Squaring the letter of California's new fee disclosure law with the realities of alternative investment funds

In September, California enacted a law intended to provide transparency with respect to the fees and expenses paid by California public pension or retirement systems to private equity funds, venture funds, hedge funds and absolute-return funds in which they invest. The law goes into effect Jan. 1, and applies to all new contracts, including subscription agreements, between a public pension plan and a private fund entered into after that time. The pension plans also are required to undertake “reasonable efforts” to obtain information required by the law for contracts entered into with private funds before that date.

An existing California disclosure law, the California Public Records Act, already requires that public pension plans, upon request, provide some basic disclosures on the private funds in which they invest, including cash contributions made by the pension plan to the private fund, cash distributions received by the pension plan from the private fund, net internal rate of return and investment multiple of the private fund, and the dollar amount of management fees and costs paid by the pension plan to the private fund. In addition to the information required to be disclosed under the CPRA, the new disclosure law also mandates that a public pension fund obtain from the private funds in which it invests certain information with respect to fees and expenses paid directly and indirectly by the plan to the investment fund, the fund manager and related parties. Specifically, the law calls for disclosure by the public retirement plan at least once annually in a report presented at a meeting open to the public of the following:

• fees and expenses the public pension plan pays directly to the private fund, the fund manager and related parties;

• the public plan's pro rata share of fees and expenses not included in (1) above that are paid from the private fund to the fund manager or related parties;

• the public plan's pro rata share of carried interest distributed to the fund manager or related parties;

• the pension plan's pro rata share of aggregate fees and expenses paid by all portfolio companies held within the private fund to the fund manager or related parties;

• any additional information from the CPRA; and

• gross and net rates of return of the private fund since inception.

Executives at public pension plans and private fund managers alike are starting to grapple with the application of the disclosure law. In doing so, it is becoming clear that implementation of the new law will raise a number of interpretive issues, given its sweeping wording and one-size-fits-all approach.

Initial drafts applied the legislation only to “private equity.” This was later revised to “alternative investments,” a broader term also used in the CPRA, and which is defined as “private equity funds, venture funds, hedge funds or absolute-return funds.” Notably, the definition does not include a catchall covering “all other similar funds.” Moreover, the term “private equity fund” is not defined. Accordingly, sponsors of special situations funds, real estate funds, credit funds, royalty funds, natural resources funds, energy funds, infrastructure funds and funds of funds may argue that on its face the disclosure law does not apply to them. Given the legislative intent and the fact that the CPRA has been applied to one or more of these strategies by public pension plans in the past, it is not clear this argument will be persuasive.

The concept of “related party” is extremely broad and somewhat unclear. For example, it encompasses “related persons,” which is defined in terms of the relationship of certain persons to “related entities.” However, since the term “related entity” is not defined, it will be necessary for public pension plans and investment managers to come to an agreement on what this term means. In the first instance, agreeing that it as an entity “controlled by or controlling” the manager may be appropriate. The “related parties” definition also picks up consulting, legal and other service providers regularly engaged by portfolio companies that also provide advice or service to the manager or its affiliates. “Service providers” could cover anyone from accountants to information technology specialists to caterers.

The disclosure law defines portfolio companies as individual portfolio investments made by the private fund. In the private equity context, a private fund is likely to have a limited number of investments, robust control or information rights with respect to those investments and low turnover of investments. Further consider that private equity portfolio companies may be directed into contracts requiring fees to be paid to service providers common to the sponsor and its affiliates, and the application of the law and the public policy behind it becomes relatively clear. The same cannot necessarily be said for other alternative investment strategies. For example, given the limited information rights and lack of control that a hedge fund will typically have with respect to its portfolio companies, the fund's ability to get any meaningful information on the portfolio company's dealings with service providers will be extremely limited or even non-existent. In any case, for all private funds, the information may be impossible to obtain given the ethical or other professional obligations of the service providers. Finally, although there is no materiality threshold in the disclosure law, private funds may need to negotiate for one (e.g., annual payments in excess of $25,000 by both the manager and the portfolio company to the service provider) to make compliance with the law practical.

Public pension plans are required to undertake “reasonable efforts” to obtain information required by the disclosure law for contracts entered into with private funds before Jan. 1. The new law provides no guidance on what the plans must do to meet this standard. Given the objections raised by some public pension plans to the legislation before it became law, it is unclear how hard they will push managers of current funds for information, especially because the managers in general have no legal obligation to accommodate such requests. If a pension plan does insist on information and the investment manager is not willing to provide it, a secondary sale (in private equity and venture funds) or redemption (in hedge funds), might be the only practical solution.

The disclosure law will affect all California-based public pension plans that invest in private funds and all private funds that have (or seek) public plan investors in the state.

Compliance with the law will require flexibility and pragmatism from both sides. Even when the parties are able to agree on the scope of the required disclosure, another key issue is how the cost of the disclosure will be borne. If the governing documents of the private fund allow for the cost to be charged to the fund and this is the approach the investment manager chooses to take, all investors in the fund will bear the cost of complying with the disclosure law. Otherwise, the public pension plan itself or the manager will have to bear the cost. This will be a business conversation, but given that costs have the potential to be quite substantial, the latter option is not likely one that will be embraced by investment managers.

Raj Marphatia is a partner in Ropes & Gray LLP's private investment funds practice and the co-managing partner of the firm's Silicon Valley and San Francisco offices; Catherine Skulan is a counsel in Ropes & Gray's private investment funds practice.