On appeal from the Final Administrative Actions of the Treasurer, the State Investment Council and the Division of Investment.
NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE APPELLATE DIVISION
Before Judges Cuff, Lihotz and Simonelli.
In these consolidated appeals, we review two sets of regulations adopted by the Division of Investment (Division) of the Department of Treasury. One set authorizes the Director of the Division to invest pension funds in alternative investments such as private equity funds and hedge funds. The other set authorizes the Director to engage external investment managers to manage pension fund investments. The issue is not the wisdom of either set of regulations but whether the course adopted by the Division is authorized by statute. In addition, the Communications Workers of America (CWA) and the New Jersey Education Association (NJEA), collectively referred to as "the unions," challenge four investments made by the Director in private equity funds. The unions requested a copy of the contracts relating to those investments, and the Director and representatives of the private equity funds claimed that the contracts are confidential and refused to produce them. The unions ask this court to order production of these documents; the Director and the private equity funds seeks a protective order. We hold that the regulations authorizing and governing the engagement of external investment managers, N.J.A.C. 17:16- 2.1 to -2.4, are invalid. The regulations authorizing investments in private equity funds and hedge funds, N.J.A.C. 17:16-90.1 to -90.4 and 17:16-100.1 to -100.4, are valid subject to the standard of care set forth in N.J.S.A. 52:18A-89b.
The Division is an agency within the Department of Treasury, N.J.S.A. 52:18A-79, that manages State-employee pension funds, N.J.S.A. 52:18A-88.1, in accordance with policies and procedures established by the Securities Investment Council (SIC), N.J.S.A. 52:18A-91. The Director has the "authority to invest and reinvest the moneys" of the pension funds, to "acquire [assets] for or on behalf of" the pension funds, N.J.S.A. 52:18A-88.1, and "to sell or exchange any such investments." N.J.S.A. 52:18A-89a.
In August 2004, the SIC issued a Request for Qualifications (RFQ) for Real Estate Investment Consulting Services for the Division. The RFQ sought a real estate investment consulting firm that would (1) "assist and advise . . . [the State Treasurer, the Director and the SIC] in making prudent real estate investment management decisions, implementing such decisions, and evaluating current and proposed investment strategies, structure and design"; and (2) "assist in conducting searches for real estate investment managers," including interviewing candidates and "providing analyses and information" on reasonable fees. According to the State Treasurer, the Director and the SIC, the SIC issued the RFQ as the first step in implementing an alternative investment program (AIP) to expand the types of investments that the Director could make to include real estate equity, private equity funds and hedge funds. Until that time, regulations only authorized the Director to invest in "traditional investments."
The SIC initiated the AIP in response to recommendations made by Independent Fiduciary Services, Inc. (IFS) in its September 2003 report. IFS had examined the structure of the Division and its investment practices to determine ways in which it could improve operational efficiency and the rate of return on investments. IFS reported that the Division employed a unique management and investment practice inconsistent with industry best practices. Unlike other public employee pension funds, the Division actively managed all of its investments without the aid of external investment managers and invested only in "traditional, publicly-traded securities." IFS recommended the Division retain external investment managers to assist in managing some of its investments and more broadly diversify its investment portfolio by using nontraditional asset classes and strategies, such as real estate equity, private equity, appropriate hedge fund strategies and greater use of high yield bonds. The SIC accepted these recommendations and initiated the AIP. The first step in the AIP process was issuance of the RFQ.
The SIC adopted a Resolution Regarding Investment in Alternative Asset Classes on November 8, 2004. The resolution designated real estate, private equity, absolute return strategies, and hedge funds as alternative classes. The resolution did not define private equity fund or hedge fund.
An excerpt from an article concerning private equity fund disclosures provides a useful definition of private equity funds. The author states:
Private equity funds are investment vehicles. Primarily accessible only to the wealthy and large institutions, they invest in a nondiversified portfolio of businesses to provide both investment capital and managerial expertise. . . . [T]hey provide both high returns - an estimated 23.5 percent in 2004 - and an opportunity for diversification not possible with other mainstream investments.
Frequently, private equity funds are set up as limited partnerships or limited liability corporations. In this arrangement, the private equity firm acts as the general partner or manager, and the investors in the fund, usually 'a limited number of sophisticated investors,' act as limited partners or members. To augment the capital contributions of these investors, the private equity firms make some kind of financial commitment to the fund, usually 1 percent of the total capital raised. The total capital raised in any particular fund can exceed a billion dollars; this is almost always invested in a portfolio of private companies with the intent to take the companies public, sell them, or liquidate them at a later date. Because the general partner manages the day-to-day investing, the distribution of profits is usually 20 percent to the general partner (after management fees and expenses) and 80 percent to the limited partners. Due to the work involved in managing the investment and advising portfolio companies, most private equity firms raise only a few funds. The investments are not designed to be held indefinitely - most have a horizon of seven to thirteen years, with the investments liquidated or distributed to investors before the end of the fund's life. [Steven E. Hurdle, Jr., Comment, A Blow to Public Investing: Reforming the System of Private Equity Fund Disclosures, 53 UCLA L. Rev. 239, 241-42 (2005) (footnotes omitted).]
An official from the Securities and Exchange Commission (SEC) offered the following definition of hedge funds and their differences from private equity funds during testimony before a Congressional committee:
Hedge funds are pools of investment capital that are managed by professional investment advisers and that are not offered generally to the public. They are operated so that they are not subject to the same regulatory requirements of mutual funds, which are governed by the Investment Company Act of 1940 which contains many safeguards for retail investors. [Testimony Concerning Hedge Funds: Hearing Before the Subcomm. on Sec. and Inv. of the U.S. Senate Comm. on Banking, Hous., and Urban Affairs, 109th Cong. (May 16, 2006) (Statement of Susan Ferris Wyderko, Dir., Office of Investor Educ. and Assistance U.S. Sec. and Exch. Comm'n), http://www.sec.gov/news/testimony/ts051606sf w.htm).]
Hedge funds differ from private equity funds in that they are not characterized by a single dominant investment strategy, although many seek to obtain returns that are not correlated to market returns and instead seek to obtain an "absolute return" in a variety of market environments. Some adopt a "multi-strategy" approach that permits the adviser to determine, at any given time, what investment strategy to follow to pursue returns for the investors. Hedge funds also do not have a single risk profile. Some utilize leveraging techniques that expose investors to substantial risks, while others adopt investment strategies more similar to mutual funds. [Ibid.]
On January 20, 2005, the SIC adopted an Alternative Investments Policy (the Policy) and an AIP. The Policy explains that "[t]he AIP calls for the establishment of a new common trust fund to be known as 'Common Pension Fund E,'" in which funds from CWA and NJEA pension funds could participate for the purpose of investing in "Alternative Investments in order to provide enhanced returns for the Pension Funds, at an acceptable level of risk." Alternative investments include real estate and assets, private equity, and hedge funds. The Policy further provides guidelines and standards for the investments and a procedure for selecting investment managers to manage the alternative investments.
At the time the SIC adopted the Policy and procedures, the State Treasurer, the Director and the SIC solicited and obtained advice from several private equity advisors and fund-to-fund managers for their views on the state of the private equity market and how it might influence the investment strategy for pension funds. Based on this advice, the State Treasurer, the Director and the SIC decided to commit $1.5 billion to $2 billion dollars in the first year to private equity investments.
To that end, the State Treasurer, the Director and the SIC entered into partnership agreements that created interests in two private equity funds, Oak Hill Capitol Partners II, L.P. (Oak Hill) and Quadrangle Capital Partners II, L.P. (Quadrangle). The former was executed in December 2004, the latter in March 2005. During this period, Common Pension Fund E was created by regulation. This fund was named as a limited partner in the Oak Hill, Quadrangle and a third private equity fund formed in June 2005, Warburg Pinkus IX, L.L.C. (Warburg). In June 2005, the SIC took another step in implementing an AIP by adopting three sets of regulations: one set, N.J.A.C. 17:16-69.1 to -69.10, created Common Pension Fund E; the second set, N.J.A.C. 17:16-90.1 to -90.4, allows investment in private equity funds; and a third set, N.J.A.C. 17:16-100.1 to 100.4, authorizes absolute return strategy or hedge fund investments.
The regulations authorizing investment in private equity funds provides that the Director may invest and reinvest the moneys of any eligible fund in private equity through separate accounts, funds-of-funds, limited partnerships, direct investments, co-investments and joint ventures in any of the following ways:
1. Buyout Investments: Purchase of a control position (primarily majority positions, with some minority positions) in established companies, with or without leverage.
2. Venture Capital Investments: Purchase of an equity position in small, privately-owned, high-growth companies.
3. Debt-related Investments: Purchase of investments which combine a debt instrument with equity participation. [N.J.A.C. 17:16-90.2.]
"Private equity" is defined as "investments in businesses made through means other than through publicly traded securities. Private equity may consist of buyout funds, venture capital funds and debt-related investments." N.J.A.C. 17:16-90.1. The remaining private equity regulations list the funds that could invest in private equity, N.J.A.C. 17:16-90.3, and the limitations on the Director's ability to invest in private equity. N.J.A.C. 17:16-90.4.
The regulation authorizing investment in absolute return strategy investments, or hedge funds, provides: the Director may invest and reinvest the moneys of any eligible fund in absolute return strategy investments through funds-of-funds, separate accounts and direct investments in individual ...