Alternative investments can be rewarding for private foundations — higher risks can mean higher returns, and many outperform the standard markets. Money managers have good reasons for moving general purpose and endowment funds to these investments, which are increasing in appeal as organizations realize the opportunities afforded by an extremely low interest rate environment. But the rewards can be offset by inaccurately evaluating fair value for a new investment, as errors in fair value evaluation can result in misstatements and costly restatement efforts. Determining fair value is complex because there is often a lack of transparency. Fund managers do not provide detailed underlying asset information, which means the foundation cannot challenge the fund manager’s valuation. Fortunately, existing professional accounting standards provide guidance.
With considerable complexity in alternative investments and more sizable positions taken by private foundations and other nonprofits, it is critical to have the proper policies, procedures and controls in place for evaluation and reporting.
An alternative investment is not exchange-traded or one of the three traditional asset types or classes — stocks, bonds or cash. Alternative investments include hedge funds, managed futures, real estate, commodities, private equity, structured products and derivatives contracts.
Understand fair value challenges
Private foundations are required to report all investments at fair value. For most traditional investments, fair value is easily determined and is reported to the organization by the investment custodian or manager. For example, the fair value of equity securities is based on publicly traded market prices. The fair value of bonds can be calculated based on the interest rate, term and risk level of the bond issuer.
Foundations are faced with significant issues in applying fair value measurement standards to alternative investments. In addition to the general challenges in applying fair value concepts under GAAP — such as understanding complex structures in order to accurately model cash flows or understanding the observability of inputs to fair value to properly disclose the level in the fair value hierarchy — unique challenges arise from the inherent nature and characteristics of alternative investments:
Unlike registered investment companies available to the general public, alternative investments are not registered with the SEC and, thus, are available only to sophisticated investors. This creates a limited market with limited information available.
For various tax and regulatory reasons, sponsors of alternative investments do not permit investors to transfer their interests without the sponsor’s permission. Accordingly:
– There is no organized market for trading interests in alternative investments. This creates a lack of transparency in fair value.
– Transactions are infrequent and difficult to complete. This is the core reason for a limited market for trading alternative investments.
– In transactions occurring directly between investors, there is extremely limited, if any, transparency in pricing.
As a result of the lack of transparency and an active trading market, it is often difficult to obtain sufficient audit evidence to determine the reasonableness of fair value for alternative investments. This makes it especially important that the auditor have an in-depth understanding of the entity’s procedures in order to assess the reasonableness of the fair value.
Gain assistance from FASB guidance
The FASB issued accounting standards in September 2009 to provide guidance in measuring the fair value of alternative investments. The standards provide a practical expedient for measuring the fair value of certain alternative investments that do not have a quoted market price but calculate net asset value (NAV) per share. Nuances of the guidance impact how a private foundation classifies investments measured at NAV or its equivalent in the fair value hierarchy (i.e., Level 2 or Level 3), which requires judgment.
The accounting standard also amends the fair value guidance for specific disclosures about investments eligible for the practical expedient. The disclosures are required even if an entity doesn’t apply the practical expedient. They are intended to help financial statement users understand the nature and risks of the investments, and to assess the probability that investments will be sold at an amount different from the NAV or its equivalent.
In considering investing in alternative investments or reporting on existing ones, make sure you understand the financial statement and disclosure implications, because complexity in structure and lack of transparency can introduce the risk of financial statement errors.
See the full report: The State of the Not-for-Profit Sector in 2015