Updated Disclosure Rules for Hedge Funds in Australia
Fadi Khoury, Partner
Norton Rose Australia
The Australian Securities and Investments Commission (ASIC) has released Consultation Paper 174 Hedge funds: Improving disclosure – Further consultation (CP 174), which seeks further feedback in respect of ASIC’s earlier Consultation Paper 147 (CP 147) released in February 2011. CP 147 prescribed various key features and risks that should be addressed in the Product Disclosure Statement (PDS), and other communications, for a hedge fund.
A separate disclosure regime does not currently apply to hedge funds and the application of the law and general ASIC policy to a particular hedge fund is left to the individual issuer and its advisers to determine.
The paper follows a recent approach by ASIC to prescribe specific disclosure principles and benchmarks for particular asset classes such as mortgage schemes, unlisted property schemes and infrastructure funds.
Scope of CP 174
It is proposed that the disclosure principles and benchmarks will apply to any registered managed investment scheme that is, or has been promoted as, or is generally regarded as, a hedge fund or a fund of hedge funds. ASIC is formulating its definition of hedge fund for these purposes and it seems it will apply a broad definition that looks at whether a fund has some or all of the following features:
strategy – the fund pursues complex strategies that aim to generate absolute returns, returns with low correlation to equity and bond indices, or a positive return in both rising and falling markets
leverage – the fund often uses leverage to increase investment returns
derivatives – the fund often uses derivatives to create complex investment strategies or for gearing purposes
short selling – the fund often engages in short selling
complexity – the fund often has exposure to diverse risks and complex underlying products.
This approach could potentially sweep up a broad range of funds with any or some of these features, even those which may not traditionally be regarded as hedge funds.
The disclosure requirements outlined in CP 174 consist of a combination of disclosure principles and ‘if not, why not’ benchmarks. An issuer is required to state in the PDS and in certain ‘other disclosures’ whether it meets a benchmark (and if not, why not). Failure to comply with the disclosure principles and benchmarks may result in ASIC issuing a stop order on an offer.
Interestingly, ASIC also notes that ‘as a matter of best practice’, disclosure of information similar to that set out in CP 174 would be useful for investors in other types of funds, not just hedge funds.
The proposed disclosure principles and benchmarks
A brief summary of the proposed disclosure principles and benchmarks applicable to a PDS for a hedge fund is set out below:
Benchmark – valuation and custody of assets
The fund should implement a policy that requires:
(a) valuation of the fund’s assets that are not exchange traded to be provided by independent third party administrators; and
(b) all custodians involved in the fund structure (including custodians of any underlying funds) to be unrelated to the responsible entity or investment manager of the fund.
If the fund does not meet this benchmark, it should disclose why not.
Benchmark – periodic reporting
The fund should implement a policy to provide periodic reports on certain key information:
the current FUM of the fund;
the actual allocation to each asset type;
the liquidity profile of the assets as at the end of the period – the representation of asset liquidity (the time required to sell an asset at its market value) in a graphical form that allows easy comparison with the maturity profile of the leverage;
the maturity profile of the leverage as at the end of the period – the representation of maturities in a graphical form that allows easy comparison with the liquidity profile of the assets;
the leverage ratio (including leverage embedded in the assets of the fund) as at the end of the period;
the undrawn amount of loan facilities as at the end of the period;
the derivative and structured product counterparties engaged (including capital protection providers);
the investment returns over at least a five-year period (or, if the fund has not been operating for five years, the returns since its inception); and
the key service providers if they have changed since the last report given to investors.
The fund should also ensure the latest report, which addresses the above matters, is available on the fund’s website.
The following information is to be available on the fund’s website and is to be disclosed monthly or, if less often, at least on each date investors are able to redeem their investments:
the current FUM, the undrawn amount of loan facilities as at the end of the period, and the key service providers if they have changed since the last report given to investors; and
for each of the following matters since the last report on those matters:
the pre-tax return on the fund’s assets on both a before and after fees and costs basis;
any material change in the fund’s risk profile;
any material change in the fund’s strategy; and
any change in the individuals playing a key role in investment decisions for the fund.
If the fund does not meet this benchmark, it should disclose why not.
Disclosure principle – investment strategy
a description of the fund’s investment strategy, including: the asset classes typically invested in; the typical location and currency denomination of the assets; and the role of leverage, derivatives and short selling;
an explanation of how the strategy will produce investment returns;
any key dependencies or assumptions underpinning the strategy’s ability to produce investment returns (e.g. market conditions or interest rates);
what the diversification guidelines are;
any specific risks associated with the relevant investment strategy;
disclosure of the key aspects of the fund’s risk management strategy; and
if and how the investment strategy can change and what notification would be provided to investors.
Disclosure principle – investment manager
any relevant significant adverse regulatory findings against any investment manager appointed by the responsible entity of the fund;
the identities, relevant qualifications and commercial experience (including relevant significant adverse regulatory findings) of the individuals playing a key role in investment decisions and the proportion of their time each will devote to executing the fund’s investment strategy;
if any of the assets are not managed by the responsible entity, any unusual or materially onerous terms in the agreement under which the fund manager is appointed and the scope of this appointment; and
the circumstances in which the responsible entity is entitled to terminate the investment manager’s appointment and on what terms (including any payments).
Disclosure principle – fund structure
the fund’s investment structure, including the key entities involved (e.g. companies, schemes and limited partnerships), their relationship to each other and their roles, together with a diagram showing the flow of investment money through the structure;
the identities of the key service providers and intermediaries (e.g. prime broker, custodian, administrator, compliance service provider and auditor), where applicable;
the rationale for the structure and the jurisdictions used;
the risks of the structure, including any risks associated with holding assets overseas or, for funds of hedge funds, with investing in underlying funds overseas;
where a fund invests in underlying funds or structured products, or invests through managed accounts, the fees and costs paid at each layer together with a worked example of the accumulated impact of these fees and costs over a year. This should be based on a reasonable estimate of the likely or anticipated fees and costs, and a reasonable and disclosed assessment of investment performance, as a proportion of the amount invested (e.g. for each $1 invested by an investor, the accumulated impact of the direct and indirect fees and costs will be x cents);
the due diligence process performed on underlying funds and the key service providers;
how the responsible entity ensures that key service providers will comply with service agreement obligations;
any related party relationships within the structure, including any related party relationships with the investment manager; and
the existence and nature of material arrangements in connection with the fund that are not on arm’s length terms.
Disclosure principle – valuation, location and custody of assets
the key aspects of the valuation policy;
the types of assets and the allocation range to each asset type, using a specified list of asset types provided by ASIC (including the assets of collective investment vehicles invested in by the fund);
any policy about asset location;
the geographic location of any material asset; and
the custodial arrangements, including details of the roles provided by custody service providers.
Disclosure principle – liquidity
If more than 20% of a fund’s assets cannot be sold at market value in less than 10 days:
a description of any illiquid asset class that has a value greater than 10% of the fund’s net asset value; and
the key aspects of the liquidity management policy.
Disclosure principle – leverage
the sources of leverage, including type, amount and providers of the leverage;
whether any assets are used as collateral and the extent to which they are otherwise encumbered or exposed to set-off rights or other legitimate claims by third parties in the event of the insolvency of the responsible entity, a service or credit provider, or a counterparty;
the maximum anticipated or allowed level of leverage (including leverage embedded in the assets of the fund), as a multiple of the amount invested by an investor (e.g. for every AUD$1 the investor invests, the fund is leveraged AUD$x); and
a worked example showing the impact of leverage on investment returns and losses, assuming the anticipated level of leverage (including leverage embedded in the assets of the fund).
Disclosure principle – derivatives and structured products
the purpose and rationale for the use of derivatives or structured products (e.g. investment, hedging, leverage and liquidity), including how they form part of the fund’s investment strategy;
the types of derivative or structured product used or planned to be used;
the criteria for engaging derivative and structured product counterparties (including principal protection providers);
the key risks to the fund associated with the collateral requirements of the derivative counterparties; and
whether the derivatives and structured products are OTC or exchange traded.
Disclosure principle – short selling
If a fund intends or is likely to engage in short selling:
the purpose and rationale of short selling, including how short selling forms part of the fund’s investment strategy;
the risks associated with short selling;
how these risks will be managed; and
an example showing the potential gains and losses from short selling.
Disclosure principle – withdrawals
The PDS should disclose the following information:
any significant risk factors or limitations that may affect the ability of investors to withdraw from the fund, including any gating restrictions that may be imposed or the requirement for a statutory withdrawal offer if the scheme is non-liquid;
how investors can exercise their withdrawal rights, including any conditions on exercise;
if withdrawal is to be funded from an external liquid facility, the material terms of this facility, including any rights the provider has to suspend or cancel the facility; and
how investors will be notified of any material changes to their withdrawal rights (e.g. if withdrawal rights are to be suspended).
The paper requires careful consideration and fund managers will need to adopt additional measures to be in a position to comply. Some of the key issues for consideration by issuers of hedge funds and funds of hedge funds arising out of the proposals in CP 174 include the following:
as mentioned above, the proposed approach for determining whether a scheme is a hedge fund, involving consideration of a number of ‘indicia’, may potentially sweep up a broad range of funds, even those which may not ‘traditionally’ be regarded as hedge funds;
ASIC has indicated that, where a scheme could be characterised as a hedge fund but also falls ‘more specifically’ within another category of schemes covered by other ASIC disclosure guidance, the more specific disclosure guidance will apply. This may lead to some confusion as to the applicable disclosure guidance;
ASIC will ‘encourage’ issuers to apply the disclosure benchmarks and principles when providing similar offers to wholesale investors and offers by listed investment companies that have some of the features of hedge funds;
On 22 December 2011, the Government announced that hedge funds would be excluded from the shorter PDS regime until these products could be fully considered in light of the policy intent of that regime. As such, all hedge funds are required to disclose against the proposed benchmarks and apply the proposed disclosure principles, regardless of whether the fund meets the definition of a simple managed investment scheme.
Responsible entities of hedge funds should disclose against the benchmarks and apply the disclosure principles in any PDS dated on or after 1 March 2013. ASIC also expects responsible entities to provide the benchmark and disclosure principle information in their ongoing disclosure from that date.
By 1 March 2013, if an existing PDS is still in use, responsible entities should:
include the benchmark and disclosure principle information on its website (if the omission of this benchmark and disclosure principle information from the PDS is not materially adverse); or
update the PDS by a new or supplementary PDS so that it includes the benchmark and disclosure principle information.
he deadline for comments on the consultation paper is 19 April 2012. It is expected that, following the close of the consultation and subject to comments from stakeholders, ASIC will release a regulatory guide in late 2012.
Fadi Khoury is a financial and investment services lawyer based in Sydney. Fadi has extensive experience advising local and offshore firms on the establishment and offering of investment funds and products, particularly real estate, private equity, hedge funds, managed funds, MITs and structured products. He is a trusted advisor to some of Australia’s leading asset managers, superannuation funds and financial services firms.
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