The call for changes in the way that alternative fund boards are constituted, and in the role played by directors on those boards, is becoming increasingly evident in both the press and in the opinions being expressed by investors. At a time when investors are already keen to increase their allocations to alternative funds, the governance issue is acting as a drag on the flow of investment.
The changing responsibilities
Directors are increasingly being held to account by investors and regulators. Investors are demanding that independent fund directors devote adequate time to the individual boards of the funds that they sit on, that they have the appropriate skills, experience and background to understand those funds they are responsible for, and that they are sufficiently independent from the investment manager (and its service providers) to be able to provide autonomous oversight.
Private equity funds have historically valued non-executive directors because of the industry expertise they bring to the fund's board, helping to advise the fund on portfolio company acquisitions and exit routes within a specific industry, or being available to sit on the boards of companies within the fund's portfolio. But are such directors sufficiently independent to also represent the interests of investors?
New liabilities and risks
The boards of alternative funds are increasingly being challenged on a range of issues, where competent independent directors can add substantial value:
- Valuation: Directors are charged with overseeing the inherent conflicts of the valuation of underlying portfolio companies and investments and the management and incentive fees payable to Investment Managers.
- Allocation of investments: Appropriate allocation of investments in portfolio companies across successive vintage funds concurrently within their investment terms can be contentious. Independent directors can ensure that groups of investors in successive vintage funds are treated fairly and that certain groups are not unfairly compromised by inappropriate allocations driven more by incentive allocation or timing and crystallisation of incentive fees.
- End of investment term: Ensuring the appropriateness of portfolio company investments around the time of the end of the investment term, or any extension thereof, and the consideration of the criteria whereby successor funds can be launched are also instances can also fall within the purview of the board. Independent directors can ensure that the fund's interests are maximised rather than simply the Investment Manger's interests.
- Fiscal neutrality: The centre of control and the location of mind and management of the fund with respect to the composition of the boards of funds will also be an increasing consideration for many funds globally, in order to preserve the their fiscal neutrality in a changing tax environment in many jurisdictions.
The financial crisis has illustrated the value of independent board members with experience across the life cycle of investment funds including prescribed duration closed ended funds. An appropriately composed, independent board can be of great benefit to private equity investors and managers. It can provide independent consideration of various exit strategies and refinancing options within challenging market conditions together with the experience and discipline to understand and evaluate components of value in underlying portfolio companies. This can help with the optimal realisation of such value to the fund.
New regulatory role and responsibilities
The global regulatory environment for private equity funds is becoming increasingly onerous, but fund directors can play an important role in helping the fund to meet these challenges, for example by helping to document that proper and appropriate procedure is being followed, or providing an additional layer of oversight for the management of conflicts of interest.
The reaction of jurisdictions
Fund domiciles are beginning to react to investor and political pressure in order to preserve their integrity as respectable financial centres. The Jersey Financial Services commission issued a statement of support-endorsement in February 2013 in relation to the adoption of the AIC by Jersey-domiciled investment companies.
In addition, the Guernsey Financial Services Commission finance sector code of governance which came into effect on the 1st of January 2012 provides boards with a framework for sound governance.
Elsewhere, the Luxembourg fund industry association (ALFI) has issued a code of conduct for Luxembourg investment funds to provide boards with a framework of high level principles and best practice recommendations for the governance of locally-domiciled funds.
The recent Statement of Guidance published by the Cayman Islands Monetary Authority has gone some way towards outlining the requirements CIMA has for proper fund governance with respect to CIMA registered funds.
The challenge for fund boards and managers
Carne is speaking to many alternative investment fund managers who are beginning to address the composition of their existing boards. This is frequently being driven by investors, who are demanding changes before they will make allocations to the fund. While this is less of an issue for closed funds at present, firms that are now embarking on new fund raising activities will confront this prospect on a more regular basis.
For directors, the challenge will be one of demonstrating that they are doing their job, and have the requisite skills, experience and capacity to perform the role appropriately. Investors are increasingly seeking to engage with fund boards to the fullest extent possible, and will begin to raise objections if they feel the board is not representing their interests effectively.
Originally published in the Augentius Technical Newsletter on 4th April 2014
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