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.