Pension Investments in Hedge Funds: Issues and Solutions for Fiduciaries

Transcription

1 Pension Investments in Hedge Funds: Issues and Solutions for Fiduciaries Yasho Lahiri American Bar Association Section of Taxation Employee Benefits Subcommittee Boca Raton, Florida January 22,

2 Agenda Hedge Funds -- An Overview Issues Hedge Funds Present for ERISA Fiduciaries Some Approaches to the Issues

3 I. Hedge Funds An Overview

4 What is a Hedge Fund? Hedge Funds are a Structure, not an Asset Class Key Elements: Offer investors some liquidity In addition to asset based fees, managers are paid incentive compensation based on net asset value of the portfolio, including unrealized gains and losses, not on cash realized from the disposition of investments Fully funded, investor commitments not drawn down over time Evergreen, not self-liquidating

5 Comparison of Hedge and Private Equity Funds Capital Contributions New Investors Liquidity Distributions Management Fees Performance Compensation Hedge Funds Fully funded at time investor becomes a shareholder or limited partner Generally accepts new investors (or additional investments) based on fund's net asset value Generally allows withdrawals at specified intervals, subject to certain limitations Generally, none (though some onshore funds provide tax distributions) Based on fund's net asset value (which includes portfolio appreciation) Percentage of increase in fund's net asset value (i.e., net realized and unrealized gains) Private Equity Funds Investor's capital commitment drawn down over time Not accepted, after short initial offering period. None Cash is distributed as investments are realized (subject to certain restrictions) During investment period, based on capital commitments; thereafter, generally based on invested capital (less write-downs) Percentage of cash distributed

6 Hedge Fund Investment Strategies Multiple strategies in one fund Funds of Funds Single manager, multi-strategy funds

7 Hedge Fund Investment Strategies (cont.) Single Strategies Asset Classes and Investment Styles Long-short equity Global macro Fixed-income Distressed Arbitrage and trading strategies Lending Emerging Markets Exotic Assets Commodities

8 Growth of U.S. Hedge Fund Industry Estimated Growth of Assets Hedge Fund Industry * 2,000,000 1,900,000 1,800,000 $1,868,000 $1,770,000 Assets (in $MM) 1,700,000 1,600,000 1,500,000 1,400,000 1,300,000 1,200,000 1,100,000 1,000,000 $972,608 $1,105,385 $1,430,000 $1,600,000 $1,407, ,000 $820, , ,000 $625, , , , , , ,000 $38,910 $58,370 $95,720 $167,790 $167,360 $185,750 $256,720 $367,560 $374,770 $456,430 $490,580 $539, Sources: HFR, Inc., The Bank of New York Mellon and Casey Quirk Analysis 2009 *2010 data as of September 30, 2010

9 Pension Investments in Hedge Funds Share of Fortune 500 pension plans with hedge fund investments grew from approximately 11% in 2001 to approximately 51% in Average allocation to hedge funds among plans with such investments was less than 5% in Highest reported hedge fund allocation was approximately 29% of total assets.

10 Share of Large DB Plans Investing in Hedge Funds P ercentage Source: Pensions & Investments 2009 annual survey

11 Pension Plans with Hedge Fund Investments by Size of Total Plan Assets S hare of Plans (percenta $250 - $500 m illion > $500 m illion - $1 billion >$1 billion - $5 billion Ove r $5 billion Source: Greenwich Associates, 2009

12 II. Selected Hedge Fund Issues

13 A. Valuation

14 Effects of Inaccurate Valuation Since manager compensation is based on portfolio value, overvaluing the portfolio overcompensates the manager Valuation errors result in wealth transfers between existing and subscribing investors An inaccurately high value shifts wealth to redeeming investors and other existing investors, because new investors are overpaying for their interests The reverse is true for an inaccurately low value

15 Key Valuation Issues Try to determine information source and process, not just the identity of valuation agent Fair value How is the fund s portfolio, which may include fairly esoteric instruments, marked to market? Particular sensitivities ( Level 3 Assets ): Manager-valued securities Dealer quotes Side pockets Contingent liabilities

16 Fair Value FASB definition FAS 157: "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." Basic notion: fair value = exit price Hierarchy of pricing sources Rebuttable presumption that transaction price between unrelated parties is fair value, absent "persuasive evidence"

17 B. Liquidity Will you get your money when you want it?

18 Main Liquidity Issues: Gates Suspension rights Side pockets

19 Gates A gate is a pre-specified limit on the portion of a fund s capital that can be redeemed on any given dealing day Issues Limits investor liquidity, with uncertain effect Can be waived, but probably not on an investor-byinvestor basis Usually not first in time, first in right -- rather, all redemptions scaled back pro rata Redemptions which are scaled back sometimes get first preference for the next redemption date There is sometimes a time limit by which redemptions must be satisfied or else the fund is liquidated

20 Suspension Rights Typically, the fund board or investment manager may have the right to suspend all redemptions due to extraordinary circumstances Issues Suspension rights have at times been read very broadly Result is that there is no guarantee of liquidity, at any price

21 Side Pockets Side pockets are commonly used by hedge funds to deal with comparatively illiquid or difficult to value assets. Assets are segregated and the value of these assets is excluded for performance-fee purposes until the investment is realized. Side pockets have existed for a long time, but we are finding that they are used more frequently as hedge funds invest in more illiquid investments, and as a result of FAS 157.

22 Side Pockets Creation and use of side pockets can raise a number of issues: Determination to include an asset in a side pocket, particularly for existing positions/investments Determination of when to remove an asset from a side pocket Generally valued at cost, but the discretion to carry at "fair value" or cost or to write off can be an issue If improperly structured, can be used to delay recognition of losses

23 C. Side Letters

24 Side Letters Hedge fund managers are frequently asked to alter investment terms through side letters. Investor side letters may be sought to : 1. address regulatory concerns (e.g., ERISA) or to accommodate large investors; 2. provide different redemption or withdrawal rights; may be problematic as a matter of law 3. provide additional transparency and information rights.

25 Side Letters "Most Favored Nations" provisions Great tool, if you can get them Soft versus hard MFNs Results in disclosure you wouldn t otherwise get

26 D. Bad Apples

27 Egregious Conduct A few "bad apples" (e.g., Madoff feeders, Bayou, Wood River) have garnered a lot of media attention Reputational risk, in addition to investment losses Long-tail nature of hedge fund liabilities Redeemed investors Madoff trustee argues there can be a look-back and recoupment of proceeds received A new investor may have economic losses for liabilities (e.g., unpaid taxes) where it had no benefit from the activity which gave rise to the liability and no direct exposure

28 III. Solutions

29 Usual Tools of the Pension Fiduciary Appropriate process Reliance on advisors Investment consultants Lawyers

30 Role of Lawyers v. Role of Consultants Consultants ("narrowing the universe"): Whether to use hedge funds? Which types/categories of funds? Proposed set of funds? Lawyers: Review appropriate process, including redemption decisions Identification of category-wide issues Due Diligence on particular funds Contractual documentation and structuring

31 Documentation -- Three Stage Process Stage 1 -- Of all possible hedge funds, why this one? Stage 2 -- Due diligence on particular prospective funds Stage 3 -- Negotiation and execution of legal documents

32 Stage 1 -- Narrowing the Universe of Possible Funds Investment consultants play the key role Document why hedge funds at all Diversification Absolute return Access to particular asset classes (e.g., currencies, physical commodities) Document why this hedge fund Focus is on the report of the investment consultants Document follow-up to fiduciary questions (e.g., as to fees)

33 Stage 2 -- Diligence Investment Due Diligence Legal Due Diligence Comingled v. single-investor approaches Review of legal documents for comingled funds Structural Considerations

34 Stage 3 -- Legal Documents Comingled Funds At a minimum, "plan assets" side letter Other possible side letter points MFN "Key Person" provisions Comfort as to issues raised in diligence Single Investor Vehicles Managed Accounts v. "Funds of One" Domicile UBTI ECI

35 Yasho Lahiri Partner Baker Botts L.L.P 30 Rockefeller Plaza New York, NY Telephone: (212) Facsimile: (212)