This research paper represents the most comprehensive survey to date of institutional hedge fund allocators’ views on the issue of corporate governance in hedge funds. Hedge fund governance is an issue that has increased inimportance since 2008, with allocators now actively pressing for changes in the way that hedge fund boards are managed.
The call for changes in the way that hedge fund boards are constituted, and in the role played by directors on those boards, is becoming increasingly evident in both the trade press, and in the opinions being expressed by investors in the various forums open to them.
Moody’s, in its recent note on fund governance, said:
“Corporate governance practices for hedge fund firms are more closely examined today than at any other time in the history of the industry…hedge funds firms have experienced a shift in their investor composition from high net worth individual investors to institutional investors…Institutional investors have shown that they view the evaluation of governance and oversight as it relates to risk management, valuations, operational controls, transparency and the investment process as important as analysing a hedge fund manager’s investment performance.”
In addition, investors have been lobbying individual fund managers and regulators, including the Cayman Islands Monetary Authority, for change. At a time when investors are already keen to increase their allocations to hedge funds, it is becoming evident that the governance issue is acting as a drag on the flow of new investment into hedge funds. The majority of hedge fund investors want hedge fund managers to fully support investor protection values. The recent judgement by Justice Jones in the Cayman Islands relating to the Weavering case also shed light on some of the expectations which the judiciary have of directors on fund boards. These include the onus on the directors to perform their duties on behalf of the investors, including demonstrating a solid awareness of the underlying activities of the fund and its investment manager. In his judgement, Justice Jones expected that investment managers and boards of Cayman Islands funds should ensure that they put in place adequate governance processes, and that any conflicts of interest are addressed. Directors, the case revealed, need to be remunerated for the work they perform, but at the same time they must be performing that work.
The Weavering case analysed the motivations of the directors as well as their actions. An obvious conclusion is that, due to potential conflicts, investment managers and the employees from their firms acting as directors ontheir funds [see Appendix C], require independent directors in order to demonstrate that the interests of investors can be considered and that this is properly analysed and documented. However, these independent directors must meet Justice Jones’ criteria of fit and proper directors.
The changes being called for in hedge fund governance represent an opportunity for hedge fund managers themselves to seize the initiative, and to help to build new bridges with the investor community, while at the same time improving the overall image of the alternative investments industry. It is an initiative that is being increasingly supported by regulators, by the Alternative Investment Management Association (AIMA), by the Hedge Funds Standards Board (HFSB), and by other industry-level associations.
This is further encapsulated by new layers of the operational due diligence process applied to potential new investments, as evidenced in the recent Transparency Report questionnaire compiled jointly by a number of major allocators [see Appendix D]. This represents a good indicator of the levels of awareness investors are now seekingabout the boards of the funds they invest in, and the credibility of firms providing independent directors to those boards
Although the hedge funds industry continues to achieve some of the best risk-adjusted returns of any single component of the asset management sector over the last five years, it still suffers from an image problem. This industry is deserving of a better reputation, a reputation which can only be enhanced if fund managers take the opportunity to assure investors via improved governance. Pension funds, for example, continue to treat hedge funds with caution, and would no doubt be more enthusiastic if they could see that not only do hedge funds generally offer them superior returns on a risk adjusted basis when compared to investment in traditional funds, but also offer higher governance standards. Good governance can help here, by improving the culture of the industry and demonstrating that hedge funds can reduce downside risk and protect investors’ capital.
Hedge funds are also coming under greater scrutiny from regulators. Better governance standards may help to mitigate some of this. As Amelia Fawcett, Chairman of the Hedge Fund Standards Board (HFSB) said: “Standardsdon’t replace regulators, but they can do things they can’t. Can standards be more effective than regulations? Absolutely.”
Some institutional investors devote substantial amounts of time and money doing their own due diligence, to provide themselves with adequate oversight, some of which should also be delivered by the directors of fund boards.
The case for good governance is compelling: an industry-wide governance regime would reduce risk for both investors and investment managers at a time when they are seeking to trim down the number of risk factors they have to deal with. Carne believes that this research paper can form the basis for such governance standards, and represents the opinions of institutional investors.
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