to be applied to private investment fund corporate governance
Setting the stage
Most private investment funds established in jurisdictions such as the Cayman Islands, the British Virgin Islands, Bermuda, Luxembourg, Ireland, Malta and other fund jurisdictions are created as corporate entities (corporate private investment funds or CPIFs). The governance of CPIFs vests on the board of directors in accordance with local company law (whether common or civil law).
The corporate governance practice of CPIFs has evolved in different ways in each jurisdiction subject to various factors, including, but not limited to: the economic and legal history of the jurisdiction, local company law, national regulation, tax and audit policy, history of regulatory and tax enforcement actions, national “character” and politics, applicable federal or supra-national regulation, evolution of the local funds industry and the preferences of fund managers, lawyers and other service providers on one end of the spectrum and investors on the other end.
However, regardless of the jurisdiction in which a CPIF is established, the corporate governance of CPIFs stands in sharp contrast to the corporate governance of public companies and, particularly in the case of the United States, publicly registered mutual funds (40 Act Funds). Compared to public company corporate governance, CPIF corporate governance tends to be formalistic and limited in scope.
This article analyses some of the reasons for the significant differences between the various public company and CPIF corporate governance models and offers suggestions that would move CPIF corporate governance closer to that of their public company cousins.
At the most basic level, it can be argued that a CPIF is a handicapped version of a public company. Whereas a public company relies on its tripod of constituents (ie the board of directors, the CEO/management and shareholders) to define the basic relationships and interactions that add up to public company corporate governance, a CPIF is effectively a two-legged stool: it has a board of directors and shareholders but no management or employees.
CPIFs do not have employees and therefore outsource all or substantially all operations to service providers acting either as delegates or agents. The actions of delegates are typically subject to fiduciary standards while those of agents are subject to contractual standards, but in both cases such outsourcing adds to the difficulty of implementing substantively meaningful corporate governance at the CPIF level. CPIF directors must by definition rely on delegates and agents over whom they have contractual but ultimately limited legal and operational control.
Another aspect that makes it difficult to implement substantively meaningful corporate governance at the CPIF level is the role of the investment manager (IM) who generally is also the sponsor/initiator of the CPIF. In its capacity as investment manager, the IM is tasked mainly with the portfolio and risk management of a CPIF although it may also discharge other functions, such as distribution, various aspects of operations, regulatory and tax compliance and overseeing the CPIF’s other service providers.
Indeed it is the dual role of the IM as investment manager and sponsor/initiator of the CPIF that renders a CPIF the inverse of a public company – as sponsor/initiator the IM sets the investment management and risk strategy of the CPIF, identifies and selects the service providers and perhaps most importantly selects and appoints the board of directors of the CPIF, whereas as investment manager the IM acts as the CEO and management of a CPIF either as itself or effectively controlling the CPIF’s relationship with the various delegates and agents. In a public company context, strategy would be determined by the board either by itself or in conjunction with management, the service providers would be selected by management, and the board members would be appointed by the shareholders or co-opted by the current board.
It is difficult to envision a CPIF model in which the IM does not design the structure of the fund – shareholders ultimately invest in a CPIF due to the expected risk adjusted returns that may be generated by an IM and not because of the CPIF’s board or service providers. However, the fact that the IM selects and indirectly appoints the service provider and the board at inception creates at best a potential conflict of interest and at worst the actual possibility that a board may be beholden to interests of the IM rather than upholding the best interests of the CPIF and by extension its shareholders.
Yet another aspect that makes it difficult to implement substantively meaningful corporate governance at the CPIF level is the notion that the market dictates the level of governance of a company. Shareholders of typical public companies can simply sell their shares if they feel that a company has weak corporate governance or indeed for any other reason.
This is also true of CPIFs, ie shareholders can “vote with their feet”, but only to the extent that the CPIF provides periodic redemption liquidity, which may not always be available either due to the limited redemption terms of the CPIF or the portfolio of the CPIF becoming illiquid. As a practical matter, it is becoming increasingly common for a potential investor not to invest in a CPIF due to weak corporate governance, but it is rare to see a shareholder redeem from a CPIF for the same reason.
Diagnosing the principal differences
A CPIF differs from a public company in the following areas (which is not an exhaustive list):
The IM sets the strategy of a CPIF through the following actions:
- selecting the CPIF’s jurisdiction, legal structure and regulatory status;
- defining its investment policy and investment objectives;
- defining its risk, valuation and other policies;
- identifying, interviewing, negotiating with and selecting its services providers;
- identifying, interviewing, negotiating with and selecting its directors;
- choosing its accounting standards;
- defining its marketing and distribution strategy;
- defining its liquidity and dividend policy; and
- defining the timing of its launch and commencement of operations.
While the board of the CPIF legally makes the various choices highlighted above on or before the launch of the CPIF , it is rare for a board to disagree with the choices made by the IM as reflected in the CPIF’s disclosure documents and various agreements with its service providers.
For example, in my experience of 21 years in the fund industry I have never seen a board refuse an administrator, custodian, prime broker, law firm or auditor selected in advance by the IM. I have at times seen a board question the selection or criteria for selecting a service provider but in all cases the service provider in question was ultimately approved.
In contrast it is not uncommon for a public company board to disagree with management on strategy, the appointment of service providers, or the determination of accounting, tax and other corporate policies and to assume the lead developing such policies or working with management to develop such policies.
Appointment of board members
Most Cayman Islands funds (as opposed to CPIFs established as regulated vehicles in jurisdictions such as Luxembourg, Ireland or Malta) have formal voting powers directly or indirectly in the hands of the IM. While investors retain voting rights under Cayman Islands common law to the extent that their rights as shareholders may be adversely affected, the inability to vote on matters such as the appointment of directors is clearly a form of voter disenfranchisement.
Investors in most public companies either nominate and approve or have the ability to approve or ratify the appointment of directors.
Corporate governance philosophy
Typically the corporate governance philosophy of a CPIF will be determined principally by the CPIF’s drivers for corporate governance (ie regulation, tax, investor demand for independent board, or to some extent, by individual board members etc) but also by the IM’s views on corporate governance (ie whether or not the IM believes that corporate governance can be a value added proposition to the CPIF and/or its investors).
All public company boards have to develop a corporate governance philosophy (even if it is in effect a minimalist philosophy).
Appointment and termination of CEO
In a CPIF context no one appoints the IM in a meaningful sense. The board legally appoints the IM but this is only a reflection of the IM’s role as the sponsor/initiator of the CPIF. I have only witnessed two instances in my career in which a board has terminated an IM.
Arguably the most important function of a public company board is to appoint the CEO. Public company boards also fire CEOs depending on the performance of CEO and/or the public company.
Recent statistics from the CPIF industry suggest that most CPIFs have some level of independence on their boards, although rarely a majority, and that those that do not are considering the appointment of independent directors.
Most public company boards including those of 40 Act Funds have appointed independent directors and often have a majority of independent directors.
Few CPIFs have appointed a chairperson (although this practice is more frequent in Luxembourg CPIFs).
Almost all public companies have a chairperson although in North America the chairperson also tends to be the CEO. Most 40 Act Funds have an independent chairperson although the Securities and Exchange Commission in the United States failed to adopt a requirement for 40 Act Funds to have an independent chairperson in the face of strong opposition from mutual fund sponsors in the US. UCITS funds in Europe generally have a chairperson.
Most CPIFs do not have a broad set of skill sets represented on their boards. CPIF directors tend to be former administrators, trust officers, lawyers and accountants and rarely former portfolio managers, risk managers or C-level managers of IMs.
Increasingly public company boards are moving towards a balanced skill set among the directors on their boards.
In my experience CPIF boards tend to have 2-4 directors with a significant minority having five and very few having more than five directors. However, even those with more than two directors rarely use committees to focus on specialised areas of oversight such as audit.
Most public company boards have at least an audit committee and often have multiple committees.
Separate advisors to the board
A CPIF board will rarely avail itself of the ability to seek advice from service providers retained by the board (as opposed to advisors to the IM or effectively working for the IM even though they nominally represent the CPIF itself). The tendency of CPIF boards not to use advisors exists even though in many cases the CPIFs constituent documents permit the board to retain such advisors at the CPIF’s expense.
Depending on the context, public company boards often retain their own service providers such as consultants, legal counsel and investment bankers.
Time commitment and capacity limits
The average CPIF director probably spends one business day or less per calendar quarter working on any one CIPF. Such a limited time commitment inevitably restricts the impact any one director or even the entire board can have on a CPIF. CPIF directors tend to have substantial numbers of CIPF directorship appointments although a strong view is developing in the CPIF industry that directors have limited capacity and therefore should reduce or restrict the overall number of directorships held.
The average director of a public company in North America spends approximately 12 business days per annum working on matters related to the company. The number of appointments of public company directors range between three and 12 depending on the aggregate work required from, and the time devoted by, each director.
The average CPIF director is likely to be paid less than an entry level administrative staff person working for the IM. This reflects in part the relatively low levels of expertise and commitment of CPIF directors but also the low value added perception IM have of CPIF directors.
Directors of public companies tend to be paid significantly more (from tens to hundreds of thousands particularly in the US) reflecting the higher requirements, expectations and potential liability of public company directors.
Directors of CPIFs rarely invest in the CPIFs as such investment is generally viewed as a potential conflict of interest. In my experience I have seen less than a dozen directors of CPIFs (other than CPIF directors who were executives of the IM) invest in their respective CPIFs.
It is common for directors of public companies to invest in their stock and be compensated in stock options. Such investment and compensation are viewed as aligning the directors’ interests with those of the public company. Two thirds of 40 Act Funds in the United States require or strongly recommend that their directors invest in them.
Continuing professional education
CPIF directors rarely undertake any form of training to enhance the skills they need properly to discharge their duties as directors, although there a trend is developing towards such training.
Public company directors and often required to attend training programs and have more resources at their disposal to undertake continuing professional education.
This article is an abridged version of a paper presented by William Jones to the INSEAD International Directors Program (“IIDP”) as part of his accreditation in corporate governance. www.mplgroup.com