[ Due to the stock market downturn, public pensions invested in
private equity are about to face a reckoning — but thanks to lax
transparency regulations, pension members have no way of knowing how
bad it might get.]
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A PUBLIC PENSION RECKONING – WALL STREET READIES AN AVALANCHE OF
LIES  
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Matthew Cunningham-Cook
November 17, 2022
The Lever
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_ Due to the stock market downturn, public pensions invested in
private equity are about to face a reckoning — but thanks to lax
transparency regulations, pension members have no way of knowing how
bad it might get. _

Public pension funds could soon face a reckoning, as the downturn in
the stock market spreads to alternative investments., AP Photo/Richard
Drew // The Lever

 

Public pension funds benefiting nearly 26 million
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$1.3 trillion in high-risk, high-fee “alternative” investments
like private equity, hedge funds, and private real estate that have
been wracked with corruption scandals and financial misconduct. Those
pension funds could soon face a reckoning, as the downturn in the
stock market spreads to these alternative investments, resulting in
costly reductions of their estimated value and in turn, increased
contributions from state and local governments to meet those losses.

But most public pension members and beneficiaries have no way of
knowing the extent of distress facing their investments. That’s
because public pension funds rely on valuations provided by the
managers themselves — and thanks to secret contract clauses,
managers can significantly massage
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numbers.

“Alternative investments give pension funds the opportunity to hide
their losses, which means that they are made to order for this
contractionary environment,” said Ted Siedle, a former attorney with
the Securities and Exchange Commission who now represents financial
industry whistleblowers. “It’s a perfect place to hide. It’s no
surprise that the increase in private equity and alternative
investments was accompanied by an increase in secrecy. The bottom line
is nobody knows what these investments are, nobody knows how they are
performing, or what they are worth.”

As of publication, the main stock market index is down 17.4 percent
since January, the longest period of falling stock prices since the
2008 financial crisis.

Public pension deals in the alternative space are notoriously opaque,
with no full public disclosure of the underlying investments and
accompanying contracts, the amount of debt or risk that a fund has
taken on, the total fees paid to the firms involved, or the underlying
performance and cash-flow data of these investments.

This is in stark contrast to investments in publicly traded companies,
which disclose a wide range of information about their finances and
face penalties for misrepresentation.

“In a general way, the whole [alternative investment] industry has
been running on autopilot for the last 15 years with almost zero
regulation,” said Jeff Hooke, a retired investment banker who now
lectures on finance at Johns Hopkins University. “There’s no cop
on the beat. There’s no sheriff in town. They’ve been able to
report, without too much scrutiny, these glowing returns.”

Cratering Value

Private equity and other alternative investments were originally
peddled as vehicles that could deliver higher returns to investors, no
matter the market environment, by taking over and transforming
companies — often by loading them up with debt and laying off
workers.

Such promises helped inspire public pensions to enter the space. Forty
years ago, most public pension funds didn’t invest in private equity
or hedge funds at all, instead pursuing far more orthodox investments
in stocks and bonds. Now, public pensions have more than a trillion
dollars invested in alternatives.

In total, public pensions supply
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than a third of the capital to private equity, and they likely provide
a similar share of the capital going to hedge funds and private real
estate. And they are shoveling ever more money at the alternative
investment industry, despite sky-high fees and returns that either
meet or trail the broader markets.

In part by using public pension capital, private equity in particular
has expanded into every corner of the economy, from the prison
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children with disabilities, to fossil fuels
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care
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and veterinarians
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Their investments are rife with bankruptcies
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and aggressive
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But the outsized returns promised by the money managers themselves
have not been borne
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data that have found that private equity does not beat the S&P 500
index of large stocks. Hedge funds have also massively trailed the
broader stock market, and private equity real estate trails publicly
traded real estate.

Now, the repercussions of the industry’s overly optimistic forecasts
are starting to be felt, as their portfolios’ performance begins to
reflect the economic downturn.

Financial reports for alternative investments typically lag by one
quarter, or three months. But accounting rules also allow them to
measure their value at “net asset value,” determined by a complex
and subjective
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process, as opposed to fair market value, or what it would be
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if the pension fund tried to sell it on the open market.

This problem came into view recently when the California Public
Employees' Retirement System (CalPERS), the country’s largest
pension fund, sold a $6 billion private equity portfolio at a 10
percent discount
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or $600 million _less_ than what the agency had valued the portfolio
at in its public financial filings.

Eileen Appelbaum, co-director of the Center for Economic and Policy
Research and co-author of _Private Equity at Work_,_ _said that the
CalPERS writedown is indicative of broader problems in the industry.
“A lot of the info you’re getting from the fund managers have a
lot of guesstimates in it,” she said. “Public markets have been
declining since January. The industry wants to make the case that they
don’t decline like that, that they are way less volatile.”

Appelbaum, for one, isn’t buying it. “The official private equity
returns at the end of the second quarter were down 4 percent,” she
said.“Public equities are down 18 percent and private equity down 4
percent? It’s just not believable.”

An Industry Built On Secrecy

The alternative investment industry is built on a lack of
transparency. The risks inherent in the space mean that managers have
great incentive to create rosier returns. Poor return numbers make it
harder to raise money for new investments. It’s why investment
managers work to shield information about themselves and their
activities from public view, so they are free to peddle stories of
outsized returns with no accountability.

Now, that same secrecy will keep the true dangers currently facing
these investments from going public.

Industry lobbyists have successfully pushed anti-transparency
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the country exempting contracts and raw performance data from public
view. To this day, only a small handful of contracts between
alternative investment managers and public pension funds have been
released to the public, and none of the raw performance data from
these investments have been disclosed.

The contracts that have been made public have revealed many hidden
fees, plus a variety of provisions that aggressively tilt the playing
field in favor of alternative investment managers. That
includes clauses
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a waiver
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the managers’ fiduciary duty to the pension, which limits the
firms’ legal obligation to act in the pension’s best interest.
Contracts also include provisions requiring binding arbitration for
any disputes, eliminating the ability of pensions to seek redress in
the courts.

What’s more, there is little incentive for public pension trustees
to push for greater transparency, since plan managers are
typically unpaid.
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the little education they receive on such investments is typically
from consulting firms with deep ties
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the industry or at industry-sponsored conferences filled with industry
representatives. Numerous state treasurers and other politicians with
oversight over pensions also have deep ties to Wall Street, like
Virginia Gov. Glenn Youngkin (R), a former Carlyle Group executive
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makes appointments
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the state pension fund’s board.

No wonder, then, that there are very few pension trustees raising
concerns about the rapid growth and risks surrounding alternative
investments. One notable exception is Pennsylvania State Sen. Katie
Muth, who has played a leading role
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disrupting business as usual at a more than $70 billion pension fund
that has been plagued by scandal in recent years. (Muth won
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to the state Senate on November 8, and is a legislative representative
on the pension fund’s board.)

President Joe Biden’s Securities and Exchange Commission has
proposed modest
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industry that would require increased transparency on performance,
risk, and fees in the alternative investments space. But these reforms
have been fiercely opposed
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the industry.

Sen. Elizabeth Warren (D-Mass.) has proposed a much broader set of
major reforms to the industry in the Stop Wall Street Looting Act
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which among other things would rein in the amount of debt taken on by
the industry and require new disclosures around fees and performance.

But considering the financial industry spent more than
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million in the 2022 elections, the legislation faces an uphill battle
in Congress. The private equity and investment industry has
spent more than $13.8 million
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lobbying in Washington this year alone.

Will the coming crisis in declining values in the industry trigger
increased scrutiny? Hooke isn’t so sure.

“Things might change in a few months when people start to see red
ink,” he said. “The SEC has been totally off the radar when it
comes to supervision and enforcement of the industry. With the coming
downturn, there might be a cry for a closer inspection of the business
by appropriate authorities. But the dark side is very powerful.
They’ll pull out all their lobbyists and lawyers.”

_[MATTHEW CUNNINGHAM-COOK is a researcher and writer focusing on
capital markets, health care and retirement policy.]_

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* Pensions
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* pension funds
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* public pension funds
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* Wall Street
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* private equity
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* stock market
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* alternative investments
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* hedge funds
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* investment managers
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* money managers
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* financial transparency
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* Stop Wall Street Looting Act
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* Elizabeth Warren
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