Although doing so is not a regulatory necessity, hedge funds actively seek independent directors. The funds prefer “busy” independent directors who bring reputational capital that leads to better monitoring, which in turn can improve fund quality.
How Is This Research Useful to Practitioners?
Hedge funds attract a lot of investment but tend to be opaque with regard to investment strategy and having an observable market value. Given this asymmetry of information, hedge funds need other means of demonstrating the quality of the fund. One way to do so is to retain independent directors, although this is not a regulatory necessity.
Independent directors have valuable reputational capital that is maintained through vigilant monitoring of a fund. Furthermore, “busy” independent directors (in excess of 20 directorships) tend to work for directorship firms. The structure of a directorship firm allows for efficient monitoring and adds a second layer of reputational capital.
Consequently, high-quality hedge funds seek high-quality, busy independent directors. The process to match funds and directors is mutually beneficial because a directorship on a high-quality fund adds to the reputational capital of the independent director, and the independent director’s reputation signals the quality of the fund, which is beneficial to practitioners.
Additional analysis indicates that the benefit to practitioners is genuine because funds with busy independent directors have significantly less incidence of fraud and risk shifting after poor performance (i.e., riskier investments seeking to recover from earlier poor performance).
How Did the Authors Conduct This Research?
The authors’ data are from US SEC filings and other sources and are made up of 5,400 directors and 5,126 hedge funds between 2009 and 2013. The authors’ statistical techniques allow them to determine the attributes that lead particular types of independent directors—busy directors who belong to directorship firms—to be more likely to take on new directorships.
To determine the benefit of busy independent directors, the authors segment the data to analyze cases of fraud, the use of discretionary liquidity restrictions, and the incidence of risk shifting after a period of poor performance. In all three cases, a benefit is demonstrated with the presence of busy independent directors.
I found the research interesting because it illustrates the certification benefit of having a high-quality, busy independent director without simply appealing to a “best practices” rationale that I have often found to be a weak justification.
Furthermore, the idea of a directorship firm is intriguing from an efficiency-in-monitoring standpoint. I am curious whether such a structure exists, possibly implicitly, in other directorship/monitoring settings.