A fine balance to avoid overregulation of hedge funds

June 1st, 2012

By Kerry Kopke

South Africa’s hedge fund industry is not large enough to present any systemic risk to its financial industry. Therefore, the need for regulatory oversight to manage systemic risk is questionable.

Hedge funds are private investment funds that pursue alternative investment strategies predominantly targeted at sophisticated investors.

Historically, hedge funds have not been regulated. However, the 2008 global financial crisis prompted a response from foreign regulators to include previously unregulated financial investment products, including hedge funds, within the legislative framework.

While hedge funds were not considered to be the cause of the crisis, they were viewed as having placed additional stress on the financial sector and were identified as a source of systemic risk.

As credit conditions tightened, hedge funds reduced their leveraged positions and the investors redeemed their investments – which compounded the financial situation and impaired market liquidity. In recognition of this, last year the South African Finance Minister announced plans to expand the scope of financial legislation to include hedge funds and other unregulated investment products to achieve the objective of bringing ‘all sources of systemic risk into the supervisory net’ (National Treasury, ‘A safer financial sector to serve South Africa better’, National Treasury Policy Document, Republic of South Africa, 23 February 2011 at 21).

If hedge funds are regulated, it is possible that South African legislation will be developed along the same lines as the regulations imposed in other countries, like the United States and European Union members, which have already developed legislation to address hedge funds as a source of systemic risk. However, it should be noted that the legislation in these countries provides an exemption from the regulations for smaller hedge funds because their size is not deemed to be significant enough to present systemic risk. At over R 30 billion, the South African hedge fund market is a relatively small sector of the financial industry (Novare Investments, South African hedge fund 2011 Survey at 4 (www.novare.com, accessed 26-4-2012). In comparison, consider the private equity industry, at R 97,6 billion in assets under management (KMPG and SAVCA ‘Venture capital and private equity industry performance survey of South Africa covering the 2010 calendar year’ (June 2011) at 5 (www.kpmg.com, accessed 26-4-2012) and the estimated collective size of the private pension fund industry of some R 1 trillion (Africa Fund Manager, ‘Reg 28: Open the floodgates’ (3 July 2011) (www.africa-fm.com, accessed 26-4-2012).

On this basis, the hedge fund industry is hardly large enough to present any systemic risk to South Africa’s financial industry.

Be that as it may, developments in South Africa under the Pension Funds Act 24 of 1956 (PFA) have supplemented the argument for hedge fund regulation.

Regulation 28 to the PFA, which regulates the spread of assets in which a pension fund may invest, has been amended to allow pension funds to invest up to 10% (from the previous 2,5%) of their portfolios in hedge funds (with up to 2,5% investment per hedge fund). The sum is obviously substantial, given the size of the private pension funds industry (R 1 trillion).

Regulation 28 currently defines a ‘hedge fund’ as ‘an asset … which uses any strategy or takes any position that could result in the portfolio incurring losses greater than its fair value at any point in time, and which strategies or positions include but are not limited to leverage and net short positions’.

The broadness of this definition means that a number of investment structures may fall within its ambit. The Financial Services Board (FSB) is, however, expected to issue strict conditions under reg 28 with which hedge funds must comply in order to be eligible for pension fund investments.

These conditions will limit the type of hedge fund structures that would fall within the definition of a ‘hedge fund’ under the PFA. It should also be noted that the hedge fund conditions may be used as the basis to guide any further hedge fund regulation. Therefore, any draft conditions published by the FSB should be carefully scrutinised.

Although hedge funds, as a financial investment product, are currently not regulated in South Africa, local hedge fund managers must be registered with the FSB and are regulated under the Financial Advisory and Intermediary Services Act 37 of 2002.

To be approved as a hedge fund financial services provider (FSP), the manager has to meet certain fit and proper, financial soundness and operational requirements similar to those imposed on other types of FSPs. Foreign hedge funds are able to market their hedge funds in South Africa under a basic category I FSP licence (in securities and instruments) without having to register as a hedge fund FSP.

Currently, the only limitation on hedge fund investment in the PFA is that the hedge fund manager of a local hedge fund must be registered as a hedge fund FSP and a foreign hedge fund must have a category I FSP licence.

Well before the financial crisis and the enactment of reg 28 in 2004, the FSB, the Association of Collective Investments and the Alternative Investment Management Association produced a discussion paper that called for a regulated product structure specifically for hedge funds. They noted that regulating hedge funds allowed for marketing to a broader investor base by providing local investor protection and attracting foreign fund managers to use South Africa for their new funds.

Increased regulations could boost investor confidence in hedge funds and help to grow the relatively small hedge fund market. The points raised in the discussion paper are particularly relevant given the amendments to reg 28 of the PFA. Owing to the traditional lack of financial education of pension fund trustees, formally regulating hedge funds would help safeguard pension fund investments and increase investor confidence in this form of investment product.

While hedge funds, in their own right, should be regulated in South Africa to boost investor confidence and promote the growth of the industry, overregulation could create too many hoops through which hedge fund managers are compelled to jump, thereby rendering hedge funds an unattractive form of investment vehicle.

It is therefore recommended that hedge fund regulation be developed with this fine balance in mind.

Kerry Kopke BBusSci (cum laude) LLB (cum laude) (UCT) is an attorney at Bowman Gilfillan in Cape Town.

This article was first published in De Rebus in 2012 (June) DR 42.

De Rebus