Alternative investments: A good choice or not?

So-called “alternative investments” started out as a way for nonprofits with significant investment portfolios to either improve their overall investment return or diversify their portfolios — or both. But such investments have thrown a new wrinkle into the annual financial statement audits of most organizations, moving the American Institute of Certified Public Accountants (AICPA) to issue an auditing interpretation along with a practice aid for auditors.

What are they?

Alternative investments aren’t like other publicly traded stocks, bonds and mutual funds where market prices are readily available. They’re often investments in:

• Oil and gas or real estate limited partnerships,

• Private equity funds that invest in publicly or privately held businesses,

• Venture capital funds, and

• Hedge funds.

By their very nature, these investments are generally not as liquid as those that are publicly traded and may require investors to make additional phased-in investments. Information on performance and current value also isn’t as readily available for alternative investments as it is for publicly traded investments. Yet for auditing purposes, there must still be appropriate evidence to support the investment’s valuation.

What investment information is needed?

Under the AICPA auditing interpretation, auditors are advised, when verifying the existence of alternative investments, to confirm the holdings on a security-by-security basis, rather than simply confirming investments in the aggregate. This process isn’t an easy one: Private investment fund managers generally don’t want to reveal the details of specific positions within their portfolio. So, the transparency that is sought in today’s environment is often missing.

If a fund won’t provide details on its underlying investments, the AICPA practice aid suggests alternative or additional procedures to obtain the needed information. This includes reviewing:

• The investee organizing documents,

• Correspondence between the investee organization and the fund regarding transactions, and

• Periodic statements from the investee.

Any fund activity should also be compared with the amounts recorded by the investor.

What’s the investment’s value?

Determining the fair value of a nonprofit’s holdings in an alternative investment may be more difficult. According to the AICPA practice aid, management is responsible for making the fair value measurements and disclosures included in the financial statements. But, this may be a tall order for most not-for-profits to fulfill.

Valuation responsibility is a complex process when dealing with investments without readily available current market values. A not-for-profit’s management will rely on the fund manager to provide valuation information details for each underlying investment. But your management is ultimately responsible for deciding whether the valuation methodology and conclusions are appropriate.

The management team can make the right decision by studying the fund’s annual audited financial statements and any interim internal financial information. Other suggestions mentioned in the AICPA’s practice aid include interviewing fund management to understand the fund’s strategy, positions and valuation methods, and comparing other sector or industry information, indexes and cash distributions.

Are THEY right for you?

Many nonprofit organizations have shied away from alternative investments because of the management complications and concerns about increased audit costs, which would likely offset the expected investment return. And less than an unqualified audit opinion might result if you are unable to obtain satisfactory support for investment valuations.

The significance, or relative size, of a nonprofit’s use of alternative investments compared to its publicly traded investments and annual operating budget and net worth will determine how onerous these valuation issues will be on management. Relatively insignificant holdings in nonpublicly traded investments may require little or no change in your valuation process and monitoring of investments.

What can you do?

It’s important to anticipate what auditors will be looking for. When evaluating alternative investments, complete your regular due diligence, monitor the fund’s financial reporting, and identify what controls you need to put into place if and when you do invest. •