Mark Lewis and Heidi de Vries from Walkers examine the expanding hedge fund industry in Cayman and the anticipated impact of the Alternative Investment Fund Managers Directive.
As the world's leading offshore jurisdiction for hedge funds, industry trends in the Cayman Islands are closely watched, traditionally proving a good indicator for the health of the global funds sector and performance in 2010 has seen Cayman's hedge fund industry continue to expand at an impressive rate, compared to other jurisdictions.
With the number of hedge funds registered with the Cayman Islands Monetary Authority (CIMA) poised to pass the all-time high watermark of 10,000 funds in the first half of 2011, coupled with growth in private equity fund formations, the outlook for Cayman is brighter than ever. Cementing this positive picture is the certainty that both EU alternative investment fund managers (EU AIFMs) and non-EU alternative investment fund managers (non-EU AIFMs) managing non-EU funds will continue to have access to European investors.
Confirmation of the final terms of the Alternative Investment Fund Managers Directive (the Directive), which were approved by the European Parliament on November 11, 2010, ensures that both EU AIFMs and non-EU AIFMs will be able to continue marketing Cayman Islands, BVI and Jersey funds to professional investors in Europe. Understandably, this news was well received by participants in the funds industry not only in those countries but also by European investors who will not lose access to the attractive investment fund products offered by these jurisdictions.
The final text of the Directive, which emerged from the trialogue meeting of representatives of the European Parliament, European Council and European Commission, also demonstrates that Europe's ministers have recognised that it would be inappropriate to restrict non-European based funds from Europe, which would have been contrary to the G20 principles of competition.
With regard to the Cayman Islands, going forward the Directive allows for the continued marketing of Cayman-domiciled investment funds to professional investors in the EU, through the traditional national private placement regime until at least 2018. It is proposed (subject to the European Securities and Markets Authority's (ESMA) recommendation) that this regime will transition in 2015 to allow full access to an EU passport marketing regime to both EU AIFMs managing non-EU funds and non-EU AIFMs on the same terms as EU funds.
Between 2015 and 2018 it is expected that the private placement regime and the passport marketing regime will co-exist. The Directive applies to both open ended and closed ended funds and applies regardless of the legal form or whether or not the fund is listed on a stock exchange.
The private placement regime introduces certain conditions on both EU AIFMs and non-EU AIFMs for the marketing of non-EU funds in the EU. For non-EU AIFMs these conditions include the need for supervisory co-operation agreements to be in place between the regulator of the EU member state in which a fund is being marketed and the regulator of both the fund manager and the fund, which must ensure the efficient exchange of information for the purposes of systemic risk oversight.
Additionally, the country in which both the investment fund and the fund manager are established must not be listed as a non-cooperative country or territory by the Financial Action Task Force (FATF) with regard to AML or terrorist financing. The fund also needs to comply with certain basic transparency requirements with regard to its annual report, disclosure to investors and reporting to competent authorities.
The conditions applied for access to the EU marketing passport will be similar to those for the private placement regime. In addition, the non-EU fund manager will be required to be authorised in its relevant EU member state of reference. Also, OECD compliant tax information exchange agreements will need to be in place between the fund domicile and both the fund manager's EU member state of reference and each other member state in which the fund interests are proposed to be marketed.
It is expected that non-EU funds, including Cayman Islands funds, will be eligible for marketing in the EU under the passporting regime from 2015, being two years after the final transposition date for the Directive (being the deadline for transposition of the legislation in the individual EU member states, (the ’Final Transposition Date‘)). As it is proposed that the private placement regime will be terminated five years after that Final Transposition Date (around 2018), both EU AIFMs and non-EU AIFMs looking to market Cayman domiciled funds in the EU will need to be in position to meet the conditions for the passport in order to be ready for EU passport eligibility in 2015.
In preparation for the Final Transposition Date, CIMA has confirmed its commitment to entering into co-operation agreements with EU regulators as a matter of priority. This follows Cayman’s long history of working with regulators worldwide and reflects Cayman’s own strong regulatory framework.
Cayman is also a member of the OECD's 'White List' of nations, which have substantially implemented the internationally agreed standards on tax and information exchange. The Cayman Islands has signed 20 such Tax Information Exchange Agreements, with many G20 and European Union nations including the USA, UK, France, Germany and Australia, with further agreements to follow.
While it is still early days in determining the exact nature of any legislative changes that may be required in the Cayman Islands to accommodate the Directive, there have been some very positive developments over the past six to 12 months in relation to public/private sector collaboration, providing stakeholders with confidence that any proposed legislative changes in Cayman will be done with full consultation.
The passing of the Directive and the removal of a cloud of uncertainty for both EU AIFMs and non-EU AIFMs with respect to marketing non-EU funds in Europe, has the potential to deliver a significant boost to the hedge fund industry in Cayman, which has now rebounded strongly from the liquidity crisis following the meltdown in the banking and credit markets towards the end of 2008.
The number of hedge fund registrations with CIMA has continued an upward trajectory through 2010 with approximately 100 new funds registered each month (excluding the significant number of new single investor funds and private equity funds which are not required to be registered). With the number of terminations back at historical norms, Cayman is seeing around 60 net new funds registered each month, which is significantly ahead of competing jurisdictions.
Some of the industry headlines earlier in 2010, which pointed to investment managers' preference for registering funds in UCITS jurisdictions such as Luxembourg at Cayman's expense would appear to be inaccurate. The more likely scenario had always been that these domiciles would co-exist with the Cayman Islands, each appealing to different, if partially overlapping, segments within the investor and investment manager communities.
In fact, very few funds have re-domiciled from Cayman to set up elsewhere. While UCITS funds are suitable for particular strategies and investors with certain requirements, they are often unsuitable for a large number of others that continue to enjoy the benefits of the Cayman regulatory regime. This demonstrates that the Cayman model is incredibly resilient, as borne out by the statistics on fund registrations as well as the experience of Walkers and other firms regarding recent instructions for the establishment of new funds.
One trend that Walkers has recognised has been the preference of managers and investors to establish parallel funds in the Cayman Islands and in European Union jurisdictions. This was one of the reasons that Walkers established an office in Dublin, Ireland in October 2010.
For North American investors, the responsiveness of Ireland's financial regulator as well as cultural and language similarities with the US make it an attractive jurisdiction to do business with compared to other European fund centres.
Another important development in the jurisdiction has been the establishment of the Grand Court of the Cayman Islands' new Financial Services Division (the FSD), which has delivered tangible improvements in the manner in which civil litigation is conducted in Cayman. With dedicated and highly respected judges assigned to the division, the FSD has provided greater capacity for civil litigation, which raises complex and novel legal issues.
The introduction of the FSD is also timely, given the increase in these complex, high-value disputes and demonstrates a clear commitment by the jurisdiction to being able to service the needs of the financial sector. This was demonstrated with regard to the recent investment funds cases assigned to be argued before the FSD, including a number of winding up petitions brought against funds by investors dissatisfied with the informal wind down process undertaken by managers and directors. One recent case before the FSD, which Walkers was involved in, marked the first time that a pure loss of substratum has been fully argued in this jurisdiction.
Overall for the Cayman Islands, all the conditions, which over the years have made this jurisdiction the domicile of choice for hedge funds, remain intact, essentially the pro-business, cost efficient environment within a strong system of regulation that adheres to international standards under UK common law.
Now for the first time in over two years, following the passing of the Directive, there is some legislative certainty for international investment managers and the way forward to raising capital is much clearer. There will be some significant opportunities for managers, particularly in Europe, which the hedge fund industry in Cayman is extremely well placed to capitalise on.
Walkers Bermuda, British Virgin Islands, Cayman Islands, Dubai, Guernsey, Hong Kong, Ireland, Jersey, London and Singapore.
Mark Lewis Managing Partner- Clients
Heidi de Vries Partner