The hedge fund market crossed $3 trillion in assets at the close of 2014. These private funds, often incorporated in offshore jurisdictions as limited liability companies exempt from taxation, continue to attract investors seeking appealing absolute returns in a low interest rate world.
The privacy that is attractive to these investors, many keeping their funds offshore as an accepted way to avoid taxes in their home jurisdictions, is a two edged sword as there is little ability to hold the manager accountable. Understanding the way these funds work becomes, therefore, very important for investors considering investments in this arena. Unhappy investors, having asserted themselves to be sophisticated enough to accept the risk associated with these private investments, have little recourse should things not go as hoped.
To organize such funds offshore, the US based prospective manager typically engages a US law firm to advise on structure, and an offshore firm is in turn typically engaged to form a limited liability company, and the memorandum and articles of association created.
Fund offering documents are often drafted to retain maximum flexibility for the manager and list every possible risk factor, which has the effect of absolving the manager from responsibility under virtually all loss scenarios. The offshore vehicle, typically a corporation, requires the existence of a board of directors, responsible as the governing body for overseeing the affairs of the corporation. In an often overlooked wrinkle, however, the offshore company typically issues participating shares to the company’s investors, who receive the economic benefits of investment, and the manager receives shares that carry the voting rights of the company, and thus controls the appointment and removal of directors. The board is typically comprised of manager appointees and professional directors supplied by affiliates of the offshore law firm or the offshore registered agent.
Why focus on this? A number of the apparent safeguards there to protect investors depend significantly on the hegemony of the board of directors as the ultimately responsible party. At the same time, however, the board is fundamentally a creature controlled by the manager. Its ability to act as an independent fiduciary is thus illusory, and therefore dangerous. Though various regulatory and industry organizations defer to the ultimate authority of the board when defining desired practices, the board cannot use its authority without the agreement of the manager.
As an example, many parties assume that, if a recognized administrator has accepted appointment, it will independently price the portfolio, keep the books, and calculate the NAV. From the administrator’s point of view, however, responsibility for pricing lies with the board as governing body. Administrators increasingly accept manager prices for hard to value instruments, which are, of course, proliferating. These instruments, to which much of the alleged excess return is often attributed, are the very ones for which independent oversight is most critical.
Clearly, pricing of investments is the most critical function in the entire process of managing these funds, and often the most difficult. Were these funds not organized as companies with a perpetual life, discrepancies might not matter as the value would come clear at fund termination, when realized value would tell the tale. These are, however, open ended vehicles with no finite life. And managers are typically paid a management fee as much as 2% of assets and an incentive fee as high as 20% of upside.
So, we have managers controlling the board of directors not just de facto but de jure. We have administrators unwilling or unable to independently price the manager’s portfolio, which is more and more often comprised of hard to value instruments. We have an open ended structure in which there will never be a day of reckoning to determine the realized value of those hard to value holdings selected by the manager.
Finally we have managers being paid not only their fees but also their incentive compensation based on values that have been provided by the very same manager who is being paid on the basis of those values. And we are operating in a market in which there is no public visibility for results and no recourse for investors.
Many investors, as well as other parties involved, may be unaware of the extent to which the manager is both in total control of these funds AND incentivized to manage portfolio pricing for the manager’s benefit. No matter how honorable the manager’s intentions, the scale of the money involved and the lack of manager accountability create monumental temptation. Though $3 trillion says this is an attractive marketplace, that same $3 trillion and more might appreciate reform.
Excerpted from article appearing in the April-June issue of Risk & Compliance Magazine. To see the entire issue, click here.