Defined Benefit Pension Plans
Plans Face Valuation and Other Challenges When Investing in Hedge Funds and Private Equity Gao ID: GAO-10-915T July 20, 2010Millions of Americans rely on private or public defined benefit pension plans, which promise to pay retirement benefits that are generally based on an employee's salary and years of service. Plan sponsors are increasingly investing in "alternative" assets such as hedge funds and private equity. This has raised concerns, given that these two types of investments have qualified for exemptions from some federal regulations and could present more risk to retirement assets than traditional investments. This testimony discusses (1) the extent to which defined benefit plans have invested in hedge funds and private equity, (2) challenges that such plans face in investing in hedge funds and private equity, (3) steps that plan sponsors can take to address these challenges, and (4) the implications of these challenges for the federal government. To prepare this statement, GAO relied primarily on its published reports on hedge funds and private equity (GAO-08-692 and GAO-08-200), and obtained new data on the extent of plan investments in hedge funds and private equity. GAO has previously recommended that the Secretary of Labor provide guidance designed to help ERISA fiduciaries better assess their ability to invest in hedge funds and private equity. Labor generally agreed with our recommendation, but has yet to take action.
A growing number of private and public sector plans have invested in hedge funds and private equity, but such investments generally comprise a small share of total plan assets. According to a survey of large plans, the share of plans with investments in hedge funds grew from 11 percent in 2001 to 51 percent in 2009. Over the same time period, investments in private equity were more prevalent but grew more slowly--an increase from 71 percent in 2001 to 90 percent in 2009. Still, the average allocation of plan assets to hedge funds was less than 5 percent, and the average allocation to private equity was less than 8 percent. Available data also show that investments in hedge funds and private equity are more common among large pension plans, measured by assets under management, compared to mid-size plans. Survey information on smaller plans is unavailable, so the extent to which these plans invest in hedge funds or private equity is unknown. Hedge funds and private equity investments pose a number of risks and challenges beyond those posed by traditional investments. For example, investors in hedge funds and private equity face uncertainty about the precise valuation of their investment. Hedge funds may, for example, own thinly traded assets whose valuation can be complex and subjective, making valuation difficult. Further, hedge funds and private equity funds may use considerable leverage--the use of borrowed money or other techniques--which can magnify profits, but can also magnify losses if the market goes against the fund's expectations. Also, both are illiquid investments--that is they cannot generally be redeemed on demand. Finally, investing in hedge funds can pose operational risk--that is, the risk of investment loss from inadequate or failed internal processes, people, and systems, or problems with external service providers rather than an unsuccessful investment strategy. Plan sponsors we spoke with address these challenges in a number of ways, such as through careful and deliberate fund selection, and negotiating key contract terms. For example, investors in both hedge funds and private equity funds may be able to negotiate fee structure and valuation procedures, and the degree of leverage employed. Also, plans address various concerns through due diligence and monitoring, such as careful review of investment, valuation, and risk management processes. The Department of Labor (Labor) has a role in helping to ensure that plans fulfill their Employee Retirement and Income Security Act of 1974 (ERISA) fiduciary duties, which includes educating employers and service providers about their fiduciary responsibilities under ERISA. According to plan officials, state and federal regulators, and others, some pension plans, such as smaller plans, may have particular difficulties in addressing the various demands of hedge fund and private equity investing. In light of this, in 2008, we recommended that Labor provide guidance on the challenges of investing in hedge funds and private equity and the steps plans should take to address these challenges.
GAO-10-915T, Defined Benefit Pension Plans: Plans Face Valuation and Other Challenges When Investing in Hedge Funds and Private Equity
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Testimony:
Before the Subcommittee on Health, Employment, Labor, and Pensions,
Committee on Education and Labor, House of Representatives:
United States Government Accountability Office:
GAO:
For Release on Delivery:
Expected at 10:00 a.m. EDT:
Tuesday, July 20, 2010:
Defined Benefit Pension Plans:
Plans Face Valuation and Other Challenges When Investing in Hedge
Funds and Private Equity:
Statement of Barbara Bovbjerg, Managing Director:
Education, Workforce, and Income Security:
GAO-10-915T:
GAO Highlights:
Highlights of GAO-10-915T, a testimony before the Subcommittee on
Health, Employment, Labor and Pensions, Committee on Education and
Labor, House of Representatives.
Why GAO Did This Study:
Millions of Americans rely on private or public defined benefit
pension plans, which promise to pay retirement benefits that are
generally based on an employee‘s salary and years of service. Plan
sponsors are increasingly investing in ’alternative“ assets such as
hedge funds and private equity. This has raised concerns, given that
these two types of investments have qualified for exemptions from some
federal regulations and could present more risk to retirement assets
than traditional investments.
This testimony discusses (1) the extent to which defined benefit plans
have invested in hedge funds and private equity, (2) challenges that
such plans face in investing in hedge funds and private equity, (3)
steps that plan sponsors can take to address these challenges, and (4)
the implications of these challenges for the federal government.
To prepare this statement, GAO relied primarily on its published
reports on hedge funds and private equity (GAO-08-692 and GAO-08-200),
and obtained new data on the extent of plan investments in hedge funds
and private equity.
GAO has previously recommended that the Secretary of Labor provide
guidance designed to help ERISA fiduciaries better assess their
ability to invest in hedge funds and private equity. Labor generally
agreed with our recommendation, but has yet to take action.
What GAO Found:
A growing number of private and public sector plans have invested in
hedge funds and private equity, but such investments generally
comprise a small share of total plan assets. According to a survey of
large plans, the share of plans with investments in hedge funds grew
from 11 percent in 2001 to 51 percent in 2009. Over the same time
period, investments in private equity were more prevalent but grew
more slowly”an increase from 71 percent in 2001 to 90 percent in 2009.
Still, the average allocation of plan assets to hedge funds was less
than 5 percent, and the average allocation to private equity was less
than 8 percent. Available data also show that investments in hedge
funds and private equity are more common among large pension plans,
measured by assets under management, compared to mid-size plans.
Survey information on smaller plans is unavailable, so the extent to
which these plans invest in hedge funds or private equity is unknown.
Hedge funds and private equity investments pose a number of risks and
challenges beyond those posed by traditional investments. For example,
investors in hedge funds and private equity face uncertainty about the
precise valuation of their investment. Hedge funds may, for example,
own thinly traded assets whose valuation can be complex and
subjective, making valuation difficult. Further, hedge funds and
private equity funds may use considerable leverage”the use of borrowed
money or other techniques”which can magnify profits, but can also
magnify losses if the market goes against the fund‘s expectations.
Also, both are illiquid investments”that is they cannot generally be
redeemed on demand. Finally, investing in hedge funds can pose
operational risk”that is, the risk of investment loss from inadequate
or failed internal processes, people, and systems, or problems with
external service providers rather than an unsuccessful investment
strategy.
Plan sponsors we spoke with address these challenges in a number of
ways, such as through careful and deliberate fund selection, and
negotiating key contract terms. For example, investors in both hedge
funds and private equity funds may be able to negotiate fee structure
and valuation procedures, and the degree of leverage employed. Also,
plans address various concerns through due diligence and monitoring,
such as careful review of investment, valuation, and risk management
processes.
The Department of Labor (Labor) has a role in helping to ensure that
plans fulfill their Employee Retirement and Income Security Act of
1974 (ERISA) fiduciary duties, which includes educating employers and
service providers about their fiduciary responsibilities under ERISA.
According to plan officials, state and federal regulators, and others,
some pension plans, such as smaller plans, may have particular
difficulties in addressing the various demands of hedge fund and
private equity investing. In light of this, in 2008, we recommended
that Labor provide guidance on the challenges of investing in hedge
funds and private equity and the steps plans should take to address
these challenges.
View [hyperlink, http://www.gao.gov/products/GAO-10-915T] or key
components. For more information, contact Barbara Bovbjerg at (202)
512-7215 or bovbjergb@gao.gov.
[End of section]
Mr. Chairman and Members of the Subcommittee,
I am pleased to be here to participate in today's hearing on creating
greater accounting transparency for pensioners. As you know, millions
of Americans rely on defined benefit (DB) plans for their financial
well-being after their working years. Historically, public and private
sector pension plans have primarily invested in traditional
investments such as stocks and bonds; but more recently, plans are
increasingly investing in "alternative" investments such as hedge
funds and private equity.
While there is no statutory definition of hedge funds, the phrase
"hedge fund" is commonly used to refer to a pooled investment vehicle
that is privately organized and administered by professional managers,
and that often engages in active trading of various types of
securities, as well as futures and options contracts. Similarly,
private equity is not statutorily defined, but is generally considered
to be privately managed investment pools administered by professional
managers who typically make long-term investments in private
companies, taking a controlling interest with the aim of increasing
the value of these companies through such strategies as improving
operations or developing new products. Both hedge funds and private
equity may be managed so as to be exempt from certain aspects of
federal securities law and regulation that apply to other investment
pools such as mutual funds. There are a number of investments that are
considered to be alternative investments, but my statement today will
focus on our prior work on pension plan investment in hedge funds and
private equity.
Much has happened in the financial markets since we issued three
reports--one which addressed pension plan investments in hedge funds
and private equity, another which addressed federal oversight and
other issues regarding hedge funds exclusively, and a final report
addressed private equity funds--in 2008.[Footnote 1] Hedge funds have
been deeply affected in the financial turmoil. According to an
industry survey, most hedge fund strategies produced double-digit
losses in 2008, and hedge funds saw approximately $70 billion in
redemptions between June and November 2008.[Footnote 2] Some observers
blamed hedge funds for dramatic volatility in the stock and commodity
markets in 2008 and some funds of hedge funds[Footnote 3] were heavily
invested in the Madoff fraud. Nevertheless, an industry survey of
institutional investors suggests that these investors are still
committed to investing in hedge funds in the long term.
My statement today is based primarily on our 2008 report on pension
plan investments in hedge funds and private equity. My comments will
focus on 1) the extent to which DB plans have invested in hedge funds
and private equity, 2) challenges that such plans face in investing in
hedge funds and private equity, 3) steps that plan sponsors can take
to address these challenges, and 4) the implications these challenges
for plan sponsors and the federal government.
In conducting our prior work, we reviewed relevant literature and
survey data and conducted in-depth interviews with pension plan
representatives and industry experts. We obtained and analyzed data on
the extent of pension plan investments in hedge funds and private
equity from private organizations such as Greenwich Associates,
Pensions & Investments, and Pyramis Global Advisors. We updated these
data for purposes of my testimony today. We also conducted in-depth
interviews with representatives of 26 public and private sector DB
pension plans and, where possible, obtained and reviewed supporting
documentation. These plans were selected based on several criteria,
including the range of investment in hedge funds and private equity
and the amount of total plan assets. We also interviewed officials of
regulatory agencies, relevant industry organizations, investment
consulting firms, and other national experts. We conducted our prior
work from June 2007 to July 2008 in accordance with generally accepted
government auditing standards. Those standards require that we plan
and perform the audit to obtain sufficient, appropriate evidence to
provide a reasonable basis for our findings and conclusions based on
our audit objectives.
Background:
Millions of current and future retirees rely on private or public DB
plans, which promise to pay retirement benefits that are generally
based on an employee's salary and years of service. The financial
condition of these plans--and hence their ability to pay promised
retirement benefits when such benefits are due--depends on adequate
contributions from employers and, in some cases, employees, as well as
prudent investments that preserve principal and yield an adequate rate
of return over time. The plan sponsor must make contributions to the
plan that are intended to ensure it is adequately funded to pay
promised benefits. To maintain and increase plan assets, fiduciaries
of public and private sector pension plans choose investments that are
expected to grow in value or yield income. Plan fiduciaries invest in
various categories of asset classes, which traditionally have
consisted mainly of stocks and bonds. Pension fiduciaries may also
invest in other asset classes or trading strategies, such as hedge
funds and private equity, which can generally be riskier investments,
so long as such investments are prudent.
To obtain favorable tax treatment private sector pension plan
investment decisions must comply with the provisions of the Employee
Retirement and Income Security Act of 1974 (ERISA), under which plan
sponsors and other fiduciaries must act solely in the interest of the
plan participants and beneficiaries, (1) for the exclusive purpose of
providing benefits to participants and their beneficiaries, as well as
defraying reasonable expenses of administering the plan; (2) with the
care, skill, prudence, and diligence then prevailing that a prudent
man acting in a similar situation would use; (3) by diversifying plan
investments so as to minimize the risk of large losses; and (4) in
accordance with plan documents consistent with ERISA.[Footnote 4]
Under ERISA, the prudence of any individual investment is considered
in the context of the total plan portfolio, rather than in isolation.
Hence, a relatively risky investment may be considered prudent if it
is part of a broader strategy to balance the risk and expected return
to the portfolio. The Employee Benefit Security Administration (EBSA)
at the Department of Labor (Labor) is responsible for enforcing these
standards, as well as educating and assisting plan participants and
plan sponsors.
In the public sector, governments have established pension plans at
state, county, and municipal levels, as well as for particular
categories of employees, such as police officers, fire fighters, and
teachers. The structure of public pension plan systems can differ
considerably from state to state. Public sector DB plans are not
subject to funding, vesting, and most other requirements applicable to
private sector DB plans under ERISA,[Footnote 5] but must follow
requirements established for them under applicable state law and have
generally adopted fiduciary standards similar to those of ERISA.
Generally privately managed and engaged in active trading of various
types of securities, hedge funds are typically structured and operated
as limited partnerships or limited liability companies exempt from
certain registration, disclosure, and other requirements under the
Securities Act of 1933,[Footnote 6] Securities Exchange Act of 1934,
[Footnote 7] Investment Company Act of 1940,[Footnote 8] and
Investment Advisers Act of 1940[Footnote 9] that apply to other
investment pools, such as mutual funds.[Footnote 10] Unlike a mutual
fund, which must strictly abide by the detailed investment policy and
other limitations specified in its prospectus, most hedge funds
specify broad objectives and authorize multiple strategies. They may
invest in a wide variety of financial instruments, including stocks
and bonds, currencies, futures contracts, and other assets.
Like hedge funds, there is no legal or commonly accepted definition of
private equity funds, but the term generally includes privately
managed pools of capital that invest in companies, many of which are
not listed on a stock exchange. Although there are some similarities
in the structure of hedge funds and private equity funds, the
investment strategies employed are different. Unlike many hedge funds,
private equity funds typically make long-term investments in private
companies and seek to obtain financial returns not through particular
trading strategies and techniques, but through long-term appreciation
based on corporate stewardship, improved operating processes, and
financial restructuring of those companies, which may involve a merger
or acquisition. Private equity is generally considered to involve a
substantially higher degree of risk than traditional investments, such
as stocks and bonds, in exchange for a higher return.
A Growing Number of Pension Plans Are Investing in Hedge Funds or
Private Equity, but Such Investments Are Generally a Small Portion of
Plan Assets:
We reported in 2008 that DB plan investments in hedge funds and
private equity have grown, but such investments are generally a small
portion of plan assets, and this trend has continued. According to a
Pensions & Investments survey, the percentage of large plans (as
measured by total plan assets) investing in hedge funds grew from 11
percent in 2001 to 51 percent in 2009 (see figure 1). Over the same
time period, the percentage of large plans that invest in private
equity grew at a much lesser rate--71 percent to 90 percent--because a
much larger percentage of plans were already invested in private
equity in 2001.
Figure 1: Share of Large DB Plans Investing in Hedge Funds and Private
Equity:
[Refer to PDF for image: vertical bar graph]
Year: 2001;
Hedge fund: 11%;
Private equity: 71%.
Year: 2002;
Hedge fund: 14%;
Private equity: 68%.
Year: 2003;
Hedge fund: 15%;
Private equity: 67%.
Year: 2004;
Hedge fund: 21%;
Private equity: 71%.
Year: 2005;
Hedge fund: 27%;
Private equity: 75%.
Year: 2006;
Hedge fund: 36%;
Private equity: 77%.
Year: 2007;
Hedge fund: 47%;
Private equity: 80%.
Year: 2008;
Hedge fund: 49%;
Private equity: 84%.
Year: 2009;
Hedge fund: 51%;
Private equity: 90%.
Source: Pensions & Investments‘ 2009 annual survey.
[End of figure]
Data from the same survey reveal that investments in hedge funds and
private equity typically comprise a small share of plan assets. The
average allocation to hedge funds among plans with such investments
was not quite 5 percent in 2009. Similarly, among plans with
investments in private equity, the average allocation was less than 8
percent. Although the majority of plans with investments in hedge
funds or private equity have small allocations to these assets, a few
plans have relatively large allocations, according to the Pensions &
Investments survey. Of the 61 plans that reported hedge fund
investments in 2009, 12 had allocations of 10 percent or more (see
figure 2). The highest reported hedge fund allocation was 29 percent
of total assets. Similarly, of the 108 plans that reported private
equity investments in 2009, 23 had allocations of 10 percent or more
and the highest reported private equity allocation was 26 percent.
Figure 2: The Number of Plans with Investments in Hedge Funds or
Private Equity by Size of Allocation:
[Refer to PDF for image: stacked vertical bar graph]
Pension plan: Hedge funds;
Plans investing less than 10 percent of total assets: 49;
Plans investing 10 percent or more of total assets: 12;
Total: 61.
Pension plan: Private equity;
Plans investing less than 10 percent of total assets: 85;
Plans investing 10 percent or more of total assets: 23;
Total: 108.
Source: GAO analysis of Pensions & Investments 2009 annual survey data.
[End of figure]
Available survey data show that larger plans, measured by total plan
assets, are more likely to invest in hedge funds and private equity
compared to mid-size plans. As shown below, a survey by Greenwich
Associates found that 30 percent of mid-size plans--those with $250 to
$500 million in total assets--were invested in hedge funds, compared
to 53 percent of the largest plans--those with more than $5 billion in
total assets (see figure 3). Survey data on plans with less than $200
million in assets are unavailable and, in the absence of this
information, it is unclear to what extent these plans invest in hedge
funds and private equity.
Figure 3: Pension Plans with Investments in Hedge Funds and Private
Equity by Size of Total Plan Assets:
[Refer to PDF for image: vertical bar graph]
Size of plan: $250-$500 million;
Hedge fund: 30%;
Private equity: 22%.
Size of plan: Greater than $500 million to $1 billion;
Hedge fund: 35%;
Private equity: 37%.
Size of plan: Greater than $1billion to $5 billion;
Hedge fund: 35%;
Private equity: 48%;
Size of plan: Over $5 billion;
Hedge fund: 53%;
Private equity: 71%.
Source: Greenwich Associates, 2009.
Note: The figures above include public and corporate plans.
Information on the investments of collectively bargained plans by size
of total assets was not available.
[End of figure]
Hedge Fund and Private Equity Investments Pose Various Risks and
Challenges for Plan Sponsors:
Valuation:
One of the major challenges that both hedge fund and private equity
investments pose to plan sponsors investing is uncertainty over the
current value of their investment. With regard to hedge funds, we
noted that plans may lack information on both the nature of the
specific underlying holdings of the hedge fund, as well as the
aggregate value on a day to day basis. Because many hedge funds may
own thinly traded securities and derivatives whose valuation can be
complex, and in some cases subjective, a plan may not be able to
obtain timely information on the value of assets owned by a hedge
fund.[Footnote 11] Further, hedge fund managers may decline to
disclose information on asset holdings and the net value of individual
assets largely because release of such information could compromise
their trading strategy. In addition, even if hedge fund managers were
to provide detailed positions, plan sponsors might be unable to fully
analyze and assess the prospective return and risk of a hedge fund. As
we noted in our August 2008 report, hedge fund managers may seek to
profit through complex and simultaneous positions and can abruptly
change their positions and trading tactics in order to achieve desired
return as changing market conditions warrant. Consequently, a plan may
not be able to independently ascertain the value or fully assess the
degree of investment risk posed by its hedge fund investment. Although
we noted in January 2008 that some hedge funds have improved
disclosure and transparency about their operations due to the demands
of institutional investors, several pension plans cited limited
transparency as a prime reason they had chosen not to invest in hedge
funds.[Footnote 12] During our research for that report,
representatives of one plan told us that they had considered investing
in hedge funds several years before, but that most of the hedge funds
it contacted would not provide position-level information, and they
were reluctant to make such an investment without this information.
Similar to hedge funds, valuations of private equity investments are
uncertain during the fund's cycle, which often lasts 10 years or more.
Unlike investments which are traded and priced in public markets,
plans have limited information on the value of private equity
investments until the underlying holdings are sold. Some plan
representatives we interviewed explained that fund managers often
value underlying holdings at their initial cost until they are sold
through an initial public offering or other type of sale.[Footnote 13]
In some cases private equity funds estimate the value of the fund by
comparing companies in their portfolio to the value of comparable
publicly-traded assets. However, an investment consultant explained
that such periodic valuations have limited utility. Prior to the sale
of underlying investments, assessing the value of a private equity
fund is difficult. In 2008, plan officials we interviewed acknowledged
the difficulty of valuing private equity investments and generally
accepted it as a trade-off for the potential benefits of the
investment.
Investment risk:
While any plan investment may fail to deliver expected returns over
time, hedge fund and private equity investments pose investment
challenges beyond those posed by traditional investments. For example,
both hedge fund and private equity managers may use leverage--that is,
borrowed money or other techniques--to potentially increase an
investment's return without increasing the amount invested. While
registered investment companies are subject to strict leverage limits,
a hedge fund or private equity fund can make relatively unrestricted
use of leverage. This is noteworthy because while leverage can magnify
profits, it can also magnify losses to the fund if the market goes
against the fund's expectations. In addition, a private equity fund
manager's strategy typically involves concentrating its holdings in a
limited number of underlying companies--generally about 10 to 15
companies, often in the same sector. Further, hedge funds and private
equity funds also feature relatively costly fee structures, which have
significant impact on net investment returns.[Footnote 14] In 2008, we
reported that hedge funds and private equity funds often charge an
annual fee of 2 percent of invested capital and 20 percent of returns,
whereas mutual fund managers reportedly charge a fee of about 1
percent or less of assets under management.[Footnote 15] For private
equity, if the gross returns are not sufficiently high, net returns to
investors will not meet the commonly cited goal of exceeding the
return of the stock market and, thus, plans will not have earned a
premium for assuming the risks inherent in private equity investments.
Lack of liquidity:
Hedge funds and private equity are also relatively illiquid
investments--that is, investors generally cannot easily redeem their
investments on demand. Hedge funds often require an initial lockup of
1 year or more, during which an investor cannot cash out of the hedge
fund. After the initial lockup period, hedge funds offer only
occasional liquidity, sometimes with a prenotification requirement.
Hedge funds impose such liquidity limits because sudden liquidations
could, for example, disrupt a carefully calibrated investment
strategy. Nonetheless, they also pose certain disadvantages to plan
sponsors, such as inhibiting a plan's ability to limit a hedge fund's
investment loss. Private equity funds require an even longer-term
commitment than hedge fund investments. Private equity funds can
require commitments of 10 years or more, and during that time, a plan
may have no ability to redeem its investments. A private equity fund
cycle typically includes an initial period in which investors must
provide the fund with capital when called upon, which may not be
redeemed for several years, to invest in underlying companies and then
obtain returns over time as investments mature. Several plan
representatives and other experts we interviewed stated that the
nature of private equity necessitates long commitments as returns are
generated through long-term growth strategies, rather than short-term
gains. Representatives of several plans noted that they expect higher
returns from private equity investments in exchange for the long-term
commitment.
Operational risk:
Finally, we reported that pension plans investing in hedge funds are
also exposed to operational risk--that is, the risk of investment loss
due not to a faulty investment strategy, but from inadequate or failed
internal processes, people, and systems, or problems with external
service providers. Operational problems can arise from a number of
sources, including inexperienced operations personnel; inadequate
internal controls; lack of compliance standards and enforcement;
errors in analyzing, trading, or recording positions; or outright
fraud. According to a report by an investment consulting firm, because
many hedge funds engage in active, complex, and sometimes heavily
leveraged trading, a failure of operational functions, such as
processing or clearing one or more trades, may have grave consequences
for the overall position of the hedge fund. Several pension plans we
contacted expressed concerns about operational risk; one noted back
office and operational issues become deal breakers in some cases.
Plan Sponsors Take a Number of Steps to Address the Risks of Hedge
Fund and Private Equity Investing:
Pension plans we spoke with take a number of steps in an attempt to
mitigate the risks and challenges of investing in hedge funds and
private equity.
First, discussions with plan sponsors revealed the importance of
making careful and deliberate fund selection when investing in hedge
funds and private equity. In the case of hedge funds, plan sponsors
emphasized defining a clear purpose and strategy for their hedge fund
investments. One plan fiduciary noted that plan sponsors should decide
exactly why they want to invest in hedge funds. The official noted
that there are many different possible hedge fund strategies, and a
simple desire for the reportedly large returns of hedge funds is not
sufficient. Most of the plans we contacted described one or more
specific strategies for their hedge fund investments, such as a pure
long-short strategy.[Footnote 16] Several sources stated that private
equity investments have greater variation in performance among funds,
particularly among venture capital investments, compared to other
asset classes, such as domestic stocks, and, therefore, they must
invest with top performing funds in order to achieve long-term returns
in excess of the stock market.
Plan sponsors and others also cited the importance of negotiating key
terms of investments in hedge funds and private equity. They said in
the case of hedge funds, such terms can include fee structure and
conditions, degree of transparency, valuation procedures, redemption
provisions, and degree of leverage employed. For example, pension
plans may want to ensure that they will not pay a performance fee
unless the value of the hedge fund investment passes a previous peak
value of the fund shares--known as a high water mark. Key contract
terms for private equity may also include fee structure and valuation
procedures, though one plan sponsor noted the ability to negotiate
favorable contract terms is limited when investing in top performing
funds, because investing in such funds is highly competitive. In
addition, any "side letters" or contracts that may grant special
rights or terms to other investors are also thought to be critical.
Side letters document specific arrangements regarding, for example,
prohibited transactions, redemption rights, reporting, and disclosure
under which investors that are party to them receive advantages that
may come at the detriment of other investors.
Due diligence and ongoing monitoring, beyond those required for
traditional investments, are also important. For hedge funds, due
diligence can be a wide ranging process including study of a hedge
fund's investment process, valuation, risk management processes, and
compliance procedures, as well as a review of back office operations.
As with hedge fund investments, plans take additional steps to
mitigate the challenges of investing in private equity through
extensive and ongoing monitoring, beyond that required for traditional
investments. Plan representatives we interviewed said these steps
include regularly reviewing reports on the performance of the
underlying investments of the private equity fund and having periodic
meetings with fund managers. In some cases, plans participate on the
advisory board of a private equity fund, which provides a greater
opportunity for oversight of the fund's operations and new
investments; however this involves a significant time commitment and
may not be feasible for every private equity investment.
Finally, several plan sponsors address some of the risks and
challenges of investing in hedge funds and private equity by investing
via funds of funds. Investing in a fund of funds provides investors
with diversification across multiple funds, which can mitigate the
effect of one manager's poor performance. In particular, funds of
private equity funds can allow plans to invest in a variety of
managers, industries, geographies, and year of initial capital
investment. In addition, a plan sponsor may be able to rely on a fund
of funds manager to conduct negotiations, due diligence, and
monitoring of the underlying hedge funds. As we reported, funds of
funds can be appropriate if plan sponsors do not have the skills
necessary to manage a portfolio of hedge funds. In addition, investing
through a fund of funds may provide a plan better access to hedge
funds or private equity funds than a plan would be able to obtain
directly. Nonetheless, investing in a fund of funds has some drawbacks
and limitations, including an additional layer of fees--such as a 1
percent flat fee and a performance fee of between 5 and 10 percent of
returns--on top of the substantial fees that a fund of funds manager
pays to the underlying hedge funds. Furthermore, funds of funds also
pose the same challenges as hedge funds, such as limited transparency
and liquidity, and the need for the plan to conduct a due diligence
review of the fund of funds firm. Investing through a fund of funds
does not relieve plan sponsors of their own fiduciary duties;
accordingly, the plan sponsors must act prudently in selecting and
monitoring fund of funds.
The Federal Government Can Help Educate Plans on the Challenges of
Investing in Hedge Funds:
According to plan officials, state and federal regulators, and others,
some pension plans, especially smaller plans, may find it particularly
difficult to address the various demands of hedge fund investing. For
example, an official of a national organization representing state
securities regulators told us that medium-and small-size plans may not
have the expertise to oversee the trading and investment practices of
hedge funds. Some plans may also lack the ability to conduct the
necessary due diligence and monitoring of hedge fund investments. This
official said that smaller plans may have only one or two person
staffs, or may lack the resources to hire outside consulting
expertise. A labor union official made similar comments, noting that
smaller pension plans lack the internal capacity to assess hedge fund
investments, and that such plans may be locked out of top performing
hedge funds. While such plans might often be smaller plans, larger
plans may also lack sufficient expertise. A representative of one
pension plan with more than $32 billion in total assets noted that
before investing in hedge funds, the plan would have to build up its
staff in order to conduct the due diligence necessary during the fund
selection process.
In light of these challenges, Labor can play a role in helping to
ensure that plans fulfill their ERISA fiduciary duties when investing
in hedge funds and private equity. For example, in 2006, the ERISA
Advisory Council recommended that Labor publish guidance about the
unique features of hedge funds and matters for consideration in their
use by qualified plans.[Footnote 17] In 2008, the ERISA Advisory
Council recommended that Labor publish guidance to clarify the role of
ERISA fiduciaries in selecting, valuing, and accounting for hard to
value assets, of which many hedge funds and private equity funds are
comprised.[Footnote 18] In addition, the Investor's Committee formed
by the President's Working Group on Financial Markets published a
report in January 2009 on the best practices for hedge fund investors.
[Footnote 19] The report acknowledges that hedge fund investments are
not necessarily suitable for some investors and provides many
recommendations for investors selecting and monitoring their hedge
fund investments--including best practices for valuation--such as
obtaining a written statement of the fund's valuation policies and
procedures and assuring the fund's portfolio is being valued in
accordance with Generally Accepted Accounting Principles (GAAP).
In 2008, we recommended that Labor provide guidance for qualified
plans under ERISA on the unique challenges of investing in hedge funds
and private equity and the steps plans should take to address these
challenges. For example, we stated that EBSA could outline the
implications of a hedge fund's or fund of funds' limited transparency
on the fiduciary duty of prudent oversight. EBSA can also reflect on
the implications of these best practices for some plans--especially
smaller plans--that might not have the resources to take actions
consistent with the best practices, and thus would be at risk of
making imprudent investments in hedge funds. Finally, we noted that
while EBSA is not tasked with offering guidance to public sector
plans, such plans may nonetheless benefit from such guidance. To date,
Labor has not acted on this recommendation.
Concluding Observations:
As plan sponsors seek to better ensure adequate return on assets under
management, recent trends suggest that investments in alternative
assets such as hedge funds and private equity are becoming more
commonplace. It is reasonable to expect that the number of plan
sponsors making such investments will increase in the future. Our past
work indicates that such assets may serve useful purposes in a well
thought out investment program, offering plan sponsors advantages that
may not be as readily available from more traditional assets.
Nonetheless, it is equally clear that investments in such assets place
demands on plan sponsors that are significantly beyond the demands of
more traditional asset classes.
In light of these challenges, which can be daunting even for large
plan sponsors, we believe that, as we recommended in 2008, the
Secretary of Labor should provide guidance regarding investing in
hedge funds and private equity specifically designed for qualified
plans under ERISA. In particular, we believe that a discussion of the
challenges that such investments pose to small plan sponsors would be
particularly beneficial.
This concludes my prepared statement. I would be happy to answer any
questions that the subcommittee may have.
GAO Contact and Staff Acknowledgments:
For further questions on this testimony, please contact me at (202)
512-7215. Individuals making key contributions to this testimony
include Joseph Applebaum, Michael Hartnett, Sharon Hermes, Angela
Jacobs, David Lehrer, Ryan Siegel, and Craig Winslow.
[End of section]
Footnotes:
[1] GAO, Hedge Funds: Regulators and Market Participants Are Taking
Steps to Strengthen Market Discipline, but Continued Attention Is
Needed, [hyperlink, http://www.gao.gov/products/GAO-08-200]
(Washington D.C.: Jan. 24, 2008); Defined Benefit Pension Plans:
Guidance Needed to Better Inform Plans of the Challenges and Risks of
Investing in Hedge Funds and Private Equity, [hyperlink,
http://www.gao.gov/products/GAO-08-692] (Washington D.C.: Aug. 14,
2008); and Private Equity: Recent Growth in Leveraged Buyouts Exposed
Risks That Warrant Continued Attention, [hyperlink,
http://www.gao.gov/products/GAO-08-885] (Washington D.C.: Sept. 9,
2008).
[2] Greenwich Associates and SEI Knowledge Partnership, Hedge Funds
under the Microscope: Examining Institutional Commitment in
Challenging Times (January 2009).
[3] Funds of funds are investment funds that buy stakes in multiple
underlying hedge funds. Fund of funds managers invest in other hedge
funds rather than trade directly in the financial markets, and thus
offer investors broader exposure to different hedge fund managers and
strategies.
[4] 29 U.S.C. § 1104(a).
[5] 29 U.S.C. § 1003(b)(1).
[6] Ch. 38, tit. I, 48 Stat. 74 (codified at 15 U.S.C. § 77a et seq.).
[7] Ch. 404, 48 Stat. 881 (codified at 15 U.S.C. § 78a et seq.).
[8] Ch. 686, tit. I, 54 Stat. 797 (codified as amended at 15 U.S.C. §
80a-1 et seq.).
[9] Ch. 686, tit. II, 54 Stat. 847 (codified as amended at 15 U.S.C. §
80b-1 et seq.).
[10] Although certain advisers may be exempt from registration
requirements, they remain subject to anti-fraud, anti-manipulation,
and large trading position reporting rules. Under the Dodd-Frank Wall
Street Reform and Consumer Protection Act advisers of all private
funds, including hedge funds and private equity funds with $150
million or more in assets under management in the U.S. may be required
to register with the Securities and Exchange Commission (SEC),
obligated to comply with new recordkeeping and reporting requirements,
and subject to enhanced SEC scrutiny and audit. H.R. 4173, 111th Cong.
tit. IV (as reported out of conference on June 29, 2010).
[11] A security is described as thinly traded when trading
infrequently and/or in low volume.
[12] See [hyperlink, http://www.gao.gov/products/GAO-08-200].
[13] The definition of fair value has been codified by the Financial
Accounting Standards Board (FASB) at Accounting Standards Codification
(ASC) 320-10-20 Investments--Debt and Equity Securities, Overall,
Glossary. ASC 320-10-20 defines fair value as 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. As discussed in SFAS No. 157, Fair Value Measurements, which is
codified at FASB ASC 820, Fair Value Measurements and Disclosures, the
changes to current practice resulting from the application of ASC 820
relate to the definition of fair value, the methods used to measure
fair value, and the expanded disclosures about fair value
measurements. The definition of fair value may change the manner in
which some entities, such as private equity funds, determine fair
value.
[14] For example, we reported that the typical hedge fund fee
structure consists of 2 percent of total assets under management and a
performance fee of about 20 percent of the funds annual profits. This
fee structure would reduce a 12 percent return to only 7.6 percent,
after fees are deducted.
[15] Some plans may ensure they will not pay a performance fee unless
the value of the investment passes a previous peak value of the fund
shares. This provision is known as a high water mark.
[16] A long-short strategy exploits perceived anomalies in the price
of securities. For example, a hedge fund may buy bonds that it
believes are under-priced and sell short bonds that it believes to be
over-priced.
[17] The Advisory Council on Employee Welfare and Pension Benefit
Plan, which was created under ERISA to provide advice to the Secretary
of Labor, published the report on Prudent Investment Process in 2006.
[18] The Advisory Council on Employee Welfare and Pension Benefit
Plan, which was created by ERISA to provide advice to the Secretary of
Labor, published the report on Hard to Value Assets and Target Date
Funds in 2008.
[19] Principles and Best Practices for Hedge Fund Investors: Report of
the Investors' Committee to the President's Working Group on Financial
Markets (Jan. 15, 2009). The President's Working Group on Financial
Markets includes the heads of the U.S. Department of the Treasury, the
Board of Governors of the Federal Reserve, the Securities and Exchange
Commission, the Commodity Futures Trading Commission, and the
Investors' Committee consists of a broad array of investor and
investor advocates.
[End of section]
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