What are the pros and cons of on/offshore hedge funds from a legal perspective? How do the options vary among on/offshore jurisdictions?

On or off? This is a moot question given the recent attacks on, misunderstanding of and bad press for offshore locations. All of this has combined to make many hedge funds nervous of being associated with any offshore location. At the same time the majority of funds continue to use the traditional model of Cayman Islands domicile, Irish fund administration and London or US-based managers. How long this will continue and what, if any, impact regulation will have on this pattern is an open question. The EU’s Ucits brand continues to gain in popularity. This, coupled with changes to UK laws that could encourage onshore funds, expands the choices for hedge funds for onshore products.

Gray Smith at Appleby in the Cayman Islands believes there is room for both. “We are seeing managers setting up parallel or master/feeder structures in both. Offshore tends to be quicker and cheaper, and is well established with the industry. EU and US protectionism may try to persuade funds onshore, but the market is still keen on the offshore product,” he concludes.

At Conyers Dill & Pearman, Tania Dons and Richard Finlay say offshore jurisdictions tend to be similar from a legal services and legislation point of view, although there is still a perception that some jurisdictions are more efficient. They believe flexibility of legislation and fund structures, tax neutrality, the lack of restrictions on investment policy and the quality and expertise of local service providers, regulators, infrastructure and legal systems are all positives for establishing funds in offshore jurisdictions. The perception of a lack of transparency and under-regulation offshore – a view they say is unjustified – is a factor that may make investment managers look onshore.

Maples and Calder partner Nicholas Butcher is enthusiastic about Cayman. “The beauty of Cayman as a jurisdiction is that it has a legal and regulatory structure capable of accommodating the full range of investment fund models required by onshore investors,” he says. Cayman fund structures are widely acknowledged by institutional fund managers, investors, lenders and swap counterparties as the product of a tried and tested legal system, he adds.

“While traditionally we talk about onshore and offshore, we are also seeing the emergence of a hybrid jurisdiction – an on-offshore jurisdiction if you like in Ireland and to a lesser degree, Luxembourg. In many ways the Irish fund industry is a good compromise,” notes Butcher. “We believe that while the offshore jurisdictions will continue to be attractive and remain highly competitive, there is a growing class of investor that wants the efficient regulatory environment of an offshore jurisdiction in a jurisdiction that is not generally recognised as offshore,” he concludes.

Ogier’s Simon Schilder in the British Virgin Islands says the differences between offshore jurisdictions are subtle and not substantive. “The overall regulatory convergence between offshore jurisdictions as it relates to the regulation of hedge funds will continue,” he declares. “In many respects the events of the last 18 months have perhaps enabled everyone to focus their minds and recognise the existence of a convergence which has been ongoing for some time now,” says Schilder.

Craig Fulton in the Mauritius office of Conyers Dill & Pearman believes whether a fund is set up offshore or onshore is largely determined by the nature of the investment manager, particularly its regulatory regime, by the nature of the proposed investors and by the nature of the investments that the fund intends to make. “Once it has been determined that an offshore structure is appropriate, then the next question is to determine which offshore jurisdiction best serves the needs of the investment manager and the investors,” he says. For example, if a fund intends to make significant investments into jurisdictions such as Africa, China and India, then forming a fund in Mauritius will make a great deal of sense, he says.

“The pros and cons are all relative and must be considered in light of the relevant business objectives,” states Mitch Nichter at law firm Paul Hastings in New York. “The basis calculus should be: in which jurisdiction should I locate ‘X’ – with ‘X’ being any crucial product, investment, management, marketing or operational component of the business – to maximise the chance of achieving the business objectives at an acceptable cost?,” he says.

At Sadis & Goldberg, partner Ron Geffner believes the domicile of the offshore fund will have a material impact from an investor’s perspective. “For example,” he says, “both investors and managers alike should determine the integrity of the judicial system in the country in which the fund is domiciled, as well as the service providers in that country.”

Robert Duggan at Walkers in London says “taxation is one of the more complicated items in any jurisdiction shopping list and it is not particularly surprising to see entities domiciled in several jurisdictions – both onshore and offshore – within a fund structure.” He concedes that tax rates are not the sole determinant of jurisdiction choice. “Offshore jurisdictions such as the Cayman Islands, while embracing tax transparency, are often compelling prospects in any tax analysis for its zero tax rate,” he notes.

“Undeniable is the importance of striking a balance between effective regulation of funds and managers, with regard to their activities, and the need to protect investors and the integrity of the financial system,” says Duggan.

“Onshore and offshore jurisdictions offer graded levels of regulation and extensive choice exists, both as to the extent of regulation and to the philosophy of regulatory approach. The constructive approach adopted by regulators in leading centres such as the Cayman Islands, the British Virgin Islands and Jersey has resulted in different levels of regulation by reference to sophistication of underlying investors and therefore the need for regulatory protection,” he says.

The flight towards regulation, however, appears to have been driven by political expedience rather than a need for overhaul where fine-tuning would suffice, notes Duggan.

“Offshore jurisdictions are generally more cost-effective than their onshore counterparts and the costs can vary significantly. However, depending on the size of the proposed fund the costs of establishment and maintenance of the fund are likely to be relatively insignificant, although cost is always of concern,” he concludes.

John Langan at Withers says the main reason hedge funds were incorporated offshore in the past was to take advantage of the low tax rates in those jurisdictions and their greater legal and regulatory flexibility. “The recent focus on regulatory supervision and tax avoidance suggests, however, those onshore jurisdictions with significant financial services industries such as the UK may be able to win some of this business back if they can develop the right legal and tax structures for hedge funds,” he says.

Omar Zerafa at Aequitas Legal in Malta points out that the choice between offshore and onshore jurisdictions has to take into consideration the quality of the service providers, legislative remedies in default and adequate judicial systems that can assist the fund in times of crisis.

Frank Chetcuti Dimech at CDF Advocates in Malta says offshore jurisdictions typically offer fast licensing, maximum flexibility and minimal regulatory oversight, while regulation and flexibility of varying degrees and various licensing speeds would be encountered in onshore jurisdictions. “The battleground between onshore regulators is how to strike the right balance in terms of regulation, flexibility and speed of response. With tax disclosure being gradually imposed on all offshore jurisdictions, fund managers will seek tax-friendly structures onshore to provide greater peace of mind to their investors,” he concludes. n