risks and issues of managing unique assets

Risks and Issues of Managing Unique Assets

Risks and Issues of Managing Unique Assets

Presentation to FIRMA Dennis Moon

Washington, DC National Executive

April 9, 2006 Specialty Asset Management

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NON-FINANCIAL ASSETSNON-FINANCIAL ASSETS

Non-Financial Asset ManagementNon-Financial Asset Management

• Oil, Gas and Minerals

• Real Estate

• Farm and Ranch

• Timberland

• Private Businesses

Non-Financial vs. Financial AseetsNon-Financial vs. Financial Aseets

• Difference is traded vs. non exchange traded

• Asset allocation (remember UPIA?) deals with both

• View asset managers / property managers like portfolio

managers for non-financial assets

• Unique assets are asset classes just like stocks, bonds

and cash and we must view them as such

• Can no longer “exclude” non-financial assets from the

overall analysis of the account


Reviews should be similar to reviews of other investments– Hold or Sell and why?

– Concentrations, documentation and effect on the account

– Increasing, decreasing or going sideways?

– Incorporate in overall investment review – highest and best use

– Marketability, control and timing

• Non-financial assets in an investment portfolio– Just like stocks and bonds, they are an investment and should be

viewed as such

– They can be an integral part of the overall portfolio in providing both diversification, income and capital appreciation

• Non-financial assets pose some challenges such as:– Liquidity

– Valuation

– Require unique expertise to manage

– Have unique risks of ownership

– Liability - may have liabilities beyond just the amount invested, unlike stocks and bonds


CONTROLLING vs. MANAGING RISK• Control risk at acceptance

– Evaluation– Inspection– Professional expertise

• Understanding the asset• Pre-defined review form and structure

• Manage risk during ownership through well-defined policies and procedures– Design– Administer– Review and escalate issues for resolution– Self-Identified Audit Issues


People and Processes are the keys• Have the right people (with the right skill sets)

– People who understand the industry– People with experience in the industry– People who have industry recognized certifications– Skilled, knowledgeable people are your first and best line of

defense

• Have the right processes– Have prudent processes, specifically designed to address the

unique risks associated with these assets– Have regular reporting processes around the key risk items of

these assets– Have appropriate committee or review structures in place to

handle issues or exceptions that need to be escalated


Overall ApproachOverall Approach

For each of these asset types we will look at:• Current Trends

• Types of Services related to this asset

• Risks and Challenges of this asset type

• Acceptance (control of risk)

• Administration (management of risk)

• Personnel and Qualifications

Note: All statements regarding returns, yields and appreciation rates are general figures based on past history and experience. Returns vary greatly between individual assets of the same general type as well as between asset classes.

OIL, GAS & MINERALSOIL, GAS & MINERALS

Current TrendsCurrent Trends

• Product prices - Crude oil price trend remains high. Average annual West Texas Intermediate Spot Prices for 2005, 2006, and 2007 are $54.69, $64.98 and $60.63 (2007 forecast), respectively. Natural gas price trend remains high. Average annual Henry Hub Spot Prices for 2005, 2006, and 2007 are $9.00, $8.87, and $8.70 (2007 forecast) respectively (source: U.S. Dept of Energy / EIA).

• Drilling activity - Active U.S. drilling rig trend is upward. Average rig counts for 2004, 2005, and 2006 were 1192, 1383, and 1481 respectively (source: Baker Hughes North American Rig Report).

• Leasing activity - With high product prices and a significant increase in drilling activity, leasing activity remains very high. Barnett Shale “play” in North Texas is one of the hottest “plays” in the country at the current time. Anticipate robust leasing activity will continue through 2006.

• Seller’s market - Sales of oil and gas properties remain a strong sellers‘market, with producing royalties getting up to 8-10 times net annual income.

• Samples of Services – Property Management– Negotiate oil and gas leases, farm-outs, joint

operating agreements and other exploration and production agreements

– Satisfy title curative requirements and verify ownership to ensure prompt and proper remittance of oil and gas revenues

– Client interaction and activity reports as needed– Professional ad valorem tax rendition, and

payments– Safekeeping of account document records, and

files– Coordination with legal counsel regarding ancillary

administration and other probate issues relating to mineral properties

Oil, Gas & Mineral ServicesOil, Gas & Mineral Services


• Samples of Services – Engineering– Review operators’ invoices and expenditure

requests for non-operated properties– Review new well proposals, re-working

operations, plugging, and other maintenance or enhancement work for non-operated properties

– Prepare appraisals of oil and gas assets as needed

– Evaluate new oil and gas investment opportunities– Analyze historical production and forecast

production, revenue, and expenses– Review and evaluate drilling programs, gas

contracts, and operating agreements


• Samples of Services – Accounting– Ensure timely processing of revenues and

expenses from oil and gas properties– Code for proper expense type and pay all joint

interest billings for working interest properties– Code for production type, date, severance taxes,

deductions and other pertinent well information for royalty properties

– 1099 reporting, filing and mailing– Full revenue distribution services for working

interest properties as needed– Complete electronic image of check stub detail– Depository lockbox services for royalty checks

Risks and ChallengesRisks and Challenges

• Environmental issues

• Title issues

– Dormant Mineral Statutes

• Insurance (working interests)

• Leasing (specialized forms)

• Regulatory

• Commodity prices and potential to market in kind for large interests

• Special tax provisions, such as on tight sand gas

• Suspended funds

• Escheated funds

• Operating agreements, Gas Balancing agreements, Pooling or Unitization agreements, and Regulatory filings

AcceptanceAcceptance

• All available information relating to oil, gas and mineral assets should be reviewed prior to acceptance for the following:– Type and number of interests (mineral, royalty, working interest)– What type of records are available. Deeds, Leases, Division

Orders, Tax returns, Ad Valorem Tax Statements/receipts are all evidence of oil, gas and mineral ownership

– Location of the interests. Accounts with interests in multiple states typically present certain challenges (Ancillary Administration, Dormant Mineral Statutes, Prescription, etc.)

– Working interests should be inspected prior to acceptance to determine if any environmental issues exist

– Are there any operating working interests. These would present unique challenges and significant risk

– Number of oil company payors should be noted

Administration and ReportingAdministration and Reporting

• Property Management– Contract Negotiation (leases, farmouts, unitization agreements, etc.)– Title and Division Order services– Property review and analysis– Client Interaction and reporting

• Engineering– Appraisals of assets as needed– Review of all Joint Operating Agreements, AFEs, new well proposals,

plugging operations, etc.– Review of Joint Interest Expenses on Working Interests– Location inspections of Working Interests as needed

• Accounting– Timely processing and coding of all production revenue and expenses– Working Interest revenue distribution services as needed. Includes 1099

reporting, filing and mailing

Personnel and QualificationsPersonnel and Qualifications

Samples of Useful Qualifications• Certified Professional Landman (CPL)• Petroleum Engineer (PE)• Environmental Site Assessor (ESA)• Certified Petroleum Lease Title Analyst (CPLTA)• Certified Mineral Manager (CMM)• Environmental Site Assessor (ESA)• Advanced Degrees (Master of Science of Business, Law)• Bank of America

– Dedicated oil and gas staff of 88 associates centrally located in Texas and Oklahoma– 10 CPLs, 4 PEs, 1 MS - Geology, 3 MBAs, 1 ESA, 2 CPLTAs, 2 Attorneys

Some Industry Trade / Professional Organizations• National Association of Royalty Owners (NARO)• National Association of Division Order Analysts (NADOA)• American Association of Petroleum Landman (AAPL)• National Associates of Lease and Title Analysts (NALTA)


TIMBERLANDTIMBERLAND


• Strong Demand for a Limited Supply of Timberland – Early 2006, $10+ billion in committed, unplaced capital

• Historic Real Price Appreciation for most Timberland assets and commodities

• Timberland is unique due to Biological Characteristics and commodity and real estate play– Growth results in increased inventory and value regardless of

economic environment. Harvesting can be curtailed during cyclical market pricing downturns, while timber is stored on the stump adding value through biological growth.

– Returns are realized through commodity market and real estate appreciation

• Attractive returns, low correlation, and low volatility– 15 year mean returns: 10+% Southeast, 13+% in Northwest, and

14+% in Northeast (since 1994). (Source: NCREIF)

Timberland ServicesTimberland Services

• Timberland Trust Assets– Complete fiduciary management of assets– Pre-acceptance, preparation and review of

management plans, and implementation– Hold / Sell analysis and asset disposition if

necessary

• Timberland Investments– Acquisition, management, and administration of

timberland assets as a single asset or part of a larger portfolio

– Investment assessment including asset sale analysis and administration

– Offer alternative management strategies for family ownerships to help improve financial productivity

• Advisory Services– Provide advisory services to clients on timberland

asset management and transactions seeking risk diversification or an assessment

– Conduct thorough risk assessments on client ownerships and recommend and implement risk abatement strategies

• Unique Risks – Property Specific– Micro-Market Risk

• Mill Closures• Local Supply / Demand Imbalances• Operational issues related to normal or extraordinary weather patterns

– Legislative / Regulatory – Local– Natural Disasters

• Hurricanes• Fire• Ice• Pests

– Trespassing / Vandalism / Timber Theft



• Standardized pre-Acceptance Procedure– On-site professional inspection– Land use categorized as Agricultural, Silvicultural, Recreational,

Transitional, or a combination– Current products (crop, pasture, timber, etc.) identified– Leases (agricultural, recreational, silvicultural) reviewed– Environmental issues identified and classified– Past uses identified– Committee approval of acceptance

• Review of Account Goals– Some accounts have specific goals, compatibility assessment with

risk controls– Ability to manage to identified goals

Acceptance – continuedAcceptance – continued

• Review of the profitability and appreciation of the investment– Assessment of timber and agricultural micro-markets– Identification of complementary uses and values (recreation,

conservation easements, etc.)– Identification of appreciation drivers (shifting land use patterns,

urban and ex-urban interface, etc.)

• Appropriateness for the portfolio– Return Expectations and Risk Tolerance– Correlation with Other Asset Classes– Time Horizon

• Establishment of management plan– Consistent with risk control responsibilities– Reflective of account goals


• Annual or More Frequent Inspection (except for small interests)– Environmental issues, such as dumping– Timber theft, crop or other vandalism– Signs of trespass or other liability issues– Assessment of timber or crop health and status– Inspection of timber or crop planting, management, and harvesting

operations

• Annual Review– Status or adjustment of management plan– Review of account goals

• Liability Insurance – annual renewal consistent with review

• Property Taxes – annual review of tax assessments and determination of appeal opportunities and preferential assessments

• Maximizing Value & Income– Forest Optimization

• Application of appropriate harvest scheduling techniques

• Investments in intensive silviculture where appropriate

– Appropriate Management of Transition Properties

• Sale of Assets– Timber Sales

• Balance biologic attributes of the forest with client objectives and market opportunities

• Mid-rotation sales vs. final harvest


• Sale of Assets (cont’d)– Land Sales

• Timberland vs. HBU

• HBU = Higher and Better Use

• May be able to allocate portion of acreage for HBU sales and manage remaining acreage as timberland, particularly on large tracts

• Leases– Recreational Leases

– Other Leases

• Conservation Easements / Development Rights



Samples of Useful Qualifications• Registered Forester or Certified Forester (RF, CF)• Bachelor of Science Forestry (BSF)• Master of Science Forestry (MSF)• Master of Science Forestry Management Economics (MSFME)• Master of Science Forest Biometrics (MSFB)• Master of Business Administration (MBA)• Juris Doctor (JD)• Bank of America

– 5 Professional and 2 Support Associates strategically located in 3 offices– 5 RF/CF, 5 BSF, 1 MSF, 1 MSFME, 1 MSFB, 2 MBA, 1 JD

Some Industry Trade / Professional Organizations• Society of American Foresters (SAF)• Forest Landowners Association (FLA)• National Council of Real Estate Investment Fiduciaries (NCREIF)


FARM AND RANCHFARM AND RANCH

Current Trends Current Trends

• Farm Land • Average 4-5% annual return • Appreciation ranges from 3% to 5% and more in certain areas• Competing land uses/urban sprawl helps to insure these increases

• Recreational Ranch Land• Strong appreciation potential in areas with wildlife, habitat, scenery and

water• Appreciation can easily exceed 10% • Recreational uses supplanting productivity as the dominant ranching

enterprise in many areas of the nation• Purely productive ranch land with no wildlife appeal has a much lower

appreciation rate and averages 1% annual return at best

• Summary• Farm and ranch lands can be viable investments that fit well into

most diversification models.(Source of returns: National Council of Real Estate Investment Fiduciaries)

Private Bank Trust

Farm and Ranch ServicesFarm and Ranch Services

• Samples of Services– Identify / qualify prospective lessees– Develop hunting / recreational enterprises– Negotiate & oversee surface damages– Negotiate leases– Analyze lease rates for specific areas– Oversee all lease types – crop share, cash, custom

hire– Provide recommendations for soil, water, and wildlife

conservation practices– Provide periodic on-site inspections and client-

specific reporting– Provide land marketing plans, identify the optimum

method of sale, and coordinate the process– Recommend and purchase farm / ranch properties

for investment diversification– Manage a diverse array of crops from vegetables to

row crops, as well as rangeland across the nation

• Environmental Issues• Title issues• Insurance (crop, liability, etc.)• Ag Management Plan & economics of asset• Stewardship of the land• Easements and Surface Damages• Direct Management vs. Lease

– Leasing – cash vs. share crop– Tenant quality

• Regulatory - Endangered Species, Water laws, Wetlands, etc.• Commodity marketing and harvest decisions• Physical risks, such as fire, insects, and weather• Land sales – timing and need to get the highest price• Beneficiary involvement• Maintaining technical proficiencies over the entire agricultural spectrum


Acceptance Acceptance

• Acceptance sequence – Identify property – location – size

– Perform pre-acceptance on-site inspection and any subsequently required inspections

– Confirm ownership

– Estimate value

– Accept property via proper legal document

– Place insurance on improvements and liability

– Receive sell / retain analysis

– Procure market-value appraisal

– If to be retained, provide management assistance

– If to be sold, establish marketing plan

• Overriding goal is to conserve and improve the asset

• Current Management– Coordinating / negotiating appropriate lease arrangement plus

lease administration

– Overseeing cash rent or crop share leases, including sale of crops

– Regular on-site property inspections

– Coordinating & supervising repairs, maintenance and capital expenditures

– Monitoring & paying ad valorem taxes to include maintaining special use exemptions

– Maintaining liability, casualty and crop insurance

– Reviewing, managing and negotiating easement requests


• Future Use Planning– Developing long-range plan including highest and best use

analysis in accordance with the overall wealth management plan – Utilizing government conservation programs to maximize long-term

asset value– Recommending soil, range and wildlife conservation practices– Developing hunting and recreational activities

• Asset Disposition– Making sell / retain recommendation– Managing and negotiating sales



Samples of Useful Qualifications• Bachelor Degree in Agriculture (BA)

• Advanced Degree in various fields of Agriculture (Master of Science)

• Accredited Farm Manager (AFM)

• Bank of America– 18 Professional and 7 Support Associates strategically located in 11 offices

in 7 states

– 4 AFMs, 5 MSs, 1 PHD, 6 RE / Brokers License

Some Industry Trade / Professional Organizations• American Society of Farm Managers & Rural Appraisers


COMMERICAL & RESIDENTIAL REAL ESTATECOMMERICAL & RESIDENTIAL REAL ESTATE


• NCREIF National Returns*2005 Annual return 20.042005 4Q National 5.43 2005 Apartment 4Q 5.76 2005 Retail 4Q 5.992005 Office 4Q 5.122005 Industrial 4Q 4.92

• Outstanding 2005 - Performance comparable to S&P 500 over last 25 years• Investment Characteristics – Provides portfolio balance, lower risk, lower

volatility. Low correlation to financial assets.• Inflation concerns are pushing interest rates up. Long term interest rates have

risen modestly in response to increases in the short term Fed. rate. However, the yield curve is flat to almost inverted. An inverted curve has preceeded every recession over the past 30 years. (Source: Property and Portfolio Research, 2006)

• Significant capital committed to real estate via fee ownership and REIT’s Skepticism of stock market’s ability to produce attractive returnsIn 2005, foreign investors bought $20.5 B of U.S. real estate – a 35% increase from the prior year (Source: Property and Portfolio Research, 2006)

• Soft landing for housing – average 3% dip in prices in 2006 (Source: Property and Portfolio Research, 2006)

• Samples of Services– Purchase and sale of real estate properties

including 1031 tax-deferred exchange execution

– Leasing, lease administration and negotiations, and tenant relations management and oversight

– Property management and maintenance oversight either direct or with third party property manager involvement

– Income and expense accounting, bill-paying and property tax, and insurance oversight

– Income and expense analysis and asset performance analysis relative to client objectives and market competition

– Environmental and regulatory oversight

– Land and commercial real estate development

Real Estate ServicesReal Estate Services

• Environmental Issues– Underground Storage Tanks, Dry Cleaner Solvents, Asbestos, Mold, Lead

Based Paint• Title issues• Insurance and Insurability• Property Taxes• Leasing and Tenant Quality• Regulatory

– ADA, EPA, Zoning, Water Laws, Wetlands, State Real Estate Commission rules and regulations, property restrictions, etc

• Property Development, Repairs, Maintenance• Economic - Interest Rates, Housing Markets



• Standardized pre-Acceptance Procedure– Based upon on-site professional inspection

– Identify past / current uses, neighborhood compatibility

– Assess physical condition

– Review leases for performance and compliance

– Identify and classify environmental issues

– Obtain committee acceptance approval

• Review of Account Goals– Consider account objectives– Confirm powers and authority relative to real estate– Confirm liquidity to repair, improve, market property

– Assess ability to manage to identified goals


• Review of Investment Profitability and Appreciation– Assess the real estate property relative to competition and markets

– Identify alternative uses or re-positioning opportunities within market

– Delineate appreciation drivers • Land use patterns

• Labor and housing markets

• Economic shifts

• Property Management– Review of deed or titling

– Physical inspection and repair management

– Property maintenance and renovation

– Annual review

– Asset valuation administration

– Insurance review of property and liability coverage

– Tax management of value, exemptions, and payment

– Leasing and lease administration

– Environmental issues and management

– Income and expense accounting


• Asset Management– Financial Analysis

• Yield / return performance and decisions

• Consider investment objectives

– 3rd party management engagement and oversight

– Acquisition and disposition of real estate

• Establishment of Management Plan– Consistent with risk control responsibilities

– Reflective of account goals

– Consider exit strategies



Samples of Useful Qualifications• Certified Commercial Investment Manager (CCIM)• Certified Property Manager (CPM)• Advanced Degrees (MBA, JD)• Real Estate / Broker’s License• Certified Trust Financial Advisor (CTFA)• Certified Financial Planner (CFP)• Bank of America

– 120 professionals located in 32 offices in 17 states– 14 CCIMs, 14 CPMs, 2 JDs, 1 CFP, 1 CTFA, 5 MBAs, 45 RE/Broker licenses

Some Industry Trade / Professional Organizations• National Trust Real Estate Association (NTREA)• Institute Real Estate Management (IREM)• Commercial Investment Real Estate Institute (CIREI)• International Council of Shopping Centers (ICSC)• National Council of Real Estate Investment Fiduciaries (NCREIF)


PRIVATE BUSINESSESPRIVATE BUSINESSES


• Family Holding Companies – These structures, limited partnerships and limited liability companies, are increasing in their complexity both in terms of underlying asset diversity and the relationships among the control vs. passive owners. Financial Services providers will have to evolve in order to adapt to and fulfill the ever-changing needs of these entities.

• Effect of the “Age Wave”– Acquisition/Disposition - The effect of the Baby Boom generation is

accelerating among the business owner segment. The number and magnitude of transactions are increasing and will continue to increase for years to come.

– Estate Settlement – Increasingly, banks are being asked to take estates that hold controlling positions in operating family businesses. This dramatically increases the required resources and capabilities among bank staff to handle these complex engagements. This is especially true when poor or inadequate planning leaves a void at the helm of an operating business.

• Valuation - Business valuation has become increasingly subjective as a result of tax court cases with often conflicting conclusions. Understanding these issues is important from a fiduciary perspective, since valuation issues drive the reporting of market value on statements and determining when an asset should be retained or sold.

• Samples of Services– Analyzing the operating performance of the closely-held asset– Evaluating the risks associated with owning the interest– Providing insightful, unbiased input regarding the long-term

prospects for the closely-held business– Making an investment recommendation based on the analysis– Estimating the market value of the interest for the account– Consulting with company management, accountants, business

partners, attorneys, family members and other interested parties regarding the ownership of closely-held business interests

– Additionally, we represent the trust or estate in such functions as:

• Reviewing business proposals• Voting proxies• Negotiating sales of the interest, if appropriate• Coordinating preparation of death tax valuations of closely-

held business interests• Performing any function necessary as a shareholder of the

entity

Private Businesses ServicesPrivate Businesses Services

• Form of ownership• Minority Interest or Controlling Interests• Valuation Issues• Board Representation or involvement in management• Environmental Issues• Insurance (D&O?)• Management Quality and succession plans or key man

insurance• Regulatory Issues of the applicable industry• Sale or disposition of Business• Liquidity Issues• Obtaining Company Financial Information



• Form of ownership– C-Corporation– S-Corporations– Limited Liability Companies (L.L.C.)– General Partnerships (normally discouraged)– Limited Partnerships

• Pre-Acceptance Review must be performed to assess the risks associated with managing the asset and determine if the interest can be profitably managed in the account.

• A more detailed pre-Acceptance Review shall be performed if the interest– Is a General Partnership or Joint Venture, or– Is a 50% or more holding (controlling interest)– Has known company or family problems/disputes, lawsuits in progress,

environmental issues, etc.

• Lower risk assets are limited partnership interests or minority interests in corporations.


• Pre-Acceptance Review should be a standardized procedure utilizing a standard form which requires basic information depending on the nature and size of the asset. The form serves as a checklist and provides consistency to the process.

Examples:– Minority interests in a corporation - require a copy of a stock certificate and

most recent financial statement for review– Limited partnership interests - require most recent K-1 (to confirm actually

a limited, not general, partnership interest)– LLC interests - require most recent K-1, most recent financial statement,

copy of the LLC Operating Agreement– Account must be eligible to hold the proposed asset (pass-through entities

in charitable accounts or S-Corporation holder rules)


• Three Key Processes for the on-going Management of Closely Held Assets:

– Review of assets under management: Independent, objective analysis of the performance of the non-traded equity security.

– Update market value: Employ appropriate valuation techniques to estimate the fair market value of closely held assets. Methodologies are tailored for all the levels of ownership and assume that some information may not be available to minority owners.

– The asset review and asset recommendation are forwarded to the trust officer and portfolio manager for inclusion in the overall portfolio review.


• Specialized Private Business Group Reporting System– Answers the key process questions regarding closely held asset

management– Receives downloads from trust accounting system to ensure that

management reporting always reconciles to the trust accounting system

– Allows for identification of new assets• Reviewed carefully to identify any assets that were not reviewed prior to

booking onto the trust accounting system

• Provides notification of removed assets• Facilitates reporting on asset review progress• Each asset record contains fields downloaded from the

trust accounting system and asset specific fields determined by departmental needs


Samples of Useful Qualifications• Advanced Degrees (MBA)• Chartered Financial Analyst (CFA)• Accredited Senior Appraiser (ASA)• Certified Public Accountant (CPA)• Certified Trust Financial Advisor (CTFA)• Bank of America

– 22 professional asset managers– 9 Masters degrees, 2 CPAs, 10 of whom have completed all 4 parts of the ASA four-part

business valuation training, (4 others have completed two parts), 2 CFAs, 4 CTFAs, and 1 Professional Engineer (PE)

– Advanced degrees include MBA, M. Economics, M. Accounting, M. Finance, and M. Industrial Relations

Some Industry Trade / Professional Organizations• American Society of Appraisers• CFA Institute• American Institute of Certified Public Accountants (AICPA)• National Trust Closely Held Business Association

risks and issues of managing unique assets

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