By Christopher Day – independent director at financial advisory firm Carne Group

The topic of fund governance is moving quickly to the top of the agenda for investors in hedge funds. Institutional investors, now representing over 60% of the global hedge fund asset base, are in the driving seat when it comes to governance standards in alternative investment funds. In the wake of the 2008 financial crisis, they are asking managers to provide evidence that independent directors have been appointed to offshore fund boards, and that these directors are truly independent.

As the Asian hedge fund industry matures, we are seeing growing hedge fund firms with solid track records seeking to tap institutional capital pools, frequently using offshore funds in the Cayman Islands or via UCITS funds in Ireland or Luxembourg. It is important that aspiring hedge fund managers realize the higher standards of governance that investors now demand if they are going to succeed in building successful businesses.

According to research carried out by the Carne Group, institutional investors rated the overall standard of governance on the boards of funds being managed from Asia as only 5/10 on average, compared with 7/10 for European funds. They cited Asia as the toughest environment from which to obtain information on fund boards, the identities of fund directors, and directors’ relationship to the investment manager of the fund. The investors polled represented over 30% of the total hedge fund asset base globally, and included many of the largest allocators to hedge funds (the smallest managed over US$2 billion).

It was also significant that 91% of the allocators surveyed said that they would not invest in a hedge fund with poor corporate governance standards. In particular, they pointed to the inferior governance prevailing on the boards of Cayman Islands funds, with 63% of the investors interviewed expressing dissatisfaction with Cayman fund board governance (this compares with 20% for Luxembourg, for example). Given that many Asia-based managers continue to favour the Cayman Islands as a jurisdiction for offshore hedge funds, it is a statistic those seeking to raise capital need to be aware of.

Hong Kong is one of the most active centres for hedge fund management in the Asia-Pacific region. Its Profits Tax Exemption for Offshore Funds provides guidelines requiring central management and control of the fund to be exercised outside Hong Kong itself. Many fund managers are therefore already familiar with the idea of using an offshore fund board – frequently in the Cayman Islands – to fulfil fiscal requirements, and to have a majority of that board resident outside Hong Kong. However, the levels of dissatisfaction evident among major allocators point to a need for the levels of transparency surrounding the identity and background of directors and their relationship to the fund manager to be improved.

Managers who are serious about winning and retaining institutional mandates therefore need to consider who they have appointed to the board of their offshore fund, and whether they have enough independent directors sitting on that board. About 87% of investors would like to see the majority of a fund board composed of independent directors.

By this they mean directors with no relationship to the investment manager or the service providers to the fund, including its lawyer and administrator.
At the same time, investors are looking for competent financial professionals, with a minimum of 10-15 years’ experience in the fund management industry, who ideally work as fund directors on a full-time basis.

For funds seeking capital within the Asian region, it also looks increasingly as if regional investors will be enhancing their governance criteria. The AIJ Investment Advisors scandal in Japan is already impacting the way Japanese pension funds will be carrying out operational due diligence in the future. Research by J.P. Morgan found that 20% of Japanese pension funds plan to increase their exposure to alternative investments in the near future, while over 60% are also taking preventive measures to ensure against future failures of this type, with enhanced governance requirements being part of their new investment policies.

The recent Weavering judgement in the Cayman Islands served to illustrate how courts are likely to treat failures of governance and oversight on hedge fund boards. In this case, two directors were found to have failed in their fiduciary duties to the shareholders of the fund, and damages were awarded against them to the tune of US$111 million. The case highlighted that fund directors are expected by courts to act in the interests of the shareholders of the company – i.e. the investors in a fund. The size of the award also draws attention to the potential risks that poorly qualified or rubber stamp directors are running, as well as the financial risks poor governance can represent for the fund manager.

The corporate governance issue is not something that will go away. Institutional investors are already adding governance questions to their operational due diligence surveys and probing in more detail the identities and relationships of fund board members. Asian fund firms with poor or opaque governance arrangements will suffer needlessly if they fail to meet these new benchmarks.