Introduction

ASIC has released Consultation Paper 147 Hedge funds: Improving disclosure for retail investors (CP 147), which describes ASIC’s proposal to introduce disclosure principles and benchmarks for hedge funds. CP 147 prescribes various key features and risks that ASIC considers will need to be addressed in the Product Disclosure Statement (PDS), and other communications, for a hedge fund.

A separate disclosure regime does not currently apply to hedge funds and the application of the law and general ASIC policy to a particular hedge fund is left to the individual issuer and its advisers to determine.

The paper follows a recent approach by ASIC to prescribe specific disclosure principles and benchmarks for particular asset classes such as mortgage schemes, unlisted property schemes and infrastructure funds.

Scope of CP 147

It is proposed that the disclosure principles and benchmarks will apply to any registered managed investment scheme that is, or has been promoted as, or is generally regarded as, a hedge fund or a fund of hedge funds. ASIC is formulating its definition of hedge fund for these purposes and it seems it will apply a broad definition that looks at whether a fund has some or all of the following features:

  • strategy – the fund pursues complex strategies that aim to generate absolute returns, returns with low correlation to equity and bond indices, or a positive return in both rising and falling markets
  • leverage – the fund often uses leverage to increase investment returns
  • derivatives – the fund often uses derivatives to create complex investment strategies or for gearing purposes
  • short selling – the fund often engages in short selling
  • complexity – the fund often has exposure to diverse risks and complex underlying products.

This approach could potentially sweep up a broad range of funds with any or some of these features, even those which may not traditionally be regarded as hedge funds.

The disclosure requirements outlined in CP 147 consist of a combination of disclosure principles and ‘if not, why not’ benchmarks. An issuer is required to state in the PDS and in certain ‘other disclosures’ whether it meets a benchmark (and if not, why not). Failure to comply with the disclosure principles and benchmarks may result in ASIC issuing a stop order on an offer.

Interestingly, ASIC also notes that ‘as a matter of best practice’, disclosure of information similar to that set out in CP 147 would be useful for investors in other types of funds, not just hedge funds.

ASIC is also considering excluding any fund that would fall within the scope of the CP 147 disclosure guidance from being able to use the new ‘shorter PDS’ regime.

The proposed disclosure principles and benchmarks

A brief summary of the proposed disclosure principles and benchmarks applicable to a PDS for a hedge fund is set out below:

 Disclosure principle – Investment strategy

The PDS should disclose the following information:

  • a description of the fund’s investment strategy, including: the asset classes typically invested in; the typical location and currency denomination of the assets; the role of leverage, derivatives and short selling; and the resources available to execute the investment strategy
  • an explanation of how the strategy will produce investment returns with reference to the general market circumstances in which the fund trades,
  • what the diversification guidelines are
  • any specific risks associated with the relevant investment strategy
  • disclosure of the key aspects of the fund’s risk management strategy, and
  • how the investment strategy can change and what notification would be provided to investors.

Disclosure principle – Investment manager

The PDS should disclose a description of:

  •  the identities and relevant commercial experience of the senior officers playing a key role in investment decisions
  • if the fund manager is not the responsible entity, any unusual or materially onerous (from the investor’s perspective) terms in the agreement under which the fund manager is appointed and the scope of this appointment, and
  • the circumstances in which the responsible entity is entitled to terminate the manager’s appointment and on what terms (including any payments).

 Disclosure principle – Fund structure

The PDS should explain:

  •  the fund’s investment structure, including the key entities involved, their relationship to each other and their roles
  • the identities of the key service providers and intermediaries (e.g. prime broker, custodian, administrator, compliance service provider, independent auditor and sub-advisers), where applicable
  • the jurisdictions involved
  • the rationale for the structure and the jurisdictions used
  • the risks of the structure, including any risks associated with holding assets overseas
  • the due diligence process performed on underlying funds and the key service providers
  • for all collective investment schemes invested in by the fund that make up, or are likely to make up, more than 10% of the fund’s net asset value, the identities of the key service providers for any underlying collective investment schemes
  • how the responsible entity ensures that key service providers will comply with service agreement obligations
  • any related party relationships within the structure, and
  • the existence and nature of material arrangements in connection with the fund that are not on arm’s length terms.

Disclosure principle – Assets

The PDS should disclose the following information:

  • the key aspects of the valuation policy
  • the types of assets and the allocation range to each asset type, using a specified list of asset types provided by ASIC (including the assets of collective investment vehicles invested in by the fund)
  • any policy about asset location, and
  • the custodial arrangements, including details of the roles provided by custody service providers.

Benchmark – Custody

The PDS should disclose that all custodians (including custodians of any funds invested in by the fund) involved in the fund structure are independent third party custodians. If the fund does not meet this benchmark, it should disclose why not.

Disclosure principle – Liquidity If more than 20% of a hedge fund’s assets cannot be sold at market value in less than 10 days, the PDS should disclose the following information:

  • a description of any illiquid asset class that has a value greater than 10% of the fund’s net asset value, and
  • the key aspects of the liquidity management policy.

Disclosure principle – Leverage

The PDS should disclose the following information:

  • the sources of leverage, including type, amount and providers of the leverage;
  • whether any assets are used as collateral and the extent to which they are otherwise encumbered;
  • the anticipated level of leverage (including leverage embedded in the assets of the fund), as a multiple of the amount invested by an investor (e.g. for every $1 the investor invests, the fund is leveraged $x), and
  • a worked example showing the impact of leverage on investment returns and losses, assuming the anticipated level of leverage (including leverage embedded in the assets of the fund).

Disclosure principle – Derivatives

The PDS should disclose the following information:

  • the purpose and rationale for the use of derivatives or structured products (e.g. investment, hedging, leverage and liquidity), including how they form part of the fund’s investment strategy
  • the types of derivative or structured product used or planned to be used;
  • the criteria for engaging derivative and structured product counterparties (including principal protection providers)
  • the key risks to the fund associated with the collateral requirements of the derivative counterparties, and
  • whether the derivatives and structured products are OTC or exchange traded.

 Disclosure principle – Short selling

If a hedge fund intends or is likely to engage in short selling, the PDS should disclose the following information:

  • the purpose and rationale of short selling, including how short selling forms part of the fund’s investment strategy
  • the risks associated with short selling
  • how these risks will be managed, and
  • an example showing the potential gains and losses from short selling.

Benchmark – Periodic reporting

The PDS should disclose that the fund will report on the following as soon as practical following the relevant period end:

  • the current FUM of the fund
  • the actual allocation to each asset type
  • the liquidity profile of the assets as at the end of the period – the representation of asset liquidity (the time required to sell an asset at its market value) in a graphical form that allows easy comparison with
  • the maturity profile of the leverage the maturity profile of the leverage as at the end of the period – the representation of maturities in a graphical form that allows easy comparison with the liquidity profile of the assets
  • the leverage ratio (including leverage embedded in the assets of the fund) as at the end of the period
  • the undrawn amount of loan facilities as at the end of the period
  • the derivative and structured product counterparties engaged (including capital protection providers)
  • the investment returns, and
  • the key service providers if they have changed since the last report given to investors.

Benchmark – Periodic reporting

The PDS should disclose that the latest periodic report is available on the fund’s website. If the PDS does not meet this benchmark, it should disclose why not.

Disclosure principle – Withdrawals

The PDS should disclose the following information:

  • any significant risk factors or limitations that may affect the ability of investors to withdraw from the fund, including any gating restrictions that may be imposed or the requirement for a statutory withdrawal offer if the scheme is non-liquid
  • how investors can exercise their withdrawal rights, including any conditions on exercise;
  • if withdrawal is to be funded from an external liquid facility, the material terms of this facility, including any rights the provider has to suspend or cancel the facility, and
  • how investors will be notified of any material changes to their withdrawal rights (e.g. if withdrawal rights are to be suspended).

 Key issues

The paper requires careful consideration and fund managers will need to adopt additional measures to be in a position to comply. Some of the key issues for consideration by issuers of ‘hedge funds’ and ‘fund of hedge funds’ arising out of the proposals in CP 147 include the following:

  • as mentioned above, the proposed approach for determining whether a scheme is a hedge fund, involving consideration of a number of ‘indicia’, may potentially sweep up a broad range of funds, even those which may not ‘traditionally’ be regarded as hedge funds
  • ASIC has indicated that, where a scheme could be characterised as a hedge but also falls ‘more specifically’ within another category of schemes covered by other ASIC disclosure guidance, the more specific disclosure guidance will apply. This may lead to some confusion as to the applicable disclosure guidance e.g. if a scheme can be characterised as a hedge fund and an unlisted property fund, both the CP 147 requirements and the requirements under ASIC Regulatory Guide 46 Unlisted property schemes: Improving disclosure for retail investors may apply
  • ASIC is considering whether to ‘encourage’ issuers to apply the disclosure benchmarks and principles when providing similar offers to wholesale investors and offers by listed investment companies that have some of the features of hedge funds
  • ASIC indicates that it is separately considering alternative or supplementary measures to deal with the perceived risks of investing into hedge funds, e.g. investor education, enhanced licensing requirements, enhanced compliance plan requirements, statutory suitability tests and banning retail investor access to hedge funds. No detail is provided in the paper. These possible measures may have major implications for ‘hedge fund’ issuers if implemented
  • if an underlying investee scheme of a hedge fund makes up more than 10% of the fund’s net asset value, the identities of key service providers for the underlying scheme will need to be disclosed in a PDS and updated in periodic disclosures. This may require a hedge fund issuer to ensure that suitable reporting or notice requirements are in place with operators of underlying schemes (e.g. in side letter arrangements) to ensure it can comply with such disclosure requirements
  • ASIC suggests that, although the Corporations Act requires a fund to give investors at least an annual periodic statement regarding FUM and investment returns, it is ‘current market practice’ to provide more frequent reports. Going forward, issuers of hedge funds may need to provide more frequent periodic statements regarding the fund and ad hoc reports (in addition to the periodic reports) where there are changes to key features of a hedge fund that might not currently be required under the Corporations Act.

Way forward

ASIC proposes 1 July 2012 as the commencement date for:

  • new and current issuers of hedge funds to apply each of the disclosure principles and address each of the benchmarks in PDSs given after that date, and
  • existing issuers of hedge fund to provide updated disclosure to existing investors that applies each of the disclosure principles and addresses each of the benchmarks.

The deadline for comments on the paper is 21 April 2011. ASIC has flagged that it may undertake a second round of consultation in mid-2011 once it develops more detailed proposals following on from the first round of consultation. It is expected that, following the close of the consultation and subject to comments from stakeholders, ASIC will release a regulatory guide in late 2011.

In addition, ASIC has indicated that it is considering what ‘other measures’ may be desirable to adopt in light of recommendations flowing from the ‘Hedge funds oversight’ report issued by the International Organization of Securities Commissions (IOSCO) in June 2009 and the ‘Review of the differentiated nature and scope of financial regulation’ report issued by the Joint Forum in January 2010.