Proposed changes to Hong Kong’s code of conduct rules for asset managers are expected to have a particularly negative impact on smaller private equity and hedge funds.

There has been support for planned measures relating to disclosure of commission payments, covered in the second part of a Securities and Futures Commission (SFC) consultation paper issued on Wednesday.

But the measures in part one, relating to fund managers’ code of conduct (FMCC) are more wide-ranging and potentially damaging for Hong Kong’s fund industry, say local market experts.

Rolfe Hayden, partner at law firm Simmons & Simmons in Hong Kong, told AsianInvestor: “The proposals are like a mini-AIFMD [Alternative Investment Fund Managers Directive], which is a bad thing in my view, because in effect this will introduce backdoor regulation of offshore funds.”

AIFMD is an EU law introduced in 2011 as a direct result of the global financial crisis in 2008. It requires alternative fund houses to obtain authorisation and make various disclosures as a condition of operation.

“We keep thinking that the ripples from the financial crisis have died down, but this is quite a large one, now washing up on the shore,” Hayden said.

A hit to fund launches?

“The additional compliance for funds and fund managers will effectively raise a barrier to entry into the market for new funds and small managers," he noted. "This is what has happened in the UK, where the additional costs of compliance mean that there are comparatively few fund launches.”

Small and start-up alternatives managers tend to be lean operations – typically two responsible officers, a trader and a compliance officer. Under the revised code of conduct rules, those firms will suffer higher costs, challenging their viability, noted Hayden.

Hong Kong experienced a drop-off in hedge fund launches after the 2008 crisis, as capital-raising became much tougher. Just when it seemed the worst was over, these new rules could be a major new blow for alternatives managers, said Hayden.

The rules are too broad and should potentially be tiered to give smaller funds some leeway, he argued, though he doesn’t think the SFC is considering that. As things stand, said Hayden, the benefits of the proposed changes do not justify the cost, given that it will be experienced (non-retail) investors allocating to such products.

In need of an update

He and others acknowledged that the SFC’s fund manager code of conduct was in need of updating; its main revisions last occurred in 1997.

Josephine Chung, director at Hong Kong advisory firm CompliancePlus, said it was appropriate to amend the code given the significant increase in the number of ‘type 9’ firms (those managing private client funds/ discretionary accounts). According to SFC figures, the number in Hong Kong has risen from 1,107 to 1,238 in the year to September 2016.

The regulator is concerned about inflows of “hot money” to Hong Kong into SFC authorised funds, private funds and the growth of external asset manager accounts in the city, Chung told AsianInvestor. This is seen to be coming from Europe, the US and China due to political instability.

The new proposals make it clear that private funds, including hedge funds, non-SFC authorised funds and discretionary accounts will henceforth be subject to the FMCC, added Chung. That means type 9 managers would need to beef up their internal compliance, risk controls, risk monitoring and management resources, she said. 

Custody concerns

Hayden said another issue was that the proposed rules would require asset managers to appoint an independent custodian or to make sure it has an independent party monitoring the portfolio assets. 

He cited the example of a PE fund, which may invest in four or five assets, all of which are registered in the name of the manager. The proposed rules state that if there is no third-party custodian, the PE fund manager must have someone in-house monitoring the custody of the assets, who is independent of the investing side of the firm, said Hayden.

“I am unsure this will work,” he noted. “By nature, these private equity fund houses tend to have a small number of highly paid individuals who negotiate deals. Where an asset is an unlisted shareholding in the name of the PE fund, the only custody is of the share certificate – if any – which can be locked in a drawer.”

The SFC has set a three-month consultation period, ending in mid-February. Chung said following that, the new rules may take effect in the third or fourth quarter of 2017, or later if the industry views are very mixed.