- Audit found appearance of overpayment of fees
- So far, system found no instances of overpayment
- New team to assess validity, accuracy of capital calls
Kentucky Retirement Systems wasn’t double-checking the capital calls it paid to fund managers and, for a little while, it appeared as though the deeply underfunded pension system overpaid investment fees on 15 of its alternative investment funds.
The possible overpayment was uncovered by an internal investment performance audit completed by Compliance Officer Erica Bradley on November 24. Buyoutsobtained a copy of the audit through an open-records request.
A follow-up review conducted by the retirement system’s investment office found no evidence of overpayment for 14 of the 15 funds, Chief Investment Officer David Peden said.
A review of the final alternative fund was still pending as of April 22, but “we don’t believe there was overcharge,” Executive Director William Thielen told Buyouts.
Citing the confidentiality of fee agreements, the retirement system denied open-records requests for documentation of how the audit uncovered instances in which Bradley believed the retirement system had been overcharged.
Even if Kentucky paid its fund managers the proper amounts, the audit also determined the investment staff lacked internal controls to prevent general partners from overcharging the $14.4 billion retirement system on management fees.
“At the end of the day, we did not pay anyone the incorrect amount. The takeaway is that we weren’t checking the amounts before we paid them,” Peden said. “Nobody disagrees with that.”
The retirement system can ill-afford mistakes. Bloomberg data ranked Kentucky as the second most underfunded state pension plan in the country behind Illinois.
Earlier this year, the pension formed a four-member investment operations team to review, process and clear future capital calls, Peden and Thielen said. Thielen expects Kentucky’s board to formalize the new team’s processes in the next few months.
Many public pensions have staff or outside advisers check capital calls against fund agreements to prevent mistakes or misallocations, more than a half-dozen sources told Buyouts. Though uncommon, human error can cause some general partners to overcharge their investors on management fees.
“As far as the management fees go, it can get complicated with offsets, waivers and other complicated structures that need to be taken into account,” said Jack Raderof ACA Compliance.
Confusion around how private equity firms charge management fees may have contributed to the findings of Bradley’s initial audit.
Firms vary in their methodologies, and Thielen and Peden attributed the appearance of overpayment in the audit to a general misunderstanding of whether funds charged management fees as a percentage of committed capital, invested capital or net asset value.
GPs have been known to make similar errors, sources said. One LP adviser described seeing fund managers who calculated fees against committed capital, rather than the capital the fund had invested. A fund attorney said he’d seen a GP client neglect to write-off a fund asset, thereby increasing the fund’s total valuation. This resulted in a larger fee.
“I don’t know if there’s a standard frequency with which errors occur, but from what we see it’s more rare with respect to management fees,” Rader said.
However rare an occurrence, Kentucky Retirement Systems’ leadership hopes the new back-office functions will prevent confusion and safeguard the pension against possible overpayments moving forward.
Peden said he also supports the Institutional Limited Partners Association’seffort to standardize the reporting of fees and expenses, which should ease the the burden of manually inputting and double-checking fund reports.
“It was a situation that got blown up into something it wasn’t but, in the end, it was one of those things where the recommendation [to check capital calls] was correct.” Peden said. “We’re fully on board.”
The retirement system’s $4.8 billion alternatives portfolio includes its allocations to private equity, absolute return, real return and real estate funds. Kentucky valued its private equity portfolio at about $1.4 billion as of Feb. 29, according to an investment report.
Action Item: For more information about Kentucky, visit https://kyret.ky.gov/Pages/default.aspx