FSA hedge fund paper will have little impact, says lawyer
The Financial Services Authority's proposed disclosure obligations for hedge funds will have little impact for investors, a legal expert has told Complinet. This follows the release of the regulator's feedback statement to its hedge fund discussion paper.
The feedback statement, which will further ease the hedge fund industry's fears about the imposition of broad new statutory regulation, sets out two specific areas that have come under FSA scrutiny. The regulator, in a separate paper, has also set out proposals that will allow retail investors to invest in UK-based hedge funds, albeit on an indirect basis, for the first time.
The statement notes that the failure of hedge fund managers to disclose that side letters have been granted to certain clients could result in some investors receiving more information and preferential treatment. The FSA said that managers should ensure that all investors understood that a side letter had been granted and that conflicts might arise. Typically, large-scale investors in hedge funds are given letters indicating that they will be given more favourable contract terms.
Philip Rubens, partner at Finers Stephens Innocent, told Complinet that the practice was unfair for the majority of investors that did not get the same terms that the major funds of funds received. Despite the change, hedge fund managers would not be obliged to disclose the actual terms.
"Most professional investors know that certain large and significant funds of funds have insisted on side letters. I can't see how it is going to make any difference unless the preferential terms are disclosed and all the other investors can actually see what preferential terms have been given. To simply be obliged to notify investors that there is a side letter, but not being obliged to disclose the contents of the side letter is not going to make much difference," he said.
Jonathan Herbst, partner at Norton Rose, said that the practice of side letters was widespread. Listed funds operating out of Dublin, for example, were not allowed to engage in the practice because of rules allowing for the equal treatment of shareholders, he said. Hedge funds that decide to list on the Alternative Investment Market will also have to disclose the contents of side letters to investors and not just their existence, under similar rules.
"Historically it has taken place in the context of unlisted hedge funds. Really, the FSA is trying to get at the transparency and disclosure of the side letter regime. The prospectus normally states that the manager might rebate such sums it decides on its discretion. Managers need to take a careful look at whether this is sufficient or not," he told Complinet.
Detrimental letters
An FSA spokesman told Complinet that the regulator was concerned that the existence of the letters could be detrimental to other investors.
"Investors might be aware of the issue of side letters, but they might not be aware of the existence in their case. It is all well and good knowing that they exist but investors need to know they exist for them in particular," he said.
The other main area of concern for the FSA is the issue of asset valuations. The regulator is worried that hedge fund managers might be exposed to conflicts to interest as their remuneration is based on fund performance and the amount of assets under management. This, the FSA said, could create incentives for managers to overstate the valuations they provide to administrators, who might not be able to challenge them.
The FSA is currently undertaking themed visits and will release its results later in the year. It has also sponsored an International Organisation of Securities Commissions project on valuing complex and illiquid assets in hedge funds.
Rubens said that the asset valuations area was one that could be open to abuse. He said there was a danger that the hedge fund manager might overstate the value of a fund to receive additional performance-based remuneration. He added that the regulator may consider legislation where the valuation would have to be independently conducted by a third party, such as an administrator, despite the potential costs that would invoke.
"I don't think this is the end of it. I think they will go further with regard to asset valuation because it is potentially an area of concern and abuse that assets could be over-valued. The way around it is to take it out of the power of the manger and to insist that all assets are independently verified," he said.
The lawyer said that one of the dangers of hedge funds is that because of their quest to produce higher than normal returns they can invest in assets in developing countries. This can lead to a situation where it can be hard to rely on valuations.
"A valuation can be very subjective and I wouldn't say it would necessarily solve the problem but investors might find more comfort in knowing that the asset had been independently valued. Perhaps a stop-gap measure could be that investors should obtain information on all assets that are valued solely by the manager and are not independently valued by the administrator," he said.
Herbst agreed it could be a potential issue for hedge funds.
"The problem is that, particularly when you are dealing with OTC instruments, the administrators often don't have the technical knowledge to do this alone. So what actually happens is that the managers and the administrators talk about the net asset value calculation and the manager has very strong input in that. The problem is that the manager has every incentive to up the NAV in order to up the performance fee," he said.
Integrated regulatory returns
Rubens added that the FSA's proposals that a fund should identify the firm's prime broker, third-party administrator and the fund auditor in its integrated regulatory return, was "fairly basic".
"That's information that I don't think anyone would be surprised that the FSA is asking for. One might be a little surprised that the FSA hasn't asked for this before. Most of this information could be obtained elsewhere anyway. It's hardly a surprise," he said.
The paper notes that the FSA gained broad industry approval for its decision to set up a dedicated hedge fund manager supervisory team to look at hedge funds that pose the greatest risk to its statutory objectives. At present it is has 37 entities, including 25 firms, under its gaze. The FSA told Complinet that it did not want to increase this number because of the strain it would put on its resources. Herbst said this was an issue that could be addressed.
"At the moment they are focused on the 25 firms they are supervising. The big question is for firms that don't fall in that category but are in fact very large managers," he said.
The FSA said that it had also looked at the issue of whether trading errors should be borne by the fund or the fund manager. The regulator reiterated that if an error was caused by a manager's "carelessness" then it would expect liability to rest with the manager. It said that this position could be reversed by the use of contractual documents, but added that it would look more closely at exclusion clauses from a regulatory perspective.
Retail hedge funds
Separately, the FSA's decision to consult next year on allowing retail investors to invest in UK hedge funds has received a broad welcome from the industry. One industry source told Complinet that the decision signified the regulator's growing acceptance of the funds.
"They are not going to recommend hedge funds for retail investors if they are not happy with them. It seems to me that this is an overriding conclusion from the FSA. If they are opening up funds of hedge funds to retail investors you have to conclude that the FSA is happy with the hedge fund market," he said.
Under the proposals retail investors would be allowed to invest in the products, which would be subject to the FSA's regime for authorised collective investment schemes. The funds would be subject to structural and operational safeguards, such as having an independent depository. In addition, funds of hedge fund managers would not be able to invest in all hedge funds.
"Given the reality of the contemporary retail market, it seems sensible to permit the marketing of funds of hedge funds through an authorised, onshore vehicle. These onshore funds of funds would benefit from the protections already in place for authorised funds," said Clive Briault, FSA managing director for retail markets.
Both the Investment Management Association and the Alternative Investment Management Association welcomed the move.
"There is a common will shared by the industry and the FSA to optimise the investment environment for investors. The FSA has correctly concluded that retail investors should be given the opportunity to invest in market leading investment products that can deliver absolute return performance in all markets," said Florence Lombard, executive director at AIMA.