Investors are increasingly looking for more transparency in the investment funds industry and none more so than institutional investors. However, there is debate about what transparency means. An important aspect to transparency is appropriate disclosure and information rights. Independent oversight is also key, especially with regard to valuation of assets and when they are or become illiquid. There is now a trend for detailed valuation policies to be worked up and provided to investors in advance.
Even where a fund has an independent administrator whose responsibility is to provide the NAV, investors are drilling down further, to establish whether the administrator is doing this merely on the basis of data provided by the manager or whether this data comes from an independent source. The former is far less attractive to investors. Already, investor desire for enhanced independent valuation is having effects. For example, it has helped spawn a new up-and-coming industry of valuation firms whose specialised role is to provide independent data.
The credit crisis has brought some issues to the fore. Although lock-ups, gates and side-pockets can be legitimate mechanisms that a fund may adopt to deal with liquidity problems, unsurprisingly, investors do not like them. Whether such a view is justified or not, some institutional investors consider their use as being a fundamental breach of the relationship given that liquidity of their investment was a key feature to having invested in the first place.
In talking to investors, there is a definite sense of investor frustration with the industry generally. Having spent considerable effort in whittling down the long list of possible products in which to invest, institutional investors find that the documentation of the selected funds falls short and is too manager friendly. They then resort to the process of negotiating information rights and other variations in side-letters to obtain anything close to the levels of transparency that they require. This can be a time-consuming process. Often, complex structural issues arise in trying to implement the variations. In a Cayman fund, the fundamental principle that investors of the same class must be treated equally can present obstacles to variations and so require innovative solutions. This is where law firms, such as Appleby, have such a key role to play in problem solving.
Bear Stearns/Lehman Effect
Following the Bear Stearns and Lehman Brothers collapses, the investment funds industry were rudely awakened to the issues arising out of rehypothecation of assets for example, where collateral posted by a prime broker's client to the prime broker is used as collateral by the prime broker for its own purposes, for example. Prior to the credit crisis, it was not unheard of for investment funds to be content to have their assets commingled with those of the prime broker or at least isolated from the assets of the prime broker but commingled with assets of other investment funds. There is now a trend for fund assets to be isolated even from other funds' assets. Despite the added costs imposed for this level of service, managers are increasingly seeking this option. Managers are looking increasingly to spread risk and utilise more than one prime broker, in order to avoid having all their eggs in one basket.
Investors are generally more wary than in the past for a number of reasons. Certainly, the Bear Stearns/ Lehman effect has had an impact – even more so has Madoff. There is enhanced focus on due diligence. Fraudulent schemes, such as ponzi schemes like the one Madoff carried out are prevalent. The Securities and Exchange Commission (SEC) is flooded with reports of such schemes and its resources are stretched such that it is forced to focus on the most material wrong doers.
Institutional investors are looking much more to the independent director as the guardian of their interests. Generally, investors find that fund structures are geared more in favour of managers rather than investors. This is hardly surprising given that it is managers who form funds and they are advised by counsel who look after the manager's interests. When problems arise in an investment fund, investors gravitate to the independent directors as their champions. There is a clear desire on the part of investors to partner with the independent directors, and to have the independent director 'in their corner'. As a result, investors are more wary than ever of any conflicts of interest that the independent director may have.
Where there are two independent directors appointed, investors prefer to see that each one is provided by a different independent director service provider, so as to maximise the four eyes on everything approach. Where the same firm provides two directors, there is sometimes a tendency for one of the two to take the lead. This may mean diminished oversight and poor value for service if full fees are paid to both board members.
Controversially, investors are concerned to ensure that the independent director has sufficient capacity and resources such that the director can devote adequate time to each fund. The perennial question is always over what is the maximum desirable number of directorships. Independent directors provide services as a livelihood. Restrictions on the number of their appointments, requirements to devote more time to each fund and to be more proactive is bound to have a knock on effect on their fees. However, some investors maintain that they are fully prepared for that and this is a cost worth paying to ensure that their interests are preserved.
Redemption Rights – Now and the Future
There are a variety of redemption provisions which have emerged from the credit crisis to deal with illiquidity. Suspension rights have become more focused and afford the ability for the fund to suspend redemptions without the prerequisite of suspending the NAV calculation. There are provisions for distributions in kind, in the form of interests in liquidating accounts and liquidating trusts. Gates on redemptions have been introduced, which allow the fund to reduce redemption requests to a certain percentage of the fund's total assets during any redemption period in order to prevent a run on the fund. Side-pockets are increasingly considered.
The Cayman court case of Strategic Turnaround has resulted in more careful consideration than before of redemption provisions in corporate funds. The case determined that redemption is a process comprising of several stages and, in the absence of anything to the contrary in the fund's documentation, the investor remains a shareholder in the fund until the proceeds of redemption are paid to the shareholder and the register of members is updated by the administrator to show it is no longer a shareholder. Furthermore, if the fund suspends redemptions, the suspension applies to all of the stages that have not been completed, which could, therefore, include the payment of redemption proceeds. Fund documentation is now far clearer on exactly what powers the fund has, with regard to its ability to suspend the redemption process and the status of the investor in the redemption process so that the desired results are achieved.
Cayman as a Domicile of Choice
Cayman is the domicile of choice with 80% of hedge funds; a total just short of 10,000 funds. The Cayman fund is a tried-and-tested product to a level which no other jurisdiction can match. The registration procedure for open-ended funds, where the regulator has no discretion to refuse registration if the simple documentary and fee requirements are met, is popular within the industry. However, Cayman needs to maintain its competitive edge and especially in these difficult economic times. The AIFM directive is an area for concern. However, on balance, it may not have that much of an impact on the jurisdiction.
The Future for Appleby
Appleby is the leading provider of offshore legal, fiduciary and administration services with over 800 lawyers and professional specialists globally. While many competitors have recently reduced in size, Appleby has seen great expansion in the past 12 months. The group now has 12 offices with the most recent office opening in Guernsey in April 2010 and the merger with leading Isle of Man firm, Dickinson Cruickshank in October 2009.
In order to enhance the service that Appleby is able to offer, the group has also strengthened its expertise particularly in the corporate and commercial practice group with the lateral hires of Richard Addlestone, Julian Black, Matthew Feargrieve, James Gaudin and Matthew Stocker. All join from other leading offshore law firms.
This article first appeared in the Hedge Fund Manager Week, Special Report (Cayman 2010).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.