Flaws in cross-border fund distribution – and, of course, Brexit – were two of the issues discussed at our Luxembourg funds industry roundtable.
Steve Bernat (chief executive officer, Carne Group Luxembourg)
Gary Janaway (chief operations officer, Kneip)
Michael Hornsby (EMEIA real estate fund leader, EY Luxembourg)
Funds Europe: Esma [the European Securities and Markets Authority] wants to deepen the market in European cross-border funds. It has identified flaws, such as the fact that many funds mainly sell back into the manager’s own market, and that funds are comparatively small. How does the Luxembourg industry view this situation?
Steve Bernat, Carne: This has been debated in Luxembourg for many years. With Ucits in 1985 and the Alternative Investment Fund Managers Directive (AIFMD) since 2013, we’ve come a long way in the EU towards harmonising the framework for investment funds, including the distribution passport. Now we’re at the next stage of this evolution – but as Luxembourg service providers, although we have developed solutions over the last few years to help asset managers distribute their funds, there is only so much we can do.
There are still local market nuances to take into account with registering a fund for distribution. Firms need to have a legal representative or paying agent in certain countries, for instance. Reporting requirements may also differ by country. In reality this is not harmonised at all.
Michael Hornsby, EY: From the standpoint of alternative investment funds, the US market for PERE [private equity-real estate] is dominated by very large and diversified funds. They have real scale and are very cost-effective. In Europe the market is more fragmented, with more managers and smaller funds finding it challenging to be efficient. In contrast to Ucits funds, alternative fund structures generally have far more complex operating models with multiple special purpose vehicles and holding companies, and different business processes at the AIFM [alternative investment fund manager] and investment adviser level related to non-frequently traded assets. Although the idea of passporting management company activities around Europe is fine in theory, there are many factors related to this complexity, and especially substance considerations, which can make this difficult.
Gary Janaway, Kneip: I don’t think the domicile of a fund makes a material difference when it comes to an asset management firm selling into a particular European market – regardless of whether the fund is considered to be in a domestic, or a cross-border member state like Luxembourg.
The problem is not to do with there being too many small funds in Luxembourg; it’s that there are plenty of small funds across Europe. The fact that they are small is reasonably problematic from the point of view of scale – yet why is that, though?
It’s down to regulation. A firm can passport funds across borders, it can carry out a number of services from different locations and firms can register funds for distribution in other countries – but if you then look at the cost of providing tax information and local reporting requirements that are market-specific, the cost of doing so for small funds becomes prohibitive.
As the costs of tax and regulatory reporting are often borne by the funds, the cost of distribution in multiple countries can have a drag on fund performance directly translating into lower investment returns to investors.
Hornsby: In theory, a Luxembourg AIFM can manage an Italian or a French fund. But, practically, there is a whole business ecosystem around a fund platform that is either very French or very Italian. A number of managers reach the conclusion that it is easier to set up a family of AIFMs, with a common operating model that can adapt to local requirements, rather than running a cross-border management company activity from Luxembourg.
Bernat: The idea behind having local market nuances was always to make it easier for local investors to subscribe to a fund. I can fully understand that – but one has to wonder whether the additional cost justifies the additional value it brings to the end investor.
Hornsby: And I think we have to make a big distinction there between institutional investment funds and real retail investment funds. In the institutional world, which mainly comprise of large pension funds and insurance companies around Europe, although they are subject to a similar broad regulatory environment, they are each subject to varying local tax and regulatory requirements. This leads to different approaches and perspectives to investing in alternatives. It is therefore actually quite difficult to build something that is of technical appeal to a wide range of large institutions in one product.
Bernat: We can certainly harmonise distribution more, but there are obstacles we cannot overcome. With 28 countries in the EU, there are 28 sets of investor requirements and perhaps different distribution channels. The US is one market with probably one set of investors, primarily, in terms of what they’re looking for, whereas if a firm is distributing a fund to the Nordics or to Germany, France, or to southern Europe, they will encounter investors with different requirements and who may not want to buy the same product that the Nordic investor, for example, wants to buy.
Hornsby: Inrev [European Association for Investors in Non-Listed Real Estate Vehicles], and other trade organisations representing the investor agenda, develop standards covering investor reporting, estimating fair value positions and calculating net asset values. They also promote practical concepts covering liquidity mechanisms in funds, and attempt to align institutional investors and allow managers to build products of appeal to a broader audience.
Luxembourg is very much plugged into this agenda and it is open-minded to developments that are in the best interest of investors. Regulators also need to be agile and responsive to these ideas and trends.
Funds Europe: To what extent does Luxembourg allow the delegation of fund management activities to non-EU countries and how will this affect firms in the context of Brexit?
Bernat: In a typical third-party management company set-up, portfolio management is delegated to a manager who very often is the same as the initiator of the fund. Management companies in Luxembourg are used to delegating portfolio management to managers in the EU and elsewhere, such as the United States. The UK for me is just going to be another United States after the Brexit, so I don’t see any changes there.
As an industry we will continue to delegate portfolio management to managers in the UK. I don’t see that fund managers will have to move their portfolio managers to Luxembourg or any other countries within the EU.
However, to be able to access EU investors, firms will need some kind of presence in the EU, at least as things look right now. The Luxembourg regulatory authority has been very clear that they will require some substance in terms of key functions in Luxembourg, such as people and systems. They don’t expect managers to transfer substantial numbers of staff to Luxembourg, but they will apply proper proportionality. So as a business grows, the substance in Luxembourg should grow too. I think that’s just fair.
Alternatively, there are plenty of management company solutions in Luxembourg that have substance on the ground already, including infrastructure and people. UK managers, instead of managing their fund using their own management company in London, or instead of creating their own management company in the EU, they can appoint a third-party management company to provide that substance.
Hornsby: It is similar for AIFMs. There are plenty of models that exist today where portfolio management is delegated to other countries such as the US. This makes sense, an underlying investor might be very concerned if their US real estate portfolio was managed from the other side of the world. I would say, though, that there is a difference in the way in which tax and legal substance are considered in the alternatives world. Whereas the substance issues around regulation and taxation are not so critical for liquid assets, in alternatives it is often far more critical. The role of the investment adviser is a lot more complex, supporting large illiquid asset acquisitions, with complex financing and legal structures and significant due diligence requirements. The portfolio management function here in Luxembourg is operationally more of a governance activity over the process and controls over the investment management process. This model is probably a more common model than delegating everything over to a non-EU country. The possibility nonetheless exists.
As far as the UK is concerned, and thinking about Brexit, the UK has been part of the EU for a long time and is used to the AIFMD regulations. It understands the operating models, the documentation, the processes and workflows, so it will be very easy to continue to fit within this framework.
What is also interesting, assuming the UK leaves the EU eventually, is to follow the path the UK takes in terms of financial regulation. Will it continue to align with the EU and try and operate alongside the EU market, or will the UK go in a completely different direction?
Janaway: Asset managers operating in the UK that want to continue distributing in Europe will likely have to establish a fund management presence to provide substance inside the European Union. This is unlikely to impact the activities related to the management of assets. I don’t think there’ll be much difference at all with investment management activities being delegated to group entities outside of Europe.
The exception might be those alternative investment managers who trade in real assets and other securities off-exchange. As equities, bonds and even derivatives are traded on-exchange with brokers, custodians here in Luxembourg have access to the trade information they need, as do the management companies. However, with real or alternative assets, many trades are documented in paper contracts that need to be reviewed by suitably qualified professionals.
Funds Europe: Which are some of the most urgent issues in your clients’ minds at present, apart from Brexit, and what can be done about the challenges they perceive?
Janaway: On the regulatory front it is MiFID II – more so than Priips. The focus for us is the product governance and target market information.
Priips being delayed by a year was sensible, given the uncertainty about the definitions of terms. The new effective date of January 1, 2018, coincides with MiFID II and means a number of fund providers are going to have to decide how they will produce documents and manage data for both sets of regulation, either in-house or using an external service provider.
However, with MiFID II, people are just putting the blueprints on the drawing board. They’re awaiting clarity from Esma and Efama [the European Fund and Asset Management Association] as to the definition of ‘target market’ data. Only once this is available can solutions be finalised. There is a limited time for a whole industry to prepare and it’s not just about piecing together the manufacturing side of the asset management world, but also considering distribution. Distributors also have a need to receive and store target market data for the investment products they distribute.
Most asset managers will follow the RFI/RFP [request for information/request for proposal] process to help them select a provider. Normally this incorporates a due diligence review on the shortlisted providers and then the final selection. The lapse time to complete this process is typically several months. With the January 2018 effective date looming, it is evident that time is in short supply. Given the overlap or similarity in much of the data used to be Priips- & MiFID- compliant – such as transaction charges – choosing a provider who has solutions for both sets of regulations should help reduce the time pressure.
Selecting an existing provider who can extend their service to accommodate MiFID II regulations may also reduce the effort of running a full RFP process. In the current environment the selection process will remain a topic open to scrutiny by fund management companies, fund boards, internal auditors and other internal control functions within companies.
Bernat: We still have 100 new managers coming to Luxembourg every single year and a lot of them are not familiar with the framework that surrounds Ucits or alternative investment funds. Hence, there is an educational need on regulation and distribution. I think we still have managers who come to Luxembourg because they see how many of their peers may have had success with Ucits or an alternative investment fund and they sometimes think that they can easily replicate that. But some forget that they need to define their distribution strategy very early on in the process when they decide to set up a cross-border fund.
Many managers underestimate that task and there are still managers who open up new funds and then close them again simply because the distribution strategy wasn’t well thought through. Or they did not even have a plan, or they were lacking knowledge and didn’t have access to the market intelligence that they needed in order to be successful in the various markets they wanted to target. Some just tried to do everything from their home country and didn’t necessarily show real commitment to any new market that they wanted to enter.
Hornsby: Agility and scalability in the alternative world is a critical success factor. Managers struggle with ever more demand for alternative products with a wide variety of investment structures to choose from, including separate accounts, club deals, closed funds and open funds. In addition, underlying portfolios and classes of asset are even more global.
Time to market is very important and fund platforms have to be capable of on-boarding different product formats quickly.
In the alternative world, unlike Ucits, as already mentioned, operating platforms are very different. They typically consist of disaggregated IT systems and multiple service providers spread across a range of jurisdictions that need to be linked together. In this environment, how can managers avoid doubling the size of their headcount as they double the size of assets under management? Cost and resources are always a challenge.
Funds Europe: KPMG recently asked if Luxembourg will lose its fund crown if, in the not-so-distant future, the back and middle office of asset management firms are located wherever the leading digital distribution technology is located. Is this threat real?
Janaway: I don’t see why. I see digital technology as a modern media by which to interact with clients and investors. To manage the cost of developing digital capability, it makes sense for development centres to be located where overhead costs are lower. We mentioned the impact of costs on funds and performance earlier, so we are underlying the pressure on asset managers to actively manage their cost base and those of the funds.
However, I don’t see the connection or a material impact on the Luxembourg funds industry. Today it is common for the back-office activities of fund managers and securities services organisations that provide custody and fund accounting to be located outside of Luxembourg, whereas typically most middle offices sit closer to the investment managers’ operations than the fund management companies. This makes sense when you consider that investment management activities are often delegated to parts of an asset management operation located in investment centres outside of Luxembourg. Regulation still requires a management company and custodian responsible for these activities to be based in Luxembourg. Whilst there is infrastructure supporting these functions, it is difficult to envisage them being materially impacted by digital technology.
Will digital really impact these parts beyond modernising them? Maybe – but quite a long time in the future, not immediately.
Hornsby: I do not get that relationship either. Luxembourg alternative fund platforms typically sit within and as part of a global operating model, with the manager running multiple funds across the world, so the middle and back office should be a global concept. There are many areas of potential innovation, such as the deployment of robotics. Further integration and development of IT infrastructure will improve efficiency, speed up and improve the granularity of reporting to investors. Luxembourg also has a significant focus on fintech developments, which will help maintain our competitiveness.
There is no doubt that a combination of digitalisation, technology, and, innovation and areas such as robotics will be huge themes in the industry going forward. I see these developments within the frame of global operating platforms. I do not see how it is specifically related to a particular fund domicile, which is driven by other considerations such as proximity to investors, the tax and regulatory environment, and availability of competent service providers, as well as overall operating efficiency considerations.
Janaway: What impressed me about property and private equity funds was during my first experience in providing services to them back in 2003-04. The use of online communication was far in advance of where the retail Ucits market was. So I look at alternatives and think they’ve been ahead of the game for a long while and they will be amongst the first to benefit from digital technologies.
Hornsby: Developing technologies alongside ever more integrated platforms is all great news for both investors and managers, but I do not think it will change where you locate a fund, whether it is Delaware, Cayman, Luxembourg, Jersey or Guernsey.
Bernat: Luxembourg has always embraced change and developed solutions in line with changing industry dynamics, otherwise we wouldn’t have had the success that we have had, and the same goes now with fintech.
Luxembourg has created The House of Fintech, for instance, a platform where financial institutions and fintech companies can interact, where they will hopefully develop innovative solutions that will shape the future of this industry. Luxembourg isn’t just sitting here and watching this industry develop, we try to shape it.
Funds Europe: Over the past year, what has caught your interest the most within the funds industry and why was it so important?
Hornsby: In many ways, some of the ideas already discussed above will enable alternatives to catch up with other industries in the way they process and manage information on a global scale. And hopefully this will make alternatives more investable with the benefits of improved transparency.
Bernat: For me it’s the Raif (reserved alternative investment fund) structure in Luxembourg. There are 40-plus structures that are up and running in Luxembourg already. Since this was passed by parliament in July last year, many of the enquiries we are getting are for reserved alternative investment funds.
As a management company we’ve launched four already and there’s a few more in the pipeline to go live. Clients that have launched a Raif with us are primarily family offices that have consolidated their assets in a Raif structure – we’re talking about one billion-plus of assets. But also insurance companies because of Solvency II transparency requirements. Again, it’s consolidation of assets and they choose the Raif structure because there’s no distribution going on. So they don’t care about whether the product itself is fully regulated or supervised.
Funds Europe: What items are going to be top of the Luxembourg work agenda for the next 12 months?
Bernat: Brexit is still going to be top of the agenda. We have close ties to the City of London and will continue to have close links. How the whole environment is going to develop post-Brexit, I think that’s what we’re working through right now.
Janaway: I would say the adoption of digital technology across the fintech sector. [Also] in the world of investment, I am curious as to whether we are at the dawn of change in the interest rate environment for reserve currencies. The US has been the first to start increasing rates. I’m not sure if Europe will be able to follow suit, although there are signs of increasing bond yields.
Will other developed countries also start to slowly increase interest rates to tackle the nascent growth in inflation? Having experienced a decade of zero or negative interest rates, what will a change with positive interest rates bring in terms of investor sentiment and new investment products?
Ironically, the UK cut interest rates on the back of Brexit, cutting the returns to savers. The reduction in interest rates has been so severe, creating a long-term demand for yield. This has led to reducing bond yields that have been underpinned by the buy-back schemes operated by central banks, but these too are beginning to taper off. I’m watching to see if we are at the point where the tides will change and what this will bring.
Hornsby: I expect Brexit to be a dominant theme. Clearly there is a big opportunity if Brexit goes ahead. Luxembourg could strengthen its ties with the City of London and develop a model that works in a post-Brexit environment.
Another area of interest I am following at the moment, with the new US administration, is a potential change in the relationship between the US and Russia. What will happen to the current sanction programme with Russia? If sanctions with Russia ease, this might create business opportunities for Luxembourg.
Another elephant in the room is China’s policy towards the West. Will China develop a more active foreign policy in the financial world as well as in the real world? This is something else I think Luxembourg has to watch very carefully. We already have excellent relationships with Chinese financial institutions. Luxembourg hosts the European headquarters of some of the largest banks in China and the world. It remains to be seen how these banks will roll out their European activities and what role Luxembourg could play.
©2017 funds europe