FRANKFORT — The struggling Kentucky Retirement Systems last year paid $55 million to outside firms to manage its investments. More than half of those fees — at least $31 million — went to the managers of hedge funds, private equity, real estate and other "alternative investments" that hold just one-fourth of the system's $15 billion in assets and produced its lowest returns.
The fees, many flowing to powerful New York firms, are a closely guarded secret although they involve public money. KRS won't reveal how much any individual manager is paid, saying the roughly 80 firms prefer that their fees not be disclosed. Instead, the agency releases the total annual fees it pays for each "asset class," such as U.S. public equities or hedge funds, lumping all of those managers together.
"We feel like we're giving our constituents the level of detail they need," David Peden, KRS' interim chief investment officer, said last week.
A rising chorus of critics warns that public pension funds like KRS should avoid the high-risk, high-cost world of alternative investments and stick with common stocks and bonds. Fees aside, KRS lost millions of dollars after investing in one start-up private equity fund that was drained by its founder to pay for his luxurious lifestyle, according to prosecutors, and in another start-up venture that failed to launch.
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"There's a great degree of risk in hedge funds, and the ultimate return just isn't enough to justify the fees," said Cincinnati attorney Ronald Parry.
Parry represents the Northern Kentucky city of Fort Wright, which this month sued KRS for allegedly squandering its municipal pension money in "illegal and imprudent investments (and) start-up funds with virtually no track record." Fort Wright wants full disclosure of individual management fees that KRS pays, and it wants its share of the agency's assets returned to more conservative investments.
Other local governments around Kentucky have expressed interest in joining the lawsuit, angered by soaring pension contribution rates, Parry said. Fort Wright last year had to give KRS $550,000, or about $100 for every man, woman and child in the small city, he said.
"It's a substantial consideration for them. Their contribution rate has doubled in the last few years," Parry said.
KRS provides pension and health care benefits for 340,626 present and future retirees from state and local governments. Some experts consider it the weakest state retirement system in the country. It faces $17 billion in unfunded liabilities due largely to inadequate state payments for most of the last 15 years, starting in Gov. Paul Patton's administration. Several nonprofit agencies are suing for the right to exit the system.
KRS officials defend their alternative investments as a shrewd way to diversify the system's portfolio over the long run.
While it's true alternatives charge higher fees and have not performed as well while the stock market boomed, the market inevitably will slump, officials said. The sophisticated balance of investments found in alternatives — ranging from venture start-up capital to leveraged corporate buyouts to commercial real estate — will partly offset those losses, they said. A system as cash-strapped as KRS could not survive another market crash if most of its money was directly invested in public stocks, they said.
"You have to take a long-term approach with KRS. We're looking out 10 years or more," said Daniel Bauer, who teaches business at Bellarmine University in Louisville and serves as vice chairman of the KRS board of trustees.
Critics previously have questioned the lack of transparency at KRS.
In 2011, state auditors identified $11.6 million in fees paid or committed to "placement agents," middlemen who help private investment firms sell their products to KRS. One placement agent in particular, Glen Sergeon of New York, enjoyed close access to KRS through his relationship with Adam Tosh, then KRS' chief investment officer, yielding Sergeon nearly $6 million in fees, auditors said.
Tosh resigned in 2010 after being questioned about Sergeon, who died three years later. The U.S. Securities and Exchange Commission opened an inquiry into the matter but ultimately filed no charges.
KRS' staff kept the role of placement agents a secret from at least some on the board of trustees until auditors pulled back the curtain, said Chris Tobe, a Louisville financial consultant who sat on the board from 2008 to 2012. The 13-member board includes gubernatorial appointees, as Tobe was, and elected representatives of state and local government employees.
Tobe said it was next to impossible to pry loose certain details about the agency's investments, returns and fees.
"We don't even know what country our hedge funds are in," said Tobe, who last year published a book critical of KRS, Kentucky Fried Pensions: A Culture of Cover-up and Corruption.
"We've got 70-odd external managers, 30 percent of them in private equity, and we don't really know where they've put our money except for the occasional newspaper headline saying there's been a scandal and, oops, we just lost some more," Tobe said. "Once you go into alternative investments, there's really no checks and balances. It's not like you own a thousand shares of a publicly listed company that you can check on. You have to rely on what the managers tell you, and unfortunately, that's when you get into the (embezzling investment adviser) Bernie Madoff situations."
Most recently, KRS has agreed to write off at least half of its $24 million investment in The Camelot Group, a New York private equity fund in which it was one of the first and largest investors. Lawrence E. Penn, the fund's managing director, faces criminal charges related to the alleged diversion of nearly $10 million from the fund to buy himself jewelry, a fancy car and other luxury goods.
The Camelot Group paid $780,000 in fees to placement agent Sergeon in order to win KRS' business. KRS and other investors subsequently were fooled by false assurances about where their money went, the SEC said.
"Penn held himself out as an ultra-sophisticated and well-connected investor in the private equity world," said Andrew Calamari, director of the SEC's New York office. "Behind the scenes, Penn disregarded his obligations to the fund's investors and treated their assets as his own personal and professional slush fund."
The SEC's director of compliance, Andrew Bowden, cited The Camelot Group in a speech he gave last month warning about the complex and often hidden fees and expenses that hedge funds pass along to their unknowing clients.
Having examined more than 150 private equity firms since October 2012, "we have identified what we believe are violations of the law or material weaknesses in controls over 50 percent of the time. This is a remarkable statistic," Bowden said. "A private equity adviser is faced with temptations and conflicts with which most other advisers do not contend."
'Way too chummy'
State Rep. Jim Wayne, D-Louisville, sponsored a bill during the 2014 General Assembly to shine light on KRS investments. Wayne's bill would have banned placement agents and required KRS to use the state's competitive bidding process to solicit investment proposals. The terms of each deal, including management fees, would be made public. The Bluegrass Institute, a free-market think tank, swiftly endorsed Wayne's bill.
"This is the proven way that government is supposed to work, with a procurement code that guarantees objectivity and transparency," Wayne said last week. "The current model smacks of the good ol' boy system. You have this closed system where it's privately decided who gets to manage billions of dollars in public money and what they'll get paid for it, no questions allowed. That's just way too chummy for my tastes."
KRS opposed the bill. It died without a committee hearing.
Bill Thielen, KRS executive director, said his agency's investment staff meets with potential managers and brings the terms of every proposed deal to the board of trustees for approval at meetings. Thielen disputed that any relevant information was withheld from Tobe or other trustees.
KRS this month denied an Open Records Act request submitted by the Lexington Herald-Leader for the fees it paid in 2013 to individual investment managers. KRS consulted with the managers, who opposed disclosure, Thielen said. In its denial, the agency cited a section of state law that allows it to withhold information that could "compromise the retirement systems' ability ... to competitively negotiate vendor fees."
If KRS released the "fee structure" that determines how each investment manager is paid, few qualified firms would want to handle the agency's money anymore, said Thielen and Peden, the chief investment officer. Public pension funds compete aggressively for the right to give their money to the most talented investment managers, they said.
"There's roughly 14,000 hedge funds out there," Peden said. "But there's less than 500 that we would care to do business with."
Tobe, the former KRS trustee, rejected the argument that secrecy is necessary.
"We've got $15 billion," Tobe said. "Trust me, we can find qualified managers who would be interested in handling some of that for us."
As KRS says, its investment managers don't like to talk publicly about their work.
"I apologize, but we cannot comment on our clients," Peter Rose, senior managing partner at Blackstone Group, said last week.
Blackstone, a private equity firm in New York, holds $590 million in KRS assets through several funds. Kentucky retirement savings have gone many places via Blackstone, including Sea World amusement parks, gun maker Colt Defense and deepwater oil and gas wells in the Gulf of Mexico. They also went into hedge fund SAC Capital Advisors, rocked last year by criminal indictments from an insider trading investigation. Two SAC traders were sentenced to prison last month.
Blackstone's total management fees in 2013 for all of its clients were $406 million, up 18 percent from 2012. Fees jumped 5 percent more in the first quarter of 2014. The firm charges a structured combination of management, incentive and performance fees that all but guarantees it a good year, if not a great year, even if performance droops. The firm's executive ranks contain a handful of billionaires.
Yet Blackstone and other alternative investments are producing low returns among the asset classes in KRS' portfolio. In 2013 — a stellar year for Wall Street — KRS' returns for common investments like U.S. and international public equities ranged from 18 to 33 percent. Alternatives yielded 9 to 15 percent.
That helped drag KRS' overall investment return down to 12 percent, well under the 19 percent reported across town by another pension fund, the $17 billion Kentucky Teachers' Retirement System. Unlike KRS, the teachers' system mostly favors stocks and bonds over hedge funds and other costly alternatives.
And 2013 was unusually strong for investments. For its 5-year and 10-year returns, KRS reported about 4 percent and 6 percent, respectively, falling short of both its performance benchmarks and its annual assumed rate of return of 7.75 percent, necessary for the fund's fiscal health.
Other public pension funds share KRS' problems. The Maryland Public Policy Institute last year released a study of 35 state retirement systems. It found that states paying higher management fees saw worse five-year returns than states paying lower management fees. The systems could save billions by cutting out firms like Blackstone and putting their money in low-cost index funds that track part of the market, researchers said.
"Retired state employees and taxpayers across the country are not getting their money's worth," said John Walters, co-author of the report. "There is simply no correlation between high money management fees and high investment returns."
But Peden, the KRS chief investment officer, said that misses the point.
KRS doesn't invest in hedge funds to get high returns, Peden said, it does so because widely diversified alternatives offer stability as the stock market rises and falls. KRS is too underfunded to afford the traditional allocation of 60 percent stocks and 40 percent bonds, he said. For that strategy to work, he said, state and local governments would have to be willing to shovel in additional cash during market slumps to keep the monthly pension checks coming.
"That is why we use alternative investments, not because we are chasing outsized returns," Peden said. "If KRS was chasing returns, we would be invested 100 percent in the public equity markets."