With the investment funds world now coming to grips with the prospect of greater regulations, more challenging fundraising and increased investor scrutiny, Iain McMurdo and David Marshall of Maples and Calder take a look at recent trends and developments in the offshore investment funds sphere as exemplified by the Cayman Islands; and take stock of certain legislative developments due to be passed into law.
Many eyes in the fund industry are on the regulatory overhauls in Europe and North America in forms of the Alternative Investment Fund Managers Directive (AIFMD) and Dodd-Frank/FACTA respectively; and this scrutiny has been no less evidenced in the offshore funds industry. With respect to the AIFMD, which is due to come into force in July 2013, it is interesting to see what preparation is being put in place by non-EU fund managers in anticipation of the deadline. Despite the lack of clarity with respect to the final version of the AIFMD and its subsequent enshrinement in the laws of the member countries of the European Union, a pattern of sorts is emerging in the offshore market – if only a pattern of relative inactivity. Those managers who already comply broadly with the private placement memorandum criteria, or for whom compliance will not present a major shift from their current practices, are holding off making any changes and are taking the view that they will continue on an “as is” basis for the time being and use the private placement route, at least until the potential introduction of the marketing passport regime for non-EU managers, which is anticipated to take effect from 2015.
Time is running out to ensure compliance, where necessary, with AIFMD given the July 2013 deadline. Any analysis of the requirements for EU-based managers is beyond the scope of this article, but non-EU managers who actively market into the EU (and who do not provide portfolio or risk management services, and so on, in the EU) will need to use the private placement regime of the relevant member state (if any), subject to satisfying certain conditions as to disclosure and reporting (only) as the EU marketing “passport” regime will not be available to non-EU managers until at least 2015. Essentially, the conditions required to qualify for the private placement regime comprise the circulation of an annual report to investors, and preparation of an offering document or other disclosure document which complies with all relevant transparency provisions of the directive. In addition, the manager must report regularly to the regulators with respect to the fund’s trading activities. In addition, there are jurisdictional requirements depending upon the domicile of the manager and the fund with respect to cooperation agreements. At the time of writing, we are still waiting for the final detail of the AIFMD, after which we will be better able to advise clients on practical steps to ensure compliance. However, we know that the Cayman Islands authorities are in advanced discussions with the European Securities and Markets Authority in finalising the form of the relevant cooperation agreements, and they are confident that these will be in place with relevant member states in good time of the July 2013 deadline.
Private equity managers in particular should be aware of the proposed AIFMD regulations relating to the takeover of large non-listed companies that are subject to regulation under AIFMD and the general anti-asset stripping regulations. These regulations kick in following the acquisition of a controlling stake of 50 per cent or more and would need to be carefully considered in the context of any proposed acquisition.
CAYMAN ISLANDS CLOSED-ENDED FUNDS OVERVIEW
Much was made (at the time of publication) of the guidelines produced by the Institutional Limited Partners Association early in 2011 (the ILPA Principles) of their potential effect on fund terms. Although the broad principles have been endorsed by managers and limited partners, practice suggests there is no wholesale industry adoption of the specific terms. Clearly, bargaining power accounts for much of the disparity between managers and investors in the form of limited partners, but the overall effect is a move towards incorporating core recommendations from the ILPA Principles in fund documentation. Some of the largest private equity houses have officially and publicly endorsed the principles, but that is a far cry from incorporating their more specific terms in their fund documents. As a rule of thumb, less established managers are more willing to concede the point than those whose track record makes capital raising less onerous.
One of the most prominent changes in the North American market, as a result of the ILPA Principles, has been the increased adoption of the European-style, or whole-fund, waterfall rather than the deal-by-deal basis previously prevalent in the region. The ILPA Principles preferred a European-style waterfall in order to avoid potentially excessive carry payments being made to managers. Of the North American funds upon which we have acted, a significant number utilise a European-style waterfall. Outside North America, however, a European-style waterfall is far more likely to be the default position. A number of the other ILPA Principles are also gaining traction – for example, investors are focusing on the mechanics for early termination of investment periods other than fault-driven routes, which involve high thresholds; and no-fault divorce clauses are now generally accepted, with a large number, as we have seen, opting for a super-majority to effect it.
The investors’ battle to ensure that transaction fees charged by managers to portfolio entities are offset against management fees appears to have been, with some notable exceptions, gaining momentum and it is not unusual to see a 100 per cent offset arrangement in new fund documentation. Management fees are generally remaining static at 2 per cent, other than in the cases of certain mega-funds, as a consequence. Progress has also been made in ensuring greater consistency in documentation effecting drawdowns and distributions, again in line with the recommendations contained in the ILPA Principles.
Given the current economic uncertainties in world markets, it is not surprising to discover that a number of fund managers have been seeking to make full use of the follow-on investment and recycling provisions in their fund documents, as well as add-on transactions generally, and are seeking to augment the underlying value of portfolio entities rather than distribute surplus cash to existing investors. This undoubtedly has a knock-on effect in terms of fund-raising for new funds, given that many investors have fixed percentages of available cash for investment within the asset class.
The past year has also seen continuingly increased exposure to emerging markets, both as a result of comparatively higher perceived potential returns, generally; and reduced market regulation compared to North America and Europe. As AIFMD and Dodd-Frank bite, we may see emerging markets become still more appealing.
As has been noted in trade conferences over the last 18 months, with senior private equity professionals and founders getting nearer to retirement or scaling down their involvement, investors are increasing due diligence and negotiations with respect to succession planning and in particular key man provisions. We have begun to see key man trigger events play out on both sides of the Atlantic. The net result is often a more structured and comprehensive key man clause in new fund documents. Equally, investors are paying more attention to the no-fault divorce clauses in fund documents and ensuring that adequate disclosure is made in all offering documents relating to the fund.
With the US presidential election in November 2012 having brought increased and often heated discussions around the tax treatment of carried interest, it will be worth monitoring how new funds react to the possibility that the effective tax rate may increase under a new administration.
CAYMAN ISLANDS OPEN-ENDED FUNDS OVERVIEW
In response to greater pressure from investors generally and a more concentrated emphasis on corporate governance since the start of the financial crisis, we have seen increased use of independent directors in hedge fund structures across the board, and, where funds already had an independent director appointed to the board, we have seen the number increase (the majority of funds now appointing two such independent directors). While a good number of such independent directors are drawn from the well-developed base in the Cayman Islands, given their extensive experience in the fund industry; and in order to comply with the management and control requirements determined in certain onshore jurisdictions, this is not a requirement under Cayman Islands law. Additionally, use of independent administrators has increased in North America, Europe and Asia with each of the North American funds upon which we advised in the first half of 2012 appointing an independent administrator.
The once-sacrosanct 2/20 fee model, for management and performance fees respectively, is coming under pressure in the hedge fund market and we see less than 40 per cent of funds adhering to the traditional model in the North American regions, although Asian (around 50 per cent) and European (approximately 60 per cent) managers are more likely to use the 2/20 model. The downward pressure centres on the management fee element most commonly.
There have also been a number of cases in the Cayman Islands worthy of note. Two Cayman Islands cases have considered side letters in the context of open-ended funds. The first, Re Medley Opportunity Fund Ltd, underlined the importance of ensuring that correct parties are recorded in any side letter involving beneficial owners of interests sitting behind an investor of record. This was on the basis that the purpose of nominee agreements is to separate legal identities, so to argue the contrary was unacceptable in such a case. Of course, this case must be considered according to its facts, but the need for careful drafting of Cayman Islands’ law-governed side letters is to be emphasised particularly in the absence of third party rights under contract law.
This view has been strengthened in Lansdowne v Matador Investments Limited (in official liquidation) which, although being appealed, also highlighted the importance of ensuring consistency of any side letter with the fund’s articles of association and offering documents.
One further case, a Court of Appeal decision in ABC Company (SPC) v J & Co. Ltd, reinforced the underlying basis for the use of segregated portfolio companies (SPCs) in the Cayman Islands. The Court held that insolvency of one portfolio of a SPC will not affect the remaining portfolios such that a winding-up order must be made over the SPC as a complete legal entity. Additionally, the Court seemed to support a move away from recent first-instance case law in the Cayman Islands, which permitted winding up orders on the grounds of loss of substratum, or purpose, attributable to a suspension of subscriptions and redemptions.
CAYMAN ISLANDS’ LEGISLATIVE PROPOSALS
There are several legislative amendments on the horizon which will further cement the Cayman Islands as the offshore jurisdiction of choice for private equity funds. First is the proposed revision of the Exempted Limited Partnership Law (the Law) which is being amended with the broad intention to codify the contractual freedom of the parties to regulate their arrangements within appropriate statutory safeguards. A key amendment, so as to fall in line with the Delaware principles with which most managers are familiar, is the change in the statutorily prescribed duty of a general partner (a GP). Currently, a GP must act at all times in good faith in the best interests of the partnership. The proposed revision to the Law redrafts this as a duty to act at all times in good faith, “and subject to any express provision of the partnership agreement to the contrary” in the interests of the partnership. This allows parties to the partnership agreement to agree fully on the ambit of the GP’s duties with respect to, for example, non-fund investments and services.
Other proposed amendments include an extension of the safe harbour provisions for limited liability to advisory committees. Such committees in a properly drafted partnership agreement did not risk losing limited liability by reason only of acting on such an advisory committee; however, setting this out expressly in statute is a welcome move. Revisions are also proposed to the provisions dealing with admitting limited partners, the transfer of limited partnership interests and the modification of remedies for breach of the partnership agreement, each of which gives managers further ability to reflect the commercial intention in the relevant partnership agreement. Finally, it is worth noting that foreign (ie, non-Cayman) partnerships will be able to act as GPs of a Cayman exempted limited partnership.