Selection of Asset Managers and
Alternative Investments
Due Diligence for Plan Sponsors
Jaqueline M. Hummel, IACCP®, AIFA®
Managing Director
Hardin Compliance Consulting LLC
Speaker Biography:
Jaqueline M. Hummel, Esq. is a Managing Director at Hardin
Compliance Consulting LLC.. She counsels clients on a wide
variety of investment management issues including risk
management, compliance with SEC regulations, and
development of compliance programs. She has extensive
experience as an in-house attorney in the areas of
investment adviser, broker-dealer and investment company
regulation and compliance. Prior to joining Hardin
Compliance Consulting LLC, in January 2011, Ms. Hummel
held the position of Chief Compliance Officer for investment
adviser affiliates of PNC Financial Services Group, Inc. and
National City Corporation. In addition to her role as a
regulatory compliance consultant, Jaqi is a securities
attorney, licensed to practice law in Ohio and Massachusetts
Jaqi can be reached by sending an email to
jhummel@hardincompliance.com, or calling 216-965-0062.
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Agenda
1. Initial considerations for investing in
alternative investments vehicles
2. Characteristics of alternative investments
3. Evaluating alternative investments
4. Due diligence considerations
5. Monitoring
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INITIAL CONSIDERATIONS FOR INVESTING IN
ALTERNATIVE INVESTMENTS VEHICLES
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Plan Fiduciary’s Obligations for
Selecting an Investment Vehicle
• ERISA requires:
– Plan fiduciaries engage in a “prudent process” to select
and monitor service providers
– Evidence process is followed (documentation)
• DOL requires:
– Objective process for evaluating service providers
– Process should address qualifications of service providers,
the product quality, and the reasonableness of fees
charged
• Post-selection: ongoing monitoring required to ensure
services are being performed as promised.
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Initial Considerations For Alternative
Investments
• Determine whether plan documents permit the
investment (allowed by investment policy
statement?)
• Assess whether investment provides sufficient
liquidity for plan needs (lock up periods and
periodic redemption rights)
• Review whether investment meets the plan’s
diversification objectives
• Analyze risk/return characteristics of investment
• Assess potential for prohibited transaction
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Other Considerations for ERISA plans
Investing in Private Equity or Hedge Funds
• Plan Asset Look-Through Rules:
– General partners and advisers to private equity or
hedge funds with less than 25% ownership by ERISA
plans are NOT ERISA fiduciaries
– Venture capital operating companies (VCOC) and real
estate operating companies (REOC) are also exempt
from being classified as ERISA plan assets
• Private Fund managers may
– Not be subject to “prohibited transaction”
prohibitions
– Receive incentive and other performance based fees
– Not be bonded
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CHARACTERISTICS OF ALTERNATIVE
INVESTMENTS
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Characteristics of Alternative
Investments
• Limited partnership, LLC or collective trust
(bank-sponsored)
• Private investment company, qualified for an
exemption from SEC-registration
• No prospectus: offering made through
confidential private placement memorandum,
limited partnership agreement, and
subscription agreement
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Characteristics of Alternative
Investments
• U.S. Regulations limit investments in hedge funds
and private equity funds to “accredited investors”
and “qualified purchasers”
– Individuals with investments in excess of $5 million; or
net worth of at least $1 million; or income of at least
$200,000 in last two years
– Institutions with total assets over $5 million; or no less
than $25 million in investments or investable assets
• Hedge funds and private equity funds are not
registered with the SEC
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Characteristics of Alternative
Investments
• Higher management fees than mutual funds and/or
separate account structure
• Less disclosure than a registered mutual fund
• Performance data and calculations are not standardized
• Generally no independent board of directors
• Manager may receive other fees (consulting fees, break up
fees)
• Larger investors may get more favorable terms (side letters)
• May use different accounting methods (U.S. GAAP, IFRS)
• May invest in illiquid or hard to value securities
• Restrictions on fund redemptions
• May be domiciled offshore
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Characteristics of Alternative
Investments
• Large commitments, long term investors can
negotiate better terms
• “most favored nations”: find out what other
investors have obtained – managers may have
undertaken to provide similar terms upon request
• Key Items: liquidity, reporting, pricing, notice
• How broad is investment mandate? Potential for
style drift?
• Additional risk: use of derivatives, leverage and
hedging
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Private Equity Funds vs. Hedge Funds
Private Funds
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Specified term, limited investment period
Longer term investments (private equity, buy-out, venture capital, real estate)
Investments made in hard to value assets
Capital calls
Redemptions limited, distributions made at time of sale of assets
Management fees changes: during the commitment period fee is a specified
percentage of total capital commitments and after the commitment period is
a specified percentage of total capital contributions.
– Offsets to management fee (sometimes) for transaction fees received by
manager from portfolio companies (such as advisory fees, break-up fees for
unconsummated deals, investment banking fees, directors fees for serving on
the board of a portfolio company, etc.)
– Performance fee for fund manager based on the profits realized sale of fund
investments.
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Private Equity Funds vs. Hedge Funds
Hedge Funds
– Open-end fund with no specific term
– More liquid: allows admission and redemption at regular
intervals
– Investments in more liquid securities (marked to market)
– Management fee based on Net Asset Value of fund
– Performance fee based on increase in NAV
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Investment Strategies for Hedge Funds
• Sample:
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Convertible arbitrage
Dedicated short bias
Distressed
Emerging markets
Fixed-income arbitrage
Global macro
Long/short equity directional
Long/short equity market neutral
Managed futures
Merger & acquisition arbitrage
Risk arbitrage
Multi-strategy
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Fee Structures of Private Funds
• Hedge Fund Fee Structures:
– Management and Performance Fees for fund
managers (1-2% management fees based on Net
Asset Value of an investor’s interest in the fund,
and 20% of gains over some base return or
“hurdle rate”)
– Management Fees: designed to pay for
investment manager’s expenses, such as
employee salaries, office space, technology,
utilities
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Fee Structures of Private Funds
• Performance Fees (incentive fees, carried
interest)
– Performance Fees are paid only if the Net Asset Value
of the fund increases over specified period of time
– “High Water Mark” (when fund has losses, managers
do not get performance fees until loss has been made
up)
– “Hurdle Rate”: minimum rate of return to be reached
before fund manager receives performance fee
– Clawback provisions: return of incentive fee previously
paid if fund fails to return to its high-water mark, or if
fund fails
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Private Equity Fund Fees
• Waterfall structure, paid to private equity fund investors upon sale
of an asset:
– First distribution is made to investors until they receive all their capital
contribution for the investment sold
– Second distribution is made to investors until they receive a specified
return
– Third distribution is made to the sponsor (or g.p./adviser) until
sponsor receives 20% (or other incentive fee) of distribution of profits
– Last distribution is split: 20% goes to sponsor as its incentive fee, and
remaining 80% to investors
• May or may not have loss carryforward, where investors receive
return of invested capital, plus their full preferred return, before the
Sponsor/GP/Adviser receives incentive fee
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Fund Expenses
• Organizational expenses: paid by investors out of capital
commitments, usually capped. Includes formation
expenses such as legal, accounting, filing, and travel
• Operating expenses: management fees, costs for
purchasing, holding and disposition of investments, thirdparty services providers (fund administrator, custodian,
counsel, accountants and auditors), insurance, indemnity
and litigation expenses, taxes and other government fees
• Manager expenses: fund manager bears costs of
administrative and overhead expenses in running the fund
(employee compensation, rent)
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Buyer Beware: Other private equity
fund fees and expenses
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•
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A private equity fund manager may earn additional fees from the companies it
invests in, such as transaction fees (for putting together the deal), advisory fees
(for providing advice to portfolio companies), “breakage fees” (for deals that don’t
go through)
SEC has scrutinizing these fees, stating that many newly-registered private equity
fund advisors fails to adequately disclose their fees*
SEC noted:
– Payments to “operating partners”, engaged by fund managers to provide assistance to
portfolio companies, and get paid by the fund (not illegal, SEC doesn’t like this practice since it
appears that these individuals look like employees of the fund manager (whose salaries would
be borne by the fund manager)
– Characterization of expenses changes over life of fund – expenses change from manager
expenses to fund expenses without appropriate disclosures to investors
•
SEC has also found that fund advisers have material weaknesses in their controls
related to allocation of fees and expenses
*“Spreading Sunshine in Private Equity,” remarks of Andrew J. Bowden, Director, Office of Compliance
Inspections and Examinations, Private Equity International (PEI), Private Fund Compliance Forum 2014, (New
York, NY, May 6, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370541735361#.
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EVALUATING ALTERNATIVE
INVESTMENTS
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Basic Questions
• How are fees calculated/charged? Off sets?
• How does the fund manager address risk management?
• How often, who is responsible, and what procedures are used to
value assets?
• What are the fund manager’s trading policies, including allocation,
aggregation, soft dollars and best execution?
• How is leverage used, measured and monitored?
• How does the fund manager address key person risk?
• What type of internal controls does the fund manager have? How
often updated?
• Does the firm have continuity/succession plans? Business
continuity process?
• How are fund service providers chosen, evaluated and monitored?
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Consideration of Investment Strategy
• Understand the investment strategy
– What is the investment universe?
– How diverse/liquid are the securities the strategy invests
in?
– How much money is in the strategy and how much more
can it absorb?
– What is the niche, and what is this manager’s competitive
advantage?
– Is there a benchmark, and how does performance of
strategy compare?
– How does the manager control risk?
– How is leverage used in the portfolio?
– What types of hedging strategies are used?
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Consideration of Investment Strategy
• Prior performance
– Is there a track record, and is that record based on same
strategy, same type of investment vehicle? (are we comparing
apples to oranges)
– Was prior performance obtained using same team, same
resources?
– How was that record achieved – is it based on process that can
be clearly articulated and reproduced? Was it based any
unusual opportunities or market conditions?
– How has the strategy performed over time; can it adapt and
perform under different market conditions?
– How is performance presented – are terms understandable, is
GIPS used?
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Analysis of Investment Process
Based on Prudent PracticesTM for Investment
Fiduciaries developed by Fi360 in conjunction
with the Center for Fiduciary Excellence (CEFEX).
• Organization
• Formalization
• Implementation
• Monitoring
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DUE DILIGENCE CONSIDERATIONS
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Due Diligence on Organization
• Which entity is managing assets of the private
fund (general partner, investment adviser, etc.)
• If G.P. or affiliated adviser is registered with SEC,
review Form ADV (Investment Adviser
Registration Form) Parts 1A, 2A and 2B
• Review Form to determine ownership of firm,
firm management, any disciplinary actions,
experience of investment team, assets under
management, types of clients (Part 1) and
conflicts of interest (Part 2A)
• Review organization chart
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Due Diligence on Fund Manager
• Form ADV Part 1A (Schedule D) lists
– Affiliated entities
– Private funds managed by registered investment
adviser, including AUM and %age owned by
related parties, directors
– Service providers for private funds: custodian,
prime broker, administrators, independent
accountants, marketers
– Discloses whether financial statements contain
unqualified opinions
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Due Diligence on Fund Manager
• Form ADV Part 2A Brochure discusses:
– Structure of firm and description of business
– Compensation, including performance-based fees and side-byside management
– Firm’s investment strategies and associated risks
– Conflicts of interest and how managed (soft dollars, personal
securities trading)
– Brokerage practices (best execution, investment aggregation
and allocation)
– Proxy voting practices
– Referral arrangements and other compensation
– Disciplinary information
– Financial information (not much)
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Due Diligence on Fund Terms and
Operations
• Review L.P. agreement, subscription agreement and confidential
private offering memorandum
• Analyze key terms:
– Fees and other expenses paid by fund, including management fees,
performance allocation
– Payment waterfall
– Calculation of fees
– Valuation of assets
– Lock-up period and redemption terms
– Controls in place to manage risk (concentration by issuer, sectors)
– Trading allocation
– Leverage
– Derivatives usage
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Due Diligence on Fund Terms and
Operations
• Offering Memorandum should address:
– Investment manager has time, resources, knowledge and
skills to appropriately monitor the portfolio investments
– Process and tools used by investment manager to
implement and monitor portfolio investments
– Identification of duties and responsibilities of parties and
service providers (custodian, prime broker, investment
manager, board of trustees/directors, limited partners,
fund administrator)
– Investment and operational risks and how addressed
– Specifics of investment process, including investment
selection criteria due diligence criteria for selecting
investments
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Due Diligence on Fund Terms and
Operations
• Offering Memorandum should address
– Fees charged by investment manager and how
calculated
– Expenses borne by investors in fund
– Conflicts of interest between investment manager
and investors,
– Best execution and trading practices
– Valuation of fund assets
– Referral arrangements
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Due Diligence on Fund Terms:
Valuation
• Understand manager’s valuation practices
• Recognize difference between assets with a readily
ascertainable market value, and assets that require fair
valuation
• Review process for fair valuation
– Is there any independent evaluation of pricing?
– How often is valuation performed?
– How does independent auditor review and confirm
valuations?
• Request reports of manager evaluations of its valuation
process (if the manager doesn’t evaluate the efficacy of
its valuation process, that’s a red flag)
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Implementation
• Understand the fund manager’s trading
policies and procedures
• Understand the fund manager’s compliance
policies and procedures to monitor trading
activity
• Understand the fund manager’s risk controls
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MONITORING
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Monitoring
• Review financial statements of independent
auditor (provided annually)
• Review monthly/quarterly statements
• Review custody statements
• Hire an independent investment adviser with
expertise to review fund performance
• Onsite visits
• Due diligence questionnaires quarterly
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Questions?
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Additional Resources
• Fund manager information on SEC’s
Investment Adviser Public Disclosure website
• Managed Funds Association
www.managedfunds.org
• www.greenwichroundtable.org
• www.sec.gov
(http://www.sec.gov/investor/alerts/ib_hedge
funds.pdf)
• www.finra.org
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