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What’s driving domicile choice?

ESG, Brexit and EU regulation are just some of the emerging factors influencing private fund managers’ destination decisions, writes Stephanie Baxter.

From costs to tax and regulation, there are many important factors to consider when choosing a home for your fund. Delaware, the Cayman Islands and Luxembourg are still the preferred destinations for private equity real estate managers. But amid increasing competition and an uncertain environment, other jurisdictions are hoping to increase their share of the pie.

Speed and strength of regime

While the direct impact of the covid-19 pandemic on domicile choice seems to have been muted so far, it has made private equity managers slightly more cautious.

In uncertain times, managers and investors are seeking security and stability in their fund domicile, says Antoinette Kyriacou, director and head of private equity for Jersey at Apex Group. “They are continuing to gravitate toward jurisdictions with a good reputation and track record, as well as a supportive regulator that is robust but flexible and encouraging of innovation. From recent conversations with our clients, EU regulation, the impact of Brexit and the rise of sustainable finance are the main drivers and considerations around fund domiciliation.”

These three factors, combined with the as yet uncertain impact of the pandemic, all have the potential to shape manager considerations, according to The Future of International Fund Domiciliation 2021 report, published in April by market researcher IFI Global and supported by trade body Jersey Finance.

Outside of these macro effects, though, other environmental factors dominate. While cost remains a key factor, particularly for smaller and less mature fund structures, speed to market and the strength of the wider financial and professional services ecosystem are of growing importance for managers when considering a domicile, says Gareth Smith, head of private equity for Europe at Apex Group.

“As outsourcing continues to grow in popularity for the alternatives industry due to the clear cost and operational efficiencies it provides, the depth and breadth of the wider financial and legal services expertise in a jurisdiction becomes increasingly important,” he says.

Kyriacou adds that funds are reassured by those domiciles with a mature funds industry. Access to highly experienced administrators, a sophisticated legal system with top-tier legal firms, and Big Four and other leading audit firms will also help.

Robust regulation

Managers are increasingly attracted to European regulatory structures, which are perceived to be the ‘gold standard.’

Gavin Anderson, partner at Debevoise & Plimpton, says: “In the past few years, we’ve seen more use of European fund structures by managers based outside Europe. Years ago, they would just have a Cayman fund they could market into Europe, but now with the Alternative Investment Fund Managers Directive (AIFMD) and its potential changes, it’s harder to market into Europe than it used to be. We’ve seen some non-European sponsors set up European funds, particularly in Luxembourg, to help them market into the region and make them more attractive to European investors.”

EU regulations such as the cross-border distribution directive – which regulates the marketing of investment funds across the bloc – will also affect decision-making over the next few years. The effects will be felt beyond the EU’s borders, too.

Vistra Fund Management’s Tomas Tobolka, conducting officer and portfolio manager, and Jan Vanhoutte, managing director and conducting officer, point out that the EU has a lot of power to set compliance standards which have global reach. “Alternative managers are cautious of jurisdictions with high reporting demands and are looking for service providers that can demonstrate high standards and practice in place, and can safely navigate through the regulatory compliance maze,” they add.

Widening the net

Private managers are thinking much more carefully about where to domicile their funds and consider a wider range of jurisdictions.

“Over the last few years, we’ve been spending a lot more time thinking about fund domiciles,” says Debevoise & Plimpton’s Anderson. While previously conversations would have been short, there is now “a lot more awareness that the different jurisdictions have different pros and cons. In some quarters, there is sensitivity around not wanting to look like you are using a ‘tax haven’ and this feeds into the analysis as well. Places like Cayman find themselves every now and then on a ‘naughty list,’ such as the EU list of non-co-operative jurisdictions, which it has now been removed from, or the Financial Action Task Force monitoring list.”

Fund domiciles are introducing new vehicles or easing restrictions to entice private funds, such as Guernsey and Hong Kong. This is particularly important for governments that cannot afford to invest as much as they need in areas such as infrastructure due to the emergency funding diverted to pandemic responses.

Julie Patterson, head of asset management and regulatory change at KPMG, says: “Investment they wanted to make pre-pandemic has really hiked up now given all the money that the government has spent throughout lockdown, [and so] they want to encourage more private funding.”

Elsewhere, changes in some jurisdictions are being influenced by a desire to compete directly with regimes such as Luxembourg and Jersey, which are seen as global leaders. For example, Hong Kong has put forward a package of reforms to make itself more attractive as a fund domicile, says Anderson.

He highlights the Hong Kong Limited Partnership regime, introduced in 2019, which allows funds to pay zero percent tax on carried interest.

“Hong Kong also has a new tax exemption that gives you a safe harbor so that the fund itself won’t be taxed in Hong Kong in a way that you don’t want,” he adds.

“While Hong Kong is still early days with the new regime, it will be interesting to see how much traction it gets. It’s one to watch.”

Brexit

The UK’s exit from the EU means it has become a ‘third country’ for EU passporting purposes. While there is a transition period in place for funds selling across borders, Vistra’s Vanhoutte and Tobolka point out that alternative investment funds (AIFs) do not yet have certainty about when this period will end and new permissions will be needed.

Newly launched AIFs in the European Economic Area, or existing ones that missed the December 31, 2020 deadline, will need to apply for the national private placement regime and will no longer benefit from passporting.

In addition, following its separation from the EU rulebook, the UK government has made strong indications that it wants to be a destination of choice for fund domiciliation.

Industry trade body the Investment Association has called for a tax overhaul and a shift to ‘light-touch’ regulation to attract more international business and compete with Dublin and Luxembourg, the EU’s leading domiciles.

Assessing sustainability

The acceleration of environmental, social and governance requirements is also influencing domicile decisions – a new development, according to Apex Group’s Kyriacou. Fund managers and investors are “increasingly evaluating jurisdictions through an ESG lens,” she says.

For example, the EU’s ground-breaking Sustainable Finance Disclosure Regulation (SFDR), which came into force on March 10, has already focused attention on ESG issues. The rules apply to any manager selling into the EU, so the effects are likely to be felt globally.

Vistra’s Vanhoutte and Tobolka both say that it will take some time to understand and implement the SFDR. Asset managers must “provide transparency on the extent to which they incorporate ESG considerations into the services they provide to their clients,” the pair explain, meaning “investors and managers may favor jurisdictions with high standards and best practices which are being developed.”

From ESG considerations to Brexit uncertainty and regulatory changes, choosing a fund domicile is perhaps a more difficult task than it has ever been.

Destination features

Channel Islands

  • Politically and fiscally autonomous, with a stable political and legal structure.
  • A proportionate, flexible and competitive funds regulatory regime.
  • Strong links with the UK government and the UK funds industry, and benefits from the transport links with the UK.
  • More than £20 billon ($28 billion; €23 billon) of property is held in Guernsey-domiciled real estate funds.
  • Recent changes to Guernsey’s Private Investment Funds regime make it more user-friendly for family offices and sophisticated investors, while retaining protections to safeguard less sophisticated investors.
  • In March, Jersey Finance launched its sustainable finance strategy, making a case for Jersey’s finance industry to support the transition to a more sustainable future.
  • Last summer, the Jersey government approved a new amendment to Jersey’s legislation making it easier for managers to migrate limited partnership fund structures.

Caymans

  • Historically a top choice for Asia-based fund managers.
  • Regime is not quite as ‘light touch’ as it used to be; for example, funds must now generally register with the Cayman Islands Monetary Authority. But it is still easy to set up here and is generally process light.
  • Ongoing maintenance costs are moderate.
  • Generally provides no restriction on investment scope, flexible for capital contributions and distributions, contractual freedom between parties and broad safe harbor activities for limited partners.
  • Recent removal of the Cayman Islands from the EU’s list of “non-co-operative jurisdictions for tax purposes” has reduced some of the uncertainty for managers around application of the economic substance rules, but certain investors may still have reservations around investing in a Cayman fund.

Ireland

  • Benefits from the harmonization of EU financial services regulations and offers asset managers access to the EU-wide market.
  • Post-Brexit, Ireland will be the largest English-speaking common law jurisdiction in the eurozone and provides for a broad range of fund structures.
  • Data from Monterey Insight from June 2020 shows 223 real estate funds domiciled in Ireland with assets of $19.8 billion.

Hong Kong

  • The Hong Kong Limited Partnership is a relatively new vehicle, although in many ways similar to a Cayman limited partnership.
  • The fund manager/adviser, fund vehicles and manager may all be based in Hong Kong, which can potentially streamline the fund’s operations.
  • Formation fee and ongoing maintenance fees are reasonable compared to other regimes.
  • Unified fund exemption provides attractive tax regime, and there are potential tax concessions for carried interest.

Singapore

  • Considered one of the leading asset management locations in Asia.
  • Has an extensive network of tax treaties and offers attractive tax incentive schemes to funds managed by fund managers in Singapore, including concessionary tax rates on income earned by Singapore-based fund managers.
  • Recently introduced a new structure (variable capital company) to provide additional flexibility in structuring fund entities.

Delaware

  • Long considered the ‘gold standard’ jurisdiction for the formation of US pooled investment vehicles.
  • Provides ease of formation and amendment, superior quality of jurisprudence with respect to matters of business, and clarity and ease of interpretation of law. The Delaware limited partnership law has been used as a model by many other jurisdictions.
  • Access to an entire network of service providers, including legal counsel, auditors, registered agents, tax preparers, banks and fund administrators.
  • Ongoing maintenance costs are moderate.

Luxembourg

  • Very large and sophisticated funds industry and ecosystem of service providers.
  • Similar to US/UK-style types of partnership and provides broad contractual flexibility.
  • Can provide easier access for marketing and offering of fund interests to EU-based investors.
  • Onshore jurisdiction subject to AIFMD regulation, so ongoing compliance and maintenance costs can be considerably higher than offshore domiciles such as the Cayman Islands.