Against all odds
26 July 2010
Despite recent setbacks, Cayman’s funds industry is holding firm and proving to be a barometer for the industry as a whole. By Tania Dons
Fund launches in the Cayman Islands over the past year have revealed a number of key trends that are probably closely representative of the industry generally.
While Cayman’s funds industry has certainly taken a knock, as has the industry as a whole, we are not seeing the threatened drift away from Cayman to destinations such as Luxembourg and Dublin. Recent statistics from the Cayman Islands Monetary Authority (Cima) show that registered fund numbers are hovering at around 9,400, reflecting Cayman’s continuing market dominance. There are also thousands of private equity funds established in this jurisdiction. Accordingly, despite attacks on offshore centres, the attraction of Cayman is still strong - largely because setting up here is so simple: minimum red tape, service providers with a wealth of knowledge and experience and zero tax.
The key trends as witnessed from Cayman include:
- A buyer’s market: Managers are having to compete to attract investors and are finding fundraising difficult. This has meant a swing in the balance of power squarely towards the investor. Investors are demanding increased transparency, seeking assurances of better portfolio liquidity (and the matching of fund-level liquidity with portfolio liquidity) and conducting extensive due diligence on fund documents, custody arrangements and service providers. Investors are increasingly able to dictate terms in the fund documents prior to launch, or in side letters thereafter. This can lead to a longer lead-in time for fund launches as investors take time to review the documents and negotiate terms. The obvious impact on funds is an increase in costs.
- Structural and strategy changes: New funds are typically smaller, which is hardly surprising in the current market. There has been an increase in the use of managed accounts and single-investor funds for large institutional investors who can dictate terms and not have to compete for liquidity. However, the use of single-investor funds has not been as prevalent as was initially anticipated. The cost inefficiencies have probably made them unattractive to all but the most significant investors.
- Investors are favouring managed accounts. A popular structure is the segregated portfolio managed account platform or fund. This structure is designed so that each investor subscribes into a separate segregated portfolio of a Cayman segregated portfolio company (SPC), with each segregated portfolio then making direct investments or investing through a separate master fund. The investment of each member is ringfenced, but the incorporation and ongoing costs at the SPC level can be shared. Funds with investment strategies concentrating on distressed assets and emerging markets appear to be more prevalent.
- Fund documents: Legal advisers, investors and funds have learnt from the turmoil of the past two years and are taking the time to ensure that fund documentation is sufficiently flexible, clearly drafted and provides the tools and mechanisms necessary to deal with potential future problems. Some key amendments made to constitutional documents include: side pockets, gates, lock-ups and suspension and redemption payment terms are being scrutinised more rigorously; are being included in constitutional documents from the outset, where possible; or are being left out entirely under pressure to attract investors. Other amendments include provisions for the establishment of valuation committees, and more detailed provisions regarding payments in kind, including specific references to special purpose vehicles and/or liquidating trusts that may be established by the fund in the future for the purpose of liquidating investments.
- Fees: We have not seen the dramatic decrease in manager fees that some predicted back in 2008 and 2009. The previously standard 2 per cent management fee has experienced downward pressure so that 1.75 per cent and 1.5 per cent are now common. However, the standard 20 per cent performance compensation rate has generally held up.
Under pressure from investors, some managers are including clawback language in the fund documents so that the manager sets aside a portion of the incentive fees in a separate account that are subject to clawback, and if fund performance in a subsequent period is positive it can be released and paid to the manager. If it is negative, the clawback amount will be returned to the fund. Furthermore, some managers are taking compensation by way of allocation-class shares in the fund, aligning their interests to the continued success of the strategy. Managers are also trading lower fees for reduced liquidity (and vice-versa) to attract investors.
- Regulation: New regulation in the hedge funds industry remains something of an unknown quantity. However, adviser registration and increased reporting in the US and increased regulation in Europe is inevitable. Increased regulation will mean increased costs for funds. Offshore regulators such as Cima will likely take a lead from the form that regulation of funds and their managers in the major onshore jurisdictions eventually takes. The challenge will be for Cima and the Cayman government to increase regulation in Cayman to meet the new global standards, while continuing to apply the pragmatic approach to fund regulation that offshore regulators have evinced in the past.
The dominant theme that is presently driving trends in the hedge fund industry is the focus on liquidity. The investor is king and is able to dictate terms to a greater degree, leading to tighter liquidity and transparency terms in fund documents or side letters, different fund structures and fees aligned to the long-term performance of the fund. It is likely that these trends will have a positive impact on the industry, leaving us with a leaner but more successful, aware and efficient industry overall. n
Tania Dons is an associate at Conyers Dill & Pearman