On September 14, 2016, California Governor Jerry Brown signed Assembly Bill No. 2833. The new law obligates every California public investment fund to require alternative investment vehicles (“AIVs”) to make annual disclosures about the public fund’s share of fees, expenses and carried interest, among other things. The public fund investor must then disclose the information received and the gross and net rates of return of each AIV annually at a public meeting. AB 2833 applies to any new investment contracts signed on and after January 1, 2017, and to existing contracts for which any new capital commitments are made on or after that date.

In this Client Alert, we review the key new disclosure requirements and anticipate some issues clients may face when attempting to comply with the new law.

Summary

AB 2833 describes fee and expense information as data that public fund trustees need in order to fulfill their fiduciary duty to maximize returns, given that fees and expenses reduce gross returns needed to pay benefits.

AB 2833’s catch-all phrase, “alternative investment vehicles,” seeks to sweep in all of the legal entity structures operating as private equity funds, venture funds, hedge funds and absolute return funds. Under the law, a California public pension fund investor must require the AIVs in which it invests to disclose the following data, at least annually, and must itself disclose the information received in a report presented at a public meeting, also at least annually:

1. The fees and expenses the investor pays directly to the AIV, the fund manager or related parties.
2. The investor’s pro rata share of fees and expenses not included in (1) above that are paid from the AIV to the fund managers or related parties. (Note: The new law provides that an AIV may avoid having to report this particular data if the investor independently calculates this information based on “information contractually required” from the AIV.)
3. The investor’s pro rata share of carried interest distributed to the fund manager or related parties.
4. The investor’s pro rata share of aggregate fees and expenses paid by all of the portfolio companies held by the AIV to the fund manager or related parties.
5. Any additional information described in subsection (b) of section 6254.26. (This is the provision of the California Public Records Act that prevents disclosure of some, but not all, proprietary data relating to AIVs in which public agencies invest.)

The public fund’s annual report must also include the gross and net rate of return since inception for each AIV in which the public fund participates, which may be “based on its own calculations or based on calculations provided by the [AIV]”.

Finally, California funds must make “reasonable efforts” to obtain all of the same information from AIVs with whom they are currently under contract, and to which no new capital is to be committed.

Issues

AB 2833, though well-intentioned, arguably has all of the flaws of rules-based regulations (as compared with principles-based regulations): It imposes detailed requirements on public fund trustees without making clear how these requirements should apply. In some cases, the new law uses rather imprecise terms (e.g., addressing carried interest that is “distributed” to the fund manager or related parties, which ignores that carried interest may be allocated without being “distributed” and may, in some cases, be clawed back). In other cases, there is no clear connection between the desired disclosure and the policy goal of the statute (e.g., a pro rata share of carried interest is typically not an accurate way to describe or calculate the carried interest borne by an individual AIV investor).

AB 2833’s definitions section also is problematic. In addition to the ambiguity in the definition of “alternative investment vehicle” noted above, the definitions of “fund manager,” “related party,” “related person,” “operational person” and “relevant entity” are circular in such a way as to make the scope of required disclosures unclear. These definitions also contain similar sounding but undefined terms, such as “related entity” and “investment advisor,” which exacerbates the struggle to discern the statute’s intended scope. The definition of “gross rate of return” as the “internal rate of return” before fees and expenses is arguably too vague and, as to hedge and absolute return funds, inapplicable. These funds typically measure performance as changes to net asset value and not as an internal rate of return.

Implementation of AB 2833 will raise a number of additional questions:

• Will separately managed accounts and non-public real estate investments be considered AIVs? Most public funds have treated them as such under the analogous California Public Records Act provisions referenced in this legislation. With the law now imposing new disclosure requirements, what was once a shield now becomes a sword, which could make the public fund a less attractive investor.
• Will successful managers whose funds are typically oversubscribed avoid accepting California public funds as investors? This is a serious concern because many public funds are relying on private equity’s projected long-term premium returns in order to achieve their funding goals. If California funds alone seek to impose sensitive disclosure requirements on these managers, query whether the managers will seek investment capital from other less demanding investors. Foreclosure of this critical investment market at this point in the business cycle could present significant new funding challenges to California public pension funds.
• AB 2833 arguably lacks parity. There are other types of pooled investment vehicles, including mutual funds, to which no similar disclosure requirements apply. While mutual funds are required by federal law to disclose fees, expenses and net performance, they are not required to do so on an investor-by-investor basis; and individual returns can vary widely based on cash flow and other details. The new law’s increased burdens cannot be justified solely by the conflicts of interest and objectionable conduct highlighted in recent SEC enforcement cases against private funds. There is also a history of SEC enforcement cases against mutual funds for conflicts of interest and misuse of fund assets, such as the 12b-1 fee abuses charged in the mid-2000s.
• AB 2833 arguably removes pension fund trustees’ latitude in delegating responsibility to staff to design reporting procedures to best meet their board’s unique needs.
• AB 2833 appears to track some, but not all, of the reporting requirements found in the fee disclosure template promulgated by the Institutional Limited Partners Association (“ILPA”). Many managers are just now reconciling themselves to the ILPA regime; another imposed set of definitions and obligations may increase, not control or decrease, management fees charged by AIVs.
• Public funds will need to determine how to meet the “reasonable efforts” test for seeking the same level of fee disclosures from current AIVs. Will it be enough to request the information once? Must a fund offer to pay the AIV to develop and report the required information? AB 2833 affords no guidance on what is “reasonable.”
• AB 2833 contains no enforcement mechanism – no “or else” – for failing to obtain the desired information.
• Unlike several predecessor laws that sought to impose policy requirements on public pension funds (e.g., divestment from companies doing business in Iran and the Sudan, thermal coal producers), AB 2833 fails to harmonize its requirements with the fiduciary duties of public pension fund trustees. Must trustees forgo valuable, diversified investment opportunities if the managers refuse to disclose the information required by AB 2833? And, if so, will that violate the “prudent investor” rule?

Conclusion

AB 2833 was motivated by good intentions, to bring transparency to an opaque market in which hundreds of millions of public dollars are invested annually. Taking steps to determine how much and what kind of fees and expenses are being deducted from gross returns is clearly consistent with the fiduciary duty of public fund trustees. Implementation of this law’s mandate, however, raises as many issues as it answers, and may prompt some later mid-course adjustments, much as did the predecessor placement agent disclosure statute passed in 2010. Meanwhile, we are not expecting the market reaction to the new California disclosure regime to be a welcome one. Whether this new “sunshine in government” law will shine useful light on the opaque world of private equity and hedge fund fees, or will instead drive investment managers away from California public investors, remains to be seen.

Client Alert 2016-263