The rise of offshore structures in the Cayman Islands

The Cayman Islands have seen astonishing growth in offshore private equity and venture capital structures over the last year.

The rise of oil billionaires, increased confidence in the internal governance of companies through Sarbanes-Oxley, the opening up of the vast potential of China and India to global markets and the need for institutional investors to find higher returns have all combined to bring in a torrent of funding to the private equity and venture capital markets.

The synergy between the private equity investment structure and Sharia-compliant financing is an additional driver in the marketplace and the position is again bolstered by the strength of M&A and the IPO markets as viable exit strategies for private equity and venture capital investments.

These factors have had a direct impact on the utilisation of Cayman as an adjunct to the on-shore investment vehicles of private equity and venture capital houses. Cayman steps in principally to accommodate tax-exempt and non-resident investors, who might otherwise be subject to on-shore taxation.

But it is becoming increasingly common for on-shore counsel to require that all of the co-investment vehicles of a fund be established in Cayman, thereby providing a single jurisdiction of domicile and reducing the administrative burden on-shore. In either case, the familiar structures are limited partnership co-investment funds, blockers and feeders.

Second-quarter 2006 results in Cayman are a good indicator of the sector’s strong performance. Registrations of the most common private equity entity, the exempted limited partnership, were up from a total of 4,087 as at the beginning of 2005 to 5,626 as at the end of May 2006, representing projected annualised growth for 2006 of 1,466 registrations, or a remarkable 58% increase over the 2005 figures.

Although these statistics should be discounted a shade for limited partnerships that might be established for non-venture capital and private equity purposes, they highlight that institutional investor appetite is strong, and this is particularly so for brand name houses.

Compounding the rise of the number of funds being established, the size of each fund appears to be growing and, again in line with the global trend, the multi-billion dollar fund is not an uncommon sight on the Cayman landscape.

So where is the money flowing? In terms of assets, utilisation remains interestingly diverse. There are continued influxes into the healthcare sector, which maintains the allure of high valuations and favourable demographics; into the IT/high tech market, which always has the promise of a stellar rise; and into real estate.

However, there are also many funds that still find investment opportunities in property portfolios and distressed company acquisitions in mature markets. Private equity buying opportunities are extremely competitive in the developed markets, often resulting in big-ticket club deals and auctions.

Regionally, while it is difficult to generalise, there has been a surge in emerging market investment in China, utilising the wholly owned foreign enterprise (WOFE) route, and India, particularly through Mauritian holding company structures, with an additional focus on Eastern Europe and South America.

The barrier to entry into these fast growing markets now appears to be the ability to successfully partner with a local enterprise familiar with regional issues and the regulatory regime (or lack of one).

While there will continue to be winners and losers in these new sectors, if past returns and optimism is any gauge of future success, and due diligence is properly undertaken, there are healthy returns available for investors as these markets develop and mature.

And why is Cayman performing so well? Put simply, the Cayman Islands offer various and substantial attractions to investors. These include:

• Familiar vehicles: exempted limited partnerships, companies and trusts, similar to those found in Delaware (for partnerships) and the UK, facilitate the formation of the necessary legal entities.
• A strong legal system: based on the foundation of English common law, with investor-friendly and light but firm regulation to an internationally mandated standard. Notably for private equity structures, Cayman has no statutory “financial assistance” restriction.
• A mature and well-developed funds practice: Cayman is the industry leader for mutual fund domicile and, with approximately 8,000 licensed funds (a net growth of 1,174 licensed funds in 2005), it leads its competitors by a substantial margin. This expertise translates well into the private equity and venture capital field and is available to support its needs. Investor and rating agency exposure to the Cayman Islands is also significant, providing a marketing advantage to general partners and their brokers.
• Low-cost and ease of use: the cost of maintaining an entity in the Cayman Islands is significantly lower than that for many other comparable off-shore jurisdictions, and entities may be formed “same day”, with little formality and no requirement for local service providers.
• Absence of substantive taxation: the Cayman Islands have no forms of direct taxation, and entities established there act as a straight pass-through with no Cayman sourced cashflow attrition or exchange control.

As the growth of the mutual and hedge fund industry has demonstrated, Cayman has developed and found its place in the investment funds industry. Growth of the private equity and venture capital sector will no doubt emerge in tandem, and this may be seen as an additional level of “convergence” in the two sectors. While additional scrutiny from on-shore regulators might well follow behind that of hedge funds, which are the continuing subject of SEC and FSA attention, it is unlikely to stem the flood of investment structures into Cayman.