The variety of alternative investments available to the public has exploded in the last 10 years — just as prudent investor standards have empowered trustees to explore strategies that better serve clients. No wonder that fiduciaries increasingly consider and choose alternative investments for trusts and other estate-planning structures. And naturally, they have to get up to speed very quickly on this brave new world of alternative investments, that is to say private equity, hedge funds and commercial real estate funds. (See “So, What Exactly Is an Alternative Investment?” p. 44.)

Not all trusts-and-estates professionals have kept pace. While some are well-versed in alternative investments, many of even the most sophisticated practitioners still are at the beginning of the learning curve. Yet all involved in investing for wealthy clients — and that can mean lawyers, fiduciaries, investment committee members, accountants and clients — need to go beyond merely understanding what alternative investments are, their promises and pitfalls. Advisors of all stripes need to take a hard look at what using alternatives can mean in various legal structures and become well-versed in exactly how fiduciaries should handle these investments.

First, let's be clear. This is a conversation only about portfolios with investable assets greater than $5 million. That's because most fund managers require that an investment owner satisfy the securities laws' definitions of an accredited investor and qualified purchaser. (See “Who Can Invest?” p. 46.)

Of course, the goal in including private equity, hedge funds and commercial real estate funds in a portfolio is to enhance return or manage risk. Whomever is managing the investments — client, fiduciary or investment committee — should contemplate the client's overall estate plan and general investment strategy, a particular investment's suitability, and the administration of the trust or entity. That means it's important to keep in mind:

  • the estate plan's objectives and the type of trust or structure involved;
  • transfer tax issues;
  • the investment's suitability under securities laws (accredited investor and qualified purchaser rules);
  • prudent investor standards;
  • federal and state income tax issues (including tax reporting); and
  • the governing document and applicable state law (which may specifically address discretionary or directed trustees and affiliate language issues.)

PLANNING

Be warned: Some alternative investments may create an unacceptable risk and potential liability depending on the type of trust structure involved.

For example, some types of private equity investments may work for a grantor trust, but not a grantor retained annuity trust (GRAT).

Say, for example, that a grantor wishes to gift leveraged buy-out (LBO) interests to a grantor trust. (Note: This is a transfer that fund managers must sanction, because a trust typically has to be an accredited investor and qualified purchaser.) Let's also say that these interests are at the beginning stage of the investment, when there's a commitment period to meet capital calls (contributions to the fund at various unscheduled times) and no expectation of investment returns for five to eight years.

The advantages of this investment for a grantor trust are that the client can take advantage of lack of marketability and minority discounts for the purpose of gift taxes or possibly generation-skipping transfer (GST) taxes, because there is typically no secondary market for private equity investments at this early stage. If the LBO investment appreciates, that appreciation will be excluded for transfer tax purposes. Note that the grantor will have to pay income taxes on realized gains (for grantor trusts.) But the grantor can lend money to the trust (with no income or gift tax consequences for the grantor or trust) to meet capital calls at the applicable federal rates (which presumably will be less than the returns generated by successful funds.)1 It's also true that the client and trustee must plan to meet the investment's liquidity needs, especially because there typically will be no returns during the first five to eight years. But another benefit to using a grantor trust is there can be a trust provision that allows the grantor to substitute property of equivalent value.2 If it appears that the returns are not going to meet expectations or may be too risky, property can be substituted.

On the other hand, if the grantor is considering gifting those same beginning-stage LBO interests to a GRAT, the commitment period to make capital calls and the expectation of returns in years five to eight can create significant problems. The GRAT will need other assets to provide liquidity to meet capital calls. These other assets (that provide liquidity but likely have lower returns) may cause performance drag on the portfolio's return. This probably would reduce the GRAT's effectiveness, because the portfolio's returns during the GRAT term probably would not exceed the rate under Internal Revenue Code Section 7520. The grantor for a GRAT is prohibited from making additional contributions to help meet the payout requirements.3 And it's unclear whether the law permits the use of third-party loans. Even so, it's unlikely that third-party lenders would lend money to a GRAT at favorable interest rates, if they'd lend at all. Also, the trust's distribution of the fund's interest (distributions-in-kind) at discounted values (because of lack of marketability discounts and no secondary market) would require large portions of the trust property be returned to the grantor. This is especially true for zeroed-out GRATs.

That's a quick look at how private equity might work with specific types of trusts. Hedge funds, though, are more likely to have a broader application.

For both grantor trusts and GRATs, equity long-short hedge funds and global macro/managed futures (“global macro”) hedge funds may be effective. A grantor probably would not receive discounts for transferring these hedge fund interests into a trust, because these interests are fairly liquid and have a secondary market. But such investments may be appropriate as part of a proper asset allocation for higher-than-expected returns than traditional asset classes. This asset class's returns likely will exceed the IRC Section 7520 rate for a GRAT and applicable federal rates (under IRC Section 1274(d)) for loan arrangements for grantor trusts.4 Relative value arbitrage/event-driven (“relative value”) hedge funds are effective for diversification while providing sound returns over the long term for grantor trusts.

PRUDENT INVESTING

Once a fiduciary has determined that the trust's objectives may, at least in part, be met by including alternative investments, she should consider these first three factors in conjunction with one another, then the next two in the context of the prudent investor standards:

  1. suitability for portfolio diversification;

  2. time horizon of the investments, trust term and the trust's objectives;

  3. ability to meet liquidity needs for mandatory and discretionary distributions and administrative expenses;

  4. due diligence for the manager selection (including expected risk-adjusted returns and fees); and

  5. monitoring of manager performance.

Let's look at these in a little more depth.

  1. Suitability — Fiduciaries first should carefully examine whether alternative investments (and if so, which type or sub-class) are appropriate for the portfolio, based on the investment policy and asset allocation. Such attention is even more critical if, instead of simply receiving the investment from the client, it's the fiduciary who's choosing to purchase or exchange the investment. The need for this diligence is acute with private equity and real estate investments, because they require a greater financial commitment and are less liquid than traditional investments and most hedge funds.

    Once the asset class is deemed suitable, the fiduciary must vet the particular investment and ask whether it fits into the trust's overall portfolio. Under prudent investor rules, there is a presumption that trusts must be diversified. Some alternative investments have a low correlation to public equities or fixed income, so they help diversify a portfolio and make it less volatile. Assuming a trust or other structure satisfies securities laws to invest in these assets, alternatives can greatly enhance the portfolio diversification in two ways: underlying investments differ from traditional investments, and relative value hedge funds and fund-of-funds are specifically designed to enhance diversification.

    Because of trustees' legal obligations to beneficiaries, they typically are more conservative than many individual investors when it comes to alternative investments. Fiduciaries, therefore, tend to impose strict limitations on the asset allocation percentage of private equity and real estate as one asset class and hedge funds as another. Generally, fiduciaries commit no more than a total of 10 percent of a portfolio to private equity and real estate (because of such investments' illiquidity.) This 10 percent includes monies paid presently to purchase an interest in a fund or funds and monies committed for future payments (for instance, capital calls.)

    Typically, the portion of this class representing 5 percent of the overall portfolio is invested in a private equity fund-of-funds and/or a real estate fund-of-funds. These funds are intended to increase the diversification within the asset class and presumably reduce risk. Also, fund-of-funds usually require less financial commitment than a single-manager fund. But of course, fund-of-funds add another fee to the underlying fund managers' fees.

    Another consideration when diversifying a portfolio is whether there is a single investment or “vintage” investments. A single investment is the commitment of money to a single fund that may require capital calls during a five-year period with investment returns typically coming in the fifth through eighth years. Vintage investing entails investing in intervals in different funds over a period of years. It may allow for a more gradual entry into the asset class and may be necessary to meet the trust's cash flow for investment commitments and anticipated distributions to the beneficiaries. The fiduciary must consider that these investments tend to be illiquid for eight to 10 years, and that a trust may terminate within this timeframe.

    Even though real estate tends to be coupled with private equity for asset allocation, it generally appeals to a different client base. A fiduciary or client tends to invest in real estate or private equity, but usually not both. People who invest in commercial real estate also tend to be heavily concentrated in that asset class. And they are generally reluctant to diversify these holdings — except to include fixed income investments. But fixed income doesn't necessarily provide adequate diversification for portfolios laden with real estate investments, because both are sensitive to interest rates. As a result, real estate and fixed income investments have a high correlation to one another; their respective values tend to increase or decrease at the same time.

    In addition to the 10 percent allocation for private equity and real estate, another 20 percent of the portfolio may be allocated to hedge funds. This allocation is higher than private equity and real estate because hedge funds are more liquid. The allocation between equity long-short funds and global macro funds, as one group, and relative-value funds, as another, depends on the asset allocation model and the trust's objectives. Again, typically the portion of this class representing 5 percent of the overall portfolio is invested in a hedge fund-of-funds. There also should be limitations on the percentage that a single-manager fund has in the overall portfolio. The risk profiles for hedge funds must be matched to the risk portfolio for the trust. A larger concentration than is customary (sometimes referred to as “overweight”) in equity long-short funds and global macro funds may be too risky, depending on the trust's investment policy. On the other hand, if the trust's objectives require more aggressive returns (for instance, with a GRAT), too much concentration in relative-value hedge funds at the expense of reducing the other types of hedge funds may be too conservative.

  2. Time horizon-Clearly, the investment's time horizon must be matched with the trust's overall investment time horizon and complement the trust's objectives. So, for example, private equity in its early stages with anticipated returns in the fifth to eighth year does not coincide with a short-term GRAT. However, it may be effective for both a net income charitable remainder unitrust (NIMCRUT) or FLIP-CRUT that would benefit by postponing accounting income and having the value of its assets discounted until such time as the income beneficiary receives unitrust distributions. A dynasty trust (with long-term objectives) also could benefit from illiquid assets that generally provide a premium in returns due to lack of liquidity. The trustees, however, must consider whether the trust is expected to terminate owning interests in illiquid private equity and real estate investments and the beneficiaries are not accredited investors and qualified purchasers. The lack of liquidity may create problems for distributions.

  3. Liquidity-Different types of alternative investments have varying liquidity features that must be considered to meet mandatory or discretionary distributions and pay administrative expenses. An investment may have to be sold at an inopportune time, resulting in losses that might have been avoided. For instance, a major difference between hedge funds on the one hand and, on the other, private equity and real estate is liquidity to meet the trust (or a foundation's) cash flow needs. Depending on the particular hedge fund, a trustee typically has flexibility in liquidating hedge fund interests. Of course, that means the trustee should know the limitations of each particular fund, if any, before investing. Meanwhile, private equity and real estate may not allow for liquidation during the first few years of the investment and may pay out little or no income during that time.

  4. Manager selection — Fiduciaries must be particularly careful when selecting managers for alternative investments. It's a challenging job because:

    • Hedge funds lack historical data, as performance has been recorded for only about 18 years (as compared to public equity with more than 70 years of data.)

    • Data may be inaccurate, as many private equity investments or hedge funds do not survive and their reports are not incorporated in the data series (the so-called “survivor bias.”)

    • Certain alternative fund managers (for instance, those who gather capital privately) choose not to report their returns (or underlying investments), so these funds are not reflected in the general data (called the “selection basis.”)

    • Private equity or real estate investments are not priced efficiently (that is to say, currently) and, because of their illiquidity, often utilize inaccurate or stale pricing (as compared to those investments in the public markets.) Very often there is no secondary market for a private equity or real estate fund until the investment matures. Therefore, data on them does not accurately reflect the lack of liquidity, risk, volatility and correlation of these assets.

    • Asset allocation models use normal return performance to analyze traditional investments. Unfortunately, alternative asset returns do not exhibit the same pattern of normalcy. They are subject to event risks (events specific to that investment rather than general market conditions) that may cause significant decreases in value more frequently than anticipated. Standard asset allocation models do not incorporate this risk into the solution set.

    As for private equity, it's critical to consider “blind pool” investing and whether the prudent investor standards are met for a particular structure or trust. Without knowing the actual composition of a fund's portfolio companies, a fiduciary enters into a subscription agreement, makes an initial payment into the fund, and commits additional payments to the fund manager during a commitment period that typically lasts for as long as five years. The fund manager uses these payments to invest in portfolio companies. The fiduciary will not know how its payments have been directed until after the investment in the portfolio company is acquired. Therefore, fiduciaries should conduct a thorough due diligence review before committing to a fund. It's critical that they understand the fund manager's strategy. They also should review the prospectus to assess the special risks associated with the fund (for example, regional political uncertainties) and with the potential type of portfolio companies (industry sector and stage of financing.)

    How critical is manager selection? Consider this: there is a significant disparity between the returns achieved by top quartile managers and bottom quartile managers.5 Also, consider that substantial minimum financial commitments are required to invest in a private equity or real estate fund. It depends on the specific fund, but typically the minimum ranges from $500,000 to $1 million for a single-manager fund and $250,000 for a fund-of-funds. And, of course, investors are unable to withdraw from the fund during the commitment period (usually five years.)

  5. Monitor manager performance-Prudent investor standards require ongoing monitoring of investments. However, the fiduciary's ability to change managers, if appropriate, is dependent upon the terms of the subscription agreement. If a private equity investment no longer serves the trust's purpose, a grantor may choose to exchange property of equivalent value, if the trust document permits, or look to purchase the asset from the trustee for fair market value (if the trust is a grantor trust for income tax purposes) and the fund managers consent. The fiduciary could liquidate hedge funds interests (subject to the fund requirements) if the asset's returns or risk do not meet the fiduciary's expectation or the manager strays from his stated strategy. The fiduciary also may choose to reallocate the portfolio to meet changing circumstances (including tactical reallocation due to the value of assets changing.)

    INCOME TAXES

    Income taxes can play a large role in the propriety of alternatives' inclusion in a trust's portfolio. Different types of alternative investments typically generate different income tax consequences. Hedge funds usually generate ordinary income (and qualified dividend treatment) as well as short-term gains and, to a lesser extent, long-term gains. Private equity tends to generate long-term capital gains. Real estate investments usually generate ordinary income or long-term capital gains.

    Trustees and beneficiaries also may unexpectedly face tax reporting and the receipt of income under various state laws. First, the administrative headache: every type of alternative investment can generate income, gains or losses that are reported to the investors on Form K-1. Unfortunately, fund managers usually don't send the K-1s out in time for fiduciaries to file the fiduciary income tax returns on time. This delay means fiduciaries fail to send timely K-1s to beneficiaries, who, in turn, may be late in filing their individual income tax returns. The fiduciary, therefore, must estimate income, gains or losses to assist the beneficiaries, who then will have to file extensions on their individual returns.

There also can be unexpected state income taxes, because the underlying investments of private equity, real estate or hedge funds can generate source income from a state as a result of where the fund manager is located (which may not necessarily be the entity's situs.) Such surprises are more likely to come from portfolio companies with blind pool investing in private equity. Beneficiaries or trustees might be required to file a state income tax return solely because of pass-through source income from the trust's investment. Note that it's the grantor, not the beneficiaries, who would have this problem with grantor trusts.

Trustees of charitable trusts and private foundation managers have an additional set of tax concerns. They must be particularly wary of accepting any alternative investment without first reviewing the investment prospectus and latest financial statements to determine if the investment generates unrelated business taxable income (UBTI). For charitable remainder trusts in tax years beginning after Dec. 31, 2006, there will be an excise tax on the entire amount of UBTI.6 Charitable lead trusts (non-grantor) that have UBTI will not be able to take a full income tax deduction for distribution of income to the charity, but instead the UBTI will cause deduction limitations similar to those of individuals.7 Private foundations will not have the benefit of a 1 percent to 2 percent excise tax on net investment income for UBTI, but instead will be subject to ordinary income or capital gains tax rates, depending on the nature of the UBTI.8 Trustees of charitable trusts and foundation managers should consider funds specifically structured to avoid generating UBTI. The fund's prospectus usually will disclose whether the fund generates UBTI, or if the fund is designed to avoid UBTI for U.S. tax-exempt investors.

DIRECTED TRUSTEES

Litigation and substantial judgments against fiduciaries for lack of portfolio diversification have made some wary of serving as discretionary trustees of trusts with substantial real estate or other illiquid investment holdings. Therefore, if grantors want a concentration of private equity or real estate that exceeds 10 percent of the portfolio, they should consider using a directed trustee, with an investment committee (which may include the grantor.) The committee decides the sale, purchase or retention of trust assets, then directs the trustee accordingly.

Such an arrangement might be particularly appealing when the grantor and other family members believe they have superior business acumen and experience than the potential trustee — as often is the case with commercial real estate owners or private equity sponsors. Then the governing trust document should include language that either provides the power or direction to the investment committee to allocate a large portion of the trust portfolio to the asset class. The language also should explicitly state that the directed trustee must follow the investment committee's direction and the grantor supports this investment approach. This arrangement generally does not cause the trust property to be included in the grantor's estate for estate tax purposes, but caution is required to avoid issues of grantor's retained control and revocation.9

There are a limited number of states that have specific statutes that define the role of the directed trustee, its responsibilities and potential liability. Under some state statutes, if a governing document provides for the fiduciary to follow an advisor (committee) and the fiduciary acts under that direction, then (except for willful misconduct by the fiduciary) the fiduciary will not be liable for any loss.10 The statutes of other states that follow Uniform Trust Code Section 808(b) will not hold the trustee liable for losses unless the trustee follows the investment committee's direction when it is manifestly contrary to the terms of the trust or the trustee's actions would be a serious breach of fiduciary duty. There is less protection for a directed trustee in those states that follow Section 185 of the Restatement (Second) of Trusts, because the directed trustee has a duty to confirm that the person directing the trustee is not breaching a fiduciary duty. Therefore, it may be advisable for the trust document with a directed trustee also to contain precatory language as to the grantor's intent (or preferably specific direction) to allow for the concentration of its holdings in a particular asset or asset class. But note that, for a discretionary trustee, even a specific direction (and not merely precatory language or the power to hold concentrated positions) still may not give the trustee sufficient protection under a particular state law.

Another way to insulate the trustee is for the trust to own interests in a limited liability company (LLC) or a family limited partnership (FLP). The trustee will not be the investment decision maker for the underlying assets in FLPs or LLCs. These structures may be effective when the trust or structure's (for instance, a private foundation's) goals require higher returns than can be provided with traditional investments, and their objectives are compromised due to mandatory payouts and inflation factors.11 It is not uncommon for LLC or FLP interests to be owned by a trust with a directed trustee arrangement.

Certain jurisdictions are known for providing other benefits that can be used in conjunction with the directed trustee statutes. Most notably states such as Delaware and South Dakota have repealed the rule against perpetuities and therefore can be effective for GST tax purposes. They also have more flexible prudent investor standards. Also, South Dakota and Delaware (for nonresident beneficiaries) and certain other jurisdictions do not have a state income tax, which may create significant income tax savings for non-grantor trusts.

Those trusts governed under laws of states that do not provide clear guidance for directed trustee arrangements may expose the trustee to unacceptable liability. Some corporate fiduciaries may decline a trustee appointment but act as an agent under an agency agreement. They may provide assistance with the due diligence of choosing and monitoring fund managers. Certain jurisdictions have statutes that allow for a corporate fiduciary to invest in proprietary funds (unless there is a language to the contrary in the trust document.)12 Corporate fiduciaries may have to act as an agent when there is an absence of explicit language in the document and state law allowing corporate fiduciaries to invest in proprietary products.

Alternative investments can be important and effective additions to a trust's portfolio. Securities laws preclude individuals or entities that are not sophisticated investors from purchasing alternative investments, because they may be unable to appreciate the varied complexities of these investments. These considerations are more complex with trusts because the fiduciary must consider the structure, prudent investor standards and accountability to the beneficiaries. Yet fiduciaries with portfolios in excess of $5 million cannot ignore at least considering alternative investments because of the investment community's general acceptance and their potential to enhance returns or diversify a portfolio.

The author thanks his colleagues Peter Daytz, chief investment officer, Tom Martyn, head of Fiduciary Solutions Group, Debra Ohstrom, senior investment officer, Ralph Cheifetz, tax manager and Dennis Morgan, senior tax manager at Citi Trust, James C. Dinan, senior trust counsel, and James C. Hughes, global chief trust counsel of the General Counsel's Office at Citigroup, and Allen K. Parker, assistant general counsel of Citi Alternative Investments.

Citi Trust is a business of Citigroup, Inc. (Citigroup). This article is for informational purposes only, and does not constitute a solicitation of any kind. Opinions expressed are those of the author, and may differ from the opinions expressed by departments or other divisions or affiliates of Citigroup. Although information in this article is believed to be reliable, Citigroup and its affiliates do not warrant the accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. Neither Citigroup nor any of its affiliates provides tax or legal advice. Clients should consult independent counsel/tax advisors in connection with matters covered in this article.

Endnotes

  1. Internal Revenue Code Sections 1274(d) and 7872.
  2. IRC Section 675(4)(C).
  3. Treasury Regulations Section 25.2702-3(b)(5).
  4. Projected returns over a 10-year period of 11.2 percent for equity long-short funds and 8.8 percent for global macro/managed future funds (compared to 7.2 percent for relative value arbitrage/event-driven funds) based on indices are Citigroup Global Wealth Management's forecast as of January 2007.
  5. Difference between top quartile percent managers and lowest quartile managers' returns was 31.7 percent annualized from June 30, 1996 to June 30, 2006. See Douglas Moore, “Private Equity Comes of Age” Trusts & Estates, April 2006, at p. 28.
  6. Section 424 of the Tax Relief and Health Care Act of 2006, which amended IRC Section 664(c).
  7. IRC Section 642(c) and Treas. Regs. Section 1.681(a)-2(b).
  8. IRC Section 512(a).
  9. Sections under the Code that may inadvertently cause inclusion for estate tax purposes include 2036(b), 2041 and 2042. If the grantor's authority is subject to fiduciary standards, then there should be no inclusion under IRC Sections 2036(a)(2) and 2038. See Old Colony Tr. Co. v. United States, 25 AFTR2d 70-1549, 423 F.2d 601 (1st Cir. 1970). To avoid the issue altogether, the document can state that the grantor irrevocably revokes his right to be a manager of the investment committee.
  10. See 12 Delaware Code Section 3313(b) and South Dakota Codified Laws Section 55-1B-2. These statutes also provide additional flexibility to follow designated investment strategies under the trust document that are broader than those generally contained in prudent investor rules, which vary in different states. Other states with directed trust statutes are Alaska, Colorado, Illinois and New Hampshire. For a more complete discussion on directed trustee liability see Dennis I. Belcher, “Not My Fault-The Devil Made Me Do It! Responsibilities and Duties of Delegating or Directed Trustee,” Phillip E. Heckerling Institute on Estate Planning, January 2007.
  11. See Douglas Moore and Ajay Badlani, “Investment Challenges for Private Foundations,” Trusts & Estates, June 2005, at p. 46.
  12. Uniform Trust Code, Section 802(f), see 12 Del. Code Section 3312 and S.D. Codified Laws Section 55-1A-9.

SO, WHAT EXACTLY IS AN ALTERNATIVE INVESTMENT?

This seemingly catch-all term is actually rather precise

Alternative investments typically refer to hedge funds: equity long-short funds and global macro/managed futures funds (sometimes formerly known as directional) and relative value arbitrage/event-driven funds (sometimes formerly known as non-directional); private equity (with various sub-classes); and investment real estate (usually owned by an entity.)

Private equity funds invest in companies (portfolio companies) during various stages of a portfolio company's existence; hence the funds are sometimes broadly referred to as early-, middle- or late-stage financing. The three most common sub-classes of private equity, venture capital (VC), leveraged buyout (LBO), and mezzanine financing, have distinctly different risk/return expectations, which must be carefully considered depending on the particular trust.

As a general rule of thumb, VC (early-stage financing) tends to have greater potential returns and substantial risk, because the company is a start-up, often with a new or untested product. Because VC carries much greater risks than the other two major sub-classes, trustees are more likely to consider LBOs or mezzanine financing for that portion of the portfolio allocated to private equity.

LBOs (middle-stage financing) usually involve acquiring established businesses or products, from a public or private company. LBOs typically use significant amounts of debt to finance these transactions, which increases risk. Returns are generated through operational improvements, hiring an experienced management team, and asset appreciation or leverage. Mezzanine financing (middle-stage financing) is debt that often has a fixed maturity date that is senior to the portfolio company's equity. It is, however, subordinate to the senior debt so it is riskier, but pays out a higher interest rate.

Hedge funds are investment structures used to manage private, less regulated investment pools that can invest in physical securities and derivatives often using leverage. The structure typically takes the form of a limited partnership (LP), limited liability company (LLC) or corporation. The investment strategies generally are divided into three categories: equity long-short, global macro/managed futures and relative value arbitrage/event-driven funds. They tend to have lower volatility than equities. An equity long-short hedge fund and global macro/managed futures hedge fund employ an investment strategy that expects, and profits, when an asset or asset class goes in a particular direction: either increasing or decreasing in value. Relative value arbitrage/event-driven hedge funds are intended to enhance diversification and risk reduction if the fund has a low correlation to other securities in the trust portfolio. Those trustees who may have less money available to invest in hedge funds or want additional diversification may invest in a fund-of-funds for which the manager invests in various underlying hedge funds. This, however, creates an extra layer of management fees.

Real estate investments (generally owned by an LLC) also are considered alternative investments. These investments may have similar structures to those of private equity, but the underlying investments are in commercial real estate as opposed to either start-up companies or ongoing active business concerns.
Douglas Moore

WHO CAN INVEST?

The answer is not simple

Sometimes it's difficult to discern whether a trust or family company will be permitted to invest in an alternative investment. Fund managers usually sell limited partnership (LP) interests or non-managing member units in limited liability companies (LLCs) through subscription agreements. Typically, they sell only to someone or some entity that is both an “accredited investor” and a “qualified purchaser.”1 This way, the fund managers can be exempt from public offering securities registration rules and having to register their LP or LLC as an investment company under various securities laws. Satisfying accredited investor and qualified purchaser rules also avoids the added costs and filing requirements associated with such registrations.

Generally, these registration requirements must be met if any purchaser is not an accredited investor and qualified purchaser and the fund manager cannot rely on an alternative exemption from registration as an investment company.2 The investor categories and registration requirements exist because of the sophisticated nature of private equity and hedge funds.

So most private equity or hedge fund managers first determine whether a purchaser (for example, a trust, partnership or foundation)) is an accredited investor and qualified purchaser. If one meets the more stringent test of a qualified purchaser, then she typically also will satisfy the accredited investor requirements. However, for trusts, accredited investor rules, in part, require a trust to have total assets exceeding $5 million and a “sophisticated person” must direct the purchase.

A sophisticated person is one who “has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”3 Therefore, not only must the trust have a minimum amount of assets, but also the investment decisionmaker — discretionary trustee or investment committee (under a directed trustee arrangement) must be considered a “sophisticated person.” For revocable trusts, there will be a look-through to the grantor. A bank, acting individually and as a fiduciary, is an accredited investor.4 A bank also meets the qualified purchaser rule, because it owns $25 million or more in net investment assets. Any person authorized to make investment decisions on behalf of the trust also must be a qualified purchaser. Therefore, a grantor who anticipates having alternative investments in the trust must ensure that the investment decisionmaker (usually a discretionary trustee) satisfies these rules. Individual family members who may be asked to act as trustees may not satisfy the requirements and another person or a corporate trustee may have to be named.

The qualified purchaser rule provides that a “family company” (for example, a family limited partnership (FLP)) or LLC (owned exclusively by family members) must have a minimum of $5 million of investment assets, not be created for the specific purpose of investing in the investment, and be created and managed exclusively by qualified purchasers.

The minimum investment amount increases to $25 million for a partnership, corporation or other entity (excluding trusts) that is not considered a family company. These requirements must be satisfied for family companies owned by the trust, and may help in those situations when the trustee may not qualify.

Sometimes it may be difficult to discern whether a trust or family company is a qualified purchaser. That's because the rules were drafted from the perspective of securities, not trust law. For instance, the application of the qualified purchaser rules to private foundations created in the corporate form raises issues that are not present with private foundations created in trust form. Fiduciaries should seek counsel if it's unclear whether the fiduciary purchasing the investment for the entity is a qualified purchaser. (See “New Customers for Alternative Investments,” p. 52.)

When the purchaser enters into a subscription agreement, he typically is required to complete an investor questionnaire that solicits information regarding his status as a qualified purchaser and accredited investor. The fiduciary should consider making certain supplemental disclosures on the investor questionnaire to avoid possibly misrepresenting the entity's status. These disclosures can include financial information, the investor's type of structure, for example, trust, corporation or FLP, and the identity of the investment decisionmaker, for instance, the trustee as well as the person or people who funded the entity. Based on such responses, the sponsor then can decide whether to sell the LP or LLC interests to the fiduciary. If the purchaser/fiduciary (even unintentionally) misrepresents the entity's status, it may have to indemnify the LP or LLC for costs incurred by the entity because it failed to register as an investment company with the Securities and Exchange Commission.

Endnotes

  1. An “accredited investor” is defined under Rule 501(a) of Regulation D under the Securities Act of 1933. It's definition includes, but is not limited to, the following:

    1. any natural person (including any spouse) having a net worth over $1 million;

    2. any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

    3. any trust with total assets exceeding $5 million, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a “sophisticated person” as defined under Regulation D;

    4. any partnership, limited liability company (LLC), 501(c)(3) organization, or certain other entities, in each case not formed for the specific purpose of acquiring the securities offered and with total assets in excess of $5 million;

    5. certain banks, acting in their individual or fiduciary capacity; or

    6. any entity in which all of the equity owners are accredited investors.

    “Qualified purchaser” is defined under Section 2(a)(51) of the Investment Company Act of 1940 and the rules thereunder. The definition includes:

    1. any natural person who owns $5 million or more in investments;
    2. any family-owned organization or entity that owns $5 million or more in investments and was not formed for the specific purpose of acquiring the securities offered;
    3. any trust that was not formed for the specific purpose of acquiring the securities offered, as to which each trustee or other person authorized to make decisions with respect to the trust and each person who contributed assets to the trust meets any of these requirements; or
    4. any person, acting for his own account or for other qualified purchasers who, in the aggregate, owns $25 million or more in investments and was not formed for the specific purpose of acquiring the securities offered.
  2. Certain funds rely on an exemption from registration as an investment company that does not require such funds to restrict investment to qualified purchasers, but instead requires that the fund admit no more than 100 investors. Investors in such funds still must satisfy the definition of “accredited investor” in endnote 1.

  3. “Sophisticated person” is more specifically defined in 17 CFR 230.501(a)(7) and 17 CFR 230.506(b)(2)(ii).

  4. See supra note 1.
    Douglas Moore