Hedge funds still suffer an image problem, writes John Donohoe. Carne Global's latest investor survey reveals the institutional investors' governance concerns

One positive outcome of higher levels of institutional investment in hedge funds is the focus on governance at board level. Additionally, the relentless pace of globalisation means investors are asking for solid and consistent governance standards that can be replicated across the hedge funds industry, regardless of domicile.

Moody's, in its recent note on fund governance, observed that corporate governance practices for hedge fund firms are "more closely examined today than at any other time in the history of the industry" as institutional investors "view the evaluation of governance and oversight as it relates to risk management, valuations, operational controls, transparency and the investment process as important as analysing a hedge fund manager's investment performance". In addition, investors have been lobbying individual fund managers and regulators, including the Cayman Islands Monetary Authority, for change. At a time when investors are already keen to increase their allocations to hedge funds, it is becoming evident that the governance issue is acting as a drag on the flow of new investment into hedge funds.

Over the spring and summer of 2011, Carne Group approached the top 100 hedge fund allocators globally, and received survey responses from 50 allocators accounting for over $600bn (€435.7bn), approximately 30% of all hedge fund assets. Alongside wealth managers and funds of funds the respondents included pensions industry names such as CalPERS, Hermes BPK Partners, Mercer Investment Consulting and the UK's Universities Superannuation Scheme. This represents the most comprehensive survey to date of institutional hedge fund allocators' views on the issue of corporate governance in hedge funds.

Some 91% of allocators said that they would choose not to invest as a result of poor corporate governance on a hedge fund, and 76% have actually taken a decision not to invest based on governance concerns. Governance had become much more of an issue since 2008 for 87%. This was partly because of increased concerns surrounding the independence and involvement of fund directors in the wake of the problems experienced by some funds in 2008-09.

In addition, while other areas of operational risk have been addressed in the interim, allocators are more aware of corporate governance as an outstanding issue on their operational risk agendas. We can surmise that those managers with ambitious growth plans should address this issue so that they can fulfil them.

Not surprisingly, almost all allocators want to see improvement in the prevailing average standards of corporate governance - and it is worth stressing that where allocators find the situation ‘acceptable', they have said that this is partly because they are spending time and resources in carrying out their own due diligence and receiving regular information from managers.

Similarly, 63% of hedge fund allocators are unhappy with levels of fund governance in Caymans-domiciled funds, and many of those who pronounced themselves happy indicated that this was because of the additional due diligence and continuing oversight that they carry out themselves. Given the choice, they said they would like to be able to place additional reliance on Cayman fund boards, but are currently unable to do so.

Respondents were also asked to rate their overall levels of satisfaction with corporate governance of funds by investment manager domicile. European managers are considered to be more forthcoming with information. In the case of North American managers, allocators cited concerns about the lack of independence of directors and the use of partnerships without independent oversight. Reform here has been slower than in Europe, as North American managers have not seen the need for an independent oversight mechanism. Asia was considered to be the toughest environment from which to obtain information, and certainly there was seen to be a lack of transparency when it came to directors on funds' boards. Most allocators did, however, have sufficient experience with Asia-based managers to be able to rate them on governance-based criteria.

So which areas of fund governance require improvement? The leading concern is the fact that many of the independent directors sitting on fund boards simply have too many directorships, particularly in the Cayman Islands. The lack of independent directors emerges as the second biggest area requiring improvement. However, 70% of respondents said that all of the areas of governance we highlighted - including experience and knowledge of directors, number of board meetings, board agendas covering key risk areas, and the fact that too many directors are from key service providers - need improvement. Allocators told us that directors should be playing more of an active role in representing their interests, rather than delegating everything to the investment manager without proper supervision.

We asked allocators in which areas they had experienced the most difficulty when seeking governance-related information from managers and fund boards. Some 83% found difficulty in discovering how many directorships were held by the independent directors of fund boards and 55% had experienced problems when seeking information on board meeting agenda and other information concerning board proceedings. Allocators have also experienced considerable difficulty when seeking to establish the relationship between the fund manager and the directors on the fund board.

This brings us on to the critical issue of how many manager relationships an independent director should have. Most allocators we spoke to preferred to focus on manager relationships rather than the number of boards an independent director sits on, as it is the key demand on directors' time. The majority of allocators - 58% - would prefer independent directors to limit themselves to 30 client relationships, maximum. One allocator said: "A director would need to be able to clearly demonstrate how he was able to effectively manage more than 30 commercial relationships without compromising on their quality of oversight."

The majority of investors want four full board meetings per annum - while pointing out that some strategies might require more board meetings than others, particularly complex credit funds. The bias is towards larger boards, with an absolute minimum of three directors, although over a quarter of respondents would like to see bigger boards than that as a minimum. Allocators would like to see at least two independents on a board - only 5% would be happy with less than two and 24% would like to see three or more. Funds with only a token independent director on their board would be considered unacceptable today by 9/10 allocators.

While investors are less concerned with portfolio management than with legal and compliance skills, boards, where possible, should have a senior partner/executive from the investment manager present, as investors felt this creates greater alignment of interests and brings first hand knowledge of key issues such as investment risk and performance.

Some 76% of allocators would be happy to see current or former portfolio managers sitting on fund boards. It is worth noting Justice Jones' remarks in the Weavering case (see panel) that independent directors "rarely have the technical expertise and experience to be able to monitor sophisticated investment strategies".

There is a clear preference for directors with 5-15 years' experience, who are full-time. Allocators like to see independent directors that are heavily involved in the industry, gathering knowledge and staying abreast of current developments. One major allocator argued that professional directors, with several relationships, were preferable, as they had a reputation within the industry to protect. A director sitting on only a couple of boards has less of a stake in ensuring good practice, he explained.

Another issue allocators were asked to consider was the true meaning of independence in the context of directors. The majority of directors did not consider directors related to the manager or key service providers as independent.

In addition, those allocators who accepted some categories as independent directors tended to rule them out if they were the only ‘independent directors' on the board. Some allocators said that it can be extremely difficult to assess the real relationship between the manager and some of the directors, particularly with Asian managers. Directors appointed from the fund's administrator are less common now, allocators reported.

In the case of North American managers, allocators cited concerns about the lack of independence of directors and the use of partnerships. Traditionally, Cayman funds with a feeder status have shared the same board as the onshore Delaware master structure. The latter has usually taken the form of an LLC with a managing member, usually the investment manager. However, a number of survey participants raised concerns with this type of structure, and proposed an alternative.

According to one major global allocator: "Ideally the independent board of the offshore structure with its independent directors, will also be involved with the onshore structure. For example, where the onshore structure is a limited partnership, the independent board of the offshore fund would also sit on the board of the GP of the onshore structure. Alternatively, where the onshore structure is an LLC (where the investment manager is typically in control as a managing member), then the independent directors could at least have an advisory committee role with an oversight component."

The changes being called for in hedge fund governance represent an opportunity for hedge fund managers themselves to seize the initiative - an initiative increasingly supported by regulators, by the Alternative Investment Management Association (AIMA), by the Hedge Funds Standards Board (HFSB), and by other industry-level associations.
This is further encapsulated by new layers of the operational due diligence process applied to potential new investments, as evidenced in the recent ‘Transparency Report' questionnaire compiled jointly by a significant number of major allocators, which we noted during our research.

The questionnaire focuses in particular on individual director-level information such as directors' backgrounds, the number of board meetings they participate in and the issues they discuss, potential conflicts of interest, and instances of litigation; and director firm-level information such as the size and experience of staff and the number of commercial relationships that a firm of directors has entered into. This represents a good indicator of the levels of awareness investors are now seeking about the boards of the funds they invest in, and the credibility of firms providing independent directors to those boards.

Although the hedge fund industry continues to achieve some of the best risk-adjusted returns of any single component of the asset management sector over the last five years, it still suffers from an image problem. Pension funds, for example, continue to treat hedge funds with caution, and would no doubt be more enthusiastic if they could see that not only do hedge funds generally offer them superior returns on a risk-adjusted basis when compared to investment in traditional funds, but also offer higher governance standards.

Regulators are watching hedge funds closely. Better governance standards might help to mitigate some of this. As Amelia Fawcett, chairman of the HFSB says: "Standards don't replace regulators, but they can do things they can't. Can standards be more effective than regulations? Absolutely."

Carne believes that this research paper can form the basis for such governance standards, and represents the opinions of institutional investors. The standards that the survey respondents ask for are neither costly nor complex to implement. But they do represent a new level of focus on their part of governance issues, and a quest for robust standards that can be applied to all hedge fund boards.

As a major allocator told me: "A manager with a good board is more likely to handle a difficult situation with aplomb and more likely to retain investors' favour and capital. Hence, they have a higher likelihood of long-term success and wealth creation for their investors and themselves."

John Donohoe is CEO of Carne Global Financial Services, a Dublin-based provider of directorship, compliance, set-up and other governance-related fund services