Rogue Traders at Public Pension Funds?

Before I delve into my main topic, you might have noticed I changed the title of my last entry to better reflect the essence of the message I was trying to convey.

I know pension fund managers are going to try finding refuge in alternative investments, but shoving billions of dollars in commercial real estate as we enter a global consumer recession is just ludicrous and it will ensure catastrophic losses.

Of course, illiquid assets that compensate pension fund managers for taking undue risks using silly benchmarks may serve the purpose of senior managers, but not the beneficiaries of the pension plan.

When I see various surveys about asset allocation, I am struck at how most pension funds have little understanding about proper asset allocation which includes alternative assets. They simply do not understand the correlations between alternative asset classes and traditional asset classes.

Let's say you think public equities will underperform for the next ten years, why would you think that private equity will offer you past juicy premiums, or anything remotely close to the premiums that it offered you in the last bull market?

Today Lehman Brothers Private Equity said its net asset value fell 6.7 percent in the first 10 months of 2008, losing 3.2 percent in October alone as the fund's outlook remained cautious given persistent market volatility:

LBPE is the latest private equity fund to encounter headwinds from the global financial crisis, after Kohlberg Kravis Roberts & Co KKR.UL delayed plans last week to go public after its Amsterdam-listed affiliate suffered big investment losses.

The Lehman fund said losses in the third quarter continued into October as net asset value per share fell further to $9.68 due to the continued declines in the equity and credit markets, representing a 6.7 percent fall in net asset value from the end of 2007.

But the Dutch-listed fund of funds, whose investments include Apollo Investment Fund, Candover 2005 Fund and Blackstone Capital Partners, said it still believes dislocations caused by the credit crunch will provide attractive opportunities for distressed funds and buyout investors.

An affiliate of collapsed US bank Lehman Brothers LEH.N, LBPE said private equity funds Bain Capital Investors and Hellman & Freidman have agreed to buy a part of Lehman Brothers' investment management division in a transaction that will give them indirect control over a new investment advisor for LBPE.

While distressed debt might sound easy and lucrative, the reality is that in this credit environment, only the best PE funds will be able to properly structure these distressed debt deals .

The point is that private equity is no panacea. For years leveraged buyout funds made a killing because money was cheap and they were leveraged up to wazoo buying companies on the cheap financing their transaction with tons of debt.

As long as credit was abundant and cheap and public equity markets were doing well, financing was cheap and there was an exit strategy to exit the deal at much higher multiples. Easy as apple pie.

This is why pension fund managers were plowing billions into private equity, easily beating their bogus benchmarks for this asset class and calling it "alpha" to justify their grossly inflated bonuses.

But now that public equity markets are not doing well and credit is expensive and hard to access, private equity is hitting a rough patch, revealing its true nature.

Still, pension funds' insatiable appetite for alternative investments, especially illiquid private equity and real estate, continues unabated despite the latest debacle which clearly demonstrates that in a systemic crisis these illiquid asset classes do not offer the downside protection that pension consultants touted for so long.

When you see pension funds increasing their allocation to illiquid asset classes, you should stop and ask yourself why. They will all claim it is because private asset classes offer better risk-adjusted returns, but if you adjust for stale pricing and valuation issues, you'll quickly discover that the true volatility of these assets is grossly understated.

Now, let me delve into my topic on rogue traders in public pension funds. As we saw yesterday, more and more pension funds are bringing their assets in-house.

But as they move assets internally, you have to ask whether they have the right operational and investment risk management framework in place to prevent significant losses.

What does this have to do with rogue traders at public pension funds? We have all read or heard about famous rogue traders who brought down banks or hedge funds, but what about rogue traders who can bring down a public pension fund?

You think it can't happen? Well, if you only knew how a few individuals in some of our largest public pension funds have amassed enormous power, trading complex derivatives that are illiquid and hard to price or investing in illiquid asset classes like private equity and real estate.

Prior to 2008, these individuals were "superstars" and rewarded with huge bonuses for taking undue risks. Then the credit crisis hit and all of a sudden the floor fell out of their sophisticated models that were suppose to arbitrage away all risks.

As their positions went against them, they started borrowing more and more believing that they had the deep pockets of a public pension fund to withstand any shock. For years this strategy worked but not this year.

I mention this because I hear horror stories coming out of one large Canadian pension fund where several internal absolute return managers are each losing between $200 million to $400 million this year. Not surprisingly, the long-only guys are getting creamed too. I can just imagine what is going on in other large Canadian pension funds which undertake complex internal strategies.

Of course, the lack of transparency and the air of secrecy at these mega funds prevents the public from ever finding out about internal blowups, but I can assure you senior management and their board of directors all know what is going on. The problem is that they did not prevent these blowups and are doing too little too late to properly deal with them.

You may rightly ask how were these individuals allowed to amass so much power that their investment activities went largely unsupervised?

I wish I had an easy answer to this question but seeing what I saw with my own eyes, I can tell you that lack of oversight, lack of transparency, weak risk management, sheer arrogance and gross incompetence allowed enough individuals to get away with murder for far too long.

You might think rogue traders are criminals who bring down banks or hedge funds but the lack of oversight in our public pension funds has allowed far too many "internal rogue traders" to blossom in the last few years.

Clearly the time has come to take pension fund governance seriously. If we don't, it's only a matter of time before the next Nick Leeson, the next Jerome Kerviel or the next Brian Hunter bring down a public pension fund.