Protecting Investors: Hedge Fund Governance and Transparency
by Taylor Swope
If you’ve been keeping up with the news, you’ve probably noticed that various hedge funds, particularly SAC Capital, have been in the headlines for questionable behavior. This raises some very serious questions about the quality of hedge fund governance and the level of transparency currently required from funds.
A recent study, written by New York Law School Associate Professor Houman Shadab, analyzes historical hedge fund governance and offers suggestions for how governance can be improved upon.
What are hedge funds?
So, you may be asking yourself, what exactly is a hedge fund? For our purposes, a hedge fund is a “private investment vehicle that is not subject to the full range of restrictions on investment activities, disclosure obligations, and other regulations imposed by federal law on investment companies.” These funds are run by account managers, who are compensated through a fee based on annual profits and performance.
The primary components of hedge fund governance consist of the following:
- Investors that are cautious and quite willing to exercise their short-term redemption rights
- Fund managers that are very sensitive to the correlation between their pay and performance. This is because funds are compensated through an annual management fee (about 2%), a performance fee (usually 20%), as well as their own investment in the funds they manage
- Investor demand for quality governance and oversight
- Monitoring from creditors and derivatives counterparties
Shadab argues that, “hedge fund governance is a form of managerialism because the funds’ underlying legal regime gives managers near complete authority over the structure and operations of the funds they manage.” Managerialism, as defined in the article, is the control of a business enterprise by a manager, while shareholders and directors play a more passive role. However, hedge fund managers still have to appease their investors (limited partners).
Aren’t hedge funds a rip-off?
Shadab claims, “that hedge fund managers are not systematically ripping off investors. This is because empirical studies do not find that fraud or other types of agency costs are pervasive and significant.” His argument is that the market for hedge fund managers seems relatively competitive and well priced.
As can be expected, there are a lot of people who disagree with this sentiment. For example, Edward Siedle compared hedge fund management to theft when we wrote, “I call hedge funds ‘money management on steroids’ because these funds charge fees hundreds of times greater than traditional investments… My friends, if you’re going to steal $1 million, this is the way to do it.”
Shadab seems to disagree with this sentiment on a philosophical level. While critics of hedge funds believe fees are unpredictable (even though they are clearly laid out in a fund’s documents), his argument maintains that governance does just enough to ensure everyone is protected: investors, managers, and directors.
So, what’s wrong with hedge funds?
Shadab certainly doesn’t believe that hedge funds are perfect, though. For example, he believes that, “hedge fund boards do not provide the same level of oversight and responsiveness as do boards in public corporations.” This is primarily due to the fact that hedge funds are not required to have a board, though research suggests investors in funds without a board would welcome the change.
Shadab makes several other suggestions for improvement. For one, it has also been reported that investors prefer hedge fund directors to limit the number of boards they sit on so their attention is not too distracted. He is also very clear that governance around fraud could be improved.
While there is clearly room for improvement, Shadab cites fund performance studies that show investors still come out on top. He writes: “…a recent study found that nearly three-quarters of fund profits go to investors, not managers, which indicates that performance fees are not generally too high or structured to allow managers to be paid before losses are passed along to investors.”
Hedge fund investors are permitted to withdraw funds at any time in response to poor fund performance or governance, although if they have not had the funds invested for a certain amount of time, they may be charged a fee for early withdrawal. And, not surprisingly, hedge fund investors have long desired higher quality governance for several reasons, such as the financial crisis of 2008 and the Bernie Madoff scandal. A study from PriceWaterhouseCoopers found that an estimated 89% of hedge funds make at least monthly disclosures to investors. This aligns with Shadab’s argument that hedge fund managers are not ripping people off because the governance structure makes it difficult to do so.
There are also mechanisms that funds can include in their fee structure to help investors, such as a high-water mark, which is a section of the governance piece that limits managers from profiting from a performance fee until the account regains losses from previous years. There is also the hurdle rate, which prohibits fund managers from being paid unless a minimum rate of return is achieved. Shadab also believes that if managers invest personally in the fund, they will likely make wise choices because they have a personal stake. However, co-investment may also cause the fund manager to be too cautious when brokering deals.
Shadab raises an interesting point about hedge fund transparency in this article. He suggests that, “investors are often better off with less disclosure, higher fees, and less access to their capital.” As could be expected, this is not a popular sentiment among investors. However, Shadab believes that, “complete transparency into a fund‘s specific investment positions may be overwhelming and not provide a basis for investors to make a meaningful comparison between managers.” He also points out that too many disclosures could lead to another trader gaining access to fund information, which will damage the fund’s competitive advantage and ability to provide investors with consistent returns.
On the other hand, Halah Touryalai argues that clear reporting leads to increased operational efficiency and allows investors to focus on what works. Making evidence-based decisions allows everyone involved to strengthen the fund and working relationships. She also says there are software options that allow for targeted transparency so you can pick and choose what data is revealed to whom. However, Shadab believes that the hedge fund industry has shifted (and continues to) toward more voluntary transparency in an effort to appease investors who are concerned they do not know enough about where their money is being invested.
While the ideal level of transparency and the effectiveness of governance are currently being debated, legislators try various methods to help investors. Primarily, the SEC restricts hedge funds’ ability to advertise and potential group of investors. Currently (this may change with the JOBS Act), hedge funds cannot advertise themselves to the general public. In addition, only accredited investors are allowed to invest in hedge funds, since the government deems them wealthy enough to understand the risk involved.
However, if you’re interested in knowing how hedge funds have historically invested, you can read their 13F filings. Though they only list qualifying securities, you can fairly closely watch the investments of long funds (and NYSE Euronext has just petitioned the SEC to reduce the 13F filing period to 2 days).
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