George Soros. Long Term Capital Management (LTCM). Bernard Madoff. Genuine or not, these hedge fund (HF) names should sound familiar to you, if you are reasonably interested in capital markets. These names, however, come to our awareness only indirectly at best, as it has been mostly in foreign capital markets that the HFs have been established, operated, and for some of them, known to the general public. Currently a few examples of hedge fund investment by domestic capital can be found (e.g. Korea Investment Corp’s hedge fund investment of US$ 500 million), but it should be noted that domestic HF investment is close to nonexistent, with the main reason being the lack of proper regulatory environment for hedge fund operations.
The recent partial revision of the Financial Investment Services and Capital Markets Act (FSCMA) is expected to make the HF investment in Korean market ever more realistic and implementable. While the discussion on the regulatory easing on the hedge fund investment had been on the table for long, it is not until recently that realistic changes were made as for the settlement of the hedge fund investment culture.
Before looking at the changes in the regulation, let us briefly discuss what will be the focus of the regulation change. Hedge fund, in general, seeks to earn absolute return, which is often very small but magnifiable to a large extent by means of leverage. If a strategy produces an absolute return, then its return does not depend on the market direction or the price increase/decrease of the underlying asset. Investment styles can widely differ for each fund, but most funds employ highly talented individuals capable of using very sophisticated – mostly very hard to understand – strategies. Since the large part of the hedge fund operation is outside the lay person’s understanding, structural safety measures need to be provided to the investors for their relative disadvantage due to information asymmetry. More freedom for managers (strategy-wise), more opportunities for investors (better safety and lower barrier): these are what the changed regulations focus on, as this article will elaborate on them.
Primary focus of the revision is on lifting some of the limits of the fund operation. Leverage limit went up from 300% of the invested capital to 400%, and the maximum loss limit on the derivatives could be 400% of the capital, instead of previous 100%. Another major regulatory easing is on the investment pool; the provision that the 50% of the capital must be invested in Non-Performing Loan (NPL) was removed, and the fund could be a “mixed asset fund” with practically no limit on the range of the investable asset classes.
Secondary focus of the revision is on providing safeguards for the hedge fund investors. Hedge fund manager (company) must be qualified on three points: 1) minimum invested capital of W6.0bn, 2) trustable investment track record, 3) at least 3 investment professionals with previous hedge fund experience. Also stronger is the reporting requirement of the fund managers; quarterly filings are required on the specific investment strategies, types of invested assets, and leverages taken etc.
Marginally though, the revision also touches upon the roles and responsibilities of the Prime Brokers. Prime Brokerage Service (PBS) provides comprehensive service for the hedge fund, including financing, share borrowing, custody, clearing, and reporting. While the functions of the PBS are similar for the most part before/after the revision, a few changes on the role as the custodian are worth attention. PBS now can: 1) outsource another prime broker’s service for its client, 2) trade its own asset against the fund’s asset, 3) remove the Chinese wall between custody and trading departments.
Revision provides more opportunities for hedge fund investors as well. Individual investors with more than W0.5bn can invest in the fund, whereas the previous regulation put the limit at W1.0bn. Additional guideline is being prepared as for the investment in the fund of hedge funds, with the minimum required investment of W0.1~0.2bn and the diversification over 5 ~ 10 hedge funds.
The partial revision of the FSCMA, in conclusion, significantly lowered the hedge fund industry entry barriers for both potential managers and investors, while also providing the practical fund operation environment and the proper guidelines for risk management. Put another way, it becomes easier for managers to set up a hedge fund and easier for investors to put their money into hedge funds. Further revisions can be expected as the rule becomes in effect in September and the hedge funds actually begin to start up. The recent revision itself should be interpreted as an important doorstep to the mature and more diverse domestic capital market.