Alternative investments: Due diligence and internal control considerations for not-for-profit organizations
In recent years, investors’ appetite for alternative investments, such as private equity, real estate investment trusts, venture capital, hedge funds, funds of funds, and commodities, has grown among for-profit and not-for-profit (NFP) organizations alike. Returns from alternative investments generally have a zero, or in some cases an inverse, correlation to traditional investments such as stocks and bonds, so they are used as a potential counter to offset market volatility.
Sophisticated investors might use alternative investments to enhance a balanced portfolio through diversification and thus smooth out fluctuations in earnings. However, these investment vehicles can create new challenges for NFP boards and their accountants.
Though many NFPs turn to third-party asset managers, those charged with governance are ultimately responsible for fiduciary oversight of the organization’s assets, including investments. These responsibilities include establishing and monitoring compliance with the organization’s investment policies, setting asset allocation targets and benchmarks that are aligned with the entity’s risk tolerance, and undertaking procedures for hiring and working with outside financial advisors and investment managers.
One of the most challenging aspects from an accounting perspective is the valuation of alternative investments, depending on the type of investment vehicle. Unlike traditional investments, some alternative investments are illiquid or have market values that are not readily determinable. NFPs are responsible for selecting an appropriate valuation methodology and applying the requirements of the applicable financial reporting framework. From a tax standpoint, some types of alternative investments can generate taxable income.
Most of these challenges can be addressed proactively to avoid unexpected surprises. To that end, NFPs will want to have strong controls in place over valuation, initial due diligence, ongoing monitoring and financial reporting specifically related to investments in alternatives.
Initial due diligence
Selecting a skillful asset manager who can advise on your entire investment portfolio requires careful consideration.
- Look for a credible asset management firm and investment manager who can be trusted to work in your organization’s best interest, understands your investment philosophy and time horizon, and has a record of out-performing market averages.
- Conduct face-to-face meetings with the firm’s management team. Include onsite visits, if possible, to observe back office and operational due diligence in place. Request the financial statements prospectus, marketing materials, and other documents related to the potential investment under review by your organization.
- When working with third-party managers, keep in mind there are different ways these relationship can be structured. Non-discretionary managers essentially serve as consultants that advise and make recommendations to your organization’s leadership team. Discretionary managers are akin to hiring an outsourced Chief Investment Officer; they are authorized to initiate transactions, keeping within the targets and investment policies of the organization. These parameters should be clearly communicated within the service agreement and the NFP’s investment policy.
- Management fees can vary widely. Make sure you compare expenses, keeping in mind that you get what you pay for.
- Review the most recent service organization controls (SOC) report to ensure adequate controls and procedures are in place, if available.
It is important to maintain open communications with your asset manager and establish procedures for ongoing monitoring.
- Maintain an investment policy that defines the organization’s investment objectives, risk tolerance, authorized transactions, allocation targets and so on. Such a policy is typically recommended by the organization’s finance or investments committee and adopted by the board of directors. In the spirit of transparency, some organizations (especially fundraising organizations) make this policy available to the public on their website.
- Ensure that your discretionary asset managers remain in compliance with your policy. As an added precaution, you may consider asking them to sign off on the investment policy on an annual basis.
- Review financial statements for alternative investments for basis of accounting, summary of policies, procedures for valuation, and other pertinent information.
- Participate regularly in telephone or face-to-face meetings with the investment firm’s management team. Consider an annual onsite visit to the manager’s facility.
- Review all fund communications.
- Review portfolio holdings on a regular basis.
- On an annual basis, obtain and review the investment manager’s SOC reports to ensure adequate controls continue to be in place, making certain to implement user entity controls at your organization.
- Compare the investment’s actual performance to your organization’s chosen benchmarks on a regular basis. To get apples-to-apples comparisons, adjust for investment management fees when comparing against benchmarks. Make sure you understand market fluctuations and economic conditions affecting invested assets.
Valuations and financial reporting
Unlike traditional investments, the market value of alternative investments may not be readily available and will therefore need to be estimated. Valuation often requires much judgment and subjectivity on the part of an NFP’s management.
- Document the valuation technique(s) used, citing professional literature if available. Consider doing this on an investment-by-investment basis if your organization employs a variety of techniques.
- Document the methodology for data and assumptions used in the valuation methodology. Assumptions are frequently interdependent and therefore need to be internally consistent. A particular assumption that may appear reasonable when taken in isolation may not be reasonable when used in conjunction with other assumptions.
- When available, obtain annual audited financial statement for the alternative investments. Determine whether audits are conducted by a qualified and reputable independent audit firm and can be relied upon.
- Review changes in net assets value (NAV) from prior statements. Calculate the estimated value of your organization’s investment based on NAV and compare to recorded values.
- If your organization has an annual audit, discuss your significant estimates and valuation techniques with your auditors during the planning process. You will need to discuss the impact of the process and timing of obtaining any independent confirmations of year-end account balances (or financial statements of the investee) upon the scheduling and completion of your annual financial audit.
Some, but not all, alternative investments can trigger a tax liability under the unrelated business income tax (UBIT) regulations.
- NFPs investing in an alternative investment fund may receive an annual Form K-1 from the fund if the fund is classified as a partnership. It is important for you to review this form very carefully to determine whether the fund generated unrelated business income. Sometimes this information is contained in the footnotes to the K-1.
- There are typically two ways alternative investment funds can generate UBI for organizations investing in the funds. The first occurs when the fund incurs debt and utilizes the proceeds to purchase assets. The second occurs when the fund operates a for-profit business, as you will be deemed to have UBI based upon your proportional share of the earnings generated from the business. To the extent you would not have related expenses to offset your proportional share of the earnings, you would have to report UBI by filing a Form 990-T.
- If taxable net income reported on the Form 990-T exceeds, $1,000, the NFP will pay tax at the net income based on the regular corporate or trust income tax rates. In addition, in most states, the NFP would be liable to file a state income tax return.
- Investments in alternatives in foreign markets can also involve domestic or foreign tax liabilities. There are various possible strategies available to reduce, or in some cases avoid, tax liability resulting from these investments but properly structuring the ownership of the investment is critical.
- Additional filing requirements may also be necessary as a result of the foreign investments. Depending upon the value of the investments, Schedule F of the Form 990 may also have to be completed to disclose the foreign investment. Other potential filings such as Form 926 (foreign corporation investments) and/or Form 8865 (foreign partnership investments) may be required even when Form 990, Schedule F is not required. Significant penalties can apply for failure to file these forms when required.
When it comes to alternative investments, there is no substitute for sound judgment. Put prudent policies in place, review the organization’s investments regularly, and seek the advice of competent professionals. Contact your WK advisor at (573) 442-6171 or (573) 635-6196 if we can help.
OTHER STORIES FOR YOU
WHAT TO DO ABOUT UNCLAIMED BENEFIT CHECKS. You’ve issued a check to close a retirement account, and for whatever reason, it hasn’t been cashed. Did you know that, as a plan sponsor, you’re still responsible for those funds?