Alternative Investments: A New Staple for Public Retirement Systems
So called "Alternative Investments" have moved from being merely fashionable to a staple of many public retirement systems. Plans which have not yet adopted these strategies will likely confront repeated opportunities to do so in the near future.
The unique complexity and risk of Alternative Investments often causes one of the following opposite knee jerk reactions: (1) rejection of the strategy altogether; or (2) adoption of the strategy without full knowledge of its nature or consequences. Fiduciary obligations are left unfulfilled in either case.
Either result can be avoided by observing the basic tenets of due diligence, with an emphasis on obtaining clear, complete, and understandable information regarding the proposed Alternative Investment.
Alternative Investments: Definition
The term "Alternative Investments" is used to describe asset classes other than traditionally managed stock and bond portfolios. These classes normally refer to private equity, hedge funds (including fund of funds), and managed futures or commodities.
The Public Employee Retirement System Investment Act, Act 314 of 1965 (the "Act"), governs investments by retirement systems in the public sector. Specifically, section 20(d) of the Act permits retirement systems to invest their assets in vehicles that are not otherwise specifically allowed by the Act. § 38.1140d. This provision has become known as the "basket clause."
Distinct Legal and Practical Characteristics of Alternative Investments
The primary legal and practical differences between traditional and alternative investments can be generally summarized as follows:
- Lack of regulation. Alternatives often involve investment in entities or securities that are not publicly traded, not subject to direct Securities and Exchange Commission ("SEC") regulation, and thus operate with minimal or no federal regulatory oversight.
- No delegation to registered investment manager. Alternatives often do not involve retention of a registered investment manager who assumes fiduciary responsibility for the investment activity.
- Structure of investment. Many alternatives are structured as private limited partnerships. The general partner is the sponsoring entity and the investors are limited partners.
- Liquidity. Often, the ability to withdraw funds is limited.
- Transparency. The actual securities, holdings, or detailed strategies within the portfolio are often not fully available to investors.
- Investment agreement. Investors are required to execute a complicated set of documents which the sponsoring entity seeks to impose uniformly on all investors. Thus, flexibility in negotiating these agreements is far more limited than in the traditional setting.
- Fees. The fees associated with alternatives are often significantly higher than traditional investments.
- Time horizon. The investment horizon may be quite long compared to traditional investing. The partnership term may last 10 or more years. During this period, the general partner is paid its annual management fee even though the vehicle may post negative returns to limited partners.
- Unspecified Costs and Expenses. Capital costs and other expenses associated with the operation of the partnership or commingled fund are paid by the investor on a pro rata basis as deemed "reasonable and necessary" by the controlling entity.
- Skill and expertise of manager. These investments are not publicly traded and thus not within the common knowledge of traditional money managers, let alone traditional investors.
Specifics of Private Equity, Hedge Funds, and Managed Futures/Commodities
Private equity describes various strategies for investing in non-public securities. The major categories are venture capital and buyouts. Whether venture capital or buyout, the earnings, if any, on these investments may not materialize for a significant period. Investments are generally made by the general partner during the first 5 to 7 years, during which time capital is called from the limited partners as needed.
The term "hedge fund" derives from a style of investment which "hedges" against overall stock market movement: a combined portfolio of undervalued stocks expected to increase in price along with overvalued stocks expected to decline. It is anticipated that in rising markets, the undervalued stocks will outperform the overvalued stocks and, in a falling market, the reverse would hold true.
This strategy remains fairly new to many institutional funds. Commodities are raw materials: assets that are tangible such as energy, grains, industrial metals, and livestock. As their prices tend to have a high correlation to changes in expected inflation and a low correlation to stocks and bonds, they may be attractive from a diversification standpoint.
The same skills which trustees apply to traditional investing can be - with heightened vigilance - successfully adapted to evaluating Alternative Investments. Persistent focus on the central characteristics of such investments and insistence on clear answers to the above inquiries are essential. Regardless of the final decision, the trustees will have demonstrated their prudency, a necessary component of any investment decision, particularly when neither long term results nor incidence of liability are fully known.