliver — uncorrelated alpha under all market conditions!!

Now, is investing in infrastructure and real estate the solution for everyone? Of course not. Prices have been bid up, deals are very expensive and as Ron Mock stated in Davos, “you have to dig five times harder” to find good deals that really make sense in illiquid private alternatives.

And if my long-term forecast of global deflation materializes, all asset classes, including illiquid alternatives, are going to get roiled. Only good old US Treasuries are going to save your portfolio from getting clobbered, the one asset class that most institutional investors are avoiding as ‘Trumponomics’ arrives (dumb move, it’s not the beginning of the end for bonds!).

By the way, I know Ontario Teachers’ Pension Plan still invests heavily in hedge funds but I would be surprised if their due diligence/ finance operations people would let any hedge fund pass through dubious fees on to their teachers. In fact, OTPP has set up a managed account platform at Inncocap to closely monitor all trading activity and operational risks of their external hedge funds.

Other large institutional investors in hedge funds, like Texas Teachers’ Retirement System (TRS), are tinkering with a new fee structure to get better alignment of interests with their external hedge funds. Imogen Rose-Smith of Institutional Investor reports, New Fee Structure Offers Hope to Besieged Hedge Funds (click on image):

You can read the rest of this article here. According to the article, TRS invests in 30 hedge funds and the plan has not disclosed how it will apply this new fee structure.

I think the new fee structure is a step in the right direction but if you ask me, I would get rid of the management fee for all hedge funds managing in excess of a billion dollars and leave the 20 percent performance fee (keep the management fee only for small emerging hedge fund managers that need it).

“But Leo, I’m an elite hedge fund manager and my portfolio managers are expensive, rent costs me a lot of money, not to mention my lifestyle and my wife who loves shopping at expensive boutiques in Paris, London, and New York and needs expensive cosmetic surgery to stay youthful and look good as we keep up with the billionaire socialites.”

Boo-Hoo! Cry me a river! Life is tough for all you struggling hedge fund managers charging pass-through fees to enjoy your billion dollar lifestyles? Let me take out the world’s smallest violin because if I had a dollar for all the lame, pathetic excuses hedge fund managers have thrown my way to justify their outrageous fees and mediocre returns, I’d be managing a multi-billion dollar global macro fund myself!

If you’re an elite hedge fund manager and are really as good as you claim, stop charging clients 2% to cover your fixed costs, focus on performance and delivering real alpha in all market environments, not on marketing and asset gathering (so you can collect more on that 2% management fee and become a big fat, lazy asset gatherer charging clients alpha fees for leveraged beta!).

I’m tired of hedge funds and private equity funds charging clients a bundle on fees, including management fees on billions, pass-through fees and a bunch of other hidden fees. And trust me, I’m not alone, a lot of smart institutional investors are finally putting the screws on hedge funds and private equity funds, telling them to shape up or ship out (it’s about time they smarten up).

Unfortunately, for every one large, smart institutional investor there are one hundred smaller, dumber public pension plans who literally have no clue what’s going on with their hedge funds and private equity funds. Case in point, the debacle at Dallas Police and Fire Pension System which I covered last week.

I’m convinced they still don’t know all the shenanigans that went on there and I bet you a lot of large and small US public pensions are in the same boat and petrified as to what will happen when fraud, corruption and outright gross incompetence are uncovered at their plans.

For all of you worried about your hedge funds and private equity funds, get in touch with my friends over at Phocion Investment Services in Montreal and let them drill down and do a comprehensive risk, investment, performance and operational due diligence on all your investments, not just in alternatives.

What’s that? You already use a “well-known consultant” providing you cookie cutter templates covering operational and investment risks at your hedge funds and private equity funds? Good luck with that approach, you deserve what’s coming to you.

On that note, I don’t get paid enough to provide you with my unadulterated, brutally honest, hard-hitting comments on pensions and investments. Unlike hedge funds and private equity funds charging you outrageous fees, I need to eat what I kill by trading and while I love writing these comments, it takes time away from what I truly love, analyzing markets and looking for great swing trading opportunities in bonds, biotech, tech and other sectors.

Please take the time to show your financial appreciation for all the work that goes into writing these comments by donating or subscribing to the PensionPulse blog on the top right-hand side under my beautiful mug shot. You simply won’t read better comments on pensions and investments anywhere else (you will read a bunch of washed down, ‘sanitized’ nonsense, however).

Last month, hedge fund Albourne Partners revealed in a white paper a new fee structure it had been working on with the Texas Teachers’ pension fund.

It’s unclear how the “1 or 30″ structure will catch on in the U.S.; but it’s already gaining steam in Asia.

Institutional Investor explains the structure:

1 or 30 is designed to ensure that the investor gets 70 percent of the economics from its hedge fund investment, while recognizing the need to pay a performance fee to asset managers in lean times. Under the proposed fee model, the management fee gets paid back through a discount to the performance fees (applied over time if the hedge fund fails to perform in any given year), and Texas will pay performance fees only after reaching an agreed-upon hurdle rate. The maximum that a manager can make is 30 percent of the alpha, or performance after the benchmark, minus the one percent management fee.

The simplest way to consistently meet an investor’s 70% alpha share objective would be a fee structure with no management fee and a 30% performance fee, paid only on alpha. Such a fee structure, however, could result in significant business risk to the manager during any prolonged period of underperformance as there could be long periods without any certain revenue for the manager from either management or performance fees, wrote Albourne portfolio analyst Jonathan Koerner in the paper. To eliminate this risk, 1 or 30 structure guarantees regular management fee income to the manager on a consistent ongoing basis, identical to current traditional management fee mechanics. A reduction of the same amount is then made to the performance fee to return total fees to equilibrium at 30% of alpha.

In Hong Kong, at least two hedge funds are implementing the “1 or 30″ model. According to Albourne, over two dozen managers globally are adopting the structure.

From Bloomberg:

As investors worldwide are balking at hefty fees, Hong Kong hedge funds Myriad Asset Management and Ortus Capital Management are crafting alternatives that mark a radical departure from the industry practice of charging 2 percent of assets in management fees and 20 percent of profits.

Myriad, which manages more than $4.1 billion, is adding a new share class in its hedge fund that charges the greater of a 30 percent cut of profits or 1 percent of assets under management to better align its interests with those of investors, said a person with knowledge of the matter. Ortus in July started a fund that takes a 33 percent share of profits without charging any management fee, according to a newsletter to investors obtained by Bloomberg.

[…]

Globally, at least two dozen “well-known” managers with institutional investors have either adopted or are working on a so-called “1-or-30″ fee model that was introduced to the industry in the fourth quarter, according to Jonathan Koerner of Albourne Partners, which advises clients on more than $400 billion of alternative investments globally.

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

This is a bilingual comment, bear with me, I will translate the key points below. Julien Arsenault of La Presse Canadienne reports, Sabia repart de Davos avec beaucoup d’interrogations:

Que ce soit en raison des risques géopolitiques, de la montée du protectionnisme ou de l’arrivée du républicain Donald Trump à la Maison-Blanche, le président et chef de la direction de la Caisse de dépôt et placement du Québec (CDPQ), Michael Sabia, repart du Forum économique de Davos avec de nombreuses interrogations.

Tout cela n’est toutefois pas suffisant pour l’inciter à modifier les stratégies mises en place au cours des dernières années par l’investisseur institutionnel, dont l’actif atteignait 254,9 milliards en date du 30 juin dernier.

«Je n’ai pas changé d’avis. Avec un monde incertain, notre stratégie est de bien sélectionner les actifs et de nous éloigner, dans la mesure du possible, des risques du marché», a-t-il dit, jeudi, au cours d’un entretien avec La Presse canadienne, avant de quitter les alpes suisses.

M. Sabia a donné comme exemple la cimenterie de Port-Daniel, dont la construction a été marquée par des dépassements de coûts de l’ordre de 450 millions avant que la CDPQ prenne le contrôle du projet en y injectant 125 millions de plus. En redressant des actifs de la sorte, le grand patron de la Caisse estime qu’il est possible de créer de la valeur indépendamment de la volatilité des marchés, ce qui mitige les risques.

L’institution continuera également à se tourner vers les infrastructures ainsi que l’immobilier, des actifs «stables» à long terme, a précisé M. Sabia.

À l’instar des nombreux participants du Forum, le dirigeant de la Caisse a pris part à des ateliers dans lesquels les discussions ont tourné autour des visées protectionnistes de M. Trump, qui deviendra vendredi le 45e président des États-Unis.

«Beaucoup semblent convaincus que cette nouvelle administration mettra en vigueur des politiques au coeur des préoccupations du monde des affaires et qui vont dynamiser l’économie rapidement en 2017, a dit M. Sabia. J’ai trouvé cela surprenant, parce que c’est très axé sur le court terme.»

Il dit avoir du mal à comprendre l’optimisme de certains à Davos en raison d’un «mur de risques». Il cite l’arrivée de M. Trump, la sortie attendue du Royaume-Uni de l’Union européenne et d’importantes élections à venir en Europe, notamment en France et en Allemagne.

M. Sabia estime qu’il faut donner six mois à la nouvelle administration républicaine à Washington, étant donné qu’elle veut «faire des choses difficiles». Déjà, Wilbur Ross, désigné par M. Trump pour devenir secrétaire américain au Commerce, a prévenu que le nouveau gouvernement se pencherait rapidement sur l’Accord de libre-échange nord-américain (ALENA).

Le sujet des infrastructures a été largement discuté à Davos, puisque plusieurs représentants de firmes d’ingénierie et d’investisseurs institutionnels – qui se tournent vers ces actifs pour diversifier leur exposition aux risques – étaient présents.

«Ç’a été une confirmation qu’il s’agit d’un vecteur de croissance important dans le monde», a affirmé M. Sabia, lorsque questionné quant au message qu’il a tiré des discussions.

En date du 31 décembre dernier, la valeur du portefeuille de la Caisse dans les infrastructures était de 13 milliards, comparativement à 10,1 milliards en 2014.

Par ailleurs, malgré les visées protectionnistes de M. Trump, M. Sabia ne s’est pas inquiété pour l’avenir de la cimenterie de Port-Daniel, qui vise les États-Unis comme principal marché d’exportation.

Si le 45e locataire de la Maison-Blanche veut vraiment aller de l’avant avec son intention d’injecter 1000 milliards US dans l’économie, les États-Unis n’auront d’autre choix que de laisser entrer du ciment en provenance de l’extérieur, croit M. Sabia.

«L’offre aux États-Unis ne serait pas suffisante pour répondre à une telle demande, a-t-il estimé. Selon moi, la priorité que cette administration veut mettre sur les infrastructures représente une belle occasion.»

Michael Sabia, president and CEO of the Caisse, was in Davos last week with the world’s elites trying to figure out what a Trump administration means for the Caisse’s long-term strategy.

He basically has not changed his mind stating “it’s an uncertain world” and the Caisse will continue to select value stocks and try to minimize market risk as much as possible, mostly by focusing its attention on long-term asset classes like infrastructure and real estate which provide stable yields over the long run.

Sabia also notes that he is surprised by the optimism surrounding the new administration noting that many people think it will reinvigorate the US economy quickly in 2017 but there are still many obstacles, including key elections in Europe and how Brexit will unfold.

Sabia said we need to give the Trump administration at least six months to implement difficult policies which include renegotiating key trade deals like NAFTA. Overall, he was encouraged to see many representatives of big infrastructure and engineering companies at Davos and thinks infrastructure spending will be a key driver of growth going forward and some Canadian companies, like la cimenterie de Port-Daniel, a controversial cement plant the Caisse invested in, will benefit from US spending on infrastructure.

Last week, I shared Ron Mock’s thoughts from Davos as Ontario Teachers’ eyes a new tack. Ron stated that Teachers already invests in brownfield US infrastructure but these new greenfield projects the new administration is eying take a long time to set up and likely won’t be ready until late in Trump’s second term (if he gets a second term) or well after he departs.

My take on all this? There is way too much “Trumptimism” (Trump optimism) out there and like I stated in my outlook 2017, this silliness is propagating the reflation chimera, making US long bonds the best risk-return asset in the world.

But Ray Dalio talked about “animal spirits” being unleashed after Trump’s victory and how it’s the end of the thirty year bond bull market as we head back to the future.

Let me be crystal clear here. I couldn’t care less what Ray Dalio, Paul Singer, Kyle Bass state publicly, I still maintain that global deflation risks are extremely high and think we are entering a danger zone, one where the surging US dollar can continue rising to a level which could bring about the next global crisis.

When I hear bond bears claiming long bond yields will continue rising, I tell them to go back to school because they clearly don’t understand macro trends. A rising US dollar means lower US import prices and lower inflation expectations going forward, which are both bond friendly.

More importantly, the US is temporarily shouldering the rest of the world’s deflation problems but it’s far from clear what Trump’s administration means for emerging markets and if they aren’t careful, protectionist policies will only reinforce global deflation, ushering in a new era of ultra low growth and zero or negative interest rates.

Ironically, all the tough talk on Mexico is driving the Mexican peso lower, making it that much better for German and American car manufacturers to invest there, even if Trump imposes tariffs on cars made in Mexico. President Trump is trying to talk the US dollar down, striking a protectionist tone in his inauguration speech, but this might be short-lived as the US is still a net importer and traditionally wants a stronger dollar.

And let’s pretend the US dollar continues to weaken relative to the rest of the world and Trump manages to renegotiate trade deals quickly to put “America first”. What will that mean? A higher euro and yen going forward and more unemployment in these regions struggling with deflation. Not exactly the recipe to “make America great again” in the long run.

Michael Sabia is right to leave Davos with more questions than answers. He’s also right to question the irrational optimism which has sent global risk assets higher following Trump’s victory.

John Maynard Keynes once stated “markets can stay irrational longer than you can stay solvent.” It’s my favorite market quote of all time and what it means is you can see huge market dislocations persist for a lot longer than you think but at one point, gravity takes over and all the silliness comes crashing down.

I think the second half of the year will bring about a sobering reality that global deflation is far from dead and if Trump’s administration isn’t careful, it will reinforce the global deflationary tsunami headed our way.

A Willis Towers Watson official last week indicated the consulting giant will soon require asset managers to provide data on the gender composition of their employees.

There have been numerous studies in recent years that indicate gender diversity is linked to better financial performance.

From IPE:

Willis Towers Watson will require fund managers to provide data about the gender composition across their workforce, a move that responds to evidence that more women in the workforce improves financial performance.

The plan was mentioned by Luba Nikulina, global head of manager research at Willis Towers Watson, at an MSCI event on the subject of women in finance in London last week. She spoke of “hardwiring this into the process of allocating money”.

“If asset owners add their voice it will help to move things forward,” she added.

She was responding to a comment from a representative of a local authority pension fund about asset owners wanting better data on gender representation in roles below board level.

[…]

Linda-Eling Lee, global head of ESG research at MSCI, highlighted three possible connections between female representation in the workforce and financial performance benefits.

These benefits could stem from women being “better suited to today’s economy”, Lee suggested, from a greater diversity of thinking, or “human capital arbitrage”.

The latter is the idea that, given the barriers they face, “the women who end up at the top are extraordinary so the performance edge may erode as the pipeline to the top opens up”.

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.