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Business Officer Magazine
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In the Know

For alternative investments, ultimate responsibility for determining fund value rests with the institution.

By Dale Larson

As this article went to press, the greatest concern surrounding updated guidance from AICPA centered on detailed circumstances that could lead to scope limitations or qualified audit opinions—with no room for mitigating audit procedures. In such a worst-case scenario, analysts and stakeholders will be especially interested in sound and well-documented investment practices.

Small institutions must tackle big monitoring and auditing challenges as alternative investments become increasingly popular staples of their investment portfolios. In July 2005, the AICPA issued an audit interpretation that clarified existing guidance. It stated that simply receiving a confirmation from a third party, either in aggregate or on an investment-by-investment basis, did not constitute adequate audit evidence with respect to determining fair value. With that interpretation, auditors, business officers, and investment officers were left scratching their heads regarding the level of evidence that is adequate if confirmation is not enough.

The risk associated with alternative investments is a reality for institutions of all types. But small institutions are less likely to have an established investment office or ample due diligence resources. As a result, their leaders will be more involved with risk mitigation processes and documentation to reassure auditors that institution leaders are comfortable with the values presented on the institution’s financial statements. Despite AICPA’s activities, institutions should take several steps before and after acquiring these investments.

Strengthen Evidence of Fair Value

Alternative investments are often grouped into several categories—hedge funds, private equity, venture capital, and natural resources—and typically take the form of limited liability partnerships. The challenge that arises for both auditor and management is the inherent lack of transparency with most funds in this asset class. Hedge fund managers are often reluctant to disclose underlying investments for fear of revealing their competitive advantage or the “proprietary” strategy employed. Venture and private equity funds are composed of assets where quoted market values rarely exist. The 2003 staff report to the U.S. Securities Exchange Commission (SEC) stated: “One of our key concerns relates to the manner by which hedge fund advisers value hedge fund assets. The broad discretion that these advisers have to value assets and the lack of independent review over that activity gives rise to questions about whether some hedge funds’ portfolio holdings are accurately valued.”

The problem of valuation evidence and the implication of the 2005 AICPA audit interpretation appeared again in the March 2006 Moody’s Investor Services report “Changes in Audit Guidelines for Alternative Investments Held by Higher Education and Not-for-Profits Highlight Risks of These Strategies.” The report outlined the potential implications of qualified opinions or scope limitations that might occur if an auditor could not adequately test or evaluate the valuations of alternative investments. Specific concern was directed at small institutions that may not have the advantage of a professional investment office to undertake the necessary due diligence and required monitoring activities.

Unfortunately, the AICPA interpretation answered the question about the adequacy of confirmations only in the negative by indicating that a confirmation alone is insufficient evidence. The interpretation did not expand on what would constitute adequate evidence. The 2005 interpretation also emphasized that “Management needs to establish an accounting and financial reporting process for determining fair value.” The auditor’s role is to understand and test this process for determining fair value and the relevant controls. One critical question an institution must address is whether its process is adequate and an auditor can test the components. How is this best accomplished when management, not the auditor, is responsible for establishing a process for determining fair value?

Practice Due Diligence and Monitoring

Typically, the process begins with due diligence during the pre-investment phase. When management can’t assess the underlying detailed assets, other evidence that uses both qualitative and quantitative elements is necessary. Due diligence activities (see sidebar, “Pre-Investment Procedures”) support and validate management’s judgment of the initial value of an investment. Once the decision is made to invest in the fund, money is transferred in exchange for shares or units.

Because ownership of alternative investments does not generate additional underlying asset transparency or detail, the process continues after the investment is made. Subsequent monitoring activities supplement the fund manager’s periodic statement of value (see sidebar, “Post-Investment Procedures”).

A report by the Financial Service Authority (FSA), “Hedge Funds: A Discussion of Risk and Regulatory Engagement,” identifies the following common risks:

  • inability to challenge valuations effectively;
  • inherent pressure on managers to provide overstated values (since their compensation is often based on fund performance);
  • nondisclosure of side letters (preferential redemption terms); and
  • risks related to skill shortage due to the complexity of the underlying assets.

The FSA’s response to these risks is to increase monitoring activities through further contact with firms, prime brokers, exchanges, and so forth, and to improve understanding of the specific risks. An institution or its investment consultant or advisers should take a similar approach. The FSA report also repeatedly mentions that “the firm must conduct its business with integrity.” Since an institution has no basis for challenging valuation accuracy, assessment of fund manager integrity should be added to an institution’s process for validating the estimate of fair value. This means reading Uniform Application for Investment Advisor Registration reports (Form ADV), searching for damaging information on NASD or SEC Web sites, and reviewing press reports.

Scrutinize Audit Reports and Methodology

In addition to assessing fund manager integrity, management should always request the fund’s annual audit report and determine whether the opinion is unqualified. Another important element of this process is comparing the institution’s statement of value received as of the fund’s year-end to the value based on the fund’s audited financial statements and then following up on significant discrepancies. Although normally determined in the due diligence phase, valuation methodology is something else an institution should ask its fund manager about. For instance, does a third-party administrator independently prepare valuation of the fund’s holdings? How does the administrator value highly non-liquid assets? Answers to these questions help an institution assess the possible risks and reliability of a fund manager’s statement of value. Ultimately, monitoring activities can provide answers about whether and how a fund manager’s methodology has changed.

Even though the fund manager’s statement of value is the most significant component used in determining the value reported in an institution’s financial statements, the institution must build a case for why it believes this statement of value is accurate and correct. The evidence for this assessment of accuracy is generated through the monitoring process. An institution must not completely outsource management’s responsibility for determining fair value but instead should determine and document the monitoring activities being performed. Institution leaders can begin by asking their investment adviser for copies of the firm’s monitoring reviews.

A common question institution leaders may ask is whether the institution can simply avoid the problem by recording alternative investments at cost. This is an optional financial statement presentation allowed within the AICPA Audit and Accounting Guide for Not-for-Profit Organizations. However, the answer will likely be no. An institution still must measure fair value to assess whether an “other than temporary impairment” has occurred.

If an institution’s process for determining fair value is nothing more than waiting for the statement from the manager, that process will likely prove insufficient. Since an auditor can’t rely solely on the confirmation letter for testing fair value, the danger of a scope limitation or qualified opinion exists. How can an institution build an effective case that lends support to the value that an auditor can test? What follows is an approach implemented at the University of Dallas.

Pre-Investment Procedures
Due diligence activities support and validate judgment of an investment’s initial value.
  • Hold face-to-face meetings with the investment firm’s management team.
  • Conduct on-site visits. This includes back-office and operational due diligence—for example, a process for valuation of assets and frequency, tracking trades, monitoring cash movements, reconciliations, and other internal control issues.
  • Evaluate investment strategy, process, and portfolio. Review historical performance and attribution analysis (audited if possible) and valuation procedures.
  • Review key documents: offering memorandum, legal agreements, information requests, audited financial statements, and ADV filings (required SEC disclosures).
  • Evaluate how the specific allocation fits within the asset class and the overall portfolio.
  • Solicit information regarding the team or firm from knowledgeable third parties: investment committee (inform members that a manager is under consideration and request their input), consultants, and competing investment managers.
  • Check references of other investors, investor companies, service providers, and prior employers.
  • Conduct a third-party background check on senior professionals. Verify biographical information, and conduct a criminal background search and press search.
  • Review and negotiate legal agreements.
  • Complete a formal investment memorandum or other investment approval review.
Post-Investment Procedures

Investment manager monitoring activities supplement the fund manager’s periodic statement of value.

  • Conduct regular in-person or phone meetings with the investment firm management team.
  • Conduct an on-site visit. This typically occurs on an annual basis and often substitutes for attending an annual meeting. Many institutions delegate this function to a third-party investment adviser or consultant.
  • Review fund communications. Obtain and review Form ADV, which will disclose criminal and regulatory action disclosures including civil judicial actions. Review other fund communications such as quarterly shareholder letters. Obtain and review audited financial statements. Note whether statements are qualified and any change in the auditor or change in valuation procedures. For drawdown funds, compare partners’ capital statements with internal transaction records.
  • Perform valuation. Request and review, if available, the valuation of portfolio holdings for reasonableness. For custodial assets, reconcile with custodian’s pricing. Request and review any changes to valuation policies and procedures. For hedge funds, receive estimated value from fund and final value from fund administrator, and compare for reasonableness. Compare the institution’s statement of value received as of the fund’s year-end to the value based on the fund’s audited financial statements. Follow up on significant discrepancies.
  • Monitor portfolio performance. Compare performance to benchmark returns if appropriate. Review portfolio holdings on a regular basis. If the investment strategy changes from the original investment approach, conduct a comprehensive review of the manager, team, or strategy.
  • Monitor the firm or manager. Review press reports for significant management, structure, personnel, and portfolio developments. This often includes a search for damaging information from NASD or SEC Web sites. Monitor staffing levels and personnel changes. Monitor size of assets under management in the strategy and firmwide.

Monitoring Alternative Investments at the University of Dallas

Establishing a process for determining fair value of existing alternative investments at the University of Dallas began with developing a checklist based on monitoring activities (see“Post-Investment Procedures” sidebar). The list identified what we needed to do—or more importantly, what we were not doing.

After we set up an official monitoring file for each alternative investment manager, we started thinking about how to fill each file with documented monitoring activities and evidence that an auditor could test. Creating a case of evidence that a fund manager’s statement of value is accurate is time consuming. While our institution is too small to have an investment office, we do engage a professional investment adviser to assist our board endowment committee. I asked our adviser about the monitoring activities performed by the firm and requested documents showing the results of these monitoring activities.

I also contacted our eight alternative fund managers with several questions, including the methodology of each for setting a value on non-liquid holdings or other items for which market quotes are limited. I asked this question in part to determine whether someone independent of the fund manager valued the holdings or determined the net asset value. What I learned was that some of the funds have the portfolio values set by third parties, while others are entirely self-valued by the fund manager or general partner. (This raised a cautionary flag to take a closer look at the latter group.)

I was pleasantly surprised that all eight managers responded to my inquiry. One firm sent an extensive due diligence document along with flow charts regarding its valuation methodologies. Another firm’s chief financial officer called and explained in detail the process for determining fair value and the character of the underlying assets. While most of my valuation questions were actually answered by our investment adviser as part of the initial due diligence process, my separate inquiry produced good information for little effort.

Value Lessons Learned. Funds for which portfolios are self-valued by the fund’s manager imply a greater dependency on the integrity of the firm, its management, and its competency. One helpful source for assessing integrity is Form ADV, which is updated annually. The ADV includes criminal disclosures and violations of SEC rules. The easiest way to retrieve information about a firm’s integrity is from the SEC Web site (www.adviserinfo.sec.gov/iapd/content/search/iapd_orgsearch.aspx). While checking Web sites is not a guaranteed approach, it is a simple activity that an auditor can verify. Another good exercise is to check the primary investment manager by name from the NASD Web site (www.nasdbrokercheck.com). Because an institution’s investment adviser should already be doing this every year as a matter of course, you may be able to eliminate this step entirely by getting the adviser to provide documentation of this review.

Many hedge fund managers are now registered under the Investment Advisor’s Act. This act requires hedge funds to appoint a “compliance officer” and prepare a standard due diligence document that some call their “process and controls memorandum.” I asked each fund manager for a copy of this document, if available. Some managers said this was still under development, but others did provide helpful material.

In my initial inquiry, I also asked for the fund’s most recent audit report. These were not especially helpful for identifying the underlying assets by name, since the report typically lists investments by type, sector, or geographic focus. However, some comfort exists in knowing that an auditor has seen the underlying assets (though that might not be true for an audit report for a fund of funds). Helpful information on valuation policies is often included in the footnotes. These reports also provide share price, return percentages, or other capital information that can be used to verify the accuracy of the periodic statement of value of monies invested by the university with the fund.

Reason to Care. Understanding each fund manager’s specific investment strategy has never been my top priority. Neither have I typically paid much attention to the nature and complexity of underlying assets, in part because those activities always seemed to be “someone else’s job.” However, because an institution’s controller should always maintain keen interest in providing adequate support for any accounting estimate—particularly the value proposed by the fund manager of alternatives investments—I am now compelled to care.

An institution’s investment adviser can be a valuable resource in understanding the risks. For example, in talking with our adviser about one fund manager, I learned that the manager recently started making direct private loans with up to 8 percent of the portfolio. Formerly, this fund manager was in marketable securities, which were not complex and were easy to value. This switch led me to ask more questions, including how the fund manager planned to value these loans since no quoted market price exists. This added complexity made me take a second look at the staff biographies and put a notation regarding competency in the fund manager’s file.

With all this information now filling my monitoring files, I took the final step to write summary reports on each manager. These highlighted the elements I believed would be useful and available for the auditor to test. The entire process to build the case of evidence for fair value took between 40 and 50 hours. The ideal time to complete such a process would be prior to the arrival of an institution’s independent auditors for fieldwork. However, in reality, any time is a good time to begin, since all institutions with alternative investments in their portfolios need to evaluate and document pre- and post-investment procedures.

DALE LARSON is director of finance, University of Dallas.


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