Regulation consternation

Financial market turmoil has boosted global efforts to regulate the hedge fund industry. Although hedge funds were not at the epicentre of the financial crisis, they have nonetheless been targeted in the ensuing regulatory backlash. Bodies including the Basel Committee for Banking Supervision, the Group of 20, the International Organization of Securities Commissions and the Financial Stability Board are all seeking to subject hedge funds to more extensive regulation. In Europe and the US, hedge fund regulation features prominently in attempts to reform the financial sector.

In South Africa, the picture is much the same. Having been engaged in a period of consultation with the industry for some time, the country’s Financial Services Board (FSB) is hoping to produce firm recommendations on hedge fund regulation by the middle of 2010. “The fact of the matter is hedge funds the world over are somewhat secretive. In some respects, their desire for secrecy is understandable in the sense it’s a very competitive environment. But one of our main concerns is there doesn’t always appear to be sufficient disclosure to investors,” explains Bert Chanetsa, the FSB’s Pretoria-based deputy executive officer for investment institutions.

As with other global regulators, another of the FSB’s principal worries is leverage. “Our industry is fairly conservative as far as leverage is concerned, but it’s probably something we need to keep a handle on. The rest of it is instituting best practice,” he says.

These concerns may come as a shock to some in the local industry. South African hedge funds had 29.698 billion rand ($3.91 billion) in assets under management as of June 2009, according to a survey by Cape Town-based fund of funds Novare. A large part of the industry’s growth has taken place over the past 10 years – something market participants claim has helped institute high standards among managers.

“A lot of the industry problems you see globally with frauds have not occurred in South Africa, because the vast majority of managers came out of traditional long-only asset management houses, which were highly regulated by the FSB all along,” says Grant Watson, Cape Town-based head of the quantitative investments boutique at Old Mutual Investment Group South Africa (Omigsa).

The use of third-party service providers across the industry is high. Almost all South African hedge funds have independent administrators and prime brokers, with many using more than one prime broker. Large numbers of funds also make use of outsourced risk management, say market participants. In fact, the use of third parties is so prevalent, the local industry has been held up as a model of self-regulation (Risk March 2007, pages 52–55). This is reinforced by the role of local funds of funds, which are by far the dominant investor group in South African hedge funds, notes Watson: “The vast majority of business goes via funds of funds, which are pooling vehicles for assets. So the end-investors are going to funds of funds that do the due diligence on all the underlying single-manager funds.”

Fears about transparency of hedge funds are also misplaced in the context of the South African market, reckons Fatima Vawda, managing director at 27four Investment Managers in Johannesburg. While there is widespread use of independent risk consultancies, risk reporting standards are high, she claims. Meanwhile, the local industry is dominated by long/short and market-neutral equity funds, meaning investors have little to worry about when it comes to the accuracy of valuations. Like the FSB’s Chanetsa, she points out that leverage multiples are typically low compared with those seen elsewhere in the world: “A lot of South African managers only go up to two or three times leverage, so we don’t have the type of leverage that is employed globally.”

Despite these assertions, the FSB has been taking an increasingly active interest in hedge funds in recent years. In November 2007, the agency began licensing the country’s hedge fund managers under the Financial Advisory and Intermediary Services Act. The process involved lengthy applications and onsite visits from the FSB, which sought to ensure managers held relevant qualifications and met with minimum standards on compliance and disclosure. At the time, local market participants said they were largely satisfied with the new regime, reporting few problems in obtaining the licences (Risk October 2008, pages 74–76). By mid-2009, 128 managers were in possession of the new Category IIA licences for running hedge funds, according to the FSB.

Following on from the focus on hedge fund managers, the FSB is now looking to regulate hedge funds themselves. It has spent much of the past year consulting with the industry and has a broad idea of what form the regulations will take.

Among the measures are more rigorous risk disclosures, which will require funds to spell out their strategies and warn investors about how the value of funds could be affected by market fluctuations. It is also likely to attempt to bring hedge funds into line with industry best-practice on reporting net asset values and fund holdings. “A fund will have to spell out its strategy, and the strategy funds communicate to investors must be sufficiently indicative of the kind of activity they are going to do,” says Chanetsa.

The new regulations will also seek to differentiate between various types of investors in the local market. This would mean less-sophisticated clients are afforded greater protection than professional investors. “If you look at the needs of high-net-worth or professional investors, many of them are well able to look after themselves. So one probably wouldn’t need to have an extensive regime where they are concerned. But in the case of the retail investor or retirement fund, they are the most vulnerable and they would need more protection,” explains Chanetsa.

Consequently, hedge funds marketing themselves to non-professional investors are likely to be targeted with more prescriptive rules on leverage, for instance. In contrast, the agency is not likely to be too restrictive about leverage for professional clients, says Chanetsa.

Recognising the importance of funds of funds in the local industry, the new rules are expected to have little impact on this sector. “In our experience, funds of funds are very disciplined. I don’t think we’ll do anything radical with them outside of recognising some of the practices they already have in place,” says Chanetsa.

Two industry groups, the Alternative Investment Management Association (Aima) and the Association for Savings and Investment South Africa (Asisa), have been working with the FSB to iron out the plans. Both voice support for the agency’s ideas so far. “I don’t think we want a one-size-fits-all solution. Variety and latitude is necessary, and that derives from who the client is. It’s quite different having a high-net-worth individual prepared to risk a small percentage of a very large portfolio and protecting a pension fund member via a trustee,” says Stephen Smith, Cape Town-based senior policy adviser for Asisa.

At least for hedge funds marketed to less-sophisticated investors, the industry group is pushing a plan to incorporate the new rules under South Africa’s existing legislation for collective investment schemes (CIS). The current CIS rules regulate conventional asset managers, such as mutual funds and unit trusts, but don’t allow funds to use leverage, shorting or over-the-counter derivatives. Nevertheless, with the exception of these provisions, many South African hedge funds already comply with CIS legislation, says Smith. “We did a comparison on the extent to which existing hedge fund operations and mandates meet the CIS Control Act – and a lot of the governance controls are already in place,” he says.

As a result, many hedge funds could be swiftly accommodated under a less-restrictive CIS regime, Smith believes. At the same time, a relaxation of the rules around shorting, leverage and OTC derivatives would allow local asset managers to offer products such as 130/30 funds – giving them a similar amount of freedom to the European Union’s Ucits III regulations. “That could give asset managers an easily understandable set of rules, and people from abroad would be able to recognise the format,” argues Smith.

Although this idea is under discussion, the FSB seems anxious about possible complications. There remain some fundamental differences between hedge funds and funds regulated under the CIS, says Chanetsa. These include fee scales, legal structures, the number of investors and the average amount they invest in funds. CIS-regulated funds can sometimes have thousands of investors, whereas hedge funds have a clubbier feel, he says: “When there are some things that are so fundamentally different, can the funds co-exist in the same regulatory pocket? This is one of the things we need to look at.”

One thing the new regime is certain to have in common with CIS legislation is the need for a separation between managers and their assets. Funds will need independent custodians, although the use of these firms is already widespread across the local industry. It remains unclear whether hedge funds will be required to use outside firms in areas such as prime brokerage or risk management, says Chanetsa.

There are other possible areas of contention between the industry and the FSB. For instance, both the manner and the extent of hedge fund disclosures is a knotty issue, says Robert Foster, chairman of Aima South Africa and chief operating officer of Cape Town-based Alpha Asset Management. “We need to find a mechanism to report into a regulator or third party where there’s no competitive edge, because managers don’t want details of their positions made public, even if it is three months in arrears,” he says.

Which investors qualify as ‘professional’ under the rules could become another hot topic. Foster believes the definition could include pension fund trustees and high-net-worth investors who are receiving advice or are otherwise qualified. But the FSB’s Chanetsa appears cool on the idea of pension trustees being treated as professional investors. “There are trustees and there are trustees. Some know what they are doing and the actions of others have been questionable,” he observes.

Beyond these issues, some local hedge fund managers have deeper misgivings about the need for hedge fund regulation. Although industry bodies such as Aima and Asisa are supportive of the measures, Omigsa’s Watson says many smaller managers are less enthusiastic. “The people involved with those bodies are keen for regulation and are pushing for it. But if you speak to hedge fund managers who are not part of larger companies, their attitude is if you’re going to introduce a new layer of regulation, it’s going to mean more costs and complexity,” he says.

Warren Morton, chief financial officer and chief operating officer of Oryx Investment Management in Cape Town, agrees higher compliance costs are likely to be felt more heavily at smaller hedge funds: “If hedge funds don’t have a reasonable amount of assets, then just to comply with all these regulations will lead the industry to experience some degree of consolidation.”

Some hedge fund managers worry the new regulations could also stifle innovation in the industry, preventing the emergence of new ways to generate alpha. Elsewhere, local market participants say the new rules will effectively duplicate those regulations already in place, including the licensing regime for hedge fund managers. A further criticism is the agency’s plans seek to protect non-professional investors for whom hedge funds might not be suitable in the first place.

Nonetheless, the feedback from many of the larger market participants is mainly positive – mostly due to the possibility of attracting greater investment from more conservative investors. At the moment, pension funds are only allowed to make a maximum allocation of 2.5% to hedge funds under South Africa’s prudential investment guidelines. The FSB’s Chanetsa says the agency is discussing raising this limit with the National Treasury, but this would be a decision taken by policy-makers and not the FSB. “This is a policy aspect, not a practical one. How much can one safely allow retirement funds or retail investors to place in a hedge fund? It won’t be 100%. In fact, it won’t be anywhere near 100%,” he says. Although he is reluctant to suggest an exact figure, any changes will be fairly conservative, he adds.

Whether the rules are altered or not, it is clear many investors would prefer to put money in regulated products. Pension funds, in particular, are put off by the myriad legal structures hedge funds can currently take, say managers. Although hedge fund regulation will potentially mean higher costs, many believe this could be more than offset by an influx of new investment.

Yet increasing retirement fund involvement in hedge funds is greeted with greater cynicism elsewhere. Pension fund trustees are slow to change their asset allocations, notes 27four’s Vawda. Moreover, many funds are under pressure and may not wish to increase their exposure to the sector, adds Ian Hamilton, Cape Town-based chief executive of Investment Data Services, which provides hedge fund and private equity fund administration services. “Pension funds in South Africa are under pressure, and even if they have capacity are not putting more money in hedge funds,” he notes. In trying to protect less-sophisticated investors, the FSB runs the risk of turning hedge funds into a less appetising investment for institutional clients, Hamilton says.

At the FSB, Chanetsa insists the regulator is not out to straitjacket the hedge fund industry: “Hedge fund managers have a critical role to play in the South African investment universe. Our main concern is to ensure they operate within a legitimate environment.” While the agency doesn’t want to impede hedge fund managers, it wants investors to be as safe as they can be, he adds.

Managers say they would like to see current ambiguities cleared up quickly. Indeed, regulatory uncertainty was voted the most important issue for local hedge fund managers in Novare’s June 2009 industry survey. A particular gripe is the tax treatment of hedge funds, which remains unclear. Such worries are cited among the reasons local industry bodies are pushing for regulation as quickly as possible. But even if the FSB does produce firm recommendations by mid-year, this would only mark the beginning of a consultative process – and Chanetsa says it is difficult to predict how long this could take.