Alternatives and Retail Retirement Account Owners

The prospect of being part of millions of retail retirement plans has some financial advisors and hedge fund managers giddy with excitement. The 401(k) market alone is huge. According to the Investment Company Institute, as of Q3-2012, these defined contribution plans held an estimated $3.5 trillion in assets. In 2011, over fifty million U.S. workers were "active 401(k) participants." This compares favorably to an approximate $2.66 trillion hedge fund market size in 2013, up from $2.3 trillion one year earlier. Private equity, real estate and infrastructure comprise the rest of the alternatives investment sector according to a press release issued by Preqin, a financial research company. See "Alternative Assets Industry Hits $6tn in AUM for First Time" (January 21, 2014).

CNBC contributor Shelly K. Schwartz explains that alternative investment strategies are appearing in the form of 400 plus mutual funds and exchange-traded funds ("ETFs") that employ "complex trading strategies" such as managed futures, long/short trading in stocks and multiple currency exposures. Allocating to leveraged loans, start-up ventures and global real estate are other ways that these relatively new funds seem to be mimicking the approach taken by hedge funds and private equity funds that traditionally have catered to institutional investors and high net worth individuals. Notwithstanding regulatory differences relating to diversification, percentage of "illiquid" investments, redemption, daily pricing and how much debt can be used to lever a portfolio, statistics suggest a growing interest on the part of smaller investors to get in on the action. See "Seeking safe havens? Analysts, advisors point to liquid alternative funds" (November 24, 2013). Also check out "Goldman pushes hedge funds for your 401(k)" (Fortune, May 22, 2013) in which reporter Stephen Gandel describes new funds being offered by various financial institutions, some of which invest in mutual funds that mimic hedge fund investing strategies and others that invest in hedge funds directly.

Not everyone is an ardent fan. In "FINRA warns investors on alternative mutual funds," Reuters reporter Trevor Hunnicutt (June 11, 2013) describes regulators' concerns that "not all advisers and investors understand the risks involved," especially with respect to whether a retail-oriented fund is truly liquid. In its "Alternative Funds Are Not Your Typical Mutual Fund" publication, the Financial Industry Regulatory Authority ("FINRA") cautions investors to assess investment structure, strategy risk, investment objectives, operating expenses, the background of a particular fund manager and performance history.

Given the ongoing search for the next big thing, we are likely to see a lot more activity in the alternative investments marketplace - for both institutional and high net worth clients as well as for individuals with modest wealth levels. PensionRiskMatters.com will return to this topic in future posts. There is much to write about with respect to fiduciary implications, risk management and valuation.

In the meantime, I want to thank ERISA attorney David C. Olstein with Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates for apprising me of a 2012 U.S. Department of Labor grant of individual exemption for Renaissance Technologies, LLC ("Renaissance").  Described as a "private hedge fund investment company based in New York with over $15 billion under management" by HedgeCo.net (September 26, 2013), Renaissance holds a large number of equity positions in stocks issued by household name companies. Click to see a recent list of their transactions. The "Grant of Individual Exemption Involving Renaissance Technologies, LLC," published in the Federal Register on April 20, 2012 makes for interesting reading for several reasons. First, it describes policies relating to important topics such as valuation, redemption and disclosures for "privately offered collective investment vehicles managed by Renaissance, comprised almost exclusively of proprietary funds" and the impact on retirement accounts in the name of Renaissance employees, some of its owners and spouses of both employees and owners. Second, as far as I know, there are not a lot of publicly available documents about proprietary investment products that find their way into the retirement portfolios of asset management firm employees and shareholders. Third, as earlier described, there is evidence of a growing interest on the part of the financial community in bringing hedge funds or hedge fund "look alike" products to the retirement "masses."

Louisiana Pension Funds and Hedge Fund Redemption Concerns

As I've written many times herein, understanding transferability restrictions is a "must do" for institutional investors who allocate monies to asset managers. While a pension, endowment, foundation or family office may decide to invest part of its portfolio in illiquid securities for strategic reasons, it is still necessary to understand how to exit if necessary. In "Hedge Fund Lock Ups and Pension Inflows" (July 4, 2011), the point is made that investors who want to redeem but are barred from doing so may seek redress in a court of law. Regulators are paying close attention too.

According to recent news accounts, several Louisiana pension funds that sought to withdraw some of their money from a New York hedge fund were given promissory notes with assurances that it could get cash in several years. Moreover, it may be that the hedge fund in question has counted assets under management more than once due to a feeder fund organizational structure that boasts over a dozen smaller vehicles which cross trade with one another.

In a joint statement dated July 11, 2011, the Firefighters' Retirement System ("FRS"), New Orleans Firefighters' Retirement System and the Municipal Employees' Retirement System ("MERS") describe how attempts by FRS and MERS "to capture some of the profits that had been earned in an investment known as the FIA Leveraged Fund" initially met with resistance on the part of the fund manager to provide cash right away. Instead, the two requesting institutions were told to expect paper IOUs while certain assets were to be liquidated in an orderly manner over a period of up to two years. The statement goes on to say that the pension plans had each been promised a return of at least 12 percent per annum and that if the "collateral supporting the preferred return declines to a level that is 20% above the systems' collective account values, there is a trigger mechanism requiring a mandatory redemption of the systems' investment" with the 20% cushion" designed to protect the systems' accounts against any loss in value."

Getting a promissory note has not made for happy campers who now worry about the liquidity of the FIA fund and "the accuracy of the financial statements issued by the two renowned independent auditors." The statement goes on to say that the hedge fund manager has been apprised that the pension plans intend to "closely examine" performance records by putting together a team that consists of their board members, internal auditors and investment consultant. A forensic economist may be added to the team.

Click to read the July 11, 2011 joint statement from these Louisiana pension plans about hedge fund liquidity concerns for this particular manager.

Having just checked the SEC website, this blogger does not yet see the formal inquiry statement. Speaking from experience, complexity is never a good thing. Someone somewhere has to understand what risks might give rise to material problems. Moreover, proper due diligence of funds that invest in "hard to value" instruments has to take into account how they are modeled and who is vetting the integrity of the model numbers. Regarding organizational structures that encompass multiple money pools, it is imperative to understand who exactly has a claim to assets in a worst case situation of forced liquidation.

A few years ago, I refused to continue with a valuation engagement of a hedge fund because neither the general partner nor the master fund's attorney could adequately answer my questions about priority of claims for a complex offshore-onshore ownership structure. In several recent matters where I have served as expert witness, concerns about restrictions of transferability and collateral monitoring have taken center stage. Be reminded that in distress, book values often fall seriously short of fire sale or even orderly liquidation (auction) values.

Let's hope that questions can be cleared up in a timely fashion.

Readers may want to check out these articles:

  • "S.E.C. and Pension Systems to Examine Fletcher Fund" by Peter Lattman, New York Times, July 12, 2011; and
  • "Pensions Want Look Into Fund's Records" by Josh Barbanel, Steve Eder and Jean Eaglesham, Wall Street Journal, July 13, 2011.

Hedge Fund Lock Ups and Pension Inflows

Various sources tout increasing inflows to hedge funds from public and corporate pension plans.

In "Strong start to hedge fund activity in 2011" (April 1, 2011), Pensions & Investments reporter Christine Williamson writes that "First-quarter institutional hedge fund activity, including net inflows and pending searches, totaled $18 billion - the highest since the intense investment pace of the first quarter 2007, which saw $25 billion in activity." James Armstrong of Traders Magazine describes the billions of dollars going to hedge funds in recent months as a catalyst to "increased trading volumes for the equities trading business." See "Hedge Funds Could Juice Volume" (June 2011). Imogen Rose-Smith of Institutional Investor gives readers a detailed look at the love affair with hedge funds in "Timeline 2000-2011: Public Pensions Invest in Hedge Funds" (June 20, 2011).

Fortune writer Katie Benner says "wait a minute" to what seems to be an upward trajectory in retirement plan allocations to hedge funds with a 51% increase since 2007 and a doubling of the mean allocation to 6.6% (according to a study by Preqin). In "Hedge fund returns won't save public pensions" (March 30, 2011), she cites willful underfunding and a "mish-mash of accounting tricks" as fundamental problems that will not be corrected with more money in alternatives.

In her May 16, 2011 article for Pensions & Investments and entitled "Promises, promises: $100 billion still locked up," Christine Williamson writes that assurances made to institutional investors in 2008 and 2009 about redemptions are not being met by some hedge fund managers. At that time, jittery pension funds, endowments and foundations that wanted out were asked to be patient rather than force hedge funds to unwind hard to value positions at sub-par prices. Quoting Geoff Varga, a senior executive with Kinetic Partners US LLP, a consultancy for asset management firms, there is an estimated $100 billion in "exotic" or non-standard investments that were stuffed into "emergency side pockets." He adds that it is hard to come up with an exact number, especially since managers' valuations of these illiquid positions are not always realistic.

Certainly the issue of side pockets is unlikely to go away any time soon. On October 19, 2010, Emily Chasan reported that the U.S. Securities and Exchange Commission ("SEC") had filed a civil complaint against several hedge fund managers for overvaluing illiquid assets. See "SEC charges hedge fund of inflating 'side pockets'" (Reuters). Click here to read the SEC complaint and October 19, 2010 press release from the SEC. On March 1, 2011, Azam Ahmed with the New York Times Deal Dook described another case in "Manager Accused of Putting $12 Million in Side Pockets."

This blogger, Dr. Susan Mangiero, has written extensively on the topic of hard to value investments and liquidity and served as expert witness on cases involving due diligence allegations. Acknowledging that not all hedge funds invest in hard to value instruments, the following items may be of interest to readers:

Are Pension Performance Numbers Upside Down?

In a recent interview with Pittsburgh Tribune-Review journalist Debra Erdley, I pointed out the folly of relying solely on point in time actuarial numbers. As I state (below), no single metric is a substitute for a robust risk management process.

Susan Mangiero, CEO of Investment Governance, Inc., a group that advises pensions on best practices and risk management, said pension reports can be misleading - even when numbers are quoted accurately. "A one-point-in-time number is not very helpful. It says nothing about the riskiness of the investment portfolio. It says nothing about whether there is good due diligence in place - the vetting of the consultants, asset managers and investment managers. and it says little about the plan's ability to write checks every month," she said, adding that a pension plan with a high funding ratio could be heavily loaded with assets that are hard to convert to cash."

Others in the article (entitled "Onorato's boast about pension fund solvency raises eyebrows" - April 6, 2010) impugn politicians for their knowledge (or lack thereof) of arcane actuarial methodologies. Ouch!

I'm reminded of my finance teaching days when students were asked to rank capital projects by Net Present Value, Internal Rate of Return, Payback Period and so on. Consider Investment A with a calculated IRR of 50% and a NPV of $1,000 versus Investment B with expectations of 25% per annum and a dollar reward of $500,000. I'd rather have the cash than the cold comfort of a number that doesn't mean much.

Cash is king which is why an ongoing holistic risk management process is EVERYTHING!

Venture Capital Allocation and the IPO Drought

On March 1, 2010, Dr. Susan Mangiero, CEO of Investment Governance, Inc. sat down to talk to financial and strategy expert, Mr. Pascal Levensohn. In this ninth question of ten, read what this Investment Governance, Inc. Advisory Board member has to say about IPOs and whether institutional investors should allocate monies to venture capital ("VC") funds right now. Click here to read Mr. Levensohn's impressive bio.

SUSAN: Does an anemic initial public offering ("IPO") market will remain a deterrent to VC investing?

PASCAL: Yes I do. I believe that an entire generation of American innovation is at risk as a result of the lack of IPO’s. The statistics are overwhelming in support of my position, starting with the fact that over 90% of jobs created by VC-backed companies occur AFTER their IPO - and this has been the case for 40 years. What concerns me the most about the IPO vacuum is that it is systemic and is the result of a “one size fits all mentality” when it comes to regulation of the securities industry.  A relatively unknown emerging growth public company with a $500 million market cap has different needs for research and trading support to provide liquidity for investors than IBM. I remain surprised that this seems to be difficult for our policy makers to understand, but I am encouraged that the U.S. Securities and Exchange Commission ("SEC") has recently invited public comments for a 90 day period to address structural problems with the U.S. equity markets.

Specifically, the SEC wants to know if anyone from the public has thoughts on "whether the current market structure is fundamentally fair to investors and supports capital raising functions for companies of various sizes, and whether intermarket linkages are adequate to provide a cohesive national market system." The Commissioners expressed particular interest in receiving comments from a wide range of market participants. Comments on the Concept Release are due within 90 days after publication in the Federal Register.

Click to read "SEC Issues Concept Release Seeking Comment on Structure of Equity Markets" (January 13, 2010).

I believe that the U.S. equity capital markets must be structured with the goal of promoting the growth of publicly held small businesses in America. America had this structure in place prior to 1997. We should take a hard look at what has changed to render the small company IPO extinct. (Contrary to popular belief, it first became an endangered species before the technology bubble).

Compounding this problem is the fact that, with no IPO options, the consideration paid for companies in trade sales - acquisition by larger companies - has been declining.  Why should venture capitalists take the risks associated with starting up a new company, working through all of the difficulties with multiple financing rounds and executive changes over a six-to-eight or even ten-year period, only to get backed into a corner by a large multinational that dominates the sales channel and can wait them out?

The biggest problem the VC industry has today is that, absent access to public market capital, there are too few VC-backed companies that are self sustaining cashflow generators.  The biggest problem that the U.S. economy has today is unemployment. You would think that maybe the stewards of the U.S. economy, our legislators, could make some structural changes to our small company capital markets regulations to fuel the greatest job creation engine in America - the entrepreneur driving an emerging growth company. This problem goes way beyond venture capital. Consider that 47% of all IPO’s since 1991 were backed by neither VC’s or private equity firms. This is an American problem.

Exiting a Venture Capital Fund Allocation

On March 1, 2010, Dr. Susan Mangiero, CEO of Investment Governance, Inc. sat down to talk to financial and strategy expert, Mr. Pascal Levensohn. In this eighth question of ten, read what this Investment Governance, Inc. Advisory Board member has to say about exiting from a venture capital ("VC") fund. Click here to read Mr. Levensohn's impressive bio.

SUSAN: What happens if a limited partner ("LP") wants to exit a VC fund? What are their rights?

PASCAL: The options here are limited. The LP can try to sell its interest, including the obligation to fund future capital calls, to a fund that acquires secondary interests. The good news is that a robust market exists for such interests in venture capital partnerships today. Alternatively, an LP can default.  If the LP does wish to sell, the general partner ("GP") needs to approve the transfer. The standard partnership agreement language leaves this decision in the "sole discretion" of the GP.  There is no free lunch if you change your mind several years into a 10-year-plus partnership participation. And there shouldn't be. This means that either the secondary market buyer will take his or her pound of flesh by buying the LP's interest at a substantial discount or the GP will by offering the interest and its economic value on a discounted basis to the other LPs. It is far less disruptive to the GP and to the GP-LP relationship for the exiting partner to sell to a secondary buyer but these buyers are totally financially driven and are going to get the best deal possible for themselves.

To Exit or Not Exit - That is The Question

If a picture is worth a thousand words, limited partners will want to ask general partners a lot of questions about projected exits. According to "VC exits still not a pretty picture" (TheDeal.com - January 4, 2010), a dearth of liquidity events in 2008 and early 2009 cast a pallor over the private markets, depressing M&A activity and creating angst for anyone in search of cold hard cash. 

The tide may be turning if late 2009 activity is a bellwether for 2010 initial public offering ("IPO") volume. Reporter Cara Garretson describes research conducted by Thomson Reuters and the National Venture Capital Association that hints at a recovery, albeit modest by historical comparisons. With 67 mergers and acquisitions and 5 IPOs for venture-backed firms in Q4-2009, coupled with at least 29 companies that have filed with the U.S. Securities and Exchange Commission to go public, life may be sweet indeed for some. (See "IPO, Acquisition Activity Raises Hopes for 2010," CIOZone.com, January 4, 2010).

Closer to home, Financial Engines has signaled its intent to raise $100 million by selling stock to the public at large. Self-described as a "leading provider of independent, technology-enabled portfolio management services, investment advice and retirement help to participants in employer-sponsors defined contribution retirement plans," this California company received private market monies from giants such as New Enterprise Associates and Oka Hill Capital Partners. (See "Financial Engines Inc files for $100 min IPO" by Clare Baldwin, Reuters, December 9, 2009.) A brainchild of Nobel prize winner Dr. William Sharpe, Financial Engines recently claimed $25 billion in managed accounts and nearly 400,000 participants.

For those in the investment industry, the Financial Engines S1 filing with the U.S. Securities and Exchange Commission makes for interesting reading. Cited risk factors include:

  • "Decline or slowdown of the growth in the value of financial market assets" which reduce revenues related to management
  • "Negative public perception and regulation of the financial services industry"
  • Elimination or decrease of sponsor 401(k) matches which could lower assets under management
  • Pressure to reduce fees charged for "portfolio management, investment advisory and retirement planning services"
  • New regulations that impact any organization that offers subadvisory work, etc.

Later pages of the Financial Engines regulatory report offer insight about the growth potential for those seeking to expand their presence as part of the U.S retirement savings industry. The commentary includes reasons why management account business is likely to grow. 

Stay tuned for what could be a watershed year in terms of public filing reversals.

Return, Liquidity and Valuation

 

More than a few of our recent conversations with pension, endowment and foundation decision-makers focus on hard-to-value investing. At a time when 2010 beckons with the hope of a buoyant market, institutions seek returns from alternatives such as hedge funds, private equity and venture capital. According to "The Endowment & Foundation Market 2009," put out by the Spectrem Group, about six out of ten organizations seek to rebuild by emphasizing non-traditional asset allocations. Other recent studies confirm the same sentiment with the caveat that liqudity is key.

Therein lies the rub.

  • Can you invest in "hard to value" assets and satisfy a need for ready cash at the same time?
  • Who should monitor valuation of "hard to value" assets?
  • What areas of concern are most acute from the investment decision-maker perspective?
  • What elements are "must have" with respect to effective policies and procedures?

In my September 11, 2008 testimony before the ERISA Advisory Council on the topic of hard to value investing, I emphasized the need to subsume pricing as part of pension risk management (though the concept transcends retirement plans, with full applicability to endowments, foundations, college plans, sovereign wealth funds and other types of buy side executives).

Click to access the United States Department of Labor Advisory Council report on hard to value investing. 

Participate in a short survey entitled "Hard to Value Investing Policies and Procedures." The questionnaire consists of twelve multiple choice queries. For those interested in receiving survey results, be sure to include your name and email address before you hit the "Submit" button.

How Important Are Exit Events to Venture Capital and Private Equity Limited Partners?

 

If there is any silver lining from the recent market rout, it is (hopefully) a renewed focus on how to comprehensively risk adjust returns. For some pensions, endowments and foundations, barriers to liquefying positions have come as an unpleasant surprise. Other institutional investors appear to embrace illiquidity as a gateway to possible rewards, evidenced by their allocation of monies to venture capital and private equity.

Interestingly, there seems to be something brewing on the buy side with respect to less liquid investments. One might argue that defined benefit plans and other long-term investors should query about distributable cash along the way for a company "built to last" rather than encouraging professional fund managers to back multiple start-ups and hope that at least one or two of them can be flipped within a reasonable period of time at a higher price than cost. 

In "The Venture Capital Math Problem" (April 29, 2009), Fred Wilson, notable principal of Union Square Ventures, predicts that "We'll see some of the large public pension funds who have been drawn to venture capital over the past decade decide to leave the asset class because it does not scale to the levels they need to efficiently invest capital." If I understand Wilson's blog post correctly, he seems to be suggesting that a shrinking venture capital industry is a good thing. His arithmetic goes like this:

  • Venture capitalists raised between $20 to $30 billion each year between 2004 and 2008 or an average of $25 billion of deployable funds.
  • This money "needs to generate 2.5x net of fees and carry to the investors to deliver a decent return" or 3 times gross returns or $75 billion "in proceeds to the venture funds."
  • Assuming that each venture capitalist fund owns an average of 20% of funded companies, $75 billion in gross proceeds to them "must come from exits producing $375bn in total value."

Even allowing for Wilson's estimate of average total (multiple fund) venture capital equity interest of 50% and required sales of portfolio companies equal to $150 billion, the message is clear. At a time when capital market conditions have all but shuttered traditional exits, how can the typical VC fund return "enough" to entice new limited partners and/or maintain current allocations?

Rosetta Stone, a provider of language instruction products, brought recent smiles to investment bankers everywhere with a highly successful stock issue a few weeks ago. See "Rosetta Stone IPO Soars," U.S. News & World Report, April 16, 2009. Before then, Thomson Reuters and the National Venture Capital Association had reported an absence of Initial Public Offering ("IPO") activity for two quarters, with merger and acquisition ("M&A") exits fewer than 60 transactions for Q1-2009. See "Venture-Backed Exit Market Remains a Concerns in the First Quarter" (April 1, 2009).

According to Wilson, the venture capital math problem is this. If the industry requires $150 billion per year in exits but is getting about $100 billion instead (half of which is returned to venture capital fund managers), VCs end up earning about $40 billion, net of fees and carry. This is roughly 1.6 times on investor's capital if $25 billion per year ends up in venture capital pools. "If you assume the investors' capital is tied up for an average of 5 years..." then one should expect about 10% per annum. Whether 10% (if realized or surpassed) is sufficient reward for pensions, endowments and foundations remains to be seen. As VentureBeat writter Anthony Ha suggests, venture capital returns oft compare favorably to traditional equity investments. Consider that the reported 3 year return for "All Venture" was 4.2% compared to -10.3% for NASDAQ and -10% for the S&P 500. Refer to "Don't stop believing: Venture performance didn't dip that badly," VentureBeat.com, April 27, 2009.

The reality is that information about projected return drivers is necessary but not sufficient for pension decision-makers. Financial and regulatory exigencies now confront retirement plan fiduciaries in ways that are complex and impossible to ignore. A particular venture capital fund may look appealing to certain trustees in terms of return potential but be turned away because liquidity trumps. On the other hand, underfunded plans may seek salvation by ratcheting up their exposure to investments with the potential to generate more than the commonly used 8% return on asset assumption. Cash is increasingly king for schemes that require mandatory "top ups."

If indeed fewer monies make their way to venture capital, infrastructure and private equity fund managers, what will this trend mean for future economic growth opportunities? The answer is likely to vary, depending on your belief as to whether venture capitalists can jump start innovation. Certainly, some great companies in the United States and abroad have been backed by those general and limited partners willing to take early stage company risks. See "Venture Impact: The Economic Importance of Venture Capital Backed Companies to the U.S. Economy, Fourth Edition," Global Insight, 2007. A countervailing view is that, contrary to the desires of the National Venture Capital Association, taxpayer dollars should not subsidize attempts to restore liquidity. See "Another dumb way to spend taxpayer money" by Harold Bradley, Kansas City Star, May 1, 2009.

As an advocate of free markets and the notion that necessity is the mother of invention, it is refreshing to learn that several organizations have or are formalizing mechanisms to trade otherwise illiquid economic holdings. Financial expert Roger Ehrenberg has an interesting take on the creation of private markets for venture-backed positions. See "Private Equity Markets" Not Today, Perhaps Tomorrow" (April 26, 2009).

To exit or not exit. That is the question of the day.