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Conflicts of interest in hedge funds: Avoiding pitfalls with a culture of independent governance

By Chris Day, Director, Carne Group

First published in Q1 2013 edition

This year will see increased emphasis on the part of both investors and regulators on conflicts of interest within hedge fund management firms. Both the SEC and FSA have clearly outlined what they now expect from hedge fund managers in terms of active management of conflicts within their businesses.

In the UK, the FSA has already identified that many firms are failing to provide an adequate framework for managing conflicts of interest, including the use of customer commissions and fair allocation of trades between customers. It pointed out that the best control frameworks were those that went beyond the demesne of the compliance and legal functions to established committees within the firm, including senior management and non-executive directors. 1

Regulatory noises aside, the threat of legal action by investors is a very real danger, and fund managers will need to ensure that they have a conflicts policy in place which is independently verified and documented. This can help them to show a court that they are taking their fiduciary duties seriously.

Bruce Karpati, Chief of the SECs Asset Management Enforcement Division, has highlighted conflicts of interest within hedge funds as a regulatory priority in 2013, saying in a recent speech that: Because some hedge fund managers control every aspect of their business, severe conflicts of interest can arise. The fund manager may have the opportunity and incentive to put his or her interests ahead of investors. Related party transactions, through which the manager can misappropriate money by engaging in self-serving transactions or to hide losses, are examples of these types of conflicts. 2

Karpati also highlighted some other critical areas for conflicts of interest, including preferential treatment for investors via side letters or superior redemption terms. Commonly managed accounts, allocation practices, affiliated broker dealers, undisclosed compensation arrangements, soft dollars and best execution are also considered areas open to abuse. The lack of independent governance, Karpati argued, leaves hedge funds open to conflicts. Hence, the US regulator is being open about its plans to focus on how fund managers are addressing these issues in its inspections and the actions of its AMU unit.

For example, in June 2012, the SEC filed fraud charges against Harbinger Capital Partners for alleged illicit conduct, including preferential treatment of certain clients. In particular, it is alleging that Harbinger conferred preferential redemption and liquidity rights on some of its investors. 3

It is worth considering closely, in light of these observations, which areas within a hedge funds day-to-day operations can be subject to conflicts, and which may need to be addressed.

Cross and principal trades: Potential risks exist in the trading of securities between two or more funds. The presence of an independent advisory committee, including independent directors of the offshore funds, can help to ensure that investments are appropriately priced and suitable to the structures they are transferred to.

Side by side management / trade allocation: This covers the allocation of investment opportunities between funds managed by the same investment advisor. Conflicts can occur if preference is given to funds on the basis of the fees they are charged.

Manager pricing: Managers need to be very careful where assets are hard to price and there could be a perception of bias on their part in valuing the portfolio. Additional checks and balances should be instituted if it is not possible for an independent administrator to fulfil this role. There should be a written valuation policy to ensure that there is an independent sign off on pricing that departs from readily available pricing sources. The policy should include a hierarchical approach depending on the degree of discretion being used in the pricing decision and the board should be the final decision maker.

Incentive systems: While incentive-based remuneration systems have long been part of the hedge fund industry, they can also create conflicts, encouraging portfolio managers to take additional risks. Risk management policies must be created and enforced at both the firm and fund level.

Suspending redemptions / gating: Decisions to suspend or gate should only be made in the best interests of investors. Managers should not be capable of unilaterally taking this action. The effecting of a suspension or gating mechanism should as a minimum require the agreement of the independent board or preferably be entirely at the discretion of the board. These actions should not be available as a business continuity strategy for the manager.

Side Letters: They should only be executed with approval from legal counsel and the funds board of directors. In addition, care should be taken that new letters do not conflict with existing letters. Furthermore a register of side letters should be kept to assist in managing the obligations and rights conferred by these agreements.

Onshore / offshore governance gap: Current practices with onshore funds (e.g. Delaware) means that there is more scope for conflicts to emerge with limited partnerships of LLCs. Conflicts can occur between onshore and offshore vehicles, for instance if assets are comingled at the master fund level.

Director level conflicts: Fund boards will not be considered fully independent if the majority of directors are conflicted. This can include directors who are friends and family members, employees of the investment manager and legal counsel. Investors now want to see a majority of independent directors on fund boards as a matter of course.

Order bundling / allocation: The aggregation of different orders can be disadvantageous for some investors. Investment managers need to be careful that large buy orders do not make transactions unduly expensive, for example. Best execution should be monitored closely.

Broker relations: Best execution policy should be followed when choosing a broker for the fund and where research is provided to a trading desk / portfolio manager on behalf of the fund. Bias towards brokers in the same financial group or prime brokers that provided seed capital can still be regarded as a conflict of interest.

Investment management: Execution of the investment strategy must adhere to the parameters within the funds offering document. Managers should not deviate from the prescribed strategy. The funds board of directors must be alive to the possibility of style drift.

Group level conflicts: For funds being managed by a larger financial group, care must be taken when selecting services from within the group. Directors of the fund must be satisfied that the service being provided has been chosen from a level playing field.

Implementing a proper conflicts management policy

In its Dear CEO letter, the UKs FSA made it clear that it regarded proper management of conflicts of interest as the responsibility of a firms senior management. Conflicts committees established within a firm and staffed purely by compliance and legal personnel who have no voice at board level can be less effective. The FSA cited one example of a firm where a committee chaired by a non-executive director was more effective in ensuring that a consistent culture of good governance was maintained.

The more documentary evidence that a hedge fund manager can provide to support the decision making process, and illustrate how this was carried out with investors best interests in mind, the easier it will be to defend against accusations to the contrary, whether they come from stakeholders in a fund (and their legal advisers) or from regulators.

The role of fund boards

While the consistent enforcement of a written conflicts policy within a firm will go a long way towards addressing these concerns, fund boards with a majority of independent directors can act as an additional level of assurance for the investment manager. Fund boards that are operating a robust governance process will provide an additional layer of verification that investors interests are considered first and foremost.

If a hedge fund is seen to be establishing and maintaining a conflicts of interest policy which is both practical and fully documented, investors are more likely to be assured that the fund manager will work to ensure their interests are protected. By involving independent bodies like fund boards, conflicts policies can be further reinforced.

Hedge funds are more focused than ever before on winning and retaining institutional mandates. An important part of this is being able to clearly demonstrate that formal and enforceable procedures are in place to protect the interests of stakeholders.

[1] Conflicts Of Interest Between Asset Managers And Their Customers, Financial Services Authority, November 2012

[2] Enforcement Priorities In The Alternative Space, speech by Bruce Karpati before the Regulatory Compliance Association, New York, December 2012

[3] SEC v Falcone, No.12 Civ. 5027 (SDNY filed June 28 2012); SEC v Harbinger Capital Partners, No. 12 Civ. 5028 (SDNY filed June 28 2012)