BILL ANALYSIS Ó
SENATE COMMITTEE ON
PUBLIC EMPLOYMENT AND RETIREMENT
Dr. Richard Pan, Chair
2015 - 2016 Regular
Bill No: AB 2823 Hearing Date: 6/27/16
-----------------------------------------------------------------
|Author: |Gatto |
|-----------+-----------------------------------------------------|
|Version: |6/21/16 As amended |
-----------------------------------------------------------------
-----------------------------------------------------------------
|Urgency: |No |Fiscal: |Yes |
-----------------------------------------------------------------
-----------------------------------------------------------------
|Consultant:|Glenn Miles |
| | |
-----------------------------------------------------------------
Subject: Public records: Pension Funds Alternative Investments
Fee Disclosure
SOURCE: Author
ASSEMBLY VOTES:
Not applicable with June 21, 2016 amendments
DIGEST: This bill amends the California Public Records Act to
eliminate confidentiality protections related to alternative
investments in which a public investment fund invests, thus
requiring disclosure of partnership contract terms, as
specified.
ANALYSIS:
Existing law:
1)Pursuant to the California Public Records Act (CPRA), governs
the public disclosure of information collected and maintained
by public agencies. (Government Code Section 6250 et seq.)
Generally, all public records are accessible to the public
upon request, unless the record requested is exempt from
public disclosure. There are 30 general categories of
documents or information that are exempt from disclosure,
essentially due to the character of the information, and
unless it is shown that the public's interest in disclosure
outweighs the public's interest in non-disclosure of the
AB 2823 (Gatto) Page 2 of ?
information, the exempt information may be withheld by the
public agency with custody of the information. (Gov. Code
Sec. 6254 et seq.)
2)Exempts from CPRA disclosure the following records regarding
alternative investments in which public investment funds
invest unless the information has already been publicly
released by the keeper of the information:
a) Due diligence materials that are proprietary to the
public investment fund or the alternative investment
vehicle.
b) Quarterly and annual financial statements of alternative
investment vehicles.
c) Meeting materials of alternative investment vehicles.
d) Records containing information regarding the portfolio
positions in which alternative investment funds invest.
e) Capital call and distribution notices.
f) Alternative investment agreements and all related
documents.
3)Provides that the following information regarding alternative
investments in which public investment funds invest shall be
subject to disclosure and shall not be considered a trade
secret exempt from disclosure:
a) The name, address, and vintage year of each alternative
investment vehicle.
b) The dollar amount of the commitment made to each
alternative investment vehicle by the public investment
fund since inception.
c) The dollar amount of cash contributions made by the
public investment fund to each alternative investment
vehicle since inception.
d) The dollar amount, on a fiscal yearend basis, of cash
distributions received by the public investment fund from
each alternative investment vehicle.
e) The dollar amount, on a fiscal yearend basis, of cash
distributions received by the public investment fund plus
remaining value of partnership assets attributable to the
public investment fund's investment in each alternative
investment vehicle.
f) The net internal rate of return of each alternative
investment vehicle since inception.
g) The investment multiple of each alternative investment
AB 2823 (Gatto) Page 3 of ?
vehicle since inception.
h) The dollar amount of the total management fees and costs
paid on an annual fiscal yearend basis, by the public
investment fund to each alternative investment vehicle.
i) The dollar amount of cash profit received by public
investment funds from each alternative investment vehicle
on a fiscal year-end basis.
4)Pursuant to the California Constitution provides that:
a) The respective boards of California's public retirement
systems have "?plenary authority and fiduciary
responsibility for investment of monies and administration
of the system."
b) The Legislature retains its authority, by statute "?to
prohibit certain investments by a retirement board where it
is in the public interest to do so, and provided that the
prohibition satisfies the standards of fiduciary care and
loyalty required of a retirement board pursuant to this
section."
c) "The members of the retirement board of a public pension
or retirement system shall discharge their duties with
respect to the system solely in the interest of, and for
the exclusive purposes of providing benefits to,
participants and their beneficiaries, minimizing employer
contributions thereto, and defraying reasonable expenses of
administering the system."
This bill:
1)Eliminates existing confidentiality protections of certain
information in public records related to alternative
investments in which a public investment fund invests to
require that the following records be subject to disclosure:
a) The cover page and signature block of the proposed
alternative investment agreement.
b) All provisions in an alternative investment agreement or
related documents that govern the reclaiming of money or
benefits under stated conditions, including, but not
limited to, provisions that have the effect of allowing the
AB 2823 (Gatto) Page 4 of ?
external manager or general partner to pay back an amount
less than the full cost of the initial payment being
reimbursed, including, but not limited to, provisions
necessary to understand how recovery is to operate and all
defined terms related to or affecting recovery.
Background
Possible Consequences If General Partners Exclude California
Public Funds From Private Equity Investments?
If GPs refuse to accept CalPERS and CalSTRS as LPs because they
believe AB 2823's disclosure requirements are too great of a
governmental intrusion into their investment strategies and
partnership structures, the pension funds could experience
reduced investment performance which will translate into a need
to cover more of the systems' liabilities through increased
employer and /or employee contributions.
Public pension funds invest in Private Equity (PE) and other
alternative investment vehicles for a variety of reasons. Most
significantly, the asset class assists to enhance investment
performance in an otherwise passive investment portfolio.
Additionally, they can help smooth overall performance and
reduce volatility since commitments and returns are valued and
distributed over a longer time horizon.
GPs that manage private equity and other alternative investments
have access to an international source of capital from sovereign
wealth funds, public and private pension funds, and university
and foundation endowment funds and thus, have substantial
bargaining power when selecting LPs to invest with them. The
best performing and most successful GPs are typically
oversubscribed, meaning there are more institutional investors
wanting to commit investment funds to the GP than the GP
requires.
CalPERS and CalSTRS seek to negotiate the most favorable terms
possible when entering into alternative investment agreements
but currently retain some flexibility to accept the GP's terms
if, based on the systems' investment expertise, the advantages
of participating in the alternative investment outweigh forgoing
certain terms the funds would generally prefer. Placing
requirements on CalPERS and CalSTRS that do not apply to other
LPs eliminates that flexibility, impinges on the funds'
AB 2823 (Gatto) Page 5 of ?
investment expertise, and puts California's funds at a
significant disadvantage when GPs are considering with whom to
partner in their investment strategies.
California Public Records Act (CPRA)
In June 2003, the Alameda County Superior Court, citing the
CPRA, required the University of California (UC) to reveal
information regarding individual venture-capital partnerships.
In 2005, in response to concerns that this disclosure would lead
to some funds discontinuing partnership with UC, SB 439
(Simitian), Chapter 258, established Government Code 6254.26 to
require the public disclosure of some information regarding
investment performance, but to protect the confidentiality of
some proprietary information. SB 439 was the result of
approximately a year of work trying to work out a delicate
balance between two important public policies: the right of
access to public records produced by governmental institutions
and the fiduciary duty of public investment funds to participate
in the private capital markets in order to minimize costs for
providing retirement benefits.
Alternative Investments - What Are Alternative Investments?
According to the Pew Charitable Trust, "Although there is no
fixed definition for alternative investments, they are generally
agreed to include private equity, hedge funds, real estate and
some commodities. These investments typically lack an
established public exchange, have low liquidity, and can be more
difficult to value. Alternative investments typically carry
higher fees and can be employed to diversify investment
portfolios or to achieve higher rates of return, although often
at higher levels of risk."
Private Equity Fund Structure - How Do Private Equity Funds
Work?
According to the Institutional Limited Partners Association
(ILPA),
Private equity funds (the collection of pooled capital from
investors) are typically structured as "limited
AB 2823 (Gatto) Page 6 of ?
partnerships" that are managed by general partners
("GPs")-the financial experts at management companies that
make the actual investment decisions and help the
businesses they invest in to grow and succeed. On the
other side, the investors who provide capital to PE funds
to utilize are known as the limited partners ("LPs").
By allowing the ability to pool capital together, GPs and
LPs are able to better maximize their efforts and returns.
This structure allows LPs to increase their diversification
and purchasing power, and allows the managers (GPs) greater
leverage and opportunities to create sustainable, long-term
investment strategies. PE funds invest in multiple
companies at a time over several years during which
management, operational, and financial changes are made in
order to improve profitability. Once this occurs, the PE
fund (GP) will usually "exit" or sell their ownership
interest in the company to a strategic or financial
investor, or through a [initial] public offering (IPO).
Initially, investor capital for private equity was provided
by corporations, banks, and insurance companies. Today,
due to the strong returns prospects that private equity
offers, most investors in private equity funds are public
and private pension funds, foundations, endowments and
sovereign wealth funds.
How Are Private Equity Funds Managed?
The private equity firms, known as General Partners or GPs,
make the day-to-day and long-term decisions related to
selecting investments, managing the relationships with
those investee companies including growth strategies, and
eventually selling the ownership interests in those
companies to maximize the return to the fund's investors.
The fund's institutional investors, known as Limited
Partners or LPs, delegate the day-to-day operations and
decision making to the GPs, and rely on information
provided by the GPs to ensure that their investments are
being properly managed.
At the outset when a fund is being formed, individual
investors or LPs pledge to invest a certain amount of
capital that will be allocated to the GP over the life of
the fund, often ten years. This pledge is referred to as a
AB 2823 (Gatto) Page 7 of ?
"commitment." LPs do not provide this capital to the GP up
front, but rather capital is requested, or "called" as the
GP identifies companies for investment. When capital is
called, each individual LP provides cash equivalent to the
proportion of total capital they have committed to the
fund. LPs and GPs structure this commitment. The terms of
this transfer of funds, including any fees charged by the
GP in exchange for their services as well as the required
information to be provided at the time of any transfer of
cash -capital "called" for an investment or returned to
investors related to the sale of an ownership interest in a
company - is outlined in the Limited Partnership Agreement
(LPA), a legal document that states the obligations of the
GP and the LP in relation to the fund's activities.
In exchange for an LP's commitment to the fund, GPs are
required to return to investors a share of the profits made
from the fund's activities. Typically, 80% of any profits
generated above a minimum return are allocated to the LPs,
and GPs keep 20% of any profits, once the minimum return
has been met, often set at 8%. This dual structure
incentivizes the GPs to generate strong returns, and
ensures their interests are aligned with those of the LP in
the fund. The 20% of profits allocated to GPs is often
referred to as "carried interest" - which is the main
profit-making incentive for GPs. The method in which these
profits are distributed between GPs and LPs over the life
of the fund is referred to as a "waterfall distribution."
Finally, since PE investments are long-term strategies, LPs
also pay "management fees" to GPs, intended to cover the
GPs operational expenses including salaries and overhead,
usually 2% of the committed capital in a given fund, with a
reduction in fees once all committed capital has been
invested into companies. Many investors are increasingly
requesting that management fees are presented in relation
to a detailed operational budget provided by GPs to their
investors during the fundraising period.
How important is Private Equity?
Since the onset of the 2007-2008 financial crisis and
subsequent decline in the public markets, PE has become an
increasingly vital part of institutional investors'
AB 2823 (Gatto) Page 8 of ?
portfolios. In the past few years PE as an asset class has
continued to grow, with data showing that investment in the
industry has produced sustained investments and profits.
What Are Clawbacks?
A clawback obligation represents the general partner's
promise that, over the life of the fund, the managers will
not receive a greater share of the fund's distributions
than they bargained for. Generally, this means that the
general partner may not keep distributions representing
more than a specified percentage (e.g., 20%) of the fund's
cumulative profits, if any. When triggered, the clawback
will require that the general partner return to the fund's
limited partners an amount equal to what is determined to
be "excess" distributions.
Committee Concerns
Committee staff has the following concerns regarding AB 2823:
1) This bill may result in increased employer and employee
contributions to the pension funds if investment returns
are impacted negatively. Because the requirements can only
apply to California investment funds and because it
directly forces the disclosure of actual contract terms
between the funds and private partnerships or limited
liability companies, AB 2823 is likely to result in CalPERS
and CalSTRS exclusion from alternative investment funds by
private party General Partners. Such exclusion could
result in termination of investment strategies that
typically enhance fund investment return, smooth fund
performance, and tamper volatility resulting in a negative
impact in fund performance and greater swings in
performance.
2) The more appropriate course for addressing concerns
regarding improperly disclosed GP fee structures rests with
stricter regulation and enforcement by the SEC and advocacy
by ILPA, the national association of LPs. Under a national
solution, all LPs face the same disclosure requirements and
would not suffer a competitive disadvantage. In a July
2015 letter to the SEC Chair urging the SEC to require
better fee disclosure to LPs, several state treasurers and
comptrollers noted that "In the absence of a clearly
AB 2823 (Gatto) Page 9 of ?
defined standard, states that voluntarily disclose more
comprehensive accounts of total fees and expenses are put
at a disadvantage in state-to-state comparisons."
3) Without language that harmonizes the bill's requirements
to the pension boards' fiduciary duty, AB 2823 implicates a
potential conflict between the Legislature's authority and
the pension boards' constitutional fiduciary duties. In
effect, the requirements of this bill seek to pierce the
confidentiality required to engage in negotiations with
private investment managers and could disturb the delicate
balance between public transparency and confidentiality in
managing pension assets established by SB 439, Chapter 258,
Statutes of 2005.
Related/Prior Legislation
AB 2833 (Cooley, 2016) currently under consideration in the
Senate Public Employment and Retirement Committee, would require
specified disclosures of fees and expenses that public
investment funds pay directly to the alternative investment
vehicle, the fund manager, or related parties.
SB 574 (Pan, 2015) would have required the University of
California (UC) to obtain the information required in Government
Code Section 6254.26(b) from each private equity fund, venture
fund, hedge fund, or absolute return fund in which the UC
provides or has provided funds for investment. The bill was
held in Assembly Appropriations.
SB 439 (Simitian, Chapter 258, Statutes of 2005) required the
public disclosure of some information regarding investment
performance while protecting the confidentiality of some
proprietary information.
FISCAL EFFECT: Appropriation: No Fiscal
Com.: Yes Local: No
This bill has not had a fiscal analysis.
SUPPORT:
None received
AB 2823 (Gatto) Page 10 of ?
OPPOSITION:
California Public Employees' Retirement System (Staff
Recommendation)
California State Teachers' Retirement System (Staff
Recommendation)
California School Employees Association
ARGUMENTS IN SUPPORT:
According to the author,
California pension funds generally seem to view the
definition of "alternative investment vehicle," which
"means the limited partnership, limited liability company,
or similar legal structure through which the public
investment fund invests in portfolio companies" as
providing a pretext to invoke the GC 6254.26 exemption from
disclosure for any investment that is organized as either a
partnership or limited liability company (LLC).
A theoretically important investor protection of private
equity funds is the nearly universal existence of a
so-called "clawback" provision in the limited partnership
agreement. The clawback exists so that the fund manager
(also called the "general partner" or "GP") will not
receive more than the contractually provided for 20 percent
of fund profits over its entire life. In the extreme case,
absent a clawback, there exists a risk that the GP might
receive 20 percent of the profits from early successful
investments, and then, if the later investments are
unprofitable, find that there were no net profits over the
life of the fund. As a result, the investors need to have
returned to them ("clawed back") the profits received by
the GP early on.
The problem with clawbacks is that the LPA provisions
governing them effectively never actually require the
repayment of the full amounts overpaid to the GP. Instead,
clawbacks universally allow the GP to repay only the
after-tax amount that the GP members received. In other
words, if the GP entity (which itself is usually a
partnership or an LLC, hence not a taxpayer) received $50
million more than the 20 percent of fund profits to which
AB 2823 (Gatto) Page 11 of ?
it was entitled over the course of the fund life, then it
would only return to the fund investors an amount, perhaps
$35 million, that reflected how much the natural person
partners of the GP actually received from the overpayment
after accounting for having paid taxes on each person's
share of the $50 million.
The author also asserts that LPA provisions may limit how much
GPs must actually return to LPs under clawbacks and describes
possible manipulations of partnership tax treatments and
clawback forgiveness provisions given in exchange for promised
participation rights in subsequent investment vehicles that
essentially render clawback provisions of limited utility.
Thus, the author argues,
There is clear harm to the public interest that results
from clawback provisions of LPAs remaining exempt from
disclosure pursuant to PRA request. As such, it makes
sense to consider an amendment to the language of
6254.26(b), where the portions of alternative investment
agreements related to the GPs clawback obligation would be
a public record if the agreement allows the GP to satisfy
the clawback in full by repaying less than the full amount
of the overpayment the GP received. The portions of an
alternative investment agreement that is disclosed pursuant
to such a change in law should include not only the
clawback provision itself but also all parts of the
document that contain either the definition of terms used
or are otherwise referenced in the clawback provision.
ARGUMENTS IN OPPOSITION:
Executive staff at both CalPERS and CalSTRS have communicated to
the committee staff significant concerns regarding AB 2823.
First, because the bill was substantially amended to be a new
bill less than a week before the committee hearing to add the
current provisions, both systems are unable to provide a board
position in such a short time frame. Nevertheless, the funds'
staff indicate that they would recommend to their respective
boards that the boards adopt official "oppose" positions on the
bill.
According to CalPERS,
The passage of AB 2823 would have an adverse impact on
AB 2823 (Gatto) Page 12 of ?
CalPERS' ability to administer its investment fund on behalf
of its members.
The required release of the provisions described
in the bill might limit the alternative investment
options available to California public retirement funds,
as some alternative investment funds might refuse to
allow the required disclosures. Lost investment
opportunities could make it more difficult for CalPERS
to meet its expected rate of return, which could affect
employer (state, school district, and local agency)
contribution rates.
Imposing these requirements on California public
retirement funds would put those systems at a
competitive disadvantage compared with other states and
investors that do not have these requirements. Any such
requirements should be implemented through uniform
national disclosure requirements.
Without private equity in our portfolio the
expected rate of return of 7.5 percent would be reduced
to an estimated 7.2 percent to 6.8 percent. This
translates into an estimated increase in state
contributions of between $.7 billion (using an expected
rate of return of 7.2 percent) to $1.7 billion (using an
expected rate of return of 6.8 percent). School
districts and local agencies would also be impacted.
According to CalSTRS,
We are concerned that disclosure of specific
agreements and related documents could affect our ability
to invest assets and earn the return required to fund
pension benefits and stabilize contribution rates. As I
am sure you are aware, decreased investment returns mean
increased funding from school district and community
college employers, the State of California and ultimately
taxpayers. Over the last 10 years, the CalSTRS Private
Equity asset class had a 10.7 percent return as of
December 31, 2015, and was the highest returning asset
class by far. By contrast, the second highest earning
asset class was Global Equity with a 5.9 percent return
during this same period.
AB 2823 (Gatto) Page 13 of ?
Because this bill applies to existing contracts,
requiring disclosure of information under the bill could
be inconsistent with confidentiality provisions of
current contracts. As a result, compliance with the
bill's provisions could subject CalSTRS to litigation by
fund managers.
CalSTRS supports transparency and welcomes an
opportunity to discuss related matters with the
Legislature. However, AB 2823 is moving very quickly,
prohibiting sufficient time for meaningful conversations,
including with Teachers' Retirement Board members in a
public setting, and thereby is prohibiting broad public
discourse. In contrast, AB 2833 (Cooley), which also
deals with disclosure of information in alternative
investments, has been subject to considerable discussion
over the course of this legislative year, which has
permitted the board to have a very detailed discussion of
amendments that would result in the board supporting that
bill. I ask the committee to hold AB 2823, so CalSTRS
has a chance to work with the Legislature next year to
address the issues raised by the bill without impairing
our ability to prudently invest CalSTRS assets, and also
to permit our governing body to weigh in on the bill.