Local Hedge Fund Managers

Recently SFC completed a theme inspection of 8 locally set up hedge fund managers, which were generally smaller firms employing between 3 and 30 staff with AUM ranging between US$5m and US$800m. They mainly adopted equity long/short investment strategy. Then SFC issued a circular to set out the standard of conduct and control procedures expected of licensed hedge fund managers in HK.

Risk Management and Controls

• In some firms the CIO also takes on the role of a risk manager because the business may not afford employing an independent risk manager. This is definitely a control weakness, especially when the CIO is monitoring the risk of portfolios under his management.
• In one case noted by SFC, the parameters used in a proprietary trading model had not been updated for many years. Then how could this model cope with the extremely dynamic financial markets today?

Information for Clients

• There were instances where inaccurate information was disclosed in the newsletters or monthly fact sheets distributed to investors, e.g. largest stock holding, gearing ratios, or even NAV.
• Some side letters entered into with certain fund investors (typically those with sigificant interest) contained preferential terms, e.g. preferential redemption rights or additional transparency. Such unfair arrangements are normally only disclosed to investors upon request.

Side Pockets

• Side pocket is a structure used by hedge fund managers to assist investment in comparatively illiquid or hard-to-value assets. In essence it is similar to a single-asset private equity fund. Once an asset held by the hedge fund is designated for inclusion in a side pocket, new fund investors do not share in it. When existing investors redeem from the hedge fund, they remain as investors in the side pocket until it is liquidated, typically on the sale of the side pocket asset, or an IPO that causes the side pocket to become more liquid.
• SFC has reminded hedge fund managers to critically assess the following factors when managing side pockets: (a) operational capacity and risk management competency; (b) valuation basis; and (c) control for transferring investments in and out of side pockets.
• In addition, existing and potential investors should be kept fully informed of the side pocket arrangement. Fund offering documents should clearly disclose: (a) how the redemption lock-up period for the side pocket would be different; and (b) the policies for transferring investments in and out of side pockets.

Operational Efficiency

• When a hedge fund manager has grown considerably in terms of size and complexity, it should ensure that there are adequate staff resources and the organization structure, reporting lines and systems and controls are commensurate with business needs.