By Giorgio Subiotto (pictured) & Shameer Jasani, Ogier – We have witnessed a clear evolution in how the composition of boards of directors on Cayman investment funds has been structured.
The concept of using independent directors is not new. Many US managers have used them on their boards of the feeder fund, in large part driven by US tax rules to do with investment fees and deferral rules. It was a pure tax planning device, where little thought was given to the selection of the directors so long as they weren’t related to the Investment Manager.
But this check the box approach, using a couple of independent directors from one service provider, has evolved quite significantly since 2007. The abolition of the deferral rules and the ’08 crisis have driven this evolution so that now the focus on corporate governance is driven by a real desire by institutional investors to see strong governance at the helm of the funds they invest in.
The trends that we see as a result of that evolution are the following:
It’s much more common now to have an independent board
Indeed, it has become the norm. It’s very rare to see a non-independent board and even if one does see one, the manager will typically be focused on how they want to structure its board of directors further down the line.
Investors have started to look more closely at the composition of independent boards. They want to see the independence that a director brings to the non-executive management of the fund, as opposed to an independent board being used simply for tax purposes.
Specifically, institutional investors are looking for people on the BOD that they can communicate with. They want to know that if another financial crisis arises that they have people they can call in to and find out what the fund is proposing to do, and, possibly, make suggestions as to what solutions the board may wish to consider.
Independence from both the manager and other directors
Investors increasingly expect to see directors who are not connected to either the manager or themselves. At Ogier, we are seeing the emergence of split boards. At the time of set-up, in order to market the fund as an attractive proposition a manager will look to establish a board of three directors; where one will be representative of the manager and the other two will be carefully selected from different independent service providers.
Greater attention to corporate governance at the Master Fund level
Due to changes in Investment Manager tax deferrals in the US, more funds are being set up as master/feeder structures where the fee allocations are being done at the Master Fund level in a way that is beneficial from a US tax perspective for managers. That has given rise to the concern that, since the Master Fund holds all the assets, there needs to be proper corporate governance at that level.
Initially, these corporate governance concerns drove Master Funds to be set up as companies in the Cayman Islands so that the same board would sit at both levels. In the past year, we’ve seen a greater move towards the use of partnerships at the Master Fund level for a number of reasons.
This has given rise to an interesting trend: How to replicate within a partnership at the Master fund level the same corporate governance controls that exist on the corporate side?
We are seeing three solutions to address this shift.
First, we’ve worked with a number of funds where the General Partner of the partnership has been set up as a Cayman company. In this arrangement, the independent BOD of the feeder goes on to the board of the GP. The decision-making is made by the independent directors and the board looks very much the same for the GP.
The norm, however, is not to use a Cayman GP but rather to establish the GP as a Delaware LLP.
The main driver for this is tax. As the Investment Manager might wish to own an equity interest in the GP, owning shares of a foreign company can give rise to CFC issues for US managers in the US even though they might not be receiving any income from that equity interest.
In this context of setting up a Delaware LLC, there are two solutions.
The first is what we refer to as falling within the matrix of the partnership agreement where the GP establishes an advisory board or committee. Ogier has done a lot of work on the types of issues that GPs would make decisions on and what aspects of that decision-making process should be done in consultation with the advisory board or committee.
One of Ogier’s new clients, for example, has already settled on an advisory board and its composition for the Master Fund prior to launch or formation of the Master Fund. Investors want to know who the independent members are, what their independence, seniority and experience are, etc.
The second solution is what we refer to as falling within the matrix of the GP itself. Typically, Delaware LLCs have minimal operating agreements. However, we are starting to see more elaborate agreements that are defining decision-making in greater detail and putting on to the structure a number of independent members as well as the manager.
It is the opinion of Ogier that it will become more important and more mainstream to have independent governance at both the Master fund and feeder fund level.
As to what is driving this need for greater focus on corporate governance, there are a number of reasons. There was a backlash in the aftermath of the financial crisis. A lot of institutional investors suddenly realised the key management role that a board plays, especially in times of crisis. It is the board, for example, that will decide on whether or not to suspend.
At the same time, there has been an emergence of a growing number of independent directorship providers. Indeed, we are seeing some of the big institutional investors now using lists of independent service providers. When they visit fund managers, they are requiring them to appoint directors from those approved lists.
One start-up in New York, for example, that Ogier has been advising, has spent a lot of time thinking about a corporate governance manual prior to launch or formation: how often are board meetings going to be? What should be discussed in these meetings? The client has found that this is essential to gain credibility with investors.
The focus and composition of independent boards has become a much more salient issue. This is not, however, a trend that solely applies to new fund managers.
Over the last six months, a number of existing clients have come to Ogier to help mix up the board of directors to their existing fund(s). When we talk to them about why they are doing this, the answer, almost unequivocally, is because they are looking to get proper traction with investors. This is because one of the questions they are fielding is, ‘How do you show your real independence?’
At both the feeder and Master Fund level, corporate governance is in train and the model will keep evolving. One of the interesting points to note is that US mutual funds have a very structured corporate governance regime. We are fascinated to see how this will play out, going forward, in the hedge fund industry.
