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06 June 2019
This article addresses how the landscape for the structuring of offshore investment funds established in the Cayman Islands is changing and how this change is being driven by the evolving relationship between investors and investment fund managers – in particular, how the balance of power has in many cases shifted from the manager to the investor.
There will be a brief analysis of:
A combination of diminished returns across the hedge fund industry amid challenging market conditions for generating alpha and a continued and increased focus on performance has given rise to a shift away from more traditional hedge fund products to the more attractive returns offered by private equity investments.
As a consequence of this shift, some traditional hedge fund investors moving into the private equity space are bringing (along with their capital) an expectation of receiving offering terms that they would be familiar with from their experience of investing in hedge funds.
In addition to traditional hedge fund investors looking to make the transition to private equity offerings, there are a number of traditional hedge fund managers looking to implement private equity-style offerings, or more hybrid structures, in order to retain or attract capital flows moving in the direction of private equity chasing better returns.
Such private equity or hybrid-style offerings by traditional hedge fund managers often reflect many of the characteristics of a more traditional hedge fund, given the manager's mixed heritage.
The big allocators are getting even bigger and with an increase in size comes an increase in bargaining power and the ability to demand increasingly favourable and bespoke offering terms from managers. Often this increased bargaining power can lead not only to specific rights or benefits within an existing fund structure (eg, by means of a negotiated side letter), but also (in certain cases) the requests of institutional or strategic investors can lead to managers implementing a tailor-made structure with bespoke terms established specifically to meet the investor's requirements – commonly referred to as a 'fund of one'.
In times of challenging returns, there is often increased pressure on smaller managers to attract capital, as larger investors and allocators can be attracted by the relatively safe harbour of more tried and tested managers. In addition to expectations around performance and a healthy infrastructure with a capacity for growth, a manager's willingness to amend fund offering terms to adapt to the demands and requirements of large investors has become another common expectation, particularly for smaller and emerging managers (although this often leads to a more collaborative and supportive relationship between investors and managers).
Having examined the blurring of the lines between more traditional hedge fund terms and private equity-style offering terms, and how this combined with other market pressures has led to a shift in the balance of power between investors and managers, it is interesting to note some of the common trends that have emerged in offshore fund structures as a consequence.
Management and performance fees are obviously a key, and in many cases, the first items for negotiation for large, institutional or strategic investors, particularly during periods of lower returns. Additional items that are typically requested include favourable lock-up periods, transparency and information rights.
For existing structures, the amended offering terms are typically addressed within side letters between the investor, the fund and the manager. There has been a significant increase in both the number, as well as the length and complexity, of such side letters over the past two years.
One particular trend that has recently developed within side letters has been an increased pressure from investors arguing for a most favoured nation (MFN) provision to be included, whereby the investor would benefit from any improved terms successfully negotiated by any subsequent investor and the manager would be contractually obliged to extend such terms to the existing investor with the benefit of the MFN provision.
For existing structures, it is increasingly common to see:
For new fund launches, in an effort to attract institutional, large or strategic investors, it is increasingly common to see a founder class or seed class of shares offered, whereby select investors are provided with beneficial terms in consideration for an early and significant investment.
One side effect of the negotiation process between investors and managers for preferential offering terms, which managers have been increasingly willing to provide as the price to pay for attracting capital, is that following such a negotiation process, a trend has emerged for a more collaborative approach to investor relations. This trend stems from the fact that managers will often look to their larger investors for comfort before making significant or strategic decisions in an effort to retain such capital and avoid upsetting an established investor base.
One particular characteristic more commonly seen within hedge fund structures that, in recent years, has become increasingly visible across private equity and hybrid structures is the presence of independent governance within the operations of the fund structure. This trend can take many different forms but is often addressed by means of either direct representation for the investor's fund vehicle or representation at the general partner level.
In addition to independence at the investor facing fund level, there has been a marked increase in board representation or advisory board structures being implemented at the master fund level, with independent directors seen as providing investors with an additional layer of comfort that the level at which the assets are held benefits from the same degree of oversight as the feeder fund. In certain instances institutional investors have advocated to see the same independent representation on the governing body of an onshore entity also (although this continues to be the exception rather than the rule).
Before undertaking an investment in a fund, there has been a notable increase in the length and depth of due diligence undertaken by investors on a fund. Historically the traditional focus for an investor or allocator may have started and finished with a review of the performance data or track record for a manager. However, recently the focus for investors appears to have expanded to include a much wider frame of evaluation criteria, including:
There has been a marked increase in instructions from investors seeking to undertake a detailed review of the legal documentation and constitutional documents prior to making an investment rather than relying on the work of the investment manager's own counsel. This review is often not only to identify any critical risks or red flag items, but also to identify possible pressure points for negotiation or amendment as a condition for investment.
For more than 25 years the Cayman Islands as a jurisdiction has successfully demonstrated itself to be capable of meeting the demands of investors and managers in the ever-changing investment funds industry.
While it is impossible to say with certainty how the relationship between investors and managers will evolve in the future, managers will continue to need legal counsel and service providers to develop increasingly creative solutions to adapt to the ebb and flow of this delicate balance of power.
Recent examples of the dynamic approach taken by the Cayman Islands' government in support of the investment funds industry include the creation of new entities, such as the Cayman limited liability company and foundation companies – in each case offering greater optionality for structuring solutions.
From a legislative standpoint, the introduction of legislation in respect of anti-money laundering and beneficial ownership have further strengthened the jurisdiction's reputation for regulatory excellence, transparency and investor protection, ensuring that whatever challenges the future may bring to the dynamic between investors and managers, the jurisdiction can offer imaginative outcomes that safeguard the interests of both sides of the negotiating table.
An earlier version of this article was first published in Cayman Funds Magazine.
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