SOURCE:  Oregonian

Oregon PERS:  Private Equity Investments Pose an Unclear Future for Public Pensions

Ted Sickinger, The Oregonian

Sunday May 20, 2012

The river of profits welling from investments in private equity partnerships has long been a point of pride for Oregon's public pension managers.

Oregon was the pioneer public investor in this asset class. And the state remains one of the largest, after pumping tens of billions into these partnerships, which invest in corporate buyouts, real estate, distressed debt and startup companies.

The Treasury Department's investment prowess is so firmly rooted in Salem that there was barely a peep when the pension fund increased its allocation in these so-called alternative investments from about 11 percent of fund assets at the beginning of 2006 to more than 30 percent today.

That's two and half times the average exposure of comparably sized public pension funds. And more than half is in funds raised between 2005 and 2007, during the heyday of the corporate buyout and real estate bubbles.

Such concentration raises important questions for taxpayers, who backstop the Public Employee Retirement System's solvency when market returns lag.

Among them: What are these long-term investments really worth? Some are extremely complex. Most have no publicly traded value. And the state is basing taxpayer contributions to PERS on good faith estimates from investment managers.

Equally important is a second question: Can the private fund managers, who take 1 to 2 percent of Oregon's committed capital each year for management fees -- about $150 million in 2011 -- deliver anywhere near the double-digit returns they've promised?

From the perspective of Treasury's investment officers, there's no use second-guessing fund investments made during the boom years. Like a homeowner who bought before the crash, they say there's not much to see until the partnerships liquidate their investments, which will take years.

They expect lower performance from funds raised in 2006 and 2007, but suggest any problems will come out in the wash as investments in subsequent years benefit from depressed prices and an economic recovery.

"The expectation remains that it will outperform the other asset classes," said Mike Mueller, Treasury's acting chief investment officer.

Oregon's big commitments have raised eyebrows in some circles.

The entire private equity industry is under siege, not only because of presidential hopeful Mitt Romney's tenure running industry giant Bain Capital, but because of the industry's reputation for loading up acquisition targets with debt, then getting favorable tax treatment on the profits they extract from their deals.

The perception problem is bad enough that the secretive industry, long immune to outside scrutiny, has launched a public relations offensive extolling the benefits of its business model to companies, communities and the economy.

In Oregon, questions have circulated for years.

Meyer Eisenberg, a former deputy counsel for the Securities & Exchange Commission who teaches securities law at Willamette University, repeatedly urged former Treasurer Ben Westlund and his successor Ted Wheeler to appoint a special counsel to look at Oregon's investments. His concerns centered on the legal problems of one fund manager and private equity pay-to-play scandals in New York and California. Those problems, involving politically connected middlemen who earned huge fees for securing investments from pension funds, didn't involve Oregon directly. But they touched funds it invested in, as well as the private equity consultant that it uses to vet investments.

Last month, one of Eisenberg's former law students sued trustees of the system on behalf of two public employees. The lawsuit focuses on state investments with Lone Star Funds and the conviction of Lone Star's top executive in South Korea for stock manipulation. But it also points to the risky nature of illiquid private partnerships, and questions the accounting methods used to value them.

Portland investment consultant Bill Parish has bemoaned Oregon's 2008 Lone Star investment since it was struck, blogging and putting his own video on YouTube. But it was Eisenberg who last year caught the ear of House Co-Speaker Bruce Hanna, R-Roseburg, who then sent a letter to Wheeler asking pointed questions about Lone Star, private equity valuations and Oregon's experience with outside fund marketers, known as placement agents. He asked Wheeler if he objected to appointing a special counsel.

The Oregonian also ran a series of stories in 2010 that examined travel policies and potential conflicts of interest between Treasury investment officers and the private equity funds they monitor. Similar issues in California led to fines of investment officers there, and three of Oregon's personnel were reprimanded by the Oregon Government Ethics Commission.

Wheeler says he took over the Treasurer's office with general concerns about the industry's transparency, and has addressed specific issues as they crop up. He tightened the department's travel and expense reimbursement policies. The Oregon Investment Council, the citizens panel that sets investment allocations, started disclosing placement agents working with funds Oregon invests in. That policy does not, however, require the disclosure of fees tied specifically to Oregon's investment.

Wheeler said Thursday that he can't comment on Lone Star due to the pending lawsuit. But in a letter to Hanna last year, he said that Lone Star had been exonerated in South Korea. He added that the state's real estate consultant and several other sources had looked into the matter and put concerns to rest. Lone Star's top executive in South Korea was initially convicted of stock manipulation in 2008. The verdict was subsequently overturned, but he was retried and convicted in late 2011.

Wheeler assured Hanna that "Treasury has adopted a rigorous control structure to best determine and monitor the valuation of private assets." His own questions about valuations, he wrote, led him to create a blue ribbon panel of citizens with predominantly financial backgrounds to evaluate the valuation process. "After months of study this year, the panel concurred that Oregon's process follows the best practices in the industry," he wrote.

Members of the panel give Wheeler high marks for looking at the issue, and agree he's worked to increase transparency. But some were less than satisfied with the industry's best practices.

Brett Wilcox, CEO of Summit Power Alternatives and a policy adviser to Gov. John Kitzhaber, said he gives high marks to Wheeler for taking on the issue of transparency. But at this point, he said Treasury is essentially doing the same thing as its counterparts around the country -- relying on self-valuations by fund managers.

"I personally don't consider it best practice," Wilcox said. He added that Treasury's presentation of its investment returns on its website is also lacking. "It should be at least as good as your 401(k) statement, and it's not. It's not even close."

Another panel member, Linda Burgin of Service Employees International Union Local 503, said the unions have always been wary of buyout specialists. Lack of transparency and self-valuations are another problem.

"It's like having someone within your own company do an audit," Burgin said. "Just because it's standard for the industry doesn't mean that's what we should be doing."

Treasury's investment officers aren't directly involved in valuing funds, as their incentive pay is based on the performance of the funds they monitor. The agency doesn't have the resources to monitor the 1,800 portfolio companies underlying 190 funds Oregon has invested in. But staff and the investment council receive quarterly valuations from fund managers, and investment officers sit on fund advisory boards where valuations are approved.

Industry standards exist, and Mueller says they are typically applied consistently. Private companies are valued in comparison to public competitors, or using multiples of sales, earnings and cash flow. Real estate valuations are similar, with appraisals, comps and cash flows. While outside auditors may not value the companies, they do approve the funds' valuation methods.

Quarterly and annual valuations are vetted by the state's private equity consultant, the recently reconstituted TorreyCove Capital Partners. TorreyCove's predecessor company, PCG, was caught up in California's pension scandals and ended up losing its contract as part of the housecleaning. Harry Demorest, a retired executive who chairs the Oregon Investment Council, said the council had two or three meetings to discuss exactly what happened, and gives the new firm its vote of confidence.

David Fann, its president, says 20 percent of Oregon's private equity holdings are actually stock in public companies, some held at a discount.

Oregon typically invests with established managers over successive funds. Any incentive to inflate values would come when managers are raising a new fund, on which they earn lucrative management fees.

Whenever a manager is fundraising, Fann said, TorreyCove analyzes the financial statements of every company that's material to its existing fund valuation. Funds that have a credibility gap, or a valuation gap, don't make it to the OIC.

"We think the portfolio is valued on the conservative side of reasonableness," Fann said. "We typically don't see (asset sales) at values below the carrying value in the portfolio."

PERS coverage
PERS released pension data of its more than 117,000 beneficiaries after a decadelong tug of war between government transparency and privacy rights. PERS routinely released benefits until 2002, then started refusing the information except for prominent retirees such as an ex-governor. Former Attorney General Hardy Myers backed the agency.
When The Oregonian and the Statesman-Journal of Salem challenged that decision, current Attorney General John Kroger ordered individually identifiable benefits released to the two newspapers. PERS challenged that in court, citing privacy concerns. But it reached a legal settlement to release limited data, redacting sensitive information. This story and past coverage rely on that data. Read past stores and view the online database. 
Oregon won't realize results for years from its alternative investment binge before the financial crisis. The state is a participant in most of the marquee buyouts of the era, and many big real estate deals. Based on limited data available, some look too expensive in hindsight with too much debt. Fund returns could be low, some negative.

On the other hand, Fann points out that Oregon is a participant in many of the homerun deals, too. It should make a few hundred million off Facebook, for instance. It owned shares of Instagram.

Demorest says he's been the most aggressive advocate for alternative investments on the five-member council. While valuations are imperfect, he says he sees no evidence of inflated values, and remains a fan.

"I continue to believe that over time, private equity will outperform public equities," he said.
On the other hand, he and Wheeler agree that private partnerships owe public investors -- their largest backers -- more transparency and accountability, and could provide it without compromising their business. At home, Wheeler hopes to disclose more on Treasury's website, including additional information on investment returns, policies and even contracts with investment managers. But he said that effort has been delayed by the state's overall redesign of its websites.

Demorest says he sees no business reason for the private equity funds' secrecy, other than past practices.

"If we don't have anything to hide," he asked, "why do we try to hide it?"

--Ted Sickinger