One of the easiest types of investors for Wall Street sharpies to fleece are public pension funds that have a large shortfall they are desperate to make up. Even seasoned traders can all too easily start putting on desperate wagers to try to earn their way out of a hole, or worse, cook the books and try to make the trading profits later. Public pension funds as a groups aren’t terribly savvy; even though the California giant CalPERS has been stonewalling us on disclosure, it’s generally seen as competent, which puts it way ahead of most of its peers.
As a new article by David Sirota in Pando Daily shows, by contrast, the Kentucky Retirement System, which manages $14.5 billion, is an obvious lamb led to slaughter. Sirota’s source is Chris Tobe, an SEC whistleblower, former trustee of KRS, and author of Kentucky Fried Pensions, a book about the sorry condition of the Kentucky pension system.
KRS is one of the most severely underfunded retirement systems in the United States, with only 23% of its liabilities funded. As a result, the pension fund is up to its eyeballs in a “reaching for return” investment strategy, which means it has gone full bore into “alternative investments,” a fancy name for high risk, high return, and somewhat to very illiquid strategies like hedge funds, private equity funds, and real estate funds. Kentucky has a whopping 34% of its total funds invested in alternative investments versus the average across the pension fund industry of 22%. That allocation has increased from a mere 7% 12 years ago. More and more experts are starting to question this enthusiasm. As Sirota writes:
For instance, citing data from Wilshire Consulting, conservative 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.
Alternative investments carry much higher fees than buying stocks and bonds. Private equity and hedge funds are famed for their commonly touted 2% annual management fee and 20% upside fee, although there is a good deal of variability around these norms. For instance, very large private equity funds sport lower management fees; some hedge and private equity funds, like Bain, demand and get eyepopping 30% upside fees.
Kentucky has not done at all well with this approach. Despite taking much higher risks, its returns have lagged that of its peers. The pension fund earned only 12% last year, compared to the 16% for public pension funds overall. Tobe argues that one of the reasons is its fondness for high fee products by Blackstone, which also has particularly powerful political contacts in the state.
The article focuses on two examples for which is has some documentation, both sales-related materials. One is for a hedge fund of fund. In general, public pension funds have no business investing in fund of funds, since they carry an additional level of fees. Fund of funds typically are a product for smaller investors, like high net worth individuals and small foundations and endowments, who want to participate in alternative investment, but the amount they can dedicate to the strategy would be enough for only one or two investments, leaving them inadequately diversified. But diversification comes at a very high price. The Blackstone fund of fund charges fairly typical (as in egregious) fees of 50 basis points in annual management fees and 10% upside fees (note that retail investors, who put in smaller amounts, often pay 1% in management fees and 10% in performance fees). Mind you, that is on top of the fees paid to the actual hedge funds themselves, which Blackstone estimates with peculiar precision at 1.62% in annual fees and 19.78% in performance fees.
Now the whole premise of this exercise is silly. As we noted in an earlier post on private equity, the notion that investors can somehow out-compete their peers and wind up largely in top-performing funds has been rejected in more liquid markets, where most large players rely on index funds, yet this bad idea is very much alive in the world of alternative investments. And there’s even less justification for it with hedge funds than with private equity. At least there was a weak case to be made in PE, since top quartile funds once showed persistent outperformance. A McKinsey report has demonstrated that that is no longer true (and even in the days when that persistence held, investors were still all too easily fooled, since 80% of the funds could define their comparable universe in such as way as to claim to be in the vaunted top tier). By contrast, hedge funds don’t show this type of persistence.
And even if it might in theory be possible to find this elusive type of fund, reading the document reveals that Blackstone’s credentials in this space are unimpressive. You can see how much this section relies on the firm’s general credentials; you see nary a word about the experience of the leaders of this operation. The weasel wording is cringe-making (click to enlarge, or see first embedded document at the end of this post):
And then Blackstone tells prospective investors it has a hedge fund seeding operation, and it has the right to put those baby hedge funds that it believes will scale into the fund of fund. Not to worry, it will offset revenues it receives against the management fee at the fund of fund level. But did you miss the sleight of hand? Blackstone gets to pull its capital out of these fund, and the underlying fund (in which Blackstone presumably has a large stake due to having put the fund in business) still gets its own management and upside fees. You’d need to read the actual investment agreement to be sure of how this works, but as I read this, Blackstone takes and then credits back the management fee at the fund of fund level, allowing it to retain any upside fees at the fund of fund level, as well as its cut of the management and upside fees in the fund proper. Thus it is guaranteed some profit from its share of the management fee at the fund level. Thus the conflict hasn’t been waived, as it misleading implies.
Blackstone also touts its strength in commodities, which recent studies have concluded aren’t worth investing in either from a diversification or a return perspective.
So it should not be surprising to learn that this fund of fund vehicle, called BAAM, hasn’t done all that well:
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.”
Tobe also provided two sales documents for a Blackstone V, a $12.5 billion fund launched in 2006, the largest to this date. I’m discussing them in less detail simply because their warts will be more familiar to Naked Capitalism readers by virtue of our ongoing coverage of the private equity industry. But if you’ve got time, be sure to read about the considerable conflict of interest set forth in the second embedded document, “Risk Factors and Potential Conflicts of Interest.” “Potential”? The conflicts of interest described are numerous and glaring. It’s hard to see how Blackstone can operate as anything remotely resembling a fair broker.
And this doesn’t just happen at an institutional level; as we wrote last year, there are also conflicts of interest between Blackstone’s principals and its funds, using the example of Blackstone’s chief operating officer, Tony James, who with his two brothers also owns a “family private equity firm,” Swift River. While it’s clear that Swift River is too small to bid against Blackstone, it has conflicts on another level. Blackstone spun out a software company it had developed in-house, iLevel Solutions, to Swift River. And both Blackstone and Swift River are investing actively in offshore drilling companies. As we wrote:
On the one hand, there is no evidence that James is using his Blackstone position to have the Blackstone Energy Partners companies do business with the companies he owns. On the other hand, his iLevel deal with Blackstone shows that neither James nor Blackstone appear to have any reluctance to engage in related party transactions. Moreover, independent of any oil services transactions between Blackstone and Swift River, there are other ways that James and his family benefit from the shared interests and may cross the line into “improper personal benefit”. All of the information that James gets in his formal day job, such as contract, industry intelligence, and deal flow, can also be used to help Swift River. In fact, it’s hard to see how James could stop that from happening even if he wanted to. How can he erect a Chinese wall in his brain?
What makes these dealings particularly troubling is that Blackstone’s fund investors are absolutely powerless to even begin to monitor any of these potential related party transactions or resource-sharing in order to ensure that they are not abusive. In fact, private equity LP investors almost always sign up to fund terms (in the super-secret limited partnership agreements that are the only state and local government contracts not subject to FOIA) where the investors agree to let the PE firm executives compete against the funds they manage. This is undoubtedly the case with Blackstone’s funds, which demonstrates just how dysfunctional the entire ecosystem of private equity actually is. And remember, the dominant LP investors in private equity are your state and local governments, the universities you attended that constantly hound you for donations, and the mutual insurance companies that you theoretically own as policy holders.
The final embedded document is also a Blackstone V pitch piece. Notice that while the latest fund, Blackstone IV, has been able to monetize some of its investment quickly, it’s typical that the best deals in a PE fund are cashed out quickly. A substantial portion of the value attributed to the fund is in the unrealized investments. Recall the major finding of the Oxford study that led to our request for CalPERS data: PE funds exaggerate the value of their remaining holdings around the time they are raising new funds.
Why was Kentucky willing to entertain something as obviously dubious as Blackstone’s hedge fund of funds? Sirota argues it’s due to Blackstone’s political connections:
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…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.
Whether its mere cluelessness or whether the political connections influenced Kentucky’s decisions almost seems moot. No matter how you cut it, the Kentucky Retirement System hasn’t done well with its outsized commitment to alternative investments.