Schafer: The seeds of investment fiascos are always the same

The back-and-forth on a conference call in June for the bondholders financing the expansion of Hmong College Prep Academy in St. Paul was painful.

Professional investors just couldn't figure out, even after hearing several tries at an explanation, how the charter school agreed to let a small New Jersey hedge fund called Woodstock Capital manage its money. The fund lost almost $5 million of the schools' — and thus the bondholders' — money.

They kept asking, with impressive civility, how such a thing could have even happened.

An attorney for the school, Jay Squires of the Minneapolis firm Rupp, Anderson, Squires & Waldspurger, took the first crack at explaining.

"In a nutshell, in 2019, this investment company was identified as a potential company that the Academy could place some of its surplus investible funds with," he began. "Their investment portfolio did not fit the requirements of the school's investment policy or state law, so there was a side letter that was prepared that limited investments to safer, more liquid investments …"

What does "identified" mean? Through what due diligence process?

It didn't get much clearer when Christianna Hang, the school's founder and superintendent, took over.

"According to the side letter, they agreed that we were going to get a good return on investment per year, anywhere from 8 percent to 10 percent a year," she said. "We felt it would be a good way to generate revenue or good interest."

In addition to this conversation there's a story told in a formal complaint the school filed in court this summer against Woodstock Capital LLC. The attorneys for Hmong College Prep Academy, in its fraud, negligence and breach-of-contract lawsuit, had concluded that either $4.3 million of the school's $5 million had been lost in grossly negligent investment management or the money had simply been stolen.

But maybe looking to this 15-page complaint or the audio recording for a clear understanding only means overthinking it.

It could be just as simple as those in charge honestly thought the New Jersey hedge fund's promise of an 8% to 10% annual return from safe U.S. Treasury bonds sounded pretty good.

And it does sound good. It's also utterly unrealistic.

The first lesson when looking at the origins of an investment fiasco is how often they happen because someone doesn't know what's too good to be true.

There are years when a bond portfolio can beat 8% in total return, but they are rare.

Last year was the second great year in a row for bonds. Yet returns last year still did not hit 8% on the best-known U.S. bond market index.

Over the last decade, that index has produced something more like a 3.4 % annual total return. So far this year, the return's been negative.

U.S. Treasury securities really are safe investments, provided members of Congress don't wreck the country's credit rating by acting like toddlers playing with matches. But if there's almost no risk of default, that bond won't pay a lot in interest.

Last week, at last checking, the U.S. Treasury 10-year note yielded about 1.18%.

Schools really can't shoot for higher yields because Minnesota state law pretty much rules out anything with any risk. It boils down to choosing between government bonds including Treasury securities, short-term commercial paper issued by top-shelf American corporations as well as bank deposits.

Hmong College Prep Academy is a public charter school under Minnesota law. The school and its attorneys, through a representative, declined to talk about this investment gone south, citing the ongoing litigation.

The school's outside auditor, CliftonLarsonAllen, said in its audit that the school was "unaware" it had bought a disallowed investment, in part because of misrepresentations by the hedge fund.

The academy opened with about 200 students in 2004 and now has more than 2,300 students in kindergarten through 12th grade. It's got an ambitious curriculum and serves kids from St. Paul and a number of other communities. Most of the kids come from low-income families, which qualifies them for free or reduced-price school meals.

Hmong College Prep had money to send to New Jersey, in part, because it's borrowed a lot of money. It raised cash through a $26 million St. Paul Housing and Redevelopment Authority bond issue that was sold to investors last year to help fund a big expansion of facilities including a new 93,000-square-foot middle school.

But as Hang, the school superintendent, explained to those head-scratching bond investors on that conference call, the school still had to come up with an additional $7 million to fund the expansion. The school was looking for better investment returns to close some of that gap.

That's the second lesson out of this fiasco. Sometimes this is called "chasing yield" or "reaching for yield," and it means being too hungry when looking for places to invest.

If an annual return of 3% over the next few years sounds way too low, it's hard to resist looking at alternatives that are invariably a lot riskier.

It's "stupid" but "very human," investor Warren Buffett said in an interview last year, in his typically folksy and blunt way. "People say, 'Well, I saved all my life and I can only get 1%; what do I do?' The answer is you learn to live on 1%, unfortunately. You don't go and listen to some salesman come along and tell you, 'I've got some magic way to get you 5%.'"

The investors who pressed Hang for answers on the last investor call certainly suggested with their questions that something broke down in the governance of the school. That's a fair point.

The school really needed someone — on the board of the school, with a firm that serves as financial manager, or from Bethel University, the charter school's "authorizer" — to laugh out loud upon hearing of a promised rate of return of 8% to 10%.

That's likely all it would've taken for the whole idea to be dropped, and long before any money got wired to New Jersey.