Although perceived as a very safe and conservative country, Luxembourg has embraced innovation in a number of ways that continue to set it apart from many of its competitors.
In many respects, Luxembourg got it right in 2013 when it shook things up a bit. It embraced AIFMD, having already been comfortable with the UCITS regime. At the same time, the Luxembourg authorities finessed the permissions under the depositary regime, opening it beyond banks to service providers such as independent fund administrators, as well as also introducing new Luxembourg Limited Partnership legislation and the creation of the Special Limited Partnership.
"Those three developments, from a legal and regulatory perspective, serve as one of the compelling reasons for why Luxembourg has become such an attractive jurisdiction over the last couple of years," comments Andrew Brizell, Head of Legal and Group Head of Depositary Services, Aztec Financial Services (Jersey).
In his view, the ability for managers to appoint non-bank partners to deal with their administration and depositary requirements under AIFMD was a real "light bulb moment" for the jurisdiction.
When appointing a counterparty to provide fund administration services, a fund manager doesn't want to have to appoint several other counterparties. Historically, in Luxembourg, only banks were mandated to provide depositary services prior to the introduction of AIFMD. In a private equity context, this was relevant to SIFs and SICAR, both being regulated fund products.
When AIFMD was introduced, the regulation was widened out to allow other non-bank financial institutions to provide those depositary services. These are often referred to as `depo lite' services. PE managers can now benefit from a single counterparty advantage.
"We perform a standard depositary role for closed-ended funds, covering cash monitoring and asset verification together with fund oversight, which includes monitoring investment restrictions, valuation processes and investor transfers," explains Brizell.
Luxembourg has innovated its product universe so that fund sponsors, hedge or private equity, have a wide range of options. On the regulated fund side they can consider the Specialised Investment Fund (SIF), which can be established as a Luxembourg Common Fund (FCP) that has no legal personality and managed by a management company, or as an investment company with variable capital (SICAV).
There are two choices of limited partnerships, called a common limited partnership (i.e. société en commandite simple, or SCS) and a special limited partnership (société en commandite special, or SCSp), which can either be regulated or unregulated. And finally, the most recent product innovation called the Reserved AIF (RAIF), provides an unregulated fund option.
In addition to product innovation, Luxembourg's well-established management company ecosystem is thriving under AIFMD as more and more investment managers look to appoint outsourced AIFMs.
"When AIFMD was first introduced there was some reluctance among US managers and investors to do business in Europe but now they are coming back in full force," says Pierre de Backer, Principal, Investment Funds, Asset Management and Corporate at Deynecourt, a leading legal and corporate services firm. "They understand, for example, the concept of the third party AIFM – something that is not used in the US – where they can rank the services of an AIFM in Luxembourg, which in turn delegates the portfolio management back to the manager in the US.
"I think the reason Luxembourg is proving quite attractive to private equity managers and those running private debt funds is because there are fewer constraints; particularly those running private debt funds as compared to the loan origination QIAIF in Ireland."
The CSSF has highlighted certain aspects applicable to AIFMs when they engage in loan origination participation or creation. The manager of the fund must ensure that all the aspects and risks of the loan origination activity it engages in are properly addressed, they must ensure they have a proper organisation and governance framework in place, and they must ensure that they have the necessary expertise and skill combined with technical resources.
"These are all important considerations when the CSSF is going through the approval process for one of these funds, or if the AIFM is doing its due diligence for a RAIF application," confirms de Backer.
More funds driving up standards
One only has to walk down the street today to notice that there are demonstrably more managers coming to the jurisdiction. Private equity managers who previously only considered offshore jurisdictions are now utilising Luxembourg because of the clear cross-border distribution advantages that come from establishing Luxembourg vehicles. In light of this, local service providers have adapted to market changes to offer their services at more competitive rates.
"There are new players coming in all the time. Luxembourg used to just have all the big name law firms charging higher fees, but there are a growing number of smaller shops who offer attractive rates," confirms Peter Jakubicka, Business Development Manager at Circle Partners.
Aztec, for example, now has 180 staff in Luxembourg and as Brizell states: "We see the jurisdiction as a significant growth market going forward."
Today's environment is quite challenging, not just because of regulation but because of the higher standards that fund managers now expect of their service providers. If anything, this is playing to Luxembourg's advantage.
"When clients come to Luxembourg they do so because it is well known but also because they know there is a large high quality service provider network here," says Timothe Fuchs, CEO of Fuchs Asset Management. "If they are fund managers who already operate in Europe, or if they are non-EU managers looking to have a European passport, they benefit from the knowledge that exists here in Luxembourg.
"We are now entering our third year offering ManCo services under AIFMD. Our SICAV platform is really working well for those wishing to establish UCITS funds in a sub-fund arrangement. It is quite complicated to create dedicated UCITS vehicles for EUR30-50 million in AUM. For alternative fund managers, however, they prefer standalone vehicles for their strategies. Overall, we have 50 clients using our AIFM services."
The need for higher standards is especially important for those AIFMs who take on new RAIF applications. It is essential that the AIFM understands the strategy because the CSSF is looking out to the AIFM to basically play the role of the regulator.
"When the regulator is doing checks and appraisals of Luxembourg AIFMs, it absolutely wants to make sure that the AIFM has the right people sitting on the various committees, are they asking the right questions, etc. We are focusing on all alternatives – hedge, PE, RE and infrastructure, as well as private debt. We want to make sure we have the right technical abilities to support these asset classes. That's where we are building our infrastructure right now," remarks Kavitha Ramachandran, Director of MS Management Services.
Small or mid-sized managers are going to have second thoughts about whether or not to set up a standalone AIFM entity in Luxembourg because of the costs involved; anywhere up to EUR500-600K to set up the management company. "Managers need to do cost benefit analysis to determine the feasibility. That's why the third party AIFM delegated solution makes so much sense to a lot of alternative fund managers," adds Ramachandran.
One benefit of the RAIF compared to the other unregulated structure, the Special Limited Partnership (SCSp), is that it has the flexibility to be incorporated as a SICAV and potentially be used as an umbrella structure; this is not possible with an SCSp.
At present, however, there is little evidence of this activity.
"The fund manager could use a number of different compartments under the RAIF umbrella for different investors, different variations of the strategy, etc. There aren't many cost differences between platforms provided by service providers, where managers rent cells in the structure in a sub-fund arrangement, and setting up their own standalone fund," explains Jakubicka.
"Most managers would prefer to have their own dedicated fund because they get to keep the track record and, moreover, it avoids risks. Even though the assets and liabilities are ring-fenced, in an umbrella structure, what if one of the managers on the platform suffers bad publicity? It could contaminate the other fund managers on the platform and lead to instant redemptions in the cell."
RAIF platforms can be interesting to managers wishing to share the costs but this is more applicable to very small managers; those with EUR10-20 million in AUM.
"Clients need to begin with something. We can support them on our SICAV platform where they can choose to launch a UCITS or a SIF. The SICAV umbrella allows a manager to test out a strategy in the market and if they enjoy some success, then they can move to set up a standalone entity after two or three years," says Fuchs.
He says that although a RAIF can be incorporated in just a couple of business days there are several operational steps that need to be taken. Realistically, it takes one and a half to two months to get all the pieces in place.
The green bond revolution
Looking more broadly at Luxembourg's financial services industry, one cannot overlook the innovation taking place at the Luxembourg Stock Exchange (LuxSE).
Last year, LuxSE launched the Luxembourg Green Exchange (LGX), a platform dedicated exclusively to green, social and sustainable securities. A total of 124 green, 13 social and three sustainable bonds are currently displayed on LGX, representing an issuance value of over EUR64 billion.
"In the space of one year, LGX has grown to cover 50 per cent of all green bonds listed on exchanges," confirms Robert Scharfe, CEO of LuxSE.
To capitalise on the green and sustainable investing, LuxSE and the Shanghai Stock Exchange (SSE) expanded their co-operation by signing an addendum to an existing Memorandum of Understanding (MoU) to launch the first `Green Bond Channel' between China and Luxembourg.
"China today is the biggest issuer of green bonds in the marketplace. It has high ambitions to raise hundreds of billions of green bonds and has declared that at the same time this market should be open to international investors so that the financing of projects such as the Belt and Road Initiative (BRI) could be funded both internally and externally.
"We wanted to create a bridge between China's green bond market and the international investment community, who use the services of our platform to keep abreast of what is going on in the green and sustainable investment market. That is where the idea for the Green Bond Channel was born," explains Scharfe.
LuxSE is also one of the largest offshore RMB trading centres on the continent and the largest venue for green bonds in Europe.
This expanded cooperation agreement will enable SSE-listed green bonds to be displayed on LGX.
"We are convinced that exchanges, which provide important infrastructure for capital markets, can play a major role in developing the green finance market," asserts Scharfe. "Cooperation between exchanges, in that respect, is very important. Back in May this year, we launched the first of a series of green bond indexes that the SSE has established, which we agreed to display simultaneously on their platform and our platform. This gives people a view of the performance of SSE-listed green bonds.
"Now we are going one step further and making the underlying constituents of the indexes visible to international investors. All key information on underlying bonds will be made available on the LGX platform in English. That is what I mean about bridging the Chinese market with the international investor community," says Scharfe.
Furthermore, on 30th October 2017, ICBC Luxembourg – the European arm of one of China's largest banks – and LuxSE jointly announced the bank's inaugural issue of green bonds to be listed on Luxembourg LGX. The EUR1.8 billion offering is the bank's inaugural "Belt and Road" green bond.
ICBC is the first Chinese issuer to provide a second opinion by the Center for Climate and Environmental Research, Oslo – CICERO. The green bond framework was marked as "dark green".
"I do believe, given the huge expense of financing the BRI infrastructure project, that Chinese banks will be regular issuers of green bonds going forward. There will be a large number of infrastructure project possibilities to finance, not just the BRI.
"The ICBC announcement is an important step forward. It follows an important deal last year when the Bank of China announced a USD2.8 billion multi-tranche green bond offering," says Scharfe.
Forging closer links with China is a clear statement of intent by Luxembourg and shows the commitment it has to growing all facets of its financial industry.
"Luxembourg has built good relations with China and a number of other countries in Asia and the Middle East," confirms de Backer. "We see Sharia products being established, for example, and now Chinese green bonds are being listed on LGX. I believe the advantage for Luxembourg is being able to have a full cross-border operational framework in place for these bonds. Chinese companies will be able to simultaneously list green bonds in China and Luxembourg.
"The fact that the bonds' data will be displayed on LGX for international investors will be very beneficial, especially if one considers transparency requirements under MiFID II for instance."
A financial technology hub emerges
One other area of innovation is technology. As Lee Godfrey, CEO of KNEIP remarks, technology start-ups are very visible in Luxembourg: "The various incubators across the town are very supportive of those companies and help introduce them to companies like us."
While the US has Silicon Valley and London has the less glamorous sounding Silicon Roundabout, there are signs that the Grand Duchy is developing a FinTech hub of its own.
Martin Guérin, founder and owner of Nyuko, is set to take over the role of CEO of Luxembourg City Incubator. Along with the Luxembourg City Incubator and Luxembourg House of Financial Technology (LHoFT), Nyuko will move into the 4,200 square meter building Le Dôme in the Gare district of Luxembourg.
Although still early days, this announcement could be a sign that the Gare district will become Luxembourg's de facto FinTech hub.
Over at KNEIP, the firm is fully embracing a culture of innovation to develop new technology solutions for its clients.
A good example of this relates to PRIIPs. Godfrey remarks that a couple of staff members with insurance expertise realised that whereas KNEIP was doing a lot of reporting and data management for the fund industry, it was limited just to PRIIPs for the insurance industry.
"The idea was, why don't we build an insurance platform that runs parallel to our asset management platform? Insurers can log on and have all of their data and reporting resolved with the same technology.
"We are actively running that as an EPIC today; it's an idea that was borne out of a real business need. That's helped us to leverage our existing technology, leverage our experience in managing data and converting data into outputs, and putting it into another vertical," explains Godfrey.
Moreover, any of KNEIP's asset management clients that need to produce UCITS KIIDs can benefit from the PRIIPs platform running in parallel, given that there is an estimated 73 per cent overlap of data between the two regulations.
"All the asset manager needs to do is increase the number of data points, implement the risk calculations to meet the PRIIPs requirements, and that is it. It wasn't a whole new RFP process taking six months. The COOs of asset management organisations have been able to sit back and breathe a sigh of relief," adds Godfrey.
From regulatory and product innovations, leading the way in green bond listing and data exchange, to developing technology solutions in order to make asset managers' lives easier, one can point to several examples of how Luxembourg remains a dynamic, vibrant fund jurisdiction.
Far from just being a safe, steady jurisdiction, it is one that continues to embrace change and evolve in line with global market forces. For that reason alone, Luxembourg is in a stronger position than perhaps it has ever been before.
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