Risky Business: State Pension Funds Spurring Wall Street's Biggest Deals
Conan Edwards, a retired Wisconsin teacher, may not make the mega-deals that cause Wall Street to tremble, but he is an enthusiastic supporter of the retirement-fund investments that are helping underwrite them.
State pension funds, unfettered in the past decade from state laws limiting investment practices, have become a major source for financing leveraged buyouts, junk-bond purchases, and other high-risk--but high-yield--ventures that are the latest Wall Street fad.
But after the record-setting $25-billion takeover of rjr Nabisco Company late last month, in which 11 state pension funds participated as limited partners to assist in the leveraged buyout, some political and corporate leaders are questioning the wisdom of such investment policies.
Some of the critics are worried about the possibility of losses faced by the pension funds that knowingly engage in leveraged buyouts, which are considered to be among the riskiest of investments.
Others express concern over the economic impact of the pension-fueled buyouts, which create no jobs and mountains of tax-exempt corporate debt.
Pension-fund managers, however, point to a history of high-yield returns that can amount to 60 percent or more. For that reason, Mr. Edwards, who is president of the Wisconsin Retired Teachers Association, contends that politicans should keep their "hands off" the pension funds.
The unprecedented rjr Nabisco takeover, which was twice the sum for the previous record buyout, focused attention on how leveraged buyouts work and their attendant risks.
Pension funds participate in two ways: through leveraged-buyout funds and junk-bond purchases.
There are an estimated 100 leveraged-buyout funds. These funds are blind investment pools into which pension funds and other investors commit cash for use by a buyout specialist, such as Kohlberg Kravis Roberts and Company, the firm that engineered the rjr Nabisco takeover.
The leveraged-buyout fund provides the initial cash, usually about 10 percent of the price, for a corporate purchase.
The company's assets are then used as collateral to secure bank loans, and the newly bought firm issues unrated corporate bonds called junk bonds, or high-yield bonds, that generate the remaining purchase money.
In order to pay the debts, the purchaser sells off portions of the company, using the proceeds from the sales to repay the bank loans and junk-bond buyers.
Participants in the lbo fund earn their money when the purchaser again places the more streamlined, more efficient company back in the publicly traded stock market and its stock trades at a higher value.
The danger for investors lies in the risk that the purchaser might be unable to quickly sell portions of the company to repay the loans--or that an economic slowdown might cause the company to fall into bankruptcy, unable to meet payments on its huge debt.
Money To Invest
Private and public pension funds have been increasingly sought after as investment partners because of their tremendous wealth. The thousands of pension funds, both public and private, are estimated to have assets of $2.2 trillion, enough to pay off the entire national debt.
In a 1985 survey of education-related state and local pension funds, the National Education Association found that the assets held by 68 of the 92 funds totaled $250.9 billion.
Because there is no clearinghouse for state or local pension funds and no single organization that keeps tabs on such information, data on investment practices are difficult to come by.
The nea survey, the latest available, indicated that the education-related pension funds had an average of 25.3 percent of their portfolios in common and preferred stock, 23.1 percent in state and local bonds, 14.7 percent in corporate bonds, 7.4 percent in U.S. Government securities, 6 percent in mortgages, 2.2 percent in real estate, 1.8 percent in venture capital, and 0.5 percent in mutual funds.
Although there are no hard statistics on how much of the public pension funds are invested in lbo accounts or junk bonds, pension funds in general are major participants, investment firms acknowledge.
Drexel Burnham Lambert Inc.,4the largest junk-bond distributor, reports that pension funds, including private-sector funds, hold 15 percent of the outstanding high-yield bonds, ranking second to insurance companies, which own 30 percent.
'Arsenal for Robber Barons'
Although many public pension systems have been involved in lbo funds for several years, the magnitude of the rjr Nabisco purchase ignited a firestorm of criticism about the situation.
State pension funds in Illinois, Iowa, Massachusetts, Michigan, Minnesota, Montana, New York, Oregon, Washington, Wisconsin, and Utah were involved in the $5-billion leveraged-buyout fund managed by Kohlberg Kravis Roberts. A portion of the fund was used for the rjr Nabisco purchase.
Gov. Mario Cuomo of New York called on his state's fund to stop such investments while a task force studies its practices. In Wisconsin, Assembly Speaker Thomas Loftus has also called for a halt. And Massachusetts officials have done likewise.
U.S. Representative J.J. Pickle of Texas said that the oversight subcommittee he chairs would hold hearings early next year on the issue of public pension funds, endowments, and foundations engaging in leveraged-buyout-fund investments.
In the past two weeks, the Federal Reserve Board has cautioned banks about making loans for leveraged buyouts, and some states are taking steps to limit the amount insurance companies can invest.
And the U.S. Department of Labor is taking steps to require private pension funds to report more quickly their investments in junk bonds and lbo funds.
"In my opinion, leveraged buyouts are bad for the economy and especially bad for the midwest and Wisconsin," said Mr. Loftus. "Pension funds manage other people's money. They are supposed to invest in the American economy and receive a reasonable rate of return. They should not become the arsenal for robber barons."
The $16-billion Wisconsin retirement fund serves both public employees and teachers. Since 1985, the State Investment Board has committed $625 million to several leveraged-buyout funds and $48 million in direct leveraged buyouts handled in-house, according to Mr. Loftus.
The board had committed $197 million to the Kohlberg Kravis Roberts fund.
Jonathan Henkes, spokesman for Gov. Tommy Thompson of Wisconsin, said the State Investment Board, on its own, stopped investing in lbo funds a year ago. It had decided that because of the huge corporate debt being amassed and the increasingly hostile nature of the takeovers that the "lbo thing was getting ugly."
Despite the naysayers, some experts contend that public pension funds should be free of strict investment requirements or political directives as to where they can invest the funds.
"If there is a problem [with leveraged buyouts], it should be addressed directly," said Ian Lanoff, former director of the Labor Department's Employee Retirement Income Security Administration, which regulates private pension8plans. "The last thing that should happen is for pension funds to be denied the opportunities available to other investors."
Mr. Lanoff said it was not the fiduciary duty of pension-fund trustees to engage in "social investing." If politicians believe leveraged-buyouts are bad social and economic policy, he added, then they should prohibit them for all investors.
Carol Hewitt, chairman of the Oregon Investment Council, said limitations on pension-fund investments "would be a terrible mistake." Market forces will take care of any excesses, according to Ms. Hewitt.
The $8-billion Oregon fund, which serves teachers and public employees, has been investing in lbo funds managed by Kohlberg Kravis Roberts since 1981 and has averaged a 60 percent return on its investments, she said.
The percentage of the Oregon fund invested with the New York firm--$200 million--is small, Ms. Hewitt contended.
"I wouldn't tell any pension fund to put all its money in venture capital," she said. "There's always a tradeoff. But if you're not willing to take the risks, you're going to have a substandard return."
Foster Whaley, a Texas state legislator, said he feared the pension funds could be headed for a financial fall similar to that of the troubled savings and loan industry.
"Everything's booming and everyone thinks it's going to keep on. That seems like a good time to get out to me," said Mr. Whaley, who five months before the Oct. 19, 1987, stock-market crash sponsored an unsuccessful bill that would have required the Texas Teachers Retirement Fund to reduce its market holdings to 10 percent of its $18 billion in assets.
He is not the only one predicting a downturn. The trade publication Pensions and Investment Age also has predicted that the leveraged-buyout bubble will burst.
The magazine contended in a recent issue that purchase prices are becoming too close to the break-up value of the company, which would make it difficult to pay down the debt. It also cited rising interest rates on junk bonds--an indication that buyers recognize the risk is increasing.
"Pension funds and other institutional investors committing equity to these mega-lbo deals, or buying the junk bonds, should examine the deals and the environment with extreme care," the publication warned.
J. Daniel Lee, executive vice president and fund manager for the Teachers Insurance and Annuity Association, the private pension fund for college and university employees, said he had scaled back the $38-billion tiaa fund's participation in leveraged buyouts and junk bonds to 5 percent of its assets.
"There is simply so much money chasing so few deals that the economics and risk-rewards are unattractive," said Mr. Lee.
But he added that he too opposes government interference. And while there may be some "market corrections," he said, that does not mean that leveraged buyouts will be bad investments in the future.
'Keep Your Hands Off'
In interviews last week, teacher organizations and retired teachers themselves expressed either unconcern about the issue or support for the public pension-fund managers and the high rate of return they have been receiving from leveraged-buyout investments.
Mr. Edwards of Wisconsin said he was dismayed that Mr. Loftus, the Assembly leader, would attempt to bar investments in a particular area. "In almost every session there has been legislation telling the investment board how to invest," Mr. Edwards said. "We just simply say to those who would use the fund for political purposes to keep your hands off."
Robert Crumpton, executive secretary of the Oregon Education Association, said the teachers' union is very pleased with the retirement fund's investment policies.
He noted that the pension fund joined with Kohlberg Kravis Roberts in a leveraged buyout of an Oregon-based food and general merchandise chain in the early 1980's. It was an extremely lucrative deal that prompted participation in others, he explained.
"One could hardly look a gift horse in the mouth," said Mr. Crumpton.
Some Investment Advice
"People have to understand that the tradeoff for the high returns is the risks that go along with them," said Marilyn Moon, director of the Public Policy Institute of the American Association of Retired People. "When people give advice, they say that if it's for something like pensions, you don't invest more than you can lose."
If the pension funds are properly diversified, they should be protected from lbo fund investments that turn sour, said Ms. Moon.
But it is the prospect of losses and the implications for the taxpayers that concern some politicians. Private pension funds are backed by the government-operated guaranty association. Public pension funds are implicitly backed by taxpayers.
Should disaster strike the pension-fund investments, said Texas's Mr. Whaley, "they will be coming to the state for help."