IOSCO publishes regulatory standards for Funds of Hedge Funds

The International Organization of Securities Commissions (IOSCO) has published Elements of International Regulatory Standards on Funds of Hedge Funds Related Issues Based on Best Market Practices containing standards aimed at addressing regulatory issues of investor protection which have arisen due to the increased involvement of retail investors in hedge funds through funds of hedge funds.

A previous report, Funds of Hedge Funds–Final Report, published in June 2008 identified the particular areas of concern as:

I. The methods by which funds of hedge funds’ managers deal with liquidity risk; and

II. The nature and the conditions of the due diligence process used by funds of hedge funds’ managers prior to and during investment.

Therefore IOSCO has developed the following proposals in these two areas:

Liquidity Risk

In dealing with liquidity risk the fund of hedge funds’ manager should:

• make reasonable enquiries in order to be in a position to consider if the fund of hedge funds’ liquidity is consistent with that of the underlying hedge funds, particularly in order to meet redemptions;
• prior to investing, and during the investments’ lifetime, consider the liquidity of the types of the financial instruments held by the underlying hedge funds;
• if introducing limited redemption arrangements, consider whether these are consistent with the fund of hedge funds’ aims and objectives. Moreover, their operation should comply with the conditions defined in the proposals; and
• before and during any investment, consider whether conflicts of interest may arise between any underlying hedge fund and any other relevant parties.
  

Due Diligence Processes

These should be carried out prior to any investment being entered into and on a continuous basis following the commitment. They can be divided up into the following areas:

• Elements requiring constant monitoring and analysis by the funds of hedge funds’ managers:
  * establishing and implementing appropriate due diligence procedures for the purpose of investment into hedge funds, which are reviewed regularly;
  * assessing the specific legal and regulatory requirements applicable in the hedge fund’s jurisdiction; and
  * carrying out appropriate due diligence on the underlying hedge fund whenever it is considered necessary.

• Adequate resources, procedures and organizational structures necessary for the purpose of carrying out a proper and robust due diligence:
  * documented and traceable procedure for selecting hedge funds;
  * appropriately skilled staff and adequate technical resources to implement the due diligence procedures;
  * the resources, procedures and organizational structure to deal with any anomalies identified by due diligence system, to take the necessary corrective action and confirm that all procedures are traceable and have been catalogued;

• Regularly assess if selection procedures for eligible underlying hedge funds have been properly met, or not met, and to explain any deviations; and

• Outsourcing Due Diligence
  * If a fund of hedge funds’ manager wishes to authorize the outsourcing of any aspect of its due diligence it should:
  - determine that any conflicts of interest are adequately addressed; and
  - consider the extent that outsourcing of due diligence is consistent with the IOSCO Principles on Outsourcing of Financial Services for Market Intermediaries.

These standards form part of a larger body of work that IOSCO has been engaged in with regards to addressing the regulatory issues presented by hedge funds.