Thursday, October 8, 2015

SEC Gunning For Private Equity?

Lisa Beilfuss and Aruna Viswanatha of the Wall Street Journal report, Blackstone in $39 Million SEC Settlement:
Blackstone Group LP agreed to pay about $39 million to settle Securities and Exchange Commission charges over some of the buyout-fund manager’s fee practices, in the agency’s second settlement with a big private-equity firm stemming from its broad examination of the industry.

The SEC said Wednesday that the New York firm failed to sufficiently disclose to its fund investors details about big one-time fees Blackstone collected from companies it sold or took public, as well as discounts the firm received on some legal fees that weren’t passed on to the fund investors. Nearly $29 million of the settlement will be distributed to affected fund investors, the SEC said.

Blackstone settled the charges without admitting or denying the SEC’s findings.

The settlement follows KKR & Co.’s June agreement to pay almost $30 million to settle SEC charges that it improperly allocated more than $17 million in expenses, hurting some investors while benefiting the firm’s executives and certain clients. KKR neither admitted nor denied the allegations.

“Our clear message to the entire private-equity industry is that this is an area of great risk, and that whatever the success of the fund over time, hidden or inadequately disclosed fees will not be tolerated regardless of the size of the adviser,” SEC Enforcement Director Andrew Ceresney said in announcing the Blackstone settlement.

The 2010 Dodd-Frank financial-regulation overhaul required private-equity funds to register with the SEC, giving the agency increased authority over the industry.

“This SEC matter arose from the absence of express disclosure in marketing documents, 10 or more years ago, about the possible acceleration of monitoring fees,” Blackstone said, calling the practice common in the industry. Blackstone voluntarily made changes to the applicable policies before the inquiry began, according to a company representative.

Blackstone, the world’s largest private-equity firm, last year curbed its collection of monitoring-termination fees, which are charged by many private-equity firms but have become controversial. Behind those fees are contracts that Blackstone and other large private-equity firms often enter into with companies they buy; the contracts spell out consulting, or “monitoring,” fees paid over a set number of years, often a decade or longer.

If a company is sold or taken public before end of that period, the contract often dictates that the portfolio company “accelerate” the remaining fees, by paying a lump sum for years of future consulting work the private-equity firm won’t have performed. The payments to Blackstone effectively reduced the value of the portfolio companies before sale, the SEC said.

The SEC has criticized these as a type of poorly disclosed “hidden” fee whose cost often is borne by public pension funds and other investors in private-equity funds.

In Blackstone’s case, the SEC said the firm had in most instances only taken the fees while maintaining some ownership stake in the company, but that in a few instances it took fees for a period of 1½ to several years for which it no longer had a stake in the company.

In addition to the monitoring fees, the SEC also took aim at Blackstone’s contracts with its lawyers. Between 2008 and 2011, the SEC said, Blackstone had an agreement with its law firm under which it received a discount on legal services that was “substantially greater” than the discount the funds received, but the difference wasn’t disclosed to the fund investors. The SEC didn’t say what the different rates were.
Adam Samson, Stephen Foley and Gina Chon of the Financial Times also report, Blackstone to pay $39m over SEC probe into fees:
Blackstone is to pay $39m in compensation and fines in the latest action by US regulators to stamp out hidden fees across the private equity industry.

The Securities and Exchange Commission accused the world’s biggest alternative asset manager of failing to fully inform investors about fee practices that it said eroded the value of their holdings.

The enforcement action comes 18 months after an SEC report found “violations of law or material weaknesses in controls” in the collection of fees and allocation of expenses at more than half of the 112 private equity managers the agency inspected.

Earlier this year, Blackstone rival KKR paid $28.7m in another SEC enforcement action, and the regulator also took action against two smaller private equity firms last year.

Andrew Ceresney, director of the SEC’s enforcement division, said the settlements with KKR and Blackstone covered specific practices and did not “imply closure”. The investigation of the industry is continuing, he said, and private equity firms should voluntarily report any historic fee practices they believe may not have been properly disclosed to investors.

The Blackstone settlement focuses on the acceleration of so-called “monitoring fees” that it charges portfolio companies.

Private equity companies charge fees for consulting with companies they own, sometimes with terms as long as a decade. In a bid to recoup what would be lost revenue, many private equity companies charge a large lump-sum fee ahead of a sale or when they take a portfolio company public.

The SEC alleged Blackstone failed to properly disclose the accelerated payment scheme to investors in its funds, which often count pension funds among their ranks.

“The payments to Blackstone essentially reduced the value of the portfolio companies prior to sale, to the detriment of the funds and their investors,” the SEC said on Wednesday.

The regulator also alleged Blackstone failed to tell investors that it had negotiated steep discounts for services from an outside legal firm that were not extended to the funds.

The scale and the complexity of fees paid to the $3.5tn private equity industry has become an increasing concern to public pension funds. In June, a group of senior elected US state officials wrote to the SEC calling on the agency to ensure that all private equity fees are reported clearly and consistently to investors.

The letter was signed by 13 state treasurers and comptrollers, including those in California and New York, who helped to provide oversight for public pensions.

Blackstone, led by Stephen Schwarzman, disclosed the SEC probe into monitoring fees and legal fee discounts in May, and said that it stopped or limited the charging of accelerated monitoring fees last year. It has also said it had beefed up disclosures over such fees.

“This SEC matter arose from the absence of express disclosure in marketing documents, ten or more years ago, about the possible acceleration of monitoring fees, a common industry practice,” Blackstone spokesman Peter Rose said.

“Each accelerated fee was, however, as the SEC order acknowledges, disclosed when received and our Limited Partner Advisory Committee did not exercise its right to object. Moreover, Blackstone voluntarily made changes to the applicable policies well before this inquiry was begun.”

The SEC said nearly $29m of the settlement will be distributed to affected fund shareholders.
Lastly, Dan Primack of Fortune reports, Blackstone Group settles with SEC over fees, will pay out $39 million:
Alternative investment giant The Blackstone Group (BX) this morning reached a settlement with the Securities and Exchange Commission, related to some of the firm’s former private equity fee practices.

Blackstone has agreed to pay a $10 million fine, plus refund nearly $29 million (including interest) to limited partners in its fourth and fifth flagship private equity funds. At issue were so-called accelerated monitoring fees, in which Blackstone effectively charged its portfolio companies for services not actually rendered (without properly disclosing such arrangements to its LPs). Here is how we described the scheme last October:
For years, Blackstone and many other private equity firms have charged something called “accelerated monitoring fees.” What it basically means is that, after buying a company, Blackstone would set an annual fee that the company would pay for various (often undefined and unverified) services. For example, $5 million per year for 10 years. The kicker is that if Blackstone exits the company prior to the 10 years being up — either via a sale or IPO — it gets the extra years in a lump sum payment.

Going forward, Blackstone no longer will write acceleration clauses into its monitoring fee agreements. For existing portfolio companies, it either will distribute 100% of the accelerated fee to limited partners or will cut other fees a commensurate amount.
The SEC also took issue with certain discounts that Blackstone received from law firms from legal work done for the parent company, but which were not also extended to its funds.

Word of the SEC investigation was first disclosed by Blackstone in a May regulatory filing.

“Full transparency of fees and conflicts of interest is critical in the private equity industry and we will continue taking action against advisers that do not adequately disclose their fees and expenses, as Blackstone did here,” Andrew Ceresney, director of the SEC’s enforcement unit said in a press release.

Blackstone spokesman Peter Rose provided the following statement via email:
“This SEC matter arose from the absence of express disclosure in marketing documents, ten or more years ago, about the possible acceleration of monitoring fees, a common industry practice. Each accelerated fee was, however, as the SEC order acknowledges, disclosed when received and our Limited Partner Advisory Committee did not exercise its right to object. Moreover, Blackstone voluntarily made changes to the applicable policies well before this inquiry was begun.”
Back in June, fellow private equity giant Kohlberg Kravis Roberts & Co. (KKR) settled with the SEC over charges that it breached fiduciary duty to investors in its flagship private equity funds between 2006 and 2011.
I've already covered hidden "monitoring fees" and hidden rebates from law firms and other third parties in a previous comment on private equity stealing from clients.

What Blackstone, KKR and others did is wrong and while these SEC settlements are a pittance for these alternative investment powerhouses, they represent a sea change for the industry which has prided itself in maintaining a culture of secrecy. The institutionalization of private equity, real estate and hedge funds has attracted regulators which are doing their job, monitoring the practices of these funds to make sure they're in the best interests of their investors and shareholders.

What are my thoughts? I think these settlements will be forgotten soon enough and the reality is Blackstone, KKR and other alternative investment powerhouses have already taken steps to stop these practices.

Why are they doing this? Because the name of the game for these giants is asset gathering. Period. Paying a settlement of $39 million to the SEC after they took measures to cease these practices is well worth it if they can continue garnering ever more assets from public pension funds and sovereign wealth funds where they make exponentially more than these settlements just on the management fee alone.

And these SEC settlements won't impact Blackstone's fundraising activities in the least. In fact, it raised over $17 billion first close for its seventh global buyout fund back in May and it just raised $15.8 billion for its latest global real estate fund, Blackstone Real Estate Partners VIII where things are humming along just fine:
At present, the firm is managing two regional opportunistic real estate funds—the $8.2 billion Blackstone Real Estate Partners Europe IV and the $5 billion Blackstone Real Estate Partners Asia.

The alternative asset manager raised more than 90% of the money from institutional investors, according to people familiar with fundraising in March. Blackstone raised the remainder from the individual investors, a process that took longer to complete because of paperwork, said one person to Bloomberg.
How is Blackstone able to garner billions in assets? When you have people like Jonathan Gray and David Blitzer on your team, it's not hard to see why investors love this firm. They are the best of breed in alternative investments, literally printing money in real estate, private equity, hedge funds and anything in between.

But things are getting tough for Blackstone and other private equity funds which is why the big shops are emulating the Oracle of Omaha's approach, trying to collect ever more assets for a longer period, even if it means lower returns.

Still, with public markets getting hit, things are going to get a lot tougher for private equity superheroes which is one reason Blackstone's shares have gotten hit lately (along with the market and shares of other alternative asset managers; click on images):

Finally, while it's easy to point the finger at Blackstone, KKR, Carlyle and others, we should also pause and reflect on the role institutional investors play in tracking fees and hidden costs in their fund investments. I just wrote a comment on CalSTRS pulling a CalPERS on PE fees, criticizing both these giant funds for not doing enough to track and disclose private equity fees.

Matt Levine of Bloomberg touched on this last point in his comment, SEC Finds That Blackstone Charged Too Many Fees where he concludes:
As far as I can tell, this is a story of changing norms for private equity. Once upon a time, private equity was a sexy asset class that charged silly fees that were not subject to too much scrutiny by investors. (It was also a very well lawyered asset class that disclosed those fees reasonably clearly.)
But as returns have gotten less exciting, and as outside observers have called on public pension funds to pay more attention to what they pay for investing advice, limited partners have realized that some of the fees they paid to private equity firms were pretty silly. One response has been to stop paying those fees: Even before this SEC case, Blackstone got more conservative about accelerating monitoring fees, presumably because that's what investors wanted.
But another response has been for investors to regret that they ever paid the fees in the first place, and to attribute that regret not to their own failure to care but to the private equity firms' failure to disclose. There's an obvious emotional appeal to that result -- it's much better to blame sophisticated Wall Street fat cats for overcharging than to blame public pension managers for overpaying -- even though it doesn't quite fit the facts.
Read Matt Levine's entire comment here as he discusses many excellent points on the changing landscape in private equity and how institutional investors are responding (the smart ones are going Dutch on private equity).

Of course, you can read Yves Smith's comment, SEC Gives Blackstone $39 Million Wet Noodle Lashing Over Private Equity Abuses, but not surprisingly, I find it too harsh. 

Once again, if you have anything to add to this comment, feel free to email me at and I'll be more than happy to edit and add your comments in an update.

Below, Blackstone co-founder and CEO Stephen Schwarzman recently sat down with Fortune's Susie Gharib to explain why the Fed's decision not to raise rates at this time makes sense on the global stage. Schwarzman also talked about Asia and how even though China is weaker, he still sees growth in certain sectors (second clip below).

Wednesday, October 7, 2015

Wither Teamsters' Pension Fund?

Mary Williams Marsh of the New York Times reports, Teamsters’ Pension Fund Warns 400,000 of Cuts:
A prominent Teamsters pension fund, one of the largest, has filed for reorganization under a new federal law and has sent letters to more than 400,000 members warning that their benefits must be cut.

Any reorganization of the decades-old Central States Pension Fund would take months and would probably be a brutal battle as workers, retirees, union leaders and employers all seek to protect competing interests. It is a multiemployer plan, the type led jointly by a union and a number of companies, that has caused consternation for many years, because if it failed, it could wipe out a federal insurance program that now pays the benefits of a million retirees.

If the reorganization ultimately proves successful, however, it could serve as a model for other retirement plans with similar, seemingly intractable financial problems.

Cutting retirees’ pensions has generally been illegal, except under the most dire circumstances. But the executive director of the Central States fund, Thomas Nyhan, said that reducing payouts to make the money last longer was the only realistic way of avoiding a devastating collapse in the next few years.

“What we’re asking is to let us tap the brakes a little now, and let us avoid insolvency,” he said. “The longer we wait to act, the larger the benefit reductions will have to be.”

He said the Central States fund had been hit by powerful outside forces — the deregulation of the trucking industry, declining union membership, two big stock crashes and the aging of the population — and it was currently paying out $3.46 in pension benefits to retirees for every dollar it received in employer contributions.

“That math will never work,” Mr. Nyhan said. He said the fund was projected to run out of money in 10 to 15 years, an almost unthinkable outcome for a pension fund that became a political and financial powerhouse in the 1960s, when trucking boomed with the construction of the interstate highway system. Central States became famous back then for financing the construction of hotels and casinos in Las Vegas.

In 1982, the Teamsters were barred from investing their retirees’ money because of the union’s ties to organized crime. Under a federal consent decree, the fund’s investment duties were shifted to a group of large banks, where they have remained. The restructuring plan would not change that.

In the coming months, the Treasury Department will review the Central States restructuring plan, to make sure it complies with the new law. It will also receive comments from affected people through a special master, Kenneth Feinberg, who has been retained by the Treasury to iron out conflicts that have come up in other special circumstances, such as the dispute over whether workers at bailed-out companies could receive contractual bonuses.

The Treasury is expected to decide whether to approve the proposal by next May. If it does, Central States’ roughly 407,000 members will then vote on it. Those facing large cuts would be unlikely to vote in favor of the restructuring. But others might see it as an acceptable way to make their pension plan viable over the long term. Active workers will continue to accrue benefits, for example, and Mr. Nyhan said his projections showed that the restructuring could make the pension fund last for 50 more years.

Mr. Nyhan acknowledged that the process would be emotionally charged. Even if a majority votes no, however, the Treasury Department will have legal authority to impose the changes, because the Central States fund is so large that it qualifies as “systemically important.” That means that if it collapsed, it could take down the multiemployer wing of the Pension Benefit Guaranty Corporation, jeopardizing the roughly one million retirees who currently get their pensions through the program. (The federal insurance program for single-employer pensions would not be affected by a possible failure of the multiemployer program.)

In the past, multiemployer pension plans were popular because they gave small companies the chance to offer traditional pensions, and they permitted workers to move from job to job, taking their benefits with them. About 10 million Americans participate in multiemployer pension plans, many of them in sectors like trucking, construction and retailing, where unions are a powerful presence.

Such pension plans were also said to be financially stronger than single-employer pension plans, because if one company went out of business, others would keep contributing to the pooled trust fund that paid the benefits. Both types were insured by the federal government’s pension insurance program, but companies taking part in multiemployer plans paid much smaller premiums and the coverage was very limited — no more than $12,870 per year, compared to around $54,120 a year for a single-employer pension.

Many Teamsters have earned pensions that exceed the multiemployer insurance limit and would be hit hard if the Central States fund failed.

But in recent years, some multiemployer plans ran into severe trouble as more and more participating companies went bankrupt, leaving growing numbers of “orphaned” workers and retirees for the surviving companies in the pool to cover. Companies in the more troubled plans said lenders would no longer give them credit. Last December, Congress enacted the Multiemployer Pension Reform Act of 2014, which set up a legal framework for distressed pension plans to restructure.

According to a summary provided by the Central States pension fund, its restructuring plan would work by slowing the rate at which active Teamsters will build up their benefits in the coming years, and by lowering the payouts to current retirees, with certain exceptions.

Retirees who are 80 or older will not have their pensions cut, and those over 75 will receive smaller cuts than younger retirees. Disability pensions will continue to be paid in full.

A group of about 48,000 workers and retirees who earned their benefits by working at United Parcel Service will continue to have their pensions paid in full, thanks to labor contracts between the Teamsters and the company. UPS was for many years the largest employer in the Central States pension fund, but it withdrew from the fund in December 2007 after making one large final payment. After the stock market crash the following year, UPS and the Teamsters negotiated a separate agreement calling for UPS to shelter those workers from any cuts the Central States pension fund might have to make.

The group that seems exposed to the largest pension cuts consists of about 43,400 “orphans,” or retirees still in the pension fund, even though their former employers no longer exist. Their pensions will be cut to 110 percent of what they would get from the Pension Benefit Guaranty Corporation, or at most, $14,158.

Active workers will not lose any of the benefits they have earned up until now. But in their coming years of work, they will accrue benefits at the rate of 0.75 percent of the contributions their employers pay into the fund. In the past, their accrual rate was 1 percent.

The restructuring will also abolish a rule that bars pensioners from returning to the work force to supplement their reduced pensions.

The president of the International Brotherhood of Teamsters, James P. Hoffa, wrote to Mr. Nyhan last month, saying the new restructuring law “creates the false illusion of participatory democracy,” because it required a vote “that can simply be ignored.” Although Mr. Hoffa is president of the union, he has no say over the pension fund, which is run by a group of trustees from the companies and the union.

“Participants and beneficiaries get to vote, but their vote only counts if they vote to cut their own pensions,” Mr. Hoffa said. “The people who conceived that cynical scheme should be ashamed.” He said he preferred legislation introduced by Senator Bernie Sanders of Vermont, which if enacted would close tax loopholes and redirect the money to supporting troubled multiemployer pension plans.

Mr. Nyhan said he liked Senator Sanders’s proposal too, but recalled that a similar bill was introduced in 2010, when Democratic Party lawmakers controlled Congress, but was never approved. He said he thought it was even less likely that today’s fiscally hawkish, Republican-controlled Congress would enact such a bill. It was not safe to wait and see if the Sanders bill would pass, he said, because the passage of time made the insolvency more likely.

“The easy thing for my board to do would be ignore the problem,” he said. “We just don’t think this is the responsible thing to do.”

“We need either less liabilities or more money, and Congress is telling us we’re not getting more money,” he said.
This is a very important development which impacts all U.S. mutiemployer plans. Unfortunately, I don't expect any relief from Congress as it effectively nuked pensions last December which led to this restructuring.

Welcome to the United States of pension poverty where important social and economic policies are never discussed in an open, constructive and logical manner. Instead, there is the usual divisive politics of "less" versus "more" government which obfuscates issues and impedes any real progress in implementing sensible reforms in education, healthcare and retirement, the three pillars of a vibrant democracy.

Now, let be clear here, I don't like multiemployer pension plans because they are poorly governed which is why many risk insolvency unless comprehensive reforms are implemented. But the problem here is much bigger than multiemployer plans. U.S. retirement policy needs a drastic overhaul to properly cover all Americans, most of which have little or no savings whatsoever.

I've shared some of my thoughts on what needs to be done when I examined whether Social Security is on the fritz:
...politics aside, I'm definitely not for privatizing Social Security to offer individuals savings accounts. The United States of pension poverty has to face up to the brutal reality of defined-contribution plans, they simply don't work. Instead, U.S. policymakers need to understand the benefits of defined-benefit plans and get on to enhancing Social Security for all Americans.

One model Social Security can follow is that of the Canada Pension Plan whose assets are managed by the CPPIB. Of course, to do this properly, you need to get the governance right and have the assets managed at arms-length from the federal government. And the big problem with U.S. public pensions is they're incapable of getting the governance right.

So let the academics and actuaries debate on whether the assumptions underlying Social Security are right or wrong. I think a much bigger debate is how are they going to revamp Social Security to bolster the retirement security of millions of Americans. That's the real challenge that lies ahead.
Yes folks, it's high time the United States of America goes Dutch on pensions and follows the Canadian model of pension governance. Now more than ever, the U.S. needs to enhance Social Security for all Americans and implement the governance model that has worked so well in Canada, the Netherlands, Denmark and Sweden (and even improve on it).

I know, for Americans, these are all "socialist" countries with heavy government involvement and there is no way in hell the U.S. will ever tinker with Social Security to bolster it. Well, that's too bad because take it from me, there is nothing socialist about providing solid public education, healthcare and pensions to your citizens. Good policies in all three pillars of democracy will bolster the American economy over the very long-run and lower debt and social welfare costs.

If U.S. policymakers stay the course, they will have a much bigger problem down the road. Already, massive inequality is wiping out the middle class. Companies are hoarding record cash levels -- over $2 trillion in offshore banks -- and the guys and gals on Wall Street are making off like bandits as profits hit $11.3 billion in the last six months.

Good times for everyone, right? Wrong! Capitalism cannot sustain massive inequality over a long period and while some think labor will rise again as the deflationary supercycle (supposedly) ends, I worry that things will get much worse before they get better.

Below, watch  Tom Nyhan's testimony with regards to the Central States Pension Fund before the House Subcommittee on Health, Employment, Labor, and Pensions (October 29th, 2013).

And earlier this week, Bloomberg reported that Air France executives were forced to flee with their clothes in tatters after workers stormed a meeting at Charles de Gaulle airport in protest at 2,900 planned job cuts. You might dismiss this as "French hubris and hysteria" but I would pay closer attention to these incidents as I expect them to blossom all over the world, including the U.S., as inequality grows more entrenched and threatens our democracies.

Tuesday, October 6, 2015

CalSTRS Pulling a CalPERS on PE Fees?

Back in July, Chris Flood and Chris Newlands of the Financial Times reported on CalSTRS's private equity woes:
The second-largest US public pension fund has admitted it has failed to record total payments made to its private equity managers over a period of 27 years.

The admission by Calstrs, the $191bn California-based pension fund, prompted John Chiang, the state treasurer of California, to declare he will investigate the failure, which poses serious questions as to how pension fund money is being spent.

The news comes a week after FTfm reported that the state treasurer had voiced “great concern” that fellow pension fund Calpers, the US’s largest at $300bn, also has no idea how much it pays its private equity managers.

Mr Chiang said he would demand clear answers from Calpers over why it does not know how much has been paid in “carried interest” or investment profits over a period of 25 years to the private equity managers running its assets.

A spokesman for Calstrs, which helps finance the retirement plans of teachers, said the fund does not record carried interest. “What matters is the overall performance of the portfolio.”

Following questions from FTfm, Mr Chiang said he would demand Calstrs look into payments of carried interest to its private equity managers.

“Disclosure [of carried interest fees] is very important,” said Mr Chiang, who sits on the administration board of both Calstrs and Calpers.

The revelations come just weeks after US regulators issued an explicit warning to the private equity industry to expect more fines for overcharging investors. 
Calpers, which uses more than 100 private equity firms, identified a need to track fees and carried interest better in 2011, but it has taken until now to develop a new reporting system for its $30.5bn private equity portfolio.

But Calstrs, which manages a $19.3bn private equity portfolio and has 880,000 members, said it has no plans to upgrade its systems for tracking and reporting payments to private equity managers.

Margot Wirth, director of private equity at Calstrs, said it used “rigorous checks” to ensure private equity managers took the right amount of carried interest.

All of Calstrs’ partnerships with private equity managers were independently audited, Ms Wirth added. She said the pension fund carried out its own internal audits and employed a specialist “deep dive” team to look at private equity contracts.

Professor Ludovic Phalippou, a finance professor at the University of Oxford Saïd Business School, who specialises in private equity, told FTfm last week: “Calpers’ total bill is likely to be astronomical. People will choke when they see the true number.”

Prof Phalippou said the same would be true of Calstrs, which first invested in private equity in 1998.

Ms Wirth argued it was “wrong to conflate the fees paid to private equity managers with carried interest”.

She said: “Carried interest is a profit split between the investor and the private equity manager. The higher that carried interest is, then the better both the investor and private equity manager have performed.”

The fear is that if sophisticated investors such as Calpers and Calstrs faced difficulties in obtaining accurate information, then it could only be harder for smaller pension funds, endowments and wealth managers that are less well resourced.

David Neal, managing director of the Future Fund, Australia’s A$128bn sovereign wealth fund and one of the world’s largest investors in private equity, said: “There just are not enough decent private equity managers around to justify the fees.”

He added: “We negotiate fee arrangements that transparently reward genuine performance and drive alignment of interest. Where managers cannot meet those expectations, we do not invest. While we work hard at the arrangements with our managers, the industry still has some way to go.”
Fast forward to October where Yves Smith of Naked Capitalism just put out another stinging comment, CalSTRS Board Chairman Harry Keiley, in Op-Ed Rejected by Financial Times, Gave Inconsistent and Inaccurate Information in Carry Fee Scandal (added emphasis is mine):
The staff and board members of California public pension fund CalSTRS continue to embarrass themselves in their efforts to justify their indefensible position on private equity carry fees.

Readers may recall that the biggest public pension fund, CalPERS, had a put-foot-in-mouth-and-chew incident when it said it didn’t track the profits interest more commonly called “carry fees,” which is one of the biggest charges it incurs on its private equity investments. CalPERS added to the damage by falsely claiming that no investors could get that information. After we broke that story and a host of experts and media outlets criticized CalPERS over the lapse and the misrepresentation, CalPERS reversed itself. It asked its general partners for all the carry fee data for the entire history of all of its funds, and obtained it all in a mere two weeks, with only one exception out of the nearly 900 funds in which it has invested.

So what has the second biggest public pension fund, CalSTRS, done? Like CalPERS, it has admitted that it does not track carry fees. But in a remarkable contrast, CalSTRS is attempting to justify inaction by misleading beneficiaries as to how much information it really has and saying that it’s thinking really hard about what (if anything) to do.

The dishonesty of the CalSTRS position is evident in its e-mails with the Financial Times after the pink paper reported that CalSTRS, like CalPERS, did not track carry fees, and California Treasurer John Chiang, who sits on both the CalPERS and CalSTRS boards, said he would press CalSTRS to look into the matter. I became aware of the contretemps when an FT reporter called me to thank me for my work. I asked him how CalSTRS was taking his story. He said they weren’t happy with it and they’d offered CalSTRS the opportunity to publish an op-ed, which was running early the following week. When I failed to see any such article, I contacted the reporter, who said his editor had rejected the article. I then lodged a Public Records Act request (California-speak for FOIA) for the op-ed and all e-mails between CalSTRS and the Financial Times from the date the Financial Times ran the article on CalSTRS’ carry fee tracking.

It’s important to remember that CalSTRS had said, flatly, that it does not know what it pays in carry fees. From the Sacramento Bee on July 2:
Ricardo Duran, a spokesman for the California State Teachers’ Retirement System, said CalSTRS can estimate the fees “within a couple of percentage points” but doesn’t report the figure.

“It’s not a number that we track,” Duran said. “It’s not that important to us as a measure of performance.”
Memo to CalSTRS: if you are estimating, you don’t know for sure.*

After the Financial Times ran its CalSTRS story, Ricardo Duran, CalSTRS’ head of communications, sent a clearly-annoyed e-mail to the Financial Times’ Chris Flood. Duran tried objecting that the so-called carry fee was not a fee because… was not paid directly by CalSTRS to general partners:
The following paragraph talks about [California Treasurer and CalSTRS board member] Mr. Chiang’s demand of CalPERS about how much has been “paid in carried interest.” Carried interest is not a payment but a profit split. I believe [head of private equity] Margot [Wirth] mentioned that distinction as well.

The language throughout the piece conflated carried interest with management/manager fees. That’s fine if that’s the way you want to characterize it. I only ask if you write about CalSTRS and carried interest again, you specifically mention this and attribute it to me or Margot.
So get a load of this: CalSTRS demanding that if the FT ever dare report on CalSTRS’ carry fee reporting again, that it include the staff’s pet position that a carry fee is not a fee, even when that contradicts statements by board members who oversee CalSTRS. Since when do mere employees a California agency have the right to undercut on-the-record statements of top California government officials?

And that’s before you get to the fact that this “carry fee is not a fee” position is bogus. As Eileen Appelbaum, the co-author of Private Equity at Work, wrote:
The email exchange in which CalSTERS argues with the Financial Times over the question of when is a fee not a fee has a certain Alice in Wonderland quality. The CalSTRS representative insists that a fee is not a fee if it takes the form of profit sharing. But profit sharing is clearly a performance fee – a fee paid to the PE investment manager based on the performance of the PE fund.
And as an expert who has been writing about private equity fees for decades said:
Private equity general partners put up around 1% of the money in a fund once you back out management fee waivers. They get 20% of the profits. The part over and above their pro-rata share is clearly a fee. As we lawyers like to say, res ipsa loquitur.
But the best part is Duran’s wounded claim that the FT “conflated” interest with management fees, as if that were inaccurate. This is from the very first limited partnership agreement I looked at from our document trove, KKR’s 2006 fund:
The Partnership will not invest in investment funds sponsored by, and as to which a management fee or carried interest is payable to, any Person….
Gee, KKR says in its own agreement that carried interest is indeed “paid” just like management fees!

But this is all a warm-up to the op-ed that the chairman of CalSTRS’ board, Harry Keiley, submitted to the Financial Times. It’s troubling to see a board chairman defend staff’s delaying tactics after another board member has demanded answers.

Other public pension fund trustees thought the odds were high that the article was either originally drafted by staff or had staff input. If staff did indeed provide text that Keiley assented to have run under his name, that has the effect of committing him to their position, even if he was privately not fully aligned with them.**

Moreover, it is peculiar to have a defense of CalSTRS’ position on carry fees come from someone who is almost certain never to have seen a private equity fund’s financial statements or reviewed the language in limited partnership agreements that describe the distribution “waterfall,” as opposed to the officers who are responsible and who presumably have expertise.

The full text of Keiley’s submission is at the end of this post. Here are the telling parts (emphasis ours):
We at CalSTRS are in favor of more, rather than less, transparency and disclosure as our history and current checks and balances show. We agree that it’s important for the public to know the estimated amount of carried interest investment managers are earning, tracked as net profits, which a majority of public pension plans report. Almost all private equity partnerships split profits, with the investor (e.g. CalSTRS) taking at least 80 percent and, at most, 20 percent taken by investment managers. Typically, a partnership must earn a minimum of 8 percent return for its limited partners (e.g. investors) before an investment manager earns any carried interest. Also, there are several large, publicly-owned private equity investment managers that report their earnings to delineate their carried interest income. I am confident that the CalSTRS board will continue to examine the issue of reporting carried interest in the context of its overall private equity disclosure practices to ensure we are taking all necessary steps to have full awareness and understanding of both fee and profit structures.
The boldfaced section is simply wrong. At best, it’s a laughably inept effort to mislead the audiences CalSTRS is most concerned about: its beneficiaries and California legislators. Net profits to investors like CalSTRS are after carry fees have been taken by the general partner. Tracking net profits tells you absolutely nothing about carry fees. And Keiley effectively admits that in the next paragraph:
Within our private equity program, we have always reported our returns net of all costs and fees.
From Eileen Appelbaum via e-mail (emphasis original):
What strikes me in the CalSTRS op-ed and their correspondence with the Financial Times is the complete lack of consistency in what CalSTRS’ board is saying. Mr. Keiley, Board Chair of CalSTRS, says that the pension fund agrees that it is important for the public to know what the pension fund pays to its investment fund managers. He finishes that sentence, however, by saying that CalSTRS fulfills that obligation by tracking and reporting net profits. I don’t know what subject Mr. Keiley teaches, but is it possible that he doesn’t understand that this is the crux of the matter? Tracking net profits is not the same as tracking all fees, expenses and carried interest the pension fund pays to private equity managers.

After trumpeting CalSTRS commitment to transparency, Mr. Keiley goes on to baldly contradict himself by asserting: “Within our private equity program, we have always reported our returns net of all costs and fees.” If Mr. Keiley is to be believed, the problem is not that private equity firms don’t provide information on the amount of carried interest they collect; indeed, he asserts that they “keep investors [like CalSTERS] fully informed as to the carried interest shared with their investment managers.” Astoundingly, one is left to draw the conclusion that CalSTRS has that information but chooses not to share it with California’s taxpayers and teachers.
Remember, as we stressed with CalPERS, California taxpayers are ultimately on the hook for public pension fund shortfalls. CalSTRS’ double-speak about transparency and its tracking of carry fees reveals that staff and a complaint board are more worried about keeping relations with limited partners friction-free rather than putting the interests of their beneficiaries, Calfornia schoolteachers, first.

I encourage you to send this post to people you know in California, particularly public school teachers. Urge them to e-mail Keiley to give him feedback on the terrible arguments he presented. Tell him that CalSTRS has no excuse for dragging its feet on obtaining carry fee data given that CalPERS has done just that. It would also help to tell him that it does not reflect well on him or the board to mislead the public, as he intended to do had the Financial Times not saved him from himself.

Given the e-mail address, I am highly confident that this contact information (p. 11) is indeed Keiley’s. I request that you NOT call him unless he fails to respond to an e-mail after two attempts.
Harry Keiley
Board Chair, CalSTRS
Mobile Phone: (310) 428 3624
Thomas Jefferson said, “When government fears the people, there is liberty.” There’s clearly no fear at CalSTRS. I hope you instill some.

* Many private equity funds actually do disclose their carry fee payments in their quarterly distribution notices, so in those cases, CalSTRS would have good data. But CalSTRS uses the same private equity management system that CalPERS does, State Street’s Private Edge. Private Edge does not have a field for recording carry fees. One of CalPERS’ excuses for not capturing carry fees was that it didn’t have a system for doing so, as if it would be too difficult to keep it in a speaadsheet in Excel.
** There is a considerable body of research that shows that people become persuaded of a point of view they advocate, irrespective of whether they originally believed it or not. For instance, trial lawyers who represent clients they strongly suspect are guilty come to believe they may be or even are innocent as they develop arguments supporting a “not guilty’ plea.


By Harry M. Keiley,

Mr. Keiley is the chair of the Teachers’ Retirement Board, the governing body of the California State Teachers’ Retirement System. Mr. Keiley is a high school teacher with the Santa Monica-Malibu Unified School District, and was elected to the Teachers’ Retirement Board in 2007.

With assets of $191.4 billion and nearly 880,000 members, the California State Teachers’ Retirement System (CalSTRS) is the largest public pension plan in the world dedicated solely to serving educators.

In addition to being one of the largest public pension plans, CalSTRS has one of the most comprehensive private equity programs globally. Begun in 1988, the current market value of our private equity portfolio is $19.3 billion. Since inception, our private equity program has generated over $21.8 billion in profits for the benefit of our members.CalSTRS’ highest returning asset class, private equity has returned on average 12.3 percent per year over the last ten years – well above the plan’s overall ten-year average of 6.8 percent and that of broad-based stock indices which averaged approximately 8.2 percent. Given its healthy performance over the past decade, the private equity program has also played an important role in the total CalSTRS portfolio by contributing excess returns above our long-term earnings assumption of 7.5 percent, thereby having a positive impact on the system’s overall funding.

We at CalSTRS are in favor of more, rather than less, transparency and disclosure as our history and current checks and balances show. We agree that it’s important for the public to know the estimated amount of carried interest investment managers are earning, tracked as net profits, which a majority of public pension plans report. Almost all private equity partnerships split profits, with the investor (e.g. CalSTRS) taking at least 80 percent and, at most, 20 percent taken by investment managers. Typically, a partnership must earn a minimum of 8 percent return for its limited partners (e.g. investors) before an investment manager earns any carried interest. Also, there are several large, publicly-owned private equity investment managers that report their earnings to delineate their carried interest income. I am confident that the CalSTRS board will continue to examine the issue of reporting carried interest in the context of its overall private equity disclosure practices to ensure we are taking all necessary steps to have full awareness and understanding of both fee and profit structures.

In addition to a commitment to transparency, CalSTRS also places utmost importance on internal control measures and prudent audit practices and, as such, our private equity program adheres to U.S. Government Accounting Standards Board (GASB) standards and General Accepted Accounting Principles (GAAP). Additionally, all cash flowing into and out of the CalSTRS private equity portfolio is accounted for and certified by annual independent audits. Within our private equity program, we have always reported our returns net of all costs and fees. In all cases, CalSTRS receives and regularly reviews independently audited financial statements of its private equity partnerships. It is important to note that, many times, details of those private equity partnerships are confidential due to the agreements signed by the various investors which are funding the limited partnership. However, as referenced above, capital investors involved in limited partnerships are provided with audited financial statements that disclose carried interest distributions made by the partnerships to the investment managers. As such, there is an established system of strong checks and balances to keep investors fully informed as to the carried interest shared with their investment managers.

CalSTRS has been, and continues to be, a leader in the private equity industry. Bringing innovation and diversity to our overall investment portfolio, the CalSTRS private equity program is a leader in transparency and disclosure, and acts as a fierce defender of investor rights when negotiating partnership agreements. CalSTRS is steadfastly committed to reviewing all of the checks and balances outlined above to see if we can improve upon our long track record of transparency and accountability in our disclosure practices. And, we will continue to apply our high standards, expectations, and drive for results to our ongoing and new investment partnerships in an effort to reach and exceed our private equity performance benchmarks.
Wow, where do I begin? First, let me praise Yves Smith (aka Susan Webber) for lodging a Public Records Act request (California-speak for FOIA) for the op-ed and all e-mails between CalSTRS and the Financial Times and bringing this to our attention.

Second, in sharp contrast to other tirades, I completely agree with Yves Smith, these emails and that editorial are a total embarrassment to CalSTRS and either show gross incompetence on the part of CalSTRS's private equity staff (Keiley didn't write that without their input) or more likely, a pathetic attempt to misinform the public on how much has been doled out in management fees and carried interest ("carry" or performance) fees throughout all these years.

Third, and most importantly, I do not buy for one second that the private equity staff at CalPERS or CalSTRS do not track all fees doled out to each GP (general partner or fund) to the penny. If they don't, they all need to be immediately dismissed for gross incompetence and breach of their fiduciary duties and their respective boards need be replaced for being equally incompetent in their supervision of staff (except keep JJ Jelincic on CalPERS's board as he's the only one doing his job, grilling CalPERS's private equity team and asking tough questions that need to be answered).

I'm not going to mince my words, it's simply indefensible for any large public pension fund investing billions in private equity, real estate and hedge funds not to track all the fees paid out to the GPs as well as track any hidden rebates with third parties which these GPs hide from their clients, effectively stealing from them.

You might be wondering, how hard is it for a CalPERS or a CalSTRS to track fees and other pertinent information from their private equity fund investments? The answer is it's not hard at all. Over the weekend, I was looking at buying a few more books in finance (not that I need to add to my insanely large collection) and was looking at one called Inside Private Equity.

I was attracted to the book because one of the authors is Austin Long of Alignment Capital who I met back in 2004 when I was helping Derek Murphy set up private equity as an asset class at PSP Investments. I liked Austin and their approach to rigorous due diligence before investing in a private equity fund (like on-site visits where they pull records off a deal thy pick at random to analyze it and pick a junior staff member at random to ask them soft and hard questions on the fund's culture).

Anyways, I was reading the foreword of the book which was written by Tom Judge, a former VC investor and inductee to the Private Equity Hall of Fame (1995), and he was writing about how it used to be complicated tracking over 100 partnerships for the AT&T pension fund until he met Jim Kocis, another author of the book, and founder of the Burgiss Group which provides software-based solutions for investors in private equity and other alternative assets (click on image to read passage):

Today the tools Burgiss Group developed support over a thousand clients representing over $2 trillion of committed capital.

Why am I writing this? I'm not plugging Burgiss Group because I simply don't know them well enough and haven't performed a due diligence on them but obviously it's a huge firm with excellent experience in tracking detailed information of PE partnerships on behalf of their clients, providing them with the transparency they need to track their fund investments.

Again, in 2015, it's simply mind-boggling and inexcusable for a CalPERS or a CalSTRS not to be able to track detailed information on all their fund investments going back decades. This includes detailed information on management fees and carry.

What are CalPERS and CalSTRS hiding? I don't know but I think John Chiang, the state treasurer of California, is absolutely right to investigate and inform Califonia's taxpayers on exactly how much has been doled out in private equity, real estate and hedge fund fees over the years at these two giant funds which pride themselves on transparency.

Below, I embedded the three investment committee clips from CalSTRS's September board meeting. In the first clip, Chris Ailman, CalSTRS's CIO, discusses their risk mitigation strategies and Mike Moy of Pension consulting Alliance, discusses the performance of private equity in the third clip.

I know they're excruciatingly long (you can fast-forward boring sections) but take the time to listen to these investment committees as they provide a lot of excellent insights. Not surprisingly, nothing was mentioned on how exactly CalSTRS is going to track and disclose all fees paid to their private equity partnerships (however, in the third clip, Mr. Murphy, a teacher representing the California Federation of Teachers did mention this issue was a huge concern).

If the staff at CalSTRS, CalPERS or anyone else has anything to add, feel free to reach out to me at I have my views but I don't have a monopoly of wisdom when it comes to pensions and investments and I welcome constructive criticism on all my comments and will openly share your input, good or bad.

Monday, October 5, 2015

The Fed's Courage To Act?

Ben Bernanke, the former chairman of the Federal Reserve, wrote a comment for the Wall Street Journal, How the Fed Saved the Economy:
For the first time in nearly a decade, the Federal Reserve is considering raising its target interest rate, which would end a long period of near-zero rates. Like the cessation of large-scale asset purchases in October 2014, that action will be an important milestone in the unwinding of extraordinary monetary policies, adopted during my tenure as Fed chairman, to help the economy recover from a historic financial crisis. As such, it’s a good time to evaluate the results of those measures, and to consider where policy makers should go from here.

To begin, it’s essential to be clear on what monetary policy can and cannot achieve. Fed critics sometimes argue that you can’t “print your way to prosperity,” and I agree, at least on one level. The Fed has little or no control over long-term economic fundamentals—the skills of the workforce, the energy and vision of entrepreneurs, and the pace at which new technologies are developed and adapted for commercial use.

What the Fed can do is two things: First, by mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce. High unemployment is a tragedy for the jobless, but it is also costly for taxpayers, investors and anyone interested in the health of the economy. Second, by keeping inflation low and stable, the Fed can help the market-based system function better and make it easier for people to plan for the future. Considering the economic risks posed by deflation, as well as the probability that interest rates will approach zero when inflation is very low, the Fed sets an inflation target of 2%, similar to that of most other central banks around the world.

How has monetary policy scored on these two criteria? Reasonable people can disagree on whether the economy is at full employment. The 5.1% headline unemployment rate would suggest that the labor market is close to normal. Other indicators—the relatively low labor-force participation rate, the apparent lack of wage pressures, for example—indicate that there is some distance left to go.

But there is no doubt that the jobs situation is today far healthier than it was a few years ago. That improvement (as measured by the unemployment rate) has been quicker than expected by most economists, both inside and outside the Fed.

On the inflation front, various measures suggest that underlying inflation is around 1.5%. That is somewhat below the 2% target, a situation the Fed needs to remedy. But if there is a problem with inflation, it isn’t the one expected by the Fed’s critics, who repeatedly predicted that the Fed’s policies would lead to high inflation (if not hyperinflation), a collapsing dollar and surging commodity prices. None of that has happened.

It is instructive to compare recent U.S. economic performance with that of Europe, a major industrialized economy of similar size. There are many differences between the U.S. and Europe, but a critical one is that Europe’s economic orthodoxy has until recently largely blocked the use of monetary or fiscal policy to aid recovery. Economic philosophy, not feasibility, is the constraint: Greece might have limited options, but Germany and several other countries don’t. And the European Central Bank has broader monetary powers than the Fed does.

Europe’s failure to employ monetary and fiscal policy aggressively after the financial crisis is a big reason that eurozone output is today about 0.8% below its precrisis peak. In contrast, the output of the U.S. economy is 8.9% above the earlier peak—an enormous difference in performance. In November 2010, when the Fed undertook its second round of quantitative easing, German Finance Minister Wolfgang Schäuble reportedly called the action “clueless.” At the time, the unemployment rates in Europe and the U.S. were 10.2% and 9.4%, respectively. Today the U.S. jobless rate is close to 5%, while the European rate has risen to 10.9%.

Six years after the Fed, the ECB has begun an aggressive program of quantitative easing, and European fiscal policy has become less restrictive. Given those policy shifts, it isn’t surprising that the European outlook appears to be improving, though it will take years to recover the growth lost over the past few years. Meanwhile, the United Kingdom is enjoying a solid recovery, in large part because the Bank of England pursued monetary policies similar to the Fed’s in both timing and relative magnitude.

It is encouraging to see that the U.S. economy is approaching full employment with low inflation, the goals for which the Fed has been striving. That certainly doesn’t mean all is well. Jobs are being created, but overall growth is modest, reflecting subpar gains in productivity and slow labor-force growth, among other factors. The benefits of growth aren’t shared equally, and as a result many Americans have seen little improvement in living standards. These, unfortunately, aren’t problems that the Fed has the power to alleviate.

With full employment in sight, further economic growth will have to come from the supply side, primarily from increases in productivity. That means that the Fed will continue to do what it can, but monetary policy can no longer be the only game in town. Fiscal-policy makers in Congress need to step up. As a country, we need to do more to improve worker skills, foster capital investment and support research and development. Monetary policy can accomplish a lot, but, as I often said as Fed chairman, it is no panacea. New efforts both inside and outside government will be essential to sustaining U.S. growth.
Mr. Bernanke is a devastatingly brilliant economist who is promoting his new book, The Courage to Act. I agree with the thrust of his arguments above, given how dysfunctional Washington is, the Fed had to step up to the plate in 2008 to save the U.S. economy from another Great Depression.

But Bernanke ends his comment by stating "monetary policy can no longer be the only game in town" and here is where agree and disagree with him. In a perfect world, those politicians in Washington would all get together and pass laws by compromising on their proposals, ensuring fiscal policy would support long term growth.

Unfortunately, I just don't see this happening any time in the near future. In fact, I see the politics of division and inaction gripping Congress and the Senate becoming worse which is one reason why we're witnessing the extraordinary rise of non mainstream candidates from all sides of the political spectrum.

If someone told you we would be talking about Donald Trump, Ben Carson and Bernie Sanders as serious presidential contenders a year ago, you would have scoffed at them. Even though they don't share the same ideological views, they've been able to capitalize on the growing frustration with politics as usual in Washington.

Why am I bringing this up? Because if fiscal policy doesn't support the economy, then the only game in town by default will be monetary policy which is why Bridgewater's Ray Dalio is increasingly worried about the next downturn, and he's not the only one.

On Friday, DoubleLine Capital co-founder Jeffrey Gundlach, the current bond king, warned of 'another wave down' after the weak jobs number on Friday that the U.S. equity market as well as other risk markets including high-yield "junk" bonds face another round of selling pressure.Gundlach joins Bill Gross, the former bond king, in warning of a rout in stocks and other risk assets.

With all due respect to Ray Dalio, Jeffrey Gundlach, Bill Gross and Carl Icahn who recently warned of a looming catastrophe ahead, it remains to be seen who gets the last laugh on stocks. As I discussed in my weekend comment, with the Fed out of the way for the remainder of the year, the October surprise won't be a market crash but a huge liquidity rally in risk assets that could last well into 2016.

There is something else that happened over the weekend that received little attention as everyone was talking about Ben Bernanke's new book and how he thinks more execs should have gone to jail for causing Great Recession.

Alister Bull and Matthew Boesler of Bloomberg report, Korcherlakota Says Low Inflation Warrants Further Fed Stimulus:
Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the U.S. central bank would have been “totally justified” if it had increased policy stimulus to combat low inflation when it met last month, adding that negative interest rates could be a useful policy tool.

Speaking in an interview Sept. 29 with Arthur Levitt on Bloomberg Radio, the Fed’s most outspoken policy dove declined to say if he had recommended negative interest rates in projections submitted for the Sept. 16-17 meeting of the Federal Open Market Committee. He did say, however, that more aggressive Fed policy was warranted than the current setting of near-zero rates.

“Given the inflation outlook, given how low inflation is expected to be, to ensure the credibility of our inflation target, taking a more accommodative stance in September would have been totally justified,” Kocherlakota said in the interview, broadcast Saturday. He steps down from the Fed on Dec. 31 and is not a voting member of the FOMC this year.

The FOMC decided last month to hold rates near zero, though Chair Janet Yellen said Sept. 24 that she expected that the central bank’s first rate increase since 2006 would be warranted later this year. Kocherlakota has repeatedly argued for a delay in rate liftoff.
Accommodation Time

“My main point -- this is a time to think about adding accommodation, not a time to be thinking about taking it away,” he said.

Policy makers submit quarterly economic forecasts including their projections for the appropriate future path of the federal funds rate, which has been held near zero since December 2008. Displayed as dots on a chart, forecasts on the so-called “dot-plot” released Sept. 17 showed that one official viewed the appropriate rate at the end of this year and next to be slightly less than zero.

Kocherlakota said he was prevented by the Fed’s rules of confidentially from disclosing if this was his dot, though he expressed interest in the decision of central banks in Sweden and Switzerland to drive rates below zero.

“I think it’s another useful tool in our toolkit that we should be surely thinking about,” he said, in response to the question of whether the Fed should consider doing likewise if officials decided there was a need to stimulate the economy more aggressively.

“It’s been very interesting what the European central banks have been able to do in terms of actually provide more stimulus than I would have expected, by driving interest rates below what economists used to call the zero lower bound,” Kocherlakota said.

Yellen was asked about the negative dot in the Fed’s Summary of Economic Projections during a post-FOMC press conference on Sept. 17. She said “negative interest rates was not something that we considered very seriously at all today.”
In my opinion, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota is way ahead of his colleagues in understanding the Fed's deflation problem. He understands the real risks of deflation coming to America and I think he has been instrumental in the sea change at the Fed which impacted its big decision to stay put on rates.

Will the Fed consider negative rates any time soon? I doubt it but if inflation expectations keep sinking to record lows, this option might be considered and so will more quantitative easing (Bridgewater went on record to state more QE will come before a rate hike).

Right now, this isn't something which worries me as I believe global growth will recover in the short run, or at least that's what the stock market is indicating to me as investors bet big on a global recovery (click on image):

Is this just another countertrend rally which will fizzle out or is this part of a meaningful sector rotation back into commodities and energy following Friday's tepid jobs report? I don't know but the huge reversal on Friday may signal a change in risk appetite and you have to pay close attention to emerging markets (EEM), Chinese (FXI), Energy (XLE), Oil Services (OIH), Oil & Gas Exploration (XOP), Metals & Mining (XME) and solar (TAN) shares to see if this is part of a much bigger move.

As far as large (IBB) and small (XBI) biotech ETFs, they are down late Monday morning after popping at the open but this didn't surprise me as I expected both these indexes might retest their 400-day moving average before moving back up (click on image):

A lot of traders are fretting about the "death cross" on biotech but I never took these 'death crosses' too seriously, especially in the volatile biotech sector which unlike energy and commodities is still in a secular bull market and has the potential to surge higher and make new highs.

Below, former chairman of the Federal Reserve Ben Bernanke tells USA Today's Susan Page that more corporate executives should have gone to jail for their misdeeds. Bernanke also appeared on CNBC on Monday where he stated he sees no reason why central bank policymakers should rush to increase interest rates.

I agree with him but historic low rates are fueling inequality and the buyback binge, which is very deflationary. Still, unlike Greenspan who sent out a dire warning on bonds in August, Bernanke is very cautious as he sees many risks to this tepid recovery. No wonder he's now advising Ken Griffin, the reigning king of hedge funds, the man is brilliant and very careful in his analysis.

Friday, October 2, 2015

The October Surprise?

Akin Oyedele of Business Insider reports, Huge Miss on Jobs Report:
The US economy added 142,000 jobs in September, fewer than forecast.

Economists had been expecting the economy to add 200,000 jobs.

The unemployment rate held steady at 5.1%, a seven-year low.

Average hourly earnings were flat month-over-month in September, below expectations for 0.2% growth.

Ahead of this report, economists had noted that August and September nonfarm payrolls prints had been revised higher most of the time over the past decade. The August print, however, was revised lower to 136,000 from 173,000 in Friday's report.

Economists had noted that the broad-based slowdown in the manufacturing sector, partly because of the strong dollar and slower exports, would most likely show up in this report. Manufacturing employment fell 9,000 in September, versus expectations for no change.

Mining employment also fell, as healthcare and information added more jobs, according to the Labor Department.

The labor-force participation rate, which measures the share of Americans over 16 who are working or looking for a job, fell to 62.4%, the lowest since October 1977.

The year-over-year projection for hourly earnings growth, at 2.4%, was the most bullish forecast for wages in this economic cycle. Wages missed, at 2.2%.

In September, the Federal Reserve held off on raising its benchmark rate for the first time in a decade, citing global growth concerns and a labor market that needed further improvement. After the jobs report, Fed fund futures reflected only a 30% chance that the Fed would lift rates in December and a 52% probability for March.

Stock futures nosedived after the report — all three major indexes lost more than 1%, and Dow futures shed as many as 200 points. The yield on the 10-year benchmark Treasury note fell below 2% for the first time since the market sell-off on August 24.

Here's what Wall Street was expecting for the jobs report:
  • Nonfarm payrolls:+200,000
  • Unemployment rate: 5.1%
  • Average hourly earnings, month-over-month: +0.2%
  • Average hourly earnings, year-over-year: +2.4%
  • Average weekly hours worked: 34.6
I don't know why economists are so shocked to see the pace of job growth in the United States is decelerating. The mighty greenback, the rout in commodities and China's big bang are all weighing on the U.S. economy. Moreover, when a record 94.6 million Americans are not in the labor force, it's not a sign of economic prosperity and strength.

Although some think the weak jobs numbers are masking a strong economy, the truth is the jobs picture is even worse than you think. The U.S. economy may be in relatively better shape than the rest of the world but it's far from firing on all cylinders and the risks of another downturn are high which is why Bridgewater's Ray Dalio is worried about what happens next. In my opinion, the Fed's big decision a couple of weeks ago has been vindicated and it's right to fear deflation coming to America even if it will never publicly admit it (I warned you about this possibility a year ago).

As far as stocks, bonds and commodities, the knee-jerk reaction following the September jobs report was swift (click on image):

Stock futures reversed course and got slammed, the yield on the 10-yield Treasury fell below 1.94%, the US dollar declined spurring commodities like oil higher. Gold rallied partly because the US economy isn't doing as well as anticipated and some big investors think the Fed's next big move will be more more quantitative easing (QE), not a rate hike.

What do I think of all this? To be honest, not much. I maintain my views which I clearly outlined in my recent comments on a looming catastrophe ahead and who gets the last laugh on stocks.

If anything, I'm now more convinced than ever that the Fed won't make the monumental mistake of raising rates this year and that now is the time to load up on risk assets, especially biotech which got massacred last month, hitting major indexes and the healthcare sector very hard.

I want you all to stop listening to investment gurus scaring the crap out of you and start paying attention to markets, focusing on the sectors that have been leading us higher because they are in a secular bull market. If you look at the charts of healthcare (XLV) and biotech stocks (IBB and XBI), they got hit very hard in September but are coming back strong (click on images below):

Notice how the large (IBB) and small (XBI) biotech indexes have already crossed above their 400-day moving average and the smaller biotech shares are rallying hard on Friday as they are the ones that got clobbered the most in September. The healthcare index (XLV) is also close to crossing over its 400-day moving average (healthcare is a mix of big pharma, big insurance plans, big biotech and medical equipment stocks).

Again, this to me is very positive and if this momentum continues, it represents a change in market sentiment and risk-taking behavior. Importantly, with the Fed out of the way for the remainder of the year, I would ignore Carl Icahn's dire warning and load up on risk assets right now. Just make sure you pick your spots carefully as some sectors will rally and fizzle quickly or not participate while others will surge higher and make new highs (mostly tech and biotech).

I could be wrong, markets are crazy in October (or so everyone is conditioned to believe) but I think the big October surprise will be a huge rally that continues into the first half of next year. The bears love talking about "bull traps" but if you ask me, September was a huge "bear trap" and all these short sellers shorting this market and sectors like biotech are in for a lot of pain in the months ahead.

In fact, as I'm ending this comment, markets are staging a dramatic reversal on Friday and the small biotech companies I trade are surging higher (click on image):

Admittedly, I got clobbered in September along with many other biotech investors but I didn't panic, added more to my core positions and I'm sitting tight here (I'm better at buying the big dips than selling the big rips!).

But it's not just biotechs taking off on Friday. Check out the big moves in emerging markets (EEM), Chinese (FXI), Energy (XLE), Oil Services (OIH), Oil & Gas Exploration (XOP), Metals & Mining (XME) and solar (TAN). Below, a list of ETFs I track and how they performed on Friday (click on image):

It's clear that with the Fed out of the way, smart money is betting big on a global recovery (click on image below):

All of the stocks above are still in a downtrend but they can bounce big from these levels if market sentiment shifts and risk appetite increases (could be a violent countertrend rally).

Below, Rich Ross of Evercore ISI explains why biotech stocks are on their way back up from a recent plunge. And Len Yaffe, Stoc*Doc Partners, discusses key areas in the biotech industry, and his top stock picks.

Third, Jim McCaughan, Principal Global Investors CEO, says buying on setbacks is a promising strategy in U.S. equities. McCaughan is more cautious on emerging markets in the near term.

Lastly, Scott Minerd, CIO with Guggenheim Partners, discusses the jobs number and the markets and gives his best investing ideas, including investing in Spain (EWP) and Brazil (EWZ). Great comments on global liquidity trends, listen to this discussion.

We shall see what positive or negative surprises October has in store for us but one thing you should all be made aware of is James Bond is ditching his classic, straightforward martini for a dirty martini, combining vodka, dry vermouth, a muddled Sicilian green olive, and a measure of the olive’s brine (great choice!).

Hope you enjoyed this comment and wish you all a great weekend! Please remember to kindly donate and/or subscribe to this blog at the top right-hand side and support my efforts to bringing you the very best insights on pensions and investments. Thank you!!