A
Manufactured Crisis
EARLIER THIS YEAR, the New York Times ran a front-page story about the
outrageous pensions being paid out to a few Oregon retirees. The story,
headlined “A $76,000 Monthly Pension: Why States and Cities Are Short on Cash,”
featured a former college football coach collecting more than $550,000 a year,
and a retired university president pocketing $913,000. The story feeds into a
popular myth that retired public-sector workers are getting fat and rich thanks
to ordinary taxpayers, who are shouldering the costs of pensions so generous
they have triggered a cascade of fiscal crises.
In reality, most retired public workers are living far
more modestly. In 2014, the suburban Chicago Daily Herald looked at nine
statewide and local pensions, including those enjoyed by teachers, legislators,
and university professors. The average pensioner, they found,
received $32,000 a year. The Illinois municipal retirement fund pays an average
pension of only $22,284 a year, low enough for seniors to qualify for food
stamps. Most retired civil servants, moreover, don’t receive Social Security. Despite
the rhetoric, public workers are generally paid less than their private-sector
counterparts, even when factoring in benefits — 11 to 12 percent less,
according to a 2010 analysis of two decades of data from the Bureau of Labor
Statistics.
The Illinois Policy Institute, a conservative think tank
with offices in Chicago and Springfield, is one of several organizations that
have helped exaggerate the pension crisis myth. Its specialty has been
manipulating the numbers to make the state’s pension problems seem even more
outsized than they are. Illinois is facing, according to the Chicago Federal
Reserve, a substantial unfunded $129 billion pension liability. But Ted
Dabrowski, then the group’s vice president for policy, told me, “The state’s
really looking at a deficit of $250 billion,” a figure he reached by making the
unlikely assumption that the state invested only in low-yield bonds. Yet such
research provides the ballast for attacks on pensions by organizations such as
the Civic Committee of the Commercial Club of Chicago, a group made up of some
of the city’s wealthy, politically active business leaders. The committee uses
its influence to push a message that cutting public pensions is critical to
Illinois’s well-being.
A Houston couple, John and Laura Arnold, cut a high
profile among those interested in public pensions. John Arnold used money he
made as an energy trader at Enron to start a hedge fund in 2002. He was worth
in the multiple billions by 2010 when he created the Laura and John Arnold Foundation,
which since its inception has been funding research and campaigns around the
United States aimed at sounding the alarm about public pension debt and driving
public pension reform. Among the foundation’s biggest gives: $9.7 million to the
Pew Charitable Trusts for work on public-sector retirement systems; Pew, in
turn, has produced its own headline-generating reports about a rising pension
crisis. The Arnolds also personally wrote a $5 million check to a PAC called
IllinoisGO, which lists as its purpose giving Democrats who support “difficult, yet
responsible choices” political cover from “special interest
attacks.” (The foundation also coproduced a report with
Pew that raised concerns about pension funds moving into high-fee
alternatives.)
Almost no pension system, public or private, is 100
percent funded. But a system doesn’t need full funding, unless every person
retired tomorrow. Eighty percent is the threshold the federal government uses
when assessing the health of the corporate pension plans it monitors. The
credit reporting agencies also employ the 80 percent benchmark as an indicator
of financial soundness — if not a lower figure. Fitch Ratings,
for instance, “generally considers a funded ratio of 70 percent or above to be
adequate.” By those standards, the country’s public pensions are generally
doing fine — funded, on average, at 76 percent, according to a survey by
the National Conference on Public Employee Retirement Systems. “Seventy-six
percent is healthy,” according to Bailey Childers, former executive director of
the National Public Pension Coalition, “so long as states keep up their
contributions and the investments are managed responsibly.”
Those who care about carefully assessing the health of the
country’s public pensions would need to take into account Wisconsin, South
Dakota, and New York, three states where the pension system is over 90 percent
funded. They would need to consider Texas, Oregon, Ohio, Florida, or
any of a long list of states whose pensions systems are more than 70 percent
funded. Except those states don’t fit the narrative being put forward by those
seeking to manufacture a crisis to justify wiping out public pensions. That’s
why Illinois looms large, along with Kentucky, New Jersey, and a few other
states where there’s no denying the systems are in crisis. There first needs to
be a crisis to convince people that the problem requires a drastic fix.
Exploiting
the Pension Crisis
The governor of Illinois, Bruce Rauner, has been a leading
champion of the pensions-in-crisis narrative. Even before he entered the race
for governor in 2013, he was outspoken in his belief that the public employee
unions were a major reason, if not the top reason, Illinois was in an economic
“death spiral.”
He was also one of several wealthy corporate executives in Chicago behind a
successful effort in 2011 to make it harder for teachers in the state to
strike. One of Rauner’s first acts after taking over as governor was to
issue an executive
order allowing state employees who didn’t want to pay union
dues to opt out; he later instructed state
agencies to stop collecting the fees on behalf of the unions. That gave rise to
the Supreme Court’s Janus ruling, which dealt a crippling blow to public sector
unions when it was decided this past June. It was Rauner who preemptively
filed suit in an effort to get the case quickly in front of the
U.S. Supreme Court. But a judge ruled that he didn’t have standing, so a state
worker named Mark Janus became the lead plaintiff in a case Rauner would hail as
a “great victory for our democracy, our public employees and the taxpayers.”
Rauner’s most prominent public-sector position prior to
his run for governor was as an adviser to Chicago Mayor Rahm Emanuel. The two
had first met in the late 1990s, shortly after Emanuel left the Clinton White
House and around the time Emanuel was brought on as a partner at the investment
bank Wasserstein Perella & Co. The young politico famously earned $18.5
million during his two-and-one-half years there — much of it courtesy of his
business relationship with Rauner. The two did five deals together,
including Security Link, an alarm company Emanuel brought to Rauner for
acquisition. Rauner’s private equity firm GTCR bought the company from SBC
Communications for $479 million, then sold it six months later for $1 billion.
Shortly after he was elected mayor, Emanuel put Rauner and his wife into what
the Chicago Tribune called “unpaid
but prominent advisory roles.” Rauner left GTCR in October 2012 and
announced that he was running for governor in June 2013.
As soon as Rauner took office, he sought to slash pension
benefits, traveling the state to push a plan calling for $2 billion in pension
cuts (though he promised to exempt police and firefighters). He stopped only
when the Illinois Supreme Court slammed the door on that idea, reminding him
that the state constitution included an ironclad provision declaring public
pensions an enforceable contractual relationship, “the benefits of which shall
not be diminished or impaired.” The justice writing for the 7-0 majority, a
Republican appointee, seemed to be talking directly to Rauner when he wrote,
“Crisis is not an excuse to abandon the rule of law. It is a summons to defend
it.”
Illinois ranks in the bottom third among state spending on
core services as a share of state GDP, according to the Chicago-based Center
for Tax and Budget Accountability. The state couldn’t afford to shrink the size
of government any further, Ralph Martire, the center’s executive director,
argues, but the new governor proposed doing just that, with deep cuts not only
to pensions, but to public services. For good measure, Rauner used his first
State of the State address to propose that public unions be banned from
contributing to the campaigns of state legislators and signed an executive
order prohibiting public unions from collecting fees from government workers
who choose not to join.
The American Federation of Teachers keeps what it calls a
“watch list”: those managing their members’ money who in turn write big checks
to organizations seeking to “reform” the country’s public pensions — which is
to say, to eliminate them. Rauner deserved a “special mention” in AFT’s 2018
report for fighting the battle not just from the governor’s mansion, but also
with his checkbook. That included the $500,000 Rauner gave,
through his family foundation, to the Illinois Policy Institute. (Rauner
also employed several
staffers from the institute, including one as his chief of
staff, until his relationship with the institute unraveled late last year.)
“The anti-pension people love this guy,” said Daniel
Montgomery, president of the Illinois Federation of Teachers. The Rauner
campaign declined to comment for this article.
Aiding Rauner’s cause has been the scandal that rocked the
$51.5 billion Illinois Teachers’ Retirement System, or TRS. Illinois is home to
one of the pension funds that might be called the “overextended”: funds that
devote more than 30 percent of their assets to alternatives, the investment
world’s catch-all term for private equity, hedge funds, and other complex
investments. TRS has an astonishing 38 percent of its holdings in alternative
investments — among the highest in the country. At that point, a fund isn’t so
much investing as making casino-like desperation bets to try to make up for
pension underfunding, as well as for past investment mistakes and bad deals.
Those with the highest exposure to high-fee alternatives are also the most
vulnerable to pay-to-play. Not surprisingly, TRS has been spectacularly marked
by corruption. [Alternative investments according to PEW: hedge funds, real estate, private equity, and commodities].
Public Pensions Have Been Very, Very Good to Bruce Rauner
While Rauner has fiercely attacked public pensions, public
pensions have been very good to Rauner. He owns no less than three homes in the
Chicago area: a 6,900-square-foot palace in a tony suburb just north of the
city and a pair of units downtown, including a penthouse overlooking Millennium
Park that is just a short walk to the private equity firm that has made him so
wealthy. There, the fees that for years his private equity business charged
public pensions mean that, during Chicago’s brutal winters, he and his wife can
choose between the water-front villa they own in the Florida Keys and a $1.75
million condo at a Utah ski resort. Other options include the sprawling
property the couple owns near Yellowstone National Park in Wyoming, a pair of
ranches in Montana, or the penthouse overlooking New York’s Central Park that
they bought for $10 million. When this little-known prince of private equity
announced his candidacy for governor in 2013, the Chicago Tribune compared him to
an earlier private equity governor who was so rich, it was often viewed as a
political liability. Yet whereas Mitt Romney owned six homes, Rauner had nine.
Montgomery, of the teachers union, said that while Rauner
and the other two private equity governors in the United States like to “brag
about all the money they made for teachers, like they’re do-gooders working in
a soup kitchen or something. The part they never tell you about are the multi-million
dollars they charge each pension for providing all this help.”
Rauner’s former firm GTCR is one of the thousands of
private equity partnerships in the United States that collectively manage
hundreds of billions of dollars. GTCR raised a $3.25 billion
fund in 2011; another $3.85 billion for
its 11th fund, GTCR XI, which closed in 2014; and another $5.25 billion last
year for GTCR XII. The general partners, as those who run a private equity firm
are called, might throw a bit of their own money, but it’s the “limited
partners” who provide the bulk of the cash that firms use to buy up and invest
in promising businesses they find.
The universe of limited partners includes foundations,
university endowments, wealthy individuals — and pension funds. Rauner once
estimated that pensions accounted for half to
two-thirds of the money he and his partners had raised.
The pensions truly are limited partners. They write checks
but remain passive investors who receive occasional reports about how
everything is going and maybe an invite to an annual gathering, where the
general partners typically try to wow pension staffers and trustees, some of
whom might welcome a free trip to some enviable destination.
There are two primary ways that fund managers get rich off
the country’s pensions, a pot that exceeds $10 trillion, including both public
and private funds. First are the management fees that any private equity firm,
venture capital firm, or hedge fund charges. That’s the money the firm takes
off the top to keep the lights on and pay their own salaries, along with those
of the analysts and others they have in their employ. According to Crain’s Chicago
Business, GTCR takes 1.5 percent, rather than the more customary 2
percent, but that’s still a comfortable amount. At that rate, GTCR would take
in $75 million on a single $5 billion fund. Every successful investment ends
with the “liquidity event” that lets everyone get paid — a company goes public,
say, or sells to a larger enterprise. Typically, the partners take a 20 percent
share of that revenue, called “the carry,” before passing along the remaining
profits to the limited partners.
How much can “the carry” mean for a firm’s partners? In
1999, Rauner told the Chicago
Sun-Times that his firm had generated annual returns of 40
percent over the previous 19 years. After fees, he said, his limited partners
averaged an annual return of 30 percent. Anecdotal evidence would suggest that
Rauner was exaggerating somewhat. Data from the Washington State Investment
Board, a longtime limited partner in Rauner’s firm, published by Fortune in
2011, showed that investors in GTCR’s seventh fund (2000) earned an annual 22
percent over 10 years, while its eighth fund (2003) was providing a return of
27 percent a year. That’s far higher earnings than a safe government bond. But
look at the take for the private equity partners: Even a $2 billion fund like
GTCR VII earning 22 percent a year would have generated roughly $12 billion in
profits over 10 years. GTCR’s cut on such an investment, assuming the standard
20 percent carry, would have been $2.5 billion.
But there’s evidence that private equity firms aren’t
satisfied with even those extraordinary profits. The Dodd-Frank financial
reform required the Securities and Exchange Commission to more closely monitor
private equity firms, which the SEC began doing in 2012. Two years later, the
SEC revealed that of the roughly 400 private equity firms the agency had
examined, more than half had either charged unjustified fees and expenses, or
didn’t have the controls in place to prevent such abuses. Many were inflating
the fees they charged, Mary Jo White, then chair of the SEC, told Congress,
“using bogus service providers to charge false fees in order to kick back part
of the fee to the adviser,” which is to say, themselves. A year later, two
giants of private equity were fined for bad behavior. Blackstone paid nearly $39
million to settle an SEC investigation into such unfair
practices as failing to disclose that it had negotiated a discounted rate from
an outside law firm that continued to charge its limited partners much higher
price. KKR paid almost $30 million to settle
charges that it unfairly required its limited partners to
shoulder the cost of $338 million in “broken deal” expenses — having failed to
allocate any of these expenses to the general partners for years.
A new law in Illinois, passed after former Gov. Rod
Blagojevich’s impeachment and imprisonment, imposed strict new campaign
contribution limits. An exception was made, however, for the
wealthy. If a candidate spends $250,000 or more on their own race, the caps are
lifted for everyone in that race. Rauner gave $27.5 million to his own campaign
and raised millions more from a coterie of moguls, including fellow Chicagoans
Sam Zell and Kenneth Griffin, a hedge fund manager who ranks as Illinois’s
richest person. The New York Times’s Nicholas Confessore, who in 2015
investigated the outsized influence of just 158 wealthy families on
politics, found that
the $13.6 million Griffin and his family contributed to Rauner in 2014 was more
than 244 labor unions donated, combined, to his Democratic opponent.
Rauner’s opponents in both the primary and general
elections sought to use wealth and his private equity record against him. One
ad that aired during the Republican primary featured the
death of three women at a pair of nursing homes linked to GTCR — GTCR had
co-founded their parent company, and Rauner sat on its board. (The Rauner
campaign called the
ads “shameful” and noted that the company GTCR had helped found was bankrupt
and in receivership by the time of the three deaths.) The Daily Herald discovered that
Rauner was claiming tax breaks on three of his homes, though he was entitled to
use only one for an exemption. (Rauner paid the
back taxes he owed on the extra exemptions.) Other coverage showed that
he had falsely claimed residency in Chicago when his daughter sought to attend
a well-regarded public high school in the city and then made a $250,000
donation to the school after she was accepted. (“My daughter was highly
qualified to go to that school,” Rauner said during
the campaign.) The Chicago Tribune found SEC
filings showing that GTCR had no less than six investment pools registered in
the Cayman Islands, collectively worth hundreds of millions of dollars. “Bruce
Rauner makes Mitt Romney look like Gandhi,” a former general counsel for the
Illinois Republican Party said that fall.
Rauner won every county in the state outside of Cook
County, home to Chicago. His attacks on the state’s public pensions did little
to undermine him — in no small part because his opponent, incumbent Pat Quinn,
had himself championed a 2013 law that attempted to squeeze cost-of-living
increases for retirees. (An orange snake dubbed “Squeezy the Pension Python”
represented the pension in one of Quinn’s political ads.) Yet this was still
deep-blue Illinois. Though Rauner had said the state should cut a dollar from
its $8.25 an hour minimum wage, voters approved an advisory ballot initiative
calling on lawmakers to raise it. Though Rauner had campaigned against another
initiative calling on Springfield to impose a 3 percent tax on income over $1
million, the millionaire’s tax passed with 60 percent of the vote.
Officials
Used Pensions like a Credit Card
The first time a commission was appointed to investigate
Illinois’s pension crisis was in 1913. Apparently, lawmakers failed to learn
any lessons. For 78 years running, Tyler Bond of the National Public Pension
Coalition pointed out in 2017, the state had failed to meet its full pension
obligations. Teachers were given no choice: 9.4 percent of their salary was
withheld each year for their pension. Roughly similar proportions were deducted
from the pay of other state employees. Yet for nearly eight decades, the state
had simply failed to make its mandated contributions to all five of its public
pensions.
“Elected officials used the pension system like a credit
card,” said Martire of the Center for Tax and Budget Accountability. That way
lawmakers could keep taxes relatively low without cutting services. “They
basically said, ‘Somebody down the road is gonna have to pay for this, but by
then I’ll be out of office, so I don’t have to worry about it.” The unpaid bill
as of earlier this year was $129 billion and counting.
The teachers’ pension, TRS, accounts for roughly $73
billion of those unfunded liabilities, according to TRS’s own analysis. But
that underfunding became a true disaster in 2008, after the stock market’s
great slide. The fund lost nearly $10 billion in the crash — more than a third
of its value at the time. But rather than pursuing a path that stressed plain
vanilla investments, the fund’s trustees upped its exposure to high-fee,
high-risk investments.
The Illinois State Board of Investment, which oversees
investments made by the state employee pension fund, took a similar path. The
pension, which covers such public employees as DMV clerks, highway repair
crews, and prison guards, more than doubled its exposure to hedge funds between
2007 and 2015, from under 4 percent to 10 percent. The board paid around $331
million in fees to hedge fund managers during that period, according to a study
by the Roosevelt Institute and the American Federation of Teachers called “All That
Glitters Is Not Gold” — compared to an estimated $37 million the
board would have paid to manage the same size portfolio if it had been invested
in stocks or bonds. The board’s hedge fund strategy, according to the report,
cost the pension some $123 million in lost investment revenue during those
years.
A new chair took over in 2015, however, and since that
time ISBI has withdrawn its money from 65 hedge funds. Less than 1 percent of
its money remains with
hedge funds, and just 3.3 percent in private equity, including several million
dollars with GTCR that is left over from the tens of millions of dollars it had
invested over the years in several GTCR funds. Last year, the pension announced
that nearly half of its $18 billion fund was invested in low-cost index funds,
saving the fund $50 million in fees over two years, the fund’s chief investment
officer said, while also “increasing expected returns.”
Illinois has hundreds of public pensions, more by far than
any other state in the country. As of 2016, it had more than 650 locally
controlled funds created for firefighters and police not covered by the
Illinois Municipal Retirement System — and too small, said James McNamee,
founder and president of the Illinois Public Pension Fund Association, to risk
getting involved in private equity or other alternatives. A former police
officer who served as a trustee of his pension fund in a small Chicago suburb,
McNamee created the association in part to help inoculate his peers from
high-fee, high-risk investments that he believes are not appropriate for funds
under $1 billion. “A lot of what we do is educate trustees,” McNamee said,
“because we know there are people out there who want to talk them into things
they shouldn’t do.”
Some larger funds in the state have exercised this same
caution, such as the Illinois Municipal Retirement Fund, which Forbes
once called the
gold standard for other pensions in the state. Its advantage relative to other
pensions is that the state collects a fee from participating governments each
year, guaranteeing that its funding obligations are met. It has just 3.2 percent of
its money invested in private equity and another 6.2 percent dedicated to real
estate investments.
Others, such as the State University Employees System,
continue to gamble. At $21 billion, SURS is the state’s second-largest pension
and accounts for $23.4 billion of
the state’s pension shortfall. As of 2017, SURS still had 5 percent of assets
in hedge funds, 6 percent in private equity, and 10 percent in real estate.
“States that tend to be in more financial difficulty tend to have higher-risk
portfolios,” said Bill Bergman, an economist and the director of research at
the Chicago-based Truth in Accounting, a nonprofit that pushes for transparency
in government financing, told the New York Times in 2017. “In Illinois, the
defense is that in the long run, these investments will be good for us. But
they’re expensive, opaque, and risky.”
Corruption seemed inevitable with so much money at stake.
A former TRS trustee named Stuart Levine, who in 2012 was sentenced to five and
a half years in jail, was charged with soliciting kickback payment from
investment firms seeking a share of the pension’s assets. An outside counsel to
the pension admitted that he helped Levine use the pension’s money to reward
major campaign contributors to Blagojevich, who in 2012 was sentenced to 14
years in prison for a range of public corruption charges. Also caught up in the
probe was a Chicago lawyer who was previously finance chair for the Democratic
National Committee. He confessed that he played intermediary for a
Virginia-based investment fund seeking advice on how the backdoor system
worked: In exchange for TRS investing $85 million in their firm, he explained,
a kickback of $850,000 was customary. To make that happen, the lawyer suggested
helpfully, they could enter into a sham consulting contract to disguise the
payoff, adding,
“This is how things are done in Illinois.” Another federal indictment,
handed down in 2009, spelled out how a well-known Springfield power broker used
his “longstanding relationships and influence with trustees and staff members”
at TRS to steer funds to favored money managers. He would be sentenced to a
year in prison and fined $75,000.
Rauner was tied to the scandal through Levine. The two
first encountered one another when in 2003, Rauner and his partners were
raising GTCR XIII and Levine objected to the TRS board investing $50 million in
the fund. The deal was tabled but sailed through a few months later, after
Rauner showed up personally at a TRS board meeting. A later corruption probe
revealed that Comp Benefits, a company partially owned by GTCR, was paying
Levine $25,000 a month as a “consultant.”
TRS didn’t invest any more money with Rauner’s firm after Levine’s arrest in
2006.
Yet the scandals sparked no great moral shift inside TRS.
Barely one year after it had been caught siphoning off fees from its limited
partners, the TRS board voted to commit more money to Blackstone, on top of the
$165 million it already had invested with the marquee firm. Another behemoth of
the private equity world, the Carlyle Group, had been exposed paying
a lobbyist millions of dollars starting in 2002 to win TRS business and paid $20 million
in fines in 2009 for its involvement in a pay-to-play pension
scandal in New York. Yet since 2013, TRS’s trustees have entrusted $255 million
in pension dollars to Carlyle. Altogether, over the past 10 years, TRS
investments in private equity have more than doubled. Its investments in hedge
funds have more than quadrupled.
“It’s a vicious cycle,” said Fred Klonsky, a retired
public school teacher who writes an education blog that covers the sorry state
of his pension. “The more we’re falling behind, the more and more percentage of
the fund that goes into high-risk investments in pursuit of big returns.” So
far, it hasn’t proven a disaster. TRS has posted a respectable annual return of
6.6 percent in recent years. But that means TRS is paying exorbitant fees just
to reach the national average — 6.6 percent was the average yield Pew found when
it compared the performance of the 73 largest state pensions over a 10-year
period.
“It’s an age-old debate about whether it’s appropriate for
pension to use alternatives or not,” TRS communications director Dave Urbanek
said. “Our board is very comfortable with our asset mix, which has been
designed to reduce risk in the next downturn in the stock market,” he added,
noting that TRS posted an 8.5 percent return in the most recent fiscal year.
Yet the veiled nature of alternative investments still
troubles Klonsky. “There’s a level of secrecy, a lack of transparency that I
don’t like,” Klonsky said. “There’s basic information that we can’t get. How
much in fees are we paying? I look at the trustees and they don’t want to seem
to get directly involved in determining the direction of investments. Instead
what happens is they hire somebody who brings in consultants, and more and more
of our money ends up going into this stuff.”
The
Trouble with Private Equity
On the campaign trail in 2014, Rauner liked to describe
himself as the grandson of a Swedish immigrant who worked at a Wisconsin
cottage cheese factory and lived in a double-wide trailer. Missing were his
years growing up in Lake Forest, a wealthy suburb north of Chicago, the son of
a top executive at Motorola. Rauner rowed crew at Dartmouth, where he studied
economics, and earned his MBA at Harvard. He graduated in 1981 and moved to
Chicago to take a job at Golder Thoma Cressey, or GTC, a private equity firm
founded two years earlier by a trio who had worked together at one of the
city’s top banks. A decade later, Rauner became a named partner and an R was
added to the firm’s acronym. It was now GTCR.
Private equity firms invest in businesses in exchange for
an ownership stake, like venture capitalists, or buy up struggling businesses
that the partners think they can turn around. Over the years, GTCR seemed to
specialize in the dull and ordinary. It invested in outdoor advertising,
hospital management, steel tube manufacturing, fleet refueling, check
authorization, and funeral homes because, Rauner once told a reporter,
it produces profit margins of 35 to 40 percent and is “immune to downturns.”
Rauner and his partners were similarly drawn to the coin-operated laundromat
business because of what he described as
a “locked-in customer base.” “If prices go up, the tenants still use it,”
Rauner said.
Private equity is GTCR investing $7 million in a company
called American Medical Lab and making $200
million when Quest Diagnostics buys the company for $500
million five years later in 2002. Or, as Rauner boasted about in a 2003
interview with Crain’s Chicago Business, paying $100 million to buy a
subsidiary from one large company and selling it to another six months later
for nearly $500 million.
Other investments fail. That’s private equity, too:
dropping $200 million on a company or a sector that collapses.
Then there are the deals that really give private equity a
bad name — and make it a questionable way to invest public pensions. A health
care company GTCR bought in 1998 was accused of stripping resources from the
chain of nursing homes it owned — and then sued over
its alleged participation in a scheme to avoid liability for a string of
deaths. Another GTCR-owned company providing telephone services to the hearing-
and speech-impaired paid $15.75
million to settle allegations by the Federal Communications
Commission that it had overcharged customers. The SEC and Department of Justice
caught another
GTCR-backed company using a Bermuda-based subsidiary to skirt
domestic stock-trading laws. Rauner’s firm extracted $9 million in cash from
one of its portfolio companies right as the company was heading into
bankruptcy, but was later ordered to pay more than two-thirds of it back.
Job losses are common when private equity firms implement
“efficiencies.” In 2008, a GTCR-backed company that provides airport services
snapped up several smaller rivals, including one operating a small regional
airport outside of Chicago. At that one airport, the executive director of the
operating agency said, the transition “from a small family business to a large
corporate chain” translated into “a 30 percent reduction in workforce.” It’s
also not uncommon for private equity to load up companies they buy with so much
debt that they collapse under their own weight. In 1999, GTCR sold a
Dallas-based wireless concern to a larger company — another big revenue
generator that earned the firm more than $500 million on an $8 million
investment. Yet the sale left the wireless company so freighted with debt that
it was forced into
bankruptcy shortly after the sale.
Private equity is a game of winners and losers, and the
extent of Rauner’s winnings became clear only once the financier-turned-candidate
released excerpts of his tax returns. The Rauners claimed a mere $28 million in
income in 2011 and $27 million in 2010, but made up for down years with $53
million in 2012. Because of the carried interest loophole, Rauner likely paid
only 23.8 percent in federal taxes on the bulk of his earnings — 40 percent
less than what he would have paid if his earnings had been taxed as income.
A
Black Box
The track record of firms such as Rauner’s has spurred
some to question whether private equity, even when it outperforms other assets,
is appropriate for a pension fund. Among them is Edward Siedle, a former SEC
attorney who has been hired by a variety of public and private pensions to
examine their portfolios. “It’s the public’s money being invested, yet the
contracts with private equity firms routinely forbid an investor from sharing
details about their holdings,” Siedle said.
These investments are so opaque that a top executive at
the California Public Employees’ Retirement System confessed in
2015 that he had no clue how much in fees they were paying to private equity
firms each year. The answer CalPERS
arrived at several months later was an eye-popping $1.1 billion in the prior
fiscal year. Private equity funds typically require nondisclosure agreements —
problematic for an investment involving public funds — and the contracts are so
one-sided as to be comical. A contract the
Kentucky Retirement System inked with Blackstone, a giant of the private equity
world, waives any liability on the part of the firm for engaging in financial
conflict of interests. Another provision dictated that if management is sued,
the costs “would be payable from the assets of the Partnership” — in other
words, pensions and other investors would pick up the costs, not the general
partners.
Hedge fund investments carry the same baggage. The
contract a pension signs with a hedge fund typically forbids pension officials
from revealing much, if anything, about the investment, even to the public
employees on whose behalf a trustee is investing. The pension fund trustees who
have decided to avoid buying stock in a gun maker, say, might not know that it
owns some anyway through a hedge fund. More than 20 pension funds were in a
fund of funds that included SAC Capital, the infamous hedge fund run by Steven
Cohen, before the firm paid $1.8 billion in fines for insider trading and shut
its doors.
For a fund like TRS, these provisions mean nearly 40
percent of its portfolio “operating entirely outside of scrutiny,” said Siedle,
who refers to private equity as a “black box.” A firm might claim $200 million
in profit on a $500 million deal, but how many millions were already siphoned
off by means of “monitoring fees” partners pay themselves for dispending their
wisdom to their portfolio companies, or “accelerated monitoring fees,” the lump
sum partners charge their portfolio companies if a quick sale cheats them out
of several years of lucrative consulting services? “Private equity managers are
the most secretive money handlers out there, charging extra fees wherever they
can, running these opaque, illiquid, hard-to-value private investments,” Siedle
said.
It irked Siedle that both Rauner and Romney were able to
run for public office “without disclosing how they made whatever money they
have stashed offshore.” Perhaps that’s why Siedle chose to publicly dissect
GTCR’s most recent SEC filing on the Forbes website one week before the 2014
gubernatorial election. In the filing, the GTCR partners lay out some of the
special provisions they’d granted themselves. For instance, they had given
themselves the right to create a special “family and friends” side fund that
invests alongside the firm’s main funds. Those designated friends of the firm
would be allowed to invest on better deal terms than those granted to other
limited partners, or sell an asset to the main fund on terms determined by the
partners. “Selling the laggards to other GTCR funds in which public pensions
invest? Seems possible based upon the firm’s SEC filings,” Siedle wrote.
Additional language freed the firm to bill the limited partners for any
consulting services they deem necessary “even if another person may be more
qualified to provide the applicable services and/or can provide such services
at a lesser cost” and allows them to “withhold information from certain limited
partners or investors,” including from entities “subject to [the] Freedom of
Information Act.” Siedle then lists some of the massive public pensions that
have entrusted GTCR with their money, including TRS in Illinois, and various
state pensions in New Mexico, Pennsylvania, Massachusetts, Louisiana, and New
York. “Why would dozens of public pensions,” Siedle asked, “agree to obviously
unfair treatment?”
Randi Weingarten, president of the American Federation of
Teachers, asked the same question, though her preoccupation is with pensions
investing in private equity and hedge funds who financially support
organizations that hurt labor. It was six years ago, Weingarten said, that the
union launched an initiative to educate teachers’ pension trustees around the
country about this risk. The union started holding seminars for trustees and producing
a periodic “Assets Manager”
report, the most recent of which, published in March, singles out 21
money managers who are rich in no small part because of the money they made off
public pensions — yet now support organizations calling for pensions’
elimination. Several are generous donors to conservative think tanks such as
the Manhattan Institute and Reason Foundation, both of which have staked out
pensions as an issue. “Teachers collectively have influence over trillions of
dollars in assets,” said Weingarten, “and we intend to use it.”
Lower fees might be one answer. In 2017, the union
released a report called “The Big Squeeze” that looked at 12 of the country’s
largest public pensions. Cut in half the fees charged by private equity and
hedge funds, the AFT found, and the average fund looked at would have an
additional $360 million a year to invest. Looking ahead 30 years, and assuming
an annual interest rate of 6.6 percent, the average return for a large public
pension in the U.S., according to Pew — that means an additional $2-plus billion
for every $350 million saved.
How
to Prolong a Crisis
Rauner had been governor less than six months when the
Illinois Supreme Court thwarted his effort to slash the retirement benefits the
state had promised to its employees.
Rauner already had a backup plan in place. A state can’t
declare bankruptcy. But local governments can, through Chapter 9 municipal
bankruptcy. Rauner proposed changing state law to shift responsibility for the
teachers’ pension to individual school districts, which could then file for
bankruptcy protection as a way to dodge unpaid pension obligations. The gambit
hasn’t gotten anywhere so far in Illinois, where a Democrat majority currently
controls the legislature, but governors and legislators in other parts of the
country could pick up the idea.
More than two years passed before the state passed its
first budget under Rauner, and then only because enough legislators were scared
that the schools wouldn’t open that fall that some Republicans crossed the
aisle to overturn the governor’s veto. By finally approving a state budget in
summer 2017, Standard & Poor’s declared at the
time, Illinois had avoided the dubious distinction of becoming
the first state the ratings agency ever saddled with a junk credit rating. As
is, Illinois still has the lowest rating of any state in the country at BBB- ,
the final step before junk status.
Rauner left no doubt that he wanted a second term when he
wrote a $50 million
check to his re-election campaign halfway through his first
term, in 2016. Again, he has the financial support of other hedge fund wealth,
including $20 million from Kenneth Griffin. Yet this time, Rauner faces an
opponent who is even richer than he is: J.B. Pritzker, with a net worth
estimated at $3.2 billion.
Pritzker has promised that he would not solve the state’s
budget woes by cheating the elderly out of money they are owed. “I believe it’s
a moral obligation to live up to the commitments made to those who have been
promised pensions,” Pritzker wrote in a candidate’s
questionnaire from the Chicago Sun-Times. “While there’s no
time to waste, Bruce Rauner has squandered three years with his unwillingness
to compromise.”
Earlier this year, the nonpartisan Center for Tax and
Budget Accountability in Chicago put forward a potential solution to Illinois’s
seemingly unsolvable pension funding crisis, among the worst in the nation.
Under its plan, said Martire, the group’s executive director, the pensions
systems in Illinois would be 70 percent funded by 2045 “without cutting a dime
in benefits.” Pritzker has endorsed the idea of refinancing the debt. But
Rauner, the financier for whom these kind of deals are second nature, has not.
“He doesn’t want to solve the problem because the pension
is the battering ram he’s using to try and break the public unions,” Martire
said. “He needs to keep spinning the pension problem because he needs the
unfunded pension liability to make the case that it’s the public unions that
are destroying things in every state.”
This article was reported in partnership with The
Investigative Fund at The Nation Institute.
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