Regulatory issues a double-edged sword for alternative fund sector
With the credit-led crisis that brought the onward global march of the private equity industry to a screeching halt two years ago now starting to fade into the background, activity in the sector is starting to rebound in terms of deal-making, exits and to a lesser extent fundraising. Luxembourg, as one of the leading private equity fund domiciles and servicing centres within the European Union, appears to be well placed to capitalise on the upturn.
The crisis has made investors more wary of less regulated vehicles and domiciles, and also given them greater leverage over the structuring decisions taken by private equity houses. In these circumstances, a jurisdiction that is an EU member state, offers two tried and tested regulated vehicles and possesses an extensive network of double taxation treaties is an obvious likely beneficiary.
Luxembourg also boasts a comprehensive service infrastructure derived in large part from its position as the world’s second largest (after the US) fund domicile, with decades of experience in servicing funds of all types and a skilled international workforce drawn from practically every nation on the globe, not to mention the country’s much-cited advantage of multilingual capabilities in dealing with an internationally diverse clientele.
The 999-square mile (2,586 square kilometre) country sandwiched between Belgium, France and Germany has long mitigated any local shortage of skills, or simply manpower, by drawing on the resources of its hinterland, with the financial services industry accounting for a significant proportion of the more than 140,000 cross-border commuters who travel into Luxembourg to work every day. They also play an important role in keeping salary costs within reason in what has long been reckoned the richest country in the world.
In parallel with investor sentiment, regulatory developments across the globe appear to be driving business toward the grand duchy. With legislative proposals on both sides of the Atlantic promising to make lightly-regulated offshore centres less attractive for managers of alternative funds, Luxembourg seems to offer the right combination of regulatory rigour and flexibility that facilitates investment in less mainstream strategies or asset classes.
But the planned changes, especially the EU’s proposed Directive on Alternative Investment Fund Managers, is far from an unalloyed benefit either for private equity houses that might domicile their funds in Luxembourg or for the companies that provide services to them. The final outline of the directive remained uncertain as this report went to press, the product of a reconciliation procedure between differing versions approved by a European Parliament committee and the EU’s Council of Economic Affairs and Finance Ministers.
However, grave concerns remain about mooted disclosure requirements for private equity-owned firms, as well as the responsibility of fund custodians in a broad range of circumstances for losses of fund assets under their aegis – a measure precipitated by the role played by European feeder funds as conduits to Bernard Madoff’s fraudulent investment management business.
The fact that the AIFM Directive could make it more difficult for alternative funds and managers based outside the EU to gain access to European investors might, of course, help drive promoters toward Luxembourg, as well as Ireland and Malta, its main competitors for fund domicile and service business within the 27-nation union. “We’re certainly not seeing an exodus from Guernsey in any sense,” says Tabatha Hawkins, marketing manager of specialist fund services firm Ipes, which established a Luxembourg operation at the end of last year.
However, she adds: “Some promoters are looking to work with a provider like ourselves that has a Luxembourg office as well, to give them flexibility.” Hawkins’ colleague Simon Henin, managing director of the Luxembourg office, agrees that the AIFM Directive is unlikely to hurt Luxembourg as a private equity centre and could conceivably help it, even though the grand duchy’s government has not been among the EU members pushing to get the legislation passed.
Chris Adams, the Luxembourg-based global product head for alternative funds at BNP Paribas Securities Services, notes that the draft directive’s proposals on the role of the depository bank could have a major impact on the business upside down. He does acknowledge that the requirement that an alternative fund appoint a single depository, responsible for receipt of investor funds, safe custody of the assets and oversight of valuation procedures, could on the face of it benefit groups such as BNP Paribas with pan-European networks.
However, Adams argues that major issues exist in terms of the liability of the depository bank for a full restitution obligation, including as a consequence of events that may be outside of the depositary’s control. While the directive may allow for the mitigation of this risk, service providers believe that that a more detailed understanding needs to be forthcoming.
“In the light of the current uncertainty, we’ll have to look very carefully at how we service single hedge funds that have a prime broker,” Adams says. “We will do due diligence on these organisations, but if fraud were to take place we might be liable for making restitution of the assets.”
While these particular circumstances do not specifically affect private equity, they are casting a shadow over alternative fund custodians, which are now wondering whether there is any economic way of offering custody services in view of the much-heightened risk providers will face. “History has shown that when frauds occur, it is often as a result of deficiencies in the audit system, in the regulatory system and the legal system,” Adams says. “It would be very difficult for us to spot that, yet we might be at risk.”
“An organisation like ours that is very pan-European-focused has certain advantages, but if the AIFM Directive has a seriously negative effect overall upon alternative assets that are managed or domiciled in Europe, there will be no winners. We hope that the latest draft translates into a common desire to protect investors and mitigate systemic risk, but also to allow the industry to continue to flourish. No-one benefits if it all falls in on itself.”
Claude Noesen, the managing director for Luxembourg at Prime Fund Solutions, the alternative administration business that Fortis Bank Nederland has just agreed to sell to Credit Suisse, is also concerned about the implications of the AIFM Directive for custodians. “They are looking for scapegoats in Brussels,” he says. “If there are new rules to follow, we’ll comply with them, but there will be costs attached to it. The industry will not work for free. It’s frightening that custodians should face an obligation to make restitution of assets under all circumstances. We do due diligence on the big prime brokers, but how much due diligence can you do?”
Of course, this issue faces custodian banks servicing funds anywhere in the EU, and members of the industry are confident that Luxembourg’s competitive position remains strong by comparison with its direct rivals – especially the legal infrastructure that has been put in place for the private equity sector over the past few years. “It has successfully developed two lightly regulated fund vehicles for private equity and venture capital, the Sicar [risk capital investment company] and SIF [Specialised Investment Fund],” says Benjamin Lam, an audit partner and head of private equity at Deloitte Luxembourg.
Since its launch in 2004 more than 235 Sicars have been created with nearly EUR20bn in assets, Lam notes, while the number of alternative funds established through a SIF structure, which was introduced in 2007 and is designed to accommodate hedge and property funds as well as private equity, has swelled over the past two years to more than 1,000.
“With the AIFM Directive looming, Luxembourg is one step ahead in that it has already created a lightly regulated fund vehicle, and already has a lot of expertise in this area of regulated funds” he says. “The industry recently created the Luxembourg Private Equity and Venture Capital Association which represents the interests of all the players based here – many of the biggest private equity houses have a physical presence in Luxembourg.”
Already Luxembourg is benefiting from the rebound in private equity activity, according to industry practitioners. “We are seeing an increase in demand for the launch of private equity funds, not just venture capital or seed capital but proper private equity, especially funds investing in mid-caps,” says Olivier Sciales, a partner with the Chevalier & Sciales law firm.
“Established managers are looking to take majority stakes or shareholdings in companies in a variety of sectors, because they see a lot of opportunity with valuations so low, and prospects are improving for exits through IPOs or trade sales.” But Sciales acknowledges that in terms of the rebound, fundraising is still lagging behind. “In some cases private equity fund promoters are facing difficulties in getting commitments in place at the moment that they want to launch.”
Nevertheless, Lam is convinced that the grand duchy’s competitive advantages will ensure that it remains a jurisdiction of choice as the industry returns to something like full throttle. “Given the increasing regulation on the financial sector as a whole and on the private equity industry, Luxembourg will benefit from that,” he says. “It’s a location that is recognised not just for private equity but as the second largest fund industry overall in the global market after the US. It has experience and expertise in dealing with structures with multiple investors and in investment into a wide range of countries, including emerging economies.”
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