Monday, March 19, 2012

GAO Report Reveals How Defined Benefit Plans Meet Challenges of Hedge and Private Equity Fund Investing

A GAO report reveals that most defined benefit plans have taken actions to address challenges related to their investments in hedge funds and private equity funds, including such steps as allocation reductions, modifications of investment terms, and improvements to the fund selection and monitoring process. Plan managers have also taken steps to improve investment terms, including more favorable fee structures and enhanced liquidity. However, smaller plans would likely not be able to take some of these steps.

The Department of Labor has provided some guidance to plans regarding investing in derivatives, but has not taken any steps specifically related to hedge fund and private equity investments. In recent years, however, other entities have addressed this issue. For example, in 2009, the President’s Working Group on Financial Markets issued best practices for hedge fund investors. Further, both GAO and a Department of Labor advisory body have recommended that the department publish guidance for plans that invest in such alternative assets. To date, it has not done so, in part because of a concern that the lack of uniformity among such investments could make development of useful guidance difficult. In 2011, the Department of Labor advisory body specifically revisited the issue of pension plans’ investments in hedge funds and private equity, and a report is expected in early 2012.

Private sector pension plan investment decisions must comply with the Employee Retirement Income Security Act (ERISA), which sets forth fiduciary standards based on the principle of a prudent standard of care. Under ERISA, plan sponsors and other fiduciaries must act solely in the interest of the plan participants and beneficiaries and in accordance with plan documents; invest with the care, skill, and diligence of a prudent person familiar with such matters; and diversify plan investments to minimize the risk of large losses. Under ERISA, the prudence of any individual investment is considered in the context of the total plan portfolio, rather than in isolation.

The GAO found that most defined benefit plans have modified their investment strategies in recent years to make significant changes to their hedge fund or private equity strategies, and in some cases, reduced the overall allocation to hedge funds or private equity. Several plans have discontinued or reduced the use of certain hedge fund strategies. But shifting strategies did not mean that the plans abandoned hedge fund investments. Rather, they simply shifted to less aggressive hedge fund strategies.

In contrast to the general trend, some plans eliminated or substantially reduced their use of funds of hedge funds. However, the GAO concluded that funds of funds may be necessary for smaller pension plans and plans that lack well-developed internal investment and risk management that wish to invest in alternatives such as hedge funds and private equity.

Defined benefit plans have met some of the challenges of hedge fund investing and increased transparency and control through the use of separate accounts in place of commingled funds. Under a commingled hedge fund arrangement, the investor owns a certain number of shares in the fund, but the hedge fund manager determines what assets to invest in, and the partnership collectively owns the underlying assets.

In contrast, under a separate account, the hedge fund manager essentially serves as a consultant who manages the assets in a way that generally parallels the hedge fund itself, but the investor may specify investment guidelines that result in differences between the commingled hedge fund and separate account. Plan representatives cited multiple benefits of separate accounts, including precise knowledge of the nature of underlying assets, the ability to exclude certain assets in the commingled hedge fund from its share of the rest of the hedge funds assets, and much greater liquidity because plan sponsors own and can sell the underlying assets at will.