Reflecting on the recent global financial crisis one can’t help but wonder what lessons have been learned from the experiences of many of the world’s hedge fund participants.
Are we now better off for having suffered all the difficulties that many hedge fund stakeholders faced or will history repeat itself as it has done many times before? Is increased operational due diligence the panacea for all the ills the hedge fund industry endured recently? One thing is clear, the stakes are rising for independent directors and investors are realising that effective fund governance is an important part of the solution.
Investors are beginning to realise that more detailed due diligence is now a pre-requisite for responsible investing. It is imperative that investors evaluate the operational risks at each stage of the investing process, and while many may never fully understand the entire methodology that any investment manager may employ, it is possible to understand how the auditor, independent administrator and the independent director all interact to deliver effective governance while maintaining their independence. Investors now recognise that, for an independent director to effectively respond in a timely and informed manner to fund matters, there must be an infrastructure in place equivalent to that of the other service providers to the fund. Basics such as a professional support team, software, IT systems, personnel support, data recovery and operations management are essential.
Additionally, an independent director should strive to maintain a sufficient client base to avoid compromising his independence. An independent director who is not part of a large firm with a higher volume of business may be quite dependent on the revenue received from a fund. In every situation it is imperative that the director be able to act impartially and make the tough decisions without regard to any financial interest in any particular decision. Auditors generally believe that independence might be impaired if a client represents more than 5 per cent of revenue and this seems to be a reasonable guideline to consider when evaluating director independence as well.
A professional services firm will support a fund, not only with an individual director or directors, but also with an entire fund governance team: the director, the manager, the paralegals and the corporate administrators, providing the fund with a skilled and dedicated team steeped with hedge fund expertise. The team approach to fund governance, as in any audit, legal firm or other professional services organisation, leverages the benefits of knowledge-sharing, continuity and the ability to train and develop the directors of tomorrow. Whilst many may be entering the world of directorships, albeit with relevant industry experience, none have the depth and breadth of actual directorship experience that exists within the professional fund governance firm. Whilst the fund governance firm supports the director in the performance of his duties, the fund governance firm also supports the fund in its interaction with the investors, the auditors, the prime brokers, the administrators, the regulators and, of course, the investment manager. Fund governance today is more than a person; it is a system of processes, checks and balances that require a full documentary workflow system and processes far beyond those that a director would have been expected to have just a few years ago.
So how should hedge fund stakeholders perform due diligence on the independent director in today’s environment? Particular emphasis should be placed on the infrastructure and resources available to the director to properly discharge his duties to the particular fund and to maintain proper governance records. It is essential that directors be able to demonstrate to stakeholders in a specific, observable and measurable way, precisely what governance is occurring for the fund. Guesswork is out. Proof is in. It is strongly encouraged that stakeholders conduct in-person due diligence visits of the working environment of their directors as in many cases, check-the-box due diligence checklists are outdated and ineffective.
At a minimum, investors and managers should interact with their directors by web conference. At dms, we facilitate the due diligence process through the use of our dmsTracker web portal, to enable review of the fund’s governance history and the actual inspection of the fund governance records. Stakeholders no longer have to speculate or attempt to deduce exactly what work directors are doing on their behalf. Inspecting the fund governance files for evidence of effective oversight will provide incontrovertible evidence of whether or not the director is devoting sufficient time and attention to the fund’s affairs.
Firm size is also an important factor to consider. Two-person firms or directors operating from a kitchen table in their house with little to no infrastructure to maintain proper governance records should not be sufficient for today’s sophisticated hedge fund participants. An independent director with exposure to only a small number of funds may not have the level of experience of working through some of the multifaceted issues often faced with the best and most experienced professionals in the industry. Lack of proper infrastructure would be stunning and alarming for any manager, administrator, auditor or other key service provider engaged by the fund – so why not ultimately for directors as well?
With all this in mind, it begs the question, how long will it be before we see the emergence of further shareholder participation in the fund governance process? Perhaps we will see more shareholder due diligence being performed on independent directors or annual shareholders’ meetings? Either would give shareholders increased opportunities to interact with their directors and gain more confidence in the roles being performed by the key players who oversee the management of their investments.
Today, fortunately the view of independent directors is changing for the better. Much more scrutiny is being focused on fund governance and sophisticated investors are demanding more accountability, accessibility and independence from directors. Overall these developments are welcomed since success in this industry will accrue to those who truly understand how to super serve investors. Serving as an independent director is no longer a sinecure and today’s professional fund governance firms, with dedicated talented professionals and deep resources are available to super serve investors today. Experience shows that investor-driven reforms are most successful in effecting enduring positive changes in the industry, and as such investors should be urged to engage with their independent directors and let their voices be heard.