Hedge Funds And Their Domiciles

What Is A Hedge Fund? The Politicians Explain

An EU consultation paper on hedge funds, (prior to preparing a Directive), (2), illustrates how politicians and regulators at the time became totally divorced from reality and the cause of the GFC: “Global hedge fund assets peaked at around USD 2 trillion in 2007. The size of the hedge fund positions is amplified by ‘the extensive use of leverage’ (author’s emphasis). (3) According to the International Monetary Fund, average hedge fund leverage is between 1.4 and 1.7 times capital.”

It is worth considering this staggering statement in some detail. What the EU Commission is saying is that hedge funds pose a significant risk to the global economy, because they are leveraged 1.4 to 1.7 times. This is at a time when investment and commercial banks from Goldmann Sachs to RBS were 30 to 70 times more leveraged than that.

During the GFC, politicians fell over themselves to carpet bomb the hedge fund industry. Hans Muntefering, the German Vice Chancellor, stated that “hedge funds are like swarms of locusts that fall on companies, stripping them bare before moving on…” (4)

The German word for locust is “Heuschreck”, literally “grass-horror”, which has a somewhat more dramatic and threatening ring to it.

At a G20 meeting, Italian Finance Minister, Guilio Tremonti, in making a case for the complete abolition of hedge funds, claimed that they are “absolutely crazy bodies, which have nothing to do with capitalism.” (5)

The resolution of the GFC was the extensive bailout of banks across the world, not one of which was a hedge fund. In the USA, the list included AIG, Freddie Mac, Fannie Mae, Bear Stearns, and Merrill Lynch. Lehman Brothers, which had been in existence for 158 years, was allowed to fail.

In the UK, Northern Rock, the first British bank since 1866 to have an actual ‘run’ with people queueing outside branches, had to be rescued, as was Bradford & Bingley. The subsequent bailout of Halifax Bank of Scotland (HBOS) at £44 billion was the largest corporate rescue in UK history.

In Europe, Hypo Real Estate, Dexia and Fortis Bank all had to be similarly rescued at the taxpayers’ expense.

What Is A Hedge Fund? The Truth

The Oxford English Dictionary defines ‘a hedge’ as:

i. a fence, or boundary formed by closely growing bushes or shrubs;
ii. a word or phrase used to allow for additional possibilities, or to avoid over-precise commitment;
iii. a contract entered into, or asset held as a protection against possible financial loss.

A hedge fund is a pooled investment fund that typically holds liquid assets and makes use of trading and risk management techniques to improve investment performance and insulate returns from market risk. Among these portfolio techniques are ‘short selling’ and the use of leverage and derivative instruments. In the United States and most regulated markets, such regulations require that hedge funds be marketed only to institutional investors and other accredited investors such as high-net-worth individuals (HNWIs).

By definition, a hedge fund need not necessarily be leveraged, ie use debt as well as investor capital, but most do. An explanation of short selling and the use of derivatives is outside the scope of this article.

However, it is useful to consider that a hedge in a hedge fund is used prima facie to reduce risk, not to increase it. Hedge funds generally aim to reduce, or eliminate ‘alpha’, a movement in markets. In this, they differ from long only funds that aim to capture such movements.

In a market exhibiting volatility, a properly executed hedge fund strategy will protect investors from big drawdowns in the market, ie when markets fall. On the other side, when markets are rising rapidly, hedge funds will have modest, but still positive returns.

When Hedges Collide

Occasionally, the worlds of hedge funds and hedges intersect.

In 2007, two millionaire financiers (whose neighbours include Jerry Seinfeld and Rolling Stone publisher, Jann Wenner), got into a boundary dispute on their multi-million dollar properties located in the uber-chic town of East Hampton, NY. James Chanos, founder of hedge fund Kynikos, called the cops on his neighbour Marc Spilker, a managing director at Goldman Sachs.

Chanos alleged that Spiker had ripped up their boundary hedge with earth-moving equipment to widen a four foot wide path to the beach.

Chanos told ABC News that he knew the media would enjoy a dispute between two investment banker millionaires about a hedge … as if that would happen! (6)

World’s Biggest Hedge Fund Managers

Below are listed the top ten hedge fund managers in the world:

Interestingly, the next ten top-ranked hedge fund managers are also in either the USA (6) or the UK (4). Two are in Connecticut, which is a significant hedge fund hub owing to its proximity to New York combined with a more suburban lifestyle beloved by “Hedgies”.

Hedge Fund Domiciles

While hedge fund managers, who tend to be exceptionally well-remunerated, like to live in locations where they can have a very affluent lifestyle, such as the U.S. East Coast, California, or London, the funds which they manage are a different story completely.
Hedge funds marketed to international HNWIs and ultra HNWIs have traditionally been located in offshore jurisdictions, with Caribbean locations being pre-eminent.

However, in the past 30 years, many hedge fund managers have decided to locate their managed funds in more regulated territories. This inter alia is in order to gain access to European and Asian markets, whose HNWI investors may be restricted from, or reluctant to investing in the older traditional offshore locations.

The top hedge fund domiciles currently are (7):

                  
The fact that so many hedge funds are located in Delaware is an indication that nearly half (48 per cent) of the world’s total investment funds are domiciled in the USA, with 31 per cent in Europe, 14 per cent in Asia-Pacific, and 7 per cent in the Americas. (8)

Future Trends In Hedge Fund Domiciles

A significant survey of fund domiciliation in Europe has been undertaken by The Economist Intelligence Unit on behalf of leading international investment funds law firm Matheson. (9)
Of the 200 global asset managers surveyed, 94 per cent of their firms have investment funds in the European Economic Area (EEA), with the remaining 6 per cent planning to do so.

The value of alternative investment funds managed in the EEA by the surveyed managers was as follows:

• Less than $100 million under management 67%
• $100 million to $1 billion under management 17%
• Over $1 billion under management 16%

The asset managers were asked which European domicile they would choose if starting afresh with their fund ranges. The managers had the opportunity to select which, in their experience, are the best performing European fund domiciles in terms of the following criteria:

• Regulatory conditions such as regulatory sophistication, accessibility and responsiveness.
• The applicable legal and tax framework.
• Non-regulatory and non-tax business conditions in those domiciles, such as ease of doing business, service culture and local expertise in complex products.

So which European domiciles would fund managers choose if starting over?

Interestingly, when asked where most of their funds are currently domiciled, the results showed that the United Kingdom was in top spot with 49 per cent, Luxembourg second with 43 per cent and Ireland third with 41 per cent. This would appear to indicate that if choosing again ab initio, these top investment managers would choose Ireland in preference to the UK or Luxembourg.

This makes sense, as the UK investment funds industry is long-established around the City of London, and Luxembourg’s growth as a funds’ location started in the 1960s, whereas Ireland’s international funds industry only commenced with the establishment of the International Financial Services Centre in Dublin in 1989.

There is obviously a strong inertia factor in moving from Luxembourg to Dublin if you have been established there for decades. However, most Luxembourg commenced fund administrators and custodians have now established separate operations in Ireland.
The recent Brexit scenario, whereby the UK has left the EU, has also provided a new, but unsurprising development in the international funds industry in Ireland.

This is the large move by London based ‘Magic Circle’ law firms to either establish Dublin offices or acquire existing Irish practices. These include Linklaters, Freshfields, and Simmons and Simmons, which has a large investment fund practice. DLA Piper, the joint UK-US practice, has also established in Ireland.

These firms were preceded in the last decade by the establishment and significant growth of Cayman Islands-based international financial services specialist firm, Maples and Calder. The Philadelphia headquartered international firm, Dechert, has a large Irish FS practice and came to Dublin in 2010.

The days of alternative funds basing themselves on a sandy island have been changing over the past 20 years, not least with the growth of Ireland as a major centre for both the domicile and the servicing of such funds.

In fact, 40% of global hedge fund assets are serviced in Ireland, making it the largest hedge fund administration centre in the world (10). Included in the 40% are a significant number of funds domiciled elsewhere, such as Cayman, or the Channel Islands where the administration takes place in Ireland.

Last But Not Least

In the Sunday Times, former Top Gear presenter and Cotswold farmer, Jeremy Clarkson has even commented “I have no idea what a hedge fund is, but after a day trip to Mustique, I think I need to plant one.” (11)

References

[1]  Epitomised by the so-called “liars’ loans”, where mortgagees were allowed to “certify” their own income, without any independent verification required.
[2]  Commission Staff Working Document on Alternative Investment Funds EU Commission (2009) 207
[3]  Leverage is an investment strategy of using borrowed money to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets. (Investopedia)
[4]  Hans Muntefering … Bundestag, 7 May 2005.
[5]  CEP Newswires, 11 October 2008
[6]  ABC News 8 January 2009
[7]  PwC Luxembourg, Q1 2018
[8]  EFAMA, (European Fund and Asset Management Association) Factbook, 2023
[9]  Choosing a European Fund Domicile: the views of Global Asset Managers,
Economist Intelligence Unit, June 2013
[10]  “Why Ireland?”, Irish Fund Industry Association, 2019
[11]  Jeremy Clarkson, Sunday Times, 23 April 2006

Peter O'Dwyer
Peter J. O’Dwyer is a business and financial consultant with a number of interests. He primarily specialises in providing bespoke advice to cross-frontier businesses, in particular to those involved in international investment funds, holding company structures and structured finance and to Governments and regulatory authorities. He is Managing Director and proprietor of Hainault Capital Limited, based in Ireland. He is a non-executive director of several private and public companies, including investment companies, mutual funds, energy, property and hedge funds domiciled in Ireland and the Cayman Islands for amongst others; HBOS, Barclays Capital, Citigroup and BNP Paribas. He is a former director of a Shari’a hedge fund and has lectured widely on the subject of Shari’a investment funds.