Cayman's booming hedge fund industry passes a milestone
At the end of November the Cayman Islands' hedge fund industry passed a milestone with the registration of the 10,000th fund to be authorised by the Cayman Islands Monetary Authority since the passage of the Mutual Funds Law in 1993 paved the way for the islands to become the world's leading hedge fund domicile and a major centre for the servicing of alternative funds.
The occasion had the added twist that the Rutland Fund was previously domiciled in Bermuda. Its transfer, the result of the beneficial tax treatment of Cayman funds under the European Union's Savings Tax Directive, illustrates that for now there seems no serious challenger, onshore or offshore, to Cayman's dominance in the hedge funds field. According to CIMA, the islands' financial services regulator, the total number of Cayman-registered funds reached 6,888 at the end of September, up from 5,932 at the
end of last year. The head of the authority's Investments and Securities Division, Gary Linford, says the number of new authorisations, including redomiciliations and the registration of newly-created funds, is proceeding at an average pace of about 35 per week. The overwhelming majority of Cayman funds - about 98 per cent, according to CIMA - are non-retail structures marketed to sophisticated and institutional investors. Definitive statistics about hedge fund numbers and assets are elusive, but most analysts concur that Cayman accounts for up to 70 per cent of the world's offshore hedge funds and more than 40 per cent of the total in all jurisdictions.
This situation is unlikely to change any time soon, according to Robert Mirsky, director of hedge fund services with Deloitte & Touche in London. Mirsky, who moved to the UK earlier in 2005 after three years in Cayman, says: 'The challenge for other centres, even those like Jersey and Guernsey that may have attractions for European- based managers, is that Cayman is the default option for hedge fund domicile. If you go somewhere else, you need to justify that.'
The past year has seen a slowing of capital inflows into the sector, but this has not affected Cayman's growth - at least for now. Says Sean Flynn, chief executive and head of hedge fund services with UBS Fund Services (Cayman): 'There has definitely been an issue with the slackening of capital inflows.
'However, as far as UBS is concerned growth has been very good this year at more than 30 per cent. I doubt that we will continue to see the growth rates of 40 or 50 per cent in the hedge fund business experienced over the past few years. In the future, I think we'll be looking at more like 15 or 20 per cent a year.'
Peter Cockhill, a partner and joint head of the investment fund team at law firm Ogier, says: 'What's interesting is that statistics seem to be facing two ways at the same time. Although surveys suggest that figures for some of the hedge fund strategies have been disastrous, overall hedge fund assets have increased - up to USD1.3trn, according to one of the numbers currently being bandied around.
'It's questionable whether hedge funds will be able to maintain quite the momentum they had, because the general slowdown in the economy and the capital markets are obviously contributory factors. On the other hand, one of the factors that's driving growth is pension fund allocations to hedge funds, given the vast amount of money available.'
'I've seen more growth over the last year than ever before,' says Canover Watson, general manager of Admiral Administration. 'Although performance may not be so competitive and managers are finding it harder to find opportunities, the industry as a whole is growing as people start to recognise that hedge funds are a viable alternative to traditional investments. They are becoming more popular because people are becoming more comfortable with them.
'Over the next few years we will be watching out for all the pension money that's starting to flow into hedge funds and that should result in significant growth. Of course, it's a double-edged sword, because as you start receiving that kind of money, you're also going to get more regulation.' Lawyers and administrators in Cayman are unanimous that the Mutual Funds Law has served the islands very well. 'Without doubt it's extremely satisfactory, as evidenced by the fact that we have such a preponderance of Cayman Islands incorporations,' says Roger Hanson, managing director of Fortis Fund Services (Cayman).
However, industry members also agree it is time to make a number of changes to the legislation that should clarify the different types of fund available in Cayman and emphasise its focus on the professional rather than retail fund sector, as well as making it more attractive for Cayman administrators to service funds domiciled elsewhere.
Says John Lewis, managing director of Butterfield Fund Services (Cayman) and chairman-elect of the Cayman Islands Fund Administrators Association: 'At the moment we have a Mutual Funds Law, but our funds are not mutual funds, but what everyone calls hedge funds. It may be more appropriate to have a name that is consistent with the substance of the product.'
The Mutual Fund Working Group, an advisory body comprising representatives from CIMA, the Administrators Association, the islands' Society of Professional Accountants, Law Society and Bar Association, has submitted a series of formal recommendations for amendment of the legislation to government. The industry is optimistic that the changes will become law in the first quarter of 2006.
Another change would see the minimum investment for registered funds, a category that accounts for nearly 90 per cent of all Cayman funds, double from USD50,000 to USD100,000. 'That needs to be raised if we're to be considered a serious jurisdiction for hedge funds,' says Watson, noting however that many Cayman funds impose minimums as high as USD1m.
According to Lewis, the working group has also called on the government to abolish the requirement that a non-Cayman fund must be registered in Cayman if it is to be administered there. 'One of the main reasons is that it is difficult to ask our clients to pay an extra amount for the privilege of their fund being administered in Cayman,' he says. 'It creates an unnecessary competitive disadvantage for administrators doing business here.
'Another reason is that the standard format for services is increasingly the master-feeder structure. Not only will the offshore feeder be regulated by CIMA, but
also the onshore feeder, which is typically a Delaware limited partnership. Often the issue is not the cost but that from a marketing perspective, it is difficult for a US-based investment manager to justify why a US fund should have to be registered with an offshore regulator.
'At present the law makes it difficult - although not impossible - for a Cayman- based administrator to compete for this business. In addition, since all Cayman administrators are regulated by CIMA, the regulator effectively covers these funds indirectly anyway. It's a historical anomaly, a marketing black eye that does us a disservice and detracts from the quality of the service that we provide.'
Says Hanson: 'The current law limits Cayman's ability to grow beyond just administering Cayman-domiciled funds. If the government wants us to be a truly global player, they will have to broaden the legislation in this area. But otherwise the law is a good one, and I don't think there's any need for a major overhaul of the Mutual Funds legislation.'
Industry members are confident that the present Cayman government, which took power earlier this year, will not stray from the pro-business philosophy of previous administrations that nurtured the growth of the financial services sector.
Says Flynn: 'Traditionally there's always been very good co-operation between the private sector and the Cayman government, irrespective of whichever party is in government. I've lived in Cayman for more than 20 years, and the government has always been extremely pro-business. 'There are various forums and committees in which the private sector and government meet, including the Private Sector Consultative Committee, and the new government has established the Financial Services Consultative Committee, of which I am a member. That brings together some government ministers and members of the private sector to talk about issues that affect the financial industry.'
Hanson notes that when the new government wanted to implement a 25 per cent increase in the level of regulatory fees charged to funds by CIMA, it was careful to take soundings from the industry first. He says: 'The government got members of the industry together in one room, and said: 'We want to propose this increase. Do you think the market will bear it?''
Adds Cockhill: 'The government gave an undertaking that there wouldn't be any further increase in fees for three years from 2006, and also that the funds raised would be ring- fenced for strengthening the regulator, not used for paving roads. I think the attitude shown so far has been very encouraging.' At the moment the focus of hedge fund managers is more on the new US rules on registration of investment advisers, which come into force on February 1 (the US Court of Appeals permitting). Since the Securities and Exchange Commission will require advisers to register if they have more than 14 US investors, the managers of many Cayman funds will be affected, whether they are themselves based in the US or not, and indirectly so will their administrators.
According to Christopher Lumsden, senior vice-president for fund services at Cayman National Group, the SEC's move - initially bitterly contested, especially by offshore managers - was inevitable. He says: 'Basically the reason is scale: the hedge fund sector has grown to such an extent that it is simply too significant in terms of trading activity, asset size and the number of underlying investors for the SEC not to demand oversight.'
Lumsden says SEC regulation reflects a structural shift in hedge fund investment from high net worth to institutional investors. 'In contrast to the high net worth investor, who is mainly concerned with the risks and returns of the investment portfolio, institutions analyse structural as well as investment risks. Institutions are concerned with the same aspects of the advisors' operations as the SEC through its registration process.
'This institutional focus on structural risks extends to carrying out due diligence on the work of fund administrators and most astute fund administrators have consequently organised themselves to meet the expected standards. We operate with defined policies and procedures overseen by an effective compliance department, we use robust fund administration systems, we have a well- designed and tested business continuity plan, and we carry out our pricing and valuation work entirely independently of investment advisors.'
Jonathan Tonge, a partner and joint head of the investment fund practice at law firm Walkers, argues that SEC regulation could affect the structure of the fund administration sector. He says: 'We think the SEC regulations will have a neutral or positive impact on the industry here. If there are funds that need to be weeded out, increased regulation can only benefit Cayman's reputation. There may be some consolidation of smaller fund managers, and there may also be consolidation among administrators.' Says Cockhill: 'This seems to be part of the institutionalisation of hedge funds, because they now need to take on compliance officers and legal counsel from the major law firms, and take on a similar profile to a large institutional asset manager. It's part of that process of making them a bit Cayman, this is not an adverse thing at all.'
According to CIMA, there are currently more that 160 licensed administrators, comprising 88 full licensees, 66 restricted administrators, which are limited to servicing not more than 10 funds, and seven exempted administrators, which only service a single fund. According to Flynn, there are between 20 and 25 third-party administrators actively carrying out work in Cayman. Up to 600 people are directly employed in fund administration, plus at least another 400 in accountancy and audit practices and law firms.
Cayman's fund services industry offers a remarkable level of quality given the size of the jurisdiction, according to Mirsky. 'Cayman's got one of the strongest service provider sectors of anywhere in the world,' he says. 'It's a close match for Dublin as far as the services they can provide are concerned. It may be a smaller administration industry, but it's a very well qualified one.'
As the hedge fund industry has mushroomed in recent years, the development of the administration sector has been characterised by organic growth. Says John Lewis: 'Although a number of new players have arrived in the past few years, the influx has not been huge, nor has there been acquisition of small and medium-sized firms by the large onshore fund administrators to the extent seen in Bermuda. However, a few new entrants have come in with a green field approach, typically starting with five or 10 people and looking to grow from that.'
Watson notes that the industry in Cayman is a mixture of the big global players, led by Citco, Fortis, Goldman Sachs, Bisys and UBS, with independent operations like Admiral. He says: 'Everyone has their piece of the pie. We've had significant growth in the past three years, with assets growing from about USD4bn to around USD22bn today. That reflects what's happening in the industry as a whole.' Says Cockhill: 'Cayman is well placed with premier league players like Goldman Sachs, UBS, Fortis, Citco, Bisys, and HSBC all having a physical presence in the jurisdiction, as well as other respected administrators with a smaller asset base, like Royal Bank of Canada, CIBC and others.
'All the big international administrators have sought to ensure they are active in all the relevant time zones. As a result of homogenisation and consolidation of the industry, it means that where the administration takes place becomes somewhat secondary. It can done by a firm in Cayman but with some functions outsourced to back offices anywhere in the world.
'Administrators may be doing daily NAVs from their Cayman office, but using overnight calculations carried out in India. Cayman does quite nicely out of that, but will there be more physical administration carried out here? I suspect not. I think we're seeing a blurring between where the work's done and where the front office is.'
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