independence and conflicts” by Jason Scharfman
This well researched and referenced book is much more than a review of governance within a fund. It examines many, if not all, factors that drive the current hedge fund market and the parts played by those within,and related to funds and its service providers.
Not what I expected. At the end of the first chapter I was frustrated, as I was looking for a theoretical analysis and conclusion regarding corporate governance in hedge funds.
While there is some reference to the history of corporate governance in public companies onshore, the book is actually more useful in pointing to the fundamental issue of conflicts and independence amongst the many players in the hedge fund market.
“…governance is simply one of those interdisciplinary areas that touches on many parts of the firm. Therefore to thoroughly review governance you have to review these other areas by association and then analyse the quality of the governance oversight and control environment overlaid upon them.” (p. 161)
The book is U.S. and Cayman focused with obligatory references to other jurisdictions. Of course, comparing hedge fund jurisdictions is not straightforward when just examining regulatory provisions.
For example, self-regulatory organization (SRO) codes in one jurisdiction are not necessarily comparable to regulatory guidance in another. Good then that Scharfman does not dwell on detail of regulations and instead drives at the complete set of factors relevant to the decision for investors.
A good deal of chapter 2 is dedicated to the question why investors do not pay a lot of attention to the master board and why they should. Scharfman claims that this lack of attention along with a lack of regulation results in master boards typically adding no value.
It is for this reason that investors must consider all the service providers to the fund when conducting due diligence. Essentially, then, Scharfman claims that there is no governance oversight in many funds structures.
Of course, one would expect analysis of the role and independence of directors and their duties, although it was not clear to me whether Scharfman appreciated the extent of the directors’ fiduciary duties to the offshore fund. While the Weavering judgment is discussed at length (seven pages), the book does not benefit from the recent appeal court decision in that case.
Readers might be left with the impression that the value of independent or professional directors in the offshore fund has not been proved and there is an interesting metaphorical reference to directors as wolves and administrators as sheep.
Together with an analysis of compensation arrangements and their effect on independence, a key argument is made that management relationships are as important a factor in conflicts and capacity for directors, as actual appointments to boards.
Cayman is the main jurisdiction case study used in the book and there is discussion and commentary on the Directors Registration Law and other relevant recent reforms. While other case studies are cited, the commentary is not presented in a consistent manner.
For example, the regulatory comparative on Hong Kong only cites an example of insider trading. This is therefore not a balanced review, but just a taste of regulatory models in main hedge fund jurisdictions, with a broad conclusion that regulation has affected hedge fund governance.
Interviews with the Cayman Islands Monetary Authority, independent directors and lawyers in Cayman, and two other operational due diligence professionals and representatives of the Maltese Financial Services regulator are included.
The book also includes a short chapter on liquidations and their governance features, as well as a chapter on fund valuations, together with specific analysis of how a business continuity plan can be useful to examine the quality of governance within a fund.
Hedge Fund Governance does highlight the inequality of information and sophistication of those that are party to fund structures, a form of market failure that usually justifies regulatory intervention. However, it is inferred that the author’s view is to address this not by regulation but by reliance on investors, mainly to drive up standards by careful and informed selection of services providers and directors.
Jason Scharfman is founder and principal of Corgentum Consulting, a firm providing due diligence services. This leads to doubt as to the objectivity of the conclusions of the author, but then one cannot question that he must be relatively objective and certainly well informed. There are a number of subtle plugs in the book regarding the value that operational due diligence professionals can provide.
It is clearly written for the benefit of investors but is nonetheless illuminating for all involved in the industry. The style is entertaining and questioning, although sometimes annoyingly repetitive.
I anticipate that Cayman-based service providers would maybe find around 30 to 50 percent of the book useful and may be advised to start reading at Chapter 5 since a good deal of the book, especially at the beginning, is dedicated to convincing readers of the need to conduct due diligence on all players involved.
Overall, the book highlights potential problems with hedge funds. The examples cited cannot portray the universe of funds in their uniqueness and variety ,which may make it very tempting for service providers to dismiss the conclusions as not relevant to their structures. This is perhaps a dangerous dismissal.
The impression left is that investors should be warned that as a general rule, they themselves must take responsibility for the oversight of funds in which they invest.