On this episode of Ropes & Gray's California Law for Asset Managers podcast series, asset management counsel Catherine Skulan and Chelsea Childs provide an overview of California's fee disclosure law, its implications in connection with fundraising with California pension plans and how the market has responded and adapted to the law since its enactment over five years ago.
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Transcript:
Catherine Skulan: Hello, and welcome to another installment of our Ropes & Gray podcast series on California Law for Asset Managers. I'm Catherine Skulan, and I'm joined again today by Chelsea Childs-we are counsel in the Ropes & Gray asset management group in San Francisco.
Today, let's speak about California's Fee Disclosure Law, codified in Section 7514.7 of the California Government Code. This law requires California public pension or retirement systems to obtain and publicly disclose information on fees, expenses, and carried interest paid to alternative investment vehicles in which they invest. We frequently advise clients on the implications of this law in connection with fundraising with California pension plans, including those at the state, county and city level, as well as the University of California Retirement Systems.
Chelsea Childs: Yes, and we spoke in our last installment of this series about how California's lobbying laws impact the fundraising efforts of asset managers, and understanding the Fee Disclosure Law is another important topic for asset managers who have, or who are interested in having, California pension plans as investors. It's been over five years since the law went into effect, so this is a good opportunity to talk about not only what the law says, but also how the practice of dealing with the law has evolved since its enactment. Recall that the Fee Disclosure Law came at a time when lawmakers were scrutinizing investments by California public pensions and retirement systems-let's just call them "plans" for short-their investments in alternative investment vehicles, and the Fee Disclosure Law was a response to the perceived lack of transparency as to what plans were paying alternative asset managers.
Catherine Skulan: That's right. Consequently, now, whenever a California plan invests in an alternative investment vehicle, the plan must negotiate with the vehicle's manager to permit the plan to disclose the fees and expenses that the plan pays as part of its investment in the fund.
The Fee Disclosure Law only imposes legal obligations on plans, not on funds or managers themselves. To meet those obligations, a plan must in turn require each fund it invests in to disclose certain information to it. This information includes:
- the fees that the plan pays directly to the fund, the fund manager or related parties;
- the plan's pro rata share of the fees that are paid from the fund to the fund manager or related parties;
- the plan's pro rata share of the carried interest paid to the fund manager or related parties;
- the plan's pro rata share of the aggregate fees and expenses paid by all of the portfolio companies held by the fund to the fund manager or related parties; information that may be required to be disclosed under California Public Records Act, which is fund-level information like the name, address and vintage year of the fund, the aggregate dollar amount of commitments made to the fund; cash contributions made by, and cash distributions received by, the plan from the fund, the net internal rate of return (or IRR) of the fund since inception and investment multiple of the fund since inception; and finally
- the gross and net rate of return of the fund, again, since inception.
It's a long list, but it is also worth noting a few things that are not required to be reported under this legislation. First, the law calls for the disclosure of raw dollars, not percentage figures related to fees and expenses in connection with a plan's investment. Second, no valuation, performance or other similar information on portfolio companies is required, nor is the plan required to identify portfolio companies. Also, the law does not call for any general disclosure on partnership agreements, advisory agreements, other fund documents or information regarding other limited partners.
Chelsea Childs: Yes, and that's particularly helpful to point out. But even though the impetus for the Fee Disclosure Law was transparency on fees and compensation paid to managers, its expansive definitions mean that it ultimately requires disclosure of more than this. This point can be missed on a cursory reading of the law. The term "related party" is a good example of something that can be overlooked if managers don't dig into the definitions. Managers often assume that a "related party" means an "affiliate," when it is actually much broader than that. The term also applies to "related persons," which are current or former employees, managers or partners of a related entity that is involved in the investment, accounting or valuation functions of the general partner, the manager or the manager's parent or subsidiary entities, as well as to "operational persons"-and that's another broadly-defined term that includes any operational partner, senior advisor or other consultant primarily focused on providing operational or back office support to a portfolio company. This also includes any entity more than 10 percent held directly or indirectly by a related person or an operational person. That by itself would be quite a lot. But the most difficult part of this definition is that it also picks up any consulting, legal, or other service provider regularly engaged by portfolio companies or any fund managed by a related person and that also provides advice or services to any related person or relevant entity.
Catherine Skulan: And "service providers" could be anything from accountants to IT specialists to caterers. It would be a challenge for any fund or manager to identify all relevant service providers, and unless the fund has control rights and/or information rights with respect to the portfolio company, it will be difficult to get the necessary information from the portfolio company. In addition, certain information may be impossible to obtain given the ethical or other professional obligations of the service providers.
Chelsea Childs: We'll discuss in a moment how managers address technical issues like this in practice. But suffice it to say, when the legislation was being debated, alternative asset managers argued that the disclosure requirements were overly burdensome, unnecessary and costly to comply with. Especially given that certain disclosure obligations were often already in place, and were the result of careful negotiations between highly sophisticated parties. Most importantly, managers also worried the disclosure obligations could result in disclosure of competitively sensitive information.
Catherine Skulan: Yes, and these were points that also had some plans worried at the time. There was some opposition to the bill from plans based on concerns that high-performing managers would simply refuse to agree to the disclosure requirements and exclude plans from their funds. But ultimately, the bill passed-softened in some ways from initial drafts, enlarged in others. For example, initial drafting only had it apply to private equity funds, but this was later expanded to include hedge, venture and absolute return funds. And it's been interesting to see how managers addressed their initial concerns for fundraising with California plans under the law-in my experience, managers initially took very different approaches when it came to the Fee Disclosure Law.
Chelsea Childs: For some managers from the outset, either the continued investment from California plans was so critical, or the burdens of disclosure were viewed as minimal enough that agreeing to disclose the required information to the plan, and, in turn, allowing the plan to publish that information publicly, were viewed as an acceptable cost of continuing to do business. Side letter negotiations focused on qualifiers around information the manager would have to disclose-for example, only information that they could reasonably obtain or otherwise had available. But other managers were more cautious, particularly concerned about fee and expense information becoming public.
Catherine Skulan: For example, some managers did decide to pull back from admitting California plans into their funds because of the public disclosure concerns. Those that continued to engage with plans found that each plan board, pursuant to its interpretation of the law, determined what responses were acceptable from managers as enabling the plan to comply with the law. So, there is some variation depending on which plan is investing. Some plans developed reporting templates to make their positions clear. This could closely track the fee reporting template put out by the Institutional Limited Partners Association (or ILPA) with which the Fee Disclosure Law has much overlap, or a simplified version of that. But depending on how much a plan wants to invest in a fund, you can see some flexibility on how rigid the plan will be with respect to the reporting it requires. Some managers, in turn, also developed a reporting package to address the Fee Disclosure Law and will work hard to have that be the model agreed with all California plans in their funds. Depending on the manager and the fundraising environment, we've seen this approach meet with success.
Chelsea Childs: And it's quite standard that this information is disclosed on the plan's public-facing website. The Fee Disclosure Law only requires the relevant information to be reported at least once annually at a meeting open to the public, but plans typically push back on requests that the information not be put on the plan's website, and not agreeing to website disclosure can be a gating item to negotiations. Now, how the information is presented can vary-there is no prescribed form of reporting under the law. Most plans comply with the Fee Disclosure Law by organizing the requisite information in a consistent format, like a table where each row represents a fund the plan invests in, and each column represents a figure that is required by the Fee Disclosure Law. Other plans do not organize the data, which is a time-intensive task, and they simply disclose information in whatever form the manager provided it to the plan. The disclosure made available by these plans is informative because you can see what the manager is reporting to the plan and there is some variability on that level, as well.
Catherine Skulan: Now, the law does not mandate any particular analysis concerning information gathered, and each plan has their own approach to conducting review and analysis of the data received. Another question, though, is, "What is the public doing with this information?" It's probably fair to say that the public is not necessarily well placed to draw sharp conclusions from the information provided. As pointed out in some publications analyzing Fee Disclosure information, there is a marked lack of comparability of the data provided to the public due to lack of consistency among plans or required reporting. This is particularly interesting because a real concern when the law came out was "headline risk"-the possibility that financial information could be taken out of context by the public and reflect badly on managers. We haven't really seen this, in part, I think, because of the limited scope of comparative analysis the public can perform on the data provided.
Chelsea Childs: As one example, we can consider the difficulty of comparing data in the context of the requirement to provide the plan's pro rata share of the aggregate fees and expenses paid by all of the portfolio companies held by the fund to the fund manager or related parties. Managers are particularly concerned about the insights that might be gained from analyzing this data because it is competitively sensitive information. This information is difficult to compare because of three features. First is the issue we mentioned already-the expansive definition of "related parties," in this case, portfolio company payments to "related parties," which is difficult for managers to report consistently across the board. Second, the fact that the data is aggregated across all portfolio companies in the fund-the lack of granularity makes it difficult to manipulate the information to draw any meaningful conclusions about average fee load or similar insights. And third, the law only requires managers to provide each plan with the pro rata amount applicable to that specific plan's investment in the fund. Because private fund investments are often held simultaneously by related funds and co-investors, it is difficult to use this pro rata figure to draw conclusions about the total scale of a portfolio company fees being charged by the manager.
Catherine Skulan: It's interesting that some plans themselves appear to acknowledge that data reported under the Fee Disclosure Law doesn't really allow for apples-to-apples comparison on fees. At least one large plan, for example, has in the past cautioned against using the data in a comparative analysis given "each manager's varying interpretation of the information being requested" and lack of standardization of general partner fee reporting. Given this, you can see how some asset managers who were initially shy of engaging with California plans after the enactment of the Fee Disclosure Law might determine that the result of this disclosure is actually not so bad. Basically, the pressure to reject plans as investors decreases when there is minimal risk of being cast in a poor light compared to other managers, especially when having plan money in the investor base is otherwise attractive.
Chelsea Childs: Questions can also arise with respect to reporting beyond these fee questions. For example, another reporting requirement under the law is the IRR and the investment multiple of the fund since inception. Here, there is some murkiness as to whether the "since inception" numbers refer to the numbers since the inception of the fund or since the inception of the investor's investment in the fund. Note that under the statute, "since inception" is not defined. And on the one hand, the plain meaning of "since inception" means "since the inception of the fund." But on the other hand, this term could be interpreted as the period of time since the investor's or plan's investment. Arguably, the latter interpretation would be a more helpful form of disclosure to the investor and to the public because the reported performance would tie to the actual performance of the investor's investment as opposed to a number that could be higher or lower than the investor's performance in the fund and would depend on the results since the fund was formed. Moreover, other data required by the law refers to investor-specific data from the time of their investment. In the context of open-end funds, we've typically seen "since inception" used in relation to the investor's investment in the fund, and it's often agreed that the investor will calculate this performance based on data from the manager. So, defining the terms and expectations surrounding disclosure obligations at the outset can be very helpful in resolving these interpretive issues to the satisfaction of both parties.
Catherine Skulan: Unfortunately, that's all the time we have for today. I hope this discussion on the California Fee Disclosure Law, both with respect to its substance and subsequent handling in the industry since its enactment over five years ago has been helpful. For our listeners, please visit www.ropesgray.com for additional news and commentary about other important asset management developments as they arise. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. If you'd like to learn more about any of the topics we discussed today, or if we can help you to navigate the California Fee Disclosure Law in a more tailored way, please do not hesitate to contact us. Thanks again for listening.
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