Kentucky pension agency lost big in conspiracy to boost one company, filing alleges

Insiders at Kentucky Retirement Systems conspired in 2015 to give a private investment company full control over the pension agency’s $1.6 billion hedge fund portfolio without disclosing conflicts of interest, according to a new court filing.

The lawsuit alleges that investment firm KKR Prisma gained improper control over the pension agency’s hedge fund portfolio when the agency’s then-chief investment officer, who previously worked for the company, allowed a KKR Prisma executive to be embedded at the KRS offices as an adviser and when a KKR Prisma retiree with financial interests in the company was named to the KRS Board of Trustees.

As a result of the “self-dealing scheme,” the badly under-funded pension agency lost money that it could have earned on better investments, plaintiffs allege in their lawsuit. An additional $300 million that KRS put into KKR Prisma’s Daniel Boone Fund lost 2.3 percent over the next two years while the S&P Total Return Index saw a 30 percent gain, according to the suit.

“These investments were not made solely in the interests of the members and the beneficiaries of KRS — as required by Kentucky pension law — but to benefit KKR Prisma and disadvantage its competitors,” attorney Michelle Ciccarelli Lerach wrote in a filing last week in Franklin Circuit Court.

The lawsuit in question was filed in late 2017 by eight public employees whose pensions are held by KRS. They allege that several major investment firms cheated KRS on hedge fund investments starting in 2011, with blame to be shared by some of KRS’ current and former trustees and officials.

The firms sold KRS hedge funds that were “extremely high-risk, secretive, opaque, high-fee and illiquid vehicles,” according to the suit. They did not adequately disclose the risks to KRS, and KRS did not honestly reveal the extent of its subsequent losses to its members, the suit alleges. However, KRS itself is not named as a defendant in the suit.

KRS faces an unfunded pension liability of $23.6 billion. Its primary pension fund for state employees has only 12.9 percent of the assets it’s expected to need for future payments.

The defendants — including KKR & Co., Prisma Capital Partners, The Blackstone Group and Pacific Alternative Asset Management — have denied wrongdoing, and they have spent more than a year challenging both the lawsuit and rulings by Judge Phillip Shepherd in order to delay discovery in the case.

In a statement Wednesday, Prisma disputed the newest allegations about its control of the KRS hedge fund portfolio.

“The latest filing by the plaintiffs, which is based on a series of factual misstatements, is an unsubstantiated personal attack on various professionals. This is what happens when private plaintiffs and their contingency-fee counsel are impermissibly allowed to pursue claims on behalf of a government agency like KRS,” the company said.

Last Thursday, Lerach, one of the lawyers for the public employees, filed an argument with Shepherd in favor of continuing with discovery and doing so publicly, despite requests by the defendants to submit evidence under seal.

In her argument, Lerach said that the “plaintiffs have uncovered compelling evidence of conspiratorial actions” within KRS to benefit KKR Prisma. (New York-based KKR acquired Prisma in 2012.)

Although none of KRS’ investments in hedge funds did particularly well compared to other investments, Lerach wrote, there at least was competition for a few years between the several hedge fund firms in KRS’ portfolio. But in 2015, KKR Prisma saw its chance to take control of the portfolio, she wrote.

David Peden, then KRS chief investment officer, worked at Prisma a decade earlier and stayed in contact with executives at the company, she wrote. Peden kept open the position of KRS director of absolute return, the official who would oversee the pension agency’s hedge fund portfolio, she wrote. Filling that vacant post was KKR Prisma executive Michael Rudzik, who was allowed to “embed” himself in the KRS offices even though he worked for a company that sold its investment services to KRS, she wrote.

Overseeing this arrangement was the KRS Board of Trustees and its investment committee, both of which included William Cook, appointed in 2016 by Gov. Matt Bevin after retiring the previous year from KKR Prisma as senior portfolio manager.

Cook, Rudzik and about a dozen more KKR Prisma officials split payments of $100 million in 2012 and $123 million more in 2014 and were set to collect close to $50 million in 2017, depending on how successful they were in growing KKR Prisma’s asset base, largely by getting KRS and other pension funds to invest more in the firm’s investment vehicles like the Daniel Boone Fund, Lerach wrote.

Between 2015 and 2016, KRS divested itself of the hedge funds operated by Blackstone and PAAMCO, but not KKR Prisma. Instead, it chose to invest $300 million more with KKR Prisma.

“Once the KKR Prisma foxes took control of the KRS hen-house, the outcome was as predictable as it was devastating,” Lerach wrote. “The self-interested conspirators kept KRS heavily invested in hedge funds at a time when other pension funds were fleeing them in droves ... None of this benefited KRS, its beneficiaries or the commonwealth, but it did benefit KKR Prisma, which was able to use its improper influence over KRS’ hedge fund portfolio to survive the 2015-16 hedge fund industry implosion.”

Attorneys for Peden and Cook did not immediately respond this week to requests for comment for this story. Peden abruptly left KRS in early 2017.

In past court filings, Cook said he recuses himself from KRS board votes involving KKR Prisma to avoid conflicts of interest. In a 2016 interview with the Herald-Leader, shortly after joining the board, Cook defended KRS’ decision to double-down on its investment with KKR Prisma’s Daniel Boone Fund despite its lackluster performance.

“Well, obviously, everyone would like to make more and particularly not lose. But that doesn’t necessarily mean it’s a bad investment, and it certainly doesn’t mean that, looking forward, it’s a bad investment,” Cook said at the time.

KRS Executive Director David Eager said Wednesday that he is aware of Lerach’s allegations, but the pension agency does not comment on pending litigation.

This story was originally published April 10, 2019 at 11:29 AM.