illiquidity risk | Pension360

Kolivakis: 5 Reasons Behind Canada Pensions’ Real Estate Binge

Canadian companies and pension funds collectively invested $2.75 billion in commercial U.S. real estate in the first month of 2015.

In 2014, that number was a hefty $9.7 billion. What’s behind the binge? Leo Kolivakis of Pension Pulse gives 5 reasons why Canada’s pensions are snapping up real estate in the U.S., and elsewhere.

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By Leo Kolivakis, Pension Pulse

Why are they doing this? There are a few reasons. First, real estate has long been heralded as the best asset class among Canada’s large public pension funds which are increasingly shifting assets away from volatile public markets into private markets, especially real estate and infrastructure which offer more predictable yields over the long-run.

Second, Canada’s large pension funds aren’t dumb. They read this blog and many other market sources and I’m sure the most savvy of them agree with me, Canada’s crisis is just beginning. This is why they’re scrambling to snap up as much U.S. and European real estate even though the loonie keeps declining. They know it will fall further but they also know there are better opportunities outside of Canada at this time given their long investment horizon.

Third, some of Canada’s large public pension funds, like bcIMC, are much more exposed to Canada’s commercial real estate market than others. bcIMC recently announced it agreed to sell Delta Hotels and Resorts to Marriott International for $168 million, but it has a lot more work to properly diversify its real estate holdings outside of Canada.

Fourth, in my opinion the Caisse’s real estate division, Ivanhoé Cambridge, is by far the best real estate investment management outfit in Canada. There are excellent teams elsewhere too, like PSP Investments, but Ivanhoe has done a tremendous job investing directly in real estate and they have been very selective, even in the United States where they really scrutinize their deals carefully and aren’t shy of walking away if the deal is too pricey.

Fifth, I don’t see interest rates rising anytime soon. In fact, I see central banks pumping a lot more liquidity into the global financial system. And as I recently explained, I’m not in the camp that the Fed will raise rates in 2015 and risk making a monumental mistake.

Having said all this, the rush into real estate and other illiquid alternatives worries me. Why? Because I’m increasingly worried about global deflation and the long-term effects it will have on all investments, especially illiquid private markets.

Don’t get me wrong, done properly, real estate, infrastructure and private equity are great asset classes. But as global pension funds and sovereign wealth funds topple over each other to find deals, they are significantly bidding up prices, lowering prospective returns on all private market investments, and this will really hurt them if a prolonged period of deflation sets in.

A long time ago I wrote a comment asking whether pensions are taking too much illiquidity risk. I think you should all read that comment again and keep it mind as you plow into U.S. and global real estate. Sure, pensions should take the long, long view, but they also need to be acutely aware of price entry and how a prolonged period of debt deflation impacts all their investments, especially private market investments.

Photo credit: “Canada blank map” by Lokal_Profil image cut to remove USA by Paul Robinson – Vector map BlankMap-USA-states-Canada-provinces.svg.Modified by Lokal_Profil. Licensed under CC BY-SA 2.5 via Wikimedia Commons – http://commons.wikimedia.org/wiki/File:Canada_blank_map.svg#mediaviewer/File:Canada_blank_map.svg

Kolivakis Weighs In On Canada Pensions’ Clean Energy Bet

This week, two Canadian pension funds — the Ontario Teachers’ Pension Plan Board and the Public Sector Pension Investment Board – teamed up with Spanish bank Banco Santandar S.A. to manage a $2 billion portfolio of renewable energy assets.

Leo Kolivakis of the Pension Pulse blog weighed in on the clean energy bet in a post on Wednesday. The post is re-published below.

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Originally published at Pension Pulse

This is a big deal and I expect to see more deals like this in the future as more European banks shed private assets to meet regulatory capital requirements. In doing so, they will looking to partner up with global pension and sovereign wealth funds that have very long-term investment horizons.

The Spaniards are global leaders in infrastructure projects (Germans and French are also top global infrastructure investors led by giants like HOCHTIEF and VINCI). When it comes to renewable energy, Spain is the first country to rely on wind as top energy source:

Spain is the first country in the world to draw a plurality of its power from wind energy for an entire year, according to new reports by the country’s energy regulator and wind energy advocacy group Spanish Wind Energy Association (AEE).

Wind accounted for 20.9 percent of the country’s energy last year — more than any other enough to power about 15.5 million households, with nuclear coming in a very close second at 20.8 percent. Wind energy usage was up over 13 percent from the year before, according to the report.

The news is being hailed by environmental advocates as a sign that Spain, and perhaps the rest of the world, is ready for a future based on renewables. But the record comes at the end of a very rocky year for Spain’s renewable energy sector, which was destabilized by subsidy cutbacks and arguments over how much the government should regulate renewable energy companies.

Despite the flaws in Spain’s system, the numbers are promising for green energy fans. The renewable push brought down Spain’s greenhouse gas emissions by 23 percent, according to another industry report from Red Electric Espana (REE).

Spain also has one of the largest solar industries in the world, with solar power accounting for almost 2,000 megawatts in 2012. That’s more than many countries but still just a fraction of the energy produced by wind in Spain. In 2013, solar power accounted for 3.1 percent of Spain’s energy, according to the AEE report.

By contrast, the U.S. produced only 9 percent of its energy with renewable sources last year, and wind accounted for only 15 percent of that.

But as the world reaches for more renewables, Spain’s record-breaking year is also a cautionary tale.

Going into 2014, it’s unclear how wind will survive steep government cutbacks.

At the moment, Spain heavily subsidizes its renewable energy sector, which costs billions of dollars in a country still in the depths of a financial crisis. When the country tried to raise individual rates for renewables, people complained bitterly and the government backed off, leaving the country with a nearly $35 billion renewable energy deficit.

The idea that renewables can’t survive without heavy subsidies might be cooling off the market in Spain and elsewhere, bringing the future of renewable growth into question. Global investment in renewable energy slipped 12 percent last year, despite the fact that the European Union and the UN have set ambitious energy goals for the next decade.

It remains unclear how the world will meet those goals given the spending-averse climate of most Western governments, but there’s no doubt they’ll be looking to Spain in 2014 to see if it can be done without going broke.

Indeed, over the summer, Spain’s government dealt a death blow to renewable energy:

In the latest move to draw down Spain’s energy sector debt, Madrid unveiled a new clean energy bill this week that will cap earnings on power plants as well as introduce retroactive actions, earning a quick rebuke from the country’s already ailing renewable sector. According to a Bloomberg report, clean energy “generators will earn a rate of return of about 7.5 percent over their lifetimes,” adding that the rate may be revised every three years and is based on “the average interest of a 10-year sovereign bond plus 3 percentage points.” The new plan will be retroactively applied to programs active from July 2013.

The new plan was presented by Spain’s Industry Minister Jose Manuel Soria as a necessary evolution of the country’s renewable energy subsidy system, which he said would have gone bankrupt if no changes were made. Since taking over the country’s leadership in 2011, the right-leaning Partido Popular has continued to expand on earlier efforts to chip away at the country’s renewable energy support programs, which many critics have called unsustainable. Once hailed as one of Spain’s most viable sectors for strong growth, renewable energy has suffered under a steady restructuring of government support programs.

In addition to slowing the country’s solar and wind growth, the restructuring garnered legal action on the part of both international investors and domestic trade organizations, the latter of which has appealed to the European Commission for some level of protection from tariff and agreement reductions. Early cuts resulted in legal action against Madrid from over a dozen investment funds with stakes in the country’s solar market, adding to the unease of foreign investors.

I can tell you the cash strapped Greek government did the exact same thing on solar projects in Greece. One of the biggest risks in infrastructure projects is regulatory risk as these governments can change regulations at a moment’s notice, severely impacting the projected revenues.

What are the other risks with infrastructure projects? Currency risk and illiquidity risk as these are very long-term projects, typically with a much longer investment horizon than private equity or real estate.

But both PSP and Ontario Teachers’ are aware of these risks and still went ahead with this investments which meets their objective of finding investments that match their long-term liabilities. The Caisse has also been buying wind farms but I am wondering whether they’re blowing billions in the wind.

Interestingly, this is the second major deal between PSP and OTPP this year. In November, I wrote about how they are nearing a $7 billion deal for Canadian satellite company Telesat Holdings Inc.

And on last week, Bloomberg reported that Riverbed Technology (RVBD), under pressure from activist investor Elliott Management Corp., agreed to be acquired for about $3.6 billion by private-equity firm Thoma Bravo and Teacher’s Private Capital.

In fact, Ontario Teachers’ has been very busy completing all sorts of private market deals lately, all outside of Canada, which is smart.

Photo by penagate via Flickr CC

Kolivakis Weighs In On CalPERS’ PE Benchmark Review

It was revealed last week that CalPERS has plans to review its private equity benchmarks. The pension giant’s staff says the benchmark is too aggressive – in their words, the current system “creates unintended active risk for the program”.

Pension360 last week published the take of Naked Capitalism’s Yves Smith on the situation. Here’s the analysis of pension investment analyst Leo Kolivakis, publisher of Pension Pulse, who takes a different stance.

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By Leo Kolivakis [Originally published on Pension Pulse]

I was contacted in January 2013 by Réal Desrochers, their head of private equity who I know well, to discuss this issue. Réal wanted to hire me as an external consultant to review their benchmark relative to their peer group and industry best practices.

Unfortunately, I am not a registered investment advisor with the SEC which made it impossible for CalPERS to hire me. I did however provide my thoughts to Réal along with some perspectives on PE benchmarks and told him unequivocally that CalPERS current benchmark is very high, especially relative to its peers, making it almost impossible to beat without taking serious risks.

Almost two years later, we now find out that CalPERS is looking to change its private equity benchmark to better reflect the risks of the underlying portfolio. Yves Smith of Naked Capitalism, aka Susan Webber, came out swinging (again!) stating CalPERS is lowering its private equity benchmark to justify its crappy performance.

There are things I agree with but her lengthy and often vitriolic ramblings just annoy the hell out of me. She didn’t bother to mention how Réal Desrochers inherited a mess in private equity and still has to revamp that portfolio.

More importantly, she never invested a dime in private equity and quite frankly is far from being an authority on PE benchmarks. Moreover, she is completely biased against CalPERS and allows this to cloud her objectivity. Also, her dispersion argument is flimsy at best.

Let me be fully transparent and state that neither Réal Desrochers nor CalPERS ever paid me a dime for my blog even though I asked them to contribute. I am actually quite disappointed with Réal who seems to only contact me when it suits his needs but I am still able to maintain my objectivity.

I remember having a conversation with Leo de Bever, CEO at AIMCo, on this topic a while ago. We discussed the opportunity cost of investing in private markets is investing in public markets. So the correct benchmark should reflect this, along with a premium for illiquidity risk and leverage. Leo even told me “while you will underperform over any given year, you should outperform over the long-run.”

I agreed with his views and yet AIMCo uses a simple benchmark of MSCI All Country World Net Total Return Index as their private equity benchmark (page 33 of AIMCo’s Annual Report). When I confronted Leo about this, he shrugged it off saying “over the long-run it works out fine.” Grant Marsden, AIMCo’s former head of risk who is now head of risk at ADIA, had other thoughts but it shows you that even smart people don’t always get private market benchmarks right.

And AIMCo is one of the better ones. At least they publish all their private market benchmarks and I can tell you the benchmarks they use for their inflation-sensitive investments are better than what most of their peers use.

Now, my biggest beef with CalPERS changing their private equity benchmark is timing. If we are about to head into a period of low returns for public equities, then you should have some premium over public market investments. The exact level of that premium is left open for debate and I don’t rely on academic studies for setting it. But there needs to be some illiquidity premium attached to private equity, real estate and other private market investments.

Finally, I note the Caisse’s private equity also underperformed its benchmark in 2013 but handily outperformed it over the last four years. In its 2013 Annual Report, the Caisse states the private equity portfolio underperformed last year because “50% of its benchmark is based on an equity index that recorded strong gains in 2013″ (page 39) but it fails to provide what exactly this benchmark is on page 42.

Also, in my comment going over PSP’s FY 2014 results, I noted the following:

Over last four fiscal years, the bulk of the value added that PSP generated over its (benchmark) Policy Portfolio has come from two asset classes: private equity and real estate. The former gained 16.9% vs 13.7% benchmark return while the latter gained 12.6% vs 5.9% benchmark over the last four fiscal years. That last point is critically important because it explains the excess return over the Policy Portfolio from active management on page 16 during the last ten and four fiscal years (click on image).

But you might ask what are the benchmarks for these Private Market asset classes? The answer is provided on page 18 (click on image).

What troubles me is that it has been over six years since I wrote my comment on alternative investments and bogus benchmarks, exposing their ridiculously low benchmark for real estate (CPI + 500 basis points). André Collin, PSP’s former head of real estate, implemented this silly benchmark, took all sorts of risk in opportunistic real estate, made millions in compensation and then joined Lone Star, a private real estate fund that he invested billions with while at the Caisse and PSP and is now the president of that fund.
And yet the Auditor General of Canada turned a blind eye to all this shady activity and worse still, PSP’s board of directors has failed to fix the benchmarks in all Private Market asset classes to reflect the real risks of their underlying portfolio.

All this to say that private equity, real estate, infrastructure and timberland benchmarks are all over the map at the biggest best known pension funds across the world. There are specific reasons for this but it’s incredibly annoying and frustrating for supervisors and stakeholders trying to make sense of which is the appropriate benchmark to use for private market investments, one that truly reflects the risks of the underlying investments (you will get all sorts of “expert opinions” on this subject).

Photo by rocor via Flickr CC License

Kolivakis On Canada Pension’s Big Brazil Bet

On Tuesday the Canada Pension Plan Investment Board (CPPIB), the entity that manages investments for the Canada Pension Plan, unveiled plans to invest $396 million in commercial real estate in Brazil.

The CPPIB now has nearly $2 billion committed to real estate investments in Brazil.

Leo Kolivakis, who runs the Pension Pulse blog, weighed in on CPPIB’s Brazil bet in a post this week:

Let me share my thoughts on this Brazilian real estate deal. From a timing perspective, this deal couldn’t come at a worse time. Why? Because the Brazilian economy remains in recession and things can get a lot worse for Latin American countries which experienced a boom/ bust from the Fed’s policies and China’s over-investment cycle. This is why some are calling it Latin America’s ‘made in the USA’ 2014 recession, and if you think it’s over, think again. John Maudin’s latest, A Scary Story for Emerging Markets, discusses how the end of QE and the surge in the mighty greenback can lead to a sea change in the global economy and another emerging markets crisis.
Mac Margolis, a Bloomberg View contributor in Rio de Janeiro, also wrote an excellent comment this week on why the oil bust has Brazil in deep water, going over the problems at Petroleo Brasileiro (PBR).

The re-election of President Dilma Rousseff didn’t exactly send a vote of confidence to markets as she now faces the challenge of delivering on campaign promises to expand social benefits for the poor while balancing a strained federal budget. President Rousseff says the Brazilian economy will recover and the country will avoid a credit downgrade but that remains to be seen.
Having said all this, CPPIB is looking at Brazil as a very long-term play, so they don’t care if things get worse in the short-run. In fact, the Fund will likely look to expand and buy more private assets in Brazil if things do get worse. And they aren’t the only Canadian pension fund with large investments in Brazil. The Caisse also bought the Brazilian boom and so have others, including Ontario Teachers which bet big on Eike Batista and got out before getting burned.

Are there risks to these private investments in Brazil? You bet. There is illiquidity risk, currency risk, political and regulatory risk but I trust CPPIB’s managers weighed all these risks and still decided to go ahead with big investment because they think over the long-run, they will make significant gains in these investments.

My biggest fear is how will emerging markets act as QE ends (for now) and I openly wonder if big investments in Brazil or other countries bound to oil and commodities are worth the risk now. Also, the correlation risk to Canadian markets is higher than we think. My only question to CPPIB’s top brass is why not just wait a little longer and pick these Brazilian assets up even cheaper?

But I already know what Mark Wiseman will tell me. CPPIB takes the long, long view and they are not looking at such deals for a quick buck. As far as “egos at CPPIB” that Mr. Doak mentions in the BNN interview, I can’t speak for everyone there, but I can tell you Mark Wiseman doesn’t have a huge ego. If you meet him, you’ll come away thinking he’s a very smart, humble and hard working guy who’s very careful about the deals he enters.

Canada Pension Plan Investment Board manages $226 billion in assets.

Read the entire Pension Pulse post here.