Japan presents tough environment for hedge funds seeking investment

Although Japanese investors appear keen to invest in hedge funds, the environment for selling products in the country is difficult and highly regulated. Hedge Funds Review explores the challenges facing funds seeking Japanese investors.

According to OECD estimates, Japanese pension funds had over $1 trillion in assets at the beginning of 2007. One research company has estimated that Japanese financial institutions increased their investment in hedge funds from 63% in 2006 to just under 70% in 2007. A Nikkei survey of major corporate pension funds found that 75% of respondents included alternative investments in their portfolios.

Relative to other markets such as the US, the regulatory regime in Japan is quite favourable towards hedge funds and alternative investments. Hedge funds are securities under the Japanese Securities and Exchange Law of Japan (SEL) and are available to all classes of investors.

However, this is a double-edged sword. Hedge funds can be made available to retail investors who are free to purchase products without meeting any predetermined qualifications. It also means hedge funds that are to be distributed in Japan are subject to the same local registration and reporting requirements as any other security. This is often viewed as over-complicated and costly.

"In contrast to the other major economies, Japan operates under a higher regulatory and tax burden. The regulatory system can appear confused, particularly to those from Anglo-Saxon economies. These factors mean there are few Japan-focused funds that are domiciled in the country," says Rahul Saito, hedge fund analyst at BDO Stoy Hayward Investment Management.

According to Saito, the majority of hedge funds sit in London, New York, Hong Kong or Singapore with many operating only a research office in Tokyo. It is common practice for hedge funds to have a legally independent advisor company in Tokyo sending out investment notes on their behalf. With an investment arrangement of this type, the portfolio manager is employed by the advising company and can be based in Japan.

Essentially there are two central issues with respect to the distribution of hedge funds in Japan. The first relates to the licensing of hedge fund marketers. The second covers the methods of distribution and the form in which the product offering is made.

There are currently many unlicensed alternative marketing groups active in Japan. Although it is difficult to verify, some estimate that over 100 individuals or groups based in Japan operate illegal marketing operations. In addition to these are the countless "fly in, fly out" marketers, including hedge fund managers, who are technically breaking the securities and exchange law when they make marketing trips to Japan.

Marketers have been able to get away with this approach to marketing in the past because hedge funds and alternative products represented only a small part of personal and institutional portfolios. With the increase in allocations to alternatives by institutional investors, the amount of money invested has been rising at a rapid pace. The result is that the Japanese Financial Services Agency (FSA) is increasing its scrutiny of unlicensed groups.

Japanese institutions are growing more uncomfortable in dealing with agents who are not licensed domestically.

To raise funds legally on the Japanese market, hedge funds need to be licensed. There are several types of licences, each with their own characteristics.

"There are various licences required to market funds in Japan. The key one is the investment advisory licence that allows holders to provide investment advice to both domestic and offshore entities, regardless of whether they are individuals, corporations or financial institutions. The licence is an advisory licence only, entitling holders to speak to potential clients about investment opportunities and make recommendations concerning investment products but not raise money to manage investments nor to trade discretionarily," explains Saito.

Not so DIM

There is also a discretionary investment management licence (DIM) that allows an advisor to take in client funds and manage those funds on a discretionary basis. A DIM may either manage funds internally or allocate funds on a discretionary basis to an outside investment fund such as an offshore hedge fund.

As is the case for the investment advisory licence, the DIM does not allow the licence holder to provide fund prospectuses and subscription forms to prospective investors for the purpose of selling a specific fund.

"In short, the regulatory environment for Japanese hedge funds is tight. In fact there aren't very many Japanese-domiciled hedge funds for that very reason, maybe 150 or 200 Japanese hedge funds by the end of 2008," says Hiroshi Matsubara, head of business development at Fidessa Latent Zero, an international technology firm that specialises in developing complete front-office solutions for the buy-side community.

"In order to trade and manage hedge funds in Japan you need to obtain a trading licence. This is a DIM and it is quite a big deal to acquire this licence in Japan: it is costly and once a fund obtains it they are under total scrutiny by the Japanese FSA. There are a small number of managers who have this licence," notes Matsubara.

The securities licence allows securities companies and their agents to market and sell investment fund products. Registered securities sales employees are allowed to engage in direct solicitation including distributing prospectuses and subscription forms to potential investors.

The securities and exchange law was amended in 2004 to allow for a new group of sales agents. This was created to encourage a wider distribution of investment products in Japan. The amendment allowed securities companies to expand their sales networks by contracting outside agents to market their products. A securities sales agent must be sponsored by a registered securities company but can be either an individual or a corporate entity.

"We have just tried to set up a privately placed fund and through this we just buy the offshore funds. So it is a rather complicated process. But if you have the licence you can sell the funds freely," explains Hitoshi Yamamoto, CEO, Fortis Investments (Japan).

Individual hedge funds or hedge fund-linked products can be distributed in several ways. A public offering will reach the broadest universe of potential investors. However, it is also the most costly in terms of both the initial offering and the ongoing periodic filings.

The public offering has been the method of choice for products that are created for the retail markets, including the high net worth segment or the standard retail segment. Since the first fund of funds-linked principal guaranteed product was sold by Yasuda Trust in 2001, many publicly offered hedge fund-linked principal protected products have found their way to the market via securities companies and commercial banks.

The publicly placed investment trust funds, equivalent to the mutual funds in the UK, need to have approval from the Japanese FSA every time they decide to launch a new fund or a new product. Approval is not given by the FSA lightly.

"Although there are no written rules to prevent hedge funds selling in the retail market, the FSA has been tough on publicly placed hedge funds," says Yamamoto.

One of the restrictions for a hedge fund offered for sale in Japan as a public fund is the permitted level of short selling, which is not allowed to exceed the net asset value of the fund, according to Brian Dillon, partner financial services at Dillon Eustace.

Neverending requirements

Once a fund is registered with the FSA for a private placement, there are certain ongoing requirements. A private placement allows for up to 49 potential investors and 250 qualified institutional investors within a six-month period. Virtually all qualified institutional investors, as defined by Japanese law, are financial institutions.

The registration costs are comparatively low for private placements, making this an effective way to target a select and limited number of investors.

"The rules for a private placement in Japan are slightly different to that of a public offering. For a public offering you are required to file much of the fund documentation with the regulators in a fully translated securities registration statement. For a private placement the rules are less onerous, provided there are fewer than 50 investors. A fund of this type is only required to register with the FSA," says Dillon.

A professional private placement allows for unlimited marketing to qualified institutional investors. It is also a more efficient way of targeting a large number of institutional investors. As with the small number private placement, the registration costs are comparatively low.

If a fund is going for a private placement and targeting high net worth individuals and pension funds, the key to success is a good distribution network in Japan, believes Dillon.

"The distributors in Japan advise the investors of the best-performing funds. These are the Japanese securities houses like Nikko Cordial Securities, Nomura Securities, Mitsubishi, UFJ Securities, Daiwa Securities and Mizuko Securities. We have been working closely with many Irish-domiciled funds looking to market their products in Japan," comments Dillon.

For future success in the Japanese market, hedge funds will need to offer something other than high risk/high return with leverage products, believes Fortis Investments' Yamamoto. "They will have to resort back to the old style hedge funds. Japanese equity long/short will essentially survive," he says.

In 2009, Japanese pension funds are expected to continue to allocate to hedge funds. Other financial institutions, like regional banks, national banks and insurance companies, are expected to steer away from hedge funds and opt for conservative investments.

Despite the less-than-favourable outlook, the current government is unlikely to introduce any further restrictions or new rules on hedge funds in 2009. However, if the government changes following the general election, due before September 2009, then funds could face tougher supervision and regulation, concludes Yamamoto.

- Related articles: Japan hedge fund, page 18.

HEDGE FUND INVESTMENT COMPLEXITIES

Japanese corporations investing in hedge funds are subject to corporate tax at the rate of approximately 42% (unless size-based taxation applies, in which case the rate may vary) on income and gains from investments in hedge funds.

If hedge funds are structured as corporations or investment trusts and the paying agent is based in Japan, distributions from hedge funds may also be subject to withholding tax at the rate of 20% (reduced to 7% if the funds are publicly traded).

In the case of Japanese individual investors, distributions from hedge funds (established as corporations or investment trusts) are subject to withholding tax at the rate of 20% (reduced to 10% if the funds are publicly traded).

If the funds are not publicly traded, the distribution is subject to income tax at progressive individual income rate (up to 50%).

Capital gains arising from the sale of units in a hedge fund are subject to income tax at the rate of 20% (reduced to 10% if the funds are publicly traded and the sale is made through a broker-dealer acting in Japan.

If hedge funds are established as partnerships and treated as pass though for Japanese tax purposes, Japanese investors are treated as investing in the underlying assets in the hedge funds directly and taxed accordingly on an 'arising' basis.

Foreign hedge funds may be subject to the Japanese anti-tax haven (CFC) rule if more than 50% of its units are owned directly or indirectly by Japanese-resident (including related parties) individual or corporate investors. In such a case, investors that own not less than 5% of the total number of units of a hedge fund may be liable to tax in respect of the portion of income retained in the foreign hedge funds attributable to the investor, even if it is not distributed from the hedge fund.

A foreign hedge fund that has a permanent establishment in Japan is subject to tax in Japan on Japanese-source income. Furthermore, even if a foreign hedge fund has no permanent establishment in Japan, capital gains derived from certain sales of shares are subject to Japanese tax in certain circumstances.

Capital gains derived from the sale of shares in a Japanese corporation, holding mainly real estate assets in Japan, will be subject to taxation in specified cases based on the extent of the shareholding of the hedge fund in the corporation.

In certain circumstances, the tax rules may be overridden by the terms of double-taxation treaties with Japan.

Source: Under the spotlight: The regulation, taxation and distribution of hedge funds around the globe, June 2007, PricewaterhouseCoopers.