CLE Webinar About ERISA and Hedge Funds and Private Equity Funds

I am pleased to announce that I will be speaking as part of an upcoming Strafford live webinar, "Alternative Investments in ERISA Retirement Plans: Mitigating Liability Risks for Hedge and Private Equity Funds and Pension Plan Fiduciaries" scheduled for Wednesday, May 24, 1:00pm-2:30pm EDT. I am given ten (10) guest passes. If you are interested, please let me know.

Once the ten guest passes are gone, you can still attend the webinar. By referencing my name, you can receive a fifty percent discount. As long as you use the link shown below, the offer will be reflected automatically in your cart.

Our panel will provide ERISA and asset management counsel with a review of effective due diligence practices for institutional investors from both a legal and economic perspective. The panel will offer risk mitigation best practices at a time of increased government scrutiny and lawsuits by plan participants.

After our presentations, we will engage in a live question and answer session with participants so we can answer your questions about these important issues directly.

I hope you'll join us.

For more information or to register >

Or call 1-800-926-7926 ext. 10
Ask for Alternative Investments in ERISA Retirement Plans on 5/24/2017
Mention code: ZDFCT


Dr. Susan Mangiero, Managing Director
Fiduciary Leadership, LLC
Trumbull, Connecticut

Court Says Private Equity Funds Are Liable For Pension Liabilities of Portfolio Company

If you open a box and a dog pops out, your enthusiasm will be curbed if you were expecting something else. Surely this is how several private equity funds must feel now about one of their investments. According to "Private Equity Funds Liable to Union Pension Plan" by Jacklyn Wille (Pension & Benefits Daily, March 30, 2016), a federal judge recently ruled that several Sun Capital funds are "jointly liable for more than $4.5 million in withdrawal liability" that one of its portfolio companies, Scott Brass, "owed to a Teamsters pension fund." (You can visit Bloomberg Law to read the March 28, 2016 decision by clicking here.)

I will defer to attorneys to address the legal issues. So far, I found two commentaries on the heels of this 2016 legal decision. See "District Court Concludes Private Equity Fund Is Liable for Pension Obligations of the Portfolio Company" (Fried Frank Harris Shriver & Jacobson LLP, March 30, 2016) and "Private Equity Funds Held Liable for Pension Liabilities of a Portfolio Company" (Sullivan & Cromwell, March 31, 2016).

From my perspective as an economist, any surprise claim on future cash flows could be disastrous if it is large enough to jeopardize the ongoing viability of a business. Even if a business has sufficient resources to maintain itself as an ongoing concern, utilizing cash for something that was not planned for could lead to a lower growth rate than originally expected. Keep in mind that pension funds, endowments and foundations frequently allocate monies to private equity on the basis of expected returns for this asset class.

Projecting cash flows as part of due diligence is nothing new for many investors. That said, I am not convinced that all enterprise investigations fully address the impact of an underfunded defined benefit plan. I was recently contacted by a firm that was tasked to render a fairness opinion and wanted my views about pension math. The investment bankers were reviewing documents from bidders that radically differed with regard to the treatment of the target company's benefit plan burden. When I was asked to speak and also write about pensions and enterprise value, the invitation came from a senior valuation executive who felt that the topic was not being adequately addressed. See "Pension Plans: The $20 Trillion Elephant in the (Valuation) Room" by Dr. Susan Mangiero (Business Valuation Update, July 2013). Email me if you would like a copy of my 2013 slides about this topic.

In 2013, when this Sun Capital case originally made its way to the court, it struck me as an important issue. (I was not involved in this matter as an expert.) Several editors agreed and I ended up co-writing two articles with Groom Law Group partner David Levine. I've uploaded one of these articles to this pension blog. Click here to read "Private Equity Funds and Pension Plans: A Changing Dynamic" (CFA Institute Magazine, March/April 2014). At my request, Attorney Levine responded to this 2016 decision by emailing the following: "In short, while some private equity firms have already moved to evaluate and, in some cases, clarify their fund structures, this case is likely to lead to a second look at their structures and methods of involvement with their portfolio companies."

If certain limited partners are not already asking questions of their private equity fund general partners about the nature of portfolio company pension plans, controlling interest status and deal structure, their due diligence could quickly change in the aftermath of the 2016 Sun Capital litigation.

Interested persons can click on the links provided below to read earlier blog posts about this topic:

ERISA Litigation Webinar Transcript Now Available

Seeking to accomplish a goal without having the right tools can result in frustration and possible failure. One solution is to get outside help when needed as long as the party being hired is knowledgeable and independent. Otherwise, what looks like a solution could quickly become a problem. Applied to ERISA plans, trouble might take the form of costly and time-consuming enforcement and/or litigation. Over the last few years, that reality has set in for more than a few employers.

Recognizing the importance of abiding by good governance principles, several of us agreed to speak as part of an educational webinar on April 8, 2015 about fiduciary tools, pitfalls and lessons learned. Sponsored by fi360 and entitled "ERISA Litigation and Enforcement: The Role of the Independent Fiduciary and Best Practices for Financial Advisors," this webinar joined Attorney Tom Clark (Counsel with the Wagner Law Group), Dr. Susan Mangiero (Managing Director with Fiduciary Leadership, LLC) and Mitchell Shames, Esquire (Partner with the Harrison Fiduciary Group) to address the (a) use of an independent fiduciary (b) clarifying what an outside vendor should be doing and (c) avoiding legal and economic landmines that have revealed themselves in prominent court cases and regulatory examinations.

If you missed the event, email for a copy of the slides. Click here to download the written transcript. Edited for clarity (and because the audio file is spotty in some places), this fourteen page document lays out cornerstone concepts and includes suggestions for plan sponsors and the advisers who serve them. These include, but are not limited to, the following:

  • The outsourced fiduciary market is growing in the United States and elsewhere.
  • When an outside party is hired by a plan sponsor, it is critical to specify responsibilities and contract accordingly. When an "expectations gap" exists, some critical tasks may be left wanting or not addressed at all.
  • When multiple fiduciaries are in place, a plan sponsor must ensure that a central person or team is adequately coordinating the efforts of all fiduciaries.
  • The newly proposed Conflict of Interest rule is predicted to materially change the landscape of fiduciary relationships between plan participants and retirement advisers.
  • A fiduciary status may exist due to either a contractual agreement or by virtue of the functions assumed by an individual or organization.
  • ERISA litigation is getting more attention these days, with a particular focus on fees, use of proprietary funds, revenue-sharing and disclosure of compensation paid to investment consultants, advisers and asset managers.
  • Demonstrating procedural prudence in part depends on what others in the industry are doing (or not doing as the case may be) and whether actions make sense for a given plan.
  • A renewed focus on disclosure and transparency is in the works according to comments made by the U.S. Department of Labor.
  • An independent fiduciary can be engaged for a singular transaction or for a task that continues over a long period of time.
  • An independent fiduciary can be engaged by either a defined contribution plan or defined benefit plan or both.
  • When there is a perception or reality of a conflict of interest, it may be prudent for an independent fiduciary to be engaged. The participants pay for said party because the independent fiduciary works on behalf of the participants.
  • The concept of co-fiduciary status is important and should be paid heed by any adviser who has an ERISA plan as a client.
  • Before delegating duties (to the extent allowed) to a third party, a plan sponsor should decide what financial issues should be vetted. Liquidity, the use of leverage by asset managers and asset allocation are a few of the many topics that a delegated fiduciary could be asked to measure, monitor and manage.
  • A fiduciary audit can be extremely helpful as a tool for identifying areas of improvement for an ERISA plan sponsor.

It may be no surprise that over 500 people registered for this educational webinar about fiduciary foibles. After forty years since its inception, ERISA remains a force that cannot be ignored.

Pension Risk Governance Blog Still Going Strong After Nine Years

Nine years today marked the debut of Since then, I am proud to say that traffic has steadily grown, with continued feedback and suggestions about all sorts of topics. I am deeply grateful to visitors to this independent website for their time and encouragement. While the specific feedback tends to vary by issue or job function, a central theme is clear. Ongoing education about topics such as due diligence, fees, risk management, asset allocation, hedge funds, liquidity and valuation is both needed and desired. In 2015, this award-winning blog will continue its focus on providing objective and helpful information about important subjects that challenge investment stewards and their advisors, attorneys and regulators who oversee the management of more than $30 trillion.

As I point out in "Financial Expert Susan Mangiero Celebrates Ninth Year as Lead Contributor to Pension Risk Governance Blog" (Business Wire, March 25, 2015), "There is never a shortage of subjects to discuss, thanks to ongoing suggestions and contributions from readers and the significant realities of changing demographics, market volatility and new accounting rules."

To date, there are over 900 published analyses, research updates and guest interviews that can be readily accessed by category and keyword. Simply click on the Archives section of For a complimentary subscription to this blog, as posts are published, click here to sign up. Click here to read our Privacy Policy. If you are interested in contributing an educational essay or letting us know about a relevant news item or rule change, please email

Until the next blog post, thank you for your interest!

Private Equity Fund Limited Partners and Pension Funding Levels

Some pension plans invest in private equity funds or funds of funds. Certain private equity funds invest in companies with pension plans. This means that pension funds that invest in this asset class need to be aware of any deficiencies in their plans as well as those portfolio company plans to which they are likewise exposed. While the notion of "my brother's keeper" may not resonate well with stewards of billions of dollars, it is a reality. This is especially true, in the aftermath of the Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund decision, No. 12-2312 (1st Circuit, July 24, 2013).

Despite the "record year" described by Wall Street Journal reporter Ryan Dezember, private equity investments, like any other, necessitate careful due diligence on the part of institutional investors that seek a seat at the limited partner table. (See "Private Equity Enjoys a Record Year: Firms That Buy and Sell Companies Are Set to Return More Than $120 Billion to Investors in 2013," December 30, 2013). A critical question is whether continued gains will be diminished if a portfolio company has to divert cash to top off an underfunded pension plan. One way to address the issue is for a pension plan, endowment or foundation to ask the private equity fund general partner how much attention they pay to ERISA economics.

There are numerous other queries to make. In the March/April 2014 issue of CFA Institute Magazine, ERISA attorney David Levine (with Groom Law Group, Chartered) and Dr. Susan Mangiero, CFA (with Fiduciary Leadership, LLC), provide insights for improved due diligence, in a post-Sun Capital world. Suggested action steps include, but are not limited to, the following items:

  • Ask whether a private equity fund is "relying on the position that it is not a 'trade or business' and is therefore not subject to liability for a portfolio company's" ERISA plan deficit;
  • Request to see a list of the holdings for purposes of knowing whether a particular private equity fund has a majority ownership in any or all of its portfolio companies;
  • Investigate whether the Pension Benefit Guaranty Corporation ("PBGC") has red flagged any of the pension plan(s) of a business that is part of a private equity fund's portfolio;
  • Understand how, if at all, a private equity fund is planning to solve a pension plan underfunding problem;
  • Acknowledge that a portfolio company's ERISA liabilities could make an exit difficult, whether via an Initial Public Offering or an acquisition, and that this in turn could lengthen the time before a limited partner can cash out;
  • Identify the extent to which a private equity fund regularly examines the degree to which any or all of its portfolio companies are parties to labor contracts that may be difficult to modify; and
  • Be aware that this important legal decision could invite more litigation and regulatory actions that, regardless of outcome, have a cost and therefore a potential impact on future private equity fund returns.

If you have any difficulty in accessing our article, please send an email request to

Private Equity Performance and Underfunded Pensions

Adopting a "half glass full" attitude, my co-author and I wrote about the business opportunities for private equity fund general partners ("GPs") with portfolio company problems. In "GPs Eye New Ruling" (Mergers & Acquisitions, December 2013 Issue) by ERISA attorney David Levine and Accredited Investment Fiduciary Analyst, Dr. Susan Mangiero, we talk about the aftermath of a recent legal decision that has the private equity world on high alert.

By way of background, in Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund, the United States Court of Appeals for the First Circuit ruled that a private equity fund can be held liable for the pension obligations of a portfolio company. If left unchecked, private equity funds (and their limited partners such as pension plan investors) could see a diminution of performance for any number of reasons. For one thing, a GP may be unable to exit a position within a reasonable period of time if potential buyers get scared of being saddled with an expensive, underfunded retirement plan. In addition, cash that was otherwise earmarked to finance new growth projects may be used instead to comply with statutory contribution rules. Indeed, I have carried out financial analyses for prospective buyers on the basis of how much "extra" a pension problem is likely to cost.

While the downside possibilities are real, Attorney Levine and I point out that "lessons learned" from the Sun Capital decision enable a GP to take action preemptively as a way to potentially "maximize value from portfolio companies while also mitigating future risk." Savvy asset managers can adapt their due diligence process to help avoid any issues that could preclude an exit within the typical three to seven year time period from an initial funding round. Some of the many steps that a GP can take include, but are not limited, to the following:

  • To the extent that a private equity fund is relying on the position that it is not a “trade of business” and is therefore not subject to liability for a portfolio company’s pension underfunding, it is wise to review the potential economic, fiduciary and legal risks should this position be challenged in court.
  • Review its holdings that are at least 80 percent owned by the private equity fund. Total equity exposure should include common stock, preferred stock and possibly economic rights associated with warrants and/or equity derivatives such as swaps. Although a core focus of any such review should be with respect to holdings subject to jurisdiction in the First Circuit (Maine, Massachusetts, New Hampshire, Puerto Rico, and Rhode Island), a broader review of holdings elsewhere might also be considered.
  • Review underfunded pension plans before and after each acquisition of a portfolio company in order to develop strategies for addressing the Pension Benefit Guaranty Corporation’s aggressive litigation positions that it has been taking lately. Failure to do so could result in unnecessary delays in connection with corporation transactions, including the sale of portfolio companies. Examine the collective bargaining agreements for any or all portfolio companies. Although the Sun Capital Partners case was about liability for pension funding obligations under a multiemployer pension plan (i.e., a pension plan maintained independent of an employer pursuant to collective bargaining), there is some concern that the logic of Sun Capital Partners might be extended to conclude that a private equity fund is conducting a “trade of business” under the Internal Revenue Code through its management and oversight of portfolio companies. A decision concluding that a fund is a trade or business for Internal Revenue Code purposes could impact a fund’s representations of its attempts to minimize its unrelated business income tax liability and/or its acceptance, pursuant to the Internal Revenue Code, as a trade or business.
  • Assess the economic, fiduciary and legal attractiveness of all employee benefit plans that are offered by private equity portfolio companies. This includes traditional defined benefit pension plan, 401(k) plans, and health and welfare arrangement. Individually and collectively, ERISA plans can carry significant liabilities that have the potential to (a) materially reduce overall business profitability (b) increase insurance premiums (c) lead to expensive litigation and/or regulatory enforcement (d) impede liquidity and (e) hamper capital raising. As a result, a general partner may never be able to realize the growth targets that motivated a particular investment in the first place. Just as significant, a private equity fund may find itself limited in its ability to exit a particular investment.
  • Meet with retirement-focused advisers, actuaries and counsel before investing in a new portfolio company. The due diligence analysis should be comprehensive. This means that a private equity fund will want to assess both the current and projected pension plan liabilities for a portfolio company as well as the riskiness of its investments in its pension and 401(k) plan. If a pension plan’s assets are illiquid or overly conservative, a deficit may occur or grow bigger. It is likewise important to understand whether the assumptions underlying actuarial calculations are overly optimistic. The objective is to understand the seriousness of a given situation in terms of economic, fiduciary and legal vulnerability.
  • Assess the accounting impact for any and all retirement plans. Be prepared to explain performance volatility to LPs as the result of an ERISA problem.
  • As the family of “de-risking” products continues to expand, consider restructuring a portfolio company’s ERISA plan if, by doing so, a private equity fund owner can improve the likelihood of an exit within its target time horizon. However, because ERISA’s fiduciary rules impose a duty of loyalty to participants and beneficiaries, decisions on de-risking should be evaluated under these standards.
  • Determine, in conjunction with ERISA counsel, whether to engage an “independent fiduciary” for purposes of evaluating an array of possible restructuring solutions. Buying annuities to settle pension liabilities or investing in employer securities or other “hard to value” assets are examples.
  • Recognize that the Sun Capital Partners decision could encourage further litigation and regulatory activities. Private equity funds might be well served to consider whether minor tweaks to their structure merit use, including the creation of additional services entities that are commonly used in operating company structures. Clarification of offering documents, careful monitoring of activities and/or comprehensive documentation of its involvement with portfolio companies can go a long way to help insulate a private equity fund from a finding that it is engaged in an Internal Revenue Code trade or business.

For further reading about this important legal decision and the economic and compliance imperatives, you can read earlier blog posts and link to various law firm memos on this topic. See "Pension Liability Price Tag For Private Equity Funds and Their Investors". Also see "More About Private Equity Funds and Pension IOUs."

More About Private Equity Funds and Pension IOUs

As I discussed in my July 29, 2013 blog post entitled "Pension Liability Price Tag For Private Equity Funds And Their Investors," a recent court decision by the First Circuit could mean the difference between "good" deals and "bad" ones. In "Doubling Down on a Bad Bet: Liability for Portfolio Company Pension Obligations After Sun Capital" (August 5, 2013), ERISA trial attorney with the McCormack Firm, Stephen D. Rosenberg refers to this legal opinion as "tremendously significant" as it will directly impact how acquisitions are structured, "in terms of examining whether it is possible to legally structure the acquisition and ownership of a portfolio company in a manner which will insulate the acquirer from unfunded pension obligations or, if it is not certain whether that can be achieved, will at least make it as hard as possible for potential plaintiffs to recover, thus hopefully dissuading future lawsuits..."

As creator of the popular and insightful Boston ERISA & Insurance Litigation blog, Attorney Rosenberg talked about the imperative to think ahead. Instead of trying to fix a problem after an acquisition has take place, he references my recommendations, as a business expert, to thoroughly value "the pension exposures of the target company" and account "for that exposure financially in the purchase price."

School is still out as to whether these actions are being done to the extent they should be. I have worked on due diligence initiatives that included a forward-looking assessment of cash needs and investment considerations. However, if everyone was tackling this type of economic analysis, in conjunction with a legal review, there would be no headlines about post-deal pension surprises. In other words, there are obviously some buyers that have not done sufficient homework and end up paying more than they had anticipated. If that happens too often, a private equity fund's general partners are ultimately going to get push back from their limited partners such as other pension plans, endowments and foundations. Why? Post-transaction costs impede performance.

Attorney Rosenberg and I both agree that doing the right things, prior to the closing of a transaction, is a good offense. As relates to pension-centric due diligence by a private equity fund, he adds that "Do that correctly, and you have already accounted for the possibility of being forced to cover the portfolio company's exposure; do that incorrectly, and you may have - as occurred in Sun Capital - doubled down on a losing proposition."

Pension Liability Price Tag For Private Equity Funds and Their Investors

I have long maintained that any individual or organization that invests in a company needs to check under the employee benefits hood before allocating money initially, and regularly thereafter. I can give you countless examples where incomplete due diligence led to an overly rich acquisition or investment that resulted in a new owner having to deploy cash to write checks to retirees and/or incur the costs of restructuring an otherwise untenable situation.

Failure to carry out a comprehensive ERISA-focused due diligence of a target portfolio company is not good for numerous reasons. Having done economic analyses of companies with underfunded pension plans, I know firsthand that it is often a rude awakening for investors such as private equity funds when they are confronted with the reality that what they want and what they end up with in terms of buying forecasted growth are not always the same. Reasons to worry include, but are not limited to, the following:

  • A private equity fund may not be able to realize its target rate of return because a portfolio company cannot sufficiently grow without cash that is now redirected to support employee benefit plans.
  • A pension plan that has invested in said private equity fund will be none too happy if performance falls short of expectations, especially for something that arguably should have (and could have) been considered and addressed as part of the original deal.
  • An unhappy pension fund investor may turn around and sue a private equity fund for alleged failure to have properly researched "what if" situations, taken on "too much" risk and disclosed too little information. Litigation in turn can be an expensive proposition for a private equity fund, making it even more difficult to achieve even minimum hurdle rates.

The issue of private equity ownership and portfolio company pension liabilities was heavily discussed as the result of a 2007 Appeals Board of the Pension Benefit Guaranty Corporation ("PBGC") decision about ownership, control and responsibilities for portfolio company pension plan gaps. In "Private Equity Funds: Part of the ERISA Controlled Group?" (December 19, 2007), O'Melveny & Myers LLP attorneys Wayne Jacobsen and Jeff Walbridge explained that "[i]f the PBGC's position endures, it could have significant ramifications for private equity fund investments in portfolio companies that sponsor defined benefit pension plans...[t]he fund could be required to use any or all of its assets, including the ownership interests of the fund in any or all of its portfolio companies, to fund the pension obligations of the bankrupt portfolio company."

Imagine the happy faces in private equity land when the U.S. District Court of Massachusetts opined on October 18, 2012 in favor of Sun Capital Partners III, LP and related parties. According to "Potential ERISA Title IV Liabilities of Private Equity Firms - Eliminated by the Sun Capital Decision?" (November 2012), Edwards Wildman attorney Mina Amir-Mokri describes the decision as a "significant victory for private equity firms" but explains that Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund was to be appealed.

On July 24, 2013, the U.S. Court of Appeals for the First Circuit reversed the earlier decision and put private equity funds in a potential liability position once again. According to "Private Equity Funds Further Exposed to Portfolio Company Pension Plan Liabilities" (July 29, 2013) Latham & Watkins attorneys Jed Brickner and Austin Ozawa offer post-opinion practical hints such as the need for private equity firms to "carefully consider how to structure their funds and acquisition structures to avoid characterization as a trade or business and avoid inclusion in the same controlled group as their portfolio companies." Additionally, they urge private equity funds to pay attention to the "structure of their funds' investments"...possibly "dividing their investment between two or more of independently managed funds with distinct portfolios to support a finding that no individual fund (or group of 'parallel' funds) controls any portfolio company (and no set of funds is treated as a joint venture). Paul Hastings attorneys Stephen H. Harris, Eric R. Keller, Ethan Lipsig and Mark Poerio assert that private equity funds would do well to own "less than 80% of a portfolio company"...perhaps via "thoughtful adjustments to ownership structures and management operations" that can help to reduce the exposure to portfolio company pension liabilities. See "Private Equity ERISA Alert: Consider ERISA Pension Liability Risks from Portfolio Plans" (July 2013).

While legal experts weigh in on the important issue of what responsibilities belong to private equity funds, if any, to portfolio company ERISA plan participants, institutional investors such as pensions, endowments, foundations and family offices - and their investment consultants and advisors - should take heed. If a private equity fund's exposure to a portfolio company with a problem pension plan ends up shrinking the wallets of institutional investors, serious questions will understandably be asked about who should have done what and when.

ERISA Assets: QPAM and INHAM Audit Legal Requirements and Best Practices

I am happy to announce that I will be joined by esteemed colleagues Howard Pianko, Esquire (Seyfarth Shaw) and Virginia Bartlett (Bartlett O'Neill Consulting) on September 10, 2013 from 1:00 to 2:30 pm EST to talk about QPAM and INHAM compliance audits. See below for more information. Click to register for this forthcoming educational event about ERISA requirements. (Note: I am given a few complimentary guest passes. Contact me if you are interested and they are still available.)

This CLE webinar will prepare counsel to advise asset manager clients regarding Qualified Professional Asset Manager (QPAM) and in-house asset manager (INHAM) audits as required by the Department of Labor. The panel will review the new exemption rules, who can conduct an audit, what the process entails, and how to showcase good practices with existing and prospective plan sponsors.

Continue Reading...

Hedge Fund and Private Equity Fund Due Diligence for Pension Funds

If you missed the Strafford CLE event on June 5, 2013 entitled "ERISA Pension Plans in 2013: Due Diligence for Hedge and Private Equity Funds: Avoiding the Pitfalls with Alternative Investments for Institutional Investors and Fund Managers," there is still an opportunity to purchase the recording. Click here for more information.

In the meantime, click to access the due diligence slides that were used by Dr. Susan Mangiero (Fiduciary Leadership, LLC), private fund attorney Rosemary Fanelli (CounselWorks) and ERISA attorney Tiffany Santos (Trucker Huss).

While we ran out of time with so much left to discuss beyond our assigned 90 minute slot, the two attorneys who spoke with me talked a lot about their perception of a changed environment. Their message was that institutional investors seem to be under a lot more pressure now to demonstrate that comprehensive due diligence activities have taken place. One attorney listener in the audience echoed this sentiment presented by the two legal speakers. He offered his opinion that an investment consultant or financial advisor should work closely with both an ERISA counsel as well as a fund attorney as part of the due diligence process.

Dr. Susan Mangiero Speaks at Fiduciary Conference About Due Diligence for Alternative Investments

I am delighted to have been invited to join the faculty of the Master’s Track at the annual fi360 investment fiduciary conference, held this year in Scottsdale, Arizona. Speakers include: (1) ERISA attorney Charles Humphrey (2) Edward Lynch, AIFA, RF, GFS with Fiduciary Plan Governance, LLC (3) Dr. Susan Mangiero, AIFA, CFA, FRM with Fiduciary Leadership, LLC and (4) pension auditor Michelle Sullivan, CPA with Freed Maxick CPAs

The fi360 Master’s Track offerings are created especially for those with a knowledge of fiduciary standards and how that standard applies to the topics being presented.

Our session is entitled "Due Diligence for Alternative Investments." Our panel will focus both on the legal issues and the internal control compliance issues that cannot be ignored by anyone with a fiduciary responsibility to prudently select and monitor. This session will describe the impact of Dodd-Frank on investing in alternatives, various court cases and regulatory enforcement actions as well as the DOL/IRS regulatory guidance on alternative investment allocations. Click to read more about this session and the other sessions to be presented at this conference of investment fiduciary professionals from April 17 to April 19.

Pension Risk Governance Blog Celebrates Seventh Birthday

I am delighted to announce our seventh year as an educational resource for the $30+ trillion global retirement plan industry. With over a million visitors to, I appreciate the ongoing feedback and encouragement from financial and legal readers. This blog began as a labor of love and continues to be personally rewarding as a way to help guide the discussions about pension risk, governance and fiduciary duties.

Here is a link to the March 25, 2013 Business Wire press release about, an educational pension risk governance blog for ERISA, public and non-U.S. pension plan trustees and their advisors.

As always, your input is important. Click to send an email with your comments and suggestions.

Thank you!

Pensions and Corporate Finance: How to Avoid Buyer's Remorse

Ever since the PBGC’s 2007 opinion that a private equity fund with a controlling interest can be liable for a portfolio company’s pension problems, there is increased evidence that corporate transactions can go seriously awry if ERISA benefit plans are not properly addressed. Legal issues are not the only risk factor that could cause a merger, acquisition, spin-off or carve-out to fail to materialize. Low interest rates, investment lock-ups, participant longevity and complex vendor contracts are a few of the challenges that must be confronted by the legal and finance team in charge of due diligence. And with virtually every defined benefit plan facing funding issues in light of these circumstances, the PBGC is extremely proactive in seeking concessions to not interfere with corporate transactions yet hold parties who may have responsibility for unfunded liabilities accountable. Headlines are replete with articles about deals that were stalled or failed because ERISA due diligence was given short shrift. In 2010, the acquisition of a major chemical company took less than six months but coordinating the relationships with defined contribution managers took nearly two years to wrap up. Talks between a large manufacturing company and a potential target company are currently focused on how best to tackle the acquiree’s multi-billion dollar pension fund gap. In the aftermath of the settlement of a recent case, private equity firms and limited partners continue to be jittery about joint and several liability for pension plan funding gaps, making it harder to take a portfolio company public or sell. Taken together, the most important thing that a potential corporate buyer and its counsel can do is to acknowledge the importance of proper due diligence. These problems are not going away and arguably could get much worse.

Join Dr. Susan Mangiero, CFA, certified Financial Risk Manager and Accredited Investment Fiduciary Analyst and senior ERISA attorney Lawrence K. Cagney to talk about ways to keep a deal from derailing and to avoid buyer’s remorse due to an incomplete assessment of pension plan economics on enterprise value.

Join us to hear speakers talk about critical steps and lessons learned from their experience, to include the following:

  • How to revise investment and/or hedging strategy and policy statement(s) when organizations merge;
  • Elements of an ERISA service provider due diligence analysis when plans are combined;
  • Red flags for an institutional investor to consider when seeking to allocate to private equity portfolios with “pension-heavy” companies that may be hard to exit without costly restructuring;
  • Assuring that participant communication is comprehensive;
  • Role of the corporate finance attorney versus ERISA counsel; and
  • Installing knowledgeable fiduciaries for the new and/or merged employee benefit arrangements

Click to register for "Pensions and Corporate Finance: How to Avoid Buyer's Remorse," sponsored by the Practising Law Institute on November 15, 2012 from 1:00 pm to 2:00 pm EDT.

Public Pension Plans and Private Equity

 Reporter Michael Corkery paints a grim picture of what lies ahead for government workers. In “Pension Crisis Looms Despite Cuts by Nearly Every State” (Wall Street Journal, September 22-23, 2012), steps taken to reduce costs “have fallen well short of bridging a nearly $1 trillion funding gap.” Besides reduced benefits for new hires, increased contributions required of both new and existing workers, suspended cost-of-living adjustments and lower benefits for current workers, governments are starting to implement defined contribution plans such as 401(k) arrangements. No doubt the debate about constitutionality will rage on but the fact remains that the status quo is nearly impossible to maintain.

For some plans, a solution is to alter assets and invest more in alternatives such as private equity and hedge funds. According to the Private Equity Growth Capital Counsel, private equity and some pension funds have done well by each other. Its map of state-by-state performance shows positive returns for public pension funds such as the California State Teachers’ Retirement System. Whether the relationship between the two groups will continue is uncertain. As Kate D. Mitchell, Managing Director with Scale Venture Partners and a speaker at the 2012 Dow Jones Private Equity Analyst Conference observed, a shift from defined benefit plans to defined contribution plans for countless state and local employers will likely mean fewer dollars for the private equity industry. What happens then will depend on whether new monies will be available from other sources or instead cause a contraction in long-term deployment of assets by general partners ("GP").

In addition, political pressures are a reality, especially with respect to how capital gains are currently taxed. Should rates increase at the same time that fewer dollars are available from public pension plan coffers, the private equity industry could find itself under pressure in terms of growth potential and profitability. Other speakers at the Dow Jones Private Equity Analyst Conference were extremely upbeat about the outlook for uber growth in certain geographic sectors and industries. If they are right, investors in private equity will want to look carefully at the make-up of a GP's portfolio.

Pension Limited Partners and Private Equity Fees

News about private equity scions has dominated the headlines during this almost home stretch of the 2012 U.S. presidential campaign but other reasons abound as to why we should pay attention to this $2.5 trillion market, not the least of which is a continued allocation to this asset class by plan sponsors.

According to "Top 200 pension funds still carrying torch for alternatives," Pensions & Investments writer Arleen Jacobius (February 6, 2012) describes a 16% increase to $313 billion for the year ending September 30 or about three times the commitment to hedge funds for the same time period. Seeking diversification and higher returns are common explanations for the attraction.

The flip side is that private equity funds want pension money. In "Private equity courts pension funds for M&A finance," Reuters' Simon Meads writes that "private equity firms in Europe are sounding out yield-hungry" institutional investors as an alternative to "hard-pressed banks."

Pensions, endowments and foundations are getting the message that they may be in the cat bird seat in terms of power and the ability to negotiate on their terms (assuming that they are not creating an in-house private equity bench or partnering with industry giants as co-investors to source deals). In "Private equity LPs draw favorable deals from GPs" (The Deal, July 12, 2012), Vyvyan Tenorio writes that the current supply-demand relationship is allowing institutional investors to enjoy a bigger slice of transaction fees charged to portfolio companies when they exit. Pensions may receive a break on management fees too, depending on the willingness of market leaders to budge for large check-writers, many of which are asking that a separately managed account be established.

Besides the tug of war between general partners and limited partners over fees, the institutional presence is being felt in discussions about compliance and best practices.

Foley & Lardner LLP attorneys Roger A. Lane and Courtney Worcester cite valuation methodologies and the use of debt to finance deals as two areas that keep "Private Equity In The Crosshairs" (, July 11, 2012). Referencing several current lawsuits to illustrate each issue, they write that private equity funds are likely to face "certain specific legal hurdles and challenges" in the near future.

Law professor Steven Davidoff and New York Times contributor adds that limited and costly credit, slower fund-raising, a decline in returns and more expensive transactions are some of the reasons that small and medium players are heading for the hills. Even investing outside the United States could be a problem if local economies slow down and/or finding a partner is difficult and expensive. According to "For Private Equity, Fewer Deals in Leaner Times" (Deal Book, New York Times, May 29, 2012), Davidoff adds that industry consolidation will continue, activist deals may become more popular (when they offer more bang for the buck) and pursuing targets will require aggressive attention.

All in all, the prognosis for the private equity industry reflects structural changes in the global markets and the relationship between investors like pension plans and their general partners.

ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds


Join me on May 1, 2012 for a timely and interesting program about alternative investment fund due diligence and other considerations for ERISA plan sponsors, their counsel and consultants. Click here for more information.

This CLE webinar will provide ERISA and asset management counsel with a review of effective due diligence practices by institutional investors. Best practices will be offered to mitigate government scrutiny and suits by plan participants.


With the DOL's and SEC's new disclosure rules and heightened concerns about compliance and valuation, corporate pension plans that invest in alternatives must focus on properly vetting asset managers more than ever before or risk being sued for poor governance and excessive risk-taking.

The urgencies are real. The use of private funds by asset managers is crucial for 401(k) and defined benefit plan decision makers. Understanding the obligations of private funds is essential to any retirement funds with limited partnership interests.

In addition, suits and enforcement actions against asset managers make it incumbent on counsel to hedge fund and private equity fund managers to fully grasp and advise on full compliance with the duties of ERISA fiduciaries to plan participants.

Listen as our ERISA-experienced panel provides a guide to the legal and investment landmines that can destroy portfolio values and expose institutional investors and fund managers to liability risks. The panel will outline best practices for implementing effective due diligence procedures.


  • ERISA fiduciary duties for institutional investors
    1. Hedge funds and private equity funds compared to traditional investments
  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans



The panel will review these and other key questions:

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans
  • What are the regulatory concerns for ERISA pension plans that allocate assets to hedge funds and private equity funds?
  • What are the potential consequences for service providers that fail to comply with new fee, valuation and service provider due diligence regulations?
  • What can counsel to pension plans and asset managers learn from recent private fund suits relating to collateral, risk-taking, pricing, insider trading and much more?
  • How should ERISA plans and asset managers prepare to comply with expanded fiduciary standards?


Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.


Susan Mangiero, Managing Director
FTI Consulting, New York

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Alexandra Poe, Partner
Reed Smith, New York

She has over 25 years of experience in investment management practice counseling managers of hedge funds, private equity funds, institutional accounts, mutual funds and broker-dealer advised programs. She counsels hedge and private equity fund advisers in all stages of their business and due diligence matters.



Pension Risk, Governance and CFO Liability

My November 2011 presentation about pension risk, governance and liability to financial executives struck a chord. Part of a Chief Financial Officer ("CFO") conference held at the New York Stock Exchange, attendees alternatively listened with interest while adding their insights from the front lines here and there. It is no wonder.

With ERISA litigation on the rise and 401(k) and defined benefit plan decisions often driving enterprise value in a material way, CFOs and treasurers have accepted the obvious. Corporate governance and pension governance are inextricably linked. Make a bad decision about an employee benefit plan and participants and shareholders alike may suffer. As a result, the CFO is exposed to fiduciary liability, career risk and the economic consequences of an outcome with broad impact.

Rather than rely on luck, there is no better time to apply discipline and rigor to employee benefit plan management for those companies that have not already done so. With trillions of dollars at stake, properly identifying, measuring and mitigating pension risks continues to be a critical element of fiduciary governance.

The complexity and ongoing nature of the risk management process is sometimes overlooked as less important than realizing a particular rate of return. Recent market volatility, large funding deficits and pressures from creditors, shareholders, rating agencies and plan participants make it harder for pension fiduciaries to avoid the adoption of some type of pro-active risk control strategy that effectively integrates asset and liability economics.

In "Pension risk, governance and CFO liability" by Susan Mangiero (Journal of Corporate Treasury Management, Henry Stewart Publications, Vol 4, 4, 2012, pages 311 to 323), the issues relating to a panoply of risks such as actuarial, fiduciary, investment, legal, operational and valuation uncertainties are discussed within a corporate treasury framework. Article sections include:

  • Enterprise risk management, employee benefit plans and the role of the CFO;
  • Conflicts of interest and pension plan management;
  • Risk management principles and 401(k) plans;
  • Pension liability and mergers, acquisitions and spinoffs;
  • Prudent process;
  • Pension risks; and
  • Benchmarking success.

Click to download "Pension risk, governance and CFO liability" by Dr. Susan Mangiero, CFA, FRM.

Hedge Funds, Private Equity Funds and ERISA Pension Plans

Alternative fund managers and regulators will convene in Washington, D.C. from July 19 through 21, 2011 to talk about pension investing in hedge funds and private equity funds. Over several days, those who present before the ERISA Advisory Council will be asked to address questions such as those listed below:

  • What differentiates a hedge fund from other types of investments?
  • What differentiates a private equity fund from other types of investments?
  • How are hedge funds and private equity funds, respectively, correlated with the returns of traditional equity and fixed income investments?
  • How can defined benefit and defined contribution plan sponsors mitigate "the lack of liquidity that is characteristic of these investments?"
  • How can fee transparency be enhanced?
  • "Are there any unique diversification benefits offered by hedge funds and private equity investments as opposed to a fund of funds?"
  • What is the view of target date fund managers with respect to including hedge funds and/or private equity strategies within their funds?

According to U.S. Department of Labor documents, the aim is to create best practices guidance in areas such as leverage, liquidity, transparency. valuation, operational due diligence, client and asset concentration and offering documents. Click to download "2011 ERISA Advisory Council: Hedge Funds and Private Equity Investments." Click to read the June 22, 2011 U.S. Department of Labor news release about the forthcoming meetings to address hedge funds and private equity investments by ERISA plans.

Interested readers may want to check out the following of many items that are available for further research:

Help With Form 5500 Reporting

For those in need of help, click to access the "Troubleshooter's Guide to Filing the ERISA Annual Report" (U.S. Department of Labor, October 2010). This 70-page publication includes a handy reference chart that relates to the Form 5500 and Form 5500-SF (for small firms), along with related attachments. Another helpful resource is "FAQs About The 2009 Form 5500 Schedule C."

School's still out regarding the extent to which plan sponsors will be able to comply with new rules. So far, Schedule C seems to be a sticking point with numerous questions being asked about how to properly report "indirect" versus "direct" compensation to service providers.

As more pension plans allocate monies to mutual funds, hedge funds, private equity funds and funds of funds, they will need to report details about fees paid to these organizations as they too are now deemed service providers.

Valuing Positions in Alternatives - New DOL Scrutiny

According to "DOL rule could raise pension funds' costs: Proposed fiduciary requirement would hit appraisers of alternative investments" by Doug Halonen (Pensions & Investments, November 15, 2010), those who provide independent valuations could soon be declared fiduciaries. Remembering that there is no free lunch and that every new rule has unintended consequences, third party pricing experts are already running for cover. Some say they may exit the appraisal business at the same time that ERISA plans are enlarging their positions in alternatives and also being called upon to provide more information in their Form 5500 filings.

In case you missed it, click to access my comments on this topic, entitled "September 11, 2008 Testimony Presented by Dr. Susan Mangiero before the ERISA Advisory Council Working Group on Hard to Value ("HTV") Assets."

I had the pleasure of presenting on the same topic of risk management and valuation to the OECD and International Organization of Pension Supervisors in Paris in June 2010.

Clearly, pension plan decision-makers and their advisors, attorneys and consultants are going to be challenged to find the right balance between return and risk (with valuation questions being one type of risk). Not every alternative investment is "hard to value." Indeed, some mutual funds and other "traditional" choices have their own challenges in terms of pricing and liquidity.

Click to read "Hedge Fund Valuation: What Pension Fiduciaries Need to Know" by Susan Mangiero, Journal of Compensation and Benefits, July/August 2006.

U.S. SEC Significantly Steps Up Enforcement

In case you missed it, the U.S. Securities and Exchange Commission announced significant enforcement initiatives on January 13, 2010. These include a focus on due diligence and valuation issues with a particular emphasis on due diligence, investment advisors, investment companies, performance and valuation.

Read "SEC Names New Specialized Unit Chiefs and Head of New Office of Market Intelligence" (U.S. Securities and Exchange Commission, January 13, 2010).

This follows on the heels of our January 7, 2009 blog post wherein we reported that the FBI is hiring over 2,000 professionals with backgrounds in accounting and finance. See "FBI Hiring Spree - More Financial Fraud Expected?" and "Wanted by the FBI: Talented Professionals to Serve the Nation."

Leverage - I Love You, I Need You - Don't Hurt Me


If institutional investors thought of leverage as a bouquet of daisies, they'd be playing "(S)he loves me, (S)he loves me not" and hoping to still be respected in the morning. Now that the worst economic recession of modern times might be abating somewhat, more than a few buy side executives are looking for a sweetheart to help them replenish diminished portfolio values. Let's just hope that the love affair is not fickle, causing more hurt than help.

In "Wall Street's New Flight to Risk" (February 15, 2010), Bloomberg BusinessWeek reporters Shanon D. Harrington, Pierre Paulden and Jody Shenn write that investors are on the prowl for yield. With over $150 billion allocated to U.S. bond funds, returns are low and the only way to add some excitement is with exotics such as "payment-in-kind" bonds that encourage the issuance of more debt than a borrower's operating cash flow would ordinarily support. Derivatives are another Valentine, with banks "again pushing" collateralized debt obligations ("CDO's) that can increase in value (depending on the trade) as defaults increase. 

On January 27, 2010, Wall Street Journal reporter Craig Karmin writes that public pension funds are borrowing money to enhance returns rather than allocating to alternatives such as hedge funds and private equity pools. According to "Public Pensions Look at Leverage Strategy," funds can turn in a good performance with the use of leverage without having to resort to "volatile stocks" or illiquid assets. Others quoted in this recent piece suggest that risks exist and must be acknowledged.

Heartbreak hotel - here we come.

Call me crazy but a move towards leverage (possibly excessive) seems scary UNLESS and UNTIL asset managers and institutional investors alike can demonstrate that they know how to properly measure and manage. For every person who is asked to define investment leverage, the answer is seldom the same. AIMA Canada makes a good effort to add clarity to this important topic. See "An Overview of Leverage" (Strategy Paper Series Companion Document, October 2006, Number 4).

L'amour with leverage - how sweet it is, until it isn't. Then what?

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.

Hamsters and Investment Governance

The plight of the hamster is simple. He is cute, furry and going nowhere fast. Sure he gets exercise but, measured in inches and miles, he's stuck in the same place, treading the same pattern over and over again.

Lest this sound like a zany rant from a busy blogger, might I suggest that the current spate of "pay to play" scandals reflects what some in the industry have been saying for years? Be scared, be very scared about the dsyfunction that is roiling financial markets. 

With respect to writer George Santayana, "Those who cannot learn from history are doomed to repeat it." With Enron, Worldcom and Bear Stearns far from a distant memory, why on earth are we still reading about bad players who end up costing taxpayers, shareholders and innocent bystanders gazillions of dollars? Worse yet, those individuals who wear the fiduciary hat proudly are being unfairly tainted by those who should know better and/or simply do not care about the lives they ruin with their bad acts.

Recent articles about California and New York pension problems only add fuel to the fire and leave most folks scratching their heads, asking legitimate questions, some of which are listed below:

  • Given existing regulations, why are there so many scandals?
  • Where is the board oversight that is supposed to prevent conflicts of interest or at least nip things in the bud before losses mount?
  • How much are Sally and Joe "everyperson" supposed to tolerate in terms of broken trust on the part of those tasked with leadership?
  • Why aren't major lessons being learned sooner than later?

As an ardent advocate of capitalism (and no, we do not have a pure capitalistic system in place anywhere, contrary to Michael Moore's movie lament), I find the current state of affairs impossible to defend.

Bad practices have got to stop. We need to be moving forward, not running around and around, making no progress and chasing our tails. Let me also add that I am not objective here. Our company (newly named Investment Governance, Inc.) has been busy at work for nearly a year, building investment "best practice" tools (to debut in short order). What has kept our team going lo these many months of 15 hour days are the repeated and strident cheers from all the good guys and gals who take their institutional fiduciary work seriously and want things to improve in a big way.

Bravo to those for whom trust is a sacred word! We seek to help you gain the recognition and support you so richly deserve. 

Asset Allocation Alchemy


Asset allocation seems to be on the minds of many these days. This is not surprising since empirical studies repeatedly suggest that how monies are apportioned across sectors and instruments is a primary driver of returns.

Some states such as North Carolina are legislating more choices for state retirement funds. According to "Pension fund to get new options" by The News & Observer reporter David Ranii, the Tar Heel State Treasurer will soon have the ability to allocate to junk bonds and Treasury Inflation Protected Securities ("TIPS").

In "Asset allocation survey 2009," Mercer LLC queried European pension funds and uncovered a "continuing focus on risk management and recognition that good governance can improve the investment performance of institutional investors." Notable is the result that mature defined benefit plans tend to reduce their exposure to equity markets in favor of fixed income.

In contrast, Dr. David Gulley, Managing Director at Navigant Consulting, suggests that an exit from equity could be ill-advised for investors seeking returns over many years. In "A Surprising Bear Market Lesson About Bullish Projections" (Law360, July 2009), Dr. Gulley writes that "a substantial and objective body of evidence shows that equity returns are reliable in the long term" and that a positive equity risk premium is "actually a requirement enforced by the market's ability to deny money." If true, the impact is potentially sweeping. For one thing, a migration to Liability-Driven Investing ("LDI") which tends to favor fixed income might prove costly later on. Pension plan decision-makers seeking to reallocate away from long only strategies might incur transaction costs now, only to add opportunity cost to the mix if and/or when the sun rises again in stock land. The net result could be a doubling up of bad news bears (or worse).

Absent a universal acceptance about the role of stocks versus everything else, the debate about optimal strategic and tactical asset allocation mix will no doubt continue for many years to come.


Dr. Susan Mangiero to Speak at Dow Jones Private Equity Analyst Conference 2009

 I am delighted to have an opportunity to speak at the upcoming Private Equity Analyst Conference 2009, to be held at the Waldorf Astoria from September 16-17, 2009. With so much focus now on ethics, conflicts of interest and transparency, the panel topic I've been asked to address is near and dear to my heart.

I've reprinted the session description below. Click here to learn more information about the conference in its entirety.

Title: "Avoiding Major Trouble: Why Private Equity Firms Must Spend More Time On Ethics"

Description: Ethics has become one of the key words over the past year, especially given the fallout on Wall Street. And regulations, both in the U.S. and overseas, now place strict curbs on many established business practices in an effort to stem corruption. The consequences for companies, both in fines and damage to reputation, can be significant, which means investors need to pay attention. But as the disclosures earlier this year in New York make clear firms are not doing as good a job as they can adhering to such policies. So what should firms be doing to ensure that they themselves as well as their portfolio companies stay compliant with not only various regulatory codes, but also just doing good business? What is the message that firms can drive home to their partners and their portfolio companies? Our panel provides their thoughts.


  • Barry Gonder, General Partner, Grove Street Advisors
  • Pascal Levensohn, Founder & Managing Partner, Levensohn Venture Partners
  • Susan M. Mangiero, Founder & President, Pension Governance
  • Raymond Svider, Co-Chairman & Managing Partner, BC Partners.

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,", 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.

Business Ethics, Hollywood Style

Excited to watch handsome Clive Owen and Tom Wilkinson (a favorite actor), I paid my $10+ for a ticket to see just released "Duplicity." From an entertainment perspective, I was not disappointed. Footage of fashionable Julia Roberts and lovely backdrops from London, Zurich, Rome and New York is fun eye candy for viewers everywhere. The film's writer and director is the same Tony Gilroy who directed "Michael Clayton" (a great thriller if you haven't seen it). I don't want to give away too much about the film. Part of its appeal is a surprise ending.

What does bother me however is the almost swarmy glamorization of corporate ethics gone awry. No matter how much lipstick you put on a pig, it still oinks. Theft of intellectual property is made to seem "cool" and "hip." For those inventors and entrepreneurs who toil long hours  for little pay, and those investors (like pensions, foundations and endowments) who support them with allocations to venture capital and private equity, I found the movie disturbing to say the least. Adding insult to injury, the oft-repeated "deny everything," "make counteraccusations" and "admit nothing" seems like a page ripped from the headlines.

For a light respite after a long work week, Duplicity is worth the price of a ticket. If you are expecting to see honorable business actions being imortalized on celluloid, look elsewhere.

Hegemony in Alternatives Land - Are Pensions Getting the Upper Hand?

According to "Investors warn private equity over cash calls" (March 26, 2009), Reuters reporter Simon Meads writes that private equity firms are facing "intense pressure" from limited partners (pensions, endowments and foundations). Cash strapped themselves, institutional investors are telling asset managers not to come knocking on cash infusion doors any time soon.

Does this phenomenon present a fiduciary conundrum? For one thing, might a limited partner be sued for a contractual breach if they refuse to pony up additional monies? Second, could a dearth of new cash making its way to private equity fund managers end up creating more financial pain for the limited partners? After all, if a private equity and/or venture capital fund finds itself short of the almighty dollar (or other currency), it may be unable to invest in new companies deemed to be high growth and/or be hamstrung from keeping current portfolio companies afloat. On the other hand, limited partners may be reeling from their own pain (whether Madoff induced, stemming from equity losses or something else) and figure that the cost of incremental disbursements outweighs the expense of abstaining.

One thing seems clear.

Institutional investors are demanding more for less. In "Calpers Tells Hedge Funds to Fix Terms -- or Else" (March 28, 2009), Wall Street Journal reporters Jenny Strasburg and Craig Karmin write that this large California giant is "demanding better terms from hedge funds, including lower prices and 'clawbacks' of fees if performance weakens." Said to have been sent to 26 hedge and 9 funds of funds, a March 11, 2009 memo outlines terms, with a proviso that counter terms will be considered.

In a March 6, 2009 article by the same two writers, the deputy chief investment officer for the Utah Retirement System echoes similar sentiments. In his "Summary of Preferred Hedge Fund Terms," Larry Powell calls for lower fees, adding that "management fees should be used to cover operating expenses only, and are not appropriate funding sources for staff bonuses, business reinvestment, strategy expansion, or wealth accumulation by partners." The 4-page letter urges a share structure that transfers "liquidity risk evenly among commingled investors" that could result in how gates, lock-ups and redemption terms apply to short and long-term investors, respectively. Regarding disclosures, Powell describes a minimum laundry list to include items such as:

  • Annual audited financial statements
  • Quarterly information about fees, operational costs, concentration of clients and soft dollar activity
  • Monthly Net Asset Values, return attribution by strategy, geography and/or sector, largest long/short positions, leverage at the fund and strategy level
  • Weekly return attributions and month-to-date estimates of return.

We've heard numerous institutional investors put a stake in the ground for what they perceive to be a more level playing field (their words). Just a few months ago, I led a workshop on risk management and "hard to value" investing red flags to a group of large public plan auditors. Many of the audience members described a "disclose" or "we'll walk" policy now in force with respect to alternative funds. (Hopefully it goes without saying that not every alternative fund is a "hard to value" fund.)

Several things come to mind. Could demands from institutional investors be potent enough, if met, to stave off new regulatory mandates, some of which are outlined in "Does More Financial Regulation Make Us Safer?" (March 29, 2009)? Second, might we see a flurry of alternative fund manager fee-related lawsuits, similar to 401(k) "excessive" allegations that are making their way through the court system?

The match is on - investor versus manager. Who will get the biggest slice of the pie going forward with respect to economic rights?

You Can't Regulate Honor

As famed playwright George Bernard Shaw once said, "The most tragic thing in the world is a man of genius who is not a man of honor." I've been thinking about the "H" word a lot lately, especially given what seems like to be a never-ending onslaught of news items about fraud or outright bad practices. The current brouhaha in the Empire State is one example. 

In "Criminal Case Ensnares Aides to Ex-New York Comptroller" (March 19, 2009), Wall Street Journal reporters Craig Karmin and Peter Lattman describe a "pay to play" scheme that has the makings of a Hollywood thriller. Attempting to outgreed Gordon Gekko, several aides to a former New York State comptroller have been charged by the U.S. Securities and Exchange Commission with over 100 counts, including money laundering and bribery. According to the regulator's website (Litigation Release No. 20963), private equity and hedge fund managers were encouraged to pay many millions of dollars "in the form of sham 'finder' or 'placement agent' fees," expecting to secure asset allocation commitments from the New York State Common Retirement Fund.

Were this an isolated event (and to be fair to the defendants, these are only allegations at this point), people may be willing to look askance. Alas, we have Madoff, Sir Stanford, AIG bonus lunacy and so much more.

Not being a psychologist, I'm unclear as to why people conduct themselves in a questionable fashion. Some say that bad players rationalize their acts as short-term (not to be repeated) or legitimate entitlements ("I'm owed'). Even if one accepts fraud or sub-par practices as okay (and hopefully few do), it is not smart business. Ultimately, people get caught, even if it means mental anguish in the form of time spent, worrying about being found out, remorse or both. How sad too that innocent spouses, family members and children get a place in the "hall of shame," next to the responsible party.

I've made no secret that I'm an advocate of free markets. In response to several colleagues who demand even more mandates, my question to them is whether they think honor can be regulated. Pour moi, I think not. Force does not equate to walking a straight line.

If there is a silver lining to financial mishaps of late, perhaps it is this. More and more individuals (business persons or otherwise) are having lively debates about ethics, best practices and fiduciary standards. It's a great start, don't you think? 

One attempt at getting the message out is the recently published "Principles of Financial Regulation Reform: A Model for Change." Developed by CalPERS and other large public pension plans, the March 2009 document urges greater transparency and freedom to invest, "consistent with fiduciary responsibilities," without limitation "on the universe of available investments." Somewhat ironically, the New York State Common Retirement Fund is a signatory to this call for reform. (Could some of the newly minted principles have possibly forestalled or prevented the alleged fraud now being investigated by regulators?)

Pensions Query Private Equity and Venture Capital Funds

According to Wall Street Journal reporter Heidi N. Moore, investing in certain private equity funds may no longer be a walk on the beach. Not content to sit passively on the sidelines, "Pension Funds to Private Equity: ABCD. Always Be Closing Deals." (March 13, 2009) describes a desire to shift power to pensions, endowments and foundations, away from portfolio managers. Cited reforms include: (a) contracts that mandate the return of money to limited partners within a pre-specified period, thereby truncating fees earned by private equity funds (b) clawback arrangements that allow general and limited partners to equally participate in big wins and (c) detailed evidence that committed monies are being invested rather than left idle.

In a related article entitled "Venture Capitalists Chart a New Course" (March 13, 2009), Wall Street Journal reporter Pui-Wing Tam writes that some venture capitalists may be moving outside their comfort zone by investing in distressed assets and public companies via "registered directs" and private investments in public equities ("PIPES"). Brandon Park, a financial professional who invests in venture capital funds on behalf of institutional investors is quoted as saying that "many venture funds have charters that allow a certain percentage of assets -- typically 10% to 15% -- to be invested in assets other than private start-ups."

Indeed, there are many changes afoot in the private capital arena. They potentially impact if, and how much, pensions, endowments and foundations allocate to this asset class.

  • The credit crisis has made it difficult to do deals that depend on leverage.
  • The time period before which a company is likely to go public or be acquired has lengthened, often forcing a general partner to (a) hold onto a portfolio company for a relatively longer period of time and/or (b) possibly requiring additional cash infusions by that general partner as a result of a longer holding period.
  • Some private capital partnerships are not establishing new funds. As a result, their need to preserve cash (i.e. to keep existing companies afloat) may create even more friction for limited partners which want to see new investments being made.
  • If passed into law, a proposed rule to change the way carried interest is taxed for general partners could impact fees charged to limited partners.
  • FAS 157 applies to many alternative funds and remains a due diligence item for institutional decision-makers who must understand valuation policies and procedures for "hard to value" asset pools. 

A big plus is that some private equity and venture capital funds find themselves in an enviable position to pick and choose from a bevy of investments as entrepreneurs find more traditional funding paths closed to them. Ultimately, realized returns, ownership privileges and qualitative practices will influence how much money pensions, endowments and foundations continue to plow into non-public opportunities.

Editor's Note: Here are a few resources for interested readers.

Valuation Fundamentals - Going to the Dogs

According to Venture Deal (February 11, 2009), raised $4 million in venture capital to "improve its website and expand its management team." Founded by actress Glenn Close and her husband, the company has heretofore been privately funded. Dogs are big business. The Morning Sentinel reports that pet owners are significant spenders with approximately $43.4 billion in 2007 sales for Rover and Fido, "up 88 percent from 1998." See "Portland in growth mode..." by Ann S. Kim (February 10, 2009).

Wow and congratulations to

For those plan sponsors with allocations to venture capital ("VC"), one has to ask lots of questions about the big 3 fundamentals - economy, industry, company, right? Shouldn't an Investment Policy Statement require VC and private equity managers to explain how a company is expected to make money? It sounds straightforward enough but recent articles suggest that some VC fund managers have shelled out cash first and asked questions about business models later. In some cases, it's worked but halcyon days are long gone. The IPO market is closed for all practical purposes and easy money makes it harder for acquirers to purchase companies with debt.

What kinds of questions do you ask your VC and private equity managers about the fundamentals, a la Graham and Dodd and then some?

Private Equity - Not in Kansas Anymore

According to Financial Times reporter Henny Sender, private equity firms are facing significant challenges. Some portfolio companies are unlikely to fare well in a recession. Others are burdened by debt. Private equity kings did not count on having to "beg" (Sender's word, not mine) institutional limited partners for money. See "Capital Calls Are Tough for Institutions and General Partners Alike" for our January 18, 2009 comments about the cash squeeze for some fund managers. Click here to view Ms. Sender's comments.

A far cry from April 2007 when famed deal-maker Henry Kravis talked about the "Golden Age of Private Equity," this industry is about to get insult added to injury. In "Bill Aims for Disclosure by Private Equity," Wall Street Journal reporter Peter Lattman writes that the Hedge Fund Transparency Act will cover both hedgies as well as private equity funds with respect to "divulging the value of their funds and names of all investors. If you are a pension, endowment or foundation investment decision-maker, will you be comfortable with having your allocation to specific funds made known to the general public or will it depend on the reported performance?

Another hot button issue, likely to emerge again is whether carried interest - for both hedge and private equity funds - should be taxed at a higher ordinary tax rate. Lattman suggests that it may not make a material difference in the near-term if private equity funds do not generate better returns. He cites a Boston Consulting Group study that shows that issued debt for a large percentage of private equity portfolio companies is trading at distressed levels. In this same study, entitled "The Advantage of Persistence: How the Best Private-Equity Firms 'Beat the Fade'," authors Heino Meerkatt et al make a compelling case as to why private equity is "here to stay." The quest for institutional investors is to pick the RIGHT private equity firm which, on a risk-adjusted basis, is expected to outperform average public market returns. (Yes, we could wax poetic about efficient markets. A topic for another day?)


Private Equity and Derivatives - Double Whammy or Blissful Combo?

According to the U.S. Government Accountability Office, nearly 4 out of 10 surveyed pension plans say they allocate monies to private equity. Allowing that some managers have turned in acceptable returns, respondents also cited numerous "challenges and risks beyond those posed by traditional investments." Valuation and limited transparency are two issues cited in "Defined Benefit Pension Plans: Guidance Needed to Better Information Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity" (GAO-08-692, August 14, 2008).


To shed light on some of the intricacies associated with private equity investments, I authored a case study for the February 2009 issue of PEI Manager, a private equity and venture capital focused publication. The bottom line is that institutions that invest in private equity funds are directly impacted by their portfolio companies' use of derivatives.


"Swapping out" by Dr. Susan Mangiero, an Accredited Valuation Analyst and CFA charterholder, is reproduced below. Email Ms. Jennifer Harris, Associate Editor - PEI Manager, for permission to reprint the case study.


                                                                       * * * * * *




Private Equity Holdings (“PEH”) is required by its charter to avoid companies that use derivative financial instruments to speculate. In reviewing numbers for FAS 157 reporting purposes, a PEH managing partner notices that one of its portfolio companies, ABC Incorporated (“ABC”), recently included a FAS 133 entry for a $20 million interest rate swap hedge. During a call to the company to query about how the swap is being used, the PEH managing partner is informed that its counterparty is Global Bank Limited (“Global”). Not only has Global just reported a $30 billion loss due to poor valuation of its structured product portfolio, it posted no collateral in favor of ABC while ABC was required to pledge $2 million in U.S. Treasury Bills in order to protect Global in the event that ABC could not make its contractual swap payments to Global. Not being too familiar with derivative instrument pricing and default risk analysis, PEH hires an expert to investigate whether the swaps reflect a hedge versus a market bet and to further assess how PEH should adjust the valuation of its equity stake in ABC. What does the expert need to look at and how should she arrive at an appropriate conclusion?




This fact situation, ripped from the headlines, raises several important valuation questions, including, but not limited to the following:


  • Notwithstanding FAS 133 numbers, is the company exposed to changes in interest rates that could adversely impact cash flow, liquidity and net income?
  • Was the swap correctly valued?
  • How might ABC be impacted by Global’s deteriorating health?
  • What adjustments, if any, should PEH make to its initial valuation of ABC equity?

There are several critical issues here, all of which could seriously hamper the fortunes of both ABC shareholders and PEH investors. An inaccurate valuation of the swap leads to a flawed accounting representation for ABC and may lull treasury staff into thinking that the hedge offers full protection against unexpected moves in interest rates. PEH may report a bad FAS 157 number which in turn could lead to flawed asset allocation decisions made by institutional limited partners or the overpayment of performance fees to PEH. A poorly constructed hedge (in economic versus accounting terms) that exposes ABC to negative market conditions could force PEH to violate its prohibition against speculative trades being executed by portfolio companies. If Global does not meet its swap obligations and/or files for bankruptcy protection, ABC may not be able to recover its collateral quickly or could lose it altogether, depending on its standing vis-à-vis other creditors.


Swap pricing models can differ depending on the complexity of the transaction. However, for standard fixed to LIBOR swaps, the secondary market is large ($111 trillion, according to the Bank for International Settlements). Active trading makes it easy to readily obtain prices for various maturity interest rate swaps with quotes reflecting the discounting of future projected fixed and floating swap payment amounts. In contrast, the assessment of credit worthiness varies, sometimes considerably, across banks. Unfortunately for ABC, even if they posted more collateral than should have been required, the fact remains that they have no immediate recourse in the event that Global’s distress prevents the bank from paying what it owes to ABC. If Global defaults, ABC will then have to decide on a course of action that could include any or all of the following:


  • Enter into a second interest rate swap to replace Global at a now higher fixed rate
  • Attempt to sell the initial swap in the open market and consider another way to hedge against rising interest rates though few will be willing to accept the Global risk
  • Take legal action to reclaim its collateral
  • Write down the value of the swap on its books

There is no ideal situation. The expert will necessarily have to ask ABC what they plan to do in the event of swap non-performance and how it is expected to impact its cash flow, cost of money (which in turn affects capital budget decisions), balance sheet, dividend payments and interest coverage. Once that scenario analysis is conducted, both the expert and PEH will be able to quantify how much of an adjustment downward they will need to make for both accounting and performance reporting purposes.

Capital Calls Are Tough for Institutions and General Partners Alike

According to PE Week Wire (January 15, 2009), the Los Angeles City Employees' Retirement System ("LACERS") has rescinded its authorization to invest in Cityfront Capital Partners, L.P. ("Cityfront") since said fund has yet to raise a "minimum of $50 million in committed capital, which was to include LACERS' commitment." Part of this California pension fund's allocation to "Specialized, Non-Traditional Alternative Investment Programs," an agreement was reached on August 14, 2007 to invest $5 million in this "small and middle market buyout fund of funds investment vehicle." According to a January 13, 2009 "Report to Board of Administration," LACERS' Chief Investment Officer explains that the buyout fund has "only been able to raise $7 million in 'hard commitments' with no near-term expectations of achieving the $50 million minimum level."

Cityfront is not alone in feeling the pinch. According to "VCs Feeling the Pain of Newly Poor LPs" (January 16, 2009), PEHUB writer Connie Loizos writes that some institutional investor limited partners are strapped for cash, having lost money in the market of late. For those for which the problems are dire, they are simply failing to meet a capital call(s) when the venture capital or private equity  fund comes calling for more money.

On January 17, 2009, Wall Street Journal reporter Pui-Wing Tam wrote that, not surprisingly, venture capital investment has "dropped 30% in the fourth quarter to its lowest level since 2005." Traditional exit strategies such as issuing equity via an IPO (initial public offering) or being merged or acquired are currently seen as unlikely options for many VC-backed companies. See "Venture Funding Falls 30%." (A subscription may be required to read this article.) A few weeks earlier, fellow Wall Street Journal reporter Craig Karmin wrote that pension funds are rethinking how much money should remain in private equity, hedge funds "and other nontraditional investments." Karmin describes a capital call "crunch" with private equity funds demanding cash but pension funds expecting to "offset the payments with returns from other private-equity investments." Elusive gains create a double whammy for both limited and general partners alike. See "Once Burned, Twice Shy: Pension Funds" (January 3, 2009).

Business Week Executive Editor John Byrne and writer Steve Hamm tackle the topic of increasing risk aversion on the part of venture capitalists in a December 30, 2008 video entitled "Is Silicon Valley Losing Its Magic?" Citing Andy Grove, author of Only the Paranoid Survive, Hamm avers that the ability for young companies to innovate is being curtailed as venture capitalists and private equity bankers scale back. Institutional investors that do not make capital calls and/or step up to the plate to allocate fresh monies may prevent venture capital and private equity funds from generating robust returns. On the other hand, institutions which are not enjoying attractive, risk-adjusted returns from venture capital and private equity funds could be reluctant to make capital calls.

It is a veritable catch-22.

Editor's Note: 

Financial Domino Effect: Pensions and Alternatives

As this blogger has said for many months, pension risk management trumps a return-only focus. Few care about the risks associated with the upside. It's the extreme tail of a price distribution that gets people's attention. When low frequency (read DIRE) values occur, watch out. The dominoes crash into other, the structure crumbles and someone is left picking up the pieces. Is that happening now? You betcha! Any problems with investments, heretofore put into neat asset buckets, spill over into other parts of the portfolio, forcing major decisions about asset allocation, liquidity and cash requirements.

A November 16, 2008 New York Times article makes my point. (See "From the Valley Comes a Warning.") Writers Jeff Segal, Lauren Silva Laughlin and Rob Cox explain that the California Public Employees' Retirement System (Calpers) has to now decide whether and how to rethink its strategic asset allocation to alternative investments. Originally meant to be about 10 pecent of its overall portfolio, equity sector losses have apparently pushed the giant public plan's relative exposure to hedge funds, venture capital, private equity beyond its limit, to about 14 percent of its asset holdings. Worse yet (from a strategic asset allocation orientation) is that a market downturn may now accelerate calls for capital from the private equity and venture capital funds in which Calpers is invested, forcing an even higher allocation. (The idea is that some portfolio companies need more money now because their respective revenue projections cannot be met as corporate spending contracts. Private equity and venture capital fund managers - and their investors - can either lose everything they have invested in the portfolio companies or try to help them stay afloat, by giving them a cash lifeline sooner than anticipated. Hence, the need to accelerate capital calls.)

Calpers is not alone. We've heard from plenty of plan sponsors that the "stay the course" or bid adieu to alternatives (some or all) is at the top of their decision list. The problem is that exiting a particular private fund may be costly, so much so that the plan sponsor is made worse off in the short- and intermediate-term. Additionally, plan sponsors seldom have the legal right to turn down a request for additional capital from private equity fund X or venture capital fund Y. According to private investment fund attorney John Brunjes, a partner with Bracewell & Giuliani, "in a private equity or venture capital fund is a contractual relationship. Except for fraud or duress, pensions are on the hook to write a check when the alternative fund manager comes calling."

If true, that some plan sponsors are "stuck" for the foreseeable future (i.e. must meet their capital commitments to alternative fund managers) AND their losses continue in traditional equity land, participants may take it on the chin in the form of reduced benefits. Taxpayers and/or shareholders may be asked to make up the difference. From the mail and calls we get at Pension Governance, Inc., there are a lot of individuals who are beyond unhappy about what they see as their diminished future due to rescinded benefits, disappearing plans, sponsor insolvencies and so on. (While our company focus is on plan sponsors and their service providers, our web presence encourages communication from plan participants.)

With respect to investment fiduciary duty, will members of the investment committee be held liable for not having properly assessed correlation patterns over extreme data ranges? When things go south and investor flee to quality, "contagion" is not uncommon. This means that bad news impacts the performance of multiple asset sectors, even those thought to move inversely or independent of each other. The "one world - one market" phenomenon translates into lower diversification benefits.

Will investment fiduciaries be held accountable for not better measuring liquidity or assessing transferability restrictions or the legal implications of capital calls? What is the role of consultants and fund of funds managers in evaluating risk factors beyond the numbers themselves? Are there some private funds deemed to have done enough to vet the suitability of alternatives for their institutional investor clients.

I'll be writing much more about the changing relationship between institutional investors and private funds. What do you want to know more about in these areas? Drop me a line.

Editor's Notes:

  • On January 4, 2007, I wrote: "Contagion itself is dangerous but when you consider what some describe as an inevitable convergence towards one global market, with trading that occurs 24/7, the potential for serious harm is real. Continued technological advances, international deregulation and investors' willingness to go offshore promote lightening speed information flow. When bad news hits, it's the shot heard 'round the world. Having worked on three trading desks during volatile times, I know firsthand how quickly things can change." (See "Pension Contagion - Should We Worry?")
  • The Calpers website reports that, as of September 30, 2008, its current allocation to alternatives is 12.2% versus a target of 10 percent. For more information, click here.
  • Here is the link to the slide show that has Silicon Alley shivering in their boots. Essentially famed venture capital firm Sequoia Capital told entrepreneurs to watch their cash and acknowledge that the funding party may be over, at least for awhile. See for yourself. Read "The Sequoia: 'RIP: Good Times' presentation: Here it is" by Eric Eldon, Venture Beat, October 10, 2008.

Testimony of Dr. Susan Mangiero About "Hard to Value" Assets


At the invitation of the ERISA Advisory Council, I presented testimony about "Hard to Value Assets" on September 11, 2008 in Washington, D.C. Some of the questions I was asked to answer are listed below:

  • Should valuation issues play a role in the selection of plan investments, and in achieving proper asset allocation and diversification?
  • What, if any, modifications to plan investment policies and guidelines should plans consider when utilizing "hard to value assets?"
  • As fiduciaries, what do you deem to be or what do you expect to be "hard to value assets?"
  • Who can the fiduciary rely upon when ascertaining the value of "hard to value assets" when the fiduciary is incapable of valuing, in order to fulfill their fiduciary responsibility to plan participants?
  • What valuation policies and procedures should a fiduciary adopt when holding "hard to value" assets?
  • What disclosures and education measures are required or suggested for participants and fiduciaries with respect to plans which invest in "hard to value" assets?

Given the recent tumult in the global financial markets, it seems as if an eternity has passed since the September 11 hearing date. Valuation continues to be a hugely important topic. I hope that my comments are informative and helpful to readers. Let me know what you think. Click here to read "Testimonial Remarks Presented by Dr. Susan Mangiero." 

New Pension Report Just Released on Hedge Funds and Private Equity

Here is a link to a just-released report from the U.S. Accountability Office, entitled "Defined Benefit Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity."

In terms of full disclosure, Pension Governance, LLC provided its authors with background information about risk management and valuation considerations. Having just received this now public document, I will read it more thoroughly at a later time and report back. It looks like a comprehensive analysis.

I am off to provide testimony as part of today's meeting about "Hard to Value Assets." The meeting is being held at the request of the ERISA Advisory Council. My submitted testimonial statement will be uploaded in the next few days.


Pension Fund Governance in the Lonestar State

Hat tip to Robert Elder, journalist for American Statesman, who writes that a prominent Dallas financier has been jettisoned as chairman of the Texas Pension Review Board, "which oversees nearly 400 public pension systems that hold $200 billion in assets." In "Perry ousts head of pension board" (American Statesman, June 24, 2008), Elder describes Frederick Rowe as a vocal critic of alternative investment commitments by retirement plans that do not always fully consider risks.

According to its website, the Texas Pension Review Board has a variety of duties, including the oversight of "the actuarial analysis process" and making recommendations of "policies, practices, and legislation to public retirement systems and their sponsoring governments." If one clicks on "Tools," you can download the audio files of board meetings. The most recent one (dated April 10, 2008) is worth a listen as it centers on asset allocation and risk assessment with then Board Chairman Rowe criticizing a "backward-looking" approach to assessing investment performance and a reliance on investment consultants who advocate alternatives and "reduce what they call risk in patching together this crazy quilt of uncorrelated assets." (It's a large file and may take a few minutes to download.) 

In its "Written Investment Policies for Public Pension Systems," the section on risk is brief and focuses on the erosive impact of inflation and the possible gap between actuarial interest assumptions and realized performance. The statement that "to increase one's understanding, one can also look at the actual rates of return and volatility for the past 25 years" caught my eye. As most financial experts know, the risk-return tradeoff, along with correlation patterns (and much more), can change dramatically over time. To rely only on historical numbers without conducting a "what if" analysis (which may be a regular activity by various Texas plans) is ill-advised. Additionally, a decomposition of a period as long as 25 years into economic "regimes" goes a long way to avoid the artificial smoothing of risk measurements. Decisions based on metrics that lower risk may not always be the best ones, putting it mildly. However, to be fair, readers are urged to describe investment objectives in terms of return (absolute and relative) as well as the risk-adjusted rate of return. It would be nice to see this document beefed up to include extensive guidance on how various risks (economic, operational, default, etc) will be measured, monitored and managed.

In a separate article ("TRS switches key outside law firm," American Statesman, July 24, 2008), Elder writes about a recent change of fiduciary counsel that has apparently upset some trustees of the Teacher Retirement System of Texas. Elder describes the decision as "unusual" because of a close split vote and imminent plans to discuss "governance policies and ethics rules in September" (suggesting that some trustees favor continuity). One pension attorney with whom I recently spoke offers that a change of fiduciary counsel is not in and of itself a red flag.

In a lengthy comment, posted to Elder's blog, Public Capital, Mr. Jim Lee, Board Chairman of TRS writes that "8 trustees voted for or expressed support" for the hiring of a new outside legal expert and that trustees unanimously voted in favor of "diversification changes in April 2007." He adds that a variety of alternative investments "will make up potentially another 30 percent of the portfolio, up from approximately 4.5 percent" as part of a "very deliberate progression." Printed page 68 of the Comprehensive Annual Financial Report (for fiscal year ending on August 31, 2007) shows a private equity target allocation of 10% with a minimum range of 5% and a maximum range of 15%. The given target for hedge funds is 4% with a minimum range of 0% and a maximum range of 5%. The target for real estate is 10% with a minimum range of 5% and a maximum range of 15%.

As stated many times herein, alternative investments are not inherently "good" or "bad." However, as more U.S. and non-U.S. plans (public and corporate) invest in alternatives, it is extremely important to understand how decisions are made with respect to risk assessment, including valuation of "hard to value" assets. In the case of TRS, with a total fund value as of August 31, 2007 of $111.1 billion, the aforementioned annual filing cites the creation of a risk committee of the board to oversee "the overall risk of the portfolio" and establish "policies and practices to measure, manage and mitigate" exposures. A second initiative is the determination of "key risk parameters", derivative instrument limits and related counterparty credit ceilings, along with addressing liquidity, operational, settlement and legal uncertainties.

Editor's Note: The Teacher Retirement System of Texas was cited as "Public Pension Fund Investor of the Year" by Alternative Investment News, an Institutional Investor publication. Click to read the June 26, 2008 press release.

The "Terminator" Ends Bill to Nix Private Equity Restrictions

Governor Arnold Schwarnegger has put the kabosh on a state legislative attempt to prohibit the state's two largest public pension funds from allocating to certain money managers. Arguing that AB 1967 puts undue strain on the California Public Employees' Retirement System and the Calfornia State Teachers' Retirement System by prohibiting money managers who invest in countries with human-rights issues. If adopted, The Carlyle Group (owned in part by the United Arab Emirates) would be off limits and thereby shut off private equity deal flow. In his April 9, 2008 op-ed piece, published by the Los Angeles Times, Governor Schwarnegger writes that measure AB 1967 would "cause a deep wound to our retirement funds and government programs when we can least afford it." Though he earlier signed measures to divest from Sudan and ban investing in Iran, the state's head politico avers that this bill would (a) cost CALPERS and CalSTRS billions of dollars in lost opportunities over the next 5 to 10 years (b) do little to discourage sovereign wealth fund investing overall and (c) be a fig leaf with respect to boosting human rights. Click to read "California can't afford a symbolic divestment that won't affect human rights."

On April 10, 2007, Sacremento Bee reporter Dale Kasler writes that Assemblyman Alberto Torrico (D-Newark) is withdrawing Assembly Bill 1967 "for the time being. (See "Lawmaker pulls bill to set human-rights limits on public pension fund investments.")

Of course, this does not eliminate an obvious question. Should the state (in an editorial sense, not a particular geographic locale) direct public plan investing?

PBGC Allocates to Alternatives

According to its February 18, 2008 press release, the Pension Benefit Guaranty Corporation is changing its asset allocation mix to 45 percent invested in fixed income, 45 percent invested in equity and 10 percent left for alternative investments. A spokesman explains that ratcheting up on private equity funds and real estate is expected to generate higher returns but reduce risk because of greater diversification, giving "the Corporation a 57 percent likelihood of full funding within ten years compared to 19 percent under the previous policy." In the past, the PBGC mix favored bonds with 75 to 85 percent being invested in fixed income securities, including some monies earmarked for liability-driven investing ("LDI") strategies. Some PBGC critics recently cited high opportunity costs by concentrating on notes and bonds.

With an accumulated deficit of $14 billion at the end of fiscal year 2007 and the recognition of the long-term nature of its obligations, the decision was arrived at, after "an extensive review process that began in mid-2007." Interestingly, an "Investment Program Fact Sheet" seems to contradict the newfound logic, stating that "Because of the statutory restrictions on investment of the Revolving Funds and a change in PBGC's investment policy adopted in 2004, fixed-income securities dominate PBGC's asset mix." Additional text emphasizes a relatively low tolerance for uncertainty. "The current investment policy continues PBGC's investment focus of limiting financial risk exposure by investing the majority of PBGC's assets in long duration fixed-income securities in order to reduce balance sheet volatility."

It would be interesting to know more about exactly why the PBGC decided to move into real estate and private capital pools now. How did they net the expected lower risk (due to diversification) against incremental risks association with interests that seldom trade? Access to meeting minutes would make for good reading. Though it is not an official U.S. government agency ("financed by premiums paid by employers, assets from failed pension plans, recoveries from bankruptcies and returns on invested assets"), many people believe that American taxpayers are ultimately on the hook in the event of a PBGC bailout. With a recession on the way and relatively low interest rates that push liabilities upward, bad news for this insurance agency is not out of the realm of possibility. Additionally, though premiums have increased, few economists believe that risky plans are paying their "fair share" and that "good" plans are subsidizing poor financial management elsewhere. If true, PBGC's exposure to default is that much higher.

The PBGC says it reviews its investment policy every two years. How often does it assess its outside managers? Will due diligence for alternative fund managers differ from the check-up imposed on traditional managers? How will the PBGC address valuation issues related to private equity, venture capital and real estate? What performance metrics can we expect PBGC to share with interested parties if "hard to value" assets are held at cost versus "fair market value?" Is there or will there be a Chief Risk Officer for PBGC who addresses asset-liability management on an enterprise risk basis? How will banks be impacted if private plans decide to follow PBGC's example and shy away from LDI? Will corporate plans follow suit?

Private Equity Returns Appeal to Pensions

According to Global Pensions (January 10, 2008), Canadian, US and UK public pension fund investors are satisfied private equity investors. Surveying 108 institutions, Private Equity Intelligence Ltd (Preqin) found that "private equity out-performed for these pension plans in 82% of cases." In another survey, Preqin found that "95% of these investors predicted their private equity investments would out perform public market returns from a 2% advantge to over 4% in coming years."

Acknowledging the huge amount of money making its way into private equity, this blog's author wrote about the 4P's on December 31, 2007 - Pensions, Private Equity, Performance and Placement. We urged readers to study the risks, alongside the expected benefits, adding that valuation of private company economic interests can be challenging.

In response, Mr. Doug Miles, CEO of, Inc. wrote that life has surely changed when it comes to estimating value. We hope you find his commentary interesting. We welcome guest bloggers on any topic related to pension investing and risk management (which importantly includes the topic of valuation). Drop us a line if you want to share your thoughts with our fast-growing audience.

Private Equity Valuation - Discount Dilemmas


                             Commentary by Doug Miles, CEO of, Inc.

For the first 15 years of my investment banking career, the typical rule of thumb for pricing private equity assets was to apply a 25 percent discount to a publicly traded comparable company or adjust the relevant industry multiple. New accounting rules such as FAS 157 make it difficult to take this easy way out.

An analyst is sometimes hard pressed to find data about public offerings that closely mirror the economic characteristics of a particular private equity investment. When that occurs, news announcements that convey buying interest can be helpful. Recent headlines about CALPERS' purchase of a 9.9 percent stake in technology buyout fund Silver Lake Partners illustrate. No longer sitting on the sidelines, CALPERS has a chance to recover 10 percent (or more) of its net cost in allocating to non-public companies by participating in deal-related income such as acquisition loans originated by Silver Lake.

Playing the role of private equity banker is not new. Ontario Teachers illustrates this "soup to nuts" with its furnishing of both debt and equity for Bell Canada. (See "Bell Canada Agrees to Purchase by Ontario Teachers - July 2, 2007.) General partners save on fees they pay. Moreover, they have flexibility to take a company public again or sell to a strategic buyer for many times the original commitment. Being an operator additionally empowers the "new paradigm" owner on the governance front. Did the Bell Canada deal improve the IRR for Ontario's plan participants? You bet.

Capital market players benefit too since such deals arguably enhance liquidity and promote valuation transparency. Given the brave new world of valuation compliance (FAS 157 and international equivalents), anything that gets us closer to marketability is a good thing. Anecdotally, we see an emerging consensus among our private investor clients to access better numbers. Applying arbitrary discounts is ill-advised. Being open to better process may explain why we've seen recent private company discounts narrow to 6.5 to 7 percent, relative to public comparables, for some sectors. In our own work (creating synthetic data prices for "hard to value" instruments such as whole loans), we employ an algorithm that estimates the private-public company differential by examining factors such as the rate of completed private company asset buyouts, how they are financed and the change in IPO values over the last twelve months.

Discounts vary over time. The current environment  (i.e. depressed high yield bond prices and fewer M&A transactions) could lead to the widening of lack of marketability discounts, particularly in those industries hard hit by credit problems. Monitoring performance by industry or sector, and for a variety of cycles and calendar time periods, is paramount. Global consolidation when steel or aluminum production sectors are hot (e.g. RUSAL) reduces the liquidity premium attached to public companies as increased deal flow sheds light on when and where buyers are willing to sign checks. Will this be true next year? Only time will tell. That is why it is so important to track the changing behavior of valuation adjustments.

With a need to enhance returns, alternatives like private equity will continue to attract retirement plan money. Look for more announcements as other pension funds follow the lead of CALPERS and Ontario Teachers. Hedge funds may even seek to organize groups of pension funds to execute large M&A deals, thereby adding to their treasure chest.

Editor's Note: As pension plans become even bigger players in global capital markets, it will be interesting to watch the inevitable fiduciary schizophrenia unfold. How will pension general partners deal with doing the right thing for limited partners when doing so conflicts with their duties to plan participants?

California Dreaming...Of Private Equity Returns

Early editions of today's business papers describe an imminent sale of roughly 10 percent of technology private equity fund Silver Lake to pension giant, the California Public Employees’ Retirement System ("Calpers"). With a price tag of $275 million, Calpers will have a say in managing Silver Lake and also receive a pro-rata share of their earned investment fees. Private equity investors typically pay 2 percent of assets under management per annum plus 20 percent of gains in excess of an agreed upon benchmark. (See "California Pension Fund Expected to Take Big Stake in Silver Lake, at $275 Million" by Andrew Ross Sorkin, New York Times, January 9, 2007).  

A direct investment stake in Silver Lake creates new challenges, not the least of which is the subsequent negotiating power of Calpers with other private equity funds.

  • Will this $260+ billion institutional investor now have greater sway with alternative fund managers, bargaining hard for fewer restrictions on transferability?
  • If so, how will that impact the riskiness of its investment portfolio?
  • Will Calpers ask Silver Lake to be more institution-friendly with respect to greater disclosure, lower fees, asset selection that reflects suitability, better risk controls and so on (assuming that Silver Lake is not already doing everything it can in these areas)?
  • Will Calpers be exposed to fiduciary liability in the event of a Silver Lake buy-out gone bad?
  • How will Calpers change its internal risk management policies and procedures as a result of this investment in Silver Lake? This includes the process by which "hard to value" holdings are marked to model or market.
  • How will Calpers recognize the Silver Lake investment in terms of strategic asset allocation?

Notwithstanding these unanswered questions, this announcement is fascinating news to some, especially on the heels of a January 7, 2007 Financial Times article that quotes representatives of pension funds such as the Oregon Public Employees Retirement System and the California State Teachers' Retirement System as saying "never mind" to eroded returns. Acting defiantly, these institutional investors are in no mood to make private equity executives whole for higher taxes that may soon be mandated by Washington. (The current tax rate of 15 percent could rise to 35 percent.) (See "Pension funds in threat over private equity fees" by Francesco Guerrera and James Politi.)

Editor's Note: We talked about private equity on December 31,2007. Read "Pensions, Private Equity, Performance and Placement."

4P's - Pensions, Private Equity, Performance and Placement

As 2008 rolls in, uncertainty is on the minds of many. Will there be a recession? Will market volatility persist? Will asset prices continue to converge, making it more difficult to diversify? One question in particular is oft-discussed, notably the issue of strategic asset allocation for defined benefit plans. In a December 17, 2007 news release, the California Public Employees’ Retirement System Board of Administration announced its intent to invest nearly 70 percent of its $250 billion under management to stocks. Private equity will account for 10 percent, up from 6 percent. According to Charles P. Valdes, Investment Committee Chair, “These revised allocation markers reflect the promise of our private equity, real estate, and asset-linked investment classes."

In stark contrast, the Pension Benefit Guaranty Corporation went in the opposite direction a few years ago, now bearing the burden of a positive equity risk premium. In a December 20, 2007 article entitled "The $4 billion trade-off: PBGC misses out by eschewing stocks in favor of LDI," Financial Week reporter Doug Halonen points out the perils of allocating a high percentage of assets to fixed income. He rightly points out "the irony" that numerous companies are seriously investigating the economics of adopting a liability-driven investing strategy which almost always entails a shift away from stocks to bonds and/or interest rate derivatives.

Importantly, the decision to invest in alternatives, including private equity, must reflect a careful analysis of the likely risk-return tradeoff, mapped to the objectives and constraints of a particular pension plan. A short-term focus could create upset for those exposed to holdings that more logically lend themselves to a long-term commitment. In today's "Wall St. Way: Smart People Seeking Dumb Money," New York Times reporter Eric Dash writes that investors in Ohio Public Employees Retirement System and Fidelity Investors "would have made more money this year investing in an old-fashioned index fund that tracks the S&P 500-stock index" rather than plunking down money for the IPO of "private equity powerhouse" Blackstone Group. Perhaps that's true but does it matter if their respective goals are to realize capital gain over the next five to seven years? (Note that this blog's author has no knowledge of the intent of either investor.)

Allowing for upside potential (and statistics do validate a big move into private equity by pensions, endowments and foundations), lack of liquidity and valuation difficulties are harsh realities. However, barriers are starting to soften. Barry Silbert, CEO of Restricted Stock Partners, operates the Restricted Securities Trading Network, a mechanism for trading insider stock options, convertible bonds and private investments in public equity. A recent venture capital injection is arguably a validation of this attempt to enhance fungibility of otherwise "infrequently traded" instruments. The PORTAL Alliance, brings together the Nasdaq Stock Market and leading securities firms to "create an open, industry-standard facility for the private offering, trading, shareholder tracking and settlement of unregistered equity securities sold to qualified institutional buyers ("QIBs")." If successful in allowing for ready buys and sells, institutions may be more open to kicking the private equity tires.

For further reading, these websites (a few of many) may be of interest:

Pension Risk and Hedge Fund Cherry Picking

An October 9, 2007 Wall Street Journal article describes new academic research that suggests foul play in hedge fund orchards everywhere. In "Pricing Tactics Of Hedge Funds Under Spotlight: Some Managers Select Favorable Valuations To Lift Performance," reporters David Reilly and Gregory Zuckerman cite empirical evidence that hedge fund managers may cherry pick prices of "hard to value" instruments as a way to pretty up performance.

The issue of valuing instruments for which no ready market exists is a challenge indeed. At a time when pension funds are allocating billions of dollars to hedge funds, private equity and venture capital pools, fiduciaries risk serious fallout if they fail to establish solid ground rules regarding valuation. There are any number of "must have" elements that comprise effective policies and procedures. Ignore them and plan sponsors lose a precious opportunity to detect possible trouble before things get out of hand.

Now is not the time to take shortcuts when it comes to valuing "hard to value" instruments or conducting proper oversight of portfolio managers who trade relatively illiquid stocks, bonds, derivatives and hybrids.

If you are interested in reading other posts about valuation, click on any of the links provided below. In addition, feel free to email us if you want to read some of our many articles on the topics of risk management and valuation.

Valuation Problems Are Going to Cost Plan Sponsors Big Time

Model Risk - Great Unknown for Pension Plans

Valuation Awakening - Does the Emperor Have Clothes?

Tulip Craze Redux and What Models Mean to Pensions

Survey Shows that Pensions Worry About Risk Management and Valuation

Pensions and Hedge Funds and Private Equity - Assessing Risks

Hedge Fund Toolbox - Webinars for Pension Fiduciaries

Side Pockets and Valuation

Courts Want Evidence of Valuation Expertise

Private Equity, Mutual Funds and Valuation

Do You Really Know the Value of Your Portfolio?

Pension Funds Still Embrace Alternatives

In reading "Alternative investments still hot with pension fund managers" (Andrew Osterland, Financial Week, September 27, 2007), several things caught this blogger's eye. Summarizing a recent Citigroup Investment Research Survey of U.S. and European funds, the article states that "almost 90% of pension fund managers allocate assets to private equity investments vs. 50% to hedge funds." It was somewhat surprising then to read that "over 80% of managers expressed concern over the lack of marking-to-market of hedge fund investments."

Does that mean that pension investors are less concerned about the valuation of private equity positions? That seems odd. While true that many hedge funds actively trade (and therefore tend to have a shorter holding period than private equity managers), we've fielded valuation calls from more than a few defined benefit plan auditors and investment committees. Concern about how to fair value any position for which no ready market exists - hedge fund or otherwise - ranks high on their "watch out" list.  

Though some believe that accounting rule changes are the primary reason for concern, the Private Equity Industry Guidelines Group reports the following:

FASB Statement No. 157 did not change GAAP, it includes "provisions which required subtle changes to the guidelines which could be deemed significant! Fair Value was required for PE investments prior to Statement 157. Statement No. 157 clarified the definition, usage and disclosures necessary when using Fair Value and in certain circumstances changes historic practice in the private equity industry as further outlined below." (Source: 2007 Updated Private Equity Valuation Guidelines Frequently Asked Questions)

With more than $1.0 trillion expected to flow into alternatives by 2010 (as per survey results), understanding hedge fund and private equity valuation is critical.

Private Pools of Capital - Pensions Help to Craft Policy

According to a September 25, 2007 press release for the President's Working Group on Financial Markets ("PWG"), pension funds are playing an active role in setting policy. Following on the heels of guidelines released in February 2007, one committee, headed by Eric Mindich, CEO of Eton Park Capital Management, seeks to provide the asset management perspective. A second committee, led by Russell Read, Chief Investment Officer of the California Public Employees Retirement System, will represent institutional investors such as pensions, endowments and foundations. Click here to read yesterday's press release.

Drawing on the "Agreement Among PWG and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital," drafted earlier this year, committee members will consider fiduciary duties. Not surprisingly, decision-makers are asked to consider the adequacy of disclosure, risk and valuation policies. Excerpted text follows.

  • 5.1 Fiduciaries should consider the suitability of an investment in a private pool within the context of the overall portfolio and in light of the investment objectives and risk tolerances. Fiduciary evaluation should include the investment objectives, strategies, risks, fees, liquidity, performance history, and other relevant characteristics of a private pool.
  • 5.2 Fiduciaries should evaluate the pool’s manager and personnel, including background, experience, and disciplinary history. Fiduciaries also should assess the pool’s service providers and evaluate their independence from the pool’s managers. Fiduciaries should consider the private pool’s manager’s conflicts-of-interest and whether the manager has appropriate controls in place to manage those conflicts.
  • 5.3 Fiduciaries should conduct the appropriate due diligence regarding valuation methodology and performance calculation processes and business and operational risk management systems employed by a private pool, including the extent of independent audit evaluation of such processes and systems.
  • 5.4 Fiduciaries that determine to invest in a private pool of capital should ensure that the size of their investment is consistent with their investment objectives and the principle of portfolio diversification.

The guidelines merit more than a cursory review. One sentence in particular struck a chord. Citing the importance of news, institutional investors are urged to obtain and analyze data that is both frequent and "with sufficient detail that creditors, counterparties, and investors stay informed of strategies, the amount of risk being taken by the pool, and any material changes." As readers of this blog know, seeing is believing. More than a few asset managers may be unwilling to unlock the keys to the information gateway, citing economic hardship if forced to provide full disclosure. Just a few days ago, the SEC announced penalties for an asset manager who failed to file Form 13F, evidencing their exercise of "investment discretion over $100 million or more." (Note: There is no universal agreement that 13F filings permit "sufficient" information transparency. At least one court case asks whether an asset manager should be forced to file without recompense for the "taking" of added-value that results from "superior" analysis.)

Additionally, access to greater amounts of information does not necessarily beget better information. Even if available data is Goldilocks perfect ("just right"), what happens when pension investors are unable to process what has been received?

It will be informative to see what the two committees create in terms of operationalizing these fine, but arguably broad, guidelines.

Some Pension Funds Say to Hedge Funds - Hold On There

Wall Street Journal reporter Craig Karmin reports that, post credit crunch, some public pension funds are having second thoughts about hedge fund and private equity investments. Cited as a "significant reversal in thinking," the article points out that pension funds have oft-cited alternatives as a way to diversify against shifts in market conditions. (See "Pension Managers Rethink Their Love of Hedge Funds," August 27, 2007.)

In an August 26 article entitled "Just How Contagious is That Hedge Fund," New York Times contributor and financial pundit, Mark Hulbert, debunks the notion that all hedge funds generate market-independent returns. He attributes asset class interconnections and similar strategies made by large hedge funds as culprits. A loss in one sector or fund is likely to appear elsewhere. Investing in "hard to value" positions is another challenge. (This blog's author, an accredited appraiser, is working with the National Association of Certified Valuation Analysts to develop a hedge fund valuation course for October 2007.)

The Pension Governance team has been playing the role of Cassandra for many months. Click here for our January 4, 2007 post about contagion, the notion that what occurs in one market or fund cascades throughout the system. Regarding valuation, we've described the issue ad nauseum. Click on the Hedge Funds and Valuation folders on the left side of this blog's home page for lots of posts about these two topics.

For those who missed our six webinar series entitled Hedge Fund ToolboxSM, we're nearly finished with the ebook equivalent. Email us if you want to be notified when it's ready.

Long, Hot Summer for Pension Investors Exposed to Credit Woes

Summertime and the livin' may be easy for Porgy and Bess. If you're an investor caught in the middle of a scorching hot credit meltdown, things are far from tranquil. Besides the fact that many deals are being put on hold (thereby reducing the universe of available stocks and bonds), more than a few asset managers are reporting giant write-downs. If you haven't seen it, the Wall Street Journal's list of affected deals and organizations is sobering. Click here to read "Scorecard: Debt Dilemmas - How Credit-Market Tremors Have Affected Junk Bonds, LBOs and Hedge Funds."

Jittery traders are starting to wonder how quickly sub-prime loan problems will spread to other market sectors, ultimately impacting the ability of corporations and individuals to borrow and spend. In "Strategies correlate after credit market crunch hits," Financial Times reporters Peter Garnham and Paul J. Davies describe changing patterns across markets and strategies. What does this mean for institutional investors? Quite simply, a lot.

Hedge funds and private equity managers who tout absolute return (based on uncorrelated return patterns) are going to have a tough challenge ahead if convergence occurs. Defined benefit plan sponsors are going to have no less a difficult time.

Strategic asset allocations are going to be directly (and arguably materially) impacted by the notion that "the investment world is getting smaller." To read an earlier post about contagion, click here to access "Pension Contagion - Should We Worry?"

Large Endowment Loses Auditor Over Valuation Issues

According to the Daily Texan, the University of Texas Investment Management Company will soon have to rely on its internal audit staff. Chairman of the University System's Audit, Compliance and Management Review Committee, Regent Robert Estrada "reported to the board that Ernst & Young was uncomfortable with pricing the investment company's private equity and hedge fund investments. Regent Robert Rowling added that the firm also had issues with the time gap between UTIMCO's quarterly reports." Click here to read the article.

In a related piece, this blogger was interviewed about the topic of hedge fund valuation in Securities Industry News. Part of a June 4, 2007 special report entitled "Critical Issues for Hedge Funds," the topic of how, why and when hedge funds get valuation help (or don't as the case may be) arose. As an accredited appraiser, I know from firsthand experience that many people in hedge fund land do not acknowledge the presence of the traditional business valuation community. That's not necessarily good since the latter group has long ago acknowledged the regulatory prohibition against a formulaic approach and the need for specialized valuation training. Judges are none too happy and are tossing expert opinions out of their courtroom if they fail to reflect established valuation concepts and practices.

When asked why valuation is so important in this industry, I said the following:

<<  Valuation numbers drive nearly every financial decision. Hedge fund managers need to know how to rebalance their portfolios, adjust risk management positions and report numbers to investors upon which they earn their fees. Valuation becomes especially important in the case of illiquid investments like private equity, distressed securities, emerging-market securities and complex derivatives. It is also an issue as more hedge funds go public. How else will you come up with a net asset value for the initial public offering, without a formal assessment? Additionally, institutional investors are on the hook to understand how hedge funds value their holdings. The last thing pension fund, foundation or endowment fiduciaries want is a blowup that could have been prevented with a thorough vetting of the managers' valuation process. That includes assurance from the hedge fund managers that numbers are being provided by an independent third party. >> (To read "The State of Valuation", go to A subscription is required but you can register for a trial.)

If you would like a copy of some of the articles I've written about hedge fund, derivative instrument and asset valuation, click here to send an email.

Survey Shows That Pensions Worry About Risk Management and Valuation

In his May 16 testimony to Congress, Mr. Douglas Lowenstein, head of the Private Equity Council, extolled the virtues of non-public investments. With over $110 billion invested in private equity by twenty large public pension funds, Lowenstein cites relatively higher historical returns that have helped plan sponsors pay the bills. Click here to read his testimony.

A few months earlier, a survey conducted by the State Street Bank describes escalating interest in hedge funds. At the same time, half of respondents expressed "a need for additional reporting and analysis on the part of hedge fund managers and more rigorous due diligence practices," adding that "they find it difficult to gain a portfolio-wide view of risk, and that aggregating risk statistics provided by all hedge funds in their portfolio was problematic. The same number also agreed that obtaining an accurate valuation of hedge fund holdings can be problematic." Click here to read the executive summary of the survey.

As with any investment, there is no "perfect" choice. Selection depends on a wide variety of factors.( A discussion about optimal asset allocation and security/fund selection is outside the scope of this blog post.) However, a few points are in order.

1. Risk management and valuation concerns are not created equal. They vary across type of asset and fund. Private equity funds tend to trade less frequently than hedge funds. Even within an asset class (assuming you agree that hedge funds constitute a separate asset class), the risk-return tradeoff varies by strategy, management and much more. For example, the use of derivatives by a market neutral hedge fund can differ dramatically from that of a macro oriented fund.

2. The use of a side pocket may reduce the need for frequent valuations. However, institutional investors need to understand if a side pocket is to be used, what will go inside the side pocket and the impact on reported performance as a result of its use.

3. Knowing that a manager employs derivatives is not enough. Understanding instrument and strategy choice is likewise important (though still not sufficient).

4. Valuation numbers provided by traders or anyone else who stands to benefit by reporting high numbers should be discarded and replaced with those provided by an independent party.

If you are interested in knowing about other red flags, email us in confidence.

Pensions and Hedge Funds and Private Equity - Assessing Risks

In case you missed it, here is the link to a video of my appearance on CNBC's Morning Call.  While I concede that it's impossible to have an in-depth conversation in only a few minutes, several things are worth mentioning as a result of the May 17 chat with host Mr. Mark Haines.

1. Not all institutional investors have a large staff to vet different investment ideas. Moreover, large does not always mean better. Witness Fannie Mae and Amaranth Advisors. "Thorough" is the watch word.

2. If considering a hedge fund, ask if the fund has a functional risk manager who monitors, tests and reviews policies for financial and operational trouble spots. Does that person have independence and authority to effect meaningful change?

3. I believe the other speaker in this segment said that private equity avoids having to deal with the daily volatility of being invested in public equities. Caution - The absence of a ready trading market does not necessarily mean that there is less risk. Some could easily assert the opposite. Private equity deals, because they are private, entail valuation challenges, difficulty in liquidating ownership interests and so on.

4. The use of correlation (a measure of linear association) to gauge diversification benefits depends on having good data for all relevant time periods. If using an inappropriately long calendar period (example: last ten years), output may reflect a smoothing out effect which therefore underestimates "true" volatility.

5. There is much more to say on the topics of risk management and valuation!

Will Private Equity Stay Private? U.S. Dept. of Justice Makes Inquiries

In "U.S. Department of Justice Comes Knocking, Raising Specter of Private Equity Antitrust Concerns," law firm Goodwin Procter, LLP writes that "the DOJ has sent out requests to some of the industry's largest and most well-known firms, asking that these firms provide information and documents relating to company auctions since 2003."

Reported earlier by the Wall Street Journal ("Private-Equity Firms Face Anticompetitive Probe" by Dennis K. Berman and Henny Sender - October 10, 2006) and Red, the DOJ is interested in knowing how firms transact and the extent to which competition in bidding occurs.

At the same time, Investment Dealers' Digest reports on the imminent launch of a new trade association, the Private Equity Council ("PE Trade Group Nearing Launch Amid Intensifying Scrutiny" by Ken MacFadyen - October 30, 2006). Slated as its new head, Mr. Harry Clark "insists that the group's genesis was in no way a response to the Justice Department's inquiry and he notes its role will not be in reacting to such events."

At a time when pension funds are increasingly looking at alternative investments such as hedge funds and private equity opportunities, an issue that resurfaces time and time again is transparency. In August 2005, the State of Illinois enacted legislation to protect "the commercially sensitive information of companies that receive private equity funding from public pension funds." One of five other states at the time, the then-cited goal was to "provide transparency in public investments in private equity without damaging portfolio companies' ability to compete."

You may recall an earlier post about hedge fund competitiveness and transparency. (Click here to read "Pensions, Hedge Funds and Disclosure" about Mr. Phillip Goldstein's letter to the U.S. SEC in which he requests exemption from the filing of Form 13F. In that post, I talked about the relationship between information and fiduciary responsibility.

No doubt the issues of transparency and market structure will continue to grab headlines. It's far from trivial.

Editor's Note:
Mr. Goldstein sent a copy of the letter to share with readers. Click below.

Private Equity, Mutual Funds and Valuation

Wall Street Journal reporter, Eleanor Laise recently wrote that an increasing number of mutual funds are "venturing into the risky world of private-equity investments", "because of the prospects for higher returns." While SEC rules limit assets to no more than fifteen percent in illiquid holdings, Ms. Laise describes potential problems. Higher legal expenses for more complex deals, difficulty of unwinding a position and valuing private investments are far from trivial challenges. She cites one SEC investigation of a mutual fund that allegedly undervalued its private company positions to give the impression that it had not breached the fifteen percent limit. "The SEC also has charged funds with inflating the value of illiquid investments. Mutual-fund managers have an incentive to overestimate the value of these holdings because they collect fees that are calculated as a percentage of total assets in the fund." (See "Mutual Funds Delve Into Private Equity" by Eleanor Laise, Wall Street Journal, August 2, 2006.)

Applying a version of the transitive property from mathematics, the implication is clear. Some pension funds have increasing exposure to private equity investments that do not trade in a ready market.

1. Pension funds allocate money to mutual funds.

2. Mutual funds buy private equity.

3. Pension funds are exposed to private equity as an asset class. (This is in addition to any direct allocation by pension funds to private equity.)

The message is clear. For those pension funds investing more money in private equity (indirectly or directly), the valuation issues are real and cannot be overlooked.