Alternative Investments

AICPA Employee Benefits Audit Conference December 7-8, 2006 John Hubbe, Partner, KPMG Peggy Bradley, Vice President, Northern Trust

Recent Developments
Major melt down of a number of hedge funds Long Term Capital, Bayou Investments Increase scrutiny and questions by various government bodies and regulators including US Congress, Federal Reserve and SEC July, 2005 AICPA issues two audit interpretations challenging general practice related to investors in alternative investments Auditors of Not for Profits, Fund of Funds and Pension Plans freak out ! Auditors of said industries discuss issues with clients Clients freak out 2006 AICPA creates a task force May, 2006, John & Peggy speak at AICPA employee benefit conference July, 2006, AICPA Issues a practice aid 2006 Auditors, clients continue and now audit committees freak out December, 2006, John & Peggy speak again at AICPA conference

Limited Scope Audits

Full Scope Audit Results: Testing of alternative asset values reflected on trustee statements for full scope audits indicated that trustee reporting has limitations. Plans subjected to Limited Scope audits would reasonably have the same pricing challenges. Trustee Certifications: Limitations of trustee certifications emerged as auditors pushed for certification or confirmation of fair value. Popularity of Asset Class: Alternative asset investing by EB plan sponsors continues to increase, thus increasing the valuation risks.

Session Objective
Explore the issues that have emerged related to the audit of alternative investments:
Limited Scope Audits and Trustee Certification: A refresher Alternatives What are they? Audit Guidance: Why are limited scope audits receiving attention? What current guidance applies to the auditing of alternative investments? Recommendations: What audit procedures can you employ to ensure that the audit of these investments is meaningful?

Limited Scope Audits

Although the auditor is not required to audit certain investment information when the limited-scope audit exception is applicable, further investigation and testing are required whenever the auditor becomes aware that such information is incorrect, incomplete, or otherwise unsatisfactory for the purpose of preparing financial statements.

Trustee Certification

Best Available vs. Fair Value? What are the limitations?

Basis of Trustee Certifications: what the regs say

a listing of all transactions of the separate trust and, upon request of the plan administrator, such information as is contained within the ordinary business records of the bank, trust company, or similar institution and is needed by the plan administrator to comply with the requirements of section 104(a)(1) of the Act and Sec. 2520.104a-5

Trustees Ordinary Business Records

Includes Core Custody Service Records:
Holding cash & securities Settling trades Collecting income Gathering prices from readily-obtainable sources Providing reports that reflect activity flowing through the trust

Does not usually include Trustees Ancillary Services:

Performance Reporting Investment Management Services Investment Consulting Services Investment Oversight & Risk Monitoring Services

Also does not usually include valuation services.

Custodial vs. Valuation Services

Custody Pricing Service
Reflects asset prices that are: Obtained from reliable, industryrecognized, and independent sources, whenever possible; Scrubbed to ensure prices received from vendors fall within reasonable tolerances; Compared to other vendor prices, whenever possible; Applied accurately to custodial asset file, to ensure consistent price for all holders of the asset. For Alternative Assets: value received directly from issuer or investment mgr., if independent source is not available

Valuation Service
Provides extensive analysis of an individual investment: Analysis of partnership cash flows; predictions of market variables Utilization of industry specialists or experts Determination of mgmts competency Details of Assets & Liabilities of fund, or other proprietary information Requires confidentiality agreement Based on information not normally provided to custodian:

Trustees Alternative Asset Values: Where do they come from?

Periodic statements, such as a capital account balance statement, provided by the fund manager or GP, received 30 180 days after period end Reviewed to ensure that plans cash flows in/out of trust match the fund managers stmt. Income and expense entries reported by fund manager may be shadowed on trust stmt. Trustees are not likely to be recipients of audited fund company financial statements: clients receive them!

Trustees Alternative Asset Values: Valuation Methods Adjusted Valuation Method Lagged Valuation Method Client-Specific Method

Trustees Alternative Asset Values: Valuation Methods

Adjusted Valuation Method:
Current period values are based on prior period ending value, plus or minus any subsequent activity that the trustee was notified of, and thus, posted to the trust account. Current period adjusted values are subsequently reconciled to fund managers statement for same period, once statement is received from fund manager.

Trustees Alternative Asset Values: Valuation Methods

Lagged Valuation Method:

Current period values are based on latest values received from fund manager (which could lag from 30 to 180 days). No adjustments are made for current period contribution or withdrawal activity (may see pending settlement activity elsewhere in trustee statement).

Trustees Alternative Asset Values: Valuation Methods

Client-Specific Method:
Client may direct trustee to utilize other specified price (e.g., investment committee price, or investment managers price). May apply to one, some, or all of the clients alternative assets within the trust account. May be flagged as Client-Priced or ManagerPriced asset on trustee statement.

Adjusted Valuation Method: Sample Report

Manager-Priced Assets: Sample Report

Other Assets That Typically Might Be Priced using Best Available Price
Assets Held Elsewhere Assets reported via a shadow accounting or report only arrangements Short Sells and other arrangements where transactions are conducted through broker accounts, and reflected at a total account level on the trustees books

Trustee Certification Considerations

Custodians can devote substantial resources to ensure the integrity and reasonableness of pricing data received from selective pricing sources. But does that equate to ensuring fair value in every case? Can best available actually be fair value? Whose role is it to determine this: the plan sponsors? the trustee? the auditor? Definition of Fair Value: what a willing buyer and seller would agree upon. How do you determine fair value for an asset that is not traded or is illiquid? Does a 90-180 day-old price on a custodial statement necessarily mean it is not a fair value? Are all alternative assets hard-to-value assets? Should HTVAs based on best available prices be excluded from trustee certification?

Alternative Asset Types

Alternative Investment Types: Discussion Topics

Private Equity vs. Hedge Funds Strategies Fund-of-Funds Structure Investment Legal Structure vs. Strategy Other Investment Types & Characteristics
Common/Collective Funds Pooled Separate Accounts 103-12 Entities Pooled Separate Accounts Unit Investment Trusts REITs Commodities, Mineral Rights

Identifying Alternative Assets: What Type of Fund Is It?

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Private Equity vs. Hedge Fund

Private Equity Fund
Illiquid investment in private companies, with long-term commitments (e.g.,10 years). Direct Investments: evidenced by equity, or subordinated debt security. Indirect Investments: commingled investment fund (venture cap, buy-out, mezzanine, distressed, or special situation funds, or fund-of-funds structure). Valuation is challenging because no secondary market exists; true values may not become apparent until company goes public. Fund Manager may be more than willing to share investment list, but the list is of limited use because investments are not made in marketable securities.

Hedge Fund
Investment in marketable securities, designed to exploit inefficiencies in the market. Funds may be market-driven, market-independent or eventdriven. Strategy may include taking long or short positions (puts & calls), or leveraging via use of futures or options. Funds can be more readily market-priced, since underlying investments are marketable securities. Many hedge fund managers are not willing to share the details of underlying fund holdings with outside parties on a timely basis.

Fund of Funds
A fund which invests in several unrelated funds, rather than trading assets itself. Can give investors exposure to multiple strategies, without the high costs and extensive research required to invest in these funds individually. May be Fund of Hedge Funds, or Fund of Private Equity Funds, or hybrid Fund-of-Funds Manager performs due diligence & monitors separatelymanaged fund accounts to ensure compliance with stated investment objectives. When the custodial bank is the Fund-of-Funds Manager, they may also serve as custodian of the separately-managed portfolios, thereby giving them direct access to underlying securities detail.

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Fund Structure
Could be a Master/Feeder structure: Master Fund - closed-end privately offered fund of funds registered under the Investment Company Act of 1940 Feeder Fund - Offshore Unit Trust Feeder Fund 20-25 underlying sub-funds

Multiple Investment Strategies

Hedged Equity
U.S. Equity Hedge Non-U.S. Equity Hedge Equity Market Neutral

Market Independent
Convertible Bond Arbitrage Fixed Income Arbitrage Relative Value Arbitrage

Event Driven
Distressed Securities Merger Arbitrage Special Situations

Market Dependent
Emerging Markets Global Macro Short Selling

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Example of Sub Funds

Equity Market Neutral
O'Connor Global Fundamental Long/Short, LLC

Fixed Income Arbitrage

Burnaby Catastrophe Fund, L.P. Carrington Investment Partners (US), L.P. Nephila Catastrophe Fund, L.P.

Emerging Markets
Everest Capital Frontier, L.P.

Types of Reporting to Investors

Monthly capital balance statements * Monthly return estimates Monthly aggregate summary exposure reports Quarterly investment commentary, sub-fund return analysis, and peer group comparison Semi-annual financial statements and annual audited financial statements
* Only report received by trustee bank

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Common and Collective Funds

Commingled investment funds sponsored by a trust company or bank with trust powers; Participating entities share same tax status (e.g, cannot commingle EB assets with personal trust assets; H&W plans are not eligible to participate in Collective Trusts must appoint bank as trustee and invest in Common Fund) Regulated by the OCC; Can be valued daily, weekly, or monthly; Security description would include references such as, Common Coltv Collective Tr; NAVs are not published; however, SAS70 usually covers CCT operations. Audited financial statements required at least annually.

Pooled Separate Accounts

Like commingled investment funds but sponsored by an insurance company; On the balance sheet of the insurance company Regulated by the state insurance departments; Can be valued daily, weekly, or monthly; Security description would include references such as, PSA Confusion might not be identified as PSA on statement (in the case of a PSA that holds one asset; NAVs are not published; however, SAS70 usually covers PSA operations. Audited financial statements not always available

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103-12 Entities
Commingled investment vehicle electing to file 5500 on behalf of participating trusts/ plans Includes Group Trusts, Delaware Business Trusts, LLC or LP Funds, Business Development Corporations Participating entities (investors) are unrelated Compelling reason to file a 5500 to provide fund look-through relief for EB plans Required to submit audited financials w/5500s NAVs/prices are not published May also have a SAS70

Unit Investment Trusts

A company that purchases securities (usually fixed income) and sells shares representing proportional interest in the portfolio of those securities. The trust is normally liquidated when the securities mature. Not subject to US filing requirements.

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REIT:
Company owning, and oftentimes operating, income-producing real estate such as apartments, shopping centers, offices, or other properties, or engaging in the financing of real estate. Characteristics Files w/SEC Shares trade on national exchange Files w/SEC Shares do not trade on national exchange Not registered w/SEC Invests in REITs

Types: Publicly-Traded

Non-Exchange Traded

Private REIT Mutual Fund or Hedge Fund

Investment Legal Structure vs. Strategy

Examples of Legal Structure (not asset class!)
Limited Partnership Limited Liability Co. Joint Venture Collective Trust or Common Trust Funds Group Trust, Delaware Business Trust, Business Development Company (103-12 entities) Registered Investment Company (Mutual Fund) Pooled Separate Account

Legal Structure will tell you something about what types of regulatory oversight and financial reporting may be required.

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Custody Reporting: How to Identify Alternative Assets

Examples ACACIA CREDIT FUND 11-A LLC - SUBORDINATED NOTES AGGRESSIVE FOUNDRY FUND AIG ASIAN INFRASTRUCTURE FD II BEAR SAINT / BELLEVUE - A/S WASHING DN PARTNERS GEOLOGIC RESOURCE FUND GUGGENHEIM AVIATION INVESTMENT FUND GUGGENHEIM AVIATION OFFSHORE INVESTMENT FUND GUGGENHEIM PLUS II GUGGENHEIM REIT FUND GUGGENHEIM STRUCTURED REAL ESTATE II HBK FUND MEDIA/COMMUNICATIONS PARTNERS II MEMPHIS BIOMED VENTURES I NATURAL GAS PARTNERS V NUMERIC JAPANESE MARKET NEUTRAL EQUITIZED ONSHORE FUND II PERMIRA U.K. III [fmrly SCHRODER UK BUYOUT FD III] PRIVATE ADVISORS DISTRESSED OPPORTUNITIES FUND, LP PRIVATE ADVISORS HEDGED EQUITY FD (QP) LP YIPPEE INVESTMENTS LLC

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Identifying Alt Assets: What Type of Fund is it?

Security Description Clues: CCT, DBT, Fund I, Trust, LP, Unit Trust 5500: Schedule H segregates assets by legal structure; Schedule of Assets Held may also be sorted by legal structure FreeERISA.com: Locate 5500 DFE filings submitted by the Fund. How did the fund classify itself (E for 103-12; C for Common or Collective Trust, etc)? Required DFE Notice: Ask plan sponsor (usually the investment committee contact) for copies of notices.

What Type of Fund Is It?

Sample Required DFE 5500 Filing Notification Letter for CCT
,,,We further certify that a filing pursuant to DOL regulation section 2520.103-9(c) will be made for each of the collective trust funds identified below, on or before the filing due date, in accordance with the Form 5500 instructions. Please note that you will need to list the names of the relevant collective funds on Part I of Schedule D of the 5500 for the plan (or the 5500 for the master trust investment account, if applicable) that owns an interest in the funds. In addition, you will need to identify The Northern Trust Company, as sponsor of each fund, as well as the funds Employer Identification Number, or "EIN" (see below). Schedule D also requires that you include the proper entity code ("C", for common or collective trust) and the dollar value of the interest in the fund as of the end of the year. The EIN for the collective trust fund is as follows: Collective Trust Fund Name Collective Short-Term Investment Fund Employer ID# 36-6036794-001

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Identifying Alternative Investments: Where to go next?

Additional Sources of Information:
Investment Manager Appointments: who are the Alternative Asset Managers? Investment Policy Guidelines: what types of investments are even permissible? Trust Structure: are all LPs held within the same account? Request individual account statements, in addition to consolidated trust statements

Audit & Accounting Guidance

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AICPA Guidance: Auditing HTVAs

AU section 332, Auditing Derivative Investments, Hedging Activities, and Investments in Securities (AICPA, Professional Standards, vol. 1).
Interpretation No. 1, Auditing Investments in Securities Where a Readily Determinable Fair Value Does Not Exist, of AU section 332

AU section 328, Auditing Fair Value Measurements and Disclosures (AICPA, Professional Standards, vol. 1) ALTERNATIVE INVESTMENTS AUDIT CONSIDERATIONS: A PRACTICE AID FOR AUDITORS

2005 Auditing Interpretations

What are Auditing Interpretations?
Recommendations on the application of SASs in specific circumstances Issued under the authority of the ASB Q&A format If the auditor does not apply the auditing guidance included in an Interpretation, the auditor must explain how he or she complied with the SAS guidance.

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Interpretation 328 & 332

The Interpretation to AU 328 and 332 answers the following question:
In circumstances in which the auditor determines that the nature and extent of auditing procedures should include verifying the existence and testing the measurement of investments held by a trust, does receiving a confirmation from the trustee, either in aggregate or on an investment-by-investment basis, constitute adequate audit evidence with respect to the existence assertion and auditing fair value measurements in accordance with SAS 92 and Section 328, Auditing Fair Value Measurements and Disclosures?

Confirmation & Valuation

Simply receiving a confirmation from the trustee, either in aggregate or on an investment-by-investment basis, does not in and of itself constitute adequate audit evidence with respect to the valuation assertion.

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Audit Requirements
SAS 101 requires the auditor to:
Obtain evidence regarding GAAP Understand the entitys processes and controls Understand managements significant assumptions Evaluate managements ability and intent Evaluate the appropriateness of the method Evaluate the consistency of the application of the method Consider the use of a specialist Test fair value measurements and disclosures Communicate sensitive fair value estimates to the audit committee

Existence
Confirm Plans interest in the Fund (number of units or percentage interest) and the value of the Plans proportionate share of the Fund (capital account balance) Since just confirming in aggregate may not be sufficient, confirm existence of investments and holdings on a security by security basis Refer to Practice Aid for a sample confirmation letter

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Alternative Procedures
Observe manager site visits or calls (or documentation of such calls Review Partnership agreements Inspect other documents supporting Plans interest in the Fund Review periodic statements from Fund Vouch cash receipts and disbursements

VALUATION

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Managements Responsibility
Management is responsible for making the fair value measurements and disclosures included in the financial statements. As part of fulfilling this responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation measurements, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of fair value measurements are in accordance with GAAP.

Managements Responsibility
Management can not outsource ! Even to General Partner ! Management must have a sufficient understanding of the underlying investments, strategies and significant assumptions that underlie the valuations to challenge the investment valuation

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Audit Approach
Risk assessment
The auditor gains an understanding of the inherent risk in the portfolio The higher the risk, the more persuasive the audit evidence is needed

Considerations:
Percentage of Alternatives to total assets Nature, complexity & volatility

HIGHER RISK MORE AUDIT EVIDENCE

Audit Process
Obtain an understandings of Internal controls
Management Process to determine Fair Value Availability of Information Nature of Underlying Investments How often Management interacts with the Fund Managers and Nature of Interaction Competence and Experience of management (client) to monitor and estimate fair value Availability of SAS 70 Reports Use of Investment Advisors to monitor investments Availability of audited financial statements

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Audit Procedures
Confirmation of Investments
Since the interpretations states testing measurement of the Plans investment just receiving a confirmation in total or on a security by security basis is probably not enough

Review Managements significant assumptions and the underlying data in its valuation or analysis of the assumptions and data obtained from the Fund Manager

Audit Procedures
Obtain audited financial statements of Fund. If consistent with year end of Plan, perform the following:
Read Financial Statements. Ensure:
Net Asset Value is consistent with financial statements Fair Value Basis is consistent with accounting policies of the Plan Consider qualifications of the auditor in light of underlying investments

Agree elements of confirmation responses to elements in audited financial statement Fund of Funds !!!

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Audit Procedures
Review transactions at or near the balance sheet date

When there are no period end financial statements

Obtain previously reported unaudited value of the institutions investment as of the funds fiscal year-end and compare such to the value based upon the audited financial statements. For example, obtain December 31st unaudited value as previously reported and compare to calculated value using percentage ownership at that date (perhaps from K-1) and equity per audited financial statements. Investigate any significant variance. Compare value at funds year-end (most likely December 31) to value at institutions year-end and assess reasonableness of the change considering appreciation/depreciation, additions, distributions, and other changes. Consider reference to external hedge fund indices (e.g. S&P Hedge Fund Index) to support assessment of returns during the period.

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Common Issues
Custodial Statements reported on a lag (ie Dec 31 Statement has Sept 30 NAV)
Issue NOT GAAP

Custodians do not receive audited financial statements of LP

Issues
Accounting Policy Might not be fair value Audit report may be qualified NAV may be different (booked audit adjustments)

Common Issues
Not US GAAP
International Accounting Standards are different need to understand

Custodians may not confirm existence

Acting as a recordkeeper need to perform testwork over existence

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Management Representations
Appropriateness of measurement methods and consistency Completeness and adequacy of disclosures related to estimated fair value measures Subsequent events requiring adjustment Reasonableness of significant assumptions Whether assumptions reflect managements ability and intent

Disclosures
SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties
Are risks and uncertainties adequately disclosed?

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Reporting considerations
Emphasis of matter paragraph Modifications:
Scope Limitation regarding the sufficiency of audit evidence
Significance of alternative investments Adequacy of managements process Timeliness of estimated fair values of the underlying

GAAP Departure
If Fair value is not consistent with GAAP not based on plans year end or not fair value based ie cost, tax basis

Refer to AU section 508, paragraphs .22-.26 for guidance

Questions

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