The Cayman Islands is renowned as the pre-eminent hub for alternative investment management, but this is possible only because of the deep service offering from the banking sector, says Kristin Castellanos of MUFG Investor Services.
For many years, the Cayman Islands has enjoyed the reputation as the largest and most eminent jurisdiction for alternative investment management; as of December 31, 2018, 11,000 funds were domiciled in the Cayman Islands and this has led to a thriving financial services industry on the islands where many of the world’s most important administrators, law firms, accounting firms and related services are resident.
The Cayman Islands, apart from its importance to this specific industry, is also recognised as one of the top 10 international financial centres in the world, with over 40 of the top 50 global banks holding licences in the Cayman Islands; over $1 trillion is on deposit and booked locally.
This position has given banks in the Cayman Islands the opportunity to observe how the banking requirements of clients change and the important trends that impact the way we need to grow and develop.
Clients now look for near real-time information through web portals, end-of-day reporting sent out automatically by SWIFT messaging, foreign exchange (FX) settlements through multiple counterparties, and the ability to sweep their end of day balances into overnight or short term money market funds (MMFs).
As these requirements have developed simultaneously with the derisking efforts of our correspondent banks, particularly in the US and the move to Basel III by the Cayman Islands Monetary Authority (CIMA), there has been a great deal to consider in recent years.
Responding to these changing requirements has prompted a dramatic increase in product development for banking, FX and fund financing services in the Cayman Islands. When combined with complementary services offered on-island (particularly fund administration) these can result in meaningful efficiencies for alternative investment funds, particularly those that have non-base currency classes to attract capital from global investors. From enhanced traditional banking products to new products helping clients address their fund financing needs, this is currently an extremely active space.
Traditional banking products for alternatives managers, such as subscription/redemption accounts, have long been an important service offering to hedge funds, private equity funds and funds of hedge funds.
As a contrast to some of the high profile US and European banks that no longer provide these types of accounts, some banks in the Cayman Islands, who are more familiar with the requirements associated with the cash flows linked to these accounts, continue to serve as strong partners to their clients. Millions of dollars are spent annually to ensure that bank accounts continue to meet the evolving demands of clients and regulators alike.
Advances in technology now allow applications to share information and it has become a standard view that wherever possible, data entry should be initiated once, reviewed and approved, then passed on to other applications to reduce the opportunity of manual input error.
Wherever possible banks will seek to capitalise on system-driven efficiencies as this facilitates scalability in terms of increasing transaction processing volume without the need for large support teams. One example of this is shareholder redemption transactions automatically generating wire payments by passing these trades from the investor trade processing applications to the banking application.
FX is another area of rapid growth in banking. Although major market makers for FX are typically located in New York, London, Hong Kong and other global locations known for large trading desks, Cayman Islands banks should not be overlooked in terms of FX services. Particularly when combined with fund administration, a comprehensive FX hedging service can result in a high degree of operational and capital efficiency. MUFG Investor Services’ approach is to:
- Consume a daily feed of direct data including:
- Investor subscription/redemption data from transfer agency systems;
- Accounting data (including prior period performance);
- Current FX forwards; and
- Cash balances held on account;
- Calculate the amount of the desired FX hedge (as reflected in a customised client service level agreement [SLA]);
- Generate a FX trade ticket which can be traded at the market or a specified fixing rate (for example, the 4pm London WM Reuters FIX) with tenor and settlements date(s) based on a customised client SLA;
- FX trade recorded in the banking system; and
- Trade confirmation details automatically delivered to the accounting system.
The technology behind the straight-through processing of data resulting in FX hedge calculation and execution requires significant investment. Those banks that choose to commit resources to these initiatives often have a growing clientele in worldwide jurisdictions.
FX trade execution itself is also an area of emphasis for many alternative investment managers. Greater visibility to spreads and trading counterparties, flexibility to trade at best execution or at the WM Reuters FIX, post-trade analytics and electronic trade execution are of increased importance to many market participants.
FX platforms which were once available to only the most sophisticated asset managers are now more publicly accessible, and these tools are driving clients to consider options that they may not have had in the past.
Regarding visibility, the Bank of International Settlements’ issuance of the FX Global Code (updated August 2018), had a significant focus placed on the providers of FX hedging services and how information around FX pricing and execution are communicated and documented with clients. The Code strongly supports full transparency around all processes relating to calculation, trade execution and trade settlement and provides guidance around maintaining adequate documentation around these matters. MUFG has adopted the Code and is proud to endorse these efforts.
Another area of growth is fund financing. Although hedge funds will typically source financing from prime brokers, funds of hedge funds and private equity funds typically turn to specialist lenders for their borrowing needs. As the private equity market has rapidly expanded with record-breaking capital inflows year after year, so has the demand for credit facilities to bridge capital calls and deal financing needs.
In recent years, the fund financing market has soared above $400 billion in size, owing to private equity general partners’ increasing reliance on subscription facilities for short-term liquidity and working capital. To that effect, private equity subscription lines of credit have evolved into somewhat of a commodity for many general partners (GPs), supplemented by over 50 active bank and non-bank lenders in the space.
Conversely, the fund of hedge fund industry has experienced some consolidation through mergers and acquisitions (M&A) activity as well as a shift in investor allocations to direct investments. As a result, only a select number of key players remain in the fund of hedge fund lending space.
Nevertheless, there continues to be an appetite by large institutional investors for financing to bridge subscriptions and redemptions, as well as post margin and settle FX trades.
Although the utilisation purposes are similar, credit facilities for fund of hedge funds and private equity funds are analysed very differently from a collateral perspective. Fund financing for fund of hedge funds requires a lender to “look down” at the underlying hedge fund assets to determine the eligible value it is willing to extend credit against (often referred to as an “asset-based facility”).
Private equity fund financing, on the other hand, calls for the lender to “look up” at the unfunded capital commitments of the limited partners to determine the size of the borrowing base on which it will extend credit (referred to as a “subscription facility”).
Looking ahead, we envision more lenders participating in the close-ended private credit, real estate and infrastructure fund space. As new lenders enter the traditional private equity and fund of hedge fund markets, legacy lenders with more established business models and seasoned employees will use their experience and technology to lend to these other alternative asset class funds.
In addition to institutional lenders, the private credit market itself is filling the void and launching funds today that service other alternative funds, primarily in the middle markets, as well as newer strategy types.
Again, when combined with administration, this leads to the lender having full visibility to the assets and/or limited partners (LPs) of the borrower resulting in faster drawdowns, more flexibility in repayments, faster credit decisions and less reporting.
For clients that have both FX services and fund financing from the same bank, it is often possible to arrange for synthetic margining (which effectively means that the facility is synthetically drawn rather than posting cash margin). As cash is generally not required to be posted under the arrangement, the fund removes the cash drag that would have otherwise impacted performance.
In summary, throughout the value chain of services required by alternative investment managers, banking is a key component (Figure 1). Being able to provide a comprehensive service offering through a local Cayman Islands bank with global resources offers many advantages that managers continue to value when selecting service providers.
Looking forward, Cayman Islands banks will continue to provide attractive options to alternative investment funds but the level of investment in product development, infrastructure and technology is likely to be the best predictor of tomorrow’s future leaders in this space.
Kristin Castellanos is head of banking and treasury products at MUFG Investor Services. She can be contacted at: firstname.lastname@example.org