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Stanley Feldman on the Five Myths About the Fair Value of Alternative Investments
Episode Transcript: Jim: Stan, in our last podcast we discussed the increased responsibilities of fiduciaries in the post Madoff era and under FAS 157, the fair value standard. In particular, we discussed this current thinking as it relates to valuing alternative investments. Today we’re going to continue that discussion by delving into some of the so-called myths that have developed around the application of FAS 157 to alternative investments. First, can you tell us how you discovered these myths and who seems to believe them? Stan: Well I think the myths emerged just simply by talking to market participants, particularly fiduciaries, even investment managers. When you talk to them about what they mean by alternative investments, they talk about bonds, they talk about stocks. In addition to commodities and real estate, in many ways these are more traditional asset classes. What's alternative are hedge funds and more particularly private equities. It's really terminology that people use and they haven't clearly defined what they mean by it. So that gave rise to asking the question, when you talk about alternative investments, what do you really mean by them? That's how these myths were developed, effectively, by talking to people in the market and trying to get an understanding of what they thought an alternative investment was and various other things related to the nature of the alternative investment marketplace. Jim: How about if I state each myth and then you tell me whether it’s true or false, and explain the reasons why? Stan: Sure, that’s fine. Jim: Myth Number 1: Alternative investments do not include traditional asset classes. Stan: This is myth number one because it's the most obvious one. Typically when people talk about alternative assets they’ll talk about private equity, which is an alternative asset and then they'll talk about hedge funds. But within the hedge fund class there are many types of what I'll call classic or traditional assets. It could be fixed income, equities, for example long-short hedge funds where they both take a long and a short position, they take it with publicly traded securities, so alternative investments do include traditional asset classes. They include others as well, but traditional asset classes are also part of the alternative investment mix. In addition, people typically don't think about guaranteed investment contracts as an alternative asset, but it essentially is another asset class that is a fixed income security and while it's often excluded from the alternative asset classification, it probably should be included because it fits many of the characteristics of an alternative asset that is thinly traded and illiquid. Jim: Can other securities like CMOs or CMO Squared, those types of transactions, also be alternative investments? Stan: Yes, in a broad categorization of alternative investments you would think of things like collateralized mortgage obligations, CMOs, or collateralized debt obligations, or even some pass-throughs. Vanilla pass-throughs are alternative in the sense that they don't trade, they're illiquid, so they have many of the characteristics of what we'll call alternative assets. Jim: So moving on to myth number two. Auditors have not required that FAS 157 standards be rigorously applied to pension funds. Stan: This is a classic one because there are two types of pension funds. There are public funds. This is, for example, pension plans that are sponsored by states or local governments. And they don't file under FAS 157, they file under another standard, GASB, which doesn't require a FAS 157 fair value analysis. It does require fair value, but it doesn't stipulate what fair value actually means and how do you calculate it where FAS 157 does. So for pension plans that are in the private sector, corporate pension plans for an example, Taft-Hartley plans, which are sponsored by both the employer and unions, all of those assets that are in those plans have to be marked to fair value. That includes both obviously the level one which is their marketable, tradable securities and level two and level three as well, which are typically illiquid, thinly traded or in some cases not traded at all. All those securities have to be marked to fair value and must meet the 157 standard. Jim: Myth number three. Asset classes like alternative investments that represent a small percentage of a fund’s portfolio do not have to meet the rigorous fair value standards established by FAS 157. Stan: Right, often what will happen is that auditors will look at something and say, “Well that's a very small percentage of the total fund and therefore we can accept, you know, kind of an estimate, ballpark of what we think fair value of the particular assets happen to be.” FAS 157, AICPA (American Institute of Certified Public Accountants) guidelines, require that all assets, no matter whether those assets represent a small percentage of the fund or not, should meet the fair value standard and to meet the fair value standard you have to go through the steps and the requirements that FAS 157 stipulates. So the percentage held in a portfolio is really not the determining factor. The determining factor is all assets within a pension plan have to be valued at fair value and if you're a private pension plan, you have to follow the guidelines established by FAS 157 and the AICPA. Jim: So, myth number four. We do not need to fair value our alternative investments since the fund does not intend to sell these investments. Stan: This is typical. The best way to describe this is when Harvard and Stanford and Yale, I think most recently, they also invested in alternative investments, private equity and hedge funds, and it turns out because of the crunch in the public markets, and the mark down of their public securities, they decided that they needed to turn around and begin selling some of their hedge funds, private equity interests, mainly their alternative investments. And so when they bought they had made the determination they were going to keep it for the long term, factors changed over the investment horizon, which required that they sell some of their thinly traded, illiquid assets. So the real issue is not whether you intend not to sell, the question is, if in fact factors are such in the future that in many ways you can't project, if you do need to sell, then you need to know what the fair value of those underlying investments happen to be. So your intention has nothing to do with whether you should fair value the assets. Circumstances might change dramatically as they have for Harvard, Stanford and Yale, for an example, and they have to sell some portion of their alternatives. And interestingly enough what they found was, not necessarily in all cases, but certainly in some cases, that the values they had placed on these securities and the values they received in the marketplace varied considerably. And then the question arises, was the fair value of those alternative investments originally that were on the balance sheet, were those values correct? Were they done correctly? All this comes back to the idea that we don't want to sell, or we don't intend to sell, but circumstances change. They change for individuals as well as fiduciaries of pension plans and endowment funds. You just don't know what the circumstances are. So given that, you need to be able to determine or know what the value of your investments happen to be pretty much on a regular basis. Jim: So, finally the last myth number five. Applying the standards required by FAS 157 is expensive relative to the incremental benefit derived. Stan: Well I think the Madoff scandal probably put this myth to rest. The costs are relatively inexpensive given that if you do it correctly, you get a really good idea of whether your investment managers are doing their job properly. As a fiduciary you’re really protecting yourself. Because here you're doing what any reasonable fiduciary is expected to do in the circumstances, and that is feel comfortable that the values that you are telling your stakeholders about not only meet the FAS 157 standard, but are correct. And you have a responsibility to do that. I think the cost of not doing it far exceeds the cost of actually doing it. And I think people are beginning to realize this and one of the factors that kind of support this view is many fiduciaries are beginning to buy and spend more money on fiduciary insurance because they don't feel they may get enough protection and one way and maybe perhaps a cheaper way of dealing with this would be to have a 157 analysis done on all your investments and more specifically your alternative investments. Jim: So these myths represent some current, but incorrect thinking that exists related to FAS 157 and alternative investments, who stands to lose the most or who could be most negatively affected if these myths aren’t dispelled? Stan: Well first the fiduciaries are always on the hook for not doing their appropriate job. In the past I think most fiduciaries have felt that if their auditors signed-off on their financial statements that that offered protection. But it really doesn't because what the auditors are signing-off on is process and not value. So they're really on the hook. For an example, just say that you were invested in some auction rate securities and all of a sudden it turns out that those securities which you thought were effectively cash turn out to be not cash. You can't auction them, you can't sell them, and if you do want to sell them you have to sell them at deep discounts. That's a market value loss. And pension plans, endowment plans, any fiduciary that's responsible for those kinds of investments, they'd be on the hook for saying, well, you know, you told the stakeholders that this is essentially cash, now what you're telling us is it's not cash. We're going to hold you responsible for the difference between the cash value and what we ultimately get if we have to sell those securities. So it seems to me fiduciaries really are on the hook now. This is effectively what ERISA (Employee Retirement Income Security Act of 1974) did for fiduciaries back in the 1970s. They put them on notice that their investment policies—they just can't make them up, they have to sit down and follow a process. If they don't do the same thing here with their alternative investments, then they're personally on the hook. They could lose their wealth, certainly they could be sued. So they are the ones that really stand to lose the most personally. Now that being said, stakeholders themselves also need to be clear about what's in these pension plans and endowment funds. They put money in, they expect benefits to be subsequently paid out. If those assets aren’t worth what they think they're worth, then perhaps the benefits they expect to receive in the future won’t be there. So they take a risk as well, but for them I think it's more opaque in the sense that they have to do a lot of digging to figure all this out and they assume that the fiduciary is doing it. CapitalMarket Pulse with Jim Towne is brought to you by DerivActiv, Inc. a leading provider of web-based independent valuations for fixed-income, currency, and equity derivatives and other financial products. Copyright CapitalMarket Pulse 2009.
Episode Transcript:
Jim: Stan, in our last podcast we discussed the increased responsibilities of fiduciaries in the post Madoff era and under FAS 157, the fair value standard. In particular, we discussed this current thinking as it relates to valuing alternative investments. Today we’re going to continue that discussion by delving into some of the so-called myths that have developed around the application of FAS 157 to alternative investments. First, can you tell us how you discovered these myths and who seems to believe them?
Stan: Well I think the myths emerged just simply by talking to market participants, particularly fiduciaries, even investment managers. When you talk to them about what they mean by alternative investments, they talk about bonds, they talk about stocks. In addition to commodities and real estate, in many ways these are more traditional asset classes. What's alternative are hedge funds and more particularly private equities. It's really terminology that people use and they haven't clearly defined what they mean by it. So that gave rise to asking the question, when you talk about alternative investments, what do you really mean by them? That's how these myths were developed, effectively, by talking to people in the market and trying to get an understanding of what they thought an alternative investment was and various other things related to the nature of the alternative investment marketplace.
Jim: How about if I state each myth and then you tell me whether it’s true or false, and explain the reasons why?
Stan: Sure, that’s fine.
Jim: Myth Number 1: Alternative investments do not include traditional asset classes.
Stan: This is myth number one because it's the most obvious one. Typically when people talk about alternative assets they’ll talk about private equity, which is an alternative asset and then they'll talk about hedge funds. But within the hedge fund class there are many types of what I'll call classic or traditional assets. It could be fixed income, equities, for example long-short hedge funds where they both take a long and a short position, they take it with publicly traded securities, so alternative investments do include traditional asset classes. They include others as well, but traditional asset classes are also part of the alternative investment mix. In addition, people typically don't think about guaranteed investment contracts as an alternative asset, but it essentially is another asset class that is a fixed income security and while it's often excluded from the alternative asset classification, it probably should be included because it fits many of the characteristics of an alternative asset that is thinly traded and illiquid.
Jim: Can other securities like CMOs or CMO Squared, those types of transactions, also be alternative investments?
Stan: Yes, in a broad categorization of alternative investments you would think of things like collateralized mortgage obligations, CMOs, or collateralized debt obligations, or even some pass-throughs. Vanilla pass-throughs are alternative in the sense that they don't trade, they're illiquid, so they have many of the characteristics of what we'll call alternative assets.
Jim: So moving on to myth number two. Auditors have not required that FAS 157 standards be rigorously applied to pension funds.
Stan: This is a classic one because there are two types of pension funds. There are public funds. This is, for example, pension plans that are sponsored by states or local governments. And they don't file under FAS 157, they file under another standard, GASB, which doesn't require a FAS 157 fair value analysis. It does require fair value, but it doesn't stipulate what fair value actually means and how do you calculate it where FAS 157 does. So for pension plans that are in the private sector, corporate pension plans for an example, Taft-Hartley plans, which are sponsored by both the employer and unions, all of those assets that are in those plans have to be marked to fair value. That includes both obviously the level one which is their marketable, tradable securities and level two and level three as well, which are typically illiquid, thinly traded or in some cases not traded at all. All those securities have to be marked to fair value and must meet the 157 standard.
Jim: Myth number three. Asset classes like alternative investments that represent a small percentage of a fund’s portfolio do not have to meet the rigorous fair value standards established by FAS 157.
Stan: Right, often what will happen is that auditors will look at something and say, “Well that's a very small percentage of the total fund and therefore we can accept, you know, kind of an estimate, ballpark of what we think fair value of the particular assets happen to be.” FAS 157, AICPA (American Institute of Certified Public Accountants) guidelines, require that all assets, no matter whether those assets represent a small percentage of the fund or not, should meet the fair value standard and to meet the fair value standard you have to go through the steps and the requirements that FAS 157 stipulates. So the percentage held in a portfolio is really not the determining factor. The determining factor is all assets within a pension plan have to be valued at fair value and if you're a private pension plan, you have to follow the guidelines established by FAS 157 and the AICPA.
Jim: So, myth number four. We do not need to fair value our alternative investments since the fund does not intend to sell these investments.
Stan: This is typical. The best way to describe this is when Harvard and Stanford and Yale, I think most recently, they also invested in alternative investments, private equity and hedge funds, and it turns out because of the crunch in the public markets, and the mark down of their public securities, they decided that they needed to turn around and begin selling some of their hedge funds, private equity interests, mainly their alternative investments. And so when they bought they had made the determination they were going to keep it for the long term, factors changed over the investment horizon, which required that they sell some of their thinly traded, illiquid assets. So the real issue is not whether you intend not to sell, the question is, if in fact factors are such in the future that in many ways you can't project, if you do need to sell, then you need to know what the fair value of those underlying investments happen to be. So your intention has nothing to do with whether you should fair value the assets. Circumstances might change dramatically as they have for Harvard, Stanford and Yale, for an example, and they have to sell some portion of their alternatives. And interestingly enough what they found was, not necessarily in all cases, but certainly in some cases, that the values they had placed on these securities and the values they received in the marketplace varied considerably. And then the question arises, was the fair value of those alternative investments originally that were on the balance sheet, were those values correct? Were they done correctly? All this comes back to the idea that we don't want to sell, or we don't intend to sell, but circumstances change. They change for individuals as well as fiduciaries of pension plans and endowment funds. You just don't know what the circumstances are. So given that, you need to be able to determine or know what the value of your investments happen to be pretty much on a regular basis.
Jim: So, finally the last myth number five. Applying the standards required by FAS 157 is expensive relative to the incremental benefit derived.
Stan: Well I think the Madoff scandal probably put this myth to rest. The costs are relatively inexpensive given that if you do it correctly, you get a really good idea of whether your investment managers are doing their job properly. As a fiduciary you’re really protecting yourself. Because here you're doing what any reasonable fiduciary is expected to do in the circumstances, and that is feel comfortable that the values that you are telling your stakeholders about not only meet the FAS 157 standard, but are correct. And you have a responsibility to do that. I think the cost of not doing it far exceeds the cost of actually doing it. And I think people are beginning to realize this and one of the factors that kind of support this view is many fiduciaries are beginning to buy and spend more money on fiduciary insurance because they don't feel they may get enough protection and one way and maybe perhaps a cheaper way of dealing with this would be to have a 157 analysis done on all your investments and more specifically your alternative investments.
Jim: So these myths represent some current, but incorrect thinking that exists related to FAS 157 and alternative investments, who stands to lose the most or who could be most negatively affected if these myths aren’t dispelled?
Stan: Well first the fiduciaries are always on the hook for not doing their appropriate job. In the past I think most fiduciaries have felt that if their auditors signed-off on their financial statements that that offered protection. But it really doesn't because what the auditors are signing-off on is process and not value. So they're really on the hook. For an example, just say that you were invested in some auction rate securities and all of a sudden it turns out that those securities which you thought were effectively cash turn out to be not cash. You can't auction them, you can't sell them, and if you do want to sell them you have to sell them at deep discounts. That's a market value loss. And pension plans, endowment plans, any fiduciary that's responsible for those kinds of investments, they'd be on the hook for saying, well, you know, you told the stakeholders that this is essentially cash, now what you're telling us is it's not cash. We're going to hold you responsible for the difference between the cash value and what we ultimately get if we have to sell those securities. So it seems to me fiduciaries really are on the hook now. This is effectively what ERISA (Employee Retirement Income Security Act of 1974) did for fiduciaries back in the 1970s. They put them on notice that their investment policies—they just can't make them up, they have to sit down and follow a process. If they don't do the same thing here with their alternative investments, then they're personally on the hook. They could lose their wealth, certainly they could be sued. So they are the ones that really stand to lose the most personally. Now that being said, stakeholders themselves also need to be clear about what's in these pension plans and endowment funds. They put money in, they expect benefits to be subsequently paid out. If those assets aren’t worth what they think they're worth, then perhaps the benefits they expect to receive in the future won’t be there. So they take a risk as well, but for them I think it's more opaque in the sense that they have to do a lot of digging to figure all this out and they assume that the fiduciary is doing it.
CapitalMarket Pulse with Jim Towne is brought to you by DerivActiv, Inc. a leading provider of web-based independent valuations for fixed-income, currency, and equity derivatives and other financial products. Copyright CapitalMarket Pulse 2009.
