THE REGULATION OF HEDGE FUNDS
By Kelebogile Modise and Lili Nupen
The hedge fund industry in South Africa has been growing at a significant rate over the past few years, as institutional and sophisticated investors are realising that hedge funds can and should form a key component of any investment portfolio if they are to achieve optimal returns. In light of this development, regulatory frameworks must be implemented as they are vital to ensure that the market evolves in a systematic and operationally efficient manner, thus allowing South Africa to have a competitive edge in the global market. This update reviews the current regulation of hedge funds in South Africa.
There is no clear statutory or legal definition of "hedge funds" in any of the relevant legislation. However, a ’hedge’ has been referred to as a guard against the risk of loss, and a "fund" as a reserve of money set aside for a certain purpose. The creation of any kind of regulated financial product is conditional on agreement being reached on an acceptable definition of "hedge funds". Whether such definition should adopt a narrow or broad approach has been debated. A wide definition, which was proposed in the Discussion Paper on the Regulatory Position of Hedge Funds in South Africa 2004 ("Discussion Paper"), states that hedge funds are "funds that utilise some form of short asset exposures or short selling to reduce risk or volatility, preserve capital or enhance returns". This definition has been criticised for not encompassing all of the most important characteristics of a hedge fund, which include the following:
funds utilise short selling to reduce risks, preserve capital and enhance returns;
funds use some form of leverage, measured by the gross exposure of underlying assets exceeding the amount of capital in the fund; and
the manager of the fund charges a fee based on the performance of the fund relative to an absolute return benchmark (e.g.inflation or call interest rates).
It was proposed that, where the first two characteristics are present, the fund may be referred to as a hedge fund.
Regulation of Hedge Funds
Currently, there is no specific piece of legislation that regulates hedge funds in South Africa. However, the Discussion Paper, certain sections of the Collective Investment Schemes Control Act, 2002 and the Financial Advisory and Intermediary Services Act, 2002 apply to the sale of foreign hedge funds in South Africa.
It has been suggested that there is an urgent need for regulations to be put in place. The main shortcoming of the lack of regulation is that shareholders are not permitted to solicit investments directly from the general public. In addition, there has been increasing exposure of South African investors to offshore hedge funds and the Financial Services Board ("the Board"), a local regulator of financial services, should thus consent to the sale of foreign hedge funds in South Africa. As there is a lack of regulation, great uncertainty and a hindrance to consistent growth have been created in the industry. The slight protection that the Board affords to investors has been criticised as being insufficient to encourage new investors to invest in hedge funds.
Relaxation of Hedge Fund Regulations
In March 2004 the Board, the Alternative Investment Management Association and the Association of Collective Investments issued a Discussion Paper calling for comments on the regulation of hedge funds in South Africa. Prior to the issue of the Discussion Paper, hedge fund managers were regulated by the Board, but there was no form of regulatory approval for the hedge fund itself. The regulatory framework for hedge funds can currently be found in the Collective Investment Schemes Control Act and the Financial Advisory and Intermediary Services Act, and is enforced by the Board.
The Financial Advisory and Intermediary Services Act applies to all persons who render financial advisory and intermediary services and are thus required to be licensed by the Board. The Act requires that hedge fund managers (as well as regulating financial intermediaries which market or sell hedge fund products) meet certain minimum qualifications. In this regard, the Discussion Paper recommends that different qualifications be set out to regulate financial intermediaries and hedge fund managers so as to improve the level of disclosure and certainty for potential investors.
The Collective Investment Schemes Control Act ("the Act") regulates collective investment schemes (i.e.generally, investment schemes in which there is a pooling of funds from members of the public and investors acquire a participatory interest in the scheme). A hedge fund may be referred to as a "collective investment scheme in securities". If a fund falls within the definition of "collective investment scheme" contained in the Act, compliance with the Act is required. However, most hedge funds are unable to comply with the Act, as the Act does not permit collective investment schemes to engage in short-selling or leveraging. Therefore, hedge fund managers cannot permit members of the public to participate in hedge funds or must structure their funds so that they fall outside the ambit of the Act.
The Discussion Paper recommends that hedge funds be construed as investing in instruments similar to collective investment schemes in securities, which are already regulated under the Act. This will allow hedge funds to be accommodated as separate schemes or portfolios, but under existing schemes in securities. The advantage of using existing legislation is that hedge funds will have their own defined types of asset to be invested without having to legislate further. The process will be faster, as the relevant regulatory body will favourably consider applications by hedge funds whose investors and products are similar to those of collective investment schemes in securities.
In terms of the Act, foreign collective investment schemes wishing to solicit investments from members of the public must obtain approval from the Board. The criteria used by the Board for the approval of foreign collective investment schemes includes the registration of such foreign scheme in a jurisdiction and with conditions acceptable to the Board. This factor may prove complicated in relation to hedge funds, as many of the jurisdictions in which hedge funds are registered are not currently regarded as acceptable by the Board. Under the current regulatory environment, the Board will not approve foreign schemes which are not subject to restrictions similar to that applicable to South African collective investment schemes or which are registered in a jurisdiction that is not recognised by the Board. Therefore, the following foreign hedge funds will not be approved for sale in South Africa:
funds that employ short-selling and leverage;
funds that make use of over-the-counter derivatives; or
funds domiciled in jurisdictions not recognised by the Board.
The Discussion Paper indicates that the existing regulatory framework provides a sufficient scope to accommodate hedge funds without making any significant changes to the legislation. The necessary alterations may be made through subordinate legislation to the relevant acts and must be in line with the Board’s principles of regulation.
Based on recent discussions with the local regulator, as well as general industry debate, it is likely that hedge funds will be regulated under the Act, through a new set of regulations which are likely to be finalised during the last quarter of this year.
Potential Benefits of Hedge FundsCertain proposed benefits associated with hedge funds will be enhanced in the event of implementation of the necessary regulations. These benefits include the following:
the inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns;
having a variety of hedge fund investment styles provides investors with a wide choice of hedge fund strategies to meet their investment objectives and provides diversification which is unavailable in traditional investing; and
hedge funds provide an ideal long-term investment solution, eliminating the need to enter and exit markets correctly.
Therefore, the aim of most hedge funds is to reduce uncertainty while attempting to preserve capital and deliver positive returns under all market conditions.
The relatively short history and small number of operating hedge funds in South Africa (as compared with the international market), as well as the broad definition of "hedge funds", contribute to many of the challenges of regulating hedge funds in South Africa.
The South African hedge fund industry is in the process of bringing hedge funds within the scope of the Act, which will allow hedge funds to be offered in the form of collective investment schemes or unit trust investments. This will result in a wider spectrum of investors having their assets invested in these funds. It must, however, be noted that despite creating a greater feeling of certainty, regulation will not remove all risks associated with investing in hedge funds, in the same manner as the regulation of conventional collective investment schemes does not remove the risks associated with investment of these funds.
These risks must be understood by potential investors and avoided as much as possible.