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This fourth issue in the Carne Hedge Fund Governance Series examines conflicts of interest that exist within the hedge fund environment. Given that there are a number of different parties that contract or otherwise engage with a hedge fund, each having their own specific duties and obligations towards the fund, it is important to realise that the parties also have their own commercial interests to pursue. As a consequence of this, conflicts of interest are inevitable, both at the beginning of a hedge fund's existence and during its life.
So, what is meant by "conflicts of interest" in the context of a hedge fund environment?
A conflict of interest arises when a party is in a position whereby their impartiality and/or judgment may be compromised and actions or inactions could be influenced by matters other than those for which their judgement, actions or inactions are sought.
It is impossible to articulate a definitive list of all the conflicts of interest that may arise, but it is sufficient to draw attention to the fact that they exist and that best practice dictates that all who are involved in hedge funds should be diligent in identifying conflicts and taking the appropriate action. Set out below are some examples of typical conflicts of interest facing most hedge funds. The list is by no means exhaustive and should provoke some discussion on the subject.
Conflicts of Interest Examples
Cross Trades – these arise when the hedge fund manager arranges buy and sell trades in the same security between different funds or accounts under their management. The conflict of interest arises due to the manager's role in managing two funds or accounts, each of which should be treated equitably as regards the sale and purchase price between the two funds or accounts.
Multiple Fund Trades – where a fund manager has more than one investment portfolio under management and they are permitted to hold similar investments, the manager may place one buy (or sell) order with a broker, and then allocate the stock (or sales proceeds) to the different portfolios. There is a risk that the allocation could unfairly advantage or disadvantage one or more of the portfolios.
Favourable Dealing – many hedge funds provide that discretion can be exercised, typically by the fund's directors, in respect of the notice period for subscriptions, redemptions and for the minimum amount of subscription monies. Directors should treat each case on its merits and not be unduly influenced by extraneous matters. In particular, care should be taken to ensure that the fund's investment portfolio is not diluted or distorted in such a way as to affect it adversely.
Director's Interests and Remuneration – hedge fund directors' interests should be declared and potential conflicts should be identified. These may include other directorships and relationships, especially related to the fund. Directors acting on multiple funds that are sponsored by the same firm, typically the investment management company, will receive a director's fee from each hedge fund. The amount of the fee will typically have been negotiated and agreed with the fund sponsor. These directors may derive a significant proportion of their income from the numerous funds they act as directors for and might be financially dependent on this income source. Given that the directors' fee levels are determined to some extent by the funds' sponsors, the directors nevertheless owe their primary allegiance to each fund and must not be unduly influenced by the sponsor.
Side Letters – it is commonplace for hedge funds to enter into one or more side letters that will confer certain rights or privileges on some investors and which may not be available to other investors. Side letters typically provide investors with benefits such as more favourable commercial terms, enhanced reporting and better liquidity. In return, the privileged investors will commit to investing large amounts into the hedge fund, which in turn will result in more management fees for the investment adviser. Care needs to be taken when entering into any side letter to ensure that the benefits provided to certain investors are not unfairly prejudicial to other investors. In addition, to ensure that the terms of any side letter are adhered to, a robust procedure must be established and implemented.
Soft Commissions/Dollars – the practice of an investment adviser placing trades with a certain broker and receiving research data or information systems in return is not uncommon; the data and systems can justifiably be used to assist the investment adviser in professionally managing a hedge fund's portfolio. There have been numerous cases whereby this practice has been used inappropriately and illegally. Softing arrangements in the US and the UK are subject to regulatory control by the SEC and the FSA respectively to ensure that they are not abused.
Manager Marks – a hedge fund's administrator is generally responsible for gathering the market prices of the fund's investment portfolio in order to calculate the net asset value. Some third-party administration firms go one step further and provide a service whereby expert in-house teams can calculate the fair value of "hard to price" securities. Some administrators outsource the pricing of such securities to a specialist pricing vendor. In some cases however, securities may be valued based on valuations obtained or calculated by the investment adviser. In these situations, the valuations should, where possible, be independently verified. If they cannot be independently verified, controls and procedures should be agreed with the hedge fund directors and implemented to ensure that manager marks are fair and reasonable.
Incentive Fees – where a hedge fund pays a performance related fee to the investment adviser, the adviser may seek superior investment performance in the pursuit of higher incentive fees. This may incur higher risks than permitted or envisaged and the adviser is conflicted to the extent that a higher performance fee may be paid. There should be regular oversight at board level to ensure that the hedge fund's portfolio is being managed in accordance with the offering document and the constitutive documents and within risk management parameters established by the investment adviser.
Suspension of Net Asset Value – uncertain market conditions may lead to the suspension of the determination of a hedge fund's net asset value. This action should only be undertaken in order to safeguard all investor's interests. Suspensions should only be approved in extreme circumstances and not be used as a tool to lock in revenue streams to the investment adviser. The decision to suspend should be made by the board of directors and not delegated to the investment adviser.
Personal Account Dealing – staff within the hedge fund's investment adviser will have access to information regarding the fund's portfolio composition and investments. This information could be used to benefit themselves or their friends and families. A strict policy of confidentiality and a personal account dealing policy should be in place to prevent such instances.
Investment Adviser Fund Directors – it is not uncommon for a member of a hedge fund's investment management firm to act as a director of the fund. Indeed, many investors feel more comfortable in the knowledge that a senior member of the investment management firm is on the board, despite the fact that they are clearly not independent and therefore conflicted in many respects. However, in performing their fund director duties, their responsibilities are to the fund and therefore its investors. They should act independently and there may be occasions where a conflict requires non-independent directors to recuse themselves from any involvement or decision.
What to do?
Relationships that may create potential conflicts should be identified, and a conflicts register maintained. If conflicts of interests can be viewed as risks, or potential risks, then one can take a risk orientated approach of seeking to eliminate, mitigate or transfer the risks.
In some of the examples above, it may be possible to eliminate the risk/conflict of interest. For example, an investment adviser may elect not to enter into any softing arrangements, thereby eliminating the risk. Similarly, a disclosure in a hedge fund's offering document that sets out the circumstances under which softing arrangements will take place will provide investors with a degree of transparency over an inherently opaque activity. The risks allied with some conflicts could be transferred, which in turn could eliminate or reduce the risk. For instance, where there are cross trades, the price at which the securities are bought/sold between accounts could be independently verified.
The role of independent directors is crucial to the proper management of conflicts of interest in a hedge fund. The directors act in the best interest of investors and should be relied upon to exercise their judgement in such a way as to ensure as far as possible that where impartiality could be compromised, then the decisions and actions associated with that impartiality do not unfairly prejudice investors. Such situations should be identified, managed and documented to demonstrate this.
Carne serves it clients by providing governance and oversight solutions that help them to meet the increasingly stringent demands of investors and regulators for high quality corporate governance within the asset management industry. We provide independent directors to fund boards in both offshore and onshore locations, and we are recognised as thought leaders in the debate on higher oversight standards in the asset management industry.
In addition Carne offers a suite of additional support services for fund managers seeking to market funds on a cross-border basis, making use of offshore jurisdictions or onshore regulated solutions like UCITS funds. Our fund directors can draw on the deep reserve of knowledge and resources represented by the wider Carne network to bring further value to their roles on fund boards.
If you are a fund manager seeking support with a cross-border fund launch or advice on how to improve your overall governance posture, contact your local Carne office or our head office for help.
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.