The booming alternative investment business is driving major new competition between offshore jurisdictions. But the threat of external political interference remains a clear and present danger writes, KRIS DEVASABAI
With billions of dollars in assets under administration, offshore jurisdictions like the Cayman Islands, Bermuda and the Channel Islands of Jersey and Guernsey have become central pillars of the fast growing alternative funds business.
This is the result of much more than just the traditional tax considerations. The regulatory framework in the Cayman Islands, for instance, earned glowing praise from the IMF following a recent assessment, with officials noting the "extensive programme of legislative, rule and guideline development [that] has introduced an increasingly effective system of regulation" within the jurisdiction.
The sophistication of the regulatory environment is backed up by a concentration of expertise in fund structuring and servicing that plays a huge role in perpetuating the success of the offshore world.
Many of the established offshore jurisdictions are now more confident than ever about the strength of their position within the global financial services industry. Greg Wojciechowski, president and chief executive officer of the Bermuda Stock Exchange, for instance, is very bullish about business prospects in Bermuda. "We have been in the alternative funds space through domiciling and servicing for many years and longer than many of our competitors," he says.
"The Bermuda product and stamp and our innovative ‘Launch and List' facility are known and respected all over the world and all of the ancillary services that support the industry are well entrenched."
Ambitions are running high among a number of other jurisdictions and, for some, the focus is now on exporting their own brand of offshore financial services to every corner of the globe.
In September a delegation representing the island of Jersey set off on a tour of the Far East with plans to hold a seminar in Shanghai to promote the benefits of doing business on the island, while the Cayman Islands recently introduced a company registration system that allows promoters to structure products in Arabic in a bid to attract Islamic finance business from the Middle East.
These efforts have been paying dividends, and Bhagesh Malde, head of JPMorgan Hedge Fund Services in EMEA and Asia Pacific, says Cayman is well established as a jurisdiction of choice among hedge fund managers in Asia and the Middle East.
"While Singapore and Hong Kong are important centres of hedge fund activity in Asia the vast majority funds managed here are domiciled in the traditional offshore jurisdictions - most notably the Cayman Islands," he says. "The same is true of funds managed out of the Middle East, although it will be interesting to see if the Dubai International Financial Centre, with its new legal framework, is able to attract business away from Cayman."
Yet despite their success to date the offshore jurisdictions still face external pressures that could undermine their position in the global financial services machinery.
Last month, the UK government announced plans to impose a new tax on ‘non-domiciliaries' who currently fall outside the reach of the taxman. Alan Smith, chairman of the Isle of Man Fund Management Association, sees this as the opening salvo in a much wider push to undermine the offshore model.
"This is just the first step," he says. "The UK government is clearly looking to target offshore funds that are managed onshore, which means the days of setting up a shell company in the Caribbean and claiming that all the operations are carried out offshore are numbered."
There have been similar developments in the US, with presidential hopeful Barack Obama recently launching a withering attack on Bermuda and the offshore jurisdictions of the Caribbean.
The US Senator for Illinois - together with Senate colleagues Carl Levin and Norm Coleman - tabled the ‘Stop Tax Haven Abuse Act' in February citing the $100bn in revenue they claim is "drained from the US Treasury at the expense of honest, hardworking American families who pay their fair share."
And in September, US Senate Finance Committee Chairman Max Baucus took issue with the way managers running offshore hedge funds can defer their income for an indefinite period. "Tax deferred, in a certain sense, is tax not paid," said Baucus, though he stopped short of calling for legislative changes to deal with the issue.
While some in the offshore world brushed off these developments as old news, the industry as a whole sat up and took notice when Judge Burton Lifland, the most senior member of the United States Bankruptcy Court in Manhattan, denied a request from Bear Stearns for bankruptcy protection in the US as it sought to liquidate its two stricken hedge funds in the Cayman Islands.
In ruling that the Cayman Islands were not the proper place to liquidate the funds - and thus refusing them protection from lawsuits under US law - the judge took account of the fact that the funds had no employees or physical presence in Cayman.
"The only adhesive connection with the Cayman Islands that the funds have is the fact that they are registered there," he noted.
This is the second time that the US courts have refused bankruptcy protection for Cayman domiciled funds, with the Sphinx funds subject to a similar decision following the collapse of the Refco operation last year.
Smith says that these decisions, if established as precedent, could have serious consequences for Cayman's position in the hedge fund world.
"If this decision is upheld then Cayman's position as the jurisdiction of choice for the hedge fund industry is gone," he says.
Not everyone supports this view. Maples & Calder managing partner Gus Pope refutes the argument that the case specifically undermines the regime in Cayman. Instead, he sees the rationale adopted by Judge Lifland as having wider implications for the offshore world as a whole.
"The judgment is not Cayman specific at all - the judge made a decision on the facts as to the principal place of business of the Bear Stearns funds. The rationale behind the decision will apply equally to any offshore hedge fund irrespective of where it is domiciled," he explains.
Whatever its true long term implications, the decision by Judge Lifland has already got hedge fund managers asking some serious questions about where and how they structure their operations, while the issue of taxation is now becoming a real concern.
The response from the offshore jurisdictions themselves, on the other hand, has to date been somewhat mixed.
In Cayman the expectation is that the liquidators of the Bear Stearns funds will launch a vigorous appeal against the decision of Judge Lifland, while the rumblings in the US regarding the taxation of offshore assets are being watched carefully. But beyond that there are no plans to make any major changes to the funds regime on the island.
"The statistics year on year bear out the fact that Cayman is still in a big growth cycle, and there are no plans to change the fundamentals that underpin this success," says Pope.
Other jurisdictions are seeking to emulate that success by overhauling their own regulations with a view to replicating, or even surpassing, the flexibility and freedom granted to hedge funds in Cayman.
Just last month Jersey unveiled proposals for an ‘Unregulated Funds Regime' as part of its strategy for the future. The proposed regime will create a framework in Jersey that is even more relaxed than those found in Cayman or the British Virgin Islands.
A key change is that there will no longer be a requirement to seek prior regulatory approval before launching a fund in Jersey, while the only notable restrictions are that funds set up under the new rules must carry prominent investment warnings identifying them as unregulated products. There is no requirement for an audit and local directors, administrators or custodians are not needed under the proposed regime.
"The ‘Unregulated Funds Regime' gives fund promoters and managers a much greater degree of flexibility than was previously the case," says Natalie Sullivan, a partner in the Jersey office of Maples & Calder.
"Jersey now surpasses even Cayman in terms of flexibility in that the new rules create a truly unregulated regime that imposes no local requirements on the fund manager," she adds.
The ‘Unregulated Funds Regime' has attracted a lot of interest, and Jersey Finance technical director Robert Kirkby says the new rules will establish a platform for the island's continued growth as an offshore jurisdiction.
"What we have set out to do is create a regime that will appeal to the funds industry both today and in the future. In that sense we wanted to have rules that were not restrictive. When a new fund type comes around the corner we want Jersey to be in a position to serve as the domicile for the product," he explains.
But questions have been raised about whether this is the right route to take in light of recent developments. Smith, for one, is critical of the approach being taken by Jersey.
"I think they are going the wrong way," he says. "The increasing influence of institutional investors and the moves by onshore regulators are forcing the hedge fund industry to seek out jurisdictions that offer more transparency and regulation. In that context promoting Jersey as an unregulated jurisdiction is a bad move."
Earlier this year the Isle of Man itself launched a new funds regime as part of its drive to attract greater levels of hedge fund business - though the island is taking a different approach from its competitors.
Smith says the current Manx doctrine is geared towards positioning the Isle of Man as not only a domicile for the hedge fund industry, but also as a location for the establishment of elements of the front and middle office operations of asset managers.
He explains that the strategy is a response to the fact that recent developments - most notably in relation to the tax situation and the extra-territoriality that the US courts have sought to apply to the Bear Stearns funds - will force the industry to think differently about what it means to be offshore.
"Hedge fund managers are now looking seriously at staffing their management companies and establishing a physical presence offshore. The Isle of Man is positioning itself as a location where they can do just that," he says.
While it remains to be seen whether the moves by Jersey and the Isle of Man will prove successful, it is becoming increasingly apparent that these offshore jurisdictions will face competition from not only their contemporaries, but also from their onshore counterparts in the future.
February 2007 saw the launch of a flexible Specialised Investment Funds (SIF) regime in Luxembourg. Victor Chan Yin, a partner with KPMG in Luxembourg, says the SIF creates new opportunities for alternative investment managers catering to qualified investors to establish their funds in a well regulated onshore jurisdiction.
"The SIF is governed by a more relaxed regulatory regime that compares favourably with what you might find in the offshore jurisdictions. The sphere of investors has been broadened and there is greater flexibility with regard to the investment policy that may be pursued by a Luxembourg domiciled fund.
"Importantly, a fund can be launched under the SIF rules without the need for prior approval from the Luxembourg Financial Regulator, the CSSF, and there is no status or financial position test applicable to the investment manager. This opens up Luxembourg as a jurisdiction for hedge fund boutiques that struggled to meet the conditions under the previous rules," he explains.
As the de facto home of the European traditional funds industry Luxembourg is in a strong position to challenge the dominance of the offshore jurisdictions in the alternative investment space.
So what are the implications for the offshore world?
Malde says Luxembourg has "a very good chance of establishing itself in this space" though he believes the offshore jurisdictions will continue play an important role in the industry for the foreseeable future.
"Cayman is very well established in the hedge fund industry. It has got the track record and people are comfortable with doing business there, so I think it will be difficult for other centres - even Luxembourg - to strip away that lead," he explains.
JPMorgan is covering its bases though, and Malde confirms that the company is building up its fund administration teams in the Grand Duchy in order to cater for the anticipated growth in hedge fund activity in Luxembourg under the SIF regime.
In Cayman Gus Pope also plays down the likelihood of significant numbers of hedge funds being established onshore in the short-term, though he does think onshore jurisdictions like Luxembourg will play an important role in the future of the industry.
"Changing the regulations is just a first step - Luxembourg still has to prove that it can deliver on the cost efficiency and timeliness side of things," he says.
"However, there is certainly a blurring of the lines between onshore and offshore, and I can envisage a situation, maybe 10 or 20 years from now, where the low tax onshore jurisdictions such as Dublin, Luxembourg and Delaware have the lion's share of the hedge fund business," adds Pope.
As the hedge fund industry continues to evolve, the offshore world will have to up its game if it is to stay relevant.
Geared for growth - Mauritius targets hedge funds
Mauritius only started to promote itself as an offshore funds jurisdiction at the turn of the Millennium, and as such is a latecomer to the business. The current push to establish the island as a contender in a crowded field is driven by the favourable double taxation treaties that Mauritius enjoys with India and China.
The fact that Mauritius entities are exempt from capital gains tax in India has already made them a popular vehicle for FDI in the subcontinent, and Malcolm Moller, managing partner in the Mauritius office of the offshore law firm Appleby, says the authorities are also keen to promote the island as a hedge fund jurisdiction.
"The concept of hedge funds using Mauritius as a domicile is inextricably linked to the benefits of the double taxation treaties with India and China. We are currently seeing a move towards Cayman based hedge funds setting up sub-funds in Mauritius to act as a conduit for their investments in India.
"China's new Enterprise Income Tax law, passed by the National People's Congress on 8 March 2007, will make Mauritius even more attractive. China's new law may make life more complicated for investors based in other tax free jurisdictions that do not have double tax agreements with China. At present, such companies do not have to pay withholding tax on their investments in China. However, as of 1 January 2008, they will be subject to a 20 per cent withholding tax."
The phenomenal growth of the funds industry in Asia could also play well for Mauritius as it seeks to establish itself as a real player in the offshore world.
"The government here is very keen to promote the financial services industry in Mauritius. The growth in Asia is creating real possibilities and a number of financial services firms have set up here with a view to taking advantage of that," says Moller.