Update on Cayman's Hedge Funds Industry
A number of clear trends stand out from the Cayman Islands Monetary Authority (CIMA)’s latest statistics. Cayman remains firmly entrenched as market leader and jurisdiction of choice for offshore hedge fund registrations, but the hedge fund registration business in Cayman remains increasingly focussed and committed to the institutional, rather than retail, hedge funds sector, and the hedge funds market has clearly matured to a point where new fund registrations exceed terminations by a now steady and continuing ratio of 3:1.
In the nine-month period from January to September 2006, CIMA registered 1,406 new hedge funds. At this rate more than 1,800 new hedge funds will be registered in Cayman in 2006, surpassing the 1,700 hedge funds registered in 2005, and the 1,405 hedge funds registered in 2004, which were themselves record years for hedge fund registration activity for Cayman.
The world’s leading financial institutions and investment fund managers have long recognised the swift turnaround time for fund establishment, depth of relevant professional expertise and services and the absence of a prescriptive regime mandating location of service providers, and rewarded Cayman with a steady increase in institutional investment funds business. As a result, September 2006 saw Cayman break through the 8,000 registered funds barrier for the first time and in its 30 September report CIMA confirmed a total of 8,088 active registered hedge funds.
Although CIMA does expect more than 600 funds to have their registrations terminated in 2006 (following 575 terminations funds in 2005 and 293 in 2004) the rate of terminations remains firmly in a 3:1 ratio compared against new fund registrations.
The Cayman investment funds industry and CIMA do not view the numbers of fund closures with any concern, believing it demonstrates the efficiencies of the investment industry, where sophisticated investors do not allow poor performance or inappropriate strategies to go unpunished and where start-ups without appropriate risk controls in place do not get sufficient allocated capital.
Not all fund terminations result from poor performance. Many funds are simply unable to attract sufficient capital to commence or survive trading, funds are also affected by external factors (for example counter-party exposure to Refco) and cost of risk management and compliance has increased while legislative changes, such as the reforms to the Pensions Protection Act in the US, make certain structures redundant.
That 3:1 registration/termination ratio appears with some consistency. Cayman has registered a total of 12,000 hedge funds since the Mutual Funds Law was first introduced in 1993. With current active hedge fund registrations today totalling just over 8,000, and total terminations of approximately 4,000, we see a 3:1 ratio over the 13 year life of Caymans hedge fund legislation. Even in the 3rd quarter results for 2006, new registrations of 391 exceeded terminations of 130 – again a 3:1 ratio.
In the wake of a steady increase in business, the private sector in Cayman has backed efforts by both CIMA and the Cayman Islands Government to improve Cayman’s benchmark Mutual Funds Law and introduce a new, and unique, electronic audit filing and information reporting systems to Cayman that will offer significant benefits to the investment funds industry both in Cayman and internationally.
Amendments to the Mutual Funds Law have now been passed by the Cayman Islands Government and are expected to become operative in early November 2006. Although not as extensive as the industry had anticipated, the changes do bring a number of key benefits, particularly in relation to the administration of foreign registered hedge funds in Cayman, an increase in the powers of CIMA in relation to audit and auditors, and the long expected increase in the minimum investment threshold for Cayman hedge funds from US$50,000 to US$100,000.
The most significant change, certainly the change recognised by the CI Government’s Portfolio of Financial Services as having the most commercial impact, will permit Cayman based hedge fund administrators to administer foreign hedge funds without the need for those funds to be registered in Cayman with CIMA.
Cayman fund administrators often administer offshore funds in master-feeder structures, but miss out on the opportunity to administer US domestic feeders, typically Delaware registered, as current legislation requires the Delaware fund to register with CIMA and duplicate registration costs. A more precise definition of ‘carrying on business in or from the Islands’ in the new law will remove this impediment, permitting foreign-domiciled funds to be administered in the Cayman Islands without the need for registration with CIMA. This will effectively allow Cayman based administrators to compete for and take on more business in Cayman.
Despite the change, regulatory oversight of foreign-domiciled funds will not be completely abandoned. CIMA will retain power to limit such derogation to foreign-domiciled funds from countries with registration/oversight standards approved by CIMA and, to avoid duplication, CIMA will almost certainly make use of the ‘Schedule 3’ list that is currently used in determining appropriate jurisdictions for anti-money laundering purposes. Obviously the US, the UK and all other OECD countries are on this list.
On the audit side, CIMA will for the first time have discretion, on application and in restricted circumstances, to waive the requirement for an annual audit for hedge funds, auditors find themselves with extended reporting responsibilities, and CIMA picks up power to disqualify an audit firm, temporarily or permanently, from being an auditor to a regulated fund.
Auditors will now be required to notify CIMA if, in the course of carrying out an audit, the auditor becomes aware of solvency issues, or that a fund is carrying on business, or effecting a voluntary winding up, in a manner prejudicial to investors or creditors, is not keeping adequate, auditable accounting records or is carrying on business in a fraudulent or criminal manner.
Whistle-blowing responsibilities for auditors do already exist, but are now extended to cover an auditor who resigns or is terminated before carrying out an audit.
The distinction between private funds and public funds has been stepped up and is further strengthened by an increase in the minimum investment threshold, effectively dealing with concerns expressed by the International Organisation of Securities Commissions (IOSCO) and the International Monetary Fund (IMF). The change will have little affect in practice as CIMA indicate that more than 90% of the hedge funds registered in Cayman have minimum investment requirements of more than US$1m. All existing Cayman hedge funds are ‘grandfathered’ in and the changes will not affect any hedge fund registered in Cayman before the amendments to the Mutual Funds Law become operative and will not affect any additional issue of shares made by an existing registered hedge fund.
One further significant amendment will allow CIMA to specify the manner in which audited accounts are to be delivered to CIMA. CIMA, mindful of the increasing burden of supervising greater numbers of hedge funds, will implement an electronic reporting system (e-report) for all hedge funds with audits submitted after 31 December 2007 in which key data, reporting requirements and audited accounts will be migrated to an electronic platform.
The new audit and e-reporting system will provide reliable aggregate statistics relating to the Cayman funds industry, increase security for the filing of audited accounts, permit CIMA to conduct its existing supervisory and co-operative responsibilities more efficiently and provide ‘scalability’ enabling CIMA to accommodate increasing numbers of regulated entities without a proportionate increase in staff and costs.
Audits submitted after 31 December 2006, must be submitted direct to CIMA from one of Cayman’s approved auditors (currently 24 in total) in ‘PdF’ format through secure electronic transmission. Although not cutting edge, from a technology point of view, it will increase security considerably for CIMA by ensuring that all audits are submitted to CIMA through a known and approved audit source.
In addition to the electronic audit, every fund must also submit an e-report, completed by a director, general partner or trustee. An auditor cannot in fact submit a funds annual audit to CIMA without submitting the e-report form at the same time.
CIMA is very much aware that Cayman‘s regulatory philosophy is a significant factor in Cayman‘s success as a hedge fund jurisdiction, and CIMA has taken great care to ensure that e-reporting does not increase the scope of regulation. A total of 32 specific data items in drop down menus make up a web-based electronic form. No new information is being asked for and all data requested can be sourced from any set of financial statements or as an update to information generally found in a funds‘ offering memorandum or registration documents. Fund or manager-specific information will not be made available to the public, only aggregate industry statistics.
The legislative changes to Cayman’s Mutual Funds Law are now a reality, as is the e-report initiative. Once again Cayman leads the way with e-reporting and Cayman finds itself the first offshore jurisdiction to collect and collate information of this type. CIMA’s regulatory philosophy towards hedge fund regulation remains attractive to all and continues to balance the needs of investors, promoters, operators, investment managers, prime brokers and fund administrators while increasingly finding favour with national and international regulators who have come to realise the benefits the hedge fund industry has to play in our global financial system.