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Public Pension Managers Rethink Hedge Fund Ties

From New York to California, public pension funds staked billions in good times on the highest of Wall Street high rollers: hedge fund managers and corporate buyout specialists.

But for many of these pension funds — and the millions of people who are relying on them for their retirements — that gamble is not paying off as hoped.

Even before state and federal regulators began investigating whether several prominent investment firms had made improper payments to gain business from New York’s state pension fund, public pension funds were backing away. These private investments were supposed to outpace the stock market but, in many cases, lost value instead.

Public pension funds that embraced these ventures — which range from real estate to commodities to private equity funds — have grown uneasy over the costs and secrecy typically associated with them, as well as with their inability to withdraw their money quickly if needed.

Now news from New York is shining an uncomfortable spotlight on hedge funds and private equity, which helped define the boom years on Wall Street.

According to court papers unsealed in Manhattan on Tuesday, a central hedge fund executive has pleaded guilty to securities fraud and is cooperating with a state investigation of corruption at the state pension fund.

Among the firms whose activities are being scrutinized is the Carlyle Group, one of the nation’s largest private equity firms. A string of other scandals, capped by the Ponzi scheme of Bernard L. Madoff, only adds to the worries at pension funds.

Three years ago, the New Jersey state employees pension fund led the pack as an early, and enthusiastic, investor in hedge funds. Now, facing losses of $800 million, it is shying away. New Jersey has stopped putting more money into hedge funds, after its $4 billion investment shrank to under $3.25 billion. And, like many other public pension funds, it is beginning to rethink its relationship with hedge funds, and taking a harder look at all alternative investments that did not live up to their billing.

“Clearly, it did not work out as well as we had hoped, and expected,” said William Clark, director of the New Jersey Division of Investment. “You cannot deny that as a general asset class, it didn’t deliver what investors were led to believe.”

Many public employees — teachers, police officers and the like — may not even realize that part of their nest eggs are tied to hedge funds and corporate buyouts.

In 2005, just 13 percent of all public pension funds invested in hedge funds. By 2008, 40 percent did so, having a combined $78 billion invested in such funds. About half now invest in private-equity funds.

While such alternative investments, as they are known, account for a small fraction of public funds’ total portfolios, the hope was that they would generate outsize returns. But now the hedge fund industry is in the throes of an unprecedented shakeout. And private equity funds are struggling to make deals, and profits, now that the easy money that powered their business has evaporated.

The good news for New Jersey, such as it is, is that its stock portfolio did even worse than its investments in 35 hedge funds. But that has not stopped the state, and public pension funds across the country, from beginning to slow what had been a headlong rush into hedge fund investments and begin to drive a harder bargain with hedge fund managers on a number of fronts.

Public pension funds feel they may have some luck in gaining concessions on fees and greater view into often-secretive hedge fund operations.

No less an industry leader that the California public pension plan known as Calpers, the nation’s largest, is heading an effort to reduce hedge fund fees and change the terms of its hedge fund investments. This comes after Calpers saw its hedge fund investments fall to $5.9 billion from a high of $7.6 billion.

In addition, since beginning to invest in hedge funds in 2002, Calpers has experienced a modest 3.5 percent annual rate of return, far less than the market-beating returns that hedge fund managers had promised.

“We don’t want to pay for failure,” said Clark McKinley, a spokesman for Calpers.

Specifically, Calpers wants its hedge fund fees to be performance based, ending an arrangement where hedge fund managers could collect hefty fees regardless of whether the funds made or lost money. Calpers wants to segregate its money from that of other investors and have it individually managed, and it wants more timely information and greater transparency into the funds’ investments.

Mr. McKinley said that, so far, none of the hedge fund managers doing business with Calpers have declined to consider Calpers’ demands. “They are willing to talk,” he said.

While very few public pension funds invested with Mr. Madoff, the fallout from his Ponzi scheme has caused many public pension fund managers to ask for more detailed information on hedge fund operations. As a result, “many of these investors are running for the hills,” said Larry Powell, deputy chief investment officer for the $16 billion Utah Retirement System, which is trying to galvanize other public pensions to press for better terms with hedge funds.

Mr. Powell said that he has already gotten better terms with 10 of the 40 hedge funds that Utah does business with.

“There are too many hedge funds out there collecting fees that far exceed their operating expenses,” Mr. Powell said. The Utah fund is in the process of renegotiating fees with hedge fund managers.

In New Jersey, there is a lively internal debate about the way forward. Critics, like Jim Marketti, a union representative on the State Investment Council, said that the state fund ignored the unions’ pleas over the last few years to move cautiously as it diversified into hedge funds. “If we had invested in the mattress, we would have done better,” Mr. Marketti said.

Much of New Jersey’s foray into hedge funds came as Orin Kramer, a hedge fund manager, became chairman of the New Jersey funds’ oversight board. While New Jersey does not invest in Mr. Kramer’s fund, he remains a defender of these investments, saying that they still did better than the stock market.

“You’ve got a mindset which assumes that major auto companies or banks or home-building companies, which lost 90 percent of their value, are appropriate investments,” Mr. Kramer said. “But even in 2008, hedge funds reduced volatility and were better places to be than these stocks.”

Some experts, however, believe that the hedge funds, now more chastened, are not in any position to resist pressure from big pension funds.

“Hedge funds are going to have to incorporate pension fund concerns if they want to be anything but fringe players,” said Edward A. H. Siedle, president of Benchmark Financial Services.

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