By Simon Gray – Like writer Mark Twain, who famously observed, “The report of my death is an exaggeration,” members of the alternative fund sector in the Cayman Islands have become familiar with reading their own obituary. Since the onset of the financial crisis, and especially the G20-led campaign to clamp down on opaque and poorly-regulated financial centres, the world’s leading offshore fund domicile has been regularly written off by onshore competitors and media commentators.
For instance, last July the Financial Times cited hedge fund managers as saying that “the future of the Cayman Islands as a hedge fund domicile is bleak.” Tiburon Partners’ Mark Fleming was quoted as saying: “The Caymans will wither on the vine. It won’t go overnight but very few people are going to set up there … If I was a Cayman lawyer with more than three or four years of career expectation, I would wonder what I’m going to do with the rest of my working life.”
So far, however, most Cayman lawyers seem too busy setting up new funds to spend much time worrying about their future employment prospects. While levels of business have not returned to those seen at the frothy heights of the boom in 2006 and 2007, new fund registrations are averaging nearly 100 a month, which works out at a net increase of around 60, according to Darren Stainrod, head of alternative fund services at UBS Global Asset Management.
“Over the past 18 months the rate of new start-ups and the allocation of capital to new managers have certainly quietened compared with the heady days of 2007,” says Ogier partner Peter Cockhill. “There is no doubt that the market has changed and that the time between conception and realisation [of funds] has grown longer. We’re not back in the days when you might be asked to set up 10 funds off the shelf in the space of a week.”
However, Cockhill predicts that Cayman will soon break through the threshold of 10,000 funds registered with the industry regulator, the Cayman Islands Monetary Authority, and thereafter move back above the quarter-end peak of 10,291 set at the end of September 2008 – just at the moment when the Lehman Brothers bankruptcy tipped the financial industry into a fresh spiral of decline.
At the end of September 2010, 9,584 funds were authorised by Cima, down from 9,838 a year earlier, but the regulator’s statistics show that the sector has been growing again since the first quarter of last year. The figures do not include closed-ended funds such as private equity structures for which there is no registration requirement; numbers are elusive, but Cayman lawyers say they account for a significant proportion of business volume.
The numbers – and other green shoots such as the establishment at the beginning of this year of a Cayman chapter of the New York-based Hedge Fund Association – fly in the face of the thesis of long-term decline predicted by doomsayers as a result of institutional investors’ supposed aversion to offshore funds, the threat of unfavourable regulatory treatment under the European Union’s Directive on Alternative Investment Fund Managers, and the undoubted increased appeal to hedge fund managers and investors of the EU’s Ucits cross-border retail fund regime as a vehicle for alternative strategies.
But Cockhill adds: “The signs at the moment are very encouraging, which is testimony to two things. The North American market, which provides 65 per cent of our work, has come back, and we have seen no diminution at all in instructions coming from Asia, principally the regions serviced from Hong Kong, and from Latin America, principally São Paulo and Rio de Janeiro.
“Over the past two years Brazil has relaxed its regulations to allow Brazilian managers greater access to international markets, which has given momentum to the use of Cayman funds as vehicles for their international investors. Right now, touch wood, we seem to be in a sweet spot.”
Don Seymour, managing director of hedge fund governance specialist dms Management, argues that the jurisdiction’s recovery owes much to the concerted efforts made by Cayman to meet international standards in regulation and transparency.
“We have made great strides in the past couple of years that demonstrate we want to be a fully functioning and contributing member of the global financial community,” he says. “We have signed numerous tax information exchange agreements with countries around the world, something that shows ourselves to be a transparent and co-operative jurisdiction. The days of Cayman being perceived as a tax haven are long behind us.”
KPMG partner Anthony Cowell (pictured) adds: “A lot of politicians and regulators wanted to pass on the blame for the entire financial meltdown and the issues that they had in their local markets onto the Cayman Islands. However, according to our recent research, the additional regulation is not wanted by the majority of investors, managers or service providers.
“The widely held view is that the industry did not cause or contribute to the credit crisis, and investors don’t believe it will provide any tangible benefits. Moreover, many European investors believe that it will reduce the number of start-ups, thereby stalling the industry’s engine of creativity. It is very interesting to note that the recent changes in regulation will not have a significant initial impact upon Cayman.”
Certainly industry members say the much-discussed redomiciliation of funds domiciled in Cayman and other offshore centres to onshore jurisdictions in Europe such as Luxembourg, Ireland and Malta, or to offshore centres perceived to be in better odour with international regulators, such as Jersey and Guernsey, has so far been tiny. They suggest that the high profile of the topic is down in large part to the PR efforts of countries such as Ireland that see themselves as potential beneficiaries.
“Cayman continues to dominate the offshore hedge funds and private equity market, and we’re not seeing any significant amount of that work leaving to go elsewhere,” says Neal Lomax, managing partner of law firm Mourant Ozannes in the Cayman Islands. “Certain rival jurisdictions such as Ireland have made a lot of noise about one or two firms redomiciling funds, but it has been literally one or two.”
Cockhill notes: “Luxembourg and Ireland have both been saying that in the light of the AIFM Directive, managers should consider getting ahead of the curve by setting up in a European jurisdiction. The Irish changed their law in December 2009 to allow transfers by way of continuation – something long available in the major offshore centres – and trumpeted that they were about to be deluged by funds moving from Cayman. But up to the end of the third quarter of last year, Cima’s records show that only four funds had left Cayman, two to Luxembourg and two to Malta.”
With the EU directive having been finally agreed in a compromise form for which industry members generally have little enthusiasm but which most say they can live with, it will be harder to convince managers in the future that a European domicile is the only option, Cockhill argues.
“The good news from our perspective, and that of the fund managers, is that the directive has finally arrived at a decent compromise,” he says. “That game has come to an end, and I don’t expect to see more of those horror stories appearing in the press. Our statistics show that people aren’t buying it. If you’re a third-country manager you can still distribute in Europe through private placement, and you will have the option to obtain an EU passport.”
The AIFM Directive, which is set formally to become law during the first quarter of this year and will come into force two years later, is set to allow non-EU funds access to a European single market of sophisticated investors from 2015, two years after funds that are both managed and domiciled within the EU. In the meantime existing national private placement regimes will remain available, although the legislation envisages their eventual disappearance once the passport system offers all managers the opportunity to distribute funds within the EU on an equal basis.
One slight area of concern remaining for the industry outside Europe is that much of the detail of the directive will be filled out by secondary legislation and regulations to be promulgated over the next two years by the European Commission, and future changes such as the opening up of the passport system and the abolition of private placement arrangements will also require further legislation of this type.
These concerns have been allayed to some extent by changes made in the directive during the legislative process, making clearer the basis for determining the acceptability of non-EU jurisdictions as a domicile for funds qualifying for distribution within the union. For example, the compliance of such jurisdictions with international anti-money laundering standards will be measured by their standing with the Financial Action Task Force, while their tax transparency will be determined by the conclusion of OECD-standard tax information exchange agreements with EU member states.
Tax transparency may be an important issue for the offshore banking and fiduciary sectors, but it is beside the point for the fund industry, according to Derek Adler, a director of fund administrator Ifina. “Running around signing tax information exchange agreements simply means you are signing up to the rules of the club,” he says. “That’s helpful because it tells our clients that Cayman is a serious jurisdiction and is on the OECD white list, but it matters far more for financial planners and trust companies.
“By contrast, it doesn’t make any real difference to the fund business, which has always been regulated and properly monitored, and has always offered transparency. For many investment managers it doesn’t matter how many Tieas a jurisdiction has as long as they can set up a fund structure in a regulated jurisdiction, their investors can have confidence that their money is safe, and the fund is being serviced by an independent third-party administrator.”
Neither the anti-money laundering nor the tax co-operation requirements appear likely to cause any problem for Cayman. “By any objective standard, jurisdictions including Cayman and the British Virgin Islands will pass the tests that will allow our funds to be marketed under the passport regime,” says Henry Smith, global managing partner of Maples and Calder, the international law firm that has its head office at the now-famous Ugland House in George Town, the Cayman capital, and the registered office for almost 40 per cent of the world’s hedge and private equity funds.
“Those provisions apply not only to traditional offshore jurisdictions but to anywhere outside the EU. We think we are already a long way up the curve toward satisfying the tests demanded under the various criteria, whether for the private placement option in the interim phase up to 2018 or the passport, if the European regulators do actually apply it to non-European funds and managers.”
However, the requirement for co-operation arrangements to be put in place between the financial supervisor of the fund domicile and that of the EU member state assuming regulatory responsibility for managers of non-EU funds remains a grey area. Until such time as the Commission provides a template for such co-operation, it will not be possible to banish completely fears that the rules may be drawn up in such a way as to allow EU member states a subjective choice on which fund domiciles to accept and which to exclude.
“The devil will be in what these regulations are,” Cockhill says. “Managers will need to make an assessment over the next few years on whether or not they want to go for a full passport or whether they will continue to market their fund discretely through private placement [as long as this remains permitted]. It really depends on the proportionality of the regulations the Europeans come up with.”
Smith notes: “Cayman and the BVI are already party to the International Organization of Securities Commissions multilateral memorandum of understanding. There is already significant co-operation between their regulators and other parties to the Iosco memorandum of understanding. We have significant bilateral co-operation agreements with the UK’s Financial Services Authority and the US Securities and Exchange Commission as well, and Cayman and the BVI already have tax information exchange agreements with most of the major EU member states.
“We have been lobbying the Europeans to look to the Iosco framework as a means of satisfying the regulatory co-operation requirement of the directive, and we are very encouraged that the Committee of European Securities Regulators [predecessor of the new European Securities and Markets Authority] has mentioned the Iosco framework as something that could be considered. The preamble to the directive and G20 statements underline that the co-operation arrangements should not be used to discriminate against countries.
“Our concern was that they might require bilateral treaties between each of the 27 EU member states and every non-European country. You can’t imagine how long and complex negotiating all those bilateral treaties with every country outside the EU would be. That just doesn’t make sense, especially if the overriding objective is to introduce a globally-agreed framework of regulation of systemic risk issues within a reasonable timeframe. By contrast, the Iosco multilateral agreement would tick a lot of the boxes from a European perspective.”
One of the flaws in the arguments of those predicting Cayman’s eventual decline as a fund domicile is the assumption that most if not all managers will require access to the European market as a matter of course. Smith notes: “Some European jurisdictions historically have not had private placement regimes, which made it difficult to market non-European funds there. The passport could offer an opportunity to access those markets.
“But the passport may not be particularly helpful for non-European-based managers that don’t have pan-European marketing and distribution capabilities, but might just be looking at one or two major investors or pension funds in a couple of countries. Private placements arrangements may have worked very well for their purposes, as well as giving European pension funds access to this type of fund. Ultimately a decision on whether to seek a passport will come down to how Eurocentric each manager is.”
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