While corporate governance in the Cayman Islands has come under much attention and scrutiny in the hedge fund industry, the private equity industry has stayed just under the Cayman regulator’s radar.
The Cayman regulator’s recent statement of guidance on corporate governance standards and the directors registration and licensing regime each only apply to operators of regulated mutual funds and some Cayman management vehicles, but not to operators of closed-ended investment vehicles.
Private equity firms and their investors have played a key role in the alternative investment space in the Cayman Islands and globally. Many of the industry’s leading private equity, venture capital and fund of funds managers utilize the Cayman Islands as the jurisdiction of choice for the structuring of investment vehicles.
As interest and requests for the use of independent professional directors as operators of private equity funds and on advisory boards of private equity funds grows, this article will explore the use of professional independent directors in the private equity space, what some of the key drivers are towards independent oversight and the value proposition for institutional investors.
Why managers opt for independence?
For years Hong Kong based investment managers and others in Asia and Europe have been using Cayman Islands based professional independent directors in an effort to achieve a desired onshore tax exemption status. The key driver has traditionally related to the determination of the central management and control of the fund as being offshore.
While the residency of the board of directors of the general partner of the fund alone will not determine central management and control, many Cayman private fund structures often include the use of a Cayman based investment manager with a majority of Cayman resident professional independent directors serving as well.
Driven mainly by tax considerations, North American managers have also benefited from offshore structures using a fully independent board of directors in private equity opportunities targeted at non-US based investors. Institutional investors have also been a significant influencer in the use of independent directors with North American managers.
In addition to offering tax neutrality and benefits, independent directors can offer private equity managers prior experience on fund boards, knowledge of sound corporate governance practices, knowledge of local laws and regulation, knowledge of market trends and industry standards and depending on the individual, in depth legal strength and/or knowledge of fund administration, valuations and accounting.
Why institutional investors opt for independence?
As the world of alternatives expands, hedge fund investors have been spreading investment concentrations towards private equity investments and in doing so have come to expect a certain level of independence between the fund and the investment manager. Some large institutional investors with combined operational due diligence teams are now applying similar due diligence procedures when assessing private equity investment funds as they do when assessing hedge fund investment opportunities.
They are interested in understanding board composition, the skill set of the board members, experience and capacity of board members, the relationship between board members and the investment manager and how the day-to-day operations are managed (e.g. how are investment opportunities assessed by the independent boards).
In addition to initial due diligence assessments, there are a number of key areas of concern for institutional investors where professional independent directors can add value to the private equity structure in offering an oversight function. These areas include expenses and expense allocations, conflicts of interest and co-investment rights and allocations.
The value proposition
Whether driven by tax considerations or by investor requests, professional independent directors can add significant value to investors and investment managers in the private equity structure.
For investment managers, independent directors who specialize in corporate governance can help to ensure that the fund has an appropriate corporate governance framework in place thus allowing the investment manager to focus on its core competencies of managing the underlying investment portfolio and working on the performance of the fund and its underlying investments.
Independent oversight is particularly helpful to institutional investors in respect of areas in which the Securities and Exchange Commission has recently taken an interest. These areas are noted above and include expenses and expense allocations, conflicts of interest, co-investment rights and allocations. Key interest areas for institutional investors also include more transparency and better reporting.
Investors are keen to get a better understanding of transaction fees and expenses and how these are allocated between the various funds and accounts managed by private equity investment managers.
Independent directors can ensure that expense allocation policies and procedures exist and are up to date and more importantly are being adhered to.
Allocation of investments can be controversial and independent directors can help to ensure that the interests of investors are considered and that they are treated fairly amidst the potential competing interests of the investors of co-investment vehicles and parallel funds managed by the same investment manager. An independent board or member of the advisory committee can add arm’s length expertise in dealing with inherent conflicts of interests.
Conflicts of interest not surprisingly arise in both expense allocations and investment allocations as discussed above but it also arises in the context of valuations. Valuations can be especially complex when dealing with portfolio companies and difficult to value assets.
Having a conflicts of interest policy and independent directors and advisory board members held accountable to ensure that fund valuation policies are in place and being followed can enhance investor confidence. Independent directors and advisory board members can also assist with ensuring the consistency of the valuation process, the assessment of the standards applied and the evaluation of when those standards need to be reviewed.
These important functions can assist in bridging current gaps in regulatory oversight within the private equity structure.
The value proposition for the use of independent directors and advisory board members applies in both the early stages of a private equity fund and in the end of life stages. Depending upon the corporate governance framework in place, the board of the general partner or the Cayman based investment manager or advisory board members will have some involvement in deal flow.
This includes having the opportunity to help assess proposed investments, understand IRR’s, leverage and security and market opportunity of the underlying portfolio company or investment opportunity. Whilst in most cases, the deal opportunity is highly confidential and enhanced information is not always available, professional independent directors/advisory board members with diverse skill sets can add significant value to the deal flow discussions.
Similarly it is important when dealing with the end of life stages of a fund that the underlying investment portfolio is carefully considered against the investment term remaining, any extensions being proposed by the investment manager and any follow-on fund discussions. The independent board can help to balance the interests of investors and the investment manager.
Independence is becoming an essential ingredient in the alternative investment space so it is not surprising to see the growing interest and use in private equity structures.
As investors demand more transparency from investment managers and regulators demand a deeper understanding and greater accountability (presumably through more regulation) from private equity managers, the value proposition for using experienced independent professionals will continue to strengthen.