Pension Probe Tip of Private Equity's Woes

BusinessWeek reports that former federal pensions chief faces criminal probe:

The former head of the federal pension insurer inappropriately interfered in a contracting process that ultimately led to the hiring of Goldman Sachs (GS), JPMorgan Chase (JPM), and Blackrock to manage billions of dollars in assets and earn $100 million or more in fees, a federal watchdog concludes in a draft report distributed on May 14. BusinessWeek has learned that a criminal investigation into some of the allegations raised in the report has been requested by a group of senators and will begin shortly.

The report calls into question the process used to award contracts for managing some $2.5 billion in assets at Pension Benefit Guaranty Corp. The report's author, PBGC Inspector General Rebecca Anne Batts, who will also handle the criminal probe, recommends that the Cabinet secretaries who oversee the agency consider whether the contracts should be revoked. The PBGC's acting director said the agency would decide whether to revoke the contracts.

Among other things, the report says Charles E.F. Millard, who stepped down on Jan. 20, improperly contacted some of the firms potentially bidding on the contracts and later sought and received job-hunting help from an unnamed executive of Goldman Sachs after the company had been awarded a contract to manage up to $700 million. The report also says Millard was warned not to engage in much or all of the activity it calls into question. The inspector general's inquiry was already under way before Millard's departure. Millard said earlier this month that he has been doing some consulting work while exploring different job opportunities.

All of this comes at a challenging time for the PBGC, which could become the steward of one of the large pension plans at bankrupt or struggling companies in the auto industry and elsewhere. Now, more scrutiny is sure to come. Representative George Miller (D-Calif.), chairman of the House Labor Committee, which released the draft report, announced that the committee will launch an investigation of its own, calling the questions over Millard's conduct "very serious." Herb Kohl (D-Wis.), chairman of the U.S. Senate's Special Committee on Aging, also announced a hearing, to be held on May 20, looking into the allegations and into broader concerns about the PBGC. Senator Charles Grassley (R-Iowa) said in a statement that he and three fellow senators—Edward M. Kennedy (D-Mass.), Max Baucus (D-Mont.), and Michael Enzi (R-Wyo.)—also support further investigation. A spokeswoman for Kohl's office said Millard had received a subpoena to appear at the hearing.

In a brief e-mailed statement, Millard's attorney, Stanley Brand, said Millard's efforts to improve the PBGC's financial health were "carried out in a transparent and ethical manner."

The report says it didn't find evidence of criminal activity by bidders for the contracts, though the scope of the inquiry so far has remained internal. Spokeswomen for Goldman, JPMorgan, and Blackrock declined to comment.

A controversial switch from bonds to riskier assets

The PBGC's board—Labor Secretary Hilda Solis, Treasury Secretary Timothy Geithner, and Commerce Secretary Gary Locke—has asked the agency's interim director to determine whether the contracts in question should be reevaluated.

The PBGC insures defined-benefit pension plans—traditional pensions that pay retirees a set monthly amount for life—and as of Sept. 30 managed nearly $50 billion in assets for plans that have been abandoned by the companies that originally sponsored them, usually after bankruptcy or insolvency.

At the heart of the inspector general's inquiry is a controversial decision made in early 2008 to gradually shift billions of dollars from bonds, which make up the bulk of the agency's assets, into stocks, real estate, and private equity investments. The goal, supporters say, was to improve returns and therefore the odds that the agency's gap between its assets and its potential obligations—about $11 billion, currently—would close, avoiding the need for a government bailout at some point down the road. Critics called the move hasty and ill-informed and said it would subject the agency's assets to too much additional investment risk.

Although the shift was approved in February 2008, a PBGC spokesman said no assets have been moved yet under the "strategic partnership" contracts to farm out asset management.

"We will work with our board to decide whether these contracts should be terminated and whether strategic partnerships fit into the board's investment approach going forward," said Vince Snowbarger, the PBGC's acting director, in a written statement. Future PBGC directors won't be allowed to be directly involved in procurement, he added.

In addition to the contract Goldman Sachs was awarded to manage up to $700 billion, Blackrock and JPMorgan each received contracts to manage up to $900 million in real estate and private equity assets, the report said.

"government sachs"

Goldman's supporting role in the inspector general's report once again highlights that company's often cozy connections with the halls of government power. Those ties have earned the firm the nickname "Government Sachs," from the fact that Henry Paulson, President George W. Bush's last Treasury secretary, once ran Goldman, to the close ties between Goldman and AIG (AIG), and the bank's receipt of $12.9 billion of AIG's bailout money. Meanwhile, President Barack Obama received nearly $1 million in campaign contributions from Goldman employees, second only to University of California workers.

The PBGC report documents 29 emails between Millard's PBGC account and a Goldman pal, including the extensive assistance by the banker in Millard's job search. That assistance ranged from making introductions to passing along Millard's résumé, biography, and press clippings to CEOs at other financial firms.

Millard called the allegation of impropriety "ridiculous" and said he had a "deep personal relationship" with the Goldman executive. In a written response from Millard that is attached to the report, the former director insists: "I always acted in the interests of the agency."

In a letter Millard sent Batts, dated Apr. 28, Millard defends his position on the PBGC panels as an attempt to get things done at an agency that in the past hadn't always moved quickly. And some of his defenders imply there may be a political motivation to Batt's report since Millard is an active Republican. Batts notes that her inquiry began long before the November 2008 election and says she has seen no evidence of partisanship.

The investigation, begun on Sept. 17, 2008, as a simple review of the PBGC's implementation of its new investment policy. But within a few weeks it had broadened into a look at Millard's behavior after Batts was approached by an unnamed whistleblower with specific allegations. By Oct. 31, when the PBGC was to issue the contracts with Goldman, JPMorgan, and Blackrock, Batts suggested holding off, but Millard wouldn't, Batts said in a telephone interview.

unprecedented dual role for PBGC chief

According to the inspector general's report, a whistleblower accused Millard of contacting executives at firms bidding for PBGC business "in order to enhance his future employment prospects." The inspector general's subsequent investigation found 29 emails documenting the extensive efforts the unnamed Goldman executive made on Millard's behalf. The draft report notes that some PBGC employees involved in the investment portfolio "believed that the former Director made some decisions based on his relationship with certain industry members and not on the merits themselves."

Because Millard didn't record details of his calls, visits, and emails, "we could not determine whether [his] communications with Wall Street firms had any impact on his decisions," the report says. However, Millard's actions "made PBGC vulnerable to allegations of bias, improper influence, or abuse of position."

Many of the questions around Millard's conduct stem from his "unprecedented" role on the committee that evaluated bidders and awarded contracts; ordinarily, PBGC directors haven't served in that capacity. Batts says she told Millard that serving on the committee was "unwise," but he continued when told there was nothing expressly illegal about it.

Members of the committee aren't supposed to contact bidders during a "blackout" period, when they are being evaluated—something Millard was told several times, the report says. Yet Millard made phone calls to 8 of the 16 firms bidding on the contracts, including all four finalists and the three firms that were ultimately chosen, Batts wrote in the report. At least nine calls were made from or received at Millard's phone to Goldman Sachs during the three-month blackout period, most to an executive directly involved in the bidding process, Batts wrote. Another six calls were made to or from a key Blackrock official, and at least 10 calls to or from a managing director at JPMorgan.

The report says Millard's explanations for the contacts changed over time, and it suggests that several of those explanations didn't hold up. Batts called the contacts a violation of PBGC policy and federal acquisition regulations. Millard's "improper actions raise serious questions about the integrity of the process by which the winners…were selected," Batts wrote.

These allegations are serious. Mr. Millard had a fiduciary obligation to invest this money in the best interests of PBGC's stakeholders and beneficiaries. Any hint of impropriety will seriously undermine his defense.

Elsewhere, the Carlyle Group has agreed to pay $20 million in a settlement with the New York attorney general, Andrew M. Cuomo, and make broad changes in its practices as part of his office’s continuing pension corruption inquiry:

Mr. Cuomo hopes to use the settlement with Carlyle, one of the largest and most politically connected private equity firms, as a template for broader reform in how hedge funds and private equity firms intersect with public pensions.

His office has developed a series of guidelines that include a broad ban on firms using any kind of intermediary to provide even an introduction to officials at public pensions.

The guidelines also bar firms and their executives, and even family members of executives, from making campaign contributions within two years of doing business with pension funds. Carlyle will also have to disclose contributions to any politicians in a state in which it does pension business.

“This is a revolutionary agreement,” Mr. Cuomo said during a teleconference on Thursday. “I believe it totally changes the way people operate, it ends pay-to-play, it bans the selling of access, it puts the political power brokers out of business.”

While the agreement is sweeping in nature, it only applies to Carlyle’s nationwide business; Mr. Cuomo will need Congressional legislation or new federal regulation to make it broadly apply across Wall Street.

“Our ultimate goal is to get that code enacted, meaning, by either state law, state regulation, or in this case, federal law, federal regulation,” Mr. Cuomo said.

Christopher Ullman, a spokesman for Carlyle, said: “We are pleased to announce today that we have reached a successful resolution with the attorney general and strongly support his efforts to implement reforms that usher in a new era of transparency and accountability into the pension fund investment process.”

Carlyle also said it was suing Hank Morris, once a top aide to New York State’s former comptroller, Alan G. Hevesi, and a firm he worked for, Searle & Company, seeking more than $15 million.

Last month, The New York Times reported that state and federal investigators were reviewing whether Carlyle made millions of dollars in improper payments to intermediaries in exchange for investments from the state pension fund. While payments to intermediaries, known as placement agents, are typically legal, they are not if they are simply disguising bribes or kickbacks.

Mr. Cuomo’s office and the Securities and Exchange Commission have been conducting parallel investigations focused on the millions of dollars that friends, relatives and aides of Mr. Hevesi gained by selling access to New York State’s $122 billion pension fund. The inquiries have uncovered what investigators describe as a wide network of corruption from California to New York, in which billions of dollars of investments from public pension funds were handed out in exchange for kickbacks or other questionable payments.

“If Boss Tweed were alive today, he would be a placement agent,” Mr. Cuomo said.

Mr. Morris and David Loglisci, another former top aide to Mr. Hevesi, have been indicted on a variety of corruption-related fraud charges, and Raymond B. Harding, the former vice chairman of the state’s Liberal Party, has also been charged in the case.

Saul Meyer, a top consultant to pension funds around the country, has also been charged with a fraud-related felony, and his firm, Aldus Equity, has been charged by the S.E.C. with a number of securities violations.

Two investment executives, Barrett Wissman and Julio Ramirez, Jr., have pleaded guilty in the Cuomo inquiry.

The Carlyle deals are among the most complex described in court filings. One deal involved an energy investment fund run by Carlyle and another firm, Riverstone Holdings. As part of the arrangement, the firms paid $10 million to Searle, nearly half of which was secretly funneled to Mr. Morris, according to an S.E.C. complaint.

David Leuschen, a top Riverstone executive, also invested $100,000 in “Chooch,” a movie produced by Mr. Loglisci.

Riverstone’s activities are still being scrutinized by regulators; the company has denied any wrongdoing.

“Most of the objectionable activities were by Riverstone,” Mr. Cuomo said.

Apart from pension probe, these aren't easy times for private equity. Earlier this week, the FT reported that investors desperate to sell their stakes in private equity funds face the specter of being trapped in their holdings indefinitely due to a sharp fall in activity in the secondary market.

A swath of pension funds, insurance companies, endowments and family offices that flocked to the asset class in recent years are believed to be under pressure to exit, particularly as many stakes include legal obligations to make additional commitments they may not be able to fund.

Industry estimates suggest that $100bn-$130bn of the $2,200bn (£1,462bn, €1,632bn) committed to private equity is expected to be offered for sale in the next two years.

Yet the volume of deals closed in the secondary market slumped to $2bn in the first quarter of 2009, according to Greenpark Capital, a specialist secondary investor, suggesting full-year dealflow may not even match the $20bn recorded in 2008.

“In a year where people are considering selling a volume that is far greater than has ever been put up for sale before, the concern is that we will struggle to get to $10bn this year in terms of deals closed,” said Marleen Groen, co-founder and chief executive of Greenpark. “There will be a lot of frustrated sellers.”

Elaine Small, partner at Paul Capital, another secondaries house, said: “There is probably 10 times as much supply as available money in the market from secondary funds.”

Prices in the secondary market have fallen dramatically, with deals this year being struck at an average of 37 per cent of face value, compared with 85 per cent in the first half of 2008 and a peak of 108 per cent in 2006, according to Cogent Partners, a US advisory house. There are reports of investors having to pay buyers to take stakes off their hands.

Hanspeter Bader, head of private equity at Switzerland’s Unigestion, said pricing was poor for stakes that contain significant undrawn capital obligations.

“It could be that you have to give it away for free. We have seen some transactions of that nature. I have anecdotally heard of a fund where the buyer got money to buy it,” he said.

Ms Groen added: “The only way sellers can get out of some of the large positions is by paying a buyer to take it to compensate them for the undrawn capital and the quality of the existing investments.”

However, she believed an increasing number of investors would instead choose, or be forced, to default on their commitments, particularly if private equity funds need to make capital calls to retain control of their portfolio companies, even though defaulters risk losing the bulk of their investments as well as being sued and blackballed by the industry.

“We will see defaulting limited partners. If they don’t want to be in private equity again they can and they probably will.”

The secondaries market is estimated to have sufficient capacity to absorb about $30bn of deals over the next two years. However, the logjam is largely being driven by a wide gap in valuations between buyers and sellers.

Because private equity funds are believed to have been slow in writing down the value of their assets to reflect the deteriorating economic backdrop and lower valuations in public equity markets, would-be sellers are facing the “sticker shock” of having to accept valuations well below net asset value.

Market participants believe dealflow will pick up when the valuations of private equity funds catch up with reality later in the year.

The FT also reports that private equity faces investor exodus:

The private equity industry is poised for an unprecedented rush to the door by investors as more than a 10th of them plan to sell fund interests in the next two years, according to research published on Tuesday.

When investors commit money to a private equity fund, it is locked in for at least 10 years and drawn down as needed by the fund manager to finance investments.

During the credit bubble, when private equity deals ballooned, investors increased their commitments to the industry dramatically, expecting them to be financed by the flow of cash back from earlier deals.

Now that cash has dried up, they are being forced to turn to the opaque and unstructured secondary market to raise capital and escape from the unfunded commitments they cannot afford to meet.

Tuesday’s research from Preqin, which surveyed 568 institutional investors, also found that almost half of them were interested in buying secondhand private equity holdings from other investors in earlier funds.

As investors focus on buying secondhand assets, it is likely to mean that it will take longer before private equity groups can raise new funds from their investors.

“If you have an investment that you like in a private equity fund and someone says you can have some more for half the price, then that is a sensible thing to do,” said Brenlen Jinkens, managing director of Cogent Partners, the secondary market adviser.

Preqin said 11 per cent of institutions (excluding funds of funds, which are already regular users of the secondary market) planned to sell fund interests.

It forecast that $75bn- $100bn of private equity assets could change hands, half in the next year.

The research found that 48 per cent of active private equity investors, including pension funds, endowments, insurers and sovereign wealth funds, had indicated an interest in buying on the secondary market in the next two years.

“Why go into a primary fund when you can get secondaries more cheaply?” asked Andrew Sealey, managing partner of Campbell Lutyens, a private equity adviser.

However, specialist secondary investors said there had been very little activity so far this year, even after private equity groups published their year-end valuations, which some had expected to trigger a rush of activity.

Peter Wilson, managing director of HarbourVest’s secondary arm, said: “Buyers are anticipating a drop in forward earnings.

“Sellers are optimistic because of the rally in stock markets. The two forces are pulling in opposite directions.”

Instead of being the exclusive preserve of specialist secondary funds, he said more secondhand assets were being bought by traditional investors.

“They look at the big discounts and see a way to reduce their initial cost of entry into a fund,” he said.

Michael Granoff, chief executive of Pomona Capital, a $6bn private equity fund of funds, said: “A big problem buyers have today is that it is very hard to figure out what these assets are worth, not just today, but what they will be worth tomorrow.”

He forecast that activity was likely to pick up when private equity deal flow recovered, triggering calls for investors to meet undrawn capital commitments.

“Probably capital calls will come before distributions for most private equity investors – so that could increase the pressure to sell,” said Mr Granoff. “I think the market will clear gradually.”

The private equity and commercial real estate markets will face their worst crisis ever. Deflation will wreak havoc on their asset values and I expect a long, tough slug ahead.

As pension funds shoveled billions of dollars into these asset classes over the last five years, I expect they will also suffer more material losses in the next few years.

What was Mr. Millard thinking when he thought of shifting the PBGC's assets into private equity? What are pension funds thinking shoveling more assets into private equity right now? Have they completely lost their marbles?