In this second article in the KB Associates’ series on fund governance consideration is given to board composition and the process managers should adopt to establish an appropriate board of directors for an offshore fund.
Director selection – who decides?
It is noteworthy that while fund directors represent the interests of a fund company and its shareholders the appointment of initial directors to a fund board is driven by the manager establishing the fund. A seed investor may have input to the composition of an initial board however such investor involvement is rare.
Investors may, depending on the voting entitlements of shares issued, be entitled to determine the composition of a fund board subsequent to the launch of a fund. However, even where investors have the legal power to appoint directors the reality is that, other than in exceptional circumstances, asset managers continue to determine board composition.
Director selection – key considerations
What factors should managers consider when appointing directors? Firstly managers need to recognise that fund directors ultimately represent the interests of investors i.e. managers’ clients. This means that a smart manager will wish to establish a fund board which mirrors that which a fund’s investors would seek to appoint. Key factors to be considered when assessing potential directors include:
- Independence and avoidance of conflicts
- General industry knowledge
- Specific current industry expertise
- Communication skills
It is accepted that any directors appointed to a fund board should be of unblemished character. Managers will want to ensure that those appointed are not subject to any disqualification order, current litigation or current regulatory investigation. There should be no past adverse findings by a court or regulatory body or indeed any potentially adverse media coverage.
Independence and avoidance of conflicts
Differing views exist as to the importance of operating an entirely independent board. Investors’ preference is that a majority of board directors be independent. Indeed some investors wish to see an entirely independent board. However, KB Associates’ experience is that most investors accept one representative of the manager being appointed as a director subject to the chairman and a majority of directors being independent.
In determining independence it is important to consider not just whether or not a director is an employee of the manager. Consideration also needs to be given to family and personal ties to the manager, professional relationships which may exist between a potential director and the manager or indeed other service providers such as the administrator. Furthermore where an “independent” director receives a significant portion of his or her income from acting as a director to funds promoted by a particular manager many investors will no longer consider such a director to be truly independent.
Investors expect managers to consider the independence of fund directors and the potential existence of conflicts on an on-going basis. These are not issues to be considered only at fund inception, they must be subject to regular assessment.
General industry knowledge
Each director should demonstrate a firm understanding of the offshore fund industry and in particular appreciate the key risks relevant to the particular fund structure, investment strategy and operational arrangements. While funds operate an outsourced model with investment management, risk management, distribution, fund administration and custody all outsourced the directors are required to oversee, albeit at a high level, these functions. Investors expect a board of directors to possess sufficient knowledge to demand appropriate service provider reporting and to assess the content of such reports. It is not sufficient that directors be able to assess the reports presented to them. A board needs to be able to identify those areas, based on the risk factors relevant to a fund, where additional reporting should be provided.
Specific current industry expertise
While each director is expected to possess a general understanding of the industry, investors increasingly expect individual directors to bring particular knowledge to a board such that collectively the board will in fact have deep expertise in each of the key activities relevant to a fund company which may be responsible for hundreds of millions of dollars of assets.
Managers establishing fund boards can benefit from appointing directors with current expertise across any one of a range of disciplines including compliance, legal, investment risk management and fund operations. Not only do such appointments provide assurance to investors but individuals with specific expertise may well be able to provide useful advice to a manager aimed at reducing risk or increasing efficiency relating to the operation of a fund.
The rate of change within the industry across all disciplines is rapid and thus managers need to pay particular attention to ensuring that expertise outlined in a potential director’s resume is current and not obsolete.
Regardless of a director’s expertise there is a limit to the number of relationships which any single director can properly maintain. KB Associates recently surveyed over thirty of its asset manager clients and a majority indicated that an appropriate upper limit for the number of manager relationships which a director should maintain was thirty with a sizeable minority of managers, just over 30%, suggesting that it may be appropriate for directors to maintain relationships with up to fifty managers.
Regardless of what investors or managers believe to be the appropriate capacity limit KB Associates’ experience is that all investors now expect complete transparency with regard to both the number of manager relationships and individual fund positions held by any director. In order to meet investors’ expectations managers must adopt the same standard. Any potential director who is unwilling to disclose such information should not be considered as a director candidate by a manager wishing to attract investors to a fund.
In common with the other director attributes noted above capacity is a factor which needs to be regularly assessed and fund boards correctly require directors to disclose at least annually the number of positions held as well as requiring prompt notification of any material changes.
Increasingly potential investors wish to speak with or in some cases actually meet in person with independent fund directors prior to making an investment. While having appropriate directors will not be the factor which attracts investors to a fund it may well be that an inappropriate board of directors may disadvantage a manager seeking to raise capital. As noted above the directors must possess the appropriate expertise and capacity but equally it is important that directors be able to communicate this to potential investors as part of the operational due diligence process. Potential investors require that each director understands the nature and key risks of the fund, and is taking appropriate actions at a high level to manage these risks.
Investors seek assurance that directors are pro-active and not, to use the phraseology of the Weavering case, simply “automatons” blindly following the wishes of a manager. To facilitate successful operational due diligence it is not sufficient that fund directors understand and address the key risks associated with the operation of a fund. Directors must be able to successfully communicate this to potential investors.
While not the primary concern for investors, managers should pay attention to cultural fit when appointing directors. Directors must interact with each other and a fund’s service providers, particularly the manager on a regular basis. If maximum benefit is to accrue to all parties including the investors it is important that those relationships be open and professional. Diversity is important and can contribute to the avoidance of “group think” by the board and mitigate the risk of an inappropriately cosy relationship between directors and the manager. However, a degree of cultural fit is necessary to ensure open relationships and the free exchange of ideas and opinions. Cultural fit can support such openness and facilitate the expression of diverse opinions, indeed of frank disagreement, without issues being personalised and a defensive posture being adopted by board members or the service providers to a fund.
How to source directors
Know what you want
Before sourcing fund directors a manager should determine the profile of the directors it ideally wishes to appoint. The investment strategy, the domicile of the fund, the skills any directors related to the manager will bring to the board and the target investor base, noting both geography and sector, are all factors to be considered. As with any other appointment the manager should document the requirements for each proposed director role distinguishing between those requirements which are essential and those that are merely desirable. Where appointing multiple directors there should be an individual specification for each position as a manager should be seeking to appoint directors with complementary skill-sets.
Know where to look
Many managers turn to their legal advisors, administrators or prime brokers for assistance when seeking to identify director candidates. Given their level of activity in the marketplace these service providers will be familiar with various individual directors and firms offering directorship services. However, managers may wish to bear in mind that any director appointed will subsequently be responsible for monitoring the level of service provided and fees charged by such firms.
Managers should where possible speak with investors who may have experience of interviewing directors as part of operational due diligence in respect of other investments and be in a position to make recommendations. Discussions with other managers may also be helpful in identifying suitable candidates.
Make the right choice
The selection process needs to go far beyond simply accepting recommendations and/or reviewing resumes. An evaluation of resumes against pre-defined criteria can eliminate potential director candidates but clearly is insufficient to determine who to appoint.
In preparing for any in-person or indeed telephone interview the manager should prepare an advance briefing document for the director candidates giving information regarding both the fund and the investment manager. By providing an advance briefing document it is reasonable for managers to expect the candidates to have understood the nature of the fund and its strategy and as a result to raise various questions regarding the operation of the fund and in particular the key risks. Listening carefully to the questions raised by potential candidates may give the manager a far better sense of a director’s competence than listening to a director’s standard explanation as to why he or she should be appointed.
Given the importance of cultural fit the manager should meet in person with any director before final appointment and consider how the directors are likely to interact with each other as well as with the manager.
As investors increasingly focus on how they can best minimise operational risk fund directors are now in the spotlight. The competence of fund directors will not be the reason an investor allocates capital to a particular fund but it may well be that, on the margin, a poorly constructed board of directors will contribute to a decision not to invest.
Considering all factors, the time and effort spent by managers assembling a fund board which meets the expectations of potential investors is likely to be well rewarded.
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.