Hedge Fund Haven to Tighten Rules

Even the Cayman Islands aren't immune to the fallout of the economic crisis.
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Financial authorities on the Cayman Islands are promising a legislative crackdown to bolster investor confidence in the post-Madoff era. But while the Caymans -- long a hedge fund haven due to tax advantages and light regulation -- may push for tighter oversight, experts predict they will not lose their status as hedge funds' offshore crown jewel.

The Caymans have been touted in recent years as the "centre of choice" for hedge funds by Walkers, a major offshore law firm, as well as other service providers for several investor-friendly reasons.

Perhaps most importantly, operating in the Caymans is more profitable, because no direct corporate, capital gains, income, profit or withholding taxes are applied. The islands also have few restrictions on investment strategies and no requirement to maintain local operations, meaning that a fund can set up a nominal home base and a director there while performing tangible operations elsewhere.

Many experienced service providers are there to help set up funds quickly and easily. And as a territory of the U.K., the Caymans have a strong judicial and regulatory framework -- relative to other offshore locales -- to limit fraud and pursue litigation against perceived injustices.

The hedge fund industry has taken notice: Even amid the financial chaos, the Cayman Islands led all other domiciles for new fund registrations during the fourth quarter of 2008, at 40%, up from 34% a year earlier and 24% five years earlier, according to Hedge Fund Research.

However, market turmoil has placed the Caribbean gem under pressure, spelling trouble for an economy that is a hedge fund hot spot. The Caymans may not take in much tax revenue from hedge funds, but they do take in flights for business meetings, as well as hotel stays, conferences, food and drinks and all sorts of other services for the industry.

Ted Bravakis, a spokesman for the Cayman government's finance and economics department, estimates that 30% to 40% of the territory's GDP is derived from such business.

Now that hedge funds have been plagued by weak performance and redemption demands, some have closed, and others are preparing for the same. Among the hedge fund firms facing trouble are top names like

BlackRock

(BX) - Get Report

,

Fortress Invsetment Group

(FIG)

,

Cerberus

,

Citadel

and others, some of which launched operations in the Caymans in recent years.

On top of industry consolidation, a wave of fear has also stricken clients, due to fraudulent rackets associated with the hedge fund industry. The most prominent alleged fraud is the potential $50 billion Ponzi scheme related to Bernard Madoff Investment Securities.

Cindy Scotland, managing director of the Cayman Islands Monetary Authority, said in late January that as of Jan. 19, 123 regulated funds had suspended redemptions, 90 suspended net-asset-value calculations and two suspended subscriptions. She said a few Cayman banks have had "some indirect exposure," while 34 funds have been "directly impacted by the fraud."

Scotland said that "information is still coming in" and "the numbers are growing," predicting more potential pain ahead.

Daniel Celeghin, a director at the consulting firm Casey Quirk, which services the hedge fund industry, says U.S. investors have begun to look toward offshore sites that are closer to the Western world. He mentioned Dublin, Ireland, whose hedge fund prominence has grown in recent years due to lenient tax policies, as well as British territories like the Channel Islands, which are closer to British soil and fall under its jurisdiction.

"Because of the post-Madoff awareness ... I'm hearing a lot more from the investors that they are asking managers to register funds in jurisdictions that offer more protection," says Celeghin.

Peter Vinella, a managing director with the consulting firm LECG, also asserts that locales like Dublin and Luxembourg, rather than the Cayman Islands, have become the "hot places" for offshore hedge fund start-ups in recent years. He predicts that service providers like Walkers and Maples, which are among the biggest law firms and trustees for hedge funds on the islands, will face some pain from the financial crisis. But he doesn't expect the offshore landscape to change much.

Celeghin notes that "we've been through these cycles before where there was a sense that stronger offshore jurisdiction than Cayman or

the British Virgin Islands was needed. And somehow Cayman and BVI have always survived and always have been very popular."

Scotland warned attendees of an Ernst & Young hedge fund symposium that the CIMA is proposing tighter standards for liquidity, risk management, transparency, capital adequacy, directorships and failures. The Caymans, which once marketed themselves as a place with "flexible" or "light-touch" regulation," are also dispensing with such slogans and rebranding as responsible, investor-friendly territory to ease investor concerns.

"Anyone who thinks for one minute that increased regulation is not going to happen hasn't been paying attention," Scotland said in prepared remarks about proposed changes. "Not only will it happen, but I am confident that if we are to stay in this game we will have to adopt

all

of the regulations."

Such rhetoric might ordinarily scare off an industry that is accustomed to operating without regulators breathing down its neck. But rules will be tightening up everywhere -- from the U.S. to Europe and Asia -- meaning that stricter regulation in the Caymans on a relative basis may not be all that strict.

Sol Waksman, president of the alternative-investment database BarclayHedge, says any troubles facing hedge funds on the islands, regulatory or otherwise, are not particular to the Caribbean.

"The Cayman Islands are simply a registration venue for offshore funds," says Waksman. "Most of the funds registered there have on-shore counterparts, so whatever is happening in the industry is happening for funds registered in the Cayman Islands."

In fact, while the overall number of new fund registrations last year -- whether hedge or mutual -- dropped 18% , there were still 457 more funds in the Caymans at the end of 2008 than the previous year.

Matthew Morris, a partner in the restructuring and insolvency group at the law firm Lovells, also says that "the money being raised for new distressed funds, even if the funds aren't formed yet or registered, is actually quite significant."

Morris visits the Cayman Islands a few times a year to ensure that the liquidation of clients' offshore assets is handled properly. He says that proposed regulation may make the territory "somewhat less hospitable" as an offshore hub, but believes the Caymans will remain a top choice because it's a "tightly run ship" that facilitates quick, orderly liquidations.

"We've been through these waves before," says Celeghin, "and the great migration away from Cayman and BVI may occur -- but it hasn't yet."