The motto of the Grand Duchy of Luxembourg is ‘Mir wölle bleiwe wat mir sin’: We want to remain what we are. While the country’s approach to financial services legislation has often been rather bolder and more innovative than it is sometimes given credit for, Luxembourg nevertheless retains a reputation for conservatism and solidity that has served it well as Europe’s largest domicile and servicing centre for traditional investment funds.
But over the past decade Luxembourg has looked on enviously as Dublin, its great European rival for cross-border financial services business, has seen hedge fund administration, a small niche business in the mid-1990s, blossom into a major strand of the global asset management industry. Today the Irish Funds Industry Association estimates the volume of hedge fund assets administered across the country to have swollen to more than EUR700bn – still well short of the more than EUR2trn in fund assets serviced in Luxembourg at the end of August, but an amount far too imposing to be ignored.
In fact, far from ignoring alternative investments, Luxembourg has for several years been seeking ways to gain traction in the sector, and with some success. Helped by a series of circulars from the industry regulator, the Financial Sector Supervision Commission (CSSF), offering greater flexibility in areas such as risk diversification, there has been growing use of Part II of the country’s 2002 funds legislation – the first part of which introduced Ucits III funds into Luxembourg law – as a vehicle for hedge funds, or more commonly funds of hedge funds.
However, there were continuing restrictions on the growth of the business that ultimately stemmed from Luxembourg’s enduring vocation as a centre for traditional mutual funds, not least a requirement for approval of a fund’s promoter that placed emphasis not only on the good name of the firm and its principals but its track record. A rule designed for asset managers selling retail products across Europe made Luxembourg less than welcoming to fledgling hedge fund managers freshly breaking out on their own from an investment bank.
‘In the past, we were in a difficult position with the small and medium-sized hedge fund managers, for example traders wanting to create their own CTA funds investing in futures and options,’ says Eric Kata, director of business development for alternative investment at RBC Dexia Investor Services in Luxembourg. ‘The promoter requirements were too strict and made it difficult for them to be recognised as a suitable asset manager.’
By contrast, Luxembourg has been a prime beneficiary of the flexibility offered to managers under Ucits III to use derivatives and a certain degree of leverage in pursuit of strategies, such as equity market neutral and long/short equity, that previously were restricted to classic hedge funds and sophisticated investors. The current fad for 130/30 vehicles and similar ‘short extension’ strategies has helped to make so-called absolute return funds one of the most buoyant areas of the Ucits fund universe that Luxembourg dominates.
At the same time, the country took an important step to encourage the servicing of non-domiciled funds in the grand duchy when the Luxembourg Stock Exchange eased its rules to make it possible for funds established in the Cayman Islands and British Virgin Islands to be listed. Belatedly this move redressed the advantage offered by the Irish Stock Exchange as a major listing centre for offshore funds, which encouraged promoters to have them serviced in the same jurisdiction.
Luxembourg also quietly carved out a significant role in the European markets for property and private equity vehicles. The launch in June 2004 of the risk capital investment company or Sicar for venture capital and private equity investments helped to position the jurisdiction handily for the global buyout boom of the past three years, while it is also reckoned to be the world’s leading domicile for unregulated real estate structures, although this is hard to verify.
However, the holy grail of the European alternative investment sector has long been to develop an investment structure capable of challenging the Cayman mutual fund as the vehicle of choice for hedge funds worldwide. Within the past three years, as the number of Cayman funds has soared past 8,000, practitioners and regulators in jurisdictions including Gibraltar, Guernsey, Ireland, Jersey and the Isle of Man have all developed new products that seek to erode Cayman’s advantage in terms of cost, simplicity and speed to market.
Luxembourg’s contribution to this scramble to produce a structure that would capture the imagination of the market was the Specialised Investment Fund, brought into being by an act of parliament of February 13 this year. The SIF sought to address the concerns of hedge fund managers with features such as the absence of promoter approval, a flexible approach to risk diversification that largely eschewed quantitative investment restrictions, measures to facilitate the use of prime brokers alongside custodians, and limitations on reporting to suit managers’ desire to keep their strategies and positions confidential.
But what really caught the eye about the Luxembourg SIF was the absence of any requirement for the fund to receive authorisation from the regulator before it started raising money from investors or making investments. Instead, the legislation simply requires the promoter to submit its application to the CSSF within a month of the launch of the fund.
This provision was designed to reassure fund promoters that they would not face any regulatory hold-ups delaying the launch of their fund, and perhaps even more to send a message that Luxembourg intends to ensure that requirements designed to protect retail investors will no longer restrict the development of products aimed at a professional and institutional market. At the time the SIF was viewed as the European vehicle coming closest to the Cayman model, although subsequently Jersey has unveiled plans for unregulated funds that do not even require the local audit sign-off stipulated in Cayman.
What is certain is that the SIF has been warmly embraced in the marketplace and the number of vehicles being launched is growing at an impressive rate. According to the CSSF, no fewer than 337 SIFs were on the books at the end of August, although this total included around 200 legacy vehicles established under Luxembourg’s 1991 legislation on institutional funds as well as about 140 new SIFs. These funds, old and new, accounted for some EUR96.8bn in assets, an appreciable figure when compared with a combined total of EUR160bn for hedge fund and fund of hedge fund assets administered in the jurisdiction at the end of 2006.
That’s not to say that all or even most SIFs now being established are hedge fund vehicles. ‘Many types of product can be established under the SIF law, including transferable securities funds, money market funds, real estate funds, hedge funds and private equity funds,’ says Nina Kleinbongartz, product manager for alternative investments in Europe at Citigroup Global Markets in Luxembourg.
‘The opportunity to choose between the [contractual] FCP and [corporate] Sicav legal structures is beneficial for the real estate industry, because previously only the FCP structure was available.’ In the first months of the SIF regime, she notes, real estate accounted for some 40 per cent of applications; a large proportion of the promoters of these funds are from Germany.
The steady growth in the number of SIF applications over the past few months may well be down in part to service providers becoming more comfortable with a regime which in theory could leave them exposed, although not legally responsible, if a fund that had already launched fundraising and investment then saw its application for authorisation denied by the regulator.
While law firms, custodians and administrators may not be directly accountable to the CSSF for the conformity of SIF funds to the regulatory requirements ahead of the approval process, there are in reality checks and balances that will greatly reduce the likelihood of problems, according to Victor Chan Yin, a director with KPMG in Luxembourg.
‘Of course promoters will not take the risk of their funds not being approved,’ he says. ‘In practice service providers often go to the CSSF if they have new types of product. Discussions will take place to make sure there won’t be any problems with authorisation, but with time and experience service providers will be able to say yes for certain types of strategy because they have done it before.
‘In a way, although there is no prior approval from the CSSF, in practice there is some unofficial screening from lawyers and service providers based on their own experience. They would not want to be in a situation where the fund is launched, and then they have to dismantle everything. They are careful in what they are accepting and submitting to the CSSF.’
Michael Ferguson, a partner and leader of the asset management practice with Ernst & Young in Luxembourg, says: ‘Most players have taken a cautious approach with the post-ante approval process – many have had informal discussions with the CSSF and their advisers prior to launching their SIFs. I believe the post-ante process will evolve over time to become a real benefit in launching products once a certain protocol has developed around its use.’
SIFs may also be attracting interest from fund promoters because of the broader definition of the sophisticated and informed clients that are permitted to invest in them. ‘Previously these types of fund were aimed at institutional clients,’ Kleinbongartz says. ‘Now the definition includes private high net worth clients with a minimum investment of EUR125,000 or those with written statements from their bank confirming that they qualify as an informed investor.’
Luc Leleux, director of business development with Fortis Prime Fund Solutions in Luxembourg, believes that once the regime has bedded down the authorities may decide to ease its provisions even further, particularly regarding the minimum investment threshold. ‘I wouldn’t be surprised if after a certain period of time, the CSSF stepped back and examined how it might amend the regime,’ he says.
‘For example, they might decide to reduce the EUR125,000 minimum for a well-informed investor to perhaps EUR50,000, which would reflect the continuing convergence of traditional and alternative types of strategy. I believe that in 10 years time, traditional and alternative investments will have blended, and what we regard as alternatives will be increasingly viewed as mainstream.’
Kata believes that SIF business will continue to flow into Luxembourg at a rapid pace as the regime becomes more broadly known and understood as an alternative to a Caribbean domicile. ‘The door is open as hedge fund managers suddenly realise that BVI or Cayman funds are not the only possible solution for them,’ he says. ‘Luxembourg is a good alternative now for smaller managers and for the hedge fund community as a whole.’
He is echoed by Kleinbongartz, who says: ‘Cayman does not offer the regulated product as Luxembourg does, the proximity to other European countries, the multilingualism of staff and multicultural environment, the experience in due diligence and compliance expertise. Various countries will continue to impose reporting or other regulations governing the distribution of funds in their territory, with which Luxembourg has a great deal of experience. Domiciles like Cayman with minimal requirements have greater difficulty in responding to local regulators.’
It’s perhaps telling that complaints from fund professionals are much more muted these days on the subject of the subscription tax levied on fund assets, once an area of heated debate between the industry and the Luxembourg government, especially after Dublin grabbed the lion’s share of the pan-European money market fund business because the tax ate heavily into their wafer-thin margins.
SIFs remain liable to the subscription tax, but at a rate of just 0.01 per cent per year on net assets. ‘Given the very low level of the tax and with regard to the type of investment, I have not heard of this being an issue,’ says Chan Yin. Ferguson agrees, saying: ‘I do not believe it acts as a serious disadvantage. In my discussions with clients and others, this has never been a show-stopper.
‘Luxembourg investment funds have over the years established a brand that has enabled the opening of certain distribution channels not available to all domiciles. This is a key driver for those setting up SIFs – what is investors’ perception of the proposed domicile? The perception of Luxembourg as a fund domicile tends to be a much more important consideration than the subscription tax. It should also be noted that this tax does not apply where the SIF’s assets are for pension funds or retirement schemes.’
Ferguson argues that the SIF is helping to adjust external views of Luxembourg as its expertise in the alternatives sector gains wider recognition. ‘A great degree of convergence is occurring in the asset management industry, with the coming together of the three alternative sub-sectors, hedge funds, real estate and private equity, and to some extent between certain hedge fund strategies and traditional strategies,’ he says.
‘With developments like the SIF where you can have all three alternative sub-sectors within a single legal structure, Luxembourg’s clear lead in the creation of sophisticated Ucits III funds, and growing demand by institutional investors for lightly regulated alternative fund products, all the indicators are that Luxembourg, through early anticipation of these market trends and delivery of practical solutions to meet them, will continue to grow significantly over the coming years.’
