The rise of private equity has mirrored that of the pension industry, as the latter has been the principal investor in the former.Adrien Veczan/The Canadian Press
John Rapley is a contributing columnist for The Globe and Mail. He is an author and academic whose books include Why Empires Fall and Twilight of the Money Gods.
Last year wasn’t a great one for Canada’s major pension funds. Of the four big ones, three – the Canada Pension Plan Investment Board, the Caisse de dépôt et placement du Québec and the Ontario Teachers’ Pension Plan – all underperformed their benchmarks.
They’re hardly losing money. All three delivered percentage increases in their assets in the high single digits, retaining their status among the world’s best-managed pension funds. However, flush as they always are with new contributions, they have to deliver high returns if they’re to guarantee current contributors the same future benefits present beneficiaries now receive. And while their long-term returns are such that they can absorb a year or two of subpar performance, the risk is that this slump may not be a one-off.
Apparent points of vulnerability lurk in each of them, particularly the CPP. The national fund is especially exposed to the U.S., with half of its assets invested stateside. That bet paid off handsomely over the past decade or so, but it may look less clever going forward. Whereas European markets, for instance, have been rallying this year – the German index is already up by over one-fifth – U.S. indices are currently more or less where they finished last year. Many analysts expect that to continue. If history is any guide, U.S. stocks may not grow by much over the next decade.
The real problem, though, is this: Canadian pension fund managers have also invested heavily in private equity. In no small degree, the rise of private equity has mirrored that of the pension industry, as the latter has been the principal investor in the former. PE has been another star performer whose future now looks cloudy.
One effective strategy of PE managers has been to take their investors’ money, use it to leverage large loans, then acquire startups or struggling companies. Through restructuring and development, they then build them to be ready to go public once more, at which point they sell them on the stock market, pay off their loans and distribute what remains to their investors.
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This approach produced bumper profits during the years when interest rates were low – not only because credit was cheap and abundant, but because it juiced the stock market, more or less guaranteeing a profit when PE investors exited their investment by selling them on. But problems began brewing three years ago, when interest rates started rising and payouts began to fall.
Then last year, the slowdown in equity markets, especially the U.S., started to constrain exit activity itself. Fund managers have been forced to hold assets for longer, awaiting a resumption of market activity, which has yet to materialize. But investors still expect their cash payouts, so managers have had to resort to dipping into their credit lines or engaging in increasingly opaque deals, such as transferring assets across their own funds – when one subsidiary borrows cash to buy another, creating an illusion of an exit – to generate returns.
It goes without saying this can only ever be a temporary holding strategy. PE managers need the good times to return to get out of this pinch. But there are worrying signs such a rebound may be slow to come. For the first time, assets under management by private equity declined last year and the outlook for 2025 doesn’t look any better. Analysts now expect distributions to remain poor, and exits to remain limited for the rest of this year.
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Mind you, to look at their books, you wouldn’t know they’re under pressure. Unlike publicly-listed companies, which need to report to their investors every few months, PE ones can list the value of their assets at the price they eventually hope to sell them at, not the price they’d get if they sold them today. But if markets remain sluggish for the foreseeable future, there will come a point where fund managers are forced to sell at a loss – and their investors will take the hit.
A possible lifeline for private equity may lie in mooted regulatory changes by the Trump administration, allowing ordinary Americans to invest in private equity via their 401(k)s. But while PE fund managers are salivating at the prospect of Main Street thereby coming to their rescue, the politics could be fraught, since many analysts worry funds could thereby offload assets at inflated prices, burning mom and pop.
Barring such a retail bailout, problems in the industry will probably endure. Its little secret is that over the past two decades, central bank policy made investing in North America easy by inflating asset values. Fund managers looked like geniuses. That has changed. For as long as inflation looks more likely to rise than fall, central banks will hold off cutting interest rates again, leaving fund managers to work harder for their returns.
We’ll then see who the real star performers are.
