Hedge Fund Governance: Evaluating Oversight, Independence, and Conflicts

By Jason Scharfman

Hedge Fund Governance: Evaluating Oversight, Independence and Conflicts summarizes the fundamental elements of hedge fund governance and principal perspectives on governance arguments. An authoritative reference on governance, it describes the tools needed for developing a flexible, comprehensive hedge fund governance analysis framework. Case studies and interviews with professional fund directors shine a bright light of pragmatism on this framework. The author’s global analysis of more than 5,000 hedge fund governance structures enables him to draw realistic conclusions about best practices. He also explores the value consequences of good vs. bad governance, estimating the actual dollar losses that can result from bad governance, as well as the operational and investment performance benefits of certain governance practices.

• Presents methods for evaluating qualifications, conflicts of interests, fees, obligations and liabilities of hedge fund Boards of Directors
• Explains techniques for developing a hedge fund governance assessment program, including analyzing legal documentation analysis and financial statements for governance related information
• Uses case studies and example scenarios in hedge fund governance successes and failures to explore investor governance rights and fund manager responsibilities in onshore and offshore jurisdictions

• Language: English
• Publisher: Academic Press
• Release date: Oct 22, 2014
• ISBN: 9780128025123

Jason Scharfman

Jason Scharfman is the Managing Partner of Corgentum Consulting, LLC. He is recognized as one of the leading experts in the field of hedge fund operational due diligence. Before founding Corgentum, he oversaw the operational due diligence function for a $6 billion alternative investment allocation group called Graystone Research at Morgan Stanley. He earned an M.B.A. in finance from Baruch College’s Zicklin School of Business and a J.D. from St. John’s School of Law. He is admitted to the practice of law in New York and New Jersey. Additionally, he holds the Certified Fraud Examiner (CFE) and Certified in Risk and Information Systems Control (CRISC) credentials.

Book preview

Hedge Fund Governance

Evaluating Oversight, Independence, and Conflicts

Jason Scharfman

Managing Partner, Corgentum Consulting, LLC

Table of Contents

Cover

Title page

Copyright

Dedication

Biography

Preface

Chapter 1: Introduction to Hedge Fund Governance

Abstract

Introduction to the concept of governance

Why should investors care about hedge fund governance?

Governance: a vague concept?

How should investors think about hedge fund governance?

What hedge fund entities are investors looking at to promote good governance?

Distinguishing between governance and due diligence

Is governance controlled by the hedge fund board of directors?

Governance outside of hedge funds

The origins of hedge fund governance lie in corporate governance

Historical perspectives on corporate governance

Investor-driven governance

Defining hedge fund governance

A universal definition of governance?

Is governance defined by perspective?

Who is responsible for hedge fund governance?

Is governance primarily an investment-related concept?

Distinguishing between governance and hedge fund activists

Hedge fund governance: a working definition

Chapter 2: Hedge Fund Board of Directors: A Governance Proxy?

Abstract

Introduction to the hedge fund board of directors

Are vitriolic director criticisms merited? Clarifying a modest proposal

Understanding hedge fund board structures

Offshore versus onshore hedge funds

Different types of hedge fund boards

Clarifying director terminology

A brief history of hedge fund directors

The forgotten master fund board

Who are these board members?

The expanding director talent pool—a blessing and a curse?

Who decides who gets to be on the board?

You’re not who I hired!—the associate director bait and switch?

Director compensation—a double standard?

What do directors actually do?

Director liability—a few words about indemnification

Director delegation

Chapter 3: Regulatory Governance of Hedge Funds

Abstract

Introduction to regulatory governance

A few words on what this chapter doesn’t cover

Why so many jurisdictions?

Why the increased focus on the importance of offshore regulations?

Leading hedge fund regulators

Perspectives on global hedge fund regulatory development

How do regulations relate to governance?

Key fund regulations and their effects on governance

Hedge fund regulatory governance in other jurisdictions

Conclusion

Chapter 4: The Role of Fund Service Providers in Implementing Governance

Abstract

Introduction to hedge fund service provider governance

Are some service providers more important to governance?

Isn’t casting a broader net better?

Are ancillary service providers important in evaluating governance?

Common hedge fund service providers

Isn’t service provider governance simply fund operations?

The administrator’s governance role

Custodian and prime broker governance

Additional comments on fund directors and governance

Gauging individual service provider quality and weight in external governance

Conclusion

Chapter 5: Hedge Fund Internal Governance Mechanisms

Abstract

Introduction to hedge fund governance mechanisms

Why are hedge funds now talking about governance?

Is the JOBS Act good for hedge fund governance?

Does enhanced flexibility promote better governance?

Is technical compliance enough for good governance?

I said governance, didn’t I?

Governance mechanism classification challenges

Hedge fund internal governance by committee?

Hedge fund capacity as a governance indicator

Third-party operational control audits as governance proxies?

Conclusion

Chapter 6: Developing a Framework for Investor Analysis of Hedge Fund Governance

Abstract

Introduction to developing governance analysis frameworks

Do strong operations imply good governance?

Is governance a moving target?

Institutional investor governance: the CalPERS model

Classifying governance analysis into two camps: investment and operational

Developing a governance program

Understanding governance evaluation standards

Beginning governance assessments

Analyzing director governance

Governance analysis of service providers continued

Governance analysis continued—audited financial statements examples

Governance analysis continued—business continuity examples

Information technology governance reviews

Conclusion

Chapter 7: Investor Activist–Driven Governance and Ongoing Monitoring

Abstract

Introduction to ongoing monitoring and activist-driven governance

Do ongoing governance evaluations add value?

Ongoing governance monitoring information decay considerations

Developing an ongoing governance monitoring program—a meta-analysis program?

Beginning ongoing governance assessments

Ongoing governance monitoring—information technology examples

Bonus board governance oversight bonanza? Don’t worry, we’ve hired someone for that

Ongoing background investigation and news monitoring for funds, personnel, and directors?

The good guy problem: do house views result in weakened ongoing governance oversight?

Fast and furious—increasing governance monitoring frequency through shallow dives

Governance activism

Alternative activism in action ESG, SRI, and faith-based investing

Conclusion

Chapter 8: Case Studies and Example Scenarios in Hedge Fund Governance

Abstract

Introduction

Case studies

Example scenario: the Sark Lark—are certain jurisdictions’ regulatory governance regimes completely ineffective?

Chapter 9: Analyzing Governance in Fund Valuations

Abstract

Introduction to analyzing governance in fund valuations

What does valuation have to do with governance?

Hedge fund valuation governance considerations

Service provider valuation governance considerations

Historical perspectives on hedge fund valuation governance—the Lipper example

Chapter 10: Field Perspectives on Governance—Interviews With Those Involved in Various Aspects of Hedge Fund Governance

Abstract

Interview with Ms. Heather Smith, Cayman Islands Monetary Authority

Interview with Mark Cook and Geoff Ruddick (International management services ltd.)

Interview with George Bashforth of Appleby Trust (Cayman) Ltd

Interview with Ingrid Pierce of Walkers Global

Interview with Professor Joe Bannister and Dr. Chris Buttigieg of the Malta financial services authority

Interview with Adam Cohen of Perella Weinberg Partners

Interview with Louis Rodriguez (operational due diligence professional)

Perspectives on transparency: additional interview comments

Chapter 11: Good Governance in Bad Situations: Understanding Governance During Fund Turmoil and Liquidations

Abstract

Introduction

Background on fund liquidations

Is a closure and a liquidator the same thing?

Common reasons hedge funds close

Governance perspectives on liquidations

Conclusion

Chapter 12: Trends and Future Developments

Abstract

Introduction

The diligence governance correlation

Continued expansion of the definition of hedge fund governance

Increased implementation of boards where they are not mandated by law

Regulatory database management of board of directors

Increased regulatory scrutiny and prosecution of governance-related issues

Increased director reporting but not necessarily meaningful transparency

The future rise and fall of annual governance meetings (AGMs)

Increased focus on director disclosures to investors

Increased focus of director conflict management

Global governance codes—a self-regulatory pipe dream?

Further broadening of scope of director services

Index

Copyright

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Dedication

This book is dedicated to my wife and family for their continued inspiration and support.

Biography

Jason Scharfman, Esq., CFE, CRISC—Managing Partner, Corgentum Consulting, LLC

Jason Scharfman is the Managing Partner of Corgentum Consulting, LLC. Corgentum is a specialist consulting firm that provides the industry’s most comprehensive operational due diligence reviews and background investigations of fund managers including hedge funds, private equity, real estate, and traditional funds. Mr. Scharfman is recognized as one of the leading experts in the field of operational due diligence and is the author of Hedge Fund Operational Due Diligence: Understanding the Risks (John Wiley & Sons, 2008) and Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation and Documentation (John Wiley & Sons, 2012).

Before founding Corgentum, he previously oversaw the operational due diligence function for a $6 billion alternative investment allocation group called Graystone Research at Morgan Stanley. Prior to joining Morgan Stanley, he held positions that primarily focused on due diligence and risk management at Lazard Asset Management, SPARX Investments and Research, and Thomson Financial.

Mr. Scharfman received a B.S. in finance with an additional major in Japanese from Carnegie Mellon University, an M.B.A. in finance from Baruch College’s Zicklin School of Business, and a J.D. from St. John’s School of Law. He is admitted to the practice of law in New York and New Jersey. Additionally, he holds the Certified Fraud Examiner (CFE) and Certified in Risk and Information Systems Control (CRISC) credentials. He has consulted with the US House Judiciary Committee on the subject of hedge fund regulation. Additionally, he has provided training to financial regulators on the subject of hedge fund due diligence. Mr. Scharfman has served as a consultant and testified as an expert in hedge fund litigation, and has lectured on the subject of hedge fund operations and operational risk as an adjunct professor at New York University. He has written extensively on the subject of operational due diligence and travels and speaks worldwide on hedge fund operational risks.

Preface

Investors don’t trust hedge funds. This might seem counterintuitive because they place billions of dollars with them, but they still don’t necessarily trust them. Don’t feel too bad for hedge funds; the feeling is mutual. With this mistrust, why then do the two continue to do business?

For starters, investors can utilize hedge funds to add real value to their overall portfolios. This is especially true for the increasingly large number of underfunded pension systems who are increasingly turning to funds to generate returns. After the 2008 financial crisis, multiple large-scale frauds, and more recent insider trading scandals, however, the blind trust investors used to place with investment consultants and hedge funds was shaken to say the least.

It’s not as if the hedge funds were the only ones to blame; during the post-2008 financial crisis many investors simply couldn’t wait to redeem their capital from funds. Hedge funds, facing decreasing valuations and illiquidity, didn’t necessarily want to be forced into liquidation and employed a number of techniques such as lowering their gates and utilizing side pockets to slow the pace of capital outflows. These were the rules of hedge fund investing that investors had willingly signed up for, and now investors were complaining and even suing. You could see how this could make some hedge funds a bit gun shy of giving investors too much flexibility going forward.

Despite these tensions the two groups continue to coexist. The rules of hedge fund investing, however, have changed significantly. Investors are increasingly conscious of the fact that when allocating to hedge funds they have to consider more than just a fund’s potential for profits. More than just trading desks, it is now widely accepted that hedge funds are complex organizations that need to be managed properly from both an operational and an investment perspective in order to be successful. Increasingly investors have accepted that a key element to this success is something called governance, but what exactly does that mean? The goal of this book is to attempt to answer that question.

To start off we will frame governance in a historical context to arrive at a modern working definition of the term. This book will outline how the definition of governance has evolved and broadened over time. To do this we will focus on the expanding definition of governance including regulatory governance of hedge funds, internal hedge fund governance mechanisms, service provider governance, and governance in valuations and fund liquidations.

This book will also highlight a key player in the world of hedge fund governance, the board of directors. Investors generally fall into three camps when it comes to talking about fund boards: they love them, hate them, or dismiss them. Much of this criticism comes from a lack of clarity with regards to the roles of directors as well as a lack of in-depth director due diligence. In an attempt to reconcile the different sides of the arguments for and against directors, we will discuss the role of fund boards and provide perspectives on board-related considerations ranging from the delegation of duties and director liability to capacity considerations, and the ways that they work with other service providers. To provide recent perspectives on the role of directors and governance this book also features exclusive interviews with directors, regulators, and operational due diligence analysts.

Once you have developed a detailed understanding of governance, we will then show you how to put it into practice in the real world. To do this we will introduce techniques that investors can use to conduct initial and ongoing assessments of governance. We will also cover historical examples of governance failures. Finally this book will outline trends in the space with regards to governance practices in general and the board of directors specifically.

Governance does not live in a vacuum and is not centralized within any one part of a hedge fund such as compliance. Nor is it the sole domain of any single service provider such as the board of directors. Instead, governance can be thought of as a living system that controls the operational and investment functions of funds. It does not refer to the actual functions that are in place, but oversees them to ensure they are running efficiently and effectively. It is the glue that binds the disparate functions of a hedge fund together. Without proper oversight the system will eventually fail; hedge funds will go out of business and investors will lose money. Investors who take measures to evaluate the quality of the governance framework in place at a hedge fund through deep-dive due diligence can avoid these risks and ultimately make more informed investment decisions.

A strong governance infrastructure can help rebuild the broken confidence between hedge fund and investors. It is up to both parties to trust but verify that controls and oversight not only are put in place but also stay in place to prevent the next crisis of confidence.

Jason Scharfman

July 2014

Chapter 1

Introduction to Hedge Fund Governance

Abstract

This chapter provides an introduction to the concept of hedge fund governance. It begins with historical perspectives on corporate governance globally including the rise of agency theory and the influence of regulatory focus on insider trading cases and class action lawsuits. The chapter then considers the distinction between hedge fund activists and governance. Finally the chapter considers who is responsible for hedge fund governance and proposes a working definition of the term.

Keywords

Hedge fund

corporate governance

insider trading

activism

class action

Chapter Outline Head

Introduction to the Concept of Governance 1

Why Should Investors Care About Hedge Fund Governance? 2

Governance: A Vague Concept? 3

How Should Investors Think About Hedge Fund Governance? 4

What Hedge Fund Entities are Investors Looking at to Promote Good Governance? 5

Distinguishing Between Governance and Due Diligence 7

Is Governance Controlled by the Hedge Fund Board of Directors? 8

Governance Outside of Hedge Funds 9

The Origins of Hedge Fund Governance Lie in Corporate Governance 10

Historical Perspectives on Corporate Governance 11

Investor-Driven Governance 11

Governance in the Prewar Period 11

The Postwar Era of Governance From the 1960s 12

1970s: The Decade of Governance 15

Rise of Agency Theory 16

1980s Onward—The Growth of Modern Corporate Governance Reforms 17

Defining Hedge Fund Governance 18

A Universal Definition of Governance? 21

Is Governance Defined by Perspective? 22

Who is Responsible for Hedge Fund Governance? 22

Is Governance Primarily an Investment-related Concept? 22

Distinguishing Between Governance and Hedge Fund Activists 24

Hedge Fund Governance: A Working Definition 26

Introduction to the concept of governance

What exactly does the term governance mean? Many investors are perhaps more familiar with the term governance when it is paired up with the term corporate. Ok, so what then does the term corporate governance mean exactly? Does this definition vary based on the context of what type of corporate governance you are talking about? Can there be other types of governance besides corporate? Does the definition of this perhaps change when applied to hedge funds?

As an investor in equities, bonds, private equity, real estate, or certainly hedge funds you may have never really given this much thought. Frankly, why should you? Who cares what governance is as long as a hedge fund’s net asset value (NAV) beats its benchmark? In this chapter we will provide a working definition of hedge fund governance and outline its historical perspective. Before addressing these issues, we should address the issue of why investors should care about this important subject to begin with.

Why should investors care about hedge fund governance?

Hedge fund investing is complicated enough. There are lots of strategy and fund options. Depending on the year several of them may seem quite attractive. It can be difficult enough for investors to select a fund manager who can generate a sustainable profit year-over-year; who has the time to worry about anything else? At its core the goal of investing is to generate a profit, and things outside of that direct goal aren’t necessarily always a primary concern to investors. Of course, the investments have to be made in a legal way, but outside of these basic principles does anything else really matter to an investor’s bottom line? Especially seemingly vague notions such as governance?

It could be argued after all that governance, whatever that means, isn’t even necessary for a hedge fund to function or be profitable. Some have attempted to write off governance as being entirely unnecessary to hedge funds. To continue that analogy, a boat can successfully navigate the ocean without life preservers, can’t it? Of course it can. It isn’t necessarily a good idea for the passengers, but that doesn’t mean the propellers won’t spin. It could be argued that governance functions in the same way as the life preservers; it’s not functionally required for a fund to make investments but it’s a bad idea to proceed without it. Is this line of reasoning correct? Could it be that governance is indeed operating in the background of seemingly basic operational functions, even though it may not be readily apparent? This book will address these questions about governance.

If you are reading this book, it means you are most likely fall into one of two camps. The first group is people who are perhaps unfamiliar with hedge funds and want to learn more and the subject with a particular focus on governance. This book will certainly equip you with knowledge about hedge fund governance, but it is not meant to be a primer on the hedge fund industry. This is best left for other books, and there are a number of other introductory resources in this area (Anson, 2006). The other group of people reading this book are those who are familiar with the hedge fund industry. You are likely a direct investor in hedge funds (i.e., high-net-worth individual or family office), represent a large hedge fund allocator (i.e., corporate or public pension plan, fund of hedge funds, endowment, foundation, bank, insurance company, etc.), or work in some capacity in the hedge fund industry [i.e., an operational due diligence (ODD) analyst at a fund of hedge funds].

Regardless of your level of sophistication with the hedge fund industry, understanding the role of governance is more critical today than ever before. Governance has influence across all aspects of the hedge fund industry ranging from the managers themselves and their investments to their service providers and investors. By learning about what hedge fund governance is and trends in the space you will, hopefully, be able to promote better governance practices in your respective corner of the hedge fund world.

Analyzing, implementing, and monitoring governance in hedge funds, as this book will hopefully convince you, is a critical element of hedge fund investing. It not only relates to the implementation of checks and balances, and adherence to technical policies and procedures, but can also influence the nature of a hedge fund’s investments and ultimately affect the fund’s overall profitability. Before seeking to analyze the role of governance, however, we must return to our original question seeking to define what governance actually is.

Governance: a vague concept?

The use of the word governance has grown in popularity in recent years in the hedge fund industry. Beyond being the latest hedge fund buzzword, what does it actually mean? Originally the term in a hedge fund context was tied to hedge fund activist investors seeking to promote good governance in the companies in which they invested. We will address this concept later in the chapter.

One of the more recent applications of the term has been with regards to promoting good governance not within the companies that the hedge funds invest in, but in the hedge funds themselves. This increased attention has come about for a number of reasons including regulatory changes, historical frauds, and increased investor demands for transparency to name a few. But, returning to our original question, what exactly does this application of governance mean?

Pinning down the concept and actual definition of governance in the hedge fund industry has presented a bit of a challenge for many investors and hedge fund managers alike. Unlike many parts of the hedge fund, governance is not a heavily quantitative subject. There are no carried interest calculations, VaR analysis, turnover ratios, or leverage calculations. Instead governance is more of a qualitative subject that relates to notions of ethics, conflicts of interest, and even, depending on your perspective, things such as being a good corporate citizen.

The qualitative nature of this subject perhaps is one of the reasons that has created a definitional challenge to the term governance, in the traditionally more quantitative hedge fund industry. It’s not because people in the hedge fund industry aren’t smart. Indeed, many have argued that hedge funds house some of the financial industries’ best intellectual capital (Bloomberg, 2003). It’s just harder for most people, particularly in a quantitative slanted industry, to digest more qualitative learning concepts such as governance. Also contributing to the problem is that there is no consistent market or legal definition of what governance in the hedge fund industry actually means. Further contributing to the confusion is the fact that there is a mixed consensus on who is actually responsible for governance. But perhaps we are getting ahead of ourselves; before we can begin to talk about gauging if a hedge fund has good or bad governance we must first attempt to define the concept in a hedge fund framework.

How should investors think about hedge fund governance?

What is the appropriate way to think about hedge fund governance? This might seem like an odd question at first, but discussing it will help us better frame a definition of what exactly hedge fund governance itself is. At its core, what this question is really asking is first, how should investors classify hedge funds? The second question is, once we’ve made a decision about what a hedge fund is, how should we think about governance in that class of funds?

Let us try to tackle the first part of this question. We could take the easy way out and say a hedge fund is just that, a class unto itself of hedge funds. Continuing this line of reasoning we could say that private equity funds are their own class, and so are mutual funds, index funds, etc. This may be true, and depending on your perspective hedge funds may be in such a unique asset class unto themselves. Others may argue that this certainly may be even too much of a generalization. Under the broad category of hedge funds there are numerous subcategories differentiated by numerous categories including location, assets under management, and investment strategy. From a regulatory perspective some have suggested that certain hedge fund strategies could be compared with closed-ended US mutual funds while others suggest that they should be viewed more as private partnerships (Lehmann, 2006).

Prior to the most recent waves of enhanced hedge funds’ regulatory requirements, including that hedge fund become registered with regulatory entities such as the US Securities and Exchange Commission (SEC), some investors thought of hedge funds as merely one option in a series of largely unregulated, or exempt from regulation, investments. Further complicating the issue, the nature of many hedge fund investments has become blurred with other asset classes such as private equity. A good example of this was in the aftermath of the 2008 financial crisis. During that time many hedge funds opted to side pocket illiquid or distressed positions. For reference, for the purpose of our discussion here a side pocket can be thought of as a separate fund where illiquid assets are placed. We will address side pockets in more detail in Chapter 11. These side pockets often exhibit private equity–like characteristics and unfortunately for many investors further lengthened payout and recovery timetables. Considering it from another angle, many other types of investments have sought to take on hedge fund–like approaches and some in the academic community have suggested that hedge funds themselves are effectively not providing the alpha they promise and instead investors are really adding hedge fund beta to their portfolios when allocating to hedge funds (Jaeger, 2005; Kat and Palaro 2005).

Unfortunately for us, therefore, there seems to be no real consensus on whether or not hedge funds are a unique asset class unto themselves. This is not very good for our attempt to answer the second part of the question of how we should think about governance. If we were able to answer the first question, our approach would have then been to look at the likely body of research on governance within that particular asset class and then use that to inform our opinion of how we should think about hedge fund governance. Fortunately for us, however, we are not stuck. This exercise was merely meant to demonstrate that the issue of classification of hedge funds has been one that is debated in the industry.

For the purposes of our discussion, we are attempting to define governance in a hedge fund context. As such, despite debatable notions to the contrary, we will follow the assumption that hedge funds are a unique asset class unto themselves. This does not mean that they do not share common characteristics with other types of investments, both traditional and alternative. Rather when discussing fund governance for the purpose of this book, we will look for similarities within the hedge fund space itself, instead of seeking to overly borrow from governance concepts for other asset classes. Stated another way, to put together a working definition of hedge fund governance, we cannot simply say that it is effectively the same as governance in other funds in its class. Private equity governance is not the same as hedge fund governance that is not the same as mutual fund governance. Certain characteristics of governance across these types of funds and asset classes may be similar, but ultimately they are not identical from a governance perspective as hedge funds themselves pose unique governance challenges.

What hedge fund entities are investors looking at to promote good governance?

In developing a definition of hedge fund governance, this text will also seek to provide an overview of methodologies and techniques that are employed in hedge fund governance. Often times, hedge fund investors are the ones driving the governance process. As part of this process they are looking to implement good governance, a term which we will discuss in more detail below, in the hedge funds in which they invest. To clarify a bit of terminology the term hedge fund, as with many terms that we will encounter in this book, is a bit of a misnomer. To get technical about it, the term hedge fund is a catch-all term that can mean a number of different things depending on the context. For starters, a hedge fund may be referring to the management company of a hedge fund. This is the central legal entity that usually coordinates the firm’s business activities. For example, the employees of hedge fund organizations are usually employed by the management company.

When investors allocate to a hedge fund though, they are not typically referring to an investment in the management company. While this is possible, under perhaps a construct such as a seeding arrangement, it is not typically what is implied. Instead, investors for the large part are making investments into a hedge fund investment vehicle, which is also sometimes called a fund. These investment vehicles come in a variety of flavors. Two of the more common vehicles are based around the jurisdiction of the particular funds. The first is an onshore vehicle, which is also referred to as a domestic vehicle or fund. Taken from the perspective of a United States–based investor, an example of this type of vehicle would be a Delaware-domiciled fund. The other common vehicle type is an offshore vehicle. From the perspective of a US-based investor this would be a non–US-domiciled fund, such as a hedge fund vehicle registered in the Cayman Islands. Each of these vehicles may then have other associated funds and entities including a master fund, a General Partner, and an Investment Manager.

Returning to our original question, when investors state that they want to promote good governance at a hedge fund, in which of these entities are they referring to? The typical answer, and the approach we will take in this book, is all of them.

There are two primary reasons we make this assumption. First, beginning with the hedge fund vehicle level, many different hedge fund vehicles across the same strategy complex are typically managed in materially the same manner. In hedge fund speak, this is sometimes referred to as in a pari passu manner (Scharfman, 2008). Investors, however, generally invest in one particular vehicle within the same hedge fund strategy. This is done for a variety of reasons including the tax consequences of investing in one type of vehicle over another. There are also legitimate concerns that within the same fund complex, investors in one fund vehicle could be disadvantaged at the expense of another. Examples of this could include certain opportunities being allocated on a non–pro rata basis or not at all to an onshore vehicle instead of an offshore one. It could also be the case that there are related party transactions among the funds that negatively impact one over the other. Another example of the risks posed by related party transactions among fund vehicles would be the allegations brought by the US SEC against Martin Currie (US Securities and Exchange Commission, 2012).

To play devil’s advocate for a moment, while there are legitimate concerns of intervehicle fund risks, among vehicles in the same strategy, it could be argued that on a vehicle level an investor should primarily be concerned only with what happens in the particular vehicle they are invested in. Such an approach, however, only works when your vehicle is on the winning side of any conduct, which is disadvantageous to the other vehicle(s) in the fund complex. Furthermore, there is always the overarching risk of the potential for a claw back of profits from one vehicle to another if it is shown that a particular vehicle profited unjustly from actions that hurt investors in another vehicle.

A good corollary to this example comes from the world of hedge fund ODD. When conducting an ODD review of a particular hedge fund vehicle’s audited financial statements, it is considered best practice to review all of the financial statements from affiliated vehicles within the hedge fund’s strategy complex. This practice has developed because of an increasing acknowledgment from investors of the risks that information about other vehicles in which an investor might not be directly invested can still be valuable in conducting an overall assessment of the vehicle into which an investor is allocating capital as well as the hedge fund itself. Following up on this point, as we will discuss shortly, by focusing on the specific governance aspects of only the specific vehicle in which an investor is invested in, an investor is forgoing learning about some of the good governance aspects at the management company level.

We can next turn to the second primary reason this book will assume that investors want to promote governance across all the hedge fund vehicles and related entities. As we have stated earlier in this section, the management company of a hedge fund is the central legal entity where the firm’s business is conducted. As the saying goes leadership starts at the top. If a hedge fund has bad governance at the management company level, then it is likely that these poor practices will also translate down to the fund level.

As we outlined earlier, however, investors are not allocating their capital directly to the hedge fund management company. Once again, the narrow view of the governance relationships would be to play the cynic and take the approach, Who cares what else happens outside of the specific fund I am invested in? As intimated above, and as will be outlined throughout this book, there are significant implications for the fund vehicles based on what happens at the management company level. If investors are truly interested in promoting good governance and making more informed hedge fund investment decisions, then a holistic approach to governance is what is required. To clarify this does not mean that there should be an exclusive focus on the bigger management company entities at the expense of vehicle-level governance. Rather, promoting good governance at a hedge fund requires promoting total governance across all of the aspects of the firm.

Distinguishing between governance and due diligence

So far we have provided some general background on governance and introduced the concept of good governance. As we continue our discussion in developing a definition of governance it is important to address its relationship with due diligence.

Particularly, as we have just touched upon the concept of due diligence, it is worth clarifying the difference between the two concepts. The terms due diligence and governance are sometimes confused. To be fair, the two concepts are related, but markedly different in their meaning and application.

Further complicating the issue is that the term due diligence is in itself somewhat difficult to define. The first problem that typically arises when attempting to define due diligence, as it relates to hedge funds, is that in fact it is a broad umbrella term that encompasses a number of smaller concepts. As a result, the term due diligence can often mean different things to different investors. This is not to say that there are not common understood market norms used among investors as to what is meant by the term due diligence, but rather that there is some wide variety as to what is meant by due diligence. For example, some investors or even large allocation organizations such as fund of hedge funds may refer to due diligence as primarily encompassing a review of a fund’s investment merits. Other investors may encompass reviews of other concepts such as a fund manager’s personal backgrounds or a fund’s back-office procedures within the term due diligence. In its most basic form hedge fund due diligence can be thought of as including investment due diligence and ODD (Scharfman, 2012).

In general investment due diligence involves evaluating the investment merits of a particular hedge fund. ODD involves focusing on the other purely non–investment-related risks of hedge fund investing. For a reference on hedge fund ODD you can refer to my other book on this subject (Scharfman, 2008). ODD has evolved from analyzing traditional back-office procedures of hedge funds to include a wide array of other risks ranging from fund service providers to counterparty risk.

As it relates to the concept of the role of fund directors, to be addressed in more detail in Chapter 2, governance is typically reviewed as part of an ODD review. Indeed, as noted above, some investors, and particularly ODD analysts, may feel that fund governance is exclusively in the domain of ODD.

With this background on due diligence we can now focus on governance. Are the subjects all that different? Both aspects of investment due diligence and ODD relate to governance, but due diligence itself cannot be equated directly with governance. Instead, due diligence is the process by which investors gather information to learn about, diagnose, and evaluate a number of factors including the governance in place at the hedge fund. That being said, as we will outline in more detail in Chapter 6, due diligence alone when performed without governance in mind may not encompass all the factors relevant to conduct a thorough governance evaluation. Therefore, while many times the result of the due diligence process helps investors to promote good governance at funds, it is a diagnostic tool in the process and not the solution to governance itself.

Is governance controlled by the hedge fund board of directors?

In considering a definition of hedge fund governance, we must also address the role of a common governance mechanism, fund boards. If you talk to hedge fund investors or even hedge fund managers themselves, about the concept of hedge fund governance, not too far into the conversation you are likely to come to the subject of the role of the board of directors. This is particularly true when discussing hedge funds that employ common offshore fund structures. While we will address the roles of affiliated and unaffiliated board members in Chapter 2, for the purposes of our discussion here we will focus on the board of directors of offshore hedge funds. These unaffiliated offshore directors are typically based in a variety of jurisdictions with one of the most popular hedge fund director locations being the Cayman Islands.

In fact, many people believe that the fund governance and the role of the offshore board are synonymous. Many board of directors themselves would likely support this assertion as well. While the role of the board is certainly critical to the hedge fund’s governance, the board is not the end of hedge fund governance. Rather it is a good starting point from which we can begin our discussion of governance.

To pause for a moment and to highlight why hedge fund governance does not start and stop with the board of directors, let us consider a hedge fund that only has a domestic (i.e., US-domiciled) hedge fund. Let us further assume that, as is usually the case, unlike many popular offshore jurisdictions, the United States–based fund is not subject to any legal requirement that outlines that it must have an independent board. Does this mean that because this fund is not required to have a board, and has opted not to have one, the investors in this fund don’t have to worry about governance?

When the question is posed this way, most investors would agree that the lack of a board does not remove the need for the hedge fund to practice good governance. Assuming that is the case, the next question is, besides the board of directors of the offshore hedge fund vehicle what else does fund governance entail?

Although we will touch upon the role of the board throughout this book, we will first begin to address this question by developing a definition of governance. Once we have defined what hedge fund industry governance means, we will work to outline some of the central elements of governance. Through this process we will then start to develop a framework by which investors can begin to evaluate governance and incorporate board-level reviews into this analysis. Before proceeding to develop this definition of governance in a hedge fund context, it will be useful if we first understand the origins of governance and its development in the modern financial system.

Governance outside of hedge funds

As a starting point to develop a definition of hedge fund governance, we can look outside of the hedge fund space for definitions. The core concepts of governance are not only applicable to hedge funds. Within the realm of finance, governance concepts similar to those we will discuss in the hedge fund space are shared by those with similar fund structures. Examples of this include private equity funds or real estate funds. Although, as we have outlined above, the particulars of the ways in which governance is implemented in these fund types vary; they are still closely related to hedge funds governance at least from a fund structuring perspective for the purposes of our discussion here.

Outside of the purely financial world, the concepts of governance are also applied to many different industries in business. There are many other bodies of literature dedicated to analyzing corporate governance within the context of publicly traded companies. Considerations related to the quality of public company governance are also frequently the subject of much analysis during the investment process. Additionally many academic studies have been done with regards to corporate governance in public firms. These studies have analyzed governance from many different perspectives ranging from board compensation and monitoring conflicts of interest to even evaluating the size of CEO’s homes and swimming pools using aerial photos as governance indicators (Liu and Yermack, 2007). Governance concepts also have a wide variety of applications in social science, political science, and public policy. There are also dedicated areas of study within the field of governance seeking to examine how different types of governance structures interact with one another. An example of this would be multilevel governance (Enderlein, 2010).

The origins of hedge fund governance lie in corporate governance

The modern development and current incarnation of hedge funds governance is firmly rooted in traditional corporate governance. Corporate governance has traditionally referred to notions relating to corporate boards of directors, executive compensation oversight, and conflicts of interest monitoring. This repackaging of the term into corporate governance in this context includes many of the common characteristics of the core issues governance tries to address including promoting oversight and independence.

From an etymology perspective, the word governance has its roots from the Greek word kybernao to steer something (Clarke, 2007). Plato used the word in book VI of his book titled Republic, who was borrowing from Aeschylus’s Seven Against Thebes, to analogize the running of the government of a city to the steering of a ship, and coined the well-known phrase Ship of State (Pappas, 2013). The Oxford English Dictionary defines governance as the action or manner of governing (Oxford, 2014). While this provides us with a good starting point, it does little to inform our perspective of what governance practically is. As a more concise definition it has been suggested that corporate governance is about the exercise of power over corporate entities (Tricker, 2012).

Perhaps clarifying what is meant by the term power in the previous definition, governance in a more political context has also been defined as the act or manner of governing, of exercising control or authority over the actions of subject (Vyas-Doorgapersad et al., 2013). This definition emphasizes he control of a central authority over its members. To pause for a moment you might be asking yourself, What does Plato and concepts of power have to do with hedge funds? Well, if we think of the hedge fund as the central authority to which all its investors (i.e., members) allocate capital to, then, using this definition, it is the hedge fund that is the driver or governance, and not the investors. But is this hedge fund–centric approach the best way to define governance?

We will provide examples of these types of issues and address these questions in more detail throughout the book. For now let us simply suggest the notion that depending from what perspective you approach the issue of fund governance, there may be well-reasoned disagreement over who the market considers to be the driver of governance and what the market considers to be best practice governance. To further our understanding of governance in building our definition in a hedge fund context it will be useful to consider additional historical perspectives in this area. With the background we have laid out so far on the subject, as you read through this historical background on governance, if you keep the question How do these concepts relate to modern hedge funds? in the back of your mind, you might find yourself coming up with some new perspective on these issues.

Historical perspectives on corporate governance

In a more modern financial context, the roots of corporate governance can be classified into two basic areas. One area that has historically driven governance is the law and regulation. The other is market- or investor-driven governance. We will analyze the regulatory roots of financial governance in more detail in Chapter 3. An analysis of the recent history of market or investor governance will provide some perspective on highlights in the growth of interest in corporate governance, which we can then apply to hedge funds. More detailed discussions on the historical growth of corporate governance systems outside of the financial markets are better left for other texts (Morck, 2005).

Investor-driven governance

Governance in the Prewar Period

Outside of the political arena, the subject of governance has been largely developed in the boardrooms of corporations. It may come as no surprise that these corporations were not always focused on governance as a key element of their overall operations. Just the opposite, governance was not even on the corporate radar for a long time. Not to place all the blame on the corporations, shareholders weren’t overly focused on governance either.

This was largely the case in part before World War II. Indeed even before World War II, trends of a lack of focus on corporate governance were largely consistent globally. In Japan, for example, there were large corporate conglomerates called zaibatsu, which were controlled by individuals or families as the major stockholders. The interdealings of the zaibatsu-affiliated entities often epitomized the definition of what we would classify as conflicts of interest when viewed under a modern lens (Mallin, 2009). Likely furthering these potential conflicts was a practice in Japan known as amakudari where public officials would step down from public service to join private corporations at age 55. It was no secret that these former public officials continued to hold a great deal of influence in the public sphere and would secure preferable treatment for their new private corporate employers. Oh, and let’s not forget that when they were in public service, these civil servants were likely made very aware of the fact that in order to secure a lucrative postretirement corporate position it would be in everyone’s best interest not to make life too difficult for the corporations they were supposed to be overseeing.

In prewar Germany similar conglomerates with a handful of corporate influential shareholders existed. Similarly, during this period in the United Kingdom it was not uncommon for influential families to control businesses and collusion among the business was also permitted (Dingham and Galanis, 2009). As an aside, unfortunately the notion of a regulator having close ties to those they regulate isn’t a phenomenon solely relegated to the past. As noted above, we will address this issue in more detail in Chapter 3 that addresses regulatory governance of hedge funds.

In the United States, as compared with Europe and Asia, there was more of a separation between ownership and control of companies with the use of equity markets and stock ownership being more common. This separation of control and ownership still did little to promote any material distinction in US corporate governance. Some have also argued that the American interest in democracy was tied to a more progressive US view of democratizing the corporate boardroom as well in prewar America (Dine and Koutsias, 2013). While the roots of the American interest in corporate governance may have been tied to promotion of the ideals of democracy, it was not until many years after the war that any real changes came about in the boardroom. Much the opposite, in prewar America anything resembling the ideals of modern corporate governance was virtually unheard of. Instead, the lack of US corporate governance was more likely tied to the old robber baron style system where corporate boards were often shared with large investment bankers to facilitate their agreeing to provide financing to these companies (Musacchio, 2009).

The Postwar Era of Governance From the 1960s

It has been said that a rising tide lifts all boats, and when people are making money, they tend to have different priorities than when they are losing it. As part of this when corporations are profitable, there tends to be less of an interest among shareholders and corporations alike to focus on governance. Instead the concentration tends to be more heavily focused on profitability and sustained growth. This was the case in the post–World War II era, when the United States was experiencing an economic recovery. During this recovery in corporate America, and indeed through most of the developed world, there was little to any emphasis placed on governance and shareholders’ rights. The 1960s were defined by a general market acceptance of weak shareholders as compared with strong corporations (Jackson, 2010).

Focus on Insider Trading in the United States

The somewhat hostile political and business climate toward governance reforms began to thaw in the late 1960s. In general, this increased acceptance of governance was not magnanimously volunteered by these corporations. Rather, the initiators of much of this change have been driven by shareholders. From the perspective of the market, as opposed to the regulatory perspective, the key drivers in this area have included a continued focus on transparency, accountability, and profitability. From a financial regulatory perspective some notable examples of this include an increased focus by the US SEC on insider trading with the appointment of William Carey in 1961 as the new chair of the SEC. One of the seminal cases in this area occurred in the 1961 case of In re Cady, Roberts & Co. (40 S.E.C. 907, 1961).

This case dealt with the uses of material nonpublic information, also sometimes called insider information. Specifically, in that case it was alleged that a stockbroker received a tip from the director of a corporation that it was going to reduce its quarterly dividend (Ferrara et al., 2013). The broker then