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Luxembourg upholds its hallmark of quality under AIFMD

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Luxembourg's funds industry is marching ahead as Europe's leading funds domicile if figures released by the Association of the Luxembourg Funds Industry (ALFI) are anything to go by. According to ALFI, March saw the Grand Duchy enjoy record net sales and a growth of AUM. 

Total assets now total EUR3.53 trillion, a 3.55 per cent increase for the month and a 13.89 per cent increase since the start of the year. In addition, net sales topped EUR49.92 billion.

Over the last 12 months, Lux-domiciled funds have seen their net assets grow more than 30 per cent. The low interest rate environment has been a decisive factor, according to former ALFI Chairman, Marc Saluzzi, "in the sustained growth of assets under management by the investment fund industry". Saluzzi notes that the "diversified geographical origin of fund promoters" in Luxembourg demonstrates that it remains the domicile of choice for the international asset management community.

Saluzzi was replaced by Denise Voss as Chairperson of the Associated Luxembourg Funds Industry (ALFI), which helps to promote Luxembourg's funds industry to the global investment community, in June this year. Reflecting on this year's growth, Voss says: "Through July we have seen net growth of EUR500 billion, over half of which has been net inflows into Luxembourg funds. The amount of new money coming in reflects, I think, the diversification of Luxembourg in terms of asset classes, and the markets in which Luxembourg funds are investing in. UCITS funds, for example, are sold to investors in over 70 countries worldwide. 

"With respect to the alternatives fund industry, we see the AIFM Directive as helping further diversify Luxembourg's fund industry." 

Indeed, whilst Luxembourg has long established itself as Europe's leading onshore fund domicile for regulated funds, there is still a lot of work to do to attract global alternative fund managers to set up AIFs in the Grand Duchy. Many non-EU managers are still grappling to comprehend AIFMD, and whilst there are signs that real estate funds are growing in number, they still only make up around 1 per cent of all funds in Luxembourg. 

There are currently around 380 regulated real estate funds in Luxembourg.

"It's developing quickly but is still small," says Frederic Perard, Managing Director, Luxembourg, BNP Paribas Securities Services. "For some of our global managers who have such funds, which have become more global in their reach rather than domestic, there is a growing need to avail of depositary lite services to comply with AIFMD."

An AIFM hub as well as a fund hub

It is important that ALFI, and other Luxembourg institutions, don't sit back and expect the money to keep flooding in. Whilst there are nearly 4,000 funds domiciled in Luxembourg, the vast majority are UCITS. The next challenge is to make Luxembourg a hub for both AIFs and AIFMs.

"We have to continue to make Luxembourg attractive as an international funds centre. We communicate often with the Luxembourg government since the fund industry is such an important part of Luxembourg's economy, representing some 8 per cent of its GDP. With respect to AIFMD, it is still going through a bedding-in phase as it was only formerly introduced in July 2014. 

"The next phase will be on new products and distribution under AIFMD – I think it's still early days but we are seeing alternative umbrella funds under AIFMD being established, using that promise of AIFMD to offer regulated alternative funds to institutional investors who want alternative strategies in a regulated format," comments Voss.

Asked whether Luxembourg can indeed become a global hub, not just for funds but managers as well, Alan Picone, global head of risk consulting services at Duff & Phelps' Kinetic Partners division and managing director of the firm's Luxembourg Management Company, is unequivocal. 

"Absolutely. There's no AIF product trademark as we see with UCITS. Under AIFMD, only the manager is regulated. The fund can be anything: a Cayman fund, a Luxembourg SIF. This is what Luxembourg's challenge is: to not only build substance in terms of managers establishing operations and staff on the ground, but to also encourage investment managers to choose Luxembourg to establish new funds under the Directive," says Picone.

"Not only AIFMs, but also AIFs, are increasingly finding a suitable home here in Luxembourg for a wide range of alternative fund management activities thanks to the opportunities that AIFMD offers. However, this does not mean that a migration of portfolio management function and competence centre can be realistically expected of course. Whilst AIFMs are based in Luxembourg, the vast majority of them typically sub-delegate portfolio management to the entity where the actual trading/portfolio management activities are conducted."

With respect to fund structuring activity in 2015, Perard observes that much of the work has focused on private equity and real estate funds, particularly the latter. 

"Whereas before, real estate funds were very domestic we see an increasing trend towards global investment. Luxembourg is very well placed because of its historical trend in supporting cross-border assets. Also, just as we are seeing in the hedge fund and private equity space, we see real estate loan funds being created. They have been a clear trend so far this year," confirms Perard. 

RQFII funds

He notes that another structuring trend is the establishment of RQFII funds, which give managers the ability to invest directly into China's A-shares equity market as well as trade interbank bonds. China managers are looking closely at Luxembourg to establish funds as well, to attract global investors. The recent introduction of the Shanghai Hong Kong StockConnect programme in November 2014 has also provided a catalyst and prompted further interest to avail of Luxembourg's RQFII quota. 

"Whereas previously we saw Bank of China being used, now we are seeing ICBC, China Construction Bank, as well as HSBC and Citibank being used. Our approach has therefore been to develop sub-custody arrangements with these names as more RQFII funds get launched in Luxembourg," says Perard. 

On the one hand, Luxembourg is able to sell funds to investors in China and Asia Pacific more broadly, and on the other hand, give global investors access to fund products that invest directly in to China and the Asia Pacific region. 

This is helping to further reinforce Luxembourg's international reputation. 

"Many Chinese banks have chosen Luxembourg as their European headquarters and are now showing interest in offering products that give exposure to China. It is putting Luxembourg at the forefront of international fund product development," says Paul van den Abeele, Partner at Clifford Chance (Luxembourg). "We are also seeing interest from investors in Shariah-compliant funds that give them exposure to Sukuk bonds, for example. Indeed, on the capital markets side, Luxembourg tries to lead the way with respect to RMB-denominated bonds, Sukuk bonds; it is always looking to drive innovation." 

Part of that innovation, in recent times, has been to update Luxembourg's legal regime for private equity and real estate managers. Alongside the existing SCS regime, which has a legal personality, managers can now choose to avail of the Special Limited Partnership (SCSp) with no legal personality. The SCSp regime brings greater flexibility to help attract managers used to the UK LP regime, by allowing them to come to Luxembourg to leverage the cross-border expertise of the domicile as a hub for fund distribution under AIFMD.

"Nowadays, close to three quarters of private equity funds are structured as an SCS or an SCSp and we are seeing demand both for regulated and unregulated funds," says Van den Abeele. "With the SCSp, fund promoters are more willing to consider Luxembourg to structure PE funds as they can readily transpose their Limited Partnership Agreement and fund terms into a Luxembourg partnership structure. 

"German investors, for example, have always been more comfortable investing in Luxembourg structures than UK partnerships. Now, Anglo-Saxon managers can benefit from using the same key terms in the fund as they would use in a typical UK partnership arrangement. Providing a structure that more broadly appeals to continental European investors creates a perfect world, where the PE manager can use Luxembourg to combine different groups of investors. 

"That's why we are seeing interest build in the SCSp partnership structure. We've structured quite a few this year, for real estate assets, private equity assets, debt assets, both for open-ended funds and closed-ended funds." 

The RIF – a new fund innovation

The next proposed fund vehicle development in Luxembourg is the restricted investment fund or `RIF', for which a Bill of Law is being introduced. The idea is to create a framework to capture unregulated AIFs that operate in less traditional asset classes. 

There are some fairly exotic strategies in Luxembourg: wine funds, art funds, aviation funds etc. 

The RIF would cater to these more esoteric types of strategies to create a proper framework rather than leave them completely unregulated. 

One source who asked not to be disclosed, when discussing the possible introduction of the RIF, says: "If you are in a more exotic asset class, the liability of your valuations is more arbitrary than if you operate in an established framework where the standards have been in place for a longer time; as is the case for PERE funds and hedge funds that use the Luxembourg SIF."

"The RIF is something that will aim to hit the same objectives as other fund products; flexibility, accommodation and innovation. Luxembourg is very much aware that in order to attract asset managers, and grow as an AIFM centre, it must also offer attractive fund products," suggests Picone. 

One firm that has been building substance in Luxembourg since 2011, to provide fund administration as well as, more recently, a SIF umbrella platform service, is Circle Partners. It now has five people on the ground and has a clear perspective on what it takes to do business in the Grand Duchy.

"I would stress that any manager who intends to have a fund in Luxembourg must visit the place to have a feeling of how business is done. It's a key requirement in my view. If not, you're just going to question everything that is expected of you in terms of documentation submission and so on," says Michel van Zanten, a Switzerland-based director of Circle Partners. 

This sounds like an obvious point but what it shows is that everybody has a reputation to uphold in Luxembourg. It has one of the highest reputational standards and puts huge effort into putting Memoranda of Understanding in place with the rest of the world; hence why it was able to secure the RQFII programme with the Chinese authorities. 

"The authorities take the same rigorous approach for every new business entity and every new fund that wants to set up in Luxembourg; it's all about maintaining a hallmark of quality. Due diligence is real and so is eye for detail. If you still think you can just call a few lawyers, banks and administrators, and bolt it together you'd be wrong. It's pretty much impossible if you haven't met the people.

"Every global player is in some way represented in Luxembourg so managers will always find a solution. But it isn't a domicile for everybody. People who need to get a strategy up and running within 10 weeks will find that a challenge, even if the manager is very well established. On the other hand, if you want a fund that is widely distributable, broadly accepted by investors, then Luxembourg is a fantastic domicile and it could justify the extra time to get it right," says van Zanten. 

ALFI's Voss says that because Luxembourg has a small domestic market it has always had to look outside for its business opportunities. 

"This is important because it means it is open to different business models and that is an enormous advantage. Even the small size of Luxembourg is an advantage because it means you can speak to a wide variety of industry professionals and government officials in a short amount of time. 

"To illustrate how seriously Luxembourg safeguards its reputation, the CSSF recently created an inspection unit to focus on management companies (including AIFMs). Like the UK and Irish regulators, they had many AIFM licenses to review in the lead up to the introduction of the AIFMD. They want to ensure that they have been set up properly and are doing what they said at the time they applied for a license," concludes Voss. 

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