Draft regulations for hedge funds
The draft regulations (in terms of The Collective Investments Schemes Control Act 2002) were published on April 16 2014 and in certain aspects seem to have departed from the previous discussion papers published. The main points to consider are the robust regulatory oversights over hedge funds as well as their reporting obligations.
The draft regulations are a step towards a comprehensively regulated hedge fund industry. This should increase investment in hedge funds, particularly pension fund investments, as the industry will be deemed to be somewhat less risky by the market. Pension funds, notwithstanding their ability to invest up to 10% in hedge funds, have been hesitant to do so due to the unregulated nature of the industry to date.
Objectives and definitions (section 1 and section 2)
The definitions are largely inclusive of terms used in the Financial Advisory Intermediary Service Act (37 of 2002) (FAIS), the Financial Markets Act and the Collective Investment Schemes Control Act (45 of 2002).
The objects of the Act are to provide protection to investors in hedge funds, monitor and manage systemic risk in the markets, promote the integrity of the hedge fund industry, enhance transparency and promote financial market development.
Compliance (sections 3-8)
The draft regulations show the significant concern that regulators have in regard to the day-to-day running of hedge funds. Fund managers are required to establish permanent and effective compliance functions irrespective of the size and complexity of the business to ensure daily compliance with the Act and the draft regulations. However, a manager does not have to establish an independent compliance function if this would be disproportionate to the size of the manager or the nature, scale and complexity of the business. In this case, the manager himself may perform the compliance functions.
The manager is also required to establish a conflicts of interest policy to identify, manage and disclose any conflicts of interest between the manager's interest and the interests of the investors. The manager must appoint a fund administrator and is entitled to appoint a prime broker, who must be an equity member or a bank. In both the appointments of a fund administrator and a prime broker, the manager is required to act with due skill care and diligence.
Risk management policy and risk manager (sections 10-13)
The regulations require the fund manager to maintain, enforce and document risk management policies, including operational or risk management appropriate to the nature, scale and complexity of the business. Considerations which must be provided for are:
- The techniques and procedures used to measure and manage risks (this would include the measurement techniques to carry out stress tests, back tests and scenario analysis).
- The frequency with which stress tests and scenario analysis should be conducted depending on the nature of the fund and its investment strategy.
- Safeguards for independent performance of the risk management function.
- Daily risk managements to be performed.
A fund manager must review the risk management policy, which must be in line with risk profile of the retail fund, at least annually. Further, a manager must appoint a risk manager separate from its investment management function and fund administration function. The risk manager's primary responsibility will be to determine the risk policy of the fund, risk monitoring and reporting and ensure that the risk limits comply with the funds risk profile.
A manager may only engage in physical short selling and is strictly forbidden from naked short selling. Synthetic instruments creating short positions are not allowed in terms of the regulations. A manager is, however, entitled to borrow and secure such funds utilising the assets of the portfolio.
Qualified investor hedge funds (Ql FUND) (sections 14-23)
A manager must be registered under this section to administer a QI fund and must:
- Be a company, a trust, or a partnership.
- Have the capital and reserves determined in accordance with section 88(l)(a) of the Act.
- Have a governing body responsible and accountable for the management of the QI fund, which must comply with the requirements of King 3, the fit and proper requirements as contemplated in FAIS and have the appropriate professional expertise and knowledge of the assets in which the QI fund is invested.
- Appoint a trustee or an independent fund administrator.
A manager may only invite qualified investors to invest in a QI fund and must take reasonable steps to verify that all investors in the fund are eligible. The assets of the QI fund are to be managed by a hedge fund FSP and the manager must employ a structure that limits the liability of an investor to give effect to the principle that an investor may not lose more than his or her capital investment. Assets in a QI fund must be listed and dealt with on an exchange or on a market that is regulated and open to the public. Structured products must be based on permitted assets and securities prescribed in terms of these regulations. Instruments based on the value of commodities listed on exchange may not allow for physical delivery of same, must be subject to a liable valuation, as well as being negotiable and transferable and the liquidity of instruments must not compromise the liquidity in terms of the QI fund.
These regulations also prescribe strict prudential requirements for managers of QI funds, which require that they maintain liquid assets equal to or greater than 13 over 52 weeks of annual expenditure as well as maintaining suitable guarantees of a minimum amount of R5m or suitable professional indemnity cover of a minimum amount of R5m. Managers must also implement and maintain a repurchase policy, which must provide for:
- A level of equality allowing the manager to repurchase participatory interests within 91 days after receipt of an investment instruction to repurchase.
- The circumstances under which the manager may suspend repurchase of participatory interests.
The manager is required to advise the registrar of the maximum permitted level of leverage allowed in the line of portfolio of the QI fund. Any changes to the maximum must be made with the approval of both the investors and the registrar.
The manager must ensure that the valuation methodology applicable to the particular QI fund is consistently applied according to the policies and procedures adopted by the QI fund. These policies and procedures must be reviewed periodically, ensure that an appropriate level of independent review is undertaken for each valuation, describe the process for handling and document instances where the manager has disagreed with the valuation.
The manager has to comply with stringent disclosure and reporting obligations in terms clause 21 of the regulations. He/she is further required to report to the registrar in terms of clause 23 of the regulations.
Retail hedge fund (sections 24-42)
In order to register a retail hedge fund a manager must be registered to administer such a fund. An applicant for registration as a retail fund must:
- Be a company.
- Have the capital and reserves required by the Act.
- Appoint a trustee in terms of section 69 of the Act.
- Conform with the fit and proper requirements.
- Ensure a high standard of diligence in its election and monitoring of investments and ensure investments are made in compliance with the investment strategy and risk limits of the fund.
- Have appropriate professional expertise and knowledge of the assets in which its funds are invested.
The manager must ensure that the principle of segregation of fund assets, including collateral assets is adhered to by its trustee or nominee of its prime broker in terms of section 76 (1 )(a) of the Financial Markets Act.
The custodian must meet the requirements as set out in the Act and must be a participant as defined in section 1 of the Financial Markets Act.
The custodian will be required to fulfil the following functions:
- Hold and safeguard assets on a segregated basis.
- Securities settlement.
- Income collection.
- Corporate action processing.
- Cash management.
The valuation and pricing of a retail fund must be done in accordance with the document policies established and enforced by the manager for the valuation of assets held or employed in his portfolio. The valuation methodology must be consistently applied according to the policies and procedures which must, inter alia, he reviewed periodically and ensure daily valuations are undertaken.
The liquidity and repurchase requirements of the retail fund differs substantially from that of a QI fund in that a retail fund may only borrow tip to 10% of the value of the fund for liquidity purposes and a manager may not encumber any assets of the fund for reasons other than as provided for in the Act.
The repurchase policy of the fund must provide for:
- A level of liquidity which enables the repurchase of participatory interests within 30 days of receipt of an instruction to repurchase.
- The circumstances under which the manager may suspend repurchase of participatory interests.
A manager must limit the exposure of a retail fund to 30% of the NAV of the portfolio per counterparty, other than a bank, in relation to OTC derivatives. The total value of the exposure is calculated using the verifiable mark to market value of the derivative including any over- collateralised amount. The manager is permitted to net OTC derivative positions with the same counter-party and in the same portfolio.
A manager is obligated to ensure that the collateral arrangements satisfy the rules set out in regulation 32(2) which require, inter alia, that:
- Collateral agreements must be governed by appropriate international collateral agreements.
- The creditworthiness of the issuer of collateral must be considered.
- The collateral obligation is legally enforceable and that the collateral will be available to the fund without recourse to the counter-party.
- The fund must not accept securities of the counter-party as collateral.
- The fund must manage the reinvestment risk of cash collateral appropriately.
A retail fund may invest into the following asset classes, subject to the exposure limit set out in Schedule A to the regulations:
- Securities and money market instruments listed on an exchange, or dealt with on a market which is regulated and open to the public.
- OTC derivatives.
- Participatory interests in collective investment schemes.
- Financial indices.
The potential loss on an investment must be limited to the amount paid to acquire it and the liquidity of the instruments/securities must not compromise the ability of the hedge fund to meet its repurchase obligations.
A manager may not include in any retail fund investments:
- Commodities where physical delivery of the commodities is possible.
- Immovable property.
- Private equity.
A manager is entitled to invest in derivatives and indices provided they comply with section 35 and section 36 of the Regulations, respectively. Leverage is calculated based on one of two approaches in a retail fund. The first approach is the "commitment approach", which considers the market value of the assets underlying the derivative and takes an aggregate view of the absolute value of the underlying exposure. The second approach is the "value-at-risk" approach, which means a measure of the maximum expected loss at a given confidence level over a specific time period.
A manager is entitled to calculate the portfolio's total exposure and leverage by either of the abovementioned approaches. When using the commitment approach the manager must ensure that the portfolio's gross exposure to the market does not exceed 200% of the total net asset value of the portfolio.
A manager may consider hedging and netting arrangements for the same asset class when using the commitment approach, provided that Financial Services Provider Net Asset Value they fulfil the criteria relating to the commitment approach and that investment strategies set to generate returns are not regarded as hedging arrangements.
The manager of a retail fund has extensive reporting and transparency obligations to both investors and to the registrar.
Transitional arrangements and exposure limits
The transitional arrangements, which will presumably deal with some of the tax arrangements that need to be considered, will be promulgated at a later stage.
The exposure limits for permitted assets are set out in Schedule A to the Regulations and should be looked at carefully to ensure compliance in future.
The Regulations are comprehensive and provide a solid foundation and clear guidelines for investors in this growing form of investment.