Private equity puts down deeper roots in Luxembourg
By Simon Gray – The global private equity industry remains a long way off the glory days of the mid-2000s. Exiting investments can be problematic, especially through initial public offering markets that have blown hot and cold in the past few years, but mainly cold. The public markets have given little help to portfolio company valuations. High levels of leverage that for a time seemed to help make investments a one-way bet, have subsided.
Meanwhile, fundraising remains difficult, even as more and more private equity firms enter the market, having largely been able to find fresh investments to work through the dry powder with which they found themselves at the onset of the crisis. But taking a fund to market is one thing, closing it is another.
Simon Henin of Ipes Luxembourg notes that only around 150 new firms raised a fund for the first time last year, compared to 450 in 2007, according to Preqin’s Global Private Equity Report 2012. Nevertheless, at the start of this year there were a record 1,814 funds in the market, a 14 per cent increase in the number of funds on the road, targeting aggregate capital commitments of USD744.2bn.
Says Henin’s colleague Justin Partington: “Across Europe, the fundraising market is tough. A placement agent told me recently that top managers are getting two-thirds of their investors to re-up two-thirds of their previous commitments. Good managers may get half the capital of their previous funds from existing investors, so to match that amount, they need to find another 50 per cent from somewhere. Everyone is looking for new investors to private equity, in the Middle East and Asia, and among who have not put money into private equity before. In this environment, that is a challenge.”
Partington says that promoters are starting to close funds early with whatever capital they can actually raise, with the aim of trying to get closer to their target amount through subsequent closings over the following year or two. “Others can't raise a new fund, but they can get smaller amounts of money from a particular investor for a co-investment or side deal,” he says.
Things do seem to be improving gradually, with Preqin reporting a decline in the average time taken to raise new funds from 21 months to 17. “Right now there is a dichotomy between traditional European markets and emerging markets such as Russia, Turkey and Eastern Europe, which are still quite bullish,” Partington says. “But in the UK firms are struggling to raise capital. They may get there, but it will take longer than expected.”
Industry members say that following the slowdown in European and US private equity activity after 2007, there was an upsurge of interest in investment in the Middle East. However, the wave of the political instability and in some cases civil violence that erupted in some countries across the region since the beginning of 2011 has dampened activity there as well.
Caceis Bank Luxembourg’s Pascal Hernalsteen says the type of funds being brought to market reflects the changes in the financial environment over the past five years. “Recently we have seen more funds investing in distressed companies and assets, while pure venture capital and buyout funds have been thin on the ground,” he says. “This is partly because the leveraged loan business dried up after 2007, but also because investors are looking for true sources of diversification.”
He adds: “We are seeing a trend toward funds investing in assets such as wine, jewels, watches and diamonds. We are also seeing sustained interest in infrastructure and particularly public-private partnership structures, where Luxembourg’s position as an onshore regulated jurisdiction is important to investors. There is also interest in Certified Emission Reduction, where companies with significant carbon footprints have to offset their emissions by investing in renewable energy or in pre-compliant or voluntary carbon emission reductions.”
On top of the market conditions, private equity firms are also facing regulatory issues that are complicating their business. The provisions of the EU’s Alternative Investment Fund Managers Directive, which will come into effect in less than 12 months, are an important factor, according to KPMG Luxembourg’s Yves Courtois, who says: “The directive is likely to impose an administrative burden on many of these firms, and could create a barrier to entry to the industry.
“We sense that rationalisation of the industry may take place, with the largest players best able to absorb the costs and energy required to comply with the directive, while mid-market and small players may find it much tougher. They will need to ponder their options and the potential benefits of outsourcing some of the requirements.
“An example is the question of valuation. I doubt whether we will see many appointments of pure-play independent valuation specialists, because ultimately valuation is core to the business of private equity – they are closest to the portfolio company. An external review of internal valuations would be a far less costly but sound alternative, and might also help from a fundraising standpoint.”
Courtois also notes that other measures might ultimately have an even greater significance for the industry than the AIFM Directive. “Two other pieces of legislation that may have been overlooked, the Solvency II and pension fund directives, potentially could have a more far-reaching impact on private equity,” he says.
“Solvency II has been somewhat overshadowed, but it is one of the most far-reaching directives because its capital requirements may require investors such as insurance companies to set aside up to 50 percent of the value of their private equity investments. That would be very costly for insurers, but on the other hand, at a time of such low interest rates, they also realise the need to continue to allocate to private equity to maintain the level of returns.
“Most of the largest insurers are building so-called partial models to demonstrate that the risk factor assigned to private equity should be much lower than the standard formula. This could place the larger players at an advantage compared with the smaller insurers, which may not have the resources to demonstrate this lower risk factor to their regulators, and ultimately may simply decide to exit their private equity allocations.”
Courtois adds: “Given that insurers in Europe currently manage around EUR7trn and that between 1 and 4 per cent of their assets is allocated to private equity, the amount at stake are quite sizeable. Currently we’re still a bit in the dark about the overall impact of all this regulation on future allocations to private equity, but it’s not hard to conclude that it may be adverse.”
Pension funds, which have accounted for around one-third of total allocations to private equity in recent years, are set to face similar constraints. “Any measures that need to be put in place to demonstrate the risk factor applicable to alternative investment classes through the application of internal models will be very time-consuming and consume a lot of energy,” he says.
“In the future the industry will probably have to adapt to requests for much more information about a fund’s underlying investments, and that in a look-through manner. It will be no longer be sufficient to provide reporting to the limited partners without thinking about the way the information is framed, because it will in turn be used by these institutional investors as part of their internal models.”
That will have implications for service providers to the private equity industry at a time when depositaries in particular are trying to get to grips with the implications of the additional liability they will have to accept for assets in their custody or under their supervision under the AIFM Directive.
According to Hugh Stevens of BNP Paribas Securities Services, the position of bank depositaries in countries such as France and Luxembourg, which are already familiar with the role they will be called on to play under the directive, contrasts with that in jurisdictions where alternative funds have not historically had a depositary or custodian.
“In markets that traditionally have been relatively unregulated, bank depositaries are working to demonstrate their value to a new audience,” he says. “Now it looks as though funds might need one, the question is whether they will go for a non-bank or a banking depositary. We are working with our clients and potential clients to demonstrate the value of the latter.”
The way the directive and its subsidiary measures are shaping up, Stevens acknowledges, the industry will certainly have to shoulder additional costs, but he believes a pragmatic approach can ensure that the increase does not fundamentally upset the industry’s business model. “There is certainly more work to be done, more risk and more liability in taking that role, and there is a cost involved in providing those services,” he says.
“The important thing is that we as a provider work closely with clients to make sure that our services are reasonable, pragmatic and commercially sensible. It’s not about taking a standard product and applying to a new market. We aim to ensure that our commercial proposition is appropriate and covers the services required by the client, and that we don't try to over-engineer a solution.
“In the case of private equity it is not a standard depositary function because in this market the assets are different. They are real assets, not fungible and in many cases not assets that can be held by a bank. We need a solution that will provide a good level of due diligence and understanding of those assets that takes into account their different nature.”
Despite the scale of these challenges, industry members are confident about the ability of Luxembourg to acquire a growing share of European private equity work, not only because of regulatory issues pushing business toward onshore jurisdictions but the critical mass the grand duchy is acquiring in highly skilled and specialised service functions.
“A number of global fund administrators are looking to set up in Luxembourg,” Courtois says. “We have seen players from the US and elsewhere actively looking to acquire or establish a presence here. That is a clear sign that there is underlying demand from their clients. These providers would not come to Luxembourg unless there was a clear-cut business model and an opportunity to be seized.”
However, he expects continuing consolidation in response to an increasingly competitive environment. “The days when you could set up operations with just a few people, without a strong infrastructure, are gone,” Courtois says. “To be taken seriously now, service providers must demonstrate that they have a resilient structure in place and that their staff have an appropriate level of understanding of private equity.
“Service providers will have to guarantee a seamless and high-quality service. In part due to the new regulations, I expect to see the development of new products such as risk management and risk reporting, which will be critical for some institutional investors. Going forward administrators will increasingly need to expand their service offering and act as a one-stop shop for tasks that general partners don't want to do on their own.”
Deloitte’s Ray Krawczykowski says firms have the option of competing on price or by offering a much closer partnership-style relationship with the client. “The AIFM Directive will make it possible for non-banks to act as custodians, and that additional pressure will oblige the big custodians to compete on price, efficiency or a broader scope of service delivery, for example offering services in more countries,” he says.
“Quality of service has actually improved a lot in Luxembourg. Once upon a time the main differentiator between providers was price rather than service quality, but today the norm is improved quality at an appropriate price. There are a lot fewer complaints from clients than there were four or five years ago. The change has been dramatic.”
The country’s continuing stability should not be underestimated either at a time when that of competing jurisdictions has been called into question. Caceis Bank Luxembourg private equity senior relationship manager Frédéric Bock notes that one client with a vehicle investing in copyright eventually chose Luxembourg over Dublin because the grand duchy’s political, economic and financial environment, and the clear commitment of its political leaders to the fund industry, contrasted with Ireland’s financial difficulties.
In addition, says Credit Suisse Fund Services’ Claude Noesen (pictured), the suggestion that Luxembourg is significantly more expensive than its competitors is a myth. “We are not that much more expensive, or in some cases no more expensive at all, as our own comparisons within Credit Suisse make clear,” he says.
“Our competitors are always saying that Luxembourg lawyers are very expensive, but it’s not actually the case. One indication of how cost-effective we are is that we service a number of Maltese funds here in Luxembourg. That would not happen if our costs were significantly higher than in Malta.”
Another reflection of the country’s competitiveness is the sustained trend for private equity houses to establish their own operations in Luxembourg, which has been underway for several years since the arrival of big industry names such as CVC, Cinven and KKR. “Today even smaller firms, whose funds might be between EUR500m and EUR1bn in size, will consider establishing an operation in Luxembourg,” Krawczykowski says.
“There are a number of drivers for this. First is the advice of tax specialists that if funds are established in Luxembourg, it makes common sense to have at least some kind of substantial presence involving people on the ground. Firms are unwilling to pay that cost unless they really need it, but many have accepted the logic and the expense of establishing a Luxembourg presence.
“Very quickly, however, they find that they are actually achieving cost savings because an on-the-ground presence improves the efficiency of working with local service providers. The firms have better control over what the providers are doing, there is no duplication of work, and they can rely more on their own people. Ultimately there is a shift to Luxembourg of work that would previously have been done in London or in the US, which isn’t going to involve an increase in costs.”
Ultimately it helps private equity houses to operate Luxembourg structures from close at hand rather than from another country, Krawczykowski argues, because for example local people have better knowledge of the quality and experience of providers in the market. “You obtain added value through time savings and greater efficiency, and better solutions to your issues.” he says.
As a result, firms that may have started in Luxembourg with the bare minimum staff needed to establish a presence are now adding more personnel. “They might initially have been reluctant to invest more than the minimum in their Luxembourg platform, but they are now very happy with a rising headcount, because it’s no longer about cost but about efficiency and structure. That is why more and more firms are setting up back office operations. As soon as you have five or six Luxembourg entities, it’s worth considering establishing your own office.”
Attracting investment operations is another question, and probably not one for the short term, despite the presence of relatively high-profile local firms such as Mangrove Capital Partners and Genii Capital, as well as the presence of the European Investment Fund, which provides financing to small and medium-sized businesses through private banks and funds.
“If Luxembourg were able to attract a few players to base at least part of their investment operations here, it could create a new playing field, but this would take a lot of time,” Courtois says. “There are lifestyle and other questions rather than just structuring considerations. That would require not just new laws but rethinking in a much more holistic way how to improve Luxembourg’s visibility and make it attractive for this kind of business.”
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