Last year was another bumper year for hedge fund registrations in the Cayman Islands. The jurisdiction’s regulator, the Cayman Islands Monetary Authority (CIMA), reported more than 1700 new hedge fund registrations, topping the previous year’s record 1405 registrations. Today, the authority regulates more than 7000 active hedge funds, estimated to be about 80% of hedge funds worldwide.
The industry took off with the enactment of the Mutual Funds Law in 1993. The islands are also home to 158 fund administrators, which provide director, trustee and general partner services; transfer fund shares; calculate net asset values; and ensure regulatory compliance.
Flexible regulations have attracted investment funds that are geared up for sophisticated and institutional investors. The Mutual Funds Law affords wide scope in terms of investment objectives and fund structure while mandating full transparency to investors via the fund’s offering memorandum. This approach, combined with the licensing of mutual funds by CIMA and its regulation of mutual fund administrators, provides an effective regulatory regime.
Established reputation
“Cayman has now established such a reputation that selling the jurisdiction to hedge fund managers is a thing of the past. Fund managers know it’s the jurisdiction of choice; they can see it from the number of registrations,” says Iain McMurdo, a partner at law firm Walkers.
Cayman Islands established its market leadership with many of the same attributes that make it the world’s fifth largest financial centre. Top of the list is a regulatory regime that is effective without being intrusive. It also helps that there is no direct tax levied on funds. But the jurisdiction is also attractive because of its high number and quality of professional service providers, such as lawyers, accountants and administrators. That is what sets Cayman apart, says Mr McMurdo.
“The professional services infrastructure in the Cayman Islands is larger than and superior to any other offshore jurisdiction, especially for hedge funds,” he says. “The professional services have been built up with the growth of the hedge fund industry. Our lawyers have a tremendous depth of experience. The accounting firms are also very strong and you can find world class fund administrators. So it is something of a one-stop shop. Clients feel they get added value coming here as opposed to any other jurisdiction.”
The development of offshore investment funds business has been supported by the Cayman Islands Stock Exchange (CSX). It opened in 1997 and has become a leading exchange for the offshore mutual funds industry, and for specialist debt securities, derivative warrants, depository receipts and Eurobonds.
Exponential growth
The growth of the hedge fund industry has been exponential in recent years, attracting rising inflows as particularly institutional investors and pension funds have sought better investment returns. Despite gloomy press reports of shrinking performance and the threat of tighter regulation, assets under management are estimated to total more than $1500bn.
However, this success has been funds’ downfall as many have been unable to achieve the high returns enjoyed by early-stage hedge funds. As a result, investment managers are increasingly looking beyond conventional strategies in pursuit of higher returns.
“What we are seeing are hedge fund players looking for returns in a difficult market. They see the private equity funds generating the sort of returns they are more accustomed to and they want to get in the game,” says Jonathan Tonge, co-head of the investment funds team at Walkers.
“While the climate for hedge funds has become harsher with stronger performance in recent years in the global equity markets, the innovation of hedge fund managers continues to drive the industry and blur the lines between hedge funds and other collective investment vehicles,” note lawyers Peter Cockhill and James Bagnall of Ogier in a report. “There has been a marked increase in hedge funds moving into asset classes such as venture capital, private equity and mezzanine lending.
“Regional opportunities in developing markets (particularly in Asia) have attracted large capital inflows and hedge fund managers are now offering open-ended investment vehicles with a private equity sub-fund element that enables them to participate in illiquid securities. So-called ‘side pocket’ structures have become more common and are a very convenient way of enabling investors to combine different risk and return profiles within the same fund managed by the same manager.”
Different strategies require different set-up and administration. Responding to these changing needs is where Cayman has a competitive advantage. Having gained the know-how and reputation in different business areas, its professional service providers can easily meet the new demands of clients.
“We are seeing a lot of convergence on hedge fund and private equity strategies. Hedge funds are getting into the private equity domain, establishing funds with terms that are more like a hybrid private equity fund. There is therefore a crossover not just in terms of strategies but also the professional services these funds require. What we have in Cayman Islands are lawyers who could just as easily set up a private equity fund as they could a hedge fund,” says Mr Tonge. “We are finding that a lot of the different products that hedge fund managers are looking at, we are able to offer in Cayman.”
Flexible framework
Mr McMurdo says the legal and regulatory framework is flexible to changing investment strategies. “CIMA does not impose any investment restrictions on hedge funds, recognising that this is a sophisticated business for sophisticated players,” he adds.
One such flexibility can be found in segregated portfolio company legislation. This allows fund managers to create separate cells within a fund, putting assets into one cell, which are protected from the liabilities associated with a different cell. This permits vastly different investment strategies in the same fund.
Other jurisdictions are keen to muscle in on Cayman’s turf. Earlier this year, Hong Kong announced the removal of tax on hedge funds, clearly pitching itself to serve funds targeting China. To stay ahead of the pack lawmakers, regulators and the private sector in the Cayman Islands maintain regular interaction.
“The investment managers are not here [in the Cayman Islands]; they are in London or New York. They are deciding on strategy and the products and structures they need,” says Simon Whicker, a partner at KPMG. “What we do is to ensure we have the right sort of regulation and laws to accommodate these needs. Crucial to this is an active dialogue between practitioners and lawmakers to ensure we have the laws and regulations in place. So far, Cayman has tended to be the innovator and leader.”
