Financial risks to trust funds are one thing, but financial risks to their own resources are quite another. Trustees know that personal liability awaits a personal mistake. They should wait to be convinced that an investment is appropriate and that they will be free from blame if it should go wrong.
How can hedge funds sell themselves to such a market? They will find it easier if they understand the trustees’ perspective and position themselves in a way which allows trustees to make true investment decisions, on financial merits, not on the legal ones. The lawyers must be placated swiftly.
Trustees are always mindful of the rules; rules formulated over several centuries, designed to protect beneficiaries from those in control of their assets. Rules which are not to be undermined as they are fundamental to the preservation of wealth through the generations. They work.
In the investment context, paramount is the rule that trustees must use reasonable care and skill in deciding how their portfolio is to be invested and whether, within that investment strategy, there is room for investment in a hedge fund. Trustees will be told that risk and reward increase together. At least that is what they will be told. The rules tell them that they are allowed to take a prudent degree of risk. They must decide what proportion of their assets can be invested within a specified degree of risk.
What should be the response of a fund? Hedge funds should make trustee investors aware of what that degree of risk is. The usual list of risk warnings in an information memorandum or offer document goes a long way towards this, but they tend to be generic. It would be helpful to prioritise risk by likelihood and magnitude of damage. For example, a statement that markets can go down as well as up really helps no one from this perspective. Nor does a statement that the whole of the investment could be lost. Does either a manager or an investor ever believe that? A statement that investments are in a particular currency and therefore there is an exchange risk is blindingly obvious. It has to be there as even unregulated documents would look racy without it. But if trustees have to be told that, should they be investing?
However, a list of specific risks inherent in the particular strategy or risks inherent in the dependence on a particular investment management team are more helpful. It is these which can change a “prudent degree of risk” (markets go down as well as up) into a “hazard” (why are you entrusting money to hedge funds on this basis?), which is a level of risk that trustees are not permitted to take.
Trustees have a duty to act impartially as between the different beneficiaries of the trust, and this is particularly important when they are exercising their investment powers. The rule increases the level of caution required of trustees. The rights of those entitled to income must be balanced against those entitled to the capital. Short term income must be balanced against longer term capital gain. There can be no gambling. A clear statement of the type of return is vital here. Of course, hedge funds will frequently state an intended overall return, but if they cannot foresee whether it will remain part of the capital or will be distributed as income, trusts with interests in succession will have difficulty investing.
Trustees have a duty to safeguard the trust assets. They must not lose sight of them. Frequent reporting also helps here. If trustees are well informed, they will be more confident that they have not delegated control recklessly.
And the great friend of prudence is liquidity: the trustees will be greatly assisted if they can see an exit. Restricted dealings will give pause for thought. This is a great merit of listed funds. Although a quote does not of course guarantee a market, it might at least show an accurate price.
The fund’s aims must be consistent with those of the trust instrument from which the trustees derive their powers. The details of an investment strategy are often closely guarded secrets. It is a challenge for trustees, since they should understand to what they have committed their assets. It has been well said (in another context), if you don’t understand the business, don’t invest in it. Given that most hedge funds have no or very light regulation, and certain alternative strategies reserve themselves the right to invest in an exceptionally wide range of assets, trustees can be in difficulties. Again, the wider the management discretion and the greater the emphasis on derivative assets, the less likely that the fund is to be acceptable to the trustees.
But there is a way through. Trustees cannot be expected to have expertise equal to their advisers. To help them, funds must be clear. If, for example, the fund is making widespread use of derivatives such that it is not acquiring, for example, shares, bonds, debt or land itself, but only derivatives of these assets, the trustees must be aware of it. Funds must make clear whether they reserve the right to invest in financial instruments at any stage in the future, and if so, to what extent. If they do not, it is far less likely that trustees will feel comfortable in committing funds. It could be a breach of their own investment powers. And perhaps above all, trustees must be aware whether the underlying assets of the portfolio are wasting assets rather than those of a more permanent nature. They have case law to remind them; and to warn them of the liability of trustees who miss the point. It is all about risk profile.
From the perspective of trustees, funds, or at least their managers, are delegates of the trustees’ powers of investment. The trustees have to exercise care in choosing them. The more information available and the more contact which is possible with them during the course of the investment, the better. Thorough research is important and here, as in other areas, investment in a fund of funds can be an advantage. Clearly the relative size of the commitment to any one manager is reduced.
So there are things that funds can do to make themselves more amenable to trustees. Many of these points might be rather abstract since the legal background imposes general principles, rather than specifics, relying on the trustees to implement them as they think best. The real test for them is then to find a compliant fund.
Nigel Stone and Geoffrey Todd are both partners at Boodle Hatfield. Stone is a corporate partner who advises on the creation and management of hedge funds. Todd is a private client and tax planning partner who offers advice to trustees on investing in hedge funds.