An attorney for the North Carolina Institute for Constitutional Law is questioning whether State Treasurer Janet Cowell’s new $232 million Innovation Fund, a pension investment that is intended to boost the state’s economic development, flouts a provision in the U.S. Constitution.
The Innovation Fund will target companies that have significant operations in North Carolina or “other significant connection” to the state.
Courts have ruled that states can’t discriminate against interstate commerce in a way that favors one state over another in what’s known as the “Dormant Commerce Clause.” This phrase is not in the text of the Constitution, but courts have said the principle is a logical extension of the restrictions on state authority within the Commerce Clause of the federal Constitution’s Article I, Section 8.
For instance, a Nevada judge recently ruled that a residency requirement preventing a Texan from taking over a Nevada brothel was unconstitutional.
“You’re not supposed to create a set of regulations that disadvantages out-of-state companies,” said Jason Kay, a senior staff attorney for the institute.
State laws that affect interstate commerce must be related to state concerns and the burden on interstate commerce must be outweighed by the benefit to the state’s interests. States can get around this if they are considered a “market participant.”
Melissa Waller, a spokeswoman for Cowell, said the treasurer’s attorney “is not aware of any successful constitutional challenges to economically targeted investment funds in other states.”
The treasurer’s office also has a 2002 advisory opinion from the attorney general stating that investments of retirement funds permitted by statute cannot be disqualified if they indirectly might facilitate economic development.
Cowell told Carolina Journal that she expects the fund to outperform a stock index fund.
She hopes it will earn in the ballpark of 10 percent over 5 to 10 years. The money will be invested over the next three to five years.
The overall annual goal for the state Teachers’ and State Employees’ Retirement System is 7.25 percent, but the retirement system has met that goal in only seven of the last 12 fiscal years.
“We are looking for a market rate of return,” Cowell said. “We are only going to invest in companies that will get us that rate of return.”
Cowell wants the Innovation Fund to perform 2.5 percentage points higher than the Russell 3000 index, which measures the performance of 3,000 publicly held U.S. companies.
Edward Siedle, a former attorney with the U.S. Securities and Exchange Commission, said actively managed funds generally under perform passive indexes.
“The probability that an actively managed fund will exceed a passive index is miniscule unless the benchmark is inappropriate and you’re taking on greater risk,” said Siedle, now the president of Benchmark Financial Services in Ocean Ridge, Fla.
He also questioned why Cowell is using the Russell 3000 index as a benchmark if the Innovation Fund isn’t investing exclusively in Russell 3000 securities.
“It’s comparing apples to oranges,” Siedel said.
Waller said the benchmark “has been deemed appropriate through the fiduciary review process.”
The Innovation Fund is considered part of the alternative investments of the pension fund, which are limited by law to 5 percent of the fund’s total investments.
A recent audit faulted the treasurer’s office for exceeding that limit because plunging stock market prices boosted the relative value of alternative investments in the portfolio to 5.79 percent in December 2009. The treasurer’s office reclassified $1.3 billion in alternative investments under a 2009 law allowing reclassification to bring the alternative investments back within the limits.
The Innovation Fund is considered an “economically targeted investment” — an investament that, in addition to seeking high returns, is designed to pursue social goals, such as investing in particular types of businesses or in specific geographic areas. ETIs have had a mixed track record in other states. A 1994 study found that funds containing ETIs had returns 2.1 percent lower than funds that did not.
“Many of the states implementing these investments passed specific legislation authorizing such an investment,” said Michael Weisel, an attorney and previous candidate for state treasurer. “This did not happen in North Carolina. One might conclude there was deliberate action to sidestep the debate about economically targeted investments by rushing a Request for Proposal (RFP) through at year-end.”
Public pension funds in North Carolina and other states have been criticized for chasing higher returns with risky investments while private pension funds have been putting their money into more conservative investments like bonds.
But Cowell said North Carolina’s pension fund has always been conservative. TSERS has about 41 percent of its investments in stocks and about 47 percent in bonds.
“Corporate funds are moving toward our model,” she said.
Cowell chose Credit Suisse to manage the Innovation Fund after receiving proposals from eight firms. The other finalists were Hamilton Lane of Philadelphia and BlackRock, headquartered in New York.
North Carolina lawmakers said they think Credit Suisse was a good choice.
“They’re credible people,” said Rep. Bill McGee, R-Forsyth. “I accept that they vetted this to the extent that it should be vetted in making this decision.”
But Weisel said the timing and requirements of the RFP “appears to favor” the fund manager model of Credit Suisse’s Customized Fund Investment Group.
Credit Suisse already manages two private equity funds for North Carolina that have invested a total of $500 million from the state.
Cowell plans to meet with legislators April 6 to answer questions about the Innovation Fund. The treasurer’s office also will tour the state in late April and May to tell people about the Innovation Fund and let them know about opportunities to take advantage of it and other economic development incentives.
Cowell could put up to $160 million of the fund in equity and hybrid investments. Another $60 million could be directed into between four and six funds — with at least four from North Carolina. The fund could also invest in public/private ventures in areas such as green technology and life sciences.
“The way we have set up this fund incorporates all the best practices,” Cowell said.
She acknowledged that investments in areas such as technology and green jobs can be risky but said she plans to be careful.
“Every investment I make I have to be concerned that this is the track record of my administration,” Cowell said.
Sarah Okeson is a contributor to Carolina Journal.