All funds have been impacted by the general shift of investor risk appetite during 2008, leading to significant redemption and going concern issues for hedge funds. As initially demonstrated by a Cayman Islands Court of Appeal judgement in December 2007, it is crucial that the effect and timing of redemptions and suspensions be carefully considered in light of a fund's constituent documents. Further, fund boards must ensure that all investors are treated fairly and, given the economic climate, engage in timely and open communication with all investors.
Last year's market turmoil and investor panic revealed a fundamental mismatch between the redemption terms offered to investors and the real liquidity of many hedge funds. Future launches should therefore consider carefully the expected liquidity of strategies and the profile of investors to ensure that redemption terms are strict enough to match this liquidity. While funds usually have the power to suspend redemptions or impose gates to prevent a mass outflow of assets, managers may also reserve the right to offer redemptions in kind or establish side-pockets for illiquid assets.
There is an ongoing debate among fund managers and legal advisers over whether the use of special-purpose vehicles to hold illiquid instruments is acceptable. While they enable some level of liquidity and protect remaining investors, at the time of subscription investors would not have anticipated holding shares in these vehicles in lieu of payment, and in some cases would not have consented to receiving shares in SPVs on redemption.
All fund service businesses in Jersey must comply with codes of conduct consisting of seven core principles for the conduct of fund services business and detailed requirements in respect of each principle. Compliance with the codes must be demonstrated in the practice and procedures of the business in a way that is visible to external regulatory inspection.
Establishing and maintaining proper oversight verified by independent third-party evaluation is becoming a cornerstone of relationships with investors, who increasingly want assurances that hedge fund managers can identify, document and establish effective risk management practices related to their exposure to liquidity and counterparty credit risk.
Meanwhile, the European Union's draft Directive on Alternative Investment Fund Managers could prove extremely costly for managers and administrators. Although unlikely to take effect until 2011, in its present form the directive would require managers to hold additional capital, implement complex fund reporting and risk management systems, retain independent valuation teams, legal advisers and other professional service providers, and deploy extra staff and infrastructure to meet burdensome disclosure requirements.
Under the current draft, Jersey would need to gain recognition as an appropriate non-EU domicile for funds to be marketed in the EU, and its regulatory standards would be assessed to determine compliance with the recognition requirements. However, the island's active pursuit of tax information exchange agreements with various jurisdictions would be a positive factor.
One of the main criticisms of the directive is that it targets all types of fund - private equity, hedge funds, real estate and other asset management classes - in the same way, even though they have individual characteristics and different exposure to systemic risk. The current proposals therefore require substantial improvement. Fair and effective regulation is welcomed, not a directive drawn up without consultation that lacks clarity of objectives and threatens to jeopardise an important part of the international financial system.
Tom Amy is head of the funds and SPV group at Volaw Trust & Corporate Services