Hedge Fund Governance

Evaluating Oversight, Independence, and Conflicts

Jason Scharfman

• Publisher: Academic Press
• Year: 2014
• ISBN:
  9780128025123
• Topic: Persönliche Entwicklung
• Subtopic: Private Finanzen

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

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 quest...

Table of contents

• Cover
• Title page
• Table of Contents
• Copyright
• Dedication
• Biography
• Preface
• Chapter 1: Introduction to Hedge Fund Governance
• Chapter 2: Hedge Fund Board of Directors: A Governance Proxy?
• Chapter 3: Regulatory Governance of Hedge Funds
• Chapter 4: The Role of Fund Service Providers in Implementing Governance
• Chapter 5: Hedge Fund Internal Governance Mechanisms
• Chapter 6: Developing a Framework for Investor Analysis of Hedge Fund Governance
• Chapter 7: Investor Activist–Driven Governance and Ongoing Monitoring
• Chapter 8: Case Studies and Example Scenarios in Hedge Fund Governance
• Chapter 9: Analyzing Governance in Fund Valuations
• Chapter 10: Field Perspectives on Governance—Interviews With Those Involved in Various Aspects of Hedge Fund Governance
• Chapter 11: Good Governance in Bad Situations: Understanding Governance During Fund Turmoil and Liquidations
• Chapter 12: Trends and Future Developments
• Index