By Simon Gray – The advent in July 2013 of the European Union’s Alternative Investment Fund Managers Directive could help Luxembourg to consolidate its position as a domicile and servicing centre for private equity funds and acquisition vehicles, according to industry members and analysts in the grand duchy.
Luxembourg is best known as a centre for retail funds established under the EU’s Ucits regime, which allows funds established in one member state to be freely marketed to investors throughout the 27-country bloc as well as other members of the European Economic Area. Its total fund assets of EUR2.22trn at the end of May make it the largest fund domicile in Europe and globally second only to the United States.
But Luxembourg is already much more than a centre for retail funds. In fact, Ucits vehicles made up fractionally fewer than half – 1,864 – of the 3,749 funds overseen by the industry regulator, the Financial Sector Supervisory Commission (CSSF), at the end of May, although at EUR1.78trn they accounted for some 80 per cent of fund assets.
At the same time there were 619 Part II undertakings for collective investment, so called after the section of Luxembourg’s fund legislation (the latest version became law on December 17, 2010) governing non-Ucits funds, with aggregate assets of some EUR212bn, as well as 1,266 Specialised Investment Funds governed by the so-called SIF law of February 13, 2007, with assets of nearly EUR225bn.
Even these numbers do not give the full picture of the importance of the grand duchy as a centre of alternative investments and in particular of private equity and venture capital activity, according to Yves Courtois, head of private equity and corporate finance at KPMG Luxembourg.
“Luxembourg is a leading European private equity centre with around 300 regulated funds and around USD40bn in private equity assets under administration,” he says. There are around 250 risk capital investment companies or Sicars, a vehicle established by legislation of 2004 and designed for investment in private equity and venture capital as well as certain kinds of property investment, while as many as 50 SIFs may invest in private equity.
Courtois adds: “The grand duchy is also known as a hub for cross-border structuring of private equity and real estate transactions. Although there are no official statistics on the matter, the industry’s best guess is that there are around 30,000 Soparfis [financial participation companies] and more than 500 securitisation vehicles.”
In addition, the grand duchy has its own home-grown private equity and venture capital sector, small certainly, but known for punching above its weight. Famously, venture capital firm Mangrove Capital Partners was an early backer of (also Luxembourg-based) Skype, while the EU’s venture investment arm, the European Investment Fund is also based locally. Most recently, Genii Capital has become known globally for its acquisition of the Renault Formula One team. “In relative terms it’s fairly modest, but there is a clear desire to attract more firms who would base substantive investment management here,” Courtois adds.
Alain Kinsch, a partner and head of private equity at Ernst & Young Luxembourg, believes that a combination of the introduction of the AIFM Directive, which will eventually require compliance from any fund manager seeking to raise capital from sophisticated investors within the EU, and the determination of the government to boost the country’s role as a centre for alternative investment activity, could well result in a further surge in the industry’s growth in the coming years.
“There is a high probability that with the AIFM Directive there will be another wave of private equity houses coming to Luxembourg,” he says. “They are looking more to onshore jurisdictions, and Luxembourg is likely to be the first country in Europe to adopt the directive. It will be a viable option, certainly for those firms that would like to come under the directive quickly.”
Kinsch says the government is working on various changes to the legal and fiscal regime that should increase Luxembourg’s attractiveness as a financial a services jurisdiction generally as well as a private equity hub. “There is currently a working process underway to refine further Luxembourg’s equivalent of the UK limited partnership, and there will be some innovations around tax,” he says.
“There is currently a new circular from the tax administration on the tax regime for highly skilled workers that is particularly interesting for the private equity industry because employees actually based here in Luxembourg will pay less tax, and there is a working group on the taxation of carried interest. There are various reviews of existing legislation applicable to private equity to see what can be changed to make the country even more attractive.”
The official mood is very much pro-private equity, Kinsch notes, which has been identified by the government as an increasingly important asset class for the global investment industry in the future. One move in that direction is Luxembourg’s continued efforts to expand and refine its network of double taxation treaties, which helps in the structuring of private equity transactions. “If you put all that together, it’s broadly why private equity houses that are already here have been adding staff and others are interested in establishing themselves,” he says.
Simon Henin, managing director for Luxembourg of private equity administration specialist Ipes, says one factor that could benefit Luxembourg as a fund domicile under the AIFM Directive is its familiarity with the function of the depositary, which is already required for both SIFs and Sicars.
“If the rule tomorrow is that all EU funds must have such a depositary, we are already prepared for it,” he says. “The regulator is already used to supervising regulated private equity structures, which is not the case in most competitor jurisdictions. We might also benefit from our experience in passporting of funds and management services from the Ucits industry.”
His colleague Justin Partington, Ipes’ commercial director, acknowledges that the industry is still trying to determine to what degree the directive is likely to bring business within the EU and to what extent it may push activity outside _ a question that may only be resolved for certain with the publication of so-called Level 2 implementing measures, drawn up the European Commission on advice from the European Securities and Markets Authority.
Olivier Sciales, founding partner of Luxembourg law firm Chevalier & Sciales, points out that there may also be slight differences in the way EU member states transpose the directive into national law, which they are required to do by July 22, 2013. But he says: “The grand duchy has made great efforts over the past decade to create an attractive environment for private equity and to encourage the domicile and servicing here of both funds and acquisition and holding structures. Luxembourg’s implementation of the AIFM Directive is likely to follow the same philosophy.”
Partington adds: “Before the final version of the directive was approved, it looked like much more of a boon to Luxembourg, while non-EU jurisdictions were quite concerned about it, but now there’s much more of a level playing field. I believe it will polarise investors, with EU institutional investors such as pension funds pushing for Luxembourg structures. That will make the grand duchy a ‘super-jurisdiction’ for EU funds that will encroach to some extent on Ireland’s space as an alternatives centre.
“However other investors, particularly those from Asia and the US, will be happy with a light or medium regulation jurisdiction and with non-EU structures. We encourage our clients to set up parallel structures, in Luxembourg for EU investors and a non-EU structure for those investors that want lower costs. The outcome could be positive for all the key jurisdictions that are accepted as top-quality, but the AIFM Directive will mean those that have not yet gained traction will struggle to do so.”
Ray Krawczykowski, international tax partner and private equity industry leader with Deloitte in Luxembourg, agrees that the general shift in attitudes in the alternative fund industry toward more regulated structures and jurisdictions is a definite boost for the grand duchy.
“Traditionally private equity hasn’t favoured regulation at all, and the industry has worked hard to combat some of the provisions of the AIFM Directive,” he says. “But at a recent conference organised by the Luxembourg Private Equity and Venture Capital Association and addressed by the chairman of the European association, there was a consensus that we could no longer prevent it. The task now is to engage with Esma to make sure the directive is implemented in a way that’s acceptable and practical to work with.”
The creation of the LPEA in February 2010 is in itself an important step forward. Says Krawczykowski: “There were a lot of private equity firms established here but no industry body. We were meeting regularly and organising dinners and other events bringing together as many as 25 professionals, and it was decided that we should get together in a real group rather than under the umbrella of other organisations.”
The association is active in providing feedback to the government in areas such as accounting changes, tax regimes and the implementation of new regulation affecting the industry, both at a national and European level, as well as taking part in international efforts to promote Luxembourg as a financial services centre. As of May the LPEA had 66 members, consisting of 29 private equity houses and 37 service providers.
Courtois, who is co-head of the association’s technical committee on accounting and valuation, says: “The association is an important initiative since it gives many of the large private equity houses representation for the first time. It is making the voice of private equity better heard among local politicians and regulators, and offering a structured way to tackle technical and operational issues.”
Acceptance that the directive’s implementation is inexorable does not signify happiness with the new rules, says William Webbe, director of the corporate services division for Deutsche Bank International’s trust and securities services. “The overriding concern of people within the private equity and real estate space is the additional cost for questionable value as far as investors are concerned,” he says. “There will be increased costs in terms of reporting and disclosure, and some restrictions in terms of how quickly assets can be turned around, which may have an impact on how people do deals.
“There is a concern among general partners that some merger and acquisition deals may actually favour firms outside the scope of the directive in that it might be easier for a vendor to make a sale to a non-AIFM purchaser, which doesn’t make a lot of sense. Some general partners fear that they will be handicapped from doing deals that managers not covered by the directive and free from some of these issues could go in and complete quickly.”
The issues raised by the directive include so-called asset stripping rules, which bar general partners from carrying out, facilitating or encouraging any distribution, capital reduction, share redemption or repurchase on the part of a portfolio company that would reduce its capital base or exceed its distributable profits and reserves, for a period of 24 months following the acquisition of control of the company in question.
Says Webbe: “In a way this probably shouldn’t be a problem, because private equity firms tend to be medium- to long-term players rather than undertaking short-term flipping of underlying investments. However, it is an artificial barrier that may mean delays to certain deals. To some extent this is a handicap for the asset manager, who would otherwise just get on and run the portfolio in the best interests of the investors.
“And from the administrator’s perspective, there is still too little clarity about what is required of the various roles and about the reporting requirements for us to know exactly what we will be charged with doing. There is the issue of the independent valuation role. Whether that is something that will be handled by the administrator or depository, they may be concern about some eventual liability that will increase the cost of administration and support functions.”
Vincent Lebrun (pictured), tax partner and private equity industry leader at PricewaterhouseCoopers Luxembourg, adds: “The industry has accepted that it will have to deal with the directive, even if it complicates their way of doing business. It must also make more effort to demonstrate how private equity contributes in a positive way to the economy in terms of growth and job creation.
“Industry members still don’t understand why they have been caught up by this directive and why they have been singled out as one of the parts of the financial industry responsible for the crisis. They need to explain that they are responsible professionals who take risks and receive no reward if they fail.”
“I believe that the big firms will find it easy to manage the directive, but that it will have a greater impact on smaller firms, because there will clearly be an increase in costs. But most of them recognise it is too early to make any decision about how to structure their funds going forward, since they still have a couple of years before they need to be compliant.”
Nevertheless, Krawczykowski says that in the future private equity firms will be looking very closely at the relative merits of regulated and unregulated funds, even with the added constraints and burdens the directive will entail. “Asset managers will not go back to Cayman funds without considering the alternatives strongly,” he says.
“That was a process that started already two or three years ago, but now firms are looking at the pros and cons very closely. In the short term, say until 2015, it’s possible that they may still better off with an unregulated fund, but after the deadline in the directive for setting up a passport system for offshore funds and managers, they may well decide it is better to be regulated. That might also make sense where they are launching something like a 10-year fund whose life will extend well beyond 2015.”