Introduction
National Treasury and the Financial Services Board have after much deliberation published a proposed framework for the regulation of hedge funds for public comment. These changes are set to drastically change the South African hedge fund industry. Some say that over-regulation can hamper the industry. Others say that it is long overdue.
The hedge fund industry has until now operated in a largely unregulated arena with the only exception being that hedge fund managers themselves have been regulated under the Financial Advisory and Intermediary Services Act. This all seems set to change with the introduction of the new proposed framework as the policymaker and regulator seek to bring hedge funds under regulation by including a new chapter in the Collective Investments Scheme Control Act, (CISCA).
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Early regulation likely
The introduction of a new chapter in CISCA would necessitate an amendment to the existing legislation and this would usually entail a lengthy parliamentary process. However, the policy framework has indicated that this regulation is imminent and the Minister of Finance is likely to exercise its powers under section 63 of CISCA and deem all hedge funds to be collective investment schemes (CIS).
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The types of funds
The new framework proposes two types of hedge funds: restricted hedge funds and retail hedge funds. Restricted hedge funds will not be allowed to market themselves to the general public and will instead be limited to private arrangements amongst “qualified investors”. Restricted hedge funds will not be subjected to the entire suite of strict regulations normally imposed under the CISCA.
Retail hedge funds will be able to market themselves to general public and ordinary retail investors will be able to invest in them. Retail hedge funds will be subjected to more rigorous regulation in order to ensure adequate investor protection. It is anticipated that these funds will have more stringent asset restrictions, asset spreading requirements, leverage restrictions and obligations to clients.
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Tax treatment?
A question which remains to be answered under the proposed framework is how the returns on an investment in a hedge fund will be treated for income tax purposes. Currently, traditional CISs are tax transparent and receive favourable tax treatment by the South African Revenue Service. The investment income (normally interest and dividends) of a CIS is distributed to its investors. This distributed income retains its nature and character in the hands of the investors. If investors sell their investment in the CIS, they will be liable for capital gains tax, unless they were trading with these investments in which case they will be liable for normal tax on the profits.
There has in the past been opposition to the inclusion of hedge funds in the CIS regime on the basis that such inclusion may jeopardise the current favourable tax treatment for CISs. It remains to be seen whether National Treasury will allow hedge funds to enjoy the same benefits as traditional CISs or whether it will introduce legislation allowing for the separate taxation of hedge fund CISs.
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Hedge fund structures
Currently, most hedge funds in South Africa are structured as en commandite partnerships, bewind trusts or variable rate debenture issuing companies. Of these structures, the en commandite partnership and the variable rate debenture issuing company are by far the most prevalent. The proposed framework seems to indicate that the inclusion of hedge funds under CISCA will not require existing hedge funds to conform to any model investment structure. Hedge fund managers themselves will however need to register as CIS managers in terms of CISCA and will need to comply with the same requirements as currently imposed upon managers of traditional CISs. The proposed framework states that managers currently registered as category IIA financial service providers will be required to procure registration as CIS managers under CISCA.
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Risk management
The proposed framework introduces a number of new concepts to ensure effective management of risk in investing in hedge funds. Amongst other things, the framework introduces prudential restrictions for hedge funds (asset class limitations), a conflict of interest policy for all hedge fund managers, daily pricing and independent valuation of assets of a hedge fund, a liquidity requirement for retail hedge funds and the requirement for a risk management programme to ensure effective management of the usage of derivatives and the employments of leverage.
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Leverage
A key component in the operation of a hedge fund is the employment of leverage to mitigate against market exposures or to enhance the returns of the hedge fund. Leverage has been defined in the proposed framework as “the use of financial instruments or borrowed capital to increase the potential return of an investment”. The proposed framework intends to allow hedge funds to create leverage by borrowing funds or by engaging in derivative transactions with counterparties. The use of leverage can have a significant impact on the investment results of a hedge fund because whilst it may enhance investment gains, it may also significantly amplify investment losses. The proposed framework intends introducing broad rules for the limitation of leverage, especially in the case of retail hedge funds. For example, a manager of a retail hedge fund must ensure that the fund’s total exposure relating to derivative instruments does not exceed the total net value of its portfolio.
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Transparency
A significant move-away from the current hedge fund regime, is the introduction of a transparency requirement whereby hedge funds are required to provide certain information to investors including valuation methodology, positions and leverage exposure. Hedge funds will be expected to comply with initial and ongoing disclosure requirements. Hedge fund managers will also be expected to prepare a key investor information document which is intended to be a short document containing information such as the investment policy and objectives of the fund, a risk and award indicator, an indication of the fees and charges levied to the fund, a past performance presentation and all other practical information about the hedge fund.
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