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Administration of Alternative
Investments in Fiduciary Accounts
FIRMA 25th Annual Risk Management
Training Conference
April 18, 2011
Suzanne L. Shier
Chapman and Cutler LLP
Chicago, Illinois
312-845-2983 [email protected]
2974368
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Overview
Types of Non-Traditional Investments – Hedge Funds, Private
Equity, Real Estate, Etc.
Prudent Investor Rule and Non-Traditional Investments
Use of Non-Traditional Investments - Diversification and
Enhanced Returns
PWG Best Practices Guidance
Authority to Invest in Non-Traditional Investments
Legal Structure of Alternative Investments
Qualification to Make Alternative Investments
Dodd-Frank Volcker Rule
Valuation of Alternative Investments
Fiduciary Accounting
Fiduciary Administration
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I. Introduction
“Traditional” investment in cash, cash equivalents, fixed
income and equities
Expanded fiduciary investment in “non-traditional”
investments
– Hedge funds and funds-of-funds
– Private equity
– Real estate
– Commodities
Pensions funds
– 40% of large pension funds invest in private equity
and approximately 25% invest in hedge funds
Private trust investment in non-traditional assets
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Bonds
Foreign
Investments
Alternatives
U.S. Equities
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II. Background - Hedge Funds
Increase in number of funds 3,000 ($200 billion) in 1998 to
9,000 ($2 trillion) peak in 2007; 25% decrease by end of
2008 with numerous fund collapses
Not an asset class; employ specific investment strategies to
“hedge” against particular risk (e.g., interest rate, currency
prices)
Not marketed to the general public; not publicly traded
Investors limited to high net worth individuals and
institutions
Not regulated or registered
Managed by professional managers compensated based
on performance
Periodic but restricted or limited investor redemption rights
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II. Background - Private Equity
Increase in capital raised from $2 billion in 1980 to $207
billion peak in 2007 and increase in number of funds
from 56 to 432
Privately managed investment pools making long-term
investments in private companies
Take a controlling interest in company with aim of
increasing value
Investment made at various stages of existence of
company
– Start-up – venture capital
– Intermediate – transition from start-up
– Mature company – restructuring
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III. Prudent Investor - General Rule
Rule for Trustees, not Guardians, Executors or Investment
Managers
Duty to invest and manage as a prudent investor in light of –
– Purpose and terms of the trust
– Distribution requirements and other circumstances of the
trust
Requires exercise of reasonable care, skill and caution
– Applied to investments in the context of the trust portfolio
as a whole as a part of an overall investment strategy
rather than in isolation
– Incorporate risk and return reasonably suitable to the trust
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III. Prudent Investor - General Rule (Cont’d.)
Trustee has a duty to – Diversity the investments of the trust, unless under the
circumstances it is prudent not to do so (e.g., issues with
concentrations)
– Conform to the duties of loyalty and impartiality
– Act with prudence in deciding whether and how to
delegate
– Incur only costs that are reasonable in amount and
appropriate to the investment responsibilities
No particular investment is per se imprudent
– Review investments in the context of the trust portfolio
– Process is key
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III. Prudent Investor – Non-Traditional Assets
Duty of caution and risk management
– Risk tolerance varies from trust-to-trust and from time-totime
– Use of non-traditional investments to manage risks
Duty to diversify
– Use of non-traditional assets whose returns are not
correlated to particular traditional assets
– Real estate limited covariance with publicly traded
securities; inflation hedge
Duty to manage costs
– Use of non-traditional assets may incur substantial costs
– Investment review; legal review; managers’ fees
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III. Prudent Investor – Non-Traditional Assets (Cont’d.)
Delegation
– Expert assistance may be required with non-traditional
assets
– Engage investment managers with specific expertise
– Use of pooled investment vehicles – “fund-of-funds”
Restatement Third, Trusts §90
“Delegation” to manager of the fund
Investment in the fund itself rather than the underlying
assets of the fund
Trustee controls the decision to invest in the fund
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III. Prudent Investor – Non-Traditional Assets
(Cont’d.)
Delegation – State law
– Reasonable care, skill and caution in –
Selecting the agent
Establishing the scope and terms of the delegation
Periodically reviewing the agent’s actions to monitor overall
performance and compliance with scope and terms of
delegation
– Due diligence regarding experience, performance history,
licensing
– Subject to jurisdiction Illinois courts (consider binding
arbitration provisions)
– Investment agent liable to beneficiaries
– Advance written notice to current income beneficiaries
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III. Prudent Investment – Restatement Third, Trusts
Non-traditional Investments
Real Estate
– Enhance diversification due to limited covariance with
publicly traded securities
– Long-term protection against inflation
– Potential to augment income productivity or capital
appreciation
– Consider complexities of administrative burdens
Venture Capital (Private Equity)
– Historically not an appropriate investment
– 1979 DOL guidance “riskier” assets such as venture
capital
– Requires special due diligence and monitoring; use of
funds not a substitute
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III. Prudent Investment - Statutory and Judicial
Guidance Non-Traditional Investments
Washington Probate Code
– Authorizes investment in “new, unproven, untried”
enterprises with a potential for significant growth directly or
through commingled funds
– Aggregate amount of investment, valued at cost, may not
exceed 10% of the net fair market value of the trust corpus
– Value for purposes of 10% limitation determined at the
time the investment is made
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III. Prudent Investment - Statutory and Judicial
Guidance Non-Traditional Investments (Cont’d.)
Harley v. Minnesota Mining and Manufacturing Co. (ERISA),
42 F. Supp. 2d 898 (1999)
– Investment in hedge fund holding collateralized mortgage
obligations
– Failure to conduct sufficient investigation and to seek
independent advice
IBEW-NECA Southwestern Health & Benefit Trust Fund v.
EMG Advisors, Inc. (ERISA), 172 F.3d 876 (1999)*
– Investment in complex derivatives
– Failure to conduct thorough and independent investigation
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III. Prudent Investment - Statutory and Judicial
Guidance Non-Traditional Investments (Cont’d.)
Laborers National Pension Fund v. Northern Trust Quantitative
Advisors, Inc. (ERISA), 173 F.3d 313 (1999)*
– Investment in interest-only mortgage backed securities
– Investment was made as a hedge against countervailing
risks in the portfolio, and appropriate consideration given
and analysis done of characteristics and projected
performance of the investment
Brane v. Roth, 590 N.E.2d 587 (1992)*
– Investment in hedge funds
– Breach of fiduciary duty in retaining inexperienced
manager and in failing to attain sufficient knowledge to
properly supervise the manager
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III. Prudent Investment - Statutory and Regulatory
Guidance Non-Traditional Investments (Cont’d.)
Levy v. Bessemer Trust Company, N.A., 1997 US Dist LEXIS
11056, 1997 US Dist. LEXIS 4045*
– Claims for breach of contract, breach of fiduciary duty, and
breach of duty to supervise (among others) with respect to
failure to purchase collars to manage risk for concentrated
investment in an investment management account
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Benefits vs. Risks
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IV. Diversification and Enhanced Returns – Hedge
Funds
Objectives
– Lessen volatility
– Enhance returns by investments not correlated to other
investments
Challenges
– Active management based on skill of manager (and
manager may change)
– Use of leverage to enhance returns; not regulated as in
mutual funds
– Fees – As high as 2% AUM and 20% of profits
– Lack of transparency – valuation
– Liquidity – lock-up periods and gates
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IV. Objectives and Challenges – Private Equity
Objective – attain superior returns
Challenges
– Increased risk/volatility
– Concentration in limited number of companies in a single
sector
– Use of leverage in venture capital and limited track record
– Competitive pressures in strong market resulting in
overpayment
– Long-term commitment and valuation
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V. Best Practices - Hedge Funds
GAO Report to Congressional Requesters, Defined Benefit
Plans - Guidance Needed to Better Inform Plans of the
Challenges and Risk of Investing in Hedge Funds and Private
Equity, GAO-08-692 (August 2008)
President’s Working Group on Financial Market, Best
Practices for the Hedge Fund Industry (January 2009)
www.amaicmte.org
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VI. Authority under Governing Instrument – Nontraditional Assets
Language of governing instrument controls
– Prudent investment – non-traditional assets not prohibited
per se; question of whether appropriate to the trust
– Specific authorization is ideal
– Specific limitations should be adhered to (e.g., margin
transactions)
Consider amendment of revocable instruments and nonjudicial settlement agreements for irrevocable instruments if
authority a question
For corporate fiduciary considering investment in proprietary
funds assess conflicts of interest
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VII. Legal Structure of Alternative Investments
Organized as limited partnerships and limited liability
companies
Governed by Delaware partnership and corporate law, not
trust law
– Broader investment authority
– Reduced standards for liability
Document review
– Operating memorandum/private placement memorandum
– Entity operating agreement
– Subscription agreement
– Side letters and legal opinions
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VII. Legal Structure of Alternative Investments
(Cont’d.)
Appendix A – Summary of Delaware Limited Partnership Act
Appendix B – Comparison of Common Terms of Private Equity
and Hedge Funds
Appendix C – Model Hedge Fund Due Diligence
Questionnaire
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VII. Legal Structure of Alternative Investment – Key
Questions
Purpose of fund
Investor’s liability
– Capital contributions not in excess of specified capital
commitment
– Distribution refunding obligations (“claw back”) – Limited in
time (maximum 3 years) and amount (maximum 25%)
How distributions will be made
– Taxes
– Tax withholding
Restrictions on redemptions and assignments – lock up
periods and gates
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VII. Legal Structure of Alternative Investment – Key
Questions (Cont’d.)
Management of conflicts of interest by fund managers – at
least arm’s length
Standard of care and limitations on duties of manager
Confidentiality restrictions
Investor inspection rights
Investor representations
– Anti-money laundering and terrorist financing
– Securities laws
Exemption from securities registration – qualified purchasers
or accredited investors
Participation in new issue income from funds – not restricted
persons
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VIII. Qualification to Make Alternative Investments
Securities Act of 1933
– Accredited Investor
Investment Company Act of 1940
– Qualified Purchaser
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IX. Dodd-Frank Act §619 – Volcker Rule
Hedge fund and private equity fund investment restrictions
Financial Stability Oversight Council Study and
Recommendations on Prohibitions on Proprietary Trading and
Certain Relationship with Hedge Funds and Private Equity
Funds.
http://www.treasury.gov/initiatives/Documents/Volcker%20sec
%20%20619%20study%20final%201%2018%2011% 20rg.pdf
Principles
– Separation of banking system support from speculative
investing with bank capital
– Reduce potential conflicts of interest between bank and
customer
– Reduce risk banking entities
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IX. Dodd-Frank Act §619 – Volcker Rule (Cont’d.)
Prohibited activities
– Sponsorship of a hedge fund or private equity fund by a
banking entity
Permitted activities
– Provision of bona fide trust, fiduciary and investment
advisory services
Limitations on permitted activities
– Only in connection with designated services
– Only to customers of designated services
– Banking entity investment limited
– No name sharing
– No material conflict of interest
– No material exposure or threat to banking entity safety and
soundness
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IX. Dodd-Frank Act §619 – Volcker Rule (Cont’d.)
Restrictions on relationships and transactions with private
equity funds and hedge funds
– Treatment of fund as an affiliate
– Issues of conflicts of interest and transfer of funds from
insured bank entity
– Federal Reserve Act Section 23A covered transactions
prohibited
– Federal Reserve Act Section 23B arm’s length
transactions
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VIII. Dodd-Frank Act §619 – Volcker Rule (Cont’d.)
Volcker Rule implementation issues
– Prohibited activities
Characteristics of fund
Structure as Section 3(c)(1) or Section 3(c)(7) fund
– Permitted activities
“Customer” requirement
Feeder funds
De-minimis investments
Monitoring compliance
– Investment and risk oversight
– CEO public attestation
– Transparency – public disclosure
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X. Valuation
Duty to account/report and to inform - National Fiduciary
Accounting Standards Project
– Essential and useful information in a meaningful form
– A fiduciary account should include the inventory value and
current values
– In determining current values for which there is no readily
ascertainable current value, the source of the value should
be stated and explained
– The fiduciary should make a good faith effort to determine
realistic values
Valuation impacts fees
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X. Valuation (Cont’d.)
Financial Accounting Standard 157 – Fair Value
Measurements
– Financial statements, not trust accounting
Definition – 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 measuring date
Marketable securities – exchange price
Non-traditional assets – no market, limited transactions, limited
information
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X. Valuation (Cont’d.)
FASB Statement No. 157 Valuation Considerations for
Interests in Alternative Investments; AICPA Accounting
Standards Executive Committee and the Alternative
Investments Task Force Draft Issues Paper (January 2009)
“Inputs” for estimating fair value
– Net asset value, brokered transactions, discounted cash
flow
“Integrity” of net asset value reported by fund managers
Additional factors affecting fair value - lock-up periods,
suspension of redemptions, transfer restrictions
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XI. Principal and Income Fiduciary Accounting
Interest and dividends trust accounting income
Partnership and LLC distributions generally income unless
partial or total liquidations
Discretion under governing instrument and state law to make
allocations in accordance with duty of impartiality
Allocation fees to income
No fraud or bad faith, allocation upheld
Power to adjust under some state P&I acts
Total return
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XII. Fiduciary Administration
Tax reporting - state and federal
– Entity 1065 and partner/member K-1; state tax reporting
and withholding
– Trust 1041 and beneficiary K-1
– Beneficiary 1040
Investor qualifications and representations
– Accredited investor and qualified purchaser
Indemnification provisions of operating agreements
Regulatory oversight
Distribution and liquidity requirements of trust
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Conclusion
Universe of available investment vehicles has expanded
Non-traditional investments have been used by pension funds
for years and are increasingly used in private trusts
The Prudent Investor Rule allows for use of non-traditional
investments where appropriate
Complexity of non-traditional investments requires increased
level of sophistication, consideration in certain circumstance of
delegation, assessment of how the non-traditional investment
will interface with overall administration of the trust
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Conclusion
Keep all the ducks in a row
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Contact Information
Suzanne L. Shier
Chapman and Cutler LLP
111 W. Monroe Street
Chicago, Illinois 60603
312-845-2983 [email protected]
38
This document has been prepared by Chapman and Cutler LLP attorneys for informational
purposes only. It is general in nature and based on authorities that are subject to change. It
is not intended as legal advice. Accordingly, readers should consult with, and seek the
advice of, their own counsel with respect to any individual situation that involves the material
contained in this document, the application of such material to their specific circumstances,
or any questions relating to their own affairs that may be raised by such material.
© 2011 Chapman and Cutler LLP
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