W. Scott Simon
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.
This sharing of profits–that is, the return earned from investing in financial markets–with the manager of an alternative investment is one of the biggest money grabs on Wall Street since the manager doesn’t put up any capital itself. If the manager does well, it takes 20% (or whatever amount) of the profit. But if things don’t work out, the manager can always close down the alternative investment and start a new one that has the same inherent problems inimical to the interests of gullible investors such as many of the fiduciaries responsible for investing money at nonprofits.
This “closing down” could mean that investors in such alternatives lost 100% of the money they invested. It could also mean that they made a tidy profit–less 20% of it as a give-back to the manager. Or it could mean that the investors lost or made relatively meager sums. In all these scenarios, however, such investors have no choice in deciding whether or not to stay in an alternative investment, because it’s the manager that forces that decision by closing down the deal. Such investors are at the mercy of the manager of the alternative investment.
Contrast the foregoing with an investor that makes an investment in a mutual fund, and it then goes south. First, such an investor typically isn’t going to lose 100% of its invested money as it could if it were invested in an alternative investment. Second, it is the investor that has the power to make the decision as to whether or not it will exit the mutual fund.
Third, it’s generally more likely that alternative investments will eventually die (even successful ones) than mutual funds (even though unsuccessful funds are closed down, too, but they are often then merged into more successful funds).
The Joy of Writing Checks When Returns Are Down
Investors–such as fiduciaries responsible for nonprofit pools of money that are invested in alternative investments like private equity and venture capital–seldom have the legal right to turn down a request for additional capital from private equity fund X or venture capital fund Y. After all, a private equity or venture capital fund is a contractual relationship.
Except for fraud or duress, then, an investor in such investments facing a capital call is on the hook to write a check when the alternative fund manager comes a-calling for more dough. It’s unlikely that very many fiduciaries responsible for nonprofit pools of money would knowingly invest in these funds if they knew there was even the remote possibility of being required to pump additional money into them during market downturns.
The Vulnerability of Fiduciaries at Nonprofits
The preceding issues can leave fiduciaries that are responsible for pools of money at nonprofits in a vulnerable position. Such fiduciaries are legally on the hook for the prudence of these investments in their portfolios. They are also legally responsible for the decision- making process that led them to approve such investments in the first place.
The fact is, however, that in most cases the only entity with “standing” to bring suit against nonprofits is the Attorney General of a state. These (usually) elected officials will seldom sue nonprofits, whether or not they wish to ascend to higher political office. This reality of life leads some fiduciaries at nonprofits to merely shrug and say that they, in effect, are legally untouchable for their investment decisions, even the ones that they know make little sense. While this may be a very small minority of fiduciaries, I have heard with my own ears some of them express such sentiments.
Apart from the remote possibility that fiduciaries at nonprofits will ever be held accountable by legal action is the much more immediate possibility that they will be held accountable by community stakeholders such as donors to nonprofits, potential donors, the media, the community at large, et al. After all, nonprofits are in competition with other nonprofits for donations, so those with stellar reputations for the prudence of their investment portfolio will, in most cases, prosper against those with imprudent (e.g., poorly diversified, costly, et al.) portfolios.
Breaking the Psychological Bond Between Advisors and Nonprofit Fiduciaries
Many of the investment advisors to nonprofits would never think of assuming the status of a fiduciary. They just don’t want to be legally on the hook for the prudence of portfolio investments or the prudence of the decision-making process that led the fiduciaries at nonprofits to approve those investments.
Of course, what will be, by far, the greatest challenge for investment advisors seeking to enter and prosper in the world of nonprofits is to break the psychological/emotional bond that often seems to exist between fiduciaries and their advisors. Those fiduciaries usually really like their advisors, but weirdly those they like the most could also be the ones that are the most egregious in leading their charges down the wrong investment path.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.