KY Retirement Systems ignored adviser’s warning to avoid risky hedge funds, suit says

Kentucky Retirement Systems lost public money on more than $1.5 billion in hedge fund investments in recent years, although its own advisers privately urged the agency to stay away from such “unacceptable risks,” according to new claims in a lawsuit brought by eight public employees.

“KRS is in crisis,” Louisville attorney Ann Oldfather wrote in a memo filed Friday in Franklin Circuit Court. “In the limited discovery plaintiffs have obtained thus far, it is becoming clear why. It is apparent now the current crisis could have been avoided had this information been made public earlier.”

Oldfather’s clients are suing several major investment firms — KKR & Co., Prisma Capital Partners, The Blackstone Group and Pacific Alternative Asset Management — to recover what KRS lost on hedge fund investments and management fees to those firms, plus damages. Also named as defendants are a number of past and present KRS trustees and executives.

The KRS Board of Trustees is debating whether to join the suit as a co-plaintiff. The firms are asking Judge Phillip Shepherd for a protective order keeping much of the information in the case confidential, something the public employees are opposing by arguing that Kentucky taxpayers have a right to know what happened at the publicly funded KRS.

KRS faces a $27 billion pension shortfall.

In a memo filed in court Friday, Oldfather compiled emails, KRS meeting minutes and an internal report to show part of the story behind the agency’s controversial decision to invest in hedge funds. Hedge funds are privately run investments, usually with high management fees, put together in hopes of beating the stock market, or at least hedging against an economic downturn.

In 2010, investment adviser R.V. Kuhns & Associates studied the increasingly shaky financial health of KRS, which is responsible for providing retirement benefits for about 365,000 past and present employees of state and local governments.

By the time of the R.V. Kuhns study, years of under-funding and unrealistic assumptions about investment returns and payroll growth had left KRS struggling. Its largest pension fund for state employees had just 38 percent of the money it was expected to need to pay future benefits. And KRS lost billions in assets during the 2008 recession.

Previously, in 2006, the KRS Board of Trustees already had decided that hedge funds were not a proper investment for its public pension assets, according to the suit. Hedge funds were too risky, and KRS did not have the staff financial expertise to properly monitor them, Oldfather wrote.

“KRS’ trustees considered — and rejected — investing in hedge funds to boost returns, because they were ‘unconstrained’ and would ‘not tell investors what they do,’ including what positions KRS had,” Oldfather wrote, quoting from KRS board documents.

“From a ‘fiduciary standpoint’ this seemed at odds with KRS’ ‘obligation to be informed of its investments.’ Such investments would be ‘very labor intensive,’ requiring extensive involvement to properly oversee the investments, questioning ‘what the added value would be for KRS. Because they were ‘higher risk,’ (‘often sell[ing] assets they do not own’) the trustees were ‘concerned’ about the “perception” of KRS members, legislators and taxpayers if KRS shifted course into such exotic and risky investments,” Oldfather wrote.

“All of these ‘red flags’ led the chair to conclude there was no ‘need to go any further with this asset class’ and she ‘was not interested in hedge funds,’” Oldfather wrote.

R.V. Kuhns concurred in 2010, warning KRS that it could not invest its way out of its worsening financial crunch, and certainly not with investments as aggressive as hedge funds, Oldfather wrote. In fact, taking an “aggressive approach substantially increases the chances of the catastrophic event of depleting all assets in the near future,” R.V. Kuhns warned, according to the memo.

In its report, R.V. Kuhns advised KRS that even if it earned the 7.75 percent investment return that it assumed every year for the next 20 years — and it wouldn’t — the funding level of its state employee pension fund would fall below 20 percent during the next few years — and it did.

However, KRS ignored the advice, desperate to improve its falling numbers, Oldfather wrote.

“The deteriorating status of the KRS funds caught the attention of the hedge fund sellers,” Oldfather wrote. “They targeted KRS to sell its trustees extremely profitable (for the sellers) but very expensive (for the buyer), custom-designed ‘black box’ funds of hedge funds.”

“In rapid fashion,” Oldfather wrote, KRS invested about $1.5 billion in hedge funds, in three installments.

“In addition to being ill-advised, the investments were made without adequate due diligence that would have exposed the checkered pasts of the hedge fund sellers and warned the trustees off,” she wrote. “Over the next five years, these black box vehicles provided very poor absolute and relative returns. The absolute return portfolio returned a miserable 3.73 percent from inception and lost over 6 percent — almost $100 million — in 2015-16.”

Public employees whose retirement benefits were invested by KRS had no idea of their losses, Oldfather added. Financial reports published by KRS deliberately buried the details, she said.

“Notwithstanding their statutory duty to provide accurate and truthful information regarding the KRS plans’ financial and actuarial condition in language ‘easily understood by the members, retired members and the public,’ the most ever disclosed by these defendants was buried deep within greater than 180-page reports and then accompanied by false assurances; i.e., that the ‘Absolute Return’ ‘investments’ had ‘excellent potential to generate income’ but ‘may’ have a ‘higher degree of risk,’” Oldfather wrote.

“KRS members and taxpayers were falsely assured the new KRS investments would lower risk, reduce volatility, control illiquidity and were expected to exceed the actuarial rate of return,” Oldfather wrote. “Documents long secreted from public view at a public pension fund show these statements were not true and came nowhere close to meeting the standard of complete truthfulness and full disclosure that applies to fiduciaries.”

The defendants have filed individual responses to the lawsuit denying wrongdoing and asking Shepherd to dismiss the case.

This story was originally published April 17, 2018 at 2:17 PM with the headline "KY Retirement Systems ignored adviser’s warning to avoid risky hedge funds, suit says."