Private Funds Need Bolder Boards

The days of ‘rubber-stamping’ Cayman directors are over

If “carried interest” is not enough to fret about, US private equity and hedge fund managers now face the unwelcome prospect of “independent” boards.

The model of a couple of professional Cayman Islands directors performing a perfunctory oversight role no longer cuts the mustard. To both regulators and institutional investors around the world, ‘good governance’ of a private investment fund today is one in which its managers account for their activities to qualified outside directors who aren’t their lawyers, accountants or investors in their funds.
The Cayman Islands are a perfect laboratory for taking the temperature of the global private funds industry. The Caymans host more than 10,000 of the world’s private investment funds of which, according to a recent survey, 26% have no independent directors at all. Interestingly, US-managed funds lag far behind those of the UK and other Commonwealth countries in answering to externally-controlled boards (44% versus 72%).

The Caymans are also the bailiwick of a professional cadre of lawyers, accountants and fund administrators who each occupy dozens if not hundreds of private fund board seats. These so-called “jumbo directors” fill as many as 60% of the external directorships among Cayman-domiciled funds. Although well-trained and respected professionals in their own right, this select group of outside directors – who are paid from $5,000 to $30,000 a year for each directorship – could not possibly fulfill their serious duties as directors with the number of funds they oversee. Industry participants know that many Cayman directors cannot really provide much more than ‘rubber stamps.’

At the beginning of this year, the Cayman Islands Monetary Authority finally addressed this infirmity in its private fund governance regime by announcing the creation of a private fund registry listing the directors of each Cayman-domiciled fund and their qualifications to sit on private fund boards. The registry will be available by subscription to regulators and investors for due diligence purposes. CIMA will also now require Cayman fund directors to obtain its permission to sit on more than six fund boards.

For the founders of private investment funds, the prospect of genuine external supervision is perhaps even more antithetical than ordinary income treatment of their sacred carried interests.

For the founders of private investment funds, the prospect of genuine external supervision is perhaps even more antithetical than ordinary income treatment of their sacred carried interests. It is no secret that they form their management companies as private partnerships so that they can run their funds without interference from boards of directors or public shareholders. Although some of the largest fund managers have gone public to secure permanent capital, virtually all privately-offered funds – big, small, domestic and foreign — are currently dominated by a few strong personalities who, up to now, have never had to seek or brook any outsider’s management views.

A board comprised of truly “independent” directors would significantly alter the character of virtually every private equity, venture capital, real estate and hedge fund on earth. Even those funds which currently have external directors would now be duty-bound to keep their outside directors closely informed of internal fund developments and involve them in many more business decisions than their private fund managers would ever do voluntarily.

Until now, the term “institutionalization” used to describe the need on the part of emerging private funds to erect sophisticated infrastructures in order to attract institutional capital and satisfy complex SEC compliance and reporting requirements. CIMA’s ‘good governance’ initiative signals the importance to the global investment community of generally more effective oversight of private funds with wide-open investment strategies and ‘animal spirit’ managers. This newly-expanded definition of “institutionalization” now also extends to the world’s largest and most successful private investment funds.

In the wake of Amaranth, Bernie Madoff, the insider trading scandals and fairly unimpressive performance since the global financial crisis, private investment funds are in a weak position on the issue of independent oversight. Elite funds may be able to fend off the inevitable for awhile; the vast majority of private funds, however, will have no choice but to adopt best practices. To make matters even more disagreeable, private fund managers will have to respect the fact that their non-executive directors are going to be subject to the governance standards enunciated in the Weavering cases, which imposed eye-popping fines on the rubber-stamping directors of a UK/Cayman fund complex (see More Bad News for Hedge Funds with Domineering CEOs). Given the circumstances of the private fund industry today, how long do you think it will take for the SEC or a US court to impose similarly onerous duties on the independent directors of a US private investment fund?