Hedge Fund Governance

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday April 15, 2013 at 9:41 am
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Editor’s Note: The following post comes to us from Houman Shadab, Associate Professor of Law at New York Law School.

Concerns about the internal governance of hedge funds have dramatically increased in recent years. During the financial crisis of 2008, investors became frustrated when numerous hedge fund managers suddenly prevented them from withdrawing their capital yet nonetheless continued to charge them fees. Since the financial crisis, concerns about hedge fund governance have focused on transparency, operational practices, and the growing view that fund directors do not effectively monitor fund managers.

In my paper, Hedge Fund Governance, which was recently made publicly available on SSRN, I provide the first comprehensive scholarly analysis of hedge fund governance. In doing so, my paper makes several contributions. First, it contributes to the literature on corporate governance by conceptualizing the unique way in which hedge funds are governed and situating their style of governance within established paradigms. I argue that hedge fund governance is a type of responsive managerialism.

Hedge fund governance is a form of managerialism because the funds’ underlying legal regime gives managers near complete authority over the structure and operations of the funds they manage. Hedge fund managerialism arises from the fact that hedge funds are organized as privately-held limited partnerships (or their functional equivalents) that highly circumscribe equity investors’ rights with shares that have no voting rights nor any mechanism to replace managers or directors. Hedge fund managerialism gives hedge fund managers more control and authority over their firms than managers of public companies, mutual funds, and other private investment funds (e.g., private equity).

However, hedge fund governance is also uniquely responsive in the sense that to obtain and retain investor capital, hedge fund managers must be highly responsive to the preferences of equity investors (the limited partners). This responsiveness arises from a fundamental dynamic of hedge fund governance—the propensity of investors to “pull the plug” and cash out of a fund if they are dissatisfied. Although hedge fund investors usually face short-term redemption restrictions, they typically can interrupt the operations of a fund or cause it to wind down in a few months to a year by withdrawing their capital.

The uniqueness of hedge fund governance stems from the fact that the exit rights of hedge fund investors puts hedge fund managers on a much shorter leash than managers of public corporations and other types of investment funds. Corporate scholars recognize that an essential feature of the corporate form is that it permits a firm to have access to permanent, “locked-in” capital from equity investors. Private equity and venture capital funds likewise have access to long-term capital because investors in such funds are bound to them by contract for seven to 10 years. Managers with access to permanent or long-term capital do not have to be concerned about investors pulling the rug out from beneath them and causing their firms to shut down. Hedge fund managers do not have that luxury.

In addition to the underlying hedge fund legal regime, I argue that the primary components of hedge fund governance consist of:

  • investors with a high propensity to exercise their short-term redemption rights;
  • managers with high pay-performance sensitivity due to being compensated with an annual performance-based fee and their own investment in the funds they manage;
  • demand by sophisticated investors for quality governance; and
  • close monitoring by short-term creditors and derivatives counterparties.

The second primary contribution of my paper is to examine and assess hedge fund agency costs and the governance mechanisms used to reduce them. Overall, I find that hedge fund managers are not systematically ripping off investors. This is because empirical studies do not find that hedge fund fraud or other types of agency costs are pervasive and significant. In addition, empirical studies strongly suggest that hedge funds outperform stock and bond markets on a risk-adjusted basis even after managers are paid their fees.

Nonetheless, hedge fund governance still has plenty of room for improvement. The third contribution of my paper is to provide a normative framework and principles to improve governance. My analysis suggests that the areas in which hedge fund governance needs the most improvement are performance reporting (valuation) and the timing of performance-fee calculations.

I also argue that investors should be careful what they wish for when choosing or negotiating governance structures. Although investors generally benefit from low fees and significant transparency and liquidity, if investor-friendly governance devices are improperly structured or taken too far, investors run the risk of undermining the unique performance-based incentives and other governance mechanisms that enable hedge funds to produce superior returns in the first place. Importantly, investors are often better off with higher fees, less transparency, and less access to their capital.

The full paper is available for download here.

  1. Harvard Law School Forum
    Response to Houman Shadab post
    April 15, 2013

    Professor Shadab’s detailed and comprehensive review of hedge fund governance issues is a welcome addition to the industry discussion of these issues called for in RFG’s white paper, “The Unasked Question: Fund Directors – Worth It or Not?” (http://bit.ly/11b97wI). As anyone concerned with corporate governance will recognize, the issues here are crucial not only for fund investors but also for managing members of limited liability entities (used frequently in the US) and boards of directors of funds (organized under a corporate model in many other jurisdictions). Striking the right balance by protecting investors and avoiding unnecessary additional expenses is important for all contracting parties. It is equally important to develop an understanding of the liabilities of those in a position to exercise fiduciary oversight over a fund manager.

    With this in mind it strikes us as unfortunate that boards themselves have not called for more clarity on their roles and responsibilities with respect to fund oversight of managers and other service providers. Perhaps in time some clarity on these issues will emerge from initiatives such as the Cayman Islands Monetary Authority (CIMA) request for comments on corporate governance standards. The proposals are broad and suggestions include a public database about directors to assist in due diligence, caps on concurrent directorships, and stronger oversight responsibilities.

    However, while CIMA and the industry in general consider next steps, board members and fund investors should be one step ahead. There is no need to simply await guidance from others before addressing important issues. Managers, investors, general partners and directors of hedge funds are free to act now to address fund governance issues. Professor Shadab rightly encourages a discussion of several key topics, including valuation and performance issues.

    This should not be viewed as an exhaustive list. In today’s regulatory-intensive environment, oversight reports as simple as a monthly update on compliance with legislative initiatives must be regarded as de rigueur. A review of fund documents for antiquated, obsolete provisions might also be warranted. For example, we sometimes find Cayman funds that allow directors to appoint their own replacement or “alternate” directors. These appointees apparently take over the role of the original director – frequently relieving the original director of liability. Many investors spend the time and effort to diligence a fund’s board before they invest. Certainly, this back-door replacement cannot be what they, or even the remaining members of the board, expect.

    In short, regardless of when and how CIMA or any other regulator acts, a frank discussion on governance roles, supported by objective risk assessments, is called for. Professor Shadab’s article advances the discussion in this regard. Board members and other stakeholders in funds may wish to take this time to assess these issues themselves, instead of reacting after the fact to standards that may not be best for their organizations. Their active consideration of the issues will help funds maximize the benefits that a well-run governing body can provide.

    © 2013 The Regulatory Fundamentals Group LLC – All Rights Reserved

    Comment by Deborah Prutzman — April 16, 2013 @ 9:02 am

 

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