Applying Enterprise Governance Management to Hedge Funds

Nicholas J Price
The financial world is growing more complex as regulations and compliance become more stringent. Corporations continue to look for ways to comply with regulations while maximizing investments, which is no small feat in today's volatile marketplace. Hedge funds are becoming a front-runner for institutional investors because of the high return potential.

Hedge funds are pools of underlying securities. These funds can invest in a wider range of securities than mutual funds because they aren't regulated by the Securities and Exchange Commission (SEC). The downside is that the structure of hedge funds doesn't factor in governance as a component of responsible investing.

As the popularity of hedge funds increases, investors are becoming increasingly concerned that regulators are allowing governance related to hedge funds to continue to take a back seat. Lack of governance or weak governance leaves investors vulnerable to the ills of reputational damage and other negative business impacts.

Industry standards can hold true where regulations fail to exist. A total Enterprise Governance Management System fills the gap in governance for hedge fund investors by giving investment firms the necessary governance structure to reduce risk.

Risks and Hedge Funds

Hedge funds are consistent with the phrase, 'the higher the risk, the higher the reward.' Hedge funds get their name from the idea that they use a variety of risky strategies to increase gains and neutralize losses as an overall strategy to hedge their investments.

Hedge funds use strategies that are uniquely different from mutual funds. Such strategies may include some combination of:
  • Long-short strategies ' buying stocks
  • Short positions ' selling stocks with borrowed money and buying them back
  • Derivatives
  • Leverage
The long-short strategies work by investing some of the funds in stocks, hoping for a long-term gain, and using a short position for other funds, which means selling stocks with borrowed money and then buying them back at a more favorable rate.

Other funds, called derivatives, are contracts to buy or sell securities at specified prices. Futures and options are considered derivatives.

Leverage is a common term related to hedge funds. It's an investment technique that entails investing with borrowed money, which is a risky venture that, when successful, can lead to strong financial gain.

Hedge Funds Rising in Popularity

The lack of governance pertaining to hedge funds hasn't been lost on many institutional investors. As hedge funds began enjoying a higher level of popularity, investors have been lobbying individual fund managers and regulators for more consistent governance standards across the globe.

A quote on governance and investing by Moody's said:

“Corporate governance practices for hedge fund firms are more closely examined today than at any other time in the history of the industry…hedge funds firms have experienced a shift in their investor composition from high net worth individual investors to institutional investors…Institutional investors have shown that they view the evaluation of governance and oversight as it relates to risk management, valuations, operational controls, transparency and the investment process as important as analyzing a hedge fund manager’s investment performance.”

Despite the inherent risks of hedge funds, investors have a high motivation to move funds to hedge funds. Their hesitancy in moving forth with it comes from worries over weak governance. Unfortunately, lack of corporate concern over governance is slowing down the flow of money to hedge funds.

Investment firms will need to instill the confidence of investors by assuring them that boards are practicing high standards for governance, including independence, strong oversight, responsible planning and thorough risk mitigation measures. Investors are looking for robust internal governance, as demonstrated by good corporate governance principles such as greater transparency, strong operational policies, improved oversight and monitoring of hedge funds.

Investors cite current concerns over lack of voting rights for shareholders and having no mechanism for replacing directors or managers.

The current market is creating new opportunities for hedge fund managers to take the lead to help build new relations with the investor community and to elevate the reputation for the alternative investments industry should they choose to exercise them. Regulators and other organizations, such as the Alternative Investment Management Association (AIMA), The Standards Board for Alternative Investments (SBAI) and other associations within the industry, recognize that the standards investors are asking for are neither costly nor complex.

Enterprise Governance Management Promotes Stronger Governance for Hedge Funds

Enterprise Governance Management is the discipline of applying technical tools and resources to the full range of governance needs to govern at the highest level and to deliver long-term success and sustainability. Diligent Corporation, with its suite of electronic governance solutions called the Governance Cloud, is the only provider of a comprehensive governance management solution.

Diligent gives investment firms the software solutions that support and ensure that corporate processes meet or exceed investors' expectations for exceptionally high governance standards. The Governance Cloud includes cost-effective and efficient electronic tools such as: Together, these tools provide hedge fund investment firms and other alternative investment firms with the proper structure to uphold the highest governance standards, with or without current or future requirements by industry regulators.

The financial crisis of 2008 rocked the confidence of every investor on Wall Street and in various other parts of the world. The last decade hasn't brought us any new reasons to throw caution to the wind. In fact, the level and complexity of risk due to the Internet of Things and related interconnectivity are causing even more hesitancy among investors.

All stakeholders in the investment industry, including investors, investment managers, the C-suite and independent board directors, need to be aligned in their views on corporate governance. Working together helps to create the needed trust to move forward more confidently with hedge funds.

It's important for all stakeholders to remember that before regulations, there were governance standards. Industry standards, when agreed upon by stakeholders and set forth as accepted goals, can often be more effective than regulations. Enterprise Governance Management is the new industry term that describes how electronic solutions promote good corporate governance across the financial industry, whether regulations exist or not.
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Nicholas J. Price
Nicholas J. Price is a former Manager at Diligent. He has worked extensively in the governance space, particularly on the key governance technologies that can support leadership with the visibility, data and operating capabilities for more effective decision-making.