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.

Two potential problem areas for private equity

• Fund of funds and the Illinois Procurement Code

The new law correctly excludes from the definition of consultant "investment fund of funds where the board has no direct contractual relationship with the investment advisors or partnerships." It does not, however, provide a similar exclusion from the definition of investment adviser with regard to investment fund of funds. Under the new law investment advisors when they function as managers or sellers of fund of funds are required to be selected in a manner "substantially similar to the process required for the procurement of professional and artistic services under Article 35 of the Illinois Procurement Code” even though they are really offering securities, rather than providing services.

If left unchanged, fund of funds likely will not be able to accept state pension funds' investments since they cannot feasibly sell their funds through the Procurement Code.

Both direct funds and fund of funds offer securities as part of a collective investment vehicle allowing the risk of investment (and the ability to build a portfolio) to be shared among a pool of limited partners, potentially from throughout the world. This is in contrast to the individualized services provided by a consultant or an investment advisor offering investment advice. The limited partnership security provides a standardized offering to the limited partners that includes customary terms and conditions for all investors which cannot be customized to include unique disclosures, terms, requirements and/or timetables to accommodate the Illinois Procurement Code.

Under the new law direct private equity or venture 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 are subject to the Procurement Code under the new law because their managers are considered to be “investment advisors.” While this distinction may make sense for ERISA and related purposes, it does not make sense in the context of procurement and purchase issues.

Accordingly, while IVCA has no objection to the engagement of more “traditional” investment advisors (providing investment services) being subject to the Procurement Code, IVCA does not believe that Procurement Code-type procedures are necessary or appropriate when a pension fund purchases an interest in a fund of funds and is likely to prevent the pension funds from accessing this asset class. It is 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.

Funds of funds are collective investment vehicles which pool investment capital from multiple investors to invest in other venture capital and private equity funds. By doing this (and providing a larger pool of capital), a fund of funds may provide an investor with access to highly regarded funds which the investor might not be able to invest in directly. IVCA believes fund of fund managers should be treated the same as other venture capital and private equity fund managers in their capital-raising efforts and making them subject to the Procurement Code would likely preclude access to this these investment vehicles for Illinois pensions.

Additionally, frequently managers of funds of funds, in connection with raising their fund of funds, will agree to invest (as an investment advisor) on behalf of an investor side-by-side with the fund of funds (i.e., the investor establishes a separate account, which although not part of the fund of funds, is invested in a substantially identical manner as the fund of funds). Most typically, these co-managed assets are raised simultaneously with the fund of funds itself, and on terms substantially similar to those contained in the fund, however, the investor may have an opportunity to negotiate some additional preferential terms. In addition, some managers have “virtual” fund of funds, which operate like fund of funds by pooling a number of separate accounts. Because these services are often co-marketed with or in the same manner as fund of funds, making them subject to the Procurement Code would raise the same issues as making the sale of securities in the fund, itself, subject to the Procurement Code.

In addition to all of the Procurement Code impediments mentioned above with collectively managing a fund, private equity fund of funds managers have proprietary processes and techniques that are governed by the underlying confidentiality agreements with multiple general partners of limited partnerships and thus cannot be shared as required under the Procurement Code.

IVCA is working to educate key legislators and staff about the new law's unintended effect of potentially shutting the state pension funds out of fund of funds and we remain cautiously optimistic that the law can be amended to correct this problem prior to the end of the current legislative session.

• Prohibition on contingent or placement fees

The new law also prohibits the payment of contingent or placement fees …”No person or entity shall retain a person or entity to attempt to influence the outcome of an investment decision of or the procurement of investment advice or services of a retirement system, pension fund, or investment board of this Code for compensation, contingent in whole or in part upon the decision or procurement.”

IVCA had successfully lobbied to retain the use of placement agents in previous pension ethics reform proposals but reportedly the Speaker wanted the prohibition in the final bill. IVCA will again try to educate legislators about the legitimacy and necessity of placement agents but we are not optimistic that this prohibition will be lifted in light of the Speaker's intent and the current press coverage of ongoing investigations into illegal payments to placement agents by private equity and hedge funds to secure investments from New York pension funds.