In the current market environment, alternative investment funds are trying to find new ways to attract capital and deliver higher returns to investors and there is now a general trend toward customisation of investment fund products. The fact that investors now seek both strong performance and positive societal outcomes is no longer a novelty and institutional investors have begun incorporating environmental, social and governance (ESG) principles into their investment policies. We are seeing strong institutional investor interest in a firm's culture and employment practices. Questions around equal opportunity and diversity cannot be ignored whether or not they fall strictly within a manager's ESG principles or other internal policies. In addition to challenging managers on governance and responsible investing, investors are highly focused on fees charged by managers to fund structures. As a general proposition, despite the fee pressure in recent years, investors are not averse to paying fees, but fees need to be justified. Over the past several years there has also been increased focus from investors and regulators on the nature and amount of expenses charged by managers to funds. The fundamental principle can perhaps best be described by saying that fees and expenses must be properly payable by a fund in accordance with its constitutional documents and adequately disclosed to investors. Going forward, it seems likely that alternative investment funds will continue to customise around investors' needs, with larger managers being better placed to attract capital.
Keywords: Cayman Islands, hedge funds, governance, sustainable investing, expenses, fees
In the current market environment, alternative investment funds are trying to find new ways to attract capital and deliver higher returns to investors. While there is still some pressure on fees, investors do not object to paying fees per se; rather, they are looking for true value and the ability to justify each investment to their own stakeholders. Investors and regulators are also paying close attention to the expenses charged by managers to ensure such expenses are properly payable by the fund. The question of sustainable investing has come to the forefront, and even in the world of hedge funds, managers are beginning to place more emphasis on the environmental, social and governance (ESG) factors relevant to their investment decisions.
There is a general trend toward customisation of investment fund products. It has been quite some time since anyone referred to an 'off-the-shelf ' fund product, even in the commingled fund space. With increasing demand for customised solutions, investors have often turned to larger managers who have the ability and infrastructure to enable them to provide more bespoke products.
We have seen a number of managers offer separately managed accounts (SMAs), which are attractive in terms of providing transparency into the securities held by the SMA and offer segregation from other investors. The costs, however, can be high and present certain risks for investors in assuming responsibility for some operational aspects, including vendor selection.
'Funds of one' benefit from the ability of the sole investor to control its own capital, although the downside is that the costs of establishing and running such a fund cannot be spread across multiple investors.
In recent years there has been an increased focus by institutional investors in incorporating ESG principles into their investment policies. This has principally been driven by large pension plans, although private equity managers are also beginning to follow their lead. The basis of pursuing an investment strategy that adheres to ESG principles is to seek to have a positive effect on society. This is evidenced by the United Nations' Principles for Responsible Investment (PRI), originally released in 2006. The PRI, developed by an international group of institutional investors, are designed to contribute to a more sustainable global financial system by better aligning investment activities with the broader interests of society.1 The six key principles are as follows:
- We will incorporate ESG issues into investment analysis and decision making.
- We will be active owners and incorporate ESG into our ownership policies and procedures.
- We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- We will promote acceptance and implementation of the principles within the investment industry.
- We will work together to enhance our effectiveness in implementing the principles.
- We will each report on our activities and progress toward implementing the principles.
In the US, the Forum for Sustainable and Responsible Investment (SIF) identified US$8.72tn in total US-domiciled assets under management using sustainable, responsible and impact (SRI) strategies, at the beginning of 2016, representing a 33 per cent increase since 2014. Why the increase? Achieving strong financial performance while having a positive social impact seems to make good sense. SIF's data suggests that ESG investments achieve comparable or better returns, noting that 'sustainable and responsible investors do not have to pay more to align their investments with their values, or to avoid companies with poor environmental, social or governance practices'.2
The fact that investors are seeking both strong performance and positive societal outcomes is no longer a novelty. The Alternative Investment Managers Association (AIMA), the industry lobby group, recently reported that, based on a survey of 80 investment managers collectively overseeing US$550bn in hedge fund assets, 40 per cent had either hired a responsible investment specialist or had plans to do so and that investors are paying attention to these matters.3
The traffic is not all one way. The US Department of Labor's (DOL) Employee Benefits Security Administration recently released a Field Assistance Bulletin clarifying guidance on (among other issues) economically targeted investments by private-sector employee benefit plans. The bulletin reiterates the DOL's long-standing position that Employee Retirement Income Security Act of 1974 (ERISA)4 fiduciaries may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals. With regard to ESG investment considerations, the DOL notes that 'fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors. Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits. A fiduciary's evaluation of the economics of an investment should be focused on financial factors that have a material effect on the return and risk of an investment based on appropriate investment horizons consistent with the plan's articulated funding and investment objectives'.5
Consistent with the general shift noted above, however, we have seen institutional investors become more interested in investing with managers who also incorporate ESG principles into their investment approach. Pension plans and defined benefit plans with large cheque books are in pole position to demand this from their managers in fulfilment of their own investment mandates and in answer to their stakeholders.
We have clients who require managers to screen out particular assets from their portfolios such that they will not invest in a particular asset class. Alternatively, they will require a customised product for their sole investment, which will achieve the same result. For example, one institution prohibits investments in any weapons-related businesses, while another restricts investments in carbon-related energy businesses and certain environmental pollutants. We have seen a handful of managers interested in raising funds specifically related to the cannabis industry, although this investment falls outside the scope of acceptable investments for many larger investors who have adopted ESG policies. In particular, investors who exclude investments in companies involved in tobacco and/or alcohol would automatically exclude investments in cannabis.
Those involved in the world of operational due diligence will be very familiar with shareholder engagement on this issue and certain firms have checklists and other questionnaires specifically designed to elicit the nature and extent of a firm's commitment to ESG principles. Areas for scrutiny will depend upon the relative tolerance for particular industry sectors or geographies. This is pretty standard fare in the world of private equity but is beginning to encroach into the hedge funds industry. This appears to be fuelled by large institutional and ultrahigh net worth investors, many of whom invest in both types of fund products.
Various indices have been developed that integrate ESG factors into a composite benchmark that can be applied to achieve an ESG score. Morgan Stanley Capital International (MSCI), independent provider of research-based analytics, considers ESG factors to refer to industry specific issues, including climate change, human capital and labour management, corporate governance and gender diversity. They developed ESG-related indices, including Socially Responsible Indexes designed to exclude companies with high negative social or environmental impact and to target those with high ESG ratings relative to their sector peers.6 In April 2018, J. P. Morgan created a suite of global fixed income indices in collaboration with BlackRock, reportedly in response to demand from bond investors looking for a benchmark to target emerging market issuers with strong ESG practices.7
Firms conducting due diligence are therefore probing much more deeply into this area, going beyond pure manager attestations as to the existence or application of internal policies to examining the way in which they enforce those policies. To better prepare for these questions, managers would be advised to review their internal policies, reconsider the identification and management of ESG risks against their stated investment objectives, how they measure compliance and the seniority of those in the business to whom reports are made. Essentially probing their own methodology and (if relevant) how they monitor compliance with stated objectives by third party service providers. To the extent that a manager does not yet have an ESG policy, it is important to consider whether adopting such a policy is right for the business, depending on the investment strategy, time and cost involved. There is little point in adopting an aspirational policy unless the business can implement it. The key is determining the objectives of the business while being realistic about what is achievable in the organisation given its investment drivers and areas of risk.
Even if a manager does not have a formal ESG policy, investors may nevertheless seek to negotiate the right to opt out of certain types of investments. This can be difficult to achieve in a commingled vehicle without segregated portfolios, as investors are exposed directly or indirectly to the entire portfolio. Managers will therefore need to consider what is permissible under their fund documents and take legal advice about how best to facilitate such an opt-out.
On the governance side, investors are placing more emphasis on the underlying purpose of companies in which they invest and are challenging them to maximise shareholder value and deliver wider benefits to society. A tall order one might think in businesses designed to maximise profit. A recent initiative fostered by A Blueprint for Better Business, brought together ten leading investors from asset managers overseeing US$8tn in assets to glean insights into the extent to which a company is genuinely and effectively purpose-led. They agreed on a series of simple questions to put to chief executive officers, boards and other senior executives around responsibility and risk. Questions include these: 'How does your pay policy link to long-term success?' and 'What positive and negative impacts does your company have on society? How are you maintaining your "licence to operate"?'8
We are also seeing strong institutional investor interest in a firm's culture and employment practices. Questions around equal opportunity and diversity cannot be ignored whether or not they fall strictly within a manager's ESG principles or other internal policies. Due diligence questions are designed to measure (and in some cases rate) a manager's performance in gender equality and diversity.
In the UK, the Investment Association, the trade body that represents UK money managers,9 has called for an increase in the number of women in senior roles at FTSE 350 firms by 2020 and asked those companies to outline steps taken to move toward a stated target of 33 per cent female representation on boards.
Alternative investment managers are taking their own steps toward improving diversity within their organisations. In some cases managers absolutely believe it is the right thing to do, and in other cases, it is a response to pressure from employees and/or investors. Of course it is not a matter of drafting a policy and waiting for a change in culture. The organisation has to embrace the desire or perhaps just the need for a more diverse workforce.
As a practical matter, firms can start by using their internal resources, including their human resources department and marketing department to work on improving their methodology for recruitment, internal training and how they present themselves to prospective employees, investors and other counterparties. In the absence of internal resource, firms may wish to hire an external consultant with experience in this area. A number of clients tell us that investors tend to focus on pay equity so it would be worth conducting an internal analysis of any disparity in this area and deciding what steps the business proposes to take to deal with this.
Independent board oversight at fund level or through the imposition of an independent advisory board in a partnership or trust structure has become market standard in the offshore hedge fund space. For some years, the trend was all one way: a majority of new funds had some level of independent oversight, typically provided by directors based in the fund's domicile. In 2017, 70 per cent of new fund launches we worked on had at least one independent director, with more funds utilising independent directors from different firms.10 More recently, we have seen start-up managers with limited assets under management defer the appointment of independent directors until such time as they can attract institutional capital (or until required by investors).
For managers launching Caymandomiciled hedge funds, the market position remains three individual directors, comprising two (usually locally based) independent directors and one manager-affiliated director. Currently, however, there is no legal requirement for funds to appoint independent directors or for any directors to be Cayman-based. Institutional investors are very focused on governance in general and board composition in particular, as this is one area where the manager is subject to additional oversight. The process of director selection has therefore become more important. It is more important to have the right kind of oversight from an industry expert or someone with experience in the governance field than it is to have a particular number of directors or to appoint a director from a particular firm.
In addition to challenging managers on governance and responsible investing, investors are highly focused on fees charged by managers to fund structures.
By reviewing key terms of new Cayman-domiciled hedge fund launches we work on each year, we have developed a good sense of the market, including investor appetite for traditional fee structures and alternative fee models. As a general proposition, despite the fee pressure in recent years, investors are not averse to paying fees, but the fees need to be justified. We have therefore seen managers offering fee breaks in exchange for longer lock-ups and managers seem more willing to offer discounted fees to incentivise early stage investors.
At the end of 2016, there were 10,586 Cayman Islands-domiciled funds registered or licensed with the Cayman Islands Monetary Authority (CIMA) under the Mutual Funds Law (as amended), a decline of 3.2 per cent compared to 2015. Net assets under management, however, increased by US$17bn while management fees were down 3 per cent from the amounts reported in 2015. So far as performance fees are concerned, for the year ending 2016, CIMA-registered or CIMA-licensed funds ref lected lower performance fees, down 26 per cent on the prior year. This appears to ref lect more discounts on the usual 20 per cent fee, and on average, industry operating expenses ratios for such funds have declined from 1.95 to 1.75 per cent.11
Based on a Walkers survey of over 120 Cayman-domiciled regulated funds launched in 2017, less than 10 per cent of new funds charged a 2 per cent management fee.12 The headline rates, however, do not tell the full story as managers commonly offer reduced management fees or other fee structures to individual investors by way of side letter, while keeping the headline rate in the offering document at (say) 2 per cent. The majority of new funds launched with headline rates between 1.5 and 1.75 per cent. A handful of funds charged no management fee, but these were by and large established managers with a long track record who could absorb the absence of a management fee, which might otherwise severely restrict a small start-up manager with moderate investment tickets on day one.
The same study found that for the year ending 2017, 55 per cent of those CIMA-registered funds launched with a performance fee of 20 per cent while 27 per cent of funds launched with a performance fee of between 10 and 20 per cent.
More creative fee structures include the introduction of hurdle rates, founder's share classes (with preferential fee rates), a decreasing waterfall of fees tied to incremental increases in assets under management and (although less common) '1 or 30' fee structures, which treat management fees as an advance on performance fees. We expect to see more of these alternative fee structures going forward although portfolio managers with a large following have no difficulties capturing performance fees of 20 per cent and, in some cases, higher.
For the Cayman-domiciled private equity funds we helped to establish during the same period, 61 per cent of funds levied carried interest of 20 per cent, typically arising after a preferred return of 8 per cent. In the case of stated management fees, 36 per cent of funds charged fees between 1.6 and 2 per cent with only 15 per cent of funds charging between 1.1 and 1.5 per cent.13 As a general matter, however, fee terms for particular limited partners continue to be subject to side letter provisions.
Over the past several years, there has been increased focus from investors and regulators on the nature and amount of expenses charged by managers to funds. There are nuances in different jurisdictions although the fundamental principle can perhaps best be described by saying that fees and expenses must be properly payable by a fund in accordance with its constitutional documents and adequately disclosed to investors. What will amount to adequate disclosure may be a function of the relevant regulatory overlay applicable to the investment adviser, the fund and its fiduciaries. What is clear is that full and fair disclosure to prospective investors is key in mitigating claims in this area.
For Cayman Islands-licensed funds, CIMA requires that the fund's portfolio excluding cash is segregated and accounted for separately from any assets of any service provider. The overriding requirement is that none of the fund's service providers must use the portfolio to finance their own or any other operations in any way. For the purposes of this rule,14 paying fees, charges, expense and taxes that are properly payable by the fund and disclosed in accordance with the fund's constitutive documents, offering document or as otherwise disclosed to investors, shall not in itself constitute the financing of the service provider's own operations.
The question as to what is properly payable will therefore be determined having regard to the fund's articles of association, limited partnership agreement or trust deed, as the case may be, together with the other relevant disclosures provided to prospective investors.
Directors, general partners and trustees have particular fiduciary obligations to safeguard the interests of investors over the interest of the investment manager. AIMA's Fund Directors' Guide15 counsels directors to consider the manager's incentive to allocate expenses to the fund, rather than pay for them itself: 'Attention should be paid not only to the Fund documentation, but also what is fair and represents good market practice.'
In recent years, from our vantage point, expense disclosures in offering documents became extremely broad, largely on the theory that notwithstanding the lack of particularisation, a myriad of expenses could arguably be covered simply because of the breadth of the disclosure. Investor pressure coupled with regulatory focus on the type of expenses levied upon the fund has led to more granular descriptions in the offering document of the nature of expenses charged to the fund (or otherwise) and has thus provided much greater transparency.
In particular, we have seen investors paying much more attention to conf licts of interest around the payment of soft dollars and commissions. Different regulators have slightly different approaches to the issue. Directors and other fiduciaries with oversight of and overall responsibility for the management and administration of funds, therefore, need to understand the relevant regulatory framework and keep themselves updated of any changes. If necessary, they ought to take legal advice on what is permissible both from a legal and regulatory perspective and under the terms of the fund documents.
AIMA notes that in addition to the policy adopted by the relevant fund, directors should 'periodically understand the nature of expenses paid for using soft dollars/dealing commission, and determine whether the expenses fall within the relevant regulator's framework; if it is unclear whether the nature of the expenses fall within the relevant regulator's framework, then the Board should request an external legal opinion from a reputable firm to provide further clarity; satisfy themselves that the investment manager has adequate controls and oversight over the entire process of using soft dollars/dealing commission through, for instance, periodic reporting from the investment manager's compliance function; and where an investment manager receives bundled services and part of the service would not be permissible under a regulatory framework, the Directors should review the investment manager's mixed-use assessment and recordkeeping thereof '.16
As a practical matter, funds would be well advised to disclose in detail (even with a non-exhaustive list) the expenses that will be charged to the fund. Broad disclosures that lack clarity and can be open to different interpretations can lead to confusion and more questions from investors and regulators and potentially cause the fund to incur more costs in dealing with these matters.
THE NEXT 12 MONTHS
Going forward, it seems likely that alternative investment funds will continue to customise around investors' needs, with larger managers being better placed to attract capital. We anticipate more 'funds of one' and SMAs as investors seek bespoke products designed to better fit with their own investment policies.
Given the emerging trends toward socially responsible investing, more managers will adopt ESG principles in future. It, however, will probably take several years before we see widespread adoption of ESG principles in the alternative investment funds industry. In the short term, given the industry focus on good corporate governance and pay equity, managers are more likely to embrace the governance aspects of ESG before they embrace environmental and social aspects. Whether managers sign up to the PRI, or implement ESG principles in their investment analysis and decision making, will very much depend on the demands of large institutional investors.
In the near term, investors are unlikely to push management fees significantly lower as current fee structures are generally more f lexible. More creative fee structures, however, will come to the fore as managers need to find ways to entice investors to retain invested capital in the fund for longer periods of time. We expect some continued reduction in performance fees charged by newer managers as they develop a track record. We, however, do not anticipate any major changes for established managers who have delivered consistent returns over the long term.
Regarding the allocation of managers' expenses to funds, if properly advised, managers will be transparent about the nature of such expenses and provide detailed disclosure to investors. In the current regulatory environment, the failure to provide fulsome disclosure to investors will continue to draw regulatory scrutiny and potentially investor complaints. While regulators have to balance multiple priorities, this continues to be an area of focus for regulators of private funds.
Overall, we expect to see continued regulatory and investor focus on corporate governance, seeking better alignment of interests across the spectrum, from fair and proper expense allocations to sustainable investing.
1 Principles for Responsible Investment, 'What are the Principles for Responsible Investment?', available at: https://www.unpri.org/pri/what-are-the-principlesfor-responsible-investment (accessed 8th July, 2018).
2 US SIF, 'Performance & SRI', available at: https://www.ussif.org/performance (accessed 8th July, 2018).
3 Walker, O. (2018) 'Hedge funds boost "responsible investment" strategies', Financial Times, 26th May.
4 US Employee Retirement Income Security Act of 1974.
5 US Department of Labor Employee Benefits Security Administration Field Assistance Bulletin No. 2018-01.
6 MCSI (2017) 'MSCI SRI Indexes Methodology', June 2017, available at: www.dol.gov/general/topic/retirement/erisa (accessed 8th July, 2018).
7 Morgan, J. P. (2018) 'J. P. Morgan collaborates with Blackrock to launch new ESG suite of indices: The J. P. Morgan ESG index (JESG)', 18th April, available at: https://www.jpmorgan.com/country/US/en/detail/1320566638713 (accessed 8th July, 2018).
8 'How can investors identify purposeled companies? A blueprint for better business', May 2018, available at: http://www.blueprintforbusiness.org/wpcontent/uploads/2018/05/Blueprinthow-can-investors-identify-a-purposeled-company-May-2018.pdf (accessed 8th July, 2018).
9 With 200 members managing over £6.9 trillion globally.
10 'Walkers fundamentals: The road to 2020', White Paper, 7th November, 2017, available at: https://www.walkersglobal.com/images/Publications/Articles/2017/Walkers-Fundamentals-White-Paper---Nov2017-digital.pdf (accessed 8th July, 2018).
11 'Cayman Islands Monetary Authority: 2016 Investments statistical digest', 29th December, 2017, available at: https://www.cima.ky/upimages/publicationdoc/InvestmentsStatisti_1514498817.pdf (accessed 8th July, 2018).
12 'Walkers fundamentals', ref. 10 above.
14 'Cayman Islands Monetary Authority: Rule segregation of assets - licensed funds', 28th April, 2008, available at: https://www.cima.ky/upimages/commonfiles/1499688355RuleSegAssetsApr08.pdf (accessed 8th July, 2018).
15 AIMA Fund Directors' Guide, 3rd Edition, 2015 (Second Supplemented Version).
Originally published in Journal of Securities Operations & Custody Volume 10 Number 4
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