Supplements » Luxembourg 2010

CUSTODY: Alternatives - Taking the good with the bad

yin_yang_410Luxembourg is attracting more alternative investors from un-regulated fund centres. This is exactly what it wants, but the Grand Duchy will not let just anybody in, finds Angele Spiteri Paris.

Investors began to view alternative investments with a growing wariness as the financial crisis set in and the Madoff scandal added to this. But in spite of the reduced appetite for these products, Luxembourg hopes to win out in the post-crisis world as more alternative managers move their products to regulated jurisdictions.

Historically Luxembourg and other European jurisdictions like Dublin and the Channel Islands have fought with offshore centres like the Cayman Islands and Bermuda to become domiciles of choice for alternative investments. Now things are said to be moving in favour of Europe.

Vincent Beaujeu-Dumontel, sales manager at Caceis Bank Luxembourg, says: “Everything is moving from the pure offshore to the regulator framework – from Cayman and Bermuda to Ireland and Luxembourg. Cayman and Bermuda were very popular in the alternative scene but today we really see them collapsing. This is good for European domiciles. You are seeing large asset managers coming back to Luxembourg or even discovering Luxembourg.

“In the second half of 2009 most of the alternative funds created were sophisticated Ucits funds. This trend is now moving very fast and there is a lot of demand from asset managers to build sophisticated platforms. This shift from pure unregulated vehicles is a consequence of the Madoff scandal.”

Demand for Ucits
Olivier Sciales, founding partner of Luxembourg law firm Chevalier & Sciales, says: “The Ucits framework is attracting attention from hedge fund managers mainly because of the increased demand from investors for regulated products, transparency and liquidity sought in the aftermath of the Madoff case.”

In the past year hedge fund manager Brevan Howard Asset Management launched its first Luxembourg-domiciled Ucits III fund. Man Group and Cheyne Capital also launched Ucits funds.

Rafik Fischer, general manager and head of global investor services at KBL European Private Bankers, says: “This is the silver lining: bad news that we can transform into an advantage.”

Jean-Marc Goy, counsel for international affairs at the Luxembourg supervisory authority, the CSSF (Commission de Surveillance du Secteur Financier), says: “In the aftermath and reactions to the global financial crisis, which included the problems in the subprime sector, the Lehman bankruptcy and the Madoff scandal, we now see a general trend for more and better regulation. That can be considered as something positive for regulated jurisdictions such as Luxembourg.

“We have already noticed, throughout 2009, that promoters are saying that they want to move their funds from less regulated or unregulated offshore locations to regulated jurisdictions like Luxembourg.”

But Fischer warns that the Luxembourg funds industry needs to be discerning about which players are allowed to operate in the Grand Duchy. And service providers have a role to play here too.

He says: “Luxembourg, being a future centre for alternative investments, is good, provided that all the service providers carry out a sound vetting process and first-class due diligence on whom they want to work with.

“There are a large number of great companies in that business but you also have players who live and die with their single product and who, when things are starting to get a little bit tricky, may no longer be prepared to play 100% by the rules.”

Having been the chairman of the Association of the Luxembourg Funds Industry (Alfi), Fischer believes that bringing on lesser-quality players is simply not worth the hassle. He says: “I am convinced that the slightest mishap, like Madoff, causes Luxembourg a lot more trouble than the money we can make by accepting these lesser quality players. We have to make sure we get the right people to come to Luxembourg and not the bad apples.”

From an operational standpoint, administering sophisticated Ucits funds is more complicated than dealing with funds of hedge funds where the underlying funds were domiciled in one of the offshore centres.

Beaujeu-Dumontel says: “It is easier to do a Cayman fund where you don’t really have supervisory duties, where there are no investment restrictions to monitor.”

Setting up a Ucits fund means making sure there is some form of risk management in place and that the portfolios are monitored. Beaujeu-Dumontel says: “Sophisticated Ucits are more time consuming because there is more regulation to deal with, such as the calculation of VaR, but commercially they are good for Luxembourg. Large alternative asset managers who would have never considered Luxembourg before now come here to do that.”

Having funds move to Luxembourg from offshore locations is also a boon in the face of the Alternative Investment Fund Managers (AIFM) directive.

The first draft of the directive was received with acrid criticism and the revisions still have not eased industry players’ concerns. However, whatever the outcome, Fischer of KBL says: “Europe has more to gain from the directive than to lose. Particularly because the trend is clearly for funds to move onshore from offshore locations.”

Potential for AIFM
The pending regulation is something that cannot be ignored when discussing the custody and servicing of alternative assets. Although most actors in the industry are taking a wait-and-see approach there are concerns that cannot be ignored.

Serge D’Orazio, head of investment funds and global custody services at KBL, says: “There are some paragraphs in the Swedish version of the directive where if you read between the lines, a Cayman fund could be more interesting to be sold in Europe. They could be sold on a private placement basis with much fewer restrictions than Europe-domiciled funds. So we just have to be sure that the directive plays in favour of the European community.”

Keith Burman, senior vice president at Brown Brothers Harriman Luxembourg, says: “The directive is causing a lot of discussion because we’re uncertain what exactly is going to happen with it. It could make things better, by broadening the investor base, or it could make things substantially worse. If the European legislators get it wrong it could mean that investing in emerging markets and opportunistic transactions with any legal uncertainty becomes impossible for European real estate investment funds.”

In an article, Michael Ferguson, partner at Ernst & Young Luxembourg, says: “The choice of domiciles for alternative investment fund managers and alternative investment funds will depend on several factors such as the flexibility of the regulatory environment, fiscal environment, reputation of the financial centre, expertise and competitiveness of local service providers and knowledge of the workforce.

“These are all areas where Luxembourg scores highly, experiencing the highest growth in Europe in all alternative sectors over the last five years. In addition, Luxembourg is already the world’s leading domicile of traditional funds distributed cross-border [Ucits funds].”

He says he believes that Luxembourg will prove to be an attractive domicile for AIFM, and well placed to become a leading domicile for European alterative investment funds.

But although the future for the sector looks bright, the recent past has been bleaker, at least for some.

Market turnaround
Burman, of BBH, says: “You could sense the decline in activity in markets in general. 2007 and 2008 were record years for many financial products. In 2008 we saw about 350 property transactions while in 2009 we saw more in the 30-40 range. It’s fair to say that around 10% of transaction volume was probably felt across the board, as compared to previous years.”

Beaujeu-Dumontel of Caceis says: “Following the Lehman collapse, early 2009 was rather quiet from a funds creation perspective.” He also adds that Caceis has not seen any movement in the fund of hedge funds space.

This contrasts sharply with what KBL experienced. Fischer says: “We have a huge demand in funds of hedge funds. In these vehicles you have a risk diversification balance and you may have side pockets. So although you may have times when one or the other has problems with the underlying, it’s limited to a couple of percent of the portfolio. It’s by far a less risky environment for the custodian banks.”

KBL also saw demand on the private equity side, “What we like about private equity is that the ultimate holder of the equity is the registrar of the company. The risk is linked to the company as such, but still we only send the money of the initial investments as soon as we carry out all the verifications required by the market.

“The advantage of private equity is that if there were to be a fraud somewhere it’s going to be linked to one investment so if you have diversification in the portfolio, its not like in the case of Madoff.”

Regarding private equity, Caceis’s Beaujeu-Dumontel says: “You can still see appetite for green technology and clean technology on the capital risk side. There is a lot of buzz around the sector and people are keen to invest in these kinds of strategies. In fact, we still have new funds being created.”

Both Beaujeu-Dumontel and Fischer found that real estate fell deeply out of favour, but according to Burman, who is also head of real estate fund services at BBH, there are clear signs that this alternative asset class may be back on the menu.

He says: “Towards the end of the year we started to see a pick-up in capital flows. Banks are back in the market to finance the best quality properties, albeit at lower loan-to-value ratios, when twelve months ago they weren’t financing even the very best.

“Fund managers have also reappeared in the last six to eight weeks [the very beginning of 2010] saying that some projects that have been on hold for the last twelve to 24 months are starting to attract interest from investors again.”

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