Over the course of 2010 and into 2011, the California Public Employees’ Retirement System (CalPERS) has been investigating and addressing whether the interests of CalPERS participants and beneficiaries were compromised by the payment of placement agent fees and related activities.  See “Three Significant Legal Pitfalls for Hedge Fund Marketers, and How to Avoid Them,” Hedge Fund Law Report, Vol. 3, No. 36 (Sep. 17, 2010).  However, what started as a review arising out of the well-publicized placement agent scandals of 2009 has expanded in scope to include a special review of the organization and operation of CalPERS itself; the “fitness” of CalPERS employees and its external investment managers; and the fee arrangements among CalPERS, its external investment managers and placement agents.  See “Indemnification Provisions in Agreements between Hedge Fund Managers and Placement Agents: Reciprocal, But Not Necessarily Symmetrical,” Hedge Fund Law Report, Vol. 3, No. 41 (Oct. 22, 2010).  In a report dated December 2010, Steptoe & Johnson LLP, the law firm leading the special review, summarizes its observations and recommendations in the foregoing areas.  The report indicates that CalPERS has already implemented many of Steptoe’s recommendations, and Steptoe expects CalPERS to implement those of the recommendations it has not yet implemented.  The Steptoe report is important for all hedge fund managers, for the following reasons.  For those managers fortunate enough to have CalPERS as a current investor, the report foreshadows likely demands from CalPERS in the areas of fees, use and compensation of placement agents, conflicts of interest, gifts and travel, employment of former CalPERS board members and staff, public disclosure of information provided to CalPERS, location and lavishness of annual meetings and other topics.  Even for hedge fund managers that do not count CalPERS as a current investor, the report is relevant.  (For a discussion of when to approach certain types of investors, see “Prime Broker Merlin Securities Develops Spectrum of Hedge Fund Investors; Event Hosted by Accounting Firm Marcum LLP Examines Marketing Implications of the Merlin Spectrum,” Hedge Fund Law Report, Vol. 3, No. 39 (Oct. 8, 2010).)  Here is why: CalPERS is the largest public pension fund in the U.S.  As of January 5, 2011, the total CalPERS fund market value was $226.5 billion, with about 14 percent, or $31.7 billion, allocated to “private equity” and other “alternative investments.”  Like Yale among endowments, CalPERS among pension funds has been and continues to be a trendsetter with respect to the terms under which institutional investors allocate capital to hedge funds.  See “Lessons for Hedge Fund Managers on Liquidity, Allocations, Marketing and More from Yale’s 2009 Endowment Report,” Hedge Fund Law Report, Vol. 3, No. 15 (Apr. 9, 2010).  That is, other institutional investors look to the actions of CalPERS as precedents in the areas of terms, fees, governance, risk management, manager selection, due diligence, mitigation of conflicts of interest and others.  Indeed, the Steptoe report is cognizant of CalPERS’ stature as an institutional investor, noting that CalPERS can, by adopting the recommendations in the report, “set a standard for other public pension funds to follow.”  (By the same token, the report takes CalPERS to task for inadequately using its “purchasing power” – our phrase, not the report’s – to negotiate lower fees with external managers.  However, the report also notes that CalPERS has recently improved in this area and obtained over $200 million in fee concessions from external managers in various asset classes.)  Given the importance of CalPERS as an investor in hedge funds, the terms it demands from external managers are likely to be demanded by other investors of comparable bargaining power (or requested by investors of lesser bargaining power).  Similarly, the concerns identified by CalPERS are likely to make their way into due diligence questionnaires of other investors.  Accordingly, this article offers a comprehensive review of the Steptoe report, along with commentary on how the report’s recommendations may alter the relationship among public pension funds, hedge fund managers and placement agents.  One of the more dramatic recommendations in the report would involve shifting a greater percentage of the compensation of external managers to performance fees, and away from management fees.  We discuss (among other things) the implications of this recommendation, and how – especially for smaller or start-up managers – this revised approach to fees can make it difficult to “keep the lights on.”