Operational due diligence, also known as ODD within the alternative investment industry, has become a focal point for many investors, arguably in part due to some hedge fund failures in the recent past.
Large institutional investors, often with their own ODD teams or the financial ability to engage external specialists, are undoubtedly in a position of strength in evaluating governance considerations.
As part of their pre-investment due diligence process these potential investors will seek to independently verify the relationship with the target fund’s board of directors and assess the strength of the corporate governance framework of the fund.
The aim of this article is to assist investment managers and investors, who do not have their own internal ODD teams or independent third-party consultants, in designing their own ODD framework to help in the assessment and selection of professional independent directors.
As professional independent directors, having completed a variety of ODD questionnaires, and been the subject of numerous ODD interviews we offer some practical guidance on the evaluation process. This article will cover some key areas of focus such as professional background, board diversity, conflicts of interest, corporate governance practices and capacity.
The professional background of your proposed board members is a practical starting point in the evaluation process. Knowing whether or not they hold professional designations, knowing whether they are members of internationally recognized professional associations, knowing where they were previously employed and understanding the breadth and depth of their past professional experience assists in assessing the value and strength that each individual can bring or add to the board composition.
In addition to asking for the usual professional biographies, proposed board members may be asked for a full resume or CV offering additional insight into each board member’s reservoir of knowledge and accumulation of experience gained throughout their professional and sometimes personal lives. A board member’s approach to problem solving is often influenced, in part, by his/her professional exposure and educational background.
Following naturally on the heels of a board member’s professional background is the topic of board diversity. Historically many offshore independent professional directors have been drawn from the accountancy profession and more recently the legal profession. Today, professionals range from former accountants, lawyers, regulators, bankers, traders, investment managers, asset allocators, due diligence professionals and the list goes on.
The Cayman Islands has been very fortunate in that a pool of highly talented professional directors already exists as a result of it being a leading offshore fund jurisdiction. Having a board composed of individuals with varying professional backgrounds can be highly advantageous to fund investors and investment managers as each individual board member can offer his/her approach and perspective on issues presented to the board. Additionally, diversity through gender or ethnicity can also be beneficial and can bring a fresh approach to addressing complex issues in today’s business environment.
As fund governance further evolves, the concept of split boards, where directors from different professional services firms are engaged, is becoming more topical. It would not be far-fetched to interpret this development as the desire for investors and investment managers to expand board diversity in the widest sense.
Conflicts of interest
Conflicts of interest commonly arise in the context of hedge funds and fund of funds boards. It is important when assessing a board that conflicts are fully disclosed so that they can be minimized and managed effectively during the life cycle of the fund.
Conflicts can arise most obviously where the board member is an employee of the investment manager, but also where the board member serves as a director of third-party funds which the target fund invests in, where the board member has a long prior history with the investment manager of the target fund, or where the board member or the professional services firm providing the board member has other business relationships with the fund or the investment manager.
Ironically, one of the ways that conflicts of interests on fund boards are managed is by the addition of professional independent directors who can add an arm’s length independent and unbiased perspective to the fund’s governance framework.
Corporate governance practices
It is important to understand your professional independent director’s views, practices or procedures around governance. Early 2014 the Cayman Islands Monetary Authority issued a statement of guidance setting out its minimum expectations for the corporate governance of Cayman regulated mutual funds and in April 2015, the Alternative Investment Management Association (AIMA) issued an updated Fund Director’s Guide providing useful guidance to existing and prospective fund directors, investment managers and fund promoters alike. Familiarity with the statement of guidance and the AIMA guide offers invaluable insight into sound corporate governance and industry practices and provides a foundation on which to evaluate a potential board member’s governance practices.
Capacity or a “director’s time commitment” should be taken into consideration in the evaluation process of a professional independent director. In assessing capacity, the primary focus involves the examination of a number of relevant factors in order to determine if a potential board appointee has the time to adequately consider, add value and discharge governance requirements of the target fund.
Some of the factors that can affect capacity can include, but is not limited to, the number of boards the potential director currently serves on, the complexity of the structures involved and the number of relationships held by the professional independent director. The frequency of board meetings and the percentage of those meetings which are held in person are other important considerations.
The internal support structure of the professional services firm and technology solutions in place can also provide valuable information for potential investors and investment managers in assessing the question of capacity.
In conclusion, a level of comfort can be derived from developing and applying sound assessment practices and criterion prior to appointing potential board members. A comprehensive and consistent approach to ODD can offer a benchmark for assessing potential appointees and support a more informed decision making process for investors and investment managers.
Taking care in the appointment of the board from the onset can also contribute to the fund having a sound governance framework and can help to manage expectations on governance generally. These practices should be applied initially, and on an ongoing basis throughout the life of the fund.