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Illinois Pension Ethics Reform
Public Act 98-0006
IVCA strongly supports pension ethics reform to make the investment selection process more objective, competitive, transparent and performance based. IVCA provided ongoing input into the pension ethics reform debate focusing on how the pension funds gain access to private equity funds and preserving that access. Some of our suggestions were incorporated into the final bill.
Among other provisions, the law:
· requires ethics training for the funds’ Trustees and staff;
· sets forth extensive disclosure requirements;
· requires both investment consultants and advisors be selected by a competitive process that is substantially similar to the process required for the procurement of professional and artistic services under the Illinois Procurement Code (as determined by the pension funds’ Boards of Trustees);
· sets forth professional requirements for both investment consultants and advisors; and
· limits consultants’ contracts to a term of no more than five years, with the opportunity to bid for a new contract at the end of that period.
However, the new law contained a major problem area for private equity:
· Fund of funds and the Illinois Procurement Code
It did not require the selection of any other investment utilizing procurement code-type processes. For example, direct private equity funds in which the state pensions invest generally are not required to be selected under the Illinois Procurement Code because their managers typically do not fall within the definition of “investment advisors” (which is generally borrowed from ERISA and comparable state laws). However, fund of funds were subject to the Procurement Code under the new law because their managers are considered to be “investment advisors,” but for ERISA and related purposes only – and not because they offer individualized investment advice to pension funds. While this distinction may make sense for ERISA and related purposes, it did not make sense in the context of procurement and purchase issues given that it was commercially impracticable for the manager or seller of a fund of funds (a security) to tailor his or her offering to the requirements of the Procurement Code.
PA 96-1554
SB 3162, introduced in the Senate by Don Harmon and passed by a vote of 52-0 on March 12, addressed this problem by amending Public Act 096-0006 (the "Act") to exempt fund of funds managers from the Procurement Code obligations contained in Section 1-113.14(b) of the Act, while preserving the substantive and procedural protections of the Code as intended under the Act, including a written contract requirement, certain disclosures (fees etc.) and the duration of contracts.
Specifically the amendment excluded the investment by pension funds in private equity or venture capital fund of funds from the definition of "investment services," while retaining Procurement Code requirements for the engagement of more “traditional” investment advisors (providing investment services).
The bill was then taken up in the House and sponsored by Deputy Majority Leader Lou Lang. In January 2011 during the last days of the veto session of the 96th General Assembly, the House passed the IVCA-sponsored amendment as part of a much larger legislative package of budget and other miscellaneous items (SB 3087). It was signed into law (PA 96-1554) by the Governor on March 18, 2011.
Background
Investment funds that are commonly referred to as “funds of funds” are private equity funds that invest in other private investment funds. Typical private investment funds, regardless of whether they invest in operating businesses (direct private equity funds) or other private investment funds (private equity fund of funds), are managed in accordance with the investment objectives of the fund as opposed to the investment objectives of the individual investors in the fund. An investment in a fund of funds is made in the same way as an investment in any other private equity fund or venture capital fund. In the usual case, appropriate representatives of a Government Plan would receive a private investment fund’s offering documents (generally consisting of a private placement memorandum, a copy of the “fund agreement” (e.g., limited partnership agreement), and subscription materials (i.e., subscription agreement and investor qualification statement) and other relevant information regarding the fund).
The representatives of the Government Plan (or the Government Plan’s “investment adviser” or “consultant” within the meaning of the Pension Code) would review the offering documents and determine whether an investment in the fund is an appropriate investment for the Government Plan, and if so, would also consider the amount of capital that the Government Plan will invest in the fund. A representative of the Government Plan would then do the following: (a) complete the investor qualification statement confirming the Government Plan’s eligibility to invest in the fund, (b) complete the subscription agreement signature page indicating the amount the Government Plan is investing in the fund, and (c) sign the fund agreement by which the Government Plan becomes a limited partner or member of the fund.
When a Government Plan invests in a private investment fund, it commits a specified amount of capital to the fund in exchange for an interest in the fund (usually a limited partnership interest). The fund draws capital from all of its investors and invests this pooled capital -- in the case of private equity funds of funds, a fund invests its capital in a number of other private investment funds; in the case of other private equity funds and venture capital funds, a fund invests its capital in operating businesses. As noted above, a typical private investment fund’s investment decisions—whether the fund’s investments are in other private investment funds or in operating companies—are made in accordance with the fund’s investment objectives and not those of the individual investors in the fund.
Q. Why should a "fund of funds" investment get an exemption from the
A. The protections provided by the 2009 amendments to the Illinois Pension Code were designed to apply when an investment adviser or consultant provides investment advisory services to a Government Plan on an individualized basis to assist the Government Plan in making investments to meet its individualized goals and objectives, and is well crafted for those purposes. These intermediaries provide individualized investment advice to the Government Plans and work with the Government Plans to set objectives for investment portfolio management (mix of investments, performance objectives, balancing risk relative to returns, etc). These investment advisers and consultants then recommend to their clients that they invest in assets that will help them achieve their goals. Thus, an investment adviser or consultant might recommend that a pension fund invest in private equity fund of funds and, if that recommendation is accepted, specifically identify fund of funds in which to invest.
In contrast, the 2009 Pension Fund law did not have clear application to investments by Government Plans in typical private equity funds, which are not intermediaries, but rather manage a pool of assets in accordance with the investment objectives of the fund and not the investment objectives of any specific investor. A Government Plan’s decision to participate in a private equity fund (whether the private equity fund invests in operating businesses (direct funds) or other private investment funds (fund of funds)), just like its decision to buy stock or invest in a mutual fund, is an investment decision, rather than an engagement of services. It does not include engaging an advisor to provide individualized services. As a result, a Government Plan’s investment in private equity funds, including private equity fund of funds, should not be subject to a procurement process substantially similar to Section 35 of the Procurement Code or to the Section 1-113.14(c) contract requirements.
Q. Isn’t a "fund of funds" an investment vehicle? Isn’t there someone who manages and handles the fund of funds? Why should these criteria not apply to the person or company that manages a fund of funds for a pension system?
A. A fund of funds is collective investment vehicle which pools the investments of investors (commonly referred to as limited partners, such as pension funds, other institutional investors, and individuals) and is managed by a general partner (the venture capital or private equity firm offering the fund of funds, which is often also an investor in the fund of funds). The manager of a fund of funds manages the investments of the fund of funds similar to the way in which sponsors of a mutual fund make the investment decisions for their mutual fund. The manager of a fund of funds seeks to maximize returns for all investors in the fund of funds, but does not customize or tailor investment decisions to the needs of any single investor. Unlike the investment adviser to a pension fund or other investor, the investment decisions that are made by the general partner of a fund of funds are not focused on the investment objectives of any single investor. The 2009 Pension Fund law did not require the use of the Procurement Code for investments by Government Plans in investment vehicles other than private equity fund of funds; rather it is principally focused on intermediaries who advise the Government Plans in making investment decisions.
Q. How is the provision of a private equity "fund of funds" different than the provision for investment in a mutual fund by a pension system? Someone still gets paid to manage it as a service to the system, correct?
A. Mutual funds and private equity funds of funds have different investment objectives and styles, but share one important attribute – they are managed for the benefit of all investors collectively and are not adapted to the needs of any single investor. All investors are subject to substantially the same terms and conditions set by the mutual fund and invest accordingly. The same principles apply to private equity funds of funds. Similarly, both mutual funds and private equity fund of funds charge fees (to be paid to the manager of the funds), however, these fees are typically paid from the assets of the fund itself (i.e., are a feature of the investment), rather than being an obligation in addition to the amount of the Government Plan’s investment (which is more typical in a traditional investment advisory relationship and similar individualized service arrangements). The purchase of mutual funds is not subject to the provisions of the new law, and purchases of interests in fund of funds should not be subject to those provisions either.