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- How Will the Biden Administration Impact Public Pension Investments?
In this episode of Pensions, Benefits & Investments Briefings (formerly Public Pensions & Investments Briefings), Nossaman Pensions, Benefits & Investments Group Partner Peter Mixon and Institutional Limited Partners Association Senior Policy Counsel Chris Hayes discuss what impact the Biden administration could have on public pensions. They explore how the new administration may alter investment regulations to align with their key policy initiatives, and how public pension plan investors should approach investing to ensure compliance.
Transcript: How Will the Biden Administration Impact Public Pension Investments?
0:00:01.3 Peter Mixon: In this episode of Public Pensions and Investments Briefings, we will discuss how the Biden Administration may alter investment regulations to align with their key policy initiatives, and how public pension plan investors should approach investing in this new environment.
0:00:27.9 Speaker 2: Welcome to Public Pensions and Investments Briefings, Nossaman's podcast exploring the legal issues impacting public pension systems and their boards.
0:00:49.0 PM: My name is Peter Mixon. I'm a partner at Nossaman and a member of the Public Pensions and Investments Group. Our practice is devoted to representing public pension plans across the country and a wide variety of different matters, these include investments, plan administration, plan funding, fiduciary duties and litigation. My guest this morning is Chris Hayes. Chris is the Senior Policy Counsel of the Institutional Limited Partners Association, also known as ILPA, and leads their global advocacy efforts in the US and in Europe. ILPA is a professional association of over 550 institutional investors investing in private funds with an emphasis on private equity. Its members include insurers, endowments, foundations, corporate pensions, sovereign funds, family offices, and of course, public pensions. Its membership collectively manages well over $2 trillion in private equity assets across the globe.
0:01:46.9 PM: Chris has led a number of important ILPA projects around private fund terms, including the ILPA Model Limited Partnership Agreement, and more recently, the Model Non-Disclosure Agreement. Welcome, Chris.
0:02:00.8 Chris Hayes: Thanks, Peter, really appreciate the opportunity to speak with you today and some of your listeners, and we also really appreciate massive support on many of those fund terms projects you mentioned. You guys have been an invaluable supporter of us and we really appreciate it and look forward to speaking more about the Biden Administration today.
0:02:18.5 PM: First off, I want to ask you about the changes in Washington. Obviously, we have a new president and a new administration, as well as a changeover of control in the Senate. This means new policies and new faces, as well as a completely different tone in federal government. Focusing on institutional investors, what are some of the high-level policy changes that we can expect to see in the first year or so of the new administration?
0:02:45.0 CH: It's a great question, Peter. I think there's a few main items that the administration is going to focus on this year, core among those are climate change, diversity and inclusion, and infrastructure, as among the, I would say the main three issues that this administration will be working on in 2021. To talk a little bit more about climate change, President Biden during the campaign pledged that publicly traded companies will be required to disclose climate risk and emission levels in their operations and in their supply chains. We had had a number of discussions with the Biden transition, which unlike in previous administrations, it's really the first time that we've seen a strong focus on addressing climate change, particularly in the financial system. And so we expect this to feature quite heavily at the SEC this year, at the Department of Labor, as well as particular action in Congress. In particular in Congress, we do expect there to be some additional items added on climate change as part of an upcoming tax and infrastructure package that we would expect to see later this year.
0:03:47.9 CH: In Congress, we've already had some hearings on climate. Just last week, there was a hearing in the House Financial Services Committee on climate change reporting for public companies, so there's been a big focus on this in the public market. The new SEC Chairman Gary Gensler had his hearing in the Senate Banking Committee, and he was specifically asked about climate reporting as well, and disclosures to investors. I think there's definitely some interest in doing something here. Less has been done in the private markets, which is an area that obviously we at ILPA focus on, but we do expect that there could be some efforts to integrate ESG criteria into the investment process and fiduciary duties of both private fund managers as well as ERISA plan administrator requirements at the Department of Labor.
0:04:32.1 CH: I think it remains to be seen whether these sort of requirements on the investment process side are implemented, but also whether reporting and disclosure type requirements are also implemented, and whether that is a voluntary kind of standard, so say if you marketed a funded CSG or climate change-specific, if there would be certain guidelines for those that opt into that type of regime when marketing an investment product versus obligatory ESG framework and reporting requirements across the industry.
0:05:02.7 PM: Speaking of the, or returning to the SEC, they obviously have an acting interim chair, Allison Lee, and I believe she recently issued a statement on climate change, what was that about? And is that something that's likely to influence the new administration going forward?
0:05:20.3 CH: Yeah, I think that's a good point. Just a few weeks ago, Acting Chair Allison Lee at the SEC issued the statement indicating that climate review would be a focus of the SEC when looking at public company disclosures and they will be enforcing and updating some guidance that was released on climate disclosure by the SEC back in 2010. Furthermore, over the past few years, this committee at the SEC, the Asset Management Advisory Committee, which ILPA has been following during that time, issued draft recommendations around ESG, and that included adoption of standards for disclosure of material ESG risks which are consistent with other financial disclosures with the goal towards pushing standardization in the asset management industry. I think it's interesting how you've seen a holistic approach, and I think generally support for more standardization and clarification around these issues, both from the asset manager, fund manager perspective as well as the institutional investor community who are looking potentially for more of that information.
0:06:21.4 CH: But I think it's interesting also to see where members are, where public pensions or institutional investors are in what we would call their ESG journey. We've had a variety of conversations with our members because we would like to be more engaged on these issues and assist our members with them, and some are very far along. Our European members in particular are some of the larger pension plans in Democratic-leaning states have been very upfront in terms of integration of ESG into their investment process, as well as moving towards more reporting from the managers they invest with, including key performance indicators on the underlying portfolio companies. And in California in particular, obviously the two largest, CalPERS and CalSTRS have also taken some action on that issue. We've also seen some university endowments do more on that as well. And we are looking at how we can better assist our members in incorporating ESG into their due diligence process, or starting to think about what sort of reporting standards are helpful from product fund managers, and then we will have a better sense to share with policy makers about what is actually useful for investors.
0:07:28.4 CH: I think ILPA intends to engage in this climate disclosure debate around private funds, at least in terms of understanding what's useful for our members. And even if those members don't care about that climate reporting, it may be required anyway, so they might as well have something that's useful and effective for the cost since they will ultimately be paying for it if it's going to be regulated anyway. And we want to be part of that discussion to make sure that any kind of reporting requirement is shaped that it's beneficial for investors. And over the next year, we're going to be looking at a variety of standards in the marketplace, from SASB to TCFD to the PRI standards, to try and figure out from our members who are real deep and further along in their ESG journey, how and what standards are the best ones to use, and then be sharing that with our members so they can be thinking about that. Because many of these members are actually on the cusp of going a little bit further towards requiring reporting beyond early stages where they're talking to their managers about ESG or trying to better understand the ESG policies of their managers, to moving towards proactive tracking and reporting across their portfolio. And so that's something that we're going to be looking at.
0:08:37.9 PM: Yes, I think it's safe to say that ESG has gone from perhaps not part of the mainstream to definitely front and center for both private market and public market investors. Next I want to talk to you about action on diversity, equity and inclusion. What can we expect on this front from the Biden Administration?
0:09:00.9 CH: Well, I think the administration, as we've seen in the campaign and obviously now in power, as well as Democrats in Congress have been very vocal about trying to address economic justice issues, lack of diversity and access to capital by underserved communities in the US economy. And we've already seen legislation, both in the private market and in the public market to encourage and track diversity around public company boards, for example, or around private funds managers and who they're hiring. Just recently, and this actually came up at the hearing of the SEC Chairman, there was a real big movement forward with the exchange in New York, essentially issuing a rule proposal that would require all listed issuers on the NASDAQ exchange to have one woman and one underrepresented minority on their board or to have to explain why they weren't able to do so. And ILPA actually submitted a comment letter in support of this proposal, but I think it's illustrative of where the industry is moving towards trying to encourage proactively, aggressively greater diversity on corporate boards, both in the public markets to start, and I think we'll see that move over to the private markets as well.
0:10:16.6 CH: In the private markets, ILPA has been really proactive through our Diversity in Action Initiative, and I would obviously encourage some of the listeners to this podcast to take a look at it where we are actually trying to galvanize the private fund industry, we've seen significant uptake from both private equity managers, as well as institutional investors signing on to the Diversity in Action Initiative would actually requires you to do at least four items which are really around making sure that folks you invest with are racially diverse, or tracking the diversity of the folks that you invest with, if you're an institutional investor. If you're a manager, it's about your hiring practices, how you're increasing the pipeline of diverse candidates into your firm, as well as where you're directing your capital. And as part of that initiative, we think that we can move the private fund industry in a positive direction because ultimately, in our view, and many others, diversity leads to better investment outcomes for ultimately institutional investors and their beneficiaries.
0:11:18.2 PM: Yep. Absolutely. And the next topic I wanted to broach with you is the concept of stakeholder capitalism. On the campaign trail, Joe Biden memorably said that it's time to put an end to the idea of "shareholder capitalism". Instead, he suggested corporations should also have a responsibility to their workers, their community and to their country. What does stakeholder capitalism mean? And how is Joe Biden's view going to affect institutional investors in the administration?
0:11:55.2 CH: Well, I think the idea of stakeholder capitalism is something that's been floating around for a while, and ultimately what it is, is taking things into account beyond just the financial performance of the company and its ability to produce the maximum returns for shareholders. And so that means thinking about the impact on communities, the impact on employees, as well as other stakeholders in the company's success. This has first kind of come up as part of an effort to encourage folks to be thinking about the treatment of workers in particular at companies as well as maybe harmful practices that the corporation is doing or companies are doing in various communities as a way to address it. It also kind of fits within the social element of ESG where you're thinking about what we would call human capital management.
0:12:44.2 CH: And this human capital management issue has been a significant one in the private equity space where there has been continual focus on treatment of portfolio company employees, just part of the nature of the capitalist system where sometimes companies fail, sometimes workers lose their job, and those are negative repercussions, and how can we address those or encourage more responsibility from corporations or funds that invest into companies to consider those factors? And so this did come up in our conversations with the Biden transition. It's difficult to maybe fully understand how it'll manifest in terms of the policy changes or how companies do business, but it is something that just a few years ago, the Business Roundtable, which is a group of the largest company CEOs actually issued a statement talking about this, how they're taking account communities, employees and other stakeholders besides shareholders, so it's certainly something that folks have been talking about, and I think part of this ESG discussion.
0:13:42.8 CH: And so potentially you could see some changes if you're considering ESG factors in your investment process, you need to be thinking about other stakeholders in the company and how you should be thinking about that. And obviously, the US maybe doesn't have the strongest safety net as other places where some of the negative impacts of companies failing, workers losing their jobs are more widely felt without that safety net there. And so trying to think about the responsibility that companies have for that.
0:14:11.3 PM: I sense a theme in our discussion here today with ESG investing. Let's explore a little bit more in detail, the potential policy initiatives. We know that President Biden generally supports ESG investing. Do you expect him to actually take policy action either in Congress or at the regulatory level around these types of initiatives?
0:14:38.4 CH: I do. Starting with the Department of Labor, the ERISA plans obviously, top charity plans, union plans or corporate pension plans who are regulated by the Department of Labor. And obviously ERISA also influences us. I don't have to tell you, Peter, the public pension community in terms of their state laws. And for the past 20 years, there's been a variety of informal guidance and bulletins issued by the Department of Labor around fiduciary standards. At the end of the last year, much anticipated rule was released by the Trump Administration at the Department of Labor which sought to limit the ability for ERISA-backed fiduciary, so these types of pensions, to consider ESG factors as part of their investment process. More specifically, the rule required plan fiduciaries to make all investment decisions based on so-called pecuniary factors, i.e., those that are expected to have a material effect on risk or return over appropriate investment horizons.
0:15:36.5 CH: Although this was not a lot different than some of the informal guidance that have been issued previously, the new rule was designed to preclude these fiduciaries from making investments to promote non-financial goals, particularly around ESG. ILPA opposed this rule. A number of other groups, folks, institutional investors and managers who care about these issues also opposed this and thought it was inappropriate for investors that wanted to consider ESG factors as part of their process to do that. I think that ILPA restated their position that it's completely in line with being a fiduciary to consider environmental, social, governance impacts and weigh those as part of the investment process when you're making an investment. That's ultimately in the best interest of the beneficiaries to consider the risk rewards of those particular elements. With the Biden Administration coming in, I think we expect... And they've already indicated this, that this regulation will be "reviewed" before it's enforced, and ultimately, we expect this rule to roll back, but I think it actually would go in the other direction to require consideration of these factors, and we'll have to see what the new Secretary of Labor Marty Walsh, former Mayor of Boston, former union guy, what he thinks about this, but I would expect that to be a high priority of the Department of Labor in the next year or two, although we'll take a little bit of time to roll that rollback.
0:17:00.7 PM: Yes, I agree. I think Department of Labor is going to take a hard look at this new regulation. As you know, they finalized the regulation in December of last year, and actually didn't become effective until, I think maybe 10 days before the end of the Trump Administration. And although the Department of Labor does not have jurisdiction over governmental plans like public pension plans, they often will look at guidance from the Department of Labor, particularly when it comes to fiduciary issues in the investment arena, because there is a lot of guidance, as you mentioned. I think that although the rule itself that was issued was not startling, I think some of the material that was put out by the Department of Labor around adoption of this rule, including the idea of investigating plan fiduciaries for violation of these new rules in the context of ESG investment decision-making certainly gave people pause. Early in March, the Department of Labor made an announcement that the rule regarding "pecuniary factors" in investment decisions will not be enforced. According to the statement, the rule has created a perception that fiduciaries are at risk if they take ESG factors into account and the evaluation of plan investments. The department plans to revisit the rule in the future after taking additional stakeholder comment.
0:18:40.0 PM: I also want to bring up another topic that is infrastructure investing. I'm old enough to remember the infrastructure talk during the Trump presidency, it seemed like every other week was infrastructure week, and after a while became a running joke because the Trump Administration actually never did take any substantive steps in implementing any kind of a plan. Well, everyone, virtually everyone, anyway, agrees that there's a massive need of an overhaul of the nation's infrastructure. There is very little agreement on how to pay for it. There was a lot of discussion during the Trump Administration around PPPs, the public-private partnerships and leveraging private market investments to improve the nation's infrastructure. Some of this discussion actually included the idea of public pension plan participation in PPPs, but as I said, nothing really ever happened. Like former President Trump, President Biden supports a federal infrastructure initiative, and according to his plan anyway, he would like to invest about $2 trillion in federal money over four years to improve the infrastructure. Does Biden's infrastructure plan have any traction? That's my question to you. And if so, what does it mean for institutional investors?
0:20:01.8 CH: Yeah, I think it does. It's funny that you would mention infrastructure week because us here in Washington DC actually agreed, it was a running joke where ultimately there would be some infrastructure week announcement, and then ultimately there'd be some crazy calamity that happened that week that completely took the focus off infrastructure. We remember in the Trump Administration, they released a plan, as you indicated, that was very focused on public-private partnership, and that plan was essentially, I remember there was a lot of hype when it was released and it was ultimately a two-page bulleted suggestion of what infrastructure should look like, which to be honest, wasn't much of a plan, and ultimately, it never moved forward. And I think part of that... And a differentiation between what the Biden Administration's trying to do here is that it wasn't anticipated to be a lot of federal money that would also flow into infrastructure as part of the plan. The idea of the Trump Administration was to really try and incentivize private sector capital into these infrastructure investments, and I had a number of discussions with our member institutional investors who invest in infrastructure, and I think there were a lot of challenges to that plan, from attractiveness to investment to the muni bond market which makes it difficult to earn a return on these types of investments.
0:21:15.8 CH: But I think the Biden Administration is going to really focus on, as you indicated with this $2 trillion dollar price tag, really deploying federal capital into investing in infrastructure as well as trying to also try and encourage private sector investment along with it. But I think potentially there's more substance here than what we saw in the last administration, and I think there's a vehicle to move this later this year. So as folks listening to this podcast may be aware, with a reconciliation bill, which you can only do once per fiscal year, you can pass legislation that is budgetary in nature with only a bare majority through the Senate, which the Democrats have. They're using their first reconciliation package from actual, the last fiscal year, because there was no budget to move this COVID-19 stimulus package, $1.9 trillion package, and then they will be turning to another reconciliation package which we expect to be an infrastructure package, but also packaged together with tax changes.
0:22:16.3 CH: So ultimately with infrastructure, if you're going to do a $2 trillion dollar investment program, you need to generate some money to pay for that. And we would expect some significant tax changes that's indicated by Biden during his campaign to raise the capital gains rates, raise corporate rates, and particularly potentially eliminate the carried interest loophole as well as some other potential tax changes that would help pay for this package. I think some of the challenges to this package just generally are going to be the price tag of the package given the amount of money we would have just spent on COVID relief, and certainly now there's a big shift politically from Republicans to attack the cost and the debt of these programs. And I would expect there to be a similar shift in those sort of talking points. From an institutional investor perspective, I think you want to look at this package in two ways. So first you want to think about the negative impacts which could be through these potential tax changes. Investors need to be thinking about, if there's an inclusion of a financial transaction tax, which could impact them if they're not carved out, and they also need to think about potential carried interest changes that could ultimately come back to them as investors.
0:23:29.1 CH: And while we don't have a position at ILPA on the taxation of carried interest, we do think LP should be reviewing their investment agreements to be prepared to push back on managers who try to shift the economic burden of their increased tax rate onto investors, which we don't think would be appropriate, and investors need to unite as a group and push back on any attempts to do that. Beyond that, obviously, we had looked in the Trump Administration, when they had made tax changes, they absolutely tried to tax public pensions, apply unrelated business income tax to public pensions in their investments. ILPA, CI, some of these other groups, as well as many of the public pensions themselves were really helpful in fighting that proposal and preventing it from happening. But these sort of things need to be monitored from the tax side for an institutional investor perspective, but also there may be opportunities there.
0:24:16.9 CH: There's been a variety of pieces of legislation that floated around to try and incentivize, particularly public pensions to invest in infrastructure in the past. I would expect there to be similar types of programs that attempt to do that this time, and institutional investors should be thinking about and/or public pensions thinking about what sort of program might be attracted to them from an investment perspective that could deliver returns or there's been certain items around pension liabilities where they're able to invest in infrastructure and lessen their pension liabilities to beneficiaries. So those are the things that institutional investors should be thinking about with this upcoming package, which we expect probably to move forward in spring or summer of this year.
0:24:58.7 PM: Talking a little bit more about carried interest and a change in the taxation of carried interest to ordinary income, I agree with you, I think that if that becomes a realistic possibility, I think the fund manager community will definitely go back to their existing fund agreements and take a look and see how they can mitigate their tax liabilities, whether through additional borrowings or changes in the economics, as you suggest, or even other ways. I also think, and this is a question to you, it is a possibility that this community will call on their partners in the public pension plan and other institutional investor community for assistance in lobbying in the Congress on this issue. Do you think that's a realistic possibility?
0:25:45.8 CH: Peter, I do. This is definitely something that institutional investors seem to think about, "Wow, the private equity managers have been very effective over the years in maintaining their carried interest tax treatments." Even during the most recent tax reform in 2017, they essentially just required a three-year hold on companies, to retain that status which they were able to adjust to achieve. We do expect them to be deploying a significant amount of lobbying power on this issue, which is something they have done for decades successfully, and we do expect them to try and encourage LPs to engage for the same reason we just discussed. However, I don't think it's our role to weigh in on their specific tax status. The tax issue around what a manager is paid individually is their issue. It's not an investor issue, but investors need to make sure that they are pushing back with a united voice that it's not okay for them to try and make up that difference if they are taxed more.
0:26:49.3 CH: And we have been asked a number of years for us to come in and weigh in on carried interest, but we don't believe that it's the appropriate place for the investor to do that, particularly folks who are representing first responders and teachers to be advocating for large tax breaks for wealthy individuals at private equity firms. And in that case, I think we need to make sure that if these changes happen, that we're aware of what's in those fund agreements, Peter, as you mentioned, about where the shifts could happen by the manager by choice, make sure that those provisions aren't showing up in newer fund agreements, and if there is an attempt to either invoke those provisions or amend the LPA, that investors push back with united voice to prevent those sort of shifts in economics.
0:27:35.5 CH: And so that's something that we would encourage folks to do. ILPA's going to be looking at that over the next few months and be educating policy makers about that challenge. We aren't sure that there's a policy solution, there may be from a policy solution standpoint, but there's certainly a solution for LPs to push back and prevent that sort of thing from occurring. We do expect there to be an attempt to roll this carried interest back as part of the package. There's a significant amount of capital that could be raised there to deploy towards infrastructure and other needs, but I wouldn't count up the managers and their ability to protect their tax status.
0:28:14.3 PM: Yes, we will just have to see when that battle starts to gear up. So that's all the time we have today. I want to thank Chris for participating in our podcast. Thank you very much, Chris, it's been very interesting, and I'm sure we're going to hear more from the Biden Administration, all of these topics, but your insights are very welcome.
0:28:37.7 CH: Well, thanks, Peter. Thanks for having me today, and I really appreciate the opportunity to share with you and your listeners, and continue to work with the Nossaman team. Thanks for having me today.
0:28:49.2 PM: And thank you to our listeners for joining us for this episode of Public Pensions and Investments Briefings. For additional information on this topic or other public pension issues, please visit our website at nossaman.com. And don't forget to subscribe to Public Pensions and Investments Briefings wherever you listen to podcast, so you don't miss an episode. Until next time.
0:29:14.3 S2: Public Pensions and Investments Briefings is presented by Nossaman LLP, and cannot be copied or re-broadcast without consent. Content reflects the personal views and opinions of the participants. The information provided in this podcast is for informational purposes only. It's not intended as legal advice and does not create an attorney-client relationship. Listeners should not act solely upon the information without seeking professional legal counsel.