| “I'm
shocked, shocked to find that gambling is going on in here!”
– Captain Renault in “Casablanca”
New York State investigators may yet
unravel one of the more intriguing mysteries of new financial
order: why officials in charge of pension funds and endowment
funds outsourced over $100 billion of other people’s
money to buyout partnerships. These institutions, in fact,
provided about three-quarters of all the investment equity
used by the top 100 private equity firms to fuel the leveraged
buy-out craze of 2004-2008.In 2006 alone the ten largest,
led by Calpers, the New York State Common Retirement Fund,
and the Washington State Investment Board, sunk over $101
billion into private equity partnerships. These groups,
after borrowing another 60 to 70 percent for leverage, would
then buy entire businesses with the aim of re-organizing
and re-selling them.
Here’s how this works: the investment firm serves
as the general partner, responsible for making all the decisions
and getting all the fees. The pension or endowment fund
becomes a limited partner, which means it simply put up
money. Typically the limited partner is locked into a multi-year
commitment, often 10 years, during which time it cannot
withdraw any portion of its investment and may be called
upon to put up additional money in “capital calls.”
The limited partner also pays the general partner a lucrative
fee, typically two percent per annum of the net value of
its investment, win or lose (which, in a 10 year deal, adds
up to 20 percent of the investment). In addition, there
is a performance fee on each completed deal, typically 20
percent of the profits. If a limited partner wants to get
out of the partnership prematurely, it can entail huge losses.
The Harvard endowment, for example, tried to sell billions
of dollars in these partnership interests in 2008-9, but
even at a 35 percent discount, it could find no buyers.
Given
such a hefty fee structure, it is clear why private equity
firms want to lock in pension and endowment fund money,
and, with such fees, it is hardly surprising that their
principals, such as Henry Kravis of KKR, Steven Schwartzman
of Blackstone, and David Rubenstein of The Carlyle Group,
rank among the wealthiest billionaires on the Forbes 400.
What is less clear is why the pension and endowment funds
are willing to pay such fees, especially when it also entails
locking their money in illiquid partnerships and committing
themselves to furnishing further money when they get capital
calls.
To
be sure, many of the buyout funds have had impressive track
records. Historically, from 1996 to 2006, buy-out partnerships
had an average gain of 8.7 percent a year, which was 1.6
percent better than that of the Dow Jones Industrial Average.
When the fees as well as the costs of illiquidity and possible
capital calls are factored, the return is much less attractive.
But buy-out funds do not rely only on their track records
to recruit the pension and endowment funds.They also commonly
pay lucrative fees to “placement agents” to
use their access to corral this money for them.When they
induce fund officials to invest, they get a percent off
the top, typically one percent of the money they bring in.
If these agents of influence fail, however, they get zero.
So they have a powerful incentive to close the deal, and
it apparently works since in 2008 they earned, according
to one estimate, over $1 billion in fees. So the billion
dollar question is: how do they accomplish this feat of
inducement?
Finding
the key officials at the nation’s largest pension
and endowment funds is no problem, since on-line directories
list them. The difficult part is persuading these officials
to put their institution’s money into the illiquid
and risky partnerships with which they have arrangements.
And this is the part that New York State Attorney General
Andrew Cuomo is closely examining, especially in regard
to 20 or so powerful investment houses and their placement
agents, which received many billions of dollars in investments
from the $122 billion New York State Common Retirement Fund.
One
part of this investigation involves the activities of the
Quadrangle Group, a private equity firm co-founded by Steven
Rattner, the veteran deal-maker and Democratic Party fund-raiser,
who is currently serving at the Treasury Department as President
Obama’s auto industry czar. What has brought it into
focus is a SEC report describing how in late 2004, just
prior to getting $100 million from New York’s pension
fund, a “senior executive” at Quadrangle”
made an arrangement with a politically-connected “consultant”
acting as a placement agent. The executive was then identified
as Rattner and the consultant as Henry “Hank”
Morris, a top advisor for then-New York State Comptroller
Alan Hevesi. Afterwards, Quadrangle paid a $1.1 million
placement fee to a small company, Searle and Company, with
which Morris was affiliated. In addition, Quadrangle had
one of its subsidiaries pay $88,841 for the DVD rights to
“Chooch,” a low-budget movie that had been co-produced
in 2004 by David Loglisci, New York’s deputy comptroller,
who was the top investment officer of its pension fund.
(In March 2009, both Morris and Loglisci were charged in
a 123-count criminal indictment with “enterprise corruption”
in regard to selling access to New York’s pension
fund. Both men, through their lawyers, deny the charge.)
Nor
did Rattner’s quadrangle fund limit its placement
fees to the New York State pensions funds. According to
the Wall Street Journal, in 2005, Quadrangle paid fees to
Morris’ vehicle, Searle & Co, for millions from
the New York City Employee Retirement System, the Los Angeles
Fire and Police Pension System, and the New Mexico Pension
Fund.
Quadrangle
was not the only investment house to pay placement fees
to Morris or funnel money into “Chooch.” The
Carlyle Group, which got over a billion dollars from the
pension fund’s money, paid $10 million to the Morris’
placement company. And according to SEC documents, an executive”
of CarlyleRiverstone, a joint venture of the Carlyle Group
invested $100,000 in “Chooch.”
To be sure, there is, as yet, no evidence that any of these
investment houses did anything illegal in either paying
placement agents or, for that matter, in helping finance
“Chooch.” (The film depicts losers from Queens
cavorting in Cancun with a fun-loving prostitute ) Like
the “shock” expressed by Captain Renault in
the 1942 movie “Casablanca” after a croupier
hands him a pile of money, the investment houses can express
dismay that their agents of influence earned their fees
in any nefarious way. After all, the boilerplate in their
agreements with their placement agents requires those agents,
to quote from the Carlyle contract, to “abide by all
laws.”
The money put in “Chooch” may presents a more
difficult problem, since these payments were made many months
after the movie had totally failed at the box-office. (“Chooch”
played in a grand total of three theaters, and, in its short
run, taking in less than $33,000.) So why did these masters
of the universe decide to sink their own money in Deputy
Comptroller Loglisci’s “Chooch”? If it
was anything other than to make profits from the “Chooch”
enterprise, their investments could be construed afoul of
New York State’s strict anti-gratuity laws intended
to prevent parties from currying favor from public officials
by gifting them.
Stay tuned, as Andrew Cuomo pursues the mysteries of placement
agents, double agents, enterprise corruption and other elements
in the invisible universe of high finance, which only grow
curiouser and curiouser. While Chooch may have been a slapstick
comedy about a bag of stolen money, the corruption of an
entire pension fund system is no laughing matter.
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