Defined Benefit Pension Plans: Plans Face Challenges When Investing in Hedge Funds and Private Equity
Released: 2011-08-31T00:00:00

Letter

A Growing Number of Pension Plans Are Investing in Hedge Funds or Private Equity, but Such Investments Are Generally a Small Portion of Plan Assets

We reported in 2008 that DB plan investments in hedge funds and private equity have grown, but such investments are generally a small portion of plan assets. This remains the case today. According to a Pensions & Investments survey, the percentage of large plans (as measured by total plan assets) investing in hedge funds grew from 11 percent in 2001 to 60 percent in 2010 (see fig. 1). Over the same time period, the percentage of large plans that invest in private equity grew at a much slower rate—71 percent to 92 percent—likely because of the fact that a much larger percentage of plans were already invested in private equity in 2001.

Data from the same survey reveal that investments in hedge funds and private equity typically constitute a small share of plan assets. The average allocation to hedge funds among plans with such investments was a little over 5 percent in 2010. Similarly, among plans with investments in private equity, the average allocation was a little over 9 percent. Although the majority of plans with investments in hedge funds or private equity have small allocations to these assets, a few plans have relatively large allocations, according to the Pensions & Investments survey. Of the 78 large plans that reported hedge fund investments in 2010, 20 had allocations of 10 percent or more (see fig. 2). The highest reported hedge fund allocation was 33 percent of total assets. Similarly, of the 121 plans that reported private equity investments in 2010, 34 had allocations of 10 percent or more, and the highest reported private equity allocation was 30 percent.

Available survey data show that larger plans, measured by total plan assets, are more likely to invest in hedge funds and private equity compared with midsize plans. As shown below, a 2010 survey by Greenwich Associates found that 22 percent of midsize plans—those with $250 million to $500 million in total assets—were invested in hedge funds compared with 40 percent of the largest plans—those with over $5 billion in total assets (see fig. 3). Survey data on plans with less than $200 million in assets are unavailable and, in the absence of this information, the extent to which these smaller plans invest in hedge funds and private equity is unclear.

Hedge Fund and Private Equity Investments Pose Various Risks and Challenges for Plan Sponsors

Valuation Risk

One of the major challenges that both hedge fund and private equity investments pose to plan sponsors is uncertainty over the current value of the sponsors’ investment. With regard to hedge funds, we noted that plan officials may lack information on both the nature of the specific underlying holdings of the hedge fund, as well as the aggregate value on a day-to- day basis. Because many hedge funds may own thinly traded securities and derivatives whose valuation can be complex and subjective, a plan official may not be able to obtain timely information on the value of assets owned by a hedge fund. Further, hedge fund managers may decline to disclose information on asset holdings and the net value of individual assets largely because the release of such information could compromise their trading strategy. In addition, even if hedge fund managers were to provide detailed positions, these managers may seek to profit through complex and simultaneous positions and can abruptly change their positions and trading tactics in order to achieve a desired return as changing market conditions warrant, making it difficult for plans to independently ascertain the value or fully assess the degree of investment risk. Although we noted in January 2008 that some hedge funds have improved disclosure and transparency about their operations because of the demands of institutional investors, several pension plans cited limited transparency as a prime reason they had chosen not to invest in hedge funds.

As with hedge funds, valuations of private equity investments are uncertain during the investment’s long duration, which often lasts 10 years or more. Unlike investments that are traded and priced in public markets, plan officials have limited information on the value of private equity investments until the underlying holdings are sold. In some cases, private equity funds estimate the value of the fund by comparing the value of companies in their portfolio with the value of comparable publicly traded assets. However, prior to the sale of underlying investments, assessing the value of a private equity fund is difficult.

Investment Risk

While any plan investment may fail to deliver expected returns over time, hedge fund and private equity investments pose investment challenges beyond those posed by traditional investments. For example, both hedge fund and private equity managers may use leverage—that is, borrowed money or other techniques—to potentially increase an investment’s return without increasing the amount of capital invested. Although registered investment companies are subject to strict leverage limits, a hedge fund or private equity fund can make relatively unrestricted use of leverage. Leverage can magnify profits, but can also magnify losses to the fund if the market goes against the fund’s expectations. In addition, a private equity fund manager’s strategy typically involves concentrating its holdings in a limited number of underlying companies—generally about 10 to 15 companies, often in the same sector. The returns for such concentrated, undiversified funds are highly susceptible to the success or failure of each underlying company and related market sector conditions. Further, hedge funds and private equity funds can also feature relatively costly fee structures compared with those of mutual funds. These fee structures can have a significant impact on net investment returns. Despite these fee structures, pension plan officials we contacted cited attaining returns superior to those attained in the stock market as a reason for investing in hedge funds and private equity. One plan official noted that as long as hedge funds add value net of fees, they found the higher fees acceptable.

Lack of Liquidity

Hedge funds and private equity are also relatively illiquid investments— that is, investors generally cannot easily redeem their investments on demand. Hedge funds often require an initial lockup of a plan’s investment for a year or more, during which an investor cannot cash out of the hedge fund. After the initial lockup period, hedge funds offer only periodic liquidity, such as quarterly. Hedge funds impose such liquidity limits because sudden liquidations could disrupt a carefully calibrated investment strategy. Nonetheless, these constraints also pose certain disadvantages to plan sponsors, such as inhibiting a plan’s ability to limit a hedge fund’s investment loss. Private equity funds require an even longer-term commitment than hedge fund investments, and during that period, a plan may have no ability to redeem its investments—and can often require additional capital over the life of the investment. A private equity fund cycle typically follows a pattern known as the J-curve, which reflects an initial period of negative returns during which investors provide the fund with capital to invest in underlying companies and then obtain returns over time as investments mature.

Operational Risk

We reported that pension plans investing in hedge funds are also exposed to operational risk—that is, the risk of investment loss because of inadequate or failed internal processes, people, and systems, or problems with external service providers. Operational problems can arise from a number of sources, including inexperienced operations personnel; inadequate internal controls; lack of compliance standards and enforcement; errors in analyzing, trading, or recording positions; or outright fraud. While most investments can pose some type of operational risk, according to a report by an investment consulting firm, many hedge funds engage in active, complex, and sometimes heavily leveraged trading, and a failure of operational functions, such as processing or clearing one or more trades, and may have particularly grave consequences for the overall position of the hedge fund.

Plan Sponsors Take a Number of Steps to Address the Risks of Hedge Fund and Private Equity Investing

Pension plan officials we spoke with take a number of steps in an attempt to mitigate the risks and challenges of investing in hedge funds and private equity.

First, plan sponsors noted the importance of making careful and deliberate fund selection when investing in hedge funds and private equity. In the case of hedge funds, plan sponsors emphasized defining a clear purpose and strategy for their hedge fund investments. Most of the plans we contacted described one or more specific strategies for their hedge fund investments. Several sources stated that private equity investments have greater variation in performance among funds, particularly among venture capital investments compared with other asset classes such as domestic stocks, and therefore they must invest with top- performing funds in order to achieve long-term returns in excess of those of the stock market.

Plan sponsors and others also cited the importance of negotiating key terms of investments in hedge funds and private equity. They said in the case of hedge funds, such terms can include fee structure and conditions, degree of transparency, valuation procedures, redemption provisions, and degree of leverage employed. For example, pension plans may want to ensure that they will not pay a performance fee unless the value of the hedge fund investment passes a previous peak value of the fund shares—known as a high-water mark. Key contract terms for private equity may also include fee structure and valuation procedures, though one plan sponsor noted the ability to negotiate favorable contract terms is limited when investing in top-performing funds, because investing in such funds is highly competitive.

Due diligence and ongoing monitoring, beyond those required for traditional investments, are also important. For hedge funds, due diligence can be a wide-ranging process including study of a hedge fund’s investment, valuation, risk management processes, and compliance procedures, as well as a review of back office operations. As with hedge fund investments, plans take additional steps to mitigate the challenges of investing in private equity through extensive and ongoing monitoring, beyond that required for traditional investments. Plan representatives we interviewed said these steps include regularly reviewing reports on the performance of the underlying investments of the private equity fund and having periodic meetings with fund managers. In some cases, plans participate on the advisory board of a private equity fund, which provides a greater opportunity for oversight of the fund’s operations and new investments; however, this involves a significant time commitment and may not be feasible for every private equity investment.

Also, several plan sponsors address some of the risks and challenges of investing in hedge funds and private equity by investing via a fund of funds. Investing in a fund of funds provides investors with diversification across multiple funds, which can mitigate the effect of one manager’s poor performance. In particular, a fund of private equity funds can allow plans to invest in a variety of managers, industries, geographies, and year of initial capital investment. In addition, a plan sponsor may be able to rely on a fund of funds manager to conduct negotiations, due diligence, and monitoring of the underlying hedge funds. As we reported, funds of funds can be appropriate if plan sponsors do not have the skills necessary to manage a portfolio of hedge funds. In addition, investing through a fund of funds may provide a plan better access to hedge funds or private equity funds than a plan would be able to obtain through direct investment. Nonetheless, investing in a fund of funds has some drawbacks and limitations, including an additional layer of fees—such as a 1 percent flat fee and a performance fee of 5 to 10 percent of returns—on top of the substantial fees that a fund of funds manager pays to the underlying hedge funds. Furthermore, funds of funds also pose the same challenges as hedge funds, such as limited transparency and liquidity, and the need for the plan to conduct a due diligence review of the fund of funds firm. However, investing through a fund of funds does not relieve plan sponsors of their fiduciary duties; accordingly, the plan sponsors must act prudently in selecting and monitoring funds of funds.

The Federal Government Can Help Educate Plans on the Challenges of Investing in Hedge Funds

According to plan officials, regulators, and others, some pension plans— especially smaller plans—may find it particularly difficult to address the various demands of hedge fund investing. For example, medium-size and small plans may not have the expertise to oversee the trading and investment practices of hedge funds. Some plans may also lack the ability to conduct the necessary due diligence and monitoring of hedge fund investments. Smaller plans may have only one-or two-person staffs, or may lack the resources to hire outside consulting expertise and may be locked out of top-performing funds. To a lesser extent, some larger plans may also lack sufficient expertise. A representative of one pension plan with more than $32 billion in total assets noted that before investing in hedge funds, the plan would have to build up its staff in order to conduct the due diligence necessary during the fund selection process.

In light of these challenges, and as predecessors to this 2011 ERISA Advisory Council have concluded, the Department of Labor (Labor) can play a role in helping to ensure that plans fulfill their Employee Retirement Income Security Act of 1974 (ERISA) fiduciary duties when investing in hedge funds and private equity. For example, in 2006, the ERISA Advisory Council recommended that Labor publish guidance about the unique features of hedge funds and matters for consideration in their use by qualified plans. In 2008, the ERISA Advisory Council recommended that Labor publish guidance to clarify the role of ERISA fiduciaries in selecting, valuing, and accounting for hard-to-value assets, of which many hedge funds and private equity funds are composed. In addition, the Investor’s Committee formed by the President’s Working Group on Financial Markets published a report in January 2009 on the best practices for hedge fund investors. The report acknowledged that hedge fund investments are not necessarily suitable for some investors and provided many recommendations for investors selecting and monitoring their hedge fund investments—including best practices for valuation— such as obtaining a written statement of the fund’s valuation policies and procedures and ensuring the fund’s portfolio is being valued in accordance with Generally Accepted Accounting Principles (GAAP).

In 2008, we recommended that Labor provide guidance for qualified plans under ERISA on the unique challenges of investing in hedge funds and private equity and the steps plans should take to address these challenges. For example, we stated that Labor’s Employee Benefits Security Administration (EBSA) could outline the implications of a hedge fund’s or fund of funds’ limited transparency on the fiduciary duty of prudent oversight. EBSA can also reflect on the implications of these best practices for some plans—especially smaller plans—that might not have the resources to take actions consistent with the best practices, and thus would be at risk of making imprudent investments in hedge funds. Finally, we noted that while EBSA is not tasked with offering guidance to public sector plans, such plans may nonetheless benefit from such guidance. Although Labor generally agreed with our recommendation, the agency explained that the lack of uniformity among these investments could complicate the development of comprehensive guidance for plan fiduciaries. To date, Labor has not acted on this recommendation.

Concluding Observations

As plan sponsors seek to better ensure adequate return on assets under management, recent trends suggest that investments in alternative assets such as hedge funds and private equity are becoming more commonplace. In light of these trends and ongoing public equity market volatility, it is reasonable to expect that the number of plan sponsors making such investments will increase in the future. Our past work indicates that such assets may serve useful purposes in a well-thought- out investment program, offering plan sponsors advantages that may not be as readily available from more traditional investment options. Nonetheless, it is equally clear that investments in such assets place demands on plan sponsors that are significantly beyond the demands of more traditional asset classes.

These challenges can be daunting even for large plan sponsors. Accordingly, we believe that, as we recommended in 2008, the Secretary of Labor should provide guidance regarding investing in hedge funds and private equity specifically designed for qualified plans under ERISA. In particular, we believe that a discussion of the challenges that such investments pose to small plan sponsors would be beneficial.

This concludes my prepared statement. I would be happy to answer any questions that the council may have.

GAO Contacts and Staff Acknowledgments

For further questions on this statement, please contact me at (202) 512- 7215. Individuals making key contributions to this statement include Michael Hartnett, Sharon Hermes, David Lehrer, and Amber Yancey Carroll.

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