Originally published in American Lawyer, December 2005
The hedge fund industry has been enjoying exponential growth over recent years, despite a largely hostile mainstream press reporting environment, and more recently, a chorus of nay-sayers in the background predicting the levelling off and contraction of the hedge fund universe. With assets under management well in excess of $1 trillion and the onset of registration of managers with the Securities and Exchange Commission, the hedge fund industry has matured and, in many commentators’ eyes, has become (or is well on the way to becoming) institutionalised. During 2005 there have been many stories focusing on poor hedge fund performance, an overcrowded marketplace with too many managers playing in the same arena and not enough star players to maintain the run of success that the hedge fund sector has hitherto enjoyed. It might appear that hedge funds have become a little boring and consequently capital flows are slowing as investors are attracted elsewhere.
However, this negative impression is not borne out by empirical evidence. The figures released by the Cayman Islands Monetary Authority reveal that in 2004 growth in hedge fund registrations was up 112% from 2003 and in 2005 numbers have increased again with over 900 new funds being registered with CIMA during the first nine months of the year. Cayman is an accurate barometer of growth as more funds are domiciled in Cayman than anywhere else and it has long been the standard choice of those structuring funds, whether managed in the U.S., Europe or Asia. Whilst 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. 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 which enables them to participate in illiquid securities. These 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.
The innovative search for higher yields and the maximisation of management talent has also seen hedge fund managers move into the management of collateralised debt obligations (CDO’s). A CDO is a fixed income product that is a securitisation of other bonds, loans and financial instruments and is a means of financing pools of assets such as mortgages and credit card debt. In Cayman we have long been used to the classic CDO structure in which banks have offloaded debt from their balance sheets through the creation of a special purpose vehicle which offers participation in the collateralised debt to external investors. However, recent changes in accounting rules and the new Basel II regulatory framework is leading some of the large financial institutions to offload the management of the riskier elements of securitisations and this is where hedge fund managers are stepping in.
The concept of hedge funds investing in this type of vehicle is unusual because of the necessity for the hedge fund managers to assure the banks that they will be long-term holders of the assets. Cheyne Capital Management, one of the largest London-based hedge funds, is proposing to float an investment company that will take on the management of these high yield financial investments. In the world of hedge funds, liquidity has been a significant attraction to investors and there is an obvious lack of liquidity in this type of structure. From the manager’s perspective, the management of CDO’s (like the use of side pockets for private equity investments) can be attractive as recent experiences have shown that too much liquidity can cause problems when redemption requests by significant investors in a fund can prompt the unwinding of underlying investment positions and the unravelling of a strategy due to short-term considerations. The approach of Cheyne mimics that of other managers who have listed investment management companies on public exchanges and thus allowed investors the freedom to buy and sell shares in the management vehicle without jeopardising the long-term strategy of the manager.
Cayman is a jurisdiction ideally set up to accommodate these structures. All the signs from the service providers such as lawyers, banks, accountants and administrators, and the Cayman Islands Monetary Authority suggest that though the description of what constitutes a hedge fund manager may be changing, the demand for idiosyncratic and imaginative managers continues to be high and that the need for a sophisticated, international and tax neutral jurisdiction such as Cayman remains strong.