One Reason Why State and Local Pension Funds Are in Trouble – They Have Invested in Funds that Turn Out to Be Zombies

Not Afraid of Zombies? – Neither Were They

Private equity is the business whereby Mitt Romney made zillions.  The concept is fairly simple.  An investor group buys a company by putting in a little bit of its own money and by borrowing a lot of someone else’s money.  If the firm does well, the borrowed money is paid back and everyone gets a good return on their investment.  If the firm does not do well, the sponsors have still been paid a great deal in fees and distributions, the lenders and other investors lose big time and the employees of the company find themselves unemployed. 

This model has great appeal to pension fund managers because it promises at least the opportunity to obtain the type of returns they have committed to obtaining, returns which are for the most part unrealistic.  Unfortunately in some case the investments don’t turn out so well, the buyout fund ends up stuck with a lot of investments in companies that cannot be sold, cannot generate cash and can only just sit there year after year.  These funds are called “zombie funds” meaning they are dead but act like they are alive.

Of course the great thing from the sponsor’s point of view is that even though the money they have been given to invest is tied up and earning nothing, they still get to collect great fees.  After years of being taken to the cleaners Illinois made some threatening noise and got relief.

For Illinois's pension board, this meant that instead of charging the state 0.97% of the $35 million Illinois invested 13 years ago, Invesco will charge 0.5% of the value of Illinois's slice of the remaining assets, which is about $6.4 million. The change will cut the annual fee Illinois owes by about 90%, to $32,000.

Notice what was going on here.  The fund sponsor, Invesco was charging the full .97% fee on the original investment even though over 80% of the investment was no longer present. 

Furthermore, in many cases the pension funds were investing in funds whose only activity was to take the money and invest it in other funds.

Venture Partnership Fund II is a "fund of funds"—investing not in individual companies but in other funds. Those it invests in focus on early-stage companies, making it more of a venture-capital than private-equity fund.

So the investors were paying a management fee to a fund who then put the money in other funds where the managers of those funds also earned a fee.  If anyone’s children need career advice, managing a fund that only invests in other funds sounds like the way to go.

A large part of the problem here is that the investments have declined in value, big time, but nobody want to recognize that.

"If you push the issue, the [private-equity firm] can liquidate the fund and then we get stock certificates for private companies. What do we do with that?" says William Atwood, director of a board that handles Illinois's pension investments.

Another alternative for investors is to try to sell their stakes. But the stakes in aging or moribund funds tend to trade at an average of 30% to 40% below where the funds' managers value them, says Todd Miller, a managing director of Cogent Partners Inc., a private-equity investment bank that provides a secondary market to its clients.

Not all investors want out. Pennsylvania's retirement fund for teachers has stakes in 15 private-equity funds older than 10 years, totaling about $40 million, according to Charles Spiller, who heads the state's private-equity investments. He says he regards only a few of them as zombies and is willing to have patience with the funds' managers, because "if you don't sell at the right time, you're not going to get the full value."

Translation:  This stuff is crap, but we are all going to pretend it is not crap because if we don’t we will have to tell people we invested in crap and then we may lose our jobs.