BVI-audited hedge funds have not been immune to the problems facing the industry globally. However, audit firms in the jurisdiction are upbeat about future prospects.

Unlike nearby Cayman Islands, the British Virgin Islands (BVI) does not require companies and investment funds based in the jurisdiction to file audited financial statements with the regulator. This is expected to change following the enactment before the end of 2009 of the Securities and Investment Business Act.

Many believe this legislation will include a requirement for hedge funds regulated by the BVI Financial Services Commission (FSC) to be audited. However, the new act is not expected to require a local audit sign-off.

Despite the lack of any regulatory requirement, the vast majority of open-ended BVI funds are audited on a voluntary basis. “No law firm on the island is going to set up an open-ended investment fund without an auditor,” says one local practitioner. 

Deloitte & Touché is the largest audit firm in the BVI, employing nearly 60 people. Mark Chapman, managing partner, says around 70% of the companies audited by the firm are hedge funds. The client base is diverse and includes hedge funds from the US, Europe and Asia. Most are registered in the BVI.

Chapman is a keen observer of the BVI hedge fund sector. He believes funds based in the jurisdiction have a total of around $100 billion in assets under management (AUM). Funds of hedge funds account for around 35% of AUM in BVI vehicles, Chapman estimates.

Long/short equity funds account for a further 15%, with other types of single manager hedge funds making up the remainder.

Chapman says the issues faced by BVI hedge funds mirror those of the industry as a whole. Funds of funds and long/short equity strategies posted poor returns in 2008. They have experienced large redemptions and a significant number have been forced to close.

“The number of hedge funds registered in the BVI and the assets they have under management has probably gone back to where it was 18 months ago. However, that has to be seen in the context of the tremendous growth in hedge fund business in 2006 and 2007,” postulates Chapman.

Work changes
The market downturn and the problems in the hedge fund industry have had a direct impact on the nature of the work undertaken by auditors in the BVI, Chapman says. The restructuring proposals devised by hedge funds and their legal advisors must be approved by the auditor before they can be implemented.

“We check the proposal to ensure it complies with the law in the BVI and the constitutional documents of the fund,” says Chapman. The auditor must also assess if a fund that has seen large redemptions remains a going concern.

Hedge funds that have been restructured over the past six months are currently being audited. Chapman acknowledges that investors may challenge some of the restructuring arrangements in the future. However, so far Deloitte’s audits have not revealed any specific problems with BVI funds.

Baker Tilly is the longest established accounting firm in the BVI. Originally formed as Parnell Fitz-patrick & Co in 1973, it has an interesting history encompassing multiple name changes. In 1996 it became part of KPMG. When the Big Four stepped away from corporate secretarial work after the US passed the Sarbanes-Oxley law, the partners of KPMG in the BVI formed Baker Tilly in 2004. At around the same time, PricewaterhouseCoopers (PwC) also exited the audit and accounting business in the BVI.

Baker Tilly provides the widest range of services of any audit and accounting firm in the BVI. This includes full trust company and insurance management services through its wholly owned affiliates, Belmont Trust and Belmont Insurance Management. The firm also has an insolvency practice and an expanding business advisory and IT practice.

Baker Tilly’s BVI office audits around 70–80 hedge funds, the majority of which are incorporated in the jurisdiction. The firm employs 15 audit professionals in the islands. Nigel MacPhail, director of the audit and accounting department of Baker Tilly in the BVI, says the firm’s client base reflects the BVI’s reputation as a jurisdiction for boutique hedge funds.

The AUM of Baker Tilly’s clients range from $1 million to $500 million, although the majority are in the $1 million to $50 million bracket. MacPhail says the client base includes a high percentage of commodity trading advisors (CTAs) and only a small number of funds investing in illiquid and hard-to-value assets.

MacPhail says the firm has so far been able to weather the worsening economic conditions. “We have not seen any noticeable drop-off in business,” he says. Baker Tilly signed 12 new hedge fund clients in the first quarter of 2009, he adds.

The spate of restructurings in the hedge fund sector has necessitated a more expansive audit of existing clients, MacPhail adds. The firm is also fielding enquiries from shareholders and service providers of hedge funds that have been restructured. “When a fund opts to restructure, the mantra is ‘disclosure, disclosure, disclosure’. A lot of issues can be averted by being open and transparent with shareholders,” says MacPhail.

KPMG re-established its practice in the BVI in 2006. The partners of KPMG’s Cayman practice, who are also the shareholders of the BVI operation, drove the opening of the office. The firm provides tax, restructuring and regulatory services in the BVI alongside audit and advisory work.

The firm has been involved in providing advisory services to hedge funds in distress. This includes guidance on whether the fund documents permit the manager to suspend redemptions and impose gates and side-pockets.  “We advise our clients to provide clear disclosure to their investors of any changes in the fund. This includes the use of side pockets and gates as well as information about redemptions. Keeping the investor informed can help the fund to avoid problems further down the line,” says Tanis McDonald, director of audit at KPMG’s BVI office.

KPMG is also auditing funds that have been recently restructured. This includes verifying that restructurings are in line with the provisions in the articles of association and offering memorandum. As part of the audit process, the firm also checks that subscriptions and redemptions have been processed in line with the terms of the fund documents. The valuation policies of the fund with regard to illiquid and complex assets also fall under the microscope.

Positive outlook
McDonald is upbeat about the health of the industry. She says hedge funds have responded to investor concerns and have made significant efforts to improve liquidity and cut operational risks. “Many of the hedge funds we are currently auditing have a large percentage of the portfolios in cash. This means they are in a position to fund future redemptions if it is called for. On the whole, hedge funds have delivered and reduced counterparty risk through diversification. We have also seen a vast improvement in the level of communication with clients,” she says.    

She reports that the audits currently being carried out by KPMG have not thrown up any major concerns about the way hedge funds have been restructured.

PwC returned to the BVI in 2007 with a focus on insolvency and voluntary liquidations. The BVI office was established as a joint venture between PwC’s East Caribbean and Cayman Islands partnerships. Audit and tax services are provided out of offices in the Cayman Islands and Barbados.

PwC has been principally engaged with orderly liquidations under the BVI Insolvency Act since returning to the jurisdiction. This includes the liquidation of fund vehicles. Nicholas Carter, managing director of PwC’s BVI office, describes the Act that came into force in 2004 as a strong piece of legislation.

The Act is similar to the insolvency rules in the UK before the enactment of the Enterprise Act in 2002. It calls for the appointment of an insolvency practitioner licensed by the FSC for cases involving the liquidation of an investment fund.

In April the FSC issued a guidance note on liquidation procedures for regulated persons and companies in the BVI, including investment funds. “The guidance issued by the FSC on voluntary liquidations has been very positive. The rules strike the right balance between protecting the interests of investors and ensuring an orderly liquidation of the fund,” says Carter. “Unless there is a claim, the voluntary liquidations are quite straightforward.”

The amount of insolvency and liquidation work in the BVI is expected to rise steadily during the course of the year. According to Chicago-based Hedge Fund Research, nearly 15% of hedge funds closed in 2008, with a record 778 hedge funds liquidated during the final quarter of the year. Some have predicted the number of fund closures in 2009 could be double that.

Many hedge funds were able to stave off liquidation by restructuring. However, that may only have delayed the inevitable. “At this point, the hedge funds that came through last year believe they can survive in the long run. However, that may change if market conditions worsen,” says KPMG’s McDonald.

More insolvency
Baker Tilly expects to see an increase in insolvency work in the coming months. Hadley Chilton joined the firm as corporate recovery manager in July 2008. He has been fielding a steady stream of insolvency-related enquiries since December.

The majority of the work undertaken by Baker Tilly to date has involved the uncontested winding-up of corporations, mainly from Asia. Chilton says the firm is responding to a growing number of enquiries about hedge funds, but is yet to see a significant number of liquidations. He expects to see an upswing in this type of business in the second half of the year.

Baker Tilly’s insolvency department also undertakes asset tracing work. Given the number of BVI-incorporated fund vehicles caught up in the Madoff fraud, Chilton expects heavy demand for these services as the case continues to unravel. “There is likely to be a lot of litigation related to the Madoff fraud. It will be interesting to see what can be recovered,” he comments.