Checks and balances at the top

In an era of heightened scrutiny for alternatives fund managers, investors are demanding more accountability. One area on which they are particularly focused is fund governance, specifically the role of the board. Long a staple for publicly listed funds, the board not only serves as a source of checks and balances, it can also assuage risk-averse investors and provide vital strategic guidance to the organization. However, when it comes to the private-fund sector, there is little consistency in the composition or even existence of boards. This is complicated by a wide disparity in the attributes of the boards that do exist. Smart fund managers are looking closely at the board component of their governance structure and looking for ways to improve it. For years within the hedge fund industry, boards have been a regulatory requirement for Cayman Islands- and Europe-based funds, given their corporate structure. No such requirement exists for U.S.-domiciled funds; thus few U.S. funds have boards. But around the world, the rising outside influence of regulators and institutional investors, coupled with funds themselves becoming more institutional in nature, are ushering in changes to the way funds are governed. Over the past decade, as institutions have pushed for greater transparency and sought to conduct more-thorough due diligence, the hedge fund industry's boards have become somewhat more active. Many boards have stepped up their oversight of the more subjective portions of funds' activities — those most open to potential questions from investors or regulators. One specific area is the valuations funds place on the thinly traded or illiquid assets within their portfolios. By taking a closer look at the process used to determine individual valuations, sometimes even involving themselves on valuation committees, boards not only are able to provide an added layer of assurance to protect the organization and its reputation but also are able to provide greater comfort to the investment community. Funds would be well-served by continuing to make progress in the way they govern themselves. For private funds that are required to have a board, simply having one is no longer enough. In regions where boards are mandatory, courts and regulators have put board members on notice that they are responsible for adequately monitoring the funds they are charged with overseeing. Gone are the days when individuals were able to take board seats in name only and serve on committees that rarely met. Likewise, investors have become more involved. As investment strategies become ever more complicated amid turbulent and uncertain global market conditions, investors want to be assured that boards are actively governing the funds to which they are committed.

LEGAL CASES

Government officials recently emphasized the need for greater oversight at the board level in two separate legal cases where board members were called out for failing to adequately monitor risk within fund portfolios. In late 2012, the Securities and Exchange Commission formally accused eight former board members of Morgan Keegan & Co. Inc., alleging that the group failed to properly oversee the valuation of holdings within five mutual funds that were heavily invested in mortgage-backed securities and saw their prices plummet when the credit crisis hit in 2008. Because such valuation responsibilities had been delegated to the board, the SEC alleged that directors breached their fiduciary duty to investors when they passed the valuation responsibilities to a separate committee without providing significant guidance on how to determine fair valuations. In 2011, the Grand Court of the Cayman Islands found two members of the board of the Weavering Macro Fixed Income Fund, a Cayman-based hedge fund, guilty of neglecting their fiduciary responsibilities to investors. A judge ruled against the pair, who were each fined $111 million after it was determined that not only had they failed to ever attend a board meeting but they had repeatedly signed off on documents they never read.

FIDUCIARY RESPONSIBILITY

Not surprisingly, these cases have resonated within the private-fund industry as fund managers have taken note that regulators no longer are satisfied with the simple existence of a board, and that individuals who choose to be part of a board need to be ready to assume all the responsibilities that come with being a fiduciary. Recently, the Cayman Islands Monetary Authority published a statement of guidance that indicates its view of the minimal level of governance required. It makes clear that for CIMA-registered funds, the board is ultimately responsible for oversight and supervision of the funds' activities and affairs. In addition, the SEC recently released its examination priorities for this year. In that release, the SEC highlights “the staffing, funding and empowerment of boards, compliance personnel and back-offices” as one of the focal areas for alternative investment companies. In the United States, however, many funds haven't voluntarily adopted boards to govern their activities. But that may be changing, as fund managers are starting to realize that actively working with board members can be very beneficial. When the 2008 credit crisis hammered the returns of a large portion of the hedge fund industry, many fund managers established gates to limit redemptions or locked up illiquid assets in side pockets to protect the overall value of their portfolios. But though gates and side pockets ultimately proved to be the right decisions for many funds, they were unpopular among some investors seeking liquidity amid the global financial downturn. Hedge fund firms with strong and active boards learned the value of these relationships firsthand when directors were able not only to help determine if such measures were appropriate but to decide the best timing for establishing gates and side pockets, and how to communicate such decisions to investors. Unlike the formal boards that exist for Cayman- and Europe-based hedge funds, the majority of board oversight within the world of private equity so far has been in the form of limited-partner advisory committees. Instead of being driven by the fees commonly paid for participation in formal boards, the LPs on these committees are motivated by their own financial interests in the funds they are overseeing. Bound by the contractual-agreement terms between the fund and the board, LP committees tend to focus on enforcing best practices and proper governance within funds. However, members understandably tend to be risk-averse, drawing the line at assuming fiduciary and legal responsibility. Institutional investors have also been a factor in the more active nature of LP committees. The Institutional Limited Partners Association, a global organization comprising institutional investors that focuses on best practices within the private-equity industry, has been a vocal proponent of greater transparency and involvement at the board level.

GOVERNANCE GUIDELINES

“ILPA Private Equity Principles,” a report outlining its stance on best practices in the private-equity industry, offers a set of governance guidelines for well-run boards or advisory committees. Among the areas highlighted in the report are: • The need to make fiduciary duties clear to members. • The requirement for increased transparency for everything from fees to personnel changes. • The importance of audited financial statements and detailed breakdowns of any and all calculations made for a fund. Because of calls for action from prominent and influential members of ILPA, including powerful groups such as the California Public Employees' Retirement System, investors' requests for greater attention to best practices at the board level are being heard across industries. Hedge fund managers are starting to challenge the composition of their boards. A board with a majority of independent members is a must, but managers are starting to challenge whether the independent board members are independent of one another and independent of their service providers, leading to more objectivity. Managers are becoming more diligent in their selection of board members, engaging in extensive interviews and due diligence. In relation to U.S hedge funds or the structures that aren't legally required to have a board, hedge fund managers are beginning to consider whether more should be done. The concept of advisory committees, which are so prevalent in the private-equity industry, could be the right approach for hedge funds. Establishing a contractual arrangement for oversight and governance with independent parties in the form of an advisory committee could result in enhanced governance for the funds, and comfort investors. Natalie Deak Jaros and Michael LoParrino are partners in the financial services office of Ernst & Young.