Cayman begins to see a rise in hybrid funds
UBS Fund Services has had one of its strongest years in terms of winning new clients according to Monette Windsor (pictured), who heads up the Cayman Islands business.
“We’ve invested heavily in our business development team this year and we’ve had to beef up our client onboarding team. We have 165 staff now; we’re the largest administrator on the island,” says Windsor.
Not only has the firm seen client numbers rise, it has also seen a good number of existing managers launch new products. Interestingly, Windsor notes that many of them are not commingled funds but rather products for single investors in the form of a fund-of-one or a bespoke managed account.
Even more interestingly, it appears that hybrid structures are being employed as large institutions, always on the hunt for enhanced yields, turn to more illiquid private equity-type strategies. Windsor says that UBS Fund Services has seen increased activity among its FoHF clients as they continue down the path of reinventing their business model.
“Rather than just launch a product where they are the investment manager to a particular set of hedge fund strategies they are starting to add more illiquid strategies to the overall portfolio mix. Large institutional investors are probably having a lot more say with regards to these single investor funds being established and the type of liquidity they want in those bespoke structures.
“Fund-of-hedge-funds are adding co-investment strategies where they are investing in PE deals alongside the manager, and also in private equity funds themselves. We are seeing more of a blurring of the lines across alternatives. Although the majority of the portfolio in ahybrid structure is still in hedge funds, we are starting to see them dabble in private equity,” says Windsor.
The blurring of the lines that Windsor refers to has led to a move away from traditional structures (e.g. traditional hedge funds, private equityfunds) to structures that combine the benefits – and the operational/administrative challenges – of the traditional structures into a unified entity.
“As a result hedge fund managers are looking to diversify into more illiquid strategies (for example, bank loans, distressed credit and real estate) and/or into close-ended structures that encompass their traditional trading strategies. In all cases, the manager’s primary objective is to better align the firm’s core strategy with investors’ ever-expanding needs for liquidity, portfolio diversification and risk tolerances.
“The most common structures utilised to achieve this are the so-called ‘hybrid’ structures, which are close-ended vehicles with specific investor return profiles (e.g. preferred return profiles) and incentive fee structures that are tied to actual realisations,” says Nikolaos Perros, Global Head of Private Equity and Real Estate at Citco Fund Services.
Ingrid Pierce is Global Managing Partner at Walkers (Cayman). Pierce confirms that they have seen a few hybrid structures in 2014, “although I wouldn’t describe it as a trend. These are mainly being set up by managers who have traditionally run open-ended funds and want to offer a longer liquidity profile to investors. I would say these funds tend to be the exception rather than the rule at the moment.
“When we look at the structures being set up in 2014, a lot of them are North American and European managers setting up products to be marketed in Asia to target the region’s investor base. Unit trusts, for example, are favoured by Japanese investors and we’ve seen a good number of US managers launch these products this year,” confirms Pierce.
“We are seeing a lot of these products being created for single institutional investors who are happy to have a longer-term liquidity lock-up for a certain amount of the investment portfolio. They don’t need to have a monthly liquidity profile for 100 per cent of their investment,” says Windsor.
Daniel Allard is Chairman of the Cayman Islands Fund Administrators Association (CIFAA). Allard confirms that the CIFAA has been seeing an increase in hybrid funds “that are looking to provide different products in one vehicle – FoFs, bonds, equities, private equity and so on”.
When asked what operational challenges these funds present, Allard says that the most significant challenge is to provide customised reporting.
“Traditionally, reporting provided for Single Manager products vs FoHFs has had distinct requirements. Combined products in one vehicle require some customisation to overcome these deficiencies in reporting. Administrators have long learned the importance of integrated systems and processes; therefore the valuation and calculation of NAVs are not significant issues. The main driver behind structuring these vehicles is investor demand. They now would like access to all these asset classes in one vehicle rather than having to invest in several, which can be more costly,” comments Allard.
At a broader level, managers of Cayman funds are adjusting to the different demands that are being placed on them by different investors. Whereas 10 years ago, Cayman was the default option to set up a hedge fund, the onset of regulation such as AIFMD in Europe has not only introduced a wider range of investors, it has created added complexity for managers. Now, each manager needs to carefully evaluate who their investor base is, where potential investors will likely be located, and structure their offering accordingly.
Some commentators feared that AIFMD would signal the demise of offshore jurisdictions but that is proving to be a fallacy. Having said that, some degree of redomiciliation is taking place.
“We had a recent mandate where the investment manager was told that a German institution would allocate USD375m to the fund if it was re-domiciled to Europe,” says Derek Delaney, Managing Director of DMS Offshore Investment Services (Europe) Limited. “In that case, re-domiciling the fund actually brought the fees down. How? Because the fund dropped 4.5 basis points on the administrator basis point charge, reducing it from 12 basis points to 7.5 basis points. It ended up that all investors in the structure benefited from the lower TER.
“Therefore, I would not say that Europe is necessarily more expensive than Cayman. It is a given that if a fund redomiciled with the same AuM it would be more expensive. However, there is always going to be a hard logic dictating redomiciliation, and that is normally the ability to raise further significant assets.”
Of course, investors in the Cayman fund would need to agree to this happening. US investors, in particular, would want rock solid guarantees that they wouldn’t incur higher costs. If they are against the idea, managers are choosing to set up a European Master fund, maintaining the Cayman feeder fund for those US non-taxable investors (and other non-European investors) and in addition establishing a European feeder fund.
“The placement of some of the additional fees are then applied at the European feeder level so that the investment manager is able to maintain the continuity of fees for their Cayman investors. In addition, those Cayman investors still benefit from the depositary guarantee as this applies to the Master Fund so there is a logical reason for those investors to be okay with the amended structure,” observes Delaney.
The ability to run parallel fund structures in both the Cayman Islands and Europe is, at present, the preserve of established managers. They have the assets and sufficient working capital to absorb the costs and grow organically. For start-up managers, however, the prospect of launching a hedge fund in today’s regulatory environment is far more daunting.
This is why turnkey solution providers such as International Financial Administration Group (‘Ifina’), who established their Cayman-based Primary Development Fund a few years ago, are proving to be a vital cog in the wheel. They offer a cost-effective solution to managers who simply cannot afford to launch a standalone fund from day one.
“The first thing we ask prospective managers is, ‘Where are you domiciled and where do you plan to market your fund?’ If the US is really important to them then they can’t have a plain vanilla structure in Cayman, they need to have a master/feeder. Our advice to managers is to use our Primary Development Fund as a stepping-stone. If Europe is not critical from day one, go the Cayman route by establishing a sub-fund because it’s simpler and one can get up and running quickly. Then, add on additional markets once the strategy has built a track record. It’s a building block approach; build up the investor base piece by piece,” says Derek Adler, director and founding member of fina.
Despite changing regulation, Delaney does not think there will ever be a complete switch from offshore jurisdictions to onshore.
“The reality is the most significant portion of the market, the US, continues to be very comfortable investing into Cayman fund structures. There is nothing evident in any pending US legislation that will change that. If Cayman continues to be acceptable and accessible to the largest hedge fund investors it is always going to remain one of the leading domiciles.
“What will happen, however, is that the lead it has enjoyed over second and third largest domiciles, in Ireland and Luxembourg, will diminish. Cayman will continue to service US tax-exempts with its lower fee model and Ireland and Luxembourg will service European institutions, while the rest of the world will decide to go into one or the other.
“That split will always be maintained. Investors will always need both products,” states Delaney.
As FoHF firms have had to adapt to the changing needs of investors, so too fund administrators have had to evolve their business model. Given that they all offer the same commoditised services e.g. reconciling the books, striking the NAV etc, the emphasis has shifted to provide value-added services, particularly with respect to regulation in the form of AIFMD and FATCA.
Greg Fenlon is Global Head of Investor Relations at Citco Fund Services. Fenlon confirms that Citco has had a comprehensive FATCA offering in place for some time.
“We work closely with our client base to undertake a gap analysis of the pre-existing investor base and any subsequent remediation required. Since 1 July 2014, we have embedded FATCA compliance as a key component of our investor on-boarding process, with consideration not only to US FATCA but also to UK and other FATCA regimes. We, along with many administrators, are preparing to comply with the various reporting requirements on behalf of funds in the necessary jurisdictions,” says Fenlon.
Not only is UBS Fund Services one of the only Cayman-based hedge fund administrators to offer a Depo Lite solution for European managers running Cayman funds, it has also established a FATCA sponsored entity solution. This involves acting as the sponsor to thosefunds that would prefer to avoid FATCA by using UBS Fund Services’ GIIN number.
“We are seeing a number of Brazilian and Asian fund managers choosing to use this sponsoring solution. Some of them would prefer not to take on the burden of FATCA reporting. As the administrator we have all the information and all of the shareholder transaction records so we are well placed to provide this service,” confirms Windsor.
Allard confirms that for FATCA, CIFAA has set up a working group made up of representatives of its members firms where they discuss the operational issues facing the implementation of the Cayman IGA and the accompanying guidance notes.
“These concerns are submitted to the Cayman government to provide clarity, where required, in further revisions to the guidance notes. This cooperation is helpful in meeting the regulatory demands and addressing the challenges of practical implementation of FATCA,” concludes Allard.
