Saturday, June 26, 2010



This week, Dutch newspapers were filled with stories about a rather spectacular settlement in a criminal and civil case between a large, well-known real estate developer and a) the court / government; and b) the Philips Pension Plan. The illustration below - taken from Holland's financial newspaper FD shows how things were structured in this particular network of corrupted real estate transactions. Unfortunately the text is in Dutch, but I am sure all of you understand that the essence is that things are obscured by creating a network of related financial transactions between different legal entities that allegedly had no direct ties with - in the end - the institutional end-investor(s) funding the paycheck. 

Example: Network of obscure financial transactions and legal entities
Standard practice in Real Estate operations
This week the developed settled with the court and the victimized pension plan
LMG believes that allowing settlements in this kind of case is wrong

It was already known since ages that real estate fraud was an effective way of robbing pension plans (premium paying, hard working members and pensioners) and the community in general (tax payers). Because there is no daily pricing like with bonds and stocks, large real estate projects are always surrounded by clouds of obscurity. And sure: prices of financial assets can move rather erratically on a daily basis. So, suppose that a specific office building is developed for (or sells for) 4-5 percent more than expected, is that strange? In a world where equity prices can move up and down by 1-2 percent per day? Not really, and that is what was used by some developers in a corrupted game that involved high level officials from within the pension community as well.



In so-called A-B-C deals one piece of property (shopping mall, office building, stadium etc) could switch hands twice on a day! And no one, not even the notary that legalized and registered the deals, seemed to care or notice anything strange. How that is possible? Well, real estate developers understood that they could 'invest' more in relationships with decision takers in pension plans through expensive wines, dinners, concert tickets or even complete holidays. And more and more we notice that there was even a complete bonus culture through which corrupted officials would decide to opt for developer X or project Y with part of the 'finders fee' actually de-facto being paid by their employer (read: members of the pension plan or the population at large, depending on the type of institutional party they were working for) through a price raise compared to the 'real' price. The bonus itself would then be paid by the real estate developer  to a foreign bank account opened for or by the pension fund official.

And no one would find out because the asset class was surrounded by a foggy cloud of obscurity. And this type of corruption was/is big and Holland is definitely not the worst country. To be frank, we would not even be surprised if it is one of the least (!) corrupted and most transparent ones.


A little example:

Holland has some 600 pension plans. Pension plans with sizes of Euro 1-5 billion assets under management are 'just' mid-sized. And there are dozens of plans in the Euro 100 million to Euro 1 billion category. All-in-all one could say that our pension industry is relatively well managed, but that holds on average with management and control schemes functioning far better for those asset classes with daily price formation and registration (e.g. cash management, bonds, listed equities, financial commodities etc). 

Direct real estate investments could be some 5-10 percent of total plan size. For a plan of let's say Euro 2 billion (far smaller than the Philips Pension Plan that was settling in a case this week) this translates into Euro 100 million to Euro 200 million real estate investments. Just one plan, with probably just 1-2 people responsible for the real estate investments.

Assume that a fictitious plan ABC invests Euro 150 million in real estate. If the Director of Real Estate of ABC and his 'favorite' developer agree to increase prices by let's say 5 percent this translates into extra costs of Euro 7.5 million for the plan. A nice buffer to play with. Whenever someone ends up being faced by an ad-hoc control, the director and developer could always say that one building is not the other and that this project or portfolio faced 'some difficulties' or the other way round 'had some unique features'.

Obviously we are not suggesting that most - let alone all - plans suffered from this risk and that all developers are crooks. However, the opportunities in this asset class are so tempting and the number of corrupted deals to be uncovered (often because the corrupted parties ended up fighting with each other because the developers who 'like the game' want to do much more at a higher pace than the directors/real estate officials at the plans, because they are the ones being faced with the controls within the plans which provides them with a kind of mental 'brake' so as to not go too far) so large (almost one per 2/3 weeks at the moment! in Holland alone) that this is for sure one of the big problems of institutionalized savings and/or pension systems.




Now, as top-down specialists in asset allocation LMG has for many years suggested to reduce the weight of direct real estate in portfolios of pension plans. And the interesting thing was that no one ever seemed to agree. Which in and of itself is already remarkable, because we can proof that allocations with similar return-risk profiles can be created without direct real estate as an asset class.

The only conclusion can be that this corrupted system of white collar robbing has become institutionalized, explaining why - especially  when taking account of large imbalances in salaries between the asset management community on the one hand and the pension community on the other - this practice was hard to fight. The facilitators in the pension plans were sensitive to it, and might actually lure developers into 'creative' solutions that implied continuation of 'the game'.


But there is light at the end of the tunnel. Under pressure by the Global Crisis growing numbers of developers ended up in trouble, because the pension plans and other investors that made these games possible don't have the financial means available to continue 'at the old pace'. This leads to irritations and mistakes.

Also: pension fund governance is taken far more serious by growing numbers of plans with better controls, reporting structures, reduction of the number of situations in which one or two internal people can decide on big real estate deals alone etc.

And that is good news.



But - in line with some of the left-wing parties in the Netherlands - we do think that it is absolutely wrong to let EITHER developers (who 9 out of 10 times created the set-up) or the real estate officials in the pension plans (who made it possible because their YES funded the projects) get off the hook through settlements. And as you know, we are not exactly left-wing. If anything we are liberals that want to create a fair business climate domestically and abroad.

It was shocking to see how Dutch newspapers talked about 'pragmatic' justice when the government and the Philips Pension Plan agreed to a Euro 40 million settlement deal with real estate tycoon Harry Hilders. How can you call something 'pragmatic' when you see and hear about images of a partying developer, especially when you know that this settling guy was busy selling off properties with a value of at least Euro 750 million during the last 1-2 years. It is not pragmatic to believe that it was a good 'deal', but just plain stupid.

If my estimate of 5 percent fraud/corruption per big property deal was correct the Euro 750 million sell-off package would translate to an almost break even solution for the developer!! This is like selling call options to 'profit through corruption' on a daily basis with the downside risk being that you can always get away with things through a settlement in one of the rare cases where you will get caught.

It is a disgrace, so we continue our plea for a reduction in the direct real estate allocations of pension plans unless there is more certainty that governance structures work and plea for penalties that consist of imprisonment AND financial penalties for BOTH the creator of the structures and the facilitator.


What this has to do with our Emerging Markets focus? Well, in earlier contributions we fought against the practice of Transparency International to allocate all corruption in its CPI Index to the receiving country. This leads to statistics in which Developed Nations look like saints compared to Emerging Nations. See the illustration below:

Illustration CPI 2009

Light-blue is least corrupted according to Transparency International, 

but LMG believes that there is a lot wrong with calculation methods.

Developed nations are no saints, just better in hiding things in white-collar-crime structures

We hope that this 'common practice' in the real estate community will strengthen the case we made on those occasions for evenly dividing a corruption charge between the donor country and the recipient country in cross-border cases. Not just those related to Real Estate, but others as well. The feeling that corruption is mainly something for obscure countries in the Third World should be updated. If anything, corruption is maybe a bit more blunt, less subtle in those cases. But the institutionalized white-collar-crime-style corruption seen in Western Real Estate markets is at least as serious.

Actually, fighting it is something that could be good for Emerging Markets. When looking at asset allocations, the case for Direct Real Estate is often based on low correlations with Developed Markets equities and fixed income. Emerging Markets encompass various asset classes that do have relatively lower correlations with Developed Equities and Fixed Income as well. I.e.: what we can gain by fighting this corruption could help poor countries by increasing the allocations there. Not to Direct Real Estate, so that you would replace one problem by probably an even bigger other problem. No, by switching to a larger allocation in Emerging Markets Debt or Listed Equities.

Unfortunately we will have to end by saying: will be continued for quite some time...

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