In the early 1990s, when the fund industry started attracting increasingly more institutional business, the Cayman Islands had no laws regulating funds.
Recognising the growing trend, Cayman’s financial secretary at the time, George McCarthy, persuaded Cayman’s financial sector that regulating the funds industry would be a good thing for the jurisdiction.
At that point, attorney Anthony Travers of the law firm Maples and Calder became involved and, along with Clive Borrowman, drafted a legislative regime for mutual funds that wasn’t overly regulative and took a caveat emptor approach for offshore funds, since it was envisioned these funds would attract sophisticated and knowledgeable investors.
The formula worked.
The client-friendly 1993 Mutual Funds Law, along with a solid existing foundation of quality financial services infrastructure, quickly propelled Cayman as the domicile of choice for hedge funds.
By the end of 1994, Cayman already had 886 total mutual funds administered, licensed or registered. At end of 1998, there were 1,979 total mutual funds in Cayman. In 2003, 10 years after the passage of the Mutual Funds Law, the number was 4,811 and CIMA was receiving an average of 25 applications for new mutual funds every week.
Cayman’s financial services industry faced a number of challenges during the 2000s, but two of those challenges – the 9/11 terrorist attacks on the United States in 2001 and Hurricane Ivan in 2004 – were only minor obstacles in the meteoric rise in the number of Cayman hedge funds.
However, those challenges did have a significant effect on the fund administration sector as businesses realised they needed to improve their business continuity plans.
The globalisation of fund administration had already begun by that time as companies looked for ways to of improving cost efficiencies through the use of global platforms and lower-cost jurisdictions.
At the same time, Cayman implemented term limits on foreign workers, causing many companies conducting fund administration here to reassess their situations. In many cases, the companies decided they didn’t have to do fund administration in Cayman.
The statistics bear out the trend. As of 30 June 2004, CIMA had 179 mutual fund administrators licensed and 606 administered mutual funds. The next eight years saw a steady decline in both. By the end of the first quarter of 2012, there were only 127 licensed mutual fund administrators and 419 administered mutual funds.
HighWater Limited director John Lewis said Cayman had a chance to encourage global administrators to be in the jurisdiction.
“We missed those opportunities,” he said.
“From a government prospective, we effectively made it very difficult to run the businesses here and very expensive to grow the businesses here.”
Lewis said all the big fund administrators now have their systems globally set and that they can put their staff anywhere.
“Quite honestly, it’s expensive in Cayman and [the fund administrators] mostly made the decisions to set up operations in other locations. It’s easier to scale there, it’s cheaper there, there’s less turnover there. So Cayman missed its opportunity as those decisions have been made and infrastructure overseas has been established.”
Lewis expects the number fund administrators to continue to decline in Cayman, but he noted that it’sstill a sizeable business that employs a lot of Caymanians.
“So it’s good for the country for those [still here] to stay,” he said.
“I would hope the government can be proactive and not view this group as a group that can be a revenue source. In that case, hopefully Cayman will be able to maintain the level that we have. “
Julian Fletcher, a partner at Mourant Ozannes, also believes there still is a market for fund administration in Cayman.
“Some clients demand that their fund administration is conducted in Cayman,” he said.
“Having fund administration conducted in Cayman is a very important factor in some structures which seek to establish that the mind, management and control of the fund is conducted in the Cayman Islands.”
Global financial crisis
Although the 9/11 terrorist attacks, Hurricane Ivan and of various international regulatory initiatives all presented challenges to Cayman’s financial services industry during the 2000s, the hedge fund sector – with the exception of fund administration – continued to soar through most of the decade. By 2008, there were nearly 10,000 Cayman Islands mutual funds.
But all of the challenges prior to 2008 would pale in comparison with the global financial crisis, which became apparent to all with the collapse of Lehman Brothers in September 2008.
Even though new hedge fund registrations declined dramatically in the immediate aftermath of the Lehman Brothers collapse, the hedge fund attorneys were extremely busy dealing with a multitude of issues caused by liquidity problems and suspended redemptions in existing hedge funds.
“The year after Lehman was actually one of Walkers busiest years,” said Rod Palmer, the head of Walkers’ Global Investment Funds Group. “This activity was largely focused on distressed fund issues. The new fund launch segment largely fell away.”
Consequently, for the first time since the Mutual Fund Law was enacted, the number of Cayman hedge funds began to drop. After ending 2008 with 9,870 mutual funds, 2009 saw a drop to 9,523. The number dropped to 9,438 at the end of 2010 and to 9,258 at the end of 2011.
Lewis pointed out that although the numbers dropped, Cayman remained a major domicile of hedge funds.
“[The number] declined but it never declined to the level that it was terminal to the product,” he said. “If you put that in Cayman’s fees perspective, that’s still more than 9,000 funds paying CIMA fees, paying registered office fees, etc.”
Besides the reduction in the number of funds in Cayman, the financial crisis also affected the way the funds industry operated and the products it offered, Palmer explained.
“Prior to the global financial crisis, hedge fund documentation in the hedge fund industry was highly commoditised, but post-Lehman, what we’re seeing is more bespoke hedge fund documentation,” he said, adding that some investors won’t tolerate the provisions of hedge funds that were commonplace before the global financial crisis.
“Pressure from investors is demanding a move away from certain terms like redemption gates and side pockets in the funds. Investors now won’t tolerate restrictive liquidity terms in fund documents that don’t line up with the liquidity of the underlying strategy.”
Palmer said one of the much-talked-about trends prior to the global financial crisis was the convergence of the hedge fund and private equity industries, as more and more hedge fund managers at the time were including elective side pockets to enable them to invest in illiquid private equity-style investments in the same fund as their hedge fund strategy.
“Elective side pockets are now pretty much extinct in new hedge fund launches,” he said.
Another trend that virtually ended with the financial crisis was the fund of hedge funds, Palmer said.
“The fund of fund business model has had to re-invent itself to survive.”
Palmer said that post-financial crisis, the hedge fund industry is becoming increasingly institutional, with much of the new launch activity and assets under management growth coming from hedge fund managers with $5 billion or more.
“Investor risk aversion as a result of the crisis has contributed to this trend as the weight of money being allocated to hedge fund strategies is being invested with the larger institutional hedge fund managers,” Palmer said.
One other development since the global financial crisis has been pressure to reduce management fees. Palmer said the 2 per cent fee that was standard prior to the financial crisis is more often 1.75 per cent or 1.5 per cent now.
“We are also seeing more hedge funds offer management fee breaks to investors in consideration for giving up liquidity,” he said.
Since the financial crisis was unprecedented in the modern investment era, there were lessons learned as a result.
“We definitely learned from the financial crisis,” said Mourant’s Fletcher. “In 2008 funds were suspending redemptions left, right and centre, resulting in several cases before the courts. We’ve improved our documents to deal with the mechanics of redemptions and suspension of redemptions.”
In addition, Fletcher said Cayman court judgments arising out of the financial crisis have led to structuring considerations of which investment managers should be aware.
“One of them is where there may be a soft wind down of the fund's investment activities by the investment manager,” he said. “The constitutional documents of Cayman funds now require careful drafting to mitigate against the risk of winding-up petitions."
At the end of the first quarter of 2012, the number of Cayman Islands hedge funds was once again approaching 10,000 – in fact it was just 10 funds shy at 9,990.
However, the figure was buoyed by the first-quarter registration of 837 master funds, which were not required to be registered in Cayman previously. The categories of other mutual funds – registered, administered and licensed – all continued to fall slightly from previous quarter end, but still remained over 9,100.
Highwater’s John Lewis said Cayman’s fund product was still dominant.
“It was interesting to read about Ireland talking about their percentage growth in their non-UCITS and that they have 4.3 per cent growth this year,” he said. “But that’s a percentage. When you look at absolute numbers, Cayman is completely dominant.”
Lewis said that attorneys in onshore jurisdictions are saying there is a complete flight to quality in the hedge fund industry.
“That quality is perceived as Cayman funds and the vast, vast, vast majority of new funds are Cayman funds,” he said.
Palmer said Cayman is still the default jurisdiction for hedge funds.
“Cayman has remained the domicile of choice for hedge and private equity funds,” he said. “People still start with Cayman as the fund domicile default position unless there are clear structural drivers mandating an alternative jurisdiction.”
Palmer said a variety of factors combine to keep Cayman attractive to investors and investment managers including “speed to market, cost, Cayman’s flexible regulatory regime and established system of law, and also the familiarity and marketability of the Cayman product to investors”.
“In addition, one of the practical factors leading to Cayman’s position as the leading domicile for hedge funds, which is often underestimated, is the well-established service provider network between the law firms and the asset managers onshore and the service providers in Cayman, in particular the Cayman law firms,” he said.
“The established patterns of usage between these industry participants together with the onshore referrer’s familiarity with the Cayman regime and fund documents help to underpin growth in Cayman’s hedge fund industry.”
One of the areas of strong growth Palmer said Walkers is seeing is in the number of single investor funds being set up.
“These don’t show up in the CIMA registered hedge fund statistics, but we have been very active in establishing these for our larger hedge fund managers,” he said.
“This is a post-global financial crisis trend driven by the institutional investors’ increased bargaining power and their desire for more portfolio control and transparency, as well as for the preferred fee terms such investors are able to negotiate.”
Another big trend in the hedge fund industry is the move toward more independent directors, Palmer said.
“There’s increased demand for better corporate governance and higher-touch independent directors with a breadth of relevant experience, even though they are more expensive,” he said. “Investors are driving the managers to focus on corporate governance and board composition and the director services businesses in Cayman are responding to it.”
One such business is HighWater Limited, which markets itself as a boutique provider of director services for the offshore alternative investment industry.
Lewis said investors are driving the trend for independent directors.
“Increasingly the allocators are looking at who the directors are…because there’s an awareness that when you have situations like in 2008 and you need to gate and you need to suspend, you need to know who the directors are because those are the people who are making those decisions,” he said. “So you want quality, able people in those roles.”
Lewis said HighWater had experienced phenomenal growth and that the directorship business was growing rapidly, something he thinks is not only good for the fund industry, but also good for Cayman.
“Locally we have seen a number of individuals spin out from big groups to set up their own fiduciary shops,” he said. “And we need more quality people. There are 10,000 Cayman hedge funds out there, a number of which don’t have independent directors, so the more quality and able people we have in Cayman providing that service is a good thing.”
Lewis said there is a fundamental capacity constraint for how many directorships an individual can have in the boutique model, so there’s plenty of room for more companies to provide the service.
“The problem is, the people need to be able, so the people coming into the boutique model need to be, by definition, the seni or and more experienced people,” he said. “For example, [HighWater founder and Managing Director] Gary Linford is the ex-head of CIMA on the funds side; I used to run Butterfield Fund Services; [Director Winston Connolly was an associate at Maples and Walkers.”
The list of others providing the service in Cayman is equally impressive and includes the former managing directors of at least six local fund administration companies or fiduciary groups.
“These are not junior positions,” Lewis said. “They need to be credible, experienced people… and over time, you’ll have a bigger pool of people able to do that. But you can’t just throw in junior people and expect them to be able to fulfil the role, regardless of the technology that supports them.”
Lewis also thinks independent directorships are good thing from a regulatory perspective, especially following last year’s judgment in Cayman’s Grand Court in the Weavering Macro Fixed Income Fund Limited case, where the fund’s directors were found to be in default of their fiduciary duties.
“A lot has been made in the press outside this country about the directors of the Cayman fund Weavering,” he said. “But let’s be very clear: Weavering directors were not independent, even though they were portrayed as independent – it was the brother-in-law and father-in-law of the manager.
They were based in Sweden, they were not regulated by CIMA, they were approved by the Irish Stock Exchange – they were not approved by CIMA. That was not a Cayman issue. That was the case for why in fact you should have professional independent directors.”
Challenges on the horizon
Going back to the 1980s, Cayman – and indeed, the entire offshore financial world – has faced a steady stream of regulatory pressures from the United States, European Union and international bodies.
Many of these initiatives, like the European Union Savings Tax Directive in the early 2002s, initially seem like they could wreak havoc on Cayman’s financial industry, but in the end, they weren’t so bad.
As the former president of the Cayman Islands Bankers’ Association Eduardo D’Angelo Silva once put it:
“These kinds of legislation always start out as a big dragon and come back an iguana.”
After the global financial crisis began, onshore jurisdictions started ramping up pressure again on offshore jurisdictions to the point where now Cayman and the rest of the offshore world faces a host of effects from onshore legislation it will have to deal with in the near future.
On such piece of legislation is the US Foreign Account Tax Compliance Act, which comes into effect next January and will require overseas financial institutions that have dealings with the United States to report financial holding of all United States’ persons.
Of all the pending onshore legislation, Lewis thinks FATCA will have the most impact on the hedge fund industry.
“It is actually going to be the most work effort, particularly for the administrators,” he said. “There is going to be a lot of work. There is going to be a lot of stresses and strains on the industry, but my view is that history has shown that when increased regulation takes place, there is a flight to quality and Cayman does better.
“So, not downplaying the stress generated and the work effort that will be required, I fully expect this to eventually play to our strengths as a jurisdiction,” he said, listing Cayman’s strengths as its high quality lawyers, auditors and administrators, as well as a good work ethic and being in the right time zone
“We’re better than our competitors,” he said. “So absent a huge paradigm shift… the more regulation there is, the better, I believe, Cayman will come out of it, as has been our history in the past. Every time something happens, we do better and the others do relatively less well.”
Parts of the US Dodd-Frank Act will also affect the offshore fund industry, Walkers’ Palmer said, pointing to the overhaul of the registration regime for fund managers and the ‘Volcker Rule’, which restricts banks and certain other deposit-taking institutions from proprietary trading.
”One of the chief effects of the Dodd-Frank Act on the non-Institutional US hedge fund industry is to remove the private advisor exemption traditionally used by hedge fund managers and require most hedge fund managers to register with the Securities and Exchange Commission, subject to limited exemptions,” Palmer said. “SEC registration brings a host of new reporting and record-keeping requirements, but should not directly impact the use of offshore vehicles by US managers.”
Palmer also pointed to the European Union’s Alternative Investment Fund Managers Directive.
“The main area that the AIFMD impacts on the Cayman funds industry relates to the ability to market Cayman funds into the EU,” he said.
“Back in November last year the European Securities and Markets Authority, the new EU securities regulator, made recommendations to the European Commission on the Level 2 implementation measures for the AIFMD, which would result in a favourable outcome with respect to the marketing of Cayman funds into the EU. In essence, the position being that Cayman funds can be marketed into the EU pursuant to a modified private placement regime up until at least 2018, subject to certain pre-conditions being meet and subject to the fund meeting certain increased transparency and investor reporting requirements.”
But Palmer cautioned that all of ESMA’s recommendations haven’t been accepted yet.
“The current status of AIFMD is that the European Commission is still drafting the Level 2 regulations implementing the Directive and regulations as currently drafted do not adopt all of ESMA’s recommendations.”
One effect Palmer foresees from increased onshore regulation of the funds industry through legislation like Dodd-Frank and AIFMD is the continuing trend of institutionalisation of the hedge fund industry, “principally because the increased regulation makes it more difficult and costly for start-up hedge fund managers to survive”.
Looking ahead, Lewis thinks law firms will continue to split away from affiliated fiduciary groups.
“I certainly see a likely trend that these fiduciary groups will split out because there are many people in the industry, myself included, that think there is a conflict there of having your lawyers also affiliated with the fiduciary groups,” he said.
“I think it is only a matter of time until this separation takes place and obviously we’ve seen it now with Walkers [Fund Services] and I would expect it will happen with other firms in the not-too-distant future.”
Lewis said the splits have nothing to do with the quality of the people in the affiliated fiduciary groups.
“The people they have in those groups are very able and very capable,” he said.
“It’s just for many investors you want your directors to be fully independent with no conflicts at all. Those fiduciary groups stepped up and fulfilled a need that that market had. Our industry needed that service, but as the industry matures, I see that that the fiduciary affiliates will split away from the law firms.”
One area where Lewis sees significant growth potential in the future involves a situation where there is a UK-regulated Financial Services Authority advisor managing an offshore fund.
“They typically set up a Cayman manager, who contracts with the fund as the manager,” he said. “Based on the advice from the UK tax advisor and onshore attorneys, the Cayman manager then delegates some of the duties to the UK FSA-regulated entity – typically the portfolio management duties.”
However, Lewis said many of the other duties of the manager – like cash management, accounting for the Cayman manager, investor relations, distribution and group legal – can be performed by the Cayman resident staff of the Cayman manager
“By doing that, you are establishing a true physical presence, rather than the historical approach of everything being done in the UK or Switzerland or wherever,” he said. “If you do that, then some of the revenues are earned here and some of the revenues are earned in the UK; and jobs are created here. So we absolutely see that into the future as a growth area for Cayman.”
Although domestic legislation like that requiring the registration of master funds causes additional annoyance and additional costs – in fees and audit expenses – neither Lewis or Palmer believe it, in itself, caused any major problems in the industry.
“I don’t see the default position for Cayman as the fund domicile of choice for hedge funds and private equity funds changing in the near term, but Cayman cannot be complacent,” Palmer said.
“There is a tipping point in terms of incremental increase in regulation and cost, after which certain promoters will look to alternative jurisdiction for their fund domicile.”
Even though the fund industry has rebounded to a certain extent after the global financial crisis, things aren’t back to the way they were in the peak of the hedge fund boom in the mid-2000s – and nor are they likely to be again anytime soon.
“We are still in a period of extreme risk aversion,” said Palmer.
“This obviously makes it a difficult capital raising environment for asset classes like equities and alternatives as money has flowed to lower risk fixed interest.
“That said, the large institutional investors, like the pension funds and sovereign wealth funds, etc, continue to believe in investing in hedge funds and have largely maintained their target asset allocation percentages to hedge funds in their model portfolios. This is a key indicator for the outlook for the hedge fund industry and it bodes well for the future.”