A recent survey by the Cayman Islands Monetary Authority (CIMA) found that a majority of responding investors are not satisfied with the status quo in corporate governance. Only 11 percent of the investors polled viewed corporate governance practices as "fit for purpose”; 25 percent thought they "would benefit from some improvement"; while more than 60 percent sought further significant improvements, including information on board activities and delegations of authority.
This is consistent with a review of best practices as articulated by industry associations recently undertaken by RFG. What is particularly noteworthy is that so much of the focus of these industry standards reflects perceived governance failures by managers and boards. Valuations are a case in point. Industry organizations setting best practices recommend setting up valuation committees. In many cases the recommendations contain detailed descriptions of the role to be played by these valuation committees, starting with the need to develop and approve valuation methodologies and the sources used for valuing investment positions. Best practices also often discuss the need for a review of valuation decisions and the need to keep a valuation policy up-to-date by monitoring whether it continues to be appropriate in light of business and market changes. In short, the industry associations that are setting best practices are asking that an appropriate governance structure be created, employed and maintained on valuations—and this is the case for other areas as well.
Incidentally, the same question is being asked by the regulators—worldwide. For example, the valuation best practices are consistent with standards first promulgated by the International Organization of Securities Commissions in 2007, which also focus on governing body involvement and oversight. Only recently the SEC has brought a series of cases focusing on how the boards of mutual funds satisfy (or fail to satisfy) their fiduciary duties. In one case a manager veered away from corporate debt markets (with which he was familiar) to jump into the credit default market. The SEC alleged that the fund’s independent directors played a passive role throughout the process. Read the story here. Another case focused on the need for the board to have a meaningful process when selecting advisers (including vetting their compliance programs). Read about it here. A third case takes us back to valuation. According to the settlement order (here), the directors delegated responsibility to a valuation committee, but failed to exercise meaningful oversight or properly review the committee’s valuation processes. These cases involved mutual fund boards, but they reflect an overall concern on the part of the regulators whenever boards are not satisfying fiduciary standards.
In short, institutional investors and regulators are closely reviewing fund governance. And they are finding, to put it mildly, that governance of alternative and other funds is often murky. This should come as no surprise. Alternative funds are truly a different type of animal from other types of joint enterprises. The investors have selected an investment adviser on whom they rely uniquely for the most important function—investment expertise—and they may not want the board to play the fully strategic role that, for example, the board of a public company might play. In fact, it is for this reason that many U.S. investors conclude that an enlightened manager with a strong internal team offers strong protection and a cost effective structure to an investor. (Alternative funds chartered under U.S. law rarely have a board of directors, but rather are managed by an entity affiliated with the investment manager that sponsors the fund.)
At the same time many investors are cautious about an investment adviser having unfettered discretion. The frequent result is for investors to demand that the board have a complement of independent directors. (The CIMA survey found that investors sought independent standards for directors, minimum numbers of independent directors, management of conflict of interest standards, and a minimum number of board meetings each year.)
However, as shown by the SEC cases mentioned above, the mere existence of a board is not a magic bullet. The requirements being driven by investors miss the mark: the key question is not does the board have independent directors, but rather what is the board expected to do?
On this score investors, best practices organizations and the regulators have fallen short. Perhaps some insightful managers will set a true course here and provide their investors with a specific articulation of what the board is paid to do and how the board intends to achieve its objectives. Specifically, the questions noted below should be answered:
- What role will the board play? Will the board exist merely to satisfy local jurisdictional regulatory requirements that require local investment vehicles to have a board or will it be involved in day-to-day affairs of the fund and oversight of the investment adviser? If the latter, an additional series of question may need to be addressed, including: how much work should a director be expected to do and how often should the board meet?
- What resources are needed? Once the role is articulated it will become important to determine whether the board truly has the resources required to fulfill its role. 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? How do directors keep up to date on regulatory developments and changes in a manager’s business model before they occur? All these questions must be considered and addressed.
- 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.
- Does the board undertake an annual review? The question raised here is whether the board will provide a self-assessment of how it has undertaken its agreed upon role and, if so, what information should be included. In this case, the board will also need to consider whether its findings will be communicated to investors.
- Is director independence required and what does it mean? As discussed above, an astute manager with a strong infrastructure may be the best protection available to an investor. If this 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 having it play the minimal allowable role? 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? The industry has focused on the word “independence” but failed to consider what true independence might look like.
- 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 might provide investors with regularly scheduled opportunities to communicate with the board. Investors who want the benefits that can be obtained by using a board structure should not be satisfied with window dressing. It is incumbent upon managers and investors to clearly articulate the role they want the board to play and how much the board should be paid for playing this role.
Even when a board exists, alternative fund boards are fundamentally different from those of other financial entities. 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. 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 may 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. Perhaps this is why investors, managers and board members fail to adequately define board governance roles, leading to a disconnect between investor desires and actual board functioning.
This essay is adapted from RFG's white paper, "The Unasked Question: Fund Directors - Worth It or Not?"
Deborah Prutzman is the founder and CEO of The Regulatory Fundamentals Group (RFG), a New York-based firm that designs and implements business governance and risk solutions for alternative asset managers and institutional investors.