Cayman Funds: Lessons Learned as Hedge Fund Investments Surge

As 2009 has progressed, hedge fund investments have returned to prominence. This shift has been as welcome offshore as it has been for investment managers located in the world's major onshore financial capitals. After seeing record redemptions in the final months of last year, total hedge fund assets have increased steadily toward USD2 trillion again in 2009, according to industry database HedgeFund.net. With the Dow Jones Industrial Average crossing the 10,000 threshold in mid-October 2009, Hennessee Hedge Fund Index reports that improving equity markets have helped make January-September 2009 the best first nine months of a calendar year for hedge funds in 12 years. The Hennessee Hedge Fund Index itself rose 21 per cent in that time period.

As the leading offshore jurisdiction for hedge funds, the Cayman Islands have seen international investment trends and sentiment about investment funds strongly reflected in the pattern of hedge fund registration and terminations in the Cayman Islands. In fact, Cayman has regained much of the ground it lost in the earlier part of the year.

Third quarter 2009 hedge fund registration statistics just released by the Cayman Islands Monetary Authority (CIMA) indicate that a total of 9,838 active hedge funds were registered in Cayman as of 30 September 2009. This represents a relatively modest drop of 4.4 per cent from the 10,291 peak in registrations at the end of the same period in 2008. Hedge fund terminations are now back at normal market levels after increased termination activity in December 2008 and early 2009. Cayman has seen an increase in registrations of new hedge funds in the middle part of 2009, with 319 new funds registered in Q3 2009, at an average of more than 106 per month.

Lessons About Liquidity

Looking back at the closing months of 2008, liquidity was the outstanding contributor to hedge fund difficulties and failure. Liquidity affected the strong performers as well as the weak – even funds which had performed well in the market were affected by a surge in redemption requests from nervous investors anxious to re-balance investment portfolios.

Our collective experience from this period of difficulty suggests that funds that were properly structured with foresight and which had planned for liquidity issues from the outset and incorporated mechanisms to deal with illiquidity in their constitutive documents faired relatively well. Rather than having to undertake the lengthy and often difficult process of obtaining shareholder approval for introducing side pockets to isolate underperforming assets or gates to manage redemptions, funds with appropriate liquidity mechanisms were able to act quickly, often meaning the difference between survival and failure.

In our experience, many funds have sought to restructure in response to liquidity issues in order to preserve value and retain investors either within the same fund or in a new structure. Some funds have taken advantage of gate provisions, where available, but many older funds simply do not have the ability to limit redemptions in this way. Side pockets have frequently been utilised to deal with hard-to-value securities. Alternately, some funds that do not possess adequate side pocket provisions have been able to simulate the effect through a synthetic side pocket, into which illiquid assets are transferred. This process, which involves forming a special purpose vehicle, will only usually be appropriate if the fund has the ability to pay redemption proceeds in kind but cannot readily transfer the underlying assets in satisfaction of redemption proceeds. Where the circumstances are right, the technique has allowed funds to continue calculating their net asset value and keep on trading.

Evolution of Offering Documents

As a result of the recent financial crisis, many funds will no doubt continue to evolve their offering documents. A number of funds have updated their fund documents, often to provide greater flexibility for investment managers and directors to better steer the fund through periods of illiquidity. In other cases it is appropriate to introduce more prescriptive provisions that describe with particularity the powers of the directors and the circumstances in which they may exercise such powers. Whichever approach is adopted, investor protections must be preserved.

Impact of In re Strategic Turnaround Master Partnership

Issues related to hedge fund redemptions received significant media coverage towards the end of 2008, including a decision of the Cayman Islands Court of Appeal in December 2008 in the case of In Re Strategic Turnaround Master Partnership, Limited.

In that case, it was held that redemption is a process which is not complete until the redeeming investor has received due payment of its redemption proceeds and its name has been removed from the register of shareholders. The Cayman Islands Court of Appeal confirmed that a redeeming shareholder becomes a creditor on the redemption date, but may or may not have standing to petition for the winding up of the fund.

In the Strategic case, the Board of Directors of the fund suspended ‘redemptions’ after the redemption date but prior to the date on which payment of the redemption proceeds fell due. The fund's articles permitted the fund to suspend payment of redemption proceeds and the Court regarded the Board resolution as covering this point. On the assumption that the suspension was properly imposed, it was held that the redeeming shareholder did not have standing to petition for the winding up of the fund, because at the date of presentation of the petition, the redemption proceeds were not then due and payable.

The Court also held that until the redemption process is complete, a redeeming shareholder remains a member of the company, bound by the ‘majority’ of the fund's articles. While the decision raises a number of questions, its impact has been somewhat reduced by the passing of certain changes to the Cayman Islands Companies Law (2007 Revision). In effect from 1 March 2009, the rules for the winding up of companies were expanded, giving contingent and prospective creditors statutory power to petition for the winding up of a corporate fund.

Thus, a redeeming shareholder technically has standing to petition for the winding up of a fund, even if the date for the payment of redemption proceeds has not passed. However, any such redeeming shareholder (or indeed any prospective or contingent creditor) would still have to establish one of the statutory grounds for insolvency, for example that the fund is unable to pay its debts or that it is just and equitable for the fund to be wound up. We take the view that the prospects of success on such a petition would be slim if the only basis for the claim is the non-payment of an investor's redemption proceeds. The remedy of winding up on a just and equitable basis is discretionary and the Court would have regard to all the facts before making a winding up order.

If a fund is concerned about this possibility, it could enter into agreements with its investors not to present a winding up petition against the fund during this period.  The revised Companies Law now gives statutory recognition to non-petitions contracts and some funds are already utilising this mechanism to agree the circumstances in which investors will refrain from taking action to put the fund into liquidation.

The Matador Investments Decision

The Cayman Court has more recently considered the question of payment of redemption proceeds in the case of Matador Investments Ltd. On the facts of that case, the Court granted a winding up order on the basis that the fund failed to satisfy payment of the redemption proceeds in accordance with the fund documents. The purported suspension of redemptions was not imposed on a timely basis and the fund had no authority to suspend payment of redemption proceeds. The decision is currently under appeal. 

Looking Forward

The Cayman Islands investment funds industry underwent significant stress towards the end of last year. However, the lessons learned from the impact of the financial crisis combined with supportive legislation and greatly improved returns for hedge funds so far for 2009, all point to a positive outlook for the Cayman Islands fund industry.