IOSCO Proposes More Regulation Of Funds Of Hedge Funds

by Phillip Morton, Investors Offshore.com

13 October 2008

The International Organization of Securities Commissions (IOSCO) has published for public consultation proposals for a new system of regulatory standards aimed at funds of hedge funds managers, to address issues of investor protection in light of the increased involvement of retail investors in these investment vehicles.

The proposals were developed following IOSCO’s June 2008 Report on Funds of Hedge Funds, which identified the issues in two areas: the methods by which funds of hedge funds’ managers deal with liquidity risk; and the due diligence processes undertaken by managers prior to and during the life of an investment.

With regards liquidity risk, IOSCO proposes in its consultation document that fund of hedge funds managers 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.

With regards due diligence processes, IOSCO proposes that this should be carried out prior to any investment being entered into and on a continuous basis following the commitment. The proposals are 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;
    • 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:
    • documented and traceable procedure for selecting hedge funds;
    • appropriately skilled staff and adequate technical resources to implement the due diligence procedures;
    • capability within the organization to deal with any anomalies identified by due diligence system;
  • Regularly assess if selection procedures have been properly met; and
  • Outsourcing Due Diligence
    • If a fund of hedge funds’ manager wishes to outsource any aspect of its due diligence it should: ensure that any conflicts of interest are adequately addressed; and assess the extent that outsourcing of due diligence is consistent with the IOSCO Principles on Outsourcing of Financial Services for Market Intermediaries.

The deadline for responses to this consultation paper is 5 January 2009.

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