First published by Global Legal Group, January 2022.
Despite the challenges presented by the ongoing COVID-19 pandemic, 2021 has been an incredibly impressive year for the global subscription credit and fund finance markets, and the Cayman Islands fund finance market has certainly mirrored that success. Cayman has seen significant private equity activity generally during the first half of 2021, with increasing numbers of fund formations and general transactional activity. New fund finance facilities involving Cayman vehicles have continued to increase throughout 2021 and this, coupled with ongoing amendments and joinders, has contributed to the impressive and consistent growth of the Cayman fund finance market.
From a Cayman perspective, we have seen that growth in the fund finance market over the past few years was driven in part by expansion of the product into a broader range of fund types, increasing take-up by fund sponsors who had not traditionally used the product in their fund families, record levels of fundraising and an increasing number of bespoke transaction structures, including net asset value (NAV) and hybrid facilities, as well as equity commitment deals. It is apparent that as the demands and needs of sponsors and funds have diversified, lenders have become more innovative and specialised in their approach. While certain banks have continued to build their book of business, new lenders have also emerged on the scene, including insurance companies and other alternative lenders. Cayman has seen steady increases in funds focused on climate tech, as environmental, social and governance (ESG) factors become an increasing priority for investors, as well as significant numbers of blockchain and cryptocurrency funds.
The Cayman Islands remains a pre-eminent offshore jurisdiction for the establishment of private equity funds, having previously been named "Best Private Equity Fund Domicile" by industry publication Private Equity Wire. The exempted limited partnership (ELP) continues to be the private equity fund vehicle of choice. According to figures published by the Cayman Islands Registry of Exempted Limited Partnerships, as at the end of 2020, the number of active ELPs in the jurisdiction had risen to 31,144 from 28,469 at the end of 2019. In 2020, 4,355 ELPs were registered in the Cayman Islands and for 2021, a total of 4,152 ELPs have been registered as at the end of September. In the first half of 2021 alone, an additional 2,836 ELPs were formed, representing the highest number of ELP formations in the first six months of a calendar year (this also represents a 28% increase on the first six months of 2020).
No doubt buoyed by the familiarity of US counsel and fund
managers with Delaware limited liability companies
(LLCs), the use of the Cayman LLC as a business
vehicle has generally been on the rise since its introduction in
July 2016. According to figures published by the Cayman Islands
Companies Registry, there has been a steady rise in Cayman LLC
registration with around 4,800 active LLCs registered to date in
the Cayman Islands. The success of the Cayman LLC can, at least in
part, be attributed to the decision by legislators, in
collaboration with the private sector, to introduce a vehicle that
is similar to the Delaware LLC. Familiarity with this type of
vehicle facilitates usage and offers the benefit of operational
consistencies across the onshore and offshore segments of fund
structures. Cayman LLCs are most commonly used as joint venture
vehicles, carried interest vehicles, downstream blockers, and
investment management vehicles. We are also aware that a handful of
Cayman LLCs have been used as investor-facing fund vehicles,
including by Asia-based fund managers.
Successful public and private sector consultation and collaboration are but two of the factors contributing to Cayman's market-leading position in this space. Others include:
(i) investors' and fund sponsors' historical familiarity with the jurisdiction;
(ii) the increasing convergence of hedge fund and private equity sectors, as more fund managers offer and operate both products from the same platform; and
(iii) Cayman law's English common law roots, supplemented, as necessary, by local legislation, providing a robust and flexible legal framework that ensures that Cayman Islands funds are recognised as internationally accepted vehicles.
Fund formation and finance
Lending to Cayman Islands funds
Cayman Islands private equity funds have historically been registered as ELPs under the Exempted Limited Partnership Act, as amended (ELP Act), particularly for the North American and European markets. The appeal of this type of entity is often the ability to provide operational consistencies as between the offshore fund vehicles and their equivalent onshore counterparts (often Delaware or Luxembourg limited partnerships). The Cayman LLC, registered under the Limited Liability Companies Act, as amended (LLC Act), is a hybrid form of business vehicle, merging certain characteristics of a Cayman Islands exempted company and an ELP. The LLC has been an appealing alternative for general partner, upper tier, manager and co-investment vehicles. Cayman Islands exempted companies are also occasionally used as investment vehicles; although, given their corporate structure, they are more commonly used as general partner, manager, blocker or holdings vehicles.
Though registered pursuant to the ELP Act, an ELP is not a separate legal entity. Rather, an ELP reflects a contractual agreement between the partners, where the general partner is vested with certain duties and powers with respect to the ELP's business and assets. Any rights and obligations of the general partner and the limited partners are therefore contractual in nature and will be governed by the provisions of the limited partnership agreement (LPA) and any subscription agreements (and/or side letters). The ELP's rights and property of every description, including all choses in action and any right to make capital calls and to receive the proceeds thereof, are held by the general partner in trust as an asset of the ELP. A Cayman LLC, on the other hand, is a body corporate with separate legal personality and limited liability. It can therefore hold such property and assets and incur obligations and liabilities in its own name.
The legal treatment of an ELP and the corresponding role of the general partner have a number of implications for lenders offering subscription credit facilities (Subscription Facilities) to Cayman Islands vehicles when structuring the related security package. Limited partners of an ELP will usually commit in the LPA and/or subscription agreement to fund investments or to repay fund expenses when called upon to do so by the general partner from time to time. This contractual obligation of a limited partner to fund capital, to the extent that it has not already been called (Uncalled Capital), and the corresponding rights of the ELP to call for Uncalled Capital (Capital Call Rights), are the backbone of Subscription Facilities. Given that these rights, or choses in action, are contractual in nature, the appropriate form of Cayman law security over such rights is an assignment by way of security. As discussed above, legal title to such assets ultimately vests in the general partner of the ELP and, being contractual in nature, such rights are exercisable by the general partner for the benefit of the ELP. Consequently, the proper parties to any grant of security in a Subscription Facility are the general partner as well as the ELP (acting through the general partner), as the beneficial owner of such assets.
Where the obligor in a Subscription Facility is a Cayman LLC, however, legal title to Uncalled Capital and to Capital Call Rights should vest in the Cayman LLC itself, with the manager (or managing member, if applicable) having such power and authority as set out in the LLC Agreement to make calls for Uncalled Capital and to receive capital contributions from the members in accordance with the terms of their subscription agreements. Accordingly, where a Cayman LLC is the obligor, the security package could be simplified in that only one entity - the manager (or managing member, if applicable) on behalf of the Cayman LLC - need be a party to the relevant security documentation. The LLC Act allows considerable flexibility in the structuring, governance and administration of the Cayman LLC, as it defers in many instances to the LLC Agreement. Members of a Cayman LLC will therefore have relative freedom to introduce features typically associated with ELPs such as capital accounts, capital commitments and capital calls, provided that the provisions of the LLC Agreement do not contravene the LLC Act or any other laws of the Cayman Islands. Each member of the Cayman LLC will also typically enter into a subscription agreement, setting out the terms on which it agrees to be a member, and to fund its capital commitment to the Cayman LLC.
In all instances, the optimal security package would incorporate (i) an express irrevocable power of attorney in favour of the lender to effectively exercise the general partner's or the Cayman LLC's Capital Call Rights following the occurrence of an event of default, and (ii) the grant of a security interest over a designated bank account under the control of the lender.
Although the security over Capital Call Rights can be granted under a Cayman law document, the governing law of the security will generally depend on the market practice of the jurisdiction of the main transaction documents; for example, in facilities governed by English law, it is customary to enter into a separate Cayman law security agreement creating security over such collateral, whereas it is unusual to take additional Cayman law security in the US fund finance market, where facilities generally rely on security governed by the relevant US law. Assuming that the grant of security is permitted under the Cayman law-governed LPA or the LLC Agreement (as applicable), Cayman courts would recognise the grant of security even if such security were granted under a foreign law-governed security agreement. In such a situation, the lender will need to ensure that the local law opinion covers not only the assignability of the Capital Call Rights, as a matter of Cayman law, but also the recognition of the security assignment, the choice of foreign law to govern the same, and the steps taken to establish priority as a matter of Cayman law.
The terms of the LPA or the LLC Agreement (as applicable) play an integral role in the structuring of the Subscription Facility collateral package and must be reviewed in detail in order to ensure that a number of key elements are present, including but not limited to: (i) the ability of the ELP or the Cayman LLC to incur indebtedness and enter into the transaction; (ii) the ability to grant security over (x) the Uncalled Capital, (y) the Capital Call Rights, and (z) the related contributions; (iii) the ability to apply the capital contributions towards the secured obligations; (iv) the ability to call on non-defaulting investors to make up a shortfall in the event that an investor defaults on a capital call; and (v) acknowledgment by the limited partners of the ELP or the members of the Cayman LLC of the security assignment and their obligation to fund their capital commitments without set-off, counterclaim or defence.
Perfection of security
Except with respect to land located in the Cayman Islands, vessels flagged in the Cayman Islands, Cayman Islands-registered aircraft and interests of limited partners in an ELP or members of an LLC in the LLC, generally, no perfection steps are required in Cayman and, further, there is no general register of security interests in the Cayman Islands accessible to the public.
Perfection (by which we mean that security interests over the encumbered property will be enforceable as against third parties claiming to have a security interest in the same property) over the Capital Call Rights is achieved through the delivery of written notice of the grant of security (Notice) to the ELP's limited partners or the members of the Cayman LLC. Where a security interest is granted over Capital Call Rights set forth in a Cayman law-governed LPA or LLC Agreement, priority of the security interest as against any competing security interest will be determined in accordance with Cayman Islands law. As a matter of Cayman Islands law, where successive assignments of a chose in action are concerned, priority as between creditors is determined based on the English court decision in Dearle v Hall (1828) 3 Russ 1, according to the order in which written Notice is given to a third-party obligor (i.e. the limited partners of an ELP or the members of a Cayman LLC). Priority is not established in accordance with the time of creation of the relevant security interests. Delay in the delivery of the Notice will therefore expose the lender to the risk that the Cayman LLC, or a general partner on behalf of the ELP, may (quite unintentionally) subsequently grant a competing security interest or an absolute assignment over Capital Call Rights to another secured party; if Notice of the second security interest is given to the investors ahead of Notice of the first security interest, the subsequent secured party will rank for repayment ahead of the first secured party.
Investors in Cayman Islands funds are increasingly aware of Subscription Facilities, with sponsors and lenders alike agreeing that investors should expect transparency insofar as the use of subscription lines by fund managers is concerned. Familiarity with the product means that there is now far less resistance from funds to giving Notice to investors. In addition, a general "tightening up" by lenders of certain aspects of their facilities has led to less flexibility around timing for delivery of Notices, which are typically circulated to the investors either immediately upon execution of the security documents, in order to ensure that priority is achieved at closing of the Subscription Facility, or within three to five business days of closing, depending on the commercial agreement between the parties.
Given the importance of actual delivery of the Notice to investors, evidence of the Notice having been received also assumes some importance. With advances in the technology of delivery of Notices and reports to investors, such as posting to secure web portals and other similar platforms, the discussion of the appropriate evidence of delivery of such Notices becomes crucial. If the applicable LPA or LLC Agreement specifically contemplates how Notices are actually delivered to investors, then this may prove helpful to the discussion.
Where LPAs or LLC Agreements include provisions that specify the circumstances in which Notices delivered in accordance with their terms are "deemed" to have been received by the investors, a lender might take some comfort in proof of delivery of the Notices in accordance with the provisions of such LPA or LLC Agreement, rather than proof of receipt by way of a signed acknowledgment by the investors. In all cases, the recommendation would be that the general partner of the ELP, or an authorised person on behalf of the Cayman LLC, sign and deliver the Notices to the investors in accordance with the provisions of the LPA or the LLC Agreement governing service of Notices on the investors, with a copy delivered to the lender.
Apart from establishing priority, delivery of a Notice to investors of an assignment of Capital Call Rights has other distinct advantages, three of which are discussed below.
Firstly, service of the Notice prevents investors from obtaining good discharge for their obligations to fund their Uncalled Capital in any manner other than as specifically indicated in the Notice. Once Notice has been delivered to each investor, indicating that investors are to make all payments with respect to Uncalled Capital into a designated lender-controlled account, the investors will not be in a position to discharge their obligations to make such payments in any other manner.
Service of the Notice also prevents set-offs from arising after the date of service of such Notice. This rationale is based on the common law principle that set-off works between the same parties in the same right. If there is Notice to one party of the assignment of a right to a third party (i.e. a lender), set-off will no longer operate in the same manner. However, the service of Notice on investors does not have the same effect with respect to claims that might have arisen prior to the date of service of the Notice. Most LPAs, LLC Agreements and/or the accompanying subscription documents will now incorporate express waivers on the part of investors confirming that they will not rely on any right of set-off in order to reduce their obligations to fund their Uncalled Capital when called by a lender to repay a Subscription Facility. Usefully, these contractual waivers survive the insolvency of the ELP or the LLC, as the case may be, as the insolvency provisions of the Cayman Islands Companies Act (which apply to ELPs by virtue of section 36 of the ELP Act and to Cayman LLCs by virtue of section 36 of the LLC Act) expressly provide that the collection in and application of property on the insolvency of a company (or partnership, as the case may be) is without prejudice to and after taking into account, and giving effect to, any contractual rights of set-off or netting of claims between the entity and any persons, and subject to any agreement between the entity and any persons to waive or limit the same.
As a final point, the Notice also serves as an important informational tool insofar as investors are concerned. Once an investor has taken delivery of the Notice, it becomes more difficult for that investor to challenge the enforceability of a call (made in a facility default scenario) based on a lack of knowledge or awareness of the existence of the Subscription Facility.
Although there is no public registry relating to the grant of capital call security in Cayman, the Companies Act requires exempted companies and Cayman LLCs to enter particulars of all security created over their assets (wherever located) in a register of mortgages and charges (ROMC) maintained at their registered office. Importantly, the statute does not aim to impose perfection requirements, and failure to enter such particulars will not invalidate the security; however, exempted companies and Cayman LLCs are expected to comply with the requirement, and failure to do so will expose such companies to a statutory penalty.
While there is no corresponding requirement for an ELP to maintain an ROMC with respect to security over its assets, where the general partner of an ELP is a Cayman Islands exempted company or a Cayman LLC, then (i) the general partner is required to update its ROMC with details of security granted in its own right, and (ii) it is advisable for the general partner to update its ROMC with details of the security granted on behalf of the Cayman ELP. In practice, this puts any person inspecting the ROMC on notice as to the existence of the security.
The Cayman Islands Private Funds Act
The Cayman Islands Private Funds Act, as amended (PF Act), came into force on 7 February 2020 and created an entirely new regulatory regime for private investment funds. Although investors and lenders alike are fairly familiar with the PF Act by now, given its significance, it is worth revisiting the applicable requirements and impact on a Subscription Facility. As an indication of the significant reach of the PF Act on the Cayman private equity market, approximately 14,000 private funds were registered with the Cayman Islands Monetary Authority (CIMA) as at the end of Q3 2021.
The PF Act applies to any "private fund" carrying on business in or from the Cayman Islands other than a mutual fund or an EU-connected fund regulated under the Mutual Funds Act. The PF Act defines a "private fund" as a company, unit trust or partnership that offers or issues or has issued investment interests, the purpose or effect of which is the pooling of investor funds with the aim of enabling investors to receive profits or gains from such entity's acquisition, holding, management or disposal of investments, where:
1. the holders of investment interests do not have day-to-day
control over the acquisition, holding, management or disposal of
the investments; and
2. the investments are managed as a whole, by or on behalf of the operator of the private fund, directly or indirectly,
but a "private fund" does not include:
1. a person licensed under the Banks and Trust Companies Act
(2021 Revision) or the Insurance Act 2010 (which can be searched on
CIMA's online database here);
2. a person registered under the Building Societies Act (2020 Revision) or the Friendly Societies Act (1998 Revision); or
3. any non-fund arrangements.
Single investor funds are out of scope and are therefore not required to register. Non-fund arrangements such as joint ventures, pension funds, holdings vehicles and securitisation special purpose vehicles are expressly excluded from the ambit of the regime. Following certain legislative updates, Cayman Islands alternative investment vehicles may be relieved from the burden of certain provisions associated with registration as a private fund.
All private funds must apply to be registered with CIMA within 21 days after accepting capital commitments from investors. Failure to register within such time exposes the fund to an administrative penalty. Significantly for Subscription Facilities, an in-scope fund must be registered by CIMA before it accepts capital contributions for investments, which is obviously of primary importance for the security package of a Subscription Facility. After well over a year of jostling and jockeying between lenders and borrowers, PF Act facility language has, for the most part, settled down, and market positions in relation to conditions precedent, covenants and events of default have emerged. An issue that is still arising now is one of timing, in the situation where a Cayman fund is not PF Act-registered with CIMA by the time the sponsor wishes it to join a facility. This has led, in some instances, to closings being delayed until the applicable private fund is registered or, more frequently, the exclusion of such fund from the initial closing or borrowing base, to be subsequently added once CIMA registration has occurred; however, given that CIMA continues to process PF Act registrations efficiently and that its website is regularly updated to demonstrate evidence of registration (although there have been some delays with receiving the PF Act certificates of registration), we are not generally seeing many significant financing delays resulting from delayed PF Act registration.
Economic substance regime
The Cayman Islands introduced the International Tax Co-Operation (Economic Substance) Act, as revised (ES Act) in January 2019. The ES Act requires certain "relevant entities" incorporated or registered in the Cayman Islands, and carrying on any "relevant activity", to demonstrate that they have "adequate substance" in the Cayman Islands. Such entities will be subject to administrative penalties and, ultimately, strike-off for failure to comply.
"Relevant entities" include: (i) Cayman companies (including exempted companies and LLCs); (ii) limited liability partnerships; and (iii) non-Cayman companies that are registered in Cayman (which would include a foreign company that acts as a general partner of an ELP), but exclude (x) investment funds, and (y) entities that are tax-resident outside of the Cayman Islands. ELPs are currently out of scope. While all "relevant entities" are required to declare their ES Act status in their annual filing, only those entities that are carrying on "relevant activities" are required to comply with economic substance requirements.
The ES Act lists nine "relevant activities", the most relevant for these purposes being "holding company business" and "fund management business".
Cayman corporate blocker entities or corporate vehicles that are not classified as investment funds and not otherwise tax-resident outside of the Cayman Islands will be subject to the ES Act. A corporate vehicle carrying on "holding company business", which is defined as "pure equity holding business" - i.e. only holding equity participations in other entities and only earning dividends and capital gains - is in scope, but is subject to a reduced economic substance test. In practice, this should be met by its ongoing compliance with existing statutory obligations. Compliance by other corporate vehicles should, however, be initially assessed by lenders' counsel, and all corporate vehicles should be monitored on an ongoing basis to ensure continued compliance with the ES Act.
A foreign corporate general partner registered in the Cayman Islands would be considered a "relevant entity", but would not likely be carrying out a "relevant activity" such as "fund management business" (except in unusual situations). As such, while it would need to declare its status in its annual filing, it would not otherwise be subject to any economic substance requirements.
Beneficial ownership registration regime
Cayman companies and Cayman LLCs are required to maintain registers of beneficial ownership at their registered offices, pursuant to legislation that came into force on 1 July 2017, as amended (Beneficial Ownership Regime). As a result, barring any applicable exemptions, in-scope companies must take "reasonable steps" to identify individuals qualifying as "beneficial owners" or corporate vehicles qualifying as "relevant legal entities". Beneficial owners are those individuals who hold: (i) directly or indirectly, 25% or more of the shares, Cayman LLC interests or voting rights in the company; or (ii) the right to appoint or remove a majority of the board of directors or managers of the company. If no individual meets these conditions, the Beneficial Ownership Regime looks to those persons who directly or indirectly exercise significant influence or control over the company through direct or indirect ownership or interests. Generally, "relevant legal entities" are intermediate holding companies registered in the Cayman Islands through which beneficial owners hold their registrable interests. Subsequent amendments to the Beneficial Ownership Regime added certain exemptions that broadly seek to exempt entities already subject to a certain level of regulatory oversight (e.g. certain regulated or licensed entities) and any company that claims such an exemption must provide its corporate services provider with written confirmation of the exemption relied on.
The potential significance of the Beneficial Ownership Regime for lenders in a financing transaction lies in the possible consequences to a "registrable person" in the case of its non-compliance with a request for beneficial ownership information. If an in-scope company fails to maintain the register or keep it up to date, its corporate services provider is required to issue to the company a notice requiring compliance. If the information requested is not received within one month of receipt of the notice, the corporate services provider must issue, to the registrable person whose particulars are missing, a "restrictions notice" in respect of the relevant interest held by that person. Subject to that person's right to apply to court to object to any restrictions imposed, until the restrictions notice is withdrawn by the corporate services provider or ceased by court order, any transfer or agreement to transfer the interest is void, no rights are exercisable in respect of the interest and, except in liquidation, no payment may be made in respect of the interest.
Given that: (i) the Beneficial Ownership Regime currently applies only to Cayman companies, LLCs and limited liability partnerships (and not to ELPs) and only where an exemption is not applicable; (ii) regulated investment funds and funds (including private equity funds) having a manager or administrator who is regulated in Cayman or in an equivalent legislation jurisdiction (i.e. designated as having measures for combatting money laundering and the financing of terrorism that are equivalent to those of the Cayman Islands) remain outside the scope of the Beneficial Ownership Regime; and (iii) a restrictions notice may not be served in respect of an interest that is subject to the security interest of an arm's length security holder, the enforceability of an unaffiliated lender's security package in a Subscription Facility should remain relatively unaffected by the Beneficial Ownership Regime. Lenders should, however, be aware of any possible consequences that may be applicable to in-scope companies in the context of the wider fund structure (e.g. an in-scope downstream entity), particularly given the more diversified security packages that we are currently seeing.
The Beneficial Ownership Regime reflects the Cayman Islands' commitment to help combat tax evasion, terrorist financing, money laundering and other serious and organised crimes, by providing greater transparency on beneficial owners. Government is currently consulting with industry on proposals to enhance the Beneficial Ownership Regime. The consultation will inform the eventual drafting of legislation to effect any proposals that are adopted.
The year ahead
The forecast for private equity fundraising over the next few years remains optimistic and, given the ability of top US-based sponsors to raise money from institutional investors based in the US, we anticipate that the North American market will continue to dominate. Cayman will remain relevant for North American and Asia-focused funds, in particular, while continuing to be a popular jurisdiction for UK managers establishing offshore funds with a transatlantic nexus. As the industry matures further, the demand for fund finance solutions throughout the lifespan of the fund will likely increase, as will the need for its underlying portfolio companies to be supported. We anticipate that the types of fund-level financing and the purposes for which financing is used will continue to diversify in 2022 and we expect an increase in not only Subscription Facilities, but the more bespoke NAV facilities, management fee facilities and hybrid facilities. Continued focus on ESG will inevitably lead to an increasing number of funds and lenders incorporating ESG into their strategies.
Given that strong credit performance remains the norm in this market, the relatively low-risk profile of the product will continue to make it attractive for lenders. The strength of the fund finance market will continue to be bolstered by strong collaborative relationships between lenders and fund sponsors alike. Continual development and innovation will likely remain a feature of the industry, with the Cayman market ever willing to evolve and adapt to meet the requirements and expectations of our onshore counterparts.
We anticipate that Cayman will continue to maintain its position as the principal offshore fund jurisdiction, for reasons including the range of vehicles that can be utilised to meet a fund's structuring requirements, investor familiarity with the jurisdiction and a proportionate and adaptive regulatory framework. Due to the popularity of Cayman as a fund jurisdiction, coupled with the continual growth of the finance market generally, we expect 2022 to be another extremely busy year in the Cayman fund finance market.
First published by Global Legal Group, January 2022.
For the original chapter in GLI – Fund Finance 2022 please visit: https://www.globallegalinsights.com/practice-areas/fund-finance-laws-and-regulations/cayman-islands
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.