Hedge fund managers want to domicile their funds in trusted, well-served offshore jurisdictions (or international financial centres - IFCs), which meet the requirements of their investor base. New managers are wary of deviating from leading jurisdictions, wanting to avoid queries over domicile when they have their work cut out convincing investors to part with their cash in support of their investment strategy. Larger managers can diversify according to investor profile and appetite, and across jurisdictions with different levels of regulation.
As new products and themes develop, nevertheless there are opportunities for jurisdictions to carve a niche as innovators in particular sectors such as crypto-assets, or in environmental, social and governance (ESG) themed funds.
The Cayman Islands remain the default IFC for UK-based managers, but inroads continue to be made by other jurisdictions because of the increased level of regulation there, for example in relation to anti-money laundering (AML) compliance. EU-based alternative investment fund managers (AIFMs) have the option of using the passport available under the alternative investment fund managers directive (AIFMD) when managing and promoting EU funds, almost invariably domiciled in Ireland and Luxembourg, and some in Malta.
For managers targeting US investors, Delaware remains the default contender as the domicile for feeder funds, although managers setting up their fund in, for example, Cayman and Jersey, have the option of keeping their master and feeder funds in the one jurisdiction, using local feeder vehicles (eg a limited partnership or LLC structure) with features tuned to a US audience.
Turning to external factors, major geopolitical upheaval has uncovered instability in some IFCs, resulting in a flight of fund managers and vehicles to IFCs that can provide the requisite quality, stability and certainty. Further, the tightening of international regulatory standards, especially around substance requirements, demands that fund managers operating in IFCs evidence a substantive operational presence. That has favoured IFCs that have always required a demonstrable local infrastructure with proportionate regulation, and that have been able to codify pre-existing best practices as opposed to introducing new ones.
A corollary to the redistribution of economic power and the rearrangement of geopolitical influence evident since the Russian invasion of Ukraine is the development of IFCs in the Middle East, notably in the UAE (as discussed in detail elsewhere in this publication ), which is conveniently positioned between Asia and the West, and able to entice managers from high tax locations with attractive relocation packages.
Themes And Developments Influencing Fund Domiciliation
Recent regulatory and other developments may have a bearing on the choice of fund domicile, and investment themes can also be a factor in jurisdiction selection. Some topical issues in this context are now discussed.
The Cayman Islands and the grey list: In June 2023, the Financial Action Task Force (FATF) announced that the Cayman Islands is now eligible for removal from its “grey list” of jurisdictions subject to increased monitoring. At the next FATF Plenary, scheduled for October 2023, the Cayman Islands will receive confirmation as to whether it will be delisted. This issue has been more of an irritant than a fundamental problem for Cayman, and the expectation is that it will be delisted. Although the FATF listing and the equivalent EU AML listing currently present no specific disadvantage to Cayman funds beyond a reputational issue, a delisting will nevertheless remove an unwanted negative factor from an assessment of Cayman as a fund home. Malta had a short period on the grey list last year, a situation temporarily of more gravity for an EU state. Removal from the FATF list should also result in Cayman’s removal from the EU AML list.
The US Private Fund Advisor Rules: In August 2023, the US Securities and Exchange Commission (SEC) promulgated its long-awaited private fund advisor rules (the Rules) that will dramatically expand the compliance and operational obligations of private fund advisors when they come into force in twelve months’ time. Because of the regulatory burden that will follow, as firms prepare for the new Rules, hedge fund managers will take their impact into account when selecting fund jurisdictions. Non-US managers who are SEC-registered investment advisers or exempt reporting advisers will be caught by the Rules when advising a US client, and so legitimate avoidance of the Rules would involve, for example, avoiding Delaware as a jurisdiction for US feeder funds. Similarly, US investment advisors will be able to offset the impact of the Rules by establishing funds outside the US.
Fund marketing: The facility with which funds can be marketed remains a key factor in the choice of fund domicile. As noted in the introduction, EU funds managed by an EU AIFM can be marketed across the EU to professional investors using the AIFMD passport. Non-EU AIFMS who wish to market their funds in the EU are left relying on national private placement rules (NPPRs) of varying utility, so a number confront the marketing dilemma by using fund platform and AIFM services offered by platform providers based largely in Ireland and Luxembourg. By doing so, they can offer an EU parallel fund to EU investors without having to register and report on their main fund.
Where NPPRs are flexible and workable (the UK and the Netherlands are examples) then all the major IFCs qualify under applicable regulatory co-operation arrangements to enable their funds to be marketed.
Fund costs: Another material component of fund jurisdiction selection is cost. Fund formation expenses differ widely across IFCs, fund types, and service providers. Indeed, aversion to creeping regulation in the Cayman Islands has led to some US managers preferring to establish funds in Canada, as discussed below. As a rule of thumb, the more regulated the jurisdiction and the fund product, the higher the costs. Consequently, a fund established in a low regulation jurisdiction will be significantly cheaper to form than one in a regulated jurisdiction like Ireland or Luxembourg. Not only are legal fees higher in those fund centres, but EU regulations bite requiring, among others, AIFMD and ESG disclosures.
Canada as an alternative domicile: As referenced above, and a development of note, is that Canadian limited partnerships (usually formed in Ontario) can represent a lower cost, minimally regulated solution for entities organised as flow throughs for tax purposes, or as elective ‘corporations’ for US tax purposes, subject to certain conditions. One of those is that the fund does not invest in regulated asset classes, which include real estate and energy (and may simply give rise to Canadian federal and provincial tax filing and payment obligations). For managers seeking a blocker for US taxable investors, Canadian partnerships are cheaper and faster than Cayman partnerships, are subject to lighter regulation, and are not perceived as being organised in an ‘offshore’ or ‘tax haven’ jurisdiction. The primary drawback to Canadian limited partnerships is that many investors, institutional and otherwise, are not as familiar as other partnerships formed under the laws of other jurisdictions (eg Cayman), so some managers elect to stick with structures that investors will already be comfortable with.
Hong Kong: Turning to Asia, another specific jurisdiction keen to attract hedge funds is Hong Kong, which introduced the open-ended fund company (OFC) regime in 2018 to provide an option for collective investment funds to be established in corporate form. For a Hong Kong manager, setting up an OFC has the advantage over an offshore fund of dealing with a single jurisdiction and a single regulator. In November 2021, Hong Kong introduced legislation to provide for the re-domiciliation of offshore corporate funds to Hong Kong to boost the domiciliation and management of funds in the jurisdiction.
Crypto funds: Although the crypto-asset world is currently in a period of entrenchment and recalibration following the collapse of FTX and other industry ructions, the use of distributed ledger technology (DLT) and evolution of crypto-assets that derive from it continue apace, and many hedge fund managers are invested in crypto-assets. Some IFCs have spotted the potential in digital or crypto assets and have set out their stall to attract funds investing in these. The AIMA/PwC 5th Annual Global Crypto Hedge Fund Report (2023) cites the most common jurisdictions in which respondents are domiciled as the Cayman Islands (34 per cent), the United States (28 per cent) and the British Virgin Islands (BVI) (11 per cent), with no more than 10 per cent in any other jurisdiction. Previous reports have revealed Gibraltar as the main European domicile for crypto funds, a reward for being an early mover in regulating DLT business. Post-Brexit, Gibraltar offers a dual funds regime - either AIFMD compliant or using the local experienced investor and private funds regimes - and is an attractive fund home not only for UK but also for European fund sponsors.
Private credit funds: The Alternative Credit Council (ACC) recently published its research on trends in private funds structuring. It reported that Luxembourg and the Cayman Islands are the most popular fund domiciles for private credit fund managers amongst respondents, followed by the US, Ireland and the UK. The ACC’s research highlighted how investor preferences on domicile are driven by a combination of factors including familiarity, marketing restrictions, treaty access, tax neutrality and regulatory certainty.
ESG funds: There is no clear ‘go to’ jurisdiction for ESG funds. EU AIFMs and their EU funds are subject to the embrace of the EU Sustainable Finance Disclosure Regulation (SFDR) with its complex taxonomy and other requirements. Hedge fund managers marketing their funds in the EU are caught by some of the disclosure requirements of the SFDR and may count that as another reason to avoid marketing there. There are no ESG regulations (yet) that attach to funds in the Cayman Islands or the BVI, whilst Guernsey and Jersey are keen to be seen to take a lead among offshore centres as ESG jurisdictions. Guernsey has, for example, devised the Guernsey Green Fund Regime and the Natural Capital Fund Regime.
Last but not least: It has been long recited, but the list of fund domicile determination factors continues to include familiar and trusted legal systems, an integrated local service provider infrastructure (including experienced local directors and governance support) and tax neutrality.
Hedge fund managers have a wide choice of jurisdictions for basing their funds, their selection is best made on the back of the requirements of their investors. As we have discussed above, IFCs continue to adapt to meet the needs of the fund managers they want to attract, and to accommodate international regulatory standards.
Simon Firth’s practice focuses on funds, investment management and related regulation. He advises investment managers and sponsors on the establishment, promotion, regulation, and operation of alternative investment funds, as well as on managed account arrangements. He is increasingly involved with clients investing in cryptoassets. His related transactional work comprises fund seeding and restructuring, and acquisitions and disposals of investment firms.