The overriding lesson from the financial crisis

Mr. Jim Leech, Ex. President and CEO of Ontario Teachers' Pension Plan
An interview with Mr. Jim Leech, Ex. President and CEO of Ontario Teachers’ Pension Plan, with $129.5B in net assets.

The overriding lesson from the financial crisis: A message to CEOs on performance benchmarks, governance, risk consciousness and performance systems.

What does it take to innovate?

The majority of executives say it involves achieving technological leadership, global presence and a comprehensive portfolio of patents that will enable the company to help define major trends regarding products, systems and services, and to offering its customers important added value. They say such steps reduce costs, increase sales and achieve higher earnings. But how does one come up with new solutions, and can innovations really be part of a strategy plan? Arcus’ multi-industry survey of senior executives found that of all the challenges companies face in this area, the biggest challenge is finding ways to create a “climate for innovation”.

As Arcus research indicates, doing so means that you need to be surrounded by highly talented people.  It also means finding a way to transmit your passion to them, so they will buy into your vision of the future, perform at the highest possible levels, and come up with innovative solutions to the challenges of achieving the vision. No surprise, then, that the topic of innovation has been gaining ground as CEOs seek to incorporate concepts like “a culture of innovation” into their assessments of a company’s long-term value.

An interview with Mr. Jim Leech, President and Chief Executive Officer of the Ontario Teachers’ Pension Plan (OTPP).

Arcus: What lessons have you learned from the financial crisis?

Mr. Leech: The overriding lesson is to expect the unexpected and don’t take anything for granted. A lot of us would have said risk premiums were far too low, but I don’t think any of us contemplated the speed with which they widened and the resulting panic in the markets. I don’t think any of us anticipated that the market would freeze up and highly liquid assets would become totally illiquid in such a short period of time. There was some agreement that the housing boom in the US was unsustainable but I never believed we would see whole subdivisions abandoned. I think we were also surprised by the size of the shadow banking system and its total collapse. And we certainly did not anticipate the speed of failure of so many large financial institutions.

Arcus: The Ontario Teachers’ Pension Plan’s equity holdings have declined from 65% in 1995 to 40% today and private equity is expected to grow faster from a relatively smaller base of 9% today. What are the reasons for this shift?

Mr. Leech: When we talk about 40% equities we mean both public and private combined. The reason we reduced equities is because of the mature profile of our pension plan. Our profile is different compared to most other pension plans. We have only 1.6 teachers contributing into the pension plan for every retiree. And we pay out $4.3B in pensions every year with only $2.2B in contributions. So that’s a very different profile compared to most other pension plans.

As a consequence, we need to take a more conservative approach in the portfolio. We cannot expose our contributing members to a significant risk of deficits due to market volatility. The change in our asset mix has nothing to do with the market meltdown. It has to do with our demographics.

Arcus: Are there other lessons from the financial crisis?

Mr. Leech: Make sure your credit support agreements are signed and can be enforced tomorrow, because there are likely to be consequences. For example, no one expected Lehman Brothers to go under and were caught without appropriate collateral. People let their guard down in the euphoria of good times. In a way, it’s back to basics. The type of things you have to do managing a financial institution through these times includes keeping your eye on liquidity. The last place you want to find yourself is in an illiquid market and having to sell assets to meet your obligations. Some institutions got themselves into a position where they had to sell blue chip stocks in November last year because those where the only assets that could be sold.

Arcus: What will be the key barriers to growth in the next 5-10 years?

Mr. Leech: I think the key will be the availability of credit for acquisitions or internal growth. In 2007, you could get 10 times EBITDA as an acquisition loan but that is probably not possible today. The shadow banking system which provided a lot of corporate credit was as large as the regulated banking system. That has been effectively cut in half or by two thirds. It’s unrealistic to expect the regulated banking system to fill that void quickly.

It’s going to take time for the banks to increase their loan capacity and for alternatives such as asset backed securities to come back in to favour. The regulatory framework is likely to define the future for these securities. I don’t see credit markets normalized for at least another year. It’s because the capacity for the system to make loans just does not exist today.

Arcus: You recently said “You don’t want to lose the opportunity that a good crisis brings you”. What did you mean by that statement?

Mr. Leech: People do take you seriously in the middle of a crisis. For example, six weeks ago business continuity plans were not a priority. The Swine flu mobilized teams to fine-tune their plans. You don’t want to miss the opportunity of a crisis to mobilize people. This type of crisis will allow the markets to re-examine some of the things that have gone on. For example, how CEOs and executives in financial institutions are compensated. For years we have been saying it’s unacceptable to compensate financial executives based on their performance over a period of a year. That compensation system may have motivated some to add questionable loans on the books in order to enjoy a significant increase in compensation.

There seemed to be a short term view of performance. Now banks are introducing plans that have risk involved in their calculations. That may be one of the silver linings from this crisis. Boards will be paying a little more attention to enterprise risk management and the types of risks that the business is taking on in order to deliver results.

Arcus: You talked about the role of institutional ownership in growth and innovation. Have you seen a shift towards active management? Mr. Leech: Over the years, pension plans have been passive managers. They bought the index. Teachers’ was one of the leaders at changing from being just a passive manager to being an active manager. This meant that we owned fewer stocks in our portfolio with significantly larger positions than the index. That has allowed us to actively engage with these companies. We have a large enough voice so that we can be heard.

 Arcus: What is your outlook on inflation and short term risk of deflation?

Mr. Leech: We were concerned going into the year about the potential for deflation, which seemed to be much higher than it has ever been. The sheer magnitude of the stimulus plans announced by various governments to address the financial crisis indicated that central bankers around the world were committed to address this potential problem. I think that the risk of deflation has largely abated. So then you have to address the inverse.

We now have enormous financial stimulus entering the market. But most of the money has not yet been spent.  The real issue is whether governments will over stimulate their economies and set off uncontrolled inflation. Central bankers say they are willing to take on that risk because they have dealt with the problem of inflation in the past. The question is when will governments pull back the stimulus once the economy gets going and how fast will they be able to do it. I don’t think it is a decision that needs to be taken in the next six months. But I think they will have to take the right decisions in a year from now.

Arcus: What was your personal experience on the BCE deal and what insights do you have for other CEOs?

Mr. Leech: You have to go back to the very beginning. Teachers’ had been a major shareholder of BCE for years. Our view was that it was undermanaged and undervalued. And we made those views known to management. We went so far as to suggest some actions that they could take. I think at the end of the day management had an appeasement strategy. I think the lesson of BCE is that management should be responsive to shareholders. We felt the management and board of BCE could have moved much more quickly.

Arcus: You talked about infrastructure being a priority in context of a potentially inflationary environment.

Mr. Leech: We have a very precise definition of infrastructure:  a regulated industry or a de facto monopoly with guaranteed cash flows and an explicit or implicit inflation hedge. The preferred offset to an inflation indexed pension is a real rate bond but yields are too low. So, for us infrastructure is a real rate bond on steroids. Governments are finding it increasingly difficult to carry and maintain large infrastructure projects when the demand is for social welfare and healthcare. So they are potentially looking to sell those types of assets to produce some cash flow to use elsewhere.

Arcus: What macro trends should CEOs be concerned about over the next 5-10 years.

Mr. Leech: My long-term concerns are the potential for increased protectionism and over-regulation. We have enjoyed a decade of deregulation and free trade. The pendulum could swing back in the other direction. No doubt there are certain areas that need a degree of regulation but I fear over-regulation. Also, I could see governments becoming more protectionist as they enter the private sector to an unprecedented degree. These could be constraints on growth in the long term.

Arcus: What is your message to CEOs on performance benchmarks?

Mr. Leech: First, risk consciousness needs to be built into all processes of the business. It needs to be integral to the compensation and investment process. At times, management has taken on significant levels of risk to produce superior results so that they could increase their compensation. Risk needs to be brought into the equation. Senior executives are starting to understand that. Second, we need to ensure we implement pay for performance systems. The definition of performance isn’t only what happens in the short term. We would like to see 4-5 year performance cycles.

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