The following is an excerpt from the book Hedge Fund Governance: Evaluating Oversight, Independence and Conflicts, focusing on the sometimes strained relationship between operational due diligence and governance/fund director analysis.
Some groups, such as large institutional investors, are very passionate about the issue of governance and fund directors. At least, that is to say, they have become increasingly focused on and critical of the role of directors in recent years. In addition to citing capacity issues, a commonly cited example of director wrongdoing has been the decision in the 2011 Cayman Weavering decision. This passionate institutional criticism typically comes from disagreements on matters of principle. This includes arguments such as:
Such criticisms may certainly be merited. The goal here is not to defend one side of the argument or the other, but rather to highlight and provide perspective on the some of the key issues involved. After all, these are issues of largely ideological debate, to which there is really no correct answer. Perhaps it is best left for the market to determine, for example, how much directors should be paid. Those investors who feel directors are being paid too much or too little have every right in the world to complain about it. What’s a bit different is when this criticism, or admiration, of the directorship industry as a whole becomes automatically translated to the conclusions about a specific director sitting on the board of a specific hedge fund.
In this book we provide a roadmap to techniques by which investors can analyze governance in place at hedge funds. This includes not only an analysis of internal hedge fund governance mechanisms, but the roles played by their service providers as well. This includes, of course, hedge fund directors. If investors, however, do not perform research on the directors’ role and instead immediately extend the above-mentioned criticisms of the directorship industry to the directors at funds under review, then there is a real risk that good directors will be unnecessarily chastized along with the bad ones. But is the risk of throwing the baby out with the bathwater, so to speak, a real one? Aren’t investors devoting enough time to vetting directorship roles? Let’s provide a bit more perspective on this matter.
Perhaps somewhat counter-intuitively, one of the contributing issues in this area is that investors are doing more due diligence on hedge funds than ever before. Shouldn’t this be a good thing for directors and hedge fund governance in general? Yes, it is. The problem is that this increased scope of due diligence has not necessarily come with commensurate investor resources. This is a particular problem in the specific area of investors’ operational due diligence (ODD) efforts.
To frame the discussion in modern hedge fund times, even before the Madoff scandal came to light in 2008, investors were increasing their focus on reviewing operational risks in hedge funds. To generalize a bit, after Madoff this focus increased exponentially. When you add the increasing web of global compliance regulations, you can see how investors have increasingly full plates with regards to analyzing hedge fund operational risks. Larger allocators may employ in-house operational due diligence personnel, but they haven’t necessarily gone on hiring sprees to bulk up their ODD teams. In many cases, it doesn’t make financial sense to build up the in-house teams. As such, there has been a growth in the use of operational due diligence consultants (such as my firm, Corgentum Consulting) to support in-house ODD teams. Now add the topic of governance and directors to an already full roster of ODD work and you can see how it could be overwhelming. This doesn’t, of course, mean that they should be excused for not necessarily getting around to the issue properly; it just becomes less of a priority, particularly if they feel they are wasting their precious time with the directors, that some investors might mistakenly classify as a useless service provider.
During the investor due diligence process, some things fall through the cracks, or indeed become under-researched, and as we have discussed, fund directors and governance can be one of them. On the whole, despite the increased attention paid to governance and the directors of late, this area continues to be one that is under-researched by institutional investors. Some evidence for this is found in the 2014 Corgentum Consulting survey, which showed that only 39% of investors and operational due diligence professionals surveyed indicated that they conduct interviews with fund directors as part of their due diligence process. Furthermore, a much smaller segment (18%) performs background investigation on these directors.
This results in under-resourced investors and larger allocators with overworked operational due diligence groups not dedicating the appropriate level of review to these issues. As such, some investors and operational due diligence professionals take the default position that they are going to focus their efforts primarily on the hedge fund and what they deem to be its key service providers, and devote less effort to analyzing the directors. Shockingly, some ODD professionals, at large allocators, have expressed the sentiment that outside of checking who the directors are, they effectively ignore the function entirely because of their perceived lack of authority and ineffectiveness. This all translates into a situation where those who haven’t spent much time researching the specifics of a fund director relationship at a particular hedge fund become overly critical of it.
For those who do make the time to engage with directors, you could see how it could perhaps be frustrating when they may be inherently sceptical of some of what they are told. The biggest leap of faith for many investors and operational due diligence analysts may be believing that the directors actually protect investors’ interests over those of hedge funds or their own. While one can look to the courts for examples of cases that bolster either side of the argument, it still may be a difficult bill of goods to sell to certain people. This is particularly true among ODD people, who are paid to be professional sceptics.
To be clear, I would like to reiterate that I take the perspective that investors and ODD professionals should definitely have the right, if not the obligation, to be critical of the director function. This is particularly true when, as noted above, there are legitimate concerns in place unique to the facts and circumstances of each directorship position. These criticisms may also be well founded when focusing not on the relationship between the director and the hedge fund itself, but rather on the directors themselves. For example, an investor or ODD professional may have concerns regarding a director’s background, their qualifications, or the fact that they feel that the directors may be overcommitted to too many boards. The problem, however, is that investors and ODD professionals may be casting wide strokes with such criticisms based on ideological objections against the industry as a whole. Although related, for the purposes of analyzing the circumstances of a particular directorship under review, the two positions should, in large part, be separated.
Of course, hedge fund investors and operational due diligence analysts are not robots, nor should they be. If an investor is negative on the concept of hedge fund directors, then they should approach the review of a particular directorship position with enhanced scepticism and scrutiny. The point, though, is that they should not let such negative opinions about the industry completely blind them to conducting any analysis of the specific directorship position at hand. As noted above, the risk is that many investors, so clouded by rage or ambivalence in this area, simply don’t bother to dig deep into the role at all, and that is a mistake that can result in uninformed investment decisions.