The failure of risk oversight was a major contributor to the financial issues that ultimately led to the financial crisis in 2008. Much of the fallout fell on the shoulders of corporate board structures and governance processes, and less attention was given to investment fund governance. It’s common for people to overlook some important difference between the two types of companies. Their differences have important implications for the governance of investment funds, which requires a different governance framework for proper governance oversight.

Outside investors have struggled with how to gain assurance that companies are providing adequate risk oversight. Regulatory authorities have also struggled with how to create rules to give investors the assurance they’re looking for. Investors may take action when they’re uncertain about the strength of oversight. Depending on the circumstances, they’re likely to run into challenges in trying to engage with companies. There’s less concern over oversight and less risk of activism when investors and companies can find a way to engage and get questions and answers out in the open.

Challenges in Pursuing Engagement on Governance Oversight for Portfolio Companies 

Larger companies are more apt to try to engage with companies on the issue of governance oversight than smaller companies. Investors that are eager to engage may face various challenges.

Regional, national and cultural differences have a large impact on the company’s approach to risks, risk tolerance, attitudes of risk managers and the nature of engagement between investors and managers.

Legal issues can create barriers in communication between investors and managers. Boilerplate disclosures dissipate fears for boards and managers but may create trust issues with investors. In some jurisdictions, board directors don’t have Safe Harbor provisions and may have concerns about personal liability.

Often, the most transparent companies are the most willing to engage with investors, while the least transparent companies are sometimes the least willing to engage. It’s sometimes easier for investors to engage with companies at some other time than around the annual general meeting.

Also, the governance team and the investment team within institutional investor firms don’t always work well together. Engagements on governance aren’t always coordinated with investment decisions. Fund managers and analysts may have no participation in the decision on how shares are voted.

Portfolio companies and investors often have to consider the impact of local and national codes that don’t align and conflicting guidelines. Some companies give certain codes more weight than others. Overall, portfolio companies are complex, and that makes engagement challenging.

Developing a Risk-Based Oversight Framework

To develop an oversight framework for a portfolio company, it helps to define the basic principles of investment fund governance, better understand the unique characteristics of investment funds and consider the many parties involved in investment funds.

Because of the various stakeholders involved, it can be challenging to distinguish principles of fund governance and differing interests and perspectives among this type of investor. The goal of a governance framework is to protect investors. With this population, the framework won’t necessarily protect investors from losses related to the market. Investment fund governance helps investors to better understand the risks associated with investment fund products, prevent fraud, prevent loss to investors due to malfeasance or negligence of fund promoter organizations, and reduce the potential for conflicts of interest.

One of the things that makes investment funds unique is that they’re promoter products. The promoter organization builds the fund and investors invest in the fund, not the promoter organization. The fund provides the investors with access to professional asset management. The strength of the promoter brand attracts investors. Another notable characteristic of investment funds is that they typically outsource many of the investment management duties. Under this model, the board doesn’t have all the control, but it still has the responsibility for the funds. Where funds have been outsourced, the board should be overseeing the service providers.

What makes the governance framework for investment funds different than that for corporate boards is that the investment fund board, and sometimes the management company, are responsible for oversight. Boards need to ensure that the funds are legally compliant and that they align with the data in the fund prospectus. Management of the funds comprises the fund promoters and investment managers; other service providers, like the administrator, custodian and distributor; and support from legal and audit teams. The service providers are the frontline people who are responsible for managing day-to-day risks.

Once a fund is up and running, it can be difficult to change the governance framework, so it should be designed and implemented with an awareness of the risks that are attached to the fund. Boards need to understand how the fund operates to identify those risks. The framework should account for the fund’s legal structure, as well as how it functions in practice. The framework should also be customized according to the uniqueness of the fund. Taking the uniqueness of the fund into account will help develop the fund’s risk profile.

Governance Oversight for Portfolio Companies

Risks have many different origins, so it can be a complex process to develop a risk profile for investment funds. This step entails assigning ownership and accountability for each risk identifying existing internal controls among the various service providers. Boards may take various steps to ensure that the service providers are managing the fund well. They sometimes accomplish this by doing their homework and due diligence upfront or they may conduct ongoing testing, or request information on risks from management and reports from service organizations on controls.

Proper oversight entails comparing the board’s top-down analysis with the bottom-up analysis from each service provider. While it’s important that investment fund governance frameworks comply with regulations, the framework should protect investors at the core and position board directors so they can make wise decisions with full knowledge of the potential risks. It is critical to understand the differences between corporate governance and investment fund governance because of the need for protection for the various parties in each company. The uniqueness of investment funds calls for continuous oversight, as changes in the marketplace could open new risks at any time.

With so many groups and individuals involved in portfolio companies, it’s important that communications and file-sharing are secure. Diligent Messenger is the most secure way to send sensitive files and emails. The program integrates fully with all the other digital governance solutions that compose Governance Cloud.