Offshore: Cayman Islands

With more than 80 per cent of the world’s 8,000-plus hedge funds registered with the Cayman Islands Monetary Authority (Cima), 2004 saw a sizeable increase in investments by institutional and high-net-worth investors in US debt and equity markets carried out through Cayman-based investment funds.

And if the first quarter of 2005 is any indication, this year is on track to set another record. Indeed, the number of hedge funds registered with Cima showed an increase of approximately 23 per cent from those registered in the first quarter of 2004. The rate of hedge fund formation continues in Cayman at a rapid rate, owing largely to an array of advantages that the jurisdiction offers to investors.

Specifically, Cayman provides hedge funds with a no-tax jurisdiction, a sophisticated financial infrastructure that includes major banks and accounting firms, and therefore the ability to achieve measurable savings, which are then passed along to investors. As a result, Cayman has quickly developed as the pre-eminent jurisdiction for the offshore alternative investment industry.

Growth of the Asian marketThe Asian market will continue to be a target both from a marketing perspective for existing hedge funds and from a strategic perspective for many new hedge and private equity funds formed to leverage emerging markets, such as China and South Korea. In recent years, Asian hedge funds have grown from 162 funds managing $13.8bn (£7.6bn) in 1999 to more than 500 funds managing in excess of $59bn (£32.5bn) at the end of 2004. Cayman is a particularly attractive jurisdiction for Asia-focused hedge funds because the regulatory and legal framework mandates transparency and disclosure – a critical need for institutional investors and high-net-worth individuals – over and above even what the US currently requires.

Japanese investments in Caribbean-based hedge funds, especially those in Cayman, increased 150 per cent in 2004 from the previous year. And, as is often the case, with this rise in the total investment level, fund flows into the US markets have increased as well, in this case by an estimated rate of 50 per cent per year.

Another example of rising Asian interest in hedge funds was the creation of the first hedge fund in which a Chinese securities firm played a role. Walkers served as legal adviser in the creation of the AAM China Fund, a long-short hedge fund dedicated to investments in mainland China and started by Guangzhou-based GF Securities and Hong Kong’s Apex Asset Management.

China, already tagged as the next super-power, provides a wide range of investment opportunities for private equity funds and hedge funds. It is widely anticipated that additional funds will be formed in order to capitalise on the growing development leading up to China’s coming-out party with the 2008 Olympics.

Merger of hedge and private equity strategiesPerhaps it has been the recent lacklustre performance of the US stock market, or the attention received by some of the top private equity houses as they outperform many of the hedge funds, but whatever the reason, increasing numbers of hedge funds are employing private equity strategies and acquiring illiquid securities. The hedge funds create a class of shares known as ‘side pockets’ and the investors share proportionately in the illiquid investments, only receiving a return on the side pocket shares when the underlying illiquid investment is realised.

Indeed, the recent trend has been that an increasing number of funds are marketing these side pockets as an integral part of the fund’s strategy, allocating up to 30 per cent of capital to illiquid investments. As many of these funds raise capital in excess of $1bn (£550m), that can provide the investment manager with a hefty war chest for leveraged buyout (LBO) deals in direct competition with the traditional private equity houses. Consequently, the hedge fund managers are also headhunting the experts from the private equity houses to manage these portfolios. However, as private equity houses continue to envy how easily some hedge fund managers can raise capital, some have recently announced their intention to launch hedge funds in direct competition with those of their counterparts.

There is no doubt more to be seen on this front and the remainder of 2005 will in all likelihood help to clarify the future roles and responsibilities of the respective players.

Hedge fund compliance officersThe Securities and Exchange Commission (SEC) recently published the text of the new Rule 203(b)(3)-2 (new Rule 203) and amendments to existing rules, adopted on 26 October 2004, which will require advisers of hedge funds and other certain private investment pools to register with the SEC under the Investment Advisers Act of 1940 by 1 February 2006. The new registration provision will apply only to those advisers whose hedge funds accept new money on or after 1 February 2006, from new investors or from those already in the fund, and then only if the new money is not subject thereafter to a two-year lockup. However, advisers not resident in the US may also be required to register under the new Rule 203.

US law firms have been working, and will continue to work, furiously over the next year to prepare their clients for SEC registration and regulation.

One little-noticed byproduct of this new regulatory mandate is the increase in the number of senior funds attorneys leaving private practice for lucrative positions as general counsel and compliance officers of the investment managers, which are now required to employ senior managers in this role. And while there are a number of views as to the SEC’s decision to rein in hedge fund managers under its watchful eye, there is no question that, as a result, the hedge fund industry will become more sophisticated and transparent.

Private equity formation on the increasePrivate equity fund formation continues to be very strong, and Cayman leads the way as the preferred jurisdiction for offshore fund formation. Most of the US private equity houses have recently launched, or are in the process of launching, their successor funds for the next five to seven-year term. Moreover, these private equity funds appear to be getting bigger, as illustrated by Goldman Sachs’ recent launch of an $8bn (£4.4bn)-plus fund. As a result, the firepower of the private equity houses is at its greatest and trade buyers will have their work cut out to compete with them on the auction block sales. In addition, the private equity houses are working more closely than ever with one another on LBOs, forming equity syndicates to pull off recent mega-deals, such as the recent bid for SunGard in an $11.3bn (£6.21bn) transaction put together by a consortium of private equity houses.

The US private equity houses are also looking abroad for deal opportunities, as the US market is close to its saturation point. They are forming funds focusing on geographic locations they predict as growth markets. As a result, the emerging markets in Eastern Europe, India and Asia are predicted to receive increased attention from the private equity market in the coming years.

With new funds raised by most of the key players in the private equity sector and the added new dimension of the behemoth hedge funds infringing on their marketplace, the international LBO market in the next 12 months should be very active, despite market pressures which might otherwise depress this sector.

In summary, the trends prevalent in the marketplace today bode well for the alternative investment industry. The pace of formation of hedge funds continues to outstrip last year, despite increased regulation by the SEC. Private equity funds are having no difficulty raising new money for their successor funds and the appetite for acquisition by these funds should keep international M&A lawyers gainfully employed.

It will be interesting to monitor how the hedge fund managers adapt in employing private equity strategies within their hedge funds, and likewise how the private equity houses fare at employing traditional hedge fund strategies. Rather than predict the outcome, I would prefer to hedge my bets.

Iain McMurdo is a partner at Walkers and a member of the firm’s investment funds group