Why Independent Boards Are Essential for Hedge Fund Governance and Investor Confidence

Concerns about internal governance of hedge funds have increased considerably in recent years. Institutional investors spend significant resources performing due diligence on potential hedge fund investments and place heavy emphasis on governance. Regulators like the Securities and Exchange Commission (SEC) are demanding more from investment advisors who manage hedge funds from a risk management and regulatory perspective.

The SEC is looking very closely at high-risk areas such as portfolio valuations, conflicts of interest, security of investors' assets, and fund expenses and allocations. Nowadays, corporate governance of hedge funds is more closely scrutinized, and a board of directors with a majority of independent members can provide significant benefits.

Key Takeaways

• Independent boards are vital for hedge fund governance, helping to reduce operational risks and conflicts of interest.
• A qualified board of directors, composed predominantly of independent members, enhances investor confidence by providing oversight, transparency, and strategic advantage.
• Board members should possess a variety of skills, including portfolio management and regulatory experience, to effectively oversee and balance fund managers.

Responsibilities of the Board of Directors

Board members with the proper skills are able to minimize risks, mitigate conflicts of interest, and adequately perform responsibilities.

Institutional investors will evaluate board members' experience and determine whether the directors possess the required skill set and are able to devote sufficient time to their responsibilities.

The board of directors has a fiduciary responsibility to the fund’s investors and oversight of the fund's management. Their responsibilities include:

• Detection of fraud and misconduct
• Compliance with the fund's risk management guidelines
• Compliance with the fund's investment strategy
• Monitoring of the fund's net asset value calculations and reviewing the fund's investment performance
• Appointment and performance review of service providers
• Review of the adequacy and accuracy of information provided to investors by the fund's management

Factors to Consider When Selecting an Independent Board of Directors

Board Structure and Composition

While most offshore hedge funds have boards, requirements can differ by jurisdiction and fund type. While it’s common in jurisdictions like the Cayman Islands, Bermuda, and BVI, there are exceptions, and requirements may vary depending on fund structure and local law. In the context of U.S.-organized, the manager would establish an advisory board composed of independent members.

Regardless of the jurisdiction, a board with a majority of independent members demonstrates that the manager cares about proper supervision and is willing to be overseen by professionals who may challenge its decisions. For example, the Cayman Islands law does not require a majority of independent directors, though investors may expect it.

Independence

Investors expect an independent director to be free from conflicts of interest with the fund, its employees, and service providers, so that nothing interferes with the exercise of independent judgment in carrying out their duties.

Requesting written affirmations of independence in advance of everyone's appointment is recommended as a best practice.

Qualifications

The independent director should have adequate expertise on a wide range of matters, such as portfolio management, operational and transactional due diligence, audit, legal, and regulatory issues, current market trends, general fund operations, etc.

Not every independent member needs to have all these skills, but they should be collectively represented to have a qualified board.

Capacity

The independent director should have sufficient time to allocate to the operation of the fund to meet fiduciary responsibilities and to maintain the fund’s compliance with industry best practices for corporate governance. The analysis should not focus solely on the number of funds in which the director serves. It may also include a qualitative analysis of the portfolio, fund structures, and trading strategies of those funds. The infrastructure should be available to the director, so that they can perform their duties efficiently.

Board Diversification

Investors are paying more attention to diversity on hedge fund boards. By having a mix of professional and personal backgrounds (gender, socioeconomic backgrounds, expertise, etc.), boards can enhance decision-making, improve risk management, and showcase a commitment to good governance, while attracting a wider range of investors.

Key Factors for a Successful Board Meeting

It is also imperative that board meetings be scheduled periodically, followed by an established agenda and proper minutes. Before the meeting, it’s important to send information so they have enough time to review and prepare. The information provided to the board should not merely include a net assets value (NAV) figure, but should comprise detailed accounting reports, such as:

• Financial statements and supporting documents
• Detailed investment portfolio
• Fair market value estimates for non-marketable investments
• Expense allocation reports
• Capital transactions
• Securities transaction reports and names of executing brokers
• Anti Money Laundry reports
• Compliance and risk reports

Benefits of an Independent Board

In today’s complex regulatory landscape, establishing and maintaining independent boards isn’t just a best practice; it’s a strategic advantage. Hedge fund managers and investors must prioritize robust governance structures to build trust, enhance transparency, reduce liability, and drive long-term success. Contact us below to learn how independent boards can elevate your portfolio.