Australian hedge funds measured by assets are the second largest in the Asia-Pacific region after Hong Kong, according to the Australian Trade Commission, with over US$30 billion under management at the end of 2010.
New disclosure rules for hedge funds are being developed by the financial services regulator, the Australian Securities and Investments Commission (ASIC), and expected to take effect from 1 March 2013.
ASIC believes that disclosure guidance for hedge funds is required because in some cases, inadequate disclosure has contributed to investors not understanding the risk when purchasing a hedge fund product.
The proposed new disclosure model will involve disclosure principles around key matters such as investment strategy, investment managers and liquidity.
Funds will also have to address two "benchmarks" in their disclosure documentation on an "if not, why not" basis. In other words, if the fund does not meet a particular benchmark, it should explain why. The two proposed benchmarks relate to valuation and custody of assets, and periodic reporting.
ASIC released its proposed guidance on hedge fund disclosure in February 2012 (CP 174) and the final regulatory guide is expected to be released in mid-2012. An earlier consultation paper had been released a year ago in February 2011 (CP 147). The following commentary is based on CP 174.The final guidance may be different.
While the ASIC guidance is guidance only and not mandatory, for practical purposes it is guidance that must be followed. As ASIC points out in CP 174, failure to disclose in accordance with its regulatory guidance will result in an increased risk of a PDS being in breach of the Corporations Act and ASIC issuing a stop order for the offer or taking other action if it thinks that investors have been misled or deceived.
How Australian hedge fund disclosures are regulated
Australian hedge funds are regulated as managed investment schemes under the Corporations Act. Interests in managed investment schemes are classed as financial products by the Corporations Act. As a result, offers of interests in hedge funds fall under the regulatory regime for financial services in Chapter 7 of the Corporations Act, where the key disclosure document for retail investors is the product disclosure statement (PDS). In contrast, the offer of shares or debentures (even though they are also financial products) is governed by Chapter 6D of the Corporations Act, where the key disclosure document is normally a prospectus.
The Australian Government thinks PDSs for managed investment schemes have been too long and complex, so they will be subject to a new shorter PDS disclosure regime, alongside superannuation and margin loans. This will commence on 22 June 2012, but will apply only to what are called "simple" managed investment schemes. The Minister announced on 22 December 2011 that hedge funds will be excluded from the shorter PDS regime until they can be fully considered in respect of the policy intent of the regime.
What is a hedge fund?
Because hedge funds are not defined in the Corporations Act, a threshold issue for ASIC has been to develop a definition.
The current proposal in CP 174 is that a hedge fund is "a registered management investment scheme that is, or has been promoted as, a hedge fund or fund of hedge funds".
This is a bit circular: a hedge fund is a registered management scheme that is a hedge fund. The proposed definition is problematic in another respect: a registered management investment scheme will be a hedge fund under this definition if it promotes itself as a hedge fund, even if it does not have the commonly understood characteristics of a hedge fund. Reworking of the draft definition of hedge fund may be needed.
Coupled with this definition in ASIC's draft guidance is a list of factors that ASIC proposes may be relevant in deciding if a particular managed investment scheme is a hedge fund. These factors are perhaps more useful than the definition itself.
- Strategy: The fund pursues complex strategies that aim to generate absolute returns, returns with a low correlation to equity and bond indices, or a positive return in both rising and falling markets.
- Leverage: The fund uses leverage to increase investment returns.
- Derivatives: The fund uses derivatives to create complex investment strategies or for gearing purposes.Short selling: The fund engages in short selling.
- Complexity: The fund has exposure to diverse risks and complex underlying instruments.
Funds that are not hedge funds may share some of these characteristics. There is no hard line of demarcation. ASIC's expectation is that a fund should disclose as a hedge fund if it is uncertain whether or not it is a hedge fund.
Although the disclosure guidance is limited in scope to retail offers by hedge funds, ASIC encourages funds to disclose against the benchmarks and apply the disclosure principles when making offers to wholesale investors (when a PDS is not required) or when the offering entity has some of the features of a hedge fund.
ASIC has previously issued a number of regulatory guides about disclosure for specific kinds of managed investment schemes including mortgage schemes and unlisted property schemes. If a hedge fund also fell into the category of scheme covered by one of these other guides, ASIC expects that the hedge fund would follow the other guide.
What about funds of funds?
A fund of hedge funds would also be a hedge fund for the purposes of ASIC's guidance.
ASIC proposes that the disclosure requirements would apply to a fund of hedge funds or a structured product where a hedge fund has invested more than 25% of its assets in the fund of hedge funds or the structured product.
If there are multiple hedge funds or managed accounts with common or related managers that a hedge fund is investing in, ASIC's proposed guidance says that these investments should be aggregated for the purpose of determining if the 25% threshold has been exceeded.
ASIC proposes two benchmark disclosures for hedge funds, where the responsible entity must state whether it meets the benchmark and if it does not meet the benchmark, explain why. If the responsible entity partially meets a benchmark, ASIC expects the responsible entity to explain which parts, and also how it otherwise deals with the risks associated with the benchmark.
Benchmark 1 relating to valuation and custody of assets is that the responsible entity has and implements a policy that requires valuations of fund assets which are not exchange traded to be provided by independent third party administrators, and that all custodians involved in the fund structure must be unrelated to the responsible entity or the investment manager. This includes custodians of any underlying funds.
Benchmark 2 is that the responsible entity has and implements a policy to provide specific reports on certain key information. This includes at least annual reporting on funds under management (FUM), asset allocation, liquidity and maturity profiles, leverage ratio, undrawn loan amounts, derivative counter parties, investment returns and key service providers. The latest report of these matters should be available on the fund's website, and updates (on a monthly basis or if less often, on each date when investors can redeem their investments) would be provided on FUM, undrawn loans, changes to key service providers, and certain other material changes.
There are nine disclosure principles in ASIC's draft guidance. They cover:
- investment strategy
- investment manager
- fund structure
- valuation, location and custody of assets
- derivatives and structured products
- short selling
There are detailed breakdowns of each of these principles in CP 174.
Where a responsible entity is unable to provide particular information, the PDS should disclose why.
ASIC also recommends that a summary of the information be given in the first few pages of the PDS.
A start date of 1 March 2013 has been proposed by ASIC for the new disclosure requirements.
For existing investors, it is proposed that a responsible entity will have to provide an updated disclosure to investors using the benchmarks and disclosure principles by no later than1 March 2013.
Listed hedge funds are subject to the continuous disclosure obligations that apply to listed entities under the Corporations Act.
Unlisted funds must give retail investors notice of material changes to matters required to be in a PDS, or significant events that affect those matters.
ASIC's view is that:
for listed funds, material changes to the benchmark and disclosures principle information may be a continuous disclosure event; andfor unlisted funds, diversions from the benchmarks or changes to the benchmark or disclosure principles information are material issues that should be covered in notifications to investors.
ASiC considers that responsible entities should use a dedicated page on their websites to provide regular updates to investors on material changes.
A new or supplementary PDS would normally also be required for material changes. However, if the updated information is not materially adverse, a new or supplementary PDS may not be necessary if the responsible entity provides the information on its website and complies with the other conditions in ASIC class order CO 03/237.
The details are yet to be finalised, but the general direction is clear for the new disclosure requirements for hedge funds. Funds can now usefully begin to identify any disclosure gaps that may need to be addressed before the requirements commence.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.