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Setting up an offshore fund: five things you should know

10th October 2013

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Demand for offshore investment funds remains high despite the economic downturn. To stay competitive, many South African investment managers have little choice but to develop an offshore product offering.

By comparison with their onshore counterparts, offshore funds pay less tax and are generally cheaper and easier to establish and run. However, setting up an offshore fund can be a daunting exercise – particularly given the sometimes complex cross-border issues involved.

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Of the questions most commonly asked by fund managers wishing to set up an offshore fund, we examine the five most common ones.

WHAT IS A FUND?

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Whilst investors and investment managers have a basic understanding of what an investment fund is, financial services regulators speak a different and unique language. Not all funds are regulated and accordingly, a regulator’s definition of a fund may differ from yours. When setting up a company in an offshore jurisdiction, bear in mind that any pooling of assets for the purpose of generating a return may result in a regulated fund being formed. On the other hand, provided you understand the offshore regulator’s definition of a regulated fund, it is often possible to set up what would be regarded as a regulated collective investment scheme in South Africa in such a way as to escape regulation. For example, funds with limited rights to subscribe to, or redeem, are often referred to (inaccurately, we might add) as ‘closed-ended’ and are not regulated.

Often, the level of regulation also depends on the type of fund established; which in turn depends on the fund’s target market. Generally speaking, the level of regulation in the offshore world increases in line with the broadness of the fund target market. As such, a fund marketed to industry professionals through private placements will normally be subject to a lower level of regulation than one offered to the general public.

WHAT ARE THE BENEFITS OF AN OFFSHORE FUND?

Offshore funds are cheaper to set up and run than onshore funds and also pay no or very low levels of tax. All things being equal, these savings translate into better performance.

Offshore funds also generally offer more flexible investment strategies. For example, they do not generally require regulatory approval to switch from long-only to short-only positions, as is the case with most onshore jurisdictions. The ability to employ risk-hedging techniques that are often prohibited in domestic funds makes offshore funds even more attractive – and potentially safer – than their domestic counterparts. A skilled manager can translate this flexibility into profits.

WHO OWNS AND CONTROLS AN OFFSHORE FUND?

Most offshore funds are established as simple offshore companies or limited partnerships. Both of these structures allow for a clear separation between the interests and rights of the manager (either as the holder of management shares or as the general partner) and the investors (either as the holders of participating shares or as limited partners). Many offshore jurisdictions also offer ‘protected cell’ or ‘segregated portfolio’ companies that allow a manager to pursue a variety of investment strategies through a single legal entity.

WHAT SERVICE PROVIDERS ARE INVOLVED?

In an effort to reduce the risks associated with investments in funds, many offshore regulators now insist that a fund employ independent services providers for certain key services. These include fund administration (including the processing of subscriptions and redemptions and the valuation of the fund’s assets) and custody (retaining the fund’s assets). This ensures independent oversight of the manager’s activities. In certain cases, these providers must be based in the jurisdictions of the fund entity itself.

WHAT IS AN OFFERING MEMORANDUM?

Many offshore jurisdictions require that the fund produce an ‘offering memorandum’ that describes the terms of the investment, sets out a directory of the service providers and the risks attaching to an investment. The offering memorandum may be referred to as a private placement memorandum or a prospectus. The offering memorandum will normally (but not always) be part of the contractual agreement between the investor and the fund. The principle reason for this is to ensure that the risk disclosures made in the offering memorandum form part of the contractual arrangement between the fund and the investor. As such, the offering memorandum is not merely a marketing document but supplements the articles of association or the partnership agreement by forming the basis of the rules governing the fund’s operation.

The contractual nature of the offering memorandum has certain consequences. In the event that the fund breaches a provision of the offering memorandum, the investor’s remedy will be under the law of contract – which may restrict the compensation to a claim for damages. To illustrate this, if the fund were to forcibly redeem an investor’s shares contrary to the provisions of the offering memorandum, the investor would normally not be entitled to demand that the fund re-issue the shares to it (specific performance), but would be restricted to a claim for the damages it has suffered which would exclude the investor from any future gain made by the fund.

Written by Shayne Krige, Director, Werksmans Attorneys

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