CI hedge funds and the global financial crisis

The hedge fund industry has been severely affected by the recent turmoil in the financial markets. The dramatic fall of market prices, pressure to deleverage, short selling bans and the increased costs of borrowing have all negatively impacted hedge funds. Statistics released by the Cayman Islands Monetary Authority confirm the impact of the global financial crisis on funds regulated by CIMA. In 2008, the number of new funds processed by CIMA declined by 18 per cent, and fund terminations increased by 29 per cent, as compared to the previous year. Neal Lomax, Partner and Head of Office at Mourant du Feu & Jeune, Cayman Islands discusses in this second in a two-part series.

The evolution of the hedge fund industry: The hedge fund industry can be expected to develop in an evolutionary way. The following are some of the ways in which hedge fund structures may evolve:

 

Governing documents: Sponsors of new funds will seek to incorporate in the governing documents most if not all of the techniques described above to manage liquidity issues. Managers will also seek significantly greater latitude to restructure funds. However, the governing documents will likely also have to contain significant investor protections in the event of restructuring, given the increased bargaining power of investors vis-à-vis managers.

Sponsors of new funds will seek to incorporate in the governing documents most if not all of the techniques described above to manage liquidity issues. Managers will also seek significantly greater latitude to restructure funds. However, the governing documents will likely also have to contain significant investor protections in the event of restructuring, given the increased bargaining power of investors vis-à-vis managers.

 

Matching assets with liabilities: Managers will seek to structure new funds so that the duration and liquidity of the fund matches as closely as possible the duration and liquidity of the assets in the fund’s portfolio. For example hedge funds with a mandate to invest in less liquid assets may incorporate fund terms more traditionally associated with private equity funds. These ‘hybrid’ fund structures are attractive both to managers seeking to lock in assets and to investors looking at fees and predictability.

Managers will seek to structure new funds so that the duration and liquidity of the fund matches as closely as possible the duration and liquidity of the assets in the fund’s portfolio. For example hedge funds with a mandate to invest in less liquid assets may incorporate fund terms more traditionally associated with private equity funds. These ‘hybrid’ fund structures are attractive both to managers seeking to lock in assets and to investors looking at fees and predictability.

 

Independent administration: An increasingly frequent demand from institutional investors is that hedge fund managers appoint independent administrators, even where the manager was previously providing many or all of the administrative services in-house. Some institutional investors have threatened to withdraw its investments from large hedge funds if they do not retain full-time independent administrators.

An increasingly frequent demand from institutional investors is that hedge fund managers appoint independent administrators, even where the manager was previously providing many or all of the administrative services in-house. Some institutional investors have threatened to withdraw its investments from large hedge funds if they do not retain full-time independent administrators.

 

Managed accounts: Investors with significant assets to manage may show an increased interest in managed accounts. These investors will ask hedge fund managers to replicate their trading strategy outside of the fund’s books but instead in an account that remains in the name of the investor. Though such accounts lack the benefit of co-investment alongside a manager’s personal wealth, some investors believe this disadvantage is offset by lower fees, better liquidity and more transparency than traditional hedge fund investments.

Investors with significant assets to manage may show an increased interest in managed accounts. These investors will ask hedge fund managers to replicate their trading strategy outside of the fund’s books but instead in an account that remains in the name of the investor. Though such accounts lack the benefit of co-investment alongside a manager’s personal wealth, some investors believe this disadvantage is offset by lower fees, better liquidity and more transparency than traditional hedge fund investments.

 

Cayman Islands initiatives

The Cayman Islands Government and CIMA have already taken a number of initiatives in response to the current financial crisis and in anticipation of future developments. These initiatives include the following:

 

International co-operation is one of the four primary functions assigned to CIMA and CIMA actively continues to negotiate agreements with other securities regulators. To date, CIMA has MOUs with 11 overseas regulatory authorities, including the FSA in the UK, and two co-operation undertakings with the SEC and CFTC in the U.S.

CIMA’s international co-operation efforts also extend to facilitating jurisdictional assessments. The second assessment of the Cayman Islands by the IMF is scheduled for early 2009 and the Cayman Islands Government has indicated its intention to work actively with the IMF and to implement its recommendations.

The UK government will be conducting an independent assessment of the financial services industry in Cayman in 2009. Representatives of the Cayman Islands Government will meet with Michael Foot, a former managing director of the FSA, to share perspectives on issues such as financial supervision and transparency, financial crisis management and international cooperation.

CIMA has applied for membership of the International Organisation of Securities Commissions. IOSCO has indicated that it has no concerns about Cayman’s capacity to cooperate with IOSCO member jurisdictions on information sharing and a decision is expected in May 2009.

The Cayman Islands achieved their removal from the FATF “black” list in 2000, and are undertaking active measures to ensure that the Cayman Islands will be on the OECD’s “green” list of jurisdictions deemed to have acceptable international protocols for sharing of tax information. To this end, the Tax Information Authority (Amendment) Law, 2008 was enacted in December 2008 to enhance the provision by Cayman to other jurisdictions of tax information.

Hedge funds are unquestionably under severe pressure, and no one doubts that there will be contraction within the industry in 2009. However, the industry has evolutionary qualities that will ensure its survival. Given the traditional ability of hedge funds to provide liquidity in the markets, the hedge fund community will also have an important role to play in global financial recovery. The Cayman Islands Government, CIMA and the financial services community in the Cayman Islands for their part will support efforts to resolve the financial crisis by continuing to review and enhance the regulatory framework in the Cayman Islands, with a particular and renewed focus on liquidity, risk management, transparency and failure resolution.

 

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Neal Lomax: …hedge funds have resorted to a range of techniques, some traditional and others newly minted, to reduce the pressure to liquidate the fund’s portfolio at an inopportune time

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