Director independence

Director independence is a crucial governance feature for hedge funds, especially those set up as companies in offshore locations like the Cayman Islands. Independent directors act as objective watchdogs over fund operations. They serve as fiduciaries—meaning they have a legal duty to act in investors' best interests—and help prevent conflicts of interest between fund managers and investors.

Think of independent directors as neutral referees who monitor the game to make sure all players follow the rules fairly.

Independent directors are outsiders who have no employment or business ties to the fund manager. They serve in a non-executive role, meaning they don't handle day-to-day operations. Instead, they focus purely on oversight and governance.

These directors are typically hired through specialized director placement services or recommended by other service providers like auditors or attorneys. This ensures they maintain their independence from the fund manager.

The professional director industry has grown significantly over the years. Specialized firms now provide experienced directors to serve on multiple fund boards. This has created a pool of professionals with deep expertise in fund governance.

However, this evolution has also raised new questions. Can directors effectively serve on many boards simultaneously? What happens when a director serves on boards of competing funds? In response, many institutional investors now carefully examine director workloads and potential conflicts as part of their due diligenceThe comprehensive investigation and evaluation process conducted before making an investment or business decision. process before investing.

Most offshore hedge funds use a mixed board structure. The board of directors includes both independent directors and directors who work for or are affiliated with the fund manager (usually the fund's principals or key executives).

This combination provides a balance: the independent directors offer objective oversight, while the manager-affiliated directors bring deep knowledge of the fund's operations and investment strategy.

For hedge funds based in the United States (domestic funds Domestic fund A domestic fund is a hedge fund organized under U.S. law—typically as a Delaware limited partnership or limited liability company—that serves as the primary investment structure for U.S. taxable investors. ), the same professional directors who serve on offshore fund boards may serve on advisory boards for parallel domestic funds.

However, there's an important legal difference: Delaware partnership agreement law (which governs most US funds) doesn't have the same corporate director duties and protections that exist for offshore company directors. Therefore, the advisory board's role and responsibilities must be specifically defined in the fund's limited partnership agreementThe governing document that establishes the terms, conditions, and operational structure of a limited partnership fund..

In hedge funds, the fund manager (general partner) often has the right to select who serves on advisory committees, unlike private equity funds where large investors typically negotiate for board seats.

This approach gives hedge fund managers more control over board composition while still maintaining independent oversight. The goal is to balance manager flexibility with investor protection.

Independent directors serve as fiduciaries to fund investors. This means they have a legal obligation to act in the best interests of all shareholders, not just large investors or the fund manager. They must maintain objectivity in their oversight role.

This fiduciary responsibility covers all aspects of fund governance. It includes resolving conflicts of interest, overseeing service providers, and participating in strategic decisions that affect the fund and its investors. When conflicts arise, independent directors must prioritize what's best for investors over what might be convenient for managers.

Every offshore fund organized as a company is governed by a board of directors. This board oversees the fund's operations and ensures compliance with the fund's rules, including its governing documents, prospectus, compliance procedures, and applicable laws.

The board's typical duties include several key areas. They monitor whether the fund follows its governing documents and internal policies. They approve major transactions and determine if certain deals serve the fund's best interests, especially when conflicts of interest arise. They ensure all investors receive fair treatment regardless of their investment size. They make sure the fund has appropriate risk management procedures in place and approve the selection of key service providers like auditors and administrators.

To make operations more efficient, the board can delegate certain decision-making authority to the investment manager or fund administrator Fund administrator A fund administrator is an independent third-party company that handles essential day-to-day operations for hedge funds. These companies calculate how much the fund is worth, serve investors, ensure regulatory compliance, and manage back-office operations. They work separately from the investment manager to provide oversight and protect investors. . This allows routine decisions to be made quickly without requiring full board meetings.

However, the board retains ultimate responsibility for fund governance. They must ensure that any delegated functionsSpecific responsibilities and decision-making authority that a board of directors transfers to management or service providers to improve operational efficiency while maintaining oversight. are properly supervised and that the fund's interests are protected.

Independent directors typically receive a flat annual fee paid by the fund. This straightforward compensation structure helps maintain their independence since their pay doesn't depend on fund performance or manager decisions.

Affiliated directorsBoard members who have employment, business, or financial relationships with the fund manager, as opposed to independent directors who maintain objectivity.—those who work for the fund manager—generally don't receive additional compensation for their board service, except for travel expenses. When decisions involve matters where affiliated directors have a personal financial interest, they must excuse themselves from the decision-making process.

Independent directors must comply with various regulatory requirements while maintaining their independence. The fund's governing documents—including its memorandum and articles of association and offering documentsLegal documents provided to prospective investors that describe the terms, risks, and other material information about an investment opportunity.—give the board of directors the power to supervise the fund's operations, take action on behalf of the fund, and vote on important matters.

Directors must stay informed about changing regulations and ensure the fund complies with applicable laws in its jurisdiction.