ERISA Assets Demand Focus

NEW YORK (HedgeWorld.com)–Hedge funds that accept investments from pension plan sponsors subject to the Employee Retirement Income Security Act of 1974 (ERISA) should take extra care to ensure security valuations are accurate and fair, that they are carried out by independent parties, and that valuation policies are clearly disclosed to and understood by plan sponsors.

The rush of ERISA assets into hedge funds has highlighted the valuation issue, and Terri Messina, a partner at Ernst & Young and head of E&Y's Asset Management Advisory Services practice, recently published a paper discussing some of the key points. In that paper, "Valuation and the Management of ERISA Assets," she wrote that hedge funds have some work to do when it comes to dealing with ERISA money.

To comply with the Investment Advisers Act of 1940, registered investment advisers must adopt certain compliance policies and procedures and address conflicts of interest. "?? 1/2 [V]aluation is a requisite policy in achieving regulatory compliance," Ms. Messina wrote. "Few hedge funds today, however, recognize the regulatory implications for Plan Sponsors who invest assets in a hedge fund. Those implications may ultimately drive the policies of the hedge fund itself."

To set this up, Ms. Messina wrote that certain transactions between plans and so-called parties in interest are prohibited by ERISA regulations. The Department of Labor considers firms–including hedge funds–that provide investment management services to plan sponsors to be parties in interest, and this is true whether or not more than 25% of the firm's assets under management come from ERISA plans.

Fees paid by ERISA plan sponsors to investment management firms for services are not prohibited, but according to Ms. Messina the Department of Labor has expressed concerns about incentive fees. Specifically the department worries that such fees are calculated by investment advisers based on the advisers' own portfolio valuations. This appears to the Department of Labor to be a clear opportunity for conflicts of interest.

So the department has issued written guidance in opinions and exemptive orders on what do to in cases where portfolio valuations are used to calculate incentive fees. First, valuations should be based on available market quotations, Ms. Messina wrote. Second, plan sponsors must understand the formula used to calculate fees. Third, plan sponsors have to understand the risks of incentive fees and be fully informed about policies and procedures related to the arrangement. Finally, plan sponsors must monitor their investment advisers' valuation procedures.

These points likely apply whether the ERISA plan sponsor is investing in a separate account or in a pooled fund, Ms. Messina wrote, which means that hedge funds have to consider the requirements of the plan sponsor when they accept those ERISA assets.

"Most importantly, independent valuations (or appraisals) should be sought for fair valued securities in conjunction with the calculation of incentive fees," Ms. Messina wrote. "Independence in the valuation process ?? 1/2 should obviously be a primary goal, especially when accepting ERISA assets into a hedge fund. Both [U.S. Securities and Exchange Commission] and DOL regulation expect independence in the process."

With that in mind, she wrote, objectivity should be a priority in valuation policies. Additionally those policies should also cover what happens when errors and restatements occur. For instance, with respect to net asset value errors, there should be clear policies laying out what to do when errors occur, with the first step being to define what constitutes an error in the first place. "Differences in valuation estimates are generally not considered 'errors,' if the valuation relied on the best available market data at the time the NAV was struck," Ms. Messina wrote.

For equities, some common valuation techniques have emerged, including using the last sale price on an exchange, the most recent bid price or ask price on an exchange, or the median between the most recent bid and ask prices. Valuation of over-the-counter securities can also be done using most recent prices.

Any securities that cannot be priced this way are typically "fair valued" by the investment manager, often using a valuation committee to ensure independence. These committees can use any number of tools to verify prices, including back testing. But here is where problems can start to creep in.

"?? 1/2 [A]ddidional steps should be taken if a significant portion of the portfolio is invested in fair valued securities and the fund counts ERISA plans in its investor base," Ms. Messina wrote. "In these situations it is prudent to obtain an independent valuation of fair valued securities in accordance with the calculation of the incentive fee or allocation."

Any policies have to be clearly communicated to investors in offering memoranda, and changes to those policies should be disclosed to all investors.

"The inflow of ERISA assets into hedge funds places focus on the valuation policies employed by these funds and the disclosure of such policies," Ms. Messina wrote. That focus is heightened as hedge funds increasingly invest in illiquid and privately placed securities."

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ERISA Assets Demand Focus

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