IOSCO Issues Risk Liquidity and Due Diligence Standards for Funds of Hedge Funds

With the US and EU readying legislation to regulate hedge funds, IOSCO has set forth regulatory standards for funds of hedge funds, focusing primarily on liquidity risk and due diligence. Generally, the standards reflect a common approach and a practical guide currently acknowledged by regulators. Implementation of the standards may vary from jurisdiction to jurisdiction, depending on the circumstances.

In dealing with liquidity risk, the fund of hedge funds’ manager should make inquiries in order to be in a position to consider if the fund’s liquidity is consistent with that of the underlying hedge funds, particularly in order to meet redemptions. Prior to investing, and during the investments’ lifetime, the fund manager should consider the liquidity of the types of the financial instruments held by the underlying hedge funds. The manager should also consider whether conflicts of interest may arise between any underlying hedge fund and any other relevant parties.

If the fund introduces limited redemption arrangements for dealing with a potential liquidity issue, said IOSCO, the fund manager should consider whether these are consistent with the fund of hedge funds’ objectives. Moreover, the conditions relating to the activation of the limited redemption arrangements should be clearly specified in the fund of hedge funds’ prospectus. Further, the redemption arrangements should only be activated for a limited period of time and for the purpose of dealing with exceptional situations in the interest of shareholders as clearly stated in the prospectus.

More generally, before and during any investment, a fund of hedge funds’ manager should consider whether conflicts of interest may arise between any underlying hedge fund and any relevant other parties. In particular, the fund manager should consider the nature of the agreements entered into between any underlying hedge fund and any investors, which provide for preferential rights to some investors through side-letters or other similar arrangements. The fund should disclose the existence of any material side-letters or similar arrangements.

The hedge fund manager should also implement appropriate due diligence procedures for the purpose of investment into hedge funds; and review them regularly. Fund managers should additionally conduct due diligence on the underlying hedge fund whenever it is considered necessary.

IOSCO sets forth a laundry list of due diligence factors that the manager of the fund of hedge funds should consider, many of which deal with the underlying hedge fund’s valuation techniques, risk management, and corporate governance. Specifically, the fund manager must consider whether the underlying hedge fund complies with established valuation principles and whether the methodology used for calculating the hedge fund’s value is appropriate. Similarly, the fund manager should consider the adequacy of the method used for the purpose of calculating the underlying hedge fund’s performance history and whether the hedge fund’s reported performance is consistent with its stated strategy.

The fund of hedge fund’s manager should also consider the adequacy of the experience and qualifications of the underlying fund’s portfolio managers and the extent to which they adhere to industry professional codes. If the underlying portfolio managers have personally invested in the fund, the fund of funds manager must consider whether the underlying hedge fund has adequate systems to identify any potential conflicts of interest related to such investments.

Proper due diligence will also require adequate technical and human resources, procedures and organizational structures. More granularly, there must be documented and traceable procedures for selecting hedge funds. Relatedly, there must be in place resources and procedures to deal with any anomalies identified by the due diligence system, to take the necessary corrective action, and to confirm that all procedures are traceable and have been catalogued.

Fund of hedge funds managers authorizing the outsourcing of any aspect of due diligence it should determine that any conflicts of interest are adequately addressed; and consider the extent that the outsourcing of due diligence is consistent with IOSCO principles.

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