Flurry of legislative activity gives new impetus to alternative investment sector
By Simon Gray – A raft of legislative changes, including the transposition of the European Union’s Alternative Investment Fund Managers Directive into Luxembourg law and the establishment of a new legal vehicle equivalent to a common law limited partnership, as well as a new tax treaty with one of its most important markets, promise to give the Grand Duchy a significant boost as a centre for the domicile, third-party administration and back office operations of private equity investment.
Over the past decade Luxembourg has carved out a significant role in the sector, thanks in part to its established dominance in the traditional fund industry and growing expertise in alternative investments, but also the creation of two popular and widely-used instruments. The Risk Capital Investment Company or Sicar, launched in 2004 and updated to provide greater flexibility in 2008, is specifically designed for private equity, venture capital, real estate and some other related types of investment.
However, the Sicar has to some extent been upstaged by the introduction in February 2007 of the Specialised Investment Fund, a light-touch regulatory regime up to now largely used in conjunction with mutual fund (FCP) or open-ended investment company (Sicav) vehicles for all types of alternative investment, including hedge funds and ‘alternative alternatives’. At the end of May the number of SIFs had reached 1,433 with assets under management of €257.6bn.
In March Luxembourg’s Parliament passed legislation amending the SIF rules, removing an eye-catching (but seldom used) provision that allowed funds to be established in advance of application for approval from the regulator, the Financial Sector Supervisory authority (CSSF), as well as incorporating measures in areas such as risk management and dealing with conflicts of interest that bring the regime into line with some of the future requirements of the AIFM Directive.
The stated deadline for the adoption of the directive into national law is July 22 next year. It is highly possible that many, perhaps most EU member states will fail to carry out transposition of the legislation on time. However, Luxembourg is aiming to be one of the first countries to do so, and in all likelihood will be the very first – even though there are still grey areas surrounding some of the issues covered by the European Commission’s so-called Level 2 regulation, which will set out detailed implementing measures that will take force directly throughout the 27 members of the union.
“The focus now is very much on the directive,” says Yves Courtois, partner and head of private equity and corporate finance at KPMG Luxembourg. “We are moving into a phase where most players are getting prepared. There are still various unknowns, and practical considerations will be shaped in the coming year. Most players have stayed on the sidelines until recently, but now things have really started to get moving as people begin to take concrete steps to get prepared by next July.”
Luxembourg’s legislation will almost certainly be completed and enacted before the end of the year, according to Raymond Krawczykowski, international tax partner and private equity practice leader at Deloitte Luxembourg. “The aim is to put together a package comprising measures bringing Luxembourg law into compliance with the AIFM Directive, along with a couple of tweaks in the tax regime and a huge piece of legislation in the area of partnerships,” he says.
“Luxembourg is very conscious that one of its assets is the rapidity with which it has adopted the various pieces of European legislation, for example the Ucits directives. The AIFM Directive will be difficult and take some time to implement, but being first enables you to build knowledge quickly. You learn from your mistakes and adapt.
“That is one of the benefits for Luxembourg of being small and able to respond quickly to the marketplace. The authorities will listen to general partners, investors and service providers, and after a certain amount of time, if there are things that could be improved to make it easier for funds, they will make changes.”
Krawczykowski believes the directive will make European jurisdictions more attractive to the private equity sector because it reflects investors’ own priorities in the aftermath of the financial crisis. “It will make investors feel better protected,” he says. “In the past they may have derived that protection from knowing the people they were dealing with. However, the trust established between general and limited partners has sometimes been challenged over the past few years.
“Even without the directive, limited partners would still have asked for 80 per cent of what is in it, such as ensuring that assets are in the hands of an independent custodian, and reporting that is more frequent or in a more standardised format. There has also been pressure on the general management fees charged by private equity firms. LPs are probably not willing to pay for the privilege of investing in a fund to the extent that they have in the past. They want better control of risks and market valuation of investments, and they want to ensure that the variable part of the GP’s remuneration is connected to the long-term benefit of the fund and of its investors.”
Justin Partington (pictured), commercial director of specialist private equity administration provider Ipes, adds: “It is a major advantage that Luxembourg will be ready very early for the AIFM Directive. That’s partly because its existing legislation is already close to the requirements of the directive, but also because Luxembourg is such an important Ucits centre, since a lot of the language in the directive has been borrowed from the Ucits regime.”
There is considerable debate about the extent to which the directive will encourage alternative fund business to move onshore in Europe, and whether it may also persuade firms that are not targeting investors within the EU to keep their business and structures outside the union altogether. “Asian managers investors may not see any benefit,” admits Krawczykowski. “They may still be comfortable with Cayman structures and not see the European rules providing any added value.”
However, Pascal Hernalsteen, head of private equity and real estate at Caceis Bank Luxembourg, believes the directive should provide a boost to the Grand Duchy at the expense of non-European jurisdictions. “The domiciles that are threatened most by the AIFMD are the Caribbean and Atlantic island centres,” he says. “We have seen some managers moving funds to Europe because their investors require a regulated domicile. Luxembourg is in a good position because the regulator is so proactive regarding the implementation of the directive.”
Claude Noesen, a director with Credit Suisse Fund Services (Luxembourg), successor to the former Fortis Prime Fund Services business, agrees: “Luxembourg is very well placed in all domains. Across all strategies and asset classes, we have the expertise, the talent pool, tax transparency and a positive regulatory approach. However, I believe there will be a place for everybody, including offshore domiciles, in the future market environment.”
Perhaps of even greater importance to the private equity industry in Luxembourg is the creation of a limited partnership structure, an initiative designed to put the grand duchy on a level playing field with common law jurisdictions, and especially territories such as Guernsey, Jersey, the Cayman Islands and Bermuda that are currently prized as domiciles by the alternative fund industry as much for their legal system and structures as their tax neutrality.
“It is another of the building blocks that had to fall into place to remedy one of our weaknesses,” Noesen says. “We recognise these issues, and leading members of the Luxembourg industry have been working on them, influencing the regulator and the government to go down the right route. Obviously the channels are much shorter here than in a big country. The ‘think tank’ of Luxembourg is crucial in this area, because the financial industry is the country’s largest economic sector. We cannot afford to fall behind.”
Ipes Luxembourg managing director Simon Henin believes that offering a limited partnership-type structure will make Luxembourg more interesting for the establishment of private equity funds. “Many fund managers and investors are used to the LP structure, so being able to offer an equivalent vehicle that works in the same way should definitely raise interest,” he says. However, he thinks it may take some time to fulfil its potential: “This will be a new vehicle and there may be some questions about practical issues. But it will be useful to have available when an asset manager shows interest in Luxembourg.”
The grand duchy already offers a structure comparable with a limited corporate partnership, the Société en Commandite Simple. “This has a legal personality but a very light commercial law requirement,” Henin says. “However, it is not necessarily as easy as in other jurisdictions to create that kind of limited partnership structure managers and investors are familiar with. The proposed new vehicle would ease the process.”
Courtois argues that the Luxembourg industry should not expect too much, too soon, since industry members are unlikely to take precipitate decisions about new types of vehicle at a time when the fundraising environment remains particularly delicate.
“Most GPs will take careful steps to evaluate and ponder the various alternatives,” he says. “Ultimately it is dialogue with limited partners that will determine whether a particular solution gains traction or not. But it is clearly a positive sign that the political will is there to encourage the industry.”
Hugh Stevens, head of private equity and real estate services at BNP Paribas Securities Services, also cautions that the new vehicle may not prove an instant panacea. “I'm not surprised that Luxembourg is looking to widen its product base as managers become more sophisticated,” he says. “The ability to complement other fund structures, legislation and regulation enables Luxembourg to provide something of a one-stop shop. It is a good move in that it allows the jurisdiction to provide all types of fund.
“However, just because Luxembourg is developing this does not mean that it will be successful. The limited partnership regime is a competitive fund structure, but not everyone who has introduced that regime has been successful in the past.”
He adds: “One of the difficulties faced by managers these days, as they broaden their distribution network into Asia and other parts of the world, and also embrace greater diversity of distribution in Europe, is the need to manage the complexity of their fund structures. If there is one domicile that meets the majority of their requirements, that location will have an advantage. If a manager has to put together a structure covering multiple domiciles, it creates some headaches in terms of operational co-ordination between those locations.”
Meanwhile, Luxembourg’s role as a domicile for private equity funds is set to benefit from the signature of a revised double taxation treaty with neighbouring Germany, replacing an agreement dating back to 1958, although some aspects of the changes may bring transactions that were previously exempt into the German tax net.
The treaty is due to take effect from the beginning of 2013, subject to ratification by the parliaments of the two countries. According to Hans Stamm, a partner with law firm Dechert in Germany, the new treaty may benefit international private equity funds that often use Luxembourg holding companies (notably financial participation companies or Soparfis) for investment into Germany.
The treaty may make possible a reduction in the taxation of income from German portfolio companies (including dividends). According to Dechert, in the past it was not clear whether certain funds investing in German portfolio companies would benefit from the relief available under the treaty, but the revised agreement now clarifies that, in principle, Luxembourg investment funds (including Sicars) may claim treaty benefits.
However, other provisions may result in tax becoming payable in structures that have not been affected up to now. A new provision covers capital gains from shares in companies that derive more than 50 per cent of their value directly or indirectly from real estate assets. Henceforth, investments in German real estate companies that are held through a Luxembourg holding company may be subject to German tax.
In addition, Dechert says, investments in German portfolio companies that are capitalised through hybrid debt instruments, such as profit participating loans, by which a certain portion of German-derived profits is repatriated, will also be affected. Under the current treaty interest payments from such financial instruments were mostly not subject to German withholding tax.
However, the new agreement will authorise Germany to apply its withholding tax rate of 26.375 per cent to payments under such financial instruments, if they qualify as profit participating instruments, where the interest payment is linked to the profit of the German ‘borrower’.
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