Having a fund board of directors with multiple independent individuals who are not connected to each other by a common directorship services organization has been become known as a “split board.” Proponents of the split board model consider it to provide a more effective governance solution, but there are also some possible disadvantages to this model.
Hedge fund governance continues to evolve in a very positive way for Cayman Islands investment funds and their investors. With the increasing demand by investors for enhanced hedge fund governance, it is perhaps not surprising that the split board model is recognized by some as providing a more effective form of governance.
Proponents of this model suggest that two or more independent directors provided by the same directorship services organization is less than ideal, and perhaps not best practice.
Not that long ago, fund boards were populated solely by representatives of the investment manager. This provided investors with ineffective oversight of the investment manager and very little control in difficult situations.
Fund boards then evolved to include directors from outside the investment manager. Outside directors are often taken to be independent directors, yet the independence of some directors who meet the definition of an outsider can be questioned: For example, if such individuals are provided by affiliates of suppliers to the fund.
Although this situation is clearly still very much alive and accepted in today’s fund governance landscape, the demand for independent directors who are in no way affiliated with, or a supplier to, the fund is likely to increase. This has led to the proliferation of directorship services organizations specializing in fund governance.
From organization to organization, various models exist in the marketplace, and while it is common in the industry for individual directorship services firms to provide two independent directors to a given fund, surveys by law firms confirm that the recent trend is an increasing preference for split boards.
Many see this as a healthy development and as a step toward more effective fund governance, so much so that many funds that have not adopted the split board model are actively considering this change.
Split board advocates believe that an additional level of governance is achieved and that conflicts can be avoided by adopting this model.
A split board model can create healthy competition between governance professionals, which works to the benefit of the fund and its investors. Investment managers, for instance, often use two audit firms to create healthy competition between the firms.
The existence of a second audit firm helps to keep the service levels of both firms at their highest. With a split board model, a fund can create a similar dynamic between the individuals serving on the board. Each will be motivated to do their homework and ask appropriately probing questions, which is all in the best interest of the fund and its investors.
The full advantages of having multiple independent directors will be realized. If the effectiveness of a fund’s governance structure is a major concern for potential investors who see added value in a split board, the investment manager’s capital raising efforts may be more successful with this model.
Proponents of the split board model argue that you are more likely to obtain multiple objective points of view. Directors from the same organization may be more likely to agree on a common point of view on an issue. This may be a result of common training or internal discussions.
The need for multiple points of view can be crucial in times of trouble. It is also possible that the ramifications of a board decision may not be in the best interest of a given directorship services organization. Supporters of the split board model would suggest that this may be even more relevant when two directors are provided by an affiliate of a supplier to the fund.
Having a split board may, in many instances, result in less conflicts of interest, given the level of independence on the board.
It is possible that when one director (an employee of a directorship services organization, whether large or small) leaves that firm, it may be difficult for that organization to match the existing desired combination of experience and expertise provided by the two existing directors.
When that firm attempts to fill the board vacancy, their options will be restricted by not only the pool of candidates within their firm, but also by those who have the capacity to take on an additional appointment. In this situation, maintaining the strength of the board is reliant on not only the bench strength of the directorship services organization but also the capacity those individuals.
If the fund is able to choose from a variety of sources and organizations, it is more likely to maintain the overall combination of skills and experience investors want on the board.
In my discussions with advocates for a split board it was argued that when a fund adopts this model, it is more likely to get two fully engaged and active individuals on the board.
The thinking is that in some situations, when one organization provides two directors, it may occur that one director takes the lead and the second takes a less active role. Some would claim that this allows the organization and its individuals to take on additional appointments, while still being seen to be serve funds with two board members.
If this was, in fact, the case the fund and investors would not be receiving what they are paying for – multiple fully engaged and active professionals.
It is likely that one directorship services organization will able to provide attractive pricing for the provision of two directors and it is probable that the split board model will cost the fund more. That said, the additional cost, to have what many would argue is a more effective board, should be marginal.
If the fund is using independent directors from different organizations, it may be faced with differing views on director services terms. These issues may be minor in most cases, but different director services agreements have to be reviewed and considered.
Other issues may surface, but it has been my experience that Cayman independent directors work well together and the resolution of differences are handled effectively, efficiently and with commercial sense.
Governance in the alternative investment industry continues to evolve and there is still a place for all models. In fact, in some funds the investment manager continues to be responsible for fund governance and no independent governance is required by investors. If that is sufficient for investors of that fund, any discussion of alternative models is academic.
On the other hand, the addition to fund boards of multiple independent directors is a clear industry trend and one that is a positive step for the protection of funds and their investors.
Perhaps the next step in the evolution of fund governance is the concept of the split board. This industry trend is being driven by investors who consider that the challenges of such a model are far outweighed by the benefits provided to them by a board that will be more effective in all situations.