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Hedge Funds


The term “hedge funds”, first came into use in the 1950s to describe any investment fund that used incentive fees, short selling, and leverage.[1] This Blog Post discusses the origin of Hedge Funds, their characteristics and types, the legal framework regulating hedge funds in India and some momentous moments for Hedge Funds in the Indian securities market.


Alfred Winslow Jones (referred to by many as the father of the Hedge Fund) through his company A.W. Jones & Co., launched the first systematic hedge fund in the year 1948. Jones was a sociology enthusiast and while pursuing his Ph.D. in Sociology from Columbia University, he wrote a freelance article for Fortune Magazine titled ‘Fashions in Forecasting’ containing the report of various technical approaches to the stock market.[2] His writing convinced him that he could make a living in the stock market and in early 1949, along with four friends, he formed A.W. Jones & Co. where he experimented numerous investment approaches including ‘hedging’ an idea which was essentially his own. Jones had raised USD 100,000 with which he set forth to try to minimize the risk by utilizing the long/short equities model.[3] A Fortune Magazine story on Jones describes how while most investors built their defenses around cash reserves or bonds, Jones protected himself by selling short! Instead of investing the fund directly, he would use the sum to borrow a sum amounting to around half of the invested pool under the margin requirements however, he would then employ major chunk of the then-available sum (let’s say 70%) in stocks he likes and sell short stocks worth the rest that he thinks are overvalued.[4] If he succeeded in his efforts, he would rise more than the general market and sell stocks short that will rise less than the averages, his rewards are multiplied because he is not just employing a portion of his capital but also the borrowed sum. The main advantage of his hedge concept was the ability it gave to maximize aggressiveness.


Characteristics and Types of Hedge Funds

Hedge Funds are mostly structured as private investment partnership or offshore investment corporations and typically its investor base comprises wealthy individuals and institutions alongside a relatively high minimum investment limit. Hedge funds pay a performance fee to their managers. They use a variety of trading strategies and techniques involving position taking in a range of markets and instruments often including short-selling, derivatives and leverage.


Investment strategies in Hedge funds tend to be different compared to the typical asset manager however some of the common categories include long-short funds which take both long and short positions in securities, market-neutral funds which are a subtype of long-short funds with a twist, in this case, fund managers attempt to hedge against general market movements, event-driven funds attempt to capture gains from market events like mergers, natural disasters etc and macro funds which take directional bets on the market as a whole either long or short based on research and/ or fund philosophy.


Hedge funds were a huge hit during the 1960s and dramatically outperformed mutual funds, their popularity reduced with the recession, crashes and bursting of bubbles. However, hedge funds are still on the rise. Hedge funds today don’t necessarily utilize hedging and arbitrage strategies, they may or may not engage in relatively traditional or long-only equity strategies. Hedge funds of today trade in fixed income securities, currencies, exchange-traded futures, futures contracts and other non-securities investments too.


Legal Framework regulating hedge funds (India)

In 2004, SEBI had proposed[5] including Hedge Funds into the SEBI (Foreign Institutional Investors) Regulations to provide a window for Hedge Funds. Eventually, SEBI issued the SEBI (Alternative Investment Funds) Regulations in 2012 (“AIF Regulations”). The AIF Regulations recognize and regulate Hedge Funds which fall under category III AIF.


Per the AIF Regulations, a hedge fund means an Alternative Investment Fund which employs diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products including listed and unlisted derivatives, the AIF Regulations also define Category III AIF as those funds which employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. A hedge fund can invest in securities of listed or unlisted investee companies or derivatives or complex or structured products. Additionally Hedge Funds can invest in units of Category I and II AIFs (subject that they invest solely in such units and not in units of other Funds of Funds. Hedge funds need to maintain a risk management framework. They also have to establish and implement a liquidity management policy to meet redemption obligations and other liabilities.


The Leverage Leeway

A characteristic feature of Hedge funds is that they can engage in leverage or borrow (subject to consent from the investors in the fund and subject to maximum limit specified by SEBI). However, the hedge fund is required to make disclosures regarding the overall level of leverage employed arising from the borrowing of cash, the level of leverage arising from the position held in derivatives or in any complex products and the main source of leverage in the fund to Investors and to SEBI.


Registration

All Hedge funds need to be registered as Category III AIF and need a Certificate from the SEBI. The Present prescribed application fee is of INR 1,00,000 plus INR 15,00,000 for registration as Category III AIF. SEBI made way for all Applications and Disclosures pertaining to AIFs to be made Online and the same applies to Hedge Funds also.[6]


Structure of a Hedge Fund

A Hedge fund has to be set up either as a Company under the Companies Law, a Trust registered as a Trust under the Indian Trusts Act 1882 (registration of the Trust Deed under the Registration Act 1908 is mandatory for trust structure) or a Limited Liability Partnership under the Limited Liability Partnership Act 2008.


Tenure

In India, Hedge funds can be open-ended or close-ended and extension of close-ended AIF is permitted for up to two years subject only to the approval of two-thirds of the unitholders by the value of their investment in the AIF. Without such consent, the fund is required to fully liquidate within a year form expiration of the fund tenure/ extended tenure.


Raising funds

A hedge fund can raise funds from Indians, persons resident outside India and non-resident Indians by way of issue of units. A hedge fund scheme needs to have a corpus of at least twenty crore rupees, minimum investment per investor one crore rupees (provided that in case of investors being employees or directors of the AIF or employees or directors of manager, minimum investment requirement is of five lakh rupees).


The manager or sponsor shall have a continuing interest in the Fund of not less than five per cent of the corpus or ten crore rupees, whichever is lower. The investors are to be informed of this investment extent in the fund, no fund can have more than one thousand investors. A Hedge fund cannot solicit or collect fund except by way of a private placement.


Listing

Units of close-ended hedge fund can be listed on stock exchange subject to a minimum tradable lot of one crore rupees.


Investment options

Hedge funds can invest in securities of companies incorporated outside India subject to RBI Norms. It can invest not more than 10% of its investible funds in one Investee company and it cannot invest in associates except with the approval of 75% of investors by value of their investment in AIF. The uninvested portion of investible fund may be invested in liquid mutual funds or bank deposits or other liquid assets of higher quality such as T-Bills, CBLOs, Commercial Papers, and Certificates of Deposits etc till deployment of funds as per the investment objective.


Disclosures and Transparency

Despite the general perception towards hedge funds of being risky and less transparent, the AIF Regulations have prescribed several disclosure and transparency norms for AIFs, hedge funds included.

Placement Memorandum Disclosures: investment strategy, investment purpose and investment methodology.

Consent requirement: no AIF is permitted to materially alter the fund strategy without consent of two-thirds of the unit holders by value of their investment in the AIF

Mandatory disclosure on following by AIF to investors:

  1. financial, risk management, operational, portfolio, and transactional information regarding fund investments shall be disclosed periodically to the investors;

  2. any fees ascribed to the Manager or Sponsor; and any fees charged to the Alternative Investment Fund or any investee company by an associate of the Manager or Sponsor shall be disclosed periodically to the investors;

  3. any inquiries/ legal actions by legal or regulatory bodies in any jurisdiction, as and when occurred;

  4. any material liability arising during the Alternative Investment Fund’s tenure shall be disclosed, as and when occurred;

  5. any breach of a provision of the placement memorandum or agreement made with the investor or any other fund documents, if any, as and when occurred;

  6. change in control of the Sponsor or Manager or Investee Company.

Quarterly reports to investors including the following information within 60 days from Quarter end as applicable to the fund:

A. financial information of investee companies.

B. material risks and how they are managed which may include:

i. concentration risk at fund level;

ii. foreign exchange risk at fund level;

iii. leverage risk at fund and investee company levels;

iv. realization risk (i.e. change in exit environment) at fund and investee company levels;

v. strategy risk (i.e. change in or divergence from business strategy) at investee company level;

vi. reputation risk at investee company level;

vii. extra-financial risks, including environmental, social and corporate governance risks, at fund and investee company level.

  • Reports have to be furnished quarterly by Hedge funds not employing leverage and monthly by those utilizing hedge funds[7]

  • Reporting the amount of leverage at the end of each day to custodian.[8]

  • Changes to the PPM have to be notified to the investors and SEBI once every six months on a consolidated basis.

Valuation

Hedge Fund has to ensure that calculation of the NAV is independent from the fund management function of the Fund and that such NAV is disclosed to the investors at intervals not longer than a quarter for close-ended funds and at intervals not longer than a month, for open-ended funds. Valuation related information has to be disclosed in Placement Memorandum.


In addition for investment to and fro non-resident Indians have to comply with pricing guidelines prescribed by the Reserve Bank of India in this regard.


Additional Compliances are similar as applicable to all AIFs under the AIF Regulations pertaining to review of policies and procedures, their implementation; appointment of SEBI registered custodian, intimation to SEBI on change of sponsor; prior approval of SEBI for change in control; Annual Audit of books of Account; implementation of policies and procedures to mitigate conflicts of interest; compliance of requirements under Regulation 4 of the AIF Regulations.


Other norms regulating hedge funds include the Securities and Exchange Board of India (Foreign Portfolio Investor) Regulations 2014, various SEBI Circulars issued from time to time prescribing additional compliance and reporting requirements and Foreign Exchange Management Act 1999 and regulations and directions issued thereunder by the Reserve Bank of India.


 

[3] Ibid.

[4] Ibid.

[6] SEBI Circular No. SEBI/HO/IMD/DF1/CIR/P/2017/87.

[7] SEBI Circular No. CIR/IMD/DF/10/2013 dated July 29, 2013 for Operational, Prudential and Reporting Norms for Alternative Investment Funds.

[8] SEBI Circular No. CIR/IMD/DF/10/2013 dated July 29, 2013 for Operational, Prudential and Reporting Norms for Alternative Investment Funds.

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