Fund structuring alternatives

Alternative structuring arrangements for funds are attracting attention as managers look to find ways to reduce entry costs and deliver cost savings to investors, as Jennifer Parsons of Mourant Ozannes describes.

In June 2015, the British Virgin Islands introduced “incubator funds” to appeal to start-up managers and friends and family funds. These ‘‘regulation light’’ vehicles were undoubtedly a response to a growing segment of the investment advisory market looking for structuring alternatives beyond traditional structures and the increasing costs of regulatory compliance. Cayman, however, did not need to amend its legislation to provide such an alternative, as an alternative had existed for some time under the Mutual Funds Law.

Commonly referred to as “4(4) funds”, these are mutual funds that are not required to register under the Mutual Funds Law if they meet the following exemption criteria:

a)         the equity interests are held by not more than 15 investors; and

b)        a majority of the investors are capable of appointing and removing the operator of the fund. The operator refers to the board of directors, general partner or trustee, as applicable.

Both prongs of the above test must be met to qualify for the exemption. From a documentation standpoint, the governing document of the fund (ie, memorandum and articles of association of a company, limited partnership agreement of a limited partnership or trust deed or declaration of trust of a trust) must contain appropriate provisions that ensure the appointment and removal of the operator is done in accordance with the requirements under the Mutual Funds Law. Similarly, the fund must take steps, whether through its manager, a third party administrator or registrar and transfer agent, or otherwise, to carefully monitor its number of investors.

At the time of registration with the Cayman Islands Monetary Authority (CIMA), the requirement for a majority of the investors to be able to appoint and remove the operator is no longer required. It is therefore prudent to consider drafting the fund’s governing document to contemplate both scenarios, thereby avoiding the need to amend the document at a later date, and any investor consent issues that may arise on amendment. Similarly, the offering memorandum for the fund can include broadly drafted language reflecting the fund’s intention to register with CIMA when it is required to do so and outlining the regulatory obligations applicable to registered funds.

There are several noteworthy knock-on effects that arise in the case of 4(4) funds. If the unregistered fund is a feeder fund that invests all or substantially all of its assets into a master fund, the exemption from registration of the feeder fund with CIMA negates any requirement to register the master fund with CIMA, assuming there are no other “regulated feeder funds” within the same structure. One must be careful to ensure that the governing documents of the master fund meet the same requirements noted above for appointment and removal of the operator, but two levels of registration are avoided, at least until such time as either fund exceeds 15 investors.

Equally important to note, because the funds are not CIMA-registered, there will be no annual requirement to file audited financial statements with CIMA or to file fund annual returns. Although most funds will still produce audited financial statements, in line with investor expectations, there would not be the requirement for local (Cayman) auditor signoff where a fund is not CIMA-registered, resulting in cost and time savings.

"Because the funds are not CIMA-registered, there will be no annual requirement to file audited financial statements with CIMA or to file fund annual returns."

One must also consider ongoing compliance requirements for CIMA-registered funds. Under the Mutual Funds Law, a fund is required to file any material updates to its offering document and the prescribed details within the Form MF that it filed on registration. In each case, these filings must be made within 21 days of the updates and separate filing fees are levied by CIMA for each type of filing.

Rules for directors

A further consideration in the case of funds that are companies is director registration and licensing. The Director Registration and Licensing Law (DRLL) requires any director that serves on a CIMA-registered company (be it a fund or a company caught under the Securities Investment Business Law) to register with CIMA. Professional directors serving on many CIMA-registered funds must be licensed under the DRLL.

Frequently the board composition of a fund will include a director who is affiliated with the investment manager sponsoring and/or advising the fund. The introduction of the DRLL in June
2014 added another layer of compliance complexity, especially for these persons. While certainly persons who act as professional directors might expect a measure of regulation by CIMA in the jurisdiction in which they principally operate, the new regime proved especially challenging for those more ‘‘incidental directors’’, serving in such capacity incidental to their affiliation with an investment manager.

CIMA fees apply on registration and annually as well as on the surrender of registration (resignation as a director or termination of the company). For CIMA-registered companies, registration must also be undertaken prior to appointment of any director as a director, or penalties may be levied under the DRLL.

For a 4(4) fund, these director registration fees are effectively deferred until such time as the company CIMA registers. Registration of directors would then be undertaken concurrently with CIMA registration of the company.

It is also noteworthy that a 4(4) fund technically falls outside the reach of the Statement of Guidance on Corporate Governance (SOG) issued by CIMA. The SOG applies to ‘‘regulated funds’’ and is intended to provide such funds with a framework for sound and prudent governance. Although most of the prescriptive measures within the SOG represent best practices, on its introduction in January 2014, some smaller funds and those with solely manager-based operators expressed concern regarding the recommendation to hold at least two annual board meetings and for rigorous record-keeping to be maintained in connection with such meetings. Although 4(4) funds fall outside the ambit of regulated funds, it is difficult to see how their investors would not benefit from sound corporate governance, so in most cases adherence to the SOG guidelines is still recommended and warranted.

The cost savings associated with the foregoing deferrals can be significant over the life of a fund. In the case of a fund that takes several years to reach, or perhaps never reaches, 15 investors it is impossible to argue with the math. There is also the undeniable lessening of what is perceived as an ever-increasing regulatory burden.

Alternative structuring arrangements are certainly gaining attention in recent years as managers look to find ways to lower entry costs and deliver cost savings to investors. While for some managers the possible savings associated with deferring CIMA registration may be short-lived and therefore not warranted, for others it can mean the difference in launching or not. It is therefore important to carefully assess the circumstances of a fund when first structuring to ensure the best outcome for the fund and its investors.

Jennifer Parsons is Counsel with Mourant Ozannes. She can be contacted at: jennifer.parsons@mourantozannes.com