Luxembourg poised to raise funds game

If there is one financial centre poised to take advantage of the regulatory tsunami sweeping through Europe, it is landlocked Luxembourg, at the heart of the continent, and one of the first players to accommodate European Ucits legislation on marketing of investment products across borders into its domestic structures.

The first ever Ucits fund was launched in Luxembourg 25 years ago in 1988. Today funds with assets worth almost €2.5tn are managed there, 80 per cent of these registered under the Ucits directive.

The latest regulatory challenge of AIFMD – the Alternative Investment Fund Managers Directive – should see Luxembourg further extend the services it offers to global fund groups, keen to distribute products across Europe and beyond.

The directive will enforce tight regulation on the staff and operating structures of fund houses looking to sell ‘alternative investments’, including hedge funds, private equity and real estate vehicles, across European borders.

Regulatory topics were among the key issues of discussion at the spring conference held by the Association of the Luxembourg Fund Industry, better known as Alfi.

“Both AIFMD and Ucits V will bring fundamental changes for Luxembourg custodians; this is not the time for them to lean back,” was the verdict of regulatory specialist Silke Bernard, managing associate, Linklaters LLP in her summary of developments to the Alfi forum.

Distributors will have other regulatory concerns, including draconian US Fatca reporting rules and sweeping Mifid II adjustments to provisions on financial product sales. “But the focus will be on Luxembourg’s competitive advantage, which is about cross-border opportunities and allows us to offer a high quality service to foreign funds,” says Ms Bernard.

This notion of helping outside investment houses address distribution needs is vital to the past and future success of Luxembourg as a centre for funds registration and servicing, confirms Alfi chairman Marc Saluzzi.

“Promotion is very important to us as we do not have local markets,” he says. “We have to sell our funds in Europe, Asia and Latin America.”

Prioritising its plan of action for future impact in the funds industry, Alfi will be looking to attract more firms launching funds highlighting socially responsible investment and sharper corporate governance.

A previous plan for Luxembourg to specialise in Islamic investments has been sidelined, amid concerns about anti-money laundering and know-your-customer regulations, combined with a lack of product appetite.

“Next to the Ucits and AIFMD business, responsible investing is the area in which we want to make an impression,” says Mr Saluzzi. “We are trying to explore new opportunities in terms of distribution and need to convince fund managers outside Luxembourg of the services we can provide.”

ALTERNATIVE ANGLE

Many Luxembourg-based groups are convinced that building AIMFD-branded hedge and private equity funds for distribution across Europe and beyond will be a natural next step for them, as they already have the experience of registering and marketing long-only Ucits funds for a similar marketplace.

“The aim of AIFMD is to move the alternatives world into the Ucits context and Luxembourg is prepared for that,” was the view of William Jones, founder of Luxembourg funds consultancy ManagementPlus, who chaired a panel on AIFMD at the Alfi event.

He is seeing increasing interest from US managers, previously with an anti-European outlook, in setting up Luxembourg funds for marketing across nearby borders, as well as further afield.

“It’s no longer just about Cayman,” says Mr Jones. “And we are talking about people who were once addicted Cayman users.”

Some fund practitioners claim the step up from setting up Ucits to AIFMD-badged funds will be a relatively straightforward transition. “We know exactly what to do, as we are already doing many similar things for Ucits funds,” believes Noel Fessey, Luxembourg-based managing director of Schroder Investment Management.

“Exercises such as calculating risk exposures and a fund’s daily nav [net asset value] will be no more complicated for AIFMD than Ucits and folding our company into the new regulatory structure will not be a problem.”

But despite the feeling of smugness that sometimes appears to sweep through the Luxembourg funds industry – particularly during Alfi conferences – AIFMD opportunities are also surrounded by banana skins. “The further you get from Luxembourg, the less positive AIFMD appears,” says Mr Jones.

Starting with ‘confusion’ about the need for such restrictive legislation, the debate moved through the three cs to ‘concern’ about relationships with depositaries, to eventually centre on ‘costs’, claims Marcel Müller-Marbach, head of equity investment legal service, European Investment Funds.

“Compliance with the directive will not come for free and there is a big debate on who will pay the fees,” he says. “Fund managers will either need to increase their fees or compromise their margin. My view is that investors will eventually have to pay for the increased costs of compliance.”

Law firms trying to service the demand report a sense of uncertainty, if not panic, among many fund clients.

“Given the pace of change, it is very difficult for the client to stay on top of things, particularly when the regulator has been unable to clarify some of the rules,” says Paul Willing, chief executive officer of Ogier Fiduciary Services, a business unit of the Jersey law firm, which has recently opened up offices in Luxembourg. He reports much talk and interest among US firms about using AIFMD-compliant Luxembourg funds to sell products into Europe, but little action as yet.

Despite the looming AIFMD July deadline, few funds are yet fully compliant, confirms Charles Muller, a member of the global leadership team at consultancy KPMG, with most attempting to avoid being regulated under the controversial – and many believe unnecessary – legislation if they can. “Those who have the ability will do everything they can to stay out of it,” trying to adapt alternative funds to be regulated under the more user-friendly Ucits or ‘private placement’ regimes, he says.

“Managers in the US will do private placement for as long as they can, rather than marketing funds,” he says. “Clients in the US are now aware that AIFMD exists and know enough to say ‘we don’t want to be in it,’ with remuneration of most concern to them.”

With senior management, CEOs, portfolio managers and ‘risk-takers’ within fund groups subject to restrictions on pay and bonuses, some investment groups are exploring the possibility of setting up funds in non-EU, tax favourable jurisdictions.

The AIFMD stipulates that 60 per cent of a portfolio manager’s bonus must be deferred and only half can be paid in cash. Similar rules are also likely to be included in the Ucits V package. “Some managers will organise themselves to reduce the number of people in Europe, or if that doesn’t work, just get out of Europe altogether,” warns Mr Muller.

The notion of alternative managers adapting their strategies, to squeeze into Ucits definitions, rather than face the uncertainty of increased costs through AIFMD has been gaining traction for the last couple of years.

“For the US investor, investing in onshore Luxembourg is better than Cayman,” says Makis Kaketsis, chief investment officer of MSK Capital Partners LLP in London. “Ucits is an extension of onshore products and a brand with increasing resonance in Asia. If the costs are low enough, it is an increasing benefit to be onshore.”

But despite their acceptance in Asia, Luxembourg funds are faced with a new threat from the East. This comes in the shape of a potential mutual recognition agreement between China and Hong Kong, which would initially allow Hong Kong-domiciled funds to be sold into China, meaning the Ucits brand will not longer be all-conquering across
Asia. But even more significantly for Luxembourg, Hong Kong alternative funds are likely to be marketed into Europe under the AIFM Directive.

“A lot of global asset managers might want to start up Hong Kong funds and stop selling European funds, which would be a worry for Luxembourg,” says KPMG’s Mr Muller. “There is too much divergence between Australia and Singapore to agree on a pan-Asian Ucits-style structure, but Hong Kong-based funds are very much on the agenda.”

If global managers become comfortable producing funds in Hong Kong, then the territory could gain increasing importance as a distribution hub, putting a dent into the aspirations of European competitors. From 2015, institutional funds domiciled in Hong Kong can be marketed to European clients through the AIFMD, something most Luxembourg practitioners are quietly aware of. “That could provide serious competition for Ireland and Luxembourg,” suggests Mr Muller.

Custodians and transfer agents are also recognising the Eastern threat. “The issue of Hong Kong and Chinese funds could prove to be a big upset for Luxembourg,” says Frédéric Pérard, who heads up BNP Paribas Securities Services for Luxembourg, Dublin and the Cayman Islands. “And there are likely to be more bilateral fund marketing agreements between other countries in the region. But much will depend on what the Chinese want to do.”

The practicalities of distributing in Asia, especially conducting timely valuations for different markets and setting up master-feeder funds are also of much concern to service providers.

“There is an increasing concern about how to grow distribution capacity, particularly for Asia and Latin America,” says Mr Pérard. “The retail distribution debate is moving to local versus global funds, particularly in Asia, with some countries now refusing Luxembourg and Irish funds.”

Although BNP Paribas has made “significant wins” over the last two years, especially in Luxembourg, UK and Asian private equity, real estate and loan funds are setting up in Guernsey in rising numbers. Luxembourg needs to speed up progress on rolling out regulations to combat this threat from rival centres, he believes.

“If countries like Luxembourg can develop limited partnerships and trusts, they will have exactly the same offer as the Channel Islands and will provide fierce competition for them,” says Mr Pérard.

DIFFERENT INTERPRETATIONS

Some believe regulations such as AIFMD can be adapted differently by competing centres, to benefit countries such as Luxembourg. “There can certainly be different interpretations of rules between jurisdictions, as they have different starting-points,” says Jérôme Wigny, partner at Luxembourg law firm Elvinger, Hoss & Prussen.

But this concept of “regulatory arbitrage” between financial centres has worked both ways, believes KPMG’s Mr Muller. While some countries have competed to lower the bar to entry in order to encourage new business, others have raised the bar to show they are better regulated than competitors.

“Luxembourg regulators are trying to take a more liberal approach, following closely what Ireland and the UK are doing. Particularly on the AIFMD, we try to watch those countries,” says Mr Muller. “But if you are too liberal, Esma [the European Securities and Markets Authority] will rope you in. Luxembourg remains a little country and needs the support of bigger ones.”

In order to achieve this, Luxembourg has announced its aim to introduce automatic exchange of information on interest income with European tax authorities by 2015.

Criticism of Luxembourg somehow following the Cyprus path of disaster is also quickly deflected by Alfi’s Mr Saluzzi. “You cannot compare us with Cyprus, where two banks raised a lot of money and invested it in Greek sovereign debt, which was not a reliable business model,” he says. “Luxembourg is a fully diversified financial centre with fund, bank and insurance business. We have 142 banks, most of them subsidiaries of large financial groups, with high levels of solvency.”