The first point of inquiry of fund managers looking at establishing an APAC presence concerns where to locate the fund’s management and operations. Below we look first at the core issues relevant to hedge fund managers in general; subsequently, we shift the focus of our analysis onto the HK and Singapore specific issues relevant to hedge fund managers operating in APAC.
Legal issues when structuring a hedge fund
How the start-up manager envisages the fund-raising process and where his investors are likely to be based is the analytical starting point in terms of structuring a hedge fund, specifically:
- Will it be a global strategy marketed to a range of global investors?
- Is the intent to raise money from US tax payers and US tax-exempt investors?
(a) US structures:
US investors can be split into two categories: (i) US tax payers and (ii) US tax-exempt investors (eg., pension funds, endowments, &c.). The former wish to have opaque tax structures, whereas the latter prefer tax transparent structures (e.g., Cayman companies). Therefore, a critical initial distinction is how the legal vehicle will elect to be classified for US tax purposes. Typically, a manager will wish to establish at least two vehicles to support these different types of investors—such vehicles are commonly referred to as ‘feeder funds’.
A third structure, often called the ‘master fund’ (a tax transparent Cayman company), holds the assets and executes trades with the prime broker(s). Simply put, the two feeder funds provide a dual entry point into the master fund. Due primarily to Foreign Account Tax Compliance Act (“FATCA”) concerns, many managers prefer to keep US taxpaying investors completely separate from the rest of their global tax-paying investors for accounting purposes.
(b) European structures:
For hedge fund managers targeting EU investors, the most suitable fund structures are (i) Irish Qualifying Investor Funds (“QIFs”) and (ii) Luxembourg Specialized Investment Funds (“SIFs”). Both QIFs and SIFs are more flexible than UCITS fund structures, but not as flexible as Cayman fund structures. This EU onshore-regulated route might benefit the hedge fund manager in terms of raising capital, but they will have to accept that EU regulators are potentially going to intervene and instruct them to do things differently.
Legal issues when structuring the fund management company
Arguably, what is more critical than the structure of the fund itself is the proper establishment of the fund management entity; ultimately, this requires a solid management structure and a clear partnership agreement to help avoid potential future disputes and reputational issues. In particular, hedge fund disputes tend to originate within the fund management structure as opposed to the funds themselves.
(a) Limited Liability Partnerships (“LLP”):
Essentially a tax-transparent corporate entity, LLPs help to avoid double taxation. Specifically, management fees and incentive fees pass straight through to partners as if they were earning them themselves directly (i.e., not through the fund). Also, the fact that they are partners in the firm--not employees--avoids employee related tax and compensation issues. The success or failure of most LLPs is determined by the quality of the partnership agreement.
(b) Partnership agreements (“PA”):
The PA must be carefully constructed to address any relevant default provisions that will apply by operation of law in the jurisdiction of the fund manager unless the manager does not specifically exclude them in the PA. Examples of material default provisions may include:
- All members may be entitled to share equally in the capital and profits of the LLP;
- Every member may take part in the management of the LLP; and
- No majority of the members can expel any member unless such a power to do so has been expressly conferred in the PA.
Secondly, the PA should determine the extent to which duties of good faith are exercised within the partnership. Any partnership arrangement is subject to fiduciary duties (or duties of good faith). However, it is somewhat uncertain the extent to which the partners of an LLP owe duties of good faith either to the entity or to individual members.
Another area to consider in the PA is what happens when one of the partners decides to leave the firm. Managers should consider buy-out options so that each partner is clear on the financial implications of leaving: either voluntarily to pursue their own interests, or because of a dispute. There should be nothing left open to interpretation in a well-drafted PA.
Finally, another difficult area that might arise relates to non-performance of individuals. This can lead to a potentially destabilizing environment, but how one defines non-performance is far from straightforward and should be addressed in the PA.
(c) Profit arrangements in an LLP:
The economic returns of the management company are derived from (i) management fees (typically one or two per cent of the fund’s AUM) and (ii) incentive fees, which are typically 20 per cent of the fund’s profits. These fees go to the LLP, and the PA must provide for what’s called “residual profit”; specifically, the amount left over after operational costs, regulatory capital requirements, remuneration of employees, &c.
This raises the final material issue of consideration when establishing the management company--regulation.
For example, under the poorly conceived European AIFM Directive that came into effect in July 2013, a deferral mechanism will need to be established, which could become an issue. This means that under the PA, rather than each partner receiving his full profit allocation, it would need to be re-invested back into the fund and distributed back to the partner over a three- to five-year period.
However, most sophisticated fund managers will rarely just let’s say a UK LLP; instead, they will have a Cayman management entity, which then appoints a UK LLP to operate in an advisory capacity.
Under the AIFM Directive, start-up managers have to therefore decide whether to structure the management company purely as an LLP (and fall within the Directive), or remain outside of it by placing the balance of power with a Cayman management entity. This structure is useful for managers who succeed in building the business and end up with management entities in, for example, New York, Singapore and London, all of which would be contracted to the Cayman entity.
Regulatory treatment of hedge funds in APAC: HK versus Singapore
Having analyzed the core issues relevant to structuring funds and fund managers internationally, let us now pivot our focus on to APAC by distinguishing between the core advantages and disadvantages of Hong Kong versus Singapore from a hedge fund managers’ perspective.
(a) Hong Kong’s regulatory framework:
Essentially, Hong Kong’s Securities and Futures Ordinance treats all funds as Collective Investment Schemes (“CIS”), which encompasses:
- Mutual Funds;
- Hedge Funds;
- Structured Investments (structured products);
- Unlisted Structured Investments; and
- MPF and ORSO schemes (mandatory mutual fund schemes for employees).
Some key features resulting from HK’s quirky regulatory treatment of funds (i.e., placing of all of the above under a single CIS regime) worth highlighting include:
- Offshore funds are mostly used (e.g., Cayman, BVI and Bermuda) due to the limited choice of HK domiciled fund structures (which tend to be less innovative and aggressive structures) since retail funds can only be formed as unit trusts (i.e., no umbrella fund structures or mutual fund companies);
- HK gives tax exemptions to offshore funds (except profits tax on HK sourced income) in terms of dividends, capital gains, interest income and no stamp duty on non-HK share transfers;
- Fund managers are well regulated and low taxes makes HK an attractive center for fund managers; and
- HK (as China’s offshore financial center) still acts as a greater PRC gateway than Singapore.
(b) Singapore’s regulatory framework:
The core strengths of Singapore from the perspective of a hedge fund manager include:
- Excellent tax and regulatory incentives for fund managers (in stark contrast to the EU’s taxation juggernauts and counterproductive AIFM Directive);
- Efficiently and more clearly regulated, Singapore has avoided following the international licensing and capital unfriendly regulatory trends (also in stark contrast to HK’s blunt CIS regime described above that fails to distinguish between hedge funds as mutual funds for licensing purposes), thereby providing faster access to the market; and
- The MAS proactively promotes Singapore as a hedge funds hub, without over-burdening start-ups with excessive licensing and other regulatory hurdles.
Despite Singapore’s strengths, its key disadvantages as compared to HK include:
- Prime brokerage services tend to be concentrated in HK, London and New York; and
- Hong Kong retains an advantage in terms of the China market and RMB denominated funds.
(c) APAC’s competitive outlook:
Several general trends affecting the APAC regulatory landscape worth mentioning to prospective fund and hedge fund managers include:
- Many regulatory regimes are capitalizing upon the shortcomings of an oft-hostile EU regulatory environment, including the AIFM Directive, the limitations of UCITS, and taxation regimes that are seemingly oblivious to competition;
- FATCA continues to have a chilling effect on the market with certain segments of US investors being avoided entirely by some fund managers;
- HK’s dominance as an offshore RMB will be affected by the success of both the RQFII and HK-PRC mutual recognition initiatives, the latter allowing the ‘pass-porting’ of certain funds domiciled in either system (Hong Kong’s SFC has been working closely with China’s CSRC), although its final form has yet to be released;
- The Association of Southeast Asian Nations (“ASEAN”) Capital Markets Forum (“ACMF”) has a project to facilitate the cross-border offering of collective investment schemes within ASEAN.
The essential issues of strategy and target investors remain critical to the establishment of funds and fund management structures in APAC as elsewhere. Within APAC, HK and Singapore remain keenly competitive in terms of attracting hedge fund managers and the key features and advantages of both jurisdictions have been outlined above. There is a lot of regulatory interest and movement across APAC to be more competitive globally and even the long dominant UCITS structure is being challenged by innovative regulatory regimes within APAC. Keeping abreast of these regulatory developments and the comparative advantages and disadvantages of each will remain relevant issues for funds and hedge fund managers within APAC going forward.
Gareth Pyburn is the Founder and Managing Director of InsightLegal Asia Consulting.