Court Says Private Equity Funds Are Liable For Pension Liabilities of Portfolio Company

If you open a box and a dog pops out, your enthusiasm will be curbed if you were expecting something else. Surely this is how several private equity funds must feel now about one of their investments. According to "Private Equity Funds Liable to Union Pension Plan" by Jacklyn Wille (Pension & Benefits Daily, March 30, 2016), a federal judge recently ruled that several Sun Capital funds are "jointly liable for more than $4.5 million in withdrawal liability" that one of its portfolio companies, Scott Brass, "owed to a Teamsters pension fund." (You can visit Bloomberg Law to read the March 28, 2016 decision by clicking here.)

I will defer to attorneys to address the legal issues. So far, I found two commentaries on the heels of this 2016 legal decision. See "District Court Concludes Private Equity Fund Is Liable for Pension Obligations of the Portfolio Company" (Fried Frank Harris Shriver & Jacobson LLP, March 30, 2016) and "Private Equity Funds Held Liable for Pension Liabilities of a Portfolio Company" (Sullivan & Cromwell, March 31, 2016).

From my perspective as an economist, any surprise claim on future cash flows could be disastrous if it is large enough to jeopardize the ongoing viability of a business. Even if a business has sufficient resources to maintain itself as an ongoing concern, utilizing cash for something that was not planned for could lead to a lower growth rate than originally expected. Keep in mind that pension funds, endowments and foundations frequently allocate monies to private equity on the basis of expected returns for this asset class.

Projecting cash flows as part of due diligence is nothing new for many investors. That said, I am not convinced that all enterprise investigations fully address the impact of an underfunded defined benefit plan. I was recently contacted by a firm that was tasked to render a fairness opinion and wanted my views about pension math. The investment bankers were reviewing documents from bidders that radically differed with regard to the treatment of the target company's benefit plan burden. When I was asked to speak and also write about pensions and enterprise value, the invitation came from a senior valuation executive who felt that the topic was not being adequately addressed. See "Pension Plans: The $20 Trillion Elephant in the (Valuation) Room" by Dr. Susan Mangiero (Business Valuation Update, July 2013). Email me if you would like a copy of my 2013 slides about this topic.

In 2013, when this Sun Capital case originally made its way to the court, it struck me as an important issue. (I was not involved in this matter as an expert.) Several editors agreed and I ended up co-writing two articles with Groom Law Group partner David Levine. I've uploaded one of these articles to this pension blog. Click here to read "Private Equity Funds and Pension Plans: A Changing Dynamic" (CFA Institute Magazine, March/April 2014). At my request, Attorney Levine responded to this 2016 decision by emailing the following: "In short, while some private equity firms have already moved to evaluate and, in some cases, clarify their fund structures, this case is likely to lead to a second look at their structures and methods of involvement with their portfolio companies."

If certain limited partners are not already asking questions of their private equity fund general partners about the nature of portfolio company pension plans, controlling interest status and deal structure, their due diligence could quickly change in the aftermath of the 2016 Sun Capital litigation.

Interested persons can click on the links provided below to read earlier blog posts about this topic:

Detroit Swaps, Counterparty Risk and Valuation

When I worked on several swaps and over-the-counter options trading desks, there was always a lot to do in order in order to properly set up a program with an end-user. Sometimes this involved in-person training of a board or asset-liability management committee or otherwise authorized persons who had made an organizational decision to employ derivatives. Credit limits had to be vetted, decisions about collateral had to be made and master agreements were negotiated and signed. Throughout the process, everyone was mindful that big money was at stake and that getting the preliminaries finished on time, with diligence and care, was both crucial and important. The key was (and still is) to plan ahead for a worst case scenario wherein a contractual counterparty cannot or will not perform. Should that occur, the remaining party would likely seek to unwind or offset a given position rather than allow a bad situation to linger. A valuation of the over-the-counter derivative instrument in question, such as an interest rate swap, would be determined and mutually agreed upon. Contractual terms such as the rate of swap exchange, time remaining and the quality and quantity of collateral posted by either or both counterparties would typically be used to determine the amount of money owed by the non-performing entity. An agreement as to when "non-performance" commenced would be yet another factor. In a dispute situation such as a lawsuit, damages might be part of the calculation.

Sounds straightforward, right? Well, things are seldom simple, especially when one counterparty is in financial distress. When a counterparty owes money but cannot pay on a given date or has insufficient monies to settle a swap as part of a buyout, the remaining counterparty has to look to the underlying collateral, consider litigation and/or negotiate for some type of remuneration. Legal decisions can complicate things. Consider the situation with Detroit.

On January 16, 2014, Judge Steven W. Rhodes, U.S. Bankruptcy Court for the Eastern District of Michigan, opined that a $165 million payment to UBS and Bank of America to end certain interest rate swaps was too much money to outlay right now. Refer to "Detroit bankruptcy judge rejects $165M swaps deal with banks" (Crain's Detroit Business, January 16, 2014).

By way of background, these over-the-counter derivative contracts were related to the issuance of pension obligation bonds. The objective at that time was to protect the Detroit issuer (and taxpayers by extension) from higher funding costs if interest rates climbed. By having a swaps overlay, the bank counterparties were to pay Detroit if rates increased above a specified level. Conversely, lower rates would obligate Detroit to make periodic swap payments to the banks involved.

Reporters Nathan Borney and Alisa Priddle describe a 2009 effort to collateralize the swaps with casino-related revenue in "Detroit bankruptcy judge denies proposal to pay off disastrous debt deal" (Detroit Free Press, January 16, 2014). They add that this move was aimed at avoiding "an immediate payment of $300 million to $400 million on the swaps, potentially violating the Gaming Act" since interest rates had not risen. According to "Detroit continues talks with banks after canceling swaps truce" (Bloomberg, February 7, 2014), the swaps have a monthly price tag of about $4 million, "have cost taxpayers more than $200 million since 2009" and are being questioned by the city with respect to their "legitimacy."

Numerous questions come to mind and will no doubt be raised as the banks and city officials continue to talk or the attorneys take over, should litigation ensue. The list includes, but is not limited to, the following:

  • Who had the authority to commit Detroit to the swaps trades? Click to view an interesting visual put together by the Detroit Free Press and entitled "Were The $1.44-Billion Pension Deal And The Pledge Of Casino Tax Revenue Legal?" (September 14, 2013).
  • Were any of the recommending swaps agents subject to a conflict of interest, as has been suggested by The Detroit News?
  • What was the due diligence carried out by city officials before the swaps were put in place?
  • How were the collateral-related terms decided and by whom?
  • How were swap interest rate triggers determined?
  • Was there an independent party in place to regularly review the quality and quantity of posted collateral?
  • What role did the internal and external auditors play with respect to oversight of the reporting of the swaps and related bond financing?
  • Was there an appreciation that rising rates would mean a payment by the swap banks to the city and that this inflow could have been used to offset the higher cost of variable rate debt?
  • Who undertook the analysis of the effectiveness of the swaps as a hedge against rising rates and was the hedge deemed likely to be protective?

There are lessons to be learned aplenty about swaps, contractual protection, collateral valuation, oversight, authority and much more. No doubt there will be much more to say in future posts.

Economic Indicators to Include Focus on Pensions

In what most people would call a significant announcement, the U.S. Bureau of Economic Analysis ("BEA") will begin measuring economic growth this summer by taking pension finance into account. According to its March 2013 announcement, BEA will record defined benefit plan transactions on an accrual accounting basis. This entity, part of the U.S. Department of Commerce, will now include a pension plan subsector in the national income and product accounts ("NIPAs"). As much as possible, the BEA will "provide estimates of the current receipts, current expenditures, and cash flow for the subsector." The intended changes contrast with the current method of including information about disbursements and earnings of pension plans as participants' personal items and using a cash basis for reporting.

The goal of enhancing transparency about employer-provided defined benefit retirement plans is laudable. However, in reading the fine print, one wonders if the opposite will occur and users of post-implementation data will be more confused. For one thing, the BEA states that it will adopt an accumulated benefit obligation ("ABO") for "both privately sponsored and state and local government sponsored plans" and use a projected benefit obligation ("PBO") for federal government plans. This means that you will never be able to compare all defined benefit plans with a single set of rules. Second, the BEA describes a discount rate assumption that "will be based on the AAA corporate bond rate published by the Federal Reserve Board." Since debt issued by the U.S. is no longer rated AAA and recent regulations allow for temporary funding relief for corporate pension plans, how will BEA numbers compare and contrast with financial accounting numbers over time? Third, since certain data is not available prior to 2000, the BEA will extrapolate to generate "normal costs" for past years. Will their method of extrapolation allow for an accurate "apples to apples" assessment of historical pension earnings and costs? In the plus column, applying the same discount rate for private pension plans versus state and local offerings will help to better assess the economic viability for each sector.

Should the Public Employee Pension Transparency Act move forward, disclosures will be based on the BEA approach. Understanding what BEA numbers do or do not show will therefore be a critical exercise for policy-makers, investors and participants.

For a detailed discussion of these intended changes on the part of the BEA, read "Preview of the 2013 Comprehensive Revision of the National Income and Product Accounts: Changes in Definitions and Presentations," BEA, March 2013. Click to read about advantages of passing the Public Employee Pension Transparency Act. Click here to read criticisms of this proposed rule. On April 23, 2013, the U.S. Senate received a version of the Public Employee Pension Transparency Act in the form of S. 779. This proffered legislation cites a staggering $5.170 trillion in pension liabilities of the 50 states combined. It is no wonder that numerous individuals want a true tally of what is owed.

Withdrawal Liabilities, Corporate Sponsors and Union Members

Like many others, union members are grappling with a jittery economy and its impact on plan sponsors. As a result, companies are exploring ways to restructure employee benefit plans in order to contain costs and still keep pension promises.

Just yesterday, Pensions & Investments' Barry Burr wrote that United Parcel Service, Inc. ("UPS") is paying $1.2 billion as a withdrawal liability to the New England Teamsters & Trucking Industry Pension Plan. In exchange, and subject to approval by its employees who are union members, UPS will not have to pay for other companies' employees. According to "UPS to leave New England fund, strikes funding deal," the popular delivery company will write a check every year over the next half century for $43 million. An accounting charge of $896 million will be recognized in this year's financial statements.

On August 28, 2012, Dow Jones Newswires explains that UPS sees the creation of this new pension plan - to replace the old one - as "being fair" to multiple constituencies such as shareholders as well as to employees.According to "UPS Restructures Pension, Sees $896 Million 3rd-Quarter Change" (, August 28, 2012), over 10,000 employees will be affected.

The action did not go unnoticed by at least one rating agency. On August 28, 2012, Standard & Poor's explicitly referenced the company's liability exposure to multi-employer plans as part of its rating assessment of UPS and added that the IOU is seen as a "debt equivalent" and "significant."

The take-away points are clear.

The large and long-lived costs associated with offering ERISA plans continue to dominate the discussions in numerous corporate corridors. Besides having to infuse cash (sometimes billions of dollars), company plan sponsors may be in danger of ratings downgrades. A drop ratings boots the cost of capital which in turn narrows the universe of positive net value opportunities that help to grow enterprise value. Funding issues with employee benefit plans could force M&A deals to evaporate.

Expect other companies to announce pension restructurings.

What remains to be seen is whether a showdown between shareholders and participants will ensue with either or both groups asking ERISA fiduciaries to justify the terms of a particular deal in court.

Counterparty Credit Risk Guidance From Bank Regulators

On June 29, 2011, the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System and the Office of Thrift Supervision issued its latest thinking on derivatives trading by banks. "Interagency Supervisory Guidance on Counterparty Credit Risk Management" considers the role of senior management, methods to measure risk, ways to manage risk and model validation.

Given the increasing number of institutional investors that deploy derivatives - directly or indirectly via third party organizations - for return enhancement or risk minimization purposes, this twenty-six page document is worth a read. Anything that impacts the costs of major derivatives dealers is likely to have a trickle down impact on pensions, endowments, foundations and family offices.

The list below offers a preview of takeaways from the regulators' perspective.

  • Assessment of counterparty credit risk models should reflect their "conceptual soundness," along with "an ongoing monitoring process that includes verification of processes and benchmarking; and an outcomes-analysis process that includes backtesting."
  • Develop a comprehensive process surrounding bank monitoring of collateral.
  • Discuss how to control "wrong-way risk" which occurs "when the exposure to a particular counterparty is positively correlated with the probability of default of the counterparty itself."
  • Banks need to regularly measure the "largest counterparty-level impacts across portfolios, material concentrations within segments of a portfolio (such as industries or regions), and relevant portfolio-and counterparty-specific trends."

Pension fund investment committee members can use the guide to draft or add to an existing questionnaire for interviews they conduct with their asset managers, banks and consultants.

Private Equity and Derivatives - Double Whammy or Blissful Combo?

According to the U.S. Government Accountability Office, nearly 4 out of 10 surveyed pension plans say they allocate monies to private equity. Allowing that some managers have turned in acceptable returns, respondents also cited numerous "challenges and risks beyond those posed by traditional investments." Valuation and limited transparency are two issues cited in "Defined Benefit Pension Plans: Guidance Needed to Better Information Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity" (GAO-08-692, August 14, 2008).


To shed light on some of the intricacies associated with private equity investments, I authored a case study for the February 2009 issue of PEI Manager, a private equity and venture capital focused publication. The bottom line is that institutions that invest in private equity funds are directly impacted by their portfolio companies' use of derivatives.


"Swapping out" by Dr. Susan Mangiero, an Accredited Valuation Analyst and CFA charterholder, is reproduced below. Email Ms. Jennifer Harris, Associate Editor - PEI Manager, for permission to reprint the case study.


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Private Equity Holdings (“PEH”) is required by its charter to avoid companies that use derivative financial instruments to speculate. In reviewing numbers for FAS 157 reporting purposes, a PEH managing partner notices that one of its portfolio companies, ABC Incorporated (“ABC”), recently included a FAS 133 entry for a $20 million interest rate swap hedge. During a call to the company to query about how the swap is being used, the PEH managing partner is informed that its counterparty is Global Bank Limited (“Global”). Not only has Global just reported a $30 billion loss due to poor valuation of its structured product portfolio, it posted no collateral in favor of ABC while ABC was required to pledge $2 million in U.S. Treasury Bills in order to protect Global in the event that ABC could not make its contractual swap payments to Global. Not being too familiar with derivative instrument pricing and default risk analysis, PEH hires an expert to investigate whether the swaps reflect a hedge versus a market bet and to further assess how PEH should adjust the valuation of its equity stake in ABC. What does the expert need to look at and how should she arrive at an appropriate conclusion?




This fact situation, ripped from the headlines, raises several important valuation questions, including, but not limited to the following:


  • Notwithstanding FAS 133 numbers, is the company exposed to changes in interest rates that could adversely impact cash flow, liquidity and net income?
  • Was the swap correctly valued?
  • How might ABC be impacted by Global’s deteriorating health?
  • What adjustments, if any, should PEH make to its initial valuation of ABC equity?

There are several critical issues here, all of which could seriously hamper the fortunes of both ABC shareholders and PEH investors. An inaccurate valuation of the swap leads to a flawed accounting representation for ABC and may lull treasury staff into thinking that the hedge offers full protection against unexpected moves in interest rates. PEH may report a bad FAS 157 number which in turn could lead to flawed asset allocation decisions made by institutional limited partners or the overpayment of performance fees to PEH. A poorly constructed hedge (in economic versus accounting terms) that exposes ABC to negative market conditions could force PEH to violate its prohibition against speculative trades being executed by portfolio companies. If Global does not meet its swap obligations and/or files for bankruptcy protection, ABC may not be able to recover its collateral quickly or could lose it altogether, depending on its standing vis-à-vis other creditors.


Swap pricing models can differ depending on the complexity of the transaction. However, for standard fixed to LIBOR swaps, the secondary market is large ($111 trillion, according to the Bank for International Settlements). Active trading makes it easy to readily obtain prices for various maturity interest rate swaps with quotes reflecting the discounting of future projected fixed and floating swap payment amounts. In contrast, the assessment of credit worthiness varies, sometimes considerably, across banks. Unfortunately for ABC, even if they posted more collateral than should have been required, the fact remains that they have no immediate recourse in the event that Global’s distress prevents the bank from paying what it owes to ABC. If Global defaults, ABC will then have to decide on a course of action that could include any or all of the following:


  • Enter into a second interest rate swap to replace Global at a now higher fixed rate
  • Attempt to sell the initial swap in the open market and consider another way to hedge against rising interest rates though few will be willing to accept the Global risk
  • Take legal action to reclaim its collateral
  • Write down the value of the swap on its books

There is no ideal situation. The expert will necessarily have to ask ABC what they plan to do in the event of swap non-performance and how it is expected to impact its cash flow, cost of money (which in turn affects capital budget decisions), balance sheet, dividend payments and interest coverage. Once that scenario analysis is conducted, both the expert and PEH will be able to quantify how much of an adjustment downward they will need to make for both accounting and performance reporting purposes.

It's 10 PM At Night - Do You Know Where Your Leverage Is?

Given repeated headlines of late about the role of leverage, it may be surprising to learn that there is no universal metric that captures the likely economic impact of its use. Ask ten asset managers how they measure the use of other people's money and you are likely to get ten different answers. This is a big deal since investment leverage is a key driver of performance which in turn relates to fees paid by institutional investors. While leverage can be a boon to return-hungry pensions, endowments and foundations, misused or miscalculated, leverage can result in massive and unanticipated losses. Prudent investors need to ask managers if their funds are levered, to what extent they are levered, what strategies were used to lever the portfolio and whether stop loss mechanisms have been put in place to contain things, as market conditions sour.

According to "Overview of Leverage," published by AIMA Canada, one calculation (referred to as Net Market Exposure or Net Leverage) takes the dollar difference between long and short positions and divides by a hedge fund's capital base and then multiplies the ratio by 100%. However, as Virginia Reynolds Parker, CFA rightly points out, balance sheet inputs can limit the usefulness of leverage ratios, especially if there is a big disconnect between where an instrument is likely to trade versus its stated value for financial statement reporting purposes.  (It is too soon to know whether FAS 157 compliance will close any economic-accounting gap and therefore render point in time ratios more effective as a risk gauge.)

While not all funds employ leverage, it is not uncommon for a portfolio manager to employ derivatives, margin and/or outright borrowing in order to effect a disproportionate exposure to a particular asset or liability class. Leverage can vary by strategy as documented in "The L Word" (Investment Review, Spring 2008). As author Peter Klein shows, hedge fund strategies such as convertible arbitrage employ higher leverage levels than a "less risky" market neutral strategy. However, he warns readers to take care in relying on leverage ratios alone, adding that correlations and overal riskiness of portfolios must also be considered. This blogger agrees with the notion of looking at multiple metrics but encourages investors to go way beyond numbers and look at the asset manager's process with respect to all things leverage.

Hedge funds are not the only entities to employ leverage. Wikipedia reports that leverage, measured as total debt divided by stockholders' equity, for five major investment banks (Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley) steadily rose between 2003 and 2007 to more than 25. Click here to access the source data to verify for yourself. Institutions are well familiar with 130/30 funds and variations thereof. Mutual funds use leverage as do exchange-traded funds ("ETFs'). In "Read the Fine Print on Leveraged Funds," Wall Street Journal reporter Tom Lauricella warns about the new math that can roil investment value quickly, adding that these vehicles are not for everyone.

Investors need to decide for themselves after (hopefully) doing the requisite homework about how leverage is being managed, if at all.

Debt Clock Runs Out of Numbers

According to the website, the U.S. National Debt Clock has too few digits to measure the current state of affairs. The clock's owner, the Durst Organization, is expected to add a pair of additional placeholders next year, making "it capable of recording a quadrillion dollars of debt." (See "Financial crisis: US debt clock runs out of numbers," October 9, 2008.)

I had to look it up but it turns out that a quadrillion is a thousand trillion or a million million million million (with "quad" referring to four). To put things in context, consider the following statistics:

  • The world population is currently estimated at 6.729 billion individuals.
  • The U.S. population is roughly 305 million persons.
  • As of fall 2007, Apple had sold more than 150 million iPods in countries around the world.
  • The CIA Factbook approximates a Gross World Product as equal to $65.61 trillion (as of 2007).
  • Up to Q4-2007, the over-the-counter derivatives market, measured in notional principal terms and reported by the Bank for International Settlements, totaled nearly $600 trillion.
  • As of June 2008 and reported by the Bank for International Settlements, outstanding futures contracts, in notional principal terms, exceeded $28.6 trillion. The size of the listed options market toppled $55.6 trillion.
  • The largest corporate bankruptcy to date, as reported by, is Lehman Brothers Holdings, Inc. with a bankruptcy date of 9/15/08 and total assets, pre-bankruptcy, equal to $691.063 billion.

As U.S. Senator Everett Dirksen is credited as saying, "A billion here, a billion there, pretty soon it adds up to real money." Imagine his posture today. (According to The Dirksen Center website, it is unclear as to whether the former lawmaker did in fact utter these exact words.)

Risks with Financial Counterparties

As discussed herein many times, counterparty risk is an important consideration before entering into any transaction or relationship. (Monitoring default probabilities and the economic fallout if non-performance occurs is likewise a worthy exercise and should be done on a regular basis.)

A recent alert ("The Risks Associated with Financial Counterparties") by Schulte Roth & Zabel LLP attorneys looks at what could happen if a prime broker falls on hard times. Citing the U.S. Bankruptcy Code and the Securities Investor Protection Act of 1970, Jessica Fainman and Lawrence Gelber remind that there is always some risk, even when the law seeks to protect "customer property." The article also includes an explanation of collateral possession under various scenarios, describes the impact of contract netting and lists prophylactic measures to avoid loss.

We concur with the general theme. Investors must be "vigilant in monitoring the financial condition of its brokers." This extends to pension plan fiduciaries who are ill-advised to allocate funds without having a solid understanding of operational and legal risks (in addition to feeling comfortable with a host of other uncertainties, including market and model issues).

Given billion dollar "lemons," making lemonade in the form of mitigating operational risk (including assessment of vendor controls) is a big step in the right direction. This blog's author adds another preventative item to the list. Ask prime brokers and related parties for a copy of their SAS 70 report. Gauge whether (a) good controls are in place (including the monitoring and safeguarding of collateral) and (b) how often controls are validated for effectiveness.

You Said What About Risk?

World business glitterati leave Davos, Switzerland with a renewed vigor to tackle problems du jour. Not surprisingly, those who attended the World Economic Forum had plenty to say about financial markets and risk.  

According to Clara Ferreira-Marques and Sue Thomas of Reuters, Raymond McDaniel, Chairman and CEO of Moody's, declared that "A lot of things could have been done better - some are the responsibility of rating agencies, some of other participants in the market." Guillermo Ortiz, Governor of the Central Bank of Mexico, urged more transparency. "The complexity of the products and financial innovation made it more difficult -- even the regulators failed to understand. It was an exercise in collective confusion."

For those who stayed home, a trip to the conference website is telling. Part of a panel about financial markets, Dominique Strauss-Kahn, Managing Director of the International Monetary Fund, described "low interest rates, high liquidity, a breakdown in credit and risk management practices, and a shortcoming in US financial regulation and supervision" as culprits. Central bankers concluded that the "causes behind the latest financial crisis were complex" with "some time before regulators and market players can fully grasp what went wrong."  A session moderated by CNBC's Maria Bartiromo (who interviewed me about pension investing on June 14, 2007) included a comment by Walter Kielholz, Chairman of the Board of Directors, Credit Suisse about the struggle for banks to generate returns even though "for four to five years, financial institutions have believed there is too much of an appetite for risk in the market."

Here are a few of my favorite "you don't say" quotes about risk.

  • “The only perfect hedge is in a Japanese garden.” (Gene Rotberg, former treasurer, World Bank)
  • “Due to my inexperience, I placed a great deal of reliance on the advice of market professionals…" (Robert Citron, former treasurer, Orange County, California)
  • "There is no such thing as a free lunch." (Milton Friedman, Nobel Prize winning economist and author)

If you know of any interesting statements about financial risk (including those which defy rational belief), we'd love to receive them. Similarly, it would be great to get your feedback about the role of regulation. Do we need more rules to govern investing? Click here to send us an email.



Subprime Crisis and Pension Governance

In "Investing in Good Governance: Subprime-Related Losses Stir Up the Conversation," reporter Rachel McMurdie addresses the growing number of lawsuits in pensionland, along with an urgent focus to identify improvements that can and should be made. Interviewing this blog's author and fellow blogger, attorney Stephen Rosenberg, McMurdie describes recent attempts to codify pension governance standards. One initiative, the Clapman Report, is something I analyzed at length when it was published in the summer of 2007.

Click to read the full text of "Investing in Good Governance" (The Institutional Real Estate Letter, January 2008). Click for our take on the Clapman Report

Lonely CROs - Why Pensions Should Care

In "Morgan Stanley reviews position of risk officer over writedowns" (December 22, 2007), Financial Times reporter Henny Sender describes the hostile environment in which some risk management gurus live. Declaring that critics now accuse the Morgan Stanley Chief Risk Officer of being late in "sounding the alarm about the dangers stemming from the bank's exposure to sub-prime related trades" or having used "language that was too technical or obscure," advocates counter that his warnings were ignored. Not surprisingly, other banks are "overhauling their risk management function after announcing multi-billion dollar losses on subprime-related trades. (Morgan Stanley reported an approximate $10 billion loss.) 

The article adds that Morgan Stanley's risk guru "was very vocal in saying that there were no proper pricing models for such trades, that positions were not being properly measured, and that the history traders used in their models was not a reliable guide." A further investigation will ultimately shed light on whether Mr. Risk at Morgan Stanley had the authority to effect significant change or was instead unaware of mounting exposures until it was too late.

The lessons to be learned here are far from trivial. Spending significant money to hire a risk wizard or team of pundits is a waste unless (a) the risk control function is recognized as essential to core operating activity and (b) these individuals are empowered to work independently of line managers. A new study suggests that the tide is turning though there is room for improvement.

According to "Beyond Compliance: The Maturation of CROs and Other Senior Executives" (GARP Risk Review, November/December 2007), researchers Annette Mikes and David Townsend describe the way Chief Risk Officers are encouraged to participate in "capital allocation and group-level budgeting and planning." At the same time, more than two-thirds of surveyed bank CROs expressed frustration at not being able to convince top management to improve risk disclosures included in public financial statements. Over reliance on risk models was cited as a concern of CROs, especially when credit allocation decisions are based on "automated model responses, with little oversight from humans." The article concludes that "the ultimate test remains the ability of risk managers to influence risk-taking behavior in the business lines."

As this blog's author wrote several years ago, Chief Risk Officers are part diplomat and part rocket scientist. Ultimately, their contributions are constrained by whether a risk culture exists within an organization. One can be technically competent but lack the organizational wherewithal to put out a fire. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Dr. Susan Mangiero, Accredited Valuation Analyst, CFA and certified Financial Risk Manager.

Should pension and 401(k) plan sponsors care about bank risk management? Absolutely.

Since many retirement plans hire banks to manage assets or recommend bank funds to defined contribution plan participants, fiduciaries MUST include risk controls as part of their due diligence process when selecting, monitoring and perhaps firing money managers.

Some plan sponsors create and implement risk management policies that are separate from their formal Investment Policy Statement. Elsewhere, ERISA and public plans are hiring risk management professionals to go in-house. For example, the Ohio Public Employee Retirement System (OPERS) seeks a risk analyst who can perform tasks such as those shown below.

<< 1. Develops a comprehensive risk management program to identify, assess, manage and report investment related risks.

2. Oversees in coordination with the appropriate parties, the management of market, credit/counterparty, operations, reputation and other investment related risks.

3. Develops and participates in processes and procedures of reviewing, discussing and prioritizing risks in each major category.

4. Develops and reports risk metrics to monitor market, credit/counterparty, operations and other related risks.

5. Prepares periodic reports for senior management and OPERS Board to review investment related risks and makes recommendations, as appropriate.

6. Assesses risk management tools and capabilities, recommends improvements and implements approved solutions.

7. Reviews, monitors and oversees derivatives activities and capabilities for internal operations and for external managers in coordination with appropriate staff.

8. Performs on-site manager due diligence reviews from a risk assessment, management and monitoring perspective.

9. Leads and/or participates in various risk management committees.

10. Establishes and maintains a customer service focus work policy through example and clear, timely delineation of expectations. >>

Missing Collateral = More Risk for Hedge Funds and Pension Plans

Some investors may be getting coal for Christmas. According to a December 20, 2007 Financial Times article ("Hedge funds assess exposure to banks"), reporter Saskia Scholtes describes a role reversal with respect to risk. Whereas banks worried about hedge fund losses in the aftermath of the 1998 collapse of Long Term Capital Management, hedge funds now tally their exposure to credit-challenged banks. Noteworthy is an observation by attorney Lauren Tiegland-Hunt that one-way derivatives-related collateral agreements expose hedge funds to risk of bank failure. She adds that, even if an agreement was bilateral, banks sometimes amended terms to "prevent hedge funds from calling for collateral before a bank’s losses on the trade reached a certain threshold, with the bank’s threshold marked as 'infinity'."

Kudos to this managing  partner of law firm Tiegland-Hunt for calling attention to an important risk factor. As this blog has pointed out several times, the posting of fungible assets such as U.S. treasury bills is one way to mitigate counterparty risk. A thorough assessment of the credit worthiness of the counterparty, consideration of the expected risk associated with a particular derivative instrument and/or strategy and analysis of overall exposure to a given name are similarly important.

For those pension funds sending money to hedge fund land, make collateral assessment part of your due diligence. Derivative instruments, used properly, can sometimes offer a bevy of advantages over investing in the underlying "cash" asset. However, as Nobel prize-winning economist Milton Friedman oft-declared, "there is no free lunch." Once a derivative instrument is created, its fair value (zero at inception) changes. Unfortunately, gains can only be realized by the winner in this zero sum game if the loser does not default.

Editor's Note: To learn more about collateral issues as relates to derivative trading, check out the 2005 ISDA Collateral Guidelines. (ISDA stands for International Swaps and Derivatives Association, Inc.)

Can Sub-Prime be Funny? Listen for the Pension Punchline

If you are looking for a few chuckles and a satiric view of the sub-prime crisis, this video of British humorists John Bird and John Fortune may be the answer. On a very serious note, listen for the last line about pension funds.



Sub-Prime Losses Keep Coming

At this rate, one could spend hours blogging about sub-prime woes, risk and whether adequate controls were in place. In a December 4, 2007 Washington Post article entitled "Losses Stack Up: Local Officials in Florida Try to Assess Damage To Investments Linked to Soured Subprime Loans " by Tomoeh Murakami Tse, I was interviewed about pension risk management implications. (Click here to access the article. You may be asked to register.) The State Board of Administration of Florida itself acknowledges the importance of risk controls, both in a November 2007 account of their sub-prime losses and in later interviews about fund withdrawals, subsequent freezes prohibiting further withdrawals and the hiring of Blackrock to develop a financial game plan.

In a recent study by the Towers Group, risk management was found to be lacking at some organizations, arguably one cause for large losses. Describing the adverse consequences of siloed risk management functions in financial institutions, authors of "Multifunctional Integration: The Positive Side of Risk," cite the need to work across divisions. They add that  "Beyond defending against threats to the organization, a more integrated approach to risk management can drive other business and client-centric benefits, including: improved quality and transparency of information; relationship pricing; process simplicity and efficiency; more effective decision making; and overall resilience."

No surprise to this risk manager and blogger who has spent over 20 years in the areas of risk management consulting, forensic analysis, board and trustee training and process assessment. In trying to convey the importance of acting before the fact, our Pension Governance team oft-repeats the importance of a holistic investment risk orientation, commencing with comprehensive training for everyone - front, middle and back office staff included. Importantly, buy-in from the top drives the acceptance of an organizational-wide risk culture and allows for resources to purchase analytical systems, hire professionals and make sure everyone has a good understanding of checks and balances. (In a recent workshop I led on risk management, I encouraged pension fund professionals to spend time with the chief risk officers employed by their banks, mutual fund and hedge fund managers.) 

Whether separate risk management activity reflects a "penny wise, pound foolish" behavior depends on a host of factors and will vary across organizations. However, delay in implementing an effective process can be costly as pointed out in a December 2007 assessment of sub-prime litigation risk by Guy Carpenter & Company, LLC. In "What’s the State of Your State? E&O Risk Uneven across the Country," authors list six factors that give rise to litigation risk for real estate professionals (though noteworthy for other related parties, given the flurry of lawsuits now being filed). See below for excerpted text:

  • Percentage of mortgages in foreclosure
  • Percentage of subprime mortgages that are delinquent
  • Number of litigation attorneys per mortgage industry professional
  • Frequency of Truth in Lending lawsuits (per million households) through Q32006
  • Frequency of banking-related lawsuits (per million households) through Q32006
  • Extent to which a state is plaintiff-friendly, i.e., is deemed a “Judicial Hellhole” by the
    American Tort Reform Association (ATRA).

Mortgage bankers and real estate brokers may be getting pink slips but litigators are busier than ever. For retirement plan fiduciaries, it bears repeating. Ask external money managers if they have sub-prime problems, query about how they are addressing risk gaps and demand to know what lessons they have learned from the credit crisis.

Can Banks and Pension Clients be Friends When It Comes to Valuation?

In his November 11, 2007 blog entry, New York Times reporter Floyd Norris describes an interesting tidbit of information, tucked inside the just filed 10-Q by Wachovia Corporation. On page 27, it reads "In the third quarter of 2007, we purchased and placed in our available for sale portfolion $1.1 billion of asset-backed commercial paper from Evergreen money market funds, which we manage. We recorded a $40 million valuation loss on this purchase, which is included in our market disruption-related losses." As Norris explains, while the regulatory filing adds that Wachovia is "not required by contract to purchase these or any other assets from the Evergreen funds" they manage, a loss of that magnitude would "break the buck." When the $1 Net Asset Value typically associated with a money market fund no longer prevails, Wachovia or any other financial institution in a similar position is arguably obliged to stem the financial tide or risk loss of investors or worse. Click here to access the 10Q report.

In today's article entitled "SEI, Rival Money Funds Go on Offense to Avoid 'Breaking the Buck'," Wall Street Journal reporters Diya Gullapalli and Tom Lauricella write that money manager SEI Investments has said "it would provide financial guarantees for some of the funds' holdings of SIVs." CEO Alfred West explains the rationale for voluntarily providing credit support, in the aftermath of a threatened downgrade of SIV Cheyne Finance, LLC paper. Held by several SEI funds, "managed for SEI by Columbia Management, the money-management arm of Bank of America Corp," the funds' rating could likewise be compromised. Click here to listen to the recorded November 12, 2007 presentation to SEI investors. 

A recent IMF presentation, entitled "Regional Economic Outlook - Europe" stresses the importance of improving "risk assessment models, market and liquidity risk management, due diligence, and transparency regarding the loan origination process and counterparty risk exposure."

Color me confused. Haven't many banks held themselves out to be leaders in the area of risk control? What about the fact that banks are highly regulated? Doesn't that contribute to good oversight? What is the role of Basel II, looming right around the corner and meant to reflect robust risk management activities on the part of banks in the U.S. and abroad?

For those banks with pension clients, what is the process in place to vet all recommended money market funds, including their own? Is the process conflict-free? Conversely, are pension funds directly (or through pension consultants) asking sufficient questions about the safety of recommended short-term capital pools?

As the mysteries unfold, don't be surprised what we learn about the importance of good fund selection and risk review process.

Note: Wikipedia defines a structured investment vehicle as "an evergreen credit arbitrage fund, similar to a CDO or Conduit. They are usually from around $1bn to $30bn in size and invest in a range of asset-backed securities, as well as some financial corporate bonds. An SIV is formed to make profits from the difference between the short term borrowing rate and long term returns." Click here for more information.

A Billion Here, A Billion There...

Though there is a question about whether former Illinois Senator Everett Dirksen ever said "A billion here, a billion there, and pretty soon you're talking real money," the statement is apt.

A quick read of the headlines suggests things are going to get ugly fast, and with little chance of a let-up anytime soon. Federal Reserve Chairman Ben S. Bernanke, in his October 15, 2007 address to members of the Economic Club of New York was no less sanguine. He offered that "Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time, and we may well see some setbacks." Click here to read the full text of his speech.

Billions of dollars in losses, due to sub-prime problems and related woes, pummeled recent earnings for more than a few organizations, sending the equity markets into a tailspin on October 19, 2007. Pundits report that the Dow had its worst day since early August, with worries about a looming recession being only one of several fears. Twenty years after Black Monday (October 19, 1987), the term "deja vu" comes to mind. At that time, this blog's author worked on a futures and options trading desk and well remembers the frenzy that ensued. Names then considered "too big to fail," no longer exist. Sobering lessons learned?


At a time of unprecedented technological advances in terms of analytical capabilities and information flow, why is it that risk management is still anathema to some? Arguably there will be times when "tail" events occur, despite the best intentions to create, implement and periodically review back-office, middle-office and trading desk activities. One possible silver lining is that organizations (for which this applies) go back to the drawing board to design a more effective set of checks and balances. Improved risk architecture could include any number of things, including the following:

  • Frequent and thorough testing of valuation models by independent third parties
  • Regular and more granular correlation analysis that (a) takes into consideration the reality that market convergence does sometime occur and (b) then tries to identify when it is most likely to present itself accordingly
  • Assessment of hedge effectiveness, and by extension, (a) what factors create "hedge leakage" and (b) thereby leave an organization exposed to adverse market conditions
  • Identification of risk drivers, along with both a quantitative and common sense ("smell test") assessment of their likely behavior and probability of occurrence
  • Identification as to how to improve collateral management
  • Better training for everyone involved in trading activity and oversight
  • Improved (or creation) risk budget that explicitly lays out how money is to be allocated on a risk capital basis.

Some will win as markets tremble but what about the losers? After today, equity-laden retirement portfolios won't look so good. Entire employee teams are shutting down as the credit crisis takes hold. Depressed times will certainly force plan sponsors to rethink their investment decisions.

How much money has to disappear before billions mean something other than zeros on a piece of paper?

Liquidity Crunch, Bonds and Pension Plans

Have the last few months of negative headlines scared you yet? If not, don't be too complacent. According to a recent survey conducted by Greenwich Associates, institutional investors have grown weary of structured financial products and fixed income securities. According to a summary provided by writer Stephen Taub, a worldwide credit crisis "has caused a nearly complete disruption in the trading and use of many fixed-income products." Even trading in ordinarily liquid corporate bond markets has reportedly been difficult, leaving many scratching their heads as to whether the credit crisis is a short-term blip or a long-lived problem. Taub adds that the survey predates the Fed's recent rate cut. (Click here to read "Liquidity Crunch: How Long Will it Last?")

In his September 20, 2007 testimony before the House Committe on Financial Services, U.S. Treasury Secretary Henry Paulson describes the "interconnectedness" of global capital markets and the fallout from concerns over sub-prime mortgages - reduced investor confidence, reassessment of risk, and temporary diminution of liquidity. Describing self-correction tendencies of financial markets, Paulson's more sanguine take can be accessed by clicking here.

After a recent bridge game, I had a chance to ask my friend, Dr. Lucjan Orlowski, for his view of the world around us. As Senior Fellow at the Center for European Integration Studies (ZEI) at the University of Bonn; a Senior Fellow at the Center for Economic and Social Research (CASE) in Warsaw; a Research Fellow at the William Davidson Institute (WDI) at the University of Michigan School of Business, and a Research Professor at the German Institute for Economic Research (DIW) in Berlin, Orlowski's opinion counts in more ways than one. His prognosis? Not very good - In fact, he was downright gloomy with respect to jobs growth and continued ill-effects of this summer's incorrect pricing of default risk. Click here to read Lucjan's impressive bio.

So what does all of this mean for pension funds? Let us count the ways.

1. Diminished liquidity could imperil a plan's ability to meet its short-term obligations. This is especially serious for mature plans or in situations where labor contracts offer few opportunties to revise cash outflows. How should strategic asset allocations change to reflect a sustained credit crunch (if you accept that premise)?

2. Fewer companies are making their way to capital markets. Will a reduction in fixed income security issuance and/or a widening bid-ask spread make it more difficult for pensions to execute any type of liability-driven investing tactic that involves bonds or bond derivatives?

3. Will a weakening U.S. dollar, likely to experience even more downward pressure as oil producers switch to Euro invoicing, compel plans to seek out international assets? Will plan sponsors need to ask external asset managers more questions about risk controls, notably currency hedging techniques, as a result?

4. Could lower U.S. interest rates push some plans over the edge in terms of funding status and inevitable financial consequences?

5. Will changing correlation patterns, and the related reduction of diversification potential, leave defined benefit plan sponsors in a position of having to take on more risk? In the event that FASB requires additional pension investment risk disclosure, will corporate plan sponsors begin to feel pressure from shareholders as market volatility is more explicitly embedded in financial statements?

These are but a few possibilities for those who see the glass half empty and draining fast.

Model Risk - Great Unknown for Pension Plans

In "How Street Rode The Risk Ledge And Fell Over," Wall Street Journal reporter Justin Lahart writes that "many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the market environment had become." Warnings about model error or "model risk" are not new. In "Model Risk and Valuation" (Valuation Strategies - March/April 2003), Dr. Susan M. Mangiero, CFA and Accredited Valuation Analyst, suggests possible red flags, adding that the consequences of a poor, inaccurate or incomplete model (or problems with data) can be dire. She adds that what constitutes a "good" model is likewise important to assess. This is sometimes made more difficult when inputs themselves must be modeled. For example, in the case of derivatives related to credit risk or mortgage loans (dominating headlines of late), estimating variables such as prepayment or recovery rates is an important precursor to any valuation of the derivative instrument itself. Email us if you would like articles about model risk and valuation.

Long, Hot Summer for Pension Investors Exposed to Credit Woes

Summertime and the livin' may be easy for Porgy and Bess. If you're an investor caught in the middle of a scorching hot credit meltdown, things are far from tranquil. Besides the fact that many deals are being put on hold (thereby reducing the universe of available stocks and bonds), more than a few asset managers are reporting giant write-downs. If you haven't seen it, the Wall Street Journal's list of affected deals and organizations is sobering. Click here to read "Scorecard: Debt Dilemmas - How Credit-Market Tremors Have Affected Junk Bonds, LBOs and Hedge Funds."

Jittery traders are starting to wonder how quickly sub-prime loan problems will spread to other market sectors, ultimately impacting the ability of corporations and individuals to borrow and spend. In "Strategies correlate after credit market crunch hits," Financial Times reporters Peter Garnham and Paul J. Davies describe changing patterns across markets and strategies. What does this mean for institutional investors? Quite simply, a lot.

Hedge funds and private equity managers who tout absolute return (based on uncorrelated return patterns) are going to have a tough challenge ahead if convergence occurs. Defined benefit plan sponsors are going to have no less a difficult time.

Strategic asset allocations are going to be directly (and arguably materially) impacted by the notion that "the investment world is getting smaller." To read an earlier post about contagion, click here to access "Pension Contagion - Should We Worry?"

Are Fiduciaries Paying Enough Attention to Default Risk?

According to Wall Street Journal  reporters Kate Kelly, Liam Pleven and James R. Hagerty, at least ten funds struggle with sub-prime loan woes in the form of diminished portfolio values. As if that isn't bad enough, some institutional investors are being given the unhappy news that withdrawals are suspended. For pension funds in search of liquidity, look elsewhere. (See "Wall Street, Bear Stearns Hit Again By Investors Fleeing Mortgage Sector," Wall Street Journal, August 1, 2007.)

As the fallout continues, with no end in sight, it is worth repeating that fiduciaries are on the hook for creating, and then following, a prudent process with respect to investment selection. ERISA itself mandates that employee benefit plan fiduciaries must carry out their duties in the sole interest of the plan's participants and with the "care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."

These few words speak volumes about the many things a plan sponsor must consider before committing money to a particular instrument, strategy or asset manager. Questions naturally arise. A few of them are shown below.

1. Have plan sponsors sufficiently queried asset managers about how they measure default risk ?

2. How are structured financial transactions collateralized?

3. Who is responsible for collateral management?

4. What safeguards exist to enforce collateral quality and amount?

5. Do asset managers make their policies and procedures available to plan sponsors who want to know more about valuation, operational controls, collateral issues and trading limits?

6. Are positions being marked to model?

7. Who reviews the integrity of the model and related data inputs?

8. What could cause estimated default risk to rise for "questionable" borrowers and how are asset managers tracking identified risk drivers?

9. What are the investors' rights to withdraw funds?

10. Does an asset manager reserve any capital against its expected risk exposure, voluntarily or otherwise?

Several observations are in order. First, investment problems are not unique to small funds. To the contrary, some large mortgage-related funds (in terms of assets) are currently in crisis mode. Second, recent market drops and rising credit spreads are forcing companies to delay IPOs or incur higher costs of capital. This means that all investors are invariably impacted. Third, the fallout is global, with several prominent non-U.S. funds announcing big hits.

This may be the beginning of the end for easy credit and the start of a "brave new world" for plan sponsors who cannot afford a "see no evil, hear no evil, speak no evil" approach.