Hedge fund regimes come under closer scrutiny as industry matures and expands

Regulation differs between jurisdictions and can affect the way hedge funds conduct their business. Stephen Quigley and Jamie Wynn-Williams give an overview of regulations and fund administration, focusing on some of the main jurisdictions around the world.

While regulation of hedge funds has been relatively light so far, recent market turmoil, coupled with the growing size of the hedge fund industry, is likely to push governments to take a closer and more hands-on approach to hedge fund regimes. Service providers, and in particular fund administrators, are already the focus of much regulation.

Although there are subtle differences between regulations, jurisdictional arbitrage is a dying art. Any advantage one hedge fund domicile may have does not last long in this highly competitive marketplace.

The competition to beat is universally accepted as the Caribbean and although four locations - Cayman Islands, British Virgin Islands (BVI), Bermuda and Bahamas - are considered the leaders, in fact Cayman is far ahead of even its nearest rival, the BVI.

Caribbean and world leader: Cayman

The Cayman Islands regulatory regime, while known for its lighter touch, is nevertheless considered one of the most respected jurisdictions for hedge funds. As undisputed leader as the jurisdiction of choice for domicile, the Cayman Islands Monetary Authority's (CIMA) approach to hedge fund regulation combines flexibility with what it sees as an appropriate level of regulation.

CIMA, like most jurisdictions, makes a clear distinction between public (retail) funds and those aimed at private or professional investors. With an eye on its first place lead, CIMA remains innovative, flexible and creative in its approach to legislation.

Yolanda McCoy, head of securities and investments at CIMA, says the overriding regulatory objective for the private funds that make up the vast majority (90%-95% of the entire funds market) is to ensure proper disclosure by fund operators so that investors are not misled about the nature of the risk they are taking.

"The objective is achieved primarily by requiring these funds to prepare and file offering documents that describe the equity interests in all material aspects and contain such other information as is necessary to enable a prospective investor to make an informed decision whether or not to subscribe for or purchase the equity interests," says McCoy.

The Mutual Funds Law 2007 Revision outlined the obligations for regulated funds in the Cayman Islands and the obligations of the service providers. Licensed fund administrators and auditors have specific reporting obligations to the authority and are seen as a good way to ensure that funds with managers scattered around the globe have a sufficient degree of oversight to protect investors as well as the highly coveted reputation of the Cayman Islands.  All funds are subject to anti-money laundering rules and are expected to comply with the requirements with respect to procedures for customer identification, record keeping, internal reporting and training.  Domestic and UK requirements with respect to combating the financing of terrorism also apply to regulated mutual funds.

 "Currently, we are exploring changes to the regulatory regime. First, the implementation of phase two of e-reporting that would involve automation reporting forms. Second, transparency enhancements of the funds regime - ie best practices outlined by the [UK] Hedge Funds Working Group. And third, the establishment of a securities investment business working group to look at deficiencies in the current law and make recommendations to the CIMA board and government," says McCoy.

A distant second place: BVI

With around 20% of all hedge fund registrations, the BVI is a distant but pursuing second to Cayman Islands. Although the islands started out just over 10 years ago with slightly more domiciles registered than Cayman, it lost out to the quick introduction of hedge fund-friendly legislation by the CIMA.

Over the intervening years the BVI has made slow but steady progress. With the opening of all the major offshore legal services and three of the Big Four accountancy firms now established in the territory, the BVI Financial Services Commission (FSC) believes it is creating the critical mass needed to capture even more hedge fund business.

Bermuda continues to attract funds

Bermuda is the domicile for over 1,500 hedge fund and pooled fund vehicles. As the hedge fund industry continues to grow, the Bermuda Monetary Authority (BMA), responsible for approving mutual fund incorporations, says it is committed to both strong oversight and a sophisticated, flexible approach to fund regulation.

Bermuda's funds legislation is contained in the Investment Funds Act 2006. This outlines the registration and licensing process for retail and non-public (mainly hedge) funds. The island state has also adopted, as have other hedge fund offshore jurisdictions, rigorous anti-money laundering and know-your-client standards.

Bermuda's fund legislation has introduced a new class of funds, known as administered funds. With the introduction of licensing and regulation of administrators, it is now possible to register funds under this class with a fund administrator based in Bermuda.

Bermuda sees its competitive advantage in the depth of expertise of professionals, particularly fund administrators, based on the island. Many funds are choosing Bermudan fund administrators, claims the government. In addition the presence of brokers, custodians, auditors and legal professionals are considered another plus for the jurisdiction.

Bahamas still competitive

The Bahamas has long been a reputable jurisdiction for offshore banking. According to the Bahamas Financial Services Board (BFSB), the Bahamas administers the full spectrum of funds including equity, bonds, money market, fund of funds and hedge funds.

Wendy Warren, executive director and chief executive of the BFSB, says the jurisdiction offers a dual licensing regime. The Securities Commission of the Bahamas (SCB) is authorised to license all classes of funds, while unrestricted fund administrators may license professional and 'smart' (specific mandate alternative regulatory test) funds offered only to accredited investors.

Irrespective of the licensing procedure, the fund must adhere to the conditions of its founding documents and to Bahamian law, notably the Investment Funds Act and anti-money laundering legislation.

 "The 2003 Act established the 'smart' fund to offer industry participants the means to provide clients with innovative and flexible structuring solutions through a regulated vehicle, domiciled in a respected international financial centre. For example, funds that are essentially private vehicles can benefit from light supervision appropriate to their limited and specialised nature rather than undergo heavy-handed regulatory treatment," says Warren.

Templates approved by the regulator are used to register funds. "Using existing templates, promoters can have their funds licensed on the same day through an unrestricted fund administrator, allowing a fund to be marketed within 24 hours of company incorporation, due diligence and the completion of licensing procedures," adds Warren.

She says smart funds also offer a tool for seed capital to fund new strategies. Small groups of qualified investors such as a single or multi-family office can use smart funds to access leading managers while implementing estate-planning arrangements.

Regulation also extends to service providers. Funds domiciled in the Bahamas must have a Bahamian auditor and fund administrator, although certain functions can be delegated to a licensed service provider in another recognised jurisdiction.

Europe's attractions focus on Ireland

Ireland's regulatory developments continue to nurture innovation and growth, creating opportunities for the entire funds industry, says John Alshefski, senior vice-president and managing director of SEI's Investment Manager Services division. "The Ucits III directive has enabled managers to create new investment products and the convergence of investment strategies has led to product innovations such as 130/30 funds," he says.

The blurring of lines between alternative and traditional long-only strategies means managers need to rely on partners with broad expertise who have the infrastructure and technology in place to process these sophisticated new products.

"Side pockets have also become a hot topic this year and an industry submission for their use in qualified investor funds (QIFs) is with the [Irish] Financial Regulator. So far side pockets have been approved by the Financial Regulator on a case-by-case basis, which has been useful this year," he adds.

In addition to regulatory developments, the focus has been on fundamental valuation principles. From a fund administrator's perspective the early identification of valuation issues and the implementation of appropriate procedures to address any issues are important.

Ireland walks the tightrope well between acknowledging the commercial realities of setting up a business in Ireland and maintaining the integrity of an onshore domicile, according to Killian Buckley, partner at Kinetic Partners.

He says there are over 60 administrators in Dublin, from the large global asset-servicing companies to the mid-sized and smaller boutiques. A number of administrators have opened in Ireland recently.

An emerging trend in fund administration is the high level of consolidation in Dublin over the last two years, Buckley thinks. "This is shown where State Street bought Investors Banking Trust. We have also had new entrants: Apex came in the last 12 months; Mourant, who are established in other jurisdictions, set up in Dublin too. This consolidation has led to opportunities and challenges," he says.

"Dublin is very well placed for the more complex or hard-to-value strategies in the industry because there is a level of expertise built up in the fund industry over the last 15 years. The larger it gets, the more investors and managers become familiar with Dublin," believes Buckley.

The Financial Regulator, which grants licences to service Irish funds, is helpful, says Buckley. "It engages in dialogue with the administrator. It will point an administrator to the best manner to fill in application forms and will also make sure the policies an administrator has in place are robust, suitable and relevant," adds Buckley.

"It will also look carefully at the individuals involved in an executive and non-executive sense and it tends to pre-empt problems. It is not a full bed of roses and there have been capacity issues but that is a result of a mature jurisdiction. Dublin is working on that. For instance, there is a good pool of graduates in Ireland to cope with this," he says.

Malta is new kid on the block

The Maltese regulator, known as the Malta Financial Services Authority (MFSA), is continuously updating the legal and regulatory requirements so the EU member state can maintain its competitiveness in financial services and in particular in the hedge fund industry.

The MFSA recently issued a consultation document, Islamic Finance in Malta, to study the feasibility of introducing Shariah-compliant funds. This is of particular interest to the investors from the Arab world, says Mark De Marco, general manager of TMF Group in Malta.

He believes Malta's current legislation and regulations are particularly favourable with regard to establishing hedge funds in Malta. Hedge funds in Malta are usually established as professional investor funds (PIFs). "The MFSA regulates the setting up, registration and monitoring of all companies and service providers. Investment managers and fund administrators have to be approved and licensed by the MFSA," explains De Marco.

Luxembourg still dominates Europe

Luxembourg is a dominant jurisdiction in Europe for fund registration as it is a well-respected and well-known name in the offshore circles, says Gary Enos, executive vice-president and head of client strategy for State Street's alternative investment services business in the US.

"Luxembourg has held that position since the late 1980s and they continue to build on it. They have over 700 funds providing administration for Luxembourg-registered products. New money has been slow to come but I do not view that as a Luxembourg issue on its own. They have done what needs to be done but they just cannot control the market demands at the present time."

Channel Islands: Guernsey

In Guernsey, amendments to the Protection of Investors Law are expected to come into force in October. These propose a symmetrical system of fund authorisation and registration allowing for regulated funds and simplified registration in both the open- and closed-end funds, says Peter Neville, director general of the Guernsey Financial Services Commission (GFSC).

The GFSC has also begun consultation on rules covering prospectus, regulated closed-ended funds and registered open-ended and closed-ended funds.

Guernsey is also developing the qualified investor fund and registered fund regimes. These regimes guarantee short approval times for certain classes of fund. "We are discussing with local industry associations a fast-track process to allow more rapid licensing of related management companies where appropriate. We anticipate introducing the new licensing process later in September," he says.

The GFSC's approach to fund regulation has tended not to target specific subsets of the fund industry but rather to set regulations applicable to all funds.

Far East focused on Hong Kong

Hong Kong is home to more hedge fund assets than any other Asian city. In 2007 Hong Kong simplified its licensing requirements for overseas hedge fund managers looking to set up in the territory. Hong Kong's Securities and Futures Commission (SFC) said the changes include speeding up the licensing process for some US- and UK-registered hedge funds.

The SFC maintains a close dialogue with both local practitioners and regulators of other major financial markets and has been participating in the setting of international hedge fund regulation standards.

Hong Kong regulation primarily focuses on Hong Kong-based investment advisors that are subject to SFC licensing. Funds generally operate with private placement exemptions roughly comparable to the US, although in relatively limited circumstances Hong Kong does allow the registration of hedge funds for public offering, explains Keith Robinson, partner at Dechert in Hong Kong.

Robinson says if there were a move towards more regulation, regulators would probably take a lead from the US President's Working Group best practice recommendations. These recommendations will likely influence any future regulation of the hedge fund industry, Robinson thinks. The recommendations suggested a disclosure regime for hedge funds that was heavily modelled on US operating company reporting requirements.

The recommendations offer steps to improve market transparency and disclosure, risk awareness and risk management, capital management and regulatory policies and market infrastructure for products such as over-the-counter derivatives.

"A lot of these recommendations piggybacked on the regulatory regime that is applicable to registered advisors in the US. The recommendations are clearly designed for export and the investor-recommended practices were designed to reinforce best practice recommendations for investment advisors and fund managers," he says.

Robinson thinks with the increased globalisation of hedge fund business, it is almost inevitable that if the recommendations get traction, they will be adopted by jurisdictions outside the US.

"Generally, the industries in most Asian markets are a little less well developed, smaller and they tend to look to the UK and the US for guidance and best practices. It will impact in Hong Kong because when a big fund of hedge funds or other investor wants to invest in your fund, it will check implementation of best practice recommendations from the fund as part of the due diligence process," concludes Robinson.

US still leads the pack

It is generally accepted that the US 'invented' hedge funds and the rest of the world's jurisdictions have been playing catch-up ever since. Ian Headon, product manager alternative asset administration at Northern Trust, believes there is no agreed definition of a hedge fund in the US because they take many forms and legal personalities, have multiple investment strategies and investor bases and are exposed to varying degrees of tax and regulatory supervision.

This multiplicity of forms and rather lax regulation of the funds is, however, coming under closer scrutiny by officials. "We see a drive to quality in these uncertain economic conditions. We see investors demanding greater transparency, greater reporting of counterparty exposures, increased demands for clarity in the valuation process, more frequent reporting and a noticeable stepping-up in governance and control models," says Headon.

"Interestingly, we still encounter hedge funds in the US that self administer - in Europe this is almost unheard of - though we are seeing an increase in the trend to outsource, often driven by investor demand," he says. n

n Related articles: Throughout the year HFR has produced comprehensive reviews of a number of major hedge fund jurisdictions: Cayman Islands (April 2008), Malta (May 2008), Ireland (June 2008), Channel Islands (July 2008) and British Virgin Islands (October 2008). The Isle of Man (March 2008), Switzerland (August 2008) and Luxembourg (September 2008) were discussed in special reports. For a complete list of special reports, visit the HFR website (www.hedgefundsreview.com).

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