Disclosure and Exposure in the Private Equity and Venture Capital Industries: More to Come
The private equity and venture capital industries continue to face increasing scrutiny, especially regarding private equity fund investments by public universities and government employee pension funds. CalPERS’s second litigation over its disclosure policies, and Connecticut's state treasurer’s litigation against private equity fund Forstmann Little, have intensified the debate over disclosure, and it is safe to assume that the scrutiny of private equity will only increase.
by Timothy Mungovan and William Kelly
First published as “Disclosure and exposure: more to come” in Financier Worldwide’s 2005 Private Equity Fundraising Review.
The private equity and venture capital industries continued in 2004 to face
increasing scrutiny, especially relating to the investment in private equity
funds by public universities and government employee pension funds in the U.S.
In late 2002 and early 2003, following litigation initiated against the University
of Texas Investment Management Co. and the California Public Employees Retirement
System under state public records laws similar to the federal Freedom of Information
Act, UTIMCo, CalPERS, and several other public entities began disclosing certain
performance data of private equity funds in which they had invested. Although
there was some backlash to such disclosure (including decisions by some leading
private equity funds to bar future investments by such public entities) and
legislation was enacted in 2004 in four states (Colorado, Massachusetts, Michigan,
and Virginia) exempting some private equity investment information from the
disclosure requirements of the public records laws, two significant developments
late in 2004 caused the debate over disclosure to increase in intensity. CalPERS
faced a second litigation over its disclosure policies and entered into a settlement
under which it agreed to broader disclosure regarding its private equity investments.
Litigation initiated by the state treasurer of Connecticut against a private
equity fund in which the state had invested, Forstmann Little, which went to
trial in 2004, exposed the inner workings of private equity to intense media
scrutiny and may foreshadow increased litigation risk for private equity firms.
It is safe to assume that the intensity of the spotlight on private equity will
only increase given the continued growth of the industry and the substantial
participation of public entities as investors.
A new milestone in disclosure
On September 2, 2004, the California First Amendment Coalition filed suit
against CalPERS seeking broad disclosure of information concerning CalPERS participation
as an investor in the private equity and hedge fund markets, including the individual
fees CalPERS has paid to investment firms. CalPERS settled the suit in December
2004 by agreeing to disclose custom spreadsheets that show the amounts of CalPERS's
annual profits received from and expenses paid to private equity and hedge fund
partnerships. According to press releases, CalPERS agreed to disclose profit
received from each fund for each year from 1999 to 2003 and the management fees
and other costs that it paid to each fund for each year from 2001 to 2003. Under
the settlement, CalPERS is not required to disclose negotiated fees, carried
interest, or profit splits with the investment firms.
While the settlement is limited to CalPERS, and the decision to settle was
based presumably in part on California law, the settlement could have an impact
on other disclosure battles. As the largest public pension fund in the United
States, with assets in excess of $177 billion, CalPERS is an acknowledged leader
and the high-profile settlement could create pressure on other public pension
funds and universities to make similar disclosures.
The Forstmann Little trial: Is the litigation genie out of the bottle?
The well-publicized trial of Treasurer of the State of Connecticut v. Forstmann
Little raises several issues. The Connecticut state employees pension fund
had been a limited partner in funds managed by Forstmann Little, and in 2002
Connecticut sued Forstmann Little and several of its general partners to recover
in excess of $120 million in failed investments in two telecommunications firms,
XO Communications and McLeodUSA, which Connecticut claimed had been made
in breach of the funds partnership agreement and of the general partners fiduciary
After a month-long trial, the six-person jury found that Forstmann Little
had acted with gross negligence, bad faith, or willful misconduct, but declined
to award money damages based on its further findings that Forstmann Little had
relied on the advice of its legal counsel in managing the investments and that
Connecticut had acquiesced in the investments. To resolve the case and avoid
any appeal, Forstmann Little settled the case by reportedly paying $15 million
While the trial offers many lessons, it raises a troubling question: Does
it foreshadow further litigation between limited partners and investment firms?
At least one of the principals in trial seems to think that it does. Theodore
Forstmann told the New York Times in October 2004, shortly after the
settlement was announced, that this will be the “first of many” suits between
investors and private equity firms due, in part, to increasing competition,
high fees, and participation of public entities ( “Goodbye to All That,” New
York Times , October 10, 2004, section 3, column 1, p. 1) . While it is
too soon to tell whether such litigation will emerge, industry participants
are no doubt examining their practices and procedures in light of a potentially
higher litigation risk.