The Cayman Islands: The Good, the Bad and the Hopeful

Over the past several years, the vast majority of the financial news out of the Cayman Islands has been very positive - record year after record year of fund registrations and complex international structures. So far, 2007 has been no exception in terms of hedge funds. Cayman saw another record period for hedge fund registrations during the first three quarters of 2007.

After a slight weakening in net hedge fund registrations in the last quarter of 2006, there were some predictions of a marginal decline in net hedge fund registrations in Cayman in the early part of 2007. These predictions proved wrong, as hedge fund registrations in Cayman remained remarkably strong, with a total of 1,493 new hedge funds registered by the Cayman Islands Monetary Authority (CIMA) in the first nine months of 2007. This total compares to the 1,889 new hedge funds registered for all of 2006. What makes this number even more impressive is a steady, continuous upward trend, even as global markets were starting to shake from the sub-prime crisis.

Net new hedge funds registered in the third quarter of 2007 totalled 412 (468 new registrations and 56 terminations) compared with the corresponding quarter in 2006 of 261 net new funds (391 new registrations and 130 terminations). The third quarter of 2007 saw Cayman pass the 9,000 mark for hedge funds. As of 30 September, 2007, total net hedge funds registered in Cayman stood at 9,384.

In the next few months, data underlying these statistics will be released for the first time by CIMA from its new E-Audit and E-Reporting systems that became fully operational at the end of March 2007. Cayman’s new electronic reporting system for the submission of annual returns for hedge funds licensed, registered, and administered in the Cayman Islands heralded the start of a new modern and digital era of hedge fund regulation in the jurisdiction. All indications are that the E-Audit and E-Reporting initiatives have been an outstanding success.

The superb results in Cayman have, however, been somewhat overshadowed by news from the US, first in regards to the collapse of the sub-prime markets and the tightening of liquidity, and secondly by continued attempts by US legislators to change the way that US tax-exempt investors such as pension funds invest back into the US capital markets through offshore corporate hedge funds.

Insolvency and restructuring professionals around the world have long been aware that the calm credit markets of the past few years have allowed the creation of a considerable number of investment structures that under more normal - and less benign - market conditions would not have been able to exist.

Cheap credit masked the risks involved for lenders, and derivatives were positioned as tools to spread or negate risk, adding to growing sentiment among borrowers and investors that risk was a thing of the past. Hedge funds and other collateralised debt vehicles spurred the investment cycle onwards. Overly optimistic credit agency ratings exacerbated the upward credit cycle, with an over-dependence upon the rating agencies making matters worse. Investors relied heavily on determinations by the rating agencies, possibly misunderstanding the nature and import of these ratings to price assets and to determine whether to invest in them. With all of these problems converging, it was only a matter of time before the cheap credit dried up.

It is not surprising that lending to individuals with bad credit ratings has ended in disaster. The surprise has been seeing the full extent to which this risky lending, and its underlying security, was repackaged by financial institutions and sold to consumers as high-grade investment products. Investors were lured in by cheap borrowings. This led to liquidity in the purchase of these collateralised debt obligations (CDO s) which, of itself, enabled collateral managers to price those securities at higher levels, making the repackaging of this type of debt even more attractive to the lenders.

Now the portfolios of a number of Cayman hedge funds have been impacted by the collapse of the US housing market, and the substantial increase in defaults in US sub-prime mortgages. Funds whose assets were 10 to 15 per cent CDO s have seen relatively liquid, high-performing structures turn rapidly into illiquid, under-performing assets as a result of the credit crisis.

Since typical hedge fund structures rely heavily on cash flow, illiquidity is the worst case scenario for any hedge fund manager. If cash flow for a hedge fund dries up, and the fund is unable to meet redemption requests through either new investment capital or the liquidation of investment assets in its investment portfolio, the prospect of collapse for the fund becomes very real, very quickly.

Even the best-counselled hedge fund board of directors has few alternatives in such situations. Often the only options are to suspend the calculation of the fund’s net asset value and the payment of any redemption proceeds. Since investor goodwill is critical for a hedge fund’s survival, any suspension of redemption payments often proves fatal.

Once investors realise that the hedge fund they are invested in is not capable of meeting redemption requests in the normal course of business and their investment in the fund is, in effect, locked up, it is virtually impossible to recover investor confidence and continue trading for the fund.

Perhaps the most difficult situation is when high leverage has compromised the solvency of a hedge fund. In these cases, the directors often have little choice but to begin a formal court-based winding up or liquidation to preserve whatever value is left. While there is inevitably pressure from investment managers to continue in business for as long as possible, fiduciary obligations to investors demand that any and all attempts to garner some value from the fund be undertaken.

It is important to note, however, that only ten regulated Cayman funds reported critical problems as a result of the US subprime mortgage crisis. In fact, in many cases, investment managers forecasted the bubble and planned accordingly, and, as a result, some funds saw substantial profits.

Traditional hedge funds are not the only vehicles impacted by the collapse in the market for sub-prime-based CDO s. New investment structures have also been affected, perhaps none more than Structured Investment Vehicles (SIV s). These highly-leveraged special purpose vehicles purchase securities, such as CDO s, and make their returns on the spread between the cost of the long-term borrowing they procure to purchase their investment portfolios and the cost of rolling short-term borrowing to finance it, usually through the issue of commercial paper and other short-term financing instruments.

SIVs were viable when the cost of short term lending was cheap. However, the credit crunch has severely restricted the ability of SIVs to roll over their short-term lending, and has led to massive liquidity problems. The most common challenge has been calls on liquidity providers to honour their obligations to support the SIV and step in to finance their long-term lending obligations. With the collapse in value of the collateral underlying SIVs, the evaporation of short-term finance, and massive calls on liquidity providers, investment banks have taken another hit, and credit markets have faced additional restrictions.

While the Cayman Islands have not instituted any regulatory changes in response to the credit crisis, legal service providers in Cayman have seen a shift in business that follows the market. The use of structured credit securities such as CDOs, collateralised loan obligations (CLOs), and asset-backed securities (ABS) has dropped sharply.

The good news is that while the opportunities for CDOs and CLOs are diminishing, Cayman law firms are seeing opportunities as more and more organisations and investors look to restructure existing deals, either by renegotiating over-collateralisation tests on deals or repackaging of assets. In certain circumstances, there has been the full-scale liquidation of entities.

Cayman firms have also seen an increased use of the use of Segregated Portfolio Companies (SPCs), established to preserve as much value as possible during the market recovery period, rather than using the traditional limited recourse structure. SPCs have a strong advantage over traditional debt structures.

Normally bond or loan ‘re-packaging’ transactions use a Cayman Islands exempted company to issue notes, and use the proceeds to acquire pre-existing bonds or other financial instruments, tailored to client’s risk-profile. SPCs encompass statutory ring-fencing, which limits recourse of creditors to the assets of a specific and identified class of shares only, and not to the general assets of the SPC or the assets segregated to other segregated portfolios of the same SPC.

Another challenge for Cayman hedge fund promoters and investment managers is the uncertainty in US regulations. Offshore jurisdictions like the Cayman Islands strive to provide a legislative infrastructure for hedge funds that balance international regulators’ demands for stringent standards and the requirements of global fund managers who want legislation that is sound without being overbearing. International investment managers and offshore regulators, particularly CIMA (Cayman’s regulator who has worked diligently with international regulators to develop advanced legislation and reporting standards in the Cayman Islands) now await the latest changes proposed in the US to UBTI (Unrelated Business Taxable Income).

The proposed UBTI amendments, which are promoted as bringing the investment capital of US tax-exempt investors onshore, would, on closer examination, seem to provide no tangible benefit for anyone. If tax-exempt assets are invested onshore, but they remain taxfree, no new revenue is generated for the US. On the other hand, if the regulations are changed so that tax-exempt assets invested onshore become taxable, it is US tax-exempt investors and pensions funds, and ultimately US pensioners, that will be penalised by double taxation on their after-retirement investment funds.

While some financial professionals, including fund managers, lending institutions, and investors, will certainly be glad to see the end of 2007, Cayman experts are largely viewing the year as an outstanding success on the hedge funds front and a hiccup, rather than a catastrophe, on the structured finance/ debt side.

It is expected that current CDO - pricing issues and restrictions on liquidity in financial markets will likely be seen as overdue market corrections. Already, new hedge funds are being formed to take advantage of undervalued subprime assets. Hedge fund registrations, particularly in Cayman, are predicted to remain extremely strong, and with the E-Audit and E-Reporting initiatives, there will be more information about the investments available to help track trends and key market indicators. There is every reason to expect 2008 will be a very good year.

Walkers
Bermuda, British Virgin Islands, Cayman Islands, Dubai, Guernsey, Hong Kong, Ireland, Jersey, London and Singapore.