Friday, April 5, 2013

The Secret Pension Money Grab?

Edward "Ted" Siedle of Fortune reports, Rhode Island Public Pension 'Reform' Looks More Like Wall Street Feeding Frenzy:
According to Institutional Investor, Rhode Island Treasurer, Gina Raimondo is at work solving the nation’s retirement dilemma, showing how tough public pension reforms can pay fiscal and political dividends.

Don’t believe a word of it.

A look behind the curtain reveals her changes to the investment portfolio of the $7 billion Employee Retirement System of the State of Rhode Island will inevitably dramatically increase both risk and fees paid to alternative investment managers, such as hedge funds and private equity firms.

There’s no prudent, disciplined investment program at work here—just a blatant Wall Street gorging, while simultaneously pruning state workers’ pension benefits. It’s no surprise that some of Wall Street’s wildest gamblers have backed her so-called pension reform efforts in the state legislature. Former Enron energy trader emerges as a leading advocate for prudent management of state worker pensions? That’s more than a little ironic.

What’s happened to date in Rhode Island is unprecedented in public pension history and, given the myriad risks involved, should be setting off alarms: A little-known money manager hired by the state’s pension to manage a paltry $5 million succeeded in getting herself elected as state Treasurer. That means she’s now responsible for overseeing the entire $7 billion.

Essentially, there has been a coup—the foxes (money managers) have taken over management of the henhouse (the pension). To make matters worse, she’s an unproven veteran of the “alternative” investment industry—the hallmark of which is a profound lack of transparency.

Here are more concerns I’ve identified related to the state’s pension that should, in my opinion, be keeping Rhode Island taxpayers and state workers participating in the pension awake at night:

Revolving-doors. “Revolving-door” concerns regularly arise with respect to hiring at government agencies and involve an individual from the regulated industry either assuming the position of regulator or a regulator leaving to join the industry he or she formerly regulated. The State Treasurer has her own revolving door baggage, as does the former CIO of the pension who recently left to join an alternative investment manager—following significant hires of alternative managers by the pension. He is being replaced by a former managing director of hedge fund research at JP Morgan. (Full disclosure: I recently reviewed some JPM hedge funds on behalf of two charitable clients and was less-than-thrilled with the out-of-this-world fees and conflicts of interest I discovered.)

Performance of Point Judith II. The pension committed $5 million in 2007 to a Point Judith II venture fund managed by the soon-to-be Treasurer. Someone should take a close look at the merits related to the decision to invest in Point Judith II, e.g. the track record of the venture manager, or fund; how the investment partnership performed (audited financials) after purchase by the pension and how Rhode Island is treated vis-à-vis the other investors in the fund at redemption/liquidation. It appears that the state pension stopped disclosing the names of its private equity holdings on its website after October 2012. That’s the last time Point Judith II shows up as a private equity holding.

25% Illiquid Investments. Pension statements I reviewed indicate that 25% of the assets are invested in alternatives that are illiquid, which includes equity hedge funds, real estate, real return and private equity. That’s massive risk.

Uncertain Valuations. The 25% of the portfolio invested in alternatives is valued based on mere appraisals, versus readily ascertainable market values. Notes to the financial statements indicate that the pension relies upon the general partners of these alternative investment funds to estimate the value of the partnership investments. Bad idea. What are these assets really worth if they had to be sold quickly—in a forced liquidation? Answer: a lot less. The pension admits, “Fair value is the amount that a plan can reasonably expect to receive for an investment in a current sale between a willing buyer and a willing seller – that is, other than a forced liquidation sale.”

Of course, since the investment performance of alternative assets quoted by the pension is based upon appraisals provided by the managers themselves—managers who are subject to a conflict of interest since they are paid largely based upon performance—the performance of these alternatives is inherently as unreliable as the appraisals.

Gorging on Opaque, High-Risk, High-Cost Investments. If alternatives assets were 25% of the portfolio at year-end, how high will the allocation to alternatives go over time - 40% - 50%?

The pension recently hired 18 more hedge fund managers, greatly increasing operational and investment risk, and dramatically increasing investment management fees. Picking a new CIO for the state pension from the hedge fund industry certainly suggests that more hedge fund investing is in the cards. Just how much investment fees are increasing is unclear because, last I looked the asset-based and performance fees weren’t being fully disclosed. The operational risks related to alternatives are not well-understood, even by industry veterans. With such a massive allocation to alternatives, the pension had better have a cutting-edge knowledge of these risks and be prepared to handle them. I don’t see anything that leads me to believe the pension is rationally assessing these investments.

Reporting of Performance of Alternatives. It appears that a HFRI Fund of Funds Index is being used to benchmark hedge funds—i.e., funds which are not fund of funds. Using a hedge FOF index (that’s easier to beat on a net basis because it involves far greater fees than hedge funds) is inappropriate, in my opinion. Hedge fund performance should be compared against a more appropriate benchmark, such as the S&P 500 plus, say, a 5% operational risk premium.

Engage Rhode Island Contributors. Any connection, direct or indirect, between the pension and donors to this tax-exempt political organization backing the Treasurer should be investigated, in my opinion. The lack of transparency and regulation related to alternative investments gives rise to almost endless possibilities for abuse and I’ve learned to expect anything.

“The cost of public employee benefits in most states and communities is unsustainable,” says the foundation’s website. Not-so-sure about that; on the other hand, it is well-established that the cost and any short-term outperformance of hedge funds are unsustainable. The cure for unsustainable pensions is unsustainable investing?

Undisclosed or Illegal Placement Agent Fees Related to Alternative Investments. Given the pervasiveness of placement agent fees and the number of alternative investments, it is likely undisclosed placement fees were paid here, in my opinion. For example, D.E. Shaw in which the fund invests discloses, “Placement agent activities of the D. E. Shaw group are conducted in the United States through D. E. Shaw Securities, L.L.C., which is registered as a broker-dealer.” Has anyone asked the managers whether any placement agent fees were paid? If so, the SEC might want to know about it.

I’m all for public pension reform—prudent contributing and investing coupled with sustainable benefits. However, when alternative investment managers take control of a state pension and recklessly dump pension assets into high-cost, high-risk alternative investments, while they slash workers’ benefits, that’s no reform. Call it what it is: a money grab.
Siedle raises many valid concerns in the article above. The most important is when you hire a CIO from the alternatives industry who expands allocations into hedge funds, private equity, and real estate funds, the fees paid out are astronomical, as are the potential conflicts of interest.

Siedle is also right to point out that pensions are taking on too much illiquidity risk, and worse still, many are doing it via funds of funds getting hammered on double layers of fees. As far as valuations, he's right that these illiquid investments should be valued by an independent third party, not just the GPs. The allocation to illiquids -- 25% -- is high but within the norm of other U.S. state pension funds.

As far as hedge fund benchmarks, he notes that HFRI Fund of Funds Index  is easier to beat on a net basis because it involves another layer of fees. I'm not sure this is correct but I can tell you Siedle's suggestion of using the S&P 500 plus a 5% operational risk premium is just plain silly.

My biggest beef with the HFRI Fund of Funds Index is that it measures the performance of far too many hedge funds, most of which are just plain lousy. That is the same problem institutional investors run into when using some private equity fund of funds benchmark.

In theory, hedge funds should deliver uncorrelated absolute returns on a consistent basis and truly hedge downside risk. A benchmark of  T-bills + 500 basis points is more appropriate but the reality is most hedge funds cannot deliver this on a consistent basis. And many of them claim they "hedge" but when markets turn south, they experience serious drawdowns and still collect a nice 2% management fee, which is significant for large funds managing billions (performance fee kicks in once they pass their high water mark).

Rhode Island's public pension fund isn't the only one running into problems with alternative investments. Michael Corkery of the WSJ reports, Pushing for a Peek at Pensions' Secrets:
When Utah State Auditor John Dougall started looking into the investment assumptions of his state's $20 billion pension fund, he was surprised by what he found.

The pension fund bars the public from attending its meetings and doesn't disclose many of the hedge funds in which the retirement system for public employees invests.

"I contend they should be more transparent than they are," said Mr. Dougall, who is urging Utah lawmakers to open up the pension's books and meetings to the public.

Utah pension officials say the state's open-meeting and -record laws don't apply to the retirement system. In fact, it was a big selling point with some hedge funds that agreed to manage money for the Utah Retirement Systems, said executive director Robert Newman.

While Utah's privacy is extreme (most other state pension plans have open meetings), the state isn't alone in shielding investment information from the general public and even its own members.

Disclosure practices by public pensions are drawing renewed attention after federal regulators last month charged the state of Illinois with securities fraud for failing to inform bond investors about the dire condition of the state retirement system. The state agreed to settle the charges without admitting wrongdoing.

Last month, federal prosecutors announced criminal charges against a former Calpers chief executive that exposed the sometimes-murky relationships among pensions, so-called alternative investments such as private-equity and hedge funds, and the placement agents that serve as middle men between the parties.

Many details about private-equity investments by the California Public Employees' Retirement System, also known as Calpers, and other public employee pensions in California remain shielded from the public. Private-equity investment often involves the restructuring of nonpublic companies to boost returns. Keeping the companies' financial information private can give them a competitive advantage and increase profits, pensions officials say.

Calpers discloses the private-equity funds in which it is invested, the amount of the investments and the funds' performance.

But the underlying portfolio companies of its private-equity funds are exempt from public disclosure laws. Also exempt are due-diligence material that pension officials collect when vetting particular investment opportunities.

Other states, including Texas, have formed similar exemptions. Many pension officials had to agree to shield information or lose access to private-equity funds that they are counting on to help them hit investment targets.

In February, state lawmaker Kevin Mullin, a South San Francisco, Calif., Democrat, introduced a bill that would extend similar privacy protections to real-estate investments by pensions.

Critics say the proposed legislation could prevent the public from properly scrutinizing real-estate deals. A Calpers spokesman says the fund is still reviewing the bill.

"They want to build big buildings in L.A. and keep key information about the deal secret?" asks Peter Scheer, executive director of the First Amendment Coalition, a nonprofit group that opposes the bill. "It's hard to think of a category of investment more fraught with opportunities for…corrupt dealings than real-estate development."

Pension officials say they are trying to balance accountability to the public with protecting sensitive investment ideas, and Mr. Mullin's office says it is working with free-speech advocates to find ways the bill can be amended to address transparency concerns.

Even freedom-of-information advocates such as Mr. Scheer say some secrecy is reasonable, particularly relating to venture-capital funds that invest in highly competitive technology companies. If competitors obtain sensitive details about pension investments, it could dent the funds' returns.

The tug of war over pension transparency has also intensified in South Carolina. State Treasurer Curtis Loftis has been pushing the investment commission overseeing the state retirement system to release more information about fees paid to outside money managers.

"There is this fetish for confidentially at these pension funds," said Mr. Loftis, who sits on the commission. "They don't want prying eyes to have access to this information."

In February, Mr. Loftis threatened not to fund an initial capital call on a $50 million commitment to private-equity firm Warburg Pincus LLC unless the commission agreed to give his office a printed contract for the deal.

Most commission members view private-equity contracts using a password-protected website. Mr. Loftis says he wants hard copies so his staff can review them. The commission agreed to print out the Warburg contract, but only for the treasurer to view. It wants his office to sign a nondisclosure agreement for any printouts that would be shared with his staff.

Separately, the commission in February censured Mr. Loftis for engaging recently in what it called "false, misleading, and deceitful rhetoric" about the investment commission. Mr. Loftis called the move a "public ambush."

In Utah, the state retirement system has kept its meetings and many of its money managers private without much controversy for decades. Part of that may be explained by the fund's solid investment performance and healthy funding level of about 79% of its liabilities, above the nationwide average of about 75%. The fund's 10-year annual return is 8.3%, which exceeds its target of 7.5%. "I am not aware of any other system in the country with such a high level of protection," says state audit official Dave Pulsipher.

Utah pension officials say the retirement system has been exempt from open-records and -meeting laws since its inception in the 1960s because it functions as a trust, not a typical public agency.

"We are not doing the public's business," said Mr. Newman, the pension's executive director.

Mr. Newman says that, if the pension has to fully comply with state public-disclosure laws, it could jeopardize its relationship with hedge funds and other so-called "absolute return" money managers, which make up 15% of the pension fund's defined-benefit investments.

Many hedge funds agreed to do business with Utah partly because the pension was exempt from disclosures, Mr. Newman said. In some cases, the exemption has allowed the pension to gain access to detailed information about the hedge funds' investment positions, helping Mr. Newman and others assess risks.

The pension fund plans to work with the state legislature over the next few months studying ways it might increase disclosure. Mr. Newman said he wasn't opposed to opening up portions of the pension-board meetings to the public.
I read this article and can tell you Curtis Loftis is fighting a lonely but valiant battle. While South Carolina is throwing in the towel on alts, there is no doubt in my mind that fast times in Pensionland continue unabated.

Importantly, as I've stated plenty of times before, the real crisis in U.S. public pension funds isn't their pathetic funded status, it's their lack of proper governance. In most cases, they pay peanut salaries and get monkey results which only come to the forefront when a financial crisis hits, exposing their flawed investment strategies and flimsy governance.

As far as striking a balance between public disclosure and investment results, there are plenty of ways to do this properly using an independent third party administrator and timely risk reporting. The Ontario Teachers'  Pension Plan uses a managed account platform for their hedge funds and they are doing just fine investing with some of the world's best managers.

Utah's audit of the state retirement system is important but it isn't enough. Importantly, a financial audit isn't the same thing as a performance audit by an independent third party. Are the benchmarks correct? Is the due diligence done properly? Are there conflicts of interest with GPs or pension consultants? Is there enough disclosure on a timely basis? Are the risks taken appropriate or do they imperil the plan? Is the investment staff competent enough to understand these risks? Are risks of fraud being mitigated? These questions and more are typically not covered in the standard financial audit.

Leave you with three clips, two of which are embedded below. First, KUTV News reports that Utah's State Auditor Jon Dougall thinks 7.5 percent target rate of return is too optimistic. He says expectations should be lowered and I agree. Retirement officials say they have made more than 8 percent in the past, and they think they will in the future too, but such rosy investment assumptions will require taking on more risks in alternatives, which will likely come back to haunt them. And God forbid, what if 8% is really 0% in the future?

Second, Bloomberg Law's Lee Pacchia and Bloomberg News bankruptcy columnist Bill Rochelle discuss how although Stockton, California established the right to be in a Chapter 9 municipal bankruptcy, the judge warned the city that victory may be short-lived if bondholders prove that pensioners must take a haircut along with other unsecured creditors.

Lastly, Jim Spiotto, a partner at Chapman & Cutler LLP, talks about Stockton, California’s bankruptcy. He speaks with Erik Schatzker and Scarlet Fu on Bloomberg Televisions "Market Makers."