Member Article

The Asian hedge fund industry is comparatively new and small.  However, the industry has witnessed phenomenal growth since 2002.

The purpose of this book is to assist start-up managers to establish a hedge fund business. To date, a majority of the newly-established funds in Asia have been set up by fund managers or proprietary traders setting up their own business, after a successful career at one of the larger investment houses. They often start with a small pool of capital (their own or possibly from family and close friends) and cost plays a significant part in determining the fund’s structure. Where they are supported by prime brokers and administrators with access to investment capital, they can afford a more sophisticated structure. However, in the majority of cases, considerations of cost tend to favour a more conventional ‘off the shelf’ approach.

The structure commonly adopted is set out in the diagram on the following page. It involves the establishment of a management company in an offshore jurisdiction, an onshore investment manager or investment adviser, and an offshore fund, which is normally structured as an open-ended investment company, but may be established as a unit trust (where this is more tax efficient for investors), normally with an underlying wholly-owned trading subsidiary.

The attitude of governments and regulators in Asia to hedge funds in general and short selling activities in particular, has been relatively hostile until recently.

However, short selling rules are now being relaxed in a number of jurisdictions in the region (eg, in South Korea and Taiwan) while tightening in Europe and North America. If this is followed to its conclusion, the disconnect between Asia’s relative market capitalisation and representation in hedge funds is expected to close. Coupled with the decision by the Securities and Futures Commission in Hong Kong and the Monetary Authority of Singapore to allow fund of hedge funds and single manager/strategy hedge funds to be authorised for sale to the public in Hong Kong and Singapore, there appears to be growing retail demand for these investment products in the region.

Historically, a substantial proportion of the hedge funds sold in Japan have been established and managed offshore. It is only relatively recently that domestically managed hedge funds have been sold successfully in Japan. In the past, many Japanese investors were precluded from investing in funds which did not have an Organisation for Economic Co-operations and Development (OECD) listing. Accordingly, it was common to establish funds in Luxembourg which were to be sold to Japanese investors and to obtain a Luxembourg listing. However, with the establishment of the Dublin International Financial Services Centre, Dublin became a popular alternative.

During the 1980s, Bermuda became a popular offshore fund centre but lost a lot of ground to the Caribbean jurisdictions (and in particular the Cayman Islands) during the 1990s. Cayman was extremely successful in attracting Asian fund managers to set up Cayman management companies and Cayman-domiciled funds. The British Virgin Islands (BVI)have also enjoyed some success in this area, but it was the Cayman Islands which became the first non-OECD offshore centre to be recognised by Japan as an acceptable domicile for a fund to be sold to the retail public in Japan.

At the time when the Cayman Islands and the BVI overtook Bermuda as the domicile of choice for establishing offshore fund management companies and offshore funds, there was minimal regulation in any of those jurisdictions. However, the process of obtaining Bermuda Monetary Authority approval, although not onerous, was sufficient to drive new managers away to the Cayman Islands and the BVI. This demonstrates the low level of tolerance in the Asian hedge fund industry, whether it be of cost or delay.

In determining the most appropriate jurisdiction in which to establish a hedge fund, the following factors require to be taken into account:

• tax efficiency;
• potential investor base;
• level of regulation; and
• fund structure.

Investment funds are generally established to give investors access in the most efficient and economic manner possible to investment strategies which would not otherwise be available to them. It is essential to ensure that investing through a fund will not impose a double tax burden on investors. Investing through a fund is extremely unattractive if the fund incurs tax on its profits and investors also incur tax on any increase in the value of their investment in the fund. Accordingly, offshore funds have always been established in tax havens. In fact, for investors in some jurisdictions, investing through a fund can bring tax deferral or tax avoidance benefits. For example, UK investors used to invest in offshore roll up funds which accumulate income. They only paid capital gains tax when they disposed of their investment in the offshore fund (which was at a lower rate than income tax) and in the meantime suffered no tax on interest or dividend income being accumulated within the fund. Over time, these types of tax breaks have been eroded by legislation in many jurisdictions. Accordingly, the important thing is to ensure that investors are not subject to double tax.

While Dublin and Luxembourg have emerged as the main European centres for offshore mutual fund administration, being more regulated, they are often considered more appropriate for retail funds structured as undertakings for collective investments in transferable securities (UCITS) capable of being offered for sale to the public in other European jurisdictions without the necessity for further domestic authorisation. Previously, hedge funds could not be established as UCITS as they are unable to comply with the investment and borrowing restrictions applicable under the UCITS legislation. However, a greater degree of investment flexibility (particularly with regard to the use of derivatives) is now permitted under the UCITS III legislation. Restrictions on short selling have also been relaxed, permitting the establishment of so-called ‘130/30’ funds which are sold on a retail basis. The first of these has now been authorised for sale in Hong Kong.

Unlike most low-tax regimes, Dublin has a range of double tax treaties and that is sometimes a factor in the choice of domicile for an investment fund. Labuan also has double tax treaties, but has enjoyed only limited success in gaining acceptance as a domicile choice for offshore funds.

Historically, the more specialised alternative investment products have typically tended to be domiciled in less regulated offshore jurisdictions which offer flexibility in terms of structure as well as low or no tax environments. The more popular offshore jurisdictions are the Cayman Islands and the BVI. Mauritius is also sometimes used to take advantage of its double tax treaties, particularly with India and China, but it tends to be more expensive to establish and maintain a fund in Mauritius than in Cayman or the BVI. It is also a more time-consuming and cumbersome procedure.


The Cayman Islands

The Cayman Islands Monetary Authority (CIMA) is the primary regulator with responsibility for overseeing the mutual fund industry in the Cayman Islands.

A mutual fund is defined as any company, trust or partnership either incorporated or established in the Cayman Islands, or if outside the Cayman Islands, managed from the Cayman Islands, which issues equity interests redeemable at the option of the investor, the purpose or effect of which is the pooling of investors funds with the aim of spreading investment risk and enabling investors to receive profits or gains from investments. Thus, as in the United Kingdom, mutual funds that provide no redemption or repurchase rights to investors (ie, closed-ended funds) are excluded from the definition and regulation. In addition, funds with not more than 15 investors who, by majority, are capable of appointing and removing the directors or the trustee (depending on whether the fund is structured in a corporate form or as a unit trust) are exempt from regulation. The reasoning is that mutual funds should be excluded if the number of investors is conveniently small, and if together they control the appointment and removal of managers or operators of the mutual fund (ie, control of the mutual fund rests with those investors).

The Mutual Funds Law does not seek to impose restrictions on the commercial arrangements relating to the establishment and management of mutual funds. Instead, it focuses on regulating the promoters and managers of such products to ensure that they are suitably qualified to establish and manage such products. Mutual funds and mutual funds’ administrators are required to be licensed or exempted by CIMA prior to commencing business from the Cayman Islands.

In all cases, there is no ‘look-through’ to beneficial ownership — the term investor is defined to mean the investor of record. Thus, if all the equity interests are issued as a matter of record to, say, a single institutional nominee or custodian for the underlying investors, the mutual fund will fall outside the scope of the Mutual Funds Law. There are three available forms of regulation of mutual funds under the Mutual Funds Law:
(i) The licensed mutual fund

The first route is to file with CIMA a prospectus together with a synopsis showing the service providers on a statutory form and to pay a fee on registration and annually. If CIMA considers that the promoter is of sound reputation, that there are persons of sufficient expertise to administer the fund who are of sound reputation and who are fit and proper to hold their respective positions within the fund, and that the business of the fund and any offer of equity interests will be carried out in a proper manner, then the licence will be granted within about seven days of application.

This route will be appropriate for mutual funds which are promoted by well-known and reputable institutions and which do not propose to appoint any Cayman Islands mutual fund administrator.

(ii) The private sector mutual fund

The second route is for a mutual fund to designate its principal office in the Cayman Islands at the office of a licensed mutual fund administrator. In this case, a prospectus must be filed with CIMA but there is no requirement for the mutual fund itself to obtain a licence. Instead, the mutual fund administrator must be satisfied that the promoter is of sound reputation, there exist persons of sufficient expertise to administer the mutual fund, who are of sound reputation, and that the business of the mutual fund and the offer of equity interests will be carried out in a proper way.

Since the mutual fund administrator is charged with such responsibility and for paying the initial and annual fee for the mutual fund, this may be termed ‘private sector’ regulation. Statutory forms must be completed and filed, and the administrator must report to CIMA if it has reason to believe that a fund for which it provides the principal office is acting in breach of the Mutual Funds Law or may be insolvent or is otherwise acting in a manner prejudicial to its creditors or investors.

(iii) The Section 4(3) Mutual Fund

The third (and most popular) category of regulated mutual fund comprises two sub-categories:

(a) funds imposing a minimum investment per investor of US$100,000 or equivalent; or


(b) funds whose equity interests are listed on a recognised stock exchange.

In either case, there is no requirement for licensing or private sector regulation. A Section 4(3) mutual fund simply registers with CIMA, files prescribed details from its prospectus and pays the initial and annual fee.

Every regulated mutual fund must issue an offering document (unless exempted by CIMA), which must describe the equity interests in all material respects and contain such other information as is necessary to enable a prospective investor to make an informed decision (whether or not to invest). In addition, the pre-existing statutory obligations with regard to misrepresentation and the general common law duties with regard to proper disclosure of all material matters continue in effect. There is an obligation to file an amended offering document in the event of material changes where there is a continuing offering. There is no power for CIMA to dictate the substance or form of the offering document and no regulatory approvals or consents are required for the circulation thereof, provided that the securities are not offered to the Cayman Islands public.

Every regulated fund must also file with its initial application the written consent of the administrator to its appointment. In addition, a regulated mutual fund must appoint auditors and file audited accounts within six months of its financial year-end. The auditor must be approved by CIMA and must be a Cayman Islands firm of auditors. This determination on the part of CIMA will depend in part on the standing of the audit firm proposed. The written consent of the auditors to their appointment must be filed at the time of initial application.

To the extent that the fund requires to be registered with CIMA, it is worth noting that these registration formalities must be completed prior to the fund ‘commencing business’. It is unclear whether business is deemed to be commenced upon the opening of a fund’s initial offer period or following the close of such offer period and the commencement of the fund’s trading activities. However, to avoid the risk of any regulatory sanction, registration of the fund prior to the commencement of its offer period is the more prudent course of action.

A mutual fund administrator’s licence or a restricted mutual fund administrator’s licence is required to undertake mutual fund administration, unless the administrator is exempt under the Securities and Investment Business Law as mentioned below. Mutual fund administration is defined as the management, including control of all or substantially all of the assets of a mutual fund, the administration of a mutual fund, the provision of a principal office to that fund, or the provision of a trustee or a director of that fund (depending on whether it is a company or a unit trust).

Either type of licensee must meet the statutory test that it has available sufficient expertise to administer regulated mutual funds, is of sound reputation and will administer regulated mutual funds in a proper manner. A mutual fund administrator requires a net worth of US$480,000; a restricted mutual fund administrator has no net worth requirement. The mutual fund administrator must itself have a principal office in the Cayman Islands with two individuals or a body corporate as its agent resident or incorporated in the Islands and may act for an unlimited number of mutual funds.

A restricted mutual fund administrator may act in relation to such number of related licensed mutual funds as may be approved by CIMA, but is required only to have a registered office in the Islands. This category permits the promoter who incorporates a fund manager in the Cayman Islands to manage a related family of funds. The current policy of CIMA is that unrelated funds may not be managed. The main difference, apart from net worth requirements and fees, is that, under current policy, a restricted mutual fund administrator will not be permitted to provide a principal office to the mutual fund.

The Securities Investment Business Law (SIB Law) sets out a framework for CIMA to regulate securities investment business in the Cayman Islands. Conducting a ‘securities investment business’ will require a person to be licensed by CIMA, unless that person is exempt from holding a licence.

The SIB Law applies to any entity which is established in the Cayman Islands carrying on securities investment business (whether or not that investment business is carried on in the Cayman Islands). The SIB Law also applies to foreign entities which have established a place of business in the Cayman Islands through which the relevant activity constituting the securities investment business is carried on.

A person carrying on securities investment business may be exempt from the requirement to obtain a licence in certain circumstances. Nonetheless, such a person is still subject to certain provisions of the SIB Law as a result of carrying on securities investment business. In the case of the first three exemptions referred to below an exempted person is required to file a declaration with CIMA confirming that they are entitled to rely on the relevant exemption and pay an annual fee.

These exemptions include:

(i) carrying on securities investment business exclusively for one or more companies within the same group (a group of companies comprises every company which, directly or indirectly is a subsidiary of the same holding company, and includes the holding company);

(ii) carrying on securities investment business in connection with a joint enterprise (a joint enterprise is an enterprise into which two or more persons enter for commercial reasons related to a business or businesses (other than security investment business) carried on by them);

(iii) carrying on securities investment business exclusively for a sophisticated person, (a person regulated by CIMA or a recognised overseas regulatory authority; a person whose securities are listed on a recognised securities exchange; a person who by virtue of knowledge and experience in financial and business matters is reasonably to be regarded as capable of evaluating the merits of a proposed transaction and participates in a transaction with a value or in amounts of at least US$100,000 in each single transaction); or a high net worth person (an individual whose net worth is at least US$1 million or any person that has assets of not less than US$5 million); or a company, partnership or trust of which the shareholders, unit holders or limited partners are all sophisticated persons or high net worth persons;

(iv) carrying on securities investment business by a person established in the Cayman Islands who is regulated by a recognised overseas regulatory authority where the securities investment business is being carried on in that country; and

(v) carrying on securities investment business by a person regulated by a recognised overseas regulatory authority where the securities investment business is carried on in the Cayman Islands with or through a person who is permitted under the Securities Investment Business Law to carry on securities investment business.

As regards taxation, Cayman is a tax-free jurisdiction and certain fund structures, most notably the exempt company, exempt trust and exempt limited partnership, are entitled to apply to the government for a written undertaking that they will not be subject to any taxation for a minimum period of 20 years (in the case of an exempt company) and 50 years (in the case of an exempt unit trust). Such general undertaking may be extended for a further 10 years, upon request.British Virgin Islands

The Registrar of Mutual Funds is the primary regulator in the BVI and the Mutual Funds Act is the primary legislation governing the regulation of mutual funds in the BVI.

Hedge funds established in the BVI typically qualify as ‘private funds or professional funds’ as follows:

• The constitutive documents of a private fund must limit the number of investors in the fund to 50 or restrict its offering on a private basis (ie, to specified persons connected to the promoter).

• A professional fund may only be offered to professional investors (ie, investment institutions or high net worth individuals who sign a declaration at the time of investment that their net worth is in excess of US$1 million and that they consent to be treated as professional investors). The majority of initial investments in the fund must exceed US$100,000.

A licensed manager is required to pay an annual fee to the Registrar of Mutual Funds. A licensed manager is required to appoint an auditor. There are ongoing filing and approval requirements: for example, if there is any change in the address of the place of business or address for service, or address of the agent in BVI, the Registrar must be notified within 21 days; changes of directors require approval; and the Registrar also has power to require information to be provided or to have access to books or records relating to the business of the licensed manager.

There may be conditions imposed on the licence issued — for example, the licence may be issued for the provision of management services and specific funds only, and the approval of the Registrar may be required for provision of management services to any other fund or funds. This is generally the case if the licence is a restricted licence. Further, the holder of a restricted licence will not be able to provide management services to public funds (ie, funds which do not fall within the definition of a private fund or a professional fund).


Available fund structures

There are a number of differing fund structures available in the offshore jurisdictions discussed earlier, the more common of which are as follows:

• limited liability company;
• unit trust; and
• protected cell/segregated portfolio company.

Limited liability company
Hedge funds are typically structured through a limited liability company. Corporate funds may be structured as open-ended, closed-ended or a combination of the two. The offering of shares in an open-ended fund permits subscriptions and redemptions based on the net asset value per share. In contrast, closed-end funds normally only offer shares during an initial offer period and redemptions are prohibited. Investors cannot realise their investment in the fund until the fund is placed into liquidation at a pre-determined date, unless they can find a buyer for their shares. Closed-ended funds have not been popular in Asia owing to the fact that they are generally very illiquid (even when listed on an active stock exchange) and often trade at a substantial discount to net asset value. Alternatively, the fund may be a hybrid structure in which redemptions are prohibited for a specific (closed) period following which dealings are permitted on a regular basis.

The nature and type of investments and the investment strategy will affect the ability of the fund manager to manage liquidity within the fund and will be a key factor in determining whether an open-ended or closed-ended structure is the most appropriate. Open-ended hedge funds typically deal on a quarterly basis and may require an additional period of notice to be given by investors prior to realising their investment in the fund. This serves to provide the fund manager with sufficient time to liquidate the underlying investments required to meet realisation requests.

With a view to facilitating administration and reducing establishment costs, promoters of corporate hedge funds sometimes consider establishing an umbrella fund structure with the ability to offer different underlying portfolios. While an umbrella structure may be suitable for conventional long- only funds, the adoption of such a structure for a corporate hedge fund is considered less appropriate. From a legal perspective, a corporate umbrella fund is one legal entity albeit with different sub-funds. The ring fencing of assets (and more particularly liabilities) within each sub-fund is difficult to achieve, with the risk that the liabilities of one sub-fund may contaminate the other sub-funds within the same corporate umbrella structure. There are ways to reduce the risk of cross liability between sub-funds: for example, separate underlying trading subsidiaries can be established through which to conduct each sub-fund’s investment activities. In addition, third parties with whom a sub-fund contracts may be required to restrict their right of redress to the relevant sub-fund. However, the establishment of trading subsidiaries adds to cost, is inefficient and can lead to difficulties with trading counterparties. Contractual ring fencing is clumsy, gives rise to difficulties dealing with counterparties and is apt to be overlooked.

In view of the leverage strategies often adopted by hedge funds, the establishment of a standalone corporate vehicle has, to-date, been considered a more appropriate structure. However, an alternative which is becoming more widely available is the protected cell structure. This was originally developed for the insurance industry, and protected cell or segregated portfolio vehicles have been permitted for many years in a number of jurisdictions for insurance business. However, until relatively recently, only Guernsey permitted such structures for investment companies. In 1999, Mauritius enacted legislation for protected cell companies and in April/May 2002 both Bermuda and the Cayman Islands extended their protected cell legislation to investment companies. Protected cell or segregated portfolio funds can also now be established in Dublin and Luxembourg.


Unit trust
In contrast to a corporate structure, a unit trust has no separate legal identity and the trustee bears the risk of being personally liable in the event that a fund’s liabilities exceeds its assets. It is for this reason that trustees are reluctant to structure highly-leveraged hedge funds through a trust structure, even though the potential risks assumed by a trustee of such structure can, in part, be reduced through the establishment of a limited liability trading subsidiary through which the trust’s investment activities are conducted.

As regards umbrella fund structures, it is potentially easier to segregate the assets and liabilities of different sub-funds in a unit trust umbrella by including specific provisions in the trust deed to this effect. In fact, there is English case law which establishes that the sub-funds of an umbrella unit trust are in reality separate trusts. However, due to the risk of the trustee being personally liable to meet creditors’ claims, trustees may be unwilling to structure a hedge fund as a unit trust.

Unit trust structures have often been used for Japanese investors as they were more tax efficient for the investor. If the investors come from a jurisdiction where trust concepts are not familiar, it may again be preferable to use a corporate structure.

Protected cell/segregated portfolio companies
Dublin, Luxemburg, Bermuda, Mauritius, Guernsey and the Cayman Islands now all permit the registration of a protected cell/segregated portfolio company (SPC).

An SPC is a company which is a single legal entity, but which may segregate its assets and liabilities among various ‘portfolios’ in a way which, as a matter of the company’s law of domicile, binds third parties. SPCs operate in a manner similar to a corporate umbrella fund, but the legislation under which they are incorporated seeks to remove the risk of cross-liability between sub-funds. With conventional corporate umbrella funds, any liability incurred is a liability of the company as a whole and the allocation of assets and liabilities between the sub-funds of the umbrella is purely a matter of internal accounting. Therefore, if there is a disaster in one sub-fund, such that the assets allocated to it are insufficient to meet the liabilities incurred for the account of that sub-fund, creditors may look to the company as a whole (ie, they can satisfy their claims out of the assets of other sub-funds of the umbrella). Although the risk is insignificant where all the sub-funds of the umbrella are traditional, long-only funds which make little or no use of leverage, the risk of cross liability becomes more of a concern where the sub-funds comprise hedge funds investing in instruments which are inherently leveraged or geared through borrowing, or engaging in short selling.

To address this, SPCs are permitted to create one or more segregated portfolios in order to segregate the assets and liabilities of the company held within, or on behalf of, a portfolio from the assets and liabilities of the company held within or on behalf of any other segregated portfolio of the company, or the assets and liabilities of the company which are not held within or on behalf of any segregated portfolio of the company (called the general assets of the company). Notwithstanding the segregation of assets and liabilities within portfolios, the SPC is a single legal entity and any segregated portfolio of, or within, an SPC does not constitute a legal entity separate from the SPC itself.

The directors of an SPC have a duty to identify the particular portfolio on behalf of which each contract or transaction is intended to be made and may incur personal liability if they fail to do so. The directors also have a duty to establish and maintain procedures to segregate, and keep segregated, portfolio assets and general assets.

Segregated portfolio assets must only be used to meet liabilities due to the creditors of a particular segregated portfolio, and are not available or to be used to meet the claims of creditors of any other separate segregated portfolio.

A creditor of a particular segregated portfolio has recourse to that segregated portfolio’s assets (and, if the relevant portfolio’s assets are insufficient to the general assets of the SPC), but not to the assets of other segregated portfolios.

SPCs are subject to a special insolvency regime that provides for receivership orders to be made in respect of a particular segregated portfolio.


Limited liability partnerships
Limited liability partnerships have proved popular for US investors due to their tax transparency for US investors. Partnership accounting eases the problems of allocating performance fees fairly as discussed later. However the structure is rarely used in Asia.
Duties and responsibilities of the fund’s operators

The key operators within most hedge fund structures comprise the:

• management company;
• trustee/custodian;
• administrator; and
• prime broker.

The respective duties and obligations of such entities can be summarised as follows:


The management company
The main duties and obligations of the management company are typically set out in a management agreement (in the case of a corporate mutual fund) or contained in the provisions of the trust deed (in the case of a unit trust). The provisions of such documentation will set out the scope of the manager’s investment powers which will, typically, be wide in the case of a hedge fund. Such documentation will also contain provisions concerning the delegation of the investment management responsibilities to underlying advisers and include provisions dealing with the manager’s liability and indemnification.

While the primary function of the manager will be to manage or oversee the management of the fund’s assets, it is invariably also involved in the preparation of the fund’s offering documentation and subsequent promotion of the fund to potential investors.

The directors of the fund (in the case of a corporate mutual fund) are required to take responsibility for the contents of the fund’s offering documentation. Invariably, directors of the manager are also directors of the fund, responsible for ensuring that there is sufficient disclosure in the offering documentation to enable an investor to make an informed decision as to whether or not to invest in the fund. The following key areas in relation to the fund must be sufficiently disclosed in the offering documentation: investment objectives and policies; risk factors; details of the promoters; dealing procedures; and level of fees payable by investors and the fund. A problem frequently encountered by managers of hedge funds concerns their obligation to ensure sufficient disclosure of the investment strategy in the fund’s offering document, balanced against the risk of divulging proprietary confidential trading strategies to their potential competitors.

As investors appear more prepared to seek legal redress against the promoters of underperforming funds, adequate disclosure in the fund’s offering document is a key factor in reducing the risk of investors being able to bring a successful action against the promoters for misrepresentation.
Fund of hedge fund managers must exercise due care in connection with the appointment and ongoing monitoring of underlying hedge fund managers selected for investment by the fund. Fund of hedge fund managers will need to ensure that sufficient internal procedures are in place to monitor the selection, appointment and performance of underlying hedge fund managers.


Trustee/custodian
The primary duty and responsibility of the trustee (in the case of a unit trust) and custodian (in the case of a corporate mutual fund) is to safeguard the fund’s underlying assets. Such entities will be subject to specific duties and obligations set out in the trust deed (in the case of a unit trust) or in a custodian agreement (in relation to a corporate mutual fund). Typically, such obligations will centre around the requirement to ensure adequate custody of the underlying assets and to ensure that they are appropriately registered in a separate account for the benefit of the fund. The trustee/custodian is also responsible for the settlement of transactions instigated by the management company.


The administrator
Typically, the duties of the administrator include the processing of the issue and redemption of shares, acting as registrar, assisting with the fund’s accounting and record-keeping, valuing the fund’s assets and calculating the fees payable to the fund’s operators.


Prime broker
The facilities offered by prime brokers to hedge funds cover a wide range of services including:

• clearing and custody;
• margin financing;
• stock lending; and
• technology.

However, some prime brokers go further and can offer critical assistance in terms of capital introductions.

The prime broker’s contractual obligations will be contained in relatively standard form prime broker documentation, typically issued out of London or New York.


Performance fees

In addition to an annual management fee, typically based on a fund’s net asset value, the manager will usually receive a fee linked to the performance of the fund. The method and frequency of calculation of such fees vary enormously. The frequency of calculation and payment of such fees range from monthly to annually. Performance fees which are structured on a high-on-high basis are perceived as being fairer to investors, as the manager is only entitled to receive a performance fee where the net asset value per share of the fund as at the end of each performance period exceeds the previous highest net asset value per share as at the end of any preceding performance period in respect of which a performance fee has been paid. This avoids the situation where an investor pays a fee twice on performance. However, the simple form of performance fee calculation leads to anomalies where investors buy and redeem shares at different times: if an investor buys when the share price has fallen after a performance fee has been paid, he effectively gets a ‘free ride’ until the share price reaches the previous high. To deal with these and other concerns to ensure that the performance fee is borne fairly by investors according to the performance of their own particular holdings, more complex arrangements have been developed in recent years. Some involve the issue of series shares by which a new series is issued on each dealing day and a performance fee levied in relation to each specific series.

Others involve equalisation arrangements. There are advantages and disadvantages to all these arrangements. They are all difficult to explain to investors and complicated to administer. However, there is increasing demand from more sophisticated investors for these types of arrangements.