Is the Alternatives Gig Up?
Public pension systems are collapsing across the country. In Chicago, Mayor Rahm Emanuel is under growing pressure to find a way to mitigate the city’s nearly $20 billion shortfall to its municipal retirement plan. The mayor’s plan to reduce workers’ benefits and raise property taxes — which would only resolve half of the deficit — has met with open opposition from the unions and taxpayer advocate groups. In San Bernardino, Calif., bankruptcy hearings for the city are stalled due to failing negotiations with its biggest creditor, the California Public Employees’ Retirement System. Difficulties in meeting payments to the system were a major factor forcing San Bernardino into bankruptcy.
The primary culprit behind this decline is the country’s shifting demographics. In 1960, there were five workers to every one retiree, providing a funding base that was able to maintain adequate monetization levels with the pensions. Seeing the pensions as a nearly uncollapsible financial structure, many politicians “borrowed” from the pensions to support underfunded government issues, such as infrastructure repairs and capital investment. As the “baby boomers” started to retire and as the ratio of workers to retirees dropped due to declining birth rates to 3 to 1 in 2009 — with the ratio expected to reach 2 to 1 by 2030 — the portion of unfunded obligations with the pensions has reached a point that many governments cannot effectively manage. In 2011, according to some estimates, state debt — including pensions — had reached $4.2 trillion.
It is estimated that the current average of 20 percent of municipal budgets allocated for pension management could hit 75 percent if current trends continue. To help reduce their unfunded obligations and to help inject more money into retirement funds, the managers of many municipal and state pensions have opted to do something that would have been entirely unthinkable 20 years ago — invest public pension funds into Wall Street’s “alternative” investment vehicles.
Based on data cited from the National Association of State Retirement Administrators by Al Jazeera America, 22 percent of the nation’s public pensions’ $3 trillion in total assets — $660 billion in public money — is being tied into high-fee, high-risk investments such as real estate and hedge funds. It has been alleged that these pension managers may have entered into “alternative” investment deals in which the fee structures, nature of the confidentiality agreements and structure of the investments themselves gave the “alternative” investment vehicle owners a significant advantage at the cost of the public.
Blackstone and Kentucky
In documents obtained by Pandodaily by Securities and Exchange Commission whistleblower Chris Tobe, the public was given its first chance to look at the language of these agreements. The documents reflect an SEC inquiry into the Kentucky Retirement Systems regarding “placement agent fees” — fees paid to investment “headhunters” to secure an investment by these governmental pensions with various brokers and hedge fund managers. In this particular case, KRS failed to disclose additional placement agent fees that existed on top of the already discovered $14 million in fees. This discovery suggests that inadequate and inappropriate safeguards for protecting the state pension exist, prompting questions over whether more undisclosed payments may have been delivered.
Tobe’s documents detail KRS’s dealings with Blackstone — a significant Wall Street investment firm and a major financial backer of Senate Minority Leader Mitch McConnell. According to The Wall Street Journal, “About $37 of every $100 of Blackstone’s $111 billion investment pool comes from state and local pension plans.”
According to the documents, Blackstone is guaranteed its annual management fee, regardless of the performance of the investment. In addition, the pension money is exempt from some of the protections guaranteed to other investment capital under federal law, including bans against Blackstone engaging in conflicts of interests — such as investing in companies Blackstone already has a relationship with — and assurances that damages sought against the fund managers will be paid from the fund’s assets themselves.
Additionally, even though these documents involve government agencies and public funding, they were marked confidential and hidden from public view.
“These agreements aren’t unique to Kentucky – they are everywhere,” Tobe told Pando. “They include exactly the kind of risk and boilerplate heads-I-win-tales-you-lose (sic) language that is almost certainly standard in the contracts that so many other pension funds have been signing… This is a national problem.”I've already covered the big alternatives gamble on my blog. I think there are a lot of misleading comments on alternatives being "very risky." The reality is hedge funds, private equity funds and real estate funds have much better alignment of interest with their investors because their fund managers have skin in the game and they target high risk-adjusted returns.
High risks, low returns
There is a certain level of recklessness in this kind of investment. One of Tobe’s documents contains a 2011 memo showing that KRS wanted to invest approximately $400 million in Blackstone’s Alternative Asset Management Fund. Blackstone was guaranteed 50 basis points — half of 1 percent of all investments — in fees, plus 10 percent of the overall profits, 1.62 percent in management fees and 19.78 percent in incentive fees on top of underlying and undisclosed individual hedge fund manager fees. The decision to invest in this fund was made at a time when Blackstone was facing repeated SEC investigations.
In 2013, Blackstone’s Alternative Asset Management Fund earned a 11.54 percent return. The S&P 500 earned a 32.39 percent return, meaning that if Kentucky would have invested in a low-fee basic S&P index fund, the state would have seen almost three times the profit, or approximately $78 million.
“There is simply no correlation between high money management fees and high investment returns,” said John J. Walters, co-author and visiting fellow at the Maryland Public Policy Institute. In a 2013 press release, the Maryland Public Policy Institute pointed out that the 10 states paying the most in Wall Street fees saw an annualized five-year return of 1.34 percent, while the 10 states paying the lowest fees saw a return of 2.38 percent.
“Retired state employees and taxpayers across the country are not getting their money’s worth,” it said. “They deserve a simpler, more effective investment strategy for their retirement savings.”
A broken system
This situation represents a confluence of heavy lobbying, campaign finance and failures in public disclosure. While some reports — such as Oregon’s pension fund reporting an average annual return of 15.8 percent over the last three decades on the back of private equity — have helped to sell the notion of alternative investment to states and municipalities, the lack of disclosure makes informed decision-making difficult.
In the case of Oregon, for example, much of the positive gain in the three-decade average happened during the tech boom of the 1990s. The drop in return after the tech bubble burst convinced Oregon to make up the difference through “alternative” investment.
With much of this “alternative” investment being based on high-risk instruments — corporate buyouts, distressed and unsecured debt, venture capital and mortgage derivative swaps — a lack of a clear understanding of what exactly is going on with the investment seems foolhardy. This is even more so when taking into account that the firms offering these investments also directly lobby the administrators and finance the campaigns of politicians charged with the oversight of these public funds.
Traditionally, public pensions work under the “prudent person rule,” which states that public pensions are to avoid “shady, risky or otherwise poor investments” in order to avoid unwarranted risks. But, with Blackstone admitting that investing in its alternative asset fund “involves a high degree of risk,” “the possibility of partial or total loss of capital will exist,” “there can be no assurance that any (investor) will receive any distribution,” and an investment “should only be considered by persons who can afford a loss of their entire investment,” one must question whether such investments protect the pensioners’ or the public’s best interests.
It's also important to mention that you need to look at the internal rate of return (IRR) of all investment activities, net of all fees and costs, including foreign exchange. It's not a perfect measure but that is one way to gauge the added-value of your external managers. There is no denying that even after fees, the very best hedge funds and private equity funds have delivered exceptional risk-adjusted returns for pensions, endowments and other institutional investors.
Having said this, there is a lot of hype in alternative investments and I am convinced that U.S. public pension funds praying for an alternatives miracle are going to get clobbered when the next crisis hits. And while alignment of interests are better with alternative investments, the reality is most big alternatives funds have become large, lazy asset gatherers relying more on the management fee, which they receive no matter how poorly the fund is performing.
This is why I recently commented that hedge fund gurus are way overpaid. Along with their private equity and real estate counterparts, they literally are the chief beneficiaries of the big alternatives gamble. Dumb public pension funds chasing yield are getting raped, paying billions in fees, making these gurus obscenely wealthy. The entire hedge fund model is skewed toward the big guys which is why they keep getting richer even if they underperform.
This is how it usually goes. A hedge fund starting off will focus solely on performance. Once they establish a three year track record and if they maintain great returns, money starts pouring in fast, first from funds of funds and then via useless investment consultants looking for the next big hedge fund. Once a fund starts managing more than $1 billion, that 2% management fee really looks good and if you manage hundreds of billions like Blackstone or Bridgewater, you're part of an elite group collecting billions in management fees for turning on the lights at your shop. It's a frigging joke!
As far as Blackstone, it is everyone's favorite alternatives whipping boy. Last week, Zero Hedge blog published a diatribe on how Blackstone is fleecing taxpayers via public pension funds. The moronic and anti-Semitic commentators on that blog blamed "the Jews" for everything wrong in the financial system and took shots at Blackstone's CEO, Steve Schwarzman (if it's not Schwarzman, they go after Carlyle's CEO, David Rubenstein, another towering figure in alternative investments).
While I understand why the lowlifes on Zero Hedge love demonizing Schwarzman, Rubenstein and other successful Jewish alternative investment fund managers, I think they're appealing to the lowest common denominator. The reality is Blackstone and Carlyle are alternative powerhouses and it's not just because of political connections. If they weren't delivering results, they would have never grown as rapidly as they did.
Don't get me wrong, I've already taken my shots at Steve Schwarzman and think he and his big private equity buddies made off like bandits after the last fiscal cliff deal, but there is simply no denying that Blackstone is the best alternative investment shop in the world and that they have added billions to public pension funds' portfolios. Schwarzman co-founded Blackstone with Pete Peterson, who being a wise Greek-American entrepreneur, walked away from the business back in 2009 after discovering the meaning of enough (my dad keeps reminding me of John Updike's famous quote: "Sex is like money; only too much is enough."
I happen to believe that there is a secular shift going on in alternatives. While the Blackstones, Carlyles and Bridgewaters of this world have grown exponentially, the gig is slowly coming to an end. When you see CalPERS chopping its hedge fund allocation, you know something is afoot.
But is the alternatives gig really up? Are pension funds finally waking up to the sad reality that more hedge funds and private equity funds means more fees and not necessarily better performance?
Don't hold your breath. The new asset allocation tipping point is still the religion being fed to public pension funds. Brokers and useless investment consultants are all recommending more alternatives, which means more business for them.
What needs to take place is a frank discussion on alternative investments, fees, and what the real risks, especially in illiquid alternatives, truly are. There also needs to be a frank discussion on the benefits of alternatives and the approach pensions take to invest in alternatives.
It's nice to say "we invest with Bridgewater, Apollo, Blackstone, KKR, Carlyle, etc." but what are you really getting for your money and would you have been better off investing elsewhere or using a different approach?
Below, Paul Levy, founder & managing director at JLL Partners, discusses the role of private equity in the pharmaceutical industry on Bloomberg Television’s “Market Makers.”