NEW HEDGE FUND FRAMEWORKStudy Notes

OVERVIEW

Introduction Legal structure Registration Risk Management Transparency and Disclosure Prime broker and administrators Investment/trading activities for retail hedge

funds Investment parameters for retail hedge funds

INTRODUCTION

Framework for the regulation and supervision of hedge funds

Intention is not to regulate hedge fund service providers

Recognition of hedge funds as a special collective investment scheme

Amendment of the current Collective Investment Schemes Act 2002 (The Act) required

OBJECTIVES

greater investor protection prevention of systemic risk promotion of market integrity transparency

RESTRICTED VS. RETAIL HEDGE FUNDS

Restricted Hedge Funds not subject to strict regulation limited to private membership of qualified

investors must register as restricted funds as per Registrar

requirements and lodge returns annually certain disclosure requirements

Retail Hedge Funds Subject to more regulation Investments available for retail investors as well

as institutional investors Minimum investment between R50 000 and R100

000

LEGAL STRUCTURE

Hedge fund service providers investment vehicles include Trusts Debentures Companies Partnership arrangements

Partnerships arrangements are the most common especially as en commandite partnerships

The Act requires the manager to be a company registered as per Companies legislation and fulfill obligations of the prescribed in the Act

REGISTRATION

All hedge fund managers targeting investors in SA must be registered with the Registrar

Currently registered category IIA financial services providers must register as collective investment scheme managers for the hedge funds they currently manage.

REGISTRATION ADDITIONAL INFO

Description of manager seeking registration Current tax clearance certificate for all proposed shareholders

5.3.1. a description of the manager seeking registration as well as an organogram indicating the group structure and ownership of the company;

5.3.2. a current tax clearance certificate in respect of all of the proposed shareholders (direct and indirect) of the proposed manager;

5.3.3. full particulars of the collective investment scheme the manager proposes to carry on and the manner in which it proposes to carry on such scheme;

5.3.4. an indication of the manager's existing and proposed client base and an indication of the target market;

5.3.5. a business plan on how the marketing of the proposed scheme will be done;

5.3.6. the business objectives of the proposed scheme including the intended strategies to achieve these objectives and the different phases of achieving such objectives;

5.3.7. the names and physical addresses of the chairperson, directors and managing director of the manager together with their curriculum vitae;

RISK MANAGEMENT

Prudential requirements (retail hedge funds) Managers must carry out duties in a prudent

manner reflecting risks they take Minimum capital requirements as determined by

the registrar Investors may not lose more than capital invested

Valuation Assets in hedge fund valued by an independent

party Retail hedge funds must provide daily pricing Listed investment priced according to the market

price Unlisted investment priced using method permitted

by trustee or trustee’s representative

RISK MANAGEMENT

Liquidity 14 day liquidity requirement for retail hedge funds Provisions made in the event that payments cannot

be made when needed

Segregation Separation of assets of the fund and of the manager Collateral held not included in the value of the fund

Conflict of interest

Assessed and managed Any potential conflict of interest fully disclosed

RISK MANAGEMENT

Risk management programme Types of derivatives used must set out Risks associated with derivatives How risks will be managed Detailed report of trading process and personnel

involved responsibilities and expertise Auditor must be appointed for the fund All funds must appoint a compliance officer

who is suitably qualified and experienced

RISK MANAGEMENT Leverage “Leverage is the use of financial instruments or

borrowed capital to increase the potential return of an investment.” May be achieved by using derivatives or borrowing Derivative total exposure at most total net portfolio value

for retail HF Investment strategy determines rules for measuring

exposure Commitment approach used for measuring exposure for

simple strategies Counterparty risk exposure must be at most 20% of fund

net asset value VaR recommended for measuring exposure for complex

strategies Absolute or relative VaR may be used

TRANSPARENCY AND DISCLOSURE

All hedge funds must provide information to investors about valuation method position leverage exposure for transparency purposes.

Managers must meet disclosure requirements (section 3 and 100 of the Act)

Key investor information document (“KIID”) must be prepared by manager.

The KIID must contain key investor information and may aid retail investors in understanding the investment product on offer

TRANSPARENCY AND DISCLOSURE

The KIID must incorporate: investment policy and objectives description of main categories of eligible

financial instruments, details on focus areas risk and reward indicator showing risk levels

from lowest to highest, and risk explanation Charging structure presentation should be

clear Past performance presentation All other practical information

REPORTING

Submissions to the Registrar Monthly reports on assets, positions and

leverage by managers Quarterly reports on holdings and exposure

for retail hedge funds Yearly reports all hedge funds

PRIME BROKERS

“Prime broker” means a bank as defined in the Banks Act, 1990 or an authorised financial services provider offering prime brokerage services which include lending money, acting as counterparty to finance or execute transactions in financial instruments, lending securities for the purpose of short selling, clearing and settlement of trades, operational support facilities and customised technology.

PRIME BROKERS

Services provided Making transactions on behalf of the fund Margin deposit transactions Providing credit facilities when needed Securities lending and borrowing Share repurchase transactions

Fund assets may be used as security for debt of the fund

PRIME BROKERS

Subject to regulation and supervision Only registered banks and financial service

providers may act as prime brokers Must not be trustees to the fund Must have proper risk management in place Managers must follow certain criteria in

selecting prime brokers

ADMINISTRATORS

Separate from hedge fund managers Avoid conflict of interest Reside in the republic and registered as a

financial service providers Any contribution by manager to valuation or

pricing process must be disclosed to the trustee

INVESTMENT/TRADING ACTIVITIES FOR RETAIL HEDGE FUNDS Allowed assets for retail hedge funds

Securities and money markets instruments traded on a regulated market or listed on an exchange

Over the Counter derivatives and participatory interests.

The following criteria must be met: Loss must be limited to the original investment The liquidity of the instruments or securities must be

such that the hedge fund can meet its repurchase obligations

A reliable valuation for the investment must exist. Appropriate information on the investment must be

available. The instrument must be negotiable. The acquisition of the investment must be consistent

with the investment policy of the hedge fund.

INVESTMENT/TRADING ACTIVITIES FOR RETAIL HEDGE FUNDS

Risk management process of hedge fund must capture risks associated with the hedge fund.

A security or money market instrument may embed a derivative, if it meets certain criteria:

for securities or money market instruments embedding a derivative, the underlying assets of the embedded derivative instrument must be made up of eligible assets.

Participatory interests of registered collective investment schemes, closed or open ended.

INVESTMENT/TRADING ACTIVITIES FOR RETAIL HEDGE FUNDS

Eligible financial indices must be sufficiently diversified adequate benchmark of the market it refers to published appropriately

Indices may be metal, equity or property Exposure to indices may be obtained using

swaps

Financial Derivative Instruments Eligible assets If a derivatives makes use of an ineligible asset it

is ineligible May be over the counter derivatives Subject to SARB supervision May be subject to valuation regularly May be sold for their fair value

NON- PERMITTED ASSET CLASSES

Direct or indirect investment in Commodities, Property / Real Estate; and Private Equity.

Non-Financial Indices Hedge funds may be exempted subject to

certain

INVESTMENT PARAMETERS FOR RETAIL HEDGE FUNDS

Equity Securities subject to limits Derivatives

Leverage Collateral re-use with restrictions

Investments in other Collective Investment Schemes (“CISs”) Due diligence Suitability Limits for investments

10% NAV investment in unlisted securities

SHORT SELLING

Selling of a security that the seller does not own

Physical short selling allowed if it meets the following criteria

Economically appropriate Realised in a cost-effective manner Done for at least one of the following reasons

Risk reduction Cost reduction Generation of additional income or capital for the

fund Captured by the risk management process\

No naked short selling is allowed

CONCLUSION

The framework is not perfect Intention is to protect stakeholders May be reviewed in future