The Cayman Islands leads the world in the domicile of hedge funds. Having worked hard to achieve this status, it is not about to become complacent.
We gathered leading figures in Cayman’s fund community to find out what Cayman is doing to maintain its position, how successful the latest legal and regulatory developments havebeen, and how they see their businesses, and the market in general, developing in the near future.
Their responses make for interesting reading….
John Lewis is managing director of Butterfield Fund Services (Cayman) Limited and chairman of the Cayman Island Fund Administrators Association (CIFAA)
His previous positions include vice-president of Fund Accounting at Bank of New York in Manhattan, general manager and assistant vice president of Family of Ethical Funds in Vancouver, and public practice with Price Waterhouse and Deloitte & Touche in Johannesburg, London and Vancouver. John holds a BSc(Econ)(Hons) in Accounting from the London School of Economics and an MBA from Simon Fraser University in Canada. He is a Fellow of the Institute of Chartered Accountants in England and Wales, and has Chartered Accountant designation in Canada.
Jennifer Frizzelle is a partner, Audit, Alternative Investment Practice, KPMG
Jennifer has been in public accounting for more than 10 years and has focused on the hedge fund side of the business since joining KPMG in the Cayman Islands eight years ago. In addition to working within KPMG’s Alternative Investments Group, she has experience in auditing SEC registrants, banks and captives. In addition to her public practice experience, she spent two years as a business planner for a NYSE listed company in the US, which provided insight for a variety of internal responsibilities that she has undertaken for KPMG, both in Cayman and beyond its borders.
Neal Lomax is head of the corporate department of Quin & Hampson
Neal specialises in all aspects of corporate work with a particular focus on investment funds. He formerly practised with Skadden, Arps, Slate, Meagher & Flom LLP and Simmons & Simmons in
London, and with Edward Nathan & Friedland Inc. in Johannesburg. Neal holds a Masters of Studies degree from Oxford University, and Bachelor of Arts and Bachelor of Law degrees from the University of the Witwatersrand. He has been admitted as an Attorney of the High Court of South Africa, as a Solicitor of the Supreme Court of England and Wales, and as an Attorney in the Grand Court of the Cayman Islands.
Alan Flanagan is head of business development, Hedge Funds, the Americas Fund Services, and UBS
Alan is responsible for new business development and client relationships for the Hedge Fund Services business across the Americas. Prior to joining UBS in 2005, Alan was a manager at CIBC Hedge Funds Services in the Cayman Islands. He began his career in the Financial Services division of KPMG in Dublin where he worked for four years in the Audit department. He holds a BA in Economics from Maynooth, a National University of Ireland, and is a member of the Institute of Chartered Accountants in Ireland.
What is the Cayman market doing to maintain its competitive edge?
KPMG: The Government of the Cayman Islands, the Cayman Islands Monetary Authority and service providers have historically co-ordinated efforts very effectively to satisfy the hedge fund community that Cayman is a well-respected, yet flexible jurisdiction for their vehicles. In the past, this primarily took place through joint input on legislation, well-executed joint promotion of the jurisdiction, and regular communication between parties.
More recently, the Cayman Islands established an AIMA Chapter, wherein professionals and regulators work together to address developing trends in the industry, participate in and provide feedback to the International AIMA organisation, and look to further enhance the service offering in the Cayman Islands. As the largest domicile for hedge funds, the chapter has taken its responsibility seriously and sees this as an effective forum for further development of the Cayman Island hedge fund offering on a cross-service platform.
Finally, the Cayman Islands Monetary Authority recently began receiving electronic information on each hedge fund under its regulation. In addition to augmenting regulatory oversight, this process allows CIMA to gather and analyse data pertinent to the industry. This will assist in providing the Government of the Cayman Islands with timely and relevant information on probably the most significant industry on the island.
Butterfield: Cayman continues to take the lead in introducing innovative products and legislation with the most recent being the e-reporting initiative that will see a fund’s auditors submit information on assets, growth, etc. that will enable market information to be accurately reported for the first time. Using audited numbers, individual funds will be aggregated to enable meaningful comment regarding performance by strategy, net money subscribed, etc. This is another example of the strong public and private sector partnership that has always been one of the main factors behind Cayman’s success. These industry working groups are meeting on an ongoing basis, and are continually reviewing and advising on the laws impacting the fund industry. Another recent example of the results of such consultation include improvements to the mutual funds law, which allow Cayman-based administrators to more easily service non-Cayman domiciled funds.
Quin & Hampson: Cayman has recently enacted a number of amendments to its mutual funds law. The changes include increasing the minimum subscription limit for Cayman hedge funds, allowing Cayman-based fund administrators to administer foreign hedge funds without those funds being required to register with the Cayman Islands Monetary Authority (CIMA) and giving increased powers to CIMA in relation to audits and auditors. A further significant amendment gives CIMA the ability to specify the manner in which audited accounts are submitted to the regulators, and CIM A has now introduced an e-reporting requirement. Auditors are now required to transmit audited accounts to CIMA in electronic form together with a fund annual return form. The e-reporting initiative will provide for more accurate aggregation and dissemination of statistics relating to the funds industry, improve compliance and regulatory requirements, and assist with business recovery and continuity.
UBS: It is estimated that about 70 percent of all offshore hedge funds are domiciled in the Cayman Islands, which is a huge market share. Those who have worked hard to build the industry in Cayman are by no means resting on their laurels. In the last two years, we have seen the Cayman response to the EU Savings Tax Directive and the update to the mutual funds law. Cayman is also home to a great deal of expertise in the law firms, accountants, banks and fund administrators that facilitate the structuring and administration of funds. The Cayman model has developed into one that defines standards for control and compliance in a way that assures investors, supports capital growth and delivers speed to market.
In the medium to long term, Cayman is likely to face increased competition from onshore centres. As institutional investors increase their exposure to alternative assets, they may prefer to invest in funds domiciled in an onshore regulatory framework. At UBS, we have addressed this with the merger of our traditional and hedge fund administration business into a single global Fund Services business, which now has more than $500 billion in assets under administration.
What do you consider are the growth opportunities for your firm in the near future?
UBS: The vast majority of our large client wins have come through transfers of existing funds from other administrators. We believe that this trend will continue and is a direct result of our partnership approach to hedge fund administration. Our unique single point of contact solution offers managers and investors a dedicated, qualified account officer who has top to bottom understanding of the client’s product.
In today’s environment, you need to be able to deliver beyond the norm. Most administrators succeed in getting the accounting and valuations right. However, if administrators want to distinguish themselves, they need the ability to provide a top tier service, along with components such as a global banking platform, web reporting, foreign exchange hedging, and bridge financing.
Another potential area of growth is private equity administration. Traditionally, private equity firms have maintained all their back office support in house. However, with the heightened regulation around the corner, and the reporting requirements of institutional investors and pension funds, the need for independent administration of this asset class is sure to increase.
Quin & Hampson: Quin & Hampson will shortly be merging with Mourant, a professional services group with 900 employees spread across eight international offices. This will provide the firm with critical mass, improved brand recognition and cross-jurisdictional capability. Mourant du Feu & Jeune has recently become the first offshore law firm to open an office in New York, and further international expansion is expected during the course of this year. These developments provide enormous growth opportunities for our hedge fund practice group.
Cayman continues to take the lead in introducing innovative products and legislation, with the most recent being the e-reporting initiative.
KPMG: Besides general growth in the number of hedge funds requiring audits, we have recently seen a number of hedge funds express interest in performance attestation services. Essentially, these are agreed-upon procedures whereby the independent auditors confirm the performance of hedge funds for specific periods of time and for specific portfolios. Oftentimes, these performance attestation reports support figures that are presented to current or potential investors.
We also continue to see work on the restructuring side of the business as well. With general estimates of one in four hedge funds winding down in the first three years of operation, we continue to receive requests to assist with restructurings or liquidations.
Butterfield: Given recent changes in the mutual funds law, we are more aggressively seeking to service onshore US funds. As a result, we are building out our platform and increasing our systems to more fully service some of the unique requirements of onshore funds, specifically the need for partnership accounting. We also continue to see significant interest from larger clients asking us to perform certain Agreed Upon Procedures (rather than full NAV calculation) to support their in-house accounting operations while providing independent comfort to investors.
To ensure we have the service capacity to meet this anticipated growth, we have recently opened an office in Halifax, Canada, and we have been pleasantly reassured by the quality and quantity of the applicants we have received for the positions that we have filled there.
With specific reference to your firm’s capabilities, how can Cayman-based companies help to minimise the risk for investors in hedge funds, and indeed should this be part of their remit?
Butterfield: Directors are actively reducing risk for investors by appointing an independent, CIMA-licensed, Cayman-based administrator. While many of the controls over the risks inherent within a portfolio are delegated to the investment manager, others can be further mitigated by using an independent administrator. For example, investors can take comfort that, when calculating the NAV, the administrator has reconciled positions to prime broker, custodian or third-party administrator statements, performed pricing verification procedures and ensured that the valuation policy of the fund has been consistently followed. As mentioned previously, we also are seeing a developing trend for investment managers to ask us to perform specific additional procedures to provide additional comfort, for example, to cover certain priority items such as enhanced AML procedures to cover the investment manager’s specific internal standards and additional price verification work.
Quin & Hampson: Cayman-based service providers can advise operators on the proper structuring of hedge funds and their continuing obligations.
KPMG: All investors assume risk when participating in a hedge fund. Strategies may be unsuccessful, significant redemptions can pose liquidity challenges, and various other operational risks will always be present. Investors should be cognisant of the controls that are put in place to minimise such risks, with recognition that risk can never be eliminated.
Hedge Funds incorporated in the Cayman Islands with more than 15 investors, minimum subscriptions of US$100,000, or voluntarily registration with the Cayman Islands Monetary Authority require an annual audit. This provides investors with the comfort that an independent party is looking through the financial records, and at certain operational controls and the performance of the vehicle.
Ultimately, much of routine risk management falls with investment managers and administrators. The appropriate identification of trading limits, liquidity provisions, valuation controls, treatment of illiquid securities, etc. can go a long way towards managing investor risks. The Offering Memorandum is a crucial document for understanding the anticipated control environment that will be in place over the trading and financial reporting of a vehicle.
As auditors, we certainly feel that an appropriate three-way reconciliation of trades (between the trader communicating the trade, the custodian executing the trade and the administrator booking the trade) and independent review of valuation (besides the party responsible for valuation) are necessary controls to have in place. Trading limits and liquidity restrictions also can be effective in addressing operational risks. It is good practice to ensure that incorporation and offering documents have provisions to deal with illiquid securities through side pockets at a later point in time. Finally, one of the strongest controls to address fraud risk is the use of multiple independent service providers.
For investors, it is also worth mentioning that service providers situated in the Cayman Islands tend to have particularly strong relationships with the regulators simply due to proximity, the small local population, and familiarity with Cayman laws and regulation. Ultimately, will greater regulation and risk management help to reinforce Cayman’s position in the market, or could it detract from the speed and efficiency that has become the hallmark of the Cayman fund industry?
UBS: Cayman has built a reputation for having the right balance in terms of cost, turnaround time, quality of administrators and auditors, and first-class law firms. One of the great challenges of greater regulation is to develop and enforce standards for control and compliance in a way that supports capital growth. The Cayman model appears well on its way toward being a global model for other jurisdictions. The recent changes to the mutual funds law focus on proper disclosure, so investors are not misled with the nature of the investments and associated risks being evident.
Any regulation enforced on the hedge fund industry as a whole will also be felt in all jurisdictions. Cayman, with its current level of expertise through the administrators, lawyers, auditors and bankers, should be well poised to respond to future changes and stay ahead of the curve for some time yet.
Quin & Hampson: The success of the Cayman Islands in attracting hedge funds and the limited number of failures bears testimony to the effectiveness of the current regulatory system. Any proposal to increase the level of regulation of hedge funds would require very careful review and analysis.
KPMG: Cayman appears to have found an appropriate balance with respect to regulation. The ramifications of a hedge fund failure to service providers and the jurisdiction as a whole are significant. The light-touch regulatory environment in Cayman has proven to be successful over the years. In practice, CIMA and the service providers have an open dialogue that is supported by the Proceeds of Criminal Conduct Law. Rather than conducting time-consuming reviews and setting out strict rules, CIMA places a great deal of reliance on service providers to identify and bring forward potential issues related to a particular hedge fund. Ultimately, it is in all parties’ interests to ensure that any potential problems are identified and addressed on a timely basis.
Risk management practices should be the cornerstone of each vehicle and should be followed in such a manner that they are routine and robust, so that they don’t necessarily impact the speed and efficiency of the product offering in Cayman.
Butterfield: Our experience has been that additional regulation only serves to reinforce Cayman and the world’s premier offshore jurisdiction with a resultant flight of new business to Cayman. While other jurisdictions are indeed moving to try to reproduce the hallmark of speed and efficiency that we have built an industry around, Cayman has significant ‘first mover’ advantage and, rather, we see our jurisdiction taking a larger slice of the ever-increasing pie.
If there was one thing that you would like to see changed or improved in the international hedge fund industry, what would it be and why?
UBS: Over the last few years, we have seen an increase in allocations into illiquid investments, either directly through private equity funds or through small allocations being side-pocketed by hedge funds. The valuation of illiquid investments is one area that needs to be further developed and, from November 2007, SFAS 157 “Fair Value Measurements” requiring all illiquid investments to be fair valued will be put in place.
There are a number of challenges that lie within this regulation and it is not yet clear as to exactly how everything will play out. To date, there is no defined and established method for the accounting of side pockets, so the introduction of SFAS 157 should be an instigator to help push towards a convergence on accounting treatment.
KPMG: With the focus on returns in the hedge fund industry, it’s not surprising to see a great deal of effort put into the front office or trading side of the business. There are circumstances where the back office procedures are not given equal emphasis. For the longevity of the industry, it is in everyone’s best interests to ensure that appropriate processes and controls are established to ensure accurate and robust financial reporting.
For investors, it is also worth mentioning that service providers situated in the Cayman Islands tend to have particularly strong relationships with the regulators simply due to proximity, the small local population, and familiarity with Cayman laws and regulation.
Quin & Hampson: Improved dissemination of accurate information about the industry. The Alternative Investment Management Association (AIMA) now plays a critical role in this regard.
Butterfield: As the response to the blow-ups of Refco and Amaranth last year highlighted, our industry appears to be maturing well and to be efficiently resolving issues as they arise. Since the Washington Round Table, industry experts have repeatedly made comments that hedge funds are good for the financial markets and very little needs to be done in terms of improvement. In fact, the real threat is the general lack of understanding of sometimes under informed politicians in combination with media hype that has created a lot of unwarranted criticism of hedge funds. As such, the time has clearly come for the industry to come together to effectively communicate our role in efficient markets and to ensure that common misconceptions do not become the basis for poor regulations that could harm the sector and negatively impact the markets overall.