1 June, 2019
To accommodate various business models of private fund (i.e. segregate account) management, the Office of the Securities and Exchange Commission (“Office of the SEC”) has amended, with effect from 16 May 2019, the private fund regulations taking a more principle-based approach to regulating private fund management companies (“PF Companies”). Notable examples of the amendments highlighted below are the lifting of the fee arrangement restriction, relaxation of certain personnel requirements and amended content requirements for a private fund management agreement. And perhaps equally significant is the recognition of two emerging business models: one that employs “FinTech” to make automated investments for private funds (“FinTech Model”); and an alternative model that invests the entire assets of a private fund in mutual funds and/or capital market trusts (“MF Model”). The Office of the SEC has tailored some aspects of the private fund management regulations for these two alternative models (e.g. organizational structure, personnel, investment management, risk management and internal control), some of which are discussed below.
1. More flexibility on management fee arrangements
The Office of the SEC has now lifted the fee restriction that required PF Companies to charge either a fixed fee (fixed amount or fixed percentage of NAV) or a performance-based fee for their fund management services. Interestingly, the regulatory focus has shifted to the disclosure — as opposed to form — of fees. Specifically, PF Companies need to ensure that they appropriately disclose direct (e.g. management fees) and indirect fees (discussed below) to clients.
2. Relaxation of requirements on personnel and organizational structure
(a) Licensed fund manager requirements
Previously, PF Companies were required to have at least two licensed fund managers, which might have proved burdensome to some companies, especially those choosing to outsource part of their investment management functions to another entity. The Office of the SEC has therefore softened the language of the requirement to allow for more flexibility while making clear that the arrangement chosen by PF Companies must take into account continuity and efficiency in providing services in the best interest of the customers.
Notably, PF Companies adopting the FinTech Model or MF Model enjoy even greater flexibility in that their fund managers need not be full-time employees if certain operational requirements are met.
(b) Investment management committee
PF Companies are no longer required to have an investment management committee typically in charge of setting an overall investment framework for the funds under the companies’ management.
3. Amended requisite content of private fund management agreements
The content requirements for a private fund management agreement have been amended by revoking some prescriptive requirements to allow for more principle-based supervision and adding some disclosure requirements for the benefits of the investors.
(a) Revoked requirements
Here are some examples of content that no longer needs to appear in a private fund management agreement:
- effective and expiration dates of the private fund management agreement;
- procedure for appointing a private fund custodian;
- requisite warning about capital loss;
- timeline and method of benefit payment during the term of the private fund management agreement;
- procedure for entering into transactions with conflicts of interest; and
- conditions for amending, renewing and terminating the private fund management agreement.
(b) New disclosure requirements
Below are examples of new disclosure requirements:
- indirect fees for other services relating to the private fund management business (e.g. brokerage fees);
- benchmark — being a total return index — against which the PF Companies use to measure the private fund's performance;
- details regarding custody of customers' assets; and
- channel through which the clients can receive or access information on conflicts of interest (e.g. PF Company's website or specific report to clients).
4. Tailored requirements for adopting the FinTech Model and the MF Model
Distinct requirements are imposed on PF Companies that adopt the FinTech Model or MF Model to ensure best outcomes for customers. Below we discuss the requirements on investment management and risk management as examples.
(a) Investment management
(i) FinTech Model
FinTech-based PF Companies must appoint staff with sound understanding of the rationale, risks and rules of the technology as a “designated person” responsible for ensuring that the implemented technology complies with the generally accepted standards. The company’s fund manager can take the role of designated person as well.
(ii) MF Model
PF Companies adopting the MF Model must designate a set of key factors in analyzing and selecting mutual funds or capital market trusts for investment. These factors may include the desired investment policy, investment portfolio, historical performance and relevant fees of potential invested funds.
(b) Risk management
PF Companies must have in place risk management mechanisms or procedures and policies that could be tailored to customers' differing risk profiles and mandates. Below are additional requirements on risk management imposed on companies adopting either of the two emerging models.
(i) FinTech Model
FinTech-based PF Companies must specify appropriate risk tolerance and clearly define the threshold above which the investment model/algorithm must be revised. Companies must also conduct a review of their FinTech in order to manage its risks (e.g. by performing back-testing on the algorithm to identify errors).
(ii) MF Model
PF Companies must regularly review the performance and investment risks of invested mutual funds or capital market trusts and adjust their investment portfolios as appropriate.
For further information, please contact:
Benja Supannakul, Partner, Baker & McKenzie
benja.supannakul@bakermckenzie.com
