The Unasked Question

“Fund directors - worth it or not?”

THE REGULATORY FUNDAMENTALS GROUP LLC

Why do we call these funds “alternatives”? A key reason why alternative funds have been able to deliver positive returns for their investors is that they operate outside many of the boundaries imposed on competing institutions. Well run alternative funds offer investment opportunities managed with unparalleled strategic creativity and limited outside interference. They draw their capital from investors who are legally required to be among the most sophisticated in the world. At a time when so many others in the broader financial community have required government bailouts, the alternatives space has overwhelmingly continued to be a source of profits, liquidity and innovation. Have there been bumps in the road? Of course. One need look no further than headlines that frequently highlight scandals, real or alleged. But the far larger story is one of success. And, as will be pointed out, many of the “bumps in the road” are tied directly to failures of investors to inquire about basic governance issues – e.g. Bernie Madoff.

Due to alternatives’ superior returns, investors, including pension plans, are increasing exposure to private equity, real estate and hedge funds.1 Endowments and foundations are also moving in this direction.2 In the US, numerous state and municipal pension funds would also like to expand their investments in the alternative sector; but many are hampered by legislative or political limitations on their use of alternatives. For example, the chief investment officer of CalPERS, the largest state pension fund in the US, publicly stated that he would be able to double his investments in alternative funds were he not held back by political constraints.3 Similarly, although the state of Georgia recently ended its absolute ban on alternative investments, it nevertheless limited the allowance to 5% and continued to exclude its teachers’ pension fund, which happens to be the largest in the state.4

The reason states and municipalities have traditionally been wary of alternative investments largely boils down to their overriding concern with protecting the assets of “indirect investors”—that is, teachers, fire-fighters, police officers and various other municipal workers. Elected and appointed officials charged with this responsibility have a natural tendency to shy away from any investment that relies on the advice of only one individual.5

Today these investors, particularly the large institutional investors who are driving market growth, and the US governmental sector that would like to expand into this asset class, are beginning to more closely scrutinise fund governance. They are examining exactly what sort of governance they receive in exchange for their fees and, most crucially, whether their wealth is, in fact, being grown and preserved in the most effective manner. They are finding, to put it mildly, that governance of alternative funds is a murky area.

The US governance model differs vastly from much of the rest of the world. An alternative fund chartered under US laws rarely has a board of directors. Instead it is typically “managed” by an entity affiliated with the investment manager that sponsors the fund. It is usually formed as a limited liability company or limited partnership where the fund manager (or one of its group entities) makes the major decisions on behalf of the fund.6 US regulators, such as the SEC, focus most of their regulatory efforts on the investment manager rather than on the funds themselves.

Elsewhere, fund boards are significantly more prevalent. Take the situation in the Caymans (and in other jurisdictions worldwide). Whether or not directors are specifically required (and this varies among jurisdictions) it has become a matter of “best practice” to have a board, which may require a complement of independent directors.7 But even in many jurisdictions where boards are required or considered a “best practice,” there is a great deal of silence about the specific duties and expectations of the board. Or, in more colloquial terms, what is the board paid to do?

There is a reason for this. As noted above, we are talking about “alternatives.” Alternative fund boards are fundamentally different from those of other financial entities. For this reason, assumptions about appropriate board behaviour that are borrowed from other sectors of the financial industry are clearly inapplicable. Here’s why.

In the public company context, boards provide at least some degree of strategic vision and oversight, as they make meaningful decisions about the hiring (and firing) of key senior management as well as management compensation. In private equity portfolio entities, the same situation applies, and with an additional incentive: the directors (or their employers) often have substantial personal wealth invested in the company.

The typical alternative fund is a genuinely different financial species. Investors have already selected the manager and “bought into” his or her investment philosophy. They would not take kindly to a board overriding an adviser’s judgment in this area. Also, many board directors, particularly independents, may have little personal wealth at stake.

Moreover, investors rarely have the ability to choose or vote for the board members. Instead, these critical decisions in many cases are made by the fund sponsor.
Below, we discuss how investors, managers and board members do not adequately define governance roles, leading to a disconnect between investor expectations and actual board functions. We suggest ways to improve clarity and transparency and enhance the dialogue between these parties as to what exactly directors should be expected to accomplish. After all, directors receive compensation from the fund and ultimately its investors.

This paper argues that alternative fund investors ought to have maximum flexibility, information and independence to determine whether they want a board and, if so, what its role should be. For this reason, a board should not be a regulatory requirement. In those cases where constructive board oversight is desired (or in jurisdictions where it is required), investors deserve genuine transparency concerning the board’s structure, selection process, powers and relationship with management.

Rather than viewing the choice as a board/no board decision, it is critical for board-seeking investors to carefully consider what they hope to gain from a board. Armed with this vision, investors must also determine the specific procedures and documentation required to achieve their objectives. Only equipped with such an understanding is it possible for investors to actually have a meaningful conversation with managers—not to mention potential board members.

One view: why some investors view boards as essential
Even though alternative investment vehicles maintain barriers to entry and conductbusiness with financially sophisticated clients, questions linger regarding the wisdom of placing absolute faith in an unsupervised manager (as is the case under the US model). In this environment it is understandable that some investors seek a board structure to ease their concerns. In fact, some of the largest investors (primarily, but not exclusively, government-owned investment funds and large institutional investors) will only make allocations to alternative funds that have boards of directors.

Several factors are influencing their decisions in this regard, including the following:

First, it is clear that as a tsunami of change hits fund managers, additional eyes, ears, and brains can provide significant added value. This may both improve manager performance and attract new governance-conscious investors.

Second, a board can engender proper respect for “fund level” issues and governance in senior management who might otherwise neglect such matters. As was illustrated during the 2008 financial meltdown, a little bit of “sunshine” can go a long way. If there is one thing investors welcome, it is access to meaningful information, as illustrated by the efforts to increase transparency with respect to investment holdings themselves.

Third, for an emerging manager, the existence of a board can demonstrate to investors that the manager is ready to take on the dual tasks of building his firm and managing fund investments.

Fourth, a board can provide a forum where the adviser’s staff can raise and share concerns.

Lastly, a board can take on the role of overseeing operational safeguards that are important to investors who are sceptical of the potential risks associated with commingled funds, and who for this reason might otherwise choose to invest through managed accounts. An active and informed board can mitigate and mediate the daily conflicts that might arise between the interests of the manager and those of fund investors.

As such, there is no question that a board can be a powerful protective force and serve as an understandable marketing inducement. There is validity to this approach; but does it go far enough?

The flip side: why boards sometimes don’t work
As noted above, there is no question that a board can be a powerful protective force; but the mere existence of a board is not enough to assure that this role is served. Investors who seek the protections that a board can provide must also address the factors that tend to impede its functioning. Several of these factors are discussed below.

Time, resources, and expenses: given the limited time some directors spend on fund issues, it is fair to ask whether the resources would be better utilized at the firm level or by increasing return to investors. One study found that in 2011, at least 40 directors of Cayman Islands funds served on more than 100 boards each, and three likely sat on more than 500.8 The survey estimated that approximately 70% of the Cayman fund boards that have an independent director are served by a director who sits on more than 100 fund boards. Obviously not even the world’s most conscientious board member can diligently oversee 100 different funds when, regardless of jurisdiction, there are still only 365 days in the year.

But that is not the critical concern. As addressed below, such arrangements are not always an intrinsic negative for investors. The issue is not how many boards a director sits on. The critical issue is: what is expected of the director and can the expectations reasonably be met.

The overhead needed to maintain a highly-engaged board can itself prove an impediment to the fund’s fiscal effectiveness. Even those investors who seek directors empowered to override manager decisions might balk at the accompanying price tag. In order to provide meaningful oversight, a board needs access to skills andresources and enough time to review and understand the inner workings of the firm. Creating this type of “activist board” may involve a serious expenditure.

Meanwhile, the overwhelming majority of “independent” alternative fund directors typically make $5,000 – $25,000 per board per year and thus these directors have a very different motivation: namely, to place themselves on as many boards as possible. As noted above, the issue comes down to expectations. Is it reasonable to expect directors to play a meaningful role without substantial resources and, if not, what do investors gain? The failure of many investors to engage on these issues is a perfect example of how vital the “unasked question” can be.

One of the unaddressed considerations is simply whether the money expended to develop a strong, highly-functioning board might be better spent on strengthening the manager’s c-level team, as that team possesses greater access to information and a significantly closer connection with critical staff. This issue deserves careful consideration.

Lack of clarity on board and sponsor powers: Sometimes the motivation underlying a belief that a board is required (and that the board needs to be “independent”) is an understandable desire to check or limit the powers of the investment adviser. In situations where an adviser’s interests conflict with those of investors, these investors would expect the board to play a meaningful role.9

What is frequently missing is a discussion about the extent and circumstances when such “checks” are necessary. Investors have already chosen to give the adviser the power to make investments with their assets. No-one is suggesting that a managed account requires a board; why should it follow that pooling funds necessitates a board? Further, why should investors accept the decisions of a board (whom they hardly vet and do not personally select) over those of an adviser that they have extensively vetted?

What this really raises is the often unaddressed question for funds with boards: what powers should the board exercise? And here is the real rub—in many cases this question has not been left unanswered. All too frequently decisions about board powers and liabilities are made by a manager’s legal counsel when preparing fund documentation. At this time, lawyers, honestly trying to protect their clients, insert provisions that may run counter to investor expectations. Such provisions may include terms that disclaim fiduciary duties and provide maximum flexibility for the board, or a director, to arbitrarily delegate duties to other persons.

For example, one can find situations where a Cayman fund has a board where most directors are deemed “independent” under local standards. For those who believe independence is a key element of board effectiveness, this sounds good, right? Not so fast. Under some charters, any director can delegate one or even all of his powers to the manager while simultaneously eliminating personal liability. The articles may also provide that one director can act on behalf of all the directors and that the directors can unilaterally appoint alternate directors who would, in turn, assume their positions and responsibilities. Unquestionably, provisions of this variety, although not necessarily harmful, can add to investor uncertainty and may serve to undermine carefully considered expectations. At a minimum, investors deserve a thorough explanation of such provisions and would be wise to understand how and when changes may be instituted.

Assuming full disclosure, none of these policies are wrong on their face. They simply show the various ways in which deciding to require a board (even an “independent” board) is only the first step for an investor when attempting to understand whether an investment is adequately protected by a fund’s governance structure.

If a fund’s board provides only illusory oversight of the manager, almost nothing has changed— board-seeking investors have received little more than a costlier and less efficient equivalent of the US model. Investors might feel safer with a board and agree to higher fees, yet remain totally unaware that they have not received any meaningful additional security.

Board selection: the board selection process creates one of the greatest tensions facing the typical alternative fund investor: the investor has decided to place its trust in the hands of a manager, and the manager then selects the board. This is another example of why analogies to public companies fail. An alternative fund’s structure, stakeholder incentives and, in many instances, limited size, generates a totally different type of board-management relationship from what is normally found at a public company. Also, the typical public company board at least nominally selects, promotes and compensates the CEO, whereas in the alternatives space boards are handpicked by managers, essentially flipping the process.

Human nature tells us that there is little reason to expect a sponsor to handpick directors with a more developed sense of ethics and best practices than that of the sponsor. Also, it takes a special person to appoint board members who create an environment that fosters true critical thinking.

Fraud: Perhaps investors find solace in the thought that the board will detect whether the adviser is engaged in a fraud. However, any investor who has real concerns about fraud or even negligence, for example, would be well advised simply to refrain from investing, rather than relying on the sponsor’s board to rein in the manager. Unfortunately, history—including the recent Weavering case10—shows that boards have not stopped the most egregious instances of manager misconduct. When it comes to combating fraud or poor management, ongoing investor due diligence (including updates on business and regulatory changes and formally scheduled communications) are simply more reliable tools. Of course, increased transparency as to investments and who holds them also plays a large role.

Access to information and collusion: Within the past several years, a number of funds have confronted serious difficulties stemming from conflicts of interest. In the Philip A. Falcone/Harbinger Capital case11, the SEC alleged that Falcone moved to limit withdrawals from his largest funds in 2009 by changing from a fund-level gate to an investor-level gate. According to the SEC, three large investors provided the necessary votes to authorise the new investor-level gate in exchange for an enhanced ability to redeem their investments. These deals were allegedly not disclosed to the funds’ boards or other investors, and “most favoured nation” provisions in side letters with other investors were also allegedly not honoured.

These allegations illustrate the very real fact that board decisions are only as good as the information received from the manager.

However, the Falcone situation also conversely provides an example of how a properly informed board would (at least in theory) have the opportunity to prevent a manager and a subset of fund investors from favouring their own interests at the expense of other fund investors. Under appropriate circumstances, a conscientiously operated board is capable of achieving improved transparency and reducing inherent manager-investor conflicts. This should protect both investors and the manager over the long run. The focus for investors, therefore, should be less on what makes them “feel” more comfortable and more on what actually works.

The Falcone case is also a reminder that most directors are heavily dependent on the manager. The mere fact that a board exists does not mean it is in a position to serve a watchdog function. If this is the reason investors sought a board in the first place, they must also confirm that an appropriate design supports their expectation.

Representation issues: even on a less dramatic scale, investors still need to determine whom the board represents. As a general matter, investors tend to believe that the fund’s board exists to represent their interests and protect their investments, as shareholders of a public company would assume (rightly or wrongly). This faith in boards is understandable yet dangerously unfounded. Instances in which investors are informed of director replacements after the fact or are denied the ability to communicate with the board as a whole (or with a particular director) are not unheard of—even in this day and age. A basic question that a manager, investors and board members should answer is: who does the board represent and what type of fiduciary duties does this representation invoke? Directors should seek a clear answer to this question not just to satisfy investor concerns, but also to protect themselves from liability.

On balance, the arguments weighing against boards—including their inherent costs, probable inefficiencies and the likelihood of illusory rather than actual control and oversight—are much stronger than many investors imagine. This leads to the conclusion that one of two approaches should be used for a fund’s governance structure:

(i) The manager should either be left in control of everything (e.g., the US model which values efficiency, lower overhead and—hopefully—effective management-based oversight);12 or
(ii) The manager should at least maintain control over all investment-related decisions and provide clarity about the role and duties of the board in other areas.

The next section discusses the situations in which the latter option, a well defined board, can add real value and the best methods to obtain such value.

When investors select managed accounts over commingled funds, they are choosing a safeguard to protect their assets when their interests come into conflict with those of other investors. Investors desiring board oversight are seeking identical objectives (albeit through different means), but too often expect to obtain them without actively ensuring the board they want is the board they actually have. As noted above, a list of just a few of the functions investors seek from their boards include:

• Offering a mediation mechanism between investors (or between investors and management) that ensures a greater likelihood of fair treatment. (For example, providing a check mandating that valuations, side-letters, gates and other redemption procedures do not improperly privilege management or certain investors at the expense of others.)
• Maintaining an effective information stream that gives board members efficient and (where possible) real-time access to internal management data and compliance procedures, including relevant regulatory changes and changes to fund business activities.
• Instilling confidence that the manager will build and maintain the desired governance infrastructure in other areas.

The inherent challenges, time constraints and expenses involved with fulfilling these obligations make it imperative for the manager, investors, and directors at a board-governed fund to explicitly discuss the board members’ role(s). Such discussions should be held periodically and ought to address the following:

1. How will the expected role be fulfilled? How much work should a director do? How often should the board meet? (Some boards meet only once a year.) Is a valuation committee required and who should be on it? Should the role of the board evolve based on the stage of the fund (e.g., as the fund evolves from an emerging to an established fund)? Should the board be involved in day-to-day affairs, or only when the fund is in “crisis mode?” Does it matter what type of crisis? How should a director best perform its oversight role with respect to conflicts if he or she is not involved in day-to-day operations?

2. What resources are needed? Does the board need access to independent counsel? Will the board have independent access to information (such as evolving regulatory requirements) and some independent ability to fact-check management regarding the fund’s day-to-day operations? Relying solely on the manager for information can be little different from having no information at all. How do directors keep up to date on regulatory developments and changes in a manager’s business model before they occur?

3. How should board members be compensated? Some industry members believe investor pressure on directors to become involved in everyday details will result in the emergence of “institutional directors” capable of expertly examining work performed across multiple disciplines. Such areas could include accounting, legal, risk management, compliance, and the tracking of investment objectives. Obtaining this type of comprehensive oversight, however, can come with substantial sticker shock. Only time will tell if investors are willing to pay for such directors and whether management will deem them helpful or meddlesome.

4. What type of annual or quarterly review would be optimal? Should the board provide self-assessments of how it has undertaken its agreed upon role and, if so, what information should be included? (A sample of such a self-assessment can be obtained from RFG. Request it by emailing us at information@regfg.com.)

5. Is director independence required? As discussed above, an enlightened manager with a strong internal team may be the best protection available to an investor. If the US model works, is director independence even needed? Similarly, where regulations require a board, should a fund design the board to meet those requirements but save costs by playing the minimal allowable role?
 
6. How to determine director independence? Assuming that some level of director independence is desired or required, can directors who are selected, appointed by, and compensated by the sponsor truly be considered independent? What if they serve on more than one of the sponsor’s funds? Who should select the board members and how should the selection process work? Can a manager fire the board? If a manager is also an investor in the fund, is he eligible to participate in an investor-oriented selection process?

7. What is an appropriate level of investor involvement and oversight? In addition to granting responsibilities and powers to a board, a fund charter may also assign certain rights to investors. For instance, the fund charter may grant investors the power to set board compensation levels, or it may provide investors with regularly scheduled opportunities to communicate with the board. Investors might participate in the board selection process. Again, since it is their money at stake, investors should carefully consider the extent to which they wish to be involved in the process.

Investors who want the benefits that can be obtained by using a board structure should not be satisfied with window dressing. They must clearly articulate the role they want the board to play and how much they are willing to pay for it.

Conclusion
A board is not a magic bullet. A board can promote good governance, but a board without a well defined charter and clear objectives may be a wasteful expense. Until boards can demonstrate to investors where and how they specifically add value, there is much to be said for the US model with its clear reliance on the manager. Jurisdictions that require boards as a legal or regulatory matter should either eliminate the board requirement or clearly define the role the board is to play. It is only fair for investors to understand what they are paying for. Directors, too, deserve a clear articulation of their duties and responsibilities. Finally, investors who require a board in order to invest should work with managers to ensure that the governance structure is fully capable of meeting their expectations. The use of advisory boards, composed of uncompensated investor representatives, should also be considered if these are equally effective and cost-efficient.

Alternative investment funds have one simple, basic purpose: to grow and preserve wealth. It seems equally apparent that decisions regarding fund governance are every bit as relevant to accomplishing that purpose as is the investment strategy. Transparency with respect to fund portfolios is now the norm. Transparency in governance should be equally valued.

Footnotes

1. Public pension funds have increased allocations to hedge funds from 3.6% back in 2007 to 6.6% in 2011. See http://www.preqin.com/docs/newsletters/HF/Preqin_Hedge_Fund_Spotlight_March_2011.pdf. Also, public funds with assets greater than $1 billion had a median allocation of over 15% in alternative investments as of 30 June 2012, the highest ever and an increase from 9.2% in June of 2011, according to the Wilshire Trust Universe Comparison Service.
2. Hedge funds, private equity funds, and real estate make up over half of the investment activities of endowments and foundations today. See http://www.bnymellon.com/foresight/pdf/endowments-0912.pdf.
3. At present, only approximately $5.5 billion of CalPERS' $232 billion is invested in alternatives. See http://www. hedgefundintelligence.com/Article/3029452/Calpers-Wed-invest-more-if-hedge-funds-had-a-better-reputation. html.
4. SB 402 (Act 603) – Employees’ Retirement System of Georgia Enhanced Investment Authority Act, which can be found at http://www.legis.ga.gov/legislation/en-US/Display/20112012/SB/402.
5. The reactions to alternatives at the U.S. state and municipal level offers  the possibility that addressing the governance issue head-on could open up a lucrative public sector market for managers.
6. In the U.S., Delaware law allows LLC equity holders to appoint a board of managers while still gaining the tax and liability benefits offered by a limited liability entity. Perhaps some far-sighted manager will ask his legal counsel to draft Delaware documents that allow the manager to execute to his strategy while also addressing investor concerns about governance?
7. As a matter of policy, the Cayman Islands Monetary Authority requires that regulated mutual funds established as corporates have at least two directors. See http://www.harneys.com/files/publications/Guide%20to%20Setting%20 up%20Alternative%20Investment%20Funds%20-%20Cayman%20-%20Hedgeweek%202012.pdf.
8. See “Fund Governance at a Crossroads: Current Industry Data and Recommended Best Practices,” at p.1, available http://www.castlehallalternatives.com/upload/resources/sfawhitepaper.pdf.
9. Unfortunately, after assessing how asset management firms managed conflicts over the past year, the FSA recently reported that “in most cases senior management failed to show us they understood and communicated this sense of duty to customers or even that they had reviewed or updated their arrangements for conflicts management since 2007.” However, the FSA also found that an effective governance committee that “challenged and approved conflict identification and controls design work undertaken by others, defined the [management information] they wished to receive and reviewed the implications of materials presented to them…could demonstrate a positive influence on the firm’s arrangements for managing conflicts of interest and improve the firm’s culture of serving customers’ best interests.” See http://bit.ly/UdixSK.
10. See Weavering Macro Fixed Income Fund Limited (In Liquidation) vs. Stefan Peterson and Hans Ekstrom, Grand Court of the Cayman Islands, August 26, 2011, available at https://subscriber.regfg.com/files/products/ pathfinder/7/187.pdf.
11. The SEC press release and complaint can be found at http://www.sec.gov/news/press/2012/2012-122.htm.
12. This is not to say that investor input is irrelevant. Among other possibilities would be an outside advisory board or a group of “oversight investors” voted upon annually by the investor pool itself (something akin to the private equity approach). Not only might such mechanisms more adequately accomplish the above objectives, they could well be capable of doing so at lower cost and with the added benefit of increasing investor knowledge.