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Hedge Funds Are Not Like Banks (and That’s Okay!)

By Kevin Roose writing in The New York

I can’t decide what the funniest thing is about Azam Ahmed’s Times story* (which expands on a FT story last year) on the ludicrous world of Cayman Islands–domiciled hedge funds and their directors-for-hire, many of whom are paid up to $30,000 per year to do essentially nothing for each of as many as 260 hedge funds. It’s either:

a. This sentence, about Don Seymour, a Cayman Islands businessman who runs a directorship advisory firm and personally sits on around 180 hedge fund boards: “Mr. Seymour likens his work as a hedge fund director to that of a top doctor, who can see hundreds of patients a year.” (Yes, because conferencing in to quarterly calls on mute while muddling mint leaves for your mojito is exactly like treating cancer.)

b. This “oh, reeeeeally now” quote, also from Mr. Seymour:

“We have a bit of a Goldman Sachs problem,” he reflected from his company’s offices at DMS House, a slate-colored stucco building resembling the White House. “We are the worldwide leader in fund governance.”

c. The idea that it matters in the slightest who sits on the board of directors of a hedge fund.

For big banks and other publicly traded companies, boards of directors play (or should play) a crucial role. They set executive compensation, hold broad fiduciary responsibilities and, as the resignation of Marcus Agius today proved, provide a place for the buck to stop when things go wrong.

Accountability works differently for hedge funds, though. Hedge fund managers tend to be lone wolves who prefer to assume near-total liability when their funds gain and lose money. In fact, many hedge fund managers get into the business expressly to avoid having to answer to a boss or a board. (This is what Ahmed means by “cowboy culture.”)

In that way, the bizarre Cayman Islands board-filling philosophy makes sense; if your fund is domiciled in the Caymans for tax reasons, and local law requires you to have a board of directors, you want a guy who’s on 259 other boards, since being spread so thin will by definition make him less able to get in your way. So you pay a directorship advisory firm $10,000 a year, give it some rubber-stamp responsibilities to satisfy your legal requirements, and go on with your investing. Everyone wins.

What’s less clear is why hedge funds need boards at all. It’s not for setting executive compensation, since hedge fund managers’ compensation is largely carry-based rather than coming in salary and stock. And it’s not for accountability’s sake, since the single-star nature of most funds means that one person largely shoulders the blame — and should — when returns are bad or laws are broken. (You didn’t see Paulson & Co. board members getting embarrassed on the cover of Businessweek, for example, nor is anyone implying that an inquisitive and active board would have saved Phil Falcone from the SEC’s charges against him.)

I’ve always felt that, given the choice between regulating hedge funds as if they were banks and regulating publicly traded banks more aggressively (and assuming that there is a finite pool of manpower available for financial regulation in general), we should focus our energies on banks. Hedge fund failures don’t generally pose systemic risks (the rare exception aside), and even with a potential $5 trillion under management, the industry will not likely be needing a TARP anytime soon. Hedge funds and other “shadow banks” can distort markets, lose money for pensions, and make the playing field less even for retail investors, but they don’t make Libor submissions or issue checking accounts.

But if, as some have suggested, we do have to regulate hedge funds like banks, curbing CEO pay and requiring them to have independent boards with broad fiduciary duties, the least we could do is develop a better corporate governance system than a rubber-stamp mafia run out of a tropical paradise.

For more on this story go to:

http://nymag.com/daily/intel/2012/07/hedge-funds-are-not-like-banks.html

*See http://www.ieyenews.com/2012/07/hedge-funds-article-in-ny-times-showcases-caymans-hedge-funds-business/

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