The following article is a reproduction of a round table discussion by the global partners from White and Case's hedge fund services practice. The partners discuss recent changes in global regulations and their ramifications for Asian managers.
What are your thoughts about the upcoming investment law in Japan?
Hedge funds are currently concerned with the effect of four separate regulatory developments in Japan.
First, fund groups involved in capital raising and client servicing in Japan are carefully monitoring the effect of the Investment Services Law (Financial Products Exchange Law) on the conduct of their business in Japan after the effective date of 1 April 2007.
Second, fund groups are reacting to the recent spate of tax examinations of foreign-affiliated Japanese investment advisors in Japan and permanent establishment and transfer pricing issues that have been raised in those examinations. Also in the tax area, some fund managers have considered relocating to other jurisdictions in response to new rules that provide for the taxation of global income (rather than Japanese source and Japanese personal service income) after a foreign individual investment advisor has been resident in Japan for more than five of the past ten years (the prior rule was five years continuously).
Third, the more active enforcement environment, especially in respect of so-called “shareholder value” strategies in the wake of the indictment of Yoshiaki Murakami and his Murakami Fund on insider-trading charges, have made many funds especially sensitive regarding regulatory enforcement considerations and risks. The heightened risks associated with the new penalties for insider trading and related actions, together with the vagueness (and counter-intuitiveness) of many of these rules and the lack of accessible precedents have made it unattractive to implement these strategies.
Finally, fund groups with a significant investor base among Japanese regional and city banks, the effect of Basel II on such investor’s ability to stay in their funds is a major concern. Basel II requires banks to know the risk profile of the funds in which they invest, effectively requiring them to obtain full transparency from the fund manager. In addition to the difficulty some funds (and many funds of funds) have in providing such transparency, there are a number of related issues such as the complexity of making certain credit risk asset calculations that are making it difficult for Japanese bank investors to maintain investments in alternative investment classes.
What progress are you seeing in particular regional markets regarding the ability to take short positions?
Regulators in Asia took a dim view of short selling in the immediate aftermath of the Asian financial crisis but attitudes have softened in recent years and the general trend across the region is now towards greater relaxation of such rules.
Short selling is still prohibited in a number of Asian jurisdictions, such as China, but rules are in the process of being relaxed in other jurisdictions to allow the practice under certain circumstances, for instance, covered short sales but not naked shorts – in other words, sellers must have securities lending arrangement in place and ensure that securities are available for settlement before the sale occurs. This is still the case, for example, in Hong Kong. Certain jurisdictions still have uptick rules too (eg, Hong Kong, Japan, Singapore and South Korea), which means short selling is allowed to occur only where the trade price of the covered short sale is higher than the previously traded price, but the regulators in some of these jurisdictions have been considering abandoning this. Some jurisdictions place restrictions on the particular stocks that may be shorted and the mechanism by which the short sell may be executed (eg, South Korea and Taiwan).
New legislative developments in short selling are expected in India (where short selling is permitted for retail investors but prohibited for institutional investors), Indonesia (at the end of 2006 or early 2007), China (draft regulations issued for domestic firms) and the Philippines (fourth quarter 2006).
What legal structures would you like to see the market adopt for hedge funds that seek to become involved in private equity?
The notion of which structures should be adopted for hedge funds playing in private equity deals is driven more by considering what should be avoided. One of the major dangers of the convergence story is that hedge funds are making private equity investments, which is to say, illiquid investments. Hedge funds are generally vehicles that provide liquidity and that have many economic provisions keyed off of net asset value. Of course, these private equity investments cannot be liquidated quickly, if at all. So, vehicles with contingent short-term obligations (for example, to meet redemptions) should not be overly invested in illiquid assets and vehicles that have annual (or shorter) performance fees calculated on changes in portfolio value probably should not include changes in the value of illiquid investments in the calculation of the performance fees.
The basic premise is to match the fund terms with the underlying investment time horizon. A fund whose investors think is a traditional long/short fund but which has a significant private equity allocation might consider limiting the redemption rights it provides. Likewise, a fund manager should consider not charging performance fees on changes in the value of an illiquid investment, no matter that the valuation was made independently or not. The practice of using so-called side pockets in a hedge fund addresses both of these main issues. In this arrangement, the hedge fund is really treated as two funds: one a liquid hedge fund, charging management fees on net asset value and performance fees annually on profits; the other a private equity fund that charges carry on realisations only. The side pocket also locks up investors' capital – a redeeming investor must wait for the illiquid investments in the side pocket to be sold before receiving his share of the investment, and new investors can't participate in the side pocket investments existing at the time they come in. The side pocket mechanism generally ignores the effects of lack of a claw back and the risk that investments can be over-concentrated in illiquid investments if the liquid part of a fund's portfolio declines from trading results or redemptions. It is an important step towards equity, however.
Infrastructure has been very hot lately. While a lot of money has been raised in this sector, there is a limited number of truly talented people with good experience. Most of the people with infrastructure experience come from the debt side because equity investments require such long time horizons and are difficult to exit – you can’t flip a gas pipeline or an LNG plant. Because of that dearth of people, the rush to the infrastructure sector is coming to an end; there is a definite slowdown in the number of funds being rolled out and we think there will be many funds with disappointing results.
Although hedge funds are already heavily involved in the energy sector, we expect the private equity funds will take longer to develop in this area. As with infrastructure, the emergence of new talent is not keeping pace with the opportunities and long time horizons make this sector challenging for private equity investors. At the same time, a lot of the institutional investors are fully committed to energy, so further growth in this asset class is not likely.
The Chinese real estate play has had mixed success so far, but one thing we have seen is that funds with an acute focus on a single region in China have enjoyed a distinct advantage. With the exception of the bulge-bracket players, funds have not generally performed well with a pan-China real estate strategy because local knowledge is so important. As a result, we are expecting the star-performers of the next cycle to be regional funds with unsurpassed local market knowledge – Longridge is a good example of this. Watch this space.
Finally, China’s credit market is in its infancy but there are already a couple of firms investing in this area. This is one sector where the US firms can come in and compete very readily – they have a lot of money; they have the experience with credit analysis; they understand the tremendous power of priority in a capital structure and the need is so extraordinary right now that the lenders can have their choice of borrower. In other words, not that much quality in a borrower has to be sacrificed to gain enough lending opportunities.
Are there any new country-specific legal regulations that hedge funds are having to confront?
US: Perhaps the biggest current story is that, as of early August 2006, offshore hedge funds and hedge fund managers no longer need to face US Investment Adviser Act registration because they have more than 14 US persons invested in their funds. On 23 June 2006, the DC Court of Appeals invalidated certain rules promulgated by the US Securities and Exchange Commission (SEC) in late 2004 that resulted in many hedge fund advisors (both US and offshore) registering with the SEC. On 7 August 2006, SEC Chairman Cox issued a statement that the SEC would not seek a re-hearing en banc or petition for writ of certiorari. Accordingly, the so-called look-through rules in question are no longer of force and effect.
This continues to be a hot topic in Washington DC and there have been statements by members of the US Congress that Congress will act to adopt new laws to address hedge funds. We think the likelihood of such action is slim, but it is always possible that hedge fund managers will be the subject of rules targeted just to them in the future. The recent spectacular losses incurred by Amaranth and the shutting down of other private hedge funds focused on natural gas and other energy trades may add fuel to the fire for further regulation of hedge funds (even if those events did not show evidence of systemic problems).
UK: Another point to note is that the Alternative Asset Management Association released an Industry Guideline on Side Letters at the end of September that reflects discussions it has had with the FSA over the past several months on this topic. The FSA has advised that UK-based funds and fund managers are required to disclose to investors and prospective investors the “material terms” of any side letters. “Material terms” are defined by reference to enhanced liquidity rights that might reasonably be expected to materially disadvantage other investors in the fund. Such terms in existing side letters had to be disclosed by 31 October 2006.
Side letters have also been a focus of regulatory concern in the US, although the SEC has not yet issued any formal guidance or rules on this subject.
Japan: The major development in Japan is the passage last July of a new comprehensive financial services law (to be called the Financial Instruments and Exchange Law) comprising certain amendments to the current Securities Exchange Law and certain new provisions incorporated from a variety of existing laws that will disappear with the enactment of the new law, including the Investment Advisory Business Law, the Law Concerning Foreign Securities Firms, the Financial Futures Trading Law, the Mortgage Business Law and a portion of the Investment Trust and Investment Corporation Law. Under the FIEL, the following businesses under the current laws will be amalgamated into a single category known as a “financial instruments business”: (i) securities business; (ii) investment trust management business and investment corporation asset management business; (iii) investment advisory business and discretionary investment management business; (iv) financial futures transactions business; (v) trust beneficiary sales business; (vi) mortgage business; and (vii) commodity investment sales business.
A financial instruments business is defined to be comprised of 18 different types of activities. Any entity wishing to engage in a financial instruments business must be registered under the FIEL. There are five types of financial instruments businesses under the FIEL and a company may only engage in the type of financial instruments business that is expressly specified in its registration: (i) first financial instruments business; (ii) investment management business; (iii) second financial instruments business; (iv) investment advisory and agency business; and (v) securities administration business.
While the new law was enacted on 14 June 2006, the effective dates of its various sections are different. Note that the amendments in connection with the financial instruments business (including the investment advisory business) will come into effect no later than 13 December 2007 and it is generally expected to become effective around July 2007. Although the statutory provisions of the new law have already been made public, as the relevant cabinet orders and enforcement regulations with respect to the new law have not yet been issued by the Financial Services Agency, it is difficult for us to provide any definite conclusions on the interpretation of specific provisions of the new law. All fund groups having investment advisory firms or other regulated intermediaries are likely to have to make updating filings next year.
Another major area of change in Japan is the implementation of Basel II, which has necessitated redemptions of investments in foreign funds by Japanese city and regional banks over the past 12 months and which is expected to force additional redemptions during the period ending 31 March 2007. Currently, fund managers are attempting to develop a number of innovative new products that will let these banks remain invested in the alternative investments market without a significant adverse effect on capital.
Tax-wise, which Asian country do you think is currently offering the most preferential terms for hedge funds wanting to set up?
Singapore arguably has the most hospitable regime in Asia for fund managers setting up operations to manage hedge funds. It provides both tax and regulatory incentives to attract fund managers to Singapore. As a result, there are more than 100 hedge fund managers based in Singapore today, compared to fewer than 20 before 2001.
Singapore offers income tax exemptions for offshore funds, as well as onshore funds that are substantially owned by non-residents. Moreover, approved start-up and other fund managers qualify for a 10% concessionary tax rate on income from qualifying activities. By contrast, Singapore’s main rival in Asia, Hong Kong, only provides a profits tax exemption for offshore funds and no concessionary tax benefits for fund managers.
Singapore also continues to roll out the red carpet to fund managers wishing to set up business in Singapore. Unlike under the Hong Kong regulatory regime, Singapore has several statutory exemptions to the general rule that any person engaged in a “regulated activity” such as “fund management activity” must be licensed under the Singapore Securities and Futures Act. The exemption most relevant for offshore fund managers is the exemption available to any person resident in Singapore who undertakes fund management on behalf of not more than 30 “qualified investors”.
If a fund manager can avail itself of the less than 30 qualified investors exemption, no approval from the Monetary Authority of Singapore is required; the fund manager is simply required to establish an entity in Singapore and fulfill certain notification requirements. No minimum capital requirements apply to the fund manager and obtaining an employment or investment visa in Singapore is not difficult.
Can you explain about the benefits of using 'feeder funds' as it pertains to hedge funds, and how these work?
A master-feeder fund structure enables a fund manager to address investors’ specific tax, regulatory or other concerns while at the same time ensuring an efficient vehicle to make investment decisions and execute trades.
In this structure, the feeder funds are separate investment vehicles that invest all their assets in a single common investment vehicle, known as the master fund. The master fund, in turn, ultimately holds all the assets, engages in all the trading activities and makes distributions or allocations of profits and losses to the feeder funds.
Separate feeder funds may be created to cater for specific regulatory or tax needs of different groups of investors via the use of different forms of investment vehicles with different tax or regulatory treatment in different jurisdictions. For example, while US taxable investors typically prefer to invest in an entity that is a “pass through” vehicle for US tax purposes, US tax-exempt investors prefer to invest in an entity that is taxed as a corporation for US tax purposes. In a typical hedge fund structure, US taxable investors would invest in one feeder and US tax-exempt investors would invest in another.
Feeder funds are also commonly structured as unit trusts to suit Japanese investors’ regulatory and tax needs, or as listed entities to meet certain liquidity requirements. They are also used to isolate the costs of hedge exposures applicable to certain investors, but not the fund as a whole (such as investors investing in a separate currency).
Different feeder funds may also have different fee structures and economic arrangements that relate to the particular market in which interests are being offered. (As management and performance fees are typically charged at the feeder fund level, there is flexibility in structuring these arrangements on a feeder-by-feeder basis.)
Pooling investments from different feeder funds into a single master fund also creates an efficient trading vehicle that does not need to split tickets among funds and which it is big enough to buy securities that are restricted to investors of certain asset size or net worth.
The possible downside to the structure is that there are more up-front costs in setting up the various feeder and master fund vehicles, and master-feeder accounting is somewhat more complicated than for a single fund vehicle. However, for fund raises starting at US$25 million and above, or projected to grow to that size in the first year, these additional costs are typically considered to be negligible.
For further information, please contact:
Sharon Hartline, Partner
White & Case
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Chris Wells, Partner
White & Case LLP
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Lock Yin Mei, Partner
Venture Law LLC
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Fax: + 65 6221 6910
David Goldstein, Partner
White & Case Up
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Fax: + 1 212 819 8210