It’s easy to spell: R-I-S-K, but apparently Marshall McClain struggles with the concept.
Five-Year bonds issued by the government of Greece posted a yield of 10.88% as of the end of last week. The yield on a Five-Year US Treasury was 1.9%.
Which is the better investment? If Greece does not default in the next five years, its bond could be a sweet deal.
But who knows?
The same can be said about private equity deals. I was being kind with McClain last week when I said his confidence in private equity deals as a yield enhancer was hubris. His outlook can more appropriately be described as reckless.
One bad deal can wipe out most of the gains of any portfolio.
McClain referred to an example I provided a couple of weeks ago of how a single deal can explode as “anecdotal” (Calpers wrote off a billion dollars from one investment).
His dismissal of that event reminds me of a scene from the Godfather where Don Corleone is discussing a private equity deal of sorts with a rising drug lord.
Sollozzo: Bene, Don Corleone. I need a man who has powerful friends. I need a million dollars in cash. I need, Don Corleone, all of those politicians that you carry around in your pocket, like so many nickels and dimes.
Don Corleone: What is the interest for my family?
Sollozzo: Thirty percent. In the first year your end should be three, four million dollars. And then it would go up.
Don Corleone: And what is the interest for the Tattalgia family?
Sollozzo: I’ll take care of the Tattaglias, out of my share.
Don Corleone: So, I am to receive thirty percent for finance, for legal protection and political influence. Is that what you’re telling me?
Sollozzo: That’s right.
Don Corleone: Why come to me? What have I done to deserve such generosity?
Sollozzo: If you consider a million dollars in cash merely finance…
[raises his glass]
Sollozzo: Te salut, Don Corleone.
So, Mr. McClain, if a billion dollars is merely “anecdotal,” then “Te salut.”
By the way, Don Corleone did not think Sollozzo’s deal was “an offer he couldn’t refuse.” He deemed it to be too risky and politely dismissed Sollozzo.
The Don wasn’t going to back an aggressive deal with his own money on the line.
McClain’s own money is not on the line when the union pensions invest in private equity – it’s our money and I say we should politely dismiss Marshall McClain.
Despite his lack of regard for anecdotal evidence, McClain sure throws around enough of his own: “This week, the Texas Teachers Retirement Fund just reported a 35% return in the past year, erasing much of the market losses they suffered in the 2008-09 market,” he proclaimed.
However, he fails to mention the statement of the TRS Chief Investment Officer when announcing the results: “While the recent gains are very encouraging, we all know that this entire period has been exceptionally volatile and virtually unprecedented.”
Also, “erasing much of the market losses” means TRS still lost money.
Furthermore, it is common to experience a big rebound from a low. So don’t get too exuberant, Mr. McClain. The markets are still roiling in volatility with no encouraging developments on the long-term horizon.
I’d dare say TRS has already seen some of its recent results evaporate.
Take a look at page 83 of the TRS investment summary and you will get an idea of the volatility over the last few years.
Easy come, easy go, when it comes to private equity investments. The State of North Carolina Pension Fund recently learned that close to $300 million of cash placed with private equity manager Terra Firma is now at great risk because of a single bad deal.
McClain and I can trade anecdotal examples or cherry-pick the data until the cows come home. However, the fact that we are able to points to the volatility and lack of consistency in the markets.
Calculating valuations for private equity is an indirect process. In some cases, price-earnings ratios of companies similar to a particular private equity investment are applied to forecasted earnings, but no one really knows how a deal will pan out until it comes time to liquidate it. What may have seemed like a winner a few years ago may now be a dog – a dog with fleas. Private equity investments cannot be liquidated as easily or efficiently as securities in the broader market. It could be tougher to unload a dog at other than fire sale prices in a limited market.
Maybe the municipal pension boards know more than Paul Volker, perhaps the most competent Federal Reserve Bank Chairman who ever served since the central bank was formed.
Volker wants the banks out of the private equity market because of the inherent risk and has advised President Obama accordingly. He doesn’t want a repeat of massive bank bailouts of recent years. His position is referred to as the “Volker rule.”
Congress is poised to pass a softer version of the Volker Rule, one which would limit private equity investment by banks to 3% of capital – not quite as strong, but still pretty conservative.
Pension plans, especially defined benefit plans, are a little like banks. Participants deposit their contributions and assume the promised returns will materialize. As with banks, where most of the deposited funds are protected by FDIC insurance, the municipal pension participants are protected by the taxpayers. If investments returns fail to materialize, the beneficiaries still get their pensions and the rest of us bail out the fund. Is that right?
McClain might believe I am against the concept of private equity. Nothing could be further from the truth. I just don’t want to cover the risk of an aggressive investment strategy.
Using a realistic rate of return assumption will show that the taxpayers are already at greater risk than officially recognized. Warren Buffet recommends 6%. Using optimistic assumptions of close to 8% per year, such as McClain is suggesting, hides the exposure.
Unless participant contribution rates are increased to levels that shield the taxpayers from risk, then defined benefit plans should be replaced by contributory plans.
If that should occur, then I would say “Te salut” to Marshall McClain. Invest your members’ money as aggressively as you wish.
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