Equicapita June 2014 Update

June 2014 Update

DEMOGRAPHICS ARE STILL DESTINY

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Equicapita Update

“There is a kind of fear, approaching a panic, that’s spreading through the Baby Boom generation, which has suddenly discovered that it will have to provide for its own retirement.”

Ron Chernow

DEMOGRAPHICS ARE STILL DESTINYIt has been said that “demographics are destiny” and this is certainly a theme that figures in the investment thinking of our funds and one that we have discussed many times in the past.

By now, no investor should be surprised that the West is facing an unprecedented wave of retirements as the baby boom generation moves to the end of their productive careers - the baby boom generation being defined as those people born between 1946 and 1964.1

The magnitude of this demographic shift will create issues for the return potential of a number of currently widely held asset classes and also a number of compelling investment opportunities outside of these assets. In short, this powerful trend should not be ignored for its potential affect on both returns and risks.

Investment Liquidation: The West is generally moving into a phase where investments are liquidated to fund retirements. As baby boomers retire they will begin to sell assets, producing downward pricing pressure in some key markets – residential real estate, government bonds and public equities. This is where baby boomers’ investment capital has been focused for more than two decades. Unfortunately, we cannot all cash out at once.

Public Market Returns: From 1946 through 1997, stocks had an average compound annual return of 7.5% after inflation. Robert Schiller, author of Irrational Exuberance, argues that returns over the next 20 years could fall below 5% after inflation as price-earnings ratios move back toward their long-term mean, a view endorsed by the US Federal Reserve.

Pension Solvency: The solvency of both public and private pension plans will be tested and we believe that in many cases found to be lacking. The combination of Zero Interest Rate Policy (“ZIRP”), unrealistic return assumptions and the rapid growth in the pool of recipients will see to this.

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Equicapita Update (continued)

Sovereign Solvency: Sovereign borrowers have had unlimited privileges over the last two decades. Those privileges are gradually being revoked as the ability to repay is being called into doubt. Without the ability to roll over their obligations at current historically depressed interest rates, the truly precarious nature of sovereign finances will be revealed. Consider that while interest rates for many developed nations are at generational lows, sovereign debt loads as a percentage of GDP are at all time highs and entitlement liabilities are rapidly expanding.

Private Equity: In terms of absolute dollar size the issue of from where will the capital come to acquire the large cohort of private, baby-boomer small & medium enterprises (“SME”) coming onto the market is of the same or perhaps even greater magnitude than the other issues outlined above, but receives far less attention. Just how large of an issue is this funding gap? In a recent report CIBC estimated that “$1.9 trillion in business assets are poised to change hands in five years - the biggest transfer of Canadian business control on record.” and that “by 2022, this number will mushroom to at least $3.7 trillion as 550,000 owners exit their businesses...”

DEMOGRAPHICS INTRODUCTION:In 2000, the ratio of Americans between 15 and 59 years old to those over 60 was four to one, according to a United Nations report. In 2050, the ratio will be only two to one. In Canada the story is much the same. By approximately 2015, Canada will have more people leaving the labor force than joining. Retirees

are expected to exceed 40% of the Canadian working age population by the mid-2010s.

The emerging markets in aggregate will not face the West’s demographic challenge for several decades. The emerging markets currently have a dependency ratio (the ratio of dependents to working-age citizens) roughly equal to the developed markets. However, this overlooks the composition of the dependents:

According to the United Nations, the current dependency ratio is about even at 62% for both developing and developed nations. An important difference between developing and developed countries is the type of dependents: The majority of non-workers in developed countries are past the working age; the majority of non-workers in developing countries are not yet old enough to enter the workforce. Based on the United Nations’ projection of demographic trends to 2050, emerging countries are poised to gain a substantial advantage over developed ones.2 (Emphasis mine)

This demographic advantage is expected to emerge quite soon - by 2016, the dependency ratio in developed markets will be higher than that of emerging markets and growing faster.

“How did you go bankrupt? Two ways. Gradually, then suddenly.”

Ernest Hemingway

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Source: BCG: Ending the Era of Ponzi Finance

TABLE 1: LABOUR FORCE DATE/SIZE PEAK

Note: The labor force consists of all people ages 15 to 64. This exhibit shows only countries with a peak labor force of 30 million or more; data include the impact of immigration.

ItalyGermany Russia

ArgentinaBrazil Colombia

CaribbeanU.S.

Japan

U.K.

Algeria

South Africa

France

Burkina FasoCameroon

EthiopiaSudan

AngolaGhana

Egypt CongoNiger

NigeriaTanzania

Philippines

SomaliaYemen

IraqAfghanistan

2000 2020 2040 2060 2080 2100 and beyond

Europeanpeak

Latin American, Asian and Caribbean peak

Workforce population at peak (100 million)

Spain

Mexico

ZambiaUganda

Kenya

MalawiMali

Madagascar

Mozambique

Cote d’Ivoire

South KoreaChina Thailand

IndonesiaVietnam Turkey Nepal

IndiaIranMyanmar

BangladeshSaudi Arabia

Americas

Europe

Africa

AsiaPakistan

PUBLIC MARKET RETURNS: Developed market investors have trillions invested in bonds, real estate and public market equities. Retire-ment will require investors to become net sellers with the attendant negative affect on returns in these markets and asset classes.

Here is the analysis from the US Federal Reserve on the expected effect boomer retirements will have on US public equity markets. Bear in mind that the Fed is an organization which is much more likely to err on the side of optimism in such matters:

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“Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. …. P/E* should decline persistently from about 15 in 2010 to about 8.4 in 2025, before recovering to 9.14 in 2030…. Moreover, the demographic changes related to the retirement of the baby boom generation are well known. This suggests that market participants may anticipate that equities will perform poorly in the future, an expectation that can potentially depress current stock prices. In that sense, these demographic shifts may present headwinds today for the stock market’s recovery from the financial crisis.” 3

PENSION SOLVENCY: We currently inhabit in a ZIRP world and amazingly in Europe even a Negative Interest Rate (“NIRP”) world4. ZIRP has consequences for pensions that may not be immediately obvious to the rapidly growing ranks of retirees. Large portions of pension portfolios are in fixed income securities that are now yielding a fraction of the returns required to maintain plan benefits. Pensions are already facing solvency issues and when baby boomers start to liquidate this issue will grow in magnitude with the feed-back loop from poor equity and bond returns as the transmission mechanism.

At a recent dinner Ben Bernanke, former chairman of the US Federal Reserve, when commenting on the

Fed’s ZIRP policy is alleged to have said that he did not expect the federal funds rate to return to its long-term historical average of approximately 4% in his lifetime5.

The issue for pensions arises because a significant number assume annual returns in the range of 7%-8% when they are planning how to meet their obligations. Since a large portion of pension portfolios are in fixed income securities that are now yielding a fraction of that range, these return assumptions are unrealistic to put it mildly.

It turns out that the 8% return number is just the beginning of the aggressive assumptions that pension fund managers are building into their models in order to make their plans seem whole. Because of low bond yields pension fund managers are now implicitly assuming greater than 10% equity returns to achieve their overall return requirements. It goes almost without saying that this is most likely wishful thinking. It seems unlikely indeed that pension fund mangers will be able to generate consistent 10% plus equity returns going forward when they rarely if ever generated such returns in the past. Even less likely given the previously mentioned research from the Federal Reserve that due to baby boomer selling pressure equity returns will be below long run

“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.”

Friedrich August von Hayek

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averages over the next two decades and no where near 10%.

The longer ZIRP continues, the worse the problem will become and if you put credence in the after dinner comments of ex-chairman Ben Bernanke, the intention of the world’s monetary authorities may be to try to keep them low for a very long time indeed. Ultimately, benefits will have to be reduced and/or large amounts of additional capital in the form of higher contributions will have to be collected. Barring this, pensions will need bail-outs or go bankrupt.

Just how serious is this funding shortfall? A recent pair of studies6 concluded that the unfunded obligations of US municipal pensions were more than double the officially reported figures. By the municipalities’ accounting, they had approximately US$ 200 billion in unfunded obligations while the study put the actual amount at approximately US$ 400 billion. The state-funding gap was projected to be over US$ 3 trillion for a grand total at the municipal and state levels of around US$ 3.5 trillion. More generally, as of the 2010 accounting rules, US public pension plans had 76 cents for every dollar they must pay retirees in the future. If more realistic mark-to-market assets took place combined with lower long-term return assumptions, this number could drop to as low as 57 cents7.

Private sector pensions are also in poor condition. In Canada, 92% of private sector pension plans were in a deficit position as of December 31, 2008, with almost 40% of defined benefit plans having solvency ratios under 70%, and over 70% of defined benefit plans having solvency ratios under 80%.8 As of 2008, total defined benefit and defined contribution plan assets amounted to approximately CAD$ 600 billion and the estimated funding shortfall was CAD$ 350 billion. Put into perspective, that is 58% unfunded.9

In the US at the end of 2011, the companies in the S&P 500 had pension plan obligations of US$ 1.68 trillion and assets of US$ 1.32 trillion. The shortfall of US$ 355 billion was the largest ever reported. Without excess contributions by plan sponsors, it remains to be seen how these shortfalls can be made up in a low equity return and ZIRP environment.

A recent report from the Bank of Canada (“BOC”) supports this conclusion. According to the BOC December 2011 Financial System Review “The aggregate solvency of defined-benefit pension funds

“The debt problem facing advanced economies is even worse than we thought… Debt is rising to points that are above anything we have seen, except during major wars. Public debt ratios are currently on an explosive path in a number of countries. These countries will need to implement drastic policy changes. Stabilization might not be enough.”

Bank for International Settlements

“Inflation is the one form of taxation that can be imposed without legislation.”

Milton Friedman

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in Canada is close to an all-time low” and further that “According to the Mercer Pension Health Index, the decline in long-term interest rates over the past six months has brought the funded status of Canadian pension funds near the all-time low reached in 2008. This index declined from 71 per cent in the second quarter of 2011 to 64 per cent at the end of October, indicating that a representative pension plan faces a higher risk of being unable to fully meet its financial obligations.” No mention of course that it is exactly the ZIRP policies followed by the BOC that in part are responsible for this problem.

None other than the august PIMCO, the worlds largest bond manager and home to Bill Gross, has jumped on the “pensions are in trouble” band wagon. In some recent analysis they echo what we have been warning about ZIRP - that the value of pension fund liabilities is growing while the returns necessary to fulfill them are dwindling, leaving pension funds progressively more under-funded with each passing year that ZIRP continues.

“The United States is facing an untenable fiscal situation due to the combination of high fiscal deficits, an aging population and rapid growth in government-provided healthcare benefits. IMF and Congressional Budget Office forecasts imply that U.S. debt will rise rapidly relative to GDP in the medium to long term.”

IMF

SOVEREIGN SOLVENCY: Sovereign borrowers have had unlimited privileges over the last two decades. Those privileges are gradually being revoked as the ability to repay is being called into doubt. In a research piece proclaiming the US is “broke” and that no conceivable combination of austerity and/or tax increases will fix the problem, Morgan Stanley predicted that some form of default via the printing press is sure to happen.10 While interest rates are at historic lows this issue is being postponed. But when the ability to roll over their obligations at current historically depressed interest rates is removed, the truly precarious nature of sovereign finances will be revealed. Consider that while interest rates for many developed nations are at generational lows, sovereign debt loads as a percentage of GDP are at all time highs. What happens to western governments when their borrowing costs go from 2% to something approaching the long-term historical average of 5%?



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TABLE 2: PUBLIC DEBT TO GDP PERCENT PROJECTIONS

U.S.

France

Japan

Italy

U.K.

Portugal

Germany

Greece

No change in fiscal policy and age-related spendingSmall gradual adjustment with fiscal balance improving by 1 percentage point of GDP over the next five yearsSmall gradual adjustment with age-related spending as a percentage of GDP held constant at 2011 level

606

400

200

0

606

400

200

0

1980 2000 2020 2040

1980 2000 2020 2040

1980 2000 2020 2040

1980 2000 2020 2040

1980 2000 2020 2040

1980 2000 2020 2040

1980 2000 2020 2040

1980 2000 2020 2040

In countries like Japan and the US, the answer is that the majority of the budget would be dedicated to simply paying interest. Perhaps this sounds alarmist and unlikely. But consider that, as of 2012, US federal government debt exceeds US$ 15 trillion.

Without material changes to spending trajectories, public debt to GDP levels will reach unprecedented levels over the next two decades. Arguably they will

be unsustainable much sooner than that as can be seen in the Tables 2 and 3 below.

In 2011, the US government paid US$ 454 billion in interest (an implied rate of 2.9%). The Congressional Budget Office notes that federal government debt will rise to US$ 20 trillion by 2015. If we assume that it carried a rate of 5% instead of 3%, interest payments

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TABLE 3: TOTAL DEBT TO GDP

Total debt to GDP, 1995-2011

Note: Total debt includes government, nonfinancial-corporate, and household debt.1 Japanese data are through 2010 only (2011 data were not available); the bar chart compares Japanese data for 2010 with date for 2007 and 2009.

400%

350%

300%

250%

200%

0%1995 2000 2005 2010

Japan1 France Italy U.K.U.S. Germany Spain

Total debt to GDP, 2011 versus 2007 and 2010

100%

75%

50%

25%

0%

-25%

16

-7

2125374041

85

-11

-2

51

43

U.K.

Spain

Franc

e

Japan

1

German

yU.S.

Italy

2011 versus 2007 2011 versus 2010

would total US$ 1 trillion or 45% of current tax revenues.

According to a report by Incrementum “Even more striking is the over-indebtedness situation in Japan. As a result of the zero interest rate policy being

“I am a rich man, as long as I do not pay my creditors.”

Titus Maccius Plautus

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in force for 17 years by now, the government has already refinanced the bulk of its debt burden at extremely low interest rates. Despite such favorable financing conditions, debt service costs already amount to 25% of tax revenues. An increase of the average refinancing costs by three percentage points (to 4.6%) would consume the entire public revenue.”

Of course, the raw debt numbers understate the issue significantly. It is estimated that the present value of all future US expenditures (including such items as social entitlements and pensions etc.) less all currently contemplated future tax revenues, amounts to more than a US$ 200 trillion deficit. Now imagine this is funded with debt carrying 5% interest, then the annual interest bills would be US$ 10 trillion or 500% of current US federal tax revenues. Clearly, maturing sovereign debt must continue to be refinanced at low rates for as long as possible otherwise state solvency starts to come into question.

Rollover risk can be defined broadly as the possibility that a borrower cannot refinance maturing debt at



all or at least at rates sufficiently low enough to be serviced. Here is a concrete example of rollover risk that may be unfolding right in front of us.

By 2020, it is estimated that ~US$ 23 trillion (~75%) of the debt of the top 10 global debtors will have matured and must be rolled over. Considering that global GDP is estimated at US$ 70 trillion, the magnitude of this number begs the questions: how

Source: PFS Group

TABLE 4: CUMULATIVE DEBT MATURING OUT TO 2020

100%90%80%70%60%50%40%30%20%10%0%

‘12 ‘13 ‘14 ‘15 ‘16 ‘17 ‘18 ‘19 ‘20 ‘21 ‘22 ‘23+

“Blessed are the young for they shall inherit the national debt.”

Herbert Hoover

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will this maturing debt be re-financed and, perhaps more importantly, at what interest rates?

The world’s monetary authorities have been engaging in ZIRP for approximately 5 years now. The longer this takes place the greater amounts of maturing, higher yielding debt that are replaced, by necessity, with new sovereign debt at historically low yields –

according to Incrementum once again “in July 2012, 10-year yields in the US thus reached with 1.39% the lowest level since the beginning of records in the year 1790. In the Netherlands – which provide the longest available time series for bond prices – interest rates fell to a 496 year low. In the UK, ‘base rates’ are currently at the lowest level since the founding of the Bank of England in 1694. In numerous countries

TABLE 5: FRANCE 10 YEAR YIELDS

20%

16%

12%

8%

4%

0%1746 1766 1786 1806 1826 1846 1866 1886 1906 1926 1946 1966 1986 2006

TABLE 6: SPAIN 10 YEAR YIELDS

40%

30%

20%

10%

0%1789 1809 1829 1849 1869 1889 1909 1929 1946 1969 1989 2009

Source: Deutsche Bank, Bloomberg Finance LLP, GFD


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TABLE 7: ITALY 10 YEAR YIELDS

25%

20%

15%

10%

5%

0%1808 1828 1848 1868 1888 1908 1928 1948 1968 1988 2008


(Germany, Switzerland), short term interest rates even fell into negative territory.” According to Deutsche Bank, the 10-year sovereign rate is under 2% in France, Spain and Italy, the lowest since 1746, 1789 and 1808 respectively (see Tables 5, 6 & 7).It goes without saying that with interest rates at multiple century lows and sovereign finances still in precarious condition, the reversion to more normal long-term historical average rates will be a very powerful to shock to sovereign finances.

PRIVATE EQUITY: There is one significant opportunity that comes out of the baby boomer retirement trend - SME private equity. Consider for a moment the single largest baby boomer retirement issue in dollar terms. Is it pension solvency, retirement savings levels, healthcare funding? All important but we believe the one that overshadows all others is the question of from where will the capital come to acquire the large cohort of private, baby boomer businesses coming

“With a glut of baby boomer- owned SMEs imminently available, there is an untapped and growing opportunity for Canadian private equity firms to realize significant value at the low end of the micro- cap market. Canada is arriving at a natural inflection point where baby boomer small business owners will need to consider selling. This will sharply increase the supply of available businesses - a market reality that simply did not exist five or ten years ago.”

Deloitte, “Making a market for micro-cap, Small and medium Canadian enterprises”

onto the market? Without the ability to sell their businesses for reasonable valuations baby-boomer entrepreneurs may find it a challenge to fund their retirements.

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Source: Deloitte, CVCA 2009, * sub $250 million acquisitions

TABLE 9: PE RETURNS

10 years 5 years

Canadian PE 14.2% 16.8%

US PE* 3.4% 4.2%

TABLE 8: 10 YR PE SUPPLY AND

DEMAND PROFILE

Source: Equicapita, CVCA, CIBC

2,000

1,500

1,000

500

-Supply Demand

Projection: 10 times more deals than capital

Just how large of an issue is this funding gap? In a recent report CIBC estimated that “$1.9 trillion in business assets are poised to change hands in five years - the biggest transfer of Canadian business control on record.” and that “by 2022, this number will mushroom to at least $3.7 trillion as 550,000 owners exit their businesses...”11 So how will this large cohort of entrepreneurs exit and at what price?

The question will come down in part to the amount of acquisition capital flowing into the SME space. Given that this estimated $2 trillion of businesses is twice as large as the assets of the top 1,000 Canadian pension plans and approximately the same size as Canadian annual GDP this is a question without an immediately obvious answer. 12,13

Just based on current dedicated PE capital, projected deal flow in Canada may outstrip demand by 10 to 1 – with the supply of businesses for sale in the next decade potentially being measured in trillions while demand may be measured in billions.14

The mismatch between deal supply and capital creates an interesting opportunity in the market at the sub-$20 million acquisition size. An opportunity that reveals itself in the substantially higher returns to this size of transaction particularly in the Canadian market which already appears to have higher than average private equity returns than other developed markets due to, we believe, much lower PE capital per $ of GDP.15

On balance the baby boomer retirement trend will challenge sovereign and pension solvency in a time of historically low interest rates. The recent public market rally has to some extent postponed the day of reckoning but arguably given it required a massive

“People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome.”

George Orwell

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global expansion of the money supply including a ~$3 trillion expansion of the US Federal Reserve balance sheet to create, this effect will most likely not be permanent as the Fed may be unwinding at the same time as the peak in boomer retirements. At the same time as all these trends are reaching their conclusion, a large pool of cash generative SME assets are seeking a new home providing what amounts to almost an untouched asset class for organized private equity firms. The key will be for firms to have the expertise and capital structure which allows them to acquire businesses solely for their long standing, stable cash flows which are bundled into a larger

portfolio in order to generate yield for investors – the typical PE reliance on growth, leverage and public market exits with multiple expansions does not suit the SME market well. We believe that new approaches such as Equicapita’s Income Trust model that brings patient capital and investors focused on acquiring stable cash flow into the SME market are an important part of solution to the boomer entrepreneur retirement challenge.

Regards

Stephen Johnston - Director

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NOTES: 1 US Census Bureau2 Northern Trust, It’s More Than Just the Numbers, Demographic Shifts & Investment Strategies, June 20103 Boomer Retirement: Headwinds for U.S. Equity Markets? FRBSF Economic Letter, August 20114 June 5 2014 – the European Central Bank (“ECB”) cut the rate on banks’ ECB deposits to negative 0.1%5 Business Insider, May 16 2014, “Ben Bernanke Gave Hedge Fund Managers A Big Trade Hint, And They

All Missed It”6 Kellogg School of Management7 Center for Retirement Research at Boston College - “How Would GASB Proposals Affect State and Local

Pension Reporting?”8 Society of Certified General Accountants, Gauging the Path of Private Canadian Pensions: 2010 Update

on the State of Defined Benefit and Defined Contribution Pension Plans9 Ibid10 Morgan Stanley, Sovereign Subjects, “Ask Not Whether Governments Will Default, but How.” August 25,

201011 CBC News “Baby boomer retirement glut poses risk”12 Statscan CANSIM, table 380-0064 (C$1.879 trillion)13 Canada’s Pension Landscape Report, 2012 - C$1.12 trillion 201114 Table based on dedicated PE capital, current data and in $ billions, 10 year estimate15 Deloitte, CVCA 2009, *deal size < 250 million

AUTHOR: Stephen is the co-founder of a Calgary based family of investment funds focusing on farmland, energy and private equity. Prior to returning to Calgary in 2003, Stephen was the head of the London based emerging markets private equity team of a large French bank. Stephen is a regular contributor to various print and television media outlets and his analysis has appeared in Bloomberg, Fortune, Macleans, WSJ, FT, Canadian Business, Business Week, Business News Network, and the Globe and Mail. He is the author of Cantillon’s Curse – a book discussing the macro-economic issues facing investors in the post-2008 financial crisis world. Stephen has a BSc. (1987) and a LLB from the University of Alberta (1990) and an MBA (1994) from the London Business School.

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DISCLAIMER:

The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Equicapita and its affiliates make every effort to ensure that the contents hereof have been compiled or derived from sources believed to be reliable and to contain information and opinions which are accurate and complete. However, neither Equicapita nor its affiliates have independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which maybe contained herein or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to Equicapita and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation to enter into any transaction. Additional information is available by contacting Equicapita or its relevant affiliate directly.

#803, 5920 Macleod Trail SW Calgary, Alberta, T2H 0K2 Tel: +1.587.887.1541 www.equicapita.com

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