For example, GAO said, investors in hedge funds and private equity face uncertainty about the precise valuation of their investment. Hedge funds may, for example, own thinly traded assets whose valuation can be complex and subjective, making valuation difficult. Further, hedge funds and private equity funds may use considerable leverage—the use of borrowed money or other techniques—which can magnify profits, but can also magnify losses if the market goes against the fund’s expectations. Also, both are illiquid investments—that is they cannot generally be redeemed on demand. Finally, investing in hedge funds can pose operational risks—that is, the risk of investment loss from inadequate or failed internal processes, people, and systems, or problems with external service providers rather than an unsuccessful investment strategy.
Plan sponsors GAO spoke with address these challenges in a number of ways, such as through careful and deliberate fund selection, and negotiating key contract terms. For example, investors in both hedge funds and private equity funds may be able to negotiate fee structure and valuation procedures, and the degree of leverage employed. Also, plans address various concerns through due diligence and monitoring, such as careful review of investment, valuation, and risk management processes.
GAO said according to plan officials, state and federal regulators, and others, some pension plans, such as smaller plans, may have particular difficulties in addressing the various demands of hedge fund and private equity investing. In light of this, in 2008, GAO recommended the DoL provide guidance on the challenges of investing in hedge funds and private equity and the steps plans should take to address these challenges. While the department generally agreed with its recommendation, the agency has yet to take action. The agency explained the lack of uniformity among these investments could complicate the development of comprehensive guidance for plan fiduciaries.
According to the GAO report, a growing number of private and public sector pension plans have invested in hedge funds and private equity, but such investments generally constitute a small share of total plan assets (see Poll Finds More Pensions Using Investing Alternatives).
According to a survey of large plans, the share of plans with investments in hedge funds grew from 11% in 2001 to 60% in 2010. Over the same time period, investments in private equity were more prevalent but grew more slowly—an increase from 71% of large plans in 2001 to 92% in 2010. Still, the average allocation of plan assets to hedge funds was a little over 5%, and the average allocation to private equity was a little over 9%.The full GAO report can be found at http://www.gao.gov/products/GAO-11-901SP.
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