Calculating the size of Luxembourg’s private equity industry is not an exact science.
Calculating the size of Luxembourg’s private equity industry is not an exact science. While the number of Sicar structures that are restricted to risk capital investments is recorded by the industry regulator, the Financial Sector Supervisory Authority (CSSF), the around 200 Sicars authorised by mid-2008 are believed to include a number of opportunistic real estate funds as well as buyout, mezzanine, venture capital and other pure private equity vehicles.
It gets harder when it comes to Specialised Investment Funds, the regulatory regime for alternative investments that was introduced in February 2007 and had attracted just under 500 new funds by the end of June. The statistics for SIFs are complicated by the inclusion of institutional funds created under predecessor legislation of 1991 that have been incorporated into the new regime.
Overall, the total number of such funds grew from 222 with assets of EUR80.5bn at the end of January 2007 to 716 funds and assets of 128.7bn by mid-2008. How many of the these funds follow private equity rather than hedge or real estate strategies is largely educated guesswork, although Alain Kinsch, head of private equity with Ernst & Young in Luxembourg and armed with knowledge of his firm’s audit clientele, estimated that around one-third of the new launches over the past 17 months are probably private equity funds of one stripe or another.
There are further "known unknowns" in Luxembourg’s statistics, including the number of funds created under Part II of the fund laws of 1988 and 2002, legislation principally designed to implement successive Ucits regimes, that are in fact alternative investment vehicles. Even more pertinent for private equity is the number of financial participations companies, or Soparfis, which have been used to establish private equity funds and are even more popular as intermediate transaction vehicles, but which as unregulated entities are not counted by the CSSF.
Counting funds is hard; counting assets is even harder. "The CSSF publishes numbers for Sicars but only provide the net asset values of the various entities, not the commitments, and as many of these entities are quite new, it’s hard to say [how large they will become]," Kinsch says. "The typical size of funds is between EUR100m and EUR300m, which is relatively small. There are a handful of billion or multi-billion euro Sicars. European Capital has launched a EUR2bn mezzanine Sicar, but the market share in smaller funds is probably much higher than for larger funds."
What seems beyond question is that Luxembourg’s private equity market is growing rapidly, with service providers reporting steady increasing inflows of new business even as the credit crunch has started to put a serious crimp into the activities of the global private equity industry, certainly those areas most dependent upon borrowing. But arguably the grand duchy’s offering of regulated private equity structures may be best placed to thrive in the new environment.
Kinsch reports, unsurprisingly, that the impact has been greatest on IPOs and larger buyouts, where fewer transactions are taking place. "Some players have been more affected than others, but acquisitions have been postponed and for the most part private equity houses are focusing more on managing investments already in their portfolios," he says.
"For the fund business there’s been almost no impact because most Luxembourg funds tend to be smaller and don’t use much leverage. Their business model is to find good companies and increase their value. For them the credit crunch is not much of an issue, and for some, like the mezzanine players, it’s a good time to be around."
Kinsch argues that the private equity model has not been called into question by the credit crunch, although it might experience more difficult times over the next year or two. "We will see more regulation of private equity, most of it probably self-regulation, like the European Venture Capital Association code of governance and valuation rules," he says.
"The increasing focus on regulation is an advantage for Luxembourg, because we have a lightly regulated vehicle that other jurisdictions don’t, but also because we have in the CSSF a regulator that is extremely flexible and has created a separate private equity department. A promoter coming to Luxembourg can go to the regulator and deal with someone who does nothing apart from private equity."
It’s not only the regulator that is creating dedicated resources to serve the industry. Although Luxembourg is home to a vast number of fund administrators – many banks and asset managers still service their own funds – those firms that have ventured into the servicing of alternative investments are finding that the skills, processes and requirements involved are so different from those of traditional Ucits funds that it makes more sense to build dedicated teams for other asset classes. They are also finding themselves under challenge from new competitors that specialise in alternative funds or specifically in private equity.
"In the beginning the business was dominated by established administrators, but there has been an evolution and now we are seeing more specialists," Kinsch says. "At first the traditional mutual fund administrators tried to use their traditional value and production chain, including the transfer agent, custodian and domiciliation agent, but they found that wasn’t the way private equity works. Now about 10 players have decided to create a separate, standalone business within their company; at least one has rebranded the business.
"The traditional players have reached the stage where they need to be serious about the business and recognise that private equity is really different from mutual funds. Then there are specialist firms that are already very strong in alternative funds and are trying to ramp up their activity in private equity. Some of them are Luxembourg-based, but others mainly from Guernsey and Jersey, such as Mourant, Ipes and Aztec, have set up operations here or are looking at doing so. They tell us their clients are asking them to have a presence in Luxembourg."
The Luxembourg law firm of Chevalier & Sciales, which specialises in alternative fund work, often helps its fund promoter clients to establish local service provider relationships. "We provide a complete package," says partner Rémi Chevalier. "When a promoter comes to us, we don’t just do the legal work but negotiate offers from the bank and if need be help the client to select a custodian and administrator.
"It’s important to have the right provider – for example, for small projects it makes no sense to use RBC Dexia. We maintain good contacts with different service providers in order to be able to advise the client on the best provider for their specific fund. But service providers in Luxembourg are very competent – we have never run into any problems. One advantage is that many administrators have been here for years. It’s not a jurisdiction with a new fund law or private equity vehicle where people set themselves up as service providers without any experience in the field. Investors and promoters know that service in Luxembourg is very good."
Several providers have established one specialist team to handle hedge funds, funds of hedge funds and other funds of alternative funds, and another for private equity and opportunistic real estate funds, which share various characteristics in terms of the way they invest and their administration requirements.
Says Kinsch: "Opportunistic real estate investment follows the private equity operational model of buying something, adding value to it and selling it. The revenue model is capital gains-based and it is sometimes called private equity real estate. It makes sense for a private equity administrator to offer services to these funds as well because there are similar issues to deal with, a limited number of transactions, and it’s a customised business.
"By contrast the traditional real estate business of core or core-plus funds is a completely different business, where you invest in buildings and hold them for a certain period of time. The objective is not necessarily to make capital gains but to obtain a good rental income. You need different systems to deal with a vast number of rental income transactions and cash flows, and the processes are much more industrialised. In some respects this is closer to a mutual fund than to a private equity fund."
The Fortis group was one of the first service providers to react to the passage of the Sicar legislation in 2004 and Bernard Tancré, general manager of Prime Fund Solutions at Fortis Banque Luxembourg, believes the group remains the leading originator of Sicar structures. Fortis has established separate administration teams with their own infrastructure for different asset classes, including a 20-strong group for hedge funds, funds of hedge funds and other alternative funds of funds, and about 10 people handling client relationships and custody for direct real estate and private equity funds.
"We have put these asset classes together because of the similarities between them, and the private equity group typically works hand in hand with our colleagues at Fortis Intertrust, because a lot of the work relates more to company accounting than portfolio accounting," he says. "We realised immediately that you couldn’t handle direct private equity or real estate funds with the same tools and methodologies as a normal mutual fund. Where you have Part II funds invested in real estate, as we do for a couple of clients, that requires corporate accounting skills and tools."
Tancré is less sanguine about the impact of the prevailing environment on the private equity sector. "In current market conditions I fear we will see a lot of projects that will not take off," he says. "A big difference between traditional and alternative business is that you have quite a heavy initial investment along with the client. If you believe in their project you jump in there with them. Sometimes you will be successful and are able to set up the project, sometimes it will not take off.
"There is a loss rate that you must try to minimise. Sometimes the asset manager cannot find the commitments they wanted or appropriate investments, and in the end the structure is never launched. At the moment I don’t see a drop in the volume of demand that is coming through the door, but we are probably a bit more selective about the viability of projects brought to us."
Hervé Schunke returned to CACEIS Bank Luxembourg earlier this year as head of private equity and real estate servicing to implement plans to expand the business he had set in motion during a previous spell with the bank. He now heads a dedicated team of around 15 focusing on private equity and real estate work and says CACEIS is dealing with a pipeline of potential business two to three times as large as its current client base.
Schunke says that a crucial aspect of the business – and one in which Luxembourg is very well served – is tax planning. "We have close contact with the offices of the Big Four as well as specialist tax advisory firms such as Atoz, who have a very good reputation in the market," he says. "We point clients toward a selection of external providers in Luxembourg who can help them structure their projects.
"The intermediary vehicles in Luxembourg are already established in terms of tax treatment. They are vital to these projects, because when you invest in a project in, for example, Azerbaijan, it is important to put an SPV in Cyprus and another in Luxembourg to structure the flow of income in such a way that there is as little as tax leakage as possible, with a mix of loans, direct shareholding, a flow of dividends and a flow of invoices between the different companies."
BNP Paribas Securities Services also has separate private equity/real estate and hedge fund teams as part of its 600-strong presence in Luxembourg. Chris Adams, global product head for alternative funds, says that in contrast to the traditional fund business, the alternatives team cover all aspects of servicing rather than farm out different functions to dedicated departments. "It is important to concentrate activities so that individuals can ‘own’ a fund and its promoters have one person to talk to," he says. "That is very important in the private equity and real estate field, particularly with SIF and Sicar structures in Luxembourg."
Adams says Luxembourg and the head office in Paris are pioneering a global administration, accounting and regulatory reporting platform designed to deliver uniform levels of service and standards in the group’s offices worldwide. "When someone walks into a BNP Paribas Securities Services office and with a particular type of fund, we will have a single servicing procedure," he says.
"We will rely on industry standards wherever relevant, such as EVCA standard reporting for private equity and the Inrev model for real estate, to offer a product that is disciplined, controlled and scalable. There won’t be service variations depending on which location you go to, because we will have pooled the intellectual capital across the group. For example, clients who have both Irish Qualifying Investor Funds and Luxembourg SIFs want the same look and feel of servicing model. They want standardisation across the board."
