He who laughs last: Chris Tobe’s pension crisis warnings get traction as media starts to dig

Chris Tobe: Louisville's paying $20 million extra to fund state pensions

Chris Tobe

This is the latest in an occasional series of stories examining Kentucky’s $30 billion public-employee pension crisis, a series dating back to 2012.

In the best of circumstances, the investment world is a treacherous place.

From your 401k to derivative funds that place intricate side bets on anything you can think of – the stock market, inter-bank interest rates, currencies, or the Baltic Dry Index of shipping rates — the goal is to balance risk and reward.

Over time, the informed and cautious flourish. The greedy tend to fall prey to the manipulators and predators.

Take Kentucky’s public employee pension funds under the Kentucky Retirement Systems, which are some of the most underfunded in the United States. For the last six years, as the General Assembly diverted hundreds of millions in payments away from the funds each year, KRS’s pension investment strategy was generating tens of millions in management fees for Wall Street firms and placement agents.

Those fees were were generated as Kentucky invested in risky, opaque startup hedge funds with no track records and other investments that produced yields below what the funds could have earned from lower risk, low fee stocks and bond portfolios.

In Kentucky, it was never about yield; it was always about fees.

At IL, we’ve been reporting on the state’s public-employee pension crisis since 2012, about a year after we launched our beta site in early 2011.

No one much cared.

State officials did whatever they could to impugn the reputation of the main pension whistleblower, investment manager Chris Tobe, largely succeeding as major news outlets such as The Courier-Journal ignored the story.

Why? Because Tobe’s allegations are potentially explosive, with the U.S. Securities and Exchange Commission’s Division of Enforcement investigating KRS investment practices.

Two years later, the media finally is listening to Tobe and his message that Kentucky’s finances will crater within five years. That includes journalists Joe Sonka at LEO Weekly and James McNair at the Kentucky Center for Investigative Reporting.

Last week, investigative reporters McNair and Sonka posted long stories identifying secretive hedge fund strategies and the fees they generated as a pension fund shortfall culprit, just as Tobe has long charged.

At the same time as McNair’s and Sonka’s stories were posted, the Wall Street Journal and other national publications were reporting the nation’s largest public employee pension funds, including the California Public Employees’ Retirement System, are dumping hedge funds because fees are high while yields are no better than conventional – and transparent – investments in this current environment.

A major contributor to – though not the main cause of – Kentucky’s public-employee pension crisis is that with state employees’ financial futures at stake, lawmakers entrusted billions in pension funds to money managers with no performance incentives beyond the desire to generate ever more management fees.

At least two funds, Arrowhawk Capital and Camelot, collapsed. Others folded after they failed to perform.

Rather than try to include all the background in this post, you can see an in-depth interview with Tobe from 2012 here with all the details.

KyCIR spent months on their story, and to their credit, revealed something I didn’t know: The Kentucky General Assembly voted twice to adopt legislation to keep KRS alternative investment contract details, including fees, secret.

But no one asked the central question: “Who were the lobbyists who pushed that vote?”

We called Speaker of the House Greg Stumbo’s office, but his spokesman said Stumbo didn’t take office till early 2008. He referred us to John Schaaf at the Legislative Ethics Commission. Schaaf was out of the office, but staff members said lobbyists register and withdraw almost daily as legislation flows through general assembly sessions. So connecting the dots from lobbyists to legislation will require a trip to Frankfort to research.

In an interview, Tobe said he believes the 2008 legislation was pushed by lobbyists from Wall Street, specifically from The Blackstone Group, the world’s largest private equity firm, along with KRS staff. However, LEC officials said none of the major private equity firms or hedge funds in which KRS is invested, including Blackstone, has ever registered lobbyists in Kentucky. While Blackstone has no lobbyists registered for the general assembly, the financial giant does have seven executive branch lobbyists registered, Tobe said. Blackstone executives did not return calls for comment.

By 2013, KRS had invested $1.5 billion in three funds controlled by Blackstone and two other private equity firms, Prisma Capital Partners (part of Wall Street M&A/takeover giant Kohlberg Kravis Roberts) and Pacific Alternative Asset Management, based in Irvine, Calif., near Los Angeles.

Just what sort of investments KRS owns in the funds, or the contractual terms, is unknown because KRS redacted all documents released to KyCIR under the Freedom of Information Act.

If you go back far enough to the origins of the public-employee pension story, you know Gov. Steve Beshear fired Tobe in 2010 after Tobe went to the FBI and SEC.

Tobe exposed a system in which unqualified placement agents with accomplices inside KRS received $12 million from 2007 until 2010 for “investing” pension fund money in  risky, unrated, unproven and spectacularly underperforming funds.

KRS officials allegedly went after Tobe, charging he is not a legitimate whistleblower and is only trying to enrich himself. (As an incentive to expose wrongdoing, whistleblowers are entitled to a portion of funds recovered by the SEC.)

Journalists typically find it difficult to take financial abstractions, then translate them to the real world.

Though it was buried deep in the KyCIR story, credit McNair for debunking KRS  interim Chief Investment Officer David Peden’s argument that KRS can’t reveal details of its hedge fund investments because they’re proprietary.

Peden used the analogy of forcing Coca-Cola to reveal its “secret formula in exchange for allowing us to invest in Coke.” But last year KRS earned 12.7 percent on its investments, compared to the national median of 16 percent for public-employee pension plans, McNair reported. Who would want to copy that?

KRS’s hedge funds and private-equity investments had average annual gains of 5.5 and 4.5 percent, respectively, between their startup dates and last Dec. 31, according to the KyCIR post. To beat that yield, KRS could have bought low-risk investment grade corporate bonds, which currently are typically paying about a 5.6 percent yield.

Instead, they invested in alternative investments, including hedge funds and private equity deals created by Blackstone, Prisma and PAAMA.

KRS now has nearly 30 percent of its total assets, or about $4 billion, in alternative investments, including $2 billion possibly held offshore, most likely in the Cayman Islands, where there are extensive financial privacy laws. The fees from this $4 billion could total $100 million a year, Tobe said.

The trouble is once KRS ships it off to the Caymans, there is no way to trace any of it, he said. We tried to talk with KRS Communications Director Scarlett Consalvi, but Consalvi didn’t reply to emails or calls for comment.

If individuals invest in, say, Sequoia Fund or other reputable mutual funds, fund managers send those investors complete lists of holdings as well as management fees.

At any given time, Warren Buffett, who manages Berkshire Hathaway, is more than happy to discuss with BH holders and the financial press longterm strategies and holdings. And at any given time, you can see Berkshire Hathaway’s historic performance since inception.

But much of the KRS investments are in opaque, high-risk investments only open to what are termed Reg D accredited investors, high net worth people who can afford to gamble millions on complex alternative investments as they try to balance risk and reward, and institutional investors such as insurance companies, which generate massive amounts of cash.

For a public employee pension fund, the investment goal is far more conservative: To generate sufficient yields to ensure state employees such as teachers get paid out as they retire. Until he was fired by Beshear, Tobe was the firewall between the state and Wall Street. Tobe, who is Chartered Financial Analyst, one of the top investment credentials, was the only finance expert on the KRS board of trustees.

The public-employee pension crisis story locally got a lot more real and a lot less abstract when in May 2013, David Jones Jr., a member of the Jefferson County Board of Education, started asking how much JCPS is on the hook for after accounting rules change next year.

One of the shrewdest financial minds in the state – the former Humana chairman and CEO of Chrysalis Ventures, a private equity fund — wanted to know where the pension crisis is taking JCPS and the state.

The answer from JCPS CFO Cordelia Hardin: It could wipe out the system’s reserve fund, possibly leading to the state taking over Jefferson County Public Schools.

A few weeks ago, Tobe told IL that because of the pension crisis, the next governor will have to raise taxes and cut spending on levels never seen in Kentucky history. And that’s where the abstractions get real.