Choosing a Domicile

What do hedge fund managers and fund administrators look for in a prime broker?

The following article, which was written by Dermot S L Butler, Chairman of Custom House Group,
was originally published in the 1998 edition of the 'The IMM guide to Offshore Funds'

As this Guide to Offshore Funds clearly demonstrates, there are numerous domiciles from which to choose when considering establishing your offshore fund and they all have their "pros" and "cons" - naturally some have more "pros" than "cons" and vice versa.

Many thousands of words, indeed pages, have been written about the advantages of a particular offshore jurisdiction, often written by the commercial office of the government in question, promoting their own centre and who can blame them - that is their job. Be that as it may, the sponsor or promoter of a fund has to take into account many factors when considering the domicile of their fund. However before considering those factors, one should consider the differences between the jurisdictions.

The first thing that must be realised is that investors take a very personal view of the safety and security of their investments and therefore it is not always "facts" that will influence their decisions but often "perceptions". This is particularly true with regard to this subject, where the very word "offshore" has, for some, dubious connotations, as have some of the offshore financial centres.

Let us be absolutely clear - the prime reason for establishing an offshore fund, or, indeed, for moving any assets "offshore" is tax efficiency. Offshore funds are established in financial centres where little or no tax is paid on the revenues generated within the fund. Such a fund is, obviously, very much more attractive to investors who are not liable to taxation on their investments or, who can defer meeting such tax liabilities until they realise their profits. Thus, the offshore fund is attractive both to investors, because of tax planning considerations, and to portfolio managers, because of the potential to increase assets under management from investors that they would not otherwise have access to. Therefore all jurisdictions where one might consider domiciling a fund offer a zero or almost zero tax rate on the capital gains and income of the fund, although the fund itself may suffer withholding tax on its revenue earned in some countries.

The second main reason why funds are established offshore is to avoid, or mitigate, what are deemed by many to be intrusive and excessive domestic regulations, which result in a very high cost of compliance. The avoidance of this regulatory "hassle" can largely be achieved by moving a fund offshore, however the promoters of the fund then must recognise that investors in that fund will be seeking some investor protection and comfort, which might otherwise have been provided by those very domestic regulations that they have moved offshore to avoid.

This investor protection can be achieved either by domiciling a fund in a strongly regulated centre, or, if you choose to domicile your fund in a less regulated centre, then investor protection can be achieved by "self-regulation". This can be done by ensuring that suitable restrictions and controls are imposed within the structure of the fund and that the parties involved in the management and administration of the fund are financially strong, have a first class reputation and are both capable and willing to ensure that those restrictions and controls are complied with.

Thus the choice of domicile of the fund may depend upon the level of regulatory control imposed by the jurisdiction in question. For example, if you are establishing a fund that is targeted at retail investors in Europe then it has to be said that the logical choices are limited to Dublin and Luxembourg and probably further limited to a UCITS fund established in Dublin or Luxembourg. This is not only because the regulatory environment in Dublin or Luxembourg is stronger than most other offshore centres and more attuned to the retail market, but also because the regulations on marketing and promoting funds in Europe would, for the most part, prohibit, or severely curtail, the marketing of a retail fund which has been established in almost any other jurisdiction.

If, on the other hand, the promoter is considering establishing a highly leveraged hedge fund, (for example arbitraging between stocks and options and taking both long and short positions in the underlying stocks), then this fund will inevitably have to be targeted at sophisticated, professional and institutional investors. Because of the nature of the investment strategy, the fund could never comply with UCITS regulations and it is almost inconceivable that it would be approved as a non-UCITS fund for sale to the retail market by either Luxembourg or Dublin.

At risk of being over simplistic, I would separate the main offshore centres into three groups, each with their own distinct characteristics. (I should point out that I am writing this from the perspective of funds managed in Europe or the USA and targeted at investors in Europe, the Middle East and the Americas). These three groups are: Dublin and Luxembourg, being EU based, strongly regulated centres; the Channel Islands (Jersey & Guernsey) and Bermuda, being well regulated non-European Union; and the Caribbean group, which includes the Bahamas, British Virgin Islands (BVI), Cayman Islands, Curacao (Netherlands Antilles) and the Turks and Caicos Islands. Until fairly recently, all of the Caribbean centres could generally be lumped together as being unregulated, or at best under regulated. This situation has changed, particularly with regard to the Bahamas, British Virgin Islands and Cayman Islands and there are now mutual fund regulations in place in all three of these centres which have imposed a greater level of regulatory oversight. If the difference between the Caribbean and the European regulations however is that the Caribbean is still endeavouring to remain as flexible as possible and seem to take the view that, providing the service providers involved - Brokers, Custodian, Payment Bank, the Investment Advisor/Manager, Administrator, Auditor et al - meet their standards, they will authorise the fund, leaving the investors to make up their own minds in the context of investment strategies, leverage, market risk etc. The European regulators, on the other hand, take a much more protective role.

It cannot be denied that there are some people who believe the Caribbean financial centres to be deeply unattractive and who are innately suspicious of anything to do with the region. This attitude may have been broadly justifiable years ago when there was almost no regulation and the drug dealing industry flourished in many of the islands. But that is history. International anti-money laundering regulations now apply and, in the offshore fund environment, investor protection and financial regulation has been substantially strengthened, in most of these jurisdictions.

Having said that, I do not believe that any of the Caribbean centres provide an ideal jurisdiction for a fund targeted at the retail investor. This is not because I believe that there is anything inherently wrong, dangerous or insecure about a properly structured fund established in the British Virgin Islands, the Bahamas or the Cayman Islands. Quite the reverse - we administer some 60 funds domiciled in the Caribbean. It is just difficult to argue with the fact that, if it is possible to structure a retail fund in Luxembourg or Ireland, then that will be more appropriate for the retail investor. Why? Because the retail investor is generally deemed to be less experienced, less sophisticated and less knowledgeable and, therefore, less able to judge the risks that may be involved in a particular fund. The higher level of regulation in Europe is perceived to (and to a large extent does), provide greater investor protection than the less regulated jurisdictions.

Therefore, for funds that are targeted at the retail investor, I would strongly recommend either Luxembourg or Dublin - both come within the European Union ambit  and, if the fund is established as a UCITS fund, it should be marketable across all or most of the European Union borders.

It is possible of course that the regulators in Luxembourg or Dublin will not authorise a particular fund. This may be because the promoter or the investment manager are not considered by the regulators to be sufficiently capitalised or sufficiently experienced, or perhaps it may be because the regulators deem the investment strategy to be too aggressive and too high risk for the retail market.

In the first case, the promoters may look to another jurisdiction where they meet the capitalisation and experience criteria. If, however, the problem is the investment strategy, the investment manager has two choices - either modify the strategy to meet the regulator's criteria, or change the target investor, so that the fund falls under the professional/sophisticated investor criteria, that apply in Luxembourg and Dublin. Dublin, for example, has introduced the "QIF" - Qualifying Investor Fund - which has much greater flexibility with regard to investment strategy and borrowing/leverage, but requires a minimum subscription level of IRL200,000 (approximately US$300,000). Thus an investor seeking to place 5 per cent of its portfolio into an aggressive hedge fund has to have a portfolio of US$6,000,000 - ironically that excludes a lot of sophisticated investors, who would otherwise qualify as "Qualifying Investors" under the Irish regulations.

One important reason why a promoter should establish a retail fund within a strongly regulated jurisdiction is self protection. I do not think it is an overly cynical comment to say that, in today's regulatory environment, if a retail investor decides to sue an investment manager or a fund promoter because he lost money and there is any doubt at all as to the manner in which the management of the fund conducted itself, most courts will tend to favour the investor. It is therefore prudent for any promoter or manager to ensure that they are operating under a strong regulatory environment, providing of course they comply with those regulations.

In this context, it has to be said that if the Luxembourg or Dublin regulators have determined that the investment strategy of a proposed fund is not suitable for retail investors or indeed if the promoter or manager was deemed unsuitable for whatever reason, then opening a retail fund in another jurisdiction does carry with it a risk. It may not be sufficient defence that the fund complied with the regulation of the jurisdiction in which it has been established if the promoters had endeavoured to establish the fund in another jurisdiction and been turned down - one could describe this as the "Ford Pinto Syndrome" - that is where management will be found guilty of negligence, because, despite the fact that they had complied with the minimum statutory safety regulations, they knew that more could have been done to protect their customers from risks that they were aware of.

How does this relate to the domicile of funds targeted at professional, sophisticated and institutional investors? Shouldn't they have the same protection as the retail investor? Perhaps - but it must be remembered that these investors are perfectly capable, not only of making a judgement call on the inherent risks of any investment product, but also carrying out their own due diligence, or paying for it to be carried out by a qualified consultant. For these investors, a high level of regulatory protection is not necessary and, indeed, can be disadvantageous for two reasons:

Firstly, a high level of regulatory protection brings with it a high cost of compliance that has to be met by the service providers - the custodians, administrators, auditors, investment advisors, et al. You can be sure that these added costs will not impinge, to any great extent, upon the service providers' profits, but are rapidly passed through to the funds and, therefore, to the investors; secondly, a high level of regulation can often reduce the flexibility available to the investment manager, by the introduction of investment restrictions, such as limitations on borrowing or levels of leveraging, maximum exposures to certain markets, prohibition on owning physical commodities or real estate, etc., which may impinge upon the investment manager's strategy and thus the potential profitability of the fund.

All this is not to imply that I am against regulations - indeed I believe that for all funds some restrictions and controls are desirable and I agree that a portfolio should be structured to provide diversification and an appropriate level of liquidity - this will be acceptable to most investors.

The point I am making is that professional investors can make their own judgements as to whether the risks involved are acceptable or not. Those risks are not limited to investment policy, but also involve the quality of the management of the fund and service providers to the fund. For instance, it is essential that the fund retains a first class, financially strong clearing or prime broker. Obviously, you need an efficient and experienced administrator and a first class firm of auditors. Furthermore, it is essential that the custodial arrangements are suitable and secure and that the institution providing custody is experienced and, ideally, will take a pro-active role in overseeing the fund's activities. In this context, it is imperative that the assets of the fund are held in such a way that the fund is not liable to any third party credit risk. Accordingly, the assets must be genuinely segregated and not pooled with either the institution's own monies (although this may be unavoidable with a leveraged hedge fund using a prime broker and of course it becomes a judgement call with a AA bank), or pooled with other client's monies, with a resulting mutuality of liability.

So which jurisdiction should you choose for your fund? Quite often a decision may be imposed upon the promoter because of existing relationships or a client's requirements and preferences.

For myself, I would narrow the selection down to Europe if stronger regulation is required, or the Caribbean if less restricted regulations are needed. That is not to say that any of the other jurisdictions are inferior - this just reflects my own preference and experience to date.

For the professional investor, the Caribbean still provides very attractive and, in many cases, preferable jurisdictions in the context of cost, time and flexibility. After all, the Quantum Funds are based in Curacao and that doesn't appear to have discouraged many serious, experienced and professional investors. And you will find there are many major "household name" funds established in the Caribbean.

Another factor that should be considered, particularly when setting up specific, country funds, such as Indian or Russian Funds, is withholding tax and double tax treaty arrangements. For example, you will not see many Russian Funds that do not invest through a Cyprus subsidiary company. Similarly, most Indian funds are either domiciled in, or more commonly invest through subsidiaries established in Mauritius. This is because these territories have double tax treaties which enable the funds to substantially reduce their withholding tax liabilities.

At the start of this article I said that many thousands of words had been written on this subject - I have written some two and a half thousand and have only scratched the surface. For example I haven't mentioned many offshore jurisdictions, particularly those in the Pacific Rim and I haven't discussed many other reasons for making a specific choice - for example preference for a particular Custodian, time differences, language etc. etc.

In conclusion, I would say that the choice of domicile of an offshore fund is a function of the market sector, or asset class and investment strategy of the fund on the one hand balanced in conjunction with the requirements of the targeted investors for the fund.

Dermot S.L. Butler is Chairman of Dublin-based Custom House Administration & Corporate Services Limited ("Custom House"), a company that specialises in assisting clients in the organisation, establishment and administration of alternative investment and hedge funds. Custom House is authorised by the Irish Financial Services Regulatory Authority ("IFSRA"), (formerly the Central Bank of Ireland) under the Investment Intermediaries Act, 1995.