Our expert panel discusses the growth of private equity in Luxembourg, the impact of technology on the funds industry and the EU’s Anti-Tax Avoidance Directive.
Marc-André Bechet (deputy director general, Association of the Luxembourg Fund Industry)
Justin Partington (group head of funds, IQ-EQ)
Revel Wood (founding partner, One Group)
Funds Europe – The number of private equity funds in Luxembourg with more than $1 billion in assets has doubled while real estate Raif launches have increased by 130% in one year, according to Alfi. What has driven this increase and from which type of investor? Have insurers been significant here? They have been chasing yield and want to invest in bond-like replacement assets, yet struggle to get into alternatives due to some of the regulations. How have you seen this private market sector develop, and where do you see it going?
Marc-André Bechet, Alfi – If you want to get a broader view on that, there is from long-term investors a search for yield. We currently have negative rates, so pension funds, insurance companies, institutional investors are typically looking for long-term yields which are positive and not correlated to mainstream asset classes.
So, there is definitely a potential for alternatives. If you look at the Luxembourg market, we have increased the size of alternatives from roughly 13% to 14% to now 17.5% of assets under management (AuM) over recent years, and there is further potential there.
Based on the three surveys commissioned by Alfi on alternatives in 2019, the growth rates at the end of September 2019 were: for private debt 14.5% growth rate year-on-year, real estate regulated funds 17.7%, and private equity was 19%. If you compare that to Ucits or mainstream funds over that period of time, it was only 8.02%. So, it’s almost twice the size in terms of the growth rates.
One study by the consultancy firm Preqin published in November 2018 shows that assets in alternatives are expected to double in size to US$14 trillion by 2023, and the same study reveals that 84% of investors will increase allocation to alternatives, so really the fundamentals are extremely positive.
There’s another study by Morgan Stanley and Oliver Wyman saying that 40% of asset management revenues would come from alternatives by 2023. That’s really driving the interest of asset managers towards these asset classes and it’s also coming from investors.
Justin Partington, IQ-EQ – Preqin surveys indicate 8% global growth in alternatives over the next few years, that’s the sort of number that we work to, and so if you put Luxembourg’s growth in that context, you’re talking two to three times the global market, depending on the particular asset class at the moment.
When you get growth at that level, it’s due to a number of factors. Marc-André touched on the demand for investors and the lower yield environments driving alternative asset strategies, which deliver above-average risk-adjusted returns. We’ve also noted the critical mass that Luxembourg has established in terms of servicing fund structures including ManCos [management companies]. depositaries, lawyers and directors.
It also means that Luxembourg has a pool of talent that is able to then provide substance where we see managers setting up their own AIFMs [alternative investment fund managers], having that optionality is useful as well.
The structures have been class-leading in terms of the development of the SCSp [special limited partnership] as a good addition to Luxembourg’s toolkit, providing a bespoke LP structure that investors recognise.
We see continued concentration on quality. Where you had a wider choice of fund domiciles, maybe seven or eight within Europe ten years ago, we’re seeing investors narrow that range of choice down to a handful with critical mass.
Revel Wood, One Group – If I formalise my comments into three structures, there’s first the demand side, with negative yields and long-term performance at 8% yield.
On the access for private capital, there has also been a great opportunity over the last decade. You’ve had post-crisis banks deleveraging, so suddenly that gave a massive rise to credit and debt funds where banks were offloading balance sheet, so that gave rise to these pools of assets where private equity or debt managers could step in where the banks played a role for liquidity in the past.
There’s historically been some inefficiency in large corporates or nationals that have owned, and these private equity firms have been able to get in, create efficiency, put in more effective management teams, put in better technology, leverage from crossholdings and scale through further acquisition or roll-ups to first of all improve the quality or the efficiency of the target firms, therefore improving the yield, and therefore delivering to investors a better yield. So, that’s the demand side.
On the jurisdiction side, I think Luxembourg has done a phenomenal job, as they did 30 years ago. We celebrated 30 years of Ucits last year, in the private capital space in terms of the toolkit, the Raif, to compete with offshore jurisdictions.
The limited partnership has been very successful and competed with the UK and the Scottish limited partnerships and were very prominent and continue to be so, but I think they will suffer under Brexit.
Funds Europe – What were the issues that lay behind the European Parliament’s adoption of a trilogue agreement to remove barriers to cross-border investment funds, which Alfi welcomed last year? What happens next?
Bechet – This is a right step in the right direction but it’s probably not the end of it. If you look at the deficiencies or limitations in terms of cross-border distribution of funds across Europe, there were quite a few things which Alfi mentioned in its response to the consultation. I will give you three examples of things which were looked after and which are adequately covered by these new cross-border distribution of funds (CBDF) directives/regulations.
The introduction of harmonised pre-marketing for alternative funds across the EU is the first example: there were different rules in different markets and some markets had no rules at all.
The harmonisation of the denotification procedures applicable this time to both Ucits and AIFs, and again in some markets you had no rules, in some markets you had very strict rules; and finally something which everyone really welcomes is the removal of the requirement for a local presence or a representative agent in some markets where these reps have never seen any investors at all. If you duplicate that in ten markets and you end up spending a few thousand euros every year for something that brings no benefit to investors, it was really questionable. That’s been removed. So, these are three examples of things which went in the right direction. We welcomed it, we think this is a balanced compromise between investor protection and more efficiency.
What is next? What is left behind? What could happen? I’ll give you one example. There is no definition of material changes, so whenever you register a fund for distribution in a given country through your local national competent authority, then if there is a material change affecting the fund, a new notification is required.
What is material? If it has not been covered by the CBDF, it could be covered as part of the AIFMD [Alternative Investment Fund Managers Directive] review, it could be covered by Esma [the European Securities and Markets Authority] as well. A separate instrument would be something that would be really welcomed by the market.
Partington – The interesting thing is that the retail and the alternatives world have been kept apart, so it could be the start of acceptance in a way that changes the market and gives investors more choice, whether retail or non-retail.
It is good to see that the pre-marketing conditions are now allowing marketing under the new trial agreement with existing and new AIFs alongside each other. I think that offers more investor choice, and that’s a good thing.
Our clients’ view is very straightforward, if they are buying businesses in a jurisdiction, they’ll put people on the ground to manage those investments. It’s not about having a shop window for investors to come in and see them on the high street. Private fund managers build investor relations through other means such as regular communication, AGMs and investor reporting.
Wood – The harmonisation of Ucits in AIFMD will help, I think it improves distribution. I don’t think it benefits non-EU AIFMs to my knowledge initially, but I think there’s some welcome improvements. I think it’s been touched on, the pre-marketing… It provides a lot of clarity in this two-week window, because there were very divergent rules, and what constituted marketing or not, so that’s very helpful to provide more clarity.
There’s that whole change in the market there, you don’t need to appoint this local agent any more. Is it linked to this EU harmonisation? Or did they adopt it in parallel? No. So, there’s a new regulation that’s coming out in Switzerland in January where all these IFAs [independent financial advisers] are looking for new solutions in terms of you don’t have to appoint a local IFA.
Funds Europe – A report published by Fitz Partners last year claimed that only 10% of funds based in Luxembourg would be technically viable for distribution in Germany from January 2019 due to new performance fee rules. Alfi, however, said it believed this was not legal. Is there now more clarity about this situation?
Bechet – The question is broader in that it has to do with the discussion about performance fees, which is something which is not harmonised at the level of Ucits funds and AIFs.
Traditionally in Luxembourg, we have been always looking at the Iosco principles but there’s no common set of requirements for Ucits funds across Europe. So, the German regulator BaFin provided its own guidelines which apply to its domestic funds, but they have been tempted to say, “If you market your funds in Germany you should logically also apply these principles.”
What I am inclined to say – and I’m not saying they’re right or wrong – is if everyone does this across Europe, at the end we have an issue of possibly conflicting statement or practices. So, this is something which Esma is very conscious of and has gone to public consultation recently and we say: “Just wait for the outcome of the results of the consultation decision by Esma.”
We were under the impression that Esma would provide high-level principles, guidelines, while not being too prescriptive. Let’s wait and see what comes out of it. For the time being we are in a bit of an inbetween situation.
Funds Europe – What can investment funds domiciled in Luxembourg expect now that the EU Anti-Tax Avoidance Directive (ATAD 2) has been passed into domestic law? ATAD 2 was seen as a way for Luxembourg to clamp down on tax avoidance.
Partington – ATAD 2 is intended to address the hybrid mismatch issue where an entity gets a double tax deduction. For example, at a practical level, where you have a treatment of a financial instrument as an equity, then income can be treated as a dividend, this can be tax-free in one country. However, in the other country, a debt instrument might trigger an interest expense that is tax-deductible. So, you’re not paying tax in one country and you get a tax deduction in the other.
We have got two years to implement the ATAD 2 reverse hybrid rules so there’s a bit of time for clients to look at their structures. It will apply from 2022 in Luxembourg. AIFs have been formally exempted as collective investment schemes.
So, the majority of AIFs structured as tax-transparent vehicles push the tax obligation to the investor level. This brings us to a position whereby a lot of the more recent funds are going to be not affected by the ATAD 2 rules at the fund level.
There are SPVs [special purpose vehicles] below the fund structure that need to be carefully looked at to see if the exemption on funds is going to include that group of SPVs as part of the fund structure.
Bechet – I think there is a level playing field across Europe as we apply the same rules. This will have an impact on investment funds and asset management structures, even though we were not the prime targets.
You’ve got two different sets of rules – the anti-hybrid rules and the reverse hybrid rules. The first set of rules apply with immediate effect as of January 2020, the second set from 2022.
As far as the anti-hybrid rules are concerned, they were already existing and have been enlarged to different categories or situations and have now been extended to non-EU relationships.
It does require that you assess your fund structures, that you make sure you’re properly set up, so there’s a compliance cost.
There’s the question of fully understanding the rules and making sure that you comply with the rules. There’s also a very important concept of acting together for investors which has an impact on the way you will be eventually impacted.
Wood – Boards need to be aware and need to be getting updates from their tax advisers. They need to review the structure and ask whether the structure creates a potential hybrid mismatch.
Then the source of income, where it’s from, the type of income, is it interest versus dividend? Does that create a potential hybrid mismatch? Where there are complex structures, mandate a specialist, not someone whose tax knowledge dates to 1995. So that’s a governance piece and have a review of the structure, be it by a specialist like IQQ or one of the Big Four tax advisers.
The other piece is, again not specifically around the tax, to engage technology. There’s next-generation compliance technology, and here I think it’s important to be able to document and retain the structures, the classifications, record the tax advice that you’re getting, have alerts when new tax rules come out because they’re coming out frequently, and make sure that’s reconciling back to the tax advice to see if that needs to be revised, and there’s turnover. Having a corporate memory in a centralised technology is essential now.
Funds Europe – Luxembourg will no doubt want to be a part of the new era of digital asset investment and asset servicing. How can the Grand Duchy ensure that it is?
Partington – I think we look at this both internally, how to manage internal production efficiency, KPIs [key performance indicators], and then also externally, working with other providers in the marketplace. I think internally the key for us as a service provider is to understand how we apply technology to create more efficiency, a better client experience, higher quality of output and reporting, and ultimately do things in a more advanced way that results for clients at the highest quality.
The external side is really a bit less about blockchain and DLT [digital ledger technology], but about connecting systems and having a more system-agnostic approach, so that you can provide external data reporting and output in a way that doesn’t replace legacy systems but brings them together, especially in a market like ours where there’s a lot of consolidation and M&A activity.
Some of our largest clients are actively buying other asset managers, so there’s a lot of consolidation in the asset management sector which comes with different legacy systems. We like to think of it as building data layers, whether it’s data warehouses, data cubes or the so called ‘data lake’, and to create the tools above the different legacy systems so that they will end up exchanging information, providing a consolidated view, is actually the opportunity where we see the biggest gains.
Blockchain and DLT are often talked about, but in my view it has quite a specialist application for custody, payments, transfer agency or KYC [know your customer], which seem like a natural fit for that technology. The immediate benefits of DLT are less obvious to me than connecting systems up in a more agnostic way. So, that’s where we put our time and focus.
Wood – In terms of what I see as a trend, and we saw some of these over the last couple of years, is tech, whether it’s on the asset management or asset servicing, so BlackRock acquiring eFront, you’ve got these vertical integrations.
The space that I think has struggled and where we are trying to differentiate a bit by being next-gen tech-focused is the less sexy, boring old manual processes.
We don’t have the large volumes of transactions but it’s more the aggregation assimilation. There again, there have been some great technology developments, so governance stuff. Comms have won a number of awards, and we’re focusing on that, deploying one regulatory compliance tool to help with that corporate compliance monitoring, an AIFM tool to aggregate all that data that the administrators do exceptionally well.
Across the spectrum, where it’s high-volume trading or trading versus the back-office administration, or even the red tape governance space, I see a lot.
Bechet – With new technologies and digitalisation also comes new business. Top of the agenda is cyber security and it’s also one of the top priorities of the European Commission for its work programme for 2020. The cyber resilience of the financial sector is not good enough. That’s something which we all know, and we face security threats, so it’s something that has to be addressed.
If I have a closer look at what we have seen in the market so far, I think fintech is already a reality in a number of areas. Probably not blockchain/DLT, but payments, data mining, lending are now highly automated and you are seeing new players coming to the market.
Funds Europe – What are the top one or two issues you think are likely to dominate Luxembourg’s fund business in 2020? What’s on the agenda and what needs to be done as a priority to keep Luxembourg at the forefront?
Partington – It’s two things we’ve already talked about, tax and technology. Tax, because we’ve evolved from a post-tax evasion world into a post-tax avoidance one where social impact is key. Tax and paying your fair share and stakeholder management are important for all businesses. At the same time, trying to strike the right balance whereby investors are not paying tax twice, for example, on the same income is still important as a principle, so it’s trying to navigate that tax world in the light of BEPS [base erosion and profit shifting].
With the technology, we’ve covered it extensively. It is about disruption, it is about offering efficient platforms. Technology is also a good solution to enable competitive environments at lower cost as well. It’s a complement to lower-cost labour pools elsewhere in the world. Both can be helpful, and it isn’t just a binary choice.
Wood – People and talent, I think that continues to be a challenge, and that is not so much on the supplier side but more on the demand side. I think demand in Luxembourg will continue to rise because of all the things we talked about.
Brexit will continue to deliver more opportunity. The alts, the rise of the alts. I don’t see Luxembourg slowing down right now in terms of growth, and I think that puts pressure on the talent pool.
The second is, we’ve had this in two quotes now, ‘stagnant words,’ ‘tsunamis of regulation’. I think that’s passed a little bit, maybe that’s a nostalgic view, but we have had it a lot. I think what I see happening is now more examinations, there were two ManCos sanctioned, there have been some banks sanctioned last year around AML [anti-money laundering], and we got the FCA [Financial Conduct Authority] review in the UK.
I think there’s going to be more examinations which will result in more compliance and regulatory pressure, and that’s around governance. AML is a big focus. I don’t see it as a bad thing, but I think for those that aren’t prepared and equipped, that’s going to be a challenge and will put more pressure on the talent pool and the resource pool.
Bechet – I’ve got two topics: risk management and anything around ESG and sustainable investment.
Firstly, let us look at existing or new regulations coming up in terms of risk management. I mentioned the Esma guidelines on liquidity stress-testing, the CSSF [the Luxembourg financial regulator] Circular 19/733 of December 2019 endorsing the Iosco recommendations on liquidity risk management, Ucits risk reporting for the CSSF, the upcoming common supervisory action with national competent authorities on Ucits liquidity risk management launched by Esma.
A lot of work from Alfi’s working groups is done on ESG, in particular our recent guidelines on sustainability-related disclosure, and that’s only the first step. I think we are very modest in saying, “We are just doing our homework to help our members, but it’s only version 1.0 and there will be other versions as things go by and we understand better how to apply the new regulation in practice.”
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