By Mike Saville, Grant Thornton – Previously, a number of superstar hedge fund managers felt that investors should be honoured to have their subscriptions accepted, and consequently dictated the terms of the investment. Today, however, things have changed. Increasingly, institutional investors are dominating cash inflows to hedge funds, and their needs are different. Given the size of ticket many are writing, the tables have turned. They are now the ones dictating the terms to managers. Not surprisingly, the scene is set for conflict.

Some fundamentals remain the same. Investors continue to be sophisticated and many would resent too many imposed hurdles to flexible investment. Higher returns will always bring with them higher risks and managers will be reluctant to share their trade secrets.

The recent Weavering decision confirmed hedge funds are different. The Cayman Court found that it was to be expected that directors of funds would delegate many of their duties to other professional service providers. However, the case confirmed that directors have a core duty to the company that can never be fully delegated away.

Recent fund liquidations have provided hard-learnt lessons:

• Investors perform limited due diligence, demonstrating no real understanding of the investment structure and that monies might end up in offshore jurisdictions;
• Failure to appreciate key role of independent directors as a safety net;
• Lack of focus on the suspension and gating provisions of the OM and Articles. In particular, reliance on the directors to use these powers at the right time;
• Failure to present audited accounts on time;
• Continuing management charges, in suspension extending for several years;
• Failure of the manager to communicate effectively with investors;
• NAVs struck based upon values provided by the manager rather than an independent valuation professional.

Many of these cases are not frauds or Ponzi schemes but result from poor investment performance, disappointing, though not necessarily gross negligent, behaviour by independent directors, and a failure to consider exit strategies from inception.

With potentially high returns from hedge funds comes potentially high risk. Money will be made and lost. If lessons of the past are learned, independent directors should contemplate success and failure from inception. Insist on a robust corporate governance platform. Resist indemnities for core service providers whose involvement promotes additional confidence such as the administrators and auditors.

Valuations provided by qualified, independent valuation professionals should be regarded as a cornerstone of NAV. This provides the most immediate indication of potential problems rather than leaving valuation discretion with the manager, who has his own agenda. Frustration that can lead to forced liquidation can be avoided by prompt communication with investors.

Decisive action may allow the directors to restore confidence and propose the most cost effective and commercial solutions: Replacement of the investment manager; appointment of a director with appropriate downside expertise; appointment of an investor steering committee; a sale of hard to realise assets to an appropriate purchaser and the use of legally based schemes of arrangement to impose some of these restructuring plans with the support (at least for Cayman funds) of 75 per cent of each shareholder class.

None of these may restore the lost value but they may help avoid the additional destructive and expensive process of a forced liquidation.