Under close scrutiny

Hedge fund regulation

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South Africa's hedge funds have recently had a different kind of exposure thrust upon them. Over the past year, the country's Financial Services Board (FSB) has been engaged in officially licensing local hedge fund managers - a process that involved managers submitting lengthy applications and acquiescing to day-long on-site visits from the regulator. The initiative represents the FSB's first attempt to get to grips with the sector, which had formerly been regarded as self-regulating (Risk South Africa Autumn 2007, pages 6-8).

In all, the FSB had received 123 applications from hedge fund managers by the time Risk South Africa went to press. Of these, 106 were awarded, while 17 remain under consideration. Although the majority of applications have been granted, the process has not been without problems. Along the way, the FSB found repeated operational shortfalls at some hedge funds, while the agency struggled to meet its own timetable for completing the process.

"We started the licensing round in November last year, but January 2008 was the time when we got most of the applications," explains Wendy Hattingh, Pretoria-based head of supervision in the FSB's financial advisory and intermediary services division. "We did our on-site visits from February, and by the end of April all hedge fund managers had to be licensed."

Managers who applied for an upgrade to the so-called Category IIA licences say the application and approval process was more rigorous than for their long-only counterparts. Areas of particular focus for the FSB included risk management approaches and compliance structures - for instance, compliance monitoring and the avoidance of conflicts of interest. "There was certainly a more comprehensive set of tests than you'd find for non-Category IIA licences," comments Tom de Lange, chief investment officer at Vega Capital, a Cape Town-based hedge fund manager with over R300 million ($36.8 million) in assets under management (AUM).

While the regulator accepts some managers may have different approaches to functions such as risk management and compliance, it wanted to ensure certain standard procedures were in place. "We cannot compare an international fund manager with a small local fund. We accept their risk management systems might be different; but if they don't have it, then it's a problem," says the FSB's Hattingh.

To qualify for the licences, hedge fund managers also needed to have a relevant financial qualification at degree level, and experience in managing hedge funds of anything from one to three years. For the most part, Hattingh says this was not an issue - although making sure managers had the experience they claimed was troublesome. Other areas considered by the FSB included the legal structure of individual funds, AUM, fee structure and strategies employed. Scrutiny was also given to the procedures through which outsourcing partners were selected, and the ethical character of individuals involved in the funds.

While the vast majority of applications were approved, around 80% of the 106 licences had conditions attached to them, says Hattingh. These were related to specific issues at various hedge fund managers and some repeat problems that arose at several firms. One of these was mandate compliance.

"Mandate compliance procedures were a concern. Some people had them but only on a monthly basis, in a specific way we were not satisfied with. We would like to see closer monitoring of mandate compliance on an ongoing basis," she says. A breach of mandate is thought to have contributed to South Africa's only hedge fund mishap to date. Cape Town-based Evercrest Capital shut down in early 2007 after apparently making huge losses on a short position in financial services group Sanlam.

Another common problem identified by the FSB was a lack of sufficient professional indemnity cover - a level that is set at a minimum of R5 million for most managers, says Hattingh.

The FSB's findings will contribute to a new code of conduct for hedge fund managers, expected to be released for industry consultation in 2009. Although the exact content of the new code is in flux, any changes based on the licensing round are expected to centre on operational risk.

One area likely to be tightened up by the FSB is the procedure for receiving feedback from external business partners, such as administrators, risk managers and prime brokers. Third parties such as these play a key role in South Africa's hedge fund market, with 78% of funds employing external administrators in June 2007, according to a survey by Cape Town-based fund of funds Novare Investments.

"What is important from a market conduct point of view is to discover who is taking responsibility for what. Normally, if there is any problem with hedge funds, one party identifies an issue and they go straight to the hedge fund manager. If they don't act properly on the information, there might be a serious problem or a failure," says Hattingh. These concerns were addressed by the FSB in some of the conditions it placed on licences, she adds.

In preparation for the visits, the regulator consulted heavily with local specialists, including funds of funds, to get a feel for industry best practice and a clearer picture of the market - worth R25.89 billion in AUM as of June 2007, according to the Novare survey. "We now have a better idea of what the hedge fund industry looks like," says Hattingh.

Likewise, hedge funds also now have a better idea of how FSB regulation will work. And, despite the more onerous requirements placed on the country's hedge fund managers, many of them are positive about the way the licensing regime has progressed.

"Probably the most pleasing aspect of the process for me was they came in with an attitude of 'we don't know everything about hedge funds' and that was a very good attitude to come in with," says Theron van Wyk, executive director of Cape Town-based TriAlpha, which runs a R1.7 billion fixed-income fund of funds.

Renault Kay, principal at Trendline Funds in Cape Town, a commodities fund with R50 million under management, agrees: "It was an education process for both sides because, previously, hedge funds have never really had much contact with the FSB. Now, the FSB has had some interaction and gone around to people's offices and found out what they look like. And, from the fund manager's side, they could chat with the FSB and find out what their fears are."

In spite of the conditions placed on the majority of the licence approvals, most hedge fund managers report few problems in obtaining the green light. Adam Fletcher, head of legal services at Investec Asset Management in Cape Town and chairman of the Investment Management Association of South Africa's legal committee, says: "The largest institutions were generally comfortable with the process because we have the resources and structures in our business to comply with whatever requirements are placed on us. I think you'll find some of the smaller operators who have spent time structuring their businesses to comply would be less happy."

In these cases, he believes many firms pre-emptively embraced industry best practices, such as a separation of functions, independent compliance, risk monitoring and administration to bring them in line with the FSB's expectations. "The anecdotal evidence from the industry is that people knew what was coming and have taken steps to proactively regularise their operations so they pass muster with the FSB," Fletcher adds.

The fact licensed hedge fund managers have proved they meet certain standards with regard to risk management and compliance is likely to be positive for the industry as a whole, say market participants. "The fact we now know there are 100-odd managers out there with the skills and the credentials to run a hedge fund properly is good for all of us," says Warren Chapman, Johannesburg-based head of prime brokerage at Peregrine Securities. "My view is we need experienced and competent people out there who know what they're doing, and we need best efforts to protect the industry from mavericks and cowboys."

South Africa's hedge fund industry has enjoyed explosive growth over the past few years. Between June 2006 and the corresponding month in 2007, total AUM grew by 68.5% and at least 33 new funds had been launched, according to Novare. But much like their counterparts elsewhere around the world, South African funds have endured a rough time over the past year, Chapman claims. This phenomenon, combined with the new requirements placed on hedge fund managers by the FSB, could cause market growth to temporarily slow.

"The industry has been going through a difficult phase, and several managers have had their mandates pulled. I think a combination of the licensing process and the market environment means it will be a little bit harder for a new manager to set up a business," Chapman says.

In the long term however, many in the industry believe regulation is the only way to meaningfully increase the industry's overall share of capital. "There is a massive spectrum in the industry. You have some people who are extremely competent and disciplined, and you have others who are basically playing the stock market," opines Ram Barkai, chief executive of financial services group and asset manager Cadiz in Cape Town. "For the industry to grow to R100 billion, which is not a lot, you have to have some mechanism through which investors know there is some screening and filtering."

One type of investor many hedge funds are keen to attract is pension funds. Over recent years, many pension fund trustees have significantly upped their allocation to alternative investments elsewhere in the world, notes Grant Watson, Cape Town-based head of alternative investments at Futuregrowth Asset Management. Although South African pension funds are limited in the amount they can allocate to hedge funds by prudential investment guidelines, he predicts more will enter the market as a result of the recent licensing regime.

"With the volatility we've had over the past few months and years, pension funds are looking a lot more at absolute return-type strategies, and this is going to release a lot of pent-up capital to hedge funds," he says.

As well as bringing in a code of conduct for hedge fund managers, the FSB is also considering introducing prudential regulation for hedge funds in South Africa. For the industry, this would mean regulatory scrutiny extending beyond managers and into the hedge funds themselves. "We are still looking at, in the future, having prudential regulation over the hedge fund product," confirms the FSB's Hattingh. This could involve limits on the assets in which hedge funds can invest and the amount of leverage they use, as well as requiring fuller and more frequent disclosure of positions and net asset values.

Such ideas are controversial among market participants. For some, eager to attract capital from more conservative investors, the status of a regulated entity is one to be coveted. "Market commentators advising people like pension funds are conservative, so they are more likely to recommend regulated products," says Watson of Futuregrowth. Other proponents of regulation add that winning the moniker of 'regulated product' might force the FSB to look again at its prudential investment guidelines, which currently allow pension funds to allocate a maximum of only 2.5% of their assets to hedge funds.

But others have a different view. "I don't believe hedge funds are an asset-gathering industry - they are a performance-based industry," says TriAlpha's van Wyk. "I would rather the FSB spend the energy regulating the product providers."

Trendline's Kay says he is satisfied with the present regime, but points out some of the requirements of the recent licensing process essentially duplicate safeguards found elsewhere. "Ethical character of the individuals is almost covered by existing FSB regulations and by exchange rules as well," he says.

He also queries how the regulator can manage to standardise various aspects of an increasingly diverse industry. "The guys doing directional management are going to have different risk profiles to arbitrage guys or credit guys - how are you going to spec all of that?" he asks.

Even those in favour of prudential regulation cite other potential problems for the FSB, such as the tax treatment and legal status of hedge funds - both of which are clouded with uncertainty. However, Ian Hamilton, Cape Town-based chief executive of third-party administrator Investment Data Services and chairman of the Alternative Investment Management Association of South Africa, believes this is a good reason for further oversight. Prudential regulation would enshrine a standardised structure for South African hedge funds, which would also help clear up ambiguities - in particular, over whether they should be taxed on a revenue or capital gains basis. "There's a danger in a lot of these structures that they're not being used for the purposes in law they were envisaged - and the biggest problem you have running around them is tax uncertainty," says Hamilton.

Transparency

A sticking point for hedge funds appears to be transparency. Managers point to the rigorous disclosure requirements placed on more traditional funds that fall within South Africa's Collective Investment Schemes Act, and wonder whether this is something hedge funds could practically emulate. Pierre Groenewalde, Cape Town-based portfolio manager at Novare, says: "Mutual funds and unit trusts disclose their portfolios on a regular basis. Obviously, a hedge fund manager will not be able to do that."

Vega's de Lange says daily mark-to-market reporting could also pose difficulties for some funds. "Our portfolios would certainly be able to do that, but not all funds would mark-to-market on a daily basis - and not all funds would want to do that, because you could get wild swings."

Nonetheless, barring these reservations about the direction future regulation might take, many in the local industry are taking comfort from the FSB's approach to the recent licensing round. Like others, de Lange says he is not overly worried about the prospect of over-zealous regulation by the agency in the future.

"Up to now, the regulator has been quite effective and informative, so I'm not concerned we'll end up with regulation that's too restrictive."

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