Luxembourg has carved out a significant position as Europe's leading onshore fund domicile over the last 20 years. This has largely been based on the popularity of UCITS funds, and the fact that the UCITS brand is now one with genuine global investor appeal.
According to the Association of the Luxembourg Fund Industry (ALFI), Luxembourg funds (including AIFs as well as UCITS) have grown 23 per cent over the last 12 months to EUR3.58 trillion. The jurisdiction is home to nearly 4,000 funds and 14,000 fund units.
More than 75 per cent of UCITS funds distributed globally are based in Luxembourg; testament to the hard work put in by the CSSF, ALFI and other authorities to make it the go-to market for establishing a regulated fund. This achievement is not to be underestimated given that fund promoters can choose any European country from which to set up a UCITS for cross-border distribution.
The question now is, what must Luxembourg do to make the next transition, under the AIFM Directive, from being merely a funds centre to a management company (AIFM) centre of substance?
"Luxembourg has been driven to replicate the success it has had with UCITS funds under AIFMD," comments Alan Picone (pictured), global head of risk consulting services at Duff & Phelps' Kinetic Partners division and managing director of the firm's Luxembourg Management Company.
"To some degree, there might be a temptation to recycle some of the ingredients that fuelled the success of Luxembourg as a UCITS fund domicile. But the reality is, when you look at AIFMD, whilst you might be initially tempted to see it as an adjunct to the UCITS world, the factors of success should not and cannot be taken for granted."
For the Grand Duchy to carve out a leading reputation for management activities under AIFMD the landscape will need to change. It will be more than a simple adaptation. AIFMD is a multi-dimensional and complex piece of regulation and cannot be viewed as just an extension of the UCITS framework; the two are distinctly different.
A priori, Luxembourg has a number of advantages; thanks to UCITS, it has built a strong operational infrastructure, 42,000 professionals, some 190 UCITS management companies, 149 banks, etc. It has many of the key ingredients in place, but not all.
"I think it actually does have a competitive advantage, because of the quality on the ground, the infrastructure and so on, but it should not be viewed as being self-sufficient. What I mean here is it shouldn't be a matter of `case closed'. It can't rest on its laurels. Luxembourg has concluded that, actually, implementing AIFMD requires a lot of innovation, in particular for key functions such as risk management, which requires a shift in culture – you need real substance to support a far wider range of risk requirements. And by substance, I mean showing depth across all dimensions such as operations on the ground, expertise, systems, processes, staff, etc," says Picone.
There is, of course, a fundamental difference between the AIFMD and the UCITS IV directive. Whereas the AIFMD regulates the manager, the UCITS IV directive regulates the fund domiciled in Luxembourg. Therefore, Luxembourg needs to ensure that it becomes the default choice for AIFMs to register there and demonstrate its legitimacy; it cannot merely rely on managers coming there by relying on its reputation, which has, until recently, been that of an investment funds centre. Now it needs to attract more talent to write the next chapter of its legacy. To reinvent itself, even.
"UCITS involved exporting the trademark to the four corners of the earth, given that it has become a gold standard for regulated funds. Now, in the AIFMD world, it's about importing talent to build local substance; not to act as AIFMs per se, but to do the necessary work of substance to support AIFMs; and risk management is key to that," stresses Picone.
Clearly, with any challenge comes an opportunity. At Duff & Phelps' Kinetic Partners division, that opportunity involves providing precisely the sufficient level of substance to act as the AIFM on behalf of the investment manager. As Picone points out, AIFMD is multi-dimensional and will continue to be a challenge for managers to implement internally, irrespective of their size.
"What our firm has done to accommodate that opportunity is to act as a conduit between the asset manager and the regulator in order to fully comply with the Directive. Managers are used to thinking in terms of risk premium. What is the risk premium to absorbing the extra substance responsibilities as an AIFM? There isn't one. They take the added risks and at the same time pay for doing so," explains Picone.
To take advantage of the opportunity set on offer under AIFMD, Duff & Phelps' Kinetic Partners division has needed to adapt to the new paradigm from merely supporting the organisation of the fund, which was for so long the case under UCITS, to supporting the organisation of the AIFM.
"Luxembourg can no longer be seen purely as an organisational centre for UCITS funds, it has to also be seen as an organisational centre of substance to support AIFM activities," adds Picone.
Should they establish the AIFM in Luxembourg – either independently or by outsourcing it – investment managers are still free to choose where they domicile their fund(s). This will depend on their marketing and distribution strategy, and the investors they aim to attract but having a fund domiciled in Luxembourg alongside the AIFM will bring various synergistic advantages; the AIFM will be close to the fund's operations and key service providers, it will be in close proximity to the regulator and so on.
"We don't mind where the manager's fund is located but we recommend to clients to have their substance domiciled in Luxembourg. Over the years, the jurisdiction has developed a solid knowledge of regulations, of risk management capabilities, and remains, in my opinion, the primary centre to set up the AIFM. The corollary to this is to then say, let's offer a facility for asset managers who can be located anywhere in the world and who can appoint us as the Luxembourg-domiciled AIFM instead of having to establish their own substance on the ground. We can perform that role, and in turn sub-delegate the portfolio management function back to the investment manager.
"It's a pure outsourcing model under the AIFMD. The challenge is to make sure that you are able to provide the substance and risk management framework commensurate with the investment strategy; the same for PERE funds as it would be for hedge funds, the same operational controls etc. That is the challenge for Luxembourg: to effectively get these experts on the ground that can tick all the boxes required for regulatory compliance under the AIFMD," explains Picone.
In many ways, it makes sense for investment managers to appoint a third party AIFM in a well-established jurisdiction; one that already has a solid infrastructure and a lot of the necessary cogs in the wheel. "We have people on the ground, many of who have previously worked for the CSSF, fund administrators, and have experience across the value chain," states Picone.
The reality is that Ireland and Luxembourg, Europe's two leading fund centres, will in all likelihood become Europe's two leading AIFM centres. The more that fund managers choose Luxembourg to set up their AIFs, the more it should benefit from building out its AIFM capabilities for providing solid regulatory oversight and risk management – indeed all primary functions under the AIFMD aside from portfolio management.
"It's not always clear to understand why this assimilation has happened between fund centres and substance centres. That said, it is certainly part of Luxembourg's vision to become a leading centre for both funds and for AIFMs," concludes Picone.