Avocado, catamaran, zebra. What do these three seemingly unrelated words have in common? The answer is that they, together with over 70 more, were first recorded in English by the same man – William Dampier.
Born in Somerset in 1651, Dampier spent most of his adult life at sea, first in the Royal Navy and later captaining a pirate ship. While searching for bounty, he inadvertently became the first man to circumnavigate the globe three times. As he travelled, he kept detailed records of the new lands, animals and plants which he encountered. He subsequently published his multitude of discoveries in a best-selling tome in which he introduced both new words and new worlds to his compatriots.
What then would a seasoned adventurer such as Dampier make of the voyage of discovery that investors and fund managers have been on over recent times? What is for sure is that he would have recognised some common themes: sailing into uncharted territory, facing severe headwinds and sometimes seeing assets disappear underwater.
Many fund management platforms were dashed against the rocks during the great storm which was the global financial crisis. Although some were destroyed, most survived, albeit feeling somewhat worse for wear having had the experience. Surveying the wreckage, cases such as the Madoff scandal are the most prominent, but there are numerous less well known casualties, some of whom are even now not yet fully recuperated.
In different degrees, hubris, imprudence and recklessness all contributed to the downturn. Across sectors, these foibles were left unbridled due to the improper function of corporate governance and risk management systems. The checks and balances which were designed to minimise losses and create better decision making creaked under pressure and ultimately failed at the most crucial time.
In the real estate and private equity sectors, the results of such capitulation were acute. As the economy faltered, optimistic asset management plans were laid to waste and in many instances, resultant value declines were exacerbated by the use of leverage. Furthermore, those managers who had branched out into new sectors or territories without first ensuring they had a true understanding of the investment landscape or the legal and regulatory environments began to flounder. As equity was eroded, many such managers retrenched back to domestic markets leaving behind a trail of ruin.
Faced with increasing losses at home and abroad, investor disillusionment rose, especially in those situations when it was possible to pinpoint examples where manager actions had worsened the capital destruction caused by adverse market movements. In some instances, the level of investor dissatisfaction was so high that investors voted to remove the fund manager entirely.
Conversely, those managers who could demonstrate loss mitigation through investment acumen, robust risk-management systems and who were transparent with investors boosted their reputations, despite still suffering the difficult market environment. It is these managers that will continue to thrive in years to come.
As the tempest eventually subsided and confidence in the real estate and private equity markets rebounded, capital inflows into the sectors have increased substantially. However, investors are keen to guard against the mistakes of the recent past and thus their renewed willingness to invest has been accompanied by a greater focus on the corporate governance and risk management systems of fund managers. Many investors now implement a dual approval process, whereby their investment due diligence team and their operational due diligence team must both approve an investment. It is no longer acceptable for fund managers to just have an outstanding investment capability, they must also have a robust middle and back office too.
“Recognising the change in sentiment among investors towards corporate governance and risk management, fund managers are increasingly willing to accommodate their wishes”
One area of increased focus from investors is the fund board, which is responsible for the overall corporate governance of the fund. The board is generally located offshore for tax reasons, with Jersey and Luxembourg being the preferred locations in Europe. The directors of the board are empowered to make key decisions, including ratifying asset purchases and disposals, agreeing changes to the valuer, auditor and other third-party service providers and resolving conflicts of interest.
Historically, the composition of the board was not a key criteria for investors because the importance of the board function was underestimated. Having learnt through painful experience the detrimental impact that poorly performing boards can have, especially in times of unease, investors now want to ensure that boards are fit for purpose. This means that among other things, board directors must have sufficient knowledge and expertise to ensure a deep understanding of the investment strategy and underlying assets. Only through such understanding are they able to make the correct decisions, especially when faced with complex situations and testing market environments.
Independence of board members has also become important to investors who want to ensure there is impartial decision making and that board decisions are taken with investors’ interests at heart.
Lastly, investors also prefer directors to be individually regulated and certain offshore jurisdictions have implemented a regulatory regime for directors, which, for example, in Jersey is administered by the Jersey Financial Services Commission.
Recognising the change in sentiment among investors towards corporate governance and risk management, fund managers are increasingly willing to accommodate their wishes, especially since regulators are also focused on the same topics. As part of demonstrating a commitment to high standards across these areas of operation, assembling boards with the requisite knowledge and expertise, including independent, regulated directors is important. However, this is only one aspect and, as part of a wider scope, this commitment also involves upgrading operating systems, business continuity programmes and employing best-in-class third-party service providers.
As the old saying goes, a ship is safe in harbour, but that is not what it was built for. That is certainly true in the world of fund management, where risk and return go hand in hand and nothing ventured, nothing gained is the maxim. If risk taking is such an integral part of generating return, the key is how that risk is managed. Overall, a more robust corporate governance and risk management framework provides investors with increased comfort, helps fund managers attract and retain investors and satisfies regulatory requirements. A win-win-win situation which offers safe harbour even in the most violent of storms.
Richard Urban is an independent non-executive director