Is The Fed Making a Huge Mistake?

Neel Kashkari, President of the Minneapolis Fed explains, Why I Dissented Again:

I have been focused on looking for signs that the labor force participation story of the past year or so is coming to a conclusion: The economy had been creating a lot of jobs, but there was little movement downward in the headline unemployment rate. More people than we had expected were interested in working when jobs became available. We knew this couldn’t go on forever, and indicators that this trend was reaching its eventual conclusion would include a significant move downward in the unemployment rate, a move upward in core inflation and/or a move upward in inflation expectations.¹

We have seen a meaningful drop in the unemployment rate since the Federal Open Market Committee (FOMC) voted to increase rates in March, from 4.7 percent to 4.3 percent. That drop in unemployment suggests that we are getting closer to maximum employment, which by itself would have supported an increase in rates this week. But at the same time the unemployment rate was dropping, core inflation was also dropping, and inflation expectations remained flat to slightly down at very low levels. We don’t yet know if that drop in core inflation is transitory. In short, the economy is sending mixed signals: a tight labor market and weakening inflation.

For me, deciding whether to raise rates or hold steady came down to a tension between faith and data.

On one hand, intuitively, I am inclined to believe in the logic of the Phillips curve: A tight labor market should lead to competition for workers, which should lead to higher wages. Eventually, firms will have to pass some of those costs on to their customers, which should lead to higher inflation. That makes intuitive sense. That’s the faith part.

On the other hand, unfortunately, the data aren’t supporting this story, with the FOMC coming up short on its inflation target for many years in a row, and now with core inflation actually falling even as the labor market is tightening. If we base our outlook for inflation on these actual data, we shouldn’t have raised rates this week. Instead, we should have waited to see if the recent drop in inflation is transitory to ensure that we are fulfilling our inflation mandate.

When I’m torn between faith and data, I look at decisions from a risk management perspective.

The risk of raising rates too soon is a continuation of the FOMC’s track record of coming up short of our inflation objective. As this Atlanta Fed survey² recently indicated, many people already believe that our 2 percent inflation goal is a ceiling rather than a symmetric target. Raising rates will just further strengthen that belief. And if inflation expectations drop, as we’ve seen in some other countries (and there are signs it might be happening here in the United States), it can be very challenging to bring them back up.

The risk of not moving soon enough generally doesn’t appear to be large. If inflation does start to climb, that will actually be welcome. We will move toward our target, and I believe the FOMC will respond appropriately. And if it leads to a moderate overshoot of 2 percent, that shouldn’t be concerning since we say we have a symmetric target and not a ceiling.

So what’s the downside risk of waiting to see if the recent inflation moves are transitory? I can only think of one really concerning downside risk: a sudden, rapid unanchoring of inflation expectations. A slow drift upward of inflation expectations doesn’t concern me too much, because I believe the FOMC will respond and keep them in check.

The scenario to worry about is that somehow we break inflation expectations: We wake up one morning and instead of 2 percent, they jump to 4 percent. The FOMC would have to respond very powerfully to re-anchor them at 2 percent. I believe we would do what was necessary, but the short-term economic costs might be large.

Policymakers are concerned about this risk, but it is a risk based on faith in a sudden return of the Phillips curve and not a risk that we can detect in economic, financial or survey data. Because it is based on faith and not on data, it is a difficult risk to quantify.

Though inflation expectations became unanchored during the Great Inflation of the 1960s and 1970s, that episode is not particularly useful to help us understand this risk. As I’ve looked at data from those decades, I see wage and price inflation climbing, but the FOMC lacking the conviction to bring inflation back down. They cut rates first in 1967 and then again in 1970 without having brought inflation back under control. Some reasons why they didn’t maintain aggressive monetary policy were that they put too much emphasis on the Phillips curve and underappreciated the role of inflation expectations: High unemployment would help bring inflation down — reducing the need for monetary policy to do the job.

The outcome that the current FOMC is so focused on avoiding, high inflation of the 1970s, may actually be leading us to repeat some of the same mistakes the FOMC made in the 1970s: a faith-based belief in the Phillips curve and an underappreciation of the role of expectations. In the 1970s, that faith led the Fed to keep rates too low, leading to very high inflation. Today, that same faith may be leading the Committee to repeatedly (and erroneously) forecast increasing inflation, resulting in us raising rates too quickly and continuing to undershoot our inflation target.

This balance of risks led me to believe we should rely on the data to guide us. And that means we should have waited to see if the recent drop in inflation is transitory and if inflation is actually moving toward our 2 percent target.

My Analysis (An Update to the Framework Published in February 2017)

Let me acknowledge up front that the analysis that follows is somewhat detailed and complex; yet it is still not comprehensive: FOMC participants look at a wider range of data than I capture in this piece. I am focusing on the data that I find most important in determining the appropriate stance of monetary policy.

I always begin my analysis by assessing where we are in meeting the dual mandate Congress has given us: price stability and maximum employment.

Price Stability

The FOMC has defined its price stability mandate as inflation of 2 percent, using the personal consumption expenditures (PCE) measurement. Importantly, we have said that 2 percent is a target, not a ceiling, so if we are under or over 2 percent, it should be equally concerning. We look at where inflation is heading, not just where it has been. Core inflation, which excludes volatile food and energy prices, is one of the best predictors we have of future headline inflation, our ultimate goal. For that reason, I pay attention to the current readings of core inflation.

The following chart shows both headline and core inflation since 2010. The rebound in energy prices lifted headline inflation earlier this year, but it has since moved back down below 2 percent. You can see that both inflation measures have been below our 2 percent target for several years. Twelve-month core inflation has fallen in recent months to 1.5 percent and shows no sign of consistently trending upward. It is still below target and, importantly, even if it met or exceeded our target, 2.5 percent should not be any more concerning than the current reading of 1.5 percent, because our target is symmetric. Since the March FOMC meeting, when the Committee last raised the target federal funds range, both headline and core inflation have declined notably; headline inflation has fallen from 1.9 percent to 1.7 percent, while core inflation dropped from 1.8 percent to 1.5 percent. This is concerning. Some have attributed the recent decline in core inflation to transitory factors. That is possible, but I need to see more data before I am convinced that it is only transitory.

Next let’s look at inflation expectations — or where consumers and investors think inflation is likely headed. Inflation expectations are important drivers of future inflation, so it is critical that they remain anchored at our 2 percent target. Here the data are mixed. Survey measures of long-term inflation expectations are flat or trending downward. (Note the Michigan survey, the black line, is always elevated relative to our 2 percent target. What is important is the trend, rather than the absolute level.) The Michigan survey has been trending downward over the past few years and is now near its lowest-ever reading. In contrast, professional forecasters seem to remain confident that inflation will average 2 percent. While the professional forecast ticked upward slightly earlier this year, these readings are essentially unchanged since the March FOMC meeting.

Market-based measures of long-term inflation expectations jumped a bit immediately after the election. I’ve argued that the financial markets are guessing about what fiscal and regulatory actions the new Congress and the Trump Administration will enact, and markets seem to be less confident of those changes now than they were a few months ago. The markets’ inflation forecasts have come down in recent months and remain at the low end of their historical range.

But perhaps inflationary pressures are building that we aren’t yet seeing in the data. I look at wages and costs of labor as potentially early warning signs of inflation around the corner.³ If employers have to pay more to retain or hire workers, eventually they will have to pass those costs on to their customers. Ultimately, those costs must show up as inflation. But we aren’t seeing a lot of movement in these data. The red line is the employment cost index, a measure of compensation that includes benefits and that adjusts for employment shifts among occupations and industries. It has been more or less flat over the past six years, though it ticked up modestly since the March FOMC meeting. The blue line is the average hourly earnings for employees. The growth rate of hourly earnings has fallen since the March meeting — from 2.8 percent to 2.5 percent — and remains low relative to the precrisis period. In short, the cost of labor isn’t showing signs of building inflationary pressures that are ready to take off and push inflation above the Fed’s target.

Now let’s look around the world. Most major advanced economies have been suffering from low inflation since the global financial crisis. It seems unlikely that the United States will experience a surge of inflation while the rest of the developed world suffers from low inflation. Since the March FOMC meeting, headline inflation has increased in the United Kingdom due to last year’s sterling depreciation resulting from Brexit, but headline inflation has been roughly flat in other advanced economies. With the exception of the U.K., core inflation rates in advanced economies continue to come in below their inflation targets.

In summary, inflation has moved further below our target, and market-based measures of inflation expectations have fallen from already low levels. Some argue that the recent decline in inflation is transitory, but we don’t know that for certain.

Maximum Employment

Next let’s look at our maximum employment mandate. One of the big questions I have been wrestling with is whether the labor market has fully recovered or if there is still some slack in it. Over the past couple of years, some people repeatedly declared that we had reached maximum employment and no further gains were possible without triggering higher inflation. And, repeatedly, the labor market proved otherwise. The headline unemployment rate has fallen from a peak of 10 percent to 4.3 percent, below the level it was at before the financial crisis. But we know that measurement doesn’t include people who have given up looking for a job or are involuntarily stuck in a part-time job. So we also look at a broader measure of unemployment, what we call the U-6 measure, which includes those workers. The U-6 measure peaked at 17.1 percent in 2010 and has fallen to 8.4 percent today, which is close to its precrisis level.

One of the big surprises during late 2015 through early 2017 was how strong the job market was (creating an average of 200,000 net jobs per month, which is much higher than the 80,000 to 120,000 jobs per month needed to keep up with (trend) labor force growth); yet the unemployment rate remained fairly flat near 5 percent. This surprised us a bit because it suggests that there were many more people who were interested in working than historical patterns predicted. That storyline has lost some steam in recent months: Job gains have slowed to 121,000 per month over the past three months, while the unemployment rate has fallen to 4.3 percent as labor force growth has declined. Some other measures we look at are the employment-to-population ratio and the labor force participation rate, which capture what percentage of adults are working or in the labor force. We know these are trending downward over time due to the aging of our society (as more people retire, a smaller share of adults are in the labor force). To adjust for those trends, I prefer to look at these measures by focusing on prime working-age adults. The next chart shows that in both measures, there still appears to be more labor market slack than before the crisis.

The bottom line is the job market has improved substantially, and we are getting closer to maximum employment. But we still aren’t sure if we have yet reached it. In 2012, the midpoint estimate among FOMC participants for the long-term unemployment rate was 5.6 percent — the FOMC’s best estimate for maximum employment. We now know that was too conservative — many more Americans wanted to work than we had expected. If the FOMC had declared victory when we reached 5.6 percent unemployment, many more workers would have been left on the sideline. Since the March FOMC meeting, the headline unemployment rate has fallen from 4.7 percent to 4.3 percent. The labor force participation rate for prime working-age adults fell from 81.7 percent to 81.5 percent, while the employment-population ratio increased slightly to 78.4 percent. The story of a growing labor force, either by workers re-entering or choosing not to leave, has clearly slowed, but with few signs of pushing wages higher.

We also know that the aggregate national averages don’t highlight the serious challenges individual communities are experiencing. For example, today while the headline unemployment rate for all Americans is 4.3 percent, it is still 7.5 percent for African Americans and 5.2 percent for Hispanics. The broader U-6 measure, mentioned above, is roughly double the headline rate for each group.

Current Rate Environment

OK, so we are still coming up short on our inflation mandate, and we are closer to reaching maximum employment. Let’s have a look at where we are now: Is current monetary policy accommodative, neutral or tight?

I look at a variety of measures, including rules of thumb such as the Taylor rule, to determine whether we are accommodative or not. There are many versions of such rules, and none are perfect.

One concept I find useful, although it requires a lot of judgment, is the notion of a neutral real interest rate, sometimes referred to as R*, which is the rate that neither stimulates nor restrains the economy. Many economists believe the neutral rate is not static, but rises and falls over time as a result of broader macroeconomic forces, such as population growth, demographics, technology development and trade, among others. There are a range of estimates for the current neutral real rate. Having looked at them, I tend to think it is around zero today, or perhaps slightly negative. The FOMC raised rates by 0.25 percent in March, moving the target range for the nominal federal funds rate to between 0.75 percent and 1.00 percent. With core inflation around 1.5 percent, the real federal funds rate was between -0.75 percent and -0.50 percent. Combined with a neutral rate of zero, that means monetary policy was only about 50 to 75 basis points, or 0.50 percent to .75 percent, accommodative going into this week’s FOMC meeting. Monetary policy has been at least this accommodative for several years, including the effects of the Federal Reserve’s expanded balance sheet, without triggering increasing inflation. This further confirms my view that monetary policy has been only moderately accommodative over this period.

Financial Stability Concerns

Please see my recent essay on how I think about monetary policy and financial stability.⁴ In short, while some asset prices appear elevated, I don’t see a correction as being likely to trigger financial instability. Investors would face losses from a stock market correction, but it’s not the Fed’s job to protect investors from losses. Our jobs are to achieve our dual mandate and to promote financial stability.

Fiscal Outlook

I didn’t adjust my economic outlook when the markets made optimistic assumptions about future fiscal and regulatory policy changes following the election. Markets seem less optimistic than they were a few months ago about those future actions. Until we know more from Congress and the White House, I believe it is prudent to assume no change in the fiscal outlook.

Global Environment

The world is large and complex. There is virtually always something concerning going on somewhere. But, overall, global economic and geopolitical risks do not seem more elevated than they have been in recent years. In fact, some global risks appear to have diminished, and the outlook for global growth is somewhat stronger than it was a few months ago. The world economy is expected to grow at 3.5 percent in 2017. Developing economies are expected to grow at 4.5 percent and advanced economies at 2.0 percent.⁵ While the dollar has declined modestly this year, it has increased about 20 percent over the past three years. The strong dollar will likely continue to put some downward pressure on inflation. Overall, the global environment doesn’t seem to be sending a strong signal for a change in U.S. interest rates.

Policy Tools

I have been calling for the FOMC to put out detailed plans for when and how we will begin to normalize our balance sheet. I supported releasing the details that we published following this week’s meeting. It was an important, positive step. I would have liked us to go further and also announced a start date for the balance sheet roll-off later this year. This would give markets as much advanced notice as possible so that when the roll-off actually begins, it is as close to a non-event as possible.

What Might Be Wrong?

What might my analysis be missing? Some economic or financial shock could hit us, from within the U.S. economy or from outside. That is always true, and we need to be ready to respond if necessary. In addition, if we are surprised by higher inflation than we currently expect, we might need to raise rates more aggressively. Some argue that gradual rate increases are better than waiting and having to move aggressively. It isn’t clear to me that one path is obviously better than the other.

Conclusion

The labor market has tightened since we raised rates in March, but inflation has fallen. It doesn’t appear that we are moving closer to our inflation target. Inflation expectations appear flat or may even be drifting lower. Monetary policy is currently only somewhat accommodative. There don’t appear to be urgent financial stability risks at the moment. The global environment seems to have a fairly typical level of risk. From a risk management perspective, we have stronger tools to deal with high inflation than low inflation. Looking at all of this together led me to vote against a rate increase. We should have waited for more data to see if the recent drop in inflation is transitory.

Endnotes

1. The views I express here are my own and not necessarily those of the Federal Open Market Committee.

2. See the April 2017 question.

3. The truth is there is not much of a correlation between high wage growth and future inflation but, intuitively, they must be linked.

4. See Monetary Policy and Bubbles.

5. See the International Monetary Fund’s April 2017 World Economic Outlook.

This is an excellent comment from Neel Kashkari, probably one of the best comments I have read from any Fed official in a very long time.

In fact, I have to go back seven years ago to when James Bullard wrote a paper, Seven Faces of "The Peril", where he warned long-term deflation is a possibility.

I've been warning of the risks of debt deflation for a very long time, long before I began writing this blog in 2008 right before the financial crisis hit full force.

In a recent comment of mine where I discussed why Citadel's Ken Griffin is warning of inflation, I went over yet again six structural factors that lead me to believe we are headed for a prolonged period of debt deflation:

• The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
• Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
• The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
• Excessive private and public debt: Rising government debt levels and consumer debt levels are constraining public finances and consumer spending.
• Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality, is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
• Technological shifts: Think about Amazon, Ubber, Priceline, AI, robotics,  and other technological shifts that lower prices and destroy more jobs than they create.

Now, we can argue about the importance of each structural factor but there is no arguing that an aging population, a less than spectacular labor market, the global pension crisis, excessive public and private debt, rising inequality and technological shifts are all deflationary.

All this to say that I agree with Neel Kashkari, I think it's silly for the Fed to raise rates in a deflationary environment, especially now that the US economy is slowing. Not surprisingly, institutional investors are "increasingly uncomfortable" with the Fed tightening during a slowdown.

But the market was expecting the Fed to tighten so there was no major negative surprise earlier this week after the Fed doubled down on a bet the hot job market will stoke inflation.

You might be wondering what is the Fed thinking? Are they that dumb not to recognize what Kashkari is warning of? Of course not. It is my belief the Fed knows full well the US economy is slowing but has a small window to raise rates to "store up ammunition" to lower them again when the next crisis inevitably hits us later this year or early next year.

The problem is if the Fed raises rates one more time and the US dollar takes off, inflation expectations will continue to decline, and then you have the real risk that deflation comes to America, which is what I warned of back in November 2014.

And Kaskari is right, once inflation expectations sink to dangerously low levels, they remain "sticky" and could stay low for a lot longer than policymakers expect, making their job a real nightmare (look at Japan and Europe).

In contrast, it's much easier to nip inflation in the bud once it rears its ugly head. Yes, the adjustment is painful but swift, as opposed to dealing with a prolonged bout of debt deflation. This is why I agree with Kashkari, it's better for the Fed to err on the side of inflation.

Will the Fed raise rates one more time this year? Maybe but I doubt it, especially if we get a negative deflationary shock out of China or elsewhere. I remember very well what happened after China's Big Bang two years ago, markets got massacred and for good reason, inflation expectations plunged, the yield curve flattened and financials and other cyclical stocks got clobbered. Following that event, it was one big Risk-Off market.

Even if we don't get a global deflationary shock, as the US economy continues to slow, it will be increasingly harder for the Fed to justify raising rates one more time.

No wonder well-known bond gurus Bill Gross and Jeff Gundlach came out this week warning investors to cut risk and raise cash. Bond managers see a huge disconnect between the real economy and the financial market, and rightfully so.

But as we all know by now, markets (especially these central bank manipulated markets) can stay irrational longer than you and I can stay solvent. There is a lot of liquidity out there chasing risk assets higher, so don't be surprised if things remain crazy for longer.

Still, I've been warning my readers since the start of the year, it's not the beginning of the end for bonds, if you want to sleep well at night, you should be loading up on US long bonds (TLT) on every pullback. And so far, I've been right on that call:

And I believe the best is yet to come for US long bonds, especially if another major financial crisis hits us in the fall or in 2018. Remember, in a deflationary world, US government long bonds are the ultimate diversifier, and will protect your portfolio from huge losses. 

It's funny, when people talk about long bonds, they look at the low yield and think why invest in bonds? Wrong way of thinking. You invest in bonds to lower the volatility in your portfolio and limit the downside risk that is inherit in stocks and other risk assets.

As far as stocks, given my views on the reflation trade and the US dollar, I remain underweight and/ or short emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE)  and Financial (XLF) shares on any strength. 

The only sector I like and trade now, and it's very volatile, is biotech (XBI) but technology stocks (XLK) in general continue to do well despite the recent selloff in FANG stocks (click on images):

Will the momentum continue in the summer months? Who knows? I think it's fair to assume a lot more volatility or some consolidation here, but don't be surprised if these sectors keep making new highs (remember, it took several rate hikes back in 2000 before stocks got clobbered).

So, just to recap, I think there may be more juice in the stock market but in this deflationary environment, I would definitely hedge my risk with good old US long bonds and prepare a potential negative shock later this year or early next year (who knows, the shock might come earlier or later).

As far as the US dollar, I remain long and foresee it going higher even if the Fed doesn't raise a third time this year. The US slowdown is already in motion, Europe, Japan and the rest of the world will follow and their currencies are already starting to exhibit weakness.

Hope you enjoyed my comments this week. I want to ask all of you who value my insights on pensions and investments to please take the time to subscribe and/ or donate via PayPal under my picture on the right-hand side. I thank the few who have supported my efforts, it's truly appreciated.

Below, watch the FOMC press conference from a couple of days ago. Listen carefully to Chair Yellen but keep in mind what Neel Kashkari wrote above.

And CNBC's Steve Liesman, provides insight to the Federal Reserve's decision to hike interest rates and what it indicates about the economy and its policies going forward.

The Fed is looking to unwind its balance sheet over the next five years? If my worst fears come true, the Fed's balance sheet will dramatically expand from these levels over the next five years.

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OTPP's New Infrastructure Approach?

Bruno Alves of Infrastructure Investor reports, Lesson Learned: Claerhout on Benefits of Ontario Teachers' New Approach:

OTPP has been under-allocated for most of the 15 years it has been investing in infrastructure – until now. Infrastructure chief Andrew Claerhout tells Bruno Alves how the pension threw out the rule book, opened itself up to new sectors and geographies, and acquired the skills to become a serious developer of greenfield assets.

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When we last caught up with Andrew Claerhout, head of infrastructure and natural resources at the Ontario Teachers’ Pension Plan, two years ago, he was roughly halfway through “a journey”, as he then put it, that had started when he took over the C$180 billion ($132 billion; €120 billion) pension’s infrastructure unit in late 2013.

That journey had a simple objective: to analyse how infrastructure had changed since Teachers’ first started investing in it 15 years ago and adjust the pension’s strategy to the new reality, one that included a significantly expanded competitor landscape and a correspondingly compressed returns environment.

In fact, returns were very much on Claerhout’s mind when we talked to him in May 2015. Some of the high valuations being assigned to infrastructure assets then were leading people to accept risk-adjusted returns that were less than optimal for what Claerhout essentially called “highly illiquid levered equity”.

For a pension struggling to meet its 10-12 percent infrastructure allocation target, the situation called for a change in thinking. “Our target for the next several years is to get to C$18 billion,” Claerhout said at the time.

“We’re at C$13 billion currently, so we’re significantly under-allocated. We’re not changing that goal, but the path that we follow in order to get there may need to be more creative, because the market has become more competitive.”

RIGHT-SIZED

Fast-forward two years and OTPP is in a very different position. “Our current infrastructure portfolio stands at about C$18 billion,” Claerhout tells us on the sidelines of our Berlin Global Summit. “Our view is that infrastructure should be between 10 and 12 percent of total assets [C$180 billion, as of 31 May], which means we have room for growth. And we can exceed 12 percent – it’s not like it’s a hard target, it’s more of a guideline.”

For the first time in its infrastructure investing history, OTPP is, as Claerhout puts it, “right-sized. Our entire history in infrastructure, from the time we formed 15 years ago, we have always been under-allocated. So, we were always chasing a target, wanting to be bigger, but not quite finding the right opportunities”.

That has all changed now and the reason behind it dates back to Claerhout’s strategic review. “We’ve had tremendous growth and it has come from executing on our expanded strategy, where we decided to be more open-minded on geographies, sectors and, to a certain extent, approaches as well, in order to put more money out.”

The strategic review was a classic ‘throw-out-the-rulebook’ moment, where OTPP challenged all its assumptions to infrastructture investing. “We used to have a one-size- fits-all approach in that we were a control-oriented, brownfield infrastructure investor,” Claerhout recalls. “So we set out to look at all those things. Do we need to be control-oriented? I think so. Do we have to be just brownfield? No, we can push into greenfield. Do we have to do everything by ourselves, bedirect? No, we can be indirect through management teams, by partnering with people that have skills that we don’t have.”

As a result, the Canadian pension spent last year clinching its first deals in Mexico (Arco Norte, a toll road investment, together with the Canada Pension Plan Investment Board) and the Netherlands (Koole Terminals, a storage provider, in partnership with JPMorgan Asset Management); branching out into toll roads (Arco Norte and the Chicago Skyway); leveraging subsidiary Ontario Airport Investments to purchase London City Airport; and fully embracing greenfield development, increasing its exposure to renewables platform Cubico (spun out of Santander with PSP Investments) as well as buying electricity grids platform Anbaric.

The latter development is, of course, highly significant, especially since OTPP created its own dedicated greenfield team about a year and a half ago.

“We didn’t really know what we would find in greenfield,” Claerhout recalls. “When I asked OIivia Steedman to run that team, I told her she’d have to go out and recruit some people with different skill-sets to do this. And I told her if we do all the work and it turns out the risk-adjusted returns are worse, then we won’t do a greenfield strategy.”

But while Claerhout pretty much ruled out pursing OTPP’s greenfield strategy through funds – or even separate accounts, which he calls “funds of one” – he did not necessarily feel the pension had to go 100 percent direct. Instead, he preferred to partner with experienced teams, set up platforms with them, and use those partnerships to acquire the requisite expertise.

“If you look at what we did with BlueEarth [in 2010], we identified a management team that had experience developing power projects, we gave them an equity line of credit – a chequebook – and some initial capital to get an office and start business. But we own the business: the team has options in it, but we own the business. You could say the same thing about Cubico.”

Anbaric, which unlike renewable energy developers BluEarth and Cubico, focuses on high-voltage grids and microgrids, was a little bit different, in that it was already in existence. But OTPP approached the partnership in much the same way.

“In the deal we did with them we provided three sources of capital. Firstly, we used $75 million to both buy a 40 percent stake in the business, with management owning the remaining 60 percent, and provide a pool of money for development purposes. And lastly, we gave them a commitment that when those projects are developed, we will be their natural funders, which we expect could lead to up to $2 billion of equity being invested into them.

“This allows us to put money towards opportunities that we would not see and be these projects’ ultimate funder. We make some money on the development, but what we really care about is that the development company is originating and developing those projects to the construction-ready phase that we will then fund.” The upside, in addition to securing proprietary dealflow, is knowledge transfer. “This is why we strongly prefer direct investing over investing in funds,” he explains, pointing to the advantages of sitting at the table with the management teams Teachers’ backs.

It also gives OTPP control over what projects get funded through construction. The latter has been crucial in getting the Canadian pension comfortable with greenfield risk. “If you look at risk on a greenfield project, it’s very high at the beginning, but the capital against it is very low. And then as the risk comes down, the capital goes up, ironically. When you get to the building stage and it’s time to write a large cheque, the risk is actually much lower than when you’re spending $5 million developing a project. And that’s how we got comfortable with it. We wouldn’t be betting the farm – these are controlled experiments, which we control during the development stage and we only commit significant capital after that stage is successful.”

The endgame, for OTPP, is the ability to take on even more risk in the future. “Once we’ve been doing this for five to 10 years, we’re going to actually be positioned to take on even more risk because we will understand how to quantify and mitigate those risks. That’s why we didn’t want to compromise on having control,” he says.

Of course, OTPP can also look at taking on more risk because, unlike some of its pension peers, it is a well-staffed direct investor. At the moment, the pension counts 40 people in its infrastructure team, with that number nearing 50, if you count the employees of its fully-owned airports and Latin America-focused subsidiaries. It also does not hurt that OTPP can pay its employees well.

“We’ve taken the approach that we need to pay competitively to attract, retain and motivate the right staff. In this sense, the Canadian pension plans have taken a very different approach to the UK and certainly the US pensions. We think that if you attract the right team, capable of generating a superior return, then that more than pays for the cost of recruiting, motivating and retaining staff,” Claerhout says.

EXPLORING THE OUTER EDGES

When Claerhout and his team decided to be more open-minded about how they invest in infrastructure, they did not just have new geographies and sectors in mind, they were also willing to venture into the asset class’s outer edges. Like Westerleigh, the crematorium business it bought with the UK’s Universities Superannuation Scheme from French manager Antin Infrastructure Partners.

“We took a look at it and asked ourselves: is cremating the deceased infrastructure? Let’s get real, is it? And we gave our deal team a real hard time on this because we have looked at deals in certain markets that people have called infrastructure and we’ve just laughed,” he recalls.

What convinced him then? “We were very sceptical about Westerleigh, but as we peeled back the onion, we realised it has most – if not all – the characteristics of core infrastructure. It’s an essential service; it’s not correlated with GDP because you don’t choose when you die; it’s a regional monopolistic service, since no one wants a crematorium in their backyard and they are very hard to get licenced; the pricing represents a very small fraction of the cost of burial; and the pricing is an inelastic market.

“So when we looked at it, we thought it looked a lot like core infrastructure, but priced more like core-plus and could be exactly the type of core-plus opportunity we like, one where we get better risk-adjusted returns because most people don’t recognise what kind of business this is.”

That is not to say there are not aspects of a crematorium business that differ from your average core-type infrastructure asset. Without getting into the nitty gritty of the funeral business, there is a minor leasing component to Westerleigh’s revenue stream that is GDP-correlated, and, in times of hardship, could conceivably come under stress.

“It’s the same with an airport, though, where you accept that you have aeronautical and non-aeronautical revenues.”

WITH MATURITY COME ASSET SALES

The other change since we last spoke to Claerhout concerns OTPP itself. That is to say, OTPP as a pension fund, has continued to mature, which has a direct influence on its strategy. “We think about maturity in terms of the ratio of active members versus retired members and today we are 1.4 active members to retired and over the next 10 years that’s going to become closer to 1:1. So we are quite a mature plan compared to our peers and as a mature plan our risk toleraance has to be lower. Because if there is a major correction in risky assets we still have to pay benefits – and today we pay C$3 billion of benefits in excess of contributions. Secondly, you have less time to catch up and make up for any correction because of the maturity of our plan.”

That also means, though, that you will start seeing OTPP sell assets. “You’re going to see it more often because of us being a mature pension. We’re reaching the place where we are right-sized in infrastructure, so if we continue to see more opportunities to invest more capital and we’re doing a good job with the ones we have, we’re going to have to look at recycling capital. In that sense, we will look at some of our portfolio and try to match it with people that have a lower cost of capital, for example.”

Are there parts of OTPP’s infrastructure portfolio that are off limits though? “We have parts of the portfolio that are cornerstone, but one of the things we never want to do is fall in love with an asset. So even with the things we consider cornerstone, we will look at selling them if the right opportunity presents itself. Of course, there are things we prefer to keep because their attributes suit what we want from our infrastructure programme quite well.”

Keeping with the open-mindedness that has characterised the strategic review, Claerhout does not look at divestment in a binary fashion, explaining he sees scope for outright sales alongside partnerships, for example. In terms of what is on the block, he mentions the pension is exploring the sale of a minority stake in its UK regional airports to a “more passive provider of capital” alongside a divestment of its stake in HS1, the country’s only operating high- speed rail link, which it owns together with Borealis.

“One of the things we are looking at doing is increasingly partnering with capital providers that don’t have the expertise to invest in and manage infrastructure, but would look to us for that. In the case of Bristol and Birmingham [airports], we are looking at selling to passive providers of capital, because we think there’s a lot of capital out there looking for a home and that allows us to reduce our portfolio exposure without ceding control,” Claerhout explains.

That sounds an awful lot like what a fund manager would say, which begs the question of why these more passive sources of capital should partner with OTPP instead of a blue-chip GP.

“I think there are many benefits to partnering with Teachers’ as opposed to short-term capital,” Claerhout argues, “especially if the nature of the institution is similar. We don’t only manage assets, we also manage liabilities, so if we think about the type of assets that we want to buy into in infrastructure, they need to have very specific characteristics.”

Is this the start of OTPP, the manager of third-party money, then, a la Borealis? Claerhout laughs the question off. “What we are seeking to do is punch above our weight with partners we are well aligned with and allow ourselves to reduce portfolio concentrations in a natural way.”

That may be the case, but for managers already worried about facing muscular competition from direct investors in the deal space, here is another worry to add to their growing list.

This is a great article, one that shows you how OTPP's infrastructure team has successfully shifted its approach in light of increased competition in the space and in light of the plan maturing at a faster rate than most other plans (except for OPTrust, which I believe is maturing even faster).

You'll recall, last November, Andrew Claerhout provided great insights to my readers on what Canada's large pensions are looking for in terms of infrastucture projects in Canada:

• Andrew told me that OTPP, CPPIB, OMERS and the rest of Canada's large pensions are not interested in small DMBF/ PPP projects which are typically social infrastructure like building schools, hospitals or prisons. Why? Because they're small projects and the returns are too low for them. However, he said these are great projects for construction companies and lenders because you have the government as your counterparty so no risk of a default.
• Instead, he told me they are interested in investing in "larger, more ambitious" infrastructure projects which are economical and make sense for pensions from a risk/ return perspective. In this way he told me that they are not competing with PPPs who typically focus on smaller projects and are complimenting them because they are focusing on much larger projects.
• Here is where our conversation got interesting because we started talking about Australia being the model for privatizing infrastructure to help fund new infrastructure projects. He told me that while Australia took the lead in infrastructure, the Canadian model being proposed here takes it one step further. "In Australia, the government builds infrastructure projects and once they are operational (ie. brownfield), they sell equity stakes to investors and use those proceeds to finance new greenfield projects. In Canada, the government is setting up this infrastructure bank which will provide the bulk of the capital on major infrastructure greenfield projects and asks investors to invest alongside it" (ie. take an equity stake in a big greenfield project).
• Andrew told me this is a truly novel idea and if they get the implementation and governance right, setting up a qualified and independent board to oversee this new infrastructure bank, it will be mutually beneficial for all  parties involved. 
• In terms of subsidizing pensions, he said unlike pensions which have a fiduciary duty to maximize returns without taking undue risk, the government has a "financial P&L" and a "social P & L" (profit and loss). The social P & L is investing in infrastructure projects that "benefit society" and the economy over the long run. He went on to share this with me. "No doubt, the government is putting up the bulk of the money in the form of bridge capital for large infrastructure projects and pensions will invest alongside them as long as the risk/ return makes sense. The government is reducing the risk for pensions to invest alongside them and we are providing the expertise to help them run these projects more efficiently. If these projects don't turn out to be economical, the government will borne most of the risk, however, if they turn out to be good projects, the government will participate in all the upside" (allowing it to collect more revenues to invest in new projects).
• He made it a point to underscore this new model is much better than the government providing grants to subsidize large infrastructure projects because it gets to participate in the upside if these projects turn out to be very good, providing all parties steady long-term revenue streams.

Now, I've met Andrew's predecessor at OTPP, Stephen Dowd, and David Rogers, his partner at Caledon Capital, and can tell you there is money to be made in smaller infrastructure projects and you don't need to be a huge pension plan to gain access to this asset class.

But Andrew Claerhout is one smart cookie and he really knows his stuff. I've spoken to him on a few occasions and apart from being very nice, he understands a lot of nuances of infrastructure investments from a social, political and economic point of view and he always made logical sense to me when we discussed these topics.

In fact, and I'm stepping a little bit out of line here, when OTPP's current CEO who I know and admire decides to step down in the future, I think Andrew Claerhout will be among the top choices to lead this venerable organization. He's a smart, solid and very nice leader who will definitely make the short list.

Anyway, what struck me from the article is that OTPP's Infrastructure team is investing in some greenfield projects and Olivia Steedman was mandated to run that team and go out to recruit people with the skill sets to do these investments.

But Andrew Claerhout ruled out pursuing OTPP’s greenfield strategy through funds or separate accounts or going 100 percent direct. Instead, they partnered with experienced teams, set up platforms with them, and use those partnerships to acquire the requisite expertise.

He's not alone. Many other large Canadian pensions use infrastructure platforms to attract qualified and experienced people to help them manage infrastructure investments. But their focus has been predominantly on brownfield, not greenfield projects.

The article discusses OTPP's approach to funding businesses that are developing greenfield projects where the pension owns the business. It gives the example of BlueEarth and Cubico.

This is one approach. Another approach is what the Caisse is doing now with its massive REM project, which is a purely direct greenfield project. The Caisse got a loan from the Quebec government and will receive money from the federal government too, but what Macky Tall and his team are doing in Montreal is unlike anything any large Canadian pension is doing in infrastructure.

[Note: The Caisse de dépôt et placement du Québec just received confirmation of a $1.283-billion investment, by the Government of Canada and Prime Minister Justin Trudeau, in the Réseau électrique métropolitain (REM) project.]

I just finished covering the International Pension Conference of Montreal and PSP's fiscal 2017 results where I noted that PSP's CEO André Bourbonnais is concerned about investor complacency and rightfully warned institutional investors are underestimating valuation and regulatory risks of infrastructure, mistakenly looking at these investments as a substitute for bonds.

In a private conversation with me at last year's pension conference, Leo de Bever, AIMCo's former CEO, told me he thought some of the infrastructure deals were being priced at "insane levels". I can't tell you which deals he mentioned (will let you guess), but he did add this: "what the Caisse is doing with this greenfield infrastructure project is truly innovative and can pay off in a huge way if they get it right."

I agree. There is no large pension in the world which is doing anything close to what the Caisse is doing in terms of a purely direct major greenfield infrastructure project where it controls everything from A to Z.

In order to do this project, CDPQ Infra went out and recruited people with the requisite skill-sets, people with operational experience developing and managing mammoth greenfield projects (not just MBAs and dealmakers but engineers with MBAs who worked at large construction engineering companies like SNC Lavalin and elsewhere).

This is why I was so disappointed to learn that the new Canadian Infrastructure Bank will be based in Toronto. I respect Jim Leech but in my humble opinion, Montreal, not Toronto, should have been the first and only choice as the headquarter this new federal infrastructure bank and I would have placed someone like Bruno Guilmette, PSP's former head of Infrastructure or someone else I know well as the head of this bank (I'm getting a bad feeling that this new infrastructure bank is going to be staffed by the wrong type of people).

Anyway, that's enough opining from me. I've shared plenty here. If you have anything to add, feel free to reach me at LKolivakis@gmail.com and I will post your comments.

Below, Ontario Teachers' Pension Plan CEO Ron Mock speaks with Bloomberg's Erik Schatzker at Bloomberg Invest New York about the challenges facing pension plans and what he's doing to meet OTPP's funding obligations. Great interview, Ron lays out the foundations of OTPP's long-term success.

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PSP Investments Gains 12.8% in Fiscal 2017

Benefits Canada reports, PSP Investments posts 16.1% return:

The Public Sector Pension Investment Board earned a 16.1 per cent return (gross, not net) in its 2017 fiscal year, bringing its net assets under management to $135.6 billion.

That’s a significant increase from last year, when it earned a one per cent return, and closer to its 14.5 per cent result in 2015.

Private debt and natural resources saw the strongest returns, at 27.5 per cent and 19.5 per cent, respectively. Public markets posted a 16 per cent return, with infrastructure at 14.4 per cent and real estate at 10.8 per cent. Private equity was the only asset class that saw a negative return, at minus 3.4 per cent.

“While substantial volatility and international uncertainty remain, we continue to pursue our objective of navigating market fluctuations with a long-term investment horizon and well-diversified global footprint,” André Bourbonnais, president and chief executive officer at PSP Investments, said in a statement.

Significant real estate investments during the 2017 fiscal year included seniors’ properties in Canada, the United States and Britain. The pension fund also invested in student housing and a large office project in Britain, as well as new developments in Mexico, Colombia and China.

In terms of private equity, PSP Investments acquired significant interests in the U.S. physician services organization Team Health, global advisory firm AlixPartners, animal intelligence technology company Allflex Group, and Keter Group, which makes resin consumer products. The pension fund has also committed to acquiring Cerba Healthcare, which operates clinical pathology laboratories in Europe, before the new fiscal year ends.

Natural resources activities include new projects in Australia and the United States and expanding four existing agricultural investments.

On the infrastructure side, major investments include hydroelectric assets in New England, larger stakes in the renewable energy platform Cubico, as well as ROADIS, which owns 1,644 kilometres of roads in Brazil, Mexico, India, Spain and the United States.

When it comes to public markets, PSP Investments created an internal global equity research and investment platform that will provide sector and company-specific information.

In the past year, the pension fund also opened a European hub in London, England, and completed staffing its New York office to focus on private debt and private investment opportunities. It also created a responsible investment group and total fund portfolios to better identify opportunities and deploy capital.

PSP Investments put out a press release announcing its results, PSP Investments posts strong performance for fiscal year 2017 - Net return of 12.8% brings net assets to $135.6 billion (added emphasis is mine):

• One-year total portfolio net return of 12.8% generated $15.2 billion of net income, net of all PSP Investments costs.
• Five-year annualized net return of 10.6%, which is 1.2% above the policy portfolio benchmark return.
• Ten-year net annualized return of 6.0% generated $13.7 billion of cumulative net investment gains over the return objective.

The Public Sector Pension Investment Board (PSP Investments) announced today that its net assets under management reached $135.6 billion at the end of fiscal year 2017, compared to $116.8 billion the previous year, an increase of 16.1%. The one-year total portfolio net return of 12.8% created $15.2 billion of net income, net of all PSP Investments costs. This return continues to outperform the policy portfolio benchmark which generated 11.9% return. On a gross basis, the portfolio delivered a 13.2% return, compared to a 1.0% return in 2016.

"We couldn't be prouder of our team's accomplishments in bringing back double-digit returns and contributing to delivering the pension promises to the contributors and beneficiaries who dedicated their active lives to serving Canada," said André Bourbonnais, President and Chief Executive Officer at PSP Investments. "While substantial volatility and international uncertainty remain, we continue to pursue our objective of navigating market fluctuations with a long-term investment horizon and well-diversified global footprint."

Net assets increased by $18.8 billion in fiscal year 2017, attributable to net income, net of all PSP Investments costs of $15.2 billion and net contributions of $3.6 billion. All asset classes saw strong returns, with the exception of Private Equity.

Asset Class Performance Highlights (click on image)

As of March 31, 2017:

• Public Markets had net assets of $77.2 billion, an increase of $8.6 billion from fiscal year 2016, for a one-year return of 16.0%, compared to a benchmark of 14.9%. Despite political and economic uncertainty, gains in public equities were the strongest contributor to our absolute and relative rate of return during fiscal 2017. The largest contributor to overall performance came from the absolute return portfolio (internally and externally managed), which added close to $700 million. Going forward, PSP Investments and Public Markets will benefit from the newly created internal Global Equity Research and Investment platform, which will provide sector and company-specific research. The group also created a new absolute return strategy within Public Markets. Through the Global Investment Partnerships Portfolio, the group aims to establish itself as a key partner for all co-investments, structured and opportunistic transactions in both traditional public markets and non-traditional space between public and private markets.
• Real Estate had $20.6 billion in net assets, up by $0.2 billion from the previous fiscal year, resulting in a 10.8% one-year return versus 6.2% for the benchmark. In fiscal year 2017, the group completed new acquisitions in multi-residential properties in Canada and in industrial and retail assets in the U.S., while it disposed of non-strategic properties in Canada, the U.S., Europe and Australia. Real Estate continued to position Revera Inc., our seniors' retirement and healthcare platform, as a major operator of seniors' communities in Canada, the U.S. and the UK. Real Estate expanded the London Student Housing portfolio with Greystar UK and continued to grow our pan-European platform, SEGRO European Logistics Partnership (SELP), increasing the portfolio from 124 to 135 buildings through the acquisition of 14 assets for a purchase price of €265 million (CAD389 million), and the completion of eight developments at a further cost of €49 million (CAD72 million). SELP also successfully issued a €500 million (CAD720 million) unsecured bond listed on the Irish Stock Exchange. Real Estate also funded large, ongoing mixed-use and multi-family developments in the U.S., a large office development at 22 Bishopgate in London, as well as ongoing and new developments in Mexico, Colombia and China. The group established representation at our London office in order to better manage its total European portfolio of CAD$5.92 billion of net assets, build new relationships and originate new investment opportunities.
• Private Equity had net assets of $15.9 billion, $3.4 billion more than in fiscal year 2016, for a one-year return of (3.4) %, compared to a benchmark return of 9.3%. The group significantly expanded its global network of investment partnerships with like-minded investors, including traditional private equity funds. Private Equity also made new direct investments in the consumer and healthcare sectors, including the acquisition of significant interests in Team Health, a leading U.S. physician services organization; global advisory firm AlixPartners; Allflex Group, a global leader in animal intelligence and monitoring technologies for livestock, pets, fish and other species; and Keter Group, the world's largest maker of quality resin consumer products. The group also committed prior to year-end to acquire Cerba Healthcare, a leading European operator of clinical pathology laboratories and continued to build its presence in London with the hiring of a team of experienced and dedicated investment professionals.
• Infrastructure had $11.1 billion in net assets, a $2.4 billion increase from the prior fiscal year, leading to a 14.4% one-year return, relative to the benchmark return of 5.2%. Our Infrastructure group deployed $2.6 billion in fiscal year 2017, including the acquisition of a portfolio of hydroelectric assets in New England, an additional interest in our Cubico renewable energy platform and 33% of Vantage Data Centers, in collaboration with external partners and also with our CIO group, and Private Equity and Real Estate asset classes. Moreover, with the completion of the split of Isolux Infrastructure Netherlands B.V. and Grupo Isolux Corsan, PSP Investments is now the sole shareholder of Isolux Infrastructure. Renamed ROADIS, it has a portfolio of 1,644 km of roads across nine concessions located in Brazil, India, Mexico, Spain and the U.S. and will serve as our new global road investment platform. Infrastructure also committed to four funds which invest in a wide variety of sectors and niche markets. The group established senior representation at PSP Investments' London office in order to extend our global reach for asset management, managing partner relationships and developing investment opportunities.
• Natural Resources had net assets of $3.7 billion, an increase of $1.2 billion from the previous fiscal year, for a one-year return of 19.5% versus the 5.3% benchmark. Income was driven by strong cash flows and valuation gains, primarily in timber and agriculture. Natural Resources also made five new investments in the U.S. and Australia and expanded four existing agricultural platforms. Net assets under management grew by $1.2 billion on a year-over-year basis, resulting primarily from $729 million in net deployments and valuation gains. Long-standing investments in timber continued to account for most investment income and assets under management.
• Private Debt funded net assets of $4.4 billion, up from $640 million the previous year, resulting in a 27.5% one-year return, compared to a benchmark of 12.4%. In fiscal year 2017, Private Debt committed across 30 transactions, including investments in first and second lien term loans, unitranche term loans, secured and unsecured bonds and a credit fund. Among them was a US$125 million (CAD 163 million) commitment to a Unitranche Term Loan in support of Advent's acquisition of Quala, North America's largest independent provider of tank trailer cleaning, ISO container depot services and IBC cleaning, testing and reconditioning services. Private Debt also facilitated our CIO group's commitment to a senior equity investment in Information Resources, Inc., a point-of-sale and marketing data aggregator for consumer packaged goods, over-the-counter healthcare companies and retailers in the U.S. and internationally. Private Debt portfolio diversification continued to improve in terms of geography, industry, equity sponsors and asset type. The group committed to the international expansion of PSP Investments by hiring four investment professionals in our London office.

PSP Investments' total cost ratio was 70.5 cents per $100 of average net investment assets in fiscal year 2017, compared to 63.0 cents in fiscal year 2016. The higher total cost ratio is part of our Vision 2021, to deliver better sustainable investment returns for our sponsors. It was due to higher operating expenses—mainly attributable to increased headcount required to deliver on our strategic plan objectives and the opening of two international offices— and a rise in management fees.

Other Corporate Highlights

Additional accomplishments during fiscal 2017:

• Created a dedicated Responsible Investment group and expanded our in-house capacity to identify and monitor environmental, social and governance (ESG) factors in investment decision-making. Our inaugural Responsible Investment Report can be consulted here.
• Expanded our global footprint and reinforced the One PSP investment approach by completing the staffing of our New York office and opening a European hub in London. These new offices will pursue private investment and private debt opportunities and improve access to local knowledge and market insights.
• Increased operational agility. Through its Public Markets group, PSP Investments created a centralized equity research platform to perform sector and stock analysis on a global basis. It directly feeds all internal active public equity mandates and provides sector expertise and support to all asset classes.
• Continued the implementation of a flexible total fund approach that allows investment teams to take advantage of opportunities that do not fit current asset classes. With the oversight of the Investment Committee, we created our Total Fund portfolios, which help optimize our ability to identify opportunities, deploy capital and improve the risk-return profile of the total fund. We also established a CIO group to seek greater total fund perspective and implemented a new compensation system aligned with total fund views.
• Consolidated our approach to diversity and inclusion practices. We see diversity as a key success factor and we are enabling our increasingly diverse workforce to reach their full potential and, as a team, to successfully deliver on PSP Investments' corporate business strategy, Vision 2021. The number of women in senior roles increased from 18.2% in 2015 to 30% in 2016, compared to a national availability rate of 27.4%. As a percentage of our workforce, members of visible minority groups increased from 15.4% in 2015 to 16.6% in 2016. Representation of group members within PSP Investments is consistent with the market availability rate of 14.8%.

"We believe that attracting a talented, high-performing workforce and building relationships with the strongest institutional partners worldwide is translating directly into results in our investments," Mr. Bourbonnais said. "Our vision is to be a leading global institutional investor that puts the interests of the contributors and beneficiaries at the heart of everything we do. I am proud of the progress that our employees and partners have made to bring this vision to life."

For more information on PSP Investments' fiscal year 2017 performance, visit http://www.investpsp.com/en/index.html.

About PSP Investments

The Public Sector Pension Investment Board (PSP Investments) is one of Canada's largest pension investment managers with $135.6 billion of net assets under management as of March 31, 2017. It manages a diversified global portfolio composed of investments in public financial markets, private equity, real estate, infrastructure, natural resources and private debt. Established in 1999, PSP Investments manages net contributions to the pension funds of the federal Public Service, the Canadian Forces, the Royal Canadian Mounted Police and the Reserve Force. Headquartered in Ottawa, PSP Investments has its principal business office in Montréal and offices in New York and London, their European hub. For more information, visit www.investpsp.com or follow us on Twitter @InvestPSP.

Let me begin by thanking my contact in Ottawa for bringing PSP's results to my attention early Wednesday morning. In past years, PSP typically released its results to the public a month after they were tabled at Parliament, so I wasn't expecting them to be available so soon.

Anyway, let me delve right into my analysis and begin by stating these are impressive results. It's not just the headline figure, what most impressed me was the ramp-up of the Private Debt asset class, and of course the results this group delivered in such a short amount of time (operations began in late 2015).

At a CFA luncheon earlier this year, PSP's President and CEO, André Bourbonnais, stated that PSP is trailing its peers in Private Debt and is a late comer to this asset class. Well, I think it's safe to say that certainly isn't the case any longer.

Led by David Scudellari, Senior Vice President, Head of Principal Debt and Credit Investments, out of PSP's New York office, this group has been very busy deploying capital in high yield, leverage loans, and direct lending.

In London, PSP seeded a credit platform late last year which I'm sure has ramped up its operations. The platform, created by David Allen‘s AlbaCore Capital, will focus on private and public credit markets where there are inefficiencies in pricing, including high yield, leveraged loans and direct lending. At the time, PSP said it may deploy more capital in partnership with AlbaCore for specific deal opportunities.

Now, I don't know if Private Debt can continue to deliver an exceptional performance of 27% ++ every single year. In fact, I think it's wise to temper our enthusiasm on credit markets and private debt going forward, but clearly this is a great asset class which will grow over time and offer PSP a significant source of value added for many more years.

How did PSP ramp up its operations in Private Debt so quickly? It has the right governance which allows it to compensate people appropriately and it created these credit platforms to deploy significant capital very quickly, paying fewer fees than farming it out to traditional private equity funds that are active in this space.

As stated above, all asset classes had strong returns with exception of Private Equity. I have long warned investors these are treacherous times for private equity. If you look at results from various large US and Canadian pensions in the last year, you will see returns on private equity have come down considerably.

Still, large Canadian pensions are doing better than their US counterparts in private equity and as you will read below, there are legacy issues which explain why PSP's Private Equity team underperformed its benchmark in fiscal 2017.

There are a lot of structural factors that explain why times are tough in private equity. A wall of capital from all over the world is chasing private equity, deals are pricey, the cost of capital is cheap, strategics are flush with cash and they are competing directly with private equity firms.

In fact, you can say the same thing is happening in other private markets like infrastructure and even real estate. As more and more global funds increase their allocation to private markets, deals are getting pricier and the risk premium over public markets is coming down.

At the International Pension Confrence of Montreal on Monday, André Bourbonnais said pensions and other institutional investors are under-estimating the risks of infrastructure investments, seeing them as a substitute for bonds, but neglecting the high valuations and regulatory risks of these investments.

He also noted that following Brexit, PSP slowed its activities in infrastructure and real estate in the UK, and even sold some assets (real estate) but it remains committed to investing in that country and recently opened a London office and sees it as its European growth hub. 

Still, looking at the results above, both Real Estate and Infrasructure delivered great returns and both handily beat their benchmark, adding significant net income to PSP's overall portfolio. 

In past years, I would scutinize the benchmarks in all asset classes, but suffice it to say that even if the benchmarks in Private Debt, Real Estate and Infrastructure were much tougher to beat, the results are still very impressive in these asset classes and they would likely still beat tougher benchmarks.

In Public Markets, where it's a lot tougher beating benchmarks, the results are equally impressive for fiscal year 2017, gaining 110 basis points over the benchmark (16% vs 14.9%).  The press release states the largest contributor to overall performance came from the absolute return portfolio (internally and externally managed), which added close to $700 million.

It is worth noting that PSP allocates to a handful of top hedge funds (like Bridgewater and company) and it has also developed a significant internal alpha team covering bonds, stocks, commodities, and currencies and anything in between (like PIPEs, etc.).

This internal alpha team also co-invests with external partners on transactions where it can take bigger opportunistic positions internally. This is basically piggybacking off of external managers when they see a great idea worth taking a risk on. This is on top of generating their own alpha ideas internally ( a smart way of leveraging their public market partnerships).

Anyway, fiscal year 2017 was a great year for PSP Investments. I highly recommend you take the time to dig deeper and read the complete annual report available here.

I just finished a very brief chat with PSP's CEO André Bourbonnais as he was waiting to head through airport security to catch a flight. Here are the points we covered in our brief conversation:

• On Private Debt, André noted PSP began operations in late 2015. "We got the timing right, and we hired the right people to oversee these operations." He was referring to David Scudellari in New York and Oliver Duff in London.
• The quality of the underwriting in these credit operations is excellent and they have been able to deploy capital fairly easily without relying on getting it back.
• André told me Private Debt will grow to 7% of the total portfolio over the next 3 to 4 years.
• In Private Equity which was the only asset class that underperformed its benchmark, André said there is "transformational change" going on there where PSP is exclusively focusing on partnerships and co-investments (ie. the CPPIB approach which André knows well and has served that fund very well over the years). He told me that Private Equity also had some "legacy investments" it needed to deal with in FY 2017 (ie. they took writedowns on some purely direct deals that were there from the previous team). 
• He said that they invested in 15 new funds and 10 direct co-investment deals (to lower overall fees). In roughly two years, PSP will see major benefits to this new approach in Private Equity focusing exclusively on fund investments and co-investments to lower fees. I totally agree with this approach in Private Equity.
• Lastly, in terms of risks, André repeated what he said at the conference on Monday, namely, he is worried about "complacency in the market" where people mistakenly believe this is the new normal and underestimate geopolitical and other risks lurking out there.

That was all the time André Bourbonnais could allocate to me and it was plenty as he answered my main concerns. At this time, I had to leave in the afternoon for a long physio appointment, which is why I was late to post this comment as I wanted to get back to read it properly before posting it.

The key takeaway I got from my conversation with André is that there is a major shift going on in Private Equity to focus exclusively on fund investments and co-investments. The reason that group underperformed its benchmark this year was that they needed to write down some "legacy investments" in their portfolio which were purely direct investments from the previous group that most likely turned out to be bad investments (didn't get more details but that's what it sounded like).

Again, this new Private Equity  strategy is in line with what CPPIB has done in PE for years, namely, fund investments and co-investments with no purely direct investments. It is a bit more costly but in my opinion, this is the fiduciary right thing to do in private equity and it's in the best interests of contributors and beneficiaries.

[Note: After reading my comment, André Bourbonnais sent me a subsequent email stating: "The slight nuance I would bring is that we will not exclusively focus on funds and co-investments in PE but it will definitely be the cornerstone of our strategy for this asset class".]

I wanted to ask André Bourbonnais more questions on the new absolute return group within Public Markets, the four infrastructure funds they invested in, some "legacy" private market benchmarks, currency hedging policy and how compensation has changed. 

Unfortunately, it takes time to properly go over everything and time is something he just didn't have today as he's traveling. The job of a CEO at CPPIB or PSP is very hectic, especially when the annual reports come out, so I am glad I covered some important points and thank him for calling me.

Once more, I highly recommend you take the time to dig deeper and read PSP's complete annual report available here. At a minum, take the time to read the Chair's Report and the President's Report.

Below, as I customarily do, you can go over PSP's total direct compensation from page 69 of the Annual Report (click on image):

I would urge you to go over the details of how compensation is determined. Of course the compensation is excellent but it's in line with PSP's large Canadian peer group and it is based primarily on long-term results like all of Canada's large public pensions.

More important than total compensation, I think people need to understand that André Bourbonnais and his senior team have done a great job turning this shop around, being far more transparent, stressing the importance of effective communication, and focusing on a long-term strategy that diversifies across public and private markets all over the world.

I will also mention the move to diversify the workforce in upper management and all levels of the organization is extremely important for a lot of reasons. PSP's workforce should reflect that of the Public Service, Canadian Armed Forces, Royal Canadian Mounted Police, and the Reserve Force.

I fundamentally believe PSP and other large Canadian public pensions should always strive to diversify their workforce at all levels to gain the benefits that come from hiring smart people with different life experiences and perspectives.

Let me end this comment by once again thanking André Bourbonnais for taking a few precious minutes to answer my questions. I congratulate PSP and all its employees for delivering great results in fiscal 2017. Keep up the great work and always strive to be better.

Below, André Bourbonnais, President and CEO at PSP Investments, explains why his firm has chosen London as its European hub, despite the UK's decision to leave the European Union. He speaks on "Bloomberg Markets. Listen closely to his comments.

I also embedded a panel discussion on assessing the shifting dynamics of the LP/ GP relationship from earlier this year featuring Guthrie Stewart, Global Head of Private Investments at PSP Investments. Great discussion, well worth listening to, but I want you to focus on what Guthrie Stewart said about the PE portfolio he inherited at PSP.

Lastly, Guthrie Stewart discusses the importance of co-investing and the shifting dynamics in the LP/GP relationship at SuperReturn International 2017 in Berlin. Listen to his comments, he's spot on. 

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