©2007 International Foundation of Employee Benefit Plans
Pension plan investment consultants recommend allocations to private equity and/or hedge funds with increasing frequency. Not surprisingly, the number of pension plans investing in these “alternative” asset classes is on the rise. In fact, it is now commonplace for pension funds to invest in alternatives, and the amount of investor dollars flowing into these asset classes has increased dramatically in recent years. This is largely because of a variety of incentives and potential advantages, including the promise of higher returns, additional diversification, and the possibility of reduced overall portfolio volatility and risk. The purpose of this article is to outline the key legal differences between investing in alternatives and investing in more traditional asset classes using an investment manager.
Simply put, investing in alternatives is not the same as traditional investing in stocks and bonds.
Before pension plan trustees decide to invest plan assets in alternative investments, it is essential that they understand the differences in the legal structure of alternative investing and the differences in the legal risks and trustee responsibilities associated with these types of investments. There has been an increase in media and regulatory attention paid to these alternative asset classes, including published concerns about lack of regulation, hedge fund failure rates and a variety of other issues.
The primary legal differences with investing in alternatives can be summarized as follows:
Alternative investments generally involve “direct” investing by the trustees in securities, usually interests in a partnership or limited liability corporation (LLC). This means the trustees are directly responsible for the due diligence and investigation on the investment decision.
With the exception of fund-of-funds investing, discussed in detail below, alternative investments often do not involve the hiring of an investment manager to make investment decisions, which means the trustees are not insulated from liability in the same way as with the traditional approach of hiring an investment manager who has the discretion to buy stocks and/or bonds.
Alternatives often involve investing in underlying entities or securities that are not publicly traded, are not subject to direct Securities and Exchange Commission (SEC) registration or regulation, and are not typical securities many pension plans have held in the past. (For example, hedge funds often hold derivatives.)
The alternative investments often are not liquid (particularly as to private equity).
With the exception of fund-of-funds investments, when using alternative investments the general partner of a partnership usually will not act as an Employee Retirement Income Security Act of 1974 (ERISA) investment manager and will not acknowledge fiduciary status under ERISA. (As previously noted, a fund-of-funds manager will often agree to be an ERISA investment manager.)
Alternatives generally involve lengthy and complex investment documents on which there is little room to negotiate. These documents often contain provisions that pension plan counsel typically try to avoid, such as extensive indemnities, limitations on liability, representations by the plan, and unfavorable governing law and jurisdiction provisions.
The fees are often significantly higher than with traditional investments, and the general partner (or equivalent) often has the right to participate in profits generated.
Alternatives are more difficult to monitor as to both investment returns and compliance with policy guidelines. This is especially true given the long time horizons for returns that can be required for private equity funds. In the case of hedge funds, the underlying investments can be complex financial instruments, and there can be limitations on how much information the hedge fund manager will provide about the underlying investments (i.e., a lack of transparency).
Alternatives can raise issues under ERISA’s plan asset regulations and can create unrelated business taxable income (UBTI) for the plan.
Because of the differences listed above, trustees of pension funds should make certain they have a clear understanding of how these investments work, as well as the resulting risks and responsibilities. This is the best way to ensure that the investment will be done “right” and in full accordance with ERISA’s fiduciary standards. The authors of this article want to emphasize that they are not making an investment recommendation—one way or the other—as to whether trustees of pension plans should invest in alternatives. The decision about investing in alternatives must be made by the trustees based on their investment objectives, the facts and circumstances confronting their plan, and the recommendations of their investment advisors and consultants.
The remainder of this article is structured in a question-and-answer format in the hope of making complex issues more understandable.
The term alternative investments generally refers to investments in private equity, hedge funds or a fund of funds. Brief definitions of each appear here:
Private equity—Private equity describes several strategies for investing in nonpublic securities. Some of the most common strategies include (1) distressed debt investing (purchasing equity of established private companies that have taken on too much debt), (2) leveraged buyouts (involving acquisition of a company using mostly debt and little equity), (3) venture capital financing (investing in new businesses), (4) growth capital (a flexible type of financing used to provide additional capital to existing companies), and (5) mezzanine financing (a blend of traditional private debt financing and private equity financing). It is important to note that the key element in all of these investment strategies is that the securities to be purchased are not publicly traded. This means that investments in private equity are illiquid, and the investor may be required to hold this type of investment for a long period of time, extending to five to ten years, or more.
Hedge fund—A hedge fund is a privately organized, pooled investment vehicle that employs sophisticated investment techniques to trade in a variety of corporate and other securities. Hedge funds are attractive to large investors because these investment vehicles are able to use more aggressive investment strategies than are normally available to traditional mutual funds, such as engaging in arbitrage, taking long and short positions, and otherwise investing in securities that pension funds do not normally hold, such as futures, derivatives, options, etc. Hedge fund general partners or managers are usually not ERISA-qualified “investment managers.”
Fund of funds—A fund of funds is a fund that includes a variety of individual hedge funds. The intent of a fund of funds is to limit the risk normally associated with investing with any one hedge fund manager or in any one type of hedge fund strategy by spreading the investments over several different managers and types of investment strategies. This form of investment is also intended to provide a more consistent return than an investor would expect to receive had he or she invested in any of the underlying hedge funds individually. A fund of funds is managed by a fund-of-funds manager. This manager is quite often an investment manager (as that term is defined under ERISA) who agrees to be an ERISA fiduciary with regard to plan assets that are invested in the fund of funds.
There are three main ways in which a plan may invest in alternatives:
From a legal standpoint, it may be somewhat safer to use an investment manager or fund-of-funds approach, but the tradeoff is the added expense of the fund-of-funds manager. Regardless of the approach selected, it is essential for the trustees to make certain they understand which investment approach is being used for each hedge fund or private equity investment, especially since the approach will define to a large extent the nature of their risks and responsibilities for the investment.
Yes. ERISA does not direct that trustees of pension plans use any particular approach or method for investing assets and does not expressly authorize or prohibit any specific kind of investment. Trustees are free to make investment decisions subject only to the general fiduciary responsibility and prohibited transaction provisions of ERISA. Many multiemployer plans and large single employer plans are investing in alternatives.
There is at least one important case involving a breach of fiduciary duty in the context of hedge fund investing, but that case focused on mistakes made by the trustees in the decision process and did not hold that investments in hedge funds were otherwise improper in any way. See Harley v. Minnesota Mining and Manufacturing Company, 42 F.Supp. 2d 898 (D.Minn. 1999). The court basically said that trustees are permitted to invest in hedge funds, but they must ensure that it is done right. This case is discussed in more detail below.
Although investing in alternatives is permitted under ERISA, pension plan trustees should review their plan documents and statement of investment policy guidelines to make certain they do not prohibit investing in hedge funds, funds of funds, private equity funds or other alternative investment arrangements and that they do not otherwise prohibit investments in specific assets that may be held by these funds (such as derivatives). Trustees should ensure that the plan’s investment consultant has determined an appropriate allocation percentage for each alternative investment in light of the type of investment and the risks presented.
Generally, under ERISA, a trustee may only delegate investment responsibilities to manage, acquire or dispose of assets to an investment manager (ERISA §402(a)(2), §403(c)(3)). Investment manager means any fiduciary who has the discretionary power to buy and sell assets, who is registered as an investment advisor under the Investment Advisers Act of 1940 (or is a bank or insurance company) and who has acknowledged fiduciary status in writing (ERISA §3(38)). As noted above, almost all managers of alternative investments refuse to acknowledge fiduciary status under ERISA and do not otherwise qualify as investment managers (with the very important exception of fund-of-funds managers for hedge funds).
When a plan trustee properly delegates authority to an ERISA investment manager for a portion of the plan’s assets, the plan trustee has no further responsibility for choosing investments with regard to those plan assets or otherwise managing the assets and incurs no liability for the acts or omissions of the investment manager (ERISA §405(d)(1)). This provision of ERISA can relieve the trustees of considerable risk and liability exposure in connection with plan investment decisions. But, a trustee must still prudently engage and monitor the investment manager. See Harris Trust and Savings Bank v. Salomon Brothers, Inc., 832 F.Supp. 1169 (N.D.Ill. 1993).
However, a trustee who invests in an alternative investment vehicle remains responsible for the decision to acquire an interest in the alternative investment vehicle and the decision to retain the investment over time and is not insulated under ERISA from liability for those decisions. As noted above, however, trustees generally are not responsible for the underlying investment decisions made by the manager or general partner of a hedge fund or private equity fund. But this can be a complex issue that depends largely on an analysis of ERISA’s plan asset regulations.
When making a direct investment in a hedge fund or private equity fund, pension plan trustees are required to undertake an appropriate investigation and due diligence and are otherwise subject to ERISA’s trustee duties of prudence, exclusive benefit, diversification, etc.4 In conducting their due diligence, trustees may take into consideration advice given by attorneys, bankers, consultants, brokers and other experts. A trustee is not justified, however, in relying wholly upon the advice of others, since it is his or her duty to exercise judgment in light of the information and advice that he or she receives. See Donovan v. Mazzola, 716 F.2d 1226 (9th Cir. 1983).
In making investment decisions, especially in connection with alternative investments, it is important to note that a trustee’s lack of familiarity with investments is no excuse; under an objective standard trustees are to be judged “according to the standards of others ‘acting in a like capacity and familiar with such matter.’” See Katsaros v. Cody, 744 F.2d 270 (2nd Cir. 1984). When applying the prudence rule, the primary question is whether the fiduciaries, “at the time they engaged in the challenged transactions, employed the appropriate methods to investigate the merits of the investments and to structure the investment.” See California Ironworkers et al. v. Loomis Sayles et al., 259 F.3d 1036 (9th Cir. 2001); Donovan, as above.
Perhaps the most important illustration of these principles in the alternative investment context occurred in Harley v. Minnesota Mining and Manufacturing Company, as mentioned above. There, a federal district court found that trustees of a company plan had breached their duty by investing in a hedge fund that ended up losing money on collateralized mortgage obligations. The evidence in that case showed that:
No staff person for the company/plan had the expertise to investigate and evaluate a hedge fund investment.
Plan fiduciaries had an obligation to seek independent advice but failed to do so. (In other words, the trustees did not use a professional investment consultant to review and recommend the investment.)
The plan fiduciaries did not read the private placement memorandum, conducted no background check on the fund’s general partner, did not identify and independently analyze the risks associated with the investment strategy and did not follow their own policy of reviewing the investment manager anew when a key employee at the manager changed.
The staff person for plan investments presented the decision to the plan investment committee that authorized the investment after only a brief discussion and under circumstances for which the investment committee members later stated that they did not understand the materials and issues presented.
The Harley case presents a clear-cut illustration of the things to avoid when investing in a hedge fund. Ultimately, as with the selection of any service provider, what constitutes an appropriate method of selecting an investment manager will depend upon the particular facts and circumstances in each case. See DOL Letter to Diana Orantes, 1998 ERISA Lexis 6 (1998). Neither Congress nor the Department of Labor (DOL) has promulgated a universal set of prudence criteria, and there is no formal set of steps that must be followed in every case. The due diligence and investigation must be designed for the type of investment and the investment manager under consideration.
Yes, in part. Reliance on the advice of an investment professional can be an important element of trustee prudence and, as noted above, it is strongly recommended that trustees use an investment consultant or performance monitor whenever possible when investing plan assets (particularly when hedge funds, private equity, real estate or other alternative investments are involved). In fact, fiduciaries may have an obligation to turn to experts when they do not have the relevant underlying expertise (for example, in analyzing a complex hedge fund investment). But, reliance on expert investment advice does not insulate the trustees from liability and does not relieve them of their obligation to exercise appropriate scrutiny and otherwise act prudently in making the decision. This can sometimes be a difficult task when investing in alternative investment arrangements, given their complexity and variety.
It should be noted that this result is not changed by the fact that an investment consultant acknowledges his or her fiduciary status or that the trustees attempt to grant to the investment consultant the discretion to select an investment fund or investment manager without further trustee input.
There are a number of other issues that trustees should consider when investing through alternative investments that are structured as partnerships or LLCs, which is how many alternative investments are structured. Although most of these issues are beyond the scope of this article, there are two issues in particular that are worth noting.
First, pension plan trustees will need to pay close attention to ERISA’s plan asset regulations (DOL Regulations §2510.3-101). These regulations are complicated but are basically intended to define what exactly constitutes the assets of the plan—the security bought by the plan (such as stock or a bond) or the assets of the underlying entity. The DOL regulations create a special look-through rule that applies to investments in certain LLCs, pooled funds and partnerships. This means that the underlying assets of these LLCs, funds and partnerships are considered plan assets subject to ERISA’s fiduciary rules. This look-through rule does not apply, however, to mutual funds or to the ownership of stock in a corporation. Because investments in alternatives almost always involve limited partnerships, LLCs or other noncorporate entities, the look-through rule is an issue that must be dealt with.
There are two main exceptions to the “look-through rule” that are important in the context of alternative investments: (a) investments in pooled funds that have less than 25% of their value held by benefit plan investors and (b) investments in entities that are considered to be operating companies such as venture capital operating companies (VCOCs) or real estate operating companies (REOCs). If an alternative investment partnership or fund does not meet one of the above exceptions, the partnership’s or fund’s assets will be considered plan assets, and the individuals or entities who manage the fund (such as the general partner of a partnership) automatically will be considered fiduciaries under ERISA. This will, in turn, create a number of serious legal problems for the partnership or LLC, since all of ERISA’s fiduciary responsibility and prohibited transaction provisions would apply to the general partner or manager in its dealings with the partnership. This would make it difficult to continue operating the fund as originally intended.
As a practical matter, since the individuals who manage private equity or hedge fund partnerships or LLCs do not want to be ERISA fiduciaries subject to ERISA’s fiduciary duties, most partnerships and funds (other than a fund of funds) are careful to structure themselves to come within one of the above exceptions. Specifically, most of these partnerships and funds provide that they will either (a) qualify as a VCOC or (b) not allow more than 25% pension fund investment. Because of the serious repercussions if the underlying assets of these alternative investments are considered plan assets, plan trustees and their investment consultant should closely review and monitor these investments to make sure that they initially meet and continue to meet one of these exceptions to the plan asset rules.
Second, pension plan trustees should be aware that investing in alternatives can sometimes create taxable income to the plan known as unrelated business taxable income (UBTI). In general, UBTI means the gross income derived from any “unrelated trade or business” regularly carried on by the plan (or by a partnership in which the plan invests), less any deductions directly connected with such trade or business. The structure of the entity in which the plan invests can determine whether or not UBTI is triggered. Although dealing with UBTI can be an inconvenience and can create some minor additional administrative and accounting issues (such as the need to file a return), it is generally not a serious enough issue to cause trustees to avoid an investment that would otherwise be desirable. Also, most alternative investments are structured to limit or avoid UBTI or, in the alternative, offer tax-exempt entities the option of investing in the alternative investment through an offshore corporation or partnership that is structured to block UBTI.
When making decisions about alternative investments, pension fund trustees must be equipped with an understanding of the fundamental differences between traditional investing using an investment manager and the direct investment in limited partnerships, LLCs or other interests in hedge fund or private equity investments. Once trustees and their advisors understand these differences, they will be better positioned to evaluate the legal risks and rewards of alternatives and to conduct the type of due diligence required under ERISA’s fiduciary responsibility rules. As with any investment, pension plan trustees should consult their investment consultant, attorneys and other advisors before considering investing plan assets in alternative investments. B&C
Mitchel D. Whitehead is a partner in the Los Angeles office of Seyfarth Shaw, with over 25 years of experience advising clients with respect to ERISA and fiduciary issues. His practice is focused on the representation of large governmental retirement systems and multiemployer pension and health and welfare funds. Whitehead received his law degree from Loyola University School of Law and a bachelor’s degree from the University of California at Riverside.
Carrie J. Grove is a senior associate in the employee benefits group of Seyfarth Shaw in Los Angeles. Her practice focuses on multiemployer pension and benefit plans and includes the areas of fiduciary responsibility, benefit claims, prohibited transactions, agreements with third-party providers, and withdrawal liability and merger and spinoff issues. Grove received her law degree from the University of California Hastings College of the Law in 1998 and a bachelor’s degree from California Polytechnic State University– Pomona.
For information on ordering reprints of this article, or to subscribe, call (888) 334-3327, option 4.