06/05/2011 Author: Don Seymour

Comment: Don Seymour

Don Seymour is the founder and a managing director of dms Management 

Defining Institutional Quality Fund Governance

Today’s investors are calling for more transparency into the fund governance process, innovation, and mastery of the demands of growing institutionalization challenges. These demands are completely reasonable. Primarily, investors are seeking to mitigate the operational risks revealed by the financial crisis, but they also need to conquer new challenges in AIFMD, FATCA, Dodd-Frank – and the uncertainty of the unknown. Institutional investors, in particular, are no longer relying on the illusions created by marketing pitches and now verify through detailed on-site due diligence, applying post-crisis lessons in a rigorous and disciplined way, to truly understand which fund governance methodologies are really proving effective.

Effective fund governance is a process – a system of checks and balances – all working together to support the four pillars of investor protection that are fundamental to the success of the hedge fund industry; specifically investors expect that:

·         their investments will be managed in accordance with the fund’s investment objectives;

·         the assets of the fund will be kept safe;

·         when they redeem they will get their pro-rata share of the fund’s assets; and

·         the fund will be managed for the benefit of the fund’s investors and not its service providers

Other key fund service organizations like managers and administrators have, for many years, adopted institutional quality practices to deliver on the four pillars commitments, so this transformation seems long overdue for fund governance service organizations – but how exactly should fund governance evolve?

What it means now

The obvious answer is institutional quality infrastructure to support the fund control structure, but simply spending big on infrastructure won’t deliver superior performance.  Smart investment in critical areas is the key. 

People. Fund directors need to hire skilled staff with industry-focused expertise to assist them in applying robust governance standards and maintaining the ideals of excellence that should be achieved. This also means investing in professional qualifications and continuing professional training so the staff knows what to expect in a fast moving industry.  Even succession planning for what happens if the director is ever not available, including disability and death. 

Quality assurance process. How the people, process and technology interact with the fund organization design.  Ideally this process should be certified to an internationally recognized standard such as SSAE 16 (formerly SAS 70) or ISO 9001.   An annual external audit by an internationally recognized major accounting firm is mandatory.

Risk management.  Written policies and procedures that demonstrate the directors have a clear understanding of common operational risks, have developed sound plans to manage them and can withstand scrutiny about how the directors are consistently dealing with these risks in a sustainable way. 

Data security.  Systems that meet the realities of our modern digital world.  If you have ever been the director of a fund that was targeted for fraud by an international gang of cybercriminals resulting in an FBI investigation, you grow to appreciate the value of institutional quality data security controls over fund records.  Yes, truth is indeed stranger than fiction.

Recordkeeping.  Systems that are designed to improve the documentation of a fund’s board and the basis that will assist stakeholders in determining – in a specific, observable and measurable manner – whether fund directors are fulfilling their fiduciary duties and responsibilities to the fund. This is particularly important for regulated managers. 

Business continuity.  Systems that give the ability to survive and manage through catastrophic events.   

Scalability.  Systems that can manage growth and also keep pace with trends, including globalization, as today’s asset managers are increasingly becoming mini-multinational organizations.   

Compliance and Internal audit.  Robust compliance management and internal audit systems should be established and working effectively. Both are necessary to achieve an objective assessment of the efficacy of the risk management policies and procedures.   

Reporting. Systems that facilitate the immediacy of accurate information reporting to investors, regulators and other stakeholders.

What it means in future

Investors will continue to propel advancements in fund governance.  They will increasingly seek fund governance service organizations that share their mindset, values and commitment to protecting and maximizing investors’ interests.  DMS believes that three investor - driven themes are likely to emerge:

·         Consistent fund governance standards across the fund structure.  Onshore funds implementing the same governance standards as offshore funds.

·         Shareholder meetings to assist investors in better defining and communicating their expectations to narrow the expectations gap.

·         Independent due diligence certification prepared on the fund under the supervision of fund directors and made available to all investors.

These are all very positive future developments for investors and fortify the alignment of interests.  Fund directors cannot be satisfied with an incremental approach in a rapidly evolving industry and must embrace the highest standards of best practices in their fund governance work.  Unless directors take a holistic view of today’s fund governance landscape and make the investment necessary to adopt institutional quality practices, they will not deliver the value expected from them.