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Onshore Hedge Funds: Still a Myth!

Published on Thu, May 30,2013 | 16:22, Updated at Thu, May 30 at 16:22Source : 

By: Tejesh Chitlangi, Partner, IC Legal

SEBI a year back on May 21, 2012, had notified norms for regulating alternative investment funds (AIFs) under the SEBI (AIF) Regulations, 2012 (AIF Regulations). Three broad categories of registration were introduced under AIF Regulations for regulating all private pools of capital (barring a few exceptions like employee welfare trusts, ESOP Trusts, entities already regulated by a regulator etc.). Category I AIFs consist of venture capital funds, SME funds, infrastructure funds and social venture funds. Category II AIFs broadly consist of private equity funds, debt funds and Category III AIFs were proposed to be in the nature of hedge funds, PIPE funds undertaking diverse/complex trading strategies and employing leverage.

The SEBI regulatory regime governing the Category I and Category II AIFs has been broadly unambiguous and evolved well over the past one year with no major hiccups as compared to the regime governing Category III AIFs. Several registrations have been granted in the first two categories in the past one year as compared to registrations granted under Category III (SEBI website lists out 37 registered Category I and Category II AIFs versus 10 Category III AIFs, as on April 22, 2013).

This piece deals with the implications of certain stringent regulatory measures and policies implemented with respect to Category III AIFs in past couple of months, which  in toto are denying the country a robust domestic hedge fund industry. SEBI has prescribed strict restrictions on leverage which can be undertaken by Category III Funds and put some asset classes under prohibited list. The automatic tax pass through status has not been extended to Category III AIFs and FIPB currently seem to be disallowing foreign investments in Category III AIFs, though allowing it under the other two categories. Below is the detailed analysis of the issues involved.

First, one of the primary reasons for wealth managers to opt for a Category III AIF license was due to a prohibition on undertaking leverage for the clients under a portfolio management services license. Leverage is any method by which the exposure of an AIF increases through borrowing of cash/securities, or while undertaking derivative positions. It was expected that the use of leverage would be liberally permitted (if not fully) for Category III AIFs while ensuring that there is no systemic risk or any potential disruption to markets and economy at large. AIF Regulations did not provide for a limit on leverage and left it on SEBI to decide the same at a later point of time. Surprisingly, SEBI has started requiring Category III AIFs to declare that the maximum leverage they can undertake will not exceed by 100% of their assets (i.e. upto 200% on gross basis or 1X in market terminology) by way of borrowing and/or through exposure in derivatives.

On one hand, SEBI has defined Category III AIFs as structures in nature of hedge funds employing leverage and undertaking complex trading strategies and on the other hand has prescribed a very restrictive limit on leverage, which is globally unheard of in mature markets. In order to gauge the global practices, let’s take examples of the hedge fund regulations currently prevailing and evolving in the European Union (EU) and the USA.

The EU Alternative Investment Fund Managers (AIFMs) Directive (AIFM Directive) and the regulations issued pursuant thereto recently in 2013, would become national law of all EU Member States  by July 22, 2013, which will introduce compliances for managers of alternative investment funds including hedge funds. To prevent the build-up of systemic risk, AIFMs, from July 22, 2013, are themselves required to set up maximum leverage limits for each hedge fund they manage and hence is more on lines of self regulation. Furthermore, AIFMs having less than 100 million Euro of assets under management are exempted from key provisions and subject only to light touch regulations. Special reporting requirements will apply to hedge funds that employ leverage on a “substantial basis”, i.e. when the exposure of a hedge fund exceeds 3 times its net assets. AIFMs that breach this threshold will be required to report breakdowns on leverage to the relevant authorities and may, in certain circumstances, face limits on the use of leverage.

It is proposed that the home regulators may on case to case basis impose limits on the level of leverage an AIFM may employ in order to limit the extent to which a hedge fund may contribute to the build-up of systemic risk in the financial system. No standard limit has been prescribed with an understanding that one size cannot fit all and a single limit cannot be applied across all hedge funds (unlike the blanket 1X limit prescribed by SEBI). The home regulator can intervene to impose limits on leverage employed by a particular hedge fund only when deemed necessary.

In the USA, pursuant to the amendments brought by Dodd-Frank Act, the advisers to large hedge funds (for instance, managing assets above USD 150 million) are required to register themselves with the SEC under the Investment Advisers Act, 1940 and file Form PF. Form PF while defining hedge funds, suggests that hedge funds are such funds which may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital). Hence instead of prescribing limits on leverage, some minimum level of leverage has been prescribed, which if undertaken by an entity may categorise it as a hedge fund.

The technical committee of IOSCO (International Organization of Securities Commissions) which provided its report on high level principles for regulation of hedge funds, has recommended that regulatory oversight on hedge funds should be risk-based and proportional and should be more focused on systemically important and/or higher risk hedge fund managers. A de-minimis cut-off is one of the approaches which has been suggested. One size doesn’t fit all and hedge funds need to be segregated by the regulators keeping in view the systemic risk which one player poses compared to another smaller player in the market which does not have the potential to disrupt the system. This aspect needs to be considered by SEBI.

It can be observed that implementing limits on leverage is generally not sought by the regulators globally and disclosures, continuous monitoring and regulatory health assessments are the first line measures which are prescribed. Accordingly, domestic Category III AIFs have to be regulated by SEBI on a case to case basis. This approach has also been followed by the regulators globally including EU and also suggested by IOSCO.

Leverage is certainly a double edged sword. On one hand, if the lenders withdraw finance facilities or there are some liquidity restrictions in meeting margin calls or requests for redemption by large number of investors, then hedge funds may be forced to liquidate their underlying assets, resulting in a fire sale. Such forced selling may impact market liquidity and efficient pricing. On the other hand, it can certainly provide much needed liquidity and depth to the markets and increased returns to the risk savvy investors. Hence, a balanced and measured approach by SEBI to regulate Category III AIFs is needed to ensure that the benefits continue, while the risks are effectively mitigated.

Leverage is provided to hedge funds by banks/financial institutions on a collateralised basis. It is done to facilitate the investment strategies of hedge fund managers and, like any lending, should be done prudently and within the risk appetite of both lender and borrower. This coupled with sound risk management practices, regulatory surveillance and continuous disclosures/reporting should avoid systemic risk situations from arising.

Coming on to the second issue, applicants under Category III AIFs have been asked to declare that they will not make investments in currency and commodity derivatives. Prohibiting investments in commodity derivatives is understandable as SEBI does not have a regulatory oversight on such products, however the reason for disallowing Category III AIFs from investing in currency derivatives is still unclear as such products are regulated by SEBI.

Third, from tax perspective, Category III AIFs have been denied an automatic pass through status which otherwise would have ensured the exemption of income at the fund level and taxable only at the investor level. As vast majority of Category III AIFs are set up in form of Trusts, in absence of an automatic tax pass through status, the principles of trust taxation get attracted. Hence, unless a Category III AIF qualifies as a determinate trust (less likely due to such funds mostly being open ended with hedge fund trading strategies), the entire income of the Fund may be construed as business income and taxable at maximum marginal rate. This implies that even gains arising from disposal of listed securities on which STT is paid, may be taxed at the maximum marginal rate. This can be a clear disadvantage for investors investing in such Funds and hence may preclude their participation at first place. 

Fourth, whilst 10 registrations have already been granted by SEBI, no formal directions on operational standards, conduct of business rules and prudential requirements have yet been notified by SEBI for regulating Category III AIFs (AIF Regulations contemplated such formal notification by SEBI). Such guidance seem to be still evolving and in turn resulting in uncertainty for the new applicants as well as for entities already registered. For sake of clarity, SEBI should notify the same at the earliest.

Fifth, under the current FDI Policy, any foreign investment in domestic AIF is categorised as FDI. Analysing a situation wherein the AIF is set up in the form of a Trust (as that's the most preferred manner in which AIFs are set up in India, due to less rigorous legal and regulatory compliances compared to a company or a LLP , and also relative flexibility in tax structuring), such foreign investments will have to be approved by Foreign Investment Promotion Board (FIPB), except if the foreign investor is a FVCI investing in a domestic VCF. FIPB appears to have started granting approval for AIFs other than Category III AIFs at the moment. This may be the case as Category III AIFs with an investment objective of making investments in listed securities and derivatives, can be indirectly used by foreign investors like FIIs, NRIs, QFIs for circumvening the investment limits applicable on such investors for making listed investments in India. Going forward, norms/safeguards should be prescribed for permitting foreign investments in Category III AIFs as well.  

Developing an onshore hedge fund industry by promoting Category III AIFs may decrease reliance on FIIs for providing depth and liquidity to the Indian markets, provide additional investment options to the high net worth investors, check issues like money laundering and terrorist financing resulting out of over dependence on foreign inflows. As a fact, India permits highly leveraged hedge fund FIIs/sub-accounts to invest in India and also accord them tax incentives under the double taxation avoidance treaties. On the other hand, their domestic counterparts in form of Category III AIFs are not only restricted from leveraging beyond the 1X limit but are also likely to struggle on the tax front with a likelihood of paying taxes on their income at maximum marginal rate.
Fearing something innovative just because it may have negative consequences in an unforeseen scenario may not be the best of ideas. Hence, a balanced approach to regulate Category III AIFs is needed, while keeping the likely risks under check.


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