Hedging Your Bets

The following article by Dermot S.L. Butler appeared in "efm" (European Fund Manager) Fund Administration Supplement, Spring 2001

Dermot S.L. Butler looks at the administration and establishment of hedge funds - starting up, where, how and why.

The first question that people ask themselves when setting up a fund is where it should be set up -which jurisdiction. Unfortunately, that immediately begs several other questions, which include what type of fund to set up and who the target investors are going to be.

Let us first consider why anyone would want to set up an offshore fund in the first place. There are two primary considerations. The first is tax efficiency, both for the investors and, for that matter, for the fund manager, who can often achieve a tax deferral by delaying acceptance and recognition of management and incentive fees. The second consideration has, historically, been the fund manager's desire to try and avoid the hassle of over-aggressive domestic regulation.

It used to be easy. Take a flight to one of the islands in the sun few people could spell regulation and no one knew what the word taxation meant. Walk into a bank, a trust company or a lawyer and you had your fund package before lunch. It is not so easy today. Tax efficiency is still available and relatively easily arranged, but regulation has now been introduced, to a substantial extent, in all the main Caribbean jurisdictions.

Regulation

However much traders and fund managers may want to get away from domestic regulatory hassle, there is no doubt that all investors want some regulation. At least, they want some protection which is not necessarily the same thing - in place, so that their primary risk, indeed hopefully their only risk, is limited to market risk. But I am getting slightly ahead of myself.

I am discussing hedge funds, by which I mean any form of alternative investment or hedge fund. Although I do not know the exact figures, I suspect that about 70% of all hedge funds in the world are US-based. 70% of the balance are European-based (which, I respectfully suggest, should include the United Kingdom, regardless of the political persuasions of some of EFM's more conservative readers). Because most hedge funds are established in the Atlantic zone North America or Europe - it is the Atlantic jurisdictions that I will be discussing.

There are in my opinion three groups of jurisdictions in the Atlantic zone.

Firstly, the Caribbean, which includes the Bahamas, the British Virgin Islands (BVI) and the Cayman Islands. Each of these territories has introduced significant mutual fund legislation over the past few years and, on the whole, it is quite effective. But it is not overly intrusive and, although compliance is essential, it is not like working under the predatory eye of the SFA, IMRO, the CFTC, or the SEC.

The second group includes Bermuda, the Channel Islands and the Isle of Man. Each of these territories have, or would claim to have, stronger regulations than the Caribbean Islands, but still fall short of the two European centres - Dublin and Luxembourg - which make up the third group. In these two jurisdictions, regulation is very strong, reflecting the standards set by the European Union.

What can be seen is that as you move eastwards across the Atlantic, you climb up the regulatory curve. Of course, this means that you also move up the cost curve, both in terms of organisational costs and on-going operational costs, as well as the time curve. What may take four weeks in the Caribbean can take four to six months in Europe.

It is my opinion - and I must stress that the choice of a jurisdiction is not based on an exact science, it is often based on personal preferences and prejudices that, for most hedge funds, there is little point in considering the second group. They are neither fish nor fowl. If you believe that you, or your investors are going to require more regulation than the Caribbean offers, then go the whole way and set up in Dublin or Luxembourg. Naturally I would favour Dublin.

The Target Investor

This is where the target investor comes into the equation. It goes without saying that if you are considering a retail fund, you absolutely must go for the strongest regulation you can get. Not because it will necessarily buy more protection for the investor, but because, if anything does go wrong - and things go wrong all the time - you must be able to show that you went the extra mile in protecting the investor. If you don't and you end up in court, you are likely to lose regardless. Remember the investor (and especially the retail investor), starts with a huge advantage - they are the innocent underdog, you are that ruthless, skillful, rich, manipulator, a hedge fund manager.

Having said that, this discussion is about hedge funds, all of which will, or should be, targeted at professional, institutional and sophisticated investors - who are presumed to be able to understand and accept the risks involved. It is perhaps ironic that these investors are much more cost conscious than the average retail investor. Perhaps that is because the retail investor rarely has the opportunity to work out what the costs really are. Nevertheless, I suspect that in the light of their attitude, many of these professional investors question whether regulation actually equates to investor protection and, therefore, whether the cost of complying with such regulation is value for money.

Does Regulation Give Real Protection?

Of course, the word on everyone's lips in this industry for the past year has been Manhattan, a BVI fund, administered and audited out of Bermuda. It was managed out of New York and lost over 90% of its assets, having fraudulently reported consistent (audited) profits of circa 20% pa for the past few years. Would it have happened if Manhattan had been domiciled in a more highly regulated centre, such as Dublin or Luxembourg? One cannot answer that question, only speculate. Having said that, one senior member of the hedge fund community said to me recently that if the Manhattan had been highly regulated, the odds are that even more money would have been lost. This is because many more investors would have been tempted by the 'protection' that regulation is perceived to provide.

This perception is of course a fallacy. We should not forget that the vast majority of financial scandals over the past ten or 15 years all took place under the noses of the regulators and in highly regulated centres, including London and New York. Consider Sumitomo; Barings; Kidder Peabody-, Diawa; BCCI; Morgan Grenfell; Maxwell; and the odious Roger Levitt.

I am not sure what this proves, except that there is very little that anyone can do to stop a dedicated crook and especially one with a financial death wish, which would appear to be the case with many fraudsters. They almost never seem to run off with the money, they just wait to be caught. And what is the penalty of regulation once they have been caught? In the UK it seems to be that several million pounds of public money is spent in court. If the perpetrator is eventually found guilty (which often is not the case, because the jury cannot - indeed cannot be expected to - understand the complex financial issues involved) they will probably end up mowing the lawns in Ford open prison.

In my experience, most professional investors in hedge funds are more concerned with doing their due diligence on the investment manager than they are with the standard of regulatory supervision of the fund. It is only when the investor has made that leap of faith and decided to place money with the manager, that they will study the fund. After all if they do not like the manager, it would not matter if the fund was set up in Fort Knox. Having made that decision, the professional investor will study the offering memorandum and see who is involved and what restrictions and other conditions apply. The investor will, or should, carry out full in-depth due diligence on the administrator, review the agreements, and ensure that there is independent third party pricing all those obvious things that we all know should be done. The investor should also check the standing and expertise of the custodian or prime broker and find out who is the auditor.

Domicile of Minor Consequence

If all of this pans out, and the investor is comfortable with the parties involved and with the offering memorandum - which is, after all, a contract between the investor, the service providers and the manager - then for most professional or sophisticated investors, the actual domicile is almost of minor consequence. Indeed we at Custom House have set up multimanager funds in the BVI for both Credit Suisse Asset Management and American Express Bank, both of whom are fiercely protective of their reputations. And I have never heard of anyone who refused to invest in Haussman or Quantum just because they were Caribbean funds.

If you now accept that the Caribbean may be the best choice, from a regulatory point of view, you must now decide which of the three main jurisdictions you should choose. Again, this is often a personal choice based on prejudice and perceptions. I know one prominent UK lawyer, who would no more dream of setting up a fund in the BVI than he would bungee-jump off the Eiffel Tower. Nevertheless, Custom House has set up many - by which I mean a hundred or so - perfectly satisfactory offshore hedge funds in the BVI. We have also set up several Cayman funds, because the clients wanted it and the customer is often (not always) right. And we have set up and act for both Bahamian and Bermudan funds. However, in this ever-changing world, I believe that sentiment is changing and many people are today leaning towards the Bahamas as their jurisdiction of choice.

Targeting Tax Havens

The OECD initiative, if that is the right word, is attempting to targeting 'tax havens'. We have already seen the first rumblings in the UK, with Tony Blair and Robin Cook's guidelines concerning the disclosure that the UK is demanding from the Channel Islands, and what used to be called, the Dependent Territories - perhaps now the Vulnerable Territories. These include the Channel Islands, the Isle of Man, Bermuda, the BVI and the Caymans. I have not included the Bahamas in that list because, whereas the British Government can bring pressure to bear on its former territories, the Bahamas has been an independent nation for a quarter of a century. They can tell Tony Blair to go and play his games in Whitehall and leave them alone.

What is more, the Bahamas has very strong confidentiality regulations which are subject to criminal penalty for those who infringe them. At the same time they also have very strong anti-money laundering regulations and a good, business-friendly regulatory system which is being updated.

This is a matter that could be discussed for hours, but I think that it is very possible that the Bahamas may become once again the offshore jurisdiction of choice. Of course, I don't have a crystal ball and I don't know for sure what will happen - but if people get nervous or frightened, I believe they will head for Nassau.

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 Central Bank of Ireland under the Investment Intermediaries Act, 1995.