The Big Alternatives Gamble?
When you think of the term “public pension fund,” you probably imagine hyper-cautious investment strategies kept in check by no-nonsense fiduciary laws.
But you probably shouldn’t.
An increasing number of those pension funds are being stealthily diverted into high-fee, high-risk “alternative investments” that deliver spectacular rewards for the Wall Street firms paid to manage them – but not such great returns for pensioners and taxpayers.
Citing data from the National Association of State Retirement Administrators, Al Jazeera America recently reported that “the average portion of pension dollars devoted to real estate and alternative investments has more than tripled over the last 12 years, growing from 7 percent to around 22 percent today.” With public pensions now reporting $3 trillion in total assets, that’s up to $660 billion of public money in these high-fee, high-risk investments.
And yet… despite the fact that they deal with the expenditure of taxpayer money, the agreements between public pension systems and alternative investment firms are almost entirely secret.
Until now.
Thanks to confidential documents exclusively obtained by Pando, we can now see some of the language and fee structures in the agreements between the “alternative investment” industry and major public pension funds. Taken together, the documents raise serious questions about whether the government employees, trustees and politicians overseeing major public pension funds are shirking their fiduciary responsibilities under the law when they are cementing “alternative” investment deals.
The documents, which were involved in a recent SEC inquiry into the $14.5 billion Kentucky Retirement Systems (KRS), were handed to us by SEC whistleblower Chris Tobe, an investment consultant and former trustee of the KRS. Tobe has also written a book — “Kentucky Fried Pensions” — about the scandalous state of the Kentucky public pensions system.
The documents provided by Tobe (embedded below the Pando article) specifically detail Kentucky’s dealings with Blackstone – a giant Wall Street investment firm which has deployed a platoon of registered lobbyists in Kentucky and whose employees are major financial backers of Kentucky U.S. Sen. Mitch McConnell (R).
The Blackstone-related documents, though, don’t just tell a story about public pensions in Kentucky. The firm, which just reported record earnings, does business with states and localities across the country. The Wall Street Journal reports that “about $37 of every $100 of Blackstone’s $111 billion investment pool comes from state and local pension plans.”
In one set of documents provided by Tobe, Blackstone’s payment structure is outlined, with language guaranteeing that Blackstone will receive its hefty annual management fees from the taxpayer – regardless of the fund’s performance.
In other documents, public pension money is exempted from some of the most basic protections usually guaranteed under federal law. Other contract language appears to license Blackstone to engage in financial conflicts of interests that could harm investors.
Despite the documents involving government agencies, and taxpayer money, they are all marked confidential. The public is not allowed to see them.
Tobe says the sheer size of Blackstone – and its attendant ability to set industry standards - means that the documents he obtained represent a story that goes way beyond one state.
“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 language that is almost certainly standard in the contracts that so many other pension funds have been signing… This is a national problem.”
Blackstone’s “Fund of Funds”: Up to $200M a year in fees and underperformance that can harm taxpayers
One of those documents given to Pando by Tobe is a confidential memo to KRS investment committee members from August 2011. In the memo, KRS staff outlines their desire to invest roughly $400 million in Blackstone’s Alternative Asset Management Fund (BAAM), which is a so-called “fund of hedge funds.”
As documented on page seven of that memo, Blackstone was guaranteed whopping fees of 50 basis points plus 10 percent of any overall profits on retirees’ money. In addition, the memo estimates 1.62 percent management fees and 19.78% incentive fees to be paid on top of the Blackstone fees to the underlying (and undisclosed) individual hedge fund managers in the “fund of funds.”
Pension officials made the decision to invest in the fund despite Blackstone then reportedly being under SEC investigation. According to KRS’s latest annual financial statement, Kentucky now has more than half a billion dollars invested in BAAM.
In 2013, according to KRS data, BAAM earned an 11.54 percent return for the pension system. That was 20 percent below the S&P 500 that year, meaning, Tobe says, that Kentucky taxpayers would have earned $78 million more in an almost fee-less S&P index fund. Those figures are consistent with a recent study from the Maryland Public Policy Institute showing “that state pension systems that pay the most for Wall Street money management get some of the worst investment returns.”
Fees, says Tobe, are a driver of the underperformance. Using the secret memo’s figures, Tobe estimates that 33 percent of that stunning one-year underperformance - or about $25 million – was in the form of fees paid to Blackstone and the other managers in its “fund of funds.”
According to data from the investment research firm Prequin, 20 others public pension funds are also invested in BAAM. Assuming those funds invested in BAAM under roughly the same terms as Kentucky, Tobe estimates that Blackstone and underlying managers in BAAM raked in well over $200 million in fees in 2013 on just that one fund of funds.
Absent from the memo to the trustees are any details about which particular hedge funds are in the BAAM fund. In an interview with Pando, Tobe argues that was by design because, he says, Kentucky officials wanted trustees to vote on the investment without being able to do due diligence. Tobe says that meant trustees were not made aware that BAAM invested in SAC Capital – the firm whose executives recently pled guilty to insider trading charges, and who at the time of the Kentucky investment were already under SEC investigation.
“The crack cocaine of the private equity industry”
Other documents obtained by Pando detail Blackstone’s separate private equity fund, Blackstone Capital Partners V, which the New York Times describes as “the biggest private equity fund in history.” Prequin data show that public pension systems in 24 states have made $6.5 billion worth of investment commitments to this one private equity fund.
According to KRS’s 2013 annual report, the Kentucky pension system has $81.1 million in that and one other Blackstone private equity fund.
One document prepared by the investment consulting firm Strategic Investment Solutions shows that in Capital Partners V, Blackstone is guaranteed management fees of between 1 percent and 1.5 percent, depending on the size of the investment. Attached to that document is another Blackstone document in which the company presents its past track record. In fine print at the end of that second document, the company declares that it does not make “any representation or warranty, express or implied, as to the accuracy or completeness of the information.”
Public pensions are typically bound by the so-called “prudent person rule”. Investopedia explains that this rule, which is enshrined in many state statutes, requires public pensions to avoid “shady, risky, or otherwise poor investments.” The Organization for Economic Cooperation and Development says it operates in the United States to require “that unwarranted risk be avoided” in favor of a “culture of cautious behavior among pension” overseers.
Yet, a document detailing investment contract language for investments in Blackstone Capital Partners V appears to show quite the opposite. Marked “Risk Factors and Potential Conflicts of Interest,” the document outlines major risks for public pensions – the kind of risks that are rarely ever disclosed to the public.
For example, the document shows Blackstone admitting that investing in the fund “involves a high degree of risk”; that “the possibility of partial or total loss of capital will exist”; that “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.” Additionally, the document says investments made by the fund could subject investors to “certain additional potential liabilities” and that an investor “may be required to make capital contributions in excess” of what it originally pledged.
Amazingly, while asking public pension trustees to invest money in the fund, the Blackstone document also says that “none of the Partnership’s investments have been identified,” meaning trustees could not even evaluate the underlying investments before they decided to invest retirees’ nest eggs.
In terms of legal protections, the document says investments made by the private equity fund could be illiquid “for a number of years.” In a section marked “absence of regulatory oversight,” the document also says investors “are not afforded the protections of the 1940 (Investment Advisers) Act.” It also says that in the event of litigation brought against the managers of the fund, those costs “would be payable from the assets” of the investors.
Then there are the carve-outs for financial conflicts of interest. One section of the document declares that “Blackstone has long-term relationships with a significant number of corporations and their senior management” and that when making investment decisions, Blackstone “will consider those relationships.” Another section declares that “Blackstone may have conflicting loyalties” between the different funds it operates, and that “actions may be taken for the Other Blackstone Funds that are adverse” to investors.
According to former SEC investigator Ted Siedle, who served as counsel to Tobe during the SEC investigation, the conflict-of-interest section marked “Fees for Services” is particularly problematic. He says it permits private equity managers to assess fees on companies the private equity fund owns, but then not compensate the fund investors (like public pensions) for those fees. This stealth fee-inflating practice, which is attracting SEC scrutiny, has been called the “crack cocaine of the private equity industry.”
An official with the American Federation of Teachers, whose members are relying on pension investments, told Pando that the disclosures of huge fees and potential conflicts of interest may put pension trustees at odds with the law.
“Trustees risk violating their fiduciary duty if they don’t aggressively confront fees and potential conflicts of interest in the investment chain,” said Dan Pedrotty, AFT’s Director of Pensions & Capital Strategies.
More generally, critics of various political stripes say that while the risks outlined in the Blackstone private equity documents may be acceptable for individuals acting with their own money, they may be too perilous for public pensions, especially when a larger and larger portion of those pensions’ portfolios are in such private equity investments.
For instance, citing data from Wilshire Consulting, conservative American Enterprise Institute scholar Andrew Biggs says these kinds of dangers make alternatives “60% riskier than U.S. stocks and more than five times riskier than bonds.” Time Magazine’s Rana Foroohar reports that a recent conference of liberal scholars said the possibility of catastrophic losses mean “pension funds shouldn’t be in high-risk assets” and “should be mainly invested only in no or low fee index funds.” And both the Government Accountability Office and Siedle have raised questions about the risks inherent in private equity’s opacity and illiquidity.
Money, political influence and the alternative investment craze
In recent months, questions have been raised about why pension funds are investing so heavily in high-fee, high-risk alternative investments. For example, a New York Times report recently noted that “a number of retirement systems that have stuck with more traditional investments in stocks and bonds have performed better” than those investing heavily in alternatives. Similarly, Bloomberg News reported that “more than half of about 400 private-equity firms that SEC staff have examined have charged unjustified fees and expenses without notifying investors” of such fees.
Pension analyst Leo Kolivakis says public pensions – read: public employees and taxpayers – are among those facing the biggest downside.
“Despite hedge funds having suffered the worst performance start to the year since 2011, industry assets hit a new peak of $2.7 trillion thanks to healthy net inflows,” he recently wrote. “And who is leading the charge? Who else? Dumb public pension funds getting raped on fees.”
The question, then, is why. When The Economist magazine reports that “the average return of hedge funds has lagged a plain-vanilla portfolio (in) nine of the past ten years,” why are pension funds dumping so much cash into high-fee hedge funds? When none other than Warren Buffett is telling his own trustee to only invest his money in government bonds and cheap index funds, why are public pension officials nonetheless putting retiree money into high risk private equity firms? In short, why have public pension funds been so aggressively moving money into these alternative investments?
One part of the answer may have to do with a misguided effort by pension administrators to bet big on ever-more risky investments in hopes of earning outsized returns and more quickly closing revenue shortfalls. That, though, may be creating more problems. As a 2013 study by the International Monetary Fund showed, severely underfunded pension plans have “increas(ed) their risk exposures” ultimately “exposing them to greater volatility and liquidity risks.”
Tobe says the Kentucky Retirement Systems fits this description. He points out that according to KRS financial statements, Kentucky invests an above-average 34 percent of its assets in “alternatives.” That strategy last year delivered roughly 12 percent returns for KRS – far below the 16 percent median for public pensions. The high fees involved in such “alternatives” may help explain, in part, why a December 2013 KRS presentation (embedded below) shows the pension system is now just 23 percent funded – a rate that Tobe says is one of the worst in America.
That said, another reason why pension funds have moved into risky high-fee investments may have to do with political influence and campaign cash from the Wall Street firms that stand to benefit from the alternative investment craze.
While a spokesperson for Blackstone told Pando “I am not aware of any (Blackstone lobbyists) in Kentucky,” government ethics disclosures show Blackstone and companies Blackstone funds own actually employ 11 lobbyists in the state (when shown the disclosure forms, the spokesperson subsequently insisted that “these are not lobbyists but internal investment professionals who work with our clients on their investment objectives”).
Among the lobbyists is one from Park Hill Group, the Blackstone-owned firm whose website describes it as “a placement agent providing placement fund services for private equity funds, real estate funds, and hedge funds, as well as secondary advisory services.”
As documented by Bloomberg News, placement agents often leverage political connections to convince public pension systems to invest in their clients’ funds. Because pension funds are barred from choosing investments based on such political considerations, the controversial placement business has periodically faced legal scrutiny, with some states and cities moving to crack down on placement agents. But, as evidenced by Kentucky and its relationship with Blackstone, many states still very much permit them. Indeed, according to Forbes, “Park Hill itself received $2.35 million for lining up business in Kentucky – for Blackstone funds.”
Of course, what can supercharge the influence of lobbyists and placement agents is the campaign contributions of their clients. So, for instance, according to data from the Center for Responsive Politics, Blackstone employees are among the largest campaign contributors to Kentucky’s chief political powerbroker, U.S. Senator Mitch McConnell (R).
Some of that money can filter directly the coffers of state parties that specifically run elections for positions involved in pension policy. For example, Blackstone employees are top contributors to a joint fundraising committee “McConnell Victory Kentucky,” which, according to the Louisville Courier-Journal, donates heavily to the Kentucky Republican Party.
The potential relationship between campaign money and pension policy is not limited to Kentucky. As USA Today reported back in 2009: “More than two dozen firms that have surfaced in a broad corruption investigation of public pension funds gave at least $1.97 million in campaign contributions to officials with potential influence over the funds’ investments.”
Blackstone and private equity trade association responseAs I wrote in the New York Times, the biggest problem plaguing U.S. public pension funds is lack of proper governance. Facing a public pension catastrophe, U.S. states are implementing many reforms but until they get the governance right, these reforms are cosmetic and will do nothing to bolster public pensions.
Pando requested comment from the Kentucky Retirement Systems 4 days before publication time, but KRS did not respond. However, representatives of the alternative investment industry did.
In response to the disclosures, Blackstone senior managing director Peter Rose told Pando: “Our funds have produced equity-like returns with bond-like volatility over a market cycle and have protected capital in down equity markets. We are proud of what we have been able to achieve for our investors in over two decades of investing.”
Additionally, the trade association for the private equity industry also responded to the disclosures. Acknowledging that “A majority of private equity investment comes from institutional investors such as public pensions,” Noah Theran of the Private Equity Growth Capital Council told Pando: “Research has consistently shown that private equity is the best performing asset class for pensions over the long-term, but as is the case with any investment, it is not without risk.”
A commitment to secrecy
When Pando asked for specific comment on whether agreements between Wall Street firms and taxpayer-backed public pensions should be available to the public, Rose said: “We are going to decline to comment on this.” Likewise, the Private Equity Growth Capital Council and KRS did not respond to questions about secrecy.
That response – or lack thereof – highlights how public pension transactions with Wall Street remain shrouded in secrecy in states throughout the country. As Susan Webber has written, despite the astronomical sums of taxpayer money and retirement income at stake, “public pension funds routinely turn down requests” for such basic information in hopes of shielding the fee bonanza from scrutiny.
For example, following SEC warnings of fee abuse in private equity investments, the New York state’s Teachers’ Retirement System flatly rejected Reuters’ open-records request for information about its private equity holdings.
In North Carolina, a recent report by Siedle found that thanks to a lack of transparency, “It is virtually impossible for stakeholders to know the answers to questions as fundamental as who is managing (pension) money, what is it invested in and where is it?”
In Rhode Island, the financial industry is a major donor to the election campaigns of State Treasurer Gina Raimondo (D), who has used her power to move more pension money into high-fee alternative investments. Many of those investments subsequently underperformed and hurt pension earnings, all while generating big Wall Street fees. When transparency and good-government groups asked for the full details of the alternative investments in question, Raimondo refused.
Meanwhile, when Pando requested details of the New Jersey state pension fund’s investment in a firm that is financially connected to the fund’s investment chief, the state government refused the request.
In Kentucky, the secrecy surrounding the pension fund has prompted Tobe to work with State Rep. Jim Wayne (D) on legislation proposing to crack down on placement agents, and to mandate the public disclosure of contracts between Wall Street firms and the pension system. Though Wayne is a Democrat, the bill was praised by the state’s major conservative think tank. And though the proposal was ultimately killed, Wayne says it provides a template for other states.
“This is a national problem and there’s just such a huge amount of money involved,” he told Pando. “Billions and billions of dollars are swirling around in these retirement systems, and there are people interested in capturing big shares of this money as they advise and direct how this money is invested. Clearly, there is a trust issue here with employees and pensioners. They have to trust that the system is being honest with them because their livelihoods are at stake. But they can’t trust a system that isn’t transparent.”
But as I recently discussed in my comment on the 1% and Piketty, capitalism isn't about openness, fairness, transparency and meritocracy. Capitalism is all about crisis, sabotage, secrecy and how the elite can screw the unsuspecting masses using any means necessary, ensuring inequality which they require to thrive.
Importantly, the power elite don't want better governance at U.S. public pension funds because that will spell the end of Wall Street's license to steal. And the name of the game is to legally steal as much as possible by raping investors on fees, keeping the details top secret. This is all part of Wall Street's secret pension swindle.
Having said this, I want to be careful here because I am not against alternative investments or paying fees to alternative investment managers who are performing exceptionally well. I just think it's high time institutional investors get beyond the hedge fund curse and slash fees wherever they can, especially to large, lazy asset gatherers collecting billions in management fees while ignoring performance altogether.
There needs to be a transparent discussion on fees doled out to large alternative investment managers and I hold the Institutional Limited Partners Association (ILPA) accountable for doing a lousy job on bringing the fees down and really scrutinizing the funds they invest with.
The best metric to gauge whether alpha fees are warranted is to look at the IRR of each and every investment (net of fees and all costs, including foreign exchange). If the IRR keeps sinking as money keeps flowing into a manager, there's a serious problem. And the IRRs in many of the largest alternative investment shops have been sinking as their assets soar to record levels.
Now, the article above takes shots at Blackstone, which is an easy target. But regardless of recent performance, Blackstone is an alternative investment powerhouse, which is the main reason why they garner a huge amount of business (useless investment consultants also help). Their fund of hedge funds, private equity and real estate funds rank consistently among the best of the best.
Does Steve Schwarzman use his political connections to garner more business for Blackstone? You bet your ass he does but I would do the same thing if I was in his shoes. Park Hill is one of many placement agents that should have been abolished a long time ago. And yet, the main reason Blackstone has thrived is because they are the best in the world at alternative investments, not because of Schwarzman's political clout (to think otherwise is just plain silly).
Also, there is another problem rarely discussed in these articles, although Sirota does allude to it. Unions don't want an increase in their contribution rates, effectively forcing public pensions to take on more illiquidity risk to make their unrealistic 8% bogey. This is why Bridgewater followed the Oracle of Omaha, and recently warned on the dire outlook for pensions. Too many stakeholders are smoking hopium when it comes to achieving realistic returns over the long-run. When deflation hits the global economy, exposing naked swimmers, my fear is a lot of U.S. public pensions praying for an alternatives miracle will get decimated.
Unfortunately, sticking everything into indexed stocks and bonds isn't the answer either (if it was that easy, we wouldn't need pension funds!). And the problem isn't alternative investments per se, the problem is the entire approach to alternative investments enriching the real wolves of Wall Street. Until U.S. lawmakers tackle pension governance in a serious way, with independent investment boards, proper compensation for public pension fund managers and increased scrutiny on their investments, holding them accountable for their investment decisions, nothing will change.
Lastly, don't forget the raging fire at Tampa's hot pension fund. It doesn't invest in any alternative investments and instead puts its entire money in the hands of one investment manager nobody has ever heard of. My point is fraud and risky business doesn't just happen in alternative investments, although these investments are more prone to it by their very nature, it can happen anywhere where pension fund managers yield too much power and their dealings go unchecked.
Below, Richard Johnson, senior fellow at the Urban Institute, discusses the best and worst state and local pension plans with Mark Crumpton on Bloomberg Television's "Bottom Line." You can read the study here but I am not in agreement with many of the assertions he makes, including the benefits of hybrid plans.
Also, Warren Buffett responds to some of his own recent quotes, including his feelings about corporate boards, CEOs operating outside their circle of competency, and issuing stock as an over-valued currency. He also talked about how too much disclosure is leading to outrageous compensation in corporate America and about times he and Charlie Munger have disagreed.
Buffett, Munger and Bill Gates all appeared on CNBC this morning discussing shareholder activism, tax reforms and slamming high speed trading. All this talk of whether the U.S. stock market is rigged is misguided and detracts attention away from more serious problems, like the big alternatives gamble and the lack of proper governance at U.S. public pension funds. Unless lawmakers tackle governance, the outlook for U.S. public pension funds remains dire, enriching Wall Street but hurting the overall economy.