Cayman Finance explains the European Funds Directive

The
European Alternative Investment Funds Directive, or Directive for short, is an
attempt by European regulators firstly to restrict the marketing of non-EU
based hedge funds in Europe and secondly to restrict the range of trading
activity of hedge funds.  This arises
because EU politicians mistakenly see hedge funds as having been instrumental
in the recent financial crisis.  This is
relevant to Cayman because of the concern that the Directive may disrupt the
relationship between the Cayman Island hedge fund and any fund manager of that
hedge fund based in the City of London which is a European centre of excellence
for hedge fund management – that is to say the European location where the
assets of certain Cayman hedge funds are actually traded. 

The
first point to establish when looking at the possible effects of the Directive
on the Cayman fund industry is that only 20 per cent of Cayman hedge funds by
net assets have fund managers located in London.  Furthermore, as a result of very severe
trading and risk restrictions which the Directive is likely to impose on
EU-based hedge fund managers, many of them may seek to leave the EU altogether
and indeed many, notably Blue Crest and Brevan Howard are currently leaving
London and relocating to Switzerland.  To
the extent that the hedge fund manager leaves London and re-domiciles outside
the EU the effect of the Directive on Cayman is reduced, not increased. 

A
second consequence of the Directive is that Cayman Islands hedge funds may not
be marketed to the retail public in Europe. 
However, it is not the case under the current legislation that Cayman
funds are marketed to the public in Europe, particularly since Cayman funds are
designed as investment vehicles for institutional investors and high net worth
individuals.  Cayman funds are typically
marketed to institutional investors and it is highly unlikely that an institutional
investor seeking the superior return of a particular Cayman Island hedge fund
will not have an affiliate based outside of the EU in, for example,
Switzerland, Hong Kong, Singapore or the US that can make the investment in the
Cayman fund in any event.  However the
question that arises is whether Cayman funds will comply with the Directive to
enable the marketing of a Cayman fund by private placement within Europe which
is currently the position pre-Directive.  

The
short answer here is that it is simply too soon to say since there are two
alternative proposals that have to be reconciled as a part of the EU
legislative process.  The EU Commission’s
proposals require a cooperation agreement between the jurisdiction of the fund
manager (e.g. London) and that of the fund (e.g. Cayman) which, provided the
fund manager complies with certain aspects of the Directive, would permit
marketing of the Cayman fund in the EU by private placement – a similar
marketing arrangement to that which exists currently.  The European Parliament proposal would
require not only a cooperation agreement, but also a tax information exchange
agreement, a specific anti money laundering regime, reciprocity and
enforceability of judgments under the 1958 New York Convention.  If the approach of the EU to either the
Commission or the Parliament proposals is objective and non discriminatory,
Cayman should unquestionably comply with either proposal. Hence, the Premier’s
recent statements have a solid grounding. 
But, if on the other hand, the proposals are applied by the EU in a way
that is discriminatory, then we can anticipate that Cayman funds with an EU
based fund manager will be excluded from investment by EU residents, at least
initially. 

However,
even in that event, we must remember that 80 per cent of the net asset value of
Cayman Islands funds are not managed in the EU and so the effect of the
Directive is in no way similar to the suggested OECD black list coined after
the 1998 “Harmful Tax Competition” initiative. 
Indeed, given that the effect of the Directive on a fund manager situate
within the EU is that it will not be in a position to compete in terms of
investment return with a non-EU situate manager we can not only anticipate fund
managers moving out of the EU and continuing their relationship with Cayman
Islands funds but we should also be cognizant of the fact that the present
certainty and clarity of the Cayman Islands regulatory regime will become
increasingly attractive to fund managers globally.

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