A study on hedge fund operational due diligence reports that the lack of independent directors on a fund’s board is a major reason why investors will veto a hedge fund investment.* Seems simple enough, but what does director independence really mean in the context of alternative private fund investing?
The challenge in answering this question is two-fold:
First, issues associated with private fund directors typically relate to foreign jurisdictions. One example is the Cayman Islands, where funds are often organized as corporate entities, versus the U.S., where partnership or LLC vehicles are typically used to organize private funds. Putting money into corporate entities in offshore jurisdictions that have historically been pro-manager-oriented means that U.S. investors must be sensitive to differences in foreign corporate governance standards to protect their interests.
Second, foreign independent fund directors in places like Cayman Islands are often associated with companies whose business is to provide directors to numerous funds in order to make money. While these companies may hold themselves out as providing “independent” directors, their livelihood is dependent on the good will of managers and their service providers to generate business.
Even though industry practice has evolved to the point where some fund boards now have three directors — two of whom are not affiliated with the fund’s manager — the term independent director may ring hollow unless investors can answer one important conflict-of-interest question:
Do the independent directors of an offshore fund stand to gain any financial benefit either directly (e.g., more board appointments from the same manager) or indirectly (e.g., the offshore company that they’re affiliated with receiving more board appointments) by voting in favor of a manager’s proposal?
Can you answer this question with respect to the alternative private funds that you’re currently invested in?
*Deutsche Bank, A Study of Investor Operational Due Diligence, Autumn 2012