The challenge for any aspiring hedge fund start-up has been well documented in recent times. Year after year, the barriers to entry rise. Five years ago, the onset of global regulation prompted industry commentators to suggest that the break-even point of a hedge fund was USD100 million. One could argue that on an annualised basis, that break-even figure has risen by USD100 million. Not all will agree, but there is a growing consensus that to cope with the sheer breadth of regulation, today's start-up manager needs to be targeting Day 1 AUM of around USD500 million.
That's a scary figure, even for a Goldman Sachs alumnus with a trading pedigree.
A couple of years back, the BVI Investment Funds Association sat down and between them, ruminated over how the BVI could alleviate the problem facing start-ups. The fruits of those discussions culminated last June in the unveiling of two new funds designed specifically to give managers, and family office groups, a viable alternative that avoided the costs involved of establishing a BVI professional fund.
"The BVI Investment Funds Association felt that it was important for the BVI to offer a fund that complemented the Approved Manager regime. The incubator fund is receiving great interest at the moment and is already proving to be as successful as we hoped it would be," comments Oliver Bell, Senior Associate at Harneys, the largest law firm in the BVI.
"It used to be possible to break-even with an AUM of USD20-30 million," says Simon Schilder, Partner at Ogier (Jersey), who relocated to Europe last year but who was integral to getting the incubator and approved funds off the mark.
"There's no way on earth that is possible today. So, for those types of managers, what happens to them? Do they disappear into the distance or do they still try something? This is what the incubator fund is designed to do: to give start-up managers the chance to establish a fund platform and gain some traction with their investment strategy and if it takes off, they have the chance to raise assets and cope with the demands of running a fully-fledged hedge fund. Equally, if it doesn't take off, they're not going to spend the rest of their lives licking their wounds, having spent a significant amount of money launching a hedge fund which failed."
The difference between the two products is that the approved fund still requires an administrator for third party oversight. The incubator fund does not have this requirement, but this only applies to a finite period of two years (with the possibility of a one-year extension).
The incubator fund is known colloquially as a '20-20-20' fund. This relates to the thresholds involved: a maximum of 20 investors, each investor must allocate a minimum of USD20,000, and the fund has an AUM threshold of USD20 million; once it exceeds this threshold it is required to be re-registered with the FSC as a professional fund.
The threshold for an approved fund is USD100 million. The fund is limited to 20 investors, but this is rarely an issue given that most approved funds typically only have a handful of HNW investors.
When it comes to choosing between an incubator and approved fund, it ultimately comes down to the manager's future aspirations: if they want to launch a fund with a view to building a track record and eventually attracting a wider number of investors, they would choose the incubator fund. If they intend to run a strategy with a small number of investors, and not market it to external investors, then the approved fund route would be taken.
"There is certainly market interest in the two new fund products but as with all things new, it takes time for that interest to transfer into numbers," says Schilder. "Interestingly, so far the one that has proved of particular interest is not the incubator fund, as many expected, but the approved fund structure.
"This is perhaps due to the fact that there are a lot of club deal-like structures around, which are only ever going to be used to facilitate a handful of investors to invest in particular assets or market opportunities. The approved fund is effectively a private fund vehicle that has the normal fund protections one would expect to see in a normal hedge fund, but where things like a year-end audit aren't required," says Schilder.
There are clear tax advantages to those going down the approved fund route for the club deals that Schilder refers to. This is because whereas establishing a company means that the investors are shareholders, with a fund structure, when it comes to taking money out at a later point, this will be received by investors as the proceeds of a redemption rather than a dividend.
Family offices are a classic example of the type of investor who might look to take advantage of the approved fund and who wish to avoid the aggravations that come with running a regulated product.
"One of the things that has quite surprised me being back here in Europe is that we are seeing a lot of club deals. The key takeaway there is that the take-up in the approved fund is perhaps consistent with a wider trend in the global funds industry across jurisdictions," adds Schilder.
Both Bell and Schilder confirm that the approved fund is generating interest in Latin America, specifically Brazil.
"Brazil-based family offices have predominantly, in the past, used the Bahamian SMART fund; the BVI approved fund is now the first genuine contender to the SMART fund.
"At Harneys we run something called `The Offshore Funds Blog' (offshorefundsblog.com) and we are getting some interesting bites from that. The interest is global; one was a Latvian manager based in Norway saying he needed to set a fund and that the incubator looked like a good option," says Bell.
With the Approved Manager regime, the BVI is uniquely positioned with three products that offer a complete package for the emerging manager; no other offshore jurisdiction can offer this. "They've all got elements of it; the Bahamas has the SMART fund, Cayman has got the exempted manager, but no other jurisdiction has the complete package," states Bell.
"The BVI Approved Manager – and I don't think we thought this would happen – is actually proving extremely popular with managers running Cayman vehicles, not just BVI vehicles. A growing number of managers are coming to us looking to set up a Cayman fund but when it comes to the manager vehicle, they are enquiring about a BVI Approved Manager."
Glenford Malone is Acting Director, Investment Business Division at the BVI Financial Services Commission. He says that the BVI has always prided itself on operating a regulatory regime that develops "on the strength of an effective public/private partnership".
"The collaboration between the public and private sectors to get the Incubator and Approved Funds Regime up and running demonstrates the commitment to having a thriving fund sector in the BVI which meets the needs of the hedge fund industry. The BVI Government continues to be responsive to the needs of the industry, while ensuring that relevant steps are taken to enact appropriate legislation for the risks posed," Malone tells Hedgeweek.
With respect to the Approved Manager regime, Malone confirms that there is growing and continued interest: "It provides the right mix of regulation, supervision and a flexible business structure, which allows for start-up managers to easily test their investment philosophy."
According to the FSC's latest statistical bulletin, during Q3 a total of 15 Approved Manager licenses were granted, compared to 7 in Q3, 2014. In total, the FSC had granted 101 Approved Manager licenses through September, 2015.
When it comes to determining where best to establish the management entity versus the fund entity, there are a lot more variables involved with the latter. Generally speaking, investors are less concerned over where the manager vehicle is based and are more concerned about the fund jurisdiction and its reputation.
Therefore, the manager has entirely free reign over where to locate the manager vehicle depending on where it can be established in the most cost-efficient manner. That is why Bell welcomes the fact that more Approved Managers are being incorporated; nobody is pushing the manager, they are doing so because they clearly see the benefits on offer.
"In terms of the costs between the Cayman exempted manager and the BVI Approved Manager you're looking at probably USD12,000 versus USD10,000 for establishment, and USD8,000 versus USD3,000 on an ongoing annualised basis. So on an ongoing basis, you're looking at an extra USD5,000 a year to maintain the investment management vehicle in Cayman. That explains to some extent why start-up managers are showing a preference for the BVI Approved Manager," observes Bell.
One of the subtle differences between the Cayman exempted manager and the BVI Approved Manager is that the latter is regulated by the FSC, albeit in a light touch way: another factor that could potentially explain its growing popularity as it reassures prospective investors.
"In addition, the scope of funds that can be managed by an Approved Manager is broader," says Bell. "A Cayman exempted manager is limited to managing funds that are aimed at sophisticated, HNW investors whereas the Approved Manager can manage funds globally that are akin to a BVI private fund, which itself is not limited to the type of investors it attracts.
"I therefore think we could see more entrepreneurial managers use the incubator fund to take advantage of the 2-year window to test their investment strategy. Once they've got the track record they can convert it to a professional or private fund and then market it to a wider audience of investors. This avoids having to set up a managed account, which doesn't provide the manager with a track record."
One issue that could prove critical to the BVI is getting on ESMA's approved list of third countries to avail of the AIFMD passport. Back at the end of July, of the six countries ESMA had assessed, Jersey, Guernsey had no barriers with ESMA confirming that the passport would be extended to them. Switzerland is also well on its way.
In 2016, ESMA will extend the scope of its exercise to a broader swathe of jurisdictions and as Malone confirms: "The BVI continues to dialogue with ESMA and has a firm understanding of its criteria. Whilst we believe we meet the criteria, we are taking steps to make legislative reforms that shore up our position and enable us to include an opt-in for EU-compliant funds."
Schilder thinks it is unlikely that ESMA will extend the passport to non-EU countries in 2016. ESMA has stated that it wants to avoid market disruption in introducing third country passporting, which would happen if the passport is not made available to certain jurisdictions where there are lots of funds.
"What will be the trigger? Will it be when 10,000 Cayman funds wish to be passported? I don't think so. I think it will happen when the United States gets approved for a third country passport. It seems to me very unlikely that ESMA would open up the third country passporting regime until such time that the US has been approved. Jurisdictions like the BVI and Cayman are obviously keen to be assessed for third country passporting but how high up the list of priorities is this likely to be in the US with the SEC?
"My view is that the third country passporting regime won't be switched on until the US gets approved," says Schilder.
In conclusion, Malone confirms that for the year ahead, the Commission expects to introduce a number of measures to streamline the application process for funds, to ensure efficiency and to speed up the review and approval process.
"For example, the Commission will bring online a revised platform which will enable funds to more easily file annual returns. Additionally, we will make the application and other approval processes for funds more seamless by facilitating electronic submissions.
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