With alternate investment norms in place,hedge funds set to take off

As against a case-by-case approach that the regulator adopted while approving the funds over the last one year,the capital markets regulator announced the norms on Monday and stated that local hedge funds can borrow up to two times the net asset value of the fund and also issued guidelines on calculating exposure and outlined the redemption norms.

Market participants feel that the new norms complete the set of guidelines to operate.

“Now the complete set of guidelines are there and it will help clients as there will be no differentiation on what people can do,” said Andrew Holland,CEO,Ambit Investment Advisors which has a hedge fund called Ambit Alpha Fund.

“There was no clear guideline on how exposure would be computed on derivatives and what will be the cap on exposure. Sebi had been prescribing leverage on a case-by-case basis but there was need to have a clearer transparent guideline so that people can design their product upfront,” said Siddharth Shah,partner,funds and corporate,Khaitan & Co.

How do these funds operate

After Sebi banned pooling of clients assets under portfolio management service (PMS) offerings in 2008,the benefits of leverage and their ability to use pooled investments to maximise returns was ruled out. The third party fund management under mutual funds is limits derivative exposure and is only allowed for hedging purposes.

The AIF regulations issued in May 2012,now allows funds such as private equity,venture capital funds,hedge fund,pipe fund,art fund,SME and various forms of funds to operate. AIF’s falling in cat I invest in start ups,social ventures,Infrastructure and SME’s etc. Those falling in category II include PE funds debt funds that don’t undertake leverage and the Category III AIF include hedge funds that employ diverse or complex trading strategies and may use leverage are the only ones that can invest in listed securities.

Sebi created category III to allow to pool the resources into a fund structure and invest into securities or complex trading strategies such as those by hedge funds in line with those in global markets. Therefore these funds employ complex strategies using derivatives to maximise returns for their investors. So investors who are looking for higher returns can look to take part in such products.

In the Indian context the minimum investment has been kept at Rs 1 crore which means that it is for a certain category of investors and the maximum number of investors in a fund has been capped at 1,000.

Limit on leverage to contain systemic risk and speculation

While many developed markets allow a leverage of up to 5 times the net asset value of the fund,Sebi has restricted it to 2 times. Experts in the field say that one of the parameters while laying down the regulations was the consideration of systemic risk that such asset classes create in the economy and that has been an area of concern both for Sebi and the Reserve Bank of India.

“By using leverage,one multiplies the impact that one can have on the markets. The risk is passed on to other constituents of the market �� bank,broker or anyone who offers the leverage and in that sense it creates a systemic risk,” said Shah.

Even market players say that Sebi has been right in limiting the leverage to 2X.

“It is a good way to start. At 2X,there is no risk of a blow out and we are far from that. At best the maximum risk is of an under-performance,” said Swapnil Pawar,CIO,Karvy Capital AIF.

While Holland too approves Sebi’s approach he said that based on its experiences in future and the need Sebi can look to revise the same.

“It is good to be conservative in the beginning as it is a new product and you do not want to have problems in the beginning. As time goes by the regulator may revisit if some changes are needed based on the experiences,” said Holland.

By limiting the amount of leverage Sebi has also looked to address the amount of speculation that one can do. While individually investors can go for high leverage in a stock and one can do so directly in the market,Sebi by keeping the leverage at two times has ensured that pooled assets don’t go beyond a limit. While the impact of an individual is limited,in case of pooled assets the degree of impact can be much higher.

Benefits from the new avenue

As the final guidelines have been laid out now,people in the know say that a number of players who were on a wait and watch mode are looking to enter. While the total number of AIF’s in the category III currently stand at 10,an industry expert told that in the next one year it could go up to 25.

While a lot of PMS players may look to operate as a hedge fund,the Asset Management Companies running mutual funds will also get into hedge funds,thereby expanding the market.

“Other than domestic players foreign players may also look to enter India and operate here.

India is no longer a destination market (raise funds overseas and invest in India),a lot of foreign fund managers and hedge fund managers are looking at India as a source jurisdiction as wealth is growing locally and it has limited avenue to be deployed,” said Shah.

While the players are bound to increase,the assets under management under the category III AIF that currently stands at an estimated figure of Rs 1,000 crore is set to grow significantly over the next few years. Players expect more product innovation and expansion of investor base as more and more investors may want to look at this asset class for higher returns.

“The category of investors who invest in hedge funds are more sophisticated and are aware of such offshore products and we have found them to be receptive. With all set of regulations now in place,I think more players will come in and it is going to be a big industry in the future,” said Holland.

Changes they want going forward

Even as regulator has set the guidelines,as always there is something extra that the product manufacturers look for and the hedge fund category is no exception to it.

While market players say that two times leverage is good for now,they are hoping that the regulator enhance the limit going forward depending upon its experiences. There are some who suggest that Sebi can look at liberalising the gross leverage and can carefully watch the net leverage.

While Sebi has set a limit of Rs 1 crore as the minimum investment for participation in a hedge fund,experts say that globally there are accredited investors who are allowed to invest rather than allowing them on the basis of minimum investment and Sebi may look to revise that going forward.

“This approach limits the investors diversification tool. If an investor has Rs 2 crore then he can invest Rs 1 crore each in a max of two hedge fund strategies,however if the limit is reduced,he can diversify well,” said an expert who did not wish to be named.

New norms introduced by Sebi

On extent of leverage: Sebi has set the extent of leverage to be undertaken by a Category III AIF at two times of the Net Asset Value of the fund. The Circular also provides method of computation of leverage

On transparency: SEBI has said that all Category III AIFs should have comprehensive risk management framework,a strong and independent compliance function,resources and checks and balances which suits the size,complexity and risk profile of such AIF

On redemption: The regulations permit Category III AIFs to act as either open-ended or close-ended funds. The circular also prescribes norms for redemption of investor interest by open ended Category III AIFs,except in certain specific instances

On liquidity: Sebi has told that open-ended Category III AIFs should maintain sufficient liquidity in the fund to meet its redemption obligations

Suspension of redemption: Sebi has said that suspension of redemption requests by managers of open-ended AIFs shall be justified only in exceptional circumstances