Bert Caldwell: State pension board may see an altered future

Private equity investments have been very good for the Washington State Investment Board, and the thousands of current and former public workers whose pension funds it manages.

Over the last three years, the $11 billion invested with Kohlberg Kravis Roberts & Co., Blackstone Group, Fortress Investment Group and the like has produced a 30 percent annualized return to the state after expenses have been subtracted. By comparison, investments in public U.S. companies have returned 12 percent.

But the board’s relationship with its money managers will change as they go public, says Executive Director Joe Dear, and so will the returns. And not for the good.

Groups like KKR and Blackstone make money several ways, but mainly by buying undervalued companies or subsidiaries. They help management restructure debt, invest in profitable operations while selling or closing the losers. Eventually, the companies are resold to the public.

Pension funds participate as limited partners by putting up money for the deals. They pay management fees to the general partners — KKR and Blackstone, for example — but get their money back and more if acquired companies are resold at a profit.

One of the advantages of private investment versus public is the freedom from quarterly reporting, and the pressure that creates to produce short-term results. As the investment groups go public, as Blackstone and Fortress have, and as KKR plans to do, the dynamics will change.

Dear says the newly public general partners are going to want higher management fees from their private investors in order to satisfy demands by their public shareholders for profits. The investment board and other pension managers will suffer in the squeeze.

Limited partners have limited leverage, Dear says.

Quibbling over fees that may amount to a few percentage points makes little sense when a deal offers the prospect of double-digit returns, he says. The board passed on an investment four years ago because of the fee structure, he says, only to see the fund return 20 percent to participants willing to swallow the expenses.

“It’s not smart to fight the general partners, and the general partners know it,” Dear says. “You lose tens of millions of dollars over time.”

State Sen. Lisa Brown, D-Spokane, who sits on the board, says members are well aware relationships with money managers will change as they become public. How, though, remains unclear, and members and staff would like guidance from a consultant.

But the converging roles of consultant and manager are challenging the board’s no-conflict-of-interest policy, Brown says. How to address the problem, or at least improve disclosure, has not been resolved.

Conflicts within the investment community will add to costs, Dear says.

Last week, several takeover deals snagged on financing, including the proposed KKR purchase of Alliance Boots, a drug store chain in Great Britain. Dear says he expects that and other pending deals to go through, but banks and other lenders will charge more to offset increased risk, which mean less for the limited partners.

The state could choose to cut itself in on the public side by buying shares in KKR or the others but, Dear says, those holdings would be meager compared with the limited partner investment, and the returns are unlikely to be as high. Last week’s market downturn was particularly hard on Fortress and Blackstone, and analysts were suggesting KKR would be wise to delay its offering.

Although the board has been approached about its interest in taking an ownership position in some partnerships, Dear says deciding which private funds to invest in will remain the priority.

He does not think much of the move by private equity groups into the public domain, and finds some irony in the turnabout by companies whose business it is to take public companies private. But they must know what they are doing, he adds.

“These are some of the world’s most talented people in terms of developing wealth,” he says.

Dear does not expect a backlash from companies disappointed the state chooses not to buy their stock, or otherwise take an ownership position. The board has been a reliable and significant source of private capital since 1981. That record will stand Washington in good stead.

Whether that stead is double digit or not is another matter.