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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]
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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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