Right at the front of the hedge fund race
Paul Scrivener outlines why the Cayman Islands continues to excel in a very competitive hedge fund world
In recent years, the Cayman Islands has become the overriding domicile of choice for hedge funds and other alternative investment funds. Out of an estimated total worldwide population of alternative investment funds of close to 10,000, it is estimated that 80 percent of those funds are domiciled in the Cayman Islands. As at June 2007, the total number of Cayman-regulated investment funds was almost 9,000, and this figure does not even include closed-end funds and exempted funds because these are not subject to regulation.
Why do so many onshore fund managers choose to set up their fund in the Cayman Islands? Paul Scrivener explains why and outlines the process involved in setting up a hedge fund in the Cayman Islands.
The dominance of the Cayman Islands in this respect is attributable principally to the political stability of the jurisdiction, the regulatory regime, and the depth and breadth of the professional service providers including, in particular, fund administrators, lawyers, accountants and independent directors. The Cayman regulatory regime is particularly suitable for fund managers because of an absence of prescriptive rules (e.g. rules that constrain investment policies or strategies, or restrict leveraging or investment concentration) that must be adhered to by the fund and its investment manager. Instead, there is an overriding obligation under the applicable legislation, the Mutual Funds Law (2007 Revision) (“the Mutual Funds Law”) of fair disclosure to investors. This disclosure-based approach towards investors is entirely appropriate bearing in mind that investors in the alternative investment funds arena are made up almost exclusively of highly sophisticated investors—typically, large institutions or high net worth individuals.
Under the Mutual Funds Law, Cayman funds are placed into categories, with the dominant category being “registered funds”, the category aimed at sophisticated investors. Most registered funds must have an initial minimum subscription of at least US$100,000 (there is an exception for funds established prior to 14 November 2006, where a lower threshold of US$50,000 is still permissible, and for stock exchange listed funds). As at June 2007, Cayman registered funds totalled 8,300, accounting for in excess of 92 percent of all regulated Cayman investment funds and thereby underlining that the investor base in Cayman funds is almost exclusively made up of sophisticated investors. For most Cayman registered funds, the initial minimum subscription is significantly in excess of the US$100,000 minimum threshold mandated under the Mutual Funds Law, and it is not uncommon to find Cayman funds that have a minimum subscription in the seven figure range.
Unless there are onshore tax or regulatory reasons, or other commercial reasons why a fund should be structured as a partnership or a unit trust, a Cayman fund will invariably be established as a Cayman Islands company. This contrasts with US domestic hedge funds, which are typically established as limited partnerships with the investment manager usually acting as the general partner and the investors in the fund being the limited partners. In the Cayman Islands, the corporate structure of the fund means that the fund will have a board of directors. Therefore, rather than the investment manager being an intrinsic part of the vehicle as they would be if they were the general partner of a US domestic hedge fund, the investment manager of a Cayman fund will, strictly speaking, be a service provider to the fund under the terms of an investment management agreement. Whilst this is theoretically the case, obviously in commercial terms, the investment manager is still very much the centre piece of the action.
Tried and tested
Frequently, a hedge fund manager looking to set up an offshore fund will be guided towards the Cayman Islands by their onshore advisers. Onshore advisers have various reasons for choosing Cayman. At the top of the list is the fact that Cayman is tried and tested in the alternative investments arena. The process will be time-efficient and cost-effective. As touched on above, the regulatory regime is proportionate and ideally suited to hedge funds, with an emphasis on disclosure rather than regulatory restrictions. The service providers have a wealth of experience and a ‘can do’ approach to business.
An important aspect for any hedge fund manager is to ensure that the establishment of the fund is dealt with properly and on a timely basis. Onshore counsel, Cayman counsel, the fund’s directors, the fund’s administrator and the auditors all have important input at the set-up stage, but in most cases, onshore counsel and Cayman counsel will have the lead role.
Onshore counsel will outline the key features of the proposed fund, covering structuring, investment objective, target investors, likely size of the fund, liquidity, minimum subscriptions, tax issues and so on. Cayman counsel will invest time at the beginning to gain a clear understanding of the proposed fund and the manager’s objectives and aspirations. Onshore counsel and Cayman counsel will agree responsibility for document preparation and a timetable. The offering memorandum is typically prepared by onshore counsel and then reviewed by Cayman counsel. In cases where the fund manager has not engaged onshore counsel, Cayman counsel will draft the offering memorandum.
Timing is usually at the forefront of the fund manager’s mind. The manager will frequently have investors lined up before they have even considered the domicile of the fund. Therefore, frequently, there is considerable time pressure to get the fund up and running. Cayman service providers are used to this and, with full commitment to the process from all involved, a Cayman fund is frequently launched within four to six weeks. This rapid turnaround time has been a major factor in the huge growth Cayman has experienced in the hedge funds arena. The timeframe is assisted by the speed with which the fund vehicle can be incorporated (usually within 24 hours of all paperwork being in place) and then registered with the Cayman regulator, the Monetary Authority (the registration certificate is normally issued within three or four business days of filing the registration particulars).
A Cayman-regulated fund is required to appoint a Cayman-based audit firm and, depending on the time zone of the fund manager and/or the investors, will often appoint a Cayman-based administrator. Cayman domiciled directors of the fund may also be appointed to bring independence to the management structure.
Rapid turnaround
How do things typically unfold? At the outset, it is important to decide whether the fund falls within the regulation of the Cayman Islands Mutual Funds Law and, if so, its categorisation under that Law. A traditional open-ended hedge fund will be regulated and will not require a licence, but instead, will merely need to register certain particulars with the Monetary Authority. The Mutual Funds Law contains a general statutory requirement that the offering document must describe the securities being offered in all material respects and contain such other information as is necessary to enable a prospective investor to make an informed decision about whether or not to invest. Cayman counsel will review the draft against this yardstick. The proposed directors, administrator and auditors will also need to review the draft and, in most cases, the document will go through several drafts before it is in final form.
In parallel with the preparation of the offering memorandum, the fund manager will negotiate terms with the prime broker, auditors and administrators, decide with onshore counsel whether separate vehicles (whether onshore or offshore) should be established to act as the investment manager and the investment adviser to the fund, speak to potential investors, prepare their due diligence information for the onshore and offshore service providers, keep on top of the various drafts of the offering document and, possibly, still try to run their existing onshore fund! The time commitment required of the manager should not be underestimated.
The lawyers will progress the other principal documents—the constitutional documents for the fund (memorandum and articles of association, limited partnership agreement or trust deed, depending on the type of fund vehicle), and investment management, investment advisory, administration and prime broker/custodian agreements.
These four to six weeks will be a period of sustained activity and commitment. Efficiency and good organisational skills are essential. Approximately one week before launch, the various documents will come together in final form, the fund vehicle will be set up, organisational formalities will be taken care of and the documents will be signed. It will merely remain for Cayman counsel to file registration particulars and supporting documents with the Monetary Authority. Once the fund registration certificate is received from the Monetary Authority, the fund manager may begin receiving subscriptions and trading the fund, at which point, the fund manager will have a properly structured vehicle established in a significantly shorter time and more cost-efficiently than would be possible in virtually any other reputable jurisdiction.
A number of other jurisdictions eye with envy the dominance that the Cayman Islands has achieved in the global hedge fund industry and have taken steps to make their jurisdictions more attractive to hedge fund managers. Clearly, the Cayman Islands must not be complacent in any way, but certainly for now, it remains the lead jurisdiction by a very considerable margin.
Paul Scrivener is joint head of the investment funds group at Cayman Islands commercial law firm, Solomon Harris. Click here to email Paul.