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Financial Matters
Lawrence Chew
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The risks and rewards of alternative investments
OVER the past several years, organizations in Hawaii have diversified their portfolios with alternative investments.
What are alternative investments? They include, but are not limited to, funds including hedge, private equity, real estate, venture capital, commodity, offshore vehicles, bank common/collective trust, other common and pooled investments and "fund of funds". They may be structured as limited partnerships, limited liability corporations, trusts or corporations.
Alternative investments often offer returns higher than more traditional investments but also come with higher risk.
Also, the market value of alternative investments may be difficult to substantiate due to a lack of transparency. Fund managers may not provide detailed information of the underlying assets, may not disclose side letters addressing preferential redemption agreements and may be tempted to overstate values, since their fees are based upon the fund's performance.
Organizations should define investment policies, including the risks they are willing to take for future rewards and to choose an appropriate mix of traditional and alternative investments. Implementing additional policies, procedures and controls to address risks relating to alternative investments should also be considered.
INITIAL DUE DILIGENCE
Prior to investing in alternative investments, organizations need to conduct extensive, documented due diligence. Here are some initial procedures that should be considered:
» Assess the reputation of the fund managers through background checks and Internet searches.
» Meet with the investment managers and visit their offices to see their operations.
» Request references from other organizations that have invested in these investments.
» Ensure that the investments are audited annually by a reputable, external auditing firm.
» Obtain information on the investment managers' investment strategies, policies and operating procedures.
» Review historical performance and understand the valuation procedures of these alternative investments.
» Obtain copies of documents for the investments under consideration, including offering memorandum, legal agreements and Form ADV (used by advisers to register with the Securities & Exchange Commission as investment advisers).
» Determine whether additional investments will be required as part of a multi-year investment commitment.
» Assess exit strategies to avoid future investments or to liquidate existing investments due to poor performance.
ONGOING MONITORING
Continuous monitoring of alternative investments is critical to help protect the organization from a possible loss.
» Have periodic in-person meetings and conference calls with the investment managers to discuss the status of the investments.
» Read all communications and reports received from the investment managers on a timely basis.
» Obtain annual audited financial statements, related management letters, Statement on Auditing Standards (SAS) 70 reports (a third-party review of internal control), Schedules K-1 and Form ADV.
» Monitor press reports for significant developments relating to these investments.
» Review portfolio holdings and related valuation on a regular basis. For hedge funds, obtain estimated value from the fund and final value from the fund administrator and compare for reasonableness.
Lawrence Chew is a senior manager for Grant Thornton LLP in Honolulu. He can be reached at
Lawrence.Chew@gt.com