There was a time when taxation was the overwhelming factor when selecting a fund domicile. While that is still a consideration, other issues have risen in prominence. Regulation and legal structures, changing investment trends and client expectations and priorities are playing an increasingly important role.
The focus on private assets – notably real estate and the closely related infrastructure class – has pushed a number of jurisdictions to adapt their regulation and the fund vehicles available to attract this type of fund. Meanwhile, client concerns over ESG issues and perceptions among some clients around ‘tax havens’ are rising.
But, despite these factors, evolution in the realm of domiciles is a slow process. The well-established domiciles of the Cayman Islands, Luxembourg and Delaware remain the ‘go-to’ locations.
A 2021 survey of fund managers carried out by affiliate title PERE and RBC Investor and Treasury Services found 46 percent of respondents would choose Delaware for the domicile of their next fund launch, followed by Luxembourg (36 percent) and the Cayman Islands (27 percent). When asked specifically about tax and regulation, fund managers again placed these jurisdictions as the top three.
Strength of an ecosystem
According to Elissa Habbart, founder and director at the Delaware Counsel Group, Delaware’s pre-eminent position stems from three factors – stability, flexibility, and its deep and long-established market for financial and legal expertise.
“The first thing is we have a court system, the Court of Chancery, which is modeled after the English courts. But in contrast to most other states, here sophisticated business disputes get heard before a judge rather than a jury. Those court decisions you hear about, where the jury awards $10 million because some coffee spilled, you don’t get those here,” says Habbart. “The second is that we have so much experience in Delaware, so that while you’re operating a fund right, there’s a lot of existing guidance out there on what our statute means and how it should be interpreted.”
Delaware also operates a Corporation Law Council, of which Habbart is a member. Its role is to advise the state legislature every year. This, Habbart argues, keeps law and regulation flexible and adaptive, changing to circumstances and events.
The continuing dominance of Delaware may also be assisted by the patterns of investor behavior. The aforementioned survey of fund managers found that 37 percent of respondents expected large growth in their North American investor base.
The Cayman Islands retains a similar predominance because of its established ecosystem of financial and legal operations, and its favorable tax system, where it ranks highly among fund managers, alongside Delaware, and markedly ahead of Luxembourg.
The depth of expertise and the ease of accessing relevant services is also a key strength of Luxembourg. Its tax regime may be considered less favorable than Delaware or Cayman, but it is regarded as a stable home for funds nevertheless. Crucially, through the AIFM regulations, Jersey also offers an easier route for funds to market themselves across a European client base.
Simon Vardon, global head of real assets at corporate services group Sanne, says: “Luxembourg remains an attractive jurisdiction, as it always was. Luxembourg offers a mature financial market with a stable regulatory environment. It also offers tax certainty, which is very important, and it has a good range of fund products. It’s a bit of a default jurisdiction to use if you are marketing to EU investors.”
David Collington, wealth and asset management sector lead at KMPG’s Financial Services Regulatory Insight Centre, agrees that the community of complementary services in a domicile was a key factor. “The question about the ecosystem comes up quite often, and I think no one can ever exactly nail down which comes first exactly, is it the chicken or the egg,” he says. “But there’s no doubt that having lawyers, accountants, transfer agents, custody banks, depositories and a big financial industry already set up makes a massive difference. That’s why Luxembourg and Ireland, for example, have done really well, just because there’s a kind of snowball effect.”
But the dominance of these leading domiciles is not going unchallenged, nor is it necessarily bullet-proof. Popularity and scale bring their own issues.
“There’s no doubt that having lawyers, accountants, transfer agents, custody banks, depositories and a big financial industry already set up makes a massive difference”
Regulation and capacity in Europe
As fund activity grows globally, the sheer scale of business may come to be an obstacle for the most developed and popular jurisdictions. “From time-to-time, we do hear some capacity concerns around Luxembourg as a jurisdiction,” says Vardon. “It’s also perceived as an expensive option.”
Vardon emphasizes that Luxembourg’s status as the EU’s fund capital is not in question, but the issues of capacity and expense might be factors that in the future give an opening to other jurisdictions.
The pace of regulation in Europe is another factor Vardon says managers are monitoring, notably the Anti-Tax Avoidance Directive (ATAD 3). Published in December 2021, the proposed directive aims to clamp down on the use of shell companies in the EU. It has the potential to raise questions for EU domiciled funds about how much actual substance there is to that domicile.
The issue of substance is an ongoing issue in fund domiciliation in many jurisdictions and one that is not going away, according to Julie Patterson, a regulatory consultant and Collington’s predecessor at KPMG’s regulatory unit. The multiple layers of where a fund is domiciled, where it is managed from and where it is investing and trading in assets create a tangled web from which defining substantial presence in one jurisdiction is a moving target.
“To give the investors the best funds, it’s important for fund managers and asset managers to be able to access expertise from around the globe. So, it’s not that we shouldn’t have that happening, it’s just that we need the right mechanisms in place to ensure there’s sufficient management control in a domicile to have governance over a fund. This is the nitty-gritty debate about how you actually define substance and I think that will go on for some time,” says Patterson.
Client perception and protection
Investor perception is an issue that may begin to create differences between various offshore domiciles.
“The offshore world still remains pretty positive,” says Vardon. “However, in recent times, we’ve seen some of the offshore locations distance themselves from others. So, there is a bit of a good list and a not-so-good list developing in the eyes of many.
“The leading offshore locations tend to be jurisdictions like Jersey, Guernsey and the Isle of Man. Locations like those just mentioned tend to be the early adopters of the latest OECD BEPS measures, as well as having a history of proactively meeting questions posed from the EU, such as economic substance.”
Vardon declines to explicitly name the jurisdictions that are less successful at “keeping off the naughty list,” but fund managers will be well aware of which jurisdictions raise eyebrows among regulators, tax authorities and some investors.
Another dimension of the investor perspective is the distinction between institutional, sophisticated and retail investors. Patterson suggests the current macroeconomic environment is driving a number of jurisdictions to shift their definitions to accommodate more non-institutional investment.
“After the 2008 financial crisis, investor protection became more of an issue. So, we saw the more liberal regimes around the top end of retail, sophisticated being eroded. Now, because of the need to get more private money into infrastructure investment, we are seeing pressure on regulators to swing the pendulum back to allow the top end of retail to again get access to some of the fund vehicles.”
The interest in retail investors, whether the borderline sophisticated high-net-worth individual or the mass market, brings matters full circle back to reputation and perception. Some professional and institutional investors are more comfortable with domiciles that have a colorful reputation. But for funds competing for the growing market of retail investors or for public sector funds under political or public scrutiny, the intangible aspect of a domicile’s ‘brand’ may be a significant issue.
“There is a bit of a good list [of domiciles] and a not-so-good list developing”
Domiciles in competition
In recent years, the factors driving fund markets have seen a number of jurisdictions tweaking or innovating to attract fund managers to domicile in their territory, often with an eye on the expanding alternative assets market, including private real estate.
Within the EU, Ireland’s Investment Limited Partnerships regime, introduced in 2020, is one example. The UK, too, has joined this game. For many proponents of Brexit, the UK’s separation from the EU was seen as an opportunity to establish the UK as a financial center off the coast of Europe. It remains early days for Brexit, but several steps are underway in the UK to create a more attractive fund regime.
The UK’s Long-Term Asset Fund (LTAF) is intended to mirror the European Long Term Investment Fund, to attract highly regulated institutional investors such as pensions to invest in long-term, typically illiquid assets such as real estate. According to Vardon, these measures look like they will mirror some of the attraction of Luxembourg and its EU regulatory regime.
In Asia-Pacific, Hong Kong and Singapore are competing to take the region’s fund domicile crown. Here too, specific initiatives have been launched. The survey found Singapore was favored by fund managers over Hong Kong on all criteria.
“Across Asia, our observation is that private funds are increasingly looking at the feasibility of new fund structures and domiciles offered in Hong Kong and Singapore, in combination of the use of Cayman structures as well. Hong Kong’s Limited Partnership Fund (HKLPF) regime coupled with tax concessions for carried interest have gained some momentum since it was introduced in 2020,” says Catherine Law, Sanne’s head of business development for Asia-Pacific.
“However, familiarity from LPs still plays a key factor here, and the focus remains on using fund structures that match fundraising needs. It is still early days to assess the success of the new vehicles such as the HKLPF as business activity, particularly between Hong Kong and mainland China, has been slowed due to strict travel restrictions during 2021. And the geopolitical sensitivity between China and US is another matter in consideration.”
The factors driving domicile choice for real estate funds are slow to change, as indicated by the continuing domination of a few jurisdictions. But regulators have become more active in tweaking fund regimes, while international investment standards, tax co-operation and clients’ perceptions are a persistent factor. While a revolution in fund domicile trends may be unlikely, competition and evolution is always at work.