Assembly Bill 2833 passed by the California legislature and signed into law by Governor Jerry Brown went into effect January 1, 2017, as California Government Code Section 7514.7 (“Section 7514.7”). It received wide support in the California legislature. The express purpose of the law is to “increase the transparency of fees paid by public investment funds to alternative investment vehicles.” In other words, because the fees paid to alternative investment vehicles reduce returns, public investment fund trustees need to be able to see and understand all of the fees they are charged.
As enacted, Section 7514.7 requires annual public disclosure of the fees, expenses and carried interest, among other costs, paid by California’s public investment funds (i.e., state and local public pension and retirement systems) to private equity funds, hedge funds, venture funds, other alternative investment vehicles (“Private Funds”) and their fund managers. Significantly, as explained below, Section 7514.7 goes even further than any existing California law or that of any other state in expressly requiring such disclosure (i) at the portfolio company level and (ii) across “related parties” of the Private Funds. All California public investment funds, including CalPERS, CalSTRS, the University of California Retirement System and all county- and city-level plans (“California Plans”) will be affected as well as all Private Funds in which such California Plans are invested, their fund managers and their related parties.
The new disclosure requirements apply to all Private Fund investments made by California Plans after January 1, 2017. This covers not only new investments with Private Funds, but also any new capital commitments (i.e., commitment increases) to Private Funds that closed prior to January 1, 2017. With respect to all other investment contracts entered into prior to January 1, 2017, such California Pans will be required to undertake “reasonable efforts” to comply with the new disclosure obligations.
Existing California Public Disclosure Requirements
Under the California Public Records Act (Cal. Gov’t Code § 6250 et seq.), which existed prior to the new disclosure requirements (and now continues in effect along with Section 7514.7), California Plans are required to disclose the following information relating to their investments in Private Funds:
- The name, address and vintage year of each alternative investment fund;
- The amount of the investment made in each alternative investment fund by the California Plan since inception;
- The amount of cash contributions made by the California Plan to each alternative investment fund since inception;
- The amount of cash distributions received by the California Plan from each alternative investment fund;
- The amount of cash distributions received by the California Plan plus the remaining value of partnership assets attributable to the California Plan’s investment in each alternative investment fund;
- The net internal rate of return of each alternative investment fund since inception;
- The investment multiple of each alternative investment fund since inception;
- The amount of the total management fees and costs paid on an annual fiscal year-end basis by the California Plan to each alternative investment fund; and
- The dollar amount of cash profit received by the California Plan from each alternative investment fund on a fiscal year-end basis.
Section 7514.7 maintains the mandate under the California Public Records Act to disclose the above information and clarifies that disclosure must occur at least once annually at a meeting open to the public. In addition, California Plans will be required to make the following new disclosures at such annual public meetings:
- The fees and expenses that the California Plan pays directly to the alternative investment fund, the fund manager or related parties;
- The California Plan’s pro rata share of any fees and expenses paid by the alternative investment fund to its manager and related parties;
- The California Plan’s pro rata share of carried interest distributed to the alternative investment fund’s manager and related parties;
- The California Plan’s pro rata share of aggregate fees and expenses paid to the alternative investment fund’s manager or related parties by all of the portfolio companies held by the alternative investment fund (e.g., transaction and other offset fees); and
- The gross and net rate of return of each alternative investment fund, since inception, in which the California Plan is invested.
“Related party” is defined broadly to include:
- Any “related person” (in turn defined as 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 the relevant entity or any of their respective family members”);
- Any operational person;
- Any entity more than 10 percent of the ownership of which is held directly or indirectly, whether through other entities or trusts, by a related person or 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; and
- 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.
“Carried interest” is also defined broadly to include “any share of profits from an alternative investment vehicle that is distributed to a fund manager, general partner, or related parties, including allocations of alternative investment vehicle profits received by a fund manager in consideration of having waived fees that it might otherwise have been entitled to receive.” A California Plan may independently calculate the value of the fees paid by a Private Fund to the fund manager and related parties and the gross and net rate of return figures, based on information provided by the Private Fund.
Compliance with the disclosure requirements in Section 7514.7 are providing significant challenges due to the scope and breadth of the categories of fees that may be paid to or from Private Funds, their fund managers, operational persons and related parties. While the new law applies to affiliates of a Private Fund and its fund managers as well as operational persons whose primary activity is to provide operational or back office support to any portfolio company of any Private Fund, it also applies to any consulting, legal or other service provider regularly engaged by a Private Fund’s portfolio companies if that service provider also provides advice or services to any related persons or relevant entity. Accordingly, a broad range of operational personnel and service providers (lawyers, accountants, tax professionals, etc.) may fall within the reporting requirements of Section 7514.7 if they regularly provide services to a Private Fund and its portfolio companies.
In complying with the new law, Private Funds that wish to do business with California Plans are faced with disclosing information that has traditionally been considered confidential trade secrets. As a result, some managers of Private Funds may be less willing to accept capital from California Plans. This could put California Plans at a disadvantage when seeking to invest in certain highly sought-after Private Funds. The legislative history for Section 7514.7 cites similar concerns expressed by some of the very pension plans it is intended to protect. That said, however, California is home to some of the largest and most influential pension plans, and, therefore, predicting a chill on Private Funds seeking to raise capital from California Plans is premature.
In other recent efforts to increase transparency regarding the fees paid to Private Funds and their managers, the Institutional Limited Partners Association (“ILPA”) published its fee reporting template earlier this year, which provides for the disclosure of numerous line item revenue and expense figures to allow limited partners to better track their investments. Before Section 7514.7 was proposed, ILPA’s chief executive officer remarked that general partners should adopt use of its fee reporting template or regulators would get involved. He was not wrong. In addition to California, other states, including Alabama, Kentucky, New Jersey and Rhode Island, have considered similar legislation that mandates additional disclosures. The push for increased transparency does not appear to be slowing. If and when other states follow California’s lead, fund managers may end up being subject to a patchwork of varying (and potentially inconsistent) state law disclosure requirements. This concern may incentivize more widespread use of the ILPA fee reporting template among general partners.
By mandating the publication of returns achieved by Private Funds as well expenses, Section 7514.7 aims to provide the public with access to balanced information, allowing them to develop informed opinions regarding the cost and performance of Private Funds and the relative benefit such fund investments provide to California Plans and their participants. Implementation of the disclosures required by Section 7514.7 may have the effect of limiting the participation by certain California Plans in some of the most desirable and highest grossing investment opportunities.
Efforts within the alternative investment fund industry are underway to propose clarifying regulations for Section 7514.7, including among other things, the full implications of the extension of the disclosure rules to professional service providers. While the full implications of Section 7514.7 are yet to be determined, Private Funds should be prepared to address disclosure requirements under Section 7514.7 when accepting capital commitments from California Plans.