By Simon Gray – The past four years have brought upheaval throughout the global alternative investment fund industry, at times calling into question the role of the Cayman Islands as the world’s leading offshore hedge fund domicile. However, despite renewed difficulties in 2011 as hedge funds suffered their second worst year ever in terms of performance, in addition to continuing competition for business from onshore jurisdictions, there is little or no sign that Cayman’s industry dominance will slip any time soon.
True, the hopes of Cayman industry members last year that hedge fund numbers would climb back above their high water mark from 2008 were unfulfilled, reflecting at least in part the continuing problems for managers – especially start-up or spin-off firms – in attracting sufficient assets to establish new funds or build a sustainable business. But new launch activity was depressed everywhere in 2011, not just in Cayman.
Greater regulation of managers in Europe and North America, as well as US legislation designed to close tax loopholes relating to investment abroad, promise to increase the administrative burden on managers, driving up costs. In the case of the European Union’s Alternative Investment Fund Managers Directive, it could potentially complicate the marketing of non-EU funds to Europe-resident investors.
Yet there is little sign of the redomiciliation of funds domiciled in Cayman and other offshore jurisdictions to onshore countries, much touted (especially in jurisdictions that are potential beneficiaries) as a logical response to the EU directive. By contrast, many managers with the resources to do so are seeking to establish onshore versions of offshore funds to maximise their appeal to different investor groups.
“Cayman shows no sign of giving up its overwhelming predominance as the registration domicile of choice for hedge funds,” says Paul Harris, chairman of directorship provider International Management Services. “Its stability as a UK territory, tax neutrality, enabling laws, regulatory efficiency and abundance of professional expertise in all areas of the hedge fund universe, and its apparent ability to overcome whatever difficulty presents itself, all contribute to its continued success as the undisputed leader of hedge fund domiciles.”
Ingrid Pierce, a partner and head of the Cayman Investment Funds Group law firm at law firm Walkers, observes: “Everyone has been affected by the fallout from the financial crisis, and Cayman may be more newsworthy because of the number of funds domiciled here. However, the fact that they continue to be set up in Cayman, in similar volumes to the past, shows that people are voting with their feet. We have not seen a significant downturn – clearly the market still likes Cayman.”
At the end of September 2011 there were 9,431 mutual funds domiciled and regulated in Cayman, including 8,877 registered funds, according to the Cayman Islands Monetary Authority. This compared with 9,594 funds at the end of the third quarter of 2010, and 10,291 at the industry’s September 2008 peak. The lowest quarterly total since the onset of the crisis was 9,261 at the end of March last year.
Still, there are reasons to believe that the figures could shift in either direction in the coming months. “The accuracy of the current figures will become clear in the first quarter of 2012 when we see the final statistics for last year, taking into account whatever liquidations were put in train during the final quarter of 2011,” says Peter Cockhill, a partner at law firm Ogier.
Throughout most of last year, the hedge fund industry continued to attract investor capital, but Cockhill believes disappointing performance – the average hedge fund is estimated to have lost at least 4 per cent in 2011 – may have taken its toll on assets in the fourth quarter. “For a number of funds the performance level is below their high water mark, and those that with ongoing costs are just not profitable or sustainable will be coming off the books,” he says.
“My team is working on a number of year-end liquidations, some of which may not be finalised until halfway through 2012. There is always a natural attrition rate, and in addition the current economic uncertainty is leading to delays in fund launches. A number of launches scheduled for November may now take place in January or February. Getting money flowing from a fund’s sponsor or seed allocator is taking a bit longer than it might have done previously.”
It’s also possible that the number of funds currently recorded by CIMA is being artificially depressed by the use of umbrella fund structures by multiple managers, an attractive option to save on start-up costs at a time when investor allocations are harder to secure. Phil Griffiths, a director of JP Fund Administration (Cayman) and chairman of the JP Funds Group, says funds that are part of the firm’s segregated portfolio company structure would not be counted individually by the regulator.
Pierce sees the same phenomenon: “We have been involved in the set-up of a lot of funds within an umbrella unit trust structure that is registered as a mutual fund. The various sub-funds within that structure could each be independently registered but generally aren’t, for obvious cost reasons. Only the umbrella fund, which holds the mutual fund registration licence, is counted by CIMA, even though it might have five or six sub-funds.”
Other factors may be keeping the headline numbers down, she believes, including structures established with an institution as the sole investor whose distribution strategy may entitle it to exemption from registration with the regulator on the grounds that the fund has fewer than 15 investors. “We have a lot of funds like that,” Pierce says. “Every month we go through the list of new funds and we have set up a number of structures that don’t appear because registration was not required.”
Such exemptions tend to apply to Cayman-domiciled private equity funds, a sector that industry members say is performing robustly but that remains largely invisible because it does not use mutual funds. Neal Lomax, managing partner of law firm Mourant Ozannes, says that while information on private equity business tends to be largely anecdotal, the number of new exempt limited partnerships – the private equity vehicle of choice – being set up in Cayman is a useful proxy for activity in the sector.
What is not happening, industry members unanimously report, is the redomiciliation of Cayman funds to European jurisdictions. This option has been much discussed as a possible answer to the distribution challenges that will be posed by the AIFM Directive or to capitalise on the opportunities perceived by managers in offering hedge fund strategies through highly-regulated retail fund structures compliant with the EU’s series of directives on Undertakings for Collective Investment in Transferable Securities.
Managers are certainly setting up so-called Newcits, usually in Luxembourg, Ireland or Malta, or alternatively funds in those jurisdictions under rules designed for sophisticated investors. However, members of the Cayman industry say there is little evidence that this is draining any significant amount of business away from the jurisdiction – not least because set-up and ongoing costs are higher onshore, significantly so in the case of Ucits funds.
Bryan Hunter (pictured), head of the corporate and commercial practice group at law firm Appleby, says there has been virtually no redomiciliation of funds to other jurisdictions. “There has been a negligible number given the size of Cayman’s fund industry,” he says. “Managers seeking to target European investors are considering EU-based fund structures, but not to the exclusion of offshore funds. Instead they are establishing parallel structures to target both EU investors and those elsewhere in the world.”
Pierce adds: “We can’t say redomiciliation will never happen, but the evidence so far is that the numbers are minuscule. A report by KPMG and RBC concluded that although there was a lot of talk about it, the managers they questioned for the survey considered that the offshore domiciles had stepped up their game and increased due diligence efforts, and that investors were satisfied with what they considered appropriate levels of regulation. There was sufficient comfort in funds’ service providers being regulated themselves either in Cayman or an onshore jurisdiction such as Ireland or Luxembourg.”
Griffiths says JP Fund Administration has dealt with a number of managers who considered establishing a Ucits fund but ultimately concluded that a Cayman structure would be more cost-effective. “People have been trying to shoehorn alternative strategies into Ucits structures, but the returns may not be as good because you don’t have the same flexibility in terms of eligible assets and leverage,” he says.
“When managers say they need a Ucits structure, we ask them about their strategy, their current and targeted assets under management, and tell them how much it will cost to establish and run a Luxembourg or Dublin structure. Realistically, you need between USD50m and USD80m to make a Ucits structure pay for itself. We are very cost-effective here, with all the right people including lawyers, administrators and auditors, and nine times out of ten, the conversation ends with the manager deciding that what they need is a Cayman structure.”
A significant cloud of uncertainty has been taken away by the inclusion in the final form of the AIFM Directive of the principle that two years after the legislation comes into effect in July 2013, non-EU managers and funds should become eligible to benefit from a cross-border marketing ‘passport’.
Subject to detailed rules that are still being drawn up, managers of Cayman funds should be able to enjoy access to sophisticated investors throughout Europe as long as they comply with the terms of the directive and their home jurisdiction meets conditions in areas such as regulatory-co-operation, tax information exchange and anti-money laundering enforcement measures. In the meantime, existing distribution channels under national private placement arrangements remain operative.
Darren Stainrod, the Cayman-based head for Americas and Asia-Pacific at UBS Fund Services, acknowledges that early drafts of the legislation threatened to crimp Cayman funds’ access to European markets and could weakened the appeal of the jurisdiction. “It would potentially have been very damaging to US hedge fund firms, which are the largest share of our market, and taken away part of the lifeblood of the hedge fund industry in Cayman,” he says. “As it is, there will be some changes, but the directive should have less effect on US managers.
“If the third-country access conditions are implemented as they were outlined in the level 2 advice from the European Securities and Markets Authority, Cayman should be very well placed to meet those rules and qualify as an acceptable jurisdiction under the passporting arrangements. For UBS, the rules on the duties and responsibilities of depositaries could actually be beneficial because of out status as a bank.”
Stainrod notes that the Cayman authorities are making extensive efforts to ensure the jurisdiction meets the European rules, conducting an ongoing dialogue with the EU, re-examining the jurisdiction’s financial regulatory structure and continuing to sign tax information exchange agreements with countries both inside and outside Europe.
He does caution, however, that there are no guarantees on how individual EU member states will adopt the directive into their national law, and whether they will make changes to their private placement rules (where these exist). “We will have to see whether different countries make it easy for investors to access offshore funds,” he says. “There is always the fear that someone might move the goalposts and seek to exclude certain offshore domiciles. However, for now the signs are good, and Cayman as a jurisdiction is optimistic that the directive will not have a significant effect on our business.”
Some US managers with Cayman funds are already facing new regulatory burdens as a result of the Dodd-Frank Act, which requires all managers of assets exceeding USD150m to submit to regulation by the Securities and Exchange Commission, and imposes a lesser reporting requirement on smaller firms. But industry members note that the US rules apply to all managers, regardless of whether they run offshore funds, and that in any case many managers of Cayman funds are regulated by the SEC already.
“Under the Dodd-Frank regulatory overhaul, hedge funds face a barrage of new regulatory requirements, but large hedge funds are mostly unaffected since most are already registered with the SEC,” Harris says. “The smaller ones will be affected because the costs of complying with the new regulatory requirements are disproportionate. But offshore funds could gain an advantage since the new rules and regulations may limit the strategies and instruments available to US domestic hedge funds.”
However, he notes that some hedge fund managers actually feel that Dodd-Frank might have a positive impact. According to a survey by research and advisory firm Aksia, 40 percent of relative value managers polled said the new laws could help their businesses. “For example, the Volcker rule restricts banks from speculative trading, which reduces the competition for hedge fund managers, and the banks themselves may invest with hedge funds as an alternative,” Harris says.
Industry members are similarly sanguine about Cayman’s extension of its regulatory regime to master funds within master-feeder structures, which were previously exempt. The Mutual Funds (Amendment) Law 2011 was published on December 22 and CIMA issued the new form MF4 for the registration of master funds a week later.
“This can be seen as a natural evolution of the feeder fund registration regime,” says Jon Fowler, head of the investment funds group at law firm Maples and Calder. “The fact that master funds have not needed to be registered up to now was mentioned by the Organization of Economic Co-operation and Development in its Phase 1 Peer Review Report on Cayman. The new rule reflects the desire of the government and the regulator to address the concerns of the international community.
“The key from a legal perspective is to make as cost-effective and user-friendly as possible, because at the end of the day it will be investors who bear the cost of implementation. As it stands, we are hopeful that the regime strikes the right balance by providing effective regulation coupled with relatively straightforward practicalities of registration. Given that it’s a simple registration form and the fee for registration of master funds is relatively small, I don’t see it being a big issue – most clients caught by the regime will just register and move on.”
Don Seymour, managing director of fund governance provider DMS Management, says the new requirement stems in part from one of the lessons of the crisis. “In some cases frustration was directed at professional or offshore directors, who were perceived to be not doing enough to safeguard the interests of investors because the manager had implemented some form of liquidity management techniques that the investors felt was not in their best interests,” he says.
“What was often overlooked was whether the directors had any control over those decisions. In many cases there was an offshore feeder fund that invested in a US partnership whose general partner was the US-based investment manager. They had sole control over these structures, and over the release of money from the partnership to the feeder for distribution to investors.
“Today large institutional investors in the US are starting to agitate with hedge fund managers for independent governance of onshore structures. Professional directors like ourselves are being asked to serve in an advisory board capacity or at general partner level, which would bring greater independence to these decisions.
“Investors also approached the Cayman regulator because the feeder funds were all regulated structures, but CIMA was as powerless as the offshore board. It decided that to avoid this situation in future, it should be able to exercise the same level of regulatory control over the master fund that it does over the feeder fund if the former is domiciled in Cayman.”
Although the master funds in most structures are currently domiciled in Cayman, Seymour believes that in the future more of then will be established onshore. “We are at an inflection point in the industry,” he says. “Prior to the crisis, most master funds were domiciled in Cayman, in most cases controlled by a general partner who was the investment manager. However, more and more master funds are being set up as US limited partnerships.”
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