BILL ANALYSIS                                                                                                                                                                                                    



          SENATE COMMITTEE ON
          PUBLIC EMPLOYMENT AND RETIREMENT
                               Dr. Richard Pan, Chair
                                2015 - 2016  Regular 

          Bill No:            AB 2823         Hearing Date:     6/27/16
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          |Author:    |Gatto                                                |
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          |Version:   |6/21/16    As amended                                |
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          |Urgency:   |No                     |Fiscal:    |Yes              |
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          |Consultant:|Glenn Miles                                          |
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          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  







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            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  








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               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  








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               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'  








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          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  








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               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  








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               "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'  








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               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  








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               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








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          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  








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               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  








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             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.









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                     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.