In the years since the financial crisis, numerous shortcomings were exposed in the hedge fund industry, yet the standard of governance still requires significant improvement. However, there now appears to be some progress being made with increased scrutiny by investors on hedge fund governance and the expectation that the Cayman Islands regulator will introduce some positive reforms to increase disclosure and raise standards.
Until relatively recently, the quality of hedge fund governance has been an issue largely ignored by investors and has been notable in its absence from their due diligence process of potential hedge fund investments.
Responsibility for the governance of the fund rests with its board of directors, who owe the same duties as directors of any other corporate entity. Although the board may delegate the management and administration of the fund, the directors are responsible for the management of the company and have a fiduciary duty to shareholders for supervision and control.
USS Investment Management, along with some other allocators, incorporates a governance assessment into its due diligence process to ensure that our interests as investors will be effectively addressed and protected by the board and its directors. A key part of our due diligence process focuses on the background, role, contribution and oversight functions of the independent directors as well as the board’s overall governance structure.
Where we feel governance is sub-standard, we will offer proposals for improvement but USS IM is prepared to walk away from a potential investment, and has done so on several occasions, if the governance is deemed inappropriate and there is no commitment to make the necessary improvements.A key challenge, which responsible hedge fund allocators such as USS IM continue to face, is that the rate of progress in transparency and standards espoused by the regulators in offshore jurisdictions has, to date, not kept pace with the increasing demands of discerning investors. There is however some light at the end of the tunnel with a recent consultation process which was initiated by the Cayman Islands Monetary Authority (CIMA), the regulator of the jurisdiction in which the majority of hedge funds are domiciled.
The proposals indeed present an opportunity for the hedge fund industry – including both fund management firms and investors – to enhance transparency and hedge fund governance standards. Two key proposals are particularly noteworthy, namely the creation of a director database and the development of a best-practice framework for hedge fund governance.
USS IM has long-supported the development of an investor-led best-practice framework for hedge fund governance which would provide new, or existing, hedge fund investment managers and their boards of directors with practical advice on how to improve governance and clarification of their fiduciary responsibilities which cannot be delegated.
Our preference is for a principles-based approach which is adaptable, to take into account the variety of hedge funds and other Cayman regulated entities. To provide appropriate leverage for investors (and the Cayman regulator) to ensure that the principles are adopted, we would advocate the Statement of Guidance is introduced as a Code of Best Practice on a ‘comply or explain’ basis. This mechanism has served as a useful platform for investors in public equities in markets such as the UK and creates a non-prescriptive level playing field. Investors’ expectation is that the Code is followed unless companies provide an appropriate explanation for areas of ‘non-compliance’.
The development of a director database, which we have also advocated, could also greatly assist institutional investors in their due diligence work by providing information to investors on directors and service providers to Cayman-based funds. For each director, we currently seek out information regarding their workload commitments as a director and their past experience. A director with adequate capacity, and who may have successfully navigated difficult circumstances, would be an obvious asset to the governance of the fund.
The enhanced transparency, through the creation of a database, should enable investors to verify the details provided by directors and hedge fund managers and allow for a more effective assessment of directors’ experience and appropriateness to serve as independent directors. It would also enable investors to verify the service providers used by hedge funds which auditing firms, in particular, are often reluctant to provide.The database would therefore need to be fully functional and searchable for it to be effective.
The time is ripe for CIMA to act and introduce the requisite reforms at the conclusion of their consultation process. Offshore jurisdictions such as Cayman Islands are under intense scrutiny both by regulators as well as by investors, some of whom are considering screening out off-shore incorporated hedge funds from their potential investment portfolio. A move towards greater transparency and higher standards will lead to increased confidence in the industry and the Cayman Islands jurisdiction and allow investors to make more informed investment decisions.
Daniel Summerfield is Co-Head of Responsible Investment at USS Investment Management