ERISA Compliance Issues Surrounding Alternative Investments

ERISA Compliance Issues
Surrounding Alternative
Investments

Ken Pink, CPA
Partner

Agenda
 Monitoring alternative investments

2

Monitoring Alternative
Investments

 What are “Alternative Investments”, and what’s
all the fuss about?

 What practical steps can you incorporate into
your due diligence process as it relates to
alternative investments?

3

What are alternative
investments?
There is no standard definition, but it is
understood as any investments beyond
traditional stocks, bonds, and money
market investments.
Traditional investments
- Stocks, bonds, mutual funds
- Typically long only, priced daily, liquid

4

Alternative Investments - What
Happened?
 “Old World” for Trustees and auditors:
Trustees read quarterly investment statement

Auditors confirm investment statements with
custodians
Move on!

 “New World” for Trustees and Auditors:
 Stop: How much does the investor really know
about its holdings?

5

Alternative Investments – What
Happened?
Rules in the “New World”:
 SAS No.92, Auditing Derivative Instruments, Hedging
Activities, and Investments in Securities
 SAS No. 101, Auditing Fair Value Measurements and
Disclosures
 AICPA Interpretation No. 1 of SAS 92, Auditing
Investments in Securities Where a Readily
Determinable Fair Value Does Not Exist. (July 2005)
 AICPA Interpretation No. 1 of SAS 101, Auditing
Interests in Trusts Held by a Third-Party Trustee and
Reported at Fair Value (July 2005)
 AICPA Practice Aid, Alternative Investments, Auditing
Considerations (July 2006)

6

Alternative Investments – What
Happened
The AICPA Interpretation issued in July 2005 carried a consistent
message:
 Confirmation is not enough
 Receiving a confirmation from the alternative
investment fund manager or custodian does not
constitute adequate audit evidence with respect to
valuation
 Further: receiving a confirmation from the fund
manager or custodian does not constitute sufficient
audit evidence of existence unless the holdings are
identified in the confirmation on a “security by
security” basis

7

Traditional Confirmation
CUSTODY STATEMENT
December 1, 2007 – December 31, 2007
EQUITIES

Holdings* Shares Cost Prince/ Market Accrued Estimat Current
(description sorted by type/alphabetical) Unit*** Value Income ed Yield
Annual
Income
HEIDELBERGER 950.00 50,004.59 33.63 31,948.50 0.00 0 0.00%
DRUCKMASCHINEN (EUR)
(Ticker Symbol: HDD-GREUR)

HSBC HOLDINGS PLC 5,265.00 96,921.85 16.75 88,188.75 0.00 0 0.00%
(Ticker Symbol: HBCYF)

KINGFISHER PLC 20,040.00 81,723.28 2.95 59,118.00 0.00 0 0.00%
(Ticker Symbol: KGFHF)

L’OREAL 770.00 80,471.38 143.25 110,302.50 0.00 0 0.00%
(Ticker Symbol: OR)

LONGZA AG 965.00 47,177.31 121.88 117,614.20 0.00 0 0.00%
ISIN #CH0013841017
(Ticker Symbol: LONN-VX)

MACQUARIE GROUP LIMITED 1,420.00 89,038.80 66.91 95,012.20 0.00 0 0.00%
(CUSIP #B28YTC2)

MISYS PLC 13,945.00 56,278.35 3.67 51,178.15 0.00 0 0.00%
(CUSIP #: 0385785)

NESTLE SA 250.00 57,960.25 452.50 113,125.00 0.00 0 0.00%
(CHF1 (REGD)
ISIN #CH0012056047
(Ticker Symbol: NSRGF)

NITTO DENKO CORPORATION 2,600.00 127,804.26 52.99 137,774.00 0.00 0 0.00%
(CUSIP #: 6641801)

NOBEL BIOCARE HOLDINGS AG 210.00 59,716.39 267.63 56,202.30 0.00 0 0.00%
(CUSIP #: 7385722)

NORBORD INC 14,490.00 120,701.47 8.00 115,920.00 0.00 5,796 5.00%
(Ticker Symbol: NBDFF)
* All values reported in U.S. dollars
** Includes Accrued Income
*** Prices are rounded to the nearest 100 th decimal place for statement formating purposes

8

Alternative Investment
Confirmation

9

Overview of AICPA Practice Aid
 The Practice Aid addresses challenges associated
with auditing investments for which a readily
determinable fair value does not exist.
 The Practice Aid:
 Is applicable to investments in hedge funds, private equity
funds, venture capital funds, commodity pools, fund of
funds, and bank common/collective trust funds

 Provides guidance on auditing the existence and valuation
assertions associated with alternative investments.

10

(con’t)
Existence Assertion
 The Practice Aid requires that auditors confirm existence
with the underlying fund managers.
 Items to be confirmed include:
 Number of units held or percentage ownership
 Value of net assets/capital balance
 Holdings of the underlying fund’s investments on a security-
by-security basis.

 Although the auditor may be uncertain if the fund
manager will provide the requested
information, such information should still be
requested.
11

(con’t)
Existence Assertion
 If the requested information is not received by the
auditor, alternative procedures should be considered, as
follow:
 Observing management site visits or telephone calls to
investee funds (or reviewing documentation of such calls
or visits)
 Reviewing executed partnership, trust, limited liability
corporation, or similar agreements
 Inspecting other documentation supporting the investor’s
interest in the fund (for example, correspondence from the
fund or trustee acknowledging transactions with the fund)
 Reviewing periodic statements from the fund or investment
advisor reflecting investment activity and compare to
amounts recorded
 Vouching relevant cash receipts and disbursements

12

(con’t)
Valuation Assertion
 Auditors need to obtain an understanding of and perform
tests over internal controls as they relate to valuations.
 This would entail obtaining an understanding of:
 Management’s initial due diligence and continuous monitoring
process of the underlying investee funds
 Management’s significant assumptions
 Management’s valuation methodology
 The controls and procedures in place at service providers in
determining net asset values (typically obtained from a SAS 70
report)
 The controls in place over financial reporting

13

Management’s Responsibility
Management is responsible for making the fair value
measurements and disclosures included in the
financial statements. As part of fulfilling this
responsibility, management needs to establish an
accounting and financial reporting process for
determining the fair value measurements and
disclosures, select appropriate valuation
measurements, identify and adequately support any
significant assumptions used, prepare the
valuation, and ensure that the presentation and
disclosure of fair value measurements are in
accordance with GAAP.
14

Management’s Responsibility
Management can not outsource!

Even to General Partner!

Management can use an external party for the mechanics of
valuation.

… but

Management must have a sufficient understanding of the
underlying investments, strategies and significant assumptions
that underlie the valuations to challenge the investment
valuation.

15

Alternative Investments – Seven
Steps to an Unqualified Opinion
Step 1 Clearly assign responsibility for fair valuation
policies and processes
Step 2 Perform due diligence throughout the year
Step 3 Challenge your investment managers
Step 4 Document, document, document
Step 5 Meet with your audit firm early and agree to a plan
Step 6 Roll forward investments
Step 7 Formally approve valuations

16

Alternative Investments – Example
Controls & Documentation
Example Controls Possible Documentation

Clear assignment of responsibility By-laws defining roles of Investment
Committee

Procedural manual defining roles of
investment department vs.
accounting
department

Oftentimes, smaller organizations are
set up with an investment advisor
who reports directly to the Investment
Committee and who serves as the
default CIO
17

Controls & Documentation (con’t)

Investment Committee Bios of Investment Committee

Select members who question
decision within the framework

Investment Committee Minutes

18


Investment policy for asset Written policy adopted by
allocation and valuations Investment Committee

Exception to policies presented to
full Investment Committee for
acknowledgement

19


Selection, hiring, and evaluation of Written due diligence summaries
fund advisor / managers
Minutes of committee meetings
approving advisor / manager
changes

20


Understanding of the fund’s Documented risk assessment for
strategies and holdings, each investment
ascertaining underlying investments,
if possible

21


Periodic visits or conference calls Formalized schedule of visits or
with fund advisor / manager conference calls

Documentation of visits or
discussions

Can be handwritten notes or
checklist

22


Review of SAS70s for service Written checklist prepared by
providers (fund managers, back- reviewer
office, trustees, custodians)
Type I or Type II report

Review exceptions

23


Review of annual fund audited Written checklist prepared by
financial statements reviewer

Unqualified opinion on a GAAP
basis provided by a credentialed
firm

Comparison of audited to unaudited
NAV

24


Review of valuations prepared by Written notes on valuations or
fund manager memo documenting review by
finance staff

25


Review monthly / quarterly Comparison of actual returns to
information from investment advisor/ benchmarks with explanations of
fund manager major variances

26


Cut-off and reconciliation Reconciliation of audited NAV to
recorded fair value at investor’s year
end

Roll-forward of audited holdings to
investor’s year end

27

Summary of SFAS 157
 Defines fair value
 Provides a framework for determining fair value
(describes various methods)
 Expands disclosure about fair value measurements
 Increases transparency
 Does not prescribe new uses for fair value
 Effective for FY beginning after 11/15/07
-Nonfinancial assets-beginning after 11/15/08 if not
measured at FV on a recurring basis

28

Definition of Fair Value
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-
EXIT PRICE

29

What does price mean?
 Price is determined in the “principal market”,
meaning the market with the greatest volume
and level of activity. If there is no principal
market, then the “most advantageous
market” is used.
 Price does not include transaction costs.
 Fair value of a block of financial instruments
traded in an active market is “price x
quantity”. No block adjustments.

30

Valuation Techniques
 Market approach- uses prices and other relevant
information generated by market transactions
involving identical or comparable assets or liabilities.
 Income approach- uses valuation techniques to
convert future amounts (e.g., cash flows or earnings)
to a single present amount (discounted).
 Cost approach- based on the amount currently
required to replace the service capacity of an asset.

31

The Role of Inputs
 Inputs are market participant assumptions that are included in
valuation models.
Observable Inputs- Developed based on market data obtained
from sources independent of the reporting entity.
Unobservable Inputs- Reflects the reporting entity’s own
assumptions about market inputs based on its own data.
 Valuation techniques should maximize the use of observable
inputs
 Cannot disregard market-based information that is reasonably
available

32

Fair Value Hierarchy
Level 1 Inputs:
Quoted prices for identical assets or
liabilities in active markets
Most reliable source of fair value
Input examples-Prices derived from
NYSE, NASDAQ, Chicago Board of
Trade, Pink Sheets

33

Level 2 Inputs
Observable inputs for:
 Similar assets or liabilities in active markets
 Identical or similar assets in inactive markets
 Inputs other than quoted prices that are directly
observable
 Inputs derived from observable market data by
correlation or other means
-Input examples: Matrix pricing, market corroborated
pricing; inputs such as yield curves and indices

34

Level 3 Inputs:
Unobservable inputs:
 Reporting entity’s own assumptions about the assumptions
market participants would use.
 Other entry specific inputs (historical or projected financial
information) that are not derived from market data.
 Unobservable inputs shall be developed based on the best
information available in the circumstances.
 In developing unobservable inputs, the reporting entry need not
undertake all possible efforts to obtain information (if not
reasonably available without undue cost or effort).
 Input examples: Investment manager pricing for Private
Placements, Private Equities, Hedge Funds, etc.

35

New Disclosures
Recurring measures
 What is measured at fair value
-Level 1, level 2, level 3
 Valuation techniques used and if changed
 If level 3 measurements are used
- Reconcile beginning to ending balances

36

Investment Valuation
“Unit of account”-refers to the level at which the
asset is measured at fair value for purpose of
financial reporting
 May need to review underlying investments
 Consider restrictions, contract provisions, NAV
calculations and potential impact to FV.

37

Unit of Account
Investment Unit of Account
 Mutual Fund  Shares in the mutual fund
 Common/collective trust fund  Units of participation in
or Pooled Separate Account CCT/PSA
 Separately Managed Trust  Underlying assets and
Account liabilities
 Synthetic GIC  Wrap contract and underlying
assets
 Hedge Fund  Units of Participation in the
hedge fund
 Private Equity Fund  Limited Partnership interest in
private equity fund, which
includes both the funded
and unfunded capital
commitments.
38

FAS 157 Valuation Considerations

 Tax-exempt organization owns the valuation
responsibility
Can outsource the mechanics but not the ownership
 Custodial reporting tools will only be the starting point
Final FAS 157 bucketing decisions will rest with the
organization
 Understanding the pricing process is a must
 Must increase collaboration with outside parties

39

How to apply FAS 157 to Hard to Value
Investments

 Are Hedge Fund and Private Equity Funds Level 2 or
3 investments?
 Hedge Funds-To the extent there is adequate
observable subscription or redemption activity, could
support Level 2 or Level 3 classification
 Private Equity Funds-Given lack of redemption
provisions, most commonly Level 3

40

Derivatives
 Are the derivatives traded on an exchange or traded
OTC?
 Is the derivative priced solely on information from the
counterparty or is an independent price from another
vendor obtained?
 Are models used?
 Has counterparty credit risk been considered in fair
valuing the derivative contract?

41

New disclosures
Tabular format required
Encouraged to combine with other
required fair value disclosures
SFAS 107, SFAS 124

42

Example
Description Level 1 Inputs Level 2 Inputs Level 3 Inputs Total at End
Of Year

Equity Securities $ 10,000,000 $ - $ - $ 10,000,000

Corporate debt 2,000,000 2,000,000
securities

Mortgage backed 1,000,000 1,000,000
securities

Real estate 500,000 500,000

Alternative 1,500,000 1,500,000
investments

Interest rate swap - - (500,000) (500,000)
contract

Total $ 10,000,000 $ 3,500,000 $ 1,000,000 $ 14,500,000

43

Example
Fair Value Measurements Using Significant
Unobservable Inputs
(Level 3)
Alternative Interest Rate Swap Total
Investments Contrast
Beginning balance $ 500,000 $ 1,000,000 $ 1,500,000

Total gains or losses
Realized
Unrealized (250,000) (1,500,000) (1,750,000)
Purchases 1,250,000 1,250,000

Sales, withdrawals

Transfers in and/or out of Level 3
-
Ending balance $ 1,500,000 $ (500,000) $ 1,000,000

44

FSP FAS 117-1
Endowments of Not-for-Profit
Organizations: Net Asset Classification
of Funds Subject to an Enacted Version
of the Uniform Prudent Management of
Institutional Funds Act, and Enhanced
Disclosures for All Endowment Funds
Effective for fiscal years ending after
December 15, 2008
45

FSP FAS 117-1
Applicable to all not-for-profit
organizations that have Board-
designated or donor restricted
endowment funds

46

What is an Endowment Fund
?
FAS 117 definition:
 An established fund of cash, securities, or other
assets to provide income for the maintenance of a
not-for-profit organization.
 Use of the assets may be permanently restricted,
temporarily restricted or unrestricted.
 Organization’s governing board may earmark a
portion of its unrestricted net assets as a board
designated endowment (quasi-endowment).

47

Uniform Prudent Management of
Institutional Funds Act (UPMIFA)

 In July 2006, the Uniform Law Commission approved
UPMIFA
 UPMIFA is a revision of the Uniform Management of
Institutional Funds Act of 1972 (UMIFA), which has
been adopted by 46 states and the District of Columbia
 Thus far, UPMIFA has been enacted in over 30 states
and the District of Columbia and is being considered for
enactment by several others
 New York State has not enacted UPMIFA

48

FSP FAS 117-1
If UPMIFA applies, it may be necessary
to reclassify certain funds as temporarily
or permanently restricted
If UPMIFA does not apply, there is no
change in classification
Additional disclosure is required for all

49

FSP FAS 117-1
A not-for-profit organization, whether or not it is subject
to UPMIFA, shall disclose the following:
 A description of the governing board’s interpretation
of the law(s) that underlies the organization’s net
asset classification of donor-restricted endowment
funds.
 A description of the organization’s policy(ies) for the
appropriation of endowment assets for expenditures
(its endowment spending policy(ies).

50

FSP FAS 117-1
 A description of the organization’s endowment
investment policies. The description shall include the
organization’s return objectives and risk parameters;
how those objectives relate to the organization’s
endowment spending policy(ies); and the strategies
employed for achieving those objectives.
 The composition of the organization’s endowment by
net asset class at the end of the period in total and by
type of endowment fund, showing donor-restricted
endowment funds separately from board-designated
endowment funds.

51

FSP FAS 117-1
A reconciliation of the beginning and
ending balance of the organization’s
endowment in total and by net asset
class.

52

Example
Unrestricted Temporarily Permanently Total
Restricted Restricted
Endowment net assets, beginning of year $ 6,947 $ 46,380 $ 95,673 $ 149,000

Investment return:

Investment income 298 2,396 286 2,980
Net depreciation (413) (2,185) - (2,598)
Total investment return (115) 211 286 382

Contributions - - 2,000 2,000

Appropriation of endowment assets (448) (7,002) - (7,450)

Other changes:

Transfers to create board designated
endowment funds 500 - - 500

Endowment net assets, end of year $ 6,884 $ 39,589 $ 97,959 $ 144,432

Endowment Net Asset Composition by Type
of Fund as of end of year

Donor-restricted endowment funds $ - $ 39,589 $ 97,959 $ 137,548

Board-designated endowment funds 6,884 - - 6,854

Total funds $ 6,884 $ 39,589 $ 97,959 $ 144,432

53

FSP FAS 117-1
 In accordance with the requirements of SFAS 117
and 124, an organization shall also provide
information about the net assets of its endowment
funds, including:
The nature and types of permanent restrictions or temporary
restrictions (paragraphs 14 and 15 of Statement 117)
The aggregate amount of the deficiencies for all donor-
restricted endowment funds for which the fair value of the assets
at the reporting date is less than the level required by donor
stipulations or law (paragraph 15(d) of Statement 124).

54

ERISA Compliance Issues Surrounding Alternative Investments

Recomendados

Recomendados

Más contenido relacionado

La actualidad más candente

La actualidad más candente (6)

Similar a ERISA Compliance Issues Surrounding Alternative Investments

Similar a ERISA Compliance Issues Surrounding Alternative Investments (20)

Último

Último (20)

ERISA Compliance Issues Surrounding Alternative Investments