The pace of Hong Kong's race to put hedge funds onto the
retail market is slowing. Although a small, but still significant
queue has formed to register products, some unexpected potholes
have appeared as managers, lawyers and the regulators attempt
to reconcile differing requirements. That there would be teething
troubles was seen as inevitable, given the pioneering aspect
of the Securities and Futures Commission's initiative in opening
the way for hedge funds to be offered to the wider public.
The SFC was having to set standards that would allow freedom
of fund management while ensuring maximum investor protection.
No precedent was available, as in other jurisdictions hedge
funds remain exempt products, although Singapore has also
taken steps to regulate the public offering of the vehicles.
Most market professionals now doubt that any funds will actually
be on sale much before the end of the year, instead of by
the third quarter as had once been expected. Even so, this
would represent rapid progress, as it would mean that hedge
funds were on sale to the public within around one year from
when the wheels starting to turn. The key to the registration
process was the publication in May of the SFC's guidelines,
which followed a comprehensive consultation with the industry.
New provisions relating to hedge funds were incorporated in
Chapter 8.7 of the Hong Kong Code on Unit Trusts and Mutual
Funds. The headline issues were the minimum subscription limits
on the funds, which was the preferred method of limiting the
hedge fund distribution to those with deeper pockets, and,
supposedly, greater sophistication in investment matters.
Fund of funds products would require a minimum investment
of $US10, 000, while the more focussed single strategy funds
required US$50,000. The commission also laid down rules on
the experience of the managers in their chosen fields, and
the minimum size of a fund. This cleared the way for hedge
fund managers who wished to target Hong Kong investors to
start the process of building and registering suitable products.
No-one has been killed in the rush. Only around 15 or so applications
have been put forward, according to insiders. Most will be
for fund of funds, which are expected to have a wider appeal
to the retail market because of their diversity.
"Some managers are attempting to take a short cut by
taking an existing fund off the shelf, others are building
products specifically for the Hong Kong market", says
Rory Gallaher, a partner with law firm Deacons. A crucial
issue in presenting a product is the domicile of the manager,
who must be in a jurisdiction recognised by the SFC. These
include the US, the UK, Dublin and Luxembourg.
Even this is not enough to ensure automatic registration,
as the Commission will examine the fund to make sure it complies
with its own criteria. Even with traditional funds, the jurisdiction
scheme is becoming less and less significant, as the SFC examines
all applications, and requires managers to comply with any
particular aspect of the code, explains Gallaher. Despite
the comprehensive consultation that led to the publication
of the code, managers would still like to see the rules modified,
or waivers issued as the differences between the SFC's rules
and the mechanics of individual funds have emerged. "It's
only when people concentrate on a particular product that
they want to get authorised that they realise it doesn't quite
fit in. There are definitely areas where people want to make
changes," says Gallaher. "There is more involved
than people thought," confirms James Walker of rival
lawyers Clifford Chance. "To some extent mistakenly,
people thought they could take an existing product, whether
incorporated in the US or the Caymans and try and get it authorised,"
he adds.The chances of any major changes to the May code is
regarded as low by lawyers and other advisors - and the SFC
is saying nothing about the process in public. "The SFC
is going to apply those rules strictly in the early stages.
I can understand that, though it doesn't work for us,"
comments one fund manager seeking registration.
Structural issues have caused few problems, according to
one lawyer, although some fund managers believe the requirement
for five year's experience in hedge funds, and a minimum of
US$100 million under management will cause problems. There
has been some movement on the issue of experience, according
to lawyers. The initial requirement that the fund must have
two investment executives with five years experience in a
fund with the same strategy has been modified. Now only two
years out of the five have to have been spent in the same
sort of strategy, a concession that recognises that some strategies
just don't run for five years in this business. Despite that
shift, at least one major fund manager reports difficulty
in convincing the commission that his fund - one of the world's
biggest unit trust players - actually has five years experience
in hedge funds. Down in the finer print, issues taking up
registration time include performance fees. Many hedge fund
managers are used to taking their fees on a quarterly basis,
but the commission insists that the existing rules for standard
unit trusts will apply, so they can only be collected annually,
even if they are accrued on a more frequent basis. With the
majority of products to be launched in Hong Kong expected
to be fund of funds, some practitioners complain that some
of the rules on the structure of these funds are too onerous.
A minimum of five other funds must form part of the overall
fund, but none can be another fund of funds, and both lawyers
and fund managers are querying that requirement, when the
whole concept of such products is to diversify risk.
A clause which rules that if a manager has a feeder fund,
both the fund and the feeder have to be authorised in Hong
Kong is also causing some problems. "What is the point
in having a feeder," asked one applicant. "Sometimes
a fund may not wish to be authorised in Hong Kong, or may
be obligated not to by the way in which it was set up."
Umbrella funds are also facing a requirement to provide proof
that the assets of the fund authorised in Hong Kong are ring-fenced
from the assets of all other funds under management. For funds
invested in the Cayman Islands this could be a problem, for
although the cell company rules have been introduced, which
separate the assets of individual funds under the umbrella,
existing products will still have to go through the commission's
hoops. It's not just this sort of fine print that causes some
hassles - the commission is also cracking down on the presentation
of registration documents. On June 24, the Investment Products
Division issued a letter calling for standardisation of fund
authorisation procedures. This set out which documents had
to be submitted, including marketing approvals. All documents
were to be heavily annotated in the margin with reference
to the sections of the code to which they applied. While there
is a general recognition that the SFC has been doing its best
to break new ground, there is unanimous opinion that the process
is going to take much longer than expected. Defenders of the
SFC argue that its staff are on a learning curve, and are
already heavily committed to the flow of standard products
such as guaranteed funds, which continue to flood the market.
The consensus now is that first registrations will be completed
by August or September, but the real marketing of hedge funds
in Hong Kong will not take place until the end of the year.