Sunday, March 18, 2012

Hedge Fund Standards Board Revises Global Standards to Enhance Governance and Increase Disclosure

In the light of the financial crisis, the Hedge Fund Standards Board has revised its global standards to enhance governance, increase disclosure, improve risk management, ensure consistent valuations, and prevent market abuse. These are international standards, and the Board has broadened the global scope of the standards by deleting any specific reference to the UK FSA Principles in the standards in the light of the growing international base of signatories and investors and in order to avoid the standards being tied to a particular national regulatory regime

The HFSB has suggested that in instances where there is no independent governing body, more specific rules governing fund behavior should be included in the fund documentation. For example, investors should have the right to approve key actions or should be given sufficient notice to redeem before such actions take effect. The revised standards therefore focus on increasing investor confidence in governance procedures in those cases where no independent governing body is in place.

In addition, prior to the establishment of a fund, a hedge fund manager should assess where the fund governance structure will lie on the spectrum of governance. In the light of that assessment, the manager should be proactive in seeking to ensure that a fund governance structure which is suitable and robust to oversee and handle potential conflicts of interest is put in place at the outset

The hedge funds should disclose the fund’s investment policy and strategy and associated risks in the fund’s offering documents. The HFSB envisages that in most circumstances such disclosure would include a description of the investment strategies and techniques employed and prominent disclosure of the risks involved, as well as general details of the investments and instruments (including, for example, derivatives) likely to be included in the fund's portfolio. The fund should also disclose an explanation of the circumstances in which the fund may use leverage, the sources of such leverage, and any restrictions on the use of leverage, and, where applicable, an explanation of how the fund manager defines leverage and net exposure levels.

If the investment policy is deliberately kept very broad to enable the manager to pursue many different strategies within the mandate, the HFSB would not expect the manager to obtain investor consent or provide advance notice sufficient for investors to redeem in situations where changes in the fund’s investment approach are within the parameters of the investment policy.

The HFSB acknowledges that there are situations where investor consent cannot be easily obtained and agrees that in such situations, allowing investors to redeem prior to the change in investment policy taking effect might be a more suitable approach.

A hedge fund manager should make periodic disclosures (generally monthly or quarterly) regarding material developments in the investment strategy, the manager’s business and the fund’s risk profile. The HFSB leaves it to the manager to determine the appropriate frequency of disclosure and where ad hoc notifications might be suitable.

The HFSB envisages that such disclosure would include material changes in investment strategy or process and items in relation to the manager’s business or the fund, such as key staff changes, new or terminated funds, or changes to any key service providers.

From an investor perspective, it is relevant if material litigation is brought against a hedge fund manager since it might draw upon manager resources, or otherwise flag issues that investors wish to be aware of. Thus, the standards require that, upon reasonable request, a manager should disclose to investors any material litigation in which it is involved (other than proceedings which the manager considers to have been brought frivolously or vexatiously) and any material formal regulatory enforcement proceedings against it. The HFSB leaves it to the manager to determine the appropriate level of disclosure. Of course, disclosing simply that the manager is involved in material litigation or a formal regulatory enforcement proceeding may lead to requests by investors for further detail.

The revised standards also require hedge funds to disclose fees and expenses, including disclosure of the methodology used to calculate performance fees. There should also be disclosure of any other remuneration received by the manager in connection with its management of the fund, which will be especially relevant where a hedge fund is a feeder fund into another fund managed by the same manager.

Further, the fees and expenses , including but not limited to management and performance fees, charged to the fund should be disclosed in the fund’s audited financial statements. This includes explanations in the annual report which allow investors to readily compare the fees and expenses charged with the description of such fees and expenses set out in the fund's offering documents where this is not obvious from the disclosure in the financial statements. For example, the categories and captions in the fund’s financial statements might correspond to those used in the fund’s offering documents so that they can be easily compared. Fund managers might also consider disclosure of a total expense ratio (TER) or gross vs. net return for the period under review.

Under the revised standards, a hedge fund manager must have a policy to prevent market abuse. There is no requirement for regulated hedge fund managers to disclose the fund’s market abuse policy. However, for managers that are not regulated, a summary of the policy should be made available to investors upon request

In order for investors to better understand valuations and the characteristics of the fund’s portfolio, the percentage of the fund's portfolio that falls into each of the three levels prescribed by FASB ASC 820 or IFRS 7, and the extent to which internal pricing models or assumptions are used to value components of the fund’s portfolio invested in hard-to-value assets, should be periodically disclosed. Moreover, notification of any material increase (as determined by the fund governing body) in the percentage of a fund's portfolio invested in what the manager considers to be hard-to-value assets should be timely disclosed.


To enable investors and creditors to be confident that operational risks are managed satisfactorily, a hedge fund manager should also make available a summary of its procedures and controls applying to the management of operational risk to investors and creditors undertaking due diligence.

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