Focus: New disclosure rules for retail hedge funds
3 March 2011
In brief: The Australian Securities and Investments Commission has released a consultation paper that outlines proposals to require detailed additional disclosures to be made by Australian retail hedge fund (and fund of hedge fund) product issuers. In this Focus, Partner Susan Burns and Senior Associates Marc Kemp and Geoff Sanders look at the scope of the proposals and the impact they may have on an industry already facing increased world-wide regulatory scrutiny in the wake of the global financial crisis.
- Who will the new disclosure rules apply to?
- What will need to be disclosed
- Are the disclosure requirements appropriate?
- Timing and next steps
How does it affect you?
- ASIC Consultation Paper 147 (CP 147) contains proposals which, if implemented, will require detailed additional disclosures to be made by any registered managed investment scheme that can be described as, or promotes itself as, a 'hedge fund' or a 'fund of hedge fund'.
- The issuer of each hedge fund product covered by CP 147 would need to include detailed disclosures in its Product Disclosure Statement (PDS) on a range of specific matters that ASIC considers to be necessary for retail investors to make a fully informed investment decision. The specific disclosures include details of a fund's investment strategy and holdings, information on the use and source of fund-level leverage, and details of the use of derivative and short-selling strategies employed.
- Although the rationale behind these new proposals is generally positive, there are some potentially negative outcomes that may discourage funds, so we advise those affected to become involved in the consultation process. Submissions are requested to be made by 21 April 2011.
The proposed disclosure rules will apply to any registered managed investment scheme that 'is, or has been promoted as, or is generally regarded as (a) a hedge fund; or (b) a fund of hedge funds'.
Despite this deceptively simple approach, coming up with a clear definition of exactly what is a 'hedge fund' is not always straightforward (something that ASIC itself recognises in CP 147). To address this, ASIC has deliberately cast a wide net, by seeking to define the scope of the application of the rules by listing a set of broad 'indicative factors' designed to assist issuers in determining whether or not the rules will apply to their products. These factors include whether a fund:
- pursues 'complex strategies' that aim to generate absolute returns;
- 'often' uses leverage to increase investment returns, derivatives to create complex investment strategies or for gearing, and/or short selling techniques; and
- 'often' has exposure to 'diverse risks and complex underlying products'.
While we appreciate the difficulty ASIC faces in defining the nature of the hedge fund industry, there is, in our view, a risk that the inclusive manner in which a 'hedge fund' has been defined for the purposes of the new rules will result in a large number of fund products not traditionally seen as 'hedge fund' products becoming subject by default to the new disclosure requirements in circumstances where some of the additional disclosure requirements imposed may be of little or no practical assistance to investors in those products. Given this, we expect the broader retail fund industry to work closely with ASIC during the consultation period to seek to limit the concept of a 'hedge fund' to which the rules will apply.
As noted above, the enhanced disclosure requirements only apply to registered managed investment schemes and do not, therefore, directly apply to wholesale or institutional hedge fund products established outside the registered managed investment scheme regime. However, ASIC has made it clear in CP 147 that, while the new rules may not strictly apply to institutional hedge fund products, it considers the enhanced disclosure requirements would be of equal use to institutional investors, and that there may be merit in 'encouraging' wholesale funds to comply with the disclosure requirements.
The proposed rules will require the issuer of a hedge fund product to which the rules apply to include specific disclosure in the PDS for the fund that addresses each item contained in ASIC's list of 'disclosure principles'. ASIC also proposes a small number of 'if not, why not' benchmarks (eg in relation to whether a fund's assets are valued by an independent third party or not).
While the precise list of disclosure principles is detailed and prescriptive, in broad terms each hedge fund's PDS would need to include disclosures addressing the following issues:
- a fund's investment strategy (including detailed information on asset classes targeted, diversification limits, the key risks inherent in implementing the strategy, the role of leverage, derivatives and short-selling, and information on the liquidity of the fund's portfolio);
- the terms of the management arrangements applying to a fund (including the identity and experience of senior management personnel, unusual or onerous terms in management agreements and circumstances in which the appointment of the manager can be terminated);
- a fund's downstream investment structure (including details of holding structures, identity of jurisdictions involved, details of due diligence undertaken on investments, and the identity of service providers and intermediaries);
- a fund's investment holdings (including information on the size of the fund and past investment returns, details of target and actual asset class allocations, actual liquidity profile information and details of valuation policies and custody arrangements);
- valuations of any assets that are not exchange-traded or independently valued;
- detailed information on leverage at both a fund and investment level (including the sources, amount and providers of leverage, details of assets used as collateral, anticipated levels of leverage and a worked example of the impact of leverage on investment returns);
- information on the use of derivatives and short-selling (including the rationale for using derivatives and short-selling, the types of products used and the criteria for engaging, and identity of, counterparties); and
- details of the terms on which investors can withdraw from the fund (including full disclosure of the limitations applying to withdrawals such as gating restrictions).
Failure to include the disclosure required under the proposed rules may result in ASIC issuing a 'stop order' on the PDS in question.
Many (if not all) of the heads of disclosure listed in CP 147 are already addressed in many retail hedge fund PDSs as a matter of best practice in the Australian hedge fund industry, and are unlikely to meet significant opposition from product issuers. However, some of the more detailed and prescriptive disclosure requirements listed under these heads may unnecessarily burden or restrict issuers and, in some cases, may ultimately prove to be counterproductive for retail investors. For example:
- The need to include detailed information on fund investments (including on investment strategies, precise asset class allocations, investment structures, investment holdings and investment returns) may inadvertently create a practical impediment to a fund rapidly adapting its investment strategy to suit changing market conditions, a hallmark of the global hedge fund industry and something that investors in hedge funds are ultimately relying on the manager to provide.
- Given the highly secretive and competitive nature of the industry, some of the requirements to disclose (essentially, publicly) detailed information on investments and the sources and terms of leverage may be questioned, and could even have the unintended result of forcing some international managers out of the Australian retail market.
- The prescriptive nature of the information required under the proposed rules may inadvertently lead to longer, more complex PDSs being produced by product issuers who feel they are forced by the rules to apply a 'tick-the-box' attitude to disclosure and to include detailed information on items that are ultimately of little interest to investors.
We expect these issues to be aired during the consultation process.
ASIC is currently seeking feedback on the proposals contained in CP 147, with comments required to be made to ASIC by 21 April 2011. ASIC may then issue a second consultation paper (in mid 2011), before releasing a formal regulatory guide detailing the final form of the new disclosure rules by late 2011. The new rules are currently expected to come into force from 1 July 2012.
- Mark CerchéPartner,
Ph: +61 3 9613 8872
- John BeckinsalePartner,
Ph: +61 7 3334 3520