Alternative Investment Management Association
Rory Gallaher and Karen Kaur
Deacons, Hong Kong
In May 2002, the Hong Kong Securities and Futures Commission (SFC) issued its guidelines governing the authorisation of hedge funds for public distribution in Hong Kong. On November 28 2002, the SFC announced the authorisation of the first three hedge funds: one fund of hedge funds (FoF) and two single strategy hedge funds. Concurrently, the SFC also released the Guidelines on Hedge Funds Reporting Requirements and investor educational materials on hedge funds. Since then, 10 further funds have been approved: three single strategy, one of which is linked to a guaranteed fund, and seven FoFs.
On December 5 2002, the Monetary Authority of Singapore (MAS) announced new rules for the authorisation of hedge funds in Singapore, which were closely modeled on the Hong Kong guidelines. These new rules are set out in the Code on Collective Investment Schemes (Singapore Code).
On March 21 2005, the MAS prescribed new provisions in the Singapore Code requiring hedge fund managers to prepare the accounts and reports in the manner set out in Annex 4a to the Singapore Code entitled “Reporting for Hedge Funds”.
The SFC issued a Consultation Paper on the review of the hedge fund authorisation guidelines on May 26 2005. The consultation conclusions were published in September 2005.
The consultation proposals focused on three main areas:
• To adopt a holistic approach in assessing the acceptability of the management company as a hedge fund manager
• To increase transparency of the management company’s operations through enhanced disclosure in the offering document (particularly disclosures regarding the relationship between prime brokers and the scheme), the management of conflicts of interest, risk management and due diligence processes, the conduct of a fair and independent valuation and the calculation of performance fees
• To consolidate and codify the SFC’s regulatory practices in the application of the hedge fund guidelines by proposing additional notes to the guidelines in relation to compulsory redemption, ring-fencing provisions, equalisation and prohibitions on the use of ‘managed accounts’ by funds of hedge funds.
Authorisation of hedge funds
The requirements for authorisation in Hong Kong are contained in the SFC’s Code on Unit Trusts and Mutual Funds (HK Code). Requirements applicable specifically to hedge funds are in Chapter 8.7. In Singapore, the retail hedge fund requirements are contained in the Singapore Code, which was last revised in March 2005 to include the new reporting requirements for hedge funds. Appendix 4 deals specifically with hedge funds. Neither the HK Code nor the Singapore Code has the force of law, with the result that the SFC and the MAS have considerable discretion in implementing or adopting provisions on a case-by-case basis. Waivers may be granted if an application is supported by appropriate arguments.
In Hong Kong, the hedge fund guidelines in Chapter 8.7 of the HK Code set out the specific criteria that a hedge fund and its operators must satisfy in order to be authorised. The other provisions in the HK Code, which are of general application, must also be complied with. The SFC’s authorisation process has a dual focus, namely:
• the SFC reviews the suitability of the operators of the fund, in particular the manager and the custodian
• the SFC also reviews the suitability of the fund itself and its offering and constitutive documents.
The requirements of the MAS are similarly structured. The Singapore Code divides hedge funds into three main categories (i) single hedge funds; (ii) funds of hedge funds; and (iii) capital guaranteed or capital protected hedge funds, with differing guidelines for each category.
Suitability of the manager
There are new criteria that the manager of a Hong Kong authorised fund must fulfill in addition to the normal requirements for managers approved to manage public funds.
The HK Code also requires that the investment management operations of the manager be based in a jurisdiction with an inspection regime that is acceptable to the SFC (an ‘acceptable inspection regime’).
The Cayman Islands, Bermuda, the BVI, and the other Caribbean jurisdictions are not considered by the SFC to have acceptable inspection regimes, neither are the Channel Islands, Singapore, Japan or Switzerland. As many hedge funds have managers based in these jurisdictions, this can be a major obstacle to getting a hedge fund authorised in Hong Kong.
There is no equivalent requirement in Singapore. This requirement has posed particular difficulties where the investment discretion is delegated: the SFC’s approach has generally been to require that all levels of management with investment discretion must fully comply with all the SFC’s criteria, including being based in an acceptable inspection regime and having the requisite key personnel with relevant experience.
The new criteria that managers of hedge funds authorised in Hong Kong must fulfill are:
• That a manager should have at least US$100 million in hedge fund assets under management. Singapore has no equivalent requirement.
• The manager must have sufficient resources including at least two key personnel with relevant experience. ‘Relevant experience’ for a single strategy fund means at least five years’ experience in hedge fund strategies in general and two years’ experience in the relevant strategy of the fund. For a fund of hedge funds, it means five years’ general hedge fund management experience and two years’ experience as a fund of hedge funds manager. Singapore has similar requirements. The recent revisions to the guidelines have clarified and expanded on the types of experience which will qualify. In particular, the SFC will look to the public funds experience of the management company. This is expected to favour the alternative investment arms of larger ‘traditional’ asset management groups, as the personnel of ‘pure’ hedge fund managers will be unlikely to have managed public funds before.
• Suitable risk management and internal control systems must be in place, including, in the case of a fund of hedge funds, a due diligence process for the selection and monitoring of underlying funds. Singapore has similar requirements.
The SFC has been applying these requirements strictly and requires detailed and specific information demonstrating compliance.
Note that in the case of a fund of hedge funds authorised in Hong Kong, while the manager of the FoF needs to fulfill all the criteria set out above, the managers of the underlying funds (which do not need to be authorised) do not. The only requirement is that 90% of the underlying funds in which a FoF invests must have key personnel with at least two years’ hedge fund management experience. However, the FoF manager will have to submit a detailed compliance plan to satisfy the SFC as to how it proposes to monitor the activities of the underlying fund managers on an ongoing basis.
The requirements of the Singapore Code are more general in nature. Managers or advisers are generally required to have expertise in managing hedge funds. More particularly, a single hedge fund manager must have at least two executives who have at least five years’ experience in the management of hedge funds and for a FoF manager, at least three years out of the five years’ experience must have been in the management of FoFs.
Suitability of the fund and its offering/constitutive documents
The HK Code and the Singapore Code each set out the requirements that the fund itself must fulfill, and the requirements are strikingly similar in many respects.
While the philosophy of the SFC with respect to investment restrictions is generally to permit managers to employ their strategies quite freely provided proper disclosure is made, the SFC has been resistant to allowing FoFs to invest in managed accounts. This issue was readdressed in the May 2005 consultation, and the SFC decided to maintain the prohibition on the use of managed accounts by FoFs.
The Singapore Code contains no requirements in relation to prime broker arrangements, whereas the Hong Kong guidelines set out various requirements that the prime broker must adhere to. One issue for most prime brokers has been the limit on the value of the assets which may be charged to the prime broker to secure the fund’s indebtedness. This issue was also readdressed in the May 2005 consultation, but again the SFC decided not to raise the limit.
The SFC, being mindful that distribution agents who have direct contact with the investing public play a big role in investor education and protection, requires the manager to take all reasonable care in the selection of the distribution agents selling hedge funds and to provide all necessary information and training to these agents. The Singapore guidelines contain no equivalent provision.
The HK Code and the Singapore Code can be accessed on the SFC’s and the MAS’ respective websites: www.hksfc.org.hk and www.mas.gov.sg.