By Peter Cockhill, Partner
Given the protracted bear market in US and European equity markets in recent years, it may be surprising to the casual observer to discover that hedge funds and in particular offshore hedge funds have continued to expand and attract investors. The figures released by the Cayman Islands Monetary Authority ("CIMA") continue to reflect a strong demand for offshore services, in particular regulated mutual funds have grown by 50% over the figures for 2000. The appeal of hedge funds is that they aim to provide returns regardless of prevailing market conditions. The appeal of Cayman is a combination of factors.
Part of the continued success of Cayman as the domicile of choice for offshore funds can be attributed to its recognition of the current regulatory zeitgeist and its willingness to set standards rather than simply react to those suggested or imposed by others. The foresight shown by the Cayman financial services industry in adopting stringent anti-money laundering policies and procedures in 2000 has paid off as the regulatory bar has now been raised onshore as well as offshore. Leaving aside the question as to whether or not there is a level playing field for both the OECD member states and the offshore centres, the greater flexibility and lighter regulatory touch available offshore for non-retail business gives sophisticated and well-regulated offshore centres an advantage in attracting capital.
The area of hedge funds provides an illuminating example of the interaction between offshore and onshore and perhaps gives an indication as to where the plethora of international initiatives, industry consolidations and the ongoing redefinition of financial and legal service providers will lead us. At present the hedge fund industry comprises more than 6,000 funds with assets of more than $600 billion and it is estimated that the industry will have assets of more than $1 trillion in the next five to ten years. Cayman dominates the offshore market with approximately 65% of the market share. Institutional investors continue to move into hedge funds and State Street Global Advisors, the largest institutional fund manager in the world, recently announced that it is creating a dedicated hedge fund strategies group. Furthermore, there is an increasing recognition amongst mainstream managers and onshore regulators that there is a place for hedge funds and the long/short strategies they employ beyond sophisticated and institutional investors and restrictions on retail investors, especially in the fund of funds arena are slowly being lifted.
The convergence of regulatory requirements has contributed to the internationalization of fund service providers, which in turn has led to opportunities for offshore centres, such as Cayman, to attract the best of the onshore world to an offshore setting. A recent example of this dynamic at work was the establishment of a physical presence in Cayman of a number of the leading specialist hedge fund auditors (outside the big four) following the introduction of a local audit sign off policy in 2002.
Many developments in offshore hedge fund structures can be attributed to developments onshore. The ongoing drive for greater corporate governance in the US and the expected rules to be introduced by the SEC on investment managers in 2004 following its review of the hedge fund industry will have implications offshore. However, in many cases the requirements of offshore law and procedure are substantially similar to those onshore and it is increasingly evident that developments offshore have come around due to changes in circumstances (such as prevailing economic conditions) which are neither onshore nor offshore, but universal. A good example of this is the capture of performance fees. The classic hedge fund model involves a manager receiving a fixed management fee and a performance fee which will be a percentage of the net profits of the fund. In order to ensure equitable treatment amongst investors it has long been an established practice that some form of per investor method be utilised to capture the performance fees so that investors who subscribe for shares at different times only pay the performance fee on the amount by which the value of the shares which they hold increased during a financial period. There are a number of different methods in use, the most common are the use of series accounting (whereby a separate series of shares is issued on each subscription date and their performance is separately tracked to ensure accurate collection of the performance fee) and equalisation (whereby each shareholder has the same amount of capital at risk and collection of the performance fee is collected by redeeming or issuing an appropriate amount of shares). It is usual for performance fees to be subject to a high water mark or loss carryforward provision so that an investor only pays performance fees on its shares to the extent that the net asset value ("NAV") of the shares exceeds their previous highest NAV. Over the last few years during the prolonged bear market, the performance fee capture methodology has been refined to allow for a rebasing of the loss carryforward (or high water mark) so that losses will only be carried forward for, say, one financial period, so that the manager will receive a performance fee on growth thereafter. Where performance has been poor investors have redeemed out of a fund, which has necessitated the liquidation of underlying positions. In recognition of the need to ensure equality of treatment between redeeming and remaining shareholders, many funds have instituted gateway provisions so as to rollover redemption requests beyond certain thresholds, eg. no more than 25% of existing shares may be redeemed on any redemption date with the excess requests being carried over to the next available redemption date.
Another economic development, which has led to different structural approaches, is the attraction of seed and strategic investors. When setting up a hedge fund a manager will be hoping to attract a significant investor to provide him with the critical mass required to employ his strategy. Hedge fund incubators and strategic investors know their worth and will frequently seek to extract more favourable treatment than that being offered to standard shareholders and described in the offering memorandum. Typically a strategic investor will request reduced fees and improved liquidity terms, either by way of an exemption from a lock up (if applicable) on redemptions or waiver of redemption fees. In addition the strategic investor may require certain information regarding the underlying positions held by the fund. Dealing with rebate of fees is quite straightforward as it is a matter between the manager and the investor, but variations in other offering terms of shares are more problematic. Accordingly, the articles of association of hedge funds are being drafted more broadly to allow the directors specific and express discretion to enter into side letters and to designate additional classes or sub-classes of shares to give effect to such arrangements and to ensure equality of treatment amongst members of the same class or sub-class.
By keeping the constitutional documents broad it is possible for hedge funds to cater for a wide variety of different investors. The economic terms of the shares might be equivalent, but where there are tax or regulatory implications it is common to provide the affected investors with non-voting shares or shares with a restricted aggregate number of votes regardless of equity held (a reverse Bushell v Faith provision).
The legal developments in offshore hedge funds will continue to reflect the market developments and, although there will always be a difference of emphasis between the offshore and onshore world, it is increasingly the case that there is one global market and trends in that market, such as the consolidation of service providers, the emergence of pre-eminent jursidictions and the globalisation of approach, will be as relevant to Cayman as they are to the onshore financial centres.
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