ASIC has released new guidance on hedge fund disclosure obligations which holds hedge fund managers to a higher standard than managers of other funds. Also, proposed reforms to the Australian superannuation system may result in less superannuation allocations to hedge funds. Are we regulating Australian hedge fund managers to extinction?
ASIC RG 240 – disclosure requirements for hedge funds
Earlier this year ASIC singled out hedge funds for special treatment in relation to retail product disclosure when it excluded them from the shorter PDS regime.1 On 18 September 2012 ASIC released “Regulatory Guide 240 – “Hedge funds: Improving disclosure” (“RG 240”), which again singles out hedge funds for a prescriptive and burdensome disclosure model. RG 240 sets out benchmarks and disclosure principles which ASIC thinks will improve disclosure and better enable investors to make more informed decisions about investing in hedge funds and to compare hedge funds.
What funds are covered by RG 240?
For the purposes of RG 240, ASIC defines hedge funds based on certain distinguishing characteristics including:
- the use of leverage, derivatives (other than for hedging purposes), or short selling;
- targeting a return with low correlation to equity or bond markets; and
- charging a performance fee2.
A fund does not have to have all of these characteristics to be classified as a hedge fund. This is very broad definition and will catch categories of funds that would not ordinarily be considered hedge funds – eg leveraged property or infrastructure funds that charge a performance fee. Funds of hedge funds are also caught by RG 240.
What is ASIC’s new disclosure model?
In RG 240, ASIC sets out a disclosure model for hedge funds that consists of a combination of disclosure principles and “if not, why not” benchmarks. ASIC states that failure to disclose against the benchmarks or to apply the disclosure principles will result in an increased risk of ASIC issuing a stop order (which gives teeth to ASIC’s “guidance”).
The benchmarks relate to whether the responsible entity:
- gets independent valuations of non-exchange traded assets; and
- gives periodic disclosure of certain key information about the hedge fund’s holdings monthly and annually.
The disclosure principles relate to descriptions of:
- the fund’s investment strategy;
- the people responsible for managing the fund’s investments (eg their qualifications and experience);
- the investment structures (including jurisdictions) and fees;
- the types of assets, their location, how they are valued and their custodial arrangements;
- the liquidity profile of the portfolio;
- the fund’s leverage (including maximum leverage levels and synthetic or embedded leverage);
- the fund’s use of derivatives and short selling arrangements and associated risks; and
- the circumstances in which withdrawals will be permitted.
For each benchmark and each disclosure principle, ASIC gives prescriptive guidance on the information it considers should be disclosed in the PDS for a hedge fund.
What will RG 240 mean for hedge fund managers?
Hedge fund managers will need to decide whether to comply with the RG 240 disclosure model. In making this decision, they should consider the increased risk of an ASIC stop order should they elect not to comply with the disclosure model.
The most obvious consequence of complying with RG 240 is that it will increase the length and complexity of hedge fund PDSs. This will result in increased costs which might be reflected either in higher fees charged to hedge fund investors, or in fewer hedge fund offerings to retail clients (or both).
ASIC’s requirement for issuers to provide more fulsome and complicated disclosure in relation to hedge funds is in direct contrast with the drive towards simpler and shorter retail product disclosure as reflected in the new shorter PDS regime. It widens the gap between the level of disclosure required for hedge funds and that required for simple managed investment schemes that are not hedge funds (and so are subject to the shorter PDS regime).
Stronger Super might preclude super funds allocating to hedge funds
New transparency requirements proposed under the Stronger Super reforms will oblige super trustees twice-yearly to disclose a super fund’s underlying portfolio holdings, including portfolio holdings of funds (such as hedge funds) in which the super fund is directly or indirectly invested.
The proposed trace-through provisions will impose obligations on intermediate holding vehicles (eg hedge funds or other funds in which a super fund invests) to provide information sufficient for the super trustee to meet its disclosure obligations. Grandfathering will be available – the obligations will only apply in relation to arrangements entered into after the new law receives royal assent.3
The breadth of the proposed disclosure requirements will likely pose significant compliance burdens both on super trustees and on the managers of funds in which super funds invest. As currently drafted, disclosure will be required in respect of each asset of each investment option of a super fund, and each asset of each underlying fund in which each investment option’s assets are invested, and each asset in any further underlying funds, and so on.4
If enacted in their current form, the Stronger Super transparency requirements are expected to pose particular problems for hedge fund managers, who typically treat portfolio information as a confidential trade secret. In addition, at each underlying fund level the disclosing entity will be required to take on potential liability under the Corporations Act in connection with the required disclosures.
If hedge fund managers are not prepared to accept the commercial and compliance risks associated with the proposed transparency requirements hedge funds may become closed as an asset class for Australian super funds.
This month, the Federal Government’s Parliamentary Joint Committee on Corporations on Financial Services (“PJC”) released its report, “Inquiry into the Super Legislation Amendment (Further MySuper and Transparency Measures) Bill 2012” (see our alert here). The Report disappointed many of the industry bodies that gave submissions on the draft transparency requirements. The PJC ultimately recommended that the legislation be passed in its current form, and did not address many industry submissions in a meaningful way.
Given the significant practical difficulties posed by the proposed transparency requirements, many industry participants remain hopeful that exemptions will be granted. ASIC has indicated that it will be issuing guidance in relation to these requirements, but to date no detail has been publicly released. Further clarification regarding the implementation of the proposed transparency requirements is needed, either from ASIC or in the form of regulations.
Other challenges facing hedge funds
A number of other recent and proposed regulatory reforms in Australia and overseas will challenge Australian hedge fund managers.
Performance fee restrictions under Stronger Super
The Stronger Super reforms impose restrictions on performance fees for funds in which MySuper products are invested5. This will present another hurdle to super funds allocating to hedge funds, which typically include performance fees.
Tighter regulation for US and European fund raisings
The US Dodd-Frank legislation significantly narrows the scope of SEC registration exemptions for Australian fund managers. The traditional exemption from SEC registration for private advisers6 has been removed. Instead, Australian managers seeking US fund raisings must either rely on one of the far narrower registration exemptions under the Dodd-Frank regime7, or face the considerable compliance burdens associated with SEC registration.
The EU directive on alternative investment fund managers (AIFMD) which is now in force and will be reflected in the laws of each EU Member State by 22 July 2013, will affect Australian and Asian based funds and fund managers that market to EU investors. In particular additional conditions for EU private placements will apply after July 2013.8
FoFA challenges for Australian retail distribution
The bans on distribution commissions introduced under the Future of Financial Advice reforms will pose significant challenges for Australian retail distribution of hedge funds.
The combination of these reforms may result in Australian hedge fund managers facing significant challenges in tapping some of their most important traditional sources of fund raising. A narrower universe of investors can only be bad news for the hedgies.