19 July 2017
The industry's number one - importance of the Cayman Islands to the US hedge fund sector
Partner Jarrod Farley explains the importance of the Cayman Islands to the US hedge fund sector, which first appeared in the HFM Special Report: How to start a hedge fund in the US 2017.
The Cayman Islands is the most popular domicile for hedge funds, with close to 11,000 funds registered with the local regulator (Cima), which constitute over 60% of global hedge funds by number and by net assets. Of these funds, more than 70% are managed by US managers and close to a third are administered by US administrators. Evidently, the Cayman Islands are a key participant in the US hedge fund industry, but why is this?
The need for an offshore solution
The Cayman Islands as a financial centre, in common with other offshore financial centres, exists to provide solutions to onshore tax and regulatory problems. The starting point for any US manager looking to launch a hedge fund will quite naturally be to establish a vehicle in the US, generally a Delaware limited partnership. This may be fine when the fund only admits or intends to admit US taxable investors, but it can be problematic for funds that want to admit US tax exempt investors or non-US investors.
US tax issues can be complex, and it is not the intention of this article to delve into them in detail. Suffice to say that there are two principal issues that arise, primarily as a result of investments being made through a tax transparent vehicle. First, US tax exempt investors may be taxed on their share of the vehicle's investment income as "unrelated business taxable income", and second, non-US investors may be taxed on any income that is "effectively connected" with a US trade or business. The solution, in each case, is to invest through a corporation or a vehicle that can "check-the-box" to be treated as a corporation for US tax purposes. If that vehicle is itself established in the US, it will be subject to tax on its income and gains, which would negate the benefits for US tax-exempt investors and result in double taxation for non-US investors (who would still pay tax in their own jurisdictions on any distributions they receive from the corporation). The solution is to establish the vehicle in a jurisdiction that does not impose any direct taxation, such as the Cayman Islands.
As with US tax issues, the US regulatory issues are fiendishly complex, but the goal for all alternative investment funds is generally to avoid the costs of unnecessary regulation by falling within available exemptions. So, for example, hedge fund managers will generally try to avoid registering the fund as an investment company under the US Investment Company Act of 1940, by ensuring that it falls within one of the exemptions, such as the exemption in s.3(c)(7) for funds that only admit investors who are qualified purchasers (as defined). We understand that when the fund vehicle is established in the US, such restrictions generally apply to all the fund's investors (whether US investors or non-US investors), but where the fund vehicle is established outside the US, the restrictions will, in certain cases, only apply to the US investors in the fund. This helps to explain why a US feeder fund and a Cayman Islands feeder fund will generally pool their investments through a Cayman Islands master fund, rather than through a US master fund.
Why the Cayman Islands?
Of course, the Cayman Islands is not the only offshore financial centre with no direct taxation, so why has the Cayman Islands become such an integral part of the US hedge fund industry instead of those other jurisdictions? The Cayman Islands has certain geographical and historical advantages that put it in the right time zone to service the US market, with a well-respected legal and judicial system based on English common law, but more importantly, the public and private sectors have co-operated closely since the early 1990s to produce a simple but effective regulatory regime for hedge funds.
Cayman Islands regulation of hedge funds
Cayman Islands hedge funds are regulated under the Mutual Funds Law (as revised) of the Cayman Islands, and the undeniable success of the regulatory regime has largely been a result of its simplicity. There are three tiers of regulation: at the top, fully licensed funds whose operations are subject to full regulatory scrutiny by Cima. These funds are few in number and mainly service the local Cayman Islands market. In the second tier are administered funds, where a locally licensed administrator operates a form of delegated regulatory responsibility. These are mostly funds that could register under the third category, but do not wish to impose the minimum investment requirement. There are only a few hundred of these funds. The third, and by far the most popular category is the registered fund, accounting for around 96% of all Cayman Islands regulated funds. Finally, there is an exemption from any regulation for hedge funds with no more than 15 investors, who have the power to appoint and remove the fund's operator (directors, general partner or trustee, as applicable) by majority vote.
Registered funds register with Cima pursuant to s.4(3) of the Mutual Funds Law, which requires: (i) a minimum investment of $100,000 (or its equivalent in any other currency); (ii) an offering document with sufficient information that a prospective investor can make an informed decision about investing; and (iii) the appointment of a local auditor approved by Cima. There are no other local service provider requirements, no restrictions on investment strategy, leverage, liquidity or risk and investors can be admitted and trading can commence as soon as the registration filings are made with Cima. On an ongoing basis, the only requirements are to update Cima if there are any material changes to the matters disclosed in the offering document and to file audited accounts (and certain extracted information compiled in an annual return) with Cima within six months of the fund's financial year end.
Cayman Islands expertise
Over the years, the success of the Cayman Islands as a hedge fund jurisdiction has been self-perpetuating. It has become the most familiar hedge fund jurisdiction to advisers in the US and elsewhere who are the first port of call for managers looking to launch a new hedge fund, and it has a large body of local service providers including fund accountants and auditors, fund attorneys, independent directors, fund administrators and trustees, with over two decades of accumulated expertise. This familiarity and concentration of expertise inevitably makes the establishment and ongoing operation of hedge funds in the Cayman Islands more efficient in terms of timing and costs than less-specialised jurisdictions.
For the past few years, the US itself has been the most popular domicile for new hedge funds. Without going into the underlying reasons for this, it suggests there may be a large number of hedge funds that have so far only raised capital within the US, perhaps on a relatively small-scale to fall outside the SEC's regulatory ambit. As the more successful of these funds attract or seek to attract larger investments from institutional investors inside or outside the US, they are likely to encounter the tax and regulatory issues mentioned above and reach out for the structuring solutions that the Cayman Islands provides.
This article first appeared in the HFM Special Report How to start a hedge fund in the US 2017.