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Kentucky Investment in Blackstone Fund of Funds Shows Desperation and Cluelessness of Some Public Pension Funds
No matter how you cut it, the Kentucky Retirement System hasn't done well with its outsized commitment to alternative investments.
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 upEven 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 laterPublic 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 slaughterSirota’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 fundedAs 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 fundsKentucky 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 agoMore and more experts are starting to question this enthusiasmAs 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.Sstocks 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 bondsPrivate 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 normsFor 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 approachDespite taking much higher risks, its returns have lagged that of its peersThe pension fund earned only 12% last year, compared to the 16% for public pension funds overallTobe 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 materialsOne is for a hedge fund of fundIn general, public pension funds have no business investing in fund of funds, since they carry an additional level of feesFund 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 diversifiedBut diversification comes at a very high priceThe 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 sillyAs 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 investmentsAnd there’s even less justification for it with hedge funds than with private equityAt least there was a weak case to be made in PE, since top quartile funds once showed persistent outperformanceA 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 unimpressiveYou 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 operationThe 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 fundNot to worry, it will offset revenues it receives against the management fee at the fund of fund levelBut 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 feesYou’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 properThus it is guaranteed some profit from its share of the management fee at the fund levelThus 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 systemThat 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 fundThose 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 dateI’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 industryBut 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 glaringIt’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 RiverWhile it’s clear that Swift River is too small to bid against Blackstone, it has conflicts on another levelBlackstone spun out a software company it had developed in-house, iLevel Solutions, to Swift RiverAnd both Blackstone and Swift River are investing actively in offshore drilling companiesAs 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 ownsOn the other hand, his iLevel deal with Blackstone shows that neither James nor Blackstone appear to have any reluctance to engage in related party transactionsMoreover, 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 RiverIn fact, it’s hard to see how James could stop that from happening even if he wanted toHow 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 abusiveIn 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 manageThis is undoubtedly the case with Blackstone’s funds, which demonstrates just how dysfunctional the entire ecosystem of private equity actually isAnd 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 pieceNotice 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 quicklyA substantial portion of the value attributed to the fund is in the unrealized investmentsRecall 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 clientsSo, 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.SSenator Mitch McConnell (R).
Some of that money can filter directly the coffers of state parties that specifically run elections for positions involved in pension policyFor 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 mootNo matter how you cut it, the Kentucky Retirement System hasn’t done well with its outsized commitment to alternative investments
Blackstone Risk Language
This entry was posted in Hedge funds, Investment management, Private equity on May 6, 2014 by Yves Smith.
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Moneta May 6, 2014 at 7:19 am
It’s not just Blackstone Many firms can start more than one fund but it’s not clear which fund gets the quality investments.
Yves Smith Post authorMay 6, 2014 at 7:21 am
Blackstone isn’t putting only incubated funds in this fund of fundThere’s the much bigger issue that even if Blackstone was choosing only third party funds,, there’s no reason to think they can outcompete other investors trying to do precisely the same thing.
Moneta May 6, 2014 at 7:35 am
Agreed I was just emphasizing the conflict of interest.
There are good PE deals out there, not sure many pension plans will get them!
Moneta May 6, 2014 at 7:28 am
Even small underfunded plans are going into alternatives One IPS came across my desk… grossly underfunded, closed to young ones so the money would run out faster… going from 60/40 E/FI to 75/25 Fixed income getting immunized so that means going longer term And the difference going into alternative investments It’s being sold as volatility control for coearnings.
BTW, I don’t touch these mandates with a ten foot pole.
Jim in SC May 6, 2014 at 8:04 am
South Carolina’s pension fund has a far larger percentage in alternatives than Kentucky does, something over 50% It has become a huge political football My mother is a SC state government pensioner
There was recently an audit, which declared everything hunky-dory Only two firms bid to do the audit, and the one who lost–which is run by a Forbes columnist and critic of the alternative asset industry–got into an online name calling fight with one of the members of the Retirement System Investment Commission.
Thank you for pointing out how money is likely changing hands.
financial matters May 6, 2014 at 8:15 am
As we’ve examined in detail the stock market is also a very poor investment choice and corporate bonds not much better
We need more of a responsible long term investment option and under current conditions this looks like one of the best options
Instead of bailing out fraudulent financial systems the Fed backstop could let pension funds invest in numerous projects that would be in the public interest and allow for a vibrant economy which would be able to support pension funds rather than an austerity based economy which deflates them
But what else can the Fed chair do? Actually, quite a lotInstead of pumping more money into the banking system, where much of it feeds speculation, the chairman should figure out how to get it to the sectors of commerce or industry that really need it.
The Fed could help organize and finance major infrastructure projects, like modernizing the national electrical grid, building high-speed rail systems, and cleaning up after Hurricane Sandy—public works that create jobs the old- fashioned wayThe Fed could influence the investment decisions of private capital by backstopping public-private bonds needed to finance the long-neglected overhaul of the nation’s common assetsOne recommendation that was floated long ago is to allow state and local governments access to bond markets to finance infrastructure investment at low Treasury rates (through a Federal government guarantee of specified projects).
Alternatively, the Federal government could provide funding to pay the interest (or a portion of it) so long as state and local governments could service the principal.
These are plausible examples of what the central bank might do if it truly tries to fulfill its dual mandateOrthodox monetary economists will be horrified by such talk: these alternatives, they will say, are technically impossible, maybe even illegalA few of the suggestions would probably require clarifying legislation and congressional cooperationBut the Fed can carry out direct interventions to help the economy recover because it has done them beforeIn the 1920s, believe it or not, the Federal Reserve even underwrote the bonuses promised to World War I veterans when private banks wouldn’t honor their certificates of service.
During the Great Depression, the Federal Reserve was given open-ended legal authority under section 13(3) of the FRA (enacted in 1932) to lend to practically anyone if its Board of Governors declared an economic emergency—without approval from Congress.
Whether or not the Fed’s recent interventions during the GFC were justified, the point here is that the central bank was willing to save certain corporate enterprises when it believed the consequences of their failure would threaten the largest banking institutionsYet, the Fed declined to do something similar for the overall economy and help millions of indebted homeowners and unemployed workers.
The central bank can lend to industrial corporations and small businesses, including partnerships, individuals, and other entities that are not commercial banks or even financial firmsThe Fed made thousands of direct loans to private businesses during the New Deal.
Jane D’Arista, author of The Evolution of US Finance147 and a leading reform advocate, insists that the central bank has numerous levers to drive reluctant bankers to support a vigorous recovery with more plentiful lending“The Federal Reserve as an instrument of credit policy is weak, and right now we need it to be strong,” she saidThe Fed could alter reserve requirements to punish bankers or reward themIt could stop paying interest on the enormous idle reserves banks are now sitting on and start charging a penalty rate for banks that won’t use their lending capacityThe Fed can steer banks to neglected categories of lending—small businesses, for instance—by lowering the reserve requirement on those loansAbove all, D’Arista believes, the Fed can simultaneously begin to reform the banking system from the bottom up.
“Let’s forget the big guys,” she saidThey’re hopelessWe’re not going to get anywhere with themHowever, the community bank is an engine of growth, and here is a way to help themCommunity banks are naturally skittishThey need real reassurance for the kind of lending that isn’t corporate-scaleThis could also involve them in infrastructure projects initiated by state and local governmentsThat’s where the Fed’s discount window could come in and helpIt is a way of backstopping the little community bank and the medium-sized bank.148
She envisions consortiums of small banks participating in big projectsThe Fed could help organize them.
Stephen Sleigh, a labor economist and director of the national pension fund for the International Association of Machinists and Aerospace Workers union, has similar ideas about how the Fed can persuade private capital investment to finance major infrastructure projects“Part of Bernanke’s strategy of pushing down interest rates, both short-term and long-term, is to force conservative money into investments like construction,” Sleigh observed“That makes perfect sense, but the capital is not flowingIt’s still on the sidelinesI would love to see the Fed start talking about infrastructureThe Fed needs to be working on new tools and find ways to get the conservative money off the sidelines and start rebuilding the American economy.”149
Conservative investors like pension funds and insurance companies lost an important source of income when the Fed lowered interest rates drasticallySleigh explained: “As a pension fund manager, I need investments that are going to provide reliable, steady income that can sustain our long-term assumptionsTraditionally, the ten-year Treasury bond was a way to pay the bills, but it doesn’t do that anymore, because it is trading now at less than 2 percent.”
A solution Sleigh envisions would involve bond borrowing for public-private infrastructure projects that would be “labor-intensive and great for long-term economic growth and would absolutely help us meet our obligations, because these bonds are going to yield 6 to 8 percent on our investments.”
If this country ever gets back to a time when real questions are asked about democracy and our unrealized aspirations, people and politicians will have to talk about the Federal Reserve and its “money power.” It no longer makes sense to keep fiscal and monetary policy separate, pulling the economy in opposite directionsThe present crisis suggests that monetary tools are (and should be) coordinated with the fiscal side—and that could even be strengthenedHow this could be done in a democratic way is a tough question, but it is one that can be explored once we peel back the layers of fog that cloud thinking about monetary and fiscal operationsWhen asked where he got all that money that the Fed was using to purchase assets, Chairman Bernanke correctly answered that the Fed created itIt did not come from taxpayersIf the Fed can spend by “keystroke” to buy financial assets, why can we not find a way for government to spend in the public interest by “keystroke”?
The challenge now is to convince ourselves that money created by government could be used—judiciously—to finance long-term public projects, like infrastructure and high-speed railWhat about Hyman Minsky’s proposal to use government as employer of last resort? Imagine if highest-priority projects were financed with the new money created by the cooperation between the Treasury and the Federal Reserve—breaking in a single stroke the logjam in Washington created by the belief that Uncle Sam has “run out of money” as President Obama wrongly believes.
Moneta May 6, 2014 at 9:35 am
Theoretically, these PE funds should be investing in this “new” economy That’s what PE is supposed to do!
So at this point in the cycle, we are in a conundrum… you, and many others are asking pension plans to fund risky investments because as a nation that is what the US needs, However, pensioners want risk free cash flow.
financial matters May 6, 2014 at 9:43 am
That’s the point of having a Fed backstop except this time telling us beforehand what they are investing inUnlike PE the Fed has a Congressional mandate.
FBeard May 6, 2014 at 10:25 am
Pensions should be the responsibility of the monetary sovereign so long as it subsidizes the boom-bust cycle by subsidizing credit creation.
allcoppedout May 6, 2014 at 5:19 pm
FM – I accuse you of talking sense Off to re-education for you!
James Levy May 6, 2014 at 9:36 am
You’d need a cadre in government that believed in itself and its ability to get things done without recourse to endless subsidies and intermediaries in the “private sector” (actually a huge apparatus designed to suck up and skim off public funds)
Such men and women do not exist in any numbers anywhere near the levers of power
Forty years of endless indoctrination in the glories of the “free” market and that “government is the problem” plus a lowering of ethical standards so that everywhere you look you see corruption has convinced the willing and demoralized those who would use government to right the wrongs of this systemRube Goldberg nightmares like Obamacare are the absolute limit of the ruling elite’s notion of what government can do for people (i.esubsidize a for-profit institution to do what would be better and cheaper if done universally by government)
Creation is a function of self-belief, systems that are responsive to change, and resources made available for action to be takenAll are effectively lacking in our moribund polityOur society will be undone as much by a lack of courage and belief as it will be by venal men and oversized, sclerotic institutions.
financial matters May 6, 2014 at 9:51 am
We do have good people who want change as with the students who want to reform economic teaching
This was also strongly endorsed by Robert Skidelsky who said economists desperately need crosstraining in other social sciences.
Layman May 6, 2014 at 2:28 pm
Great reading all thatHere’s a suggestion in the form of a question:
Why not let these massive and systemically mismanaged (if not outright corrupted) pension funds go bankrupt, then bail them out — but contingent upon them ceding managerial control to gov’t? Perhaps this vast source of capital could be earmarked to more productive and less risky (gov’t-sponsored) projectsI should also add that this wouldn’t be a “bailout” in the conventional sense; the injection of gov’t capital wouldn’t be used to acquit mismanagement/fraud (“moral hazard”), but rather as a vehicle to restructructure the pension systemA benign hostile takeover, if you will.
financial matters May 6, 2014 at 4:37 pm
Sounds reasonable to me and more in line with how the Fed should have handled the financial institutions.
Doug Terpstra May 6, 2014 at 11:41 pm
This is a profound mission statement, FM, compelling and visionary An Apollo program for alternative energy and carbon sequestration can kindle the global imagination, but this is quite beyond the miserly twisted minds of the criminal reserve cartel, our militarist emperor and his minions So until the criminally insane are swept out of leadership, a revolutionary agenda like yours has zero prospect of traction It needs to be aired far and wide so the sweeping can begin.
Chris Tobe May 6, 2014 at 9:16 am
I disagree with the underlying premise that Kentucky was “reaching for return”I think this is an industry driven slogan designed primarily to cover up the underlying pay to play corruption First of all our
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