The difficulty of institutions that need cash for payment have grown acute during the chalk-brained professors’ zero-interest-rate pogrom. Insurance companies are one victim, pension plans another. Looking specifically at defined-benefit pension plans, the plan sponsor (corporation, maybe, or municipality) is obligated to pay current and future retirees a specific dollar amount from now until a spouses’ death.
The discrepancy between income received from investments and cash needed to pay beneficiaries of public (state, municipal) pension plans dumbfounds the mathematically inclined. Actuaries make long-term projections of returns on assets and the change in liabilities. The assets on hand to pay benefits in 2025 will not look as susceptible to downgrade if the actuary projects annual investment returns at 8% rather than 3%. Thus, 8% is a typical investment return projected on plan assets today. High-yield bonds are often a sanctuary to justify such assumptions. Now in our fifth year of interest-rate confiscation, such bonds are bought, then bid up for their yields, thus compromising the virtue of such holdings since the higher prices drive the yields lower.
Investment managers supply what pension funds want. It has been a curiosity that private-equity funds, that do a little bit of everything today, have been buying houses in quantities not seen since the Bolsheviks annexed Moscow. Among others, Texas Pacific Group (TPG Capital Management LP) is planning to buy at least $1 billion of real estate later this year. Others with similar initiatives, who are known better for buying companies, taking them private, then selling them back to the market, are Blackstone Group, Carlyle Group, and KKR. Other than the certainty that most similar organizations, be they private-equity firms or banks, spend more time looking at their competitors than at the investment, thereby misestimating the end of the cycle, why might there be this lurch for houses in 2013?
Art Cashin, at UBS wondered the same, and asked one of the “very smartest” investors he knows. He quoted his informant in the March 15, 2013, “Cashin’s Comments”:
“The more headlines I see like this [TPG buying $1 billion of real estate - FJS], the more I think these mega fund managers (KKR, Carlyle, Blackstone, Apollo) are gearing for the next leg of the MACRO economy. My opinion, this aggressive move into real estate is not just allocating capital to take advantage of a distressed sector. Funds managing $50 to 100 billion and more in some cases have determined that there is just not enough hedging product (CDS, options) to offset massive positions in private equity, credit, etc. I believe they have made the bet that economic theory has not changed that much in 500 years and the next leg will be much higher interest rates and consequently inflation. What is the poor fund manager to do when he has been forced to hold largely illiquid securities (private equity, credit)? Find a hedge. With none available at 35,000 feet you move to 70,000 feet. Hard assets combined with LONG term financing. I would guess that these funds are borrowing as much as possible in the debt markets for as long a duration is possible. (Not just funds, Disney and others have 100 year bonds)
“Conclusion, smart money is betting on coming inflation, possibly hyper-inflation. Hard assets and long term borrowing prudent at this point. Thesis supports a bid under real estate, so bubble is not imminent. Buy as much real estate as possible, borrow as much as possible (FIXED RATE), for as long a duration as possible.
“And of course, stay very nimble with a tip of the hat……”
“The next leg” of inflation is apparent all day long: subway, parking, magazine, soup, sandwich, oil change, groceries: from $3.29 to $3.69, a seven-ounce rather than nine-ounce serving. The collective American mind, having been told otherwise for so long, may, in a flash, think: “it’s 1973!” and the concerted efforts to inflate assets (“massive positions in private equity, credit, etc.”) will come undone when the real costs of living are hot news.
It is impossible to hedge an entire market. The Smart Investor surmises Big Money is preparing and is buying the least bad alternative (for a company managing $100 billion). They are borrowing at miniscule interest rates, as much as possible, at a FIXED RATE, and buying long-term assets that may get squashed in the short- to middle-term. The squashing is a worst case, not assured, but one the investor should consider. When interest rates rise (“they have made the bet that economic theory has not changed that much in 500 years”), the value of assets, which are priced now for no interest costs, could – surprise a lot of people.
The May 15, 2013, Wall Street Journalpublished a laundry list under the title: “Private Equity Firms Build Instead of Buy.” The heart of such an approach was expressed by David Foley, head of energy investing at Blackstone Group LP: “We always look at our returns as buy and hold forever, because you might.”
Blackstone, teaming up with the Aga Khan Development network, built a new dam at the headwaters of the White Nile. The dam produces almost half of Uganda’s electricity which Blackstone sells “at rates that ensure profits for Blackstone for years to come.”
David Foley may have frowned when reading “ensured,” since there are untold contingencies that could disrupt a steady flow of profits. Speculating a bit here, a pension fund may invest in Blackstone’s project and be permitted to log an 8% (for example) return-on-investment each-and-every year, for the next 30 years, or, until the dam is sold. Should evil spirits temporarily halt the flow of electricity (“rituals had to be performed to appease spirits…. A feud between two diviners who laid competing claims to remove the spirits went on for two years”), the fund may still be permitted to log an 8% return, given the long-term objective.
The Wall Street Journal story discusses other such projects: “Blackstone is pursuing similar dam projects elsewhere in Uganda, in Tanzania and along Rwanda’s border with the Democratic Republic of the Congo. Using its power-plant builder Sithe, the firm has plants under construction in India and the Philippines…. Apollo [Global Management], for its part, is managing the investment of money that small savers put into fixed annuities promising them a steady rate of return…. KKR is developing a tract of houses and apartments in Williston, N.D., for the oil workers pouring into that region…. [KKR] has teamed up with Chesapeake Energy Corp. to drill for oil for years to come.”
A similar strategy was described in the May 17, 2013, issue of Grant’s Interest Rate Observer. NovaGold (NG) is “nature’s own hyper-leveraged option on a much higher gold value expressed in terms of Federal Reserve notes….” In one estimation: “Only a value on the order of $2,000 an ounce would justify the projected outlays…” Tom Kaplan, through his Electrum Group LC, and owner of 86 million NovaGold shares, has done well buying resource companies that do not meet the criteria of the standard institutional investor: “[I]f you’re trying to make 100 times on your money, whether or not you’re right in 24 months or 60 months, it doesn’t matter.”
Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and “The Coming Collapse of the Municipal Bond Market” (Aucontrarian.com, 2009)