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James Williams, hedgeweek

Incubator Fund could provide long-term growth trajectory


"We see the funds industry as continuing to contribute to the overall offering of financial services. There remains good interest in the BVI product and we envisage that will continue," asserts Glenford Malone, Director, Investment Business Division, BVI Financial Services Commission, when asked to comment on the growth of the BVI's funds industry. 

Like every fund jurisdiction, the estimated 40 per cent drop in new fund launches in the hedge fund industry last year negatively impacted the BVI. And as the costs of running a hedge fund business increase, some are choosing to call it a day and revert to the family office model.

"One client here in the BVI is deciding to close up shop because of the cost of compliance and the tedious nature of complying with all of today's regulation, including AIFMD," says Robert Briant, Partner at leading offshore law firm Conyers Dill & Pearman. "They are shutting down five or six funds. It was a sound business but it was no longer cost effective. There are costs of moving towards higher compliance and regulation. The client will be redeeming all outside investors and operate as a family office instead."

It is an unfortunate symptom of where the industry is today although the latest Preqin figures reveal that global hedge fund assets reached a record USD3.22 trillion at the end of November 2016; this was achieved by industry gains of 7.40 per cent, offsetting net investor outflows of USD102 billion.

What the BVI has done well to adjust to the new world order – one of increased regulatory compliance and higher costs of doing business – is to support start-up and emerging managers with a light touch regulatory regime. Moreover, it is making the necessary adjustments to uphold its commitments to international governance standards. 

Malone says that the BVI is committed to ensuring that "it meets all relevant international standards and where those standards have changed, so too has the BVI". 

"For example, the BVI is committed to ensure that its Anti-Money Laundering and Combating the Financing of Terrorism Regime fully meets the Financial Action Task Force (FATF) 40 Recommendation. In keeping with the FATF requirement, the BVI has undergone a National Risk Assessment which will allow the BVI to maintain compliance with the FATF Recommendation and preparation for a Mutual Evaluation by the Caribbean Financial Action Task Force (CFATF). 

"We are also keeping fully abreast of issued raised by IOSCO and other standard setters," outlines Malone. 

BVI Partnership Act

To continue its evolution as a leading offshore funds jurisdiction, the BVI is making several amendments to its legislative framework. One of these amendments relates to the BVI Partnership Act, 1996, which many of the islands' practitioners agree is well overdue an update. 

"It was certainly time to overhaul the existing legislation. We're confident that it's going to open up some new opportunities for the BVI, in particular on the PE and VC side, where I think there will be a big push in the market. The draft legislation is currently with the BVI Government for consultation, and we hope to have the new Act in force as soon as possible. It will expand the BVI's offering considerably," comments Oliver Bell, Partner at Harneys, the largest law firm in the BVI.

One of the key benefits to the updated BVI Partnership Act will be the ability to create LPs with separate legal personality. 

"In relation to companies, the BVI has always had the most innovative and sophisticated legislation compared to other jurisdictions, but where we have fallen short in recent times is on the limited partnership side. The updated BVI Partnership Act will remedy the situation with world-beating legislation," adds Bell.

AIFMD Opt-In Regime

A second important development currently underway is the creation of an AIFMD opt-in regime for the BVI, called the Securities and Investment Business (AIFMD) Regulations, as the BVI looks to seek approval from the European regulator, ESMA, for third country equivalence and introduces into the BVI an AIFMD equivalent regime. 

One of the things that ESMA looks for in assessing third countries is that they have an AIFMD equivalent regime in place. When one looks at the offshore jurisdictions that have been assessed so far, such as Jersey and Guernsey, they've all got AIFMD equivalent regimes in place. 

"When ESMA were assessing Cayman and Bermuda, one of the obstacles was that they had no AIFMD equivalent regime," says Simon Schilder, Partner at Ogier and head of the firm's BVI Investment Funds Practice. "Whilst the BVI has not yet been formerly assessed, there are ongoing discussions between the BVI and ESMA around the assessment and in contemplation of its formal assessment the BVI has prepared and released its AIFMD equivalent regulation. It is not yet in force but it is on the statute book."

"We continue to demonstrate that we have the regulatory infrastructure to fully satisfy the requirements of third party that ESMA is responsible for assessing. Clearly, each time an external third party reviews your standards and finds them robust will be a benefit to those using the jurisdictions," adds Malone.

BVI managers will be able to choose whether or not they wish to opt in to the regime and be subjected to AIFMD equivalent regulatory oversight. If someone decides to opt in and the fund which they are managing opts in as well, that will give the manager `EU equivalency'. 

"For managers opting-into the AIFMD equivalent regime to take advantage of passporting rights, they would do so in respect of their BVI Professional, Private or Public Funds, rather than in respect of the more lightly regulated Approved or Incubator Funds. These lighter touch regulated funds wouldn't work for an AIFMD opt-in regime (and would actually be inconsistent with the whole strategic purpose of these two lighter touch regulated fund products)," explains Schilder.

Indeed, managers use the Approved and Incubator Fund where they are looking to get an easier regulatory ride; most are start-up managers who want to control costs. When someone opts in to AIFMD, they are effectively committing to a `BVI Professional Plus' regulatory regime, as it were; in other words, even greater regulatory scrutiny. 

Asked what impact last June's Brexit decision could have on the BVI, Schilder replies: "It's impossible to say what impact Brexit and the next two years of negotiations will have once Article 50 is triggered. For both the UK's overseas territories and crown dependencies, my personal view is that the ride they are likely to get with the EU would have been better if the UK had chosen to remain in the EU. Ultimately, with the UK out of the EU, who is going to be fighting the corner for the UK's overseas territories and crown dependencies at the EU?"

Based on figures for Q2 2016, there were three times as many new licences granted for Approved Funds than Incubator Funds (12 compared to four). The Approved Fund can effectively be thought of as a BVI private fund with guaranteed exemptions. 

"That was the original rationale behind creating the Approved Fund. What are people using BVI vehicles for? Historically, it has been to run friends and family money. What would be interesting is to know the geographic spread of those structuring Approved Funds. 

"For example, a few years ago there was a flurry of Brazilian HNW families converting investment vehicles into funds for Brazilian tax reasons. I wonder how many of the BVI's Approved Funds are structured for tax considerations that can benefit family offices using a more formal fund structure, taking money out of redemption proceeds as opposed to dividends?" queries Schilder.

Malone confirms that there continues to be good interest in these products. 

"They continue to serve the purpose of allowing small and new startups to test their investment ability," he says.

There are two limitations to the Incubator Fund: first of all, it can have no more than 20 investors and no more than USD20 million in AUM. Then, after two years, one has to switch it to a BVI Professional Fund. 

One company that actively helps new managers bring a new fund to market, taking care of each step of the pre-launch phase (and then, if necessary, the ongoing fund administration role) is Circle Partners, who provide a turnkey solution. 

Peter Jakubicka is Business Development Manager at Circle Partners. He explains that with the Approved Fund the limitations are 20 investors, USD100 million in AUM but there is no time limit. 

"They can be run indefinitely, until they cross the USD100 million or 20 investors thresholds, at which point they have to be converted to either a BVI Professional Fund; these will then have a minimum investment of USD100K for each professional investor that the manager targets," says Jakubicka.

Briant explains that the Incubator Fund was not designed to be used indefinitely. "Incubator funds can only operate for two years (extendable by one year). However, by moving to an Approved Fund, one can keep that running ad infinitum (provided it remains below USD100 million). Both fund products, however, do require two directors," says Briant.

What the Incubator Fund does is to keeps fees down. However, given that it is a very lightly regulated product, investors have to be aware of Caveat Emptor.

"To launch a BVI professional or private fund you need to have an administrator, a prime broker, and when you also factor in compliance with regulation such as FATCA and CRS, plus AIFMD, it soon becomes very expensive. The minimum AUM to manage a fund profitably has increased to a significant number. Most new managers start out with their own money, or money from friends and family. The barriers to entry are much higher than they were," comments Briant.

For those managers who wish to market a BVI Professional Fund to European investors under national private placement rules, they will be required to use a licensed AIFM in Europe. This is something that Jakubicka says Circle Partners can help with.

"We have a network of lawyers and other counterparties that we work with in the EU and we can introduce third party management companies to clients, who will sponsor the fund with their AIFMD license for marketing and distribution purposes. We help set that arrangement up between BVI managers and European AIFMs in our network." 

He thinks there is still a long way to go until ESMA approves a third country passport for the BVI but has no doubt it will help the BVI as a jurisdiction. 

"Usually, people who go offshore aren't too interested (at least initially) in raising capital in Europe otherwise they would remain onshore. But the passport will give them another option. It will be a market changer for sure," adds Jakubicka.

The Closed-ended SPC

Aside from introducing an AIFMD opt-in regime later this year and an overhaul of the BVI Partnership Act, 1996, the BVI is expected to extend the use of Segregated Portfolio Companies for unregulated closed-ended structures in 2017. 

This is something that certain jurisdictions have been able to offer for some time but for one reason or another the BVI Government has previously wanted SPCs to be regulated. 

"Allowing them to be used for unregulated closed-ended vehicles is a natural move and will really expand the potential for people to use these vehicles," says Bell.

With respect to regulated funds, he sees a lot of interest, in general, for SPCs, at present.

"Due to current market conditions, a lot of managers aren't looking to launch new funds but would rather have a different strategy within the same fund structure: the statutory segregation of an SPC allows managers to run different strategies within the same vehicle, without running the risk of cross-contamination, making for a highly cost-effective solution," explains Bell.

Another important development is that it will also be possible to establish Approved Funds as SPCs. Previously, says Bell, it was only possible to establish SPCs in the BVI as BVI Private, Professional or Public Funds.

"We are seeing a huge demand at present for Approved Fund SPCs and this is something that we are now able to provide. One of the main thrusts of demand is coming from family offices where there is a need to be able to ring fence assets and liabilities within a single entity."

Two year review 

One interesting sign of how well the BVI's funds industry is faring will be this summer when the first wave of Incubator Funds that launched in 2015 reach their two-year time limit. The more that re-register as Approved Funds or BVI Professional Funds, the more one can assume that, going forward, the BVI will be well positioned to support sustained long-term growth, both in terms of fund numbers and aggregate AUM. 

"We are receiving enquiries from clients on whether they should move to an Approved Fund. If there's a pipeline of investors knocking on the door with another USD20 to USD30 million the manager would have no hesitation moving to an Approved Fund and appoint a third party administrator to do all the NAV and KYC work but if they have USD5 million under management, is it worth it?

"One existing client wants something easy for friends and family money and plans to launch an Incubator Fund although he expects to quickly raise USD20 million, at which point he will convert it into an Approved Fund," says Briant.

"You are correct that the regime for Incubator and Approved Funds is approaching its two year anniversary," continues Malone from the FSC. "We envisage that the impact of the incubator and approved funds regime will be positively felt as at the end of this two-year anniversary period and that a number of these funds will convert into private or professional funds having satisfied the threshold requirements."

However, the flipside is that depending on how well these incubator funds have done, the BVI might equally be on the cusp of more funds shutting down as opposed to being re-licensed. 

"The point of an Incubator Fund is to enable start-up managers an opportunity to have a cost-effective fund vehicle in which to test their strategy and build up a track record which they can then market. For those managers who have gained traction and investor interest then they can then go onto convert into a Professional or Private Fund. For those managers where the two years have been a struggle and haven't seen much progress, the arrival of the two-year anniversary might signal the time to close down.

"There's no guarantee that everyone will have had a successful time and will seek to convert because in life not everyone can be successful. By the summer we will get a clearer sense of what is happening," observes Schilder.

Ultimately, these products were introduced as a long-term investment for the BVI. If a small number of start-ups go on to become successful blue-chip names in the hedge fund world running hundreds of millions or billions of AUM, this will be a boon for the BVI and prove that it was a good idea.

"We are the only jurisdiction to have targeted smaller managers," says Briant. "I am extremely pleased the regulator stepped up and allowed the BVI to do this. We are not the Cayman Islands, nor are we trying to be. I think the Approved Manager Regime and Approved and Incubator fund products have helped the BVI to stand out. It has been good for our reputation of being innovative and responsive to the industry."

In conclusion, the FSC's Malone is asked what his hopes for the BVI are in 2017: "We will continue to monitor the industry and adapt to the needs. We expect to continue our close collaboration with the Industry to ensure that the right level of regulation is applied commensurate to the risk.

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