The Importance of Good Governance for Asian Investment Funds

The evolution of the investment fund industry continues apace in Asia as Hong Kong and Singapore gain greater maturity as fund centres, with the planned introduction of new domestic fund vehicles and a growing appetite for international capital.  At the same time, there has been a move towards the adoption of higher standards of corporate governance for funds managed in Asia which, from an institutional investor perspective seeking exposure to the region, can only be seen as a positive development in the mirroring of practices more customary in the US and Europe.

While Western style investment funds have always been quite prevalent in Asia, there are also significant numbers of funds, characterised by more of a focus on raising capital from friends and family investors, as well as acting as a conduit for investment on behalf of Chinese institutions and entities through Cayman Islands vehicles.  Average fund sizes from Asia of this type are also comparatively smaller and with less demand from these investors for the kind of corporate governance policies that have been fundamental over the past decade in Western investment markets, there has to some extent been less incentive for managers to  incur the additional  costs that would otherwise come out of performance.

Times have changed, however.  While there is little doubt that Asian capital is becoming far more influential on a global scale, there is also a realisation that for Asian managers seeking to attract institutional money and build up their track record, it is essential to have the right infrastructure in place, which includes a solid approach to corporate governance.

Independent Oversight for Institutional Allocations

For an open ended Asian fund to register on the radar of Western investors, in the current climate, it needs to have features and qualities similar to the Cayman Islands hedge funds that they are familiar and comfortable with.  As far as robust corporate governance goes, that includes the presence of experienced independent directors on the board, with full oversight of all of the fund’s operations and service providers.  It also means holding regular board meetings, with all decisions taken and matters of business considered and fully documented, as well as ensuring the fund operates free from any conflicts of interest in accordance with all relevant laws and regulations.

Many North American and European institutional investors would argue that these basic principles represent the minimum standards they would expect to see for a fund in today’s complex global regulatory environment.  When the financial crisis sharpened attention on issues of governance and safeguarding the interests of a fund’s investors, these standards evolved as many funds attempted to implement measures to prevent investor redemptions.  Events culminated with the landmark Weavering Macro Fixed Income case, which collapsed in 2009, with damages of US$111 million awarded by a Cayman Islands court against the directors who were related to founder Magnus Peterson, who was subsequently jailed for 13 years in the UK for fraud.  The directors were harshly criticised for a complete absence of governance procedures and failing in their supervisory duties, including not reading quarterly reports or requesting information from service providers, not holding board meetings or reviewing accounts and numerous other shortcomings, all of which left the manager’s fraud unchecked.

In addition to the independence, which was completely lacking in the Weavering case, what can often make the difference for a sophisticated investor in terms of allocating capital is the level of experience that a professional independent director can bring to the table, in terms of their familiarity with the types of issues that can typically arise, whether a fund is gearing up for launch, investing in hard-to-value assets or communicating to investors in a stressful scenario.  Furthermore, experienced professional independent directors, particularly where they can leverage on an institutional infrastructure, will have that additional insight and ability to apply collective knowledge and best practice to funds across the spectrum of strategies, anticipating problems before they occur and bringing a greater level of comfort to investors.

Importantly, investment managers and advisors appointing independent directors are well advised to thoroughly research the background of potential candidates, rather than just relying solely on word of mouth.  In Asia, there is increasing regulation generally and certainly greater scrutiny by regulators  of directors. For example, the Monetary Authority of Singapore is considering the introduction of a fit and

proper test for directors of its new Variable Capital Company (“VCC”) vehicle which will launch shortly.  With the greater emphasis on directors meeting and adhering to such criteria, it’s fair to say that funds will face negative consequences for the failure to do so, regardless of the jurisdiction.

Going hand-in-hand with independent oversight and crucial to the fortunes of managers in Asia seeking institutional allocations, is a familiarity with the operational due diligence procedures that are now firmly embedded into the fabric of major investors.  Performance may tell one story but the days when an impressive track record would mask any concerns about the day-to-day operations of a hedge fund are long behind us.  Investigations into the background of directors, conducted either by regulators or due diligence consultants, will also examine their track record with regard to any failed funds that they have been involved in in the past.  How directors performed on those occasions, as well as any market feedback on directors deemed unreliable, acting improperly or going rogue in times of stress, could present a problem, as could cases where directors are seen as being too close and subservient to a manager’s interests.  Truly independent directors add significant value to a fund’s corporate governance practices but if a director is dependent on a particular manager’s engagements for his or her livelihood, then their level of independence can be called into question.

As Asian managers look to replicate best practice from North America and Europe, it is vital to understand how not just the structure of their business but every aspect of their policies and procedures, will be scrutinised by pension funds, endowments and other institutional investors.  There are many things that an investment manager may have paid little attention to previously that will be imperative to potential investors.  It’s not only about performance anymore and managers should be aware of the extensive list of concerns institutional investors will have when assessing a fund, as well as the ability to identify the parts of their infrastructure that may be in need of some attention.

Key areas under the microscope will be the organisation of management and ownership, with manager interests expected to be aligned with investors, as well as the composition of the investment team and reasons for any unusual departures.  Other questions will drill down on issues related to audits and service providers, as well as policies and procedures regarding outsourced functions and how they are reviewed.  Managers can also expect their own accounts to be closely examined, while risk management and compliance functions, along with IT systems and cyber security policies will all need to come up to scratch.  Further  probing will likely consider a fund’s regulatory status and general back office capability, alongside the relatively more recent focus on environmental, social and governance (“ESG”) factors.  From an institutional investor’s perspective, a fund’s ESG principles are becoming more important  both in terms of  its  investment policies and operational activities.  That means funds globally, with Asia being no exception, will need to demonstrate a commitment to promoting ESG in investment decisions, with a focus on sustainable investing and avoiding sectors like alcohol, tobacco and armaments, in addition to issues related to diversity, equal opportunities and remuneration at the operations and board level.

Local Knowledge – Global Expertise

As the investment funds sector has grown in Asia and attracted more attention globally, the presence of independent directors has become  an important check and balance for investors.  While both Hong Kong and Singapore have developed rapidly as key fund centres in Asia, they are only the tip of the iceberg for the region.  The real weight of money is focused on the power bases of Beijing and Shanghai, where Hong Kong has also been able to exploit its close links to mainland China, with a similar culture and shared language.  Given the opaque nature of business activities in China, investors can be apprehensive, so the ability of service providers to offer local language capability with fluency in Mandarin and Cantonese can be a major plus point, along with the provision of time­ zone sensitive responsiveness.  These factors have meant the traditional model, therefore, of two Cayman Islands-based independent directors and one locally­ based representative of the manager has also been accompanied by a number of Asian-based directors operating outside of Hong Kong, who can provide the added advantage of greater familiarity with Asia and its assets, strategies and markets.

Key recent developments in Asia, designed to attract more funds to the region and increase the development of Hong Kong and Singapore as major asset management hubs, have implications for management firms and raise key questions regarding effective corporate governance, in line with the more pronounced onshore regulatory environment.  In Hong Kong, the advent of the Open Ended Fund Companies structure in July 2018 allowed managers the option to establish a domestic fund as a company, having been previously restricted to the unit trust form, providing greater choice of investment vehicles and more effective international distribution.  More recently, the Financial Services and Treasury Bureau tabled amendments to Hong Kong’s tax exemption policy which allows onshore domestic funds the same exemption on the tax on profits provided to offshore funds.  Singapore, meanwhile, is well advanced with the introduction of its VCC product, which provides a flexible domestic corporate structure suitable for collective investment schemes, with tax incentives to help attract the investment management industry to Singapore.

From a corporate governance perspective, a Cayman Islands-domiciled fund, managed in Hong Kong can now obtain preferential tax treatment  with a full board of Hong Kong resident directors. This can be highly beneficial for local managers who wish to avail of personal contact with directors in the same time zone, while independent directors across Asia provide further convenient options for funds in Hong Kong and Singapore.  There is also the building view that Singapore is a safer choice for assets than Hong Kong by being out of reach of China and even some large Chinese managers have expressed that opinion, underscored by the recent democracy demonstrations.

All these developments bring into focus the highly specialised and niche role that Cayman Islands independent directors perform, highlighting the contrast between fiduciaries possessing significant experience of global fund issues, compared to resident non-executive directors who may have experience that is more limited to the local market. Cayman Islands fund directors are well placed to demonstrate their deep understanding of fund operations and industry practices with a truly global perspective.  As managers in Asia seek to grow their business with the backing of Western based institutions, it will be helpful to their success that such investors are comfortable with their corporate governance policies and infrastructure.  With a continued alignment to the standards more evident in the US and Europe and increased pressure on open ended funds to appoint independent directors to their boards it will often be the case that directors with the greatest experience will make the greatest difference.