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Cayman fund regulation: Marginal gains

Friday, July 3, 2020

(AVCJ by Tim Burroughs) - Private equity firms that use the Cayman Islands as a fund domicile are coming to terms with the realities of registration. Is the cumulative weight of increased regulation making them consider other jurisdictions?

It should come as no surprise that comparisons are drawn between private funds legislation currently being rolled out in The Cayman Islands and rules implemented in the likes of Luxembourg. From compulsory registration of almost all private equity vehicles through local audits and ongoing monitoring, the quintessential “offshore” jurisdiction is borrowing from the “onshore” playbook.

“The changes implemented are borne out of an ongoing consultation between Cayman and various onshore regulatory bodies to ensure certain international standards you see in select onshore jurisdictions are also reflected in Cayman’s private equity industry,” says Nicholas Plowman, a Hong Kong-based partner at law firm Ogier. “The new law will provide greater transparency. We don’t expect these registration requirements will give GPs any material cause for concern.”

A clear majority of private equity firms that are active in Asia and raise capital from international LPs locate their funds and their fund management entities in Cayman. Sub-advisors – typically located in Hong Kong or Singapore – are responsible for certain local activity. From August, Cayman-domiciled funds must register, giving the Cayman Islands Monetary Authority (CIMA) a lot more visibility into how they are run, by whom and for whom.

It all stems from efforts by the Organization for Economic Cooperation & Development (OECD) to stop investors exploiting gaps in the tax system to artificially shift profits to low or no-tax jurisdictions. Substance is a key consideration. If investors do not have a meaningful local presence, it prompts suspicions that a jurisdiction is being used purely for tax reasons. Private equity funds are exempt from substance requirements, but registration gives the OECD more comfort.

Stretched resources

The Cayman Islands Private Funds Bill details several fund monitoring requirements: independent annual valuations of assets; safekeeping of assets, which performing custodial duties such as the verification of ownership; checking cash flows and ensuring they are booked properly; and maintaining a register of securities that are regularly traded or held for long periods. While these will take some getting used to, they can be conducted outside of Cayman by experienced administrators.

Neither are the registration fees – a one-off charge of $366, an annual fee of $4,268, and $305 for each downstream investment vehicle – likely to prove much of a burden. However, the need for a locally appointed auditor could present more of a challenge, at least in the near term. Hedge funds already adhere to this mandate, with most of the work carried out in Hong Kong and then signed off in Cayman. If private equity doesn’t follow the same procedure, it will place a strain on resources.

“Have they got the bandwidth, experience, and expertise locally to suddenly start signing off on these audits? That’s something everyone is looking at,” says Darren Bowdern, a Hong Kong-based tax partner with KPMG. “The answer will be that they find a way to do it by leveraging the resources of the other offices. We will get there, but it may involve a bit more work than before.”

There were nearly 30,000 active exempted limited partnerships in Cayman at the end of last year, plus more than 10,000 mutual funds already covered by registration systems. There are fewer than 50 investment funds approved auditors and it is estimated that 5-10 do most of the work. While the big four have standardized internal procedures that make it easier to operate across different jurisdictions, smaller firms – used by a significant number of onshore Chinese managers looking to raise US dollar-denominated funds – are likely to find it harder.

“There was a lot of pushback [on these requirements] from the big four. They were worried that sign-off dates would be missed because the volume of funds coming through is too substantial for them to handle,” says one industry participant. “Everyone is signing up funds because they don’t have a choice, but they are scratching their heads as to who will do this work. Issuing financial statements in the first three months of the year requires significant input from the Cayman team.

Moving out?

This alone is not enough to dissuade investors from using Cayman; ultimately there will be a spike in local hiring activity and the supply-demand balance will reset. But it is part of a wider debate as to whether increased regulation will encourage private equity firms to align each layer of their investment structures in a single location. While there are reasons for Cayman’s longstanding popularity – tax efficiency, reliability, preferred by many LPs – it remains to be seen how much investors are willing to pay for the sake of demonstrating onshore credentials.

Last year, there was a chance this could be put to the test when Cayman decreed that fund management entities – as opposed to funds – would need to accumulate local resources capable of running a fund or relocate elsewhere. Amid warnings that failure to find a commercial solution would hurt the local financial services industry, Cayman arrived at a compromise. According to the latest round of guidance, as long as the management entity’s functions are limited to “providing non-binding investment advice” it will also be exempt. However, qualification is not a given.

“Some Cayman managers are indeed putting substance on the ground in Cayman. The vast majority however have been removed or restructured from Asian fund structures,” says Ogier’s Plowman. “A lot of this restructuring has happened in the last 6-9 months and you now see far more direct engagement between the Cayman fund and its Hong Kong manager.”

If the management entity is being moved from Cayman, how long before the funds go as well? Hong Kong and Singapore can both accommodate management entities, while the former is playing catch-up with the latter as a funds domicile – although it is still very early days even for Singapore.

Jayesh Peswani, head of relationship management for Asia Pacific at Alter Domus, notes that his firm is receiving more inquiries about Hong Kong, Singapore, and Luxembourg structures, but uptake will be gradual and vary based on a GP’s priorities.

“I can see smaller boutique managers and project funds coming this way first along with some  ‘master’ funds, but Cayman won’t lose its status,” Peswani says. “It won’t be Usain Bolt in 2008, maybe more Usain Bolt in 2016: still number one, just not as fast as before and others are catching up.”

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