Philippine Institute of Certified Public Accountants

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Philippine Institute of Certified Public
Accountants

• Alternative Investments Past, Present, and
  Future
• September 18, 2009

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Todays Speaker

• Tomoko Nagashima is an assurance partner in
  PricewaterhouseCoopers Asset Management
  practice.
• Tomoko has over sixteen years of experience,
  primarily serving asset management clients,
  including 1940 Act registered funds as well as
  non-registered domestic partnerships, hedge
  funds, private equity funds and funds of funds.
• Tomokos clients invest in a full range of
  complex securities, including mortgage-backed
  securities and related derivative instruments,
  options, swaps, futures and forward foreign
  currency contracts and foreign securities.
• Tomoko also leads the Diversity Initiative for
  PricewaterhouseCoopers Los Angeles Financial
  Services Group.

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Agenda/Contents/Section

• Industry Overview
• Audit Considerations
• Current Developments
• Conclusion
• QA

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Industry Overview

• What is an alternative investment product?
• Relevance

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What is an alternative investment product?
Industry Overview

• Broadly, alternative investments are any
  investment product other than traditional
  investments such as stocks, bonds or cash
• For institutional investors and wealthy
  investors, alternative investment products most
  often fall into two general categories
• Hedge funds
• Private equity funds
• Both categories typically consist of unregistered
  investment funds with significant minimum
  investments. These funds generally charge
  significant asset-based and performance-based
  fees.

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What is an alternative investment product?
Industry Overview

• Hedge funds
• May employ a wide range of trading strategies in
  liquid and illiquid assets
• Investments used are generally limited only by
  the operating agreements
• Typical risks for an investor
• Limited regulatory oversight (but this may
  change)
• May make high risk investments that are difficult
  to fair value
• May employ significant leverage
• Limited transparency
• Limited liquidity
• Redemptions are typically permitted no more
  frequently than monthly, and are often quarterly
  or annual.

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What is an alternative investment product?
Industry Overview

• Private equity funds
• Typical investment strategies are more focused
  and less diverse than hedge funds
• Often take significant positions with long-term
  holding periods
• Capital is usually raised by obtaining
  commitments from investors, which the fund draws
  down as investments are made over time.
• Venture capital funds are a sub-set of this
  category
• Investors face many of the same risks as hedge
  fund investors, but private equity investors also
  have
• No liquidity investors cannot redeem
• Less diversification

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Relevance
Industry Overview

• A significant amount of public and private
  capital is allocated to alternative investment
  products. For example
• Government pension plans
• University endowments
• Funds of funds
• Many of the entities that we provide professional
  services to as CPAs have alternative investments
  on their balance sheets.
• So, what are some of the implications to CPAs?

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Audit Considerations

• Key audit risks
• Auditors responsibility
• Financial statements

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Key audit risks
Audit Considerations

• Valuation and existence
• Can management and the auditors of the investor
  accept the net asset value (NAV) provided by an
  investee as fair value?
• How robust is managements understanding and
  monitoring of the investees policies and
  procedures?
• How does management know that their investment
  exists, and that the investee fund is providing
  complete and accurate reporting? Consider Bernard
  Madoff (more on this later).

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Auditors responsibility
Audit Considerations

• Guidance in AICPAs AU 9332 issued in 2006
• Understand, assess, and test managements
  monitoring and risk assessment controls (critical
  to success of the audit)
• Tailor audit procedures based on the results of
  tests of controls and the risk assessment of the
  portfolio
• Higher risk investments should be subjected to
  more, and more robust, substantive audit
  procedures. Some suggested substantive procedures
  may include
• Reviews of investee fund audited / unaudited
  financial statements
• Reviews of investee fund portfolios
• Confirmation directly with investee fund managers

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Financial statements
Audit Considerations

• Significant disclosures may be required.
  Consider
• Managements policies
• Nature and key terms of investee funds
• Key accounting policies of significant investee
  funds
• Information about significant investments held by
  investee funds
• Risk disclosures

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Current Developments

• Recession
• Fraud
• Regulation

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Recession
Current Developments

• The credit crisis that began in 2007 and
  accelerated throughout 2008 had a significant
  impact on alternative investment funds
• Private equity funds found it more difficult to
  obtain the credit necessary to continue to pursue
  leveraged buy-outs
• As all asset classes declined in value,
  alternative investment products no longer
  appeared uncorrelated to general market returns
• Many funds experienced significant losses during
  this period
• Investors began demanding that their capital be
  returned to them
• Many funds were forced to liquidate
• Others froze redemptions until they were more
  comfortable selling their assets in order to fund
  redemption requests.

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Fraud
Current Developments

• Several frauds were uncovered as investors began
  to redeem their money
• Bernard Madoffs ponzi scheme was the most
  prominent of these
• Madoff avoided significant regulatory scrutiny
  for years
• Use of connections to intimidate and distract
  regulators
• Use of sophisticated computer programs to
  simulate trading activity
• Warning signs
• Did not use third-party custodian for client
  assets
• Audit firm lacked resources relative to nature
  and complexity of Madoffs firm
• Consistent returns every year
• Unnecessarily complex investment strategies

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Regulation
Current Developments

• Although alternative investment products are
  typically subject to limited regulation, this may
  change in the U.S. and globally
• Many regulators (examples United States,
  European Union, Japan) are considering proposals
  for additional oversight of investment managers
  and the funds they manage
• In the United States, Congress and the SEC are
  considering new legislation and changes to
  existing regulations that could substantially
  alter the regulatory environment.
• For example, investment managers may be required
  to register with the SEC to subject them to
  additional oversight

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Conclusion

• The world is changing

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The world is changing
Conclusion

• Alternative investment funds have played a
  significant role in the expansion of liquidity
  and trading activity in global markets in the
  past decade
• Recession and fraud may fundamentally alter the
  nature of the industry.
• The reduction in availability of credit has
  resulted in reduced leverage and therefore
  reduced investment activity.
• Governments, attracted by significant losses and
  fraud, may substantially change regulatory
  requirements.
• Many investors, focused on access to capital, are
  demanding changes to the liquidity and fee
  structures of the funds they invest in.

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The world is changing
Conclusion

• Audit firms face increased risks
• Valuation
• In illiquid markets, validation of prices has
  become increasingly difficult
• Significant new measurement and disclosure
  requirements have been issued by the FASB in the
  last two years
• Litigation
• Some investors that have experienced losses have
  filed lawsuits against investment managers,
  auditors, and other parties to try to recoup
  their losses
• In some cases, this has included the CPA firms
  that audit the entities that invest in the
  products that experience losses, not just the
  firms auditing the products themselves

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The world is changing
Conclusion

• In light of these risks and uncertainties,
  alternative investment managers are attempting to
  continue to innovate
• Many have been responsive to investor requests
  for changes by highlighting the funds value
  propositions, making changes, or both.
• As in other industries, investment managers are
  identifying opportunities for efficiencies and
  cost savings
• Investment strategies have been fine-tuned
• Returns have significantly improved in 2009
• Many large alternative investment firms are
  looking to become financial services
  institutions, with better controls, processes,
  and reporting.

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QA