Investors are increasingly focused on corporate governance as part of their decision making and due diligence procedures when considering investment in a hedge fund, and a key consideration is that their investment be protected through the appointment of non-executive independent directors to the board of the hedge fund.
Investment managers in turn are seeking to meet investor demand by ensuring that their fund has one or more non-executive independent directors on its board. There remains however scant practical guidance as to how an investment manager should go about evaluating and selecting a non-executive independent director.
In fairness, the process is not markedly different from the selection of any other service provider to the fund in terms of requiring a sufficient level of due diligence of potential candidates on the part of the investment manager. However, the relevant factors that need to be considered as part of this due diligence process are more complex and require an innate understanding of the specific nature and requirements of the role of the non-executive independent director, which is constantly evolving in line with investor demand and expectation.
In general the investment manager of a hedge fund should consider the following factors as part of their due diligence process when evaluating the appointment of a non-executive independent director to the board of directors of its fund:
Does the director have sufficient time to allocate to the operation of the fund so as to meet his or her fiduciary responsibilities and further ensure compliance by the fund with industry best practice for corporate governance? The issue of capacity continues to be controversial and widely debated, however most would concede that this involves a more sophisticated analysis than merely examining the number of directorships that a person holds, it further being acknowledged that setting any kind of arbitrary limit on the number of directorships as a screening factor may in fact deprive the fund of a director who is able to bring a wealth of experience to their position given their experience across a wide range of trading strategies.
The analysis therefore requires a more subtle assessment of a number of factors, including (a) a breakdown of the existing portfolio of directorships, including the number of manager relationships, fund structures and trading strategies related thereto, and (b) the infrastructure available to the director to ensure that he or she is able to perform his or her duties in an efficient manner (information technology and the availability of further support staff).
A crucial further question from the viewpoint of the investment manager is how transparent the director and his or her related firm are concerning the question of capacity, given that in many cases investors are now engaging directly with the director and his or her related firm and requiring specific disclosures from each of them in order to facilitate the analysis described above.
Relevant qualifications and industry experience
Qualifications plus relevant industry experience should provide a sufficient background so as to enable the Director to fulfil a credible oversight function. Further specific experience gleaned from other funds with similar structures and trading strategies to the Fund is a valuable attribute to be considered.
Independence remains the key factor when considering any proposed appointment. “Independence” from an investor viewpoint requires that no actual or perceived conflicts of interest exist that would potentially prevent the director from exercising an independent decision in the best interests of the fund even where such decision would be in conflict with the interests of the investment manager, this in essence being the core reason for investor demand for non-executive independent directors. Investors having learnt from their experiences of the 2008 crisis, when in some particularly egregious distressed fund cases, the independent directors meekly acquiesced to the will of the investment manager, now expect credible candidates untainted by any such conflicts of interest who will be in a position to challenge the investment manager and protect their interests when these conflicts arise.
Typically this now requires that the director be free from any relationships with the investment manager as well as the other service providers to the fund, such as law firms and administrators, and increasingly that where there is more than one non-executive independent director on the board, that they are further “independent from each other” in terms of not being from the same firm.
The board requires a diversity of skills, background and experience, including legal, investment management, fund administration and audit, to understand the investment policy, strategies and risks of the operation of the fund, and the investment manager should consequently ensure that the skill set of the proposed director adds to this collective diversity of skill set and experience so as to enable the board to collectively provide a credible oversight function. Increasingly investors are also now requiring that the composition of the board consist of a majority, and in some cases entirely, of non-executive independent directors, such that this entails the appointment of more than one non-executive independent director to the Board.
Nature and requirements of the role
The objective is to ensure that the fund complies with industry best practice as regards corporate governance. Crucial to this is an understanding of (i) the fiduciary responsibilities of the director (and the Board collectively) and more importantly how these translate to the operation of the fund in terms of the duties to be undertaken by the director (and collectively, the board) and (ii) whether the director has a detailed understanding of (i).
It is typical that the day-to-day management authority of the fund is delegated to the investment manager and other specialist functions to other specialist service providers to the fund, such as administrators, registrar and transfer agents, law firms etc. Notwithstanding any such delegation, the board bears the ultimate responsibility for the conduct of the fund’s affairs, including the monitoring of such specialist service providers to the fund, and as such owes a number of duties to the fund which they are obliged to meet under common law, relevant statute or contract (with the nature and scope depending on the relevant jurisdiction), including (i) fiduciary duties such as good faith, proper purpose, unfettered discretion, conflict of duty and interest and (ii) a duty of skill, care and diligence.
In order to meet his or her fiduciary and other duties as described above and ensure that the corporate governance of the fund is consistent with industry best practice, the director should, together with the board collectively, undertake the following practical tasks:
- (i)Liaise with representatives of the fund’s sponsor and/or investment manager and service providers in the preparation, negotiation and conclusion of the offering documents, constitutional documents and related agreements on the establishment of the fund, ensuring that the overall structure and terms of the fund are broadly consistent with industry standards;
- (ii)Review and vet all service providers and monitor their performance, eg investment manager, administrator and/or prime broker;
- (iii)Review regular reports from the administrator and the investment manager, including reports provided to investors, as well as other service providers to whom functions of the board have been delegated;
- (iv)Conduct a minimum of four quarterly board meetings per annum with the investment manager and representatives of service providers as required, to discuss the fund’s performance against its targeted returns, investment objectives, strategies and risks as well as the performance of the investment manager and other service providers;
- (v)Exercise independent oversight of on-going matters of the fund that require the attention of the board outside of regularly scheduled meetings, by way of written resolutions or ad hoc board meetings, such as for example in relation to the approval of a material variation to the terms of the offering;
- (vi)Provide insight and direction to the investment manager, investors, other service providers and creditors in distressed and conflict of interest situations;
- (vii)Meet and/or liaise with investors and prospective investors in the fund as well as their representatives and regulators as may be required or requested by same for the purposes of due diligence or the investment manager (seed investor arrangements).
The investment manager should thus ensure that the director has a sound understanding of the nature and requirements of his or her role, including what constitutes industry best practice from a corporate governance perspective.
Remuneration: The director should be paid a fee commensurate with his or her expected role and duties. Disproportionately low fees suggest that the director will not be sufficiently incentivised to allocate sufficient time to his or her duties and will potentially be a red flag for the purposes of investor due diligence.
Reputation; regulatory oversight: Does the director and his or her related firm have a sound market reputation?
Recommendations from other service providers as well as investment managers may assist in this regard. Is the director and related firm subject to effective regulatory oversight?
Ability to represent the fund: Increasingly investors are requiring direct access to the fund’s non-executive independent directors in terms of their initial due diligence procedures as well as ongoing operation of the fund. In addition to other attributes discussed above, is the director an effective communicator able to address investor queries and concerns in a credible manner as and when required?
The selection and evaluation of a non-executive independent director requires a considerable level of due diligence on the part of the investment manager, however those investment managers that are willing to allocate the required resources to the due diligence process by considering the above factors, will undoubtedly find that this will aid in the development of a sound corporate governance structure for their fund(s) which will ultimately constitute a powerful tool in retaining existing as well as attracting new investors in an increasingly challenging fundraising environment.