Luxembourg’s emergence as a European centre for alternative funds as well as for UCITS is attracting increased interest from US asset managers, according to speakers from both Luxembourg and the US at the ALFI Digi Pulse USA virtual event on September 30. The degree of that interest was demonstrated by more than 500 registrations, not only from the United States and the Grand Duchy but from Canada and Latin America as well.
The challenges for US fund groups seeking to distribute products in European markets include a complex regulatory environment, the preferences of European investors, the rapid evolution of sustainability legislation and a new round of anti-money laundering rules.
In addition, a number of asset managers have previously accessed the EU single market through the United Kingdom, which completed its withdrawal from the European Union at the end of January 2020.
But Luxembourg has grown in stature as an alternative base for American groups, not least because of its ongoing stature as Europe’s predominant investment fund domicile, behind only the US itself worldwide. Luxembourg fund assets totalled some $6.6 billion at the end of August, noted ALFI Deputy Director General Marc-André Bechet, after 20% growth over the previous 12 months – 38% of which came from net inflows from investors.
Alternative funds have been growing steadily over the past two decades as a proportion of Luxembourg assets, according to PwC Luxembourg partner Serene Shtayyeh, with most demand to date coming from North America, although she predicts that in the future it will be overtaken by investors in Asia and Europe itself.
Between 2011 and 2020, European fund assets grew at a compound annual rate of 9.5% while alternative funds grew even faster, at an average of 12.7% a year. Over the past decade, Luxembourg has maintained its lead in fund assets over Ireland, and also as the continent’s principal jurisdiction for cross-border funds, accounting for 56.5% of registrations for sale in other countries.
“Today, Luxembourg alternative investment funds officially have around $1 trillion in assets, but the real total is much, much higher,” said Ms Shtayyeh. “An undisclosed but very large volume of assets are not included in the figures because they are held in unregulated funds, principally reserved alternative investment funds and special limited partnerships.”
James Hays, a partner with law firm Simpson Thacher Bartlett in Houston, notes that US fund sponsors targeting European investors are principally concerned with cost, time to market and, especially, EU regulatory requirements.
Revision of the Alternative Investment Fund Managers Directive is due to be unveiled in the coming weeks, following this year’s introduction of the Sustainable Finance Disclosure Regulation in March and the Cross-Border Distribution Directive and its accompanying regulation in August.
With reverse solicitation becoming a less attractive option because of tighter regulatory scrutiny, he says, their approach to the market will depend on whether they have experience in gathering assets in Europe, the asset classes involved and how much capital they are seeking to raise.
Using national private placement regimes on a country-by-country basis is generally less costly than AIFMD passporting. However, Mr Hays says more US managers are creating European structures, especially Luxembourg limited partnerships, in parallel with their existing Cayman or Delaware funds. Drivers include the prohibition on pre-marketing of funds by non-EU AIFMs in some EU countries, but notably the increasing appetite among European investors for regulated alternative funds.
Alexandre Pini, a member of the management committee at Carnegie Fund Services in Geneva, notes that of around 10,000 funds sold in Switzerland, more than 8,200 are domiciled abroad, including some 5,400 in Luxembourg – a phenomenon dating back to the heyday of Swiss banks in the Grand Duchy in the 1980s and 1990s.
“The Swiss market is used to Luxembourg funds and most investors already own them,” he told ALFI Digi Pulse USA participants. “They like what they are familiar with.”
A restricted approach via private placement will be less costly for US asset managers seeking to raise under $150 million in Europe, says Jérôme Mullmaier, a partner with Luxembourg law firm Loyens & Loeff.
However, he warned that “bigger offerings are liable to be targeting investors who do not want a Cayman product, while managers would not be able to accept opportunistic investments from countries as Spain, France and Italy where private placement access is restricted or effectively barred.”
Mr Mullmaier notes that US groups must also consider their distribution options, from using their own resources to contracting EU intermediaries. “They need to consider not only whether the fund is eligible for distribution but whether the distributor is authorised to do so,” he said. “And managers with boots on the ground in Europe, in the form of an AIFM or a MiFID-authorised firm, face a problem if they have established their presence in London, now the UK has lost the AIFMD passport.”
He notes that to maintain a level playing field, SFDR rules now apply to US managers selling funds in the EU. Sustainability is an import consideration for US managers targeting European investors, notes Anne-Gaëlle Delabye, a partner and member of the private equity team at law firm Ogier in Luxembourg: “ESG fund assets have doubled over the past three years, and demand has spread from equity funds to fixed-income and asset allocation vehicles, as well as among passive funds.”
Carlo Funk, head of ESG investment strategy for EMEA at State Street Global Advisers, says ESG has rapidly evolved from requests among a sub-set of clients to becoming an integral element of requests for proposal solicitations. “Almost no client meeting takes place without ESG on the agenda,” he said. “It is a standard part of the conversation in the same way as risk management. It’s no longer just about products but the value chain and a firm’s very DNA.”
He highlights a wide range of new sustainability guidelines and rules being developed by the European Commission, including the progressive implementation of the SFDR and the Taxonomy Regulation as well as the future Corporate Sustainability Reporting Directive, as well as a raft of subsidiary legislation in the form of delegated acts.
Mr Funk reports that the fund industry has registered massive relief over the delay until July 2022 of Level 2 requirements under the SFDR – not least because the detailed requirements have yet to be finalised. “It gives time to resolve ambiguities in many areas of the legislation, to consult with market participants and pose questions to the European Commission,” he says, “and to get our hands on better data.”
For example, he notes, the Commission has said the majority of investments in SFDR Article 9 ‘dark green’ funds should be in sustainable assets, with the balance available only for hedging and liquidity. “How does that translate for passive funds, even those following Paris-aligned benchmarks, that are based on market capitalisation?” Mr Funk asks.
“The data required to calculate what proportion of companies’ activities are in taxonomy-aligned activities is not fully available – and the taxonomy itself is not yet finalised.”
However, he is confident that the resolution of these issues will boost ESG investment even further: “In 10 to 15 years, roles like mine should no longer exist – sustainability will be so normal we won’t need specialists. But a great deal of investment will be needed to get us there.”
Nadia Bonnet, head of the New York office of Luxembourg law firm Arendt & Medernach, says US fund sponsors must also prepare for a new round of anti-money laundering and financing of terrorism legislation unveiled by the European Commission in July – with the caveat that full implementation is likely to take until 2024 and 2025, and changes to the initial proposals, perhaps significant ones, are likely.
Fund groups have the option of using other providers to conduct AML due diligence checks but they must ensure such firms are subject to comparable regulation, notes Christian Hertz, head of Luxembourg AIFM Sanne LIS, with requirements covering not only investors but fund assets.
Luxembourg requires funds to determine their risk appetite and to conduct risk-based assessments of all asset owners and relevant counterparties; for real estate funds this would include property managers and, in some cases, tenants.
Multiple speakers touched on a key aspect of US managers’ ambitions in Europe: the retailisation of alternative products. Jason Carss, a managing director with KKR in New York, says mass affluent and lower-end HNWI investors represent a fast-growing market that is under-allocated to alternatives because of high minimum investment levels and regulatory restrictions governing investors’ sophistication and understanding of complex products.
EY Luxembourg partner Laurent Capolaghi says demand is being fuelled by a generational shift as well as the emergence of platforms geared to less wealthy investors. He notes that vehicles already in use in Luxembourg include alternative funds of funds as well as funds established under Part II of the Grand Duchy’s investment fund legislation – flexible vehicles that permit retail investment and are less restrictive than specialised investment funds and risk capital investment companies, while still benefiting from regulatory oversight and investor protection measures.
Luxembourg life insurance policies also can invest in private equity as underlying assets and benefit from an EU marketing passport.
Hopes are also pinned on the planned revision of the EU legislation on European Long-Term Investment Funds, which have been slow to gain traction since their launch in 2015.
“ELTIFs could provide the ideal solution for alternative products aimed at pan-European retail investors,” said Linklaters Luxembourg partner Silke Bernard. “However, so far there are only 51, mostly in Luxembourg, and the original regime has been criticised as too complex and not well adapted to alternative investment classes apart from infrastructure.”
The proposals, due in November, are expected to allow funds of funds and maybe master-feeder structures, improve redemption rules and offer liquidity windows (whereas the first-generation of funds has been exclusively closed-ended), as well as streamlining the authorisation process. “There is massive market appetite,” said Mr Carss. “There will be a lot of room for innovation with the ELTIF 2.0.”
He argues that these changes illustrate the progressive approach of EU policy-makers, which is helping to consolidate the appeal of Luxembourg as a European jurisdiction of choice for US asset managers. With the UK’s withdrawal from the EU single market, adds Mr Carss that appeal is only set to grow.