Texas teachers’ pension fund invests in casinos, loses $99 million
http://www.dallasnews.com/investigations/headlines/20120512-texas-teachers-pension-fund-invests-in-casinos-loses-99-million.ece
May 12, 2012
By STEVE McGONIGLE The Dallas Morning News Staff Writer
First of two parts
As public investments go, this one looked like a roll of the dice.
But the Teacher Retirement System of Texas wanted a big win, so it put $100 million into the buyout of a Las Vegas gaming company called Station Casinos.
The company went bankrupt, and like many an unlucky jackpot-chaser, the state’s largest pension fund walked away a loser. More than $99 million of Texas teachers’ retirement money had vanished.
“There is no getting around it,” said Britt Harris, the fund’s chief investment officer. “This was a bad investment.”
It wasn’t the only one. Between April 2006 and last September, the teacher fund saw the value of its “opportunistic,” or high-risk, real estate deals drop by $599 million, a data analysis by The Dallas Morning News found.
In all categories of real asset investments, including real estate, the worth of the TRS portfolio fell by more than $1 billion over that same period, according to the evaluation by The News.
A spokesman for the teacher fund disputed the newspaper’s calculations The News on Friday, contending the decreases in high-risk real estate values were much less.
TRS is the nation’s fifth-largest public pension provider, with current assets of $110 billion. It serves 1.3 million public education employees, about one-fourth of whom are retired.
Like many pension plans, TRS faces a widening gap between assets and long-term obligations, a result of market volatility, tight state budgets and a rising tide of retirees. Last year, this unfunded liability reached $24 billion and forced the teacher fund to continue a decadelong freeze on increases in benefit payments.
The response by TRS and other funds has been to shift from traditional stocks and bonds toward alternatives that offer higher returns but present larger risks.
TRS has a higher share invested in alternative assets — 31 percent — than any of the 10 largest public pension funds, according to Preqin, a London-based research firm.
Harris and other Texas fund officials credit the diversification with helping TRS to weather the global financial crisis better than most pension funds. In 2011, TRS had one of the highest returns of any state pension fund.
TRS spokesman Howard Goldman, in a summary provided Friday, said more recent data than his office initially released to The News paints an upbeat picture of the last six years. When earnings are included, Goldman said, opportunistic investments have dropped $250 million, and the entire real asset portfolio gained $430 million.
Critics contend alternatives are too risky, too costly and not transparent enough. They predict the investments will falter, leaving taxpayers with a massive bailout bill.
Edward Siedle, a Florida lawyer who has investigated several public pension systems, including TRS, said the Texas fund’s alternative investments were typical. “We see every single day public pensions investing in schemes that make no sense and are doomed to fail,” he said.
The $99 million Station Casinos loss was modest by TRS standards, said Harris, the chief investment officer. “No loss is insignificant. It’s still real money,” he said. “But it hasn’t affected the [overall] return on the fund.”
Nothing, however, in the TRS portfolio quite matches the casino deal for implausibility or colorful settings. By investing in Station, TRS backed a politically connected Las Vegas family, in a city on the brink of a real estate catastrophe, and an activity — casino gambling — that is illegal in Texas.
That investment and a related transaction also featured a financial side trip to a disastrous entertainment mall in the New Jersey Meadowlands.
The $99 million was only part of the loss. Altogether, the Texas teacher fund committed $400 million to those privately managed investments. At last count, the market value was roughly one-third that amount.
It looked, TRS officials said, like a good deal at the time.
Investment revolution
The Texas Constitution prohibits the teacher fund from owning real estate,
but managers have repeatedly tried to skirt that ban.In the 1980s, loan defaults on commercial developments forced TRS to repossess almost 20 office buildings. Investment officials not only were accused of violating the constitutional ban but of mismanagement and conflicts of interest.
The TRS board flirted in the late 1990s with reviving the real estate program but shelved the idea under pressure from legislators.
Then came a lingering bear market. In 2002, the fund had its second straight year of losses and owed $3.2 billion more in long-term obligations than it had in assets.
A projected state budget deficit made help from the legislature improbable. State contributions, along with those from active members, account for about 25 percent of the fund’s annual revenues.
So in 2003, the TRS board voted to allocate more money to alternative assets, including real estate. Linus Wright, a former board chairman, said members felt they had no choice. “We had to have a better investment program,” he said. “So we did completely revolutionize.”
Trustees hired The Townsend Group, a nationally regarded real estate consulting firm, to devise an investment strategy. Next, they brought in Harris, a former hedge fund executive, to implement the new plan.
In April 2007, the Texas fund made headlines by announcing it would commit 35 percent of assets to such things as hedge funds, private equity or real estate. To comply with the constitutional ownership ban, investments would be made through limited partnerships.
Eric Lang was the TRS point man on real estate. Through Townsend, Lang said, he learned about a $4 billion fund called Colony Investors VIII that was advertising a portfolio of commercial property investments around the globe.
The fund was a type known as opportunistic. Such funds are considered high risk because of the amount of debt they assume and presumptions that properties are undervalued but will rise in worth.
The first deals in the pipeline were a management-led buyout of Station Casinos and the bailout of Meadowlands Xanadu, a stalled retail-entertainment project in the former swamplands of northern New Jersey.
Colony estimated returns at 15 percent or more. Lang was all in.
Vegas boom
Station Casinos was a Las Vegas success story, thanks to Frank
Fertitta Jr. and his sons.Fertitta was a former Galveston resident who began work in Las Vegas as a hotel bellman and rose to the status of local legend.
His great uncles were Sam and Rose Maceo, kingpins of a Galveston gambling empire that dominated the island city for four decades.
The state closed the Maceos’ operations in 1957. Some of the family moved to Las Vegas, where Sam Maceo helped finance the Desert Inn, an early Strip casino.
Organized crime ran much of Las Vegas then, and Fertitta managed mob-backed casinos before opening his own business. He was investigated for years for alleged cash skimming but was never charged with a crime.
He started what became Station Casinos in 1976 as a slot machine parlor attached to a motel. Unlike the glitzy gaming halls on the Strip that catered to tourists, Fertitta targeted local residents with cheap food, bingo and greater odds of winning.
His sons, Frank III and Lorenzo, joined the business after college. They assumed control when their father retired in 1993 and took the company public. (Frank Fertitta Jr. died in 2009.)
The brothers built Station into a giant. As Las Vegas grew, so did the number of casinos the Fertittas opened. They built or bought 15 in 14 years. They also gobbled up hundreds of acres of raw land on the edge of Las Vegas for future development.
“We’ve had a lot of stupid gunslingers in this market,” said David McKee, a Las Vegas journalist who writes a blog on the casino industry. “These guys, what they aimed at, they usually hit.”
One of their best bets was paying $2 million for the Ultimate Fighting Championship, a promoter of the mixed martial arts style of caged combat. Estimates of UFC’s current worth start at $1 billion.
Perhaps their biggest setback was the demise of a riverboat gambling operation in Missouri. The Fertittas sold out in 2000 and later paid $38 million to settle civil allegations that their attorney had obtained their gaming license by improper influence.
But by 2005, Station was rated as one of the best places to work in America, its stock was soaring and the Fertittas were on the cusp of becoming billionaires.
Still, the brothers felt stifled by Wall Street’s short-term vision. “Being private, it seemed like it had advantages in terms of our autonomy and then doing something that we wanted to do,” said Scott Nielson, Station’s chief development officer.
The Fertittas declined to be interviewed. Nielson agreed to answer some questions from The News.
He said the Fertittas were contacted by Colony Capital, a Los Angeles private equity firm, to explore a joint venture that would take Station private.
Colony was led by Tom Barrack , a charismatic investor who once advised Fort Worth financier Robert Bass. Barrack had built a storied career dealing in distressed properties.
Barrack said he was convinced that a buyout of Station made sense, and he agreed to a partnership with the Fertittas. The Las Vegas economy was booming, he said, and so was Station. “Kind of all the ingredients at the time were there,” he said.
On Dec. 1, 2006, Fertitta Colony Partners made an initial bid of $4.7 billion, or $82 per share, to Station’s stockholders.
Two weeks later, Barrack appeared before the Alternative Assets Committee of the Texas teachers’ fund board to pitch a $150 million investment in Colony Investors VIII, a major financier of the Station Casinos buyout.
Lang, the TRS real estate manager, made the staff presentation. He mentioned Station twice in recommending a commitment to Colony. The committee, and later the full nine-member board, gave unanimous approval.
Jersey Xanadu
The only other investment in Colony VIII that trustees heard Lang mention was
Xanadu, an eclectic development with a name made famous by English poet Samuel
Taylor Coleridge.The project, spread over 104 acres of the New Jersey Meadowlands, was a combination shopping mall and entertainment complex. The plans included a large indoor ski slope, simulated skydiving tunnel and 30-foot chocolate waterfall.
There were environmental issues from the start, and concerns about the economic impact on an area rife with other malls. Critics fretted that the location near one of the busiest highway interchanges in the New York City area would worsen gridlock.
Construction delays and cost overruns had driven the price from $1.3 billion to $2 billion. The original developer, Mills Corp., was teetering on the brink of bankruptcy.
“I called this the Vietnam of malls,” said Jeff Tittel, director of the New Jersey Sierra Club, an early opponent.
As it emerged, the exterior would be ridiculed for its mix of shapes, colors and patterns. It was compared to children’s Lego blocks or a bar code. Critics bestowed the nickname “Xanadon’t.”
But where some saw disaster, Barrack saw gold. “It’s probably the best retail location ever,” he said. “Mills’ problem was capital structure. It wasn’t that they had a project that wouldn’t work.”
Colony Capital announced in 2006 that it was taking control of Xanadu and would spend $500 million to complete the project. The takeover was finalized just before Barrack made his investment pitch to the committee of the Texas teacher fund’s board.
Seven months after making the first $150 million investment with Colony, the teacher fund board agreed, at Lang’s urging, to double the amount.
Lang also pitched an additional, $100 million co-investment with Colony. Unlike the pool investment, which included multiple properties, the co-investment was solely directed toward the Station Casinos buyout. This boosted the teacher fund’s total commitment to Colony to $400 million.
Lang touted the success of the Fertittas’ company and called the brothers “very dynamic people.” He did not mention Station’s problems in Missouri and said in an interview this year that he was unaware of them.
Dory Wiley, a Dallas investment banker who chaired the committee that approved the Station and Colony investments, sounded one of the few cautionary notes by saying there was growing sensitivity about morality and public investing.
Wiley was one of a breed of less orthodox thinkers that Gov. Rick Perry appointed to the TRS board. He was a strong advocate for diversifying into alternative asset investments. He also had an ear for political reality.
“There may be a day where you bring a gambling deal to us, and it gets turned down,” Wiley told Colony’s chief investment officer, Jonathan Grunzweig.
But it was not that day.
Worst investment
The teacher fund invested in Station Casinos at a time when there were clear
signs that the formerly robust Las Vegas economy was withering.Housing in the area was hit especially hard by the subprime mortgage crisis. Foreclosures were rising, as was unemployment.
Because all but one of Station’s 17 casinos catered to Las Vegas-area residents, the company’s fortunes were tied less to tourism and more to the health of the local economy.
In July 2006, The Wall Street Journal had warned that Station was “a slave to the housing market,” and its shares could be hard hit should the real estate bubble in Las Vegas come to an end, as some analysts were projecting.
There was also a matter of debt. Station had $3.4 billion before the proposed buyout, and the $5.4 billion plan finally accepted by Station shareholders required steady growth in cash flow to service the debt.
The plan called for Colony to contribute $2.7 billion for a 76 percent share of the private company. The Fertitta family would put in $870 million and control 24 percent. The remaining capital would come from loans.
A few gaming analysts and state regulators raised the debt issue but were assured by the Fertittas and Barrack that the company could survive any economic downturn.
Decades of steady profits had made the casino industry feel invincible, said Bill Thompson, a retired professor of public administration at the University of Nevada, Las Vegas. “Nobody,” he said, “was worried about debt.”
Lang told The News that he vetted Colony Capital but relied on its own analysis of Station. He insisted that an appropriate amount of research was done. “Who knew that the markets would collapse like they did?” he said.
Texas law exempts documents deemed part of the due diligence process from public disclosure. As a private company, Colony is not required to reveal its research.
Trouble surfaced soon after the buyout in November 2007. The following February, Station conducted layoffs. It also revealed that earnings had been down sharply in the fourth quarter of 2007.
Then, in September 2008, came the bankruptcy of Lehman Brothers, the giant investment bank, and the virtual collapse of credit markets. The Las Vegas economy, and casino revenues, went into freefall.
The Texas teachers’ fund and other large institutional investors began to write down the value of their investments in Station.
Yet the Fertittas kept rolling. They announced a $10 billion casino development in Las Vegas, their biggest ever. With Station trying to renegotiate with its lenders, Frank Fertitta III paid $28 million for an oceanside home in Laguna Beach, Calif.
Time finally ran out on Station Casinos in July 2009. The company filed for Chapter 11 bankruptcy protection, citing $5.7 billion in assets and $6.4 billion in debts.
In August 2010, a bankruptcy court judge approved a deal that allowed the Fertittas to regain control of Station and most of its properties while shedding $4 billion in debt. Colony became a minor partner.
Barrack called the Station deal the worst investment of his career.
“That process, and the problem, and the fault, quite honestly, are mine,” he said in an interview. “It was on my watch. It was my team. It was my decision. It was my responsibility.”
The same month, Barrack surrendered control of Xanadu to a consortium of lenders. It was later sold to a Canadian mall developer, who renamed the project American Dream. It remains an empty shell.
Barrack called the New Jersey development “a disaster” but one that would have been avoided had his lenders held to their commitment. “It would probably be one of the most successful retail entertainment malls in the nation, for sure,” he said.
‘Old TRS’
The amount TRS lost in Xanadu is not publicly available. The market value of
the $300 million TRS committed to the entire pool of 27 properties in Colony
Investors VIII has dropped to $122 million, state records show.A Colony spokesman declined to say how much of the TRS loss was attributable to Xanadu or the Station Casinos buyout. Barrack said investments are made on a proportional basis, with money put into every project in the pool.
Value increases from other properties in Colony’s pooled fund should rebound to allow TRS to earn back 110 percent of its investment, Barrack said.
TRS has written down its $100 million TRS co-investment in Station Casinos, and does not expect to recover the losses. The investment is now worth $516,000.
Station Casinos, meanwhile, seems to have turned a corner.
Revenues are rising. In February, Station announced that the Fertittas were planning to buy a 15 percent share held by JP Morgan Chase, which would give them 60 percent control of the company.
After two years of steep investment losses, the Texas teacher pension fund has rebounded to the level of assets it had before the financial crisis. An 11 percent return in 2010 earned Harris and 53 other investment staffers $9.7 million in bonuses.
The commitment to alternative assets remains strong, although results are mixed. Investments in private ventures have posted big gains. Opportunistic real estate investments continue to lag behind other types.
Harris said the Station Casinos investment was a vestige of “the old TRS.”
Since 2007, he said, the entire TRS investment process has been overhauled. The number of staff reviewing deals has been increased tenfold, he said, and there are more thorough risk assessments.
The casino investment did offer a painful lesson, Harris said.
“It’s not worth it to invest in the gaming industry,” he said. “We are not going to do this again.”
Staff writer James Drew in Austin contributed to this report.
KEY PLAYERS: Station Casinos deal
Thomas Britton “Britt” HarrisTRS Chief Investment Officer. Hired in 2006 to implement a more diversified investment strategy. Former chief executive officer of Bridgewater Associates, one of the nation’s largest hedge funds.
Eric Lang
TRS Real Assets Manager. Chief sponsor of the TRS investment in Colony Capital and Station Casinos.
Tom Barrack
Founder and chairman Colony Capital Inc., a Los Angeles-based real estate investment company. Personally pitched the investment in one of his investment funds, Colony Investors VIII, to the TRS board in 2006. Described as “the best real estate investor on the planet” in 2005 by Fortune magazine.
Frank Fertitta III
Chairman and chief executive officer of Station Casinos. Co-owner of Ultimate Fighting Championship.
Lorenzo Fertitta
Board member Station Casinos. Chairman and CEO of Ultimate Fighting Championship.
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