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ERISA Compliance Issues Surrounding Alternative Investments

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What are “Alternative Investments”, and what’s all the fuss about? …

What are “Alternative Investments”, and what’s all the fuss about?

What practical steps can you incorporate into your due diligence process as it relates to alternative investments?

Published in: Business, Economy & Finance

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  • 1. ERISA Compliance Issues Surrounding Alternative Investments Ken Pink, CPA Partner
  • 2. Agenda  Monitoring alternative investments 2
  • 3. Monitoring Alternative Investments  What are “Alternative Investments”, and what’s all the fuss about?  What practical steps can you incorporate into your due diligence process as it relates to alternative investments? 3
  • 4. What are alternative investments? There is no standard definition, but it is understood as any investments beyond traditional stocks, bonds, and money market investments. Traditional investments - Stocks, bonds, mutual funds - Typically long only, priced daily, liquid 4
  • 5. Alternative Investments - What Happened?  “Old World” for Trustees and auditors: Trustees read quarterly investment statement Auditors confirm investment statements with custodians Move on!  “New World” for Trustees and Auditors:  Stop: How much does the investor really know about its holdings? 5
  • 6. Alternative Investments – What Happened? Rules in the “New World”:  SAS No.92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities  SAS No. 101, Auditing Fair Value Measurements and Disclosures  AICPA Interpretation No. 1 of SAS 92, Auditing Investments in Securities Where a Readily Determinable Fair Value Does Not Exist. (July 2005)  AICPA Interpretation No. 1 of SAS 101, Auditing Interests in Trusts Held by a Third-Party Trustee and Reported at Fair Value (July 2005)  AICPA Practice Aid, Alternative Investments, Auditing Considerations (July 2006) 6
  • 7. Alternative Investments – What Happened The AICPA Interpretation issued in July 2005 carried a consistent message:  Confirmation is not enough  Receiving a confirmation from the alternative investment fund manager or custodian does not constitute adequate audit evidence with respect to valuation  Further: receiving a confirmation from the fund manager or custodian does not constitute sufficient audit evidence of existence unless the holdings are identified in the confirmation on a “security by security” basis 7
  • 8. Traditional Confirmation CUSTODY STATEMENT December 1, 2007 – December 31, 2007 EQUITIES Holdings* Shares Cost Prince/ Market Accrued Estimat Current (description sorted by type/alphabetical) Unit*** Value Income ed Yield Annual Income HEIDELBERGER 950.00 50,004.59 33.63 31,948.50 0.00 0 0.00% DRUCKMASCHINEN (EUR) (Ticker Symbol: HDD-GREUR) HSBC HOLDINGS PLC 5,265.00 96,921.85 16.75 88,188.75 0.00 0 0.00% (Ticker Symbol: HBCYF) KINGFISHER PLC 20,040.00 81,723.28 2.95 59,118.00 0.00 0 0.00% (Ticker Symbol: KGFHF) L’OREAL 770.00 80,471.38 143.25 110,302.50 0.00 0 0.00% (Ticker Symbol: OR) LONGZA AG 965.00 47,177.31 121.88 117,614.20 0.00 0 0.00% ISIN #CH0013841017 (Ticker Symbol: LONN-VX) MACQUARIE GROUP LIMITED 1,420.00 89,038.80 66.91 95,012.20 0.00 0 0.00% (CUSIP #B28YTC2) MISYS PLC 13,945.00 56,278.35 3.67 51,178.15 0.00 0 0.00% (CUSIP #: 0385785) NESTLE SA 250.00 57,960.25 452.50 113,125.00 0.00 0 0.00% (CHF1 (REGD) ISIN #CH0012056047 (Ticker Symbol: NSRGF) NITTO DENKO CORPORATION 2,600.00 127,804.26 52.99 137,774.00 0.00 0 0.00% (CUSIP #: 6641801) NOBEL BIOCARE HOLDINGS AG 210.00 59,716.39 267.63 56,202.30 0.00 0 0.00% (CUSIP #: 7385722) NORBORD INC 14,490.00 120,701.47 8.00 115,920.00 0.00 5,796 5.00% (Ticker Symbol: NBDFF) * All values reported in U.S. dollars ** Includes Accrued Income *** Prices are rounded to the nearest 100 th decimal place for statement formating purposes 8
  • 9. Alternative Investment Confirmation 9
  • 10. Overview of AICPA Practice Aid  The Practice Aid addresses challenges associated with auditing investments for which a readily determinable fair value does not exist.  The Practice Aid:  Is applicable to investments in hedge funds, private equity funds, venture capital funds, commodity pools, fund of funds, and bank common/collective trust funds  Provides guidance on auditing the existence and valuation assertions associated with alternative investments. 10
  • 11. Overview of AICPA Practice Aid (con’t) Existence Assertion  The Practice Aid requires that auditors confirm existence with the underlying fund managers.  Items to be confirmed include:  Number of units held or percentage ownership  Value of net assets/capital balance  Holdings of the underlying fund’s investments on a security- by-security basis.  Although the auditor may be uncertain if the fund manager will provide the requested information, such information should still be requested. 11
  • 12. Overview of AICPA Practice Aid (con’t) Existence Assertion  If the requested information is not received by the auditor, alternative procedures should be considered, as follow:  Observing management site visits or telephone calls to investee funds (or reviewing documentation of such calls or visits)  Reviewing executed partnership, trust, limited liability corporation, or similar agreements  Inspecting other documentation supporting the investor’s interest in the fund (for example, correspondence from the fund or trustee acknowledging transactions with the fund)  Reviewing periodic statements from the fund or investment advisor reflecting investment activity and compare to amounts recorded  Vouching relevant cash receipts and disbursements 12
  • 13. Overview of AICPA Practice Aid (con’t) Valuation Assertion  Auditors need to obtain an understanding of and perform tests over internal controls as they relate to valuations.  This would entail obtaining an understanding of:  Management’s initial due diligence and continuous monitoring process of the underlying investee funds  Management’s significant assumptions  Management’s valuation methodology  The controls and procedures in place at service providers in determining net asset values (typically obtained from a SAS 70 report)  The controls in place over financial reporting 13
  • 14. Management’s Responsibility Management is responsible for making the fair value measurements and disclosures included in the financial statements. As part of fulfilling this responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation measurements, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of fair value measurements are in accordance with GAAP. 14
  • 15. Management’s Responsibility Management can not outsource! Even to General Partner! Management can use an external party for the mechanics of valuation. … but Management must have a sufficient understanding of the underlying investments, strategies and significant assumptions that underlie the valuations to challenge the investment valuation. 15
  • 16. Alternative Investments – Seven Steps to an Unqualified Opinion Step 1 Clearly assign responsibility for fair valuation policies and processes Step 2 Perform due diligence throughout the year Step 3 Challenge your investment managers Step 4 Document, document, document Step 5 Meet with your audit firm early and agree to a plan Step 6 Roll forward investments Step 7 Formally approve valuations 16
  • 17. Alternative Investments – Example Controls & Documentation Example Controls Possible Documentation Clear assignment of responsibility By-laws defining roles of Investment Committee Procedural manual defining roles of investment department vs. accounting department Oftentimes, smaller organizations are set up with an investment advisor who reports directly to the Investment Committee and who serves as the default CIO 17
  • 18. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Investment Committee Bios of Investment Committee Select members who question decision within the framework Investment Committee Minutes 18
  • 19. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Investment policy for asset Written policy adopted by allocation and valuations Investment Committee Exception to policies presented to full Investment Committee for acknowledgement 19
  • 20. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Selection, hiring, and evaluation of Written due diligence summaries fund advisor / managers Minutes of committee meetings approving advisor / manager changes 20
  • 21. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Understanding of the fund’s Documented risk assessment for strategies and holdings, each investment ascertaining underlying investments, if possible 21
  • 22. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Periodic visits or conference calls Formalized schedule of visits or with fund advisor / manager conference calls Documentation of visits or discussions Can be handwritten notes or checklist 22
  • 23. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Review of SAS70s for service Written checklist prepared by providers (fund managers, back- reviewer office, trustees, custodians) Type I or Type II report Review exceptions 23
  • 24. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Review of annual fund audited Written checklist prepared by financial statements reviewer Unqualified opinion on a GAAP basis provided by a credentialed firm Comparison of audited to unaudited NAV 24
  • 25. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Review of valuations prepared by Written notes on valuations or fund manager memo documenting review by finance staff 25
  • 26. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Review monthly / quarterly Comparison of actual returns to information from investment advisor/ benchmarks with explanations of fund manager major variances 26
  • 27. Alternative Investments – Example Controls & Documentation (con’t) Example Controls Possible Documentation Cut-off and reconciliation Reconciliation of audited NAV to recorded fair value at investor’s year end Roll-forward of audited holdings to investor’s year end 27
  • 28. Summary of SFAS 157  Defines fair value  Provides a framework for determining fair value (describes various methods)  Expands disclosure about fair value measurements  Increases transparency  Does not prescribe new uses for fair value  Effective for FY beginning after 11/15/07 -Nonfinancial assets-beginning after 11/15/08 if not measured at FV on a recurring basis 28
  • 29. Definition of Fair Value The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date- EXIT PRICE 29
  • 30. What does price mean?  Price is determined in the “principal market”, meaning the market with the greatest volume and level of activity. If there is no principal market, then the “most advantageous market” is used.  Price does not include transaction costs.  Fair value of a block of financial instruments traded in an active market is “price x quantity”. No block adjustments. 30
  • 31. Valuation Techniques  Market approach- uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.  Income approach- uses valuation techniques to convert future amounts (e.g., cash flows or earnings) to a single present amount (discounted).  Cost approach- based on the amount currently required to replace the service capacity of an asset. 31
  • 32. The Role of Inputs  Inputs are market participant assumptions that are included in valuation models. Observable Inputs- Developed based on market data obtained from sources independent of the reporting entity. Unobservable Inputs- Reflects the reporting entity’s own assumptions about market inputs based on its own data.  Valuation techniques should maximize the use of observable inputs  Cannot disregard market-based information that is reasonably available 32
  • 33. Fair Value Hierarchy Level 1 Inputs: Quoted prices for identical assets or liabilities in active markets Most reliable source of fair value Input examples-Prices derived from NYSE, NASDAQ, Chicago Board of Trade, Pink Sheets 33
  • 34. Fair Value Hierarchy Level 2 Inputs Observable inputs for:  Similar assets or liabilities in active markets  Identical or similar assets in inactive markets  Inputs other than quoted prices that are directly observable  Inputs derived from observable market data by correlation or other means -Input examples: Matrix pricing, market corroborated pricing; inputs such as yield curves and indices 34
  • 35. Fair Value Hierarchy Level 3 Inputs: Unobservable inputs:  Reporting entity’s own assumptions about the assumptions market participants would use.  Other entry specific inputs (historical or projected financial information) that are not derived from market data.  Unobservable inputs shall be developed based on the best information available in the circumstances.  In developing unobservable inputs, the reporting entry need not undertake all possible efforts to obtain information (if not reasonably available without undue cost or effort).  Input examples: Investment manager pricing for Private Placements, Private Equities, Hedge Funds, etc. 35
  • 36. New Disclosures Recurring measures  What is measured at fair value -Level 1, level 2, level 3  Valuation techniques used and if changed  If level 3 measurements are used - Reconcile beginning to ending balances 36
  • 37. Investment Valuation “Unit of account”-refers to the level at which the asset is measured at fair value for purpose of financial reporting  May need to review underlying investments  Consider restrictions, contract provisions, NAV calculations and potential impact to FV. 37
  • 38. Unit of Account Investment Unit of Account  Mutual Fund  Shares in the mutual fund  Common/collective trust fund  Units of participation in or Pooled Separate Account CCT/PSA  Separately Managed Trust  Underlying assets and Account liabilities  Synthetic GIC  Wrap contract and underlying assets  Hedge Fund  Units of Participation in the hedge fund  Private Equity Fund  Limited Partnership interest in private equity fund, which includes both the funded and unfunded capital commitments. 38
  • 39. FAS 157 Valuation Considerations  Tax-exempt organization owns the valuation responsibility Can outsource the mechanics but not the ownership  Custodial reporting tools will only be the starting point Final FAS 157 bucketing decisions will rest with the organization  Understanding the pricing process is a must  Must increase collaboration with outside parties 39
  • 40. How to apply FAS 157 to Hard to Value Investments  Are Hedge Fund and Private Equity Funds Level 2 or 3 investments?  Hedge Funds-To the extent there is adequate observable subscription or redemption activity, could support Level 2 or Level 3 classification  Private Equity Funds-Given lack of redemption provisions, most commonly Level 3 40
  • 41. Derivatives  Are the derivatives traded on an exchange or traded OTC?  Is the derivative priced solely on information from the counterparty or is an independent price from another vendor obtained?  Are models used?  Has counterparty credit risk been considered in fair valuing the derivative contract? 41
  • 42. New disclosures Tabular format required Encouraged to combine with other required fair value disclosures SFAS 107, SFAS 124 42
  • 43. Example Description Level 1 Inputs Level 2 Inputs Level 3 Inputs Total at End Of Year Equity Securities $ 10,000,000 $ - $ - $ 10,000,000 Corporate debt 2,000,000 2,000,000 securities Mortgage backed 1,000,000 1,000,000 securities Real estate 500,000 500,000 Alternative 1,500,000 1,500,000 investments Interest rate swap - - (500,000) (500,000) contract Total $ 10,000,000 $ 3,500,000 $ 1,000,000 $ 14,500,000 43
  • 44. Example Fair Value Measurements Using Significant Unobservable Inputs (Level 3) Alternative Interest Rate Swap Total Investments Contrast Beginning balance $ 500,000 $ 1,000,000 $ 1,500,000 Total gains or losses Realized Unrealized (250,000) (1,500,000) (1,750,000) Purchases 1,250,000 1,250,000 Sales, withdrawals Transfers in and/or out of Level 3 - Ending balance $ 1,500,000 $ (500,000) $ 1,000,000 44
  • 45. FSP FAS 117-1 Endowments of Not-for-Profit Organizations: Net Asset Classification of Funds Subject to an Enacted Version of the Uniform Prudent Management of Institutional Funds Act, and Enhanced Disclosures for All Endowment Funds Effective for fiscal years ending after December 15, 2008 45
  • 46. FSP FAS 117-1 Applicable to all not-for-profit organizations that have Board- designated or donor restricted endowment funds 46
  • 47. What is an Endowment Fund ? FAS 117 definition:  An established fund of cash, securities, or other assets to provide income for the maintenance of a not-for-profit organization.  Use of the assets may be permanently restricted, temporarily restricted or unrestricted.  Organization’s governing board may earmark a portion of its unrestricted net assets as a board designated endowment (quasi-endowment). 47
  • 48. Uniform Prudent Management of Institutional Funds Act (UPMIFA)  In July 2006, the Uniform Law Commission approved UPMIFA  UPMIFA is a revision of the Uniform Management of Institutional Funds Act of 1972 (UMIFA), which has been adopted by 46 states and the District of Columbia  Thus far, UPMIFA has been enacted in over 30 states and the District of Columbia and is being considered for enactment by several others  New York State has not enacted UPMIFA 48
  • 49. FSP FAS 117-1 If UPMIFA applies, it may be necessary to reclassify certain funds as temporarily or permanently restricted If UPMIFA does not apply, there is no change in classification Additional disclosure is required for all 49
  • 50. FSP FAS 117-1 A not-for-profit organization, whether or not it is subject to UPMIFA, shall disclose the following:  A description of the governing board’s interpretation of the law(s) that underlies the organization’s net asset classification of donor-restricted endowment funds.  A description of the organization’s policy(ies) for the appropriation of endowment assets for expenditures (its endowment spending policy(ies). 50
  • 51. FSP FAS 117-1  A description of the organization’s endowment investment policies. The description shall include the organization’s return objectives and risk parameters; how those objectives relate to the organization’s endowment spending policy(ies); and the strategies employed for achieving those objectives.  The composition of the organization’s endowment by net asset class at the end of the period in total and by type of endowment fund, showing donor-restricted endowment funds separately from board-designated endowment funds. 51
  • 52. FSP FAS 117-1 A reconciliation of the beginning and ending balance of the organization’s endowment in total and by net asset class. 52
  • 53. Example Unrestricted Temporarily Permanently Total Restricted Restricted Endowment net assets, beginning of year $ 6,947 $ 46,380 $ 95,673 $ 149,000 Investment return: Investment income 298 2,396 286 2,980 Net depreciation (413) (2,185) - (2,598) Total investment return (115) 211 286 382 Contributions - - 2,000 2,000 Appropriation of endowment assets (448) (7,002) - (7,450) Other changes: Transfers to create board designated endowment funds 500 - - 500 Endowment net assets, end of year $ 6,884 $ 39,589 $ 97,959 $ 144,432 Endowment Net Asset Composition by Type of Fund as of end of year Donor-restricted endowment funds $ - $ 39,589 $ 97,959 $ 137,548 Board-designated endowment funds 6,884 - - 6,854 Total funds $ 6,884 $ 39,589 $ 97,959 $ 144,432 53
  • 54. FSP FAS 117-1  In accordance with the requirements of SFAS 117 and 124, an organization shall also provide information about the net assets of its endowment funds, including: The nature and types of permanent restrictions or temporary restrictions (paragraphs 14 and 15 of Statement 117) The aggregate amount of the deficiencies for all donor- restricted endowment funds for which the fair value of the assets at the reporting date is less than the level required by donor stipulations or law (paragraph 15(d) of Statement 124). 54
  • 55. Questions? 55