Cayman fund structures: limited partnership vs. limited company

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The Cayman Islands has become the most common domicile for most hedge funds these days. The increase in legal entity options has made deciding on legal formation more complicated than ever. The most common structure used to be a Cayman limited company (Ltd). However, since the introduction of the exempted limited partnership (LP) in 2014, we have seen increased use of the Cayman LP structure. There are a number of reasons why new funds would consider launching a Cayman LP master fund rather than the more traditional Cayman limited company structure. The chart below outlines some of the key considerations and differences when deciding between a Cayman LP or a Cayman Ltd.

Cayman LP Cayman Ltd

Legislation Exempted Limited Partnership Law, 2014 Companies Law (2016 Revision)

Inception An LP requires at least one general partner (GP) and at least one limited partner. The main requirement is that at least one GP is required to be either an individual resident in the Cayman Islands, a company incorporated or registered as a foreign company in the Cayman Islands, an exempted LP in the Cayman Islands or a registered foreign LP.

There are no residency or qualification requirements for directors or shareholders of a company.

Amendment of constitution

Provisions governing the amendment of a limited partnership agreement (LPA) are invariably contained in the LPA itself. Notwithstanding any term in the LPA to the contrary, any term of the LPA may be amended orally by the partners.

Amendments to the memorandum or articles of association, or the name of the company, may only be made by special resolution of the voting shareholders.

Liability An LP does not have separate legal personality, and a limited partner should not take part in the conduct of the business of the partnership. A limited partner may lose the benefit of limited liability if it engages in the conduct of the business of the partnership with persons who are not partners in the partnership who reasonably believed the limited partner to be a GP.

A limited entity is a corporate body with separate legal personality. No contribution shall be required from any member of the limited entity exceeding the amount, if any, unpaid on the shares in respect of which they are liable.

Taxation for masters

An LP is by default a flow-through entity for US tax purposes, and therefore, all profits and losses flow directly to the partners and the character of income earned by the partnership is preserved.

Although no entity classification election would be required in the US, it should be noted that even when the master entity is set up as a Cayman LP, if the GP in an LP feeder has no economic interest, then the IRS could take a position that the foreign master LP is not technically a partnership. Many managers setting up a Cayman master LP file protective US check-the-box elections to treat the Cayman LP as a partnership for US tax purposes to eliminate any tax risk on the issue.

The Cayman LP structure may have tax benefits for non-US investors whose home country tax rules allow for treaty withholding rates in foreign jurisdictions. Depending on the trading strategy of the fund and the investor profile, the LP structure may allow for reduced tax leakage for those specific investors.

Master funds formed as limited entities will need to make a “check the box” election (i.e., Form 8832) to be taxed as a partnership for US tax purposes. This election ensures that the entity is treated as a partnership for US tax purposes and that income flowing through to the investors retains its character, i.e., dividends, short-term/long-term gains (losses). Given that there is no taxation on income, profit or capital gains in the Cayman Islands, the limited entity can accumulate earnings without taxation at the corporate level, while at the same time limiting liabilities to the corporation.

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Cayman LP Cayman Ltd

Taxation for feeders

Non-US investors, investing through a fiscally transparent structure, may be entitled to lower withholding rates for income that the fund earns when investing in other countries. The entire investment structures would need to be transparent to the non-US investor; therefore, investment through the offshore feeder would require both the offshore feeder fund and the trading master fund to be structured as Cayman LPs. The Cayman LP feeder would likely want to elect to be treated as a corporation for US tax purposes, allowing it to continue to eliminate exposures to US trade or business and unrelated business taxable income, and otherwise would function the same way a Cayman LTD would for US tax purposes. The feeder would be a passive foreign investment company to any US taxable investors.

Cayman feeders that are organized as limited entities are by default treated as corporations for US tax purposes. No entity classification filings are required other than work filing on a protective basis. Investors from non-US jurisdictions would invest through a non-transparent entity under their local tax laws as well, so they are likely unable to claim home treaty benefits through this structure. The feeder would be a passive foreign investment company to any US taxable investors.

Governance There is no legislation covering governance of Cayman partnerships; however, the Cayman Islands Monetary Authority (CIMA) has published a Statement of Guidance for Regulated Funds – Corporate Governance (SOG) that sets forth the minimum guidance for operators of Cayman Islands regulated funds. Operators include the GPs of an LP. The SOG addresses oversight functions, conflicts of interest, operator meetings, duties, documentation, relations with CIMA and risk management.

Under the SOG, the operator of a regulated fund has the ultimate responsibility for effectively overseeing and supervising the activities and affairs of the fund and for ensuring that the fund conducts its affairs in accordance with all applicable regulations, rules, laws, anti-money laundering requirements, statements of principles and guidance. The operators of a regulated fund should meet at least twice a year in person or via telephone or video conference and, where necessary, request the presence of the fund’s service providers at the meetings. They should also exercise independent judgment, acting in the best interests of the regulated fund and taking into consideration the interests of the investors as a whole.

Similar to Cayman partnerships, there is no legislation covering governance of Cayman limited entities. However, the SOG referred to under Cayman partnerships also applies to Cayman limited entities.

For directors of limited entities, under the Directors Registration and Licensing Law, 2014, all natural persons appointed as directors of regulated funds are required to be registered and pay an annual fee. CIMA may refuse to register an applicant under certain circumstances, and when that occurs, the director can no longer serve as a director of the regulated fund.

Professional directors are required to be licensed as professional directors under the law. CIMA may refuse to grant a license if it is not satisfied that the director has sufficient capacity to carry out its duties as a professional director and is not a fit and proper person for licensing as a professional director. There are further requirements for professional directors to be insured to minimum levels.

Accounting The accounting for an LP fund is considered to be simpler than with a limited entity. There are no shares to issue, no authorized capital to consider, no equalization and no series roll-ups.

Allocation of gains and losses to partners is easier as the allocation is simply based on the dollar amount of the partner’s capital balance. Allocations to/from the GP and limited partner (e.g., incentive allocations) are easier due to not having to issue shares or redeem shares at the GP level when incentive is allocated.

Accounting for a limited entity structure can be complicated. Shares are required to be issued, and authorized capital, equalization and series roll-ups are all factors to consider.

Allocations of gains/losses are performed based on the number of shares held by each investor. Shares will need to be issued and redeemed if performance fees are allocated to the investment manager as an investor in the fund.

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Cayman LP Cayman Ltd

Financial statements

Financial statements require a few less disclosures under US GAAP. There is no requirement to disclose a net asset value per share roll in the financial highlights. All that is required is total return percentage, expenses to average net asset ratio and investment gain/loss to average net asset ratio. Financial statements also do not need to take into account series roll-ups, share roll forward disclosures or net asset value per share disclosure.

Financial statements require some disclosures under US GAAP that an LP does not need to consider. These include a net asset value per share roll in the financial highlights, series roll-ups, share rollforward disclosures and ending net asset value per share disclosures.

Final thoughtsIn June 2016, the Cayman Islands enacted the Limited Liability Companies Law, 2016 (the LLC law), which provides yet another kind of Cayman Islands vehicle: the limited liability company (LLC). An LLC is a hybrid entity that essentially combines characteristics of an exempted company with those of an exempted LP. Like an exempted company, it is a corporate body with separate legal personality, but it does not have share capital. The LLC is similar in many respects to a Delaware LLC but with added amendments and modifications based on corresponding provisions from the Companies Law and the Exempted Limited Partnership Law for greater consistency with those laws.

Fund managers looking to launch new funds should consider the legal, operational and tax aspects to the various forms when deciding which option is right for them. There is no longer a one-size-fits-all approach to structuring.

Ernst & Young LLP key contacts

Jeff ShortPartner, Wealth and Asset Management Assurance+1 345 814 9004jeffrey.short@ky.ey.com

Rosa NolanSenior Manager, Wealth and Asset Management Assurance+1 345 814 9038rosamond.nolan@ky.ey.com

Seda LivianPartner, Wealth and Asset Management Tax+1 212 773 1168 seda.livian@ey.com

Bill BaileyPartner, Wealth and Asset Management Tax+1 441 294 5319bill.bailey@bm.ey.com

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