On Wednesday the U.S. Government Accountability Office (“GAO”) released a report examining investments by defined benefit pension plans into hedge funds. The report is titled: Defined Benefit Pension Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity. To produce the report, the GAO talked with hedge fund instry associations, government administrative entities and both private and public pension funds. Some of the private pensions interviewed include: American Airlines, Boeing, Exxon Mobil, John Deere, Macy’s and Target. Some of the public pensions included: CalPERS, New York State Common Retirement Fund and the Washington State Investment Board.

I had a chance to read through the 65 page report and found it to be very well written and researched. The report also accurately and succinctly summarizes the applicable laws and regulations which apply to pensions investing in hedge fund and private equity funds. Overall I think that the report contains a good deal of very useful information. For start up hedge fund managers looking to eventually raise money from institutional investors, the report should be required reading. Some of the more salient points raised in the report include:

• pension plans investments into hedge funds is expect to continue to increase
• pension plans are aware of the risks of investing in hedge funds including: liquidity risk, transparency risk, valuation risk (potentially), high fees, and leverage
• pension plans are not afraid to pull money from non-performing hedge funds; however, hedge fund managers should not focus on investment ideas at the expense of operational considerations
• due diligence will become more important as time goes on (and as more frauds are caught)

Below I have produced (what I view are) the most useful or intersting parts of the report. The headings and the emphasis in the text below, along with all information in brackets, are my own. Any footnotes have been omitted. The entire report can be found here.

Background and purpose of the report

Millions of retired Americans rely on defined benefit pension plans for their financial well-being. Recent reports have noted that some plans are investing in ‘alternative’ investments such as hedge funds and private equity funds. This has raised concerns, given that these two types of investments have qualified for exemptions from federal regulations, and could present more risk to retirement assets than traditional investments.

To better understand this trend and its implications, GAO was asked to examine (1) the extent to which plans invest in hedge funds and private equity; (2) the potential benefits and challenges of hedge fund investments; (3) the potential benefits and challenges of private equity investments; and (4) what mechanisms regulate and monitor pension plan investments in hedge funds and private equity.
GAO recommends that the Secretary of Labor provide guidance on investing in hedge funds and private equity that describes steps plans should take to address the challenges and risks of these investments. Labor generally agreed with our findings and recommendation.

Hedge fund definition

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 and commodity futures and options contracts. Similarly, private equity funds are not statutorily defined, but are generally considered 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 improved operations or developing new products. Both hedge funds and private equity funds 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.

Description of pension plan investment into hedge funds

Pension plans invest in hedge funds to obtain various benefits, but some characteristics of hedge funds also pose challenges that demand greater expertise and effort than more traditional investments, which some plans may not be able to fully address. Pension plans told us that they invest in hedge funds in order to achieve one or more of several goals, including steadier, less volatile returns, obtaining returns greater than those expected in the stock market, or diversification of portfolio investments. Pension plan officials we spoke with about hedge fund investments all said these investments had generally met or exceeded expectations. However, at the time of our contact in 2007, several plan officials noted that their hedge fund investments had not yet been tested under stressful economic conditions, such as a significant stock market decline. Further, some indicated mixed experiences with hedge fund investments. At the time of our discussions, however, officials of each plan interviewed indicated that they expected to maintain or increase the share of assets invested in hedge funds.

Nonetheless, hedge fund investments pose investment challenges beyond those posed by traditional investments in stocks and bonds. These additional challenges include: (1) the inherent risks of relying on the skill and techniques of the hedge fund manager; (2) limited information on a hedge fund’s underlying assets and valuation (limited transparency); (3) contract provisions which limit an investor’s ability to redeem an investment in a hedge fund for a defined period of time (limited liquidity); and 4) the possibility that a hedge fund’s active or risky trading activity will result in losses due to operational failure such as trading errors or outright fraud (operational risk). Although there are challenges of hedge fund investing, plan officials and others described steps to address these and other challenges. For example, plan officials and others told us that it is important to negotiate key investment terms and conduct a thorough “due diligence” review of prospective hedge funds, including review of a hedge fund’s operational structure. Further, pension plans can invest in funds of hedge funds, which charge additional fees but provide diversification and the additional skill of the fund of funds manager. According to plan officials and others, some of these steps require considerably greater effort and expertise from fiduciaries than is required for more traditional investments, and such steps may be beyond the capabilities of some pension plans, particularly smaller ones.

ERISA considerations

Under the Employee Retirement and Income Security Act (ERISA), plan fiduciaries are expected to meet general standards of prudent investing and no specific restrictions on investments in hedge funds or private equity have been established. Labor [the DOL] is tasked with helping to ensure plan sponsors meet their fiduciary duties; however, it does not currently provide any guidance specific to pension plan investments in hedge funds or private equity. Conversely, some states do specifically regulate and monitor public sector pension investment in hedge funds and private equity, but these approaches vary from state to state. While states generally have adopted a “prudent man” standard similar to that in ERISA, some states also explicitly restrict or prohibit pension plan investment in hedge funds or private equity. For instance, in Massachusetts, the agency overseeing public plans will not permit plans with less than $250 million in total assets to invest directly in hedge funds. Some states have detailed lists of authorized investments that exclude hedge funds and/or private equity. Other states may limit investment in certain investment vehicles or trading strategies employed by hedge fund or private equity fund managers. While some guidance exists for hedge fund investors, specific guidance aimed at pension plans could serve as an additional tool for plan fiduciaries when assessing whether and to what degree hedge funds would be a prudent investment.

… all [the pension plans] said that their hedge fund investments had generally met or exceeded expectations, although some noted mixed experiences. For example, one plan explained that it had dropped some hedge fund investments because they had not performed at or above the S&P 500 benchmark. Also, this plan redeemed its investment from other funds because they began to deviate from their initial trading strategy.

Challenges and risks of hedge fund investments

While any plan investment may fail to deliver expected returns over time, hedge fund investments pose investment challenges beyond those posed by traditional investments. These include (1) reliance on the skill of hedge fund managers, who often have broad latitude to engage in complex investment techniques that can involve various financial instruments in various financial markets; (2) use of leverage, which amplifies both potential gains and losses; and (3) higher fees, which require a plan to earn a higher gross return to achieve a higher net return.

Hedge Fund Fees

Several pension plans cited the costly fee structure fees as a major drawback to hedge fund investing. For example, representatives of one plan that had not invested in hedge funds said that they are focused on minimizing transaction costs of their investment program, and the hedge fund fee structure would likely not be worth the expense. On the other hand, an official of another plan noted that, as long as hedge funds add value net of fees, they found the higher fees acceptable.

Operational Risk

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. Concerns about some operational issues were noted by SEC in a 2003 report on the implications of the growth of hedge funds. For example, the 2003 report noted that SEC had instituted a significant and growing number of enforcement actions involving hedge fund fraud in the preceding 5 years. Further, SEC noted that while some hedge funds had adopted sound internal controls and compliance practices, in many other cases, controls may be very informal, and may not be adequate for the amount of assets under management. Similarly, a recent Bank of New York paper noted that the type and quality of operational environments can vary widely among hedge funds, and investors cannot simply assume that a hedge fund has an operational infrastructure sufficient to protect shareholder assets.

Several pension plans we contacted also expressed concerns about operational risk. For example, one plan official noted that the consequences of operational failure are larger in hedge fund investing than in conventional investing. For example, the official said a failed long trade in conventional investing has relatively limited consequences, but a failed trade that is leveraged five times is much more consequential. Representatives of another plan noted that back office and operational issues became deal breakers in some cases. For example, they said one fund of funds looked like a very good investment, but concerns were raised during the due diligence process. These officials noted, for example, the importance of a clear separation of the investment functions and the operations and compliance functions of the fund. One official added that some hedge funds and funds of funds are focused on investment ideas at the expense of important operations components of the fund.

Importance of hedge fund due diligence

Pension plans take steps to mitigate the challenges of hedge fund investing through an in-depth due diligence and ongoing monitoring process. While plans conduct due diligence reviews of other investments as well, such reviews are especially important when making hedge fund investments, because of hedge funds’ complex investment strategies, the often small size of hedge funds, and their more lightly regulated nature, among other reasons. Due diligence can be a wide-ranging process that includes a review and study of the hedge fund’s investment process, valuation, and risk management. The due diligence process can also include a review of back office operations, including a review of key staff roles and responsibilities, the background of operations staff, the adequacy of computer and telecommunications systems, and a review of compliance policies and procedures.

Smaller pension plans are not as active hedge fund investors

Available data indicate that pension plans have increasingly invested in hedge funds and have continued to invest in private equity to complement their traditional investments in stocks and bonds. Further, these data indicate that individual plans’ hedge fund or private equity investments typically comprise a small share of total plan assets. However, data are generally not available on the extent to which smaller pension plans have made such investments. Because such investments require a degree of fiduciary effort well beyond that required by more traditional investments, this can be a difficult challenge for plans, especially smaller plans. Smaller plans may not have the expertise or financial resources to be fully aware of these challenges, or have the ability to address them through negotiations, due diligence, and monitoring. In light of this, such investments may not be appropriate for some pension plans.

Conclusions

The importance of educating investors [pension plans] about the special challenges presented by hedge funds has been recognized by a number of organizations. 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. To date, EBSA [Employee Benefits Security Administration] has not acted on this recommendation. More recently, in April 2008, the Investors’ Committee formed by the President’s Working Group on Financial Markets published draft best practices for investors in hedge funds. This guidance will be applicable to a broad range of investors, such as public and private pension plans, endowments, foundations, and wealthy individuals. EBSA can further enhance the usefulness of this document by ensuring that the guidance is interpreted in

Available data indicate that pension plans have increasingly invested in hedge funds and have continued to invest in private equity to complement their traditional investments in stocks and bonds. Further, these data indicate that individual plans’ hedge fund or private equity investments typically comprise a small share of total plan assets. However, data are generally not available on the extent to which smaller pension plans have made such investments. Because such investments require a degree of fiduciary effort well beyond that required by more traditional investments, this can be a difficult challenge for plans, especially smaller plans. Smaller plans may not have the expertise or financial resources to be fully aware of these challenges, or have the ability to address them through negotiations, due diligence, and monitoring. In light of this, such investments may not be appropriate for some pension plans.

GAO Recommendation

To ensure that all plan fiduciaries can better assess their ability to invest in hedge funds and private equity, and to ensure that those that choose to make such investments are better prepared to meet these challenges, we recommend that the Secretary of Labor provide guidance specifically designed for qualified plans under ERISA. This guidance should include such things as (1) an outline of the unique challenges of investing in hedge funds and private equity; (2) a description of steps that plans should take to address these challenges and help meet ERISA requirements; and (3) an explanation of the implications of these challenges and steps for smaller plans. In doing so, the Secretary may be able to draw extensively from existing sources, such as the finalized best practices document that will be published in 2008 by the Investors’ Committee formed by the President’s Working Group on Financial Markets.

DOL Response to GAO Recommendation

With regard to our recommendation, Labor stated that providing more specific guidance on investments in hedge funds and private equity may present challenges. Specifically, Labor noted that given the lack of uniformity among hedge funds, private equity funds, and their underlying investments, it may prove difficult to develop comprehensive and useful guidance for plan fiduciaries. Nonetheless, Labor agreed to consider the feasibility of developing such guidance.

GAO’s Response to the DOL’s Response

Indeed, the lack of uniformity among hedge funds and private equity funds is itself an important issue to convey to fiduciaries, and highlights the need for an extensive due diligence process preceding any investment.