The Grand Cayman Pension Scam?
The release of the so-called “Paradise Papers” touched off new scrutiny of how moguls, celebrities and politicians stash their cash in offshore tax havens. The practice, though, is hardly limited to the global elite. In fact, government documents show that state and local officials have sent hundreds of billions of dollars of public sector workers’ retirement savings to a tiny archipelago most famous for white-sand beaches — and laws that shield investors from taxes.This article has generated quite a bit of interest and a back and forth discussion between David Sirota and AQR's Clifford Asness on whether hedge funds and private equity funds are appropriate for public pension funds.
Operating outside the U.S. legal system, the offshore accounts in the Cayman Islands give Wall Street firms leeway to make complex international investments and to earn big fees off investors' capital. But with offshore accounts featuring prominently in high-profile Ponzi schemes, some critics warn that the use of tax havens can endanger the retirement savings of millions of teachers, firefighters, cops and other public workers — a situation that could put taxpayers on the hook for losses if the investments go bust, or the money goes missing.
The tidal wave of cash has flowed from public pension systems into so-called “alternative investments”: private equity, hedge funds, venture capital firms and real estate. While many alternative investment firms operate in Lower Manhattan, more than a third of all the cash in those private funds flows through vehicles domiciled in the Caymans, according to Securities and Exchange Commission records reviewed by International Business Times. Those same records show that public pension plans, university endowments and other nonprofits have funneled a massive $1.8 trillion into alternative investments.
“Based on SEC data, it appears that public pensions alone hold around $300 billion offshore in the Cayman Islands in hedge funds and private equity,” said Chris Tobe, a former state pension trustee and author of the book “Kentucky Fried Pensions.”
In recent years, SEC regulators have tried to crack down on alternative investment firms’ fee schemes that regulators say can end up enriching money managers at the expense of investors. At the same time, state officials and investor groups have pushed for more transparency in the alternative investment industry as a whole.
But with so many of the investments now running through a maze of shell companies in lightly regulated tax havens, some experts say the outflow creates the conditions for rampant fee abuse and financial shenanigans — and prevents pension officials and law enforcement officials from even knowing exactly where billions of dollars of public money is being held.
“The additional risks related to investing in funds established, regulated and custodied in tax havens are real,” former SEC attorney Edward Siedle has warned.
A trove of confidential hedge fund documents reviewed by IBT shows that major financial industry players acknowledge some of the potential risks that can arise when money is invested outside the United States. The documents show that in the fine print of their agreements, the firms admit that shifting cash to less-well-regulated foreign locales can end up putting money into brokerages that may not adhere to traditional banking regulations. They also acknowledge that moving money into international securities can reduce basic protections for investors and ultimately increase the risk of significant losses.
“How does investing in funds established in loosely regulated offshore tax havens benefit government workers — participants in a pension that doesn’t even pay taxes?” Siedle has written.
One answer to that question, say lawyers, involves pension systems seeking to preserve their existing tax exemptions. Under laws passed in the 1960s, those tax-exempt entities would have to pay taxes on the kinds of debt-financed earnings involved in private equity and hedge fund investments — but they can avoid those levies if they first route their investments through “blocker” corporations in tax-free jurisdictions like the Caymans.
“This is very standard planning — it’s a plain vanilla technique,” said the Tax Policy Center’s Steven Rosenthal, a former partner at the global law firm Ropes & Gray LLP, who advised universities on investments.
Public pension systems vary in how they report their investments. Many simply list the firms that are managing retirees’ money, but not where the firms are located, or whether the funds are ultimately being moved offshore. However, occasional references to offshore funds are scattered throughout public filings.
In South Carolina, for instance, the annual report for the government workers’ retirement system listed nearly $60 million invested in a Cayman-based fund run by Reservoir Capital Partners, which received more than $2 million in fees from the state last year. In New Jersey, state investment officials have in recent years committed more than a quarter-billion dollars of state pension money to hedge funds based in the Cayman Islands and Bermuda, the country at the center of the Paradise Papers controversy. And in Texas, a 2015 report from the teachers retirement system showed the state paying a combined $13 million in fees to Cayman-based funds run by Bain Capital and Soroban Capital Partners.
Siedle told IBT that Wall Street firms may set up shell corporations in tax havens “not to help public pension fund investors, but really to protect the managers from taxes and regulations.”
A 2008 Government Accountability Office report detailed some of the potential benefits financial managers can glean from domiciling their operations in the Caymans. The agency found that “some U.S. persons can minimize their U.S. tax obligations by using Cayman Islands entities to defer U.S. taxes on foreign income.” GAO also warned that “some persons have conducted financial activity in the Cayman Islands in an attempt to avoid discovery and prosecution of illegal activity by the United States.”
Law firms openly promote the benefits of offshore investment vehicles.
“The tax exempt, tax transparent, non-regulated and highly flexible nature of the [exempted limited partnership] and the absence of regulatory or licensing requirements touching the general partner, together with the flexibility of the Cayman Islands exempted limited company, combine to make the Cayman Islands the preeminent jurisdiction for offshore private equity funds,” said a recent memo from Mourant Ozannes, an offshore law firm whose website says it is “advising many of the world's foremost financial institutions” on the laws in the Caymans, British Virgin Islands, Guernsey and Jersey.
“The American People Are Not Against Offshore Wealth”
In the political arena, members of both parties have offered varied messages about the flow of American capital offshore.
Republicans faced Democratic attacks over Mitt Romney’s involvement with Cayman funds, but four years later, Republican Donald Trump ran for president promising to discourage the use of offshore tax havens. Some Democrats have sponsored legislation designed to try to stop the use of offshore tax havens. During the 2012 election, though, the Cayman Islands Journal reported that longtime Democratic Party official Donna Brazile told investors at a Cayman Islands conference that “the American people are not against offshore wealth, offshore ‘tax havens’, but they’re often told that, you know, this is taking something away from them."
When it comes to billions of dollars of public pension money leaving the country, Rosenthal said there is nothing inherently problematic about tax exempt organizations using offshore accounts to avoid taxes.
“If you thought the rules about debt-financed income make a lot of sense, then sure, you could get worked up about how this kind of tax planning contravenes congressional intent,” he told IBT. “But I don’t think those rules make a lot of sense, and this is an alternative way to structure investments to sidestep those rules.”
Some lawmakers have disagreed.
In 2007, Michigan Rep. Sander Levin, a Democrat, proposed a bill to allow tax-exempt organizations such as pension systems to invest directly in private equity and hedge funds, without incurring the tax on debt-financed income — a move designed to discourage the use of foreign blocker corporations.
Two years later, his brother, then-Sen. Carl Levin, introduced legislation that would have subjected offshore blocker corporations to U.S. taxes. Both measures were designed to keep investments within the domestic financial system and to discourage the use of offshore vehicles, but some lawyers who help financial firms navigate tax laws warned that the Senate legislation would harm the alternative investment industry.
“If enacted [the bill] could significantly reduce investment in U.S. hedge and private equity funds,” wrote Steve Bortnick of Pepper Hamilton, a compliance law firm. “The provision would tax income that simply should not be taxed in the U.S. (i.e., foreign source income) or tax it at inappropriate rates. This likely would force these funds to restructure in a manner that nevertheless would alienate tax-exempt and foreign investors. At a time when the U.S. economy is struggling, these provisions appear to establish an unnecessary impediment to investment in U.S. investment funds.”
Proponents of the legislation argued that offshore vehicles were being abused to help financial managers shield themselves from taxes.
“This would prevent companies (notably hedge funds) that are American for all practical purposes from avoiding U.S. taxes by claiming to be a foreign company simply because it did certain paperwork and maintains a post office box in a tax haven country,” declared Citizens for Tax Justice when the senate initiative was launched.
The Managed Funds Association, the self-described “voice of the global alternative investment industry,” was among the universities, foundations and advocacy groups lobbying Congress and the Internal Revenue Service on Sander Levin’s bill, federal lobbying forms show. The organization also lobbied throughout 2009 on Carl Levin’s bill. Other financial industry players that lobbied on the bill included the Blackstone Group LP, Credit Suisse, the American Bankers Association, the Investment Company Institute, the Cayman Islands Financial Services Association and the Private Equity Council.
The legislation never passed.
“A Number Of Unusual Risks, Including Inadequate Investor Protection”
As public pension money continues to move offshore, taxes are not the only policy question at issue. There is also the matter of potential risks associated with investments outside of the United States.
One set of risks has to do with regulations — or lack thereof.
“Tax havens generally have laxer laws and oversight than in the United States,” wrote researchers Norman Silber and John Wei in a recent Hofstra University study of offshore investments. “The use of foreign blocker corporations also reduces the amount of information available to the government and the public.”
Some potential risks are outlined in documents from major hedge funds that have managed public pension money. While those documents are confidential — and have been exempted from state open records laws, at the behest of the financial industry — IBT reviewed some that show hedge fund managers admitting the potentially enormous risks of shifting retirees’ money outside the U.S. financial system.
For instance, 2015 documents from a Canyon Partners fund based in the Caymans tell investors that the fund is registered under a Cayman law that “does not involve a detailed examination of the merits of the fund or substantive supervision of the investment performance of the fund by the Cayman Islands government.” It also tells investors that “there is no financial obligation or compensation scheme imposed on or by the government of the Cayman Islands in favor of or available to the investors in the fund.”
A similar 2015 document from a Cayman-based Fir Tree Partners fund notes that while there is a Monetary Authority in the Caymans, “the fund is not subject to supervision in respect of its investment activities or the constitution of its investment assets by the Authority or any other governmental authority.”
The Cayman-based funds say they can move investors’ money into foreign assets. In separate disclosures applying more broadly to those assets, the hedge funds acknowledge the risk of international investing in emerging markets. These specific risk disclosures apply only to the international assets that the Cayman funds are investing in — and not the Cayman funds themselves. However, the disclosures appear to illustrate the general risks pension systems may face when they move money outside the U.S. financial system. For example:
Government records and reports from the financial analysis firm Preqin show that public pension systems in Rhode Island, Texas, Florida, California, Florida, Arizona, Oregon, Illinois, Washington, Louisiana, New York and New Jersey have invested in at least one of these aforementioned hedge funds.
- Canyon’s documents warn that international investments in emerging markets can involve the risk of “lack of uniform accounting, auditing and financial reporting standards and potential difficulties in enforcing contractual obligations.” The same document later notes that those international investments can also expose investors “to a number of unusual risks, including inadequate investor protection.”
- The Fir Tree Partners documents note that “accounting and financial reporting standards that prevail in foreign countries generally are not equivalent to U.S. standards and, consequently, less information is available to investors...There is also less regulation, generally, of the financial markets in non-U.S. countries than there is in the United States.”
- A 2013 documents from a Cayman-based Mason Capital fund warn that risks of international investments include “difficulties in pricing securities and difficulties in enforcing favorable legal judgments in court.”
- A Cayman-based Och-Ziff fund’s offering documents from 2014 note that “there is generally less government supervision and regulation of exchanges, brokers and issuers outside the United States” and that “the fund might have greater difficulty taking appropriate legal action in non-U.S. courts.”
- Even though public pension trustees are legally obligated to adhere to United States fiduciary standards, Canyon’s Cayman-based fund points out that when it comes to its international investments, “anti-fraud and anti-insider trading legislation, and the concept of fiduciary duty, may be less developed or limited compared to those in more developed markets.” A 2014 offering document from Cayman-based AQR Capital fund similarly warns that foreign investments can expose assets to “less stringent laws regarding the fiduciary duties of officers and directors and protection of investors.”
“Shareholders May Be Unable To Liquidate Their Investment"
There is also the issue of investor rights. Last year, Rhode Island retirees sounded an alarm about the prospect of their state pension system’s financial managers allowing certain anonymous investors to receive more favorable terms from the same funds in which the pension system puts its money. They asserted that such schemes could end up enriching anonymous investors and financial managers at the pension fund's expense. Other experts have warned that because firms’ investments are not independently valued by third-parties, managers can use their own valuation process to fleece investors.
Those potential dangers were spelled out in 2015 documents from Luxor Capital and AQR funds in the Caymans, where, according to the Tax Policy Center’s Rosenthal, foreign investors and managers can avoid filing IRS disclosure paperwork and exposing themselves to U.S. transparency laws.
The Luxor fund, said the documents, had signed “side letter” agreements that allow the firm to provide certain shareholders “access to more frequent and/or more detailed information regarding the fund’s securities positions...performance, finances, and management.” That includes “notification of the commencement of certain disciplinary actions, legal proceedings, investigations or similar matters against the fund...possibly enabling such shareholders to better assess the prospects and performance of the fund.”
The documents also said “the fund may give certain shareholders the right to redeem all or a portion of their shares on shorter notice and/or with more frequency,” and that “shareholders may be unable to liquidate their investment promptly in the event of an emergency or for any other reason.”
The AQR fund, meanwhile, warns that it could put investors’ money into assets that “may be extremely difficult to value accurately.” That means “there is a risk that an investor that makes a redemption while the Fund holds such investments will be paid an amount significantly less than it would otherwise be paid if the actual value of such investments is higher than the value designated.”
Preqin data show pension funds in Texas have invested in Luxor’s Cayman-based fund, and government records show the state teachers’ retirement system has paid the offshore fund more than $21 million in fees between 2013 and 2015.
Most Cayman-based hedge fund firms managing pension money — including those whose documents IBT reviewed — are registered with the SEC. However, that does not necessarily mean the agency or American courts have as much power over them as they do over onshore funds.
“The Cayman Islands’ strong bank secrecy laws help shield assets,” wrote University of Hawaii accounting professor Thomas Pearson in a 2009 paper. “Therefore, because of concern that not all the assets are apparent or accessible, a U.S. bankruptcy court may refuse to provide assistance to liquidation of hedge funds domiciled in the Cayman Islands. Although the SEC has tried to collaborate with authorities offshore, hedge funds’ use of the Cayman Islands or another tax haven country lowers their risk that the SEC or other major securities regulators can acquire the real identity of certain traders and properly enforce insider trading laws.”
Taken together, the risks of investing offshore are significant, said Deborah Hicks Medanek, whose firm, the Solon Group, advises corporations on restructuring.
“If I were a fiduciary responsible for a large pension fund, I would be very careful not to assume that the legal environment in Cayman or Curacao or the British Virgin Islands was really similar to the legal environment I’m used to,” Medanek told IBT. “You cannot assume that the same kind of investor protections are out there. If I’m sitting there as a fiduciary of a public pension fund, my ass is already seriously on the line for people who can’t afford not to have pensions when they come due — so I don’t think I’m going to go take those risks, unless I am utterly convinced that the offshore investment gives pensioners access to an attractive manager that’s otherwise not available onshore.”
None of the hedge funds whose documents IBT reviewed offered any on-the-record comments for this story.
“The Fund Will Not Maintain Custody”
Out of all the risks of moving pensioners’ money overseas, few raise as much concern as “custody,” or where pensioners' money and assets are ultimately stored and accounted for, said South Carolina State Treasurer Curtis Loftis. He noted that whereas state and local governments’ investments in stocks and bonds are typically held in U.S.-regulated banks, offshore funds can hold money in opaque accounts and brokerages across the globe.
“Custody was a pretty big part of the Bernie Madoff and Jon Corzine problems,” Loftis told IBT, referring to high-profile cases where investors lost their money. “Those guys were custodying money all over the world, allowing them to do all sorts of things with it because offshore does not have the same protections as in the United States. So when public pensions are investing offshore, they are agreeing to have their money custodied in ways that are very risky.”
The hedge fund documents reviewed by IBT underscore Loftis’s assertion.
Under the heading “Absence of Regulatory Oversight,” a Cayman-based Governors Lane vehicle says “the fund will not maintain custody of its securities or place its securities in the custody of a bank or a member of a U.S. securities exchange in the manner required of registered investment companies under rules promulgated by the SEC.” Governors Lane has managed money for the Kentucky public pension system.
Och-Ziff’s documents include similar language, and note that the custody methods means that a bankruptcy “might have a greater adverse effect on the Fund than would be the case if it maintained its accounts to meet the requirements applicable to registered investment companies.”
In its section on custody risk, Mason Capital’s Cayman-based fund says it “may use counterparties and other financial institutions located in various jurisdictions outside the United States” and that “financial institutions may use sub-custodians and disclaim responsibility for any losses.” The firm warns that “investors should assume that the insolvency of any non-U.S. counterparty or other financial institution would result in a loss.”
The custody risks relate to other concerns about the overall governance of Cayman-based investment vehicles. A 2011 Financial Times investigation found that “a small group of Cayman Islands ‘jumbo directors’ are sitting on the boards of hundreds of hedge funds” based there. These directors are supposed to be watching over investors’ money and protecting their interests, but some experts have questioned whether they are adequately independent and able to provide oversight when they are working for so many different funds. Those questions, which have been simmering for years, have resurfaced in a recent hedge fund case in the Caymans.
“With perhaps two-thirds of all hedge funds domiciled in the Cayman Islands, Bermuda, and British Virgin Islands, a web of ‘independent directors’ has developed in these island paradises,” wrote George Mason University professor Janine Wedel, who has studied corruption and corporate governance. “Officially, these directors are independent watchdogs who protect the interests of investors, such as pension funds. The problem is that some appear to be little more than ‘paper directors,’ with perhaps billions of retirement dollars exposed to funds with weak oversight and potentially conflicted governance.”
While these risks of offshore investing may seem hypothetical, a landmark case in Louisiana suggests the opposite. There, three public pension systems found themselves unable to withdraw their collective $144.5 million in investments and earnings from a Cayman Islands-based hedge fund of New York City-based Fletcher Asset Management in 2011. The funds than had to rely on a Cayman court to force the fund to relinquish the money, the Wall Street Journal reported.
The following year, a Louisiana state legislative auditor produced a report urging the three pensions to better document any risk that stemming from an inability to quickly and easily withdraw their investments at market price. In 2013, trustees of the pensions sued affiliates of Fletcher, along with a law firm and an financial services firm involved, for overstating the fund’s value and liquidity.
Months after the case moved to a U.S. federal court, a trustee the pensions appointed — who, after on-site examination in the Cayman Islands, found the fund to be insolvent — placed the fund and its affiliates into bankruptcy in 2014. The case — which is ongoing — is exactly the kind of situation that Loftis says he fears for states and cities all over America.
“I’m sure some of these firms set up offshore in order to offer pensions a way to avoid paying taxes, but I’ve always believed it is mostly about the managers creating a way in which they can limit their own taxes and their own legal liability and do whatever they want with the public’s money,” he told IBT. “The custody issue is one of the biggest problems: these offshore accounts mean we don’t really know where all of this money actually is. If we have another economic downturn, I’m not sure the money custodied all over the world ever makes it back home.”
STUMP even followed up to take a look at allocations to alternative asset classes by public pensions and whether it has paid off.
My answer is it depends but overall, allocations to alternative asset classes have definitely benefited alternative asset managers and big banks on Wall Street a lot more than chronically underfunded US public pensions funds struggling to stay solvent. I've documented all this in the big squeeze.
Put bluntly, the astronomical fees paid out to hedge fund and private equity lords of finance over the last thirty years are nothing short of stupendous, propelling many elite and not-so-good managers to the ranks of the world's rich and famous. You won't read much about this in Thomas Piketty's book on inequality but there is no question that US public pension funds have contributed to rising inequality and most have gotten little to show for it.
Is there a rationale for alternative investments? Absolutely. In Canada, our big pensions also dole out huge fees to private equity funds but they hire qualified staff to do a lot of co-investments to lower overall fees.
In the US, top hedge funds and private equity funds have been milking public pensions dry for years, raking them on fees, which I have publicly stated need to be significantly cut.
The problem is all institutional investors -- pensions, endowments, sovereign wealth funds, insurance companies, family offices, etc. -- need to band together to put pressure on hedge funds to lower fees.
Anyway, one way or another, lower fees are coming, and there will be a paradigm shift in fees alternative investment funds charge. Why? Because deflation is headed our way, which means much lower rates for a lot longer. In a deflationary environment, it's much harder justifying 2 & 20.
I foresee another major shakeout in the hedge fund industry. In fact, the silence of the bears won't last forever, and when they come back growling, a lot of hedge funds are going to get killed.
Of course, a lot of index funds are also going to get killed, but it's a bit more palatable when they're charging negligible fees for tracking the market.
Is the solution getting out of hedge funds and private equity funds altogether, putting more money in index funds like North Carolina's pension? They're a bit late in the game, they should have done this years ago following the financial crisis.
But unless you have a qualified staff managing external hedge funds and private equity funds, forget about these alternative investments, most of the time you will end up relying on advice from useless consultants who will shove you in the latest hot funds, and you will get burned.
In a low return world, alternative investments definitely can play a role in a pension plan's asset allocation, but theory doesn't always translate well in practice, especially in these central-bank manipulated markets where literally every asset class is way overvalued.
As far as the Caymans and offshore tax havens, it's much ado about nothing. I know for a fact Canadian pensions investing in US dollars in hedge funds and private equity funds prefer this type of arrangement and if done properly, it works in the best interest of everyone, including the plan's beneficiaries.
The big difference is a CPPIB and Ontario Teachers' which collectively invest billions in hedge funds and private equity funds, have specialized due diligence teams doing intensive due diligence on funds, their administrators, their prime brokers and directors at these offshore entities.
I guarantee you those Louisiana pensions unable to withdraw their collective $144.5 million in investments and earnings from a Cayman Islands-based hedge fund of New York City-based Fletcher Asset Management in 2011 didn't do a good job in terms of their due diligence.
Let me end by sharing with you a story that happened to me when I was investing in directional hedge funds at the Caisse back in 2002-2003. I asked one of our CTAs to shift assets from the high leverage to lower leverage fund and for some reason, his administrator said it could take up to a week.
I was pissed, really pissed. I called the manager up and said: "What's going on? You trade futures which are very liquid. Call your administrator immediately and I'd better see that money in the low vol fund tomorrow morning."
Trust me, the next day, the money was in the low vol fund and I never had any other issues with this manager's administrator.
I think there is a lot of misinformation and scaremongering going on with the potential risks of offshore funds.
Earlier this year, the Caisse's CEO, Michael Sabia, had to defend the Caisse's investments in offshore tax havens (they doubled from $15 billion in 2013 to over $30 billion now). Why the need to do this, especially since it's not in the best interest of the province to remove those assets from these tax havens.
No doubt, we need lower fees, more fee transparency and better reporting information linking fees to returns, but spreading misinformation and lies about offshore tax havens isn't helpful and most certainly isn't in the best interests of the plan's sponsors and beneficiaries (or taxpayers).
Maybe I'm missing something. If so, drop me an email at LKolivakis@gmail.com and let me know what you think. As far as I'm concerned, when it comes to hedge funds and private equity funds, these offshore structures have benefited everyone, not just the managers.
Below, a Bloomberg report from last summer on how Caymans ranked third among foreign holders of US debt, with hedge funds leading the trend. I wonder if hedge funds scared of the silence of the bears and VIX are increasing their exposure to US long bonds (TLT) now (if they're smart, they are).