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Wednesday, 24th April 2024 |
| Corporate Governance of hedge funds |
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| Julian Bartlett asks whether corporate governance is relevant to hedge funds, and finds that a strong regulatory environment will help to broaden the appeal of this type of fund to a wider investment community. |
Corporate governance is here! Major listing authorities have been increasing governance obligations covering the composition of boards, risk management and internal control. Listed companies have detailed requirements and guidelines to ensure good stewardship of the businesses. In the investment management industry customers can impose similar obligations on custodians, administrators and investment management companies. These service providers are often required to present customers with a statement of their control processes and subject this to examination by auditors in accordance with SAS 70 or FRAG 21. In addition financial regulators impose governance standards on those they regulate. Corporate governance is here to stay. But is it relevant to hedge funds?
Hedge funds tend to be set up with little external requirement for governance. Whilst investment managers may be regulated, the funds generally are not. If they are listed there will be additional governance requirements imposed by the listing authority. These may include a minimum number of independent directors and the obligations to report any significant changes made to the fund prospectus.
Clearly there is a fiduciary duty to hedge fund investors to manage the assets according to the investment strategy disclosed in the prospectus and to protect the ownership of the fund assets. The prime broker has a role here but what of the responsibility of the board and the investment manager?
Fund boards have very clear responsibilities in relation to prospectuses. The board is ultimately responsible for the accuracy of the entire prospectus. The directors will rely on their advisers and other professionals involved but need to satisfy themselves that reasonable steps have been taken to verify its contents. Once the fund is established, the board have an on-going responsibility for its operation. The board will consider investment reports from the investment manager and take responsibility for the financial statements but to what extent should they be concerned about operational procedures and internal controls? What is the risk of loss to investors from failure to protect the assets or from investing beyond the disclosed strategy?
The hedge fund manager has a primary interest in achieving the investment objective. However, as we all know, risk is an inevitable factor in the achievement of investment returns. The bigger the bets, the greater the potential returns but the greater the potential for losses. How open should the hedge fund manager be in disclosing the risk management policies adopted. Further, how can the board be satisfied that appropriate risk limitation strategies are in place and are operating as described?
Ultimately the level of detail in investment policy disclosure is a matter for the board and the investment manager to agree with a view to the needs of investors. Many investors are unlikely to invest if there is insufficient disclosure of the risk taken with their investment. Past performance and the reputation of the investment manager continue to be key deciding factor for investors choosing which funds to invest in but increasingly they wish to understand the risk taken to achieve that return. The investment manager and the board need to decide on the balance a disclosure consistent with the expectations of target investors, the marketing objectives and the level of assets to be raised.
The extent of corporate governance appropriate to a hedge fund is a matter to be determined primarily by the board in consultation with the investment manager. With the increasing institutionalisation of hedge funds, the trend is towards increased disclosure and more rigorous governance. So, what matters should be addressed in a fund intent on improving its governance arrangements, or increasing disclosure of its governance practices?
At the heart of good governance are the overriding principles by which the fund is operated. What are the values by which issues are judged or decisions made? How is responsibility allocated between the various parties involved? What is the policy on disclosure? Consideration of these questions will establish the foundation of the fund’s governance and the framework by which more detailed operations can be put in place.
The board, by expressing clear principles of governance, will set an expectation of control for the parties involved. This creates the culture and atmosphere in which the activities will be undertaken. A control environment is difficult to evidence but it is supported by the arrangements put in place to monitor the operations. Audit and compliance arrangements confirm the intent of the board and can help foster the desired approach.
Investment risk management is possibly the most important aspect of hedge fund operation. Some funds will wish to offer the investment manager considerable investment freedom, others will wish to ensure that the positions taken do not result in disproportionate risk. The balancing of risk and return is a highly complex issue requiring much more examination than this article will allow. But however the issue is addressed, governance principles would suggest that there should be a mechanism in place to implement and monitor the policies adopted.
The prime broker will already be keeping a close watch on the hedge fund positions. It will have contractual provisions in place to ensure it can enforce closeout of excessive position where the fund capital provides insufficient margin to allay the market risk. The board too should be concerned about the extent of capital that is at risk. As well as the gearing levels, the concentration of investment risk and volatility based risk measurement should also be of concern.
The board should establish clear guidelines within which the investment manager may operate in order to keep investment risk within an acceptable range. These guidelines will generally be more detailed than the investment restrictions set out in the prospectus. A mechanism for reporting and monitoring of the portfolio risks should be established. The investment manager, with primary responsibility for investment risk management, will be central to this process and the services of the prime broker and administrator may also be of use.
The board is responsible for the completeness and accuracy of the fund’s financial statements. However, its duties and responsibilities to the fund extend to the whole administration and operational arrangements. Although these functions have been delegated to other parties the board should ensure that the arrangements in place are suitable. Such arrangements should ensure that the assets of the fund are protected from fraud, theft or counterparty failure, that the recording of transactions, balances and valuations is accurate and that all income to which the fund is entitled is recognised and collected.
Having identified many of the high level considerations of its governance the board will then need to consider the detail. The effectiveness of the governance arrangements is ultimately dependent on the internal control systems in place. The board should consider their key control objectives and ensure that these are met by the internal controls operated by the fund’s service providers. They should institute reporting arrangements for the service providers to confirm that the controls are in place they continue in operation.
If hedge fund investment becomes a more common asset class, particularly for large retirement plans and other institutional investors, they are likely to become subject to the same demands that are made of traditional investment managers. The investors will want assurance that their assets are being well looked after both in terms of investment and operation. The time will come when hedge fund boards will need to provide regular disclosures about the governance arrangements and the operation of internal controls.
Whilst the preparation of detailed descriptions of operations typical in SAS 70 and FRAG 21 reports may be some way off, there is surely a case now for increased disclosure and regular confirmation that processes have been reviewed. The extent of disclosure can be determined by optimising the judged marketing benefit, the negative impact of excess detail and the commercial sensitivities of the investment process.
If hedge fund investment is really to become an established investment class, the industry will need to adapt to the needs of the more conservative institutional investors. A voluntary adoption of the highest standards of corporate governance will remove many of the doubts and bring alternative investment strategies into the mainstream. |
Julian Bartlett is director of UK Financial Services Advisory Group, RSM Robson Rhodes.
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| Article appeared in the June 2001 issue.
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