Improving due diligence
By Pensions & Investments | October 17, 2011
As defined benefit plans get a better grasp on the valuation of their pension liabilities, there is growing uncertainty about the value of their assets.
That is because the landscape of asset management has evolved not just for defined benefit plans, but also for endowments and foundations and even to some extent for defined contribution plans.
That evolution has brought about increasing allocations to alternative investments, including hedge funds, private equity, real estate, timberland, mortgage-backed and other asset-backed securities and distressed debt, as well as swaps and other derivatives strategies.
In general, these are all hard-to-value assets — whether physical assets like properties, or equity, or debt securities in non-publicly traded companies, or strategies based on non-exchange-traded derivatives — where prices are not readily and publicly available.
Fiduciaries have a responsibility to account for the value of the investments, including alternatives, in their funds. The limited transparency of some alternatives, such as hedge funds, compounds the challenge in verifying valuation of the investments.
Fiduciaries would benefit from better guidance on the valuation and risk management of investing in alternatives, much as new rules from the Financial Accounting Standards Board and the Pension Protection Act, among other measures, led corporate pension funds in recent years to better accounting, and improved valuation of their liabilities.
More guidance on alternative asset valuation could help funds examine the issues without dictating practices in a field of investing that could use more transparency and more independence in determining value.
This guidance could come from the Department of Labor. The FASB offers guidance for its rule on fair value, placing assets in three different levels of valuation, depending on the strength of tradable prices. But the FASB guidance doesn't help on lack of transparency or other risk issues for alternative investments
The Department of Labor, which enforces the Employee Retirement Income Security Act and is responsible for ensuring pension executives fulfill their fiduciary responsibility, should play a leading role in providing such guidance.
The Government Accountability Office has raised concerns about valuation, as well as issues of risk management, of alternatives and recommends the DOL take action in providing guidance.
The GAO study, released Aug. 31, noted alternative investments “may serve useful purposes in a well-thought-out investment program, offering plan sponsors advantages that may not be as readily available from more traditional investment options. Nonetheless, it is equally clear that investments in such assets place demands on plan sponsors that are significantly beyond the demands of more traditional asset classes.”
The Labor Department's Employee Benefit Security Administration to its credit is taking some action. It is “considering the feasibility of developing and issuing the specific type of guidance called for regarding investments in hedge funds and private equity funds,” Phyllis C. Borzi, assistant secretary of labor for EBSA, said in a statement. The “ERISA Advisory Council is also looking at a similar issue and we are expecting to receive their recommendations next month,” her statement said. “We will review these inputs to see whether the department should take any action in this area.”
But it is because of that lack of uniformity and complexity of the investments that guidance would be most useful in the due diligence undertaken by pension funds and other institutional investors that aren't regulated by the department but often use ERISA guidance as a foundation for their policies and practices.
Alternative allocations aren't new, but they are growing in use as fund executives allocate a larger share of total assets to them, and they're becoming more diverse as these institutional investors move into newer areas, such as infrastructure investing.
Midsize and smaller plans without the resources and sophistication of larger plans would especially benefit from some guidance. Some 22% of corporate plans, whose asset range from $250 million to $500 million, were invested in hedge funds, according to the GAO study, citing Greenwich Associates data.
Better guidance would help these plans examine fiduciary issues and the risks involved in alternative investments as they do their due diligence to decide whether or not to make commitments to the area.
The unfavorable public markets in equities and fixed income are driving pension funds and other institutional funds to alternatives to improve return and dampen volatility to meet their obligations. This year through Oct. 10, the Standard & Poor's 500 stock index's total return, including dividends reinvestment, was -3.48%.
“There is widespread recognition” that “in a world where the 10-year Treasuries have a 1.85% yield and you're trying to make a 7.5% return over long periods of time ... no one's business model works on a 3% yield,” said Matt Botein, managing director and head of BlackRock (BLK) Alternative Investors, based in Boston. “Our clients are all agonizing over what do they do to make their models work in a world where there is not enough yield to meet your actuarial assumptions.”
Alternatives have risk factors investors in public market investments don't generally face. Lack of transparency in alternatives adds to their risk. Often investors cannot view the underlying assets to evaluate their valuation.
To gain more transparency and accountability, the $10.7 billion Illinois State Board of Investment, Chicago, for example, recently restructured its $241 million investment in a Grosvenor hedge fund of funds, moving to a separate from a commingled account, said William R. Atwood, ISBI executive director.
In addition, alternatives are often illiquid investments, locking in investors for a number of years and making it hard for them to cut losses to get out early. Valuations are subjective. Leverage, often used to boost returns, complicates valuation.
The value of alternative investments often is based on appraisals and estimates, or on comparisons with assets considered similar in publicly traded markets, or in recent transactions in non-public markets.
Fiduciaries cannot independently verify the valuations of their alternative investments because the process would be too costly. So they often rely on the determination of investment managers, consultants and others. Fund executives need to exercise due diligence to evaluate both the integrity of these firms and the integrity of the valuation processes they use.
Operational risks, ranging from organizational to compliance issues, raise another set of concerns fiduciaries must examine and monitor.
Even who to hold liable in the event of a fraud can be unclear.
Guidance will not eliminate risks of alternatives, but it will serve to assist funds in evaluating the complex investments.