State Pension Funds and Big Investment Firms: What Could Possibly Go Wrong?

piggy bankThe financial crisis brought havoc to just about every financial institution in the country. But let’s focus on the current status of state pension funds, where the crisis is beginning to look particularly grim.

Just how underfunded are state pension funds?  The estimates start at well over a trillion dollars and go up from there.  The answer depends on the observed time period, the difficulty in raising taxes on an already overtaxed public, and the severe problems in getting decent returns without taking unacceptable risks.

But consider the fundamentals.  The disproportionately large baby boomer generation born from 1946 to 1964 already has begun retiring. This represents a demographic time bomb even without the economy faltering.

Then consider that a study of state pension funds released in 2012 showed that annual returns for large public pension funds averaged about 5.9% over the last ten years despite the fact that the target returns for these funds were generally in the 7% to 8% range.   

Add to this the outbreak of underfunded pension fund horror stories, which have become a staple item in news coverage.  A textbook example is the downgrading of the Illinois state credit rating to the lowest in the nation in large part due to its public pension crisis.

While pension funds traditionally have sought the safety of only the most conservative investments, that’s a hard course to maintain in a period of tiny returns.

The temptation for financially pressed state pensions is to increase allocations to so-called “alternative investments.”  This trend has been responsible for an increase in such investments as real estate, private equity, real assets, and hedge funds.

While such investments can bring higher returns, they also can bring higher risk.

Public pension funds try to minimize that risk by carefully researching both the proposed investment as well as the investment firm pitching the investment.  This due diligence by the pension fund is all the more critical when the proposed investment is more exotic than the usual mix of stocks and bonds.

Since the National Legal and Policy Center has been covering ethics and accountability issues in public life over its more than 20 year existence – with a strong emphasis on working with investigative journalists, we decided to take a closer look at the due diligence process used by public pensions when assessing alternative investments.

Using state freedom of information laws, which apply to most of the state public pension fund operations, NLPC spent months obtaining thousands of pages of documentation from a range of state and local pension funds.  We focused on the due diligence process, especially as it related to investment firms promoting alternative investments.

One such pension fund was the New Mexico Educational Retirement Board, which oversees teachers’ pensions.  NMERB had had its share of difficulties in the past.  It had been badly burned by millions of dollars in losses in the Bernie Madoff Ponzi scheme.

NMERB was under new management from the time of its ill-fated investment with Madoff. NLPC found their operation to be far more professional and efficient in many ways than other pension funds.

Even more impressive was the very carefully prepared due diligence questionnaire used by NMERB to vet investment firms seeking the pension fund’s business.

One of the alternative investments by NMERB was a total of about $125 million invested with the Greenwich, Connecticut firm Gramercy, which was seeking investments in the Gramercy Distressed Opportunity Fund II, an investment in distressed foreign debt.

The due diligence questionnaire submitted to Gramercy asked:

Has the organization or any of its staff ever been the subject of any regulatory action or warning?

The Gramercy response was:

Neither Gramercy nor any of its staff has ever been subject to any regulatory action or warning.

Since Gramercy had been the subject of a December 18, 2012 New York Times article, “Hedge Fund in Middle of Argentine Debt Battle,” by Pulitzer Prize winning financial reporter Gretchen Morgenson, an article laying out the controversial past of Gramercy, a closer look was in order.

The New York Times article stated:

According to federal and state court filings, Gramercy Advisors arranged deals involving distressed Brazilian debt that the Internal Revenue Service later ruled to be sham transactions.

The records of the Brazilian equivalent of the Securities and Exchange Commission, known as CVM for short, had a case described as Punitive Administrative Proceeding CVM No. 12/04.  The parties in the Punitive Administrative Proceeding were Gramercy Participacoes Ltda., Robert Koenigsberger, Jay Johnston, and Ronen Oshansky.  The address for these parties is the same as Gramercy’s current address and Mr. Koenigsberger is the Managing Partner of Gramercy while Mr. Johnston was his Co-managing Partner at the time.

This punitive administrative action dragged on for several years before settling with an agreement on March 30, 2007. Click here for 3-page download of Agreement.  The agreement involved a payment by the Gramercy parties of some R$70,000 (seventy thousand reals, worth about $35,000 in U.S. currency at that time).

The agreement stated that this was not an acknowledgment of wrongdoing.

But the real issue is whether a multi-year punitive administrative proceeding against a Gramercy affiliate and its top leaders by Brazil’s leading financial regulatory body, which concluded with a payment of approximately $35,000 by the Gramercy parties, just might mean that “the organization or any of its staff” just might have been “the subject of a regulatory action.”

Considering that the New Mexico Educational Retirement Board invested some $125 million of its pension funds with Gramercy in possible reliance on a due diligence questionnaire answer that seems a bit incomplete, if not outright dodgy, NLPC filed a followup request for public records with the retirement board. Click here to download 3-page letter. The request sought any disclosure by Gramercy at any time to NMERB regarding the punitive administrative action taken by Brazil’s financial regulatory body, the CVM.  NMERB conducted a search of its records and responded that no such records exist.

The postscript to this story involves the huge investment Gramercy had made in distressed Argentine debt, the subject of the New York Times article by Gretchen Morgenson. While Argentina had been paying investors in Argentine distressed debt through the agreement worked out by Gramercy, those holders of debt who did not want the cents on the dollar deal of that arrangement had gone to federal court to get Argentina to pay its debts.

These holdout investors won at the federal court level and in August they won a sweeping victory against Gramercy in the Second Circuit Court of Appeals.  A three-judge panel decided unanimously against Gramercy on all issues.  Argentina has taken the position that it will never pay the holdouts what they are seeking but the courts will not allow Argentina to just pay those investors in the Gramercy.

While an appeal to the Supreme Court of the United States by the losers is expected, recent petitions for Supreme Court consideration have been about ten thousand a year, with only about 100 cases getting a hearing.

Argentina appears to be risking another default on its debt at a time when the country’s economy is already in dire straits.  It is unclear what effect this will have on pension funds that invested with Gramercy in Argentine distressed debt, but losing on all issues by a unanimous decision of a three-judge federal appeals court is never a good thing.

So as more public pension funds desperate for better returns turn to more alternative investments, one lesson seems clear: Better due diligence examinations of investments and investment firms are absolutely essential.