Luxembourg must innovate to stay on top of funds distribution pile

While Luxembourg continues to be the funds hub of choice for distribution of investment products across European borders and beyond, for banks and investment houses, the Grand Duchy has started to face up to looming fears which may threaten its growth.

Figures released at the end of 2013 show Luxembourg’s managed fund assets at €2,615bn, 10 per cent up on the previous year. The authorities report an influx of €193bn in new money last year, with the landlocked country accounting for 50 per cent of Europe’s net sales of mutual funds.

More than 100 new providers came to Luxembourg during 2013, reports industry association Alfi, with Asian and Latin American product promoters also prominent, next to a strong showing of continental European players.

The country’s investments regulator, the CSSF, has already dealt with 37 of the 188 applications it has received for cross-border alternative investment vehicles under Europe’s AIFMD regulatory regime for alternative investments and is laying down a strong marker in this area, planning to double market share of all alternatives from 5 to 10 per cent over the next five years. In real terms, this means boosting hedge, private equity and real estate funds registered in Luxembourg from today’s €250bn to €500bn further down the line.

“Our most challenging objectives are in the hedge funds asset class,” confirms Alfi chairman Marc Saluzzi, acknowledging pressure from other centres including Cayman, the Channel Islands and Dublin. “We have more competition to overcome in this asset class and we have to be patient. But the trend is there.”

One of the latest innovations which Alfi has introduced for its membership is a feedback facility, including interviews with ‘C-suite’ level executives of 15 leading banks, following particular criticisms about the country’s regulator being overburdened and less responsive to requests for consultations than rivals in Ireland.

While 70 per cent of feedback about regulatory responses is broadly positive, Alfi acknowledges that occasional disquiet among fund promoters needs to be addressed, suggesting this should also be a two-way process. Fund promoters have sophisticated compliance and regulation specialists, who also need to step up to the plate, believes Mr Saluzzi.

“If your file is not well prepared, you may experience delays,” he says. “Some managers may put the blame on the regulator, but this can be unfair. It is also up to the managers to sharpen up their dealings with the CSSF and come up with better files.”

However, there is a tacit admission from the industry body that by attracting so much new business, Luxembourg has become a “victim of its own success” and may have slowed down its speed of dealing with clients. This challenge, according to Alfi officials, needs to be addressed by the whole financial centre, including the regulator. The regulator will also be recruiting more qualified individuals to deal with the increasing workload provided by “complex regulations” such as the AIFMD.

Alfi’s feedback from fund providers, all committed to Luxembourg as the cornerstone of their global funds set-up, showed a desire to focus on regulatory efficiency, costs and profitability, which has a long way to go to reach pre-crisis levels of 2006 and 2007.

One of the biggest concerns for fund managers based in Luxembourg is Europe-wide regulations which threaten to destroy or seriously curtail the thriving €200bn constant net asset value (Cnav) money market funds industry. Legislation expected from the European Commision in 2015 will require those funds wishing to maintain a constant net asset value of typically €1 per share, to field 3 per cent of their assets as a cash buffer.

Leading global asset manager BlackRock, which believes money market funds have made a huge positive contribution to the financial health of foundations, charities, hospitals and pension schemes, has run a series of calculations through its models.

The 3 per cent capital buffer will end up costing an asset manager at least three times any revenue it collects, according to BlackRock, making the much relied-on Cnav structure unviable to run.

“These provisions are problematic,” says Joanna Cound, BlackRock’s head of government relations and public policy for Emea and a panellist discussing money market funds at Alfi’s recent spring conference in Luxembourg. She calculates that up to 50 per cent of BlackRock clients using the current set-up, would not be prepared to switch to variable nav funds. Even those prepared to change fund would probably reduce investments.

The European Commission’s proposal to abolish ratings for money market funds also came under fire, due to its massive expected effect on end-investors.

“With a lot of institutions, it is a specific requirement that a rating must be available,” according to fellow panellist Jim Fuell, head of global liquidity Emea at JP Morgan Asset Management.

“A lot of charities and foundations do need a rating and are unhappy to invest without one,” confirms Ms Cound.

Speaking on the sidelines of the conference debate, Charles Muller, partner at consultancy KPMG and former Alfi director general, makes no bones about the seriousness of the regulatory threat.

“Changes to the constant nav money market funds industry in Europe will make it so complicated and costly to operate that it may well disappear,” he says. “Many countries in Europe, like Germany and France, don’t have these funds and don’t care. But for us it is a lost opportunity to have this fund product in Europe.”

Clients who want to carry on investing in Cnav products will switch to US or Cayman funds, leading to inevitable shrinkage of money market funds in Europe and Luxembourg in particular, he says.

In order to replace any lost business, Luxembourg must carry on innovating in new products and markets. One of the key regions for such development prioritised by Alfi is Asia. Luxembourg already claims to be one of the world’s largest players in domiciling RMB-denominated funds for international distribution, having been the first European jurisdiction to squeeze the product of a Chinese product provider (Harvest) into a European-style Ucits cross-border investment fund.

“Chinese asset managers will set up funds in Luxembourg to reach out to Europe and the rest of the world,” says Alfi’s Mr Saluzzi. As soon as he heard about the proposal of a mutual recognition arrangement between Hong Kong and China, he “immediately went to Hong Kong to see what Luxembourg Ucits can offer to the local industry.”

He has been re-assured by the China Securities Regulatory Commission (CSRC) that after initially letting in a handful of European Ucits vehicles for distribution, the potential offering from Luxembourg will be permitted to expand.

“We can explain to them why opening the door to Ucits is good for Chinese customers,” he says. “Are we confident that at some stage they will open the door to us? Yes, we are.”

From 2015, non EU fund managers will be able to passport Alternative Investment Funds (AIFs) to institutional investors in Europe. Luxembourg is therefore asking for reciprocal access to China. “We have given Chinese managers access through AIFMD, so they need to give this back to us,” suggests Mr Saluzzi. “We might not get the retail market immediately, but if we have access to the institutional market in China, we will be more than happy.”

Latin love affair

Indeed, five to 10 years ago, Asia was thought to be one of the biggest potential sources of new business for Luxembourg-based fund servicing groups. Custody banks were bracing themselves to service both European managers seeking Asian expansion and Asian banks creating funds in a Ucits format for European consumption. But the reality is that Latin American groups are showing just as much, if not greater, interest in using the Grand Duchy as a funds distribution hub.

“During the last two or three years, Latin American groups shifted their interest for distributing funds from the US to Europe,” says Georg Lasch, head of client development at BNP Paribas Securities Services in Luxembourg. “Banks in Brazil, Chile, Columbia and Mexico are all looking at creating funds in Luxembourg.”

Their main problem, he says, is that few brands have any resonance outside Latin America. Currently, and for the foreseeable future, it is still European fund houses that provide the lion’s share of Luxembourg’s business, with the UK in particular vastly increasing the number of funds established there. Mid-sized French managers, who used to use only domestic servicing capabilities in Paris, are also stepping up their foreign distribution.

“They have realised that they can’t avoid Luxembourg any more,” says Mr Lasch. “The biggest users of master-feeder capabilities [allowing promoters to pool assets while targeting niche markets] under Ucits IV regulations are French fund managers.” In the aftermath of the eurozone crisis, even Spanish managers are beginning to come to Luxembourg.

Among types of assets increasingly serviced in Luxembourg are “real alternatives” including private equity and real estate. This is where fiduciary companies are muscling into the custodians’ former exclusive feeding ground.

“The private equity and real estate business is the one that is booming more than any other,” points out Mr Lasch, giving an entry card to Luxembourg business for fiduciary companies, law firms and other new market entrants.

“Fiduciaries are also moving into the depositary banking space, while groups like us are moving into corporate accounting,” a traditional heartland of the fiduciary firms.  “Clearly, we will compete with each other. This will become an open battlefield and clients will decide the winners and the losers.”

Larger institutional investors are likely to choose a stronger banking provider rather than an accounting specialist with insufficient financial banking during a crisis period, he suggests. “Smaller, niche funds are more likely to go to fiduciaries.”

This trend is confirmed by Denise Voss, conducting officer at Franklin Templeton and a Luxembourg stalwart. “If you are looking for a global, transferable securities offering, recognised everywhere, you would go to the likes of JP Morgan,” she says. “But for a smaller, alternative fund, a fiduciary might be serving a niche. If you are such a small fund, becoming a priority client of State Street, JP Morgan or BNP Paribas might prove quite a challenge.”

The AIFMD is the key reason Jersey fund service provider Crestbridge started operating in Luxembourg in 2010, according to its country head Daniela Klasen-Martin. Major mainstream custodians are more likely to “struggle with real estate and private equity,” she says.

Luxembourg remains a funds centre of opportunity, believes Martin Vogel, CEO of MDO Services. He reports new clients more interested in selling cross-border into Asia, South Africa and Latin America, rather than just neighbouring European markets. “It is really the cross-border distribution hub that makes Luxembourg attractive,” he says.

Ucits woes

But there is a sinister danger lurking below the surface which many custodians and distributors, comfortable with steady business books, have yet to become aware of.

“The biggest challenge for us is not about Luxembourg itself, but about ruining the Ucits brand,” suggests Mr Vogel, with costs constantly being added to every product by additional regulations.

“Luxembourg receives 90 per cent of its revenues from Ucits. European and US regulators could ruin the whole Ucits concept and Luxembourg’s revenue stream.”

This new new trend to internal criticism, self-analysis and transparency – avoided by fund centres during the formative years of the 1990s – is a strong indicator that Luxembourg’s funds industry has matured faster than that some competing jurisdictions, believes Diana Mackay, consultant with Mackay Williams and one of the cross-border industry’s founding figures from the 1980s.

“This is a very mature industry here,” says Ms Mackay, mixing with old friends at the Alfi event in the functional yet soulless purpose built conference centre at Kirchberg. “They are not sitting and waiting for business to come in. For some time now, they have been very pro-active. They are almost constantly on the road, talking about solutions to current problems, more than any other centre or organisation I have come across.”

Luxembourg has thrived she says, because its practitioners have burst out of the ghetto of being a purely fund servicing and custody centre. “Key to them is not being seen as a service centre, but providing solutions to whatever issues asset managers need to deal with,” says Mr Mackay. “It’s not just about the back office anymore.”