In Japan: Regulators Arm Touches Hedge Fund Shoulder

"You cannot push a cow's head down unless it is drinking water by its own free will"

Ancient Chinese Proverb

So it finally came down to this: according to a Nikkei newspaper article, Japan's Securities and Exchange Surveillance Commission plans to take the biggest step yet by any G-7 financial authority to tackle the issue of hedge funds. They will "comprehensively review risk management and solicitation procedures" with a special emphasis on funds catering for general investors (which means mass retail).

Interestingly, for investment funds failing this new regime of qualitative inspections the FSA (Financial Services Agency) will be called in to bring the "hammer down" in the form of penalties.

The definition of "investment funds" will be qualified under a soon-to-be-announced financial instruments law, also expected to come into effect this September. By all accounts the regime will be looking at hedge funds (potentially fund of hedge funds), buyout funds and real estate funds...and what about private equity or venture capital funds??!!!

Apparently, those soliciting money from at least 10 general investors (in the Japan or offshore??!!!) will be obligated to register with the FSA, while institutional directed funds with fewer investors also needing to meet a filing requirement.

That this initiative aims at offshore funds is a bold step by Japan's authorities and firmly lays a line in the sand that might have a number of short term and longer term consequences.

First, it most certainly increases the cost of compliance that must be borne by emerging managers. It is already very well known that a number of smaller Japan-focused managers have been moving to other jurisdications for reasons of lower bureacratic burdens, the lower cost of doing business plus (most importantly) lower corporate and personal tax rates.

I expect this latest bold (mis) step to inevitably speed up that process, which could mark a slowdown in the growth potential of the industry. I am sure that the TSE will not be particularly happy with that. Prime brokers that have beefed up operations in Tokyo in recent years might soon be scratching their heads in meetings to try and find ways to "grow" their business in the future. If necessary, future growth might come by way of Hong Kong, which might benefit Morgan Stanley rather than the heavy GS "gorillas" of the industry. Expect a few innovative structures to emerge...

Second, it might make the offshore manager more eager to strike up relationships with Japan-based intermediaries such as the trust banks or brokers who might be able to provide some of the compliance infrastructure for product manufactuers. In this way costs can be defrayed by the managers, but ultimately, that cost will end up on the investor! Same product as one offered in Europe but at higher cost. How fair is that to domestic investors??!!!

Third, it might prompt some established managers to simply manage their clients effectively "gaming the requirements" and refraining from the added regulation that is sought by the authorities. Again, this might lead to some investors in Japan being "denied" access to certain managers in view of the higher preceived cost of doing business in the specific financial center. So, we might see a pulback of sorts from some global hedge funds.

Fourth, a further impact might be to indirectly help the domestic onshore fund manufacturers who might utilize this change to establish greater credibility in terms of operating "under compliance". Clearly, it remains to be seen how domestic investors react to this new initiative, in addition to the the reaction from the hedge fund managers themselves. But, it might just be the kind of regulation that finally provides a kind of "invisible fence" for Japan-based, fully regulated and licensed hedge fund managers to make market share gains. Is this fair to investors, especially if the better performing product manufactuers (in terms of risk/return) are not included in this universe???!!!

Fifth, service providers like financial security attorneys, accountants and risk management providers will look carefully at this change of events. Singapore, Hong Kong, Sydney and Hawaii might now renew in earnest their battle to attract emerging managers in the aftermath of this move.

It is early days yet, but as in the U.S. , some form of rallying together of investment fund participants by an industry representative body should be "heard" in coming months. If not, then when a lot of these managers come back from their summer vacations they could face the proverbial fair accompli.

As ever, the cost-benefit analysis of such a move has probably been forgotten by the authorities in all the hoopla of getting something done. Kudos for action. But, with the costs of doing business for hedge fund managers in Japan likely to increase and with investor choice likely to decrease, it is hard to see whether the benefits will offset the considerable costs. Let the defence of Japan's hedge fund industry begin.

There are a whole host of open issues related to this...

Mahalo.