Until August 2007, hedge funds were unregulated investment vehicles providing investors with exposure to a wide range of products including derivatives and leveraged positions. A hedge fund is defined in the new Regulations discussed below as a portfolio which uses any strategy or takes any position which could result in the portfolio incurring losses greater than its aggregate market value at any point in time. If properly run, and if the hedge fund manager has the correct strategy, clients can enjoy good returns, even in situations where the equity market is falling.

In August 2007 the FSB, in cognisance of the many inexperienced hedge fund managers operating in the South African market, introduced Regulations under the Financial Advisory and Intermediary Services Act, 2002 (FAIS) governing the managers of hedge funds and funds of hedge funds.

The Regulations require all hedge fund financial services providers to be licensed under FAIS as Category IIA FSPs. A hedge fund financial services provider is defined as any financial services provider that renders intermediary services of a discretionary nature in relation to a particular hedge fund or fund of hedge funds.

Category IIA FSPs must prove to the FSB that they have a track record of managing particular hedge fund strategies and are able to adequately demonstrate knowledge, skills and competency in managing all instruments in asset classes comprising a hedge fund portfolio.

Anyone establishing and operating a hedge fund needs to ensure that the structure utilised is not regarded by the FSB as an unregistered collective investment scheme in terms of the Collective Investment Schemes Control Act, 2002 (CISCA). The structure would generally be a collective investment scheme if funds are raised from members of the public, pooled and invested on the basis that the investors enjoy a proportionate right to the pooled assets and associated returns.

To avoid onerous disclosure requirements in relation to the offering of shares or debentures to the public as required by the Companies Act, 1973 (Companies Act), many hedge funds use the exemption in the Companies Act which does not require a prospectus document if the minimum subscription for shares or debentures in the investment vehicle by each investor is at least R100 000.

Hedge funds should also be structured so as not to contravene the provisions of the Banks Act, 1990 (Banks Act) which regulates any activity that constitutes the taking of a deposit (including the taking of money against the issue of a debenture or note) from the general public. The Banks Act regulations provide certain exemptions that can be usefully implemented by hedge funds.

Hedge fund financial services providers must, according to the Regulations, obtain a signed mandate from their client authorising the hedge fund FSP to exercise its discretion in terms of its client's investments. This mandate must contain specific requirements, such as detailing the risks associated with investing in a hedge fund and the risk management principles which will be adopted by the hedge fund FSP.

An appropriately structured hedge fund will operate without contravening the provisions of Acts discussed above. From 29 April 2008, any person operating as a manager of a hedge fund or a fund of hedge funds must be licensed as described above. The Regulations represent a means by the FSB to ensure that hedge fund managers understand the regulatory and common law landscape within which hedge funds operate and are regulated and accountable in terms of FAIS.

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.