Independent directors have become synonymous with offshore investment funds, in particular, hedge funds, in a trend driven squarely by investors looking for greater oversight and protection for the funds they are involved in. As the provision of fund governance solutions gets more sophisticated, with split independent boards a notable preference among institutional investors, emerging trends in this space include the adoption of independent directors on private equity funds, as well as a greater interest in adding a level of independent oversight at the onshore level and master fund level, particularly where the master fund is an onshore limited partnership or limited liability company.
Onshore hedge fund oversight covers similar ground to offshore funds, such as reviewing financial statements, changes of service providers and fees paid to the manager. Where private equity is concerned, directors can add specific value, particularly in the area of valuations, which is so central to the private equity investment process and quite often subjective, without a readily available liquid market for prices to be obtained and verified.
The independent director, who may be acting for the general partner of a private equity fund established as a limited partnership, will often be required to approve investment activities. Information packs will be prepared for the director with all the relevant data on both the buy and sell side and usually, the investment committee will make a recommendation to the board, who will consider if the deal makes sense and should proceed.
As the SEC is stepping up its oversight of the U.S. mutual funds market, which is a more highly regulated space, it is not a stretch to consider the trickle down impact this could have on private equity and hedge funds. In particular, it could suggest that we may be in for a period of enhanced oversight of independent directors of hedge funds and private equity funds in the U.S. Recent comments by SEC Chair Mary Jo White pointed to the need for directors to toughen up the questions they ask fund managers in order to hammer out how potential issues coming down the line will be handled, as well as to keep a check on what possible problems might be being missed.
It can certainly be argued that the move towards increased governance oversight on onshore funds as a result of experiences from the offshore world is a natural progression for stakeholders and independent directors and we are seeing a preference for oversight at all levels – and greater representation for investors – not just for the master feeder structure.
Case study – Ronan Guilfoyle acted for offshore fund while onshore fund had no independent representation
In particular, on one structure in which I had personal involvement, there was an offshore fund and an onshore fund running pari-passu. While I was acting as an independent director for the offshore fund, there was no such representation on the onshore fund side, which was controlled by the investment manager, who also dually served as the general partner. The investment manager received a Wells notice from the SEC indicating certain principals would be charged with insider trading, at which time those principals immediately sought indemnification from the offshore fund. As directors, we undertook the appropriate analysis.
However, as things were not moving quickly enough for the manager concerned, the manager took his indemnity from the onshore fund, where there was noone to oversee or question these actions. In the end, the principal pled guilty to insider trading and served a jail sentence. I was able to negotiate directly with the SEC and secured a discount in the penalty which was charged to the offshore fund as a result of his actions, having been convicted of disgorgement of profit and interest. The offshore investors represented by the independent director ended up in a better position than the onshore investors where the manager filed for bankruptcy and he was unable to pay back the indemnity he so easily took from the onshore fund.
Other emerging trends concerning independent directors for investment funds include the constantly changing regulatory environment, which continues to present complex issues for boards, even though best practices are ever evolving. With regulations like the Foreign Account Tax Compliance Act (FATCA) and the EU Alternative Investment Funds Managers Directive (AIFMD), managers want their directors to help ensure they are operating within the rules so that the funds remain compliant at all times. Alongside other issues like expense allocations and the moves towards split independent boards, cyber security has fast become the number one threat for funds and managers alike. Everyone wants to know that they are taking all due measures to treat sensitive and confidential information safely and directors need to ensure that the fund is in a position to respond to and counter cyber threats at all levels. As the SEC has already stated it does not believe that U.S. mutual funds are prepared enough to deal with the full extent of this risk, independent directors can expect similar questions for the private equity and hedge funds they represent.
To see a general improvement in the standard of fund governance throughout the investment fund sector over recent years has clearly been of benefit to both investors and the industry as institutional allocations and pension fund participation continues to grow. At the end of the day, whether onshore or offshore, good directors need to be seen to be proactive rather than reactive, with education part of a continuous process, which can be achieved through regular discussions with investors, fund managers and all related counterparties including auditors and administrators.