STUMP » Articles » Are Hedge Funds or Private Equity Investments Appropriate for Public Pension Funds? » 28 November 2017, 03:39

Where Stu & MP spout off about everything.

Are Hedge Funds or Private Equity Investments Appropriate for Public Pension Funds?  


28 November 2017, 03:39

Inspired by a piece by David Sirota and a response by Cliff Asness:

There’s a fun thread to follow on that Asness tweet, with a back-and-forth between Sirota and Asness (and others).


Now, I don’t particularly have a problem with hedge funds, private equity, the Caymans, Bermuda, etc.

But let us not be coy about the reasons for these items: they’re trying to optimize returns by using legal structures that can give them something better than public securities can. For the specific locations, like the Caymans, they’re taking advantage of the regulatory/legal environment (just as so many corporations are incorporated in Delaware.) As for hedge funds and private equity, generally capital is deliberately tied up, ownership is closely held & controlled, with the idea that certain expertise and illiquidity will help them boost returns.

I think this is just fine for private investors, to pursue their own ends. If a private investor wants to be involved this way, and keep an eye on their investments this way, there’s no problem: they’re looking out for their own, direct interests.

I don’t think this is fine for public pensions.


Paradise Papers: Your Retirement Cash May Be In The Caymans. Can You Get It Back?

I will excerpt a few bits:

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.

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.

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.”

Well, duh. But this doesn’t mean the money will simply go poof.

It is not really public pensions’ problems whether asset managers are avoiding local taxes (or, more likely, simply deferring tax hits til later.) Also, the fees are up for negotiation, yadda yadda. But back to the fees later.

Later down in the article:

“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.”

“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.”

Sirota focuses on the tax issue first (which, again, isn’t really the pension fund managers’ problem). The liquidity issue is not necessarily concerning either — it depends on how much oversight the public pension fund managers can provide. Private investors are not kept in the total dark (not savvy investors – they keep tabs on their private equity holdings)… maybe public pension fund managers have similar access…. though they’re precluded from sharing that information publicly, unlike with their public securities like common stocks and bonds.

And that lack of transparency to the outer public is the real problem.


Just another tweet:

So here’s the problem as a member of the public: I can read the CAFR for a public pension plan. For public securities, anyone can get the valuation information.

But not for hedge funds or private equity.

More to the point, if all these arrangements are private… how do we know the deals are aboveboard? Sirota and Ted Siedle like to point to the asset management fees. But fees aren’t the only issue.

Top 10 Reasons Why Stealing From State And Local Public Pensions Is The Perfect Crime:

8. Many public pensions are not audited annually by independent certified public accountants. State auditors lacking expertise in complex foreign investment schemes may not be up to the task of ferreting out wrongdoing.

9. Ever-growing percentages of public pension assets are being swept into offshore accounts and illiquid, hard-to-value assets. Nobody’s checking to see if the money is even really there.

10. As long as taxpayer rage continues to focus upon the amount of money flowing into public pension plans and the supposedly “rich” benefits they pay to state and local retirees, investment scamming related to the pension portfolios will not be a priority.

Do these investments really have adequate oversight?

We saw some incredible meltdowns in Dallas over awful alternative investments, and that was local real estate.

And while Siedle and Sirota want to make everything look skeevy and illegal… it doesn’t take that for a lot of money to be lost in these arrangements.


There are two big problems here:

1. These assets are opaque, difficult to value, and when they go bad, they can go catastrophically bad without the legal protections common stockholders or bondholders get in the U.S. system.

It does not take any outright fraud for a lot of money to be lost. Long Term Capital Management wasn’t a fraud — they just screwed up massively.

Is it appropriate for pension funds which are supposed to guarantee very non-volatile pension benefits to get into such risky assets?

Or, let me put it another way: is it appropriate that public pension funds put so much of their portfolios in such strategies?

2. The lack of transparency in the arrangement makes the situation ripe for outright corruption. If outside interested parties cannot tell the terms of the arrangement – such as fees, etc. – how do we know these arrangements are on the up-and-up?


Now, what grabs the headlines are intimations of possible corruption and illegality.

That’s what gets Asness’s hackles up, and I understand that. Nobody likes their character impugned.

But it doesn’t take low character to ruin somebody else’s fortune. One can be legitimately trying to optimize returns… but the very way one goes for these returns can be extremely risky. Again, if a private investor wants to try it, why not? It’s their money.

But it’s not the public pension fund manager’s money.

It’s supposed to cover the pension benefits. And if the manager assumes that the taxpayers can make investment losses good, then they’re really playing with taxpayer money.

Is it an appropriate use of taxpayer money to try to chase yields? I understand you’re trying to achieve the assumed investment returns that evidently public securities haven’t provided. But this can be like doubling down at the casino – the martingale betting system of doubling bets, of making larger and larger bets, often ends in complete ruiin as one does not have infinite money to bet with.


Here is the overall graph of asset allocation for public plans in the U.S., using data from the Public Plans Database:

3.4% of portfolios in 2001 up to 17.7% of portfolios in 2016.

That is concerning.

I will do a separate post on which plans have the highest allocations to alternative assets.

Let’s not blow up supposedly sneaky doings in the Caymans. Because it doesn’t take doing business in the Caymans to have hedge funds and private equity investments. And it takes nothing untoward at all to chase yields right into the ground.

Related Posts
Kentucky Pensions Even Closer to the Brink: New Assumptions, New Report
Public Pension Returns Start to Roll In for FY 2022
Around the Pension Blogosphere