New California Law Requires Public Pension and Retirement Systems to Disclose Compensation and Expenses

Investment Funds, Advisers and Derivatives Update

Under a new California law (AB 28331), starting January 1, 2017, each California public pension and retirement system, including that of the University of California, must require vehicles in which the system has made "alternative investments" to provide certain information related to those alternative investments, including information regarding fees and expenses borne directly or indirectly by the system, and investment performance. Each California public pension and retirement system must also disclose this information, at least annually, at a public meeting. Under the new law, an "alternative investment" is an investment in a private equity fund, venture fund, hedge fund or absolute return fund.

The new disclosure requirements apply to all new contracts that a California public pension or retirement system enters into (e.g., fund subscriptions) on or after January 1, 2017 and to all existing contracts pursuant to which a California public pension or retirement system makes a new capital commitment on or after that date. For "grandfathered" investments (i.e., existing investments for which the public pension or retirement system has not made a new capital commitment on or after January 1, 2017), the law requires the public pension or retirement system to undertake "reasonable" efforts to obtain the same information that it is required to obtain from non-grandfathered investment vehicles and to comply with the same public reporting requirements for any such information it obtains.

Here are the types of information that California public pension and retirement systems (which the law refers to as "public investment funds") must obtain from each of their alternative investment vehicles (other than grandfathered investments) and publicly disclose at least annually:

• the fees and expenses the public investment fund pays directly to the alternative investment vehicle, the manager of the vehicle or "related parties";
• the public investment fund's pro rata share of other fees and expenses that are paid from the alternative investment vehicle to the vehicle's manager or related parties;
• the public investment fund's pro rata share of carried interest to the alternative investment vehicle manager or related parties;
• the public investment fund's pro rata share of aggregate fees and expenses paid by all of the portfolio companies held with the alternative investment vehicle to the alternative investment vehicle manager or related parties;
• the gross and net rate of return of each alternative investment vehicle since inception; and
• certain additional information on each alternative investment that, until now, has generally been subject to mandatory public disclosure only if someone requests it under the California Public Records Act.2

A public investment fund may report the required information based on its own calculations or based on calculations the alternative investment vehicle provides to it.

Under the new law, fees and expenses borne by a public investment fund through an alternative investment vehicle are subject to disclosure if they are paid to the manager of the vehicle or to any "related party" of the manager. The definition of a "related party" is broad and multi-layered, and includes:

• Any "related person," which means "any current or former employee, manager or partner of any related entity that is involved in the investment activities or accounting and valuation functions of a 'relevant entity' or any of their respective family members."
  • "Relevant entity" means "the general partner, any separate carry vehicle, the investor [sic] advisor, any of the investment advisor's parent or subsidiary entities, or any similar entity related to any other alternative investment vehicle, account, or fund advised or managed by any current or former related person.
• Any "operational person," which means "any operational partner, senior advisor or other consultant or employee whose primary activity for a relevant entity is to provide operational or back-office support to any portfolio company of any alternative investment vehicle, account or fund managed by a related person."
• "Any entity more than 10 percent of the ownership of which is held, directly or indirectly, whether through entities or trusts, by a related person or an operational person regardless if the related person or operational person participates in the carried interest received by the general partner or the special limited partner."
• "Any consulting, legal or other service provider regularly engaged by portfolio companies of an alternative investment vehicle, account or fund managed by a related person and that also provides advice or services to any related person or relevant entity."

Alternative investment vehicle managers should expect to receive requests from California pension and retirement systems for special contractual provisions in new subscription documents and side letters, as well as requests from existing California pension and retirement system investors in support of the new law's "reasonable efforts" requirement as to grandfathered investments.

The scope of these disclosure obligations may have surprising implications for managers of alternative investment vehicles that admit California public retirement and pension systems as investors. For example:

• If an alternative investment vehicle's manager (or a related party) engages an independent law firm or other service provider for itself, and also regularly engages that firm or other service provider for the alternative investment vehicle's portfolio companies (as is frequently the case for private equity and venture capital funds), the public investment fund's share of any fees and expenses paid to the firm or service provider by those portfolio companies is likely to be subject to disclosure.
• If the manager of an alternative investment vehicle (or a related party) pays a fee or expense on behalf of the alternative investment vehicle and then seeks reimbursement of that fee or expense from the alternative investment vehicle (as is frequently the case for fund organizational expenses), the public investment fund's share of that fee or expense is presumably subject to disclosure, even though it would not be if the alternative investment vehicle paid the fee or expense directly.