Monday, December 29, 2008

Novices Running Pension Funds?

Let me ask you a question: should pension fund managers get high salaries and huge bonuses if they lose 30%, 40% or more in a year?

I know 2008 was a brutal year and we are going to hear a chorus of explanations from the presidents of the top public pension funds telling us that this was "a once in a lifetime event" and that we need to remember that they "invest for the long-term".

Give me a break! If you've been reading the Pulse regularly, you would see that these pension fund turkeys got clobbered because they all grossly underestimated the biggest risk in the financial system, namely, systemic risk - risk they helped fuel by blindly investing billions in alternative investments like commercial real estate, private equity, hedge funds, commodities and whatever else the investment banking sharks were peddling to them.

Importantly, they all fell victim to the illusion of stability, believing that things will continue to move along just as they did for the last 25 years. Now, they all got a rude awakening and they are left wondering how come with all their sophisticated risk management systems, they were unable to protect against severe downside risk.

The simple reason is that when systemic risk hits you, the only asset class that can protect you are good old government bonds. But these pension funds got out of bonds over the last decade to invest in stocks and "absolute return assets" like real estate, private equity and hedge funds.

It's hardly surprising that some are concluding that novices are running pension funds:

Stratford Finance Director John Norko wasted little time earlier this month when he learned Fairfield had likely lost $42 million in pension funds in a fraudulent scheme run by Wall Street trader Bernard Madoff, which may have cost his investors as much as $50 billion.

Norko went into work early on a Saturday to fire off a memo to town employees assuring them that Stratford had not invested in any of Madoff's funds and had not lost any money.

A similar reaction was played out across the region as the citizen volunteers who serve on town and city pension boards digested news of the Madoff scandal and counted their own good fortune for not having invested with the once-respected trader.

A former Nasdaq chairman, Madoff was arrested for orchestrating a maze of allegedly fraudulent investing schemes. Investors big and small could be out millions.

"Was it a wake up call?" asked Dan Roach, a longtime member of Bridgeport's Board of Police Commissioners, which also oversees the department's multimillion-dollar pension fund.

"No question about it. The first thing I thought was, 'are we affected by that.' Inquiries were definitely made and we had a meeting," Roach said.

Bridgeport, like other communities in the region, had not invested its pension funds with Madoff. Still, the financial nightmare Fairfield faces struck a chord with those who oversee retirement funds.

For the most part, pension boards are made up of ordinary citizens, and many of those unpaid volunteers have little financial expertise. Some towns place a city official -- either a finance director, treasurer or elected council member -- on the board, but that's more the exception than the rule.

These guardians are on their own, charged with making decisions about how to invest millions of dollars in an increasingly complex financial world. All pension boards in the region hire professional managers to offer recommendations and develop strategies, but at the end of the day each board member knows the buck stops with them.

"Sometimes I wonder myself," said Roach, who runs a Black Rock store. "I'm not a financial expert. The board members are not trained for this. We rely on the fund manager."Along with Roach, Bridgeport's police pension board includes several lawyers, the former president of the regional water company and a minister.

To understand what pension boards do, think of a 401(k) plan on steroids. The boards authorize investments in various types of funds, based on the fund's history and the likelihood of generating regular returns on the investment. The main difference is the amount invested by a person fund, and the risk is much greater than with any personal 401(k) plan.

Joseph Sartor, a retired air-conditioning technician, has served on the Milford Pension and Retirement Board for 24 years. Milford does not allow politicians or city employees to serve on its board, only citizen volunteers.

"We are all unpaid volunteers and we have exclusive control and power," Sartor explained. "And we take that role seriously."

Like most pension boards, Milford hires a manager or adviser to make recommendations and plot strategy. Sartor said the pension adviser is more crucial today than ever.

"In the old days we invested in stocks and bonds. Today, everything travels together. We have $300 million invested. It's a lot of money," Sartor said.

Sartor said he heard talk about Madoff and his supposed record of investing success, adding that some had urged Milford to invest with the trader. He was promising returns of up to 14 percent, an unheard of gain over the long term in the world of pension investments, Sartor said.

"Fairfield put too much money into it. You have to diversify. This guy was the biggest con artist. He had so many people snowed over," Sartor said.

"Our adviser is expensive, but we get every penny back. He gives advice and he knows the business. We set the guidelines," he said.

Dan LaBelle, a Westport lawyer and a member of Trumbull's pension board, agreed that board members rely on their adviser. "At the end of the day you have to trust that person," LaBelle said.

LaBelle said Trumbull looked closely at its fund and investment choices after the Madoff scandal became public.

"It could happen to anyone. The truth is people like myself are investing town pension money and you try to do the best you can. Who would have thought. You can't expect pension board members to know the in and out of every fund. You get quarterly reports and you ask questions. A lot of it is getting the diversity right," LaBelle said.

Stratford Town Councilman Joseph Kubic, R-9, is the chairman of the town's Pension Board.

He said the recent Madoff crisis is a "frightening example of what can happen because pension boards are comprised of mostly people who know very little about how to invest pension funds."

"These boards are made up of citizen volunteers with virtually no in-depth knowledge of the world of stock and bonds investments. This scandal must serve as a reminder that these investments must be made very carefully and conservatively, and only after consulting with experienced financial experts," Kubic said.

"It was a relief to know we had none of our investments tied up with [Madoff]," Kubic added.

After reading this article, you might might not be surprised to find out that three local public pensions for Houston government employees have declined by a combined $1.9 billion in value since the beginning of the year.

But what about those massive public pension funds in Canada and elsewhere which are comprised of board members with years of experience who get paid for their expertise? It turns out they didn't fare much better than those other boards made up of laypeople.

Moreover, some laypeople exercised a lot more caution when sitting on these boards than more "sophisticated" board members who took undue risks by blindly following the pension herd into alternative investments. They all got burnt this year.

And now that the Madoff scandal broke, expect a serious crackdown on hedge funds:

Half a dozen lawsuits have been filed by Madoff investors, mainly focusing on the failure of due diligence by the middlemen, such as hedge fund of funds, which channelled money to Madoff.

Paul Kanjorski, a top Democratic Congressman, on Monday said a hearing would be held next Monday to examine the alleged fraud and how it went undetected for so long.

The affair is likely to lead to a crackdown on due diligence by fund of funds – which hold more than 40 per cent of hedge fund money – according to hedge fund marketers and advisers.

Switzerland’s Union Bancaire Privée, the second-biggest fund of funds, last week said it would require funds in which it invests to use independent administrators.

One hedge fund adviser, who looked into investing with Madoff and declined, said: “This is just the start. Third party administrators, greater transparency in investments, more regulatory oversight – we can expect them all.”

Mr Madoff did not use a third party administrator – an independent company that values fund assets and creates investor statements. Many in the industry consider a requirement for an independent administrator to be best practice, but it is not widespread.

The scandal also highlights a gap in regulatory supervision and is likely to fuel fresh calls for oversight of hedge funds.

Yet despite the debacle in hedge funds this year, punctuated by the Madoff scandal, public pension funds aren't writing them off, at least not yet:

Chief investment officers for pension funds note that despite some worrisome drawbacks, hedge funds continue to outperform stocks, and by a good margin. Hedge funds are down less than 18% this year, while the Standard & Poor's 500 index has dropped close to 41%.

Huh? Since when did hedge funds cease to be absolute return vehicles and turn into relative return vehicles? If you want beta, you can obtain it for a fraction of the cost with zero risk of redemption withdrawals when systemic risk hits the markets!

Keep in mind that most pension funds that invest in hedge funds use a portable alpha strategy where they swap into traditional bond and stock indexes to invest the proceeds in hedge funds that were suppose to be non-correlated to traditional asset classes.

For example, say a $100 billion pension fund invested 10% of its assets in hedge funds using this portable alpha approach, it would pay Libor + a few basis points to swap into traditional bond and stock indexes and use the cash proceeds to invest in hedge funds.

If the hedge funds consistently produced T-bills + 500 or 700 basis points (the typical benchmark for pension funds' investing in hedge funds) with little or no correlation to traditional asset classes (ie. no beta, pure alpha), then they would add 50 to 70 basis to the overall pension fund returns each and every year. Although this does not sound like a lot, the cumulative effects increase the likelihood that the pension fund will meet its actuarial rate of return, which is an absolute return figure.

But all this breaks down in an environment where systemic risk hits and both traditional and alternative investments get clobbered. Worse still, for alternative investments, there are extra costs (management fees) and the cost of illiquidity.

That is why I have a hard time swallowing this line that hedge funds are down double digits but they outperformed mutual funds and the stock market. So what? The bottom line is that they are paid huge performance fees which should kick in once they start returning above T-bills.

The fact is that most hedge funds failed to deliver this past year which is why they are facing the wrath of investors who are redeeming. Some hedge funds put up gates and are freezing withdrawals, but they are only trying to buy time, delaying the inevitable.

And if you think hedge funds are going to get slaughtered, wait till you see what's going to happen with private equity and real estate funds. Indeed, most private equity groups face tough choices:

For Philip Davidson, head of European restructuring at KPMG, the speed with which recession has hit Britain reminds him of “Looney Tunes” cartoon characters like Road Runner and Wile E. Coyote.

“A year after we started to hear about the credit crunch, the economy ran off the edge of a cliff,” he says. “But like the Road Runner we kept on going, with the legs still spinning. But then in September we started to plunge towards the ground.

“That’s different from the past recession and it’s taken a lot of people by surprise.”

One of the groups caught out is private equity. The lack of availability of debt financing has not only made it difficult for private equity funds to put new deals together, it has also made it tougher for the companies in private equity portfolios to deliver targeted returns.

This, in turn, increases the reluctance of private equity backers to put money into underperforming funds.

Mr Davidson says: “The extent to which their portfolio companies have begun to feel the effect of the loss of top-line growth has had a rapid impact on a lot of private equity groups. There are a number of private equity companies we believe that are facing portfolios that are not going to be able to deliver the returns they promised.”

That is likely to lead to a rise in bank lenders forced into debt-for-equity swaps, he says, reflecting a realisation by banks that, since the last recession, they believe that they will have to take stakes in companies and engineer a turnround.

Moreover, unlike the past, private equity must now prove its value, leading Felix Salmon to ask what happens when private equity companies fail:

What happens when a private-equity shop fails? Boston Consulting Group thinks that will happen a lot in coming years:

The consultants expect 50% of all companies backed by private-equity funds to default on their debt; as many as 40% of buyout firms to shutter their own operations and only around 30% of partnerships to survive intact through the next few years.

A private-equity shop which loads up its portfolio companies with too much debt naturally stands to lose control of those companies if and when it fails to service the debt. That's not a major problem, especially if the companies in question have good businesses: if done well, bankruptcy doesn't mean closing down, it just means a change of ownership.

But what happens when the PE shop itself closes down? Who manages the portfolio companies which haven't gone bust? Do they just get liquidated or sold off in fire sales, with the proceeds then given to the limited partners? That could be very bad indeed.

But with their portfolios underwater and little prospect of performance fees in the future, it's easy to see why the general partners might want to give up the hard work of running their portfolio companies and retire to an island somewhere instead on all the money they've trousered thus far.

The same can be said about private real estate funds where the current spate of retailer bankruptcies and those expected in the new year - along with still-healthy companies limiting or stopping their expansions - could have a ripple effect on the commercial real estate market:

Burt P. Flickinger, managing director of New York consulting firm Strategic Resource Group, expects 2,000 to 3,000 U.S. malls and shopping centers to close in March and April.

General Growth Properties Inc., the nation’s second-largest shopping mall owner, already is in trouble. The cash-strapped Chicago company, which owns the Natick Collection and manages Boston’s Faneuil Hall Marketplace under a lease with the city, in mid-November warned of a possible bankruptcy filing it if couldn’t refinance $900 million in debt. It’s now trying to sell its management rights for Faneuil Hall management rights along with two properties in New York and Baltimore.

“The easiest way of looking at which shopping centers or (real estate investment trusts) are real cause for concern for potential reorganization would be any whose stock has declined 80 or 90 percent or whose stock is trading in the $1 to $5 range,” Flickinger said.

Normally, the large banks and financing companies would have adequate funds to “backstop” the REITs and other retail center owners. But so many retailers and property owners are either “retracting or collapsing” at the same time that there’s insufficient credit to save every one, according to Flickinger.

“It’s a natural falling out,” he said.

The United States had twice as much retail selling space than any other industrialized nation at the end of the 1990s. And since then, it’s added 50 percent more selling space to an already over-stored situation. Led by Wal-Mart, the nation’s top eight retailers alone built more than a billion square feet of selling space in the last decade.

The commercial real estate market could take as hard a hit as the residential real estate market did under the mortgage crisis, according to Michael Tesler, founder of Retail Concepts, a Norwell-based retail consultancy.

“Landlords are going to face a difficult reality,” Tesler said. “They’re going to have to adjust their rents, and they’re going to have a real tough time filling vacancies going forward.”

Guess who else is going to face a difficult reality? Pension funds who invested heavily in alternative investments and are now stuck trying to figure out how the hell they're going to get out of this mess.

I wish them luck because they are all ill-prepared to confront the massive challenges that lie ahead and many are perpetuating the same mistakes that got them into this mess in the first place, acting like novices running pension funds.

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