New York Pension Regulator Shellacks State for Overpaying for Hedge Fund Underperformance, Enabling Private Equity Fee Secrecy

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New York’s feared former Superintendent of Financial Services, Benjamin Lawsky, appears to have left a mark on the agency. Yesterday, the agency issued a blistering report on the failings of the New York State Comptroller in managing the state pension fund system’s “alternative” investments, specifically hedge funds and private equity funds. We’ve embedded the document at the end of this post.

We may have played a role in the section that discusses private equity, since we called the problem of private equity fee abuses and lack of transparency to the Department of Financial Service’s attention in January 2015.

The entire report is worth reading if nothing else for its exceptional direct style and harsh criticism. The DFS, which supervises state pension funds, found no excuse for the fact that the two state pension funds, which together make New York State the fourth biggest public pension fund in the US, were overpaying for hedge fund duds: over $1 billion in excess fees to hedge fund managers who underperformed to the tune of $2.8 billion.” Even worse, the state only now has gotten around to addressing the fact that many of its managers charge hefty fees for the privilege of lagging the stock market, while most other public pension funds have woken up to the problems with hedge funds and have been cutting allocations to or firing doggy fund managers.

The report cuts the hedge fund data every way conceivable and has nothing nice to say about it. For instance (emphasis original):

In comparing the 10-year 5.38% return for the Global Equity6 category with the hedge fund 3.23% return, the bulk of the hedge fund underperformance is due to the higher fees. The State pension system simply gave away tens or even hundreds of millions of dollars in fees every year for 10 years to hedge fund managers, and received no value in return.

Over the most recent 5 years, the story is even worse as the gap in performance is well in excess of the fees paid. Global Equity returned 8.03% while the Absolute Return Strategy returned only 3.69%. The State pension system paid a premium price for significantly subpar performance….

Having seen three straight years of massive underperformance in 2009, 2010 and 2011, when the System’s Absolute Return Strategy underperformed the Global Equity investments by at least 10 percentage points each year, the State Comptroller failed to reassess an obviously failing hedge fund strategy…

It is easy to see how a more thoughtful approach, simply paying attention to the conventional wisdom that it is practically impossible to beat the market over any sustained time period, would have benefited both New York State taxpayers and employees. Even simply putting the System on autopilot by investing in index funds would have saved billions of dollars

The report points out that not only have public pension funds in California, Illinois, and New Jersey shrunk or ended their hedge fund investment programs, but even the New York City comptroller woke up to the problem of excessive hedge fund fees and lousy performance in 2015 and early this year, the trustees of the New York City pension system voted to wind down the program.

The section on private equity is just as harsh. It called out the fact that the Comptroller ‘fessed up that it knew there was gambling in Casablanca, um, a lack of private equity fee transparency and resulting abuses, yet tried to fob its problem onto the SEC. And get a load of the action it deems to be necessary (emphasis ours):

Simply waiting for the SEC to fully investigate an industry, and then craft and adopt appropriate rules, is not action by the sole trustee of the State pension system charged with protecting its assets and promoting the interests of beneficiaries. At the very least, if there were a lack of transparency as to whether the general partners, or their affiliates, are overpaying themselves at the Common Retirement Fund’s expense, pursuing a freeze on fees and expenses until full information is provided would be in order. Continuing to pay the bill in full – and perhaps overpaying – is not the path to eliminating excessive expenses. Instead, the Comptroller should confirm that full disclosure occurs before any payments go out the door.

Heads would explode in private equity if a pension fund were to withhold fees pending a better accounting. However, the general partner would likely deem that to be a failure to meet a capital call, and the remedies for that are draconian (typically seizure of the defaulting limited partner’s interest with it distributed to the fund). However, contracts rest on a premise of good faith and fair dealing, and if the limited partner could allege an underlying breach (and the abuse of monitoring fees, which Ludovic Phalippou called “money for nothing,” might be a place to start), they might not be in as weak a position as most general partners would think. Moreover, if the limited partner had a strong enough case to get past summary judgment (likely), he’d be able to do a lot of digging in discovery, which is something general partners would be very keen to avoid.

Now of course, this line of thinking goes utterly against the widespread assumption that no one dares stand up to the general partners because they would be blackballed by the industry and would be outgunned legally. But the DFS is the New York State pension funds’ regulator, and if the DFS presses the issue, the Comptroller is going to have to take some action.

At a minimum, the DFS has flatly rejected the idea that New York should passively accept the meager information provided them by the general partners and rely on the bogus excuse that pressing for more might make them unpopular. The report cites state regulations that hold the Comptroller to standards it is arguably not meeting, particularly in light of the fact that many smaller public pension systems are succeeding in obtaining much more information about fees and costs.

The DFS report concludes with a list of tough demands:

As to transparency of private equity fees and expenses, the Comptroller should at a minimum:

1) Develop a comprehensive accounting for all fees and expenses related to CRF’s private equity activity;

2) Develop an internally consistent method to record and report all expenses incurred across all private equity investments so that fees and expenses can be compared
and opportunities for reducing costs can be identified;

3) Impose and/or reinforce processes to review existing private equity arrangements to assure that existing fee and expense allocation comply with their agreements;

4) Make public all information regarding fees, expenses, and carried interest; and

5) Require general partners to restate prior reports to provide transparency consistent with any new requirements, and to affirmatively self-report any prior questionable practices for further review

The DFS is a young agency and it has yet to flex its muscles in this area. However, it proved to be a very tough infighter despite being at what appeared to be a very disadvantaged position in taking on major international banks and end-running Federal regulators, who were initially outraged by a second-tier regulator embarrassing them. So while the balance of power would appear to be stacked against the DFS, it would be a big mistake to underestimate what the agency might be able to achieve. Few regulatory bodies are willing to use all the tools at their disposal, and the DFS has proven to be a rare and welcome exception.


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  1. allan

    As valid as the points in the DFS report might be, it shouldn’t be read in a vacuum. Comptroller Tom DiNapoli is in a virtual war with Andrew Cuomo over corruption in the state’s economic development projects and procurement practices. This has already led to indictments of people very close to Cuomo.
    The DFS report, whatever its merits, comes from an agency which is now run by a close Cuomo ally.
    Here is a story with some background by an Albany-based Gannett reporter:

    Banjamin Lawsky, the first superintendent of the DFS, from 2011-15,
    was highly independent and accomplished a lot.
    His successor served under Cuomo for years. Just saying.

    1. Pat

      Why one might think there is a link…

      If Cuomo achieves his obvious ambition, he could be the blunt instrument that makes the quid pro quo limit of corruption clearly inadequate. He makes the Clintons appear subtle.

    2. KYrocky

      If it walks like a duck and quacks like a duck then it’s criminal. When the sums are this big the cause is not incompetence, it’s corruption.

      The looting of pension funds by private equity has long been understood, just not quantified. What possible motivation would exist for fund managers to allow billions of dollars so be diverted to PE and hedge fund managers for no apparent reason? Not to mention structuring deals to hide the amounts being diverted.

      These deals were structured to be crooked. End of story. The questions is why, who were the individuals involved on the inside, and what did they get in return. Of course Albany is involved. What needs to be learned is exactly what those involved received for the billions in public funds diverted to their friends on Wall Street.

      If only this country had a Justice system that worked.

    3. societax

      Benjamin Lawsky was one of the most senior deputies in Cuomo’s attorney general administration. Maria Vullo, the current DFS superintendent, joined Cuomo three years into the administration and thus worked for Cuomo for a shorter period.

      When Cuomo created DFS, it served two purposes: reorganizing some state agencies (which he did with other agencies, too), and eroding the attorney general’s power to the detriment to Cuomo’s adversary Eric Schneiderman.

  2. cnchal

    Heads would explode in private equity if a pension fund were to withhold fees pending a better accounting.

    Then that’s what the pension funds ought to do. I would like to see the Pirate Equity heads explode. They have been blowing up all sorts of companies for decades and destroying people’s lives for fun and profit. Crimp their cash flow so that refueling the Pirate’s ship becomes impossible.

    Same with the hedgies. Explode their heads too.

    The State pension system simply gave away tens or even hundreds of millions of dollars in fees every year for 10 years to hedge fund managers, and received no value in return.

    What is that really? Grand theft by Wall Street, and they got away. Physically robbing someone of a few hundred dollars gets years in prison, robbing billions from the people gets years in the Hamptons.

    Why any pension fund manager places losing money with these thieves is beyond comprehension, unless the entire pension scheme is no more than an elaborate ponzi. Having Pirate Equity destroy the tax paying capacity of the companies that they loot, while using the pension beneficiaries money to do it, is ultimately like shooting yourself in the ass. It’s going to hurt and could kill you.

    Are the pension fund managers that corrupt? It seems, yes.

  3. Sluggeaux

    The DFS report concludes that:

    A contract to overpay hedge fund managers, when the probability of underperformance is high, makes no sense.

    However, as Upton Sinclair pointed out way back in 1935:

    It is difficult to get a man to understand something, when his salary depends on his not understanding it.

    These Hedge Fund and “Private Equity” LBO scam-artists are playing with Other Peoples’ Money, and have no problem spreading a little of it around as bribes. Ironically, they don’t even have to directly pay-off the petty bureaucrats charged as fiduciaries. Instead, they make political contributions to the executive and legislative players who can make the putative fiduciaries’ lives miserable, or who can influence their promotion to less a less onerous sinecure, leaving no direct quid pro quo as evidence of the pervasive corruption that allows the looting of the pension savings of public servants.

  4. none

    Are these PE investments like the stock market, where you can cash out whenever you want? Or are the limited partners stuck for some period (how long)? I have no idea how this stuff works.

    1. Yves Smith Post author

      Investors commit funds to private equity, so in the case of New York State, the commitment might be for $100 or $500 million to a specific fund. The general partner (the fund manager) calls capital as needed to buy companies and for management fees (if that is included in the commitment amount, some funds have that set up as a charge outside the commitment amount). The investors get their money back when companies are sold.

      The expected life of a PE fund is expected to be 10 years, but as you can see from CalPERS website, there are some funds from the 1990s that are still alive, as in they have a company or some sort of stub asset like options that they haven’t sold.

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