Because alternative investments, such as private equity, hedge funds and real assets, are typically accessed though a limited partnership structure, retirement plan fiduciaries are charged with more extensive due diligence as compared to monitoring daily valued mutual funds or separate accounts. With endowments, foundations and pension portfolios having increased their commitments to alternative investments, more fiduciaries are becoming aware that they need a detailed monitoring process for their complex investments.
The investment advisers duties of conducting routine due diligence on alternatives should include a quarterly checklist to aid board members and key employees at the organization in carrying out their fiduciary duties. Heres a roadmap of some key areas that should be reviewed periodically by both the investment adviser (IA) and a key employee (KE) at the company sponsoring the retirement plan. In addition to helping fiduciaries, an alternative investment checklist may assist an institution with its annual audit. The criteria below can be applied to all types of alternative investments.
- Conduct regular in-person or telephone meetings with the investment firms management team (IA)
- Conduct an on-site visit on regular basis (IA)
Constant communication is an essential element to keeping up with the developments at each firm. In addition to participating in the alternative investment firms monthly or quarterly conference calls, having scheduled and unscheduled person-to-person contact helps foster trust.
Review fund communication
- Review fund communications including quarterly shareholder's letters (IA)
- Obtain and review audited financial statements, note whether the opinion is qualified, and if there have been any changes in the auditor or valuation procedures (IA and KE)
- For drawdown funds, compare partners' capital statements with internal transaction records (KE)
- Compare cash distributions from a fund to the amount of cash received to the capital statement provided by the fund, if applicable (KE)
In addition to vocal communication, reviewing reports produced for all investors is important, especially if there is any discrepancy between what is discussed in person, on the phone or via email.
Perform valuation analysis
- Request and review, if available, the valuation of portfolio holdings for reasonableness (IA)
- Request and review changes to valuation policies and procedures (IA)
- For hedge funds, receive the estimated value from the fund and the final value from the funds administrator and compare for reasonableness (IA)
- Compare the institution's statement of value as of the fund's year-end to the value based on the fund's audited financial statements and follow up on significant discrepancies (KE)
Because alternative investments tend to be liquid on a periodic basis, such as quarterly, having a process in place to monitor valuations is critical. Since most investments do not provide valuations on a daily basis, reviewing statements from both the administrator and the auditor is essential. At year-end the valuation from the funds audit should match up with the statement the plan sponsor receives.
Monitor portfolio performance
- Compare performance to the products benchmark and expected returns if appropriate (IA)
- Compare performance to publicly available data (e.g., public sector indices for hedge funds) (IA)
- Inquire periodically throughout the year as to the total long and short positions (for hedge funds) (IA)
- Review portfolio holdings on a regular basis (IA)
- Analyze any shift in strategy allocations (IA)
- If the investment strategy changes from the original investment approach, conduct comprehensive review of manager/team/strategy (IA)
In addition to the valuation analysis, a comprehensive review of performance should be conducted to make sure that performance is in line with expectations. When performance seems outside the boundary of what is expected, positive or negative, a follow up conversation with the investment manager is warranted. It is also important to obtain as much transparency of underlying holdings as possible. Following the global financial crisis, alternative investment managers have become more willing to share such information.
- Review press reports for significant developments in the firms management, structure, personnel, and portfolio (including search for damaging information on NASD or SEC sites) (IA)
- Obtain and review Form ADV (used by investment advisers to register with SEC) (IA)
- Monitor staffing levels and personnel changes (IA)
- Monitor the size of assets under management in the strategy and firm-wide (IA)
Besides communicating with the manager, there are a number of outside sources to gather information about a firm or an employee. General internet searches can sometimes uncover information that a manager might not want to share.
Although following a checklist will not alleviate all of the risks associated with alternative investments, it will aid the endowment, foundation or pension board to fulfill their fiduciary responsibilities and hopefully provide more comfort in investing in alternatives.
Steven Karsh, MBA, is a principal and director at Innovest Portfolio Solutions.
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