May|June 2005




STATE PENSION FUNDS, AMONG THE WORLD'S LARGEST POOLS of investment capital, have for years maintained a veil of secrecy over how they invest a portion of the billions of public dollars that finance the retirement of teachers and government officials. But the funds began to reveal themselves two years ago when the nation's largest—the California Public Employees Retirement System, or CalPERS—settled a lawsuit by agreeing to say where that money had been invested and how it had performed.

The settlement prompted much backslapping among advocates of the public's right to know. For the first time, people could judge whether CalPERS's private equity investments—mostly in high-risk venture capital funds that finance start-up companies—were made for sound financial reasons or, as some had charged, as payback for contributions to officeholders who were also on the fund's board. It was a victory for the Freedom of Information Act and other laws that force sunlight into the government's business. And disclosure advocates were just getting started. Later in 2003, they won a lawsuit demanding that the University of Texas disclose the performance of its investments in venture capital and other private equity funds. In 2004, they forced the University of California's pension fund to make similar disclosures. Without prompting by litigation, the University of Michigan and the retirement fund for California teachers soon divulged the performance of their investments as well. Last December, CalPERS settled another case by agreeing to make public the fees it pays to outside managers of its private equity investments.

But these victories have come at a significant price. Although aimed at making government more transparent, in some ways they may make it less. Venture capitalists and others in the private equity world fear that they will be forced to divulge the confidential products, finances, and technologies of the fledgling companies they back. So they have persuaded some states to leave the extent of disclosure up to state officials, a result that could limit access to a broad range of important information. Letting government decide how much it has to divulge sets a dangerous precedent, particularly at a time when officials are interpreting the Freedom of Information Act narrowly, punishing journalists for publishing leaks, and generally cracking down on the free circulation of information. Rather than press for more transparency and risk an even stronger backlash, disclosure advocates should consolidate their gains and work with funds and investors to create disclosure laws that investors can live with and that preserve the public's right to know.

THE PEOPLE WHO SUED CALPERS ACKNOWLEDGE that they have accomplished most of their goals. Peter Scheer, who heads the California First Amendment Coalition, which filed the fee case against CalPERS, said the new information will show whether public funds "are paying too much or too little" for their investments. "We will," he explained, "get a better picture of the political connections involved. We will be able to see whether or not apparent conflicts of interest caused investments to underperform."

In announcing the fee-case settlement, Scheer's coalition highlighted the conflicts that can result when people at the firms that manage CalPERS's investments contribute to the political campaigns of CalPERS board members. The coalition cited press reports that three funds managed by Yucaipa Companies, to which CalPERS has committed $450 million, were headed by Ron Burkle, who made campaign contributions to California Treasurer Phil Angelides, a member of the CalPERS board and a candidate for governor. Another CalPERS board member, former San Francisco mayor Willie Brown, worked directly for Burkle. "The CalPERS documents show the Yucaipa funds were paid $8.7 million in management fees in 2003," the coalition said in a press release, "or 17.3% of capital invested. Two of the three Yucaipa funds have negative rates of return."

Venture capital experts respond that private equity investments often lose money at the beginning but pay off handsomely in the long run. They also note that CalPERS board members like Angelides don't usually have a direct say in individual investments. But as The Wall Street Journal declared in a recent editorial, "CalPERS has committed $19 billion to more than 350 private equity funds. These aren't small numbers, and CalPERS owes it to its employee clients to account for this money."

What most concerns venture capitalists, though, are not revelations of political payoffs, but disclosure of what they consider confidential information about the companies they fund. According to Mark Heesen, head of a venture-capital trade group, these companies are "very early stage and cutting-edge" and could be seriously hurt by people who use disclosed information to copy or otherwise appropriate the companies' intellectual property. He also notes that the information could compromise negotiations between the start-up companies and their suppliers, landlords, or banks. "Other investors," he said, "do not want to be in funds whose returns can be jeopardized by excessive disclosure."

Disclosure obligations have led to public pension funds being excluded from certain lucrative investments. Carl Metzger, a lawyer who represents investment funds, said that he has "already seen top-tier firms not include public entities as investors." Kleiner Perkins, Sequoia, and other venture capital firms have told some public funds that their money is not welcome. Sequoia, one of the University of California's star investments, sent a letter to the UC Regents excluding the university from future investments and asking them to sell its existing positions. As of March 2005, the university had not divested. CalPERS also fears being shut out and losing part of the "over $6 billion in cash returns" generated through private equity investments, said Mark Anson, CalPERS's chief investment officer. He added that the ultimate losers could be the public, which would have to cover with tax dollars any loss of investment income that caused a shortfall in pension obligations.

But disclosure advocates are skeptical about CalPERS's claims of vulnerability. Judy Alexander, a lawyer who helped sue the fund and the University of California, does not dispute the fact that private equity investments are profitable; she just doesn't think disclosure will reduce profits. "We have been getting information [on rates of return] for the last two years," she said, "and the sky has not yet fallen." She admits that some public funds may be excluded from some private equity investments, but she believes that "public entities have a duty to invest in the kinds of funds that allow them to be transparent enough to show the public how their funds are being spent."

Scheer contends that resistance to disclosure has less to do with economics than with embarrassment. Some of the private funds, he said, are likely to be "embarrassed at the magnitude of the fees" they charge. But that is "not a good enough reason" to prevent disclosure. He believes that if any private equity fund excludes CalPERS from investing, it will do so not out of concern for the companies it backs, but to make a point: "Even the most in-demand, top-tier venture capital funds would be irrational to completely close the door on a fund the size of CalPERS."

ACCORDING TO CARL METZGER, SOME DATA are less sensitive than others for private equity investors. Although venture capitalists would rather lose investors than reveal how they calculate fees or value start-up companies, he noted, they don't much care about disclosing the amount of their fees or their returns on investments. If Metzger is right, there is an opportunity for compromise. Both Scheer and Alexander said they see the point in keeping confidential the information about companies in investment portfolios. "Nothing we asked for," explained Scheer, "requires the private equity investors to disclose portfolio company information, which is where I think their argument begins to get traction. I understand that if there is too much disclosure, then the funds are truly being put at a disadvantage." In the end, the pro-disclosure groups want political accountability rather than full transparency about portfolio companies. And that requires knowing four things: how much money is involved in an investment, where that money is being invested, whether it is being wisely managed, and whether the investment was made as a result of political cronyism. That is the information CalPERS and others have agreed to disclose, and with it, the public interest in transparency should be satisfied. Venture capitalists and pension fund managers should have nothing to fear.

Unfortunately, some states have gone much further in protecting venture capitalists. Massachusetts, Virginia, Illinois, Michigan, and Colorado have either considered amending, or have already amended, statutes to exclude certain private equity data from disclosure. Metzger contends that the legislation to limit disclosure is appropriate because most disclosure statutes were drafted in the "post-Watergate era when there was concern" over government secrecy. "At that time," he said, "no one anticipated the sort of venture capital and private equity investments that public entities would one day be making." But some of the state laws give the discloser too much discretion. Rather than define the information beyond which the public doesn't have a right to know, they let public officials like the state attorney general determine how much needs to be revealed about an investment. As Scheer pointed out, "If these laws simply immunize institutions from [Freedom of Information Act] requests, then it is a tragic mistake."

Because they are being outflanked in state legislatures, disclosure advocates can no longer rely on the leverage of litigation to help them get their way. They should preserve their gains by coming to terms with public funds and private equity investors on the kinds of information they need to know. That way, they could preserve the public's right to know whether sound judgment, or political cronyism, determines how its money is invested.