Long Europe’s leading domicile and servicing centre for traditional retail investment funds, Luxembourg has been taking active steps over the past few years to attract a significant share of the burge
Long Europe’s leading domicile and servicing centre for traditional retail investment funds, Luxembourg has been taking active steps over the past few years to attract a significant share of the burgeoning alternative investment industry. While the grand duchy’s efforts to lure hedge fund business have garnered most international attention, the country has been quietly building up a solid reputation as a home to private equity vehicles and property funds.
Industry participants are quick to enumerate the advantages Luxembourg offers alternative funds and their promoters, from tax-transparent structures to a wealth of professional expertise in areas such as accounting and audit services, fund administration and legal services. The flexibility and co-operative spirit of the industry regulator, the Financial Sector Supervisory Authority (CSSF), is also widely commented upon.
But probably the most important factor in Luxembourg’s development into a leading alternative funds centre has been a succession of investment structures that have proved particularly useful for international private equity funds and transaction structures, and which have dovetailed with the country’s broader expertise and experience in financial and corporate services.
The financial participation company or Soparfi was first introduced in 1990 as a successor to Luxembourg’s venerable holding company dating back to 1929. As a fully taxable company, it was designed to benefit from the country’s network of double taxation treaties as well as from the European Union’s parent-subsidiary directive. Until four years ago, the main involvement of Luxembourg in the private equity industry was the use of Soparfis as intermediate transaction vehicles.
However, the jurisdiction took a major step forward as a centre for private equity business with the enactment in June 2004 of legislation establishing the société d’investissement en capital à risque (risk capital investment company, or Sicar), conceived as a corporate alternative to the traditional limited partnership structure for private equity and venture capital funds. Around 200 Sicars have been established over the past four years.
The latest addition to Luxembourg’s armoury, and one that some members of the industry believe the most important to date, was the launch in February 2007 of the Specialised Investment Fund regime, which is designed principally for alternative funds and allows the use of a range of corporate, contractual and other fund structures. The SIF has been a runaway success with nearly 500 created in the first 16 months of the new regime.
"A lot of interest is coming from foreign promoters of funds, who are driving the growth of private equity vehicles in Luxembourg," says Oliver Sciales, a partner with law firm Chevalier & Sciales. "There is a lot of demand from US and other promoters for a suitable jurisdiction with a good reputation and a vehicle in which they can have confidence but is lightly regulated.
The jurisdiction has been put on the map, he says, by a number of high-profile transactions that have helped to showcase the grand duchy’s role as a centre of private equity expertise. One was the USD2.6bn acquisition of Luxembourg-based internet telephony provider Skype by eBay in September 2005, in which one of the vendors was also from Luxembourg, venture capital firm Mangrove Capital Partners. Another was the creation of KKR PEI Sicar, a vehicle for making non-US investments on behalf of the Amsterdam-listed company KKR Private Equity Investors.
Although they are also being used for property investment and hedge funds, SIFs have emerged as a serious rival to the Sicar as a private equity vehicle, according to Alain Kinsch, head of private equity with Ernst & Young in Luxembourg. "The advantage of the SIF over the Sicar is that you can do other things beside private equity, in fact anything," he says.
"You can put in real estate, hedge funds or quoted securities, and you can package different sub-funds for different types of investor within a single SIF. This cannot be done within a Sicar, which as a risk capital vehicle is reserved for private equity and venture capital as well as opportunistic real estate and some other areas such as microfinance."
Hervé Schunke, head of private equity and real estate servicing at CACEIS Bank Luxembourg, says: "The SIF has really speeded up the creation of structures, thanks to its flexibility in terms of legal structure and the regulated label. You can set up a SIF as a Sicav [open-ended investment company] or an FCP [contractual fund], as a limited liability company or as an SCA [partnership limited by shares], a structure bringing it very close to the UK limited partnership and other types of partnership that investors and promoters are used to.
"There are a number of promoters looking at creative ways of structuring their projects, always driven by tax optimisation considerations, looking at structuring like associations as well. We still haven’t seen all the possibilities that are there."
Bernard Tancré, general manager of Prime Fund Solutions at Fortis Banque Luxembourg, notes that the SIF has built on many of the innovations introduced by the Sicar. "The SIF enjoys many of the advantages that the Sicar brought two years before, in terms of flexibility, and the absence of the need for promoter approval, which was a big hurdle for a lot of small boutique asset managers.
"It has a true fund status, which the Sicar does not have, being an investment company, which still creates some uncertainty in other countries. Luxembourg has learned the lesson of its experience with the Sicar. The SIF also has more flexibility because there is no requirement to be linked with venture capital. Asset managers often approach us to use a SIF because it offers a structure within which they can offer private equity in some compartments, and hedge funds, real estate or traditional funds in others.
"The Sicar has also been used by a section of the real estate investment industry, but you have to be able to demonstrate that it is really opportunistic real estate and that there is an element of risk in the investment. You cannot use a Sicar to acquire a Luxembourg office building that is rented on a long lease to the government. However, that is not really an issue any more now that the SIF is available."
Tax considerations are often the reason for choosing one or other structure. "The Sicar is a company that pays tax normally, but revenues from transferable securities are exempt," Kinsch says. "Since it pays tax, it can in theory benefit from all Luxembourg’s double taxation treaties. However, since it is a relatively new vehicle, there are still questions about the response of some foreign tax authorities. This is a normal process – when the Soparfi was created nearly 20 years ago it also took four or five years until there was complete tax certainty."
He note that as a fund, SIFs do not pay corporate income tax but a subscription tax on their assets of one basis point. They can only benefit from those tax treaties that include funds, about half, and cannot use the parent-subsidiary directive. "Another disadvantage of the SIF is that it must demonstrate diversification, which is a key criterion for an investment fund, but is not strictly defined," Kinsch says. "In practice the SIF needs to invest with at least three different issuers, which means it cannot be used for a typical IPO transaction where it invests initially in only one target company."
In addition, the Sicar has built up something of a branding advantage in the industry. "Private equity houses and their lawyers are quite familiar with the Sicar, which they are not yet with the SIF," he says. And some of the drawbacks from which the Sicar currently suffers in comparison with the SIF, notably the inability to create multiple compartments or sub-funds within the same corporate structure, are set to disappear once a set of amendments to the 2004 legislation, drawn up in close consultation with the industry, are enacted.
Says Tancré: "The changes to the Sicar law will remove some of the differences between Sicars and SIFs, such as the ability to create compartments, as well as other elements such as the extent of responsibility of the custodian bank, which currently differs slightly between them." In addition, the requirement to calculate a net asset value – a concept borrowed from the traditional fund industry – has been removed and the concept of fair value clarified. "In retrospect these differences [with the SIF] do not really make sense. The government does not want people making regulatory arbitrage."
Schunke adds: "The Sicar offers a dedicated Luxembourg vehicle for private equity, risk capital and venture capital investment that’s recognisable by its name. There has been some uncertainty about how you would apply double taxation treaties to the Sicar. Among our current clients the only occasion on which the tax structure has not really turned out in real life the way it should have done was a Sicar. However, it will now benefit from the same definitions as a SIF in terms of, for instance, a specialised investor."
Nevertheless, the Soparfi remains an important part of the private equity landscape – albeit one which, as an unregulated entity, complicates further the already difficulty task of estimating the size of the industry in Luxembourg. "The Soparfi is still extremely popular as an intermediary vehicle, and will remain so because it is waterproof from a tax standpoint," Kinsch says.
"It has been around for nearly 20 years, people know how it works, and it is not challenged by anyone. If you combine the Soparfi with instruments such as preferred equity certificates and Cpecs, convertible preferred equity certificates, you can channel interest and dividend income very efficiently between locations. The ultimate goal is that if you invest in a company through a private equity fund, you should be treated in exactly the same way as if you invested in it directly, avoiding additional taxes. This is what the Soparfi is really good for."
Sciales says Soparfis are also used as private equity vehicles where investors have no preference for a regulated entity. "The introduction of the Sicar doesn’t mean the Soparfi is not used any more," he says. "Choosing between the different types of vehicle is a decision taken on a case-by-case basis and is influenced by different factors such as the identity of the target country, the use of hybrid financial instruments, and the type of investment. The choice between Sicar and Soparfi is primarily whether you want a regulated vehicle or not. The Soparfi can also benefit from double taxation treaties and the EU parent-subsidiary directive."
While the range and flexibility of investment vehicles is an important selling point for Luxembourg to the private equity industry, broader advantages equally play their part, according to Chris Adams, global product head for alternative funds at BNP Paribas Securities Services. He argues that the grand duchy combines the suppleness of the offshore financial industry with the depth of skills (and breadth of labour pool) enjoyed by the world’s major onshore financial centres.
"Offering tax transparency within the European Union is a big deal," Adams says. "There are more judges and lawyers within two hours’ drive of Luxembourg than probably anywhere in the world outside Washington DC. The political risk is essentially zero, and the regulatory risk is extremely low. And everyone speaks three, four or five languages.
"Luxembourg trades on its reputation and the competence of the advisory staff here to service the funds. The Big Four accountants employ thousands of people, there are any number of magic circle and specialist local law firms, and a wide choice of fiduciary companies. The huge industry servicing the funds sector is highly attractive. If you don’t like your lawyer here, there are three or four others with similar levels of competence. If you don’t like your accounting or fiduciary, there are three or four others. There’s a wide range of banks. That kind of flexibility is important."
Adams notes that business often gravitates toward a particular jurisdiction because the availability of expertise and experience creates critical mass and makes it the default option for a particular kind of activity, like special purpose vehicles in the Cayman Islands. "It’s pretty much the same for private equity in Luxembourg," he says. "We have the right controls in place, we know the regulatory framework, and when we get an instruction we know instantly whether we can do it or not. If there’s any shade of grey, we can call any number of law firms for an instant opinion on what we should or should not be doing, so we can move forward with a level of confidence. It’s all about confidence."
