New hedge fund policy framework welcomed, but some issues to consider, says ENS

National Treasury and the Financial Services Board released a policy document in September which will have a marked impact on hedge funds and collective investment schemes. While the policy document could have some very positive effects on the hedge fund

This is according to Johan Loubser, Director at ENS (Edward Nathan Sonnenbergs), referring to the policy document, which was released on 13 September 2012 - “The Regulation of Hedge Funds in South Africa”.

Loubser says the policy document sets out a framework for the direct regulation of hedge funds in South Africa. “At the moment, hedge funds are not directly regulated in South Africa, but are indirectly regulated through the regulatory oversight which the Financial Services Board exercises over hedge fund managers, prime brokers and fund administrators. This policy document proposes that hedge funds be directly regulated as a new category of collective investment scheme under the Collective Investment Schemes Control Act (“CISCA”).”

The policy document proposes that hedge funds be categorised as either “restricted hedge funds” or “retail hedge funds”. “Restricted hedge funds will be subject to lighter regulatory requirements and must have a restricted investor base consisting only of “qualified investors” who invest pursuant to private arrangements. Retail hedge funds, who will be permitted to market themselves more widely, will be subject to a greater degree of regulation and will, among other things, be required to meet investor redemption requests within 14 days, publish a key investor information document (“KIID”) containing short-form prescribed information aimed at assisting investors to understand the investment product, and will be subject to prudential investment requirements,” says Loubser.

The policy document further proposes that each hedge fund will require a collective investment scheme manager approved under CISCA. Service providers to hedge funds such as prime brokers and fund administrators will be subject to specific regulatory requirements.

Loubser says while there are many details still to be worked out, the publication of the policy document and the changes set out therein should have some encouraging effects on the industry.

“We believe the regulation will promote investor choice. Having hedge funds regulated through CISCA will permit investors who have to date been wary of investing in unregulated investment structures, or who may not have known of suitable hedge funds because of restrictions on marketing, to gain exposure to alternative investment strategies through a regulated investment product which can be marketed under an established regulatory framework,” he says.

According to Loubser, the regulation will likely encourage further product innovation in the collective investment scheme industry through the creation of more portfolios following different investment strategies.

“It will also lower investor due diligence costs through the standardisation of legal structures and documentation as well as permit industry participants to plan ahead as a result of greater certainty in relation to the likely regulatory framework,” he says.

Direct regulation of hedge funds will, in addition, enhance regulators’ knowledge and insight into the nature and use of derivatives. Loubser says this will be useful in related areas of regulation given the wide-spread use of derivatives in the financial services industry.

“Furthermore, adoption of the CISCA regulatory framework will improve governance since it will create checks and balances given the respective roles of the trustee/ custodian on the one hand and the manager of the collective investment scheme on the other. The role of the trustee/ custodian under CISCA is to verify, as an independent party, that the manager administers the relevant portfolios in compliance with CISCA and with the founding documents of the scheme. This type of oversight is not currently in place in all hedge fund structures,” he says.

According to Loubser, government’s stated intention in the policy document is to introduce the regulatory changes in two stages. “The first stage, which will be an interim measure, will commence when hedge funds are declared to be collective investment schemes under section 63 of CISCA and then regulated through subordinate legislation. The second stage will commence following legislative amendments to CISCA,” he says.

However, he warns that there are some potential issues to consider regarding the proposed changes, including the tax treatment of investors, insolvency risk, whether the proposed prudential investment requirements set out in the policy document are too restrictive and whether or not the name “hedge fund” will still be appropriate.

He therefore urges industry stakeholders to respond to government’s call for comments on the framework document by 15 November 2012.