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Growing expectations of independent hedge fund directors

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Institutional investors are forming a larger proportion of the investor base of hedge funds globally.

Institutional investors are forming a larger proportion of the investor base of hedge funds globally. These institutions are highly demanding in terms of the level of returns they seek, transparency they expect and investor protection they demand. Demand for greater investor protection has led to the need for improved corporate governance, which can only be good for the hedge fund industry in general.

It is no surprise that, as institutional investors push for stronger corporate governance, more is being demanded from fund directors. It follows that the role of the fund director has changed dramatically, from one perceived as a largely non-active, fee collector, to a truly active, hands-on player who is not afraid of asking tough questions of management and respective service providers.

At Ernst & Young, we have seen a marked growth in the number of fund board meetings we are invited to attend and the substance of those meetings, with directors posing questions about subjects such as audit, the business, and management.

The auditing rules are also evolving. The Statement of Auditing Standards No. 114, The Auditor’s Communication With Those Charged With Governance, effective for financial periods beginning on or after 15 December , 2006, requires auditors practicing under US standards to communicate with those charged with governance (directors), certain significant findings and issues relating to and from the audit. From our perspective, these communications have been generally well received by directors and fund management alike.

For boards to become even more effective, the shift towards more independent directors must continue to grow. In the past, fund boards were made up of representatives of the investment manager and service providers, such as administrators and lawyers. More independent directors are now being invited to join fund boards, which is a positive step in terms of both the avoidance of conflicts of interest and looking out for the interests of shareholders.

Hedge fund boards will increasingly be expected to function like those of public companies and registered funds, thus, more will be expected from their independent directors. As a result, these directors will be forced to invest more time on boards, monitoring and communicating with the manager and service providers, keeping up to speed with compliance and regulatory issues, and being more strategic in their thinking in this evolving industry. However, the increased involvement will allow them to command a higher fee.

Clearly there are challenges to overcome. Given the pace at which hedge funds are being launched, one has to wonder whether there are enough independent directors out there. A limited supply of independent directors could result in them being spread too thin to truly be effective.

Conflicts of interest and confidentiality issues could arise, with directors serving on the boards of funds that could potentially cross-invest in each other. What about litigation and reputational risk? Perhaps the trending of higher fees will help mitigate and manage these challenges.

Regardless, the role of the hedge fund director is changing for the better and should bring nothing but positive long-term benefits to investors and the viability of the hedge fund industry.

The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young Ltd.

Jessel Mendes has been a partner with Ernst & Young since 1999. Chad Critchley was promoted to partner in 2002. Chris Gauk has been a partner with the firm since 2005. All three work with numerous investment vehicles in the onshore and offshore markets.

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