Many not-for-profit organizations are considering how alternative investments could play a part in their investment strategy. Whether the goal is to increase the returns on the endowments of private foundations and universities or preserving the capital of the cash reserves of public charities, implementing a prudent investment strategy is the key to success. This article will discuss what alternative investments are, factors to consider in implementing effective due diligence procedures, and the impact these investment vehicles have on the financial statement audits of not-for-profit organizations.

What are alternative investments?

A trend in the search for diversification and optimizing strategies for either growth or preservation of capital has been the increased use of alternative investments. Examples of alternative investments include hedge funds, private equity funds, real estate investment trusts, and pooled separate accounts. Alternative investments can provide a not-for-profit organization with exposure to different strategies, industries, geographies, or even real assets, making them increasingly attractive to boards and committees of organizations seeking alternative sources of returns and risk profiles. Unlike their publicly traded counterparts, alternative investments do not have a readily determinable fair market value. This characteristic presents challenges to both the organizations who investment in them and the organization’s auditors.

Due diligence

As a result of the wide range of investment vehicles and strategies that become available should an organization chose to add alternative investments to their portfolios, an increased focused should be placed on the due diligence process prior to entering into such investments. Some alternative investment strategies can be complex or volatile, may lack certain transparency, or may be subject to lock-up periods limiting liquidity and redemptions. It becomes increasingly important for management and the board of directors to maintain a written investment policy which outlines the due diligence procedures it deems appropriate. Such a policy should describe desired asset allocations and risk characteristics, monitoring activities, and benchmarks to evaluate performance.

There are multiple sources for information on a prospective new investment including the prospectus of the fund, its audited financial statements, and the reputation and background of the fund manager. The proposed fund should be carefully vetted to ensure all available information is reviewed and evaluated. The not-for-profit organization should have the opportunity to meet with and interview the fund’s managers. If an organization utilizes an external consultant or qualified investment advisor to assist in gathering information and providing advice, the fiduciary duty remains with the board of the organization to ensure any decision aligns with the organization's mission, vision, and values.

Audit considerations

Do not be surprised if auditors perform different procedures over alternative investments based on their complexity and significance. Procedures are likely to focus on two key assertions: existence and valuation. The primary test for existence is to verify that the assets are actually held by the not-for-profit, which is typically performed through confirming the balance directly with the investment custodian. This process is no different than procedures performed over other assets such as cash balances or accounts receivable.

To verify that the investment values are stated at the appropriate amounts, the auditor will test the valuation assertion. This is more challenging for alternative investments compared to publicly traded investments, as there generally is no open market where these investments are bought and sold. Recognizing these inherent difficulties, the accounting profession has responded by providing a practical expedient that allows the valuation to be based on the net asset value of the fund. If certain criteria are met, the auditor can utilize the not-for-profit’s ownership percentage in the fund to estimate the value of the organization’s investment.

Such procedures are most effective if the not-for-profit's year-end matches that of the investment fund. If the year-ends differ, additional procedures are necessary to test the activity during the time period between the audited year-end of the investment fund and the year-end of the nonprofit organization. This could add considerable time to the audit process.

Lastly, there are considerations for how the activity of the investment is recorded by the not-for-profit. For instance, traditional investments may have its activity recorded between components such as unrealized gains or losses, interest, and dividends. In comparison, alternative investments are adjusted through unrealized gains or losses for any change in value unless cash has been returned from the investment or there is a capital transaction when the investment is liquidated.

Are these investments right for my organization?

In summary, alternative investments may provide a not-for-profit organization with exposure to markets and strategies it cannot find on the actively traded market and offer an additional element of diversification. This article outlined just some of due diligence procedures necessary prior to entering into alternative investments, and potential impacts on financial statement audits.

Beyond these considerations, there can also be tax considerations relating to alternative investments, which will be covered in a follow-up article.

To discuss this, and other strategies specific to not-for-profit organizations, contact Konrad Schweitzer at kschweitzer@citrincooperman.com.