What's driving your jurisdiction choices?

With a wealth of domiciles at their disposal, Mary Bruen, of PwC, examines the reasons why hedge fund managers should consider those in the Channel Islands 

Bio

Mary Bruen is a Associate Director in PwC Channel Island’s Advisory team, she's based in Jersey. Mary spent one year with the FSA working on policy development on the AIFMD and represented the UK at Esma meetings. Her current focus is working with clients on assessing strategic and operational issues associated with new and proposed regulations.

Good governance is emerging as a vital ingredient for success. Yet in order to govern themselves well, hedge funds need the resources and operating environments that only the highest-quality, most-established specialist domiciles can offer.

Investors, regulators and tax authorities are pushing hedge funds to build the substance of their activities in the centres where they’re based. Investors and regulators want fund governance to be based there, and tax authority scrutiny is forcing funds to carry out more economic activities locally.

So hedge funds need to base themselves in high-quality centres that have strong regulatory regimes – but still offer flexible corporate and tax structures. They require large pools of competent staff, networks of world-class service providers, close proximity to the largest hedge fund management centres – and respected regulators. In other words, in order to show substance themselves, hedge funds have to be based in centres of substance.

These changing dynamics are making the Channel Islands of Guernsey and Jersey more competitive as hedge fund centres. They have long-established financial services infrastructures, flexible structuring options designed for hedge funds. In addition, these fund centres have a commitment to matching up to the new hedge fund regulations whilst providing investors and managers with a choice as to the degree of regulation.

Right now, hedge fund managers are re-examining their choices of jurisdiction and reassessing the appropriateness of their previously well-trodden paths for fund set up. This article outlines the merits of the Channel Islands as the future-proof alternative for forward-looking hedge funds and their managers.

Achieving growth in a post-crisis environment

A new financial world is taking shape. In it, investors, regulators and tax authorities have all become more assertive about the standards of governance and controls they expect. Providing hedge funds meet these standards, they have a large potential marketplace, albeit in a world where investment returns are lacklustre and economic activity is gravitating to the south.

Taken together, these factors are making choice of jurisdiction critically important to the success of a fund.

Investor demands

Hedge funds are now relying ever more on institutional investors for funding. Pension funds, sovereign wealth funds (SWFs) and other institutional investors regard strong governance as being equally important to performance, and want to see the controls and valuations that support it.

Answering to trustees in the case of pension funds or governments in the case of SWFs, these investors tend only to invest in funds with strong governance backed by effective fund boards. The Hedge Fund Standards Board (HFSB), has released guidance calling for fund governing bodies to have a majority of independent directors, possessing suitable experience and qualifications to hold the manager to account for its performance and conduct*.

But not all fund domiciles have large enough pools of directors to populate these stronger boards, or the service providers to provide the kind of transparency and controls requested. With this shift in investor priorities, some traditional hedge fund centres might struggle to provide the environment needed to meet these changing needs. This trend is making the Channel Islands especially suitable as a hedge fund domicile, not least because a large number of high-calibre potential directors live on the islands.

*Hedge Fund Standards Board strengthens standards with international dimension. www.hfsb.org 17 February 2011

Meeting regulatory demands

New regulations governing hedge fund managers in both the United States and Europe are changing what’s needed from a fund domicile. In both cases, they’re raising the governance bar, meaning that managers who want to make sure they’re complying with the spirit and letter of the rules can only do so by locating funds in centres with strong networks of service providers and adequate numbers of well-qualified fund directors.

Under the Dodd-Frank Wall Street and Consumer Protection Act, any hedge fund adviser using US means to conduct business must comply with parts of the Investment Advisers Act of 1940, even if that adviser doesn’t have to register with the Securities and Exchange Commission (SEC).

The SEC expects to see compliance frameworks and governance structures throughout the entire structure – from manager/adviser through to fund/LP. In order to achieve this, hedge funds/managers have an advantage if they’re based in jurisdictions that possess the resources for them to do so.

Europe’s AIFMD is similarly forcing managers to improve governance. Many will choose to register with EU regulators under the private placement regime for as long as possible, currently until 2018, to avoid the full force of the directive which requires changing current operating models. Under this regime, funds can be either ‘internally managed’ or ‘externally managed’, providing they demonstrate ‘substance’, which means they have to be much more than ‘letterbox entities’.

In practice, for funds/managers to have such substance their boards must control all delegated functions. According to the AIFMD, AIFMs must have sufficient resources to supervise the risks of delegated functions, and they must perform more tasks in-house than they delegate in relation to portfolio management. Once again, this points to the need for better governance and stronger infrastructure.

To avail of the passport (post 2015) it will be important for structures to be based in high-quality financial centres. In order to qualify under the AIFMD’s passport regime, domiciles must have equivalent levels of regulation and supervision to EU countries. Both Guernsey and Jersey intend to qualify by creating AIFMD ‘opt in’ regimes.

In effect, the new regulations in both the US and EU will force managers to significantly change what they need from a jurisdiction. In future, specialist hedge fund centres must offer strong networks of service providers and be close to the major hedge fund management centres such as London or New York, so that managers can meet far tougher governance requirements.

The tax dynamic

Across the world, governments are seeking to minimise tax leakage as they look to bolster public finances. Consequently, they’re placing more emphasis on the tax doctrine of ‘substance’, which says that funds should carry out economic activities in the centres where they’re based and not just be there for tax reasons.

There are examples of both European and Asian governments challenging the substance of structures based in specialist financial centres. In some cases they’re aiming to tax fund investors based in their countries and, in others, they’re looking to tax the profits on investments made by funds in their countries through offshore.

So revenue authorities are also pushing hedge funds towards basing more tasks within the centres where they’re based.

Channel Islands advantages

As high-quality jurisdictions, with developed networks of service providers and strong regulatory environments, the Channel Islands have earned recognition for being among the leading offshore centres. According to the latest Global Financial Centres Index, published in March 2012, they’re by far the most competitive of these centres*. Such competitiveness is more important than ever at a time when hedge funds are seeking to conduct more of their governance, administration and compliance activities within these centres.

For hedge funds/managers, the islands’ greatest advantage comes from the combination of this quality with flexibility. The islands’ authorities are highly adaptive, tailoring solutions and structuring options to the needs of investors and managers alike – whether they’re based in the US, Europe or the BRIC regions.

On the one hand, the islands possess a large pool of well-qualified directors and an extensive service provider infrastructure; on the other, they have an innovative approach to emerging regulatory frameworks and are well-prepared for the AIFMD.

*Jersey and Guernsey rank 21 and 31 respectively

Conclusion

As the hedge fund industry evolves, the governance and in-house administrative activities they carry out in specialist financial centres are likely to increase.

The best centres will balance high-quality regulation and infrastructure with the potential for tax-efficient structuring. With investors in the driving seat, financial centres must give managers the flexibility to match transparency and governance to investor profiles.

The Channel Islands’ competitiveness internationally endows hedge funds with credibility and a competitive edge in a new world where a jurisdiction’s quality has assumed far greater importance.

In the new world hedge funds have great opportunities to attract capital from developed world pension funds and developing world SWFs, both of which are seeking fresh ideas for generating investment returns. But in the competition for capital, the choice of fund domicile has just become a critical factor.