Like many aspects of the European hedge fund industry, the practices surrounding the appointment, role and accountability of the fund’s governing body have been “standard” for a number of years. Historically, the primary role of the governing body has been more about keeping the fund offshore for tax purposes, but now investors expect it to have much more focus on its fiduciary obligation to protect the interests of investors.
The Weavering judgement has not suddenly made investors concerned about hedge fund governance. The level of focus has been increasing in line with the institutionalisation of hedge fund investors, and interest peaked in 2008 and 2009 when the actions of those governing bodies, which imposed gates, suspensions and other limits on redemptions, fell far short of investor expectations.
Nevertheless, the Weavering judgement has put the spotlight back on hedge fund governance and has presented an opportunity for managers and investors to reconsider what they want the key functions of the governing body to be and to consider how to improve today’s prevalent form of governing body – the board of non-executive directors.
Whilst fund boards are getting all the attention at the moment, not all funds will be companies and, consequently, not all governing bodies will be boards (e.g. the governing body of a limited partnership will be the general partner and the governing body of a unit trust will be the trustee). Sometimes a fund structure may not have any governing body at all.
Part one of this note is therefore intended to be of general application and attempts to identify the key functions of the governing body.
What should be the key functions of a fund’s governing body?
Whilst the fundamental responsibility of a fund’s governing body should be to protect the interests of investors as a whole, it is necessary to establish what investors want the key functions of a hedge fund’s governing body to be and then to consider how each of the various functions may be best performed in a hedge fund structure.
Before principles and/or regulation can be adopted, if that is the way to proceed, the industry must reach an accepted view about the key functions of a hedge fund’s governing body. Whilst there is no such accepted view as yet, I would propose the key functions described below.
Timely access to adequate information is crucial for the effective performance of all of these functions. A fund’s documents and structure should therefore ensure that its governing body is able to obtain the necessary information and explanations from the most appropriate sources.
Engagement with investors
How can a governing body fulfil its fundamental responsibility of protecting the interests of investors as a whole unless they know the views of those investors?
Despite this, the investors’ primary, and often only, relationship is with the manager. An investor will regularly receive manager reports but will, most likely, never receive any reports, or any other direct periodic communication, from the governing body. This should change.
A governing body should periodically meet with its major shareholders and perhaps hedge fund investors will more regularly be asked to vote on a particular course of action. In any event, it is important that any engagement is two way.
In other contexts, the annual general meeting (AGM) is often used to discover shareholder views. Most hedge funds are not required to hold AGMs but perhaps they should.
Linked to engagement with investors is accountability to investors. The investors’ role in governance should be to appoint/remove the governing body. Surely the levels of engagement and the awareness of this accountability would be markedly improved by making governing body appointments subject to annual approval (at the AGM?)?
Managing conflicts of interest
The Hedge Funds Standards Board considers that management of conflicts is the primary function of a fund’s governing body. It is difficult to argue with that, although governing bodies need to be sufficiently empowered in order to manage conflicts of interest (especially the manager’s) effectively.
In the E&Y global hedge fund survey 2011 it was clear that the investor respondents felt that the governing body, rather than the manager, should have ultimate responsibility and accountability for resolving disputes over valuations and imposing gates and suspensions of redemptions.
The question of who should have the responsibility for valuation is an interesting one. It is unlikely that a governing body would have the necessary expertise to resolve all disputes over valuation and, like its administrator, a hedge fund’s governing body will generally rely on the manager’s view. It is particularly interesting that the AIFMD provides that AIFMs, not the AIF governing bodies, are responsible for the proper valuation of AIF assets.
In any event, governing bodies should increase the use of independent external valuers, especially where there is a dispute.
One final point on conflicts: it is standard practice for the same legal counsel to advise both the manager and its fund. Given the fundamental duty of a governing body to manage conflicts of interest (especially, for example, in relation to side letter or managed account negotiations or where it is proposed to impose gates or suspensions of redemptions), it is not certain that this practice should continue.
Monitoring compliance with investment restrictions
In the E&Y global hedge fund survey 2011 it was less clear where the investor respondents felt that the responsibility should lie in relation to compliance with investment restrictions, although this is often put forward as a key function of the governing body. Again, it is unlikely that a governing body would have the necessary expertise to effectively monitor this, although it should be monitored on behalf of the fund (and by someone other than the manager).
Under the terms of its appointment, an administrator will often be exempted from any liability for monitoring the manager’s compliance with the investment restrictions. In the absence of any other suitable candidate, however, this may have to change.
Under the Jersey Expert Fund Guide, for example, the “responsibility of the administrator, Manager or trustee (as applicable) in relation to the actions of the Investment Manager shall be to take reasonable measures to satisfy itself that such actions do not breach the investment and borrowing restrictions applicable to the Expert Fund ... and to promptly notify the entity that appointed the Investment Manager of any concerns it has in that regard so that appropriate action may be taken”.
Monitoring and evaluation of the manager and other service providers
The manager will select the initial service providers of a fund and, generally, governing bodies will heavily rely on the manager to carry out ongoing monitoring and evaluation.
It does not appear necessary to make radical changes to this practice. It should be remembered, however, that these are service providers to the fund, not the manager, and the governing body should therefore have a formal procedure to review the performance of, fees paid to, and contractual arrangements with service providers (including the manager) on a periodic basis.
This could be an annual review and, if so, an AGM could be a useful forum in which to put forward the review’s findings and the governing body’s conclusions to the investors for their input.
Part two of this note will consider how the governance provided by a fund’s board of directors can be improved.