Despite the at times disconcertingly polite tone, the SEC has now announced that more than 50 percent of private equity firms it has audited have engaged in serious infractions of securities laws. These abuses were detected thanks to to Dodd Frank. Private equity general partners had been unregulated until early 2012, when they were required to SEC regulation as investment advisers.
Bowden heads the SEC’s examinations unit, and his rap sheet was based on his two years of experience in auditing private equity firms. As bad as embezzlement and other sharp practices are, at least as troubling is the revelation that the limited partners have been derelict in their duties. They’ve agreed to terms in their relationship with the general partners to make it easy for the general partners to abuse the investors. The general partners can steal from their limited partners because the limited partners are asleep. The LPs have failed to negotiate for contractual protections when they have the most leverage, prior to investing, and they’ve been unwilling or unable to monitor their investments effectively once they’ve handed over their money. Note that the industry was warned about this possible outcome; it corresponds to the worst scenario, ” A Broken Industry,” in a 2011 paper by Harvard Business School professor Josh Lerner.
One of the most pernicious financial schemes of the post crisis era relates to a practice most Americans are entirely in the dark about, but may end up harming retirement plans down the line. I refer to the pervasive, incestuous and shady relationship between public pension fund managers, politicians and alternative asset firms (hedge funds and private equity).
Indeed, in the “new normal” of rigged financial markets, much of the investment industry no longer cares all that much about performance. The name of the game is to simply collect as massive an asset under management pile as possible and earn tremendous wealth by collecting fees risk-free. The enormous amount of “dumb money” residing at public pension funds provides the perfect mark, and pension managers as well as corrupt politicians and their appointed bureaucrats appear more than willing to comply.
David Sirota, investigative journalist at the International Business Times, has been one of the leading figures in exposing such schemes, and his latest piece, Wall Street Fine Print: Retirees Want FBI Probe Of Pension Investment Deals, is extremely important. Here are a few excerpts:
Diane Bucci and her fellow retired Rhode Island schoolteachers were angry about a deal last year to cut their promised retirement benefits. For 28 years, the elementary school teacher devoted between 7 and 9 percent of her paycheck to the state’s pension system. In return, the 72-year-old had been promised a consistent cost-of-living increase to make sure her retirement stipend kept pace with inflation. Now, though, state officials were trimming her check in the name of replenishing the depleted pension fund.
“There was a lot of unrest and anger among teachers, but at that point we buckled down and focused on how we could get to solvency,” said Bucci, who is on the board of the 700-member Rhode Island Retired Teachers Association. “So even though we aren’t Wall Street experts, we just started to ask questions about how the pension fund was managed, and what it was invested in. That’s when we realized the fees we’ve been paying to the investment companies were the problem.”
Those levies — which hit $79 million last year — were the product of the state’s recent investment strategy. Following a controversial national trend, Rhode Island pension officials led by then-General Treasurer Gina Raimondo shifted roughly a quarter of the state’s pension portfolio into high-fee hedge funds, private equity firms and other so-called “alternative investments.”
Of course, Gina is far from the only treasurer accused of scheming to help the financial industry pillage retirees. Recall: Meet Janet Cowell – The North Carolina Treasurer Desperately Pushing to Keep Criminal Public Pension Fees Secret
The shift by Raimondo, a Democrat who is now governor, has generated big revenues for Wall Street firms, but only middling returns for a $7.6 billion pension fund on which more than 58,000 current and future retirees rely.
When Bucci and the members of her organization began asking questions about those results, they learned of a federal review showing that roughly half of all private equity firms are charging hidden fees, and they saw a hedge fund industry whose returns have failed to keep pace with the stock market. When they dug deeper, they stumbled onto an even more disturbing revelation. What they found, they say, is evidence that some investors can obtain special rights that may let them secretly siphon money from the state pensioners’ retirement savings.
The retirees are now petitioning federal law enforcement officials to investigate whether the widely used provisions are violating laws designed to make sure all investors are treated fairly. In a letter sent last month to the Securities and Exchange Commission and the FBI, the retirees’ adviser — former SEC investigator Edward Siedle — pointed out that some of the firms managing Rhode Island pension money claim the right to offer different fee rates, inside information and cash-out rights to some investors but not to others.
12 out of 18 hedge funds in the Rhode Island portfolio have filed documents with the SEC showing they assert the right to give certain investors preferences over other investors. In the public sector, the 12 firms oversee money for 85 public pensions and public university endowments in 36 states, according to data compiled by the research firm Preqin.
“When money managers disclose that secret investors may be given preferences, state pension officials and pensioners deserve to know whether they are being harmed in the process,” Siedle told International Business Times.
“There is a legitimate reason for some of these preferences,” said Harvard University’s Jay Youngdahl, an attorney who serves as a trustee for a steelworkers’ pension fund in Ohio. “But there’s also a not-so-legitimate reason for these preferences: If you are a Wall Street money manager, it allows you and your buddies to build a black box and loot retirees’ money.”
Over the last decade, SEC officials have repeatedly warned that such preferences could improperly shield favored investors from expenses that should be shared by all investors. In 2013, the agency brought successful cases against hedge funds over their decision to give certain investors special privileges. Earlier this year, the SEC sanctioned private equity giant KKR for charging fees to investors that it didn’t charge to its own executives in the same investments.
Fears about such schemes are acute for pension funds, which are often controlled not by the retirees, but by public officials. The worry is that with no skin in the game — and with campaign contributions and junkets working to influence their behavior — pension officials may not always prioritize the best interests of retirees. Some analysts use the term “dumb pension money” to describe the issue of pension officials potentially being less rigorous in their decision making — which could make retirees susceptible to being harmed by special privileges given to other investors. Concerns are particularly intense when it comes to pension investments in hedge funds, which generated poor returns for retirees last year but still made headlines spending investors’ money on lavish year-end parties.
Rhode Island’s retiree association appears to be the first to request a criminal probe of whether the preferences are harming taxpayers and government workers. In all, municipal and state pension funds now have roughly $660 billion in alternative investments.
With the fees generated on that much money, it doesn’t matter to the fund managers whether they make a dime from performance or not.
Rhode Island has led the charge into those riskier investments at the behest of Raimondo — a former venture capitalist at a firm that has charged the state pension some of the highest fee rates of any in its portfolio. She won the treasurer’s office in 2010 and quickly pushed to shift roughly $2 billion of retirees’ assets into private financial firms. Raimondo simultaneously proposed cuts to pension benefits in a state where the average retired teacher gets a $45,000 annual stipend.
As government workers protested the cuts, a Rhode Island union hired Siedle to evaluate whether the pension fund’s investments were draining the system. When he and Rhode Island’s largest newspaper requested the text of agreements between the state and private financial firms, they were blocked by Raimondo’s office, which at one point justified the decision by noting that Wall Street managers seek “to minimize attention around their own compensation.” Rhode Island, like many states, allows public officials to withhold details of their agreements with private financial firms.
Yes, you really did just read that.
Siedle’s 2013 report concluded that Raimondo’s push into alternative investments such as hedge funds would help financial firms rake in more than $2 billion in new fees. Since 2011, Rhode Island’s $1.2 billion hedge fund portfolio has overall generated $140 million in fees for hedge fund firms while delivering returns that have significantly trailed traditional low-fee stock index funds. Rhode Island’s pension finances have slightly improved in recent years, but the state still faces a $1.8 billion gap between pension assets and liabilities.
SEC forms from Och-Ziff, a hedge fund that manages $106 million of Rhode Island pension money, say the firm “typically” prevents investors from withdrawing their money for a certain time period — but that when “partners, principals, employees and their respective family members (and those of our affiliates) also own interests in Funds, they will generally be permitted to withdraw from the Funds at more frequent intervals than other investors.” The firm says that if one of its funds is “required to liquidate holdings to satisfy these withdrawal requests” from the privileged investors, “additional costs and expenses will be incurred and will be borne primarily by the remaining investors.”
Since 2011, Och-Ziff has been paid more than $14 million in fees by the Rhode Island pension fund and has generated returns that have fallen short of a low-fee S&P 500 index fund, according to state documents.
“A lot of these investments have a ‘roach motel’ quality: the ability to get in but not get out,” pension consultant Chris Tobe said. “When there’s a secret door for privileged people to get out of the roach motel, that can help them and hurt everyone else who is still stuck in there.”
Similarly, private equity giant GTCR (which does not manage Rhode Island money) says “family members, certain business associates, other ‘friends of the firm’ or other persons may invest alongside funds” it runs for regular investors. GTCR notes that it “might have an incentive to improve the performance of one fund by selling underperforming assets to another fund in order, for example, to earn fees.” The firm, whose most famous stakeholder is Illinois Republican Gov. Bruce Rauner, says it may withhold some information from certain investors “that are subject to Freedom of Information Act or similar requirements” — meaning governments.
Many of the firms downplayed the provisions, telling IBT that the language about preferences is standard in the industry. None of them would respond on the record to IBT’s questions.
“There’s nothing illegal about secrecy in and of itself, but when you set up a highly secretive, highly profitable investment scheme and then you allow public officials to direct public money into it, you have to wonder if there are kickbacks and financial favors for insiders — and that does lead to the question of whether these investments fulfill the law’s fiduciary requirements,” Greenwood told IBT. “If you hand someone else’s money to someone and say, ‘I won’t ask what you will do with it,’ you can’t be terribly surprised if one of the people you hand money to is Madoff. You are setting yourself up to be robbed.”
Bucci told IBT that she and her group don’t expect any help from Gov. Raimondo — who still maintains an ownership stake in a firm that manages Rhode Island pension money. So in June, the retirees’ group contacted Rhode Island Attorney General Peter Kilmartin, a Democrat, asking for an investigation.
That request was denied in letters from Kilmartin’s aides telling the group his office “has limited investigatory power [and] no stand-alone investigatory staff.” Kilmartin’s staff suggested that the retirees contact the state or local police, which they did. Bucci’s colleague, retired music teacher Ann Gardella, said that one local police chief she contacted advised the group to try to get the FBI involved through a private attorney — one from out of state who would not be compromised by Rhode Island’s notoriously insular political culture. That’s when they hired Siedle.
“When we started looking into this, we had no idea that the people we were giving our retirement savings to were allowed to use our money to give special favors to their friends,” Bucci told IBT. “These investments may be fine if it was all just rich people, but they are not appropriate for pensioners. Why are we investing money in funds that don’t even tell us what’s being done with our money? The lack of transparency at best makes it too easy to mismanage our money — and knowing what I know now, I’m afraid something much more diabolical is happening.”
Of course something more diabolical is happening, the entire U.S. economy is pretty much diabolical at this point.
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