In the United States, public pension plans face challenges that other asset owners don’t, from funding and governance issues stemming from political considerations to requirements for transparency. They are common problems but they vary considerably by jurisdiction.
(The transparency is great for those interested in learning about the investment business and/or pension plans — or in keeping up on trends in asset classes, strategies, and managers. A wealth of information is available for anyone willing to look at the websites of the plans.)
Another facet of public plans versus most other asset owners is the attention that can be paid to the plans in the media, both locally and — due to their size and importance — nationally.
It can be a combustible mix when things go wrong.
The soap opera
Perhaps no plan typifies that more than the Kentucky Retirement System. (“KRS” is used here to match the matters being referenced below, even though there is a new name and an altered structure.)
KRS has long been cited as the poster child for chronic underfunding of pension plans by state governments. Unfunded mandates and a lack of contributions have led to extreme shortfalls in funding status that have persisted over time. Those circumstances limited the investment choices available to keep the plan solvent and pay the beneficiaries over time. One trustee commented in a 2010 meeting:
This is a fool’s errand, because no matter . . . what choice you make you can’t invest [your] way out of it.
Illiquid investments couldn’t be considered to any great extent, since they would hamper the ability to pay benefits in certain kinds of environments, and increasing equity exposure might improve the chances of narrowing the funding gap, but it would also elevate the probability of a disaster scenario. Significant increases in contributions were needed and, well, there’s lots of politics involved whenever that’s the case. Year after year, this part of the story line remained the same.
In regard to investment performance, the evidence was mixed. A 2008 report from a consultant called it “unacceptable,” saying it lagged both actuarial assumptions (although they are not a good measure of performance in isolation) and peer retirement systems. In addition, it said that “the governance structure responsible for investment oversight is inadequate; the investment portfolio has insufficient diversification of asset classes; and the investment manager structure has concentrated positions, increasing risk.”
Add to all of that frequent turnover among the cast of characters at KRS — trustees, CIOs, and staff members — plus investigations and litigations and media attention. A foundational principle of the Academy course on due diligence is that “all organizations are messy” (and your job is to figure out how and whether it matters or not). Some of them are really messy.
Looking for lessons
Why spend any time on KRS, since it’s an outlier in a number of ways? Why do a posting on it? There are lessons in its story that are broadly applicable. A review of the decisions that were made and the process for making them provides examples of common practices that should be questioned, as well as tendencies that should be avoided if you want to lower organizational risk.
Investigation
In 2020, KRS commissioned the law firm Calcaterra Pollack to conduct an investigation into the events outlined below. The report and attached exhibits run 2,256 pages.
Making appearances within the report are trustees and investment staff members of KRS, as well as firms and individuals providing asset management, investment consulting, fiduciary and liability guidance, and actuarial projections. (The names are left out here for the sake of simplicity, but are there in the report for all to see.)
The report
The substantive conclusions of the report won’t be judged here, since there are more things you’d want to know before pronouncing it to be an accurate assessment.
What can be said is that it is poorly constructed, and therefore fails to effectively array information in a way that would be of greatest benefit to KRS. Granted, those at KRS would have a better chance of following the story than an outsider can, but that shouldn’t be the standard on which it is measured. Even a complex story can be told effectively, and the report fails on that score.
Events are addressed out of logical order, people and concepts appear without context, hundreds of pages of exhibits appear that don’t really add anything, and the exhibits in general aren’t organized and marked in a way that is conducive to comprehension.
A separate report — “the Legal Recommendations” for KRS from the investigation — has not been made public. While that may be defensible because of attorney-client privileges, this is not: “As required, the Legal Recommendations also provide recommendations regarding best practices for investment activities.” While the legal considerations around past events are obviously consequential, on a going-forward basis nothing is as important for the public to know as whether “best practices” are in place to avoid future problems and to generate acceptable returns.
Legal analyses of investment matters (like those found in litigation, for example) often lack the kind of industry and market perspective that is necessary to make recommendations about best practices. Add to that the poor quality of the report overall and it’s not hard to wonder about what has been put forth to KRS for consideration regarding necessary improvements in the investment function.
Not keeping up
The consultant assessment mentioned earlier stated that there were “two possible explanations” for the underperformance at KRS:
1) similar funds performed as poorly and no reasonable changes could have altered the situation; and/or 2) the investment world had changed its approach and [KRS] had not kept up.
It said that the latter was the reason and that “alternative asset classes should play a significant role in a diversified portfolio,” noting that the exposure to them at KRS was lower than that of its peers. That started a drive to increase exposure to alternatives, specifically absolute return strategies, that would lead to the investigation.
Major events
A soap opera can be hard to keep track of unless you watch it regularly. One of the challenges faced by Calcaterra Pollack in preparing the report was identifying the critical plot lines and weaving them together in a comprehensible way. Here are the big pieces:
Multi-strategy fund. When KRS staff examined whether to start increasing alternatives exposure, it looked at hedge funds of funds (HFoFs) and multi-strategy funds (MSFs), deciding on the latter for its first investment in its absolute returns bucket. Two consulting firms weighed in on manager selection; the one that “played second chair” in the process (to use its own description) listed these as challenges for one MSF: (1) newly established firm; (2) limited track record information; and (3) partial investment team structure. But that is the firm that KRS selected, in part because the MSF was claimed to be “designed as a next generation absolute return investment which addresses the portfolio needs of pension plans.” It also was swayed by the past performance of the MSF’s leader at another firm.
After implementation in 2010, it became apparent that a placement agent was involved in getting the business for the MSF, at a time when that had become a big issue among public fund asset owners. So:
KRS found itself facing a barrage of negative press, internal and external audits related to placement agents and associated fees, as well as an eventual Securities and Exchange Commission investigation that resulted in no action by the enforcement agency.
The MSF was unwound. In retrospect, the investigative report said that the whole episode was “marked by impropriety.”
The selection of FoHFs. After that, KRS concentrated on finding a collection of FoHFs to build the absolute return portfolio. Many documents from the process are available to review, bringing up a variety of questions about how the managers were selected.
In August 2011, the staff recommendations were presented to the investment committee, without the groundwork being properly laid by the staff. The committee asked for further information and clarification, which was provided at another meeting two weeks later.
The report had this conclusion about the whole process:
The manner in which the Investment Staff proceeded in the FoHF process without advising the Investment Committee was improper. The Investment Staff reports to the Investment Committee, not the other way around.
But added:
It was the Trustees’ duty to provide oversight of the FoHF selection, not simply accept whatever recommendation was made.
The trustee’s acquiescence planted seeds that, years later, became ripe for manipulation from the future CIO.
As you can tell, the plot was about to thicken, but first there was a public relations bombshell.
Onslaught of attention. A former trustee of KRS wrote a book called Kentucky Fried Pensions: A Culture of Cover-up and Corruption, which dealt with the specifics there as representative of broader issues at public plans. The resulting media attention and investigations related to the assertions put a further strain on KRS, as one staff member wrote in an internal note:
These gratuitous, ad-hominem attacks may make for good copy, but they create a hostile, unhappy work environment for those professionals tasked with managing the assets responsibly in the face of a constant stream of insults.
In addition, he cited extensive staff time and internal expense, as well as the cost of external experts and lawyers.
Part of the plan for using HFoFs was to “learn from them,” and to add direct hedge fund investments to supplement and perhaps eventually supplant the HFoF investments in whole or in part. Those direct hedge fund investments had begun by this time, and the writer of the memo said that, because of the publicity, some hedge fund managers would not consider KRS as a limited partner because of the potential hassles.
The strategic partnership. In May of 2015, the CIO recommended that KRS enter into a “strategic partnership” with one of the FoHFs, billed as lowering costs and taking advantage of an expanded range of services from the manager, including having a portfolio manager on site at KRS part of the time.
The CIO said that the three providers would be in competition for the business. However, he set up a partnership with just one of them, noting that it was “just a trial.” When a trustee asked, “What is the downside?” he said, “There is no downside. [It is] in the informal stage.” But within nine months, it was all a done deal and the other FoHFs, which were “funds of one” rather than commingled with other asset owners, were being dismantled.
All of that might be viewed as a normal — if somewhat quick — progression of events, except for the presence of lots of pre-existing ties between that strategic partner and decision makers at KRS. The CIO, two past trustees, and one very-soon-to-be trustee had been employed by the strategic partner or an affiliate or predecessor firm. That brought into question not only the selection of it as a strategic partner, but its inclusion as one of the three FoHFs to begin with. Emails reproduced in the report include some of the interactions of the parties with members of that firm. The favoritism shows through.
Mayberry. Litigation into the above matters was initially filed in 2017, in a case known as “Mayberry,” after the lead plaintiff. From the report:
The primary allegations set forth in Mayberry are that KRS invested in funds of funds that were allegedly the product of a large conspiracy by [three FoHFs] to target underfunded and vulnerable public pension systems. The FoHFs were described as, among other things, exotic, risky and illiquid. Mayberry also alleged that the FoHF documents provided to KRS were misleading and false to cover up the fees being charged to KRS and that they “understood the vulnerability of Kentucky Retirement and its Officers and trustees and targeted them by offering exotic and risky investment vehicles that were marketed as ‘absolute return strategies’.”
The defendants include KRS, trustees and staff members, the FoHF providers, and investment, actuarial, and fiduciary advisors. The litigation, a winding tale of its own, is ongoing.
Backtrack. KRS scaled back its efforts in late 2016. The slide deck from the presentation to the trustees says that hedge funds “as a stand-alone self-diversifying allocation makes little sense for KRS,” citing high fees and “unattractive NET returns.” (Emphasis from the slide.) A tabulation of funds to cut included columns for the applicable reasons for each: excess beta, opportunity relative to fee, and AUM concern.
Communication lessons
As noted before, the Calcaterra Pollack report is a study in how not to prepare a large, complex assessment. One wonders how the staff and trustees of KRS, for whom it was intended, have wrestled with it.
In the exhibits of the report are copies of memos and presentation materials created by KRS staff members, advisors, and investment providers. They serve as examples of what works and what doesn’t in communicating investment information. (Surfing the broader spectrum of public plan websites serves the same purpose.)
Aesthetics are important, since an attractive piece conveys professionalism to the reader. Beyond that, comprehension — for the reader of a report or the observer of a presentation — is crucial. Too often slides are crammed full of text or have charts that are too small or are hard to understand.
What’s missing to the reader years later is a sense of how a speaker used those slides, but dense text is never productive (put it in a document to be read in advance!) and charts that are hard to figure out are — whether original or cut and pasted from somewhere else — particularly annoying and unproductive.
Every organization should assess how well its communication materials measure up. Much good work is lost in translation unnecessarily.
Due diligence lessons
A few observations about due diligence and manager selection processes:
Misplaced expectations. The 2008 consultant report that argued for greater allocation to alternatives stated, “While aggregate returns from hedge funds are likely to be below most investors’ expectation, we are confident in the small group of managers that we work with.” Such confidence is common, and commonly misplaced. It would be interesting to know how the consultant’s specific recommendations would have played out. Also, its expected return forecast for hedge funds was 8%; another consultant later said 7.5%. Those were aggressive expectations for a mix of strategies that was expected to have a relatively low volatility of returns.
Consultant data dumps. In the exhibits, there were four versions (produced at different times) of a consultant’s “search book” of possible managers for KRS to use. They were essentially identical in construction. Here’s what one of them, covering seven managers, looked like: 8 pages of data points comparing the managers; 13 pages of comparative performance; and for each manager, a page of manager-provided narrative, single-page biographies for all of the named team members, and five years of allocation and AUM data. 114 pages total and not much there, really. Many search processes start that way, with screens and data dumps, from which users cherry-pick data points here and there but mostly look at performance. You can’t capture the essence of a manager that way.
Differentiating factors. In the document recommending the three FoHF providers, the “topics Staff wished to assess most in depth included firm structure, portfolio construction, operational due diligence, risk management, client service, and strategic partnering capacities.” Do you notice anything missing? How about investment due diligence methods, which one would expect to be of critical importance? (In the recommendation, two clear differentiating factors were offered: All of the FoHFs selected used a strategy specialist model and they all had PhDs heading their risk management functions, while none of the other candidates did. How important should those very specific attributes be in comparison to other considerations?)
Meeting counts. It’s typical for allocators to tout the number of meetings that they conduct in a given year, but that says nothing about the nature of those meetings — how they were conducted and with whom — and the quality of them. Many meetings are too short or too narrow to really get to the bottom of things, and they can be made up mostly of the presentation of manager narratives as opposed to true opportunities for discovery. On their own, the meeting counts can easily impress, for no good reason.
Passing along the narrative. It’s always instructive to determine whether conclusions about a manager — and specific language used to describe its attributes — are the words of the person doing due diligence or just the manager’s narrative being passed along. For example, where do you think these bottom-line characterizations came from?
Staff was most impressed by [manager one’s] formulaic implementation of top down views into its strategy selection parameters, [manager two’s] detailed implementation of its risk management process through position level transparency into its top-down and bottom-up decision making processes, and [manager three’s] experienced and specialist approach to making alpha-generating bottom-up manager selection decisions.
Focused on the numbers. The Sharpe ratio holds sway, targeted volatilities are used as if they could be dialed in, and short-term results (“they are killing it”) are persuasive. Decisions about the hiring and firing of managers are heavily dependent on past performance rather than forward-looking qualitative assessments.
Other lessons
None of us would want to have our body of work parsed by litigants or become fodder for media attention. Public funds have a particular burden in that regard, but any organization or person could be subject to discovery (including of those telling emails) if something has gone wrong.
The KRS situation is a reminder that the governance and decision processes of organizations — from public entities to very private ones — need to be reviewed and improved on a regular basis. The notion of good practice can veer off track over time, simply grow outdated, or never have been solid in the first place.
The investment ecosystem is fluid, with people jumping from place to place (sometimes ending up on a different side of the table than they were before), firms buying each other, new strategies coming out of nowhere, and the popularity of strategies and organizations ebbing and flowing — all while everyone is trying to keep up with their peers and competitors. There is a web of connections among the people involved and influence games being played all of the time. There’s a lot of money on the line. The KRS story is one example of how it all came together.
While the names of FoHFs, standalone hedge funds, advisors, and individuals aren’t included in this review, they are all identified in the report and exhibits. One question keeps coming up: “Where are they now?”
Of the asset managers who are cited, which have done well and which have done poorly? Which have not even survived? Their assembled stories would tell a tale of a decade or so when there were significant changes in hedge funds, FoHFs, and how they are used.
The same question can be asked about the individuals on all sides of the KRS drama, some of whom are still subject to litigation, and of KRS itself. Many changes have been made there in the last five years; will they be the foundation on which a new era — and a new reputation — are built?
The soap opera continues
It came to light that the Calcaterra Pollack report cost $1.2 million, but it wasn’t publicly available until recently. According to one opinion writer affiliated with the Kentucky Open Government Coalition, KRS “vigorously resisted disclosure of the report, denying multiple open records requests over a span of 18 months.” Two months ago, a judge ordered it to be released.
The next shoe to drop thereafter was a new lawsuit arguing that “there was an illegal bid-rigging conspiracy behind the hiring of the firm contracted to do the report.” That was not unexpected after a May 2021 posting on the blog Naked Capitalism laid out concerns about Regina Calcaterra, her new (and tiny) firm that was awarded the contract, and the process for selection.
Where will the story go next? It seems like there’s always something new to keep viewers engaged.
Published: December 18, 2022
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