It is unlikely that any sector has been unaffected by the crisis in credit and financial markets, but fund managers and the service providers that support the fund industry are subject to particular challenges.
For the funds industry rapidly changing economic circumstances have coincided with massive regulatory and political pressures which continue to provoke questions as to the optimal approach for the fund management industry.
Jersey, together with certain other offshore jurisdictions, has been in the middle of many of these debates and many commentators have suggested a “paradigm shift” in the way that the alternative fund industry will operate going forward.
For a jurisdiction like Jersey where there is expertise across many areas of the fund industry from advisers, including legal, audit and tax, to directors and administrators, this has been a critical time to consider how clients and the structures that they operate are best served. Far from being paralysed by market developments, the past 18 months have been a time of significant innovation for fund managers who have continued to operate in these markets.
This article considers a few of the patterns which we have seen emerging, as well as some of the regulatory and tax initiatives which are influencing the business environment.
Changing dynamics in fundraising
Due to a number of economic factors, and above all the need of investors to conserve cash, the process of successfully closing a fund has become a significantly more complex operation. In the short term the scarcity of cash has signalled a shift in the balance of the negotiating table from fund sponsors who, in the case of strong performers have for some years dictated terms, in favour of investors who have exploited more negotiating leverage in their demands.
A number of patterns have developed in order to balance investor demands with the desire of the manager to close funds on the other.
• A greater need to secure “cornerstone” investors in order to demonstrate a momentum to a fundraising process.
• At the same time, where in a more favourable economic environment it was common for funds to be raised on a “blind” basis, i.e. without any specifically identified assets for the fund portfolio, it is increasingly necessary to demonstrate that pipeline assets have already been secured for the fund.
• Drawdowns and documentation to achieve these have become more carefully negotiated in order to provide cash when it is needed for the fund.
• There has also been an increased focus on excusal mechanisms for certain investors and in some cases on combining this with means of reducing commitments, or where not successful, the use by managers of default mechanisms.
More pressure on investor cash-flows once funds are launched
For existing (rather then new) funds, a number of key mechanisms have been tested, often in ways that their creators did not envisage and have led to new restructuring techniques in order to deal with changing markets and investor conditions. Examples of these measures are set out below:
Side Pockets – In light of the credit crunch experience, promoters and their legal advisers have increasingly negotiated provisions into the constitutional documents of open ended funds to allow the fund to convert redeemable interests into non-redeemable interests (whether units, shares or partnership interests) where these represent illiquid or difficult to value assets.
Redemptions and Gates – A number of steps can be taken by funds which are dealing with a large number of redemptions. These can range from negotiating “gate” mechanisms into the fund documents in order to manage the amount of redemptions at any one time, to suspending valuations or redemptions, all as alternatives to winding up the fund. Without a gate mechanism, a sudden surge in redemption requests may force a fund to miss out on good investment opportunities or to liquidate prematurely favourable positions.
Judgements in recent months in Cayman and the BVI have brought renewed focus on redemption mechanics which will also have an effect on the drafting of Channel Islands fund documentation. Redemptions for Jersey funds also need to reflect the changes to company law effective from June 2008 which have been further amended in March 2009 in order to apply the test for an “open-ended investment company” to all types of open ended corporate funds.
Many funds have gates that provide that any redeemer whose redemption is delayed wholly or partially by operation of the gate will be automatically rolled over and prioritised over subsequent redemption requests on the next redemption day, which can exacerbate problems facing the fund, giving rise to a run of redemptions as investors seek to preserve priority in the line for the exit.
Suspensions of redemptions – The exercise of a discretionary power contained in the constitutive documents is sometimes referred to as a “fiduciary gate”. The exercise of that power can, in practice, be highly challenging. Managers and promoters are aware of the taint associated with suspension and strive to avoid invoking the provisions. In determining whether to invoke a suspension the directors, and not the investment manager, make the decision.
Key Investors – Investment managers and directors naturally confer with key investors on restructuring proposals to ensure that proposals will garner sufficient support to work, but a fund must be careful that the same proposals are extended to all and do not invite litigation from investors aggrieved that others have been treated more favourably.
Increased focus on investor rights
At all stages of a fund’s life there has been increased focus on rights of investors, whether statutory, constitutional or contractual in order to negotiate more favourable positions from funds or their managers. Where these rights are traditional for shareholders in a company, the focus has increased on employing similar rights for general partners in limited partnership structures. Typically this has included consideration of some or all of:
• the replacement of managers.
• challenging boards or replacing them by corporate or contractual methods.
• increased pressure by minority investors in order to influence the decisions taken by boards.
• threat and use of litigation in certain circumstances.
• enforced liquidation of fund structures.
This has required increased focus in accommodating the often conflicting positions between investors, managers and the boards of funds.
The changing fiscal and regulatory environment
In addition to the commercial and financial pressures which funds have faced, the environment in which funds operate has been affected by significant uncertainty from a fiscal and regulatory perspective. This is currently a very fluid issue which is driven by a number of political and economic agendas in the global financial system.
Tax initiatives have been driven by the obvious concerns of governments due to the global recession and to fiscal challenges which have led to actual or potential increases in tax revenue policies. These have included:
– the OECD’s grading of jurisdictions depending on the level of implementation of tax standards for information exchange and cooperation.
– A number of reviews covering tax and regulatory aspects of the financial crisis. These include the FSA "Turner Report" which made it clear that offshore financial centres were not to blame for the financial crisis nor were they a major contributor to it as well as the British review of offshore financial centres (the "Foot Review") which was commissioned by the UK government. The results of which are expected to be released towards the end of the 2009.
– A number of USA tax and regulatory initiatives. In particular, rival proposals put forward by Senate Finance Committee chairman Max Baucus, have consorted with the alternative, highly publicised, "Stop Tax Haven Abuse Act" put forward by Senator Carl Levin.
– The G20, in declaring a newly formed financial services board (FSB) which would replace the existing Financial Stability Forum which would develop global stability principles by the end of 2009.
– In particular, a much commented-on proposal has been the European Union’s draft Alternative Investment Fund Managers Directive. This has been a particular focus of concern for managers dealing with European-based investors.
The Draft Alternative Investment Fund Managers Directive (the “Directive”)
Published at the end of April 2009, the draft Directive was produced with a mixed set of aims of ensuring high level consumer and investor protection by creating a regulatory framework for all managers of alternative investment funds, while also attempting to address systemic concerns.
The consultation period was extremely short and driven by the desire of the European Commission and Parliament to take the initiative regarding the adequacy of the existing regulatory framework.
In its current draft the impact of the Directive is far-reaching and will affect not just managers but also service providers of both onshore and offshore funds and the repercussions will be felt by all funds which currently fall outside the UCITS framework as currently drafted.
From Jersey’s perspective, as well as impacting on managers, the Directive would significantly impact on a number of fund functionaries including Depositaries (Custodians) and Administrators.
The proposal reflects the opinions of the European Commission and the European Parliament over the benefits and risks of hedge and private equity. On the one hand, the European Commission has since 2006 been looking at creating a single (professional) European market for non-UCITS funds. On the other hand, the European Parliament and some member states have a very different agenda, namely to impose much tougher regulation on hedge funds and private equity funds.
Until this is resolved, it is difficult to see how a satisfactory directive can be agreed, so the expectation is that the current Directive will be heavily amended. A major lobbying effort against the Directive has been initiated by industry groups such as AIMA, EVCA and the MFA as well as by investors who may be affected by the Directive.
Whilst still in its draft stages, the Directive has met with a lively response from both those directly affected and those indirectly affected. It is anticipated that Jersey may also be able to seek “equivalence” under the Directive, in which case Jersey Managers could obtain a “passport” to market funds into any EU member states after the expiry of the transitional period.
It remains to be seen the extent to which the lobbyists will change the Directive as it currently stands. What is clear, however, is that until the Directive is in its more advanced stages, and the secondary legislation implementing its effects in each Member State is rolled out, anticipating and planning around the impact of the Directive will affect all asset managers with European investors whether inside or outside the EU.
In the meantime, Jersey, together with other offshore jurisdictions has focused on significantly articulating and explaining its status as a well regulated financial centre. This has been reflected particularly in a recent report from the International Monetary Fund as well as in negotiations and discussions with a number of governments across the EU.
Prognosis for fund structures
The number of funds dealing with distressed situations is increasing, and it has been important to draw structuring and drafting lessons, which can impact all structures, from the widest pool and from the whole range of offshore jurisdictions, particularly where directors and funds, as well as their service providers, are being advised as to the best practice which can change from month to month.
It appears still too soon to be able to call a turning point from the current mood to one of greater confidence. However, it is clear that whatever pattern the investment industry settles into going forward, we can be confident that in order to provide the best position for fund managers as well as investors, the lessons and techniques that characterise fund documents and negotiations will now be crucial in designing fund structures for the future.
It will be jurisdictions which, like Jersey, can best articulate this that will see opportunities coming out of the turbulence.
Tim Morgan is partner, business and trust law group at offshore legal firm Ogier
