NEW YORK, NY August 03, 2009 —An investigation into corruption at the New York State pension fund has raised questions about the fund's dealings with Wall Street. Federal and state regulators are examining how the pension fund chooses its private money managers. Last month we reported on the tangled relationships between the pension fund and Wall Street. Today we follow the money. WNYC's Lisa Chow reports.

REPORTER: It was a Friday morning in May when Tom DiNapoli delivered the bad news.

DINAPOLI: As we are all aware, 2008 was one of the most difficult years in Wall Street history.

REPORTER: DiNapoli is in charge of New York’s pension fund, which is supported by taxpayers. He says the fund was down 26 percent. It had lost roughly 45 billion dollars in the past year.

DINAPOLI: And the fund's value, as of March 31, 2009, was $109.9 billion.

REPORTER: DiNapoli kept his announcement brief, and then took questions from reporters, who were eager to know about something else.

GOLDMAN: Can you state what the returns have been from certain investments handled by Quadrangle or Carlyle or and Liberty Oak?

DINAPOLI: You're referring to firms that have been cited in the investigations and the indictments.

REPORTER: In March state prosecutors said close associates of DiNapoli's predecessor took bribes to steer billions of pension fund dollars toward certain investments. Reporters wanted to know how those investments had performed.

SCOTT: I just want to go back to this question of performance of the investments related the pension fund inquiry.

HAKIM: I don't understand what the investigation has to do with not releasing it?

DINAPOLI: Again, as you know, you've been following this, there’s been certainly on our part, a deference in terms of timing on releasing information and we have our own attorneys that are advising us.

REPORTER: Each time, DiNapoli said the same thing: Our lawyers tell me not to talk about the investments. The 23 funds under investigation all fall in the category of "alternative" investments.

We're not talking stocks and bonds, which make up the bulk of the pension fund's portfolio. We're talking about less transparent and riskier investments, like private equity and hedge funds. Which raises a question: Is there anything about this space that makes it more vulnerable to corruption? Neal Berger used to run a hedge fund. He says, yes.

BERGER: The fees are enormous that are going back and forth between these investors and these fund managers.

REPORTER: Berger says private equity and hedge funds can charge higher fees because they're using more sophisticated investment strategies, than managers of stocks and bonds.

They'll typically charge a management fee, two percent of all the money you invest with them, and an incentive fee, 20 percent of all the profits. In the boom years, those numbers added up.

BERGER: There's not necessarily anything wrong per say with the fees, but there is a lot more juice to go around where potential corruption could happen.

REPORTER: And yet, New York state and many other public pension funds have not shied away from these private investments. In fact, they've put more money into them. With the growing number of retired government workers to support, pension funds have been under pressure to increase their returns.

Roy Smith is a professor at NYU's Stern School of Business. He says pension funds used to invest more conservatively, in stocks and bonds, but after the stock market crashed in 2002, that changed.

SMITH: The pension funds had taken quite a hammering in that period following the Enron crisis and they needed to get some sort of return in their stock portfolios or they were going to be in danger of having no equity in the pension funds at all. So they felt some extremis and they wanted to do want smart people seemed to be doing, the ones at Harvard and Yale that had made money throughout this difficult time, because they were very heavily invested in these alternative assets classes.

REPORTER: New York State was part of that. Carl McCall ran the pension fund for much of the 1990s. He lobbied the state legislature, which limits the percent of the pension fund's money that can be invested in private equity and hedge funds.

MCCALL: The legislature, they were reluctant to see us put more money in that. They limited us to 5 percent. And I got that limit increased because that seemed to me to be a place where we could make a lot of money, and it was a place where we made a lot of money.

REPORTER: And McCall wasn't alone. His successor Alan Hevesi did the same, and by 2006, the pension fund could invest up to 25 percent of its money in these private investments.

Now when a pension fund invests in stock, it's buying a share of a company. When a pension fund invests in private equity, it's pooling its money with other institutional investors to buy companies. It's through private equity firms, the ones under investigation, that the New York state pension fund has bought power plants in Texas, gas storage facilities in California, the pet food chain PetCo, health clubs in Toronto, the men's magazine Maxim, the bra and panty company Maidenform.

The list goes on and on. When you buy companies, as opposed to buying their stock in smaller numbers, you have a lot more control over those companies. And private equity managers have another tool: leverage. Pete Peterson co-founded Blackstone, one of the largest private equity firms in the world. Peterson spoke to WNYC earlier this year.

PETERSON: During the 90s, it was the heydays of private equity because it was the perfect environment. Plenty of money was available for borrowing. Interest rates were low and the stock prices doubled during that period. So if you couldn't make money, you'd have to be almost retarded, I think.

REPORTER: But Peterson says, in this century, private equity is in much tougher shape.

PETERSON: If you have a lot of leverage and the values go up, you get a multiplier effect. But we should also focus on the fact that if you have a lot of leverage, and the values go down, you have a multiplier effect on the downside.

REPORTER: In other words, private equity firms got a lot of money from public pension funds, then borrowed a lot more money from banks, and went on a buying spree in 2006 and the first part of 2007, targeting companies in all different sectors, with the hope that they could grow those companies and sell them at a profit. Then, the markets tanked. Brian Mooney is with Cogent Partners, an advisory firm in private equity.

MOONEY: Those private deals have more debt, more leverage, than the average company in the S&P 500.

REPORTER: With so much leverage, Mooney says now in a down market, private equity funds, on average, are performing worse than stocks. So the big question facing New York and many public pension funds around the country is this: How do we now make up for our losses, which are in the billions?

We could require taxpayers to pay more now. We're going to have to do that anyway because of our looming liabilities to retirees. Or we could take another bet on high-risk, potentially high return investments, and hope that this time they don't go sour. Right now, the man in charge of the New York state pension fund, Tom DiNapoli, knows his answer.

DINAPOLI: Obviously we're in a different climate right now so we need to assess where we’re at with that, but I still believe there are great opportunities out there with regard to private equity investments, and we shouldn't close the door on them.

REPORTER: And like his predecessors, he's lobbying the state legislature to once again increase the limit on private equity. For WNYC, I'm Lisa Chow.

Also: Understanding Wall Street’s Dance with Public Pension Funds.