In the world of private funds, 2017 has been anything but dull. Global events have influenced not only fund strategies and the geographies in which funds invest, but also where managers choose to locate their business operations. Funds are attracting international capital and are using multiple jurisdictions to domicile their products. The Cayman Islands continue to be the primary offshore jurisdiction for private fund managers in the US, the UK and parts of Asia, including Japan.
We have seen new funds offering incentives for longer lock-ups and preferential fee terms, and an increase in funds and other corporate entities restructuring and merging.
The regulatory overlay has a continued impact on every aspect of Cayman investment funds, including new international rules regarding tax information exchange, requirements for entities to have written policies and procedures for CRS compliance, beneficial ownership reporting for certain entities and compliance with data protection requirements. Where Walkers acts as fund counsel, our regulatory team has been involved in almost every fund launch or update, as managers and directors come to grips with the new regime.
US private equity fundraising has increased, which has in turn led to an increase in closings and downstream activity for Cayman-domiciled funds. We continue to see many new credit funds although we have seen an increase in real estate funds, particularly those with underlying assets in Asia. Other operational asset businesses are engaging in more downstream activity and the market for 2018 appears buoyant.
In the latter part of 2016 we saw a decline in the number of start-up managers in the Cayman hedge fund space, but there has been an uptick in 2017 with spin-outs and new launches in equity strategies, private debt and global macro. We continue to see founders’ classes in the majority of new launches, although side letters remain extremely popular for new and existing funds, with particular emphasis on longer lock-ups and preferential fee terms.
Asia-based managers continue to use open and closed-ended Cayman vehicles, although fundraising has been a major concern as established managers seek to make the leap into the US$1 billion-plus club, but face stiff competition for investor capital. Cayman Islands segregated portfolio companies (SPCs) have come back into vogue in this market, liked for their flexibility, their speed to market and the cost efficiencies for managers with multiple portfolios. The majority of these SPCs are regulated by the Cayman Islands Monetary Authority (CIMA).
We have also seen the intersection between private funds and the beguiling world of Silicon Valley. Many managers are taking advantage of the rise in digital currency offerings, both launching and investing in cryptocurrency funds. We have worked on several of these for new and established managers. Regulators are grappling with recognition of the types of currency that may be accepted as subscriptions for interests in a fund, the nature of controls in place as well as expected levels of risk disclosure. There are many legal and regulatory issues regarding initial coin and token offerings, including with respect to valuations. There is a good deal of uncertainty as to how, if at all, they fall to be regulated. At the time of writing, there is no specific Cayman regulation regarding the type of currency that a regulated fund can use for subscriptions or redemptions or any specific disclosures required, although we expect the Cayman Islands Monetary Authority will issue guidance in the near future.
The global regulatory landscape has continued to raise the bar to entry in multiple jurisdictions and whether regulatory compliance is insourced or outsourced it has become a significant cost of doing business. Consistent with the focus on governance, we have seen even more emphasis on independent boards and advisory committees constituted with industry experts and others with strong business or academic records relevant to the fund’s investment focus. While independence at the fund level has become market standard, funds are rightly concerned to ensure there is tangible value to the fund when adding another layer of governance. Thus, the demands for more experienced independent directors and advisory board members has increased in recent years.
The critical importance of proper governance comes sharply into focus when viewed through the lens of potential directors’ liability. In the context of Cayman-domiciled open-ended mutual funds, it remains the case that various important matters such as investment management, administration and accounting functions (eg, calculation and determination of NAV) will invariably be delegated to suitably qualified professional service providers. Such delegation will almost certainly be expressly permitted and authorised by the relevant constituent documents and is very much market practice. Notwithstanding this, the delegation does not absolve directors from responsibility altogether; there remains an underlying duty to supervise the delegated functions. Most practitioners will recall the stinging observations of the judge at first instance in the Weavering case, regarding directors who fail to apply their minds and exercise independent judgement over matters for which they have supervisory responsibility.
On a related note, one topic of contention has been the scope of indemnities available to directors, managers and other professional service providers to Cayman investment funds. The specific terms and conditions of indemnities in fund documents and in service agreements can vary materially and we have seen a wide range of terms from the mundane to the unusual. In the case of Cayman investment funds, indemnities purporting to exclude liability for conduct amounting to dishonesty, wilful default or fraud will typically be ineffective which means that ordinary negligence, and even gross negligence, on the part of directors will usually be covered by the applicable indemnity. The Cayman Islands Court of Appeal in the Weavering case relatively recently determined (largely in line with existing English authority) that neglect or default will not be considered wilful unless a director has made a conscious or deliberate decision to act, or failed to act in knowing breach of his or her duties. Put another way, wilful default only arises where the person knows that they are committing, and intends to commit, a breach of duty or is recklessly careless in the sense of not caring whether the act or omission is a breach of duty.
All of this should not cause any real concern to a non-executive director of a Cayman investment fund who delegates responsibility to suitable professional service providers, continues to monitor and supervise those delegated functions at an appropriate level and who seeks expert legal advice where appropriate.
It remains extremely rare for funds which are trading as a going concern to assert claims against directors. By contrast, we continue to regularly see actions brought by liquidators of Cayman funds against various professional service providers, including non-executive directors. While from a legal standpoint it remains difficult to invalidate the typical indemnities, every case of course turns on its own facts. In circumstances where the fund in question has suffered severe losses due to a Ponzi scheme or other fraudulent activity, stakeholders tend to have more appetite for all manner of claims which, if successful, may provide the only, or major, source of recoveries for the insolvent estate.
In the current environment, if a particular investment fund structure has an abnormally high risk, professional service providers are on notice that they may be expected to undertake greater supervision in order to avoid liability and it may be insufficient simply to follow minimum industry standards. Even if the inherent underlying risks of the fund (for example with respect to conflicts of interest or an undue concentration of responsibility or risks) are or should be understood and accepted by the investors, there may still be duties owed.
An example of this played out in the recent Primeo case decided in August 2017 where the Cayman court, although ultimately dismissing the plaintiff’s claims, found the custodian in breach of various obligations largely due to its failure to recommend the use of a second or sub-account with the depository trust company (DTC) in order to properly segregate the “assets” purportedly held on behalf of the Madoff feeder fund. In essence, when the normal procedures are known to be ineffective, failing to apply a readily available alternative will be negligent. In that case, the court also observed that while administrators are not expected to perform audit procedures, they ought to be concerned to satisfy themselves that the published NAV is accurate. An appeal has recently been filed by the unsuccessful plaintiff.
We have seen a significant amount of activity in the area of appraisal disputes regulated by section 238 of the Companies Law (ie, where a dissenting shareholder objects to the merger price and requests the court to determine “fair value” for its shares) and several cases are beginning to work their way through the courts. With the increasing use of the relatively new statutory merger regime in Cayman as a take-private mechanism, we have seen a marked increase in these fair value cases. Given that the Cayman provisions have largely been modelled on the Delaware statute (noting that Canada has similar legislation), it is perhaps unsurprising that to date the Cayman Courts have been content to place significant reliance on Delaware and Canadian jurisprudence.
At the time of writing, only two petitions filed by shareholders have gone to trial, resulting in significant uplifts to the dissenters in terms of the fair value ultimately awarded, however, both cases were very fact specific. Such uplifts are becoming less common in other jurisdictions although given the absence of real comparables it is difficult to discern a specific trend at this stage. We expect that in time, as more diverse examples of transactions are litigated and valuation methodology expectations are better understood, material uplifts from the merger price are likely to decrease, resulting in greater synergy with the approaches taken in Delaware and Canada.
Nevertheless, it is certainly exciting to see such a high level of market activity at present. We are fortunate to have been involved in many of the cases (both on the company and the dissenter side) which have either completed, settled or are in progress.
The Cayman market reflects many of the themes practitioners are seeing onshore, particularly in the US investment funds market. The indicators are that investors are allocating capital to fewer managers and as more traditional asset managers continue to migrate into private funds, competition for capital and pressure on fees will continue. In addition to shareholder actions of the kind described above, we expect to see more mergers and consolidations in the Cayman market. With new ventures into fintech overlaid with ever increasing regulation, 2018 promises to be another busy year.