According to Pensions and Investment, the Boston office of the US Department of Labor (the “DOL”) recently issued a letter to an (unidentified) US Pension Plan subject to ERISA (the Employee Retirement Income Security Act) stating that the plan was in violation of ERISA regulations. The DOL is responsible for monitoring - and sanctioning - ERISA plans and, in their letter, threatened legal action if the plan in question did not remedy the noted violations.
When valuing hedge funds and other alternative assets for purposes of the Plan’s annual filing, the pension investor had apparently relied upon valuations provided by the underlying funds’ general partners and, in some cases, on audited financial statements for those funds.
This is, of course, standard practice for many hedge fund investors. It appears, however, that this approach could create a major roadblock for ERISA plans.
According to the DOL, “it is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan. Such a process would include a complete understanding of the underlying investments and the fund’s investment strategy. In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to ensure that it comports with the fund’s written valuation provisions and reflects fair market value. A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”
In other words, the entity which has to value all assets – and especially hard to value assets – is the pension investor subject to ERISA. There is no way of dodging this poison chalice - the ERISA investor cannot simply rely on the hedge fund’s own valuation.
This is an enormously challenging obligation, particularly in the context of the severe fiduciary standards set by ERISA. Indeed, the DOL position raises a broad question - is it even possible for ERISA plans (or indeed any hedge fund investor) to meet this duty of care?
We have three observations.
Firstly, very few hedge funds provide position level transparency. However, it is stating the obvious to say that, without position level transparency, it is impossible for an ERISA investor (or any other investor for that matter) to have a “complete” understanding of the underlying investments and the fund’s investment strategy. Moreover, even if managers do provide position information, how can investors ensure that it is timely and accurate? The best solution to the transparency issue is a managed account – as such, would one outcome of the DOL’s position, if enforced, be for ERISA plans to only invest through managed account structures?
Secondly, the DOL states that ERISA plans must have a “thorough knowledge of the general partner’s valuation methodology”. However, in practice, most hedge fund offering documents have deliberately vague and unspecific clauses as to valuation and calculation of the net asset value, especially in relation to hard to value instruments. To add salt to the wound, every prospectus we have ever read includes a final caveat along the lines of “notwithstanding the above policies, the general partner (or the Board of directors in “consultation” with the investment manager for an offshore fund) may elect any “alternative method” of fair valuation. “ There is hence very limited specificity as to valuation procedures in virtually all hedge fund offering materials, and certainly insufficient information to provide a “thorough knowledge” of the valuation methodology which will be applied.
If the prospectus gives an inadequate description of the valuation process, investors need to turn to supplementary information from the hedge fund manager. At this point, however, things get worse - many hedge fund managers have not developed any internal, written valuation policy at all. For those funds which do have a valuation document, there is no standardization, and many valuation policies remain uncomfortably vague and unspecific (although, in fairness, we congratulate the minority of managers who have some stepped up and do furnish investors with comprehensive valuation information.)
The worst case is when a manager does have a valuation document, but will not provide it to the investor. Ironically, the worst culprits in this situation are some of the industry’s largest and most well known hedge fund managers. The issue is liability: hedge fund lawyers now appear to advise managers that the more information provided to investors, the more the potential liability. (As an aside, we recently spoke with the CFO of a large hedge fund: he noted that the sight of the Bear Stearns hedge fund managers being led away in 'cuffs had resulted in urgent calls from the firm's lawyers, advising the manager to reduce the amount of information it provided to investors.)
The third area of concern is the ongoing assumption by many investors, including many ERISA plans, that third party administrators assume responsibility for valuing hedge fund portfolios. As such, the administrator, it is perceived, can provide the necessary independence in the valuation process.
Not so fast. As we have noted before, much of today’s administration industry is now emphatic that they perform only the services of a “calculation agent” not a “valuation agent”. This is a relatively mute point when dealing with exchange traded securities, but it is an enormous issue when looking at a hedge fund which trades hard to value instruments (it goes without saying that we need help to value exotic CDOs, not IBM stock).
As a “calculation agent”, many administrators have amended their legal contracts to retain the right to “consult with” the manager and, indeed, accept prices from the hedge fund manager without further verification. Again, we hate to make an “emperor has no clothes” comment, but this is obviously nonsense: taking prices from the manager is like a police officer issuing speeding tickets on the basis of asking drivers how fast they were going.
These issues, in our mind, share a common theme. In recent years, with an ever-accelerating pace, we have watched the legal pendulum which defines how investors and hedge fund managers transact drift ever further in favor of the manager at the expense of the investor. It is trite, but uncomfortably accurate, to say that, in today’s hedge fund industry, no-one wants to be responsible for anything. Everyone is instead seeking to be indemnified to the point of invulnerability.
And this is the disconnect between the hedge fund industry and DOL. ERISA establishes onerous standards of fiduciary responsibility, deliberately designed to make those responsible for ERISA plans accountable, responsible and liable for their actions. Today’s hedge funds, however, are increasingly structured to ensure the lowest possible degree of accountability and liability on the part of pretty much everyone involved.
Against this background, we will watch with great interest ongoing developments as the DOL monitors ERISA plans with material hedge fund portfolios. The question, of course, is whether investing in opaque, uncommunicative hedge funds (even when they are some of the largest in the world) is too close to pushing a square peg in a round hole for investors who do operate within a strict fiduciary framework.
Hedge Fund Operational Due Diligence