Do hedge funds carry a corruption fee?

Wed Apr 4, 2012


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In general, many public pensions have embraced the direct-allocation approach and use of specialist consultants in the name of fee reduction


By Susan Barreto

It's been more than a year since Hank Morris received a four-year prison sentence for his role in the placement agent scandal that brought to light 'pay-to-play' practices within the New York State Comptroller's office, which oversees the state's pension system.

Since the use of placement agents (a practice where managers pay politically connected agents to help them win mandates) came to light in New York roughly five years ago, it seems that more public pensions have focused on what they are actually paying their managers in both management and incentive fees. Some of this action is due to plummeting hedge fund returns and a willingness on the part of some firms to negotiate. In other instances, it is a case of pension investment staffers wondering what they were really paying for all these years - performance or marketing.

In New York, for instance, a recent report from the Independent Democratic Conference (IDC) found the New York State Common Retirement Fund's investment portfolio has actually reported negative growth since 2007, while management and performance fees have risen by 160%. The research paper adds that in 2008, the New York pension system paid $272 million in fees. The following year, when the market crashed and the pension fund lost $45 billion, the pension fund paid even more in fees.

Hedge funds, which were at the centre of the 'pay to play' scandal, are the main culprit for the rising fees in New York, say critics. The IDC found that in 2010 when hedge funds underperformed equities, the pension fund paid $50 million in fees. Then in 2011, when hedge funds delivered the worst returns of any asset class, the pension fund paid the most it ever paid to hedge fund managers - roughly $123 million. The public-interest group has plans to draft legislation requiring public, online disclosure of all management and performance fee arrangements.

Comptroller Thomas DiNapoli has disputed the report's findings, claiming that the IDC did not take into account that the pension fund's assets under management have fluctuated significantly over the past several years, which also drives fees. Perhaps the biggest part not taken under consideration was the move away from funds of hedge funds to a broader direct hedge fund programme, which was originally put in place to save on fees.

In fact, in other states where placement agent scandals hit home (such as New Mexico and California) most pensions have generally taken on more single-manager hedge funds at the expense of FoHFs - in the name of saving fees. In general, many public pensions have embraced the direct-allocation approach and use of specialist consultants in the name of fee reduction ( see March's Institutional Letter).

In New Mexico, the $15 billion retirement fund has had redemptions totalling more than $1 billion since 2008 and saw liquidations of 13 funds, leaving only three FoHF managers in the portfolio. In California, 2008 marked a time of significant negotiating with hedge fund managers lowering fees in exchange for longer lock-ups or other provisions.

In an independent report on the Kentucky Retirement System, attorney Edward Siedle recently pointed out that following a review of placement agents at CalPERS, the pension plan was able to negotiate $215 million in fee reductions from alternative asset managers. Kentucky also has found itself in the middle of a placement agent scandal that is still being investigated by the SEC (see story).

The risk of inflated manager fees is heightened if a pension, such as Kentucky, does not solicit competitive bids from investment managers, according to Siedle.

It is a seemingly logical conclusion, but in light of the ban of placement agents going forward, is this 'politicisation' of mandates a real or imagined concern? It might be that hedge fund consultants or advisors forming strong ties with public pension boards across the US should stay out of local politics. Seeing what historically has played out, ensuring transparent and fair business practices will be the key to lowering a lingering 'corruption' fee that trustees can't afford if they want to meet their obligations.