Originally published in Hedge Funds Review, May 2007.
Corporate governance is not just about conformance – in fact it’s rather about performance and is an indicator of a strong and well-managed company.
Traditionally corporate governance has been viewed as simply burdensome bureaucracy – a set of procedures that distract from the core focus of maximising return and as such it has often been stuck at the foot of the priority list.
The corporate scandals in the early years of the twenty-first century such as Enron and Worldcom were rooted in a failure of corporate governance, raising concerns about the (poor) levels of corporate governance across the wider commercial landscape. This provided the catalyst for a refocusing of minds onto the application of better corporate governance practices.
There has been an increasing realisation that best corporate governance is not just conforming to a set of procedures (monitoring and control) but also part of developing a strategy and organising an execution of it to attain specific objectives (strategy and structure). The importance of this second element is illustrated by a Booz Allen Hamilton study, which shows that more value has been wiped out by poor strategic execution than the sum of all the corporate scandals.
So, particularly in the post-Enron environment, with good corporate governance indicating a strong and well-managed corporate entity and evidence (worldwide) of a high correlation between poor performing companies and low levels of governance, is it any wonder that high standards of governance receive a better rating from investors and lenders?
It would be easy to suggest that such conclusions do not apply to hedge funds and funds of hedge funds because their make-up means that they are already considered caveat emptor (literally, ‘let the buyer beware’) types of vehicles. I would take issue with this on two counts: firstly, the name itself implies that the risk is being ‘hedged’, which means it is not necessarily any more risky than other vehicles and in fact, statistically, for smaller portfolios hedge funds can be a less risky option; secondly, hedge funds are now more mainstream, indeed, not only are they an accepted part of a portfolio but it has become increasingly uncommon to find a portfolio which excludes this investment category. The story that hedge funds do not need good corporate governance because they are caveat emptor vehicles is a myth. The same standards of corporate governance should apply to hedge funds or funds of hedge funds as for any other company and in fact it is arguable that because of this myth they should be even stronger.
What is Best Practice?
Offshore fund companies are eligible for exemption from the requirements of the Combined Code. However I would recommend, as is common place in jurisdictions such as Guernsey, that the board take advantage of the option to put in place a code of best practice, which enables the company to voluntarily comply with the main requirements of the Code and hence establish principles of good governance.
The Mix in the Boardroom
Important in corporate governance is the constituency of the board of directors. For a hedge fund based offshore in a jurisdiction such as Guernsey there are no direct rules as to the make-up of the board. However, as the control element is offshore, there will be greater demand on the time of directors based in that jurisdiction and so it makes practical sense that the majority would be located offshore. Taking this approach also helps provide clear delineation between the onshore investment management and the offshore overall management and control of the company.
The value of diversity in the boardroom though must not be over-looked. I completely concur with the sentiments expressed in the UK Government’s Department of Trade and Industry publication of December 2004, which says: "…introducing diversity isn’t about tokenism." Boards with greater diversity have a wider range of perspectives and are therefore more likely to anticipate problems and produce high quality solutions."
Historically one of the key criticisms of the offshore funds industry has been that there are a small number of directors sitting on the boards of a large number of funds and as such there has been a long-running debate over whether the number should be limited by law. I would reject such a notion.
- Are there a small number of directors with a large numbers of funds? Certainly it is less so the case today than in the past, particularly in Guernsey where there has been a real focus in the last few years on strong corporate governance.
- Directors do on the whole take their various fiduciary responsibilities very seriously. Being a non-executive director is a ‘real’ job!
- Directors naturally limit the number they take on because (as the previously mentioned corporate scandals have illustrated) with unlimited liability there can be a heavy price to pay if things go wrong.
- The specific number each person can take on varies according to individual circumstance and the fact that the types of funds and their related time commitments vary considerably.
- In Guernsey, the regulator, the Guernsey Financial Services Commission (GFSC), approves all directorships for locally registered funds and their intimate knowledge of the pool of directors means that they can monitor the spread of directorships, as can the Channel Islands Stock Exchange.
- Guernsey boasts a large pool of experienced and qualified non-executive directors. During the past five years more than 100 people have completed the Institute of Directors’ Company Direction programme and the Island has 22 Chartered Directors out of 500 nationally. There is even a local register of directors.
A further contentious issue in some centres is the appointment of the same directors for a number of funds. Generally investment vehicles established in such a manner do not list on the London Stock Exchange because the Combined Code looks for independence and separation – with different non-executive directors being appointed for each fund launched by the same sponsor/investment manager. However, being involved in more than one related fund assists directors in performance of their duties, as they have not just detailed knowledge of a particular fund vehicle but a wider perspective, including an overview of the asset manager’s business.
Indeed, central to successful corporate governance is maximising the contributions of the directors. A comprehensive induction process for new arrivals to the board is vital for them to have a full understanding of the business. The company employs them and they have a wealth of experience and expertise so it is vital to use them productively, whether for investor marketing or due diligence or ongoing management and control.
Duties and Responsibilities
It is also important to be clear about the directors’ duties and responsibilities. In Guernsey the GFSC has a corporate governance code and guidance for boards to follow, but many funds go much further by detailing duties, responsibilities and reserved powers. Good governance includes establishing sub-committees of the board to review and report on the company’s activities. In offshore funds it is usual for the Chairman to be an independent non-executive director and so it is not always necessary to establish either a remuneration or nominations committee. The audit committee is though in my mind a ‘must have’, providing a very important function. On top of these checks and balances there should be annual reviews of risk, responsibilities, the performance of the board and of individual board members.
The Gold Standard
What we have established is that the best corporate governance is more than just monitoring and control but is also strategy and structure. These companies have the right mix of directors, the duties and responsibilities of the directors are clear, they are utilised as effectively as possible for the experience and expertise that they offer and there is a culture of review and report. Investors favour companies applying such principles because it shows that the company is well run and evidence suggests that they perform better. The gold standard of corporate governance though is for the hedge fund manager to also establish a physical presence in the jurisdiction in which they are based. This illustrates real commitment to governance and provides an aura of confidence that drives performance onwards and upwards.
For more information about Guernsey's finance industry please visit www.guernseyfinance.com.
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