When you imagine a person with one hand in overseeing your retirement, do you envision them holding a blender drink in the other hand? Perhaps you should.
Islands like the Caymans are well-known as corporate tax havens, and earlier this week in the Huffington Post, Vermont Senator Bernie Sanders railed against rampant offshore tax abuse.
What's less well-known, but perhaps just as troubling, is that hedge funds use these havens to avoid something else as well: proper governance. This is especially disturbing because many pension funds have poured money into offshore hedge funds, desperate for higher and higher returns to cover their rising liabilities.
With perhaps two-thirds of all hedge funds domiciled in the Cayman Islands, Bermuda, and British Virgin Islands (BVI), a web of "independent directors" has developed in these island paradises. Officially, these directors are independent watchdogs who protect the interests of investors, such as pension funds. The problem is that some appear to be little more than "paper directors," with perhaps billions of retirement dollars exposed to funds with weak oversight and potentially conflicted governance. This might not be an urgent concern if hedge funds lived up to their hype, but broadly speaking, they do not: hedge funds have actually been underperforming the S&P.
Recently, investors and politicians who have sought more transparency scored a partial win: the Cayman Islands has reportedly proposed creating a public database revealing details of their funds including information about their independent directors (pending ongoing negotiations), letting a few rays of that powerful Caribbean sunlight into one of the darkest corners of the financial world. But other crucial questions necessary for investors to reasonably judge risk remain unanswered: hired by hedge fund managers themselves, whose interests do these directors really have at heart? How many boards do they sit on simultaneously, and is it alongside other directors who also are serving on the same multiple boards? What is their level of competence, and does their supposed oversight have any teeth? Hedge funds are known for their "lone wolf" approach, without the same supervision as, say, a mutual fund or a typical corporation. This gives hot-shot managers enormous latitude to invest and operate as they see fit. And the culture of hedge funds is straight from today's Shadow Elite playbook in that accountability is elusive.
This black hole of accountability might be easier to accept if the money at stake came solely from super-rich, private investors who want to take a personal gamble. But as we said, institutional money is now deeply tied up in hedge funds -- and not just mom and pop pensions, but also academic and charity endowments. Given the wall of secrecy, it is likely that many institutional investors lack the information to sort out the potential perils. Can we afford, literally, to take these risks?
Our Mapping Shadow Influence Project has seen some of this disturbing data up close and is prepared to dig deeper to identify potential risk that institutional investors - and you - may well face. The Foundation for Fund Governance granted us full access to their unique database of 10,000+ hedge fund directorship positions, including the names of nearly 2,000 individuals, on the boards of 5,000 offshore hedge funds (compiled from SEC and other regulatory filings.) The Foundation also provided us with the names of some institutional investors in these funds (compiled from Labor Department filings). This list includes many state, city, county and corporate pension funds, as well as university endowments and foundations.
Who are the so-called independent directors charged with providing some measure of oversight? Linking information in the media with that in the database, we were able to document several glaring red flags.
Consider the two Bear Stearns funds that collapsed in summer 2007 and served as harbingers of the eventual financial crisis. They shared not only the same fund managers, but also independent directors -- in this case, both professional independent directors, meaning they were affiliated with a financial services company. According to the Foundation database, one of these directors sits on the boards of 120 funds and the other 38, as of the end of 2012. Both directors were cited by U.S. courts for not performing their oversight duties adequately by approving 165 trades with other Bear Stearns funds... after those trades already happened. The trades allegedly allowed the Bear Stearns fund to hide investor losses. According to the most recent data (the end of 2012), both directors sat on funds with U.S. public pension money invested, between them at least seven, in fact, including the Pennsylvania Public School Employees Retirement System, the Fairfax County Retirement System, and the California Public Employees Retirement System. The directors serve together on several of these funds.
Indeed, many independent directors hold multiple directorships, sometimes numbering in the hundreds. Moreover, many of these directors are interconnected, sitting together on multiple boards, as the Foundation database shows. And they appear often to be appointed with little regard to the complexity of the investments, whether there might be conflicts of interest, and whether it is possible for a director to feasibly oversee and assess risk when he or she sits on such a large number of funds.
These examples should motivate anyone with pensions or other money in institutional investments, along with institutional investors themselves, to ask more questions. And, now that information is coming online, journalists and academic institutions, too, can help address pressing questions by examining the relationships, incentives, and cultural dynamics around hedge funds.
The recent news that the Cayman Islands will seek to increase transparency is a welcome step, but it is only one step. The New York Times back in July has one financial observer describing the hedge fund business as "....still trying to figure out what it wants to be when it grows up." That's a scary thought for anyone well past grown up, nearing 65, relying on a pension that just might be invested in a hedge fund with little or no governance. Pass the blender drink.
This piece is based on analysis by Julia Pfaff, Maciej Latek, and Matt Dickert of the Mapping Shadow Influence Project, shadowelite.net, directed by Janine R. Wedel, university professor at George Mason University.