ASIC released guidance on new disclosure benchmarks and principles for hedge funds entitled ‘Hedge funds: Improving disclosure’ (Regulatory Guide 240 (“RG 240”)) on 18 September 2012. This follows industry consultation and the Parliamentary Joint Committee on Corporations and Financial Services report into the Trio collapse in which $176 million of superannuation funds were lost. ASIC is concerned that a lack of adequate disclosure is resulting in investors being exposed to a heightened risk when investing in these kinds of products.
The number of hedge funds in Australia has remained relatively stable over the last two years, with 14 new hedge funds being established in 2011. Total funds under management for the hedge fund industry was approximately $47.7 billion, up from $46.5 billion in December 2010. As at 31 December 2011, there were at least 677 hedge funds and funds of hedge funds available for investment in Australia. In excess of 48,000 investors invest in hedge funds in Australia. Given the significance of the asset class, the regulatory guide is part of ASIC’s plan to improve the conduct of gatekeepers for managed investment schemes and strengthen the regulatory requirements applying to hedge funds.
RG 240 provides that responsible entities of hedge funds should:
Definition of ‘hedge fund’ and ‘fund of a hedge fund’
The definitions of ‘hedge fund’ and ‘fund of a hedge fund’ used in RG 240 closely follow the approach taken in Class Order 12/749 ‘Relief from the Shorter PDS regime’ (CO 12/749).
A hedge fund is defined in RG 240 as a registered managed investment scheme which:
A. is promoted by the responsible entity using the expression, and as being, a ‘hedge fund’, or
B. exhibits two or more of the following characteristics:
i. complexity of investment strategy or structure – the scheme:
a) pursues investment strategies that aim to generate returns with a low correlation to equity and bond indices, or
b) has a complex investment structure that invests through three or more interposed entities (or two or more interposed entities if at least one of the entities is offshore) where the responsible entity of the scheme or an associate has the capacity to control the disposal of the products or two or more of the interposed entities,
ii. use of leverage – the scheme uses debt for the dominant purpose of making a financial investment,
iii. use of derivatives – the scheme uses derivatives other than for the dominant purpose of,
a) managing foreign exchange or interest rate risk, or
b) more efficiently gaining an economic exposure, through the use of exchange-traded derivatives, to the underlying reference assets of those derivatives, but only on a temporary basis (ie less than 28 days),
iv. use of short selling – the scheme engages in short selling, and
v. performance fees –a right to be paid a fee based on the unrealised performance of the scheme’s assets.
This approach to determining a hedge fund raises a number of difficulties and challenges for responsible entities:
i. as a practical matter, hedge funds are not frequently promoted using the expression, or as being, a ‘hedge fund’, so the first limb of this test (in paragraph (A)) will rarely have application, and
ii. the broadness of the second limb of the test (in paragraph (B)) may result in a simple managed investment scheme which would not be commonly regarded as a hedge fund qualifying as a hedge fund.
As an example, the definition would capture a leveraged fund (such as a property trust) where the responsible entity is entitled to a performance fee.
A ‘fund of hedge funds’ is defined in RG 240 as a registered managed investment scheme:
A. where at least 35% of a fund’s assets are invested by the responsible entity in one or more hedge funds (including a scheme or body in or outside this jurisdiction that would be a hedge fund if it were a registered managed investment scheme), or
B. that promotes itself as a fund of hedge funds.
If a responsible entity is uncertain about whether a registered scheme is a hedge fund or fund of hedge funds:
A. the responsible entity can elect to state that they are a hedge fund and disclose against the benchmarks and apply the disclosure principles in RG 240, otherwise
B. ASIC expects the responsible entity to seek clarification from ASIC.
Benchmarks and disclosure principles for hedge funds
ASIC’s disclosure model in RG 240 is a combination of disclosure principles and ‘if not, why not’ benchmarks. The benchmark and disclosure principle information should be:
A. addressed upfront in the PDS,
B. updated in ongoing disclosure as material changes occur (for example, in a supplementary PDS), and
C. supported in, and not undermined by, advertising material.
ASIC expects responsible entities to clearly and prominently disclose a summary of the information identified in the benchmarks and disclosure principles in the first few pages of the PDS, with cross-references to where further information can be found in the PDS.
RG 240 identifies two ‘if not, why not’ benchmarks for hedge funds:
A. Valuation of assets – the hedge fund should require valuations of its assets that are not exchange traded to be provided by an independent administrator or an independent valuation service provider.
B. Periodic reporting – the hedge fund should provide periodic disclosure of certain key information on an annual and monthly basis.
The hedge fund’s PDS and other disclosures must disclose whether it meets these benchmarks and if not, why not, and explain any additional risks that this may pose for the investor.
RG 240 identifies nine “disclosure principles” for hedge funds for inclusion in its PDS:
A. Investment strategy – details of the investment strategy for the fund.
B. Investment manager – details about the people responsible for managing the fund’s investments.
C. Fund structure – the investment structures involved, the relationships between entities in the structure, fees payable to the responsible entity and investment manager, the jurisdictions involved (if these involve parties offshore), the due diligence performed on underlying funds, and the related party relationships within the structure.
D. Valuation, location and custody of assets – the types of assets held, where they are located, how they are valued and the custodial arrangements.
E. Liquidity – the fund’s ability to realise its assets in a timely manner and the risks of illiquid classes of assets.
F. Leverage – the maximum anticipated level of leverage of the fund (including embedded leverage).
G. Derivatives – the purpose and types of derivatives used by the responsible entity or investment manager, and the associated risks.
H. Short selling – whether and how short selling may be used as part of the investment strategy, and of the associated risks and costs of short selling.
I. Withdrawals – the circumstances in which the responsible entity of the hedge fund allows withdrawals and how this might change.
If the responsible entity is unable to provide the information above, the PDS should disclose the reasons why the information has not been provided and outline how and when investors will be provided with the information.
Where a benchmark or disclosure principle is not relevant, responsible entities need not disclose against them.
Interaction with the shorter PDS regime
The shorter PDS regime applies to ‘simple managed investment schemes’ as defined in the Corporations Act 2001 (Cth). CO 12/749 released on 18 June 2012 specifically excludes hedge funds and funds of hedge funds from the shorter PDS regime until 22 June 2013.
Given the definition of hedge funds and funds of hedge funds closely follow the approach taken in CO 12/749, ASIC expects all hedge funds and funds of hedge funds to disclose against the benchmarks and apply the disclosure principles in RG 240, regardless of whether the fund meets the definition of a ‘simple managed investment scheme’.
Application to other products
Despite the benchmarks and disclosure principles in RG 240 being primarily directed at PDSs for hedge funds, ASIC encourages issuers to disclose against the benchmarks and apply the disclosure principles when providing information to investors in similar situations, such as:
A. similar offers to wholesale investors, and
B. offers of shares in investment companies pursuing investment strategies normally associated with hedge funds.
A copy of ASIC’s guidance can be accessed here.