KKR, Blackstone sued by Lerach Group over hedge fund returns

[NEW YORK] KKR & Co, Blackstone Group LP and their founders are accused of failing to deliver hedge-fund returns as advertised, in a Kentucky lawsuit that could preview new legal challenges for managers of alternative investments.

The lawsuit was filed on behalf of state taxpayers and the Kentucky Retirement Systems' pension plans by a group whose lawyers are advised by William Lerach, a now-disgraced, former class-action lawyer who once sent shivers through corporate boardrooms for his brass-knuckled negotiating tactics.

The plaintiffs, including a retired state trooper and a firefighter, allege that the big asset managers misrepresented expensive and risky "black-box" bundles of hedge funds as safe ways to generate high returns. Instead, those investments contributed to the pension system's virtual insolvency, the plaintiffs said, while the managers pocketed excessive fees.

The defendants include KKR co-founders Henry Kravis and George Roberts, Blackstone founder Stephen Schwarzman, Prisma Capital Partners CEO Girish Reddy and Paamco CEO Jane Buchan. Claims are also made against several outside advisers and Kentucky pension fund officers and directors.

"The claims are baseless," Matt Anderson, a spokesman for Blackstone, said in an emailed statement. "The Blackstone fund referenced in the complaint delivered to the Kentucky Employees Retirement System positive returns outperforming relevant benchmarks." KKR also denied any wrongdoing.

"We take our fiduciary duty very seriously and believe that the allegations about our firm are meritless, misplaced and misleading," Cara Major, a spokeswoman for KKR, said in an email.

Among the allegations is that the fund managers were negligent and breached their fiduciary duties in convincing Kentucky Retirement Systems to invest as much as US$1.5 billion in three bundles of hedge funds, or funds of funds. Tailor-made to attract Kentucky retirement investments, the funds of funds performed far worse than their sellers predicted, the investors claim."I'm very supportive of this lawsuit and the effort to enforce state fiduciary law through litigation, if necessary," said Chris Tobe, a former Kentucky Retirement Systems trustee and author of Kentucky Fried Pensions: A Culture of Cover-up and Corruption. "It also goes directly after the Wall Street firms that enjoyed no-bid contracts, which I believe have led to higher fees than we'd have paid in a competitive environment."

The plaintiffs' lawyers say the Kentucky pension funds didn't disclose returns for individual funds of funds. But the overall "absolute return" strategy, which they believe incorporates results from the three funds, returned less than 4 per cent annually in the five years through June 2016, according to state pension data. That compares to the 11.8 per cent annual average return during that time for a low-cost S&P 500 fund.

The asset managers told the investors that the funds of funds would help the state exceed its 7.75 per cent investment return targets, according to the lawsuit.

Contrary to the managers' sales pitch, "these unsuitable 'investments' did not lower risk, reduce illiquidity or generate sufficient returns" to sustain the pension system, according to the lawsuit. "They did generate excessive fees for the hedge fund sellers, poor returns and ultimately losses for the funds, in the end damaging KRS and Kentucky taxpayers."

Filing a so-called derivative suit, the plaintiffs seek to represent the interests of Kentucky pension plans and taxpayers by recouping unspecified fees and other payments made to money managers and advisers. They also seek punitive damages.

Plaintiff attorney Michelle Ciccarelli Lerach said her law firm and three others behind the suit believe it could open a new path for state and municipal pension systems to seek compensation from managers of other alternative assets. Kentucky state law, she said, provides considerably more latitude than federal securities law to hold "control persons" personally liable for the actions of the entities they supervise.

"When I read through Kentucky pension and trust law, I was struck by how strongly it protects the beneficiaries and taxpayers, including through disgorgement of fees, while at the same time protecting our clients' right to a jury trial, where a nine-to-three verdict is a victory," she said. "And, as we've alleged in the complaint, each of the managers, actuaries and pension advisers owes a fiduciary duty under Kentucky law. It's not a stretch to say they've breached it."

Federal pension law requires anyone deemed a fiduciary to manage retirement funds in the interests of beneficiaries. Hedge fund critics have raised questions about whether that duty is being met in the case of funds of funds, which often charge investors fees in addition to those collected by the underlying funds, while providing what the critics call limited disclosure."It's offensive and wrong that it would take an army of investigators, lawyers and a lawsuit for us to see what's going on in our funds," said Brandy Brown, one of the plaintiffs and a sitting district court judge.

Ciccarelli Lerach, a Kentucky native who runs her own law firm in La Jolla, California, is married to William Lerach, formerly of Milberg Weiss Bershad & Shulman. Now disbarred over a conviction for a client-kickback scheme, he's a consultant to the plaintiffs' lawyers through his firm, Pensions Forensics LLC.

Kentucky's state pension funds and the Kentucky Teachers' Retirement System are among the worst-funded in the nation, with just 31 per cent of the assets they need to fulfill their pension promises, according to a recent Bloomberg analysis.

The state pension system was overfunded in 2000, but by 2010 had barely one-third of the assets it needed to cover retiree pensions, due to steady benefit increases and poor investment returns. Around that time, the fund managers, with support from outside advisers, presented the three funds-of-funds - Prisma's Daniel Boone, Blackstone's Henry Clay and Paamco's Newport Colonels - as "an absolute return strategy," according to the suit.

KKR Prisma was formed in 2012 when KKR acquired Prisma. Prisma merged with Paamco in February to form Paamco Prisma Holdings, which is 60 per cent owned by employees and 40 per cent by KKR, the firm said at the time.

Peter Grauer, chairman of Bloomberg LP, is a non-executive director at Blackstone.

The case is Mayberry v KKR & Co, County of Franklin Circuit Court, Commonwealth of Kentucky.

BLOOMBERG