Will Pensions Keep Shorting Volatility? (w/ Leo Kolivakis)
ED HARRISON: Let's go to thinking about some of the things that are popping up right now in terms of pensions, because you write about things on the fly as they're occurring. One thing I thought that was interesting was AIM Co, that's the Alberta Investment Management Corporation. You talked about how they were selling volatility, and obviously when volatility rose, that cost them a lot of money. Is that, number one, a viable investment strategy for a pension fund going forward and two, were they being responsible in terms of taking those risks? Because obviously, they were getting returns during the Great Financial Crisis, the period after that. LEO KOLIVAKIS: Canadian pension funds are a lot more sophisticated than US pension funds in the sense that they hire very, very qualified people internally to manage assets in order not to farm them out to hedge funds to do the same strategies. This particular volatility selling strategy, selling volatility was not just on AIM Co, but by many key pension funds. Unfortunately, what happened in March was a spike in volatility was so unprecedented and the duration that spike was unprecedented, that the particular strategies got into trouble. If you understand the way they're engaging this sold volatility was using variant swaps and if you understand the mechanisms, when in these negatively convex strategies, you get a very abrupt spike in volatility that's really unprecedented, the losses mount so quickly that you don't have any way to get out because nobody's going to take the other side of that trade. What surprised me was, quite frankly, why they weren't able to pull the plug earlier. Again, I understand that given the unprecedented situation, and given that the losses mount so quickly, maybe that was one of the reasons they weren't able to this. I have to say for a lot of years, pensions were collecting-- Canadian pensions were collecting 6% to 10% plus on these type of strategies annually, and doing it very, very well and managing the risks appropriately. Unfortunately, with any selling volatility type of strategy, if you're not really careful on understanding the risks of the strategy, it can really blow up. I don't know exactly what happened here, because I know the people at AIM Co were very, very competent. Obviously, something went wrong in terms of the risk management of that strategy, whether it was the positions they were taking relative to the size of the pension plan. When you have a $3 billion, whopping 100 billion dollar pension plan, that's significant. This is something they will have to review internally, and I know that there are a lot of questions being asked by their clients and by their board, and they will come with a transparent statement in the annual report to explain exactly what happened. Now, people are asking me whether or not Canadian pensions or any pensions should be doing these type of strategies, my answer is, if you have the competence to do it properly internally, why not? Ontario Teachers' and HOOPP have been doing these strategies for a long time, and they've been doing very well, because they have derivatives experts who are able to manage the risks of these strategies. It's all about managing the risk. If you can do it internally, as opposed to farming it out to hedge funds who're going to charge you a ton of fees on it, why not? ED HARRISON: That leads to the next question about private markets, because Canadian pensions in particular, are very forward looking in terms of taking that on to their balance sheet. That is taking it in house in terms of investing in private markets where other pension companies in the US as an example are using private equity companies. You and I, we were talking earlier before we got on this call about Neiman Marcus and CPP IB buying them in 2013, and how that is now likely to go to bankruptcy. The first question I have is, what does that say about private market and Canadian pensions getting involved in that in terms of A, returns and returns going forward and also B, in terms of the diversification of that strategy versus stocks and bonds? LEO KOLIVAKIS: Neiman Marcus was a core investment of CPP IB I did with Ares Management, a big private equity shop and unfortunately, Neiman is encountering problems not being able to pay its interest payment on its $4.8 billion loan. The ramifications of this aren't just with CPP IB, in fact, I was reading this morning, OMERS, which its real estate subsidiary of Oxford Properties Group owns Hudson Yards in New York. One of their biggest anchor tenants was going to be in Neiman Marcus and they have concessions on that. There's going to be a few, a lot of Canadian pensions are going to get hurt if Neiman Marcus goes bankrupt, we'll see. I'm not privy to what's going on in the background. CPP IB and Ares are trying to figure out a solution. CPP IB has the liquidity to help even in the short run if that's the case, however, what I can tell you is many private markets are getting hit. Airports, toll roads, infrastructure assets, which the Canadian pension funds have invested quite a bit in, malls, hotels, office spaces, private equity especially private equity that got into energy, thinking there was going to be a major recovery and we see what's going on with oil prices and the energy markets. There's going to be a world of hurt, private debt, by the way, which is a major asset class for Canadian pension funds, which is lending money basically to medium sized businesses, which many of them are going to go bankrupt. There's going to be a world of hurt. However, we're not going to see that right away. There's a bit of a lag I say of three months to six months before those assets are marked to market. Canadian pensions, though invest directly, US pensions are also going to get hurt in their private equity investments. They're paying fees to funds, and many of these funds are going to have terrible returns and are also going to get hit on in private markets. It's a matter of thinking about it over the long term. For example, airports are shut down all over the world. Not all airports, but many of them are, but if you think about it, at one point, people are going to start traveling and airports are going to open up again. Yes, over the one or two-year period, you're going to have a major decline in revenues in these airports, but over long one, will need to come up and make a lot more money than investing in bonds, for example. Public markets, I'll come back to this. The reason why Canadian pension funds are fully unprecedented public markets is there's a lot of volatility in public markets. They are looking to get the best risk adjusted returns over the long run and diversifying across public and private markets and in private markets, they're able to do a lot of direct deals and infrastructure, completely direct in private equity through co-investments with their partners. I think over the long run, they're going to capitalize on many dislocations that are going on in the markets right now. They're going to come out ahead, however, over the next year, there's no question in my mind, especially if the duration of this crisis continues longer than what most people anticipate, there's no question there's going to be a world of hurt in Canadian pensions, and quite honestly, global pensions. ED HARRISON: Basically, what you're telling me is that yes, there is diversification to going public and private markets. My next question for you has to do with liquidity then in terms of the ability to help in these situations because I think that the Neiman Marcus situation is a leading example of where things could go. I don't see Neiman Marcus as a brand that is destroyed. In fact, I've heard the Wall Street Journal was talking about Hudson Bay's Saks Fifth Avenue wanting to take over that brand and they've been wanting to take that brand over for a number of years now. That's a potential outcome from this, is that they merge in some capacity, but at the same time, it could be that Ares and CPP IB have the liquidity to be able to help Neiman Marcus through this difficult time. Do you think that Canadian-- having taken these private investments in-house, that they're in a position to be able to provide liquidity that public markets wouldn't be able to provide or that PE companies that are-- just PE companies wouldn't be able to provide? LEO KOLIVAKIS: 100%. I know for a fact they are looking at all these liquidity needs of all their portfolio companies, including-- it's not just Neiman, there's a lot of portfolio companies that these Canadian pensions that they need some liquidity to be able to withstand the storm, and then they will come out ahead and what the Canadian pension funds are doing right now is they're evaluating the liquidity needs of all these portfolio companies, whether they're small or big, and they're trying to see, okay, how can we help you get through this so that this investment, which we believe is a great investment over the long run, will able to withstand the storm and come out ahead over the long run? The focus right now is over the long run. If there's short term liquidity needs, the good thing is Canadian pensions have a ton of liquidity to provide through various mechanisms. They can do this and help these companies get through this.