At the outset, it is important to put Cayman hedge funds in their global context. At the height of the 2008/2009 financial crisis, hedge funds were frequently mischaracterised by politicians in many of the G20 countries as the cause of the crisis, rather than the victim of it, so as to deflect attention away from clear inadequacies in regulatory oversight in their own countries. At the time, many wondered whether hedge funds would survive the negative publicity. However, as we, hopefully, begin to emerge from the worst recession in 80 years, hedge funds are demonstrating that they still have a major role to play in the global financial services industry. In February, it was reported that the Dow Jones Credit Suisse Hedge Fund Index showed hedge funds up 10.95 percent for 2010 after posting positive performance for 7 out of 12 months. In the final quarter of 2010, estimated inflows reached $8.5 billion, bringing overall inflows for the year to $22.6 billion, the largest annual inflow since 2007. For many years the Cayman Islands has been the overwhelming domicile of choice for hedge funds. Has anything changed?
Statistics from the Cayman Islands Monetary Authority (CIMA) at December 31, 2010 show 9,438 regulated funds. Taking into account the very slow growth in new fund formations during the time of the crisis, coupled with a very significant number of terminations, this figure is a very healthy one. It is important to remember that Cayman’s large number of closed-ended funds do not even feature in these numbers. The all-time high-water mark of Cayman regulated funds was 10,200 in 2008. In October 2010, CIMA reported that the yearly month-on-month average for new fund registrations was at 105 per month, demonstrating the continuing confidence among managers in the Cayman product and the general resilience of Cayman’s hedge fund industry. This growth reflects the new vitality in fund formation that we saw in the latter part of 2010 and this has continued in 2011.
Nevertheless, behind the statistics, no one connected with the industry in Cayman would suggest that it is simply business as usual again and that we are back to the heady days prior to the crisis. Funds now tend to have a much longer gestation period and, in many cases, the seed capital is much lower than used to be the case. The industry continues to evolve. The changes arise in a number of different ways.
Investor requirements have certainly changed post-crisis. While some predictions of a major shift in the balance of power from manager to investor have not generally materialised, many investors; principally institutional investors, have exercised their muscle to require increased due diligence and greater access to trading information. Most managers, anxious to raise new capital, have had little choice but to meet these requirements. There was much talk of potential restructuring of the traditional 2%/20% fees model, but in our experience, this has not been as prevalent as had been predicted. It is true that there has been downward pressure on management fees, with some now in the range of 1% to 2%, but for the most part, performance fees have remained at 20%, subject, typically, to hurdle rates and high-water marks. Gates and lock-ups, whether hard or soft, have also tended to remain, although managers that abused these provisions to restrict liquidity at the height of the crisis have either gone from the industry altogether or been forced to adopt a more flexible approach.
Investors have much greater expectations these days with regard to corporate governance of the funds in which they invest. No longer is it simply a case of backing a ‘best of breed’ manager and relegating the operational structure low down the list of priorities. Most start-up funds these days have at least one independent director on the board, and frequently the independent directors will be located offshore in jurisdictions such as the Cayman Islands. There is a strong pool of talent among Cayman’s growing body of professional directors, with the Cayman Islands Directors Association numbering some 180 members. The increasing focus on corporate governance has led CIMA to work on a corporate governance policy review, and at the time of writing this article, it remains to be seen what will emerge. However, some observers believe that the thorny issue of number of directorships will resurface and there may be a call again for details of directors to be made public via an electronic database.
In the recent past, the greater focus for Cayman’s hedge fund industry has been post-crisis regulatory developments onshore. The most prominent was the EU AIFM Directive. As draft after draft of the directive emerged over many months, considerable time and energy was devoted to what it would ultimately mean for Cayman funds. While European fund business is not as significant to the Cayman Islands as that from North America, the greatest concern was that Cayman funds might ultimately be closed off to European investors. The biggest difficulty was the uncertainty over the shape the directive would finally take. Consequently, many managers looking to set up new funds fell into ‘analysis paralysis’, unsure whether to go with the tried and tested Cayman product or look to an onshore UCITS offering. As we now know, the final text of the directive was approved by the EU Parliament in November 2010. The general consensus is that the directive should not pose a threat to Cayman’s traditional offering. The private placement regime will continue for some time and Cayman already ticks many of the boxes that should enable it to meet this regime. There is further work to do, particularly with regard to transparency requirements, but a CIMA/private-sector committee is working diligently to ensure that all bases are covered. CIMA is actively engaged with the EU and, in January of this year, submitted a response paper to the ESMA’s request for input on implementation strategy.
Partly driven by the AIFM Directive and partly by the increasing profile given in the financial media to UCITS funds, there was onshore speculation that so far as Europe was concerned, the Cayman offering would ultimately be eclipsed by the UCITS product, most likely the Irish PIF or QIF. This was further fuelled for a period by pro-Irish/anti-Cayman media comments by a number of Irish service providers and the Irish Government introducing legislation to facilitate offshore funds to move onshore to Ireland. If the media were to be believed, funds were leaving Cayman in their droves. In reality, only six Cayman funds redomiciled and what was actually happening was that some larger managers with a European focus were setting up UCITS as largely retail versions of their traditional Cayman products, rather than replacing their Cayman products. The regulatory constraints, which lead to a drag on performance and increased costs, did not make it practicable or desirable to go UCITS only, and the UCITS product would never have been suitable for the smaller start-up manager.
The regulatory challenges on the US side came in the form of the Dodd-Frank Act, including the registration requirement for most hedge fund advisors, and perhaps even more significantly from Cayman’s perspective, the Foreign Account Tax Compliance Act. The potential impact of FACTA dawned gradually, but it is clearly going to have a major operational impact on Cayman hedge funds that are engaged with the US because of the need to identify any ultimate investors who are US persons and enter into information exchange agreements with the IRS. As always, the devil is in the detail, and the Cayman industry continues to scrutinise this carefully as more colour emerges. However, one of the positive aspects that we have seen come out of the Dodd-Frank Act is the emergence of a new wave of start-up managers, as investment banks shed their proprietary trading desks in response to the Volcker Rule.
With the challenges facing Cayman, it becomes even more important that, on the global stage, Cayman continues to make great strides in demonstrating that it adheres to the highest international standards. In this regard, Cayman has had a good deal of success of late. In the final quarter of 2010, the OECD, based upon a qualitative review, recognised that Cayman’s legal and regulatory regime complied with international standards for transparency and exchange of tax information. No doubt, Cayman’s commitment to the signing of tax information exchange agreements - now numbering 25 -was an important factor in the OECD’s decision. Adding to recognition previously given by the IMF and IOSCO, the positive review from the OECD can only assist in demonstrating to both fund managers and investors that Cayman is the natural funds domicile, free of reputational risk.
It is also fair to say that Cayman’s private sector has been getting an awful lot better at delivering a clear and consistent message about what Cayman has to offer, which was not always the case in the past. The continuing efforts of Cayman Finance and the Cayman Chapter of AIMA as well as the recently formed Cayman Chapter of New York-based Hedge Fund Association will continue to be important in this regard.
Interesting times indeed and inevitably the challenges will continue to come. However , whether you are speaking to informed, independent observers in North America, Europe, Brazil or Hong Kong, the resounding message we hear is that Cayman remains the global domicile centre for hedge funds and shows no signs of slipping from a position that it has worked so hard to achieve.
Paul Scrivener is a partner with Cayman Islands commercial law firm, Solomon Harris, where he heads the corporate/commercial group and the funds group. Scrivener was formerly a partner with international law firm, Eversheds and has practised corporate/commercial law for more than 26 years both in the UK and the Cayman Islands. His main areas of focus are hedge funds, captive insurance and mergers and acquisitions.
Jonathan Fitzgibbons is a partner with Solomon Harris’s corporate/commercial group and funds group. Originally from New Zealand, Fitzgibbons has been in private practice for more than 10 years, with more than four years of his experience practising in the Cayman Islands. He specialises in corporate and commercial matters and investment funds.