Hedge fund governance : evaluating oversight, independence, and conflicts

368 Pages·2015·2.109 MB·English

by  Jason Scharfman

Hedge Fund Governance
Evaluating Oversight, Independence, and Conflicts
Jason Scharfman
Managing Partner, Corgentum Consulting, LLC
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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 investiga-
tions 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 Informa-
tion 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.
xv
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 gen-
erate 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 tech-
niques 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 in-
creasingly 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.
xvii
xviii Preface
This book will also highlight a key player in the world of hedge fund gover-
nance, 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 ca-
pacity 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 invest-
ment 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
Chapter Outline Head
Introduction to the Concept The Postwar Era of Governance
of Governance 1 From the 1960s 12
Why Should Investors Care 1970s: The Decade of
About Hedge Fund Governance? 2 Governance 15
Governance: A Vague Concept? 3 Rise of Agency Theory 16
How Should Investors Think 1980s Onward—The Growth
About Hedge Fund Governance? 4 of Modern Corporate Governance
What Hedge Fund Entities are Reforms 17
Investors Looking at to Promote Defining Hedge Fund Governance 18
Good Governance? 5 A Universal Definition
Distinguishing Between of Governance? 21
Governance and Due Diligence 7 Is Governance Defined
Is Governance Controlled by the by Perspective? 22
Hedge Fund Board of Directors? 8 Who is Responsible for Hedge
Governance Outside of Hedge Funds 9 Fund Governance? 22
The Origins of Hedge Fund Is Governance Primarily
Governance Lie in Corporate an Investment-related Concept? 22
Governance 10 Distinguishing Between
Historical Perspectives on Governance and Hedge
Corporate Governance 11 Fund Activists 24
Investor-Driven Governance 11 Hedge Fund Governance:
Governance in the Prewar Period 11 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 “cor-
porate.” Ok, so what then does the term “corporate governance” mean exactly?
Does this definition vary based on the context of what type of corporate gov-
ernance 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
Hedge Fund Governance
Copyright © 2015 Elsevier Inc. All rights reserved 1
2 Hedge Fund Governance
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 work-
ing 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 gover-
nance, 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.
Introduction to Hedge Fund Governance Chapter | 1 3
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 invest-
ing. It not only relates to the implementation of checks and balances, and adher-
ence 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 pro-
moting 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 contrib-
uting to the problem is that there is no consistent market or legal definition
of what governance in the hedge fund industry actually means. Further con-
tributing to the confusion is the fact that there is a mixed consensus on who
4 Hedge Fund Governance
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 numer-
ous subcategories differentiated by numerous categories including location, as-
sets 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 require-
ments, 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 ex-
empt 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 in-
vestors 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).