As institutional investors continue to drive asset growth in the hedge fund industry since the 2008 financial crisis, they are also acting as a catalyst for positive change that benefits the interests of all investors.
These institutional investors include pension funds, both public and private, insurance companies, foundations and endowments and sovereign wealth funds, whose capital account for the majority of the industry.
A global survey of institutional investors, conducted in 2013 by AIMA's Investor Steering Committee, found that institutional investors had either invested in hedge funds for the first time, or had increased their allocations, in some cases to more than double since the financial crisis. Quite significantly, the survey also revealed that investors viewed hedge funds as a vehicle to help them "meet individual objectives in terms of risk-adjusted returns, diversification, lower correlations, lower volatility and downside protection" and that they were quite bullish about allocating even more to hedge funds in the future.
A Call for Greater Transparency
Generally, institutional investors welcomed the industry's increasing emphasis on transparency, the survey found, and were not at all daunted by the increasing regulation of the industry, except for some disquiet about the cost of such regulation. In fact, these investors have called for even greater transparency, changes to governance within the industry and enhanced operational infrastructure.
These and other considerations are helping to fuel a new round of debate amongst industry participants and give institutional investors, in particular, a bigger say about the future of the industry. Indeed, new investor advocacy groups of influential institutional investors formed during 2014 are adding new perspectives to these core issues.
A Focus on Independent Directors
Governance is of particular importance and the value of independent directors who are nonaligned to the investment manager and its service providers is being further underscored.
The U.S. Securities and Exchange Commission's (SEC) fund governance standards released in 2004 (Federal Register/Vol. 69, No. 147/Monday, August 2, 2004/ Rules and Regulations) provide the hedge fund industry with benchmark guidelines for some of the key governance issues that are of lingering concern to institutional investors. In particular, the role of independent directors on the fund's board and how directors act in the interest of investors will always be a salient issue. Institutional investors are making it a point to not only ensure that the funds they're investing into have independent directors, but to meet with and assess these independent directors.
From our experiences, we have seen the benefits of an independent board where a fund finds itself in a distressed situation. Where questions of redemptions and payouts arise, an investment manager could act on his own accord and, without the impartial oversight and other checks and balances, could potentially "loot" the fund of its resources under the veil of a required indemnity for example, or make preferential payments to affiliated parties.
Quality, institutional hedge fund boards must be capable of managing conflicts of interest and ensuring that investors have all the information they need to make an informed investment decision. Approving material changes within the fund structure like service providers, approving side letter terms, approving financial statements and ensuring the fund's compliance with what has been stated in its Offering Memorandum are a few of the examples of the responsibilities that an independent hedge fund director may need to undertake to achieve this.
Today, some key fund governance considerations remain around board performance and the quality of fund documentation.
Board and committee performance continues to be a focal point of institutional investors and should be assessed in-depth at least annually. Consider whether the composition of the board, the capacity of its members, plus the frequency (and location) of its meetings and transparency reporting meet stakeholders' expectations. Direct interactions with board members have continually increased since the 2008 financial crisis, with board members now providing greater transparency and more information to demonstrate and explain board involvement, performance and effectiveness.
A critical part of this assessment, however, is out of the control wof the board and the scope of its authority. If the voting shares of the fund are not held by an independent party, or the fund is a feeder into a master fund that is not governed independently, or the fund documents impose undue constraints, the board may be rendered impotent or severely hampered in achieving effective fund governance. In these instances, board composition, capacity and other performance considerations become less relevant.
It is important to review the tax status of the board members annually and ensure that all directors or officers of the fund have provided evidence of required filings with their home jurisdictions. For example, US citizens and US residents who are officers, directors, or shareholders in certain foreign corporations (including offshore investment funds) may be responsible for filing Form 5471 Information Return of US Persons With Respect to Certain Foreign Corporations. The form and attached schedules are used to satisfy the reporting requirements of transactions between foreign corporations and US persons under sections 6038 and 6046 of the Internal Revenue Code. Substantial penalties exist for US citizens and US residents who are liable for filing Form 5471 and who fail to do so.
The location of board meetings is also important. In recent years, a series of US court decisions have found that the center of main interests (COMI) of various Cayman Islands funds was not in the Cayman Islands. An important consideration of these courts in determining the COMI, included the finding that "none of the directors resided in the Cayman Islands and there was no evidence of any board meeting taking place there". If a Cayman Islands fund is assumed by an official authority to not conduct a trade or business in the Cayman Islands, it may cause adverse tax and regulatory consequences for the fund. It is generally accepted that "substantially all" of the board meetings of a Cayman Islands fund be conducted in or from the Cayman Islands.
Fund Document Review
Material fund documents should be reviewed at least annually to ensure they are fully and fairly informing investors of current practices, considering the pace of regulatory changes in the industry and fiduciary obligations. The board should consult with its professional advisors on any proposed changes, including benchmarking current and proposed practices against industryleading trends, to ensure fund documents remain compliant with best industry practices.
With greater scrutiny from institutional investors, and as the hedge fund industry evolves its governance structure to respond to the new reality, the onus is not just on directors, but all service providers and fiduciaries to hedge funds to advance their practices to institutional standards.
About the Author
Kevin Phillip is an Executive Director of DMS Offshore Investment Services and Business Unit Leader of the DMS International Tax Compliance Group and DMS Outsourcing Ltd. He leads a team of professionals at DMS, supervising the governance of hedge funds and Cayman Investment Managers, and provides guidance on accounting, regulatory, legal and financial matters. He also serves on the boards of a variety of hedge funds and related structures.
Originally published in Cayman Finance Magazine, 2015-2016, Issue 2
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.