Public Investors, Private Funds, and State Law

Abstract

Public pension plans in the United States invest hundreds of billions of dollars in private funds. As pension underfunding problems have deepened across the nation in recent years, public plans have dramatically increased their exposure to these lightly-regulated vehicles. This has raised concerns about whether the trustees and officials running state and local plans—often targets of academic criticism for poor management practices—adequately protect pension interests when they invest in this market.

This Article considers the role of state law in this new era of massive investment by public plans in private funds. State pension law has historically focused primarily on the internal governance of public plans by imposing fiduciary duties on plan trustees and officials and setting up guardrails on the decisions that they make. However, after controversial practices in private funds were exposed in the mid-2010s, the California state legislature moved in a more aggressive direction by directly regulating certain terms in the private fund contracts entered into by California public plans. This approach, which many states took steps to follow or seriously considered following, focused on fee transparency concerns, but it could easily be expanded to regulate any aspect of private fund contracts.

After identifying some of the distinctive challenges associated with this approach, I argue that state efforts to regulate private fund contracts directly have limited potential to compensate for ineffective governance within public plans. Challenges include the fact that states lack direct authority over private fund managers, widespread discriminatory treatment of private fund investors through “side letters,” diversity in the size of public plans in each state, and volatility in the fundraising market for private funds, among others. In light of these and other challenges, I also argue that the explosive growth of public pension investment in private funds calls into question some of the basic assumptions on which private fund policy has long been based, raising important questions for federal securities law.

Keywords: public pension plans, private funds, private equity, fiduciary duties, conflicts of interest, state lawmakers, pension underfunding