Outlook for offshore-registered hedge funds in 2011
February 2011 | TALKINGPOINT | INVESTMENT FUNDS
FW moderates a discussion between Tanis McDonald at KPMG, Paul Govier at Maples and Calder, and Nick Rogers at Ogier, on the outlook for offshore-registered hedge funds.
FW: How would you characterise the relationship between fund managers and investors? Has there been a shift in power, perhaps reflected in fund terms and documentation?
Rogers: The hedge fund industry has clearly been a buyers’ market since 2008. Managers are having to respond to investor demands and sensitivities to attract new money. With net profits down or still below high-water marks, managers have been more reliant on management fees, so boosting AUM is not just desirable but necessary. As always, the main pressure points in fund documents are in relation to fee levels and liquidity. The most striking thing, however, is that there has been no widespread investor rebellion against the concepts of gating and suspension. Sophisticated investors seem to have recognised that, with a few notable exceptions, suspensions put in place in 2008 Q4 and 2009 did actually do what they were meant to do by preserving value and equalising treatment of investors. So suspension seems to have been accepted as a necessary evil, and the focus in drafting fund documentation has been on defining the scope of the fund’s discretion.
Govier: At the risk of stating the obvious, the relationship between manager and investor varies depending on the nature of the manager and the nature of the investor. There are very different approaches on both sides of the dynamic and the shift in power, if any, is not always readily apparent. Having said that, if one was to generalise then it would be to acknowledge that investors have become more demanding of hedge fund managers. It seems to me that there are two key drivers behind the change. Firstly, although the hedge fund industry generally outperformed the wider market during the financial crisis and few actually restricted liquidity, the negative experience of the few has informed the perspective of the many. As a result, investor due diligence has been enhanced, including in relation to fund terms which are now examined more closely. Second, the scarcity of capital has allowed investors, following on from their due diligence, to seek to negotiate terms that cause them concern and, generally speaking, the manager is more willing to enter into that discussion if the investor is to be a key investor.
McDonald: Up until four years ago, fund managers believed that performance was the number one priority for investors. Not surprisingly priorities have changed in recent years following the market crisis and financial scandals. In order to be successful, fund managers are now concentrating on client service and reacting to the demands of investors. The impact of investor demands on fund managers has been pervasive, ranging from downward fee pressures to improvements in communication, transparency of strategies and risk exposure, capital investment to illustrate their commitment to their product, and to investment in robust due diligence processes and systems.
FW: What changes, if any, have you seen in fund types and structures being adopted recently by offshore hedge fund managers?
Govier: We have not seen a major change in the structure of a classic hedge fund. The problems encountered by hedge funds during the crisis were problems of liquidity, not systemic problems in the structure of the funds themselves. That is perhaps reflected in the relative paucity of litigation in the aftermath of the crisis. In fact, even though managers’ AUM and funds’ NAV may have suffered, the structure itself withstood the rigours of the crisis remarkably well. Having said that, we have seen an increase in demand for more bespoke products and products with specific liquidity profiles. But again, while the terms of the fund may be bespoke, the structure itself tends to follow the tried and tested path.
McDonald: In addition to managed account platforms, fund managers are focusing on single strategy hedge funds and private equity funds. Fund managers expect the latter products to achieve the largest returns. Managed account structures have experienced recent growth because they provide investors with greater transparency, liquidity and operational advantages. Fund of funds, on the other hand, are not as popular as they once were. Many fund of funds did not have a good market crisis. Finally, as investors regain confidence in the sector, it is expected that they will begin to search for more innovative products, with a return to structured products and other investments such as wine or art funds.
Rogers: If there was one positive that came out of the financial crisis, it was that it proved the validity and robustness of the hedge fund model. So we have seen no significant changes in the overall types and structures of offshore hedge funds favoured by managers or investors. There has been an increase in the number of single-investor vehicles set up for sovereign wealth funds. More generally, the financial crisis shone an even brighter spotlight on liquidity, and this has come through into fund structures with more sophisticated and flexible side-pocket provisions, refined suspension provisions and investor level gates.
FW: Given that some offshore tax structures have come under fire in recent months, what effect, if any, would you expect there to be on offshore hedge funds?
McDonald: Regulation, driven by onshore politicians and regulators that continue to blame the offshore centres for the meltdown of the global financial system, is not wanted by the majority of investors, managers or service providers. The widely held view is that the industry did not cause or contribute to the market crisis. Nonetheless, fund managers recognise that they cannot escape from the increase in financial regulatory supervision occurring around the world, whether it is the EU AIFM Directive, the US Dodd-Frank Act or the Foreign Account Tax Compliance Act. Generally, it is widely feared that the growing regulatory burden will deter start-ups, given the extra costs. Our experience to date is running contrary to this fear. The recent changes in regulation have not had a significant initial impact on offshore jurisdictions.
Rogers: I don’t think that the onshore focus on increasing tax revenues has any bearing on hedge funds. Hedge funds are not formed or promoted as ‘tax structures’. Hedge funds are set up in offshore jurisdictions because such jurisdictions provide a level playing field for international investors, because of the targeted and easily understood regulation in such jurisdictions, and because establishing the fund in an offshore jurisdiction eliminates a third layer of taxes, that is, taxation of the fund vehicle itself. Offshore hedge funds remain subject to taxation on their investment activities in the onshore jurisdictions in which they trade. In addition, investors in hedge funds will be subject to taxation under the laws of their home jurisdiction.
Govier: It is perhaps not unexpected that in the wake of the near meltdown of the financial system, offshore centres should be subject to scrutiny as part of the wider investigation into what went wrong. On the whole we have found that the more progressive offshore jurisdictions such as the Cayman Islands and the British Virgin Islands, with long track records of international regulatory compliance and commercial success, have withstood such scrutiny very well. Detractors developed an understanding of what such centres do and how, ultimately, they are beneficial to the broader financial market. That is not to say that there has not been an increased drive for regulated products by certain investors, reflected, for example, in the growth in ‘UCITs’ hedge funds. But that growth is driven by different factors: first, that the target investor is not a typical hedge fund investor but rather requires a more regulated vehicle that approximates a classic hedge fund; and second, that the investor is focused on liquidity and prefers the mandated liquidity of, say, a UCITs fund to the liquidity premium available in less liquid strategies. Offshore and onshore happily co-exist. One will not replace the other as they achieve different things for different investors.
FW: To what extent are funds re-domiciling either into or away from offshore jurisdictions? Do you expect this to change over the year ahead?
Rogers: The notion that there is some sort of stampede to redomicile onshore is a fabrication. We have seen minimal evidence of migration from Cayman, the BVI, Jersey and Guernsey. This makes perfect sense. The products for which onshore and offshore jurisdictions are each best suited are quite different. The offshore jurisdictions cater principally to funds aimed at institutional and HNW investors who don’t need the comfort blanket of prescriptive regulation. Onshore jurisdictions are better set up for retail investors. For the huge majority of managers who do not offer products to both retail and institutional investors, the choice remains binary. There will only be a wave of migrations in either direction if the products available have similar risk/reward characteristics and there is some other collateral benefit.
McDonald: Historically, the alternative investment industry and offshore jurisdictions have been synonymous. From a traditional investor perspective, there is no evidence that domiciliation is of concern. However, a combination of investor tension and the changing regulatory environment have led fund managers to question whether they should continue to domicile their funds offshore or re-domicile onshore. So for the next wave of investors, a different strategy looks likely to be beneficial to secure such investors’ capital. Accordingly some fund managers have launched funds in onshore locations, such as Dublin, whilst keeping their offshore funds in operation for the traditional investors.
Govier: We have not seen that there is any meaningful trend of redomiciliation away from offshore jurisdictions to onshore jurisdictions. There are definitely certain managers who for their own reasons may find that an onshore product better serves their purpose than an offshore product. However, the classic hedge fund manager in New York or London or Hong Kong, running a Cayman or BVI fund and seeking to attract investors from around the globe, is not moving their fund to an onshore jurisdiction. Instead, if they have particular investors who require them to have an onshore product they are establishing a parallel fund for those investors and maintaining their classic fund for their usual target investor base.
FW: Some major regulatory changes look set to affect the offshore hedge funds industry going forward. What are your thoughts on the potential impact of the US Dodd-Frank Act?
Govier: Our analysis is that it will have minimal impact on offshore funds, other than perhaps to note the increase in work flows created by spin-offs from investment banks as a result of the Volcker rule.
Rogers: The Dodd-Frank Act is such a wide-ranging piece of legislation that it is inevitable it will have some sort of impact on the offshore funds industry. However, many of the effects will be invisible to investors and the structure and practice of the funds themselves will remain largely unchanged. The onus in respect of most of the provisions relevant to offshore funds falls on the US managers themselves.
McDonald: The passage of the Dodd-Frank Act, and its provisions for adviser registration, regulation of derivatives, the so-called Volcker Rule, and the regulation of entities for systemic risk purposes, will profoundly affect the investment management industry. In particular, the Volcker Rule prohibits banks from engaging in proprietary trading and from investing in or sponsoring a hedge fund or private equity fund. The impact of the ban will likely be considerable for the offshore investment industry, as talent migrates. In their search for new capital, proprietary traders and managers of bank owned or sponsored hedge funds or private equity funds are expected to move to offshore structures.
FW: What issues do you expect to arise from the European AIFM Directive?
McDonald: After many long months of lobbying, there is a sense of relief that the EU AIFM Directive was finally approved by the EU Council of Ministers on 17 November 2010. However, the reality is that the most important stages of the directive’s development still lie ahead. There is considerable potential for the large volume of Level 2 measures to have a fundamental impact on how this directive is interpreted and applied by the EU Member States. For existing funds, there is time to conduct the necessary reviews and consider the implications. For fund managers launching new funds, careful consideration will need to be given to their target investors.
Govier: The key point, for now, is that the risk that EU investors would be prevented from accessing some of the best hedge funds worldwide has been averted. Non-EU managers and non-EU funds will be able to access EU investors until at least 2018 using the National Private Placement Regimes. If the passport regime is made available to Third Countries in 2015, then that will only enhance the ability of those funds and managers to attract EU investors. At the same time, EU managers focused on distribution in the EU may well consider setting up an EU fund to allow them to access the passport from 2013. In those cases, places such as Ireland should benefit in providing a European offering to complement the European manager’s existing offshore products.
Rogers: The AIFM Directive will rumble on in the background in the year ahead without leading to any actual changes in practice. It is positive for the industry that the Directive has been agreed, and that it contains no nuclear material. The details of the Third Country provisions still need to be developed, but it seems clear that managers and funds domiciled in the leading Channel Islands and Caribbean jurisdictions will have little difficulty in satisfying the proposed requirements once they come into effect. This will help managers and their advisers have continued confidence in setting up new structures using the traditional well-tested jurisdictions. Issues to monitor will be details of how Third Countries satisfy the regulatory cooperation requirements; and whether some of the more protectionist EU Member States start to quietly adopt a more restrictive approach when applying the existing private placement regimes that will initially apply to non-EU funds.
FW: Do you expect reporting and disclosure requirements to increase for offshore hedge funds, forcing them to reveal more about their methods and operations?
McDonald: There is no doubt that fund managers have to significantly improve transparency if they want to be successful in today’s environment. The simplification of fund information and enhancement of reporting mechanisms has proven to be difficult to achieve. As a first step, fund managers are improving transparency by re-engineering the processes for creating marketing materials, client reports, disclosures and financial statements. Fund managers are also engaging third party risk evaluation and reporting on their portfolio investments, increasing the frequency of NAV calculations, more frequent investor calls and meetings, and, on an individual investor level, specific reporting and disclosure.
Rogers: A move towards greater transparency and disclosure is in step with the regulatory zeitgeist, and you see this reflected in both the Dodd-Frank Act and the AIFM Directive. Even if one is cynical about the efficacy of this, the aim of allowing regulators to identify and defuse systemic risk is admirable. But the important, if obvious, point to note is that in both cases the reporting and disclosure is to be made to the relevant regulators. There are provisions – and international cooperation agreements – that permit the regulators to share such information with their counterparts in other agencies and jurisdictions; but even in this era of heightened transparency, we see no drive to mandate offshore funds to make proprietary information available to investors or the wider public.
Govier: I think increased reporting and disclosure requirements are a global trend rather than one specific to offshore funds. The key is to ensure that the right type of information is being disclosed and that it is able to be used effectively and appropriately by the person receiving it. In the case of regulators, that means that the information is designed to help the regulator assess possible systemic risk across the market or to ensure that investors are protected. In the case of investors, that means an understanding of what the manager is trying to achieve, rather than second guessing their strategy.
FW: In your experience, what internal governance and risk management issues are offshore hedge fund managers looking to address? What considerations do they need to make on this front?
Rogers: The vast majority of managers of offshore hedge funds have been switched on about the importance of a strong governance and risk management culture for years. It is incredibly unusual for us to deal with funds that don’t have an independent administrator calculating NAV and doing anti-money laundering checks on investors; non-affiliated directors on the board – normally constituting the majority; household names acting as brokers and auditors; and experienced in-house compliance and administrative staff. So although we continue to assist managers to refine their processes, overhauls are rarely required these days.
Govier: One of the trends we are seeing is a renewed focus on the quality of independent boards of directors of funds. The days of the manager controlling the board or asking for a ‘piña colada’ director are long gone. Investors require credible, professional individuals of standing to be appointed to boards; people who they trust will protect the interests of the fund and its shareholders. Equally, managers need board members who understand the challenges of managing a fund and can balance the interests of the various stakeholders appropriately. We are also seeing an increased compliance responsibility fall on the manager and, in particular, their legal team, with the role of general counsel expanding to encompass a broader compliance function. That has also translated into a demand for outsourced compliance capability in the offshore market, something the larger more established players are able to provide.
McDonald: Investors are driving the impetus for change within fund managers. Both existing and prospective investors want clear and transparent operational oversight. This has led fund managers to invest internally in robust systems, to carefully choose their fund’s third party service providers, and to evaluate those service providers on a regular ongoing basis. It has become essential to have organisations listed on the fund’s prospectus that reassure investors. Service provider name recognition is becoming paramount. Once chosen, due diligence of service providers, fund administrators in particular, has become a lot more intrusive and regular. There has also been a trend for enhanced internal governance through appointment of audit committees and investment committees.
FW: What trends do you expect to emerge for offshore hedge funds industry during 2011?
Govier: In the short term I think the aftershocks from the financial crisis will mean that we will continue to see a preference for larger, more established players – whether that is the fund managers, lawyers, accountants, prime brokers and so on. However, as time goes by, it will be interesting to see if some of the more successful strategies are sufficiently scalable to maintain their historic performance levels. I also think we will continue to see increased scrutiny by regulators and interaction with investors, leading to more bespoke products which require innovative thinking and experience on the part of advisers in order to design a product that meets both the managers’ and investors’ requirements. Finally, I think we will continue to see growth in the traditional centres for the establishment of hedge funds, tried and tested centres such as the Cayman Islands and the British Virgin Islands. But I think that growth will be complemented by growth in places such as Ireland, which are able to offer products that are not available offshore and which can complement a managers’ existing suite of funds while targeting different types of investors.
McDonald: Regulation and governance are some of the most important trends, and challenges, that the industry will face over the next few years. Though this is clear, and despite regulation being widely promoted as a way to protect the investor, it is the investors who are most strongly against it. According to our research, few investors believe it will produce any tangible benefits. Some see it as being protectionist to certain jurisdictions and therefore detrimental to the development of the global investment industry, and others fear that it will inhibit the competitive positioning of fund managers by adding to costs. Care needs to be given to ensure that anticipated economic growth and vitality are not stifled by regulation.
Rogers: Early indications are that it is going to be another tough year for the markets and this will inevitably have an impact on how existing funds and managers operate. But as investors’ confidence in the relative solidity and stability in the markets increases, we expect allocations to hedge funds to grow. Quite a few enhancements have been made to standard fund documents in the last 18 months so we don’t expect any striking changes to the conventional offshore hedge fund structures or documentation in 2011. We expect consistent growth in new fund formation, which should take the number of funds to an all-time high – though the rate of growth is certainly expected to be lower than the pre-crisis pace.
Tanis McDonald is a director of KPMG (BVI) Limited. Over the past 10 years with KPMG, she has lived and worked in the Cayman Islands, London, and currently the British Virgin Islands. She has led audit engagements for a range of offshore financial services related clients, including fund managers, hedge funds, real estate and private equity funds, and structured products. She can be contacted on +1 284 494 1134 or by email: firstname.lastname@example.org.
Paul Govier is the joint managing partner and head of the investment funds group of Maples and Calder in London. He specialises in the establishment and maintenance of private equity funds, hedge funds, CFOs in London and fund-linked products, advising a range of investment managers, intermediaries and financial institutions. Mr Govier is named as a leading private funds lawyer in The International Who's Who of Private Funds Lawyers 2011 and is recommended in the 2011 PLC Which Lawyer? Yearbook. He can be contacted on +44 (0)207 466 1631 or by email: email@example.com.
Nick Rogers is a partner at Ogier. He advises on a wide range of corporate matters with a focus on hedge fund and private equity fund formation, joint ventures, acquisitions, and venture capital financing transactions. Mr Rogers can be contacted on +1 345 815 1844 or by email: firstname.lastname@example.org.
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