23 Dec 2010, Dara Skowron, Butterfield Fulcrum, Hedge Funds Review
When it comes to offshore hedge fund establishment, the Cayman Islands is by far the leading jurisdiction; the Cayman Islands Monetary Authority (Cima) reported around 9,500 funds registered as at September 2010.
One reason this jurisdiction has been so successful is its ability to meet the needs of the ever-evolving hedge fund industry.The Cayman Islands has historically been on the leading edge of development in the industry. An example of this is the special purpose vehicle (SPV) which is utilised to aid in structured finance deals. Due to the ease and cost effectiveness and local expertise of setting up this type of structure, the Cayman Islands became the jurisdiction of choice for SPVs.
The Cayman Islands is tax neutral. There is an absence of direct taxation. Additionally, a fund can apply to the government for a written undertaking to be exempt from taxes for a period of 20 years in the case of a company or 50 years for a limited partnership or trust.This exemption also flows through to the underlying investors.
The stable commercial infrastructure of the Cayman Islands has also contributed to its success as the leading offshore hedge fund jurisdiction; part of the reason for this is its status as a British dependent territory. Also, the strong support from the local government has helped promote Cayman as an attractive place to do business.
Establishing a fund in the Cayman Islands is a relatively easy and cost effective process. Both fund set-up and registration can be completed within days, with a set up fee not including legal fees of approximately $600.
The quality and expertise of the service providers in the Cayman Islands is high. There is an abundance of attorneys, fund administrators and auditors to choose from to help in the set-up process and ongoing operations of the fund.
When considering forming a hedge fund in the Cayman Islands, there are a variety of structures available to a fund manager. By far the most common one is the exempted company. With this structure shares are issued typically at some specified par value and all outstanding shares have the same rights. The company can be established as a stand-alone entity or as part of a multi-entity vehicle such as a master-feeder structure and is usually set-up with limited liability which limits shareholder liability to the initial amount invested.
Using a company structure, a fund can issue multiple share classes as long as the provision has been written into the articles of association. Multiple share classes give the investment manager flexibility in offering different terms to different groups of investors, for example, varying performance fee structures or restricting participation in certain types of income, such as new issues.
Another available structure is the exempted limited partnership. One advantage of this structure is that investors are automatically segregated into their own ‘class’, thus eliminating the need to create multiple share classes to deal with differing offering terms as would be required with a company. Instead, each limited partner’s investment is tracked in a capital account which will be updated to reflect profit or loss, based on the fund’s performance and each net asset value (NAV) calculation date.
The segregated portfolio company (SPC) is also another structure offered in the Cayman Islands. The SPC facilitates the creation of multiple investment portfolios in a cost effective way. The benefit of this structure is the ability to separately manage different pools of assets under a common governance framework while limiting any cross-liability. If losses occur in one segregated portfolio, the shareholders of the other portfolios cannot be held liable.
The unit trust is a fund structure that has been popular among investment managers marketing to Japanese investors. The unit trust is viewed by Japanese investors as the preferred vehicle for investing because of advantages from a tax and regulatory perspective.
Regardless of the entity or structure chosen, once the fund is established and the offering document has been finalised, an important aspect will be to appoint an administrator to manage the day-to-day operational duties of the fund. This will allow the investment manager to focus on their areas of expertise: performance of the fund and attracting investor capital.
The administrator’s role has increased significantly over the last couple years, in large part due to some high profile hedge fund frauds and Ponzi schemes. Such scandals, combined with the recent financial crisis, have left investors much more cautious and disciplined with regards to investing in hedge funds.
Topics like operational due diligence and transparency are now just as important as a fund’s performance. Having an independent administrator is viewed as a requirement by most institutional investors looking to allocate capital to hedge funds. It provides an added level of confidence in the calculation of the net asset values of the fund. The services an administrator provides can help the investment manager achieve their goals and satisfy their investor demands at the same time.
Having an administrator calculate the NAV of the fund provides an independent verification of the assets and liabilities. Some of the steps in this process include: recording transactions, reconciling cash, reconciling investment positions, valuation of investment positions, market value reconciliations, booking accruals and calculation of performance and management fees.
The investors of a fund are essentially the ultimate client of an administrator. Maintaining a high level of communication with and providing accurate information to the investor is one of the most important duties of the administrator. The investment manager relies on the administrator to maintain a good relationship with the investors but at the same time the administrator is responsible for ensuring that investors satisfy compliance and anti-money laundering obligations. Achieving this balance can be difficult.
Other functions of investor relations include: performing applicable anti-money laundering (AML), know your client (KYC) checks on all prospective investors, processing subscription and redemption requests, administering the receipt and payment of capital related to subscriptions and redemptions, confirming trade requests with the investor and the investment manager, requesting additional or updated investor information and sending periodic investor statements confirming the NAV of the fund.
The administrator of a Cayman Islands-domiciled fund will ensure the entity is compliant with local regulatory requirements. An administrator also keeps the investment manager abreast of any impending changes to the regulatory that may be relevant to their fund.
This function includes: provision of registered office, maintenance of the corporate records, assisting with the reporting of the annual audited financial statements and payment of annual governmental or company registration fees.
A Cayman Islands administrator can also provide custody services for a fund of hedge funds (FoHF). By combining administration and custody work with a single service provider, the investment manager can expect to gain efficiencies. For example, client service can be enhanced by having a single point of contact that is familiar with all operational matters related to the fund, and there can be cost advantages if pricing for administration and custody can be bundled.
Although not required by Cima, there are some advantages to choosing an administrator who has a local Cayman presence. Administration providers in the Cayman Islands employ highly skilled staff, most of whom are qualified accountants with many years of previous work experience at local audit firms that service hedge funds. This expertise is increasingly important where complexity of investments by hedge funds has become more the rule than the exception.
Fewer hedge funds are trading long/short equity strategies and more are moving into complex derivatives such as swaps or holding illiquid investments that usually require the set-up and administration of side pockets.
Local administrators are also well-versed in the regulations of the Cayman Islands and can ensure the fund’s adherence to rules such as the AML rules and Cima’s record retention requirements. Locallybased administrators also benefit from the physical proximity to regulators and law-makers. Most hedge fund industry participants’ offices are concentrated within one square mile in George Town so they can be up-to-date on the most recent legislation and issues affecting the industry.
As the hedge fund industry continues to face new challenges, having an administrator capable of adapting with the industry will be an important part of a fund’s overall success. An administrator should display a proven track record of servicing hedge funds, have dedicated staff who exhibit the ability to support any type of fund structure or strategy and should also offer a compelling technology solution which provides reporting on a daily, weekly or monthly frequency as required.
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