For Hong Kong based managers, the preferred hedge fund structure has long been a Cayman Islands exempted company. However, there has been a lot of talk over the last year or so about the Hong Kong government initiative to introduce an open-ended fund company (OFC) vehicle, and to make changes to taxation laws, with the aim of allowing for Hong Kong domiciled hedge funds.
But will the OFC and proposed tax changes really entice Hong Kong based hedge fund managers to set up funds in Hong Kong?
Much of the talk of the “advantage” for a Hong Kong manager in setting up an OFC over a Cayman domiciled fund relates solely to a requirement for dealing only with the Securities and Futures Commission (SFC) and not also the Cayman Islands Monetary Authority (CIMA).
This seems to me a little simplistic.
As a starting point, with a Hong Kong manager directly managing a Hong Kong fund, and without any offshore manager, there will be no opportunity for any management or performance fees to be earned at the Cayman level and tax-deferred.
Moreover, hedge funds are cross-border by their very nature. Most hedge funds have investors from a lot of different countries and have investments in a lot of different countries. Accordingly, managers will already need to be considering the securities laws of various countries.
All the investors in a hedge fund will have their own local tax obligations, so as a very base condition a manager is seeking to domicile their fund somewhere with no additional taxes. However, this is not enough.
A manager also needs to domicile their fund somewhere that provides investors from a lot of different countries the relevant level of comfort to place their investments in such a vehicle. There are some very important factors that are considered by the type of sophisticated investors that invest into hedge funds in determining this comfort level. Such factors that a jurisdiction must exhibit include the absolute rule of law, respect for property rights and access to a sophisticated judiciary free from political interference.
The Cayman Islands is a jurisdiction that fulfils these requirements and has reliably proven itself to do so over decades. As a result, over 85 per cent of the world's hedge funds are domiciled in the Cayman Islands.
Hong Kong is a jurisdiction that some might consider is rapidly being subsumed into the People’s Republic of China.
Even when you drill down into more of the minutiae of the OFC regime it appears that the Cayman Islands remains a clear leader. The level of prescription and oversight which is contemplated by the OFC regime, whilst it may be familiar to operators of Hong Kong retail funds, is far more than would be familiar to hedge fund managers, or than applies to private Cayman funds.
- The OFC’s governing document is required to contain certain prescribed provisions, including the kinds of property in which the OFC can invest. Any change to this governing document will require the SFC’s approval. There are no restrictions imposed by the Cayman regime on investment strategies of Cayman funds or their use of leverage. A Cayman fund does not have prescribed provisions in, and CIMA’s approval is not required for any changes to, its memorandum and articles of association.
- The appointments of the directors of an OFC are subject to the SFC’s approval, and the SFC will require the directors to be appropriately qualified and experienced. By contrast, CIMA requires directors to register via a web portal but does not impose an approval process nor any requirements as to qualifications, experience or independence.
- An OFC must appoint a custodian approved by the SFC which meets the eligibility requirements set out. In practice, many hedge funds appoint one or more prime brokers, and many prime brokers may not, and may not wish to, meet these eligibility requirements. A Cayman fund sold in Hong Kong by private placement is not required to appoint a custodian.
- The OFC regime requires that the valuation and pricing of the OFC’s property is the investment manager’s responsibility. This is inconsistent with the typical hedge fund model, where valuation and pricing is typically delegated to the fund’s administrator.
- Any change of name of an OFC is subject to the SFC’s approval. No approval is required to a change of name of a Cayman fund.
- Transfers of OFC shares will be subject to Hong Kong stamp duty, in contrast to Cayman funds that maintain their register of shareholders outside Hong Kong.
As a result of both the differences in their jurisdictional foundations, and shortcomings in the detail of the OFC regime, my personal view remains that the OFC is unlikely to tempt many Hong Kong hedge fund managers away from the flexible, well-tested and more globally accepted Cayman structure.
I suppose time will tell.