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Susan Lock

Increased use of ‘funds-of-one’ among hedge funds

Susan Lock (pictured) is a partner in the investment funds team at Campbells, a leading Cayman Islands law firm which has been established for over 45 years, advising on both Cayman Islands and British Virgin Islands law.

She observes that the launch environment for new funds and emerging managers has become "manifestly harder, more competitive, costly and more time consuming". Fund launch costs are rising, primarily because of the increased need to meet regulatory and compliance reporting and investor scrutiny.

"Investment managers now have to not only show a compelling investment strategy and a proven track record but they also have to show sophisticated systems, controls, policies and procedures that support their business structures. That is putting pressure on emerging managers. They have to structure their products to satisfy institutional investors and answer due diligence requests regarding all aspects of their business and structuring, rather than simply answering investment strategy questions," says Lock. 

One of the consequences of these increased costs is that investment managers are becoming more aware of where their potential investors are based and may launch funds in different jurisdictions at different times. Rather than create a Cayman master offshore/onshore feeder structure from day one, managers may opt to launch an onshore fund first to build traction, before deciding to add a Cayman feeder vehicle.

"What we have also seen is emerging managers using platforms which may operate as a segregated portfolio company with each manager establishing a portfolio as a sub-fund within the SPC. Smaller investment managers who cannot guarantee a large initial AUM may gravitate to fund platforms with the primary reason being cost saving. But while they are saving on upfront set-up fees and expenses, they may actually pay more from an ongoing cost perspective as these platforms may be expensive with potential escalation in service provider fees."

Investing in a commingled fund exposes investors to fund performance risk if the manager receives redemption requests and is required to force sell positions. With a fund-of-one, investors are insulated from that commingled risk. Funds-of-one established in Cayman fall outside of the definition of `mutual fund' under Cayman Islands law and are not, therefore regulated by CIMA. 

Lock says that she is seeing signs of increased use of this fund structure among hedge funds. 

"We are also seeing established managers offering managed accounts and fund-of-one arrangements. Sometimes such funds are structured with segregated portfolios for individual investors but such vehicles can be difficult to administer and manage from a contractual perspective so they are not without their problems," comments Lock.

Alternatively, a fund-of-one co-investment strategy may be structured in the same way as the original fund with any co-investment strategy. However, the fund and the investment manager must ensure that it maintains adequate disclosures of any conflicts in terms of valuations, co-investments or expenses.

"In terms of disclosures, funds need to ensure that all of their documentation – not just their offering documents but all of the marketing documents, investor communications, etc – contain clear, consistent messages about the manager and the investment strategy. In addition there needs to be full and clear disclosures with regards to expenses and adequate disclosures as to any potential conflicts with regards to expenses, valuations, co-investments and self-dealing with regards to the investment manager and their key personnel," concludes Lock

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