Regulation ushers in new era for fund industry

South Africa's hedge fund industry is about to move from a system largely characterised by self-regulation to one in which managers will be under greater supervision from the country's regulator, the Financial Services Board. While some members of the industry believe that regulation will help raise awareness and improve the image of hedge funds, there is some concern that the end result will be an industry divided between regulated and unregulated managers and products.

Up to now the regulatory status of hedge fund managers has been a matter of uncertainty, but arguably this state of affairs has served the industry and its investors reasonably well, even though there is no supervision of hedge fund managers since their investment techniques fall outside the remit of the Collective Investment Schemes Control Act. In theory, this situation leaves private and institutional investors without regulatory protection.

In practice, however, the structure of the industry has prompted managers to take a more conservative approach and run fewer risks, according to Carl Liebenberg, who recently stepped down as chief executive of fund of hedge funds manager Clade Investment Management.

Liebenburg notes that in the absence of regulation, institutional investors have preferred to invest through funds of hedge funds in order to benefit from their due diligence capabilities; funds of funds accounted for just under 60 per cent of total single manager assets at the end of June 2007, according to research provider and fund of funds manager Novare Investments.

'Because the bulk of institutional money is coming through funds of hedge funds, allocations to hedge funds in South Africa are generally based on their objectives, which has resulted in managers becoming quite conservative,' Liebenberg says. 'Levels of leverage are very low and transparency are very high, because managers are trying to market themselves to the funds of funds.

'We probably have one of the best self-regulated industries in the world. As many as 80 [out of more than 130] hedge funds report their daily data to an independent risk manager. As a fund of funds manager, Clade receives risk reports on every hedge fund it invests in from the risk manager, and they also do an aggregate risk report on the fund of funds. There are phenomenal levels of transparency and a high degree of compliance with international best practice.'

Pressure from funds of funds, Liebenberg argues, has been a driving force behind the growing use of independent third-party administrators. 'Clade wouldn't invest in a fund unless it had an independent administrator, which is now pretty much the norm in South Africa,' he says. 'Amaranth would never have happened here.'

He acknowledges that independent administration is no guarantee against blow-ups: 'A fund called Evercrest produced the industry's first blow-up last April when the manager put on a massive short position that was out of mandate. You can't stop a manager doing something stupid, but you can at least ensure good practice in how they conduct themselves.'

But this is now changing as a system of formal regulation of the industry by the Financial Services Board finally comes into effect after years of discussion and debate. The regulator has set a deadline of February 29 for managers to apply for a licence that will give them the classification of hedge fund manager but will require them to demonstrate appropriate management experience and expertise.

'The investment manager needs to be registered with the FSB and must have the necessary experience to be managing a hedge fund,' says Gavin Butcher, head of research at Oryx Investment Management, which runs Oryx SA, a South African-domiciled fund of hedge funds, as well as three offshore funds of funds. 'The requirements for long-only portfolio managers have been extended further for hedge funds, involving three years' experience of managing a long-only fund or two years of working for a hedge fund.'

The new system is intended to provide a framework that should ease some of the regulatory constraints on hedge fund investment by institutions and also by retail investors, and at present funds themselves will continue to sit outside the regulatory environment. But some managers fear it will lead inexorably to much more detailed prescription of what hedge fund products should and should not do.

'For the past five years we have been promised some kind of hedge fund regulation,' says Lee Dalley, a portfolio manager with Blue Ink Investments, a fund of hedge funds manager that serves principally individual investors and which was acquired at the end of last year by Octane Group, a Swiss-based alternative fund of funds provider.

'It's not an easy thing to do, but the FSB has slowly begun to regularise the industry by establishing the category 2A licence for FSB-approved hedge fund managers. There are quite tight criteria, including the need to demonstrate industry experience in the particular strategy you will be managing. A lot of people have been going obtaining references from the various companies they've worked with in order to prove their experience to the FSB.'

Dalley believes regulation may prove a double-edged sword, especially if the regulator than moves on to regularising products. 'It may give private clients and independent financial advisers more comfort if the FSB has some sort of oversight over who becomes a hedge fund manager,' he says. 'However, it depends on how the market will be regulated, and there has been concern everywhere that regulators might limit what managers are allowed to do.

'That would have the detrimental effect of forcing many managers not to become regulated if restrictions were to be imposed on how they can trade. In all likelihood the FSB will establish a regularised hedge fund vehicle and prescribe what it should look like. Some managers will be willing to go down that route, but others won't.

'The question arises what happens to hedge funds that are already in existence and closed to new investment. There is no incentive for them to become regulated funds, because they don't need to attract any more money. Short of them being told they have to comply or close down - and I don't think the FSB would have the authority to do that - they would continue to exist as unregulated hedge funds.'

Dalley believes the result will be a regulated industry, which will offer easier access for investors, and an unregulated market, where investors will have to sign disclaimers signalling their acceptance of a lack of regulatory oversight and protection. However, he is not convinced that the move will bring hedge funds into the mainstream retail market

'The presumption has been that once funds are regulated and form part of the broader collective investment scheme world, it will be easier for everyone,' he says. 'But these aren't funds for everybody. It's not an environment where managers will want to start collecting ZAR50 a month from investors, as they do in the traditional space.'

He is echoed by Barry Shamley, head of trading at Oryx, who questions whether the new regulations will be a significant factor in the growth of either individual or institutional investment in hedge funds. Noting that institutions are already willing to invest in the sector without regulation, he adds: 'It might be helpful in getting private clients on board, but I'm not sure whether most hedge fund managers will want to deal with them because they tend to bring smaller amounts of money and require a lot of administration.'

However, Veit Schuhen, chief operating officer of Maitland Fund Services, believes that greater regulation will ultimately benefit the industry. He says: 'Regulation doesn't necessarily mean restriction, but it can provide assurance that makes investors more comfortable. Domestic investors feel much safer than in an environment where nothing is regulated. Fund managers may feel differently, but they should think about the investor if in the end it helps them become more successful.'

Schuhen is comfortable about administrators themselves being regulated and taking on a larger portion of responsibility for overseeing the operations of the funds they service. 'It's the right thing for more compliance work to fall on third-party administrators,' he says. 'The effect will be to require the administrator to monitor that everything is working properly and to report to the regulator on an ongoing basis. If things go wrong, the administrator will be as much responsible as the manager. It's probably the best way to force hedge fund managers to outsource to third-party service providers.'

He argues that this is a logical development as administrators develop a different kind of relationship with their fund manager clients, one much more based on partnership. 'The old-style administrator sitting somewhere in the suburbs, employing people aged between 50 and 60 and simply doing NAV calculation and accounting, has gone,' Schuhen says.

'Now it's an industry driven by people with sophisticated skills and specialist expertise, and we are moving toward a consultancy or advisory role. Fund managers expect us to ask what they want to achieve. They tell us their goals, and we come up with recommendations on the structure, build it together in partnership with the manager and provide the key IT systems to support it.'

Schuhen says this bespoke advisory capability is what distinguishes medium-sized administrators such as Maitland from the global giants of the industry. 'At a sophisticated, specialised administrator like Maitland, you create a product, you don't run a sausage machine. You advise the client on which direction to go. We are much more aligned with market needs and changes than the big players.'

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