Stanley Feldman on Fiduciary Responsibility, Post-Madoff

Episode Transcript:

Jim: Stan you recently submitted an article to the Wall Street Journal titled "Fiduciary Responsibility in the Post-Madoff Era."  Before we tackle the subject of your article, why don't you tell us a little bit about yourself?

Stan: Well I'm Chairman of Axiom Valuation Solutions, which is a nationally recognized valuation firm.  We've been in business since 1999. We focus in on the valuation of thinly traded illiquid securities, fixed income, equity, embedded derivatives for both fixed income and equities.  I have a Ph.D. in economics from New York University.  I'm a former Associate Professor of finance at Bentley University, worked for the Federal Reserve System for a while, also was on the investment management side for a few years.  And most recently I was part of the Valuation Resources Group, which is an advisory panel to FASB, the Financial Accounting Standard Board, and we worked on the development of the Fair Value Standard, FAS 157. 

Jim: Stan, why don't you talk about the article that you've written recently about fiduciary responsibility and maybe tell us how some recent developments have changed the way you look at fiduciary responsibility today.

Stan: Sure.  Well first fiduciaries are responsible for other people's money and how this money is invested.  So this responsibility has not changed.  There is a formal definition, if you will, of a fiduciary’s responsibility in ERISA (Employee Retirement Income Securities Act), which is the national law that regulates qualified retirement plans.  But effectively fiduciaries are responsible for other people's money and how that money is invested.  So this responsibility hasn't changed at all.  Now what has changed is the level of due diligence that fiduciaries have to do or are responsible for, that's the major change.  And the reason why that change is major is because there is a whole category of assets that endowment plans, retirement plans, are investing in which are termed alternative investments.  And these investments tend to be opaque, in general, as opposed to transparent.  So the burden put on the fiduciary is to understand what these assets are and how they're valued and in fact whether the valuations provided are accurate.  So it puts an additional burden on them that they didn't have before.  And it's a burden they can't send out to somebody else.  They can't outsource it, they have to accept it themselves.  So I think they're under a tremendous additional pressure, above and beyond what they were under prior to the financial crisis and more specifically prior to the Madoff fiasco.

Jim: Some of the accounting changes recently revolve around FAS 157.  Can you briefly explain how that affects the role of the fiduciary?

Stan: Sure, FAS 157 or financial accounting standard 157 also known as the Fair Value Standard, what it does is it outlines specifically what one has to do to establish the fair value of an asset or a liability.  Now the fair value of an asset or liability in the case of an asset it's the price at which an asset would be sold at under normal market conditions between informed investors.  And 157 indicates how these assets are to be valued, what's the appropriate methodologies to use.  It sets up a set of levels, if you will, level one, level two and level three.  Level one is essentially assets that trade in markets.  Level two are assets that are not priced in markets but we can develop values using market participant inputs that are known and measurable.  And level three, of course, are assets for which the information is limited, it tends to be idiosyncratic, and it's often very difficult to value these kinds of assets.  If you look at all the FASBs, the movement in the accounting world has been to fair value accounting and prior to 157 there wasn't a consistent definition of what fair value is or how you actually calculate it, and 157 provides that. 

Jim: You talk a lot about alternative investments and the challenge that people face in valuating alternative investments.  Can you define for us what alternative investments are and what categories would fall under alternative investments?

Stan: Alternative investments first is a very broad classification.  But essentially alternative investments includes any assets that are generally not traded in markets.  For example like the New York Stock Exchange or NASDAQ, and specifically when one talks about them, we usually talk about them in terms of private equity investments or investments in private equity funds, hedge funds, which make up a very, very large percentage of alternative investments, and might also includes things like various commodity kind of funds and guaranteed investment contracts, interestingly enough.  These are liabilities that are issued by insurance companies to retirement plans, generally speaking, but they don't trade on markets and they need to be valued like any other asset that an endowment or a retirement plan might have. 

Jim: The term “fair value transparency risk,” what does it mean and why is it so important when talking about alternative investments?

Stan: Transparency risk refers to the degree to which asset values are likely to be misstated.  And it essentially is a function of the degree of opaqueness associated with various information that a fiduciary would receive as it relates to various investments that they're making.  So the greater the degree of opaqueness, the greater the transparency risk, the greater the probability that the assets themselves might be misstated or more importantly that the fiduciary does not understand whether the values that have been given to him or her are accurately calculated.  In general, the greater the alternative investment as a percent of a total invested assets of any particular fund, the greater the transparency risk. 

Jim: So alternative investments by their nature are less transparent than other asset classes and therefore harder to value.  If a fiduciary receives an audited financial statement from their investment manager, can the fiduciary assume that those reported values and returns are accurate based on the fact that they've been audited?

Stan: In general the answer is no.  What the audit actually represents is that the auditor for the investment manager has gone through, or audited I should say, the investment manager's process.  Now what exactly does that mean?  Well what it means is is that the investment manager provides information to their audit firm that says this is the way we have come up with the various values, and the audit firm goes ahead and reviews that.  It does not provide independent valuation because essentially there's an ethical conflict.  You can't audit what you value and you can't value what you audit.  So essentially what they're signing off is that the process, as far as they can tell, seems reasonable.  Now that's a much lower standard than saying, “Yes the values reported by your investment manager not only are accurate, but they meet the fair value standard.”  And in the case of alternative investments, there's a great challenge because the audit firms in general don't value these assets and don't provide enough information to the fiduciary for him to get really comfortable with the idea that the investment values that have been reported are in fact accurate, or even meet the fair value standard.  In a sense they simply don't have enough informant at their disposal to feel necessarily comfortable that the investment values they're receiving are accurate despite the fact that they've been audited. 

Jim: How have alternative investments typically been valued and who has typically performed those valuations? 

Stan: Historically what's happened is that investment managers themselves have been the providers of the valuation and the return information.  The argument there of course is that they're in the best position to do this.  That's not necessarily true, but in their minds, at least historically it's been like this, since they made the investments, they should know what they're worth.  They're conflicted however, because the only time you can be certain that the investment managers are reporting the right values to you is when they make the investment and when they sell the investment, the underlying assets of the fund.  Any other time they're effectively conflicted because what they want to report to their clients is effectively they want to limit the amount of bad news and they want to increase the amount of good news.  And that's not to say they're being fraudulent at all, and I'm not suggesting they are, what I'm saying is that there is room for being creative in reporting these values.  That has led many alternative investment managers to seek out third parties to provide independent valuations of their asset values and their returns.  The problem with third parties is they're being paid by the investment manager so they're conflicted as well.  Not as much as the investment manager, but the amount of pressure on the third party to produce values that are consistent with the investment manager's views, are pretty significant.  Therefore the very best way to do this is simply have the investment manager provide all the information to the fiduciary and then have the fiduciary go through the analysis themselves to ensure that the investment values are correct. 

Jim: What method do you use or prescribe to in valuing alternative investments?

Stan: Of course the thing that you think about immediately when somebody says, “Well I'm invested in a private equity fund and the private equity manager has told me my investment is worth several millions of dollars as of June,” for an example.  And so of course the natural thing you want to do is go and look and look at the various investments they're invested in, literally the underlying investments.  But if you look at these private equity funds or hedge funds, they could be invested in 50 or 60 different types of assets.  To go in and essentially figure out what the value of each underlying asset is would not only be time consuming, it would be essentially cost prohibitive.  Now there is a way to do this that's consistent with finance theory and consistent with the way fair value is actually, or should be generated.  And that's what we called the theory of the replicating portfolio.  So here's the way this works.  If a private equity or hedge fund manager tells us what are the asset classes they're invested in., so fixed income or equity or real estate.  What geographies they're invested in, US, Europe, China, India.  And what the industry distribution looks like, so for an example it might be in the case of equities, it might run from industrial companies to finance firms.  They provide all that information to us.  Based on the information, we create what's called a replicating portfolio based on actual assets that are traded in the market place.  Now remember we're not going ahead and acting as an investment manager, we're doing this after the fact, after they provide all this information and essentially what we do is we replicate the returns that the manager has reported and if we cannot replicate these returns, there are two reasons for it as it turns out.  One is that we have incomplete information and therefore we go back to the manager and ask the manager for the information we need, and second is if we still can't replicate the returns, then there's something wrong, something seriously wrong.  Either the manager's not reporting properly, not calculating properly, or something else.  In any case what's provided to the fiduciary is the basis for carrying out their responsibility, which is being responsible for the value of the investments that a fund, a retirement fund or an endowment fund, has invested in.  And they do this by having essentially the kind of interaction that the process I just described generates.  In the end what we do is provide fair values for their investments irrespective of what the investment manager has reported. 

Jim: Do you have any recent examples of your methodology and what kind of results you've been getting, recent transactions?

Stan: Sure.  First generally speaking, based on our experiences, there’s about 20% or so of alternative investment values need to be adjusted in some fashion.  On average if a fund were invested in ten alternative asset types, hedge funds or private equity, we would expect that of that ten there's probably two that would be problematic to one degree or another.  In one case the problem would be, and this is our experience, is that the fund said they're reporting fair value but indicated after going through our process that what they're reporting was not fair value it was something else.  And of course our client turned around and used our values as the fair value of those investments rather than those values that were reported.  In other cases it turns out that a number of these alternative investments, the return history, can be replicated with a far less expensive portfolio.  In other words they could get the same returns and volatility that the AI manager is generating using a portfolio that's less complicated and less expensive to create.  So those are the two things that have developed I would say over the period of time we've been doing this.

Jim: Stan if a listener wants to get additional information about valuing alternative investments for FAS 157, or general information, where can they go?

Stan: Well the best place to go is fairvalue157.com that's the best place to go.  That has all the information about what we do, how we do it and what a fiduciary needs to know in this day and age.  You can also go to the Axiom Valuation website, axiomvaluation.com or call us directly at 781-486-0100.  Those are probably the easiest ways.  If somebody wants to talk about it specifically with me or some member of our staff, you can always e-mail me at stan@axiomvaluation.com.