In its decade-long rivalry with Dublin as the main European centres for cross-border border investment fund services, it's generally acknowledged that Luxembourg missed a trick by failing in the mid- to late 1990s to spot the potential importance of hedge funds to an investment industry in which the Grand Duchy was already established as the continent's leading service centre.
It was only when the stock market slump that began in 2000 made traditional asset classes distinctly less attractive to investors and aroused a much wider interest in alternatives, especially hedge funds, that the industry, regulator and authorities in Luxembourg launched efforts to restore its competitiveness in a market in which Ireland had been allowed to establish itself as the jurisdiction of choice.
The growth in the hedge fund industry during this decade has swelled business for a now tried and tested approach in which offshore hedge funds are domiciled in the Cayman Islands, and to a lesser extent the British Virgin Islands or Bermuda, listed on the Irish Stock Exchange and administered by a Dublin-based service provider. One of Luxembourg's key challenges has been to provide an alternative to this approach, while building on greater interest among investors and promoters, particularly of funds of hedge funds, for structures subject to a higher degree of regulation than that applied in the offshore islands.
Although the Grand Duchy still has a long way to go to catch up Ireland as a hedge fund servicing centre, industry participants both within and outside the country agree that it has been successful in putting itself on the map and becoming a serious competitor to Dublin. That's put down principally to legal and regulatory changes that have encouraged the sector's development, but also to the changing nature of the hedge fund business, with growing involvement by major institutions that already have a significant presence in Luxembourg as investors, fund promoters and service providers.
Says Christophe Bodart, head of product management with RBC Dexia Investor Services: 'Luxembourg has always been and remains a reputable domicile for investment funds. This success is mainly due to the regulator's promptness in implementing new European directives, as well as the top quality offering of service providers operating within a stable political environment. 'Thanks to a certain extent to more flexible regulations, mainstream fund managers are using more sophisticated financial instruments to succeed in their business and in search of pure alpha. The Ucits III directives now allow mainstream fund managers to make intensive use of derivatives, under certain conditions. Luxembourg service providers that want to retain existing mainstream clients that have progressively entered the alternative business must adapt their offerings accordingly.'
According to the Luxembourg Funds Industry Association (Alfi), the country now boasts at least 39 providers of administration services to hedge funds and funds of hedge funds. The latest in the association's series of half-yearly surveys indicates that at the end of 2005, 363 funds of hedge funds domiciled and/or administered in Luxembourg accounted for assets totalling EUR72.3bn (USD90.7bn), up 31 per cent from EUR54.6bn (USD68.5bn) a year earlier, while the assets of 264 Luxembourg-serviced single manager hedge funds grew by no less than 131 per cent, from EUR12.9bn (USD16.2bn) at the end of 2004 to EUR39.7bn (USD37.3bn).
The Grand Duchy still has a long way to go to catch up with Ireland. According to the most recent survey by the Dublin Funds Industry Association, in June last year the net asset value of alternative funds serviced in Ireland totalled USD474bn, including USD289.1bn in single-manager hedge funds and USD150.1bn in funds of hedge funds.
However, the industry in Luxembourg is encouraged by a new mentality on the part of the authorities that has emerged over the past few years. In the past the country's financial services regulator, now known as the Financial Sector Supervisory Commission (CSSF), was not renowned for its flexibility and openness to innovation. But industry members and analysts now acknowledge that attitudes have changed and applaud the steps taken by the CSSF to provide the changes the sector wants without compromising the country's reputation for effective oversight of the investment business, essential to the success of the mainstream retail funds sector.
In particular, a circular issued by the CSSF nearly five years ago kick-started the business by offering fund promoters the maximum of flexibility compatible with a sure regulatory touch. Says Henry Kelly, a specialist funds consultant who set up Alfi's new products committee and was its chairman until last year: 'We had a late start, but the CSSF circular 02/80 clearly put Luxembourg on the map as a jurisdiction of choice for single hedge funds and funds of hedge funds.'
New legislation to boost hedge funds This process is set to be taken further by new legislation, currently at the draft stage, which will consolidate the existing rules in the process of replacing a 1991 law on institutional investment vehicles. It is proposed that the concept of a qualified investor, already available for private equity and venture capital structures, will be extended to hedge funds, enabling them to benefit from lighter regulatory treatment. Says Kelly: 'The draft law that has been drawn up should improve the attractiveness of the domicile further. It proposes an extension to hedge funds of the provisions of the 2004 legislation on Sicars [risk capital investment companies], which introduced the notion of a qualified investor to Luxembourg law. This will substantially widen the opportunities here by creating a new category of funds for which the regulation will be more flexible.'
For the time being, he says, Luxembourg is unlikely to go down the route followed by a number of other alternative fund jurisdictions of focusing regulation entirely on the service provider rather than the product. 'Under the proposed law, fund vehicles will still be subject to CSSF regulation, although this could be less constraining than in the past,' Kelly says.
'The issue of service provider-based regulation is all connected with the debate about what should follow Ucits III, and whether retail funds should move away from product-based regulation toward service provider-based regulation. That debate is going to go on for a very long time, and it's not clear whether Ucits will go in that direction. As far as hedge funds and the replacement of the 1991 law are concerned,it will still be product-based legislation.'
Bodart notes that even in the past, there was more flexibility available in Luxembourg than was widely recognised. 'The regulations provide an appropriate legal framework and limits, while remaining flexible enough for fund promoters to satisfy their objectives, and the supervisor may allow exemptions to the standard rules where justification is provided,' he says. 'Although it was not a major area of its business, Luxembourg was already administering alternative funds before the issue of dedicated regulations. These funds were established under Part II of the Luxembourg funds legislation, and had to comply with rules aimed at protecting the final investors. But originally most hedge funds were domiciled in less regulated jurisdictions and Luxembourg administered just a few of them.'
The ability of the Grand Duchy providers to service offshore funds received crucial impetus two years ago when a ministerial decree, complemented by a CSSF circular, authorised the Luxembourg Stock Exchange to accept for listing foreign funds including those established in Cayman and the BVI - a crucial element in attracting administration business that Dublin has exploited with great success.
According to Didier Prime of PricewaterhouseCoopers, the difficulty in listing offshore funds on the Luxembourg exchange was widely regarded as a disadvantage for the Grand Duchy by comparison with Dublin: 'The decision of the Luxembourg authorities to permit the listing of offshore funds will have a very positive impact on its development as a centre for alternative investment products.' So far it is hard to quantify the impact of the change on Luxembourg's hedge fund administration business, but anecdotal evidence suggests that most service providers are handling at least some offshore fund business, usually domiciled in the Cayman Islands. This represents a relatively new departure for the Grand Duchy in that compared with Dublin a much larger proportion of its alternative investment business is domiciled as well as administered in the jurisdiction.
Says Bodart: 'The decision of the Luxembourg Stock Exchange to quote foreign hedge funds is certainly promoting their administration in Luxembourg. Luxembourg has already attracted some foreign funds and we are convinced we will capture additional opportunities in the future.' Another leading hedge fund administrator is Caceis Bank Luxembourg, which has a total of EUR48bn in alternative assets, comprising more than EUR16bn in single hedge funds, more than EUR11bn in funds of hedge funds, and the rest in structured products, real estate and private equity funds. Says product manager Vincent Beaujeu-Dumontel: 'The industry is really booming at the moment, and within Caceis it's not alternative any more, but a major client segment. In terms of custody and fund administration it accounts for more than onethird of the total assets we service here.' 'We service funds from all jurisdictions here in Luxembourg, including those such as Bermuda, Cayman and the BVI that don't need a local administrator or custodian. We have a lot of Luxembourg-based funds, mostly Sicavs [open-ended investment companies] set up under Part II of the legislation, but also some set up under the Ucits III directive, as we start to see some hedge fund strategies managed in Ucits vehicles.'
Says Kelly: 'Approaching 20 per cent of all funds of hedge funds worldwide are domiciled in Luxembourg, so it's already attained a substantial market share in this area. For single hedge funds it's a rather different story because hedge fund managers have in general wanted as few restrictions as possible and have tended in the past to domicile their funds in jurisdictions like Cayman and the BVI, having them administered in Dublin and listed on the Irish Stock Exchange. But as the market grows, hedge fund managers and promoters are starting to understand there are alternatives to that process. The figures speak for themselves. More and more promoters are going for Luxembourg as the jurisdiction of domicile and of administration. 'The advantages of Luxembourg are its central location at the heart of western Europe, the fact that it is we ll recognised, stable and with a good reputation, it has very broad-based service providers, it's multilingual, and it already has EUR1.5trn in fund assets domiciled here. By contrast Dublin is geographically at the periphery of Europe, it is primarily English speaking, and it remains a long way behind Luxembourg in terms of the servicing of Ucits.
'Dublin has been very successful in hedge fund listing and administration, but not especially so in hedge fund domiciliation. If you look at the volumes of assets domiciled in Dublin, it's no further ahead than Luxembourg, which has been late in the game in attracting single hedge funds, but the data shows it's catching up extremely fast.' Beaujeu-Dumontel also believes that the new legislation, which is expected to be passed by early next year at the latest, will boost Luxembourg's ability to compete with Dublin. He says: 'It will build a flexible framework for hedge funds quite close to that for the Sicar, and specifically will deal with all the issues related to hedge funds, such as the possibility to appoint a prime broker, generous rules on investment and flexible regulation by the CSSF. There will be no restrictions on investment strategies and no legal minimum investment. It's quite flexible. It will be an interesting development for Luxembourg as a centre.'
He argues that in terms of regulation Luxembourg and Dublin - where Caceis also has an administration business - are now fairly comparable. 'The reasons for choosing Luxembourg or Dublin is partly where you come from - French investors often set up their structures in Luxembourg now rather than Dublin, and the Germans also. Each location has its own natural investors, and Luxembourg has an advantage for continental Europe.
'Another competitive advantage of Luxembourg is staffing. It is becoming difficult for Dublin, because it is not so easy to attract good staff [from abroad] to meet the massive growth of alternative products. We don't have this problem because we can bring in people from Belgium, Germany and France to handle the growth in assets. If alternatives continue to boom, we have the staff to cope.'
Bodart believes that Luxembourg could increase its attractiveness further by attracting prime brokers to the jurisdiction. He says: 'Obviously prime brokers play a crucial role as far as hedge funds are concerned. So far, they are mainly based in the US and UK, and sometimes in Asia, although some are establishing a presence in continental European centres like Paris. If Luxembourg continues to increase its global market share in alternative investments, it might make sense for prime brokers to set up business here too, even if operational tasks are still performed by their head office.'