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.

3/30/2005

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 duties.

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 to Connecticut.

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.

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