Investments in private equity, venture capital, and certain other ‘alternative’ investments can leave fiduciaries at nonprofits in a vulnerable position.
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.
This month’s column will conclude my discussion of nonprofits and alternative investments (for now), with a few observations.
Perhaps the best definition of an “alternative investment,” as noted in a previous column, is any investment other than a “traditional” investment such as cash, stocks, or bonds. This definition would include, for example, hedge funds, private equity, and absolute return “strategies.”
The Compensation Structure of an Alternative Investment
It is sometimes said that an alternative investment such as a hedge fund is a compensation structure in search of an investment strategy. What is that compensation structure? Typically, it is equal to 2% of the amount of the assets managed by a hedge fund manager plus 20% of any profits earned by the hedge fund on an annual basis.
Many alternative investments are not traded in any financial market, so they are essentially impossible to value. In short, they are illiquid. This often means that their fair market value (FMV), which would otherwise be established through the price discovery process in a free and fair financial market, is, in effect, “frozen in time.” Such alternative investments are valued only at the time of their purchase and remain at that value until the life of the alternative expires.
But even in cases where the FMV of an alternative investment is frozen (or “locked-up” in the vernacular of the alternative investments industry) and its FMV enters a state of “suspended animation,” its manager often continues to collect ongoing compensation (e.g., 2% per year of FMV)--regardless of the actual FMV of the alternative currently. Since there’s no market to set the FMV of the alternative, though, there’s no way to find out currently the “actual” FMV of the alternative.
Nonetheless, that no-way-to-really-determine FMV becomes the yardstick by which many managers continue to collect their fees, and profits (or losses) are eventually gauged; it’s as if the FMV never fluctuates. Those expensive advisory and management fees are often locked up at the time of purchase in a frozen FMV. As a result, the manager of an alternative investment will continue to collect its 2% annual fee based on the frozen FMV, even though it’s possible that the FMV of the alternative is something less than the FMV--maybe even zero. In contrast, when the FMV of the assets managed by my registered investment advisory firm goes down by, say, 25%, our fee goes down in the same amount.
Some may retort that the “actual” FMV of the alternative could be more than its locked-up FMV, so the manager could actually be missing out on some of its just fee. Even where that may be true (yet unknowable), it’s useful to keep in mind that the manager will still be reaping 20% of the profit at the end of the life of the alternative should it liquidate at a profit.