New fee disclosure law will increase compliance requirements

Authored by Vadim Blikshteyn

Private equity and hedge fund managers impacted along with state public pension plans

Effective Jan. 1, 2017, California’s newly enacted "fee disclosure law" will significantly increase fee disclosure compliance requirements on state public pension (SPP) plans, as well as the private equity and hedge fund managers that seek their capital. The disclosure requirements are extensive in scope and very granular within certain provisions. Below are questions and answers explaining the impact of the legislation on alternative fund managers.

What types of fund groups and fund managers will be affected by these disclosure requirements?

For purposes of this law, alternative investment vehicles include venture capital, hedge, private equity or absolute return funds. The term fund manager includes any general partner, managing member, advisor or any other person with primary decision-making authority over an alternative investment vehicle or its related party investments.

Please also note that fees paid to related parties of a fund manager are required to be disclosed under this law. Related parties of a fund manager include any related person, any operational person, entities more than 10 percent owned directly or indirectly by a related person or operational person and certain regularly engaged service providers that also provide services to a related person or other relevant entities.

Related persons and operational persons include any current or former employee, owner, senior advisor and family member involved in the investment activities, valuation function or operational activities of an alternative investment vehicle.

The definition of related party was broadly defined so that fund managers and their advisors would find limited ways to circumvent the fee disclosure rules using various compensation vehicles.

What fees and expenses need to be disclosed and what SPP funds does this law cover?

SPP funds  must disclose their pro rata share of the amount of management or performance fees, carried interest allocations or expenses paid directly or indirectly to alternative investment vehicles, their fund managers and any related parties for all new contracts that require capital commitments made on or after Jan. 1, 2017. The law also requires this fee disclosure for any existing contracts with alternative funds for which an SPP fund is asked to make a new capital commitment. SPP funds can either disclose this information with calculations that they make internally or require the alternative investment vehicle provide this information to the SPP fund.

SPP funds will also be required to disclose the gross and net return they earned from each alternative investment vehicle since inception. These return and fee disclosures will be required to be made at least once annually to the public.

All California state pension or retirement funds are required to disclose this information. Notable examples include the California Public Employees' Retirement System (CalPERS) and the Los Angeles City Employees' Retirement System (LACERS).

Will this affect my existing funds that have California SPP fund investors that are not required to make any new capital commitments?

The fee disclosure law requires SPP funds to undertake reasonable efforts to obtain similar fee disclosure information from existing investments in alternative fund vehicles. It remains to be seen how vigorously SPP officials will demand this information from existing investments made prior to the enactment of this legislation. Fund managers approaching these organizations for future fund launch capital should consider being pro-active in providing the required fee disclosure information.

What should our compliance departments expect from other state jurisdictions because of this new fee disclosure law?

Several states, including Illinois, Rhode Island and Louisiana, are considering similar fee disclosure laws. Other states, including New Jersey and Alabama, had similar bills under consideration that did not pass. Executives at major state pension funds and certain alternative investment funds have called for a national approach to fee disclosures to provide more certainty about rules and standardizing disclosures.

The Institutional Limited Partners Association has come out with a template for fee disclosures for alternative fund asset managers. Elements of this template were incorporated in the fee disclosure bills of serval states, including Illinois. Certain state pension funds have already asked alternative fund asset managers to consider completing this template as their state governments are in the process of finalizing compulsory legislation that will require fee disclosures to the public.

How will this information be used by the various state agencies of California?

The primary goal of this legislation to increase transparency regarding fees and expenses paid to alternative fund managers from public pension and retirement plans. This information will likely be scrutinized by the public and government officials that represent them.

This disclosure information may also be used by state agencies like the California Franchise Tax Board to determine whether certain alternative investment managers have nexus in California and report appropriate state source income on income tax returns. In 2014, California proposed regulations that included examples for income sourcing rules for non-registered asset managers with California based investors. California already requires registered fund managers (e.g. mutual funds) to source revenue to the state that was earned from California beneficial registered fund owners. The final 2016 regulations did not include income sourcing examples for non-registered investment advisors but the state mentioned that it will publish examples for these asset managers at a later date.  With the regulations in its current form, it remains unclear whether the state can apply the same sourcing rules applicable to registered fund asset managers to that of non-registered fund managers.

The takeaway

It remains to be seen what the impact of the fee disclosure law will be on the public perception of alternative fund investments. This will also be a test of the alternative fund manager's willingness to allow SPP funds to publicly disclose sensitive information such as management fee and carried interest rates as this information will become available to their competitors. As California is the nation's largest SPP fund market, other state governments will likely implement similar legislation in the future.

For more information on this topic, or to learn how Baker Tilly’s specialists can help, contact our team.