Bedell Cristin

Bedell Cristin

Philippa Aylmer
Originally published in the April 2005 issue

The Legal Week/Bedell Cristin Insight survey on non-retail funds reveals the key factors that fund advisers look for when deciding which offshore jurisdictions to go to. It also reveals high expectations about the market's future prospects.

One only has to look at the latest figures from the Jersey Financial Services Commission (JFSC) to get a feel for the growing importance of non-retail funds to the main offshore jurisdictions. The report shows that specialist funds now account for 45% of the net asset value of Jersey's funds, up by 19% from the end of 2003.

"While Jersey's biggest sector, by value, continues to be equity funds, venture capital, real property and hedge funds grew significantly in 2004," the JFSC says. "This demonstrates Jersey's growing importance in these niche markets."

The Legal Week Insight survey on non-retail funds, conducted in association with Bedell Cristin, the Jersey-based law firm, quizzed 50 specialist funds advisers at the UK's top law firms and in-house funds teams. It was designed to assess the key factors influencing which jurisdictions these advisers find attractive for the setting up of non-retail offshore funds. It also asked the respondents to identify those jurisdictions where they would recommend the three specific types of fund under scrutiny – property, hedge and private equity funds.

The findings to this question suggest Jersey, and its neighbour Guernsey, are among an elite of offshore jurisdictions with the right qualities to attract funds work. This grouping also includes Dublin, the Cayman Islands and Luxembourg.

Jersey comes out best of all in the survey, leading the pack for both private equity and property funds. As might be expected, given its reputation in the field, the Cayman Islands steal much of the limelight in the hedge funds category, with 62% of respondents saying they would recommend it for such business. Jersey comes in second (44%) followed by Dublin (36%).

When asked to explain what influences their choice of jurisdiction for non-retail fund work the respondents plumped for mature legal system, political stability and quality of professional services (legal and audit) as their three top choices – qualities that all the leading jurisdictions can credibly claim to have. The respondents were asked to score a list of factors that might influence their choice of jurisdiction with a mark from one to six, with six being 'very important' and one 'not important at all'. Mature legal system clocked up an average score of 4.8, while political stability and quality of legal and audit services both scored ratings of 4.62.

In hot pursuit of this trio of factors were two categories that emphasise the importance of light-footed regulatory regimes – lack of restrictions on structure and investment matters (4.44) and speed of set up (4.32).

Clearly onshore regulatory scrutiny can, and has, influenced both these factors. Nevertheless, the offshore regulators themselves have a key role to play in ensuring that their jurisdictions keep ahead of the game. Jersey's Expert Funds and Guernsey's Qualifying Investor Funds (QIF) regimes are both designed to make the establishment of specialist funds as smooth and speedy a process as possible.

As for those factors that have less influence over the choice of jurisdiction, the presence of 'costs' in third last place with a rating of 3.92 is striking. One explanation for this is that the large sums of money at stake in the specialist funds sector bring issues such as legal certainty, quality of advice and speed of set-up to the fore, with costs considerations viewed as a secondary factor.

The least important of all the factors mentioned was time zone, which scored an average rating of 2.94. Martin Paul, head of the investment funds team at Bedell Cristin, said: "We do not believe that costs are a key differentiating factor, largely because there are no longer any significant differences between the various jurisdictions in terms of professional fees and administration costs. Any perception that the Caribbean jurisdictions were significantly more competitive on fees and costs has been largely eradicated, as far as Jersey is concerned, by the introduction of the expert funds regime."

The respondents were also asked to identify the factors influencing their choice of lawyers. 'Directories' came towards the bottom of the list, with just 4% of the respondents admitting to consulting them, reflecting the traditional reluctance of lawyers to admit to using the guides. Then again, 94% of the respondents said 'reputation' helped determine their choice of lawyer, a factor which, at the very least, can be reinforced by the presence of a firm in the main directories.

Next most popular in determining the choice of offshore adviser was 'personal recommendation', a factor that 88% of the respondents rely on. Fees, which are cited by 72% of the respondents, came third. Nearly one respondent in three (32%) said the ability of a firm to provide multi- jurisdictional legal services was a factor in their choice of advisers. Several offshore firms have moved to develop cross-border offshore capability in recent years, either by opening offices in other jurisdictions or by forging mergers and alliances.

The respondents were also asked to rate the importance of the reputation of a jurisdiction's regulatory regime when determining where to set up a fund. Most respondents (64%) agreed that it was an important factor, but significantly fewer (28%) said it was crucial.

The findings were similar when the respondents were quizzed on the desirability of having regulated and licensed service providers in offshore centres, with 26% deeming this crucial, 56% describing it as important and just 14% saying it was an unimportant factor.

As well as seeking to determine the factors behind the choice of jurisdiction for the establishment of specialist funds, the Insight survey also set out to gauge business confidence in this area. This issue is a timely one, especially in relation to hedge funds, which are rarely out of the headlines. The business press has been full of reports both about their growing influence – and the headache they are giving the onshore regulators, which are battling to quantify the risk they pose to the financial system. Notwithstanding the increasing attention they are getting from the Securities and Exchange Commission (SEC), the Financial Services Authority (FSA) and other onshore regulators, the growing importance of hedge funds is good news for the major offshore centres, given that most hedge funds are based offshore. And the party is far from over, according to the survey. The survey's respondents were asked for their predictions on the level of specialist fund activity in the forthcoming year.

The respondents were bullish when considering all three categories of funds – hedge, private equity and property. But they were most bullish when it came to hedge funds with 24% predicting hedge fund work would increase a lot and a further 48% predicting the level of work would increase a little. That makes 72% of the respondents in all predicting a rise in work. Of the remainder, 20% of the respondents said the level of work would stay the same and just 8% believed it would decrease a little. Although hedge funds have been around for decades, there is no doubt that they have recently moved centre stage – and not just because of their perceived threat to financial stability.

Pension funds are increasingly turning to offshore funds in search of returns they can no longer find through traditional onshore investments into equities and fixed income. This interest, in turn, is having an impact on the funds themselves. Many pension providers such as life offices and endowment funds are faced with a severe mismatch of liabilities and assets, as the nature of their businesses requires sound investments to meet specific pension pay-outs. As more and more of the population near retirement age, pension providers are feeling the burden of those liabilities.

The trend for years for many endowment trustees was to put a significant proportion of all the money they were responsible for investing in balanced managed funds (funds made up of 50% equities and 50% bonds) with life offices. However, the bear market of recent years combined with institutional failures like that of Equitable Life and an array of mis-selling scandals affecting with-profits, split-cap and endowment schemes, have rocked the public's faith in these monolithic institutions. Life office executives and endowment trustees have realised that they are not necessarily professionals in all types of investing, especially when the returns needed to meet liabilities are to be found outside the usual onshore equity and bond markets. Many have followed the lead of Scandinavian and US institutions and hired consultants such as Russell Wilshire & Mercer to advise on higher yielding products such as hedge as well as private equity funds.

The particular lure for institutions investing in hedge funds is bond-like volatility with equity-like returns, at least on certain products. According to Van Hedge, a research group with data on more than 5,000 hedge funds, the number of offshore hedge funds increased by 1,175 to 3,225 in 2003. Van Hedge also estimates that the amount of assets under management in hedge funds has more than doubled from $480bn (£251bn) in 1999 to nearly $975bn (£509bn) in 2004.

The hedge fund landscape is a fluid one

The hedge fund industry has traditionally been dominated by investment from high net worth individuals and family offices. These private investors demand double-digit returns and are willing to accept higher levels of volatility (risk). Institutional investors, on the other hand, typically look for cash plus returns of around LIBOR plus 4% to 5% combined with very low volatility. Divisions in the expectations of investors have put hedge fund managers into one of two camps – traditional managers offering high return products or more institutional managers offering safer investments.

The sheer amount of institutional money in play has also led to two major recent trends. The first is the creation of multi-strategy hedge funds, which invest in several hedge fund strategies to reduce risk. The second and more major trend has been the plethora of fund of hedge funds launches. A fund of hedge funds is a multi-manager fund that typically invests into 30 to 40 different funds thereby providing very low volatility against often diluted returns.

ABN Amro Asset Management, which takes in 40% of its assets from institutions, will be adding three new funds of hedge funds to its range of four this year. Gary Vaughan- Smith, who heads the alternative investment group, says: "The rate at which we have taken in institutional money has been surprising – almost a third of pension funds now have something invested into hedge funds and another 30% to 50% of pensions are thinking of investing. I think we will see the third that is invested move their allocations from 2% to 3% to around 5% to 10%."

ABN Amro added more than $500m (£261m) to its total hedge fund assets in 2004, taking them to $1.2bn (£630m). Vaughan-Smith expects those assets to clear $2bn (£1bn) by the end of 2005.

Gartmore has also seen demand from institutions skyrocket for its fettered fund of hedge fund, which only invests into the Gartmore hedge fund range. Martin Phipps, head of hedge funds at Gartmore, says: "We have only just launched this fund of funds and we have already taken in $400m (£209m) from Japanese institutional investors."

Not surprisingly, this growth has not escaped the notice of either the FSA or the Government. Initiatives by the UK regulatory bodies to attract funds back onshore demonstrate that this greater scrutiny is not all about sticks – carrots are also involved in the process. As outflows of money to offshore regulators increase, onshore regulators like the UK's FSA, BaFin, the German financial regulator, and the French AMF are now allowing onshore versions of some hedge funds. For example, one onshore UK initiative is the qualified investor scheme (QIS) – a quasi-hedge fund available to market to counterparties, intermediate and sophisticated investors.

But Dan Waters, director of retail policy and asset management sector leader for the FSA, says: "We have only been approached by one asset management group to set up a QIS so far."

The major issue according to Waters is that the Inland Revenue has yet to define the tax treatment of QIS. "Until the tax issue is settled, we do not expect many approaches for approval," he says. And there's the rub. While investors and fund managers are alive to the fact that the offshore jurisdictions face ever more scrutiny, they do not exaggerate the threat that this poses. Just 16% of the sample said the attention of onshore regulators was a major threat – only slightly more than those who felt there was no threat (14%). The rest – 70% – said the threat was a minor one.

Bedell Cristin partner Michael Richardson says: "To a very large extent this [onshore scrutiny] is already a fact of life. There is an expectation that regulators will be in touch and share issues. The recent US SEC requirement for registration of hedge fund managers who have more than 14 US persons as investors, wherever the fund/fund manager is situated, shows that it is increasingly not possible to avoid complying with onshore regulatory standards.

"This is not a major reason for locating a private fund offshore. We believe that tax neutrality and a less prescriptive approach to the type of structure which can be set up and more flexibility on investment restrictions are usually the key reasons for 'going offshore'," he adds.

Elsewhere in the survey the respondents were asked how important it was when considering the location for a fund for the jurisdiction to be tax neutral. A resounding 76% of the respondents said it was 'crucial'. That left 22% describing a jurisdiction's tax neutrality as 'important' and just 2% deeming it to be unimportant.

The survey suggests that ever-increasing onshore regulatory scrutiny is unlikely to deter the best offshore centres from their pursuitof specialist funds. It all also points to the emergence of a magic circle of jurisdictions with the right mix of skills, laws and infrastructure to benefit from a market that continues to grow.