equicapita june 2014 update

5/24/2018 Equicapita June 2014 Update

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June 2014 Update

DEMOGRAPHICS ARE STILL DESTINY


2/16

Equicapita Update

There is a kind of fear,approaching a panic, thats

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 DESTINY

It has been said that demographics are destiny and this iscertainly a theme that figures in the investment thinking of ourfunds and one that we have discussed many times in the past.

By now, no investor should be surprised that the West is facing anunprecedented wave of retirements as the baby boom generationmoves to the end of their productive careers - the baby boomgeneration being defined as those people born between 1946 and1964.1

The magnitude of this demographic shift will create issues for thereturn potential of a number of currently widely held asset classesand also a number of compelling investment opportunities outsideof these assets. In short, this powerful trend should not beignored for its potential affect on both returns and risks.

Investment Liquidation: The West is generally moving into aphase where investments are liquidated to fund retirements. Asbaby boomers retire they will begin to sell assets, producingdownward pricing pressure in some key markets residentialreal estate, government bonds and public equities. This iswhere baby boomers investment capital has been focused formore than two decades. Unfortunately, we cannot all cash outat once.

Public Market Returns: From 1946 through 1997, stocks hadan average compound annual return of 7.5% after inflation.

Robert Schiller, author of Irrational Exuberance, argues thatreturns over the next 20 years could fall below 5% afterinflation 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 privatepension plans will be tested and we believe that in many casesfound to be lacking. The combination of Zero Interest RatePolicy (ZIRP), unrealistic return assumptions and the rapidgrowth in the pool of recipients will see to this.


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Equicapita Update (continued)

Sovereign Solvency: Sovereign borrowershave had unlimited privileges over the last twodecades. Those privileges are gradually beingrevoked as the ability to repay is being calledinto doubt. Without the ability to roll over their

obligations at current historically depressedinterest rates, the truly precarious nature ofsovereign finances will be revealed. Consider thatwhile interest rates for many developed nationsare at generational lows, sovereign debt loadsas a percentage of GDP are at all time highs andentitlement liabilities are rapidly expanding.

Private Equity: In terms of absolute dollar sizethe issue of from where will the capital come toacquire the large cohort of private, baby-boomersmall & medium enterprises (SME) coming onto

the market is of the same or perhaps even greatermagnitude than the other issues outlined above,but receives far less attention. Just how large ofan issue is this funding gap? In a recent reportCIBC estimated that $1.9 trillion in business

assets are poised to change hands in five years -the biggest transfer of Canadian business controlon record.and that by 2022, this number will

mushroom to at least $3.7 trillion as 550,000owners exit their businesses...

DEMOGRAPHICS INTRODUCTION:

In 2000, the ratio of Americans between 15 and 59years old to those over 60 was four to one, accordingto a United Nations report. In 2050, the ratio will beonly two to one. In Canada the story is much thesame. By approximately 2015, Canada will have morepeople leaving the labor force than joining. Retirees

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

The emerging markets in aggregate will not face theWests demographic challenge for several decades.

The emerging markets currently have a dependencyratio (the ratio of dependents to working-age citizensroughly 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 toemerge quite soon - by 2016, the dependency ratioin developed markets will be higher than that ofemerging markets and growing faster.

How did you go bankrupt? Two ways.

Gradually, then suddenly.

Ernest Hemingway


4/16


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 laboforce of 30 million or more; data include the impact of immigration.

ItalyGermany Russia

ArgentinaBrazil Colombia

Caribbean

U.S.

Japan

U.K.

Algeria

South Africa

France

Burkina FasoCameroon

EthiopiaSudan

AngolaGhana

Egypt Congo NigerNigeria

Tanzania

Philippines

SomaliaYemen

IraqAfghanistan

2000 2020 2040 2060 2080 2100 and beyond

Europeanpeak

Latin American, Asianand Caribbean peak

Workforce population at peak (100 million)

Spain

Mexico

ZambiaUganda

Kenya

MalawiMali

Madagascar

Mozambique

Cote dIvoire

South KoreaChina Thailand

IndonesiaVietnamTurkey Nepal

IndiaIranMyanmar

BangladeshSaudi Arabia

Americas

Europe

Africa

AsiaPakistan

PUBLIC MARKET RETURNS:

Developed market investors have trillions invested inbonds, real estate and public market equities. Retire-ment will require investors to become net sellers with theattendant negative affect on returns in these marketsand asset classes.

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


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Historical data indicate a strong relationshipbetween the age distribution of the U.S.population and stock market performance.A key demographic trend is the aging ofthe baby boom generation. As they reach

retirement age, they are likely to shift frombuying stocks to selling their equity holdingsto finance retirement. . P/E* should decline

persistently from about 15 in 2010 to about 8.4in 2025, before recovering to 9.14 in 2030.Moreover, the demographic changes relatedto the retirement of the baby boom generation

are well known. This suggests that marketparticipants may anticipate that equities willperform poorly in the future, an expectation thatcan potentially depress current stock prices.In that sense, these demographic shifts may

present headwinds today for the stock marketsrecovery from the financial crisis. 3

PENSION SOLVENCY:

We currently inhabit in a ZIRP world and amazingly inEurope even a Negative Interest Rate (NIRP) world4.ZIRP has consequences for pensions that may notbe immediately obvious to the rapidly growing ranksof retirees. Large portions of pension portfoliosare in fixed income securities that are now yielding

a fraction of the returns required to maintain planbenefits. Pensions are already facing solvency issuesand when baby boomers start to liquidate this issuewill grow in magnitude with the feed-back loop frompoor equity and bond returns as the transmissionmechanism.

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

Feds ZIRP policy is alleged to have said that he didnot expect the federal funds rate to return to its longterm historical average of approximately 4% in hislifetime5.

The issue for pensions arises because a significantnumber assume annual returns in the range of7%-8% when they are planning how to meet theirobligations. Since a large portion of pension portfolioare in fixed income securities that are now yielding afraction of that range, these return assumptions areunrealistic to put it mildly.

It turns out that the 8% return number is just thebeginning of the aggressive assumptions that pensiofund managers are building into their models inorder to make their plans seem whole. Because of

low bond yields pension fund managers are nowimplicitly assuming greater than 10% equity returnsto achieve their overall return requirements. It goesalmost without saying that this is most likely wishfulthinking. It seems unlikely indeed that pension fundmangers will be able to generate consistent 10%plus equity returns going forward when they rarelyif ever generated such returns in the past. Evenless likely given the previously mentioned researchfrom the Federal Reserve that due to baby boomerselling 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


6/16


averages over the next two decades and no wherenear 10%.

The longer ZIRP continues, the worse the problemwill become and if you put credence in the afterdinner comments of ex-chairman Ben Bernanke, theintention of the worlds monetary authorities may beto 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 ofhigher contributions will have to be collected. Barringthis, pensions will need bail-outs or go bankrupt.

Just how serious is this funding shortfall? A recentpair of studies6concluded that the unfundedobligations of US municipal pensions were morethan double the officially reported figures. By themunicipalities accounting, they had approximatelyUS$ 200 billion in unfunded obligations while thestudy 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 municipaland state levels of around US$ 3.5 trillion. Moregenerally, as of the 2010 accounting rules, US publicpension plans had 76 cents for every dollar they mustpay retirees in the future. If more realistic mark-to-market assets took place combined with lower long-term return assumptions, this number could drop toas low as 57 cents7.

Private sector pensions are also in poor condition. InCanada, 92% of private sector pension plans werein a deficit position as of December 31, 2008, withalmost 40% of defined benefit plans having solvencyratios under 70%, and over 70% of defined benefit

plans having solvency ratios under 80%.8

As of 2008total defined benefit and defined contribution planassets amounted to approximately CAD$ 600 billionand the estimated funding shortfall was CAD$ 350billion. Put into perspective, that is 58% unfunded.9

In the US at the end of 2011, the companies in theS&P 500 had pension plan obligations of US$ 1.68trillion and assets of US$ 1.32 trillion. The shortfallof US$ 355 billion was the largest ever reported.Without excess contributions by plan sponsors, itremains to be seen how these shortfalls can be mad

up in a low equity return and ZIRP environment.

A recent report from the Bank of Canada (BOC)supports this conclusion. According to the BOCDecember 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


7/16


in Canada is close to an all-time low and further thatAccording to the Mercer Pension Health Index, thedecline in long-term interest rates over the past six

months has brought the funded status of Canadianpension funds near the all-time low reached in 2008.

This index declined from 71 per cent in the secondquarter of 2011 to 64 per cent at the end of October,indicating that a representative pension plan faces ahigher risk of being unable to fully meet its financialobligations. No mention of course that it is exactlythe ZIRP policies followed by the BOC that in part areresponsible for this problem.

None other than the august PIMCO, the worldslargest 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 pensionfund liabilities is growing while the returns necessaryto fulfill them are dwindling, leaving pension fundsprogressively more under-funded with each passingyear 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 CongressionalBudget 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 aregradually being revoked as the ability to repay is beincalled into doubt. In a research piece proclaiming thUS is broke and that no conceivable combinationof austerity and/or tax increases will fix the problem,Morgan Stanley predicted that some form of defaultvia the printing press is sure to happen.10

While interest rates are at historic lows this issue isbeing postponed. But when the ability to roll overtheir obligations at current historically depressedinterest rates is removed, the truly precarious nature

of sovereign finances will be revealed. Considerthat while interest rates for many developednations are at generational lows, sovereign debtloads as a percentage of GDP are at all time highs.What happens to western governments whentheir borrowing costs go from 2% to somethingapproaching the long-term historical average of 5%?



Debt is rising to points that are aboveanything we have seen, except during major





not be enough.



8/16



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 spending

Small gradual adjustment with fiscal balance improving by 1 percentage point of GDP over the nextfive 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 thatthe majority of the budget would be dedicated tosimply paying interest. Perhaps this sounds alarmistand unlikely. But consider that, as of 2012, US federalgovernment debt exceeds US$ 15 trillion.

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

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

In 2011, the US government paid US$ 454 billion ininterest (an implied rate of 2.9%). The Congressional

Budget Office notes that federal government debt wrise to US$ 20 trillion by 2015. If we assume that itcarried a rate of 5% instead of 3%, interest payment


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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 datafor 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

2125

374041

85

-1

1

-2

51

43

U

.K.

Spa

in

Franc

e

Jap

an1

German

y

U

.S.

Italy

2011 versus 2007 2011 versus 2010

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

According to a report by Incrementum Even morestriking 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


10/16


in force for 17 years by now, the government hasalready refinanced the bulk of its debt burden atextremely low interest rates. Despite such favorablefinancing 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 theissue significantly. It is estimated that the presentvalue of all future US expenditures (including suchitems as social entitlements and pensions etc.) less allcurrently contemplated future tax revenues, amountsto more than a US$ 200 trillion deficit. Now imaginethis is funded with debt carrying 5% interest, then theannual 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 lowrates for as long as possible otherwise state solvencystarts to come into question.

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



Debt is rising to points that are aboveanything we have seen, except during major





not be enough.


all or at least at rates sufficiently low enough to beserviced. Here is a concrete example of rollover riskthat 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 havematured and must be rolled over. Consideringthat global GDP is estimated at US$ 70 trillion, themagnitude 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


11/16

1


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

The worlds monetary authorities have been engagingin 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 thelongest available time series for bond prices interes

rates fell to a 496 year low. In the UK, base ratesare currently at the lowest level since the founding ofthe 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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1


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 DeutscheBank, the 10-year sovereign rate is under 2% inFrance, Spain and Italy, the lowest since 1746, 1789and 1808 respectively (see Tables 5, 6 & 7).It goes without saying that with interest rates atmultiple century lows and sovereign finances still inprecarious condition, the reversion to more normallong-term historical average rates will be a verypowerful to shock to sovereign finances.

PRIVATE EQUITY:

There is one significant opportunity that comes outof the baby boomer retirement trend - SME privateequity. Consider for a moment the single largestbaby boomer retirement issue in dollar terms.Is it pension solvency, retirement savings levels,healthcare funding? All important but we believe theone that overshadows all others is the question offrom where will the capital come to acquire the largecohort 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 theirbusinesses for reasonable valuations baby-boomerentrepreneurs may find it a challenge to fund theirretirements.


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1


Source: Deloitte, CVCA 2009, * sub $250 millionacquisitions

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? Ina recent report CIBC estimated that $1.9 trillion inbusiness assets are poised to change hands in fiveyears - the biggest transfer of Canadian businesscontrol on record. and that by 2022, this number

will mushroom to at least $3.7 trillion as 550,000owners exit their businesses...11So how will thislarge cohort of entrepreneurs exit and at what price?

The question will come down in part to the amountof acquisition capital flowing into the SME space.Given that this estimated $2 trillion of businessesis twice as large as the assets of the top 1,000Canadian pension plans and approximately the samesize as Canadian annual GDP this is a questionwithout an immediately obvious answer. 12,13

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

The mismatch between deal supply and capitalcreates an interesting opportunity in the market at thsub-$20 million acquisition size. An opportunity thatreveals itself in the substantially higher returns to this

size of transaction particularly in the Canadian markewhich already appears to have higher than averageprivate equity returns than other developed marketsdue to, we believe, much lower PE capital per $ ofGDP.15

On balance the baby boomer retirement trend willchallenge sovereign and pension solvency in a timeof historically low interest rates. The recent publicmarket rally has to some extent postponed the dayof 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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1


global expansion of the money supply including a ~$3trillion expansion of the US Federal Reserve balancesheet to create, this effect will most likely not bepermanent as the Fed may be unwinding at the sametime 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 areseeking a new home providing what amounts toalmost an untouched asset class for organizedprivate equity firms. The key will be for firms to havethe expertise and capital structure which allows themto 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 andpublic market exits with multiple expansions doesnot suit the SME market well. We believe that newapproaches such as Equicapitas Income Trust mode

that brings patient capital and investors focusedon acquiring stable cash flow into the SME marketare an important part of solution to the boomerentrepreneur retirement challenge.

Regards

Stephen Johnston - Director


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1


NOTES:

1 US Census Bureau2 Northern Trust, Its 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 TheyAll 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 Canadas 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 andprivate equity. Prior to returning to Calgary in 2003, Stephen was the head of the London based emergingmarkets private equity team of a large French bank. Stephen is a regular contributor to various print andtelevision media outlets and his analysis has appeared in Bloomberg, Fortune, Macleans, WSJ, FT, CanadianBusiness, Business Week, Business News Network, and the Globe and Mail. He is the author of Cantillons

Curse a book discussing the macro-economic issues facing investors in the post-2008 financial crisis worldStephen has a BSc. (1987) and a LLB from the University of Alberta (1990) and an MBA (1994) from theLondon Business School.


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DISCLAIMER:

The information, opinions, estimates, projections and other materials contained herein are provided as ofthe 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 Equicapitaand its affiliates make every effort to ensure that the contents hereof have been compiled or derived fromsources 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 orwarranty, express or implied, in respect thereof, take no responsibility for any errors and omissions whichmaybe contained herein or accept any liability whatsoever for any loss arising from any use of or reliance onthe information, opinions, estimates, projections and other materials contained herein whether relied upon bythe recipient or user or any other third party (including, without limitation, any customer of the recipient or userInformation 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 tosell, 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 anytransaction. 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

equicapita june 2014 update

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