Fund domiciles: Barriers to entry

When it comes to winning fund business, rising domiciles like Malta and Singapore have their work cut out for them in upsetting the entrenched players.

For years, the Cayman Islands government patiently tinkered with its Exempted Limited Partnership Law (ELP), the go-to vehicle for US advisors domiciled there. Legislators were careful not to rush into anything, allowing for extensive dialogue between industry representatives, lawyers and regulators before finally debuting the reforms earlier this summer. In the end, all sides were quick to voice their satisfaction with the final outcome.

The ELP law itself was originally written in 1991, mostly as a copy of Delaware limited partnership law – so that US managers could use an offshore vehicle that was familiar and consistent with their onshore funds. In many respects, the 2014 reforms realign the ELP law with Delaware’s regime, since the two had drifted apart slightly over the years. Among other industry demands, Cayman alleviated concerns that LPs take on certain fiduciary duties when serving on an advisory committee, while it will also now allow foreign limited partnerships to act as GPs of Cayman ELPs.

But the fact that Cayman invested three years in getting the reforms right is maybe the bigger reason US managers will continue using it as their default option when structuring vehicles overseas, according to industry sources. In the eyes of industry practitioners, the amount of time and energy expended demonstrates Cayman’s commitment to its local funds industry – which has provided an enormous amount of wealth to a tiny string of islands inhabited by just 58,000 denizens.

Inbuilt inertia 

Both Delaware and Cayman partnership law trace their roots back to the English Partnership Act of 1890. For fund managers and their legal advisors, this is more than just a historical curiosity.

“The reason parties can confidently negotiate complicated fund vehicles is this concept of certainty of legal outcome,” says Rolf Lindsay of offshore law firm Walkers. “With hundreds of years of common law imported from the English legal system, Cayman has that.”

Lindsay and others explain that entrenched offshore fund domiciles like Cayman (and the Channel Islands for European managers) have a certain kind of inertia that creates specialist expertise, and thus feeds their ongoing success. Private equity and real estate are long-term investment strategies, meaning legal advisors must look 10 to 15 years in the future when recommending a home for funds. (Malta has been trying to win hedge fund business for a few years now, with some success, but most advisors say the country’s judicial system is still not tested enough to consider it a viable alternative to their regular options.)

Another factor in favor of the status quo pertains to the ‘herd mentality’ GPs often exhibit when choosing a domicile. Different jurisdictions build niche reputations as the domicile of choice for real estate work or even insurance. Accordingly some investors may question why a real estate fund was placed in the Isle of Man, say, when everyone knows Jersey has been the traditional market leader in the asset class. In practice, there may be no material reason to choose one island over the other, but it’s an easy distraction to avoid during fundraising, sources say.

“If you’ve got an hour with LPs, you don’t want to be spending precious minutes talking about the fund structure proposition. It moves the conversation away from the things that really matter like your investment strategy and performance,” says Carey Olsen offshore funds partner James Mulholland.

Lastly, new competitors run into a ‘chicken and egg’ problem. Established domiciles feature a cast of supporting actors needed for fund management: administrators, law firms and accountants have all set up shop in places like Cayman and the Channel Islands to support and service the GPs based there. This can make it tough for new entrants to lure business away; GPs want to see the necessary support services before domiciling a fund in a particular jurisdiction, but lawyers and fund administrators want to see enough GPs using a domicile before opening an office there.

Strategies for disruption

Offshore funds lawyers in emerging domiciles like Malta, Singapore and Hong Kong do candidly admit that it would take a lot to shake up the status quo. But they see a few ways to begin disrupting the market.

For starters, these emerging markets are beginning to see more home-grown GPs, who may very well search locally when choosing an offshore fund domicile for tax purposes. “A domestic Chinese manager may not want a fund administrator who doesn’t speak Chinese and is in a US or European time zone,” says David Williams, a London-based funds partner with Simmons & Simmons.

Sharing the same culture and norms is another point in their favor. Dubai, for instance, wants to be the global capital of the Islamic economy, and offers Shariah-compliant fund vehicles. Other domiciles have begun building their financial services and funds industry by catering to specific nearby markets, just as Cyprus does for Russian managers and Mauritius for India. “It’s feasible they begin expanding their scope as their reputation builds,” says one London-based funds lawyer.

More importantly, however, the new players can see what the competition does and copy their laws to keep pace. What took Cayman three years could be accomplished by a rival jurisdiction in a matter of weeks. The new regimes may not yet be time-tested, but they allow these domiciles reputations to begin accumulating praise. This is a strategy favored by Asia domiciles, in particular.

“For Asia, Singapore is emerging as they have an onshore fund regime in place,” says Luke Gannon, who heads the Asian funds practice at law firm DLA Piper. “It will still take some time before investors latch on, but it is increasing in visibility.”

Meanwhile Hong Kong – considered the financial hub for Asia but behind Singapore with respect to private equity fund formation – plans to push through the legal and tax reform needed to allow Hong Kong to be used as a fund domicile.

Mark Shipman, partner at Clifford Chance, says onshore funds in Hong Kong would attract fund managers from China – and provide some specific benefits for private equity. “There’s a lot of demand from GPs coming out of China who want to domicile their funds in Hong Kong or in Asia rather than thousands of miles away.”

Doing so would also help the dozens of private equity firms who have their offices in Hong Kong but are currently using funds domiciled in the Cayman Islands. These firms could consolidate service provision – legal, accounting and administration – in Hong Kong rather than using services in both jurisdictions, he adds.

What’s more, some established offshore centres are becoming expensive places to establish new funds, thanks to government charges, adds Gannon. “There is an opportunity for emerging domiciles to create a lower cost regime, which will have great appeal for fund sponsors and investors in Asia.”

To that end, emerging players will need to establish very clear rules and conditions, “the satisfaction of which will result in the same tax treatment as the traditional offshore centers like Cayman,” Gannon continues.

Creating tailored rules for managers that only solicit capital from sophisticated investors, as well as a smooth process for approving new funds, also seems a must-have. Emerging domiciles are no doubt headed in that direction – but industry experts agree that the entrenched players will remain the de facto domiciles of choice, at least in the near-term.

For more insights and trends on how GPs are utilizing offshore fund domiciles, see the November edition of pfm, out now.