Guiding Principles For Hedge Fund Governance: MAY 2010
Overview The relationship between investor and hedge fund is a partnership that must be based on overarching principles of fairness, integrity, and fiduciary responsibility. Periods of extreme dislocation in capital markets have posed challenges to that partnership, and produced unwanted outcomes for all parties. Market experiences and industry developments have highlighted areas in which both the spirit and contract behind that partnership can be improved. We have identified four guiding principles of hedge fund governance that should serve as a framework for transforming manager/investor partnerships and the industry as a whole. These principles are neither exhaustive nor prescriptive, but they do point toward best practices that, if implemented, should ensure the proper alignment of interests between investors and managers. These principles should not only strengthen those partnerships, but increase the viability of the industry as a whole. 1. 2. 3. 4. Investor Rights and Fund Governance: Welldefined governance procedures must strive to ensure open communication and the alignment of interests between investors and managers. Alignment of Incentives: Fee structures should properly incentivise and appropriately reward managers for delivering value-added performance and prudently managing risk over a market cycle. Managers and investors should have compatible incentives, restrictions, and expectations. Capital Access: A fund s liquidity structure should be appropriate to the strategy pursued. The liquidity structure should also properly match the fund s assets and liabilities, and in particular, the fund s potential redemption obligations. In addition, managers should make every effort to comply with their funds stated liquidity terms. Transparency: A sufficient level of information should be available from managers so that investors can appropriately gauge the investment and business risks the funds are undertaking. Improved transparency should make for better-informed clients and healthier partnerships. Mesirow Advanced Strategies, Inc. 2
Investor Rights and Fund Governance: Well-defined governance procedures must strive to ensure open communication and the alignment of interests between investors and managers. Control & Valuation of Investments Outsourced fund administration should be provided on all funds, both onshore and offshore. If however, use of a third-party administrator is impractical, there should be established procedures and controls governing asset existence and valuation. Valuation and audit service providers should be wholly independent of the manager. Investor Rights Investors of similar size and complexity should have similar terms. Significant variations on material offering terms should be prudent, approved by an independent board, and disclosed to investors. Side letter terms should be described to all investors upon request. For strategies that are not intrinsically and wholly illiquid, investors should be allowed to opt out of side pocket investments. Limits on investor-level (not fund-level) side pockets should be predefined. An investor should be permitted to transfer its interest in a fund to a new or existing investor, except in extraordinary circumstances. Where appropriate, key man provisions should be required and should apply to individual principals, rather than a group of principals. No penalties, locks, or fees should apply if redemptions are associated with a key man event. Key man provisions should be detailed within the Private Placement Memorandum and should not be relegated to side letters. Fund Governance Like outsourced administration, we believe that fund governance should be outsourced to a body that is independent of the manager, consistent with legal and jurisdictional appropriateness. For companies, the structure for this body already exists in the form of a board comprised of directors that under the corporate laws of the relevant jurisdictions have fiduciary obligations to the fund and its investors. The voting majority of those boards should not be affiliated in any way with the manager. There are no parallel statutory concepts for limited partnerships and limited liability companies. Therefore, partnership/membership agreements or other governing documents should be closely scrutinized and held to high standards. Such documentation should provide shareholders with contractual rights and oversight mechanisms that help to protect investor interests, similar to the oversight of independent boards. Independent boards should ensure a fund is being operated fairly and equitably by being active in their oversight of the operation of the fund. Consistent with this objective, board members should limit the number of board appointments they accept to an appropriate level. Independent boards should be comprised of persons with differing areas of expertise (accounting, legal, investing, etc.). Independent board members should act in the best interests of the fund and its constituent investors, particularly in situations where the manager s interests may conflict with investors. Independent boards should be receptive to direct contact from investors and should have clear authority to override the manager as necessary to advance investors expressed wishes. There should be an effective, well-defined process pursuant to which a significant group of investors can (a) require the independent board to call an investor meeting and/or (b) change the membership of the independent board. Independent boards should facilitate communication among investors who wish to speak with each other to discuss concerns regarding the fund. Mesirow Advanced Strategies, Inc. 3
Alignment of Incentives: Fee structures should properly incentivise and appropriately reward managers for delivering value-added performance and prudently managing risk over a market cycle. Managers and investors should have compatible incentives, restrictions, and expectations. Management fees should be used principally to cover operating expenses of the business. Management fees should be compatible with the size of the management firm and should be appropriate to the size of an investor s allocation. Where appropriate, tiered fee structures should be used so that larger investors do not disproportionately subsidize operational costs. Performance fees should be designed to reward outperformance versus a pre-defined return objective over market cycles. Performance fees should be appropriate to the strategy pursued and should align the manager with long-term investor interests. - We believe that investors should pay for performance in excess of cash returns; therefore, performance fee structures should typically include a hurdle rate. - Investments should be subject to only standard high water mark provisions. Disappearing high water marks should generally not be allowed (with the exception of certain short selling and other niche strategies). Provisions that pay managers for performance while investors still have losses should be strongly discouraged. - To the extent possible (with consideration for tax and other requirements), no performance fees should be paid during lock up periods (hard or soft). - Realized and unrealized losses in side pocket accounts should offset gains in the liquid capital account over a predetermined period. - Performance fees should, to the extent possible under tax laws, be subject to deferral periods, claw-back provisions, or other fee-smoothing mechanisms that harmonize investor and manager interests; this is especially true for strategies with higher potential for significant volatility. Expenses and reserves charged to the fund should be fully disclosed on a periodic basis (not less frequently than annually). - Expenses above a predetermined level should be justified to, and approved by, the independent board. Passthrough expenses should be limited to costs related to the fund s administrative, legal, and audit costs in the normal course of business. All other expenses should be borne by the management company. - Pass-through expenses should be capped at a predetermined level. - Established reserves should be compliant with Generally Accepted Accounting Principles. Any exceptions to this should be fully documented and disclosed. The manager and its principals should maintain and regularly disclose a material economic interest directly in the fund. Significant advance notification of material principal withdrawals should be required. Pro-rata liquidation rights should be available to investors in instances of material principal withdrawals on coincident redemption dates, irrespective of pre-existing liquidity constraints. The liquidity terms on which the manager and its employees invest in a fund, including the prior notice period, should be no better than those of the investors. Mesirow Advanced Strategies, Inc. 4
Capital Access: A fund s liquidity structure should be appropriate to the strategy pursued. The liquidity structure should also properly match the fund s assets and liabilities, and in particular the fund s potential redemption obligations. In addition, managers should make every effort to comply with their funds stated liquidity terms. Managers should avoid commingling investors with differing liquidity terms in the same investment vehicles, including friends and family of the general partner. In cases where exceptions to this exist, variations on liquidity among investors should be proactively disclosed. The manager should make its best efforts to immediately liquidate positions in order to satisfy pending redemptions in full. If the manager must distribute in-kind securities, the distribution must be done on a pro-rata basis across all positions insofar as possible. The independent board should be required to concur in writing with any determination by the manager that the fund is unable to fully meet redemption requests. That writing should be provided to investors before the relevant redemption date and should set forth in detail (a) the reasons the manager is unable to fully meet redemption requests and (b) the steps the independent board has taken to confirm (i) that those reasons are legitimate and (ii) that alternatives for satisfying redemptions are not available or not appropriate. If the manager is unable to fully meet redemption requests, no new exposures should be taken (i.e., no additional purchases unrelated to hedging or managing risk related to existing positions) until redemptions are satisfied in full. A predetermined methodology should be used for the implementation and satisfaction of assets that are liquidity constrained through a gate or other mechanism. Specific clean-up provisions should prohibit perpetual gates. Gated funds should immediately offer to deliver underlying positions pro-rata to any investor willing to accept the positions in-kind. No management fees should be charged on capital that an investor has requested be redeemed, but that is not redeemed or returned to the investor because of some event outside the ordinary course. In the event the manager declares a general suspension of redemptions (including gating) that lasts longer than six months, the manager and/or the independent board should call a general meeting of the investors in the funds to discuss the current status and future management of the funds. Mesirow Advanced Strategies, Inc. 5
Transparency: A sufficient level of information should be available from managers so that investors can appropriately gauge the investment and business risks the funds are undertaking. Improved transparency should make for better-informed clients and healthier partnerships. Portfolio level transparency should be appropriate for a given strategy. - Generally, a manager should provide detailed monthly exposure and profit and loss contribution data (performance attribution). - Key risk management metrics utilized by the manager and specific to the manager s strategy and approach should be provided to investors in summary form on a monthly basis, including metrics related to portfolio drawdown estimates, counterparty, leverage, and financing risk. - A fund should report full security level transparency to an independent entity that will provide aggregated risk reporting to investors. - A manager should have transparent and documented valuation policies for all investments. Disclosure/Manager notification requirements - Managers should provide investors with timely and comprehensive information that facilitates the smooth operation of investors own businesses. - Fund offering documents should specifically describe the manager s current strategies so that material strategic/policy changes may be implemented only with prior written notice to investors and the opportunity to redeem before those changes take effect. - A manager should provide proactive notification to investors of material changes to the manager s investment mandate or business structure, including but not limited to changes in service providers, employee turnover, legal actions/litigation, asset levels, and investment footprint or strategy. An Evolutionary Framework This document provides detail as it relates to specific implementation of the guiding principles and our current views of best practices in this regard. It is important to note that these practices will continue to evolve. Further, there remains some room for exceptions to certain applications outlined in this document based on current market practice, practicality, and specific facts and circumstances of particular managers, strategies, and investments. We hope to continue to see best practices evolve in the direction outlined by this document; and we believe the long-term health and growth of the industry can be best sustained through broad acceptance of many of the concepts outlined here. Mesirow Advanced Strategies, Inc. 6
Disclosures This information does not constitute an offer to sell or solicitation of an offer to buy any interest (an Interest ) in any investment fund sponsored, managed or advised (a Fund ) by Mesirow Advanced Strategies, Inc. ( MAS ). Any offer of an Interest will be made only to qualified investors by way of the approved offering materials for the relevant Fund and only in jurisdictions in which such an offer will comply with applicable rules and regulations. Funds invest in illiquid investments and are themselves illiquid, and are not suitable for all investors. Funds are less liquid than mutual funds and are not subject to the same regulatory requirements as mutual funds. Funds invest in hedge funds advised by third-party managers. Hedge funds engage in securities trading that is speculative and involves a substantial risk of loss. Hedge fund performance may be volatile. An investor could lose all or a substantial amount of its investment Interest. There can be no assurance that any Fund s investment objectives will be achieved, or that any Fund will achieve profits or avoid incurring substantial losses. Hedge funds may involve complex tax structures and delays in distributing important tax information required for income tax filings. Additionally, commodity trading involves a substantial risk of loss. Risks of investment include market, tax, partnership, operations, event risks, use of leverage, lack of liquidity in markets, use of derivatives, volatility of returns, restrictions on transferring interests, credit and regulatory risks, unrelated business taxable income, manager risk as well as risk associated with the Fund s specific investment strategies and asset allocations, including illiquidity, manager independence, strategy concentration or correlation and systemic market risk. Opinions, statements or thoughts are subject to change at any time without notice and do not constitute the rendering of legal, tax, accounting or other professional advice. The Mesirow Financial name and logo are registered service marks of Mesirow Financial Holdings, Inc. 2011 Mesirow Financial Holdings, Inc. All rights reserved. Mesirow Advanced Strategies, Inc. 353 North Clark Street Chicago, Illinois 60654 312.595.7300 www.mesirowfinancial.com 7