Tax changes mean fiduciary issues

There are special fiduciary issues associated with hedge and private-equity funds. I testified before the Senate Fi-nance Committee last month, and the committee was particularly interested in my opinion on the likely impact that a proposed change in the tax treatment of carried interest received by hedge and private-equity fund managers might have on the decision-making pro-cess of an investment fiduciary.

As I told the committee, in many cases where investment fiduciaries have invested in hedge funds and private equity, speculative hubris has supplanted procedural prudence.

A tax on hedge and private-equity fund managers, therefore, likely would have no more effect on the inappropriate use of these investment strategies than a hike in the capital gains tax would have had on investors during the dot-com bubble.

Unfortunately, there is no federal or state agency that provides education and training to our nation’s 5 million investment stewards, of whom hedge fund managers and private-equity fund managers constitute a small segment. Given the absence of sound fiduciary practices by many retirement plan sponsors when they make investments in hedge and private-equity funds, such education is vital, especially considering the vagueness of the law surrounding fiduciary responsibility.

Most investment fiduciary legislation is based on a flexible doctrine that gives consideration to incorporating changes in the types of asset classes, asset strategies and financial products made available to investors. At the root of this doctrine is the concept of a process standard and the requirement that the investment fiduciary demonstrate their procedural prudence.

No asset class is inherently imprudent; it is the way it is built and how it is used that determines whether the prudence standard has been met.

Even the most aggressive and unconventional investment strategies, such as those employed by hedge funds and private equity, can meet the standard if arrived at through a sound process. At the same time, the most conservative and traditional asset classes may be inadequate if a sound process isn’t implemented.

Therefore, the focus turns to the practices that define a prudent process for investment fiduciaries when they invest in hedge and private-equity funds.

The Foundation for Fiduciary Studies has identified 22 practices that provide the details of a fiduciary’s prudent-investment process.

What follows is a list of several of the practices, specifically addressing the special fiduciary issues associated with hedge and private-equity funds:

The hedge fund/private-equity manager demonstrates an awareness of their fiduciary duties and responsibilities.

Investments are managed in accordance with applicable laws, trust documents, and the fiduciary’s investment policy statement.

The roles and responsibilities of all involved parties are defined, documented and acknowledged.

The hedge fund/private-equity manager isn’t involved in self-dealing.

Service agreements and contracts are in writing and don’t contain provisions that conflict with fiduciary standards of care.

Assets are with a custodian that can provide an independent and objective valuation of the portfolio’s holdings.

The hedge fund/private-equity strategy is consistent with the portfolio’s risk, return and time horizon, and the fiduciary can demonstrate an understanding of the portfolio’s risk exposure.

The selected hedge fund/private-equity strategy is consistent with implementation and monitoring constraints of the fiduciary.

The fiduciary’s investment policy statement contains the detail to define, implement and monitor an investment in a hedge fund/private-equity strategy.

The fiduciary can demonstrate that a due diligence process was followed in selecting the hedge fund/ private-equity strategy.

The investment in hedge funds/ private equity is appropriate for the portfolio size.

The fiduciary receives periodic reports comparing investment performance with an appropriate index, peer group and objectives outlined in the fiduciary’s investment policy statement.

Periodic reviews are made of qualitative and/or organizational changes of the hedge fund/private-equity manager.

The fiduciary has control procedures in place to review the hedge fund/private-equity manager’s policies periodically for best execution, “soft dollars” and proxy voting.

Fees for investment management are deemed reasonable.

Don Trone is president of the Center for Fiduciary Studies and chief executive of Fiduciary 360 LP, both in Sewickley, Pa.