With the global financial markets remaining fragile, it is still unclear to what extent the secondary effects of the credit crunch will impact the fund industry in Luxembourg, but industry experts are
With the global financial markets remaining fragile, it is still unclear to what extent the secondary effects of the credit crunch will impact the fund industry in Luxembourg, but industry experts are confident that despite the possibility that assets under administration will shrink in tandem with global equity markets, the jurisdiction is well placed to sidestep the effects of the liquidity crisis and indeed to take advantage of the situation.
The country’s secret weapons include pragmatic regulatory developments, convergence between traditional and alternative asset classes and new marketing opportunities in regions such as the Middle East and Asia.
But in order for the industry to develop, industry players and the national authorities must take full account of the turbulence and be careful in the steps they take to progress. A key challenge for Luxembourg, say market participants, is to ensure that the level of skills and expertise within fund administrators, custodians and other service providers meets the ever-increasing requirements of managers and investors and the growing complexity of new, more flexible structures, innovative transactions and the growing geographical diversity of investments.
There is already evidence of assets under administration declining as a result of the credit crunch and the total has slipped back slightly from a peak of EUR2.12trn at the end of October 2007, although the trend has been positive since the end of January. "Assets under administration remain close to the EUR2trn level, largely unchanged from a year ago," says Claude Noesen, who has just joined Fortis Prime Fund Solutions from HSBC as a director of sales and relationship management.
"Meanwhile, the number of funds has increased by some 800 units year-on-year. This shows that the loss of assets in the Ucits market triggered by the sub-prime crisis has been offset by an increase in number of funds and asset volumes under Part II of the Ucits legislation and above all in the Specialised Investment Fund area."
Access to external capital markets and the collection of funds from investors has been noticeably more difficult in 2008, although industry players say that funds that benefit from a strong asset base and steady performance are well placed to avoid the effects of the global downturn.
Last year saw the first downturn in the total assets of Luxembourg single-manager hedge funds since the Luxembourg Investment Funds Association (Alfi) began gathering statistics earlier this decade. From a peak of EUR77.1bn at the end of June, the total fell to EUR62.9bn by year-end. The sharp downturn affected notably funds domiciled and administered in the grand duchy, which declined by 10.5 per cent over the year to EUR48.8bn, while funds administered in Luxembourg but domiciled elsewhere showed a mere 4 per cent year-on-year increase to EUR14.1bn.
By contrast, the fund of funds sector continued to thrive, ending 2007 with total assets of EUR132.1bn. Funds domiciled and administered in Luxembourg saw their assets grow by 40.1 per cent to EUR74.2bn at the end of the year, while funds under administration only rose by 1.5 per cent to EUR57.9bn. Despite the fall in assets of single-manager funds, the sector as a whole grew by 22 per cent in 2007 to some EUR195bn. The year saw the total number of funds serviced in Luxembourg remain stable at 603, but the number of separate portfolios administered grew to 1,686.
Nevertheless, industry members say potholes along the road to growth include an increasingly evident decline in the willingness of banks to extend credit to funds, especially funds of hedge funds. This is not only because the credit quality of funds is under scrutiny and banks are tending to tighten credit standards across the board accordingly, but because the banks have had to trim their own balance sheets because of factors such as diminished liquidity, higher costs of funding and capital adequacy rules. This ultimately means higher margins applied to fund of hedge fund financing.
Says Pierre De Backer, a transaction manager at Equity Fund Services: "First, there is a clear need for improved due diligence by firms and investors to manage their risks and to take informed decisions. Secondly, the market situation has highlighted the importance of liquidity and reputational risk in driving the assessment of exposure to complex products. Finally, the market needs to promote proper risk assessment of less liquid instruments."
But he adds: "In the longer term, access to new geographical markets and new types of products such as SIFs and risk capital vehicles will ensure the continued success of the Luxembourg marketplace as the development centre for both traditional and alternative investment funds."
Luxembourg’s attractiveness as a domicile and as a servicing centre gathers strength from the diversity of its products and regulatory innovations, but notably its extremely strong brand for mutual fund distribution in Europe. The effect of developments such as the introduction SIF last year or the Sicar (risk capital investment company) in 2004 has also played an important part by attracting hedge funds, private equity and other alternative asset classes.
Amendments to the Sicar legislation that would allow these vehicles to add multiple compartments or sub-funds, which has not been possible up to now, are now before parliament, and promise to make this structure, already widely used for private equity and opportunistic real estate funds, even more attractive. "The amendments will allow promoters to create sub-funds for different investment policies or types of investor," De Backer says. "There will no longer be requirement for a net asset value to be calculated and the share premium will be taken into account in the calculation of the EUR1m minimum share capital."
The changes will make the Sicar structure more competitive with SIFs, according to Olivier Sciales, a partner with law firm Chevalier & Sciales. "It puts the Sicar on the same basis as SIFs or Ucits funds," he says. "This is important because it means investors can be sure that in the event of the bankruptcy of the vehicle, the compartments are fully segregated."
According to Noesen, there will also be clarification in the coming weeks on the prime broker-custodian relationship as required under the SIF legislation. "This should be positive for launching hedge funds under the SIF regime in Luxembourg," he says. "Driven by the requirements of sophisticated but risk-adverse investors, we expect the recent relocation of unregulated offshore hedge funds and fund of hedge funds into regulated Luxembourg SIFs to become a trend."
Luxembourg will also certainly benefit from a solution to the deadlock over the European Union’s Ucits IV legislation – a situation to which the desire of Ireland and Luxembourg to ensure that administration of Ucits funds must be carried out in the fund’s domicile has admittedly contributed. The proposals promise solutions to various issues raised by market participants during the consultation process, including a new attempt to achieve a simplified prospectus and easier fund mergers. Says De Backer: "Luxembourg will be massively supportive of Ucits IV if some of the controversial issues are knocked off the final proposal."
While Luxembourg is seeing increased demand for a wide range of alternative funds, De Backer believes it will continue to experience a boom particularly in real estate fund and especially funds of real estate funds. "These funds generally offer investors more diversification with less overall risk than funds investing directly into real estate," he says.
The funds industry is experiencing a combination of centralisation and diversification as providers seek to centralise their core product offering as far as possible while searching for best of breed third-party solutions for some niche products. Thus many larger players may have their core fund platforms serviced by one administrator while their hedge funds or real estate products are handled by a more specialised provider. This process is set to develop as larger players broaden their support for niche products.
Noesen believes that convergence between traditional and alternative asset classes will mean sharply increased levels of compliance, corporate governance and due diligence for alternative funds. "Fund complexity, the increased use of complex derivatives and increased transaction volumes during the present period of sharply increased volatility, the latter being the seed par excellence for most hedge fund strategies, all point toward substantial infrastructure requirements, such as technology and staff," he argues.
Luxembourg has long been considered fertile ground for consolidation in the administration sector, since many asset managers continue to service their own funds in-house, but currently analysts see more existing players seeking to expand their breadth and depth in the field than players looking to exit. However, outsourcing opportunities are visibly growing as the demands of fund product from a complexity and a volume standpoint pose challenges smaller and purely in-house administrators.
Recent years have seen a series of transactions in which global institutions with massive custody operations swallowed up specialist hedge fund administrators, including the acquisitions of Bisys by Citi, IFS by State Street, Bank of Bermuda by HSBC and Tranaut by JPMorgan. This provided them with a direct business pipeline and enabled the global giants to offer all services, including credit, under one roof.
But there is speculation that as lending banks’ balance sheets shrink, some of these hedge fund services businesses may be divested in fire sales. In addition, Noesen says, new smaller administrators are likely to set up shop in the future as the large firms raise their minimum assets under administration or custody to levels that rule out many start-up managers. But he notes: "Luxembourg may not be able to attract these very interesting smaller providers in the same volume as other jurisdictions because the SIF still requires a custodian, albeit with a lighter role than in the past."
Nevertheless, Luxembourg is continuing to benefit from inflows of business from regions outside Europe and the Americas, such as the Middle East and Asia, where the Ucits brand has earned the trust of regulators and investors and Luxembourg funds make up a substantial share of some countries’ fund markets.
De Backer believes hedge funds will increasingly be domiciled in jurisdictions such as Luxembourg. "In recent years, we have experienced a shift from offshore to onshore funds due to the institutionalisation of the hedge fund industry," he says. "Institutional investors tend to be more comfortable with lightly regulated onshore centres, which try to balance minimal regulation with the degree of flexibility that managers require to pursue their chosen strategies."
Apart from existing competition in Europe from established centres such as Guernsey, Luxembourg also faces a challenge from emerging financial services jurisdictions such as Malta, but industry players are confident that the increased openness of the market will open up more opportunities. Says Noesen: "With all the new countries joining the EU and young people more prepared than ever to move around within Europe and beyond, the chance to excel in a financial centre like Luxembourg is unique."