Fund governance, particularly within the hedge fund industry, has become an increasingly important subject, primarily as a result of investors’ understanding of the risks they are taking. Several high profile fund failures resulting from fraudulent manager activity (Madoff, Weavering, Petters etc.), legal action by investors against managers (Medley), increased regulatory activity and volatile investment markets mean that investors are now far more aware of the risks of investing in hedge funds. Simultaneously institutional investors have become the primary source of investment for hedge funds. This has meant more thorough due diligence being undertaken prior to the allocation of capital. This due diligence focuses on funds’ governance structures as well as operational and compliance controls at both a fund and manager level. Investors expect to assume investment risk but they are no longer prepared to tolerate avoidable operational risk.
So what is fund governance? At its simplest, it is the control structure within which funds are managed, directed and controlled. Board independence, outsourced independent valuation, segregation of functions, absence of conflicts of interest plus increased transparency and reporting are central themes. While fund directors play a key role there is a realisation that the fund governance framework also includes the roles played by key service providers such as custodians, prime brokers, administrators and investment managers. Indeed investors may rightly consider the regulator in the jurisdiction where the fund is domiciled to be part of the overall governance framework. While the control structure, including written policies and procedures, is important good governance also requires a culture within the fund, the manager and other service providers such that investors’ interests are of primary importance. Directors with sufficient independence, commitment and knowledge to understand the activities of the manager and other service providers can certainly ensure an appropriate control structure is in place and can help create a culture which improves the likelihood of investors’ interests being prioritised.
The Global Financial Crisis and Fund Governance
The past four years has been a challenging and complex time for many hedge funds. Withdrawal of liquidity from the markets as well as a fall in asset values, particularly in late 2008 and throughout 2009, led many investors to redeem positions in funds and this led to managers seeking to liquidate positions in adverse market conditions. Unable to generate cash to meet redemptions many funds relied on little used clauses in the offering documents to restrict the amounts being paid out to investors. Gates were imposed and certain asset class valuations were suspended. As redeeming investors sought cash directors found themselves adjudicating on the appropriateness of invoking suspensions, operating gates and imposing redemption levies. In doing so directors had to be cognisant of obligations to all investors, not just those who had submitted redemption requests. Furthermore the interests of investors and those of the managers were not always aligned. When favourable market conditions existed in the hedge fund world pre-2008, with liquidity and confidence both in plentiful supply, little attention was being paid to fund governance or the role of independent directors. Only limited consideration was given to scenarios such as that which emerged post Lehman. When confidence and liquidity disappeared fund directors had to address difficult decisions while operating in unprecedented market conditions.
One positive outcome of the past four years is that investors, managers, lawyers, custodians, administrators, accountants and advisors have all become acutely aware of their roles and responsibilities when establishing and running a hedge fund. Investors in particular are driving change in the industry and are seeking more stringent operational environments and enhanced governance structures. They now understand that the risks of hedge fund investing extend far beyond performance returns.
Manager Fraud and Fund Governance
Fund failures due to fraudulent manager activity have for many investors broken the near blind trust historically placed in hedge fund managers. Investors have responded by enhancing operational due diligence and by looking to independent directors as a potential, though inevitably limited, source of investor protection. If directors have a duty of care to the investors, they have to be able to demonstrate that they have the experience, commitment and integrity to discharge these duties. Many investors now assess not just individual directors but look at board composition in its entirety considering the extent to which the directors have relevant and complementary skills and also the extent to which directors are free from conflicts of interest. The board needs to demonstrate sufficient experience and qualification to oversee the activities of the fund manager and other service providers. It needs to demonstrate that it is independent of the manager and also of the service providers so that the manager and other service providers can be held accountable for the proper performance of their duties. Indeed many investors will not allocate capital to funds where board composition is deemed inappropriate regardless of a fund’s investment performance
The Weavering case, while no doubt extreme, has highlighted some of the weaknesses and lapses in governance standards that existed and has served to clarify directors’ responsibilities. It made clear that directors cannot be reactive and simply rely on the performance of other service providers. Directors must actively review and monitor the activities which are outsourced and they are limited in their ability to delegate this responsibility to others. Furthermore directors need to consider the service providers being appointed and the contractual terms under which such service providers will operate. The need for directors to do more than just be led by the manager’s wishes was a recurring theme throughout the judgement. It was made clear that directors should drive the agenda for fund board meetings and ensure that appropriate board reporting is available from each service provider.
The Weavering case was unusual not just in terms of the extent to which the directors were found to have failed to monitor the fund’s activities but also in that all three directors were related to the investment manager. It highlighted the need for strong independent fund directors. This move towards having at least some independent directors on fund boards has been underway for some time. Historically many administrators provided directors to hedge funds, however, this practice is now increasingly uncommon as investors require independent directors and administrators no longer wish to expose their staff or indeed the firm to potentially significant conflicts of interest.
Given the increased reliance being placed on directors it is perhaps not surprising that the financial press has raised the issue of “Jumbo Directors” i.e. instances where directors sit on several hundred boards, and questioned how in such circumstances directors can pay sufficient attention to each fund to properly discharge his or her duties. Potential investors now require transparency as to the number of director positions each fund director holds and where directors sit on hundreds of boards that can be a negative factor. Directors must be able to demonstrate that they have sufficient capacity to perform their fiduciary duties to the investors.
Regulatory Focus on Fund Governance
The focus on fund governance has come not just from investors. Regulators and industry associations are also addressing fund governance. Ireland’s funds industry has been to the fore with the local industry body developing a voluntary fund governance code which requires fund boards to address issues of director independence, director time commitment and meeting participation as well as a host of other items. While voluntary the code will operate on a “comply or explain” basis and has been endorsed by the Central Bank of Ireland. Other jurisdictions are also looking at enhancements to their fund governance regimes.
The hedge fund industry is facing a period of increased competition for investor capital along with increased investor sophistication and the accompanying demands for more robust governance structures. Managers establishing funds need to ensure that they maximise the likelihood of attracting capital by developing fund governance structures which are viewed positively by potential investors evaluating the fund. With the right approach to fund governance managers can increase the chances of attracting scarce capital.
Throughout 2013 KB Associates will release a series of papers sharing our thoughts as to how funds can develop strong fund governance structures which support the funds’ capital raising objectives.
If you have any questions regarding this article or general fund governance queries please feel free to contact one of the KB Associates consultants