Fund governance that runs like a Swiss watch

Read our article in the Cayman Financial Review Magazine, eversion 

In the current investment climate, is any institutional investor going to invest in your fund if your service providers deliver an unregulated service?

Those investors today expect institutional-quality standards from all providers. How does your fund governance provider measure up? Does it run like a Swiss watch or like a hamster on its wheel? 

The long-term view of the hedge fund industry’s future is an institutional one. The industry will not go back to its ‘two guys with a Bloomberg in a basement’ roots, but instead move forward to embrace institutionalisation.

It’s no longer a question of if or when. Pre-crisis, institutional money represented only about 40 per cent of allocations to hedge funds; however, today over 60 per cent of assets are institutional (Source: Prequin). The tipping point has arrived and stakeholders have been assessing how to keep up with the pace and growth of an institutionalised industry.

The global fund industry has unquestionably been through challenging times but most stakeholders report that the lessons learned have made their operations better. Investors have instituted more rigorous operational due diligence (ODD) reviews of service providers and fund controls and service providers have realised the need for significant changes in business operations.

In recent years the industry evolved to expect that auditors, administrators and investment managers all be subject to regulatory oversight. Yet fund governance remains the only unregulated function in the fund control structure. The directors in the recent Weavering Capital case were an egregious example of the enormous risks of unregulated fund governance.

Further regulation of hedge funds is now certain with recent Cayman Islands Monetary Authority, US Securities and Exchange Commission and US Commodity Futures Trading Commission developments. Fund governance must evolve to meet current regulatory expectations and commercial realities.

The SEC has adopted final changes to implement certain provisions of the Dodd-Frank Act which expand disclosures required by investment advisers of investment funds, including the disclosure of the directors and other service providers. This effectively brings directors under the SEC’s jurisdiction as directors must now be included on the Form ADV. 

“In particular, our proposal will give the Commission, and the public, insight into hedge fund and other private fund managers who previously conducted their work under the radar and outside the vision of regulators,” said SEC Chairman Mary L Schapiro

Thus, fund governance firms can reasonably conclude that it will not be business as usual under the new SEC regime.  DMS Offshore Investment Service (DMS) is taking a proactive approach in anticipation that regulators will expect fund governance firms to meet the same strict performance standards and scrutiny of all other service providers to a fund.

Taking the lead

The need for institutional-quality fund governance is clear but how can the fund governance industry best answer the demand?

DMS is the worldwide leader in fund governance by any measure. We hold more fund directorship appointments than any other provider globally. Our market leading position is a significant strength as we represent the largest funds in the world and gain access to the top minds in the industry across all stakeholder groups ranging from investors to regulators. 

Together, we’ve cracked the code through in-depth stakeholder conversations and intense study of successful governance models such as the Authorised Corporate Director (ACD) used by all Financial Services Authority (FSA) regulated collective investment schemes (funds) in the UK. It was surprising for us to learn, for example, that every FSA regulated fund needs to appoint an ACD. DMS took these insights and created DMS Fund Governance.

SMDFG is the first ever regulated director model licensed under the Mutual Funds Law of the Cayman Islands to provide institutional fund governance services regulated by CIMA. DFG meets the demands of today’s institutional environment and is indisputably the most advanced fund governance framework available.

CIMA has a robust regulatory framework for a regulated director including a fit and proper evaluation, net capital requirements, D&O insurance, KYC policies, whistleblowing reporting and annual audit requirements. No standards are required for a personal director.

DFG goes beyond simply providing directors to a fund and is built on the philosophy that fund governance is a continuum – a system of checks and balances. DFG directors are assisted by specialised teams of associate directors and associates that audit every governance transaction with established policies and common sense judgment in ways that add to existing operational risk controls.

Our firm’s insights are grounded with over a decade of real-life governance experience that leads to trusted, reliable results. DFG provides stakeholders with unparalleled transparency and accountability of the fund governance process through real-time, online reporting tools and Fund Governance Transparency Report. This reporting demonstrates the level of oversight being delivered in a specific and measurable manner – giving stakeholders the numbers and information that matter most.

What it means

Stakeholders can now choose between two starkly different versions of fund governance – institutional or not. Unfortunately, much of what is being done today to enhance fund governance addresses only where governance has been, not where it is or should be going.

If it is true that fund governance ranks alongside performance when making hedge fund allocations, the best approach is to conduct an in-depth due diligence review of the fund governance provider.

Expect to find institutional-quality practices:

  • If fund governance firms can pass the rigors of a full ODD review then they can truly be called institutional-quality. 
  • Review the firm’s performance history, internal controls, policies, business continuity, compliance and regulatory status.

Be consistent:

  • If governance is important then consider not just the governance of the offshore structure but the onshore structure as well.
  • Since many governance failures can be attributed to ineffective governance controls in onshore structures, investors concerned about governance reform should require effective fund governance controls across the entire structure.
  • Require strict standards and uncompromising integrity:

Stakeholders should be more demanding and insist on accountability in fund governance. The future of fund governance is about performance measurement and stakeholder reporting – if you can’t measure it, you can’t manage it.

There is no proxy or arithmetical calculation for performance and no substitute for professional judgment. Proper due diligence cannot be reduced to a single question or questionnaire and must be both quantitative and qualitative in nature. 

The case for the institutionalisation of hedge funds has been made. The fund governance industry must evolve to meet current institutional expectations and stakeholders should place higher demands on and conduct more thorough reviews of fund governance providers as part of a robust ODD process.

Einstein observed that no matter how smart you are, or how long you ponder, you can never be sure how a watch works unless you actually look inside.