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Conducting Due Diligence Related to Alternative Investments

Trustees of pension plans add alternative investments to plan portfolios to diversify assets, decrease volatility and enhance plan performance.  Growing obligations and shrinking returns have accelerated a move toward alternative investments and away from the traditional mix of domestic equity and debt securities that dominated past portfolios.  

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While conducting due diligence related to alternative investments is similar to the process for evaluating traditional domestic investments, there are unique areas of concern to consider.  Many alternative investments are foreign-based and generally not subject to comprehensive disclosure requirements and regulatory standards.  Trustees have new variables to consider, such as political stability and foreign currency translation, which are not associated with domestic investments.  In addition, these foreign-based investments may lack protection from corporate fraud, depending on the country in which the investment resides. 

Effective due diligence related to any investment is critical and is best conducted as a two-part process.  Initial evaluation combined with ongoing monitoring is the most effective way for trustees to conduct due diligence when considering new additions to a plan’s investment portfolio, and alternative investments have some unique considerations along the way.

Initial Due Diligence

When evaluating a potential investment for a plan’s portfolio, the first step is for trustees to meet with the investment firm’s management team.  From there, trustees will want to assess the investment manager’s track record and check references.  For particularly substantial investments, they may choose to verify biographical information or even have third-party background checks performed on senior management.  After gathering as much biographical information as deemed necessary for the alternative investment under consideration, trustees should begin reviewing various documents related to the new investment.  With the help of legal counsel and possibly an investment advisor, trustees will want to review the investment’s governing documents, offering memorandum, partnership or LLC agreements, past financial statements and any current periodic reports. 

Perhaps the most important area in which to gain a full understanding is the structure of the investment, including its philosophy, strategy and lifecycle.  Other areas of concern are the tax considerations, other regulatory filing requirements and the fee structure.  The investment’s strategy may be to take direct investment positions in various debt or equity investments or to invest in other investment funds.  If an investment utilizes a fund-of-funds strategy, trustees may have to do more research to understand the assets of the underlying funds.

Tax Consequences

Alternative investments can create tax consequences for pension funds, due to the investment’s strategy or its structure.  The most common tax consequence is Unrelated Business Income Tax (UBIT).   Federal and State filings may be required for any unrelated business income, if that income meets certain thresholds.  If there are unrelated business losses, plan trustees may consider filing, even if not required, in order to carry forward any losses to offset any future unrelated business income.  Adequate consideration should be given not only to the UBIT cost itself, but also to those costs associated with compliance.

For more information on UBI, please see the prior Lindquist Solutions article:  Investments and Tax Awareness:  Tips for Trustees

Many foreign-based investments require additional informational regulatory filings, not only in the U.S., but also in the foreign country in which the investment is headquartered.  Simply funding a foreign investment may trigger foreign reporting requirements, depending on the amount transferred.  Again, adequate consideration should be given to the cost of regulatory compliance when an investment has these characteristics. 

The investment’s fee structure is also an area of importance.  Many alternative investments include carried interest or clawback provisions that may not be present in other investments and that will affect the overall return of the investment.  Trustees typically consider these issues when reviewing governing documents and offering memorandums with the assistance of legal counsel. 

The last major area of consideration for an alternative investment is its liquidity or lack thereof.  Most alternative investments structured as limited partnerships require a commitment to stay in the investment until its pre-determined lifecycle has ended.  This can often mean that a plan’s money is tied up for five, 10 or even 20 years.  Often these partnership agreements contain language that allows the general partner to extend the investment’s specified lifespan.  Should trustees be allowed to withdraw the investment or a portion thereof, it is typically not without penalty.  Accurately understanding the investment’s terms, coupled with an understanding of not only the plan’s current liquidity needs, but also those projected into the future, is of great importance in managing the plan’s resources to meet its obligations.

Ongoing Monitoring 

The due diligence process does not end with initial evaluation; ongoing monitoring of an investment is just as important as the decision to make the investment in the first place.  At periodic intervals, trustees should compare investments return to benchmarks, other expected return projections and publicly available data, such as sector information.  Often, investment monitors are engaged to compile this information on a portfolio basis to assist trustees with their review. 

Trustees should review the periodic communications, such as monthly or quarterly shareholder reports, received directly from the investment’s management.  Changes in valuation policies or procedures and even changes to the investment’s strategy may also be communicated directly from the investment’s management and should be reviewed for compliance with initial goals.  Annual audited financial statements are also a good source of information.  Was the audit opinion unmodified, modified or something else?  Did a reputable firm conduct the audit?  Changes in management personnel can also affect the investment’s performance.  The key to ongoing monitoring is to stay aware of potentially changing circumstances and have a plan of action, if necessary, to best meet the plan’s portfolio goals.


Conducting due diligence related to alternative investments is not an easy process.  The new economic landscape, combined with ever-growing alternative investment options, has made investment portfolio decisions not only more important, but also more expensive in terms of time and resources.  However, with a well-thought-out plan that combines both initial due diligence and effective ongoing monitoring, trustees can better position themselves to make more effective investment portfolio decisions.

Todd M. Stokes, CPA, is a manager in Lindquist LLP’s Seattle office with approximately 10 years of specialized experience auditing labor organizations and defined benefit, defined contribution, and health and welfare plans.  In addition to supervising audit engagements, Todd trains staff and helps develop technical guidance for the firm.  He is a member of the International Foundation of Employee Benefit Plans. 

© 2013

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