If fiduciaries at a nonprofit don't understand how an alternative investment really works, how can they fulfill their duty to protect the interests and contributions of donors?
W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.
As I noted last month, this month's column will delve a bit deeper into alternative investments in nonprofit portfolios and hopefully provide some guidance to advisors seeking to enter the nonprofit marketplace.
Perhaps the first thing that such advisors (and those already toiling in the nonprofit marketplace) should know is that the 2006 Uniform Prudent Management of Institutional Funds Act (UPMIFA) governs the investment conduct of the fiduciaries (e.g., directors and trustees) serving as stewards of the portfolios (e.g., institutional funds) of charitable organizations. UPMIFA also applies to the agents (e.g., investment advisors) to whom these fiduciaries have properly delegated responsibility for investment and management of such portfolios.
The Prefatory Note to UPMIFA makes clear that the 1994 Uniform Prudent Investor Act (UPIA) served as a model for much of UPMIFA--as it did for virtually every other model act that was promulgated to implement standards of modern prudent fiduciary investing in the 1990s and the 2000s. My book, The Prudent Investor Act: A Guide to Understanding, covers this in detail.
Under UPMIFA, "…standards for managing and investing institutional funds are...the same regardless of whether a charitable organization is organized as a trust, as a nonprofit corporation, or as some other entity." Further, "Like UPIA, UPMIFA imposes additional duties on those who manage and invest charitable funds. These duties provide additional protections for charities and also protect the interests of donors who want to see their contributions used wisely." (My emphasis.)
Forty-nine states (Pennsylvania is the lone exception), plus the District of Columbia and the U.S. Virgin Islands, have adopted their respective versions of UPMIFA. UPMIFA applies to a jurisdiction's nonprofits that are in existence on the day its version of UPMIFA was enacted into law and to any decisions made, and actions taken, on that day and thereafter.
A Trio of Foundations
Recently, I ran across a trio of foundations grouped in a tight geographical area, each with portfolio assets in excess of $100 million. All three foundations have retained the same nationally known advisor/investment consultant. When glancing at the FAQs on the website of one of the foundations, I was immediately struck by the excessive investment costs of its portfolio, given its size. It appeared that a lot of work and extra expense has gone into achieving the portfolio's return even though it was rather pedestrian at best. Hmmm, high investment costs and mediocre investment performance: not exactly a good prescription for helping contribute to the goals--the mission statement--of that foundation or the other two foundations that had portfolio asset allocations remarkably similar to the first.
I then looked at the investments in the foundation's portfolio--or rather its asset allocation--since the identity of actual investments are rarely (or never) disclosed. Over 25% of the value of the portfolio was allocated to what are termed "alternative investments."
There are so many definitions of alternative investments that perhaps the most simple will suffice here: An alternative investment is any investment other than "traditional" investments such as cash, bonds, and stocks.
The asset allocation of the foundation portfolio included "hedge funds," "private equity," and "absolute return." More than one commentator has remarked that a hedge fund is a compensation structure (e.g., 2% of the assets paid per year to the manager plus 20% of any profits) in search of an investment strategy. Even though many of the investment strategies employed by hedge funds, private equity, et al., appear to be quite complex (and often impossible for many investors--including board members at nonprofits--to understand), other commentators have noted that a decent mutual fund "leveraged" (i.e., borrowing money to magnify any potential return) by, say, 4-5 times would generate hedge fund-like or private equity-like returns. But such returns are possible only in bull markets.
Of course, what goes up often comes down, as many hedge fund investors found out to their dismay in 2007, 2008, and 2009. In fact, what makes possible outsized gains in bull markets--leveraged money--can turn around and magnify losses for investors in bear markets because they are forced to pay back all the money that was borrowed to help leverage any hoped-for gains.
Here's how one (notorious) trader at Goldman Sachs viewed his leveraged trading activities in an email to a friend: "More and more leverage in the system, The whole building is about to collapse anytime now! Only potential survivor, the fabulous Fab[rice Tourre] standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!"
This email illustrates what seems to be quite clear but which is rarely discussed: Although, as noted, many nonprofit board members find it impossible to understand the complexity of hedge funds, private equity, et al., those who have invented such "monstrosities," and especially those who foist them onto boards, actually have no better understanding. Close questioning of such salespeople by knowledgeable independent third parties brought in by boards during the sales process reveals that, beneath their polished surface, salespeople often have very little understanding of any aspect of alternative investments.
The use of leverage can compel investors to sell investments--due to margin calls--they'd rather not sell at times they'd rather not sell them, resulting in low prices. Selling low (and buying high on the upside) is not a good way to accumulate money to fund the implementation of a nonprofit's mission statement. In addition to often being quite costly, then, many alternative investments can be very risky as a result of the considerable leverage they carry.
Many alternatives can also be difficult to value and therefore are often illiquid. Of the over 25% of the value of the foundation's portfolio that was allocated to alternative investments, about one-quarter of that amount appeared to be illiquid--or "locked-up" in alternative investments-speak. An alternative investment (indeed, even any non-alternative investment) becomes illiquid when there is no secondary market by which it can be valued and traded.
In the absence of a current fair market value (FMV) for an alternative investment, its "worth" simply becomes the FMV at which it was purchased. In such cases, the FMV of the alternative is carried over from period to period with no real way to determine the current FMV until liquidation of the alternative, which sometimes could be years into the future. There are often only two times when an alternative investment is valued: when it's first purchased--with that purchase price serving as a continuing placeholder by which the alternative is valued--and when it's eventually liquidated, at which point a new FMV is revealed (which could even be zero).
All nonprofits, including the three foundations I reviewed, are in competition for donor contributions. A portfolio with a significant portion of its assets that are perceived by some potential donors to be "not working" (e.g., locked-up alternative investments) may be seen as a problem of mismanagement, incompetence, or inefficiency. That portion of the portfolio becomes a sort of "dead zone" that is unavailable for investing and return generation and that can't otherwise be liquidated and used to fund worthy local charitable causes. My emphasis, as noted above, of the language in the Prefatory Note to UPMIFA is instructive here: Fiduciaries responsible for managing and investing charitable funds must help "protect the interests of donors who want to see their contributions used wisely."
Of course, it may be that such investments are actually "working" just fine but maybe not in an efficient and/or a transparent way. And that's the problem: It's probable that no one at a nonprofit in such cases knows how the alternative investments are really doing.
But even when alternative investments are actually working, are they worth their higher added cost? The value of the alternative investments is certainly working for their managers and even perhaps for the foundation's advisor/investment consultant. And yet academic studies and empirical evidence have shown that the compensation structures of alternative investments often outweigh any potential advantages they may bring to portfolios, including those at nonprofits.