California funds feel private equity shock

New transparency requirements and a seller's market for private equity investments are putting California public pension funds at a disadvantage when seeking to invest.

CalSTRS and the Los Angeles Fire & Police Pension Plan are just two of the asset owners whose general partners have declined to accept their commitments, citing the state's new law. The law requires all public pension plans in the state to obtain information about private fund fees and expenses, and to make that information public.

"We've lost three opportunities," said Christopher J. Ailman, chief investment officer of the $222.5 billion California State Teachers' Retirement System, West Sacramento, in an interview.

The situation is being aggravated by the enormous amount of money chasing the asset class, as investors look to alternative investments to produce returns not expected to be delivered by traditional asset classes.

"We are in an environment where the very best funds can pick and choose their investors. And some of the best funds don't want to deal with additional reporting complexity or negotiation," said David Fann, New York-based co-founder, president and CEO of alternative investment consulting firm ​ TorreyCove Capital Partners LLC.

California is not the only state that passed an alternative investment transparency bill.

Washington and, as of last year, Virginia also have transparency laws. Colorado took a baby step in the direction of transparency as part of a pension reform bill passed May 9.

The bill, which awaits the signature of Gov. John Wright Hickenlooper Jr., requires the $49 billion Colorado Public Employees' Retirement Association, Denver, to share details of its private equity and real estate investments with a new legislative oversight subcommittee unless confidentiality considerations prohibit the disclosure.

Other states have tried but failed to pass transparency legislation for their pension funds alternative investments. A tough 2016 Illinois bill passed the Senate but failed to pass the state house before the legislative session ended.

The only nationwide effort is the Institutional Limited Partners Association's voluntary reporting template for fees, expenses and carried interest, first launched in 2016. The Washington-based investor organization in March 2017 launched phase two, which includes identifying best practices for implementation of its fee and expense reporting template.

California's law further narrows the state's public pension plans' choices of private asset managers. For years, public pension plans in the state have had far less access to venture capital than asset owners outside the state and outside the U.S. because of general partners' concerns that information, including investment details and portfolio company data, would be made public.

This is not the first time public pension plans have encountered alternative investment managers refusing their capital. Public pension plans across the U.S., starting in 2004, were shut out of venture capital funds because of managers' concerns that proprietary data would be revealed.

In response, some states took action to limit public assess to alternative investment information. For example, in 2004, Colorado passed legislation "developed by the venture capital industry" that designates information on private equity, private debt and timber investments of PERA as confidential until the transaction is completed, if pension plan officials decide that disclosing the information "would jeopardize the investment's value," according to the plan's 2004 comprehensive annual financial report.

Asset owners not bound by mandatory reporting requirements are not having the same problems as the California funds.

During a panel at the Milken Institute Global Conference, April 29 to May 2 in Beverly Hills, Calif., Nick Moakes, chief investment officer of the £20.9 billion ($28.4 billion) Wellcome Trust, a biomedical research charity in London, said the trust has "deep relationships" with venture capital firms in Silicon Valley that give it access to the managers' funds even at a time when a wave of capital is chasing alternative investment strategies. "CalPERS and CalSTRS can't get into those (venture capital) funds," Mr. Ailman, who spoke on the same panel, said later in an interview.

The California law's requirements, including disclosure of alternative investments' fees and expenses, are mandatory for contracts entered — and new commitments on existing contracts made — after Jan. 1, 2017, but are optional for earlier commitments.

Few private equity managers have shown much enthusiasm for the increased transparency. CalSTRS' disclosure report, released in March, covers the 22 new commitments made between Jan. 1 and June 30, 2017, but applies to the pension fund's fiscal year. There was substantially less information for the 353 older commitments. General partners of the remaining, older commitments provided limited and inconsistent data, according to a report for CalSTRS' March 28 board meeting. Some information was missing because there were questions whether CalSTRS was authorized to make the data public, the report said.

Tom Lopez, chief investment officer of the Los Angeles Fire & Police Pension Plan, said the $22.2 billion plan has lost out on two private equity investment opportunities since the law went into effect, and he expects more private equity managers to turn their backs on the state's public pension plans.

While Mr, Lopez declined to name the managers, he said the Los Angeles Fire & Police Pension Plan was the only California-based public pension plan that would have been in one of the funds, which made declining the pension plan's commitment an easy decision. The other general partner had more capital commitments than it needed and so chose not to accept LAFPP's capital because of the disclosure requirement.

Pension officials had a close call with a third fund, he said. That fund also was oversubscribed, but the fact that the pension plan had invested in several of the manager's previous funds "tilted the scales" in the pension plan's favor, Mr. Lopez said.

Mr. Lopez added he expects other managers to decline the pension fund's money "down the road."

"It will happen again," he said. "We had a close call with a firm that we had been with for several funds and they almost did not let us in."

Officials at the $351 billion California Public Employees' Retirement System, Sacramento, said it has had no trouble accessing alternative investment funds since the law went into effect. For starters, CalPERS has been asking for some fee and expense information for a few years. In 2015, it launched a new system to track its existing investments, including carried interest. What's more, CalPERS included fees and expenses as part of its overall contributions and distributions numbers, because limited partners rarely pay fees and expenses directly to the GP but those costs are either deducted from distributions or are included as part of the LPs contributions.

CalPERS released its first report under the state's transparency law in December. CalPERS' report included real assets along with private equity and other alternative investments in a move to err on the side of disclosure, Wylie Tollette, then-chief operating investment officer told the investment committee at its Dec. 18 meeting.

When asked by Betty T. Yee, California state controller and CalPERS board member, about the reaction to the disclosure law from general partners, Mr. Tollette explained the process but did not answer the question. (Mr. Tollette left the fund in January.) CalPERS staff is speaking with other public pension plans in the state to come up with more standardized reports because there are ambiguities in the law, including whether it covers real assets, Mr. Tollette said.

While Marina del Rey, Calif-based alternative investment consulting firm Cliffwater LLC's clients haven't had problems as a result of the transparency law thus far, "the jury is still out," CEO Stephen Nesbitt said.

"We expect some bumps in the road ahead," Mr. Nesbitt said in an email.