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January 14, 2008
Offshore Explorations: Caribbean Hedge Funds, Part 2
by Martin A. Sullivan

Full Text Published by Tax Analysts®

Document originally published in Tax Notes
on January 14, 2008.

Previously we reported that tax evasion by individual investors in offshore hedge funds was a relatively easy undertaking. Information about investors flows only in a trickle from these institutions to onshore tax collectors. ("Offshore Explorations: Caribbean Hedge Funds, Part I," Tax Notes, Jan. 7, 2008, p. 95, Doc 2007-28326 , 2008 TNT 5-4 ). And it is a fact that if income is not independently reported by the source, the likelihood of voluntary compliance declines precipitously. IRS statistics indicate that income with little or no information reporting has a compliance rate below 50 percent ("Rap on Tax Gap — It's No Snap," Tax Notes, May 21, 2007, p. 711, Doc 2007-11600 , 2007 TNT 93-8 ).

This article attempts to quantify the assets in offshore hedge funds potentially associated with tax evasion. Although hedge funds are usually managed from onshore money centers like New York and London, more than half of the world's hedge funds are legally domiciled offshore, and the four offshore leaders are the Cayman Islands, the British Virgin Islands, the Bahamas, and Bermuda. (Although Bermuda is located in the Atlantic, we have included it among Caribbean offshore jurisdictions for purposes of this series.) And of those four, the Cayman Islands by a wide margin dominates its competition.

From the calculations described in this article, we estimate that individuals have invested $262.8 billion in hedge funds domiciled in the Caribbean.

How Much?

Because hedge funds are lightly regulated and reflexively reticent to disclose information to the general public, there is no comprehensive source of hard data on the hedge fund industry. The Federal Reserve Board, the Securities and Exchange Commission, and the Treasury Department do not systematically collect data from hedge funds as they do from other major financial sectors. As a result, our knowledge of the scope of the industry is based on voluntary disclosure to private databases and participation in private surveys. Typically any one of these databases or surveys includes hedge funds with no more than one-third of the total estimated industry assets, and sometimes considerably less.

The starting point for determining investment by individuals in Caribbean hedge funds is investment by all investors in all hedge funds. Probably the most widely cited industrywide estimates are from Hedge Fund Research Inc. (HFR). Estimates from the "HFR Industry Report — Year End 2006", shown in Figure 1, show that the total number of hedge funds grew from 3,616 at the end of 1996 to 9,462 at the end of 2006. HFR estimates, shown in Figure 2, show that hedge fund assets under management grew from $456.4 billion at the end of 1996 to $1.43 trillion at the end of 2006.

      Table 1. Assigning Hedge Fund Assets to Caribbean, Method I
      (Total non-U.S. assets, end of 2006 equals $976.1 billion;
                      dollar amounts in millions)

HFR Estimates of Number of Funds   Estimated Assets
(previous column
 Domicile        World Total      Non-U.S. Total    times 2006 total)


 Bahamas            1.7%             2.5%               $24,172
 Bermuda            7.7%            11.0%              $107,028
 B.V.I.             9.3%            13.3%              $129,384
 Cayman Islands    33.7%            48.2%              $470,450
Total "Big Four"  52.3%            74.9%              $731,035
 Other Non-U.S.    17.5%            25.1%              $245,076
 United States     30.1%             0.0%
World Total      100.0%           100.0%
Source: Hedge Fund Research Inc., "HFR Industry Report — Year
 End 2006," available at

Some care must be taken in interpreting these figures. Asset totals represent total equity investment in hedge funds. Hedge funds often leverage their investment in the hope of supercharging returns to their equity investors. If a hedge fund has a debt-equity ratio of 2:1, the assets it invests in would be three times larger than those reported as assets under management.

Some hedge funds invest in other hedge funds. These funds of funds have been excluded from asset totals by HFR so as not to double-count commitments by investors to the hedge fund industry. Funds of funds have not been excluded from the estimates for the number of hedge funds. HFR estimates that with funds of funds excluded from the total, the number of hedge funds at the end of 2006 was 7,241.

Figure 1. Number of Hedge Funds

Source: Hedge Fund Research Inc., HFR Industry - Year End
2006. Data include funds of funds.

HFR estimates are similar to other published estimates. For the sake of consistency with our previous articles on offshore investment, the figure for the end of 2006 is of particular importance here. The Hennessee Hedge Fund Advisory Group estimates hedge fund industry assets under management of $1.535 trillion at the end of 2006 — 8 percent larger than the $1.43 trillion estimated by HFR (May 1, 2007, press release available at In a June 11, 2007, speech, Anthony Ryan, Treasury assistant secretary for financial markets, spoke of "approximately $1.4 trillion" of assets under management by the hedge fund industry. On July 11, 2007, congressional testimony by Kevin Warsh, a member of the Federal Reserve's Board of Governors, used a figure of "more than" $1.5 trillion of assets (testimony before the House Committee on Financial Services, available at

In addition to these similarities in magnitude, all other estimates of the size of the hedge fund industry indicate rapid growth similar to that of the HFR estimates in figures 1 and 2. In this article, we use HFR estimates for total industry assets.

          Table 2. Assigning Hedge Fund Assets to Caribbean, Method II
           (Total non-U.S. assets, end of 2006 equals $976.1 billion;
                          dollar amounts in millions)

Lipper TASS Data       Non-U.S. Totals        Estimated Assets
               ------------------    -------------------      
(previous column
                Number of             Number of                  times 2006
 Domicile         Funds    Assets       Funds     Assets           total)


 Bahamas            43    $10,301        2.4%       2.5%          $24,531
 Bermuda           116    $27,011        6.4%       6.6%          $64,321
 B.V.I.            185    $72,116       10.2%      17.6%         $171,733
 Cayman Islands    945   $220,676       52.0%      53.8%         $525,503
Total "Big Four" 1246   $319,802       68.5%      78.0%         $761,558
 Other Non-U.S.    572    $90,098       31.5%      22.0%         $214,553
Total Non-U.S.   1818   $409,900      100.0%     100.0%         $976,111

Source: Lipper TASS Hedge Fund Database, available at


Our next step is to estimate what portion of the total $1.43 trillion in hedge fund assets under management at the end of 2006 was domiciled in the Cayman Islands, the British Virgin Islands, the Bahamas, and Bermuda. Two sources provide information about the composition of assets by domicile. HFR's 2006 industry report indicates that $976.1 billion of assets were under management in non- U.S. funds at the end of 2006. The report also indicates that the four leading Caribbean hedge fund jurisdictions were the home for 74.89 percent of hedge funds domiciled outside the United States. Assuming funds in the Caribbean are on average the same size as non- U.S. funds outside the Caribbean, we estimate assets under management in Caribbean hedge funds to be $731 billion at the end of 2006. These calculations are summarized in Table 1.

Our second source of information on the domicile of hedge funds is the Lipper TASS hedge fund database. We limited our sample to the 2,873 funds reporting in December 2006. Those funds had total assets under management of $578.9 billion. Of those, 1,818 funds were domiciled outside the United States, with $409.9 billion of assets under management. Table 2 summarizes the distribution of funds by domicile found in the Lipper TASS database and then scales up the total using the HFR non-U.S. total of $976.1 billion for the end of 2006.

Figure 2. Hedge Fund
Assets Under Management
(in billion)

Source: Hedge Fund Research Inc., HFR Industry - Year End
2006. Data include funds of funds.

The strength of the first method is that the original estimates are for all funds, but there is no estimate of distribution of assets. So estimates under the first method will be less accurate to the extent funds are of unequal average sizes in different jurisdictions. Conversely, the second method provides a direct estimate of the distribution of fund assets, but it is for a limited sample. So estimates will be less accurate under the second method if the average size of funds outside the sample is different from those within the sample.

The good news is that both methods provide estimates of the same order of magnitude. In the article, we will use the average of the figures derived by each method, as shown in Table 3. The bottom line: About three-quarters of a trillion dollars — $746.3 billion — is invested in Caribbean hedge funds.

   Table 3. Estimates of Hedge Fund Assets by Domicile, End of 2006
                     (Dollar amounts in millions)

Domicile          Method I        Method II       Average of Two

 Bahamas           $24,172          $24,531           $24,352
 Bermuda          $107,028          $64,321           $85,675
 B.V.I.           $129,384         $171,733          $150,559
 Cayman Islands   $470,450         $525,503          $497,977
Total            $731,035         $761,558          $746,296


Source: Tables 1 and 2.


Among the most important clienteles of offshore hedge funds is the U.S. tax-exempt sector — mostly pension funds and endowments of charitable and educational institutions.

Under U.S. tax law, direct investment by tax-exempts in debt- financed activities conducted by most hedge funds would result in that hedge fund income being taxed as unrelated business income.

To avoid U.S. corporate tax, most hedge funds domiciled in the United States are partnerships or limited liability companies. The character of the income from these funds flows through the limited partner investors. If funds' investments are debt financed, a tax- exempt partner would be subject to unrelated business income tax.

To remove the taint of unrelated business income from hedge fund income, U.S. tax-exempts invest in hedge funds that are corporations so they can be shareholders that receive dividends not considered unrelated business income. To avoid corporate tax, those corporations establish themselves in tax havens. And so the tax-exempts invest almost exclusively in offshore funds. Accordingly, in this article, we attribute all investment by the tax-exempt sector in hedge funds to offshore hedge funds. From the results of its 13th annual survey of hedge fund managers, the Hennessee Hedge Fund Advisory Group estimates that pension funds account for 11 percent of hedge fund investment and that endowments and foundations account for 13 percent. Excluding funds of funds, those figures increase to 16.2 and 19.1 percent, respectively. Table 4 shows the figures and uses them (in combination with the HFR end-of-2006 estimate for total hedge fund assets) to derive dollar estimates of hedge fund investments for each major investment sector.

Our estimated total of $746.3 billion of Caribbean hedge fund assets from Table 3 is 76.46 percent of the $976.1 billion total of non-U.S. hedge fund assets from Table 2. To estimate investment by tax-exempts in the Caribbean, we will assume that tax-exempts invest all their assets in hedge funds outside the United States and that the ratio of Caribbean hedge funds to non-U.S., non-Caribbean hedge funds applies to hedge fund investment by tax-exempts. Therefore, we multiply total tax-exempt investment of $503.5 billion (from Table 4) by 0.7646. The product of those two figures — and thus our estimate for investment by tax-exempts in Caribbean hedge funds — is about $385 billion.

         Table 4. Estimated Distribution of Hedge Fund Assets
                          by Type of Investor
           (Based on HFR worldwide total of $1,426.7 billion
           for the end of 2006; dollar figures in millions)

Distribution of Investment
Investment in           Including       Excluding          Estimated
 Hedge Funds             All Funds     Funds of Funds         Assets


 Individuals/family       32.0%           47.1%             $671,388
 Funds of funds           32.0%            0.0%                   --
 Corporations/            12.0%           17.6%             $251,771
 Pensions                 11.0%           16.2%             $230,790
 Endowments and           13.0%           19.1%             $272,751
 Tax-exempt sector,       24.0%           35.3%             $503,541
   sum of previous

Source: First column is from Hennessee Hedge Fund Advisory
 Group press release, May 1, 2007,
available at; the
 other figures are the author's calculations.

Subtracting estimated tax-exempt investment of $385 billion in Caribbean hedge funds from the $746.3 billion total for all Caribbean hedge funds leaves us with $361.3 billion of hedge fund assets in the Caribbean not owned by tax-exempts. By dividing the percentage of investment by corporations (12 percent) by the percentage of investment by both corporations and individuals (12 percent + 32 percent, or 44 percent), we assume that 27.27 percent of hedge fund investment is held by corporations who are in full compliance with all tax laws. That leaves 72.73 percent of $361.3 billion held by individual investors.

Putting It All Together

We estimate that at the end of 2006, $262.8 billion has been invested by individuals in hedge funds domiciled in the Cayman Islands, the British Virgin Islands, the Bahamas, and Bermuda.

The data do not tell us the residence of these individual investors or the degree to which they are complying with their home countries' tax laws. There is, however, good reason to believe that a significant portion of the income from these investments goes unreported by investors because of the lack of systematic information sharing with onshore tax authorities by offshore hedge funds and their host governments.

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