A survey by RBC Dexia and KPMG of hedge fund managers has found that very few hedge funds have so far re-domiciled from offshore to onshore. If a regulated hedge fund product is desired, co-domiciliation and maintaining both onshore and offshore funds appears to be the preferred route.
The survey report titled ‘Alternative options – hedge fund redomiciliation trends in evolving markets’ found that less than 5 per cent of hedge fund managers had redomiciled fully away from offshore jurisdictions such as the Cayman Islands.
Traditional offshore centres are still widely regarded as the right choice and the offshore hedge fund continues to meet the needs of a large number of investors, the report said.
About a quarter (24 per cent) of the hedge fund managers surveyed said that they had already brought offshore funds onshore, while another quarter (27 per cent) stated they would consider it for the future. However, the majority (55 per cent) of those who have begun offering onshore funds continues to maintain its offshore funds, having opted for a co-domiciliation by creating clone onshore funds to complement their existing Cayman or other offshore funds.
Reasons for redomiciliation
The trend toward creating onshore funds was driven by three primary factors including restrictions on the ability of European institutional investors to invest in offshore hedge funds, the opportunity to replicate hedge fund strategies in a UCITS and the ability to offer more liquid, transparent and diversified hedge funds.
Survey responses showed that institutional investors do generally not have a problem with offshore funds as they are comfortable with their own extensive due diligence on the manager and the investment strategy.
However, certain European institutional investors, for example insurance companies, are penalised with additional capital charges or other restrictions when investing in offshore funds compared to investments made in EU regulated funds.
The possibility to replicate hedge fund strategies in an onshore regulated UCITS framework, after changes to in the EU’s UCITS III regulation, is another factor that explains the draw of onshore funds. But the extent of this is contentious as a number of survey respondents pointed out they are not able to offer the same strategies, for instance less liquid credit strategies, distressed debt, private equity strategies, mezzanine and small cap strategies, in a UCITS wrapper.
Several fund managers also stated the only way for them to recreate a more complex strategy employed in a Cayman Islands fund in a UCITS was to enter into a total return swap to swap the return of its portfolio for the return on a reference basket/index. However, the cost related to the index creation and the swap counter-party fees would be prohibitive, in particular because no institutional investors were willing to pay extra basis points, if they are able to access the same strategy in a Cayman fund.
In contrast, a separate study by Dexia from July 2010 stated that 90 per cent of hedge fund strategies can be replicated within the UCITS.
Other reasons for the attractiveness of onshore funds mentioned in the survey were the ability to offer more liquid, transparent and diversified hedge funds as well as the uncertainty created by the EU Alternative Investment Fund Managers Directive.
The biggest challenges for redomiciliation were the different know your client and anti-money laundering rules, tax issues relating to the underlying investments in offshore funds, the process and requirements for transferring the ownership of the investment portfolio between the old and the new structure, as well as getting shareholder approval and dealing with shareholders who did not meet minimum investment thresholds in Europe.
The very high legal and administration costs associated with the move were another factor mentioned.
The main reason for not moving was by far the lack of investor demand and the fact that most investors are satisfied with the regulation and transparency of offshore funds and their own due diligence.
Another important factor was the continued strong reputation of offshore centres such as the Cayman Islands. Additional reasons cited were inadequate distribution relationships in the EU and the already mentioned preference for setting up new funds rather than redomiciling offshore funds, as well as the inability to replicate certain investment strategies onshore.