Luxembourg funds – a market leading, agile industry with sustainability on the horizon
Jérôme Mullmaier, Maude Royer and Kevin Emeraux
With its fund formation practice now featuring more than 40 professionals, Loyens & Loeff has been at the forefront of recent market trends and is able to share some hints about upcoming challenges and opportunities. This includes a look back at the SCSp success story, the ever-increasing complexity of the regulatory and tax landscape, fund financing solutions and some perspective on how geopolitical developments could translate into further growth for the financial center (post Brexit environment, ESG).
Unrivalled growth supported by strong market demand and an innovative toolbox of fund vehicles
Leveraging on the UCITS success story, it is undisputed that Luxembourg has established itself as a prime domicile, not only for retail but also for alternative funds (AIFs). The market went through a strong acceleration over the last decade, with assets under management (AuM) in the Luxembourg fund industry now totaling in excess of 5.5 trillion, with a 20% increase over the last 12 months. The upward trend of the alternative funds industry is global. Essentially it is driven by the track record of alternative assets, which have demonstrated their ability to produce yield and outperform more traditional strategies in the ongoing low interest environment, which is yet to show any sign of easing up.
On the back of strong investor demand, Preqin (a respected data analyst in the alternative space) is expecting the AIF industry to reach an all-time high of USD 14 trillion by 2023 (up from 8.8 trillion at the end of 2017). The Covid 19 pandemic definitely created some disruption, but the industry has shown strong resilience, with AuM continuing to go up (albeit at a slower pace in the first few months after the pandemic outbreak). With hindsight, fund managers were not all on an equal footing to weather the storm. Many of the largest managers raised successor funds, sometimes largely featuring existing investors of predecessor funds. Completing the investor-onboarding process on a remote basis rapidly became standard practice. Travel bans were more problematic for first time, less established managers building up their track record.
Taking a step back, it’s essentially the innovative efforts put in by Luxembourg to build up the right toolbox of fund vehicles which has fueled the growth of the local alternative funds industry over the last decade. The SCSp regime introduced in 2013 when implementing AIFMD was a game changer for the industry as a whole. The RAIF regime which followed in 2016 gave the industry another boost.
With the SCSp, Luxembourg is equipped with an unregulated fund product largely comparable to Anglo-Saxon partnership structures but eligible for the AIFMD passport. Market appetite for this structure emerged very quickly, both on the manager and investor side. After a few years of consolidation, it has now become the default structure for private equity sponsors. A recent survey released by the Luxembourg Private Equity Association (LPEA) has shown that more than 50% of Luxembourg private equity funds are now established either as unregulated SCSp or reserved alternative investment funds (RAIF), noting that RAIFs may themselves also opt for the SCSp as their legal form.
Turning threats into opportunities
Interestingly, what seemed like threats also turned out to be growth drivers for the Luxembourg fund industry. Take for instance the recent international tax developments, such as the OECD BEPS Action 6 and the increased requirements for “economic substance” and “business purpose”. There is now convergence between regulatory and tax developments as they drive fund managers to consolidate their funds and holding structures in the same jurisdiction and to bring additional staff and business functions to that jurisdiction. Because Luxembourg has so far managed to maintain a favorable regulatory and tax environment while adhering to international standards, Luxembourg has bolstered its place as a prime European hub for fund houses.
The Brexit vote in 2016 was also an accelerator – fund sponsors are since then on the lookout for distribution-proof solutions, and seamless marketing across the EU requires at present an EU fund and an EU manager. Some large UK asset managers which already had some substance in Luxembourg have applied for their own Lux AIFM license in the aftermath of the Brexit vote, while others (mainly in the mid-market segment) opted to appoint third party AIFMs, as they await AuM growth before considering a potential AIFM application. One billion of AuM is generally the trigger for the benefits of running a sponsor-owned AIFM being likely to outweigh the merits of the host AIFM model (at least from a cost standpoint).
A quick glance at recent structuring trends
On the structuring side, another recent trend is how tax aspects are taking center stage, and this early on in the product design phase. Traditionally, the need for bespoke tax advice essentially came into play when deploying capital after completing the fundraising phase. The ever-increasing complexity brought by recent tax developments such as the ATAD Directives (which include anti hybrid rules) are now requiring tailored advice upfront. Tax concerns have become a major point of attention when opting for the right fund product to preserve its tax neutrality. More than ever, fund formation requires a holistic approach where legal, regulatory and tax aspects are of equal relevance.
The continuous growth of the Luxembourg fund industry has also led to a surge in fund finance activity. Credit providers have responded to the growing demand for financing from investment managers and are offering bespoke solutions. While capital call subscription credit facilities are still used and continue their steady growth, permanent leverage facilities have become increasingly popular to meet the liquidity needs of fund managers over the entire investment period. Besides, ESG aspects have now reached the fund finance market, and it is expected that ESG will increasingly impact the sector through the implementation of green financing (use of proceeds-based approach) and ESG-linked financing (key performance-based approach).
What the future holds
The resilience of the industry demonstrated by the steady growth of AuM suggests there can be substantial confidence for the years to come. Fund managers have accumulated dry powder (uncalled commitments) during the pandemic which they are now under pressure to put to work.
There is no room for complacency though. Competition is picking up on many fronts. Ireland has recently amended its limited partnership legislation to make it a real contender to the SCSp for illiquid strategies. Available statistics also show Ireland ahead of Luxembourg in terms of AIFM applications filed by UK managers in the aftermath Brexit.
The UK investment management industry is also lobbying hard to establish the UK as a key domicile for funds offered to non-European investors. In the same vein, a UK long term investment fund regime (UK LTF) has recently been unveiled to expand the traditional investor base of AIF products beyond core institutional/professional investors. This regime which brings in sufficiently “sophisticated” retail customers as eligible investors for AIFs meeting certain standards will become a competitor to the ELTIF regime, which is in the process of being revamped by the European Union to put down some barriers restricting access to retail (or less wealthy) investors to AIF products.
Retail investors access to alternative assets is much in demand but still is a largely untapped market full of potential given the regulatory complications and lack of suitable products. There are high hopes surrounding the revamped ELTIF and UK LTF regimes to embrace the “retailisation” of AIF products and get it on track.
Looking ahead, the uncertain political landscape of this new post Brexit environment could bring some new opportunities for Luxembourg. On the distribution side, UK MIFID firms lost the passport largely used by their investor relations team previously to market their funds across the bloc. The industry has been very innovative over the last few months to offer workarounds (secondments, chaperoning by host AIFMs) but they all bring uncertainties on the regulatory side. In the long run, fund sponsors traditionally operating with UK based distribution teams will likely be incentivized to build up some EU regulatory presence to secure their fundraising efforts (especially if the European Commission does not grant the UK regulatory equivalence). Attracting some distribution teams in Luxembourg would be a tremendous achievement for the country.
A somewhat related political consideration is responding to all the ESG needs following the flurry of associated regulations now in force (SFDR, Taxonomy Regulation). Confronted with hefty disclosure and reporting obligations, fund sponsors will undoubtedly need support from the Luxembourg ecosystem. Designing innovative tools to assist with ESG data collection and reporting should now become an immediate priority. Some food for thought for the service provider community at large!