Hedge Fund “Forum Shopping”

Hedge Fund Regulation 05 Aug 2008

Authorities in the Cayman Islands announced last week that 10,000 funds (hedge or otherwise) are now domiciled in the tiny jurisdiction.  That’s one fund for every 5 citizens – which begs the question: what attracts funds to this hurricane-prone atoll in the middle of nowhere?  Could it be that its regulations are more lax than those of other jurisdictions?  Or has the country (and/or its hedge fund service providers) simply done a better job of marketing itself?

If, as one writer recently statedthe phrase ‘regulation of hedge funds’ is a contradiction in terms”, then it follows that hedge fund managers should be searching the globe for the most flexible regulatory regime in which to operate a fund.  This is often referred to in legal circles as “forum shopping”.

This isn’t to suggest that hedge fund managers spend their days looking for some screwball jurisdiction that lets them open a fund with a note from their mother or anything.  Naturally, a fund’s jurisdiction impacts the level of comfort investors will have with the fund.  But to some, it makes intuitive sense that certain jurisdictions should attract funds with certain strategies.

But this paper by Douglas Cumming of Canada’s York University and Sophia Johan of the Tilburg Law and Economic Centre in The Netherlands concludes that this isn’t true after all.  Say the duo:

“The data examined offer little or no support for the view that hedge fund managers pursuing riskier strategies or strategies with potentially more pronounced agency problems systematically select jurisdictions with less stringent regulations…We may infer from the evidence that forum shopping by fund managers in relation to fund strategic focus is not consistent with a ‘race to the bottom’.”

In fact, they find the opposite – that hedge funds (in the CISDM and HFN databases) actively seek out the jurisdictions that are in the best interests of their investors “in order to facilitate capital raising”.

Cumming and Johan regress the regulatory characteristics of 24 countries against 30 different hedge fund strategies to see if certain strategies have a higher propensity to be domiciled in certain jurisdictions.  (By the way, if you’ve ever wondered what types of funds are domiciled in various countries, click on the chart at the right.  It’s actually kind of interesting.)

The regulatory characteristics used in the study as a proxy for a country’s regulatory burden are: a) minimum capital requirement, b) restrictions on the location of key service providers, and c) the number of permitted marketing channels.

Interestingly, the countries with the most number of permitted marketing channels are (in rank order):

  1. The Channel Islands
  2. China (yes, that China)
  3. Canada (tie)
  4. Australia (tie)
  5. New Zealand (tie)
  6. Japan (tie)

The US ranks at the bottom of the list at #24 – making it the least marketing-friendly jurisdiction (take note Phil Goldstein!).  But the US also ranks among the most flexible when it comes to minimum capital requirements with a total of $0 required to hang out a shingle.

While the authors do add a few caveats to their results, we might also add one more:  There is obviously a huge home country bias driving the decision to domicile a fund.  What would be interesting to explore is the propensity to domicile a second (i.e. off-shore) fund, not just a manager’s original fund.  I, for one, have been involved with the selection of a jurisdiction for one such fund and found that regulatory requirements did indeed factor into the decision (along with the availability of key suppliers, tax issues and a variety of other highly idiosyncratic factors).

Oh, in case you’re wondering, Cayman is one of the most restrictive jurisdictions on the list of 24 countries…

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