Offshore hedge fund is trouble for Seattle's pension fund

The pension fund for Seattle city workers is pursuing $20 million of its investment money through a maze of hedge funds on two continents and two Caribbean territories, hoping for nothing worse than the federal investigation and the court-declared insolvency that officials recently discovered.

The Seattle City Employees' Retirement System (SCERS), which holds $1.6 billion to pay the pensions of 15,000 past and present librarians, utility workers and others, got some rude shocks after it began pressing for overdue financial data about its 5-year-old hedge-fund investment.

Officials learned that SCERS may be the only investor left in the fund; that its money has been funneled through another, now-insolvent fund; and that the Securities and Exchange Commission is investigating the latter fund's accounting. Meanwhile, the fund SCERS invested in hasn't produced an audited financial statement for 2008, which ended 15 months ago.

The problems illustrate the black-box nature of hedge funds, and the perils that accompany the high returns they promise.

Invoking the Bernard Madoff and Enron investment scandals, a lawyer for SCERS told a federal judge April 2 that "it's terrifying when you're sitting in the pensioners' position. They've got $20 million invested and they can't get any meaningful information."

"It just doesn't look right, it doesn't smell right," said SCERS attorney Brad Thoreson of Foster Pepper.

SCERS invested in 2003 and 2004 in Epsilon Global Active Fund II, one of several funds controlled by Steven Stevanovich, a longtime hedge-fund manager in Florida. The Epsilon "feeder fund," incorporated in the British Virgin Islands and domiciled in Switzerland, was supposed to channel money into a larger pool based in the Cayman Islands.

Like many hedge funds, Epsilon's charter gave it wide latitude to engage in a range of moneymaking strategies. Participants were given little information about its investments.

One red flag: According to documents in the lawsuit filed by the retirement system, between January 2006 and the end of the following year about 90 percent of the money invested in Epsilon was withdrawn, leaving little except what SCERS had put in.

A recent account statement says SCERS's investment is worth about $24 million. But the SEC inquiry and the delayed audit leave that valuation suspect. As SCERS Executive Director Cecelia Carter said in a court filing, the fund "has suffered very significant losses in the past in very short periods of time."

Late last year Seattle officials grew anxious that the 2008 audited financial statement for Epsilon was still missing. They ran into a wall, however, when they first demanded better information then asked for their money back. Stevanovich refused to meet with them.

In February, he informed Epsilon investors that he was suspending all payouts. He blamed the halt on an 8-month-old SEC staff investigation into how another of his funds, called Westford Special Situations Fund, accounts for the value of the loans it made to distressed companies.

SCERS officials saw no connection to their investment; they had no idea their Epsilon money had all been channeled into the Westford fund.

"We didn't know about that until three days ago," attorney Thoreson told federal District Court Judge Richard Jones at the April 2 hearing, according to a transcript. SCERS had explicitly rejected Stevanovich's invitation to put money into the Westford fund, he said.

Meanwhile, late last month a court in the British Virgin Islands was asked to declare the Westford fund insolvent. That move was made by the pension trustees for consulting firm McKinsey & Co. and another investor, to whom the fund had owed $29 million for about two years. The court named the Grant Thornton accounting firm as liquidator to settle the Westford fund's affairs.

SCERS only learned last week that the Westford fund's $180 million in assets (including the SCERS money) had been passed on to yet another Stevanovich fund.

Harry Schneider, a Perkins Coie attorney hired to represent the Stevanovich funds, told the judge his client would provide better information about SCERS's investment by this past Friday. SCERS attorney Thoreson said Friday those records have been turned over.

Epsilon issued a statement asserting it "has earned positive returns for SCERS throughout these difficult times" and saying the lawsuit lacks merit.

It said the fund "invests in a portfolio of unidentified and generally speculative securities" and its investors are "entitled only to an annual audited report of the results of those investments."

Still, Epsilon said, it hopes to end "this unnecessary proceeding" by providing SCERS some unaudited financial statements and other information.

Pension funds have been expanding into higher-risk asset categories such as hedge funds and venture capital since the 1990s, generally arguing that such "alternative investments" can help balanced portfolios earn higher returns than more conservative investments alone.

SCERS was criticized by some employees two years ago when its $10 million venture-capital investment in Imperium Renewables ran aground as the biodiesel producer canceled a planned initial public stock offering. Susan Mangiero, a consultant and author of "Risk Management for Pensions, Endowments, and Foundations," said pension trustees shouldn't allow hedge funds to hide behind a veil of secrecy.

"If a hedge-fund manager is unwilling to explain their valuation process — and related procedures and internal controls — run, do not walk for the nearest door," she said.

SCERS has 8.8 percent of its assets in alternative investments at the end of 2009, down from 11.8 percent a year earlier.

Carter, who became the executive director of SCERS in early 2008, said those investments earned a 14.2 percent return in 2009.

The S&P 500 index of major U.S. stocks dropped 25 percent during that period, illustrating why some pension funds say they include alternative investments.

The Epsilon investment is just a small fraction of the SCERS portfolio. But the rest of the fund hasn't done particularly well during the last two years for which annual reports are available.

In each of SCERS's five asset classes, its returns trailed the benchmark to which they are compared in both 2007 and 2008.

Sometimes the differences were stark: Its fixed-income portfolio lost 4.3 percent in 2008 while the benchmark index had a 2.4 percent gain.

Carter wouldn't comment on the Epsilon situation, and wouldn't say whether the alternative investments still seem like a good idea.

But she said the SCERS board last year agreed to revisit its investment strategies.

"We are reviewing the portfolio in its entirety," she said, to "determine what is prudent" for the retirement system's future investing.

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to Rami Grunbaum: rgrunbaum@seattletimes.com or 206-464-8541.