The Kentucky Retirement Systems Board of Trustees is debating whether to join a lawsuit that says the state’s pension agency was cheated on up to $1.5 billion in hedge fund investments by several wealthy corporations, with blame to be shared by some of its own current and former trustees and officials.
At stake is whether KRS can recover part of its estimated $27 billion pension shortfall from out-of-state billionaires rather than the state budget, which is being bled dry for pensions at the expense of schools, social services and other programs. KRS is responsible for providing pensions to about 365,000 past and present employees of state and local governments.
“There are only two known ways for KRS to avert the imminent collapse of its plans: a massive taxpayer bailout and/or the success of this lawsuit,” attorneys for plaintiffs in the case wrote in a court filing earlier this month.
A special subcommittee of the KRS board met in closed session Tuesday to discuss the suit.
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“We have not yet made a decision,” said John Farris, KRS board chairman and president of Commonwealth Economics in Lexington.
“All of the actions discussed in the lawsuit happened before I joined the board and before most of the current members of the board joined,” Farris said. “So we’re having to go back and recreate a time-line and decide what the board was doing when it invested in these funds. So far, we’re looking at 37,000 pages of documents.”
The suit was filed Dec. 27 in Franklin Circuit Court by eight public employees whose pensions are held by KRS, organized by Michelle Ciccarelli Lerach, an experienced financial class-action litigator in San Diego. The plaintiffs — including a circuit court judge in Clark and Madison counties, a former assistant Jefferson County attorney and a retired Kentucky State Police captain — say they seek damages on behalf of public employees and state taxpayers.
The suit alleges that, starting in 2011, KKR & Co., Prisma Capital Partners, The Blackstone Group and Pacific Alternative Asset Management sold KRS hedge fund investments that were “extremely high-risk, secretive, opaque, high-fee and illiquid vehicles.” The hedge funds produced “excessive fees … poor returns and ultimately losses,” saddling Kentucky with a crippling debt that should be repaid by the hedge fund dealers and their owners, the suit alleges.
The “impenetrable spider web of fees” charged by the hedge fund dealers were impossible for any outsider to calculate, and deliberately so, the suit alleges. It cites a 2015 report from the nonprofit Roosevelt Institute in Hyde Park, N.Y., that found public pension systems pay an estimated 57 cents in fees to hedge fund managers for every dollar in net return.
And a report prepared for KRS by CEM Benchmarking found that its actual investment costs in 2014 were $126.6 million, or more than 100 percent higher than the $62.4 million it had publicly disclosed, the suit alleges. Most of this money was fees paid to investment managers.
The “hedge fund sellers … knew if the true nature and risks of these high-risk/high-fee vehicles were disclosed in the KRS annual reports, an uproar would have resulted and the unsuitable ‘investments’ could have been terminated, costing the hedge fund sellers millions and millions of dollars a year in fees. Hedge fund sellers let the deception continue because it served their selfish economic purposes,” the suit alleges.
Among the 30 defendants named in the suit are the hedge fund dealers that sold investments to KRS and some of the nation’s wealthiest investors, including Henry Kravis, co-founder of KKR & Co., and Stephen Schwarzman, chairman and chief executive office of The Blackstone Group. The estimated net worth of just those two men is about $15 billion. The suit also targets KRS’ fiduciary and actuarial advisers.
Meanwhile, the suit alleges, KRS trustees and officials with no expertise in complicated financial matters dithered as the pension system turned the $2 billion surplus it enjoyed in 2000 into its current state of near-insolvency. The largest pension fund for state workers today has just 13 percent of the money it’s expected to need to pay future benefits. The largest pension fund for local government employees is 53 percent funded.
For years, KRS knowingly kept in place an unrealistically optimistic set of assumptions about investment returns, government payroll growth and inflation that made the pension funds’ numbers look better than they should have, the suit alleges. And as the pension system lost billions of dollars during one of the greatest extended bull markets in the nation’s history, KRS trustees and officials made desperate bets on hedge funds while they claimed in public statements that they were being cautious with taxpayers’ money, the suit alleges.
“Trustees, with the knowing assistance of all the other defendants, chose to cover up the true extent of the KRS financial/actuarial shortfalls and take longshot imprudent risks with KRS funds to try to catch up for the funds’ prior losses and deceptions,” the suit alleges. “They misled, misrepresented and obfuscated the true state of affairs inside KRS from at least 2009 forward.”
Focusing on those who allegedly had a direct hand at KRS in investment decisions, the suits’ defendants include current trustees William Cook and Vince Lang; former trustees Randy Overstreet, Timothy Longmeyer, Bobbie Henson, Thomas Elliott and Jennifer Elliott; former chief investment officers David Peden and T.J. Carlson, former executive director William Thielen; and former director of alternative investments Brent Aldridge.
The suit also alleges certain conflicts of interest in the hedge fund deals.
For example, Cook, who was appointed to the KRS board by Gov. Matt Bevin in June 2016, retired a year earlier as a senior portfolio manager at Prisma and continued to have a financial interest in the company and a “close personal” friendship with Prisma CEO Girish Reddy, the suit alleges.
While Cook was still at Prisma, the company created and sold the Daniel Boone Fund as an investment for KRS, the suit alleges. As the $500 million fund started to lose money, Cook and others helped arrange for a Prisma executive to work inside the KRS offices in Frankfort for two weeks every month, helping with the system’s investment portfolio, the suit alleges. In 2016, even as KRS began to pull out of other hedge funds, citing their weak performances, it put an additional $300 million into Prisma’s Daniel Boone Fund, the suit alleges.
KRS’ chief investment officer at the time was Peden, who worked at Prisma himself a decade earlier, the suit alleges. The suit quotes Peden as telling interviewers that bringing the Prisma executive into the KRS offices was “like having a free staff member.” Peden said Prisma offered KRS the use of its executive when it learned the pension system could not find a qualified candidate to help with its hedge fund investments, the suit alleges.
Neither Cook nor Peden returned calls seeking comment this week. Cook is still on the KRS Board of Trustees and serves on its investment committee, according to the KRS website.
The defendants have filed individual responses to the lawsuit denying wrongdoing and asking Judge Phillip Shepherd to dismiss the case. Among their defenses, the hedge fund dealers say the plaintiffs have shown no evidence that they misrepresented their products or committed any other bad acts. Current and former KRS trustees and officials cite sovereign immunity, the legal shield that generally covers people working in public service.
In his response, Cook called the conflict of interest allegations against him “without merit on their face.” Cook said he has recused himself from every KRS board decision involving Prisma because of his past employment at the company. He said he also recuses himself from any business involving KKR, which acquired Prisma in 2012. And when KRS made the decision in 2016 to invest an additional $300 million in Prisma’s Daniel Boone Fund, Cook said that was after he retired from Prisma and before he joined the KRS board, so he had no role in the deal from either end.