Tag Archives: offshore hedge fund

Segregated Portfolio Companies for Offshore Hedge Funds

Hedge Fund Segregated Portfolio Companies

A segregated portfolio company (SPC) is a single entity structure which contains a series of segregated portfolios (sometimes referred to as “cells”), each of which is regarded as a separate legal entity for asset protection purposes. For offshore hedge funds, the segregated portfolio company is the functional equivalent to the domestic hedge fund series LLC. This article will detail: SPC jurisdictions, SPC Offshore structures, SPC offering documents, SPC advantages and SPC disadvantages. Continue reading →

Master Feeder Organizational Chart

3 Replies

For hedge fund managers which are establishing a hedge fund for the first time, it is often easier to understand the dynamics between the different entities through an organizational chart. This is especially true for an offshore master feeder hedge fund which has more moving parts and also has (generally) a different fee structure based on the characteristics of the hedge fund manager’s trading program and the expected tax attributes of the underlying investments. Additionally, the tax residence of the offshore investors must be considered in many circumstances. Continue reading →

Hedge Fund Due Diligence Firm Releases Whitepaper on Hedge Fund Industry

1 Reply

Castle Hall Alternatives, a hedge fund due diligence firm, has just released a new white paper entitled “Hedge Fund Investing in a New World: Five Questions for Investors.” We greatly respect the thoughts and opinions of Christopher Addy, President and CEO of Castle Hall, who has allowed us to repost some of his earlier blog posts (please see Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry).

In this article, I have summarized the thoughts presented in the white paper and added my own thoughts as well. The thesis of the white paper is that the hedge fund industry will change because of the recent market events. The paper is broken up into five different questions and each answer discusses how the current industry trends and what the trends will likely (or should) look like in the future. The issues the white paper raised are:

1. Is 2 and 20 fundamentally flawed?

In this section Castle Hall believes that there may be more hurdle rates in the future, that performance fees periods will need to mirror lock-up periods and that performance fees on hard to value assets need to be reconsidered.

HFLB: We agree with some of the points made in this section. While the fee structure will ultimately be decided by the market, whatever the manager decides upon can be implemented by the attorneys in the hedge fund offering documents. A good hedge fund attorney should discuss the above issues with hedge fund managers who have hard to value assets or long lock-up periods.

2. Do Hedge Funds Need Better Corporate Governance?

In this section Castle Hall argues that hedge funds, especially offshore funds, have very low corporate governance standards and that there may need to be greater oversight in the future. The paper states, “As an immediate priority, investors need a Board which can provide genuine, active oversight in two key areas: portfolio valuation and situations in which funds elect to impose gates or suspend redemptions.”

HFLB: We agree generally and in principle. However, investors will ultimately pay for the expense of greater corporate governance. If investors show themselves willing to pay for the added expenses then it seems there should not be a lot of push back from the hedge fund managers.

3. Is there an ‘Expections Gap’ in the administration industry?

Castle Hall notes that “vigilant oversight from an independent administrator remains by far the most effective protection investors have against manager errors, be they honest or dishonest.” CH then goes on to discuss how hedge fund administrators do not all provide the same services to hedge fund managers and many administrators provide “NAV Lite” services. CH believes that administrators need to have clearly defined and delineated roles which should include real asset valuation (not just rubber stamping a manager’s good faith valutation). CH notes that third party valuation specialists may be a solution but that this could be an expensive option for hedge fund managers and investors.

HFLB: We agree. The term “hedge fund administrator” is one of the loosest terms in the industry right now. Administrators may be full service, provide “NAV lite” or provide mid and back office support as stated in the paper. Sometimes hedge fund offering documents do not thoroughly discuss the actual duties of the hedge fund administrator and we believe that disclosure in the offering documents will increase in the future. In the future hedge fund managers may want to include the actual administration contract in the offering documents as an exhibit.

With regard to third party valuation specialists, we agree that these types of firms will provide valuable services to both hedge funds and administrators in the future. Hedge fund managers should discuss this option with their hedge fund attorney.

4. Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers. Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program. The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents. However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.

5. Is it possible to hold illiquid assets in an open ended vehicle?

Castle Hall questions whether funds which hold illiquid assets should have open contribution and withdrawal periods. If there are open contribution or withdrawal periods then illiquid assets must be valued so that there can be a NAV calculation.

HFLB: We agree that hedge funds need to have valuation methodologies if a fund will hold illiquid or hard to value assets. We do not necessarily agree that funds which hold illiquid assets need to be closed ended (i.e. have a private equity fund structure). Hedge fund attorneys will usually address this issue in a couple of ways: (1) through specifically delineated valuation practices to be utilized on valuation dates or (2) side pocket or similar structures. We do note that in certain instances the manager, as well as the investor, would be better served through a closed end or private equity fund structure. These are issues which the manager will need to discuss with their hedge fund attorney.

Conclusion

Castle Hall concludes with the following statement: “Ultimately, challenge brings opportunity: we remain convinced that a better, stronger hedge fund industry can emerge from the difficulties of today’s markets.”

HFLB: We agree. I have stated before that we think the hedge fund industry will come back strong. As regulations are added and due diligence increases, hedge funds should continue to grow as investors grow more comfortable with hedge funds as an asset class.

The full white paper can be found here. The press release reprinted below, can be found here.

****

November 03, 2008

Castle Hall Releases White Paper on Hedge Fund Investing in a New World

Castle Hall Alternatives, a leading provider of hedge fund operational due diligence, today published “Hedge Fund Investing in a New World: Five Questions for Investors and Managers.”

Chris Addy, Castle Hall’s President and CEO, said “the credit crisis and market events over the past year have challenged the hedge fund industry as never before. Alternative investments will remain integral to diversified, institutional portfolios, but there will unavoidably be a re-evaluation of the hedge fund model.”

Castle Hall’s focus on hedge fund operational risk has helped the firm identify five questions relevant to both investors and managers in this “New World”. The firm’s White Paper asks whether the typical “2 and 20” fee structure is fundamentally flawed; whether hedge funds need better corporate governance; and whether there is an “expectations gap” in the fund administration industry. The White Paper also questions whether the fund prospectus should be written to protect the manager or the investor and asks if it is possible to hold illiquid assets in an open ended vehicle.

“The structures and conventions accepted in the past may not be the best for the hedge fund industry going forward” said Addy. “We have highlighted a number of areas where current practices are weak and, in the New World, we expect investors to be more vocal and require greater protection and control when allocating to hedge funds. Investors will also focus more intently on operational, structural and business issues in addition to performance and strategy.”

Hedge Fund Investing in a New World, the first in a series of thought leadership papers to be published by Castle Hall, can be accessed on our Website, under the Publications section.

Please feel free to contact us if you have any comments or questions. Other relevant HFLB articles include:

Hedge Fund Due Diligence
Hedge Fund Due Diligence 2.0 (discusses some of the same issues as Castle Hall)
Side Pockets and Side Pocket Investments
Side Letters
Private Equity Hedge Funds
Hedge Fund Offering Documents
Hedge Fund Attorney
Offshore Hedge Funds Structures and Considerations
Hedge Fund Auditor
Hedge Fund Administrator

Hedge Fund Administrator – What is a Hedge Fund Administrator?

7 Replies

A hedge fund administrator is a service provider to the hedge fund; the main job of the administrator is to provide certain accounting and back office services to a hedge fund as detailed below.

Hedge fund administrator services

Generally, administrators will provide a variety of services to the hedge fund manager. The central service is monthly or quarterly accounting of investor contributions and withdrawals and computing the profits and losses for the accounting period. The administrator may also provide other back end services such as transfer agent services (handling the subscription documents and making sure checks are cashed or wires are appropriately handled).

A relatively new service which some administrators provide is a “second signer” service which is designed to give investors greater confidence that a hedge fund manager will not run off with their money. Under a “second signer” agreement, the hedge fund manager will need to get a sign off from the administrator before the manager can make a transfer or a withdrawal from the fund’s account.

In addition to the above, the hedge fund administrator may perform the following duties:

calculating the management fee and performance fee
working with the auditor
keeping certain financial records
may act as the registered agent and registrar (offshore hedge funds)
Anti Money Laundering review (generally only for offshore hedge funds)

Three types of hedge fund administrators

Small administration firms – these types of administrators are very lean organizations which are controlled and run by one or two people. Typically the one or two people will have significant experience in the hedge fund industry, many times with other administration firms, hedge fund audit firms and hedge fund consultants. The typical client will be a start-up hedge fund. While these administrators can handle funds with assets of up to and sometimes beyond $500 million, most of their clients will generally start with less than $50 or $100 million.

These administrators are going to be the most cost-effective solution for a start up hedge fund. Additionally, these administrators often provide some of the best customer service – usually the manager will be able to talk to the principal at any time. For these administrators, the manager will be looking at a start-up fee of anywhere from $500 – $1,500 and then a monthly administration fee of $750 – $1,500.

Medium-sized firms – these firms are usually established businesses with strong structure, have been around for a while, and have a fairly large and established client base. It is expected that a medium-sized firm would have one to two principals with 10-20 years of experience in the hedge fund industry. These firms will have clients that range in size from $50 to $500 million and may have clients which have $2 to $5 billion in assets.

Medium-sized firms will charge a start-up fee of $1,500 or more and will usually base their administration fee as a percentage (basis points) of AUM, subject to a minimum monthly fee which is usually around $2,000.

Large firms – these firms are well-established within the hedge fund industry and are thriving businesses themselves. These firms may be subsidiaries of large international banks or (former) investment banks. The principals of these firms are well-connected to the major players in the industry and most of the clients of these firms are the large hedge funds. If a hedge fund uses a large firm for administration, the fund should expect to pay a minimum of around $5,000 a month. Because of the relatively high costs of the large administrators, it may not make sense for a fund with less than $250 million to use such an administrator.

Offshore hedge fund administration

Offshore hedge fund administration generally refers to the administration of an offshore hedge fund. Typically the process and function will be the same, but there are more issues that come into play with an offshore hedge fund. Because offshore hedge fund fees can be structured in a variety of ways, the administrator may want to discuss the structure with the hedge fund attorney if there are any uncertainties with the structure.

Questions on hedge fund administrators

1. How do I find a hedge fund administrator?

There are many ways you can find a hedge fund administrator and other hedge fund service providers. Your hedge fund attorney can help recommend a administrator based on the needs of your fund. Please note that not all administrators offer services to all types of hedge funds. Please contact us if you would like us to recommend a hedge fund administrator (or if you have any other hedge fund administration questions). Additionally, you can reference this survey of hedge fund administrators.

2. Who pays for the costs of the administrator?

As I noted in an article on hedge fund expenses, the costs of the administrator are usually paid by the fund and not by the management company. Some managers may choose to pay the administration costs so that these costs will not be a drag on performance. You should discuss this issue with your attorney. Additionally, please note that the costs above are general guidelines – if your strategy requires more in-depth valuation practices (i.e. the fund trades hard to value instruments), the administration costs may be higher.

3. Does a start-up hedge fund need an administrator?

Yes. While there is no law that requires a domestic hedge fund to have an administrator, there is no real good reason why a hedge fund should not have an administrator. Outside verification of a hedge fund’s numbers, especially given the current state of the capital markets, is becoming a requirement for hedge fund investors. Additionally, there are law firms which will not work with start-up hedge funds that do not have an administrator. Another consideration is the audit – if there are no independent third party numbers to review, the audit becomes more difficult and potentially more costly.

Hedge Funds in the BVI – new requirement to submit annual information

Offshore hedge funds – structure and considerations

9 Replies

Many people don’t understand what an offshore hedge fund is or the purpose of the offshore hedge fund. An offshore hedge fund is simply a structure used by hedge fund managers as a way to attract offshore investors (non-U.S. citizens) or U.S. tax-exempt investors (explained later in this article). The offshore hedge fund will generally be established in various jurisdictions through a variety of structures (that is, as a single entity structure, a side by side structure or a master-feeder structure).

I provided the information in the article below to inform you about the various jurisdictions in which offshore hedge funds will be established. Please note that the driving considerations for establishing an offshore hedge fund will be tax efficiency (both the structure and jurisdiction should be discussed with your attorney), preference and perception of manager and prospective investors and the cost of establishing the fund in the various jurisdictions. Your attorney should discuss these items with you when you consider in which jurisdiction to establish your hedge fund.

Offshore Hedge Fund Jurisdictions

The offshore hedge fund can be established in a variety of different jurisdictions and the driving force for the jurisdiction of choice will be tax considerations. A vast majority of the hedge funds are established in low or zero tax jurisdictions. This means that there is no corporate level tax for the offshore hedge fund – this does not, however, necessarily mean that there are no taxes for the investors in the fund. Instead the investors in the fund will generally be taxed in their country of residence on the income from the fund. Another consideration will be the regulatory laws in place in the jurisdiction.

The two most prevalent offshore jurisdictions are the Cayman Islands and the British Virgin Islands (BVI). In both the Caymans and the BVI there are strong regulatory structures in place in order to assure investors that the managers of the offshore funds are legitimate. Other offshore hedge fund jurisdictions include: Bahamas, Bermuda, Nevis, Guernsey, Jersey, Dubai, among many others.

Structure

There are three main offshore hedge fund structures: single, side by side and master-feeder. The structure will be dictated in large part by the intent of the sponsor of the offshore fund.

Single fund structure – this is a structure which is geared primarily towards non-U.S. investors, and also potentially to U.S. based non-taxable investors (such as pensions and endowments). The sponsor and management company can be either U.S. based or offshore based, but most offshore stand alone fund structures are managed by offshore individuals.

Side by Side structure – in this structure a U.S. based (typical) investment manager will run two completely separate funds in the exact same manner. This means that the manager will form both a domestic and offshore hedge fund. This structure is often good for certain strategies such as a fund of funds strategy. It is not as good for other, trading intensive strategies simply because trade tickets are typically split between the domestic and offshore fund which creates administrative hassles.

Master-feeder structure – this is a very common structure which will have a domestic hedge fund “feeder,” an offshore hedge fund “feeder” and an offshore hedge fund “master.” In many cases the master-feeder structure is the preferable structure from an ease of administration point of view. However, please be aware that there are some accounting considerations which you should be aware of when establishing a master-feeder structure. In many instances this structure can be used to minimize tax impact on the investment manager – our firm has substantial experience with this structure and would be happy to help you think through the issues involved. Other law firms should also be able to help you use this structure to minimize tax impact to the manger.

Cayman Island hedge funds

Cayman is probably the most popular offshore jurisdiction and is viewed to be the pre-eminent offshore hedge fund jurisdiction. The Cayman Islands regulatory body is named the Cayman Islands Monetary Authority or CIMA. There are two types of offshore funds which can be structured in the Caymans: a registered or non-registered fund.

Registration

A Cayman hedge fund is required to register with CIMA if:

The fund is open-ended and has more than 15 investors, OR
The fund has 15 or less investors and those investors do not have the right to appoint or remove a director.

A fund would not need to be registered with CIMA if neither of the above items were applicable. Generally this will be the case for private equity funds and for offshore incubator hedge funds.

Requirements

If the Cayman offshore fund is registered with CIMA, it will need to comply with the following requirements:

payment of an up front and recurring annual fee of US$3048 to CIMA
at least 2 directors who must be individuals (the directors do not need to be resident in the Caymans)
an auditor who is situated in Cayman
a minimum initial investment of US$100,000 or higher

If the fund is not CIMA registered, the fund will only need to have 2 directors.

Other

It was recently released that Cayman Islands has over 10,000 offshore hedge funds registered with CIMA.

BVI hedge funds
[Information on the BVI will be coming soon!]

Tax Considerations
[Information on tax considerations will be coming soon!]

Offshore hedge fund director requirements

2 Replies

Two of the most popular offshore hedge fund jurisdictions are the Cayman Islands and the British Virgin Islands. In another post I will detail the requirements for registration or recognition with these jurisdictions, but for the purposes of this article it is enough to point out that both jurisdictions will generaly require each hedge fund entity (in the case of a master feeder structure there would normally be two offshore entities) to have two directors.

Cayman Islands Director Requirements

In the Cayman there are two types of funds – (i) Cayman Islands Monetary Authority (“CIMA”) registered funds and CIMA non-registered funds. CIMA registration is required if a hedge fund is open-ended (allows investors the option to redeem) and has 16 or more investors. CIMA registration is not required if a hedge fund is closed-edned (does not allow investor the option to redeem) or if a hedge fund has 15 or fewer investors who have the right to appoint or remove directors.

For CIMA registered funds, there must be at least 2 directors who must be individuals. For non-CIMA registered funds, there must be at least 1 director who must be an individual. The individual directors do need not to be a Cayman resident.

BVI “four eyes” policy

In the BVI most hedge funds are deemed to be mutual funds. Because they are mutual funds, they will need to be “recognized” as such with the BVI’s Financial Services Comission (“FSC”).

Pursuant to BVI laws and statutes all companies (including hedge funds) are only required to have 1 director. However the FSC has just recently instituted a new “four eyes” policy which effectively requires that all funds have two directors (the “four eyes” policy has been applied for some time in relation to BVI-incorporated investment managers; however, its application to BVI based funds is a new development). This policy is not codified and it seems to be enforced only on a case by case basis. We are recommending to our clients that they name 2 directors because the liklihood of the FSC requiring 2 directors prior to recognition is quite high.

In the BVI a hedge fund can name a company to be a director.

Offshore Nominee Directors

Not all hedge funds will not have two persons who wish to serve as directors of the fund. The reasons may vary from unwanted perceptions to unwanted responsibilities. For whatever reason in these instances the hedge fund will need to name another person (or a company, for the BVI) which will serve as a director for the fund.

In such cases an offshore hedge fund manager may want to think about using a “nominee” director. There are companies in both the BVI and the Cayman Islands which can provide nominee director services, usually on an annual basis, for a fee. While these fees will depend on a number of factors, including the percieved risk of the fund and the manager, you will probably be looking at anywhere from US $5,000-$10,000 per year.

When searching for a nominee director we recommend shopping around as there are going to be groups which naturally feel more and less comfortable with your program. Some nominees will require some sort of involvement in the high-level affairs of the fund. Some nominees will also ask to be at least be co-signatories on any bank accounts opened in the name of the fund. These precautions are understandable as the nominee services are typically provided by services companies (registered office, registered agent, etc) who could potentially lose their license if something happens with the fund.

Directors from non-US jurisdictions

Please note with all directors the issue of perception. There have been recent instances of large brokerage firms refusing to establish brokerage accounts for some hedge funds because the directors (or even a director) were from states known to support terrorism. It will be a good idea to think about selecting a director who is from country which supports or sponsors terrorism. I do not think that this is a wide-spread practice; however, if a brokerage firm does not allow for the account formation because a new director will need to be appointed, you are going to end up delaying your launch.

Confidentiallity of Director information

In the BVI, the details of directors and shareholders of BVI funds is strictly confidential and not a matter of public record. Funds can if they wish elect to file a register or a document which details directors &/or shareholders but this is not common practice. Obviously the details of directors and shareholders may come into the public domian when they are distributed to third parties (e.g. administrators or auditors) but many times these third parties have previously agreed to keep also such information strictly confidential. Any information held by a fund’s registered agent, likewise, will be kept confidential unless required to be disclosed by order of the FSC (believing it to be in the best interests of the jurisdiction – this is not common and generally requires substantial proof of criminal activity), or a BVI Court.

Offshore Director due diligence requirements

Becoming a director of a company which acts as a hedge fund is not difficult but there are many due diligence requirements for all directors of these companies. While all jurisdictions will differ, the BVI and the Caymans will typically require the following documents from each director:

List of director details – name, address, etc
Copy of director utility bill – can include: gas, power, electric, water, television/cable, phone/internet; showing home address; notarized
Copy of director passport – showing a clear picture of the director, notarized
Director bank reference – should include length of relationship; may need to include average amount of assets
Director professional reference – should be from a lawyer or accountant who has had a previous professional relationship with the director
List of owners/shareholders of director (if an entity)
Copy of director formation documents (if an entity)
Other items as requested by the registered agent

Please contact us if you have any questions on any of the above or would like to inquire about a nominee director or establishing an offshore hedge fund.

Cayman notches 10,000th hedge fund

1 Reply

In a press release statement from Walkers, the Cayman law firm announces that the Cayman Islands have over 10,000 registered hedge funds as of the end of June 2008. Please see release below:

Cayman Islands Sets Milestone with 10,000 Registered Funds
28-Jul-2008

Recent second quarter figures from the Cayman Islands Monetary Authority (CIMA), have confirmed the achievement of a key milestone by the Cayman Islands financial services industry, with over 10,000 investment funds currently registered in the jurisdiction.

At the end of June 2008 there were 10,037 funds on CIMA’s register, compared with 9,681 at the end of the previous quarter and 8,972 at the mid point of 2007. The current annual growth rate of 12% in net new hedge funds, which takes cancellations into account, is particularly striking in the context of the deterioration in global markets following the sub-prime meltdown and associated credit crunch.

“This is yet another round of impressive statistics from CIMA,” said Mark Lewis, senior investment funds partner at Walkers. “The 10,000 barrier has been breached as hedge funds continue to be formed in the Cayman Islands, which remains the clear jurisdiction of choice for investment managers and their advisers around the world.

“Business remains active and the volatility which has impacted world markets as a result of the credit crisis, and the relatively weak valuations of many securities, has provided hedge fund managers with great opportunities to create alpha after a number of years of relatively flat returns”, Lewis added. “Hedge funds have also provided the market with much needed liquidity, which has been especially beneficial amid the current tight lending conditions.”

The continued growth in net hedge fund registrations is also partly explained by the absence of a significant spike in fund terminations. While there has certainly been a slight increase in terminations over the past 12 months, funds are not being closed at an unprecedented rate.

“There have been some forced closures, but in the cases where funds are struggling, the managers we work with are being pro-active by placing hard-to-value securities in side pockets, suspending redemptions and imposing gates. Such measures may enable a fund in distress to ride out the storm or to wind down its affairs in an orderly manner,” said Walkers investment funds partner Nick Rogers. “In the Cayman Islands the key drivers behind the actions being taken are the need to treat all investors equitably and to act in the best interests of the fund, and this provides a firm foundation for protecting market participants and preserving value.”

Among the new funds that have been established in the Cayman Islands, strategies such as distressed debt and special opportunities presented by the widespread markdown in asset prices have continued to feature strongly.

“There has also been significant ongoing activity in emerging markets and commodities,” Rogers added. “The convergence of these two hot asset classes has been particularly interesting.”

There are a number of factors behind the Cayman Islands’ attractiveness as a domicile for hedge funds, in particular the stable economic and political climate, the close relationship between the public and private sector and the presence of the world’s leading professional services firms. The regulatory regime in the Cayman Islands has been recognised internationally, notably by the International Monetary Fund (IMF) and the Caribbean Financial Action Task Force (CFATF) for its high standards. In the area of transparency and “know-your-client” regulations, these standards surpass many of the world’s top international financial centres.

Hedge Fund Law Blog

Hedge fund laws, starting a hedge fund, news and events…