Financial Services
February 2014
Tone from the top
Current trends and the expected outlook require a new
look at private fund boards and governance structures
by Natalie Deak Jaros and Michael LoParrino
In an era of heightened scrutiny for alternative fund managers, investors are demanding more
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the board of directors. Long a staple for publicly listed funds, the board of directors not only serves as
a source of checks and balances, it can also assuage risk-averse investors and provide vital strategic
guidance to the organization. However, when it comes to the private fund sector, there is little
consistency in the composition or even existence of boards of directors. This is complicated by a wide
disparity in the attributes of the boards that do exist.
Today, smart fund managers are looking closely at the board
component of their governance structure and looking for ways to
improve it. For years within the hedge fund industry, boards of directors
have been a regulatory requirement for European- and Cayman Islandsbased funds, given their corporate structure. No such requirement
exists for US-domiciled funds; thus, few US funds have boards in place.
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institutional investors, coupled with funds themselves becoming more
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are governed.
Exchange Commission (SEC) formally accused eight former board
members of Morgan Keegan & Co.,1 alleging that the group failed to
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that were heavily invested in mortgage-backed securities, and which
saw their prices plummet when the credit crisis hit in 2008. Because
such valuation responsibilities had been delegated to the board, the
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investors when they passed the valuation responsibilities to a separate
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fair valuations.
Over the past decade, as institutions have pushed for greater
transparency and sought to conduct more thorough due diligence,
the hedge fund industry’s boards of directors have become somewhat
more active. Many boards have stepped up their oversight of the
more subjective portions of funds’ activities — those most open to
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the valuations funds place on the thinly traded or illiquid assets within
their portfolios. By taking a closer look at the process used to determine
individual valuations, sometimes even involving themselves in valuation
committees, boards not only are able to provide an added layer of
assurance to protect the organization and its reputation but are also
able to provide greater comfort to the investment community.
In 2011, the Grand Court of the Cayman Islands found two members
of the board of directors of the Weavering Macro Fixed Income Fund,
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responsibilities to investors.2 A judge ruled against the pair, who were
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failed to ever attend a board meeting, but they had repeatedly signed
off on documents they had never read.
Despite such recent improvements, many funds would be well served
by continuing to make progress in the way they govern themselves. For
private funds that are required to have a board, simply having one is
no longer enough. In regions where boards are mandatory, courts and
regulators have put board members on notice that they are responsible
for adequately monitoring the funds they are charged with overseeing.
This has prompted observers in other regions to take notice too. Gone
are the days when individuals were able to take board seats in name
only and serve on committees that rarely met.
Likewise, investors have become more involved. As investment
strategies become ever more complicated amid turbulent and uncertain
global market conditions, investors want to be assured that boards are
actively governing the funds to which they are committed. Investors
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investment strategy and its various committees, and that the board can
provide the right amount of oversight.
Not surprisingly, these cases have resonated within the private fund
industry as fund managers have taken note that regulators are no
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that individuals who choose to be part of a board need to be ready
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Today’s boards need to be prepared to stand up to regulatory scrutiny
and inquiries and to provide evidence to investors that the proper
governance structure and processes are in place.
Recently, the Cayman Islands Monetary Authority
(CIMA) published a Statement of Guidance that indicates
its view of the minimal level of governance required. It
makes clear that for CIMA-registered funds, the board is
ultimately responsible for oversight and supervision of
the funds’ activities and affairs.
In addition, the SEC recently released its examination
priorities for 2014. In that release, the SEC highlights
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focal areas for alternative investment companies.
Directors in the spotlight
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oversight at the board level in two separate legal cases where board
members were called out for failing to adequately monitor risk within
their respective funds’ portfolios. In late 2012, the US Securities and
2 | Tone from the top
1 Source: http://www.sec.gov/News/PressRelease/Detail/
PressRelease/1365171486708#.UsrlhvRDuVN
2 Source: http://www.hedgeweek.com/2011/09/12/130684/corporategovernance-and-weavering-judgement
Governance trends:
a checklist for fund managers
In the US, however, many funds have not voluntarily adopted boards
to govern their activities. But that may be changing, as fund managers
are starting to realize that actively working with board members can
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of a large portion of the hedge fund industry, many fund managers
established gates to limit redemptions or locked up illiquid assets in
side pockets in order to protect the overall value of their portfolios.
But while gates and side pockets ultimately proved to be the right
decisions for many funds, they were unpopular among some investors
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with strong and active boards learned the value of these relationships
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if such measures were appropriate, but to decide the best timing for
establishing gates and side pockets and how to communicate such
decisions to investors.
Private equity governance model
draws attention
Unlike the formal boards of directors that exist for European- and
Cayman-based hedge funds, the majority of board oversight within the
world of private equity has so far been in the form of limited partner
advisory committees. Instead of being driven by the fees commonly
paid for participation in formal boards of directors, the limited partners
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the funds they are overseeing. Bound by the contractual agreement
terms between the fund and the board, limited partnership committees
tend to focus on enforcing best practices and proper governance
within funds; however, members understandably tend to be risk averse,
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Institutional investors have also been a factor in the more active nature
of limited partner committees. The Institutional Limited Partners
Association (ILPA), a global organization composed of institutional
investors that focuses on best practices within the private equity
industry, has been a vocal proponent of greater transparency and
involvement at the board level. “Private Equity Principles,” a report
outlining ILPA’s stance on best practices in the private equity industry,
offers a set of governance guidelines for well-run boards or advisory
committees.3 Among the areas highlighted in the report are:
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• The increasing requirement for transparency for everything from
fees to personnel changes
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breakdowns of any and all calculations made for a fund
3 ILPA Private Equity Principles, Version 2.0, January 2011.
• Investors’ desire for transparency doesn’t end with
a portfolio’s contents. Investors now want evidence
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who are actively engaged with the funds they
oversee.
• Regulators have sent a clear message that
mandatory boards need to spend more time with
management and take a more hands-on approach to
oversight. Documentation of a board’s activities has
become crucial.
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auditors, but they can provide an additional layer of
security for investors that fund managers’ activities
are thoroughly monitored and assessed.
• A well-crafted board should not be an obstacle for
fund managers or a fund’s day-to-day activities, but
should serve as an enhancement to a fund’s ongoing
governance that it is operating to its best potential.
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of ILPA, including powerful groups such as the California Public
Employees’ Retirement System (CalPERS), investors’ requests for
greater attention to best practices at the board level are being heard
across industries.
Trends are emerging
Given the industry’s focus on governance, hedge fund managers are
starting to challenge the composition of their boards. A board with a
majority of independent members is a must, but managers are starting
to challenge whether the independent board members are independent
of each other, and independent of their service providers, leading
to more objectivity. Managers are becoming more diligent in their
selection of board members, engaging in extensive interviews and
due diligence.
In relation to US hedge funds or the structures that are not legally
required to have a board, hedge fund managers are beginning to
consider whether more should be done. The concept of advisory
committees, which are so prevalent in the private equity (PE) industry,
could be the right approach for hedge funds. Establishing a contractual
February 2014 | 3
arrangement for oversight and governance with independent parties
in the form of an advisory committee could result in enhanced
governance for the funds, and comfort investors.
Final thoughts
As investors and regulators continue to raise the bar for best practices,
more hedge fund managers are beginning to focus on the value of
an active board of directors and a robust governance structure. A
well-versed and active board not only gives comfort to investors that
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serve as a sounding board during turbulent market periods, and it can
be an important source of advice for many of the issues funds face in
day-to-day business, from complicated issues such as valuations and
gates, to simple portfolio changes for better risk management. Having
that extra layer of governance in place may ultimately make funds
more attractive to investors and help with fund-raising efforts.
About the authors
Natalie Deak Jaros is a partner in the Financial
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New York and can be reached at +1 212 773 2829, or
[email protected].
#NatalieDeakEY
Michael LoParrino is a partner in the Financial
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New York and can be reached at +1 212 773 2753, or
[email protected].
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