Cayman Islands: Some Current Structuring Trends In Asian Hedge Funds

Last Updated: 6 June 2006
Article by Peter Cockhill

These are exciting times for Asian hedge funds. A recent report put together by Hedgeweek on Asian Hedge Funds was full of upbeat statistics compiled by regional based consultants and industry directories. To give a flavour of the progress made by the alternative investment industry in the region, it is estimated that worldwide there are now more than 650 Asia-focused hedge funds with assets under management of close to USD100 billion as at the end of 2005. This represents a five-fold increase in assets under management since 2000 and is to be seen in the context of the alternative investment industry as a whole where assets under management are estimated to be around the USD1.2 trillion mark. The growth is impressive, but in the light of the current relatively weak hedge fund returns in Europe and North America and the fact that Asia is under-represented as a region in terms of allocation of assets engaged in alternative investment strategies (when compared to its 15% share of global capital markets) much more growth is expected.

Presently there are worldwide approximately 8,000 hedge funds for investors to choose from and a wide array of strategies being employed by managers in search of uncorrelated returns. Investors seeking exposure to Asian funds can do so through funds managed both in North America and Europe (where the majority of Asia focused funds are currently managed) and increasingly from funds managed in the region, principally Hong Kong, Sydney and Singapore. Historically, Asian funds have enabled investors to experience geographical diversity, but have generally been rather restricted in terms of the investment strategy being employed, with most being equity long/short funds. However, the migration of managers from North America and Europe to the region coupled with the expansion of the fi nancial institutions which provide liquidity to the funds is driving the implementation of more complex strategies utilising derivative products, leverage and structured products.

The implementation of more diverse strategies has certain structuring consequences. Most of the world’s hedge funds are domiciled in the Cayman Islands and the legal structures available in Cayman have evolved to meet the demands of the alternative investment industry. In addition to setting up funds for domestic investors, the Asia-based law firms work with offshore legal counsel in establishing an offshore fund to be managed alongside or in a master-feeder arrangement with the domestic fund. Master-feeder structures are popular as they provide an efficient way of enabling onshore and offshore investors to participate in the same investment programme as the investment manager who will manage the portfolio at master fund level. In a side-by-side arrangement the offshore fund (whether structured as a company, partnership or unit trust) will mimic the investment strategy and offering terms of the onshore fund. As currently most of the investment into Asian focused funds is coming from outside the region, there is a strong demand for tax efficient investment vehicles through which managers can raise investments in the US and Europe and elsewhere and the Cayman structures provide this. In order to obtain maximum flexibility and to create a diverse offering to investors, it is possible for managers to structure funds with a multi-jurisdictional Asia regional focus employing different strategies within the same legal entity through the use of multi-class funds (often structured as segregated portfolio companies, so as to avoid cross-class risk contamination). In this way specific classes of shares offered to investors may participate only in a specific strategy and/or jurisdiction.

The search by managers for new sources of returns has led to the encroachment of hedge funds into the realm of private equity. Private equity investments often are a natural complement to a number of hedge fund strategies – distressed investing, event-driven investing, multistrategy investing and real-estate investing. The opportunities in the developing markets of Asia has led to great interest from the private equity market and from hedge funds following, amongst other strategies, a private equity strategy, usually with a cap of up to 30% of a fund’s portfolio of investments.

Structurally, the lack of liquidity in private equity investments is the one characteristic of private equity-style investing that does not sit with a typical hedge fund structure, as hedge funds need periodically to strike a net asset value to allow scheduled subscriptions or redemptions based on the fund’s net asset value. Striking a net asset value can be problematic when a hedge fund’s investments include illiquid securities. But there are a number of structures a hedge fund can adopt to fitilliquid assets into its portfolio without impacting the balance of the hedge fund’s operations. These include the use of "side pockets," used where the illiquid investment constitutes a material portion of the portfolio; the imposition of longer, sometimes rolling, lockups, where investors are locked into the hedge fund, without a right to redeem for two, three or occasionally more years in duration; or the use of "gates," which are limits on the percentages of fund capital that can be withdrawn on a scheduled redemption date. Finally, hedge funds generally retain the ability in certain circumstances to (1) suspend all redemption rights and (2) pay the redemption price in kind.

The attraction of Asia to managers and investors is driving the development of innovative financial products and the use of evolving and more sophisticated legal structures. These are exciting times not just for those seeking dynamic returns through alternative investments in Asia, but also for those involved in the structuring of the vehicles through which such opportunities may be realised.

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.

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