Luxembourg leverages UCITS expertise to become world-class alternatives hub
These are momentous times for Luxembourg. Already at the apex of a UCITS industry which brings together fund managers and investors worldwide, the Grand Duchy has positioned itself to take advantage of a paradigm shift in alternatives. The state of the real estate and private equity industry was forensically examined at ALFI PE & RE 2018, attended by nearly 700 alternative investment professionals.
Alternatives: onshore is the new offshore
Conference speakers highlighted that real estate and private equity are raising ever more assets as investors seek diversification and liability-matching returns, and the vehicles for these assets are increasingly being launched onshore. And as investors demand a greater range of structures and vehicles, fund managers seek international centres with a range of tools and options to meet these demands. While investors are attracted to alternatives, they are also concerned about regulation and tax issues. They need their funds to be in a jurisdiction which has the skills and resources to deal with these key considerations and Luxembourg just has the answer to all these concerns.
The Grand Dutchy is now home to more than EUR 700bn in alternative assets (16% of the total) and these assets are set to grow as investors and fund managers seek the security of onshore locations for their real estate, private equity and private debt assets.
Private equity reaches new heights
Three major studies, backed by ALFI, were presented at the conference. The first, carried out with Deloitte, found that private equity assets under management in Luxembourg were up by 20% in 2018.
The number of large funds (over EUR 500m) is around 5% of the total and this is likely to rise next year as established players increasingly opt to launch in Luxembourg. In fact, said Arnaud Bon, of Deloitte, nine of the 12 largest private equity houses have established, or are in the process of establishing, an AIF in Luxembourg. This is extraordinary given the initial scepticism of the private equity industry over AIFMD.
The Luxembourg private equity industry is deepening as well as widening. “The survey indicates that all existing players in Luxembourg plan to reinforce their operations here in the coming months, especially compliance and risk functions,” said Bon.
“All existing players in Luxembourg plan to reinforce their operations here”
The private equity industry is evolving, requiring fund managers to continually review their offering. EY Luxembourg predicts that over the next three years:
- Fundraising will reach new heights through new entrants, reinvestment of funds, longer-life funds and permanent capital vehicles.
- Tech will be a key value creator as data from portfolio companies is extracted and aggregated across the portfolio.
- Impact investing will move into the mainstream.
- Private debt funds will see stronger demand.
- Demand for separate accounts will swell.
Real Estate – a sector on the move
Global direct real estate investment totalled nearly USD 240bn in Q4 2017, a quarterly record for the real estate market. And despite high valuations in real estate markets after a decade of low interest rates, investment could still increase as many investors – particularly Asian institutions – are still underweight real estate.
The real estate mix is changing fast, according to Chris Staveley, of JLL. Whereas office investment was 55% of total assets 10 years ago, it has now declined to around 50%. Retail allocations have fallen from 28% to 20%. Meanwhile, logistics has risen from 8% to 15%, and residential and “flexible space” are fast-rising real estate sub-sectors.
An annual survey by ALFI on Luxemburg-domiciled REIFs found that the total number of REIFs has climbed by 45 from last year to 304.
“The real estate mix is changing fast”
Many of Luxembourg’s REIFs are structured as SIFs or SICAVs, the survey – now in its 12th year – found, but RAIFs are fast increasing in popularity. Another shift is from closed ended to open ended funds. Only 38% of REIFs are multi-sector, a fall from 50% in 2016, reflecting the fact that institutional investors prefer to assemble their portfolios using single-sector strategies. Niche sectors are increasingly in demand, including residential, student housing, and healthcare.
How Luxembourg is responding to a changing alternatives landscape
Luxembourg has long been the connector between investor and investment, and it will facilitate change through a constantly-evolving toolbox for alternatives, said Alain Kinsch, of EY.
This toolbox was enhanced first by the SICAV, then the SIF, which allowed for reduced regulatory supervision. The AIFMD in 2013 was a major change, said Jacques Elvinger, of Elvinger Hoss Prussen, providing a passport and allowing greater competition with offshore jurisdictions. Then came the special limited partnership which could mirror offshore funds, and finally the RAIF, which can operate without regulatory supervision. From a standing start in 2016, there are now nearly 600 Luxembourg RAIFs.
“The toolbox is broad enough to satisfy all potential needs”
This range of structures and vehicles facilitates emerging trends such as co-investment, the desire by some investors for separately-managed funds, multi-compartmental funds and multi-asset classes.
The key message, said Catherine Pogorzelski of DLA Piper, is that the toolbox is broad enough to satisfy all potential needs.
Big growth in loan funds
Loan funds are the “rising stars” of asset management. There were E49bn in regulated loan funds by mid-2018, a rise of 23.5% from the previous year. With about the same assets in unregulated funds, according to a survey by ALFI and KPMG, there are loan assets of around E100bn in Luxembourg. Around 75% of regulated assets are in SIFS, with 13% in RAIFs.
The Luxembourg loans market is multi-faceted and highly-diversified by strategy, investor and fund type. The biggest single strategy is senior loans (35%), with direct lending at 18% and 22% in high-yield bonds. Most (95%) of the funds have a multi-country investment policy. The universe is evenly split between open ended and closed ended funds. Meanwhile, most (69%) of the flows to Luxembourg loans funds are from EU investors, but a significant amount (28%) are from the Americas.
Can the alternative sector harness technology?
For the real estate, private equity and private debt industries to be disruptors, as opposed to being disrupted, they will need to meet investors’ expectations around service and transparency. Technology will be at the heart of this. As Michael Jackson of Mangrove Capital Partners said: “future customers don’t want motor cars, they want to use Uber.” In 10 years, 70% of the global workforce will be digital natives who want assets in digital wallets, research reports on their devices, AML checks in a few clicks and performance on the go, not at annual meetings.
Yet, asset managers are not yet prioritising technology. A study by Cerulli Associates showed that only 25% will invest in technology such as machine learning and AI over the next two years. And those who are planning to invest view technology primarily as an investment tool to uncover new data sets, improve trade execution and optimise portfolio management and risk metrics.
The ESG challenge
The incorporation of ESG in the alternatives sector is, like technology, also a slow burn despite growing evidence that ESG is strongly demanded by investors. The result of a poll taken at the ALFI PE & RE conference showed that 35% of firms are discussing ESG but have yet to implement it. Just 24% said ESG was core to their business model.
Abigail Dean, of TH Real Estate, noted that most asset level studies find a positive correlation between sustainable certification and rental income and returns. Going forward, funds will focus more on sustainable value, so the correlation should become even stronger.
In real estate, sustainable efforts will focus partly on buildings themselves. Nancy Saich, of the European Investment Bank, believed buildings could incorporate more natural materials and greenery and could be shared to reduce unnecessary building. How the building is operated is just as important to sustainability as the build, she added.
Sustainability metrics will also focus on the location of buildings and increasingly take into account factors such as local air quality, the impact of climate change and the carbon intensity of local power grids.
In private equity, the link between ESG and performance has been made abundantly clear by the VW scandal, said Vinayak Bhattacharjee, of WRM Capital Asset Management. “VW was a failure of every letter of ESG,” he said. “Will VW recover? Definitely. Can small businesses recover from that kind of failure? No.”
Alternatives face further challenges through the constantly-evolving tax environment, as global tax regimes such as OECD BEPS have to be managed alongside local tax requirements.
It is important that tax remains a high priority throughout the lifecycle of the fund, not just in the structuring phase, said Sébastien Herzog of AXA Investment Managers. “The tax truth is only revealed with the disposal of the assets,” he added. The decades of structuring and tax expertise that exist in Luxembourg can be comforting for investors. As Margaret Fitzgerald of Hines said: “Tax is a big risk and if you are not structuring through Luxembourg, people want to know why!”
New regulation gives clarity to Luxembourg AIFs
Like other parts of the investment industry, alternatives managers are subject to changing regulations. In Luxembourg, a recent change to regulation has been widely welcomed by alternatives managers since it clarifies their delegation and oversight obligations. Circular 18/698 – better known as the “substance rule” – moves UCITS and AIF rules into line, which is helpful for investment firms which manage both types of vehicles.
Marco Zwick, director of the CSSF, the Luxembourg regulator, said: “This helps alternative managers to align governance amid all the different products and licences they have.”
The new rule, which was published in August 2018, clarifies areas such as capital requirements, control functions, the composition of the board, minimum governance requirements and the minimum number of conducting officers. It also creates tighter oversight of AML processes and cloud computing solutions. Cloud storage is now considered as outsourcing, and is therefore subject to privacy and data considerations.
“We have agreed with the market that they will conduct gap analyses,” said Zwick, who was interviewed the ALFI PERE conference by Denise Voss. “We will allow no flexibility on AML issues, but we acknowledge that governance issues cannot always be resolved immediately.”