Rod Palmer and Paul Farrell of Walkers evaluate recent developments in the offshore funds markets.
Gauging the temperature of the offshore investment funds industry over the past 12 months, there has been a notable shift from the more defensive post global financial crisis phase, heavily dominated by restructuring work, to the renewed focus on fund formation, which we are seeing now. This change offers evidence of the fund industry’s resilience to the global financial crisis.
Taking the Cayman Islands as an example, more than 80 new hedge funds were registered with the Cayman Islands Monetary Authority (CIMA) each month over the first half of 2011. This figure excludes the large number of new funds that are exempt from registering with CIMA. The mood has therefore been more upbeat, as the return to growth, which had been anticipated in 2010, actually materialised in 2011.
In our role as counsel to the offshore funds promoted by many of the world’s leading investment managers (Walkers represents the majority of the top 50 hedge fund managers and private equity fund managers worldwide) we are in a unique position to see the strategies and commercial terms being employed by these leading players and to identify the trends occurring in the offshore funds industry. Over the course of the year Walkers has seen a broad range of strategies employed by managers, including relative value, event driven, tactical trading, emerging markets and total return funds. We have continued to see a focus on managed accounts as well as a preference for single investor funds, which are set up in a bespoke manner for one particular investor client.
Investors are also conducting more extensive due diligence on the managers, service providers and directors of funds they are seeking to invest in. As investors have demonstrated a desire for more independent directors, there has been a move towards greater independence for all service providers in a fund structure. Managers need to ensure that the governance structure in place is efficient and effective, while there is an increasing trend of board compositions being tailored to the investment strategy of the fund.
As difficulties persist in the capital raising environment, we have seen a shift away from including redemption gates in many new funds. One method of liquidity management that has come to greater prominence is the use of deferred payment mechanisms in respect of redemption proceeds, whereby rather than the fund imposing a suspension or gate, it will instead delay or stagger redemption payments to investors, allowing time for the liquidation of the underlying assets. Simply put, this mechanism has been easier for investors to digest than gates, which are now being implemented less frequently.
Over the past 18-months the use of side letters has continued, however these are generally only being employed as a method for liquidity management where they form part of the investment strategy, such as acquiring illiquid assets from the outset. As a method of liquidity management, side letters were a cause of much concern for investors unable to redeem during the financial crisis and are often viewed with as much suspicion as any other means of preventing investors from withdrawing funds. In recent months side letters seem to have been more palatable where funds are acquiring illiquid assets such as real estate or private equity investments since these funds tend to immediately side pocket these assets. Elsewhere, side letters remain relatively common where there is a need for some investors to go into separate classes of shares due to ERISA issues.
On the private equity side, we have seen increased and meaningful commitment from General Partners, notably with a reduced ability to fund the commitment through management fee waivers. We have also seen the introduction of a preferred return on some new PE funds from managers who have not historically had a preferred return. Succession issues are of increasing importance and we have seen an increased number of key executives named as key men, with a reduced focus on the founding principals, as firms look to ensure an efficient handover to the emerging leaders within their organisation.
Fees have also been in focus. While fees have certainly moved lower and away from the classic 2/20 model, fee reductions have been negotiated in side letters or by having different classes linked to a break on fees, or fees linked to different levels of investment participation. Whether fees are charged at the master or feeder level is typically driven by regulatory or tax reasons and can be either investor driven or manager led.
In terms of new business, we have seen growth in two distinct areas. Firstly, there has been an influx of funds established by start-up managers, including spin outs from banks and other institutions so these already have a strong prior track record in many cases. The second key area for new business has been the increase in Latin American fund work, as managers with interests there continue to target international investors, with a view to capitalising on the high degree of investor appetite for the region at this time.
Under the United States Foreign Account Tax Compliance Act (FATCA), which will become effective as of 1 January, 2013, offshore funds are required to enter into an agreement with the IRS to disclose information on investors and beneficial owners, effectively so that US taxpayers investing offshore can be identified. If the fund fails to provide the required information then a withholding tax will apply to the entire fund with 30 per cent charged on US sourced payments.
As a result, it has become common for managers to include certain withholding tax provisions in fund offering and governing documents, permitting the fund to take action against any investor whose status may cause a withholding tax to be applied to the fund. Such action may include placing the investor into a separate class of shares, redeeming all or a portion of their shares and deducting the tax from the proceeds, or clawing back payments previously made.
For US managers with offshore funds, the overhaul of the registration regime contained within the Dodd-Frank Wall Street Reform Act has been at the forefront of attention. The primary effect of the legislation which was enacted on 21 July 2010, will be the removal of the private advisor exemption traditionally used by hedge fund managers, the net result of which will require most managers to register with the SEC, subject to certain exemptions. While enacted, the legislation is currently subject to secondary rule making, which will work out the mechanics of the process. For Walkers’ predominantly institutional client base, the impact will be limited as most will already be registered with the SEC. For others who will be required to be registered by 30 March 2012, the new reporting and record-keeping requirements will mean additional cost and a greater compliance burden but this should not affect the use of offshore vehicles by US managers.
The primary legislative focus in the offshore investment funds world over the past two years has been the EU’s Alternative Investment Fund Managers Directive (AIFMD). It aims to regulate managers of alternative investment funds who are operating in the EU or marketing their funds to professional investors in the EU, or both. The implementation of the AIFMD is currently at level 2 consultation with stakeholders and the European Securities and Markets Authority (ESMA) and is due to be transposed into national member state law by 21 July 2013.
The final draft of the AIFMD confirmed that EU and non-EU fund managers may continue marketing Cayman Islands, British Virgin Islands and Jersey funds in Europe and was undoubtedly excellent news for the funds industry in these jurisdictions, as well as a welcome development for European investors who will retain access to those leading global asset managers who offer their strategies into Europe through their funds offering.
From July 2013 EU managers with EU domiciled funds will be required to comply in full with the AIFMD and will have access to the EU cross border marketing passport. Therefore, once authorised in one member state, EU managers may avail of the passport to distribute their funds throughout other member states. The passport will not be available for their non-EU domiciled funds until 2015 at the earliest, although managers do not have to comply with the controversial single depositary regime during that time. However, EU managers with non-EU domiciled funds may rely on existing (but modified) national private placement regimes to market these funds until the passport option becomes available in 2015.
Non-EU managers wishing to market any fund within the EU will be required to rely on the private placement regime until July 2015 at which point they will be given the option to become subject to the AIFMD in the member state of reference and will be entitled to market their funds under the passport. It is important to note that the AIFMD does not cover reverse solicitation or passive marketing of funds in the EU.
Non-EU managers and non-EU domiciled funds may avail of the national private placement regime up until 2018 at which point ESMA will decide whether to phase this out so that the AIFMD becomes the only route to market in the EU. The downside to national private placement is that the rules differ from one country to the next and there is no passport available.
To qualify for continuing access to national private placement regimes, the AIFMD stipulates certain minimum criteria for the contents of a fund’s annual report and prospectus and requires managers to make regular reports to regulators on the markets and instruments in which their funds trade. There are also additional reporting requirements on funds that acquire control of large non-listed companies and a ban on ‘asset stripping’ in such companies for two years after control is achieved.
The AIFMD requires that jurisdictions in which non-EU managers and funds are based must enter into systemic risk information sharing and that such jurisdictions remain off the Financial Action Task Force (FATF) list of non-compliant jurisdictions to give their funds and managers access to the EU market under existing national private placement rules. If the passport regime is extended to Non-EU entities, the fund’s jurisdiction will be required to have Tax Information Exchange Agreements in place with the manager’s EU member state of reference and each member state in which the fund is marketed.
During the protracted period of negotiation of the AIFMD by Europe’s politicians, significant attention was directed to the question of whether offshore investment funds aimed at professional investors in the EU should instead be established in European Union centres such as Ireland or Luxembourg. This debate became largely academic after the final text of the AIFMD confirmed that non-EU offshore funds from the Cayman Islands, British Virgin Islands and Jersey would still be able to be marketed in the European Union. However, doubts remain over how willing individual states, hostile to offshore funds, are to permit marketing through the national private placement. This will persist until 2015 until the AIFMD is available to non-EU managers and non-EU funds. Therefore, depending on which countries a manager is marketing into, they may need to look at establishing onshore parallel structures.
While applications from funds to redomicile away from the Cayman Islands and the British Virgin Islands have been negligible, Ireland is thriving as a domicile for investment funds. Irish funds recorded the highest level of net inflows in Europe in the first half of 2011, according to the latest statistics from EFAMA, the European Fund and Asset Management Association. The EFAMA’s second quarter report revealed that Ireland saw net inflows of €39 billion in the first six months of 2011 – some €7 billion more than the next closest domicile.
Managers are now in a position where they may select the most appropriate regulatory framework for their investment funds and still ensure access to EU investors. Ireland is recognised as the jurisdiction of choice for EU-domiciled investment funds for its business friendly environment and the responsiveness and flexibility of the regulatory authorities. For example, Qualifying Investor Funds (the primary hedge fund product) can be authorised within 24 hours, subject to promoter approval. With this in mind, Walkers opened an office in Dublin in 2010 to meet clients’ increased demands for parallel structures and EU domiciled vehicles. Parallel structures refers to fund structures established both offshore (Cayman Islands, British Virgin Islands or Jersey) and onshore (Ireland) pursuing the same or similar strategies. Having both means the manager can accommodate different types of investor, those preferring the offshore product and those preferring the onshore product with increased regulation.
With any concerns regarding offshore funds redomiciling en masse to Europe now removed from the equation it is clear that offshore funds will continue to flourish, operating alongside funds from EU jurisdictions such as Ireland. Against the backdrop of the legislative certainty achieved by the AIFMD and continued growth in the formation of new fund structures, the outlook is bright for the leading offshore fund centres.