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New York’s feared former Superintendent of Financial Services, Benjamin Lawsky, appears to have left a mark on the agency. Yesterday, the agency issued a blistering report on the failings of the New York State Comptroller in managing the state pension fund system’s “alternative” investments, specifically hedge funds and private equity funds. We’ve embedded the document at the end of this post.

We may have played a role in the section that discusses private equity, since we called the problem of private equity fee abuses and lack of transparency to the Department of Financial Service’s attention in January 2015.

The entire report is worth reading if nothing else for its exceptional direct style and harsh criticism. The DFS, which supervises state pension funds, found no excuse for the fact that the two state pension funds, which together make New York State the fourth biggest public pension fund in the US, were overpaying for hedge fund duds: over $1 billion in excess fees to hedge fund managers who underperformed to the tune of $2.8 billion.” Even worse, the state only now has gotten around to addressing the fact that many of its managers charge hefty fees for the privilege of lagging the stock market, while most other public pension funds have woken up to the problems with hedge funds and have been cutting allocations to or firing doggy fund managers.

The report cuts the hedge fund data every way conceivable and has nothing nice to say about it. For instance (emphasis original):

In comparing the 10-year 5.38% return for the Global Equity6 category with the hedge fund 3.23% return, the bulk of the hedge fund underperformance is due to the higher fees. The State pension system simply gave away tens or even hundreds of millions of dollars in fees every year for 10 years to hedge fund managers, and received no value in return. Over the most recent 5 years, the story is even worse as the gap in performance is well in excess of the fees paid. Global Equity returned 8.03% while the Absolute Return Strategy returned only 3.69%. The State pension system paid a premium price for significantly subpar performance…. Having seen three straight years of massive underperformance in 2009, 2010 and 2011, when the System’s Absolute Return Strategy underperformed the Global Equity investments by at least 10 percentage points each year, the State Comptroller failed to reassess an obviously failing hedge fund strategy… It is easy to see how a more thoughtful approach, simply paying attention to the conventional wisdom that it is practically impossible to beat the market over any sustained time period, would have benefited both New York State taxpayers and employees. Even simply putting the System on autopilot by investing in index funds would have saved billions of dollars

The report points out that not only have public pension funds in California, Illinois, and New Jersey shrunk or ended their hedge fund investment programs, but even the New York City comptroller woke up to the problem of excessive hedge fund fees and lousy performance in 2015 and early this year, the trustees of the New York City pension system voted to wind down the program.

The section on private equity is just as harsh. It called out the fact that the Comptroller ‘fessed up that it knew there was gambling in Casablanca, um, a lack of private equity fee transparency and resulting abuses, yet tried to fob its problem onto the SEC. And get a load of the action it deems to be necessary (emphasis ours):

Simply waiting for the SEC to fully investigate an industry, and then craft and adopt appropriate rules, is not action by the sole trustee of the State pension system charged with protecting its assets and promoting the interests of beneficiaries. At the very least, if there were a lack of transparency as to whether the general partners, or their affiliates, are overpaying themselves at the Common Retirement Fund’s expense, pursuing a freeze on fees and expenses until full information is provided would be in order. Continuing to pay the bill in full – and perhaps overpaying – is not the path to eliminating excessive expenses. Instead, the Comptroller should confirm that full disclosure occurs before any payments go out the door.

Heads would explode in private equity if a pension fund were to withhold fees pending a better accounting. However, the general partner would likely deem that to be a failure to meet a capital call, and the remedies for that are draconian (typically seizure of the defaulting limited partner’s interest with it distributed to the fund). However, contracts rest on a premise of good faith and fair dealing, and if the limited partner could allege an underlying breach (and the abuse of monitoring fees, which Ludovic Phalippou called “money for nothing,” might be a place to start), they might not be in as weak a position as most general partners would think. Moreover, if the limited partner had a strong enough case to get past summary judgment (likely), he’d be able to do a lot of digging in discovery, which is something general partners would be very keen to avoid.

Now of course, this line of thinking goes utterly against the widespread assumption that no one dares stand up to the general partners because they would be blackballed by the industry and would be outgunned legally. But the DFS is the New York State pension funds’ regulator, and if the DFS presses the issue, the Comptroller is going to have to take some action.

At a minimum, the DFS has flatly rejected the idea that New York should passively accept the meager information provided them by the general partners and rely on the bogus excuse that pressing for more might make them unpopular. The report cites state regulations that hold the Comptroller to standards it is arguably not meeting, particularly in light of the fact that many smaller public pension systems are succeeding in obtaining much more information about fees and costs.

The DFS report concludes with a list of tough demands:

As to transparency of private equity fees and expenses, the Comptroller should at a minimum: 1) Develop a comprehensive accounting for all fees and expenses related to CRF’s private equity activity; 2) Develop an internally consistent method to record and report all expenses incurred across all private equity investments so that fees and expenses can be compared

and opportunities for reducing costs can be identified; 3) Impose and/or reinforce processes to review existing private equity arrangements to assure that existing fee and expense allocation comply with their agreements; 4) Make public all information regarding fees, expenses, and carried interest; and 5) Require general partners to restate prior reports to provide transparency consistent with any new requirements, and to affirmatively self-report any prior questionable practices for further review

The DFS is a young agency and it has yet to flex its muscles in this area. However, it proved to be a very tough infighter despite being at what appeared to be a very disadvantaged position in taking on major international banks and end-running Federal regulators, who were initially outraged by a second-tier regulator embarrassing them. So while the balance of power would appear to be stacked against the DFS, it would be a big mistake to underestimate what the agency might be able to achieve. Few regulatory bodies are willing to use all the tools at their disposal, and the DFS has proven to be a rare and welcome exception.

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