Board games

One of the last real operational areas of concern in the world of offshore hedge funds has to be the issue of corporate governance, especially the number and role of independent directors sitting on the boards of hedge funds domiciled in offshore jurisdictions. It is an issue that is rapidly creeping up the checklist of due diligence priorities for major allocators to offshore funds.

As the alternative investment management industry works hard to improve its image in the eyes of investors, it still has to address the way it manages its governance to maintain credibility. Investors are only too aware that money is in the funds, not with the managers, and are focusing on the ­identity and capacity of the independent directors sitting on fund boards.

Cultural revolution

Clients of hedge funds are starting to demand a majority of independent directors on fund boards in an effort to reinforce the wider culture of good governance they are expecting in the alternative investment industry.

The presence of directors with solid track records in the asset management industry can be a boon to fund managers too, as they can provide valuable independent oversight to a fund that can reinforce it against a range of risks including tax, regulatory and ­operational challenges.

A good board will know what investors want to see. A transparent board, with ­directors who are limited in the number of commercial relationships they can undertake, can only breed confidence in the investor community and show that the fund manager is taking shareholders seriously.

A low-volume director will typically have between 25 and 30 commercial relationships compared with some high-volume businesses, where a director will typically serve hundreds of funds. Where best ­practice is being followed and the fund board is meeting on a quarterly basis, there are simply not enough hours in the day for a director with hundreds of directorships to meet the schedule.

Independent directors can hail from a range of backgrounds, and it has been good to see more lawyers becoming directors. While legal advisers to funds can appoint directors, investors have pointed out that these cannot be considered fully independent, especially under circumstances where there are no truly independent directors on the board, for example, where the role is being fulfilled by appointees of the fund’s service providers.

Separate entities established by offshore law firms to provide directors to funds are great in theory, but can these directors ­really vote independently when their parent law firm is the fund’s legal adviser? Will they represent the interests of the fund’s shareholders when it comes to a disagreement with the investment manager?

In the Cayman Islands, an important jurisdiction for offshore hedge funds, fewer than 10 per cent of fund directors have a background in legal advice, but it is crucial that this core area of expertise is independently represented on fund boards. Hedge funds and their investors face more legal risks than ever before, and to have ­independent directors with a legal background on fund boards can only help them better meet the risks that lie ahead.

The landmark 2008 insolvency ruling in the case of two Bear Stearns hedge funds that filed under Chapter 15 of the US ­Bankruptcy Code shed light on the way US courts are likely to address hedge fund insolvency proceedings in future. The focus is on how much activity is carried out for that vehicle in the jurisdiction in which it is domiciled, and how much substance accrues to it.

Some form of substantive presence in offshore jurisdictions is becoming ­increasingly important, including the presence of ­resident directors in those jurisdictions, the holding of board meetings and the keeping of copies of the board minutes.

It is fair to say there is now more demand for independent directors than ever before, but the pool of experienced independent directors, especially full-time directors with no ties to law firms or other service providers to the fund, is limited.

To ensure that proper levels of governance are maintained investors are asking to see how many directorships are held by each director sitting on the board of a fund they are considering. More often than not, this information is not forthcoming. Yet investors themselves are concerned that the role of the director is being commoditised and that the important process of fund ­oversight is being subsumed into a ­process-driven environment that will not cope with the exposures of the individual fund ­structure once it is tested in a court.

Indeed, it is this that causes major ­allocators to expend considerable resource on additional due diligence rather than rely on fund directors to provide the governance culture they can be comfortable with.

Roisin Cater is a principal at Carne Group