Legislative Matchmaker: Hedge Funds and ERISA
A provision in the pension bill just passed by the U.S. House of Representatives could permit hedge funds to increase Employee Retirement Income Security Act ("ERISA") holdings before having to wear the fiduciary hat (for those that don't voluntarily assume the role now). The current limit is twenty-five percent of a hedge fund's total assets. The precise way ERISA assets are calculated is likewise expected to change.
According to Greenberg Traurig hedge fund attorney Nir Yarden, "an ERISA fiduciary is tasked with many responsibilities not otherwise required, some of which could significantly impact hedge fund strategy, investment mix, fees and reporting."
As one can imagine, advocates and critics are plenty. A healthy debate is good. After all, a particular hedge fund may be perfect for one defined benefit plan but wholly inappropriate for another. (To date, hedge funds are typically not offered as a 401K investment choice.)
What is important is that hedge fund (or fund of funds) managers who become ERISA fiduciaries truly understand what that means.
For example, with respect to the use of derivatives, a U.S. Department of Labor guidance letter is pretty clear.
As with any investment made by a plan, plan fiduciaries with the authority for investing in derivatives are responsible for securing sufficient information to understand the investment prior to making the investment. For example, plan fiduciaries should secure from dealers and other sellers of derivatives, among other things, sufficient information to allow an independent analysis of the credit risk and market risk being undertaken by the plan in making the investment in the particular derivative. The market risks presented by the derivatives purchased by the plan should be understood and evaluated in terms of the effects that they will have on the relevant segments of the plan's portfolio as well as the portfolio's overall risk.
Plan fiduciaries have a duty to determine the appropriate methodology used to evaluate market risk and the information which must be collected to do so. Among other things, this would include, where appropriate, stress simulation models showing the projected performance of the derivatives and of the plan's portfolio under various market conditions. Stress simulations are particularly important because assumptions which may be valid for normal markets may not be valid in abnormal markets, resulting in significant losses. To the extent that there may be little pricing information available with respect to some derivatives, reliable price comparisons may be necessary. After entering into an investment, a plan fiduciary should be able to obtain timely information from the derivatives dealer regarding the plan's credit exposure and the current market value of its derivatives positions, and, where appropriate, should obtain such information from third parties to determine the current market value of the plan's derivatives positions, with a frequency that is appropriate to the nature and extent of these positions.
Valuation is another touchstone. Fiduciary duties require a thorough assessment of everything related to plan investments. In "Hedge Fund Valuation: What Pension Fiduciaries Need to Know", this author emphasized the need for an independent assessment of valuation and/or valuation processes, including, but not limited to a check of price data collection, accuracy of pricing models and existence of controls that are meant to separate the trading and payment functions. The central role that valuation plays is becoming all too apparent as regulators and auditors ask tough questions.
Valuation drives nearly every investment activity. It is impossible for hedge fund managers to make meaningful decisions about asset allocation, portfolio re-balancing, risk management, fee assessments and performance evaluation in the absence of good valuation numbers. It is equally difficult for the pension fund investor to evaluate managers, decide whether to redeem or subscribe, verify calculated incentive fees charged by the typical hedge fund and otherwise carry out their mandated fiduciary duties. (Click here for a copy of the article.)
Any hedge fund or fund of funds manager, seeking additional ERISA money, should think about creating a laundry list of MUST DO items required by law and reflecting best practices. This would necessarily include a process check of risk management and valuation policies, procedures, along with reporting methodology. (A sign of the times, we've been fielding a lot of inquiries of late on these topics.)
Fees are another issue altogether and deserving of an additional post or two. (Read what we wrote in May 2006.)
So Congress plays matchmaker. Whether hedge funds and ERISA plans will represent a marriage made in heaven or a relationship destined for divorce court critically depends on prudent process.
Two little words that mean oh so much!
