In this third article in the KB Associates’ series on investment fund governance consideration is given to the various factors which a proposed director should take into account prior to accepting an appointment.
Recent judgements from the courts and related regulatory developments have highlighted the importance placed on the duties and obligations of directors. Directors of investment funds are required to play a meaningful role including appropriate oversight of the relevant activities of the investment manager and other service providers. A non-executive director will not want to be associated with a poorly run investment fund and clarification of various matters prior to appointment can certainly minimise that risk.
WHAT ARE THE KEY ISSUES TO BE CONSIDERED?
Key factors should include the following:
- Manager integrity
- Financial position of manager
- Investment strategy
- Risk management practices
- Quality and role of service providers
- Quality of fund documentation
- Delegation of board functions to the investment manager
- Valuation committee role and composition
- Director selection process
- Directors’ compensation level
- Directors and officers insurance
The efficient operation of a fund requires a degree of trust, though not blind trust, between the fund board and the manager. Furthermore a director takes on significant duties and obligations and may be personally liable in certain circumstances for the actions of a fund or its agents. Therefore it is prudent for any prospective director to carry out some checks before entering into the relationship.
Basic checks should include an internet search for information regarding the owners and key employees of the manager. Such checks may highlight legal actions or regulatory investigations that provide an insight into the integrity of the manager. Potential directors may also seek information from other industry professionals such as those in the legal firm or prime broker who may well have introduced the potential director to the manager.
The potential director should also meet with key staff at the manager, ideally at the manager’s office, to form a view as to the calibre of the senior personnel and the culture of the firm.
Financial position of manager
The investment manager has the primary obligation on behalf of the fund for compliance with investment restrictions. The proper performance of the compliance function requires appropriate resources, both personnel and systems, at the manager. While the complexity of a fund’s investment strategy will influence what is required there will always be a financial cost associated with the operation of a proper compliance environment.
A potential director needs to be confident that the manager not only has the desire but also the financial resources to operate a robust compliance environment.
The potential director should make sure he/she understands the investment strategy to be pursued by the fund along with the relevant investment risks. The director will have responsibility for ensuring that the strategy as described in the fund documentation is implemented. He/she will not be able to discharge this obligation properly without a clear understanding of the strategy
While details of the investment strategy will be set out in the offering document or prospectus the investment policies and restrictions will often be somewhat vague in order to provide the manager with flexibility. Greater detail regarding the intended investment strategy is often contained in the “pitch book” which will typically detail the investment approach, the instruments to be used to gain the desired market exposures and the extent to which leverage is to be employed. Potential directors should discuss the investment strategy in detail with the manager and understand clearly how performance is to be generated.
If a potential director does not thoroughly understand the investment strategy then it is not appropriate to accept the appointment.
Risk management practices
A key finding from various investigations into the global financial crisis was a failure of financial institutions to adequately manage risk. Recent regulatory developments have emphasised the requirement for directors to clearly understand the risks and mitigating controls that exist in relation to the operation of a fund. A director must be satisfied that the manager has a properly functioning risk management framework. In assessing the risk management systems the director needs to consider the adequacy of personnel, systems, and procedures along with the risk culture at the investment manager.
Before accepting a fund director position one needs to be confident that the fund will operate with a proper risk management infrastructure.
Quality and role of service providers
Regulated investment funds are required to appoint various service providers to operate the fund. The regulatory authority which authorises and supervises the fund will usually require that the proposed service providers meet certain minimum criteria – for example, it may be necessary that an investment manager is regulated or the custodian may be required to meet certain minimum capital levels. Normally the investment manager, the custodian and the fund administrator will each be required to be regulated. Potential directors can take some assurance from the fact that there is segregation of functions and that the providers of these services are themselves subject to regulation.
In less regulated jurisdictions funds may be established without a requirement for the appointment of such regulated service providers. It is particularly important in such cases for directors to consider the competence of the various service providers to safe-keep fund assets and accurately calculate the net asset value of the fund. Potential directors also need to satisfy themselves as to the independence of service providers from the investment manager.
Quality of fund documentation
Investment funds are governed by detailed legal documentation including a prospectus/offering document and various material contracts with service providers. Normally the legal advisers to a fund will draft the fund documentation based on instructions provided by the investment manager. Potential directors should pay careful attention to these documents as their quality can indicate the experience and expertise of the manager. The following key questions should be considered:
- Is the fund documentation well drafted?
- Is it comprehensive?
- Is it simply “boiler plate” – or is it clear that it has been tailored to the particular fund?
- Are the disclosed risk factors relevant or simply a laundry list of all possible risks?
- Is there clarity regarding the proposed investment strategy and leverage limits?
Documents which are clearly drafted and contain proper disclosure give some protection to directors. In contrast template documentation which is not properly customised for the relevant fund exposes directors to unnecessary risk.
Delegation of board functions to the investment manager
Fund directors are ultimately responsible for all of the functions involved in operating a fund. Given the outsourced model which is prevalent in the industry, various functions will be delegated to service providers. Although the board can delegate the performance of the various functions, it cannot delegate its responsibility. While certain functions such as custody, fund administration and investment management must almost inevitably be delegated there are various other powers such as the application of redemption levies, the operation of gates, the acceptance of in-kind subscriptions and the appointment of auditors for which the board would normally retain direct responsibility. Prior to accepting an appointment a potential director should establish with the manager the extent to which it wishes the board to delegate such powers. In each instance a potential director needs to be satisfied that there is sound commercial logic for any delegation which is to take place.
The number and importance of the functions the manager wishes the board to retain can give a clear indication of the importance the manager places on the role of the board. Potential directors need to be satisfied that sufficient control is retained at board level to enable the directors to properly discharge their obligations.
Valuation committee role and composition
Increasingly investors demand that net asset values are calculated by fund administrators which are independent of the investment managers. Fund offering documents typically set out the general procedure which will be followed when valuing investments. Despite the appointment of an independent fund administrator it is often the case that for certain complex and difficult to value assets the price is determined by the investment manager. This presents a clear conflict of interest which needs to be addressed.
Potential directors need to understand the process which managers will adopt when valuing such positions. Directors should require that managers operate a transparent valuation committee with clear terms of reference.
A potential director should have assurance that he/she will be provided with minutes of all relevant valuation committee meetings along with documentation supporting any valuation decisions.
Director selection process
The extent to which a manager employs a rigorous process when selecting directors indicates the importance to the manager of the role performed by the board. A potential director should expect to be subject to interview in person, or at least by telephone. The manager should adopt a structured approach and provide a briefing document with information about both the fund and the manager.
A manager that demonstrates care in identifying potential director candidates is likely to value their contribution. The reverse is also likely to be the case.
Directors’ compensation level
A director is entitled to a fee for his/her services. This fee is charged to the investment fund and the amount can vary considerably. The fee level will be impacted by various factors including the size and complexity of the fund, the number of sub-funds, the number of board meetings to be attended and the experience of the proposed director. The potential director must be satisfied that he/she will receive appropriate compensation for the service provided. Where a manager offers a fee which is well below the market rate, it may indicate that the manager does not value the role of the director or recognise its importance. Furthermore, if the primary focus is on minimising costs, potential directors should consider the extent to which such a culture may impact on the willingness of the manager to make sufficient investment in compliance and the internal control infrastructure within its own firm.
A below market rate may thus indicate that the director is assuming a greater degree of risk than would otherwise be expected.
Directors and officers insurance
Directors should expect appropriate directors and officers insurance cover to be in place. The proposed director should obtain confirmation that such cover is or will be put in place and also review the policy and level of cover.
Given the focus on director’s liability and the increase in litigation relating to investment funds directors should regard adequate insurance as a minimum requirement before accepting a position.
The role played by fund directors is subject to increased scrutiny as the importance of fund governance is recognised by both investors and regulators. There is a demand for candidates with relevant expertise and knowledge of the funds industry. However, from the perspective of the potential director, a certain amount of due diligence must be carried out before accepting an appointment. Potential directors are well advised to be confident that the investment manager intends to operate the fund in an appropriate manner before accepting a director position.
If you have any questions regarding this article or general fund governance queries please feel free to contact one of the KB Associates consultants below.