Ramona Bowry of Maples Fiduciary and Michael Richardson and Anna Goubault of Maples and Calder in the Cayman Islands describe the current regulatory backdrop and how the Maples group’s bespoke fund solutions can provide a smooth passage.
The Cayman Islands remains the offshore jurisdiction of choice for the formation of international investment funds. A cornerstone of the success of the Cayman Islands’ financial services sector is its strong legal and regulatory system, which has proved beneficial to both managers and investors.
Despite a dramatically changing regulatory landscape, Cayman structures have retained their popularity. This has largely been due to efforts by the Cayman Islands government to implement and refine the rules regulating Cayman funds and managers to ensure funds are structured and operate in a manner that meets international standards.
Furthermore, the strong partnership between the Cayman Islands government and the private sector has fostered a thriving service provider industry with many of the large banks, auditors, administrators and other financial and fiduciary service providers recognising the opportunities regulatory developments present.
Trends in fund structuring and formations
The number of hedge funds regulated in the Cayman Islands remains healthy, with 10,940 funds as of December 31, 2015 according to the Cayman Islands Monetary Authority. Anecdotal evidence suggests both managed account and closed-ended fund activity has increased in recent years although this is more difficult to quantify as the structures generally fall outside the regulatory regime in the Cayman Islands. The most useful indicator of closed-ended fund (typically private equity funds) activity is the level of registrations of new Cayman Islands exempted limited partnerships (ELPs) which were at an all-time high of 3,370 in 2015 compared with 2,893 in 2014, resulting in a total of almost 18,000 ELPs. With Maples and Calder advising on a significant proportion of Cayman Islands hedge fund and private equity funds, the firm has unrivalled insight into developments in the alternative investment community.
"A one-stop shop solution ensures that managers and financial institutions have the resources and expertise necessary to adhere to the necessary standards of corporate governance and address ongoing compliance requirements."
Exempted companies remain the most commonly used vehicle for open-ended feeders into Cayman hedge funds largely due to investors’ comfort with the share as a form of security and the well-developed reporting of fluctuating investment values on a net asset value per share basis. However, recent figures indicate that ELPs now constitute a majority of new master funds. This is due, in large part, to the ease with which an incentive allocation or carried interest can be built into the limited partnership agreement.
The vast majority of closed-ended private equity funds established in the Cayman Islands are structured as ELPs, which replicate to a significant degree the Delaware equivalent. While exempted companies are extremely flexible in the extent to which voting and economic rights can be mixed among different classes of shares, companies, by their very nature, have certain limitations that do not apply to ELPs.
Additionally, in response to requests from the investment funds industry for an alternate structuring solution, the Cayman Islands is expected to introduce legislation which will allow for the formation a Cayman Islands limited liability company (LLC). The LLC takes its inspiration, in part, from the Delaware limited liability company and the flexible nature of the vehicle will allow for a broad range of applications.
The evolution of corporate governance
In the wake of the financial crisis, a number of solutions and possible ways to help mitigate the risks surrounding its causal factors have been proposed. While regulation of the financial markets appears to have been the overarching result, one of the areas that was identified and sharply focused upon following the crisis has been the role of the board of directors.
Whereas previously, independent directors were not regarded as significant to the overall structuring of a fund, today a robust board can be critical to the fund’s success and significant decisions in crisis situations (such as gating and suspending redemptions) can rest with the board. In recent years there has been a notable increase in the use of independent directors who are charged with exercising care, skill and diligence in the performance of their duties and applying independent judgement to consider the collective interests of shareholders in the decisions they make.
As of July 31, 2015, 76 percent of Cayman funds used two or more independent directors, an all-time high and an increase from 70 percent as of December 31, 2014.
Beyond an uptick in the use of independent directors, there has been a significant shift in the manner in which directors engage with the fund, its service providers and investors. The institutionalisation of the industry and the impact of new regulatory initiatives aimed at protecting investors has led to a much greater degree of scrutiny on corporate governance, resulting in more proactive and engaged directors than ever before.
Investors have also begun to take a more active role in shaping governance structures with input on considerations such as board composition and the use of other mechanisms for independent oversight.
The increase in ELPs serving as master funds in hedge fund structures has been accompanied by an increasing number of launches with independent advisory boards to ELPs, as well as independent directors to the general partner. There has also been growing discussion around the perceived governance gap in a typical master/feeder structure where there is independent oversight at the feeder level but not at the master level which is controlled by the investment manager and where the investment and the majority of other crucial decisions will be made.
As a result, investors have specifically stated that they want an advisory board in place. While not yet commonplace, it does indicate recognition by investors and managers of the existence of asymmetry between onshore and offshore fund structures and a desire to rebalance it. It will be of great interest to see whether the advent of the forthcoming Cayman LLC structure will result in an increase in the establishment of advisory committees.
In an effort to further mitigate conflicts and increase the independence of boards, there has been a strong preference from some investors for split boards comprised of individual directors from different fiduciary service providers. While the risk of groupthink is present, each of the directors on a fund board is well aware of his or her fiduciary duty and the requirement on each of them individually to apply themselves to the issues at hand. Thus it is more important to seek to establish a well-balanced board of directors with varying and complementary skillsets who can provide appropriate guidance and oversight into the operational functions of the fund’s business and affairs.
The institutionalisation of the industry post-financial crisis has driven demand for enhanced due diligence on boards. This has led to the prevalence of more detailed due diligence questionnaires and on-site visits to understand who is responsible for governance of the fund. It also ensures that all stakeholders have a clear understanding of what investors expect from the board and how they can work with the fund manager and service providers to best meet their needs.
Similarly, directors are seeking to gain a better understanding of a fund’s infrastructure and processes to enhance their level of oversight. In response, Maples Fiduciary established a dedicated operational due diligence function to provide the board with an objective evaluation of a fund manager, key service providers and the fund’s overall operations to assist the firm’s individual directors in fulfilling their duties. Not only does this help mitigate risk at the director level but also provides a value-added, no-fee service to promote and distil best practices and sets a new standard for the industry.
Adapting to regulatory change
The spate of new regulations in recent years has, unsurprisingly, had a significant impact on the way investment funds operate. As a result, managers and institutions have demonstrated a strong preference for outsourced solutions. In turn, service providers have morphed from solely offering specific services to seeking to understand and assess their clients’ needs and to provide bespoke solutions for them.
The Maples group now offers comprehensive regulatory and compliance solutions to the European Alternative Investment Fund Managers Directive, the US Foreign Account Tax Compliance Act, Volker Rule, commodity pool operator and anti-money laundering requirements, among others. Maples and Calder has been at the forefront of advising on regulatory developments and is one of the only offshore law firms to have a dedicated regulatory financial services group. In addition to providing general governance solutions, Maples Fiduciary has taken an active role in establishing best practice policies and procedures around structuring and entity setup and working with managers and institutions on implementation to ensure they are meeting their obligations and complying with all relevant regulatory requirements. For example, many boards of funds now require much more secretarial support in organising board meetings with proper materials to demonstrate good governance practices and oversight.
While regulation has certainly prompted action in the industry, it is yet to be determined what the overall impact will be and the Maples group remains well placed to assist its clients in meeting the ongoing challenges the evolving regulatory environment presents. Providing a one-stop shop solution ensures that managers and financial institutions have the resources and expertise necessary to adhere to the necessary standards of corporate governance and address ongoing compliance requirements.
Following the global trend of institutionalisation and adapting its regulatory and legal system to meet the demands of the financial sector, the Cayman Islands continues to be the pre-eminent jurisdiction for the offshore alternative investment funds industry. The jurisdiction is recognised for its established reputation for attentiveness and responsiveness to developing international trends and commitment to high standards of professionalism and client service and continues to evolve to ensure it meets the requirements of governmental and regulatory authorities, as well as financial sector participants.
As the demand for an inexpensive, tax-neutral and secure method of pooling capital from multiple jurisdictions, and of transmitting that capital to where it can best be employed, continues to grow, the Cayman Islands will be well placed to maintain its position as the premier jurisdiction for offshore investment funds and will undoubtedly solidify its role as a pre-eminent international financial centre in 2016 and beyond.
Ramona Bowry is head of Maples Fiduciary’s in-house operational due diligence (ODD) service offering. She can be contacted at: email@example.com
Michael Richardson is a partner in the investment funds group at Maples and Calder in the Cayman Islands. He can be contacted at: firstname.lastname@example.org
Anna Goubault is an associate in the investment funds group at Maples and Calder in the Cayman Islands. She can be contacted at: email@example.com
Ramona Bowry, Maples Fiduciary, Michael Richardson, c, Maples and Calder, Cayman Islands