Domiciling a Hedge Fund: A guide for first-time managers

• United Kingdom

• Financial services and markets regulation
• Financial services and markets regulation - Hedge funds
• Financial services

15-11-2019

A fund’s domicile has a significant influence over its final shape. Making the right choice comes down to knowing your fund and knowing your investors. Seed and target markets, the investors location, investor preferences, available fund vehicles – taken together these factors all influence a manager’s choice of domicile.

There are many countries to choose from – 193 according to the UN – but a few key jurisdictions loom large in the world of fund management. In this article we will take a look at three of the better-known in greater detail.

Before getting into the particulars, it should be made clear that this article will be looking at this topic from a particular angle. Marketing within Europe is difficult. How difficult will depend on the fund domicile and this should be taken into account when looking at the selected jurisdictions. For the purposes of this note we will assume that the regulatory demands of the EU’s UCITS regime rule it out as an option. This means fund managers will have to tackle the EU’s Alternative Investment Fund Managers Directive (“AIFMD”), its passport and the compliance costs that come with it.

The Cayman Islands

Pros

For many this three island chain in the western Caribbean is the hedge fund’s natural habitat. Leaving aside the white sandy beaches, managers and investors are drawn to this jurisdiction by an efficient tax and regulatory regime, a ready supply of service providers, a trusted regulator and the islands’ common law system. With this heady combination of traits it is no wonder that the Cayman Islands continue to be a favoured fund domicile.

The maturity, extent and quality of Cayman supporting industries are widely recognised. An industry of this size offers mangers greater choice, not to mention the lower charges that can come with economies of scale. Cayman funds also benefit from plenty of structural variety. Limited partnerships, corporations and segregated fund structures with isolated liabilities are all options open to the first-time fund manager. More information on this key domicile can be found in our dedicated article here.

If assets under management (“AUM”) are below AIFMD thresholds, UK fund managers can manage Cayman funds as ‘sub-threshold AIFMs’ and enjoy the lower operating/compliance costs that come with this status (you can find out more about ‘full scope’ and ‘sub threshold’ status here).

Cons

For all the benefits, a Cayman domiciled funds will not be eligible for an AIFMD passport. This will severely hamper a manger’s ability to market funds in the EU. Funds without a passport will have to seek advice and tackle each European jurisdiction individually. This will mean higher costs and a smaller pool of potential investors.

The European regulator (ESMA) has toyed with the idea of offering non-European jurisdictions like the Cayman Islands AIFMD passporting rights. However, no movement on this issue is expected until Brexit is resolved.

Ireland

Pros

Ireland’s hedge fund industry is highly regarded. Cultural ties with the UK and the US, EU membership, a thriving network of service providers and a common law system allow Ireland to straddle the Atlantic. What’s more, recent legislative initiatives – most notably the introduction of a tailored Irish Collective Asset-Management (“ICAV”) vehicle – have improved the fund structures on offer to managers.

Significant tax and regulatory benefits have made the ICAV increasingly popular in recent years. They are also extremely flexible: ICAVs can be as formed standalone fund vehicles, incorporated into master/feeder arrangements, or established as sub-funds with ring-fenced liabilities. The ICAV is particularly attractive to US investors, who stand to benefit from tax transparency in certain master/feeder configurations and avoid the tax penalties imposed by the US Passive Foreign Investment Corporation regime on other corporate fund vehicles. More information on the ICAV structure can be found in our dedicated article here.

UK fund managers will also be eligible for an AIFMD passport. This means that a fund domiciled in Ireland can be marketed throughout Europe without having to negotiate the private placement regimes of each jurisdiction. The upshot is more prospective investors for your fund.

Cons

To secure an AIFMD passport for an Irish fund the manager must be a ‘full scope’ AIFM and this status comes with high compliance costs (you can find out more here). Irish funds will also need to secure a full-scope AIFM before they can be marketed in Europe, this applies even in countries where you would normally benefit from friendly private placement laws (like Luxembourg and the UK).

Luxembourg

Pros

Luxembourg hosts a long-standing financial centre that continues to attract new fund managers. This is hardly surprising: with world-class service providers, four working languages (English/French/ German/Luxembourgish), marketing reach across four continents and a set of finely tuned set of laws and regulations the world last Grand Duchy has much to recommend it.

As a domicile Luxembourg offers a wide variety of legal frameworks. One of the most popular is the reserved alternative investment fund (“RAIF”), which does not need approval from the Luxembourg regulator before launch. This means that RAIFs can be brought to market much faster than comparable vehicles. RAIFs are highly flexible vehicles and can be structured so that segregated sub-funds employ individual investment strategies. More information on the RAIF structure can be found in our dedicated article, click here.

As is the case for Ireland, UK fund managers with a fund domiciled in Luxembourg will be eligible for an AIFMD passport.

Cons

Again, the necessity to achieve ‘full scope’ AIFMD status may be an issue for those hoping to offer cross border services in the EU. The issues raised for Ireland apply to Luxembourg along with many otherwise attractive EU jurisdictions such as the Netherlands, Gibraltar, Cyprus and Malta.

Alternatives to ‘full scope’

So what are the options open to fund managers who want an AIFMD passport, but don’t want to shoulder the costs that come with being a full-scope AIFM? In a word, “hosting”. Third parties with full-scope status can be appointed to handle a fund’s AIFMD requirements (though depositaries will still need to be appointed by the fund manager directly).

The host’s fees will typically fall to the manager, but they will generally be lower than the cost of AIFMD compliance. What’s more, following this route leaves a fund manager more time to focus on the fundamentals: securing a decent return for investors.

AIFM hosts grant Irish and Luxembourg domiciled funds full passporting rights. The manager of a Cayman domiciled fund may wish to consider securing a host to lighten their regulatory burden, but there is currently no way for them to access the AIFMD passport.

How Eversheds Sutherland can help

Our team has been at the forefront of regulatory interpretation and product development for the fund management industry since the 1980s. We advise on all types of fund structures and prepare all documentation necessary to achieve a successful fund launch.