The hedge fund industry may be starting to feel the full impact of the global credit crunch and concomitant economic downturn but there is no sign that the sector’s difficulties are calling into qu
The hedge fund industry may be starting to feel the full impact of the global credit crunch and concomitant economic downturn but there is no sign that the sector’s difficulties are calling into question the position of the Cayman Islands as the world’s pre-eminent alternative fund domicile and a substantial provider of services to offshore funds, according to financial sector professionals.
According to provisional figures from the Cayman Islands Monetary Authority, the jurisdiction’s financial regulator, there were 10,271 Cayman-domiciled funds at the end of November, a dip of 21 since the end of September. Industry members point out that while an increased level of fund terminations has contributed to the decline, it also reflects a regular seasonal rise in fund liquidations and slowdown in new launches in the run-up to the end of the financial year.
The economic and financial upheavals of the past year have nevertheless had their effect on the Cayman financial industry, according to Jonathan Tonge, head of the hedge funds practice at law firm Walkers. ‘We have been extraordinarily busy, but the nature of the work has changed in that the number of formations and registrations of funds is lower than what we normally expect, but it’s been compensated by a lot of restructuring work,’ he says.
‘There have been some fund liquidations, but mostly clients have been looking to restructure and work their way through the problems. In the meantime a large number of new funds are being formed with different strategies, particularly credit opportunities and distressed debt.’ The beginning of January, a period that customarily sees a large number of new funds established, will provide a telling indicator of the industry’s health, he says.
There is no evidence that Cayman is suffering disproportionately from the current problems in the market, according to Paul Scrivener and Laura Hatfield of law firm Solomon Harris. ‘There have been closures and blow-ups, some high-profile, but this is inevitable when Cayman has such a large proportion of hedge funds worldwide,’ they say.
‘For some managers these have been particularly stressful times, with redemptions being suspended and gates imposed to maintain stability or, in the case of funds beyond repair, to ensure an orderly wind-down, and there has been increasing use of side-pockets to segregate hard-to-value assets.’
The view is similar from Cayman’s fund administrators. ‘Over the past 12 months we have seen a flight to cash as clients prepared to meet liquidity demands,’ says Darren Stainrod, head of alternative fund services at UBS Global Asset Management. ‘These cash surpluses are now drained as redemptions are realised and the dollar strengthens – thus realising foreign exchange hedging losses – and we are busy finding solutions for significantly increased demands for credit facilities.
‘The coming year will be a challenge, with an expected contraction of possibly 30 to 50 per cent in the hedge fund industry, partly offset by new funds seeking to exploit opportunities in the credit markets and possible recovery. With most funds heavily under water, some funds are expected to reset their high water marks if they are to be incentivised to continue.’
Valuation of assets is a key issue for managers, says Ingrid Pierce, another partner in the hedge funds group at Walkers. ‘Where funds have the ability already to create side-pockets for illiquid assets but haven’t already used it, they are now taking advantage of that,’ she says. ‘New funds generally have provisions in their offering documents to do this, but older funds may not, in which case introducing side-pockets will require some level of investor consent, which may or may not be forthcoming.’
Pierce says Walkers is seeing an increase in funds carrying out redemptions in kind as well as measures to slow or delay redemptions in order to avoid having to undertake fire-sales of assets. In return for seeing their capital locked up for longer, or for seeing the fund’s assets transferred to a new structure offering greater flexibility, investors are often negotiating a discounted level of management fees.
A key issue for many managers is the fact that the high water marks that they must exceed to earn performance fees are now out of reach for the foreseeable future. ‘The high watermarks must either be reset, or alternatively the fund is closed and a new one formed,’ she says. ‘A fund with a high water mark that is now unrealistic provides no incentive to the manager, which is not in the best interests of investors. In most cases managers find that investors are sympathetic and are prepared to work with them to reset the high water mark.’
Nevertheless, practitioners believe that Cayman has taken important steps as a fund jurisdiction over the past couple of years that will serve it well in a more difficult global environment. Stainrod points to recent amendments to the Mutual Funds Law, including an increase in the minimum investment level from USD50,000 to USD100,000 – a fairly academic move, given that the vast majority of Cayman funds already had investment minimums far above USD100,000, but nevertheless a signal of the jurisdiction’s commitment to protecting unsophisticated investors.
‘Other changes included the removal of the requirement for non-Cayman domiciled funds to be registered simply because the administration was performed in Cayman,’ he says. ‘This has helped local administrators because, although it is not a large part of the local business, it is important to be able to cater to Delaware entities that act as the onshore feeder within master/feeder structures, or to clients with both onshore and offshore products that they want serviced by the same team.’
These changes have coincided with the introduction by the regulator of a new system to collect aggregate data on the industry, in addition to the annual audited financial statements filed by Cayman domiciled funds. The first statistical report from Cima, incorporating data up to the end of 2006, indicated that the island’s funds had total assets of USD1.38trn, reinforcing estimates that Cayman accounts for at least half of the global hedge fund industry.
As a policy, Cima has consistently avoided placing additional restrictions and burdens on Cayman funds, considering that constraints are best exerted by market forces, namely investor demand. This – coupled with pressure from national tax authorities on managers of offshore funds, requiring them to demonstrate the substance underlying the funds’ offshore status – has prompted a surge in the appointment of independent directors to Cayman funds in recent years.
This development not only makes the jurisdiction more attractive to investors but reinforces the image Cayman wants to convey of expertise and professionalism, says Geoff Ruddick, senior company manager with International Management Services. ‘In today’s environment, corporate governance is no longer a luxury but a necessity,’ he says. ‘Independence is the holy grail of effective corporate governance.
‘The interests of the fund may differ from those of its service providers, creating a conflict of interests for a director provided by the fund’s administrator. The valuation and liquidity of securities can be difficult or even impossible, and often an independent director’s involvement has been critical. They can assist in making an unbiased determination in the best interests of the fund, its investors and creditors.’
Cayman’s fund administration industry continues to benefit from the growing acceptance by US-based managers, under pressure from both investors and regulators, of the independent administration model customary elsewhere in the world. ‘At the recent Gaim Cayman conference, institutional investors made clear that they no longer accept a black-box approach from the fund manager regarding valuation, but a sound and transparent methodology backed up by an independent review – all areas where an independent administrator can add value,’ says Canover Watson, managing director of Admiral Administration.
However, Cayman administrators are under pressure to keep costs down in order to compete with rivals – or even offices belonging to their own group – in lower-cost centres, which today include onshore locations in the US and Canada as well as countries such as India and Mauritius. ‘There is some concern about the number of administration jobs being lost to onshore service centres,’ says Mark Lewis, chairman of Aima’s Cayman chapter.
‘Many of these administrators have a global presence, and they are carrying out some of the work in other countries. The government is now looking at ways to improve its immigration rules to make conducting business in Cayman more attractive. It has just announced significant changes that will allow work permit applications to be handled in just two days, rather than any time between six weeks and three months at present. There are more than 26,000 work permit holders in Cayman, and the government has recognised there is a real need to speed up the process.’
It has also indicated its readiness to interpret more flexibly the provisions of the so-called rollover law, which limits to six years the maximum length of time for which a foreign individual can receive a work permit before leaving Cayman for at least a year. ‘It has affected people in our industry that are not occupying key positions and are therefore subject to the rollover provisions,’ says Pierce. ‘In the case of Walkers, we can second people to offices in other jurisdictions, but it can be a negative factor for firms and industries that don’t have this ability.’
However, Lewis says that the government has made clear to firms, especially those active in the financial services sector, that they should make it clear if they are experiencing problems. ‘They would like employers to be more proactive in applying for key employee status, and that more favourable consideration will be given to applications, particularly in the financial services sector,’ he says. ‘The government is being very proactive to ensure that a business that is so important for Cayman has the key people it needs.’
