Issue 1: An Overview

Introduction

This is the first of a series of Hedge Fund Governance Briefings in which we will focus on the practical aspects of governance in the context of the current environment for hedge funds. It is obvious that investor appetite for improved governance and controls is increasing and that investment advisors will need to respond to this.

According to research conducted by Carne in 20111, 91% of allocators to hedge funds said they would decide against investing in funds that did not meet their governance criteria. In addition, over 80% of investors rated governance as "extremely important", and 76% told Carne that they had declined to invest in a fund at least once due to governance concerns. Our findings have been supported by further research, carried out by Ernst & Young2.

In addition, the Madoff fraud aside, critical legal rulings like that of Weavering3 point to a situation where investment advisors without adequate governance on their fund boards could face serious consequences.

This all points to a situation where governance has ascended to the top of many investors' lists of concerns when it comes to carrying out operational due diligence on hedge funds. For investment advisors, the question remains: what is good governance, and how can it be achieved?

What is good governance?

This overview seeks to define in plain language what hedge funds governance means and highlights a number of specific and important components of governance. Each of these components will be the subject of subsequent issues in this series of briefings, in which we will outline some of the main ingredients in greater detail and provide constructive solutions as to how to achieve best practice in this area.

Best practice in hedge funds governance does not simply mean achieving minimum standards; it means defining, implementing, maintaining and augmenting a robust infrastructure of governance. This infrastructure must satisfy the increasing demands of investor due diligence, yet fit seamlessly into all of the other operational aspects of operating a hedge fund.

Our series of Hedge Funds Governance Briefings will guide you through the requirements to achieve the highest standards in hedge funds governance.

Definition

The starting point is to define what is meant by the expression "Hedge Funds Governance".

Hedge funds governance is the system by which hedge funds are directed and controlled. The directors are responsible for governance and their responsibilities include supervising the management of funds and reporting to investors. The directors' actions are subject to applicable laws and regulations and they must act in the best interests of investors.

As the investment management and the day to day operations of hedge funds are delegated to third party service providers - the principal ones being the investment advisor, the administrator, the prime broker and the auditor – hedge fund directors act in a non-executive capacity on the fund's board with a legally binding brief to provide management oversight of a hedge fund's activities and its delegates. This role brings with it a continuing responsibility and it is not merely limited to participation at periodic board meetings.

It is important to stress here that independent fund directors sit on the board of the investment fund itself, not that of the fund's investment advisor. The directors have a duty and obligation to the investors in the fund. Independent directors are considered to be individuals with no link to the investment advisor or its significant service providers, commercial or otherwise, and typically will have a solid track record in the investment management industry, for example working with a law firm, fund administrator or audit firm in a previous role.

A good governance policy will extend over a wide range of different fund-related functions and can help to assure investors that the fund is being responsibly managed. Carne will address these issues in this series of briefings over the coming months, but we include summaries below:

Directors

The role and responsibilities of independent directors are clearly defined, but the onus is on finding the right people to sit on a fund board, and being clear about what investment advisors and investors should expect of directors.

Board Meetings

The agenda items to be covered in a board meeting are important, including who should attend (and who shouldn't), the frequency of meetings and what should be in a board pack.

Conflicts of Interest

Investors are increasingly focusing on conflicts of interest - the investment advisor needs to be aware of the typical conflicts of interest that can occur and how to rectify them effectively. This briefing will focus on examples of common conflicts and can help the investment advisor put in place a structure to manage conflicts.

Operational Activities

Critical operational activities that should be covered by a fund board include broker/bank account opening, control over fund payments and cross trades management. This briefing also includes the operational policy documentation funds will be expected to have in place.

Investor Reporting

Good governance also covers communications with the investors in the fund. Financial statements need to be properly audited, and periodic investment updates will have to meet accepted industry standards.

Valuation Policy

Investors are increasingly devoting attention to how the fund is valued, and it is now considered essential that a proper policy for this is in place for the fund. This briefing address the wording in the fund's offering memorandum and the director's discretion to value.

Risk Monitoring

Good governance can feed through into risk management, as the board also has a role in ensuring that various investment policies are adhered to, including liquidity, pricing, compliance, credit and counterparty risk.

Confidentiality

Directors also have a duty of confidentiality and funds need to be sensitive to policies and obligations surrounding the disclosure of minutes, side letters, and treating investors fairly.

Footnotes

1. Corporate Governance In Hedge Funds: Investor Survey 2011 (Carne Global Financial Services)

2. Coming of Age: Annual Hedge Fund Survey 2011 (Greenwich Associates/Ernst & Young)

3. Weavering Macro Fixed Income Fund Limited (in liquidation) vs Stefan Peterson and Hans Ekstrom

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.