Hedge fund directors: The corporate governance conundrum facing managers
Driven by the influx of regulation and the growing demands of institutional investors, hedge funds have made significant improvements in their operations since the crisis of 2008. Despite many managers upping their game though, there still remain areas where progress is drastically needed - none more so than corporate governance.
A fund’s directors will typically have a fiduciary role. Their obligations will include ensuring whether a fund is legally compliant, structured properly - but most importantly – they will act on behalf of and protect the investors in that fund. They are, above all, responsible for ensuring safety of fund assets.
There has been widespread muttering among industry experts that directors are not always as effective as they should be. This has prompted reviews of corporate governance structures in several hedge fund jurisdictions including Ireland, Guernsey and Cayman.
Corporate governance is something that has not always been of paramount importance to a lot of institutional investors. Like many things before the 2008 meltdown, it did not really register – as long as the hedge fund was making decent returns, many investors were not really that concerned about who sat on the board.
And then 2008 happened.....
Fast-forward three years and this same lack of interest among investors about corporate governance still broadly rings true. Bar, of course, for a few but steadily growing number of incredibly diligent, institutional investors. This lacklustre investor operational due diligence is a significant error of judgement, both for the actual investor and the fund manager. Directors are there to make sure the fund operates in an orderly manner – if the wrong people are occupying these important authority positions, the fund manager and investors could be badly burnt. Having a quality corporate governance structure, given the market pandemonium of the last three years, is an absolute prerequisite.
One of London-based Carne Group’s functions is to provide high quality directors to its global fund management clients across offshore and onshore domiciles. The firm, which also has offices in Dublin, Luxembourg, Dubai, Switzerland and Cayman, stakes its reputation on allocating the cream of the crop to its hedge fund customers. “Our directors are highly knowledgeable and deeply experienced industry professionals. They are also independent of the major service providers including the manager, administrator, prime broker and legal firm. The idea of our being is to benefit the greater investment community with our expertise. Our job is to provide investor assurance. If we fail to do this, we do a disservice to the investors,” says Bill Blackwell, chief operating officer at Carne Group.
One of the biggest issues confronting the hedge fund corporate governance model is the number of funds directors actually sit on. This appears to be a big issue in offshore jurisdictions. Industry sources reveal that some directors, albeit a very extreme minority, have been known to sit on more than 1,000 boards. This is something that Carne Group strongly disapproves of. “We work for the investors at the end of the day. We believe directors should have a maximum of 20 to 30 managerial relationships. In addition, this is what European regulators are looking for,” highlights Blackwell.
Some institutional investors adopt more stringent requirements. Pierre Emmanuel Crama, head of operational due diligence at Signet Group, a multi-strategy fund of hedge funds (FoHF), believes directors should not sit on more than 20 funds. “As shareholders, we think the existing offshore model offered by the Cayman Islands whereby some directors sit on ridiculous numbers of funds’ boards needs to be broken,” he says.
If a director sits on upwards of 100 funds, one has to question their ability to service each of these companies accordingly. However, some professional firms that offer directors are incredibly well staffed. The director will, for example, have significant support from underlying employees arranging itineraries and reviewing documents for them. This ensures they are generally on top of the paperwork putting the fund and investors in good stead.
However, some believe that in the event of another market meltdown, a director sitting on a small number of boards is better placed to deal with the ensuing problems. “If you have a market event like in the recent past, everything seems to happen at once and directors have to make quick decisions. They must know the fund and its risks adequately. If you are a director with a large number of funds – what do you do? If a director has a limited number of funds, it is more probable they will be more involved to assist the manager in dealing with the situation and at the same time protecting investors’ interests. If a director sits on loads of boards, it will be the biggest fund who shouts the loudest that gets the attention whereas the others will just left behind. That is not fair on the investors,” says Chris Day, director at Carne Group.
Directors are also personally liable for the fund – if there is an operational glitch that they fail to spot and the fund goes bust as a result of that, the director could well be sued by aggrieved investors. Directors, in some circumstances, may not even be fully protected by their professional liability insurances – again this could present a worrying situation. The potential threat of legal action and subsequent reputational damage among investors is another reason why Carne limits the number of funds its directors can sit on.
However, there is a flipside to forcing directors to sit on fewer funds. Directors on average are paid between $5,000 to $7,500 per fund. Consigning an individual to just 20 funds could seriously impede their earnings – furthermore, it could possibly diminish the point of successful businesspeople venturing into professional directorship roles – that would be a very unwelcome outcome given the good work many of these individuals do.
“Directors are typically not paid much money,” says Luke Dixon, portfolio manager for absolute return strategies at the Universities Superannuation Scheme (USS). The USS made its first hedge fund investment in September 2009 – however, unlike many other sophisticated investors, USS makes solid corporate governance one of the two non-negotiable conditions funds must adhere to before they make an investment (the other being transparency). Prior to 2009, the USS invested predominantly in publicly listed companies where shareholders can have significant say over corporate governance – it therefore tries to adopt similar principles when investing in alternatives.
“If you limit them (directors) to 20 or 30 directorships, it is essential that you pay them more – especially if you want to attract high-calibre people to the profession and if you want them to do more work. Minimising director expense is a false economy – even tripling the amount you pay the right individuals could be a reasonable cost to bear to ensure better fund governance,” he adds.
Boosting directors’ pay to somewhere in the region of $20,000 to $30,000 per fund is something Crama agrees with. “Remuneration for directors should be increased to add value to the fund,” he acknowledges. Given that directors take on personal liability (and reputational risk) when they agree to sit on a board, it is fair to say that they are underpaid if one looks at the legal risks they may face.
But what will the fund managers say to this?
Assets under management, after three years of decline, do seem to be rising and look set to surpass the $1.93 trillion peak set in the second quarter of 2008, according to the latest data from Hedge Fund Research. Nevertheless, many funds are still struggling and not all have recovered from the chaos of 2008. Regulation now emanating from both the US and European Union is having a detrimental effect on the finances of these funds. Compliance costs are certainly going to rise exponentially as supervisory authorities become more demanding of managers and their operations. Is it reasonable therefore to force a small fund to be burdened with additional costs by making them pay more for the directors?
Peter Astleford, partner at law firm Dechert, is sympathetic to the plight this may cause to smaller funds. “If there is a $20 million start-up fund with five directors each taking $20,000, these combined costs are going to be a heavy drag on the fund,” he says. However, Astleford has come up with a rather novel solution to this predicament. He believes start-up fund managers with fewer assets should structure a deal with the directors whereby they are initially paid, say $5,000. “Once that fund passes a net asset value (NAV) threshold, the directors should be paid more. For example, when the fund reaches $250 million, directors could be paid something along the lines of $20,000,” he adds.
While directors need to be paid more, it also seems to appear that some lack the appropriate qualifications to sit on the board of alternative investment management companies. Despite many directors having fund expertise, there are concerns among some investors that not all boards contain individuals with the appropriate investment management experience. HedgeDirector, a newly established provider of independent directors to hedge funds, published a white paper - “Providing Better Investor Protection” -in November 2010 .
It outlines the shortcomings associated with some directors’experience. “Directors have historically been drawn mainly from the pool of offshore service providers who, while competent in the fields of administration, custody and investment law, typically do not provide any depth of actual investment experience. The fund manager is therefore being supervised by a conflicted and incomplete board, lacking the skill-set to actually understand what is going on within the portfolio,” says the white paper.
Expertise in fund administration, custody and investment law is useful – however, the lack of investment management experience among directors does raise questions. “There is a skills gap on the vast majority of fund boards, particularly with investment expertise,” agrees Dixon. “There needs to be someone who can provide oversight of what the manager is doing. There needs to be someone who has the appropriate knowledge of the markets the fund is investing in and the strategies they are trading. These individuals need to look at the balance sheets and ask the manager what they are doing with the capital. When the tide went out in 2008, there were shocking revelations over what was being held in some funds – and these were often things that couldn’t be sold easily. I once saw luxury homes, yachts and cars masquerading as private funds in a portfolio,” he adds.
Astleford is somewhat blunter on the issue. “You can’t have someone’s aunt or cousin sitting on a board who hasn’t got a clue what a fund is,” he says.”There needs to be variety on the boards with people from different backgrounds. It all adds richness to the board. It would be ideal to have people with expertise in markets, portfolio management, accounting, client or customer service, tax principles and even someone who has proven themselves in industry. A board should not be comprised of people entirely composed of one of those types – different types should be represented to ensure a mixture of all,” adds Astleford.
HedgeDirector was established by Kevin Ryan in 2010 – a man with wide experience in the FoHFs space. Ryan’s motivation for setting up the firm was brought about by his own personal experiences of hedge fund directors. “Many were just empty suits,” he rues. Ryan’s directors pride themselves on their investment management experience – the outfit also prohibits its employees from sitting on more than 15 boards – a cap far lower than what many investors and regulators are calling for. While he charges funds between $25,000 and $30,000 for each director, he believes the price is worth paying for given the high standards he says his directors adhere to. Ryan highlights funds have no other option but to appoint quality directors - especially as investors are expecting better supervisory boards.
“Hedge funds will have no choice. If they want to attract pension and insurance funds, they are going to have to raise the quality of the directors on their boards and deliver a professional standard of governance. Otherwise, they will be making themselves un-investable in the eyes of many institutions,” says Ryan.
Ireland-based KB Associates provides highly experienced directors to its hedge fund clients across the world. Expertise, according to its managing principal Mike Kirby, is a non-negotiable criteria for serving on a hedge fund board. Furthermore, Kirby stresses diversity of expertise is essential to the composition of a fund board.
“Experience is key when putting a board together. You want a diversity of skill sets. You want people with legal, financial, administration and distribution backgrounds. KB Associates believe directors should not just have general industry knowledge but also bring expertise in one specific area. I believe that those who are actively involved in the industry contribute the most to the boards. Most of our guys are actively involved in the industry,” acknowledges Kirby.
These views are shared by Sir David Walker who was commissioned by the UK government to investigate the failings of the banking system. His 2009 report stressed that non-executive directors must have the knowledge and complete understand of the business in which they operate. The same should certainly apply to directors in the hedge fund community.
Industry best practice as outlined by the Alternative Investment Management Association (AIMA) also emphasises expertise is a necessity. However, the hedge fund industry body adds firms should appoint a “majority of independent offshore directors and avoid appointing directors who represent the advisors or service providers to the fund because of the potential for conflicts of interest.”
Independence of the directors is not just in the investors’ interests but also the managers. Managers need individuals who are not compromised and will give genuinely solid advice, especially in regards to overseeing the work of the funds’ service providers. The HedgeDirector white paper warns that if directors are predominantly drawn from service providers, this could result in fund managers being supervised by a “conflicted” board.
As a rule, KB Associates has banned its directors from servicing administrators and custodians (among others) – Kirby outlines this is because such relationships could lead to a serious conflict of interest. “I think the independence is a big issue,” says Kirby. “Additionally a fund ideally should not take two directors from the same firm. The directors should be economically independent of each other. Our preference is to have only one KB Associate consultant on a fund because our guys have broadly similar expertise,” he adds.
The USS has been incredibly vocal about various aspects of corporate governance in hedge funds and has been pushing for better deals for investors. Independence from service providers is not the only concern but also independence from the fund itself. After all, the director’s mandate can include allowing the manager to restrict redemptions or side-pocket assets. They have an extraordinary amount of power – should a repeat of 2008 occur, these directors will determine at the end of the day whether or not end investors can redeem their cash and at what cost.
It is unsurprising therefore that Dixon is pushing for greater independence among directors. “The majority of directors should be independent. We go one step further and say that the quorum for any decision should comprise of at least one independent director. We want to ensure that key decisions made by the fund get the sign off from at least one of the independent directors,” says Dixon.
However, some people take this even further. Consultant Rajiv Jaitly says the potential for conflict of interest with the fund’s investors is very real because the investment manager appoints the director. “Directors are appointed by the one person they are meant to be keeping an eye on,” he says. Jaitly believes investors should have the right to nominate the directors. This, he says, would help guarantee directors worked in the sole interests of the investors and not for the fund managers’ sakes. Jaitly has pitched this idea to several sophisticated investors and has gained some plaudits – whether fund managers, however, are quite as receptive to his proposals remains to be seen. He acknowledges smaller fund managers or start-ups eager for cash would probably be more willing to compromise with the investors on this issue. Predictably he doubts the larger, more established fund managers will be as forthcoming.
Independence and expertise are increasingly becoming must-haves in the post-2008 environment. Some jurisdictions, especially Ireland, are becoming far more proactive in ensuring directors do meet very high standards. However, criticisms have been directed at several offshore jurisdictions. Signet’s Crama reckons there still remains a bit of an “old boys’ network” in some jurisdictions. This, in a nutshell, is when people have left service providers and are recommended to fund managers by old acquaintances. This is also a model Crama and others want to break.
Carne Group is in the process of expanding its business. It is currently increasing its presence in the US and Asian hedge fund markets. Blackwell and Day believe the regulated European corporate governance model, which has somewhat higher standards for directors, will start to make inroads globally – particularly in less regulated markets. “Carne is promoting a European governance model in offshore environments. In the end, governance is the back bone of every fund,” says Day.
Numerous investors are demanding greater transparency and regulation when allocating capital as is witnessed by the surge in Ucits fund launches. Ucits III absolute return funds could see more than $185 billion in capital allocations from European investors by the end of 2011, according to a recent Deutsche Bank survey. Several high profile managers including Paulson & Co and Sloane Robinson recently unveiled Ucits funds of their own. In 2010, Cayman-domiciled funds received $55 billion of capital inflows. With the offshore corporate governance model facing criticism from some sophisticated investors, could directors end up being forced onshore to more regulated environments such as Ireland?
Ingrid Pierce, head of the Cayman hedge fund practice at law firm Walkers, thinks not. “People are looking for directors with the most experience and skills and Cayman has a good track record. I cannot see there being a flight to onshore jurisdictions. The vast majority of people will remain in Cayman,” she says.
Those hoping to encourage directors to move onshore do face an uphill struggle. Offshore directors in jurisdictions such as Cayman remain very popular among US managers. After all, having a director in an onshore environment would mean that the fund would lose its generous tax breaks. However, Crama is somewhat optimistic about directors moving onshore. “I think the EU’s Alternative Investment Fund Managers Directive (AIFMD) will encourage more directors to move onshore from offshore,” he says.
So should managers be worried about the quality of their directors? In a short answer – yes! A rapidly growing minority of sophisticated investors are undertaking and improving the operational due diligence they undertake on fund boards. Many of these investors were hurt in 2008 by lock-ins and gates, while a few lost assets through their links to Bernard Madoff’s $67 billion Ponzi scheme. It is understandable therefore why these people have reason to be concerned about corporate governance.
“I want to have access to board minutes and find out what the quality of the board is like. If I see a passive board that doesn’t intervene in the course of the discussions or doesn’t seem to understand the strategies or have the experience to challenge managers – that causes alarm bells to ring,” highlights Crama. He says that poor quality boards often reside or oversee funds where operations are somewhat lacklustre. “I steer clear of managers where I have concerns that they don’t have good independent oversight. This is a red flag,” Crama adds.
At Signet, Crama will demand directors’ CVs and information about previous funds’ boards they have sat on. Another flashing light, says Crama, is if the director has been sacked from a board. However, he acknowledges that independent background checks on these individuals would be a step too far unless Signet were seeding a fund or allocating a significant amount of capital to it.
Dixon of USS concedes background checks on directors only scrape the surface. “We ask directors about the number of funds they serve on and whether they have presided over liquidations or have been removed from a board. Some directors don’t always give full responses. Some have refused to answer questions on the number of boards they sit on and are not forthcoming – some even cite privacy reasons and hide behind confidentiality which is a bit disingenuous given that if I ask managers for every offering memoranda - I can get that information because it’s out there. On the other hand, there are some directors who have been excellent and served on a limited number of boards and have tremendous experience with investment. Some have been incredibly transparent and even share our concerns and desire to improve this area of the industry,” says Dixon.
There is growing focus on the role of the fund director. While many directors do an excellent job, there are still cases of substandard corporate governance in the funds industry. Some sophisticated investors may not be doing the best operational due diligence on directors. However, others like Crama and Dixon perform in-depth, robust operational due diligence on directors - and it is getting tougher. Directors must question the managers and be totally independent. Furthermore, there needs to be a renewed focus on appointing directors with investment management experience. But perhaps most importantly, directors should be encouraged to sit on fewer funds and given financial incentives to do so. Improving corporate governance post-2008 is a sure-fire way for hedge funds to guarantee more capital allocations from potential and existing investors. Adopting these higher corporate governance standards will provide managers with invaluable oversight and help them run their businesses better.