June 2014 Update

DEMOGRAPHICS ARE STILL DESTINY

1
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 is
certainly a theme that gures 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 dened 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 ination.
Robert Schiller, author of Irrational Exuberance, argues that
returns over the next 20 years could fall below 5% after
ination 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.
2
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 nances 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 ve 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
Wests 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
3
Equicapita Update (continued)
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.
Italy
Germany
Russia
Argentina
Brazil Colombia
Caribbean
U.S.
Japan
U.K.
Algeria
South Africa
France
Burkina Faso
Cameroon
Ethiopia
Sudan
Angola
Ghana
Egypt
Congo
Niger
Nigeria
Tanzania
Philippines
Somalia
Yemen
Iraq
Afghanistan
2000 2020 2040 2060 2080 2100 and beyond
European
peak
Latin American, Asian
and Caribbean peak
Workforce population at peak (100 million)
Spain
Mexico
Zambia
Uganda
Kenya
Malawi
Mali
Madagascar
Mozambique
Cote dIvoire
South Korea
China
Thailand
Indonesia
Vietnam
Turkey
Nepal
India
Iran
Myanmar
Bangladesh
Saudi Arabia
Americas
Europe
Africa
Asia
Pakistan
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:
4
Equicapita Update (continued)
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 nance 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 markets
recovery from the nancial crisis.
3
PENSION SOLVENCY:
We currently inhabit in a ZIRP world and amazingly in
Europe even a Negative Interest Rate (NIRP) world
4
.
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 xed income securities that are now yielding
a fraction of the returns required to maintain plan
benets. 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
Feds 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
lifetime
5
.
The issue for pensions arises because a signicant
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 xed 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 ination, usually
inations engineered by governments for the
gain of governments.
Friedrich August von Hayek
5
Equicapita Update (continued)
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 worlds monetary authorities may be
to try to keep them low for a very long time indeed.
Ultimately, benets 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 studies
6
concluded that the unfunded
obligations of US municipal pensions were more
than double the ofcially reported gures. 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 cents
7
.
Private sector pensions are also in poor condition. In
Canada, 92% of private sector pension plans were
in a decit position as of December 31, 2008, with
almost 40% of dened benet plans having solvency
ratios under 70%, and over 70% of dened benet
plans having solvency ratios under 80%.
8
As of 2008,
total dened benet and dened 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 dened-benet 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
Ination is the one form of taxation that can
be imposed without legislation.
Milton Friedman
6
Equicapita Update (continued)
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 nancial
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 fulll them are dwindling, leaving pension funds
progressively more under-funded with each passing
year that ZIRP continues.
The United States is facing an untenable
scal situation due to the combination of
high scal decits, an aging population
and rapid growth in government-provided
healthcare benets. IMF and Congressional
Budget Ofce 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 x 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 nances 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%?
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
7
Equicapita Update (continued)
Source: BCG: Ending the Era of Ponzi Finance
TABLE 2: PUBLIC DEBT TO GDP PERCENT PROJECTIONS
U.S.
France
Japan
Italy
U.K.
Portugal
Germany
Greece
No change in scal policy and age-related spending
Small gradual adjustment with scal balance improving by 1 percentage point of GDP over the next
ve years
Small 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 Ofce 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
8
Equicapita Update (continued)
Source: BCG: Ending the Era of Ponzi Finance
TABLE 3: TOTAL DEBT TO GDP
Total debt to GDP, 1995-2011
Note: Total debt includes government, nonnancial-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
Japan
1
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
21
25
37
40
41
85
-1
1
-2
5
1
43
U
.
K
.

S
p
a
i
n
F
r
a
n
c
e
J
a
p
a
n
1
G
e
r
m
a
n
y
U
.
S
.
I
t
a
l
y
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
9
Equicapita Update (continued)
in force for 17 years by now, the government has
already renanced the bulk of its debt burden at
extremely low interest rates. Despite such favorable
nancing conditions, debt service costs already
amount to 25% of tax revenues. An increase of the
average renancing costs by three percentage points
(to 4.6%) would consume the entire public revenue.
Of course, the raw debt numbers understate the
issue signicantly. 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 decit. 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 renanced at low
rates for as long as possible otherwise state solvency
starts to come into question.
Rollover risk can be dened broadly as the possibility
that a borrower cannot renance maturing debt at
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
all or at least at rates sufciently 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
10
Equicapita Update (continued)
will this maturing debt be re-nanced and, perhaps
more importantly, at what interest rates?
The worlds 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
Source: Deutsche Bank, Bloomberg Finance LLP, GFD
11
Equicapita Update (continued)
TABLE 7: ITALY 10 YEAR YIELDS
25%
20%
15%
10%
5%
0%
1808 1828 1848 1868 1888 1908 1928 1948 1968 1988 2008
Source: Deutsche Bank, Bloomberg Finance LLP, GFD
(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 nances still in
precarious condition, the reversion to more normal
long-term historical average rates will be a very
powerful to shock to sovereign nances.
PRIVATE EQUITY:
There is one signicant 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 rms to realize signicant
value at the low end of the micro- cap
market. Canada is arriving at a natural
inection 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 ve 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 nd it a challenge to fund their
retirements.
12
Equicapita Update (continued)
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 ve
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 owing 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 ow 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
13
Equicapita Update (continued)
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 rms. The key will be for rms to have
the expertise and capital structure which allows them
to acquire businesses solely for their long standing,
stable cash ows 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 Equicapitas Income Trust model
that brings patient capital and investors focused
on acquiring stable cash ow into the SME market
are an important part of solution to the boomer
entrepreneur retirement challenge.
Regards
Stephen Johnston - Director
14
Equicapita Update (continued)
NOTES:
1 US Census Bureau
2 Northern Trust, Its More Than Just the Numbers, Demographic Shifts & Investment Strategies, June 2010
3 Boomer Retirement: Headwinds for U.S. Equity Markets? FRBSF Economic Letter, August 2011
4 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 Management
7 Center for Retirement Research at Boston College - How Would GASB Proposals Affect State and Local
Pension Reporting?
8 Society of Certied General Accountants, Gauging the Path of Private Canadian Pensions: 2010 Update
on the State of Dened Benet and Dened Contribution Pension Plans
9 Ibid
10 Morgan Stanley, Sovereign Subjects, Ask Not Whether Governments Will Default, but How. August 25,
2010
11 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 2011
14 Table based on dedicated PE capital, current data and in $ billions, 10 year estimate
15 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 Cantillons
Curse a book discussing the macro-economic issues facing investors in the post-2008 nancial 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.
15
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