Engaged, active players in the BVI

Keeping options open – the growing demand for BVI hybrid funds

Hedge funds and private equity funds were traditionally considered to be two completely different alternative investment classes, but as managers and investors increasingly seek to take advantage of exposure to both asset classes, the industry has witnessed a significant rise in the popularity of hybrid funds.

“Such fund structures aren’t new – the concept has been around for quite a while now. However, in the last couple of years, we’ve seen an increased demand for them, as many managers wish to establish funds with flexible mandates that combine elements of both hedge funds and private equity,” says Eric Flaye, counsel, Conyers.

A hybrid fund is one which holds a mix of both liquid and illiquid investments and seeks to combine elements of fund terms that are customary for both hedge funds (that is, liquid investments) and private equity funds (for the illiquid element), within a single fund vehicle.

Flaye outlines the potential advantages of creating such a structure from a sponsor’s perspective: “They will only need to focus on launching and operating one single vehicle and can preserve the ability to follow quite a broad investment mandate across both liquid and illiquid asset classes.

“Through such a hybrid structure, managers can have the flexibility to opportunistically invest in listed equity or tokens or liquid cryptocurrencies, for example, while not precluding the possibility of investing in something less liquid like seed equity, warrants or instruments subject to lengthy lock-up periods and vesting schedules.”

Managers often want to preserve such flexibility within a single fund vehicle, especially those operating smaller or first time funds. “Such groups are hoping they can yield significant cost and administrative efficiencies by operating this broader mandate within a single fund vehicle (as opposed to setting-up and operating two or more separate funds),” Flaye points out. For investors, the potential appeal lies in the ability to make a single allocation to a single fund. Flaye outlines: “It will give them exposure to broader investment or asset classes on a costefficient basis. And this is potentially very attractive, particularly if they have a lot of faith in that specific sponsor group.” The element of trust is always critical within the asset management industry as a whole, but when considering hybrid funds, the relationship between manager and investor is thrown into sharper focus.

Trust and expertise

Flaye explains how a number of these hybrid funds first launch as start-up efforts, often marketed to a manager’s friends and family and close business network. In these cases, the level of trust is generally high as the connection between the manager and the investors makes this implicit.

However, once those budding managers look to evolve further and set their sights higher by aiming to raise capital from third party professional investors, their value proposition and marketing pitch may need to shift. “You need a very compelling story to tell in order to be able to successfully launch off the back of a hybrid strategy,” Flaye notes. Marketing can be a potential challenge for hybrid funds, as investors may be confused about the core investment philosophy of the fund and whether it is more akin to a private equity fund or a hedge fund (which may be important for investors’ own internal allocations and investment committee approval processes). And the sponsor may need to resist the temptation to try to cherry-pick the most favourable aspects of both PE and hedge fund terms for the benefit of the sponsor group, as that may not prove acceptable to a sophisticated investor base.

The manager will also need to assure their target investor base they have the requisite expertise and track record in all relevant asset classes the fund will be investing in, given they may have broad and diverse profiles. For example, cryptocurrency trading strategies are markedly different from early-stage venture capital-style investments in emerging blockchain businesses. Flaye stresses: “It may be tempting for a sponsor to say they’re leading experts in all things crypto and digital assets generally. But they probably will need to be able to clearly articulate to investors that they have genuine expertise and a demonstrable track record in all of the relevant areas, if they want to be able to successfully launch a hybrid fund with sophisticated professional investors.”

Investors also need to place significant trust in the manager’s ability to get the liquidity profile right and in ensuring the redemption terms of the fund are appropriate. Flaye advises: “If the fund is primarily a hedge fund, or it holds the majority of its assets in liquid investments, but has a fairly meaningful portion in illiquid investments as well, then the fund sponsor has to be very careful to make sure that significant investor lock-up periods apply and/or they have the ability to side pocket or otherwise effectively segregate the illiquid portfolio or suspend withdrawals in the case of a significant run of redemptions.” Therefore, it’s inherent that hybrid funds are generally a more complicated and bespoke product, both in terms of investment strategy and fund terms but also from an operational perspective. A sponsor choosing to launch such a fund needs to have the necessary internal operational expertise in order to effectively operate and manage the various different strategies and differing liquidity profiles.

Asset classes

Historically, hybrid funds were commonly used for activist investing, distressed investing and certain credit strategies. The structure lends itself well to such strategies – e.g. activist investors take stakes in publicly listed entities, acquiring what is effectively a liquid security, but at the time of making the investment, they don’t know exactly whether they’re going to hold it for days, months or potentially even years. A hybrid structure allows them to effectively manage differing liquidity profiles in such scenarios.

Flaye notes that distressed investing is also an asset class which is well placed to benefit from a hybrid structure: “You can acquire listed securities that end up becoming delisted or otherwise illiquid.”

The emerging crypto and digital assets space is another area enjoying success with the use of hybrid structures. However, Flaye argues that, given the nascent nature of the asset class. a little more work may be required on behalf of a sponsor looking to convince sophisticated investors to invest in a hybrid strategy.

Regulatory choices

Considering the BVI perspective in terms of hybrid funds, alternative investment funds in the jurisdiction are typically either regulated as hedge funds (or what are called “mutual funds” in BVI parlance) or as venture capital/private equity-style funds (or what are called “private investment funds” in BVI).

“These are two distinct, separate regulatory regimes and although there are commonalities between them, each imposes slightly different requirements for the funds in terms of mandatory service providers, audit, fund administration, and the various different restrictions on numbers of investors, assets under management, and minimum investor buy-in amounts, etc.,” says Flaye.

Therefore, managers planning to launch a hybrid fund in the BVI will need to consider which regime they are required to follow and this largely depends on the primary investment strategy of the fund, he notes: “For some hybrid funds, it’s very obvious which is the correct one…if it’s mostly an illiquid fund that has a small portion of liquid holdings, then it should be regulated as a private investment fund. “Conversely, if it’s really akin to a hedge fund that also wants the ability to have up to, say, 20% to 30% of its holdings in illiquid assets at any given time, then you would need to be regulated as a mutual fund. If the assets are closer to 50-50, then it’s a judgement call for the manager and its legal counsel to make.”

Ultimately, the regulatory regime selected needs to appropriately reflect the liquidity profile of the fund and the investments within it. Flaye warns: “It is quite tempting for a manager to choose one; to cherry-pick the one they think will work best for them from an operational perspective. But they just need to be careful to make sure the most appropriate category of regulatory license is obtained in light of the true characteristics of the fund structure, to keep in good standing with the BVI Financial Services Commission and their investors.” Flaye concludes by noting that: “While hybrid structures can present certain unique issues and challenges in terms of structuring, the BVI fund industry is very well adapted to cater to such demands given the jurisdiction’s flexible legal regime and unique set of innovative and cost-competitive fund products.”

Conyers

Conyers is a leading international law firm with a broad client base including FTSE 100 and Fortune 500 companies, international finance houses and asset managers. The firm advises on the laws of Bermuda, the British Virgin Islands and the Cayman Islands, from offices in those jurisdictions and in the key financial centres of Hong Kong, Singapore and London. Through its global network it provides responsive, sophisticated, solution-driven advice to clients on matters including: general corporate, capital markets, M&A, banking and finance, insurance and reinsurance, investment funds, private equity and venture capital, asset finance (including shipping and aircraft finance), litigation and dispute resolution, insolvency and restructuring, and private client and trusts. The firm also provides a wide range of registered agent, registered office, corporate director and secretarial services, as well as specialised company trust, management, compliance and governance services.

Eric Flaye

Eric Flaye is counsel and head of the London office of Conyers. He is a leading advisor on all aspects of offshore investment funds, including pre-formation strategy, organisational structure, regulatory compliance and transactional activities, for both private equity funds and hedge funds. Eric is also a key member of Conyers’ growing fintech (blockchain and digital assets) practice.

The BVI can provide warmth and shelter in the crypto winter

The British Virgin Islands (BVI) have been the rightful home for some of the largest players in the digital assets space for many years now. The combination of a sophisticated public and private sector with a deep understanding of the industry, along with a stable regulatory environment have created the perfect foundation for even the most complex and intricate blockchain projects to thrive.

It is therefore unsurprising that virtual asset service providers now comprise a sizeable chunk of the approximately 400,000 corporate entities registered in the BVI. But the BVI’s contribution to the digital assets space also means it has encountered its fair share of the industry’s recent troubles.

The challenges faced by the cryptocurrency market in 2022 have resulted in financial distress and even liquidations for some large crypto funds and lenders. This demonstrates the importance of a home jurisdiction that is not merely supportive of the foundation and development of digital asset services, but also provides a supportive and, when needed, robust framework for those in difficulty. The emergence of the crypto winter has highlighted the credentials of the BVI in this regard.

Three arrows to the heart

One of the major catalysts of the current bear market was the collapse of Terra’s UST and LUNA stable coins, which lost their peg to the US dollar and with it, nearly $45bn in value. Terra’s crash caused ripple effects throughout the crypto market.

Prominent cryptocurrency hedge funds such as Three Arrows Capital (3AC), a BVI-domiciled fund structure with operations in Singapore, suffered major losses, which prevented investors from liquidating their positions after 3AC failed to meet margin calls with various digital currency lending firms. After weeks of speculation as to 3AC’s spiraling financial position, the BVI Commercial Court placed 3AC into liquidation and appointed BVI licensed insolvency practitioners to act as joint liquidators over the fund.

The 3AC liquidation has since expanded into other jurisdictions. In July 2022, the BVI joint liquidators filed a Chapter 15 petition in the US Bankruptcy Court for the Southern District of New York, ultimately obtaining a full recognition order. In late August, the High Court of Singapore recognized 3AC’s BVI liquidation as the foreign main proceeding and its BVI joint liquidators as the company’s foreign representative.

3AC is reported to have had over $3bn worth of digital assets under its management as of April 2022. As such, it was inevitable that there would be contagion and it was not long before numerous other crypto lenders, brokerage firms, funds and exchanges encountered difficulties of their own.

In June 2022, Celsius and Voyager, two large US-based crypto lenders both filed for Chapter 11 bankruptcy. At around the same time, Babel Finance, another large crypto lender, suspended withdrawals due to major losses and in the months since, there have been numerous reports of other funds, lenders and custodians experiencing significant, if not fatal levels of distress.

BVI insolvency regime

3AC’s recent liquidation illustrates the ability of the BVI insolvency regime to facilitate the appointment of licensed insolvency practitioners who could swiftly secure and preserve assets. It also demonstrates the way BVI-appointed liquidators are able to seek recognition and assistance in other jurisdictions, which is crucial in complex cross-border restructurings and insolvencies (bankruptcies).

If the commercially attractive and flexible provisions of the BVI’s Business Companies Act provide the apparatus to take off, the BVI Insolvency Act and Rules provides the safety net when things do not go to plan. The insolvency regime achieves a delicate balance of protecting the rights of creditors – both

secured and unsecured -whilst also enabling viable companies to restructure their debts if the circumstances allow.

The insolvency regime in the BVI offers similar protections to creditors that are found in other major financial centres around the world: its legislative provisions are largely based on the UNCITRAL model law. There are strict eligibility requirements for those who can be appointed as BVI liquidators of insolvent companies and appointees have wide-ranging powers that allow them to collect in and preserve assets of the company, protect them from hostile creditor actions, and ultimately make distributions in accordance with long-established rules of priority.

In cross-border cases, the BVI courts will typically empower BVIbased liquidators to seek recognition and/or use their powers in foreign jurisdictions. Similarly, the BVI courts are also wellattuned to recognizing foreign liquidators and enabling them to deal with assets located in the BVI. The BVI’s adoption of the Judicial Insolvency Network’s ‘Guidelines for Communication and Cooperation between Courts in Cross-Border Insolvency Matters’ ensures that the BVI is part of a formal framework for cross-border cooperation between foreign courts and judges to facilitate coordinated cross-border insolvencies and restructurings.

Of particular importance where financial distress is a consequence of short-term factors, the BVI courts have confirmed in recent years the availability of a restructuring mechanism. This entails the appointment of ‘light-touch’ provisional liquidators who take office alongside, and with the mandate of overseeing and advising, the existing board of directors of the insolvent company, with a view to restructuring debts and allowing the company to emerge back into solvency. Restructurings are often pursued on a group-wide basis and the BVI’s approach in this area has developed in tandem with the Cayman Islands and Bermuda.

Creditors with security over the assets of a BVI company or over the shares in a BVI company will generally be afforded the right to appoint receivers over those assets at minimal cost. Where appointed over BVI shares, receivers will generally be entitled to vote the shares and take control over assets further downstream in order to realise repayment of their debt.

Sophistication of the BVI

Due to the high volume of BVI companies and the frequency with which the insolvency and restructuring regimes are used, legal and insolvency practitioners in the BVI boast a wealth of knowledge and expertise when advising on distressed assets and corporate turn-around.

In addition, because of its familiarity with entities in the digital assets space, the BVI is spawning a more specialised practice in adapting liquidators’ duties and powers to the preservation and liquidation of digital assets.

While it is essential that a jurisdiction provides the right building blocks, the BVI also has the right architects and tools available to deal with any troubled projects in a commercial and sensible manner. This should give institutional investors and company founders alike a significant level of comfort to secure investment at a sufficient level to ensure the digital asset space thrives.

Harneys

Harneys is a global offshore law firm with entrepreneurial thinking. Experts in British Virgin Islands, Cayman Islands, Cyprus, Luxembourg, Bermuda, Anguilla, and Jersey* law, the firm’s service is built around professionalism, personal service and rapid response. Harneys advises an international client base, which includes the world’s top law firms, financial institutions, and investment funds, as well as high net worth individuals. Harneys is a full service law firm spanning all major transactional, contentious, and private client disciplines and works alongside Harneys Fiduciary, its associated corporate and fiduciary services arm.

*Jersey legal services are provided through a referral arrangement with Harneys (Jersey) which is an independently owned and controlled Jersey law firm.

www.harneys.com

Philip Graham

Philip Graham is global head of the Harneys Investment Funds and Regulatory groups and head of the firm’s transactional team in the British Virgin Islands. He advises on the laws of the British Virgin Islands and the Cayman Islands and is a leading advisor on all aspects of offshore investment funds, including pre-formation strategy, regulatory compliance and restructuring.

Christopher Pease

Christopher Pease is a partner in the Harneys Litigation, Insolvency and Restructuring team in the BVI. He has experience in all the types of disputes work that frequently arises in the BVI including fraud and bribery claims, disputes relating to the ownership and management of companies, minority shareholder claims, and insolvency and restructuring cases.

Zachary Van Horn

Zachary Van Horn is a member of the Harneys Litigation, Insolvency & Restructuring team in the British Virgin Islands. He has a broad range of experience advising on commercial and corporate disputes across various industry sectors, including contractual, property, and shareholder disputes.