Luxembourg Roundtable: “We have good reason to believe it might work”

The success of the Eltif and the tokenisation of private assets funds are among the topics discussed in Funds Europe’s private markets roundtable in Luxembourg.

  • Arnaud Bon, Head of advisory and consulting, alternatives, Deloitte Luxembourg
  • Emmanuel Gutton, Director, legal and tax, Alfi
  • Sven Rein, Managing partner, Pandoo Management
  • Stefan Staedter, Partner, Arendt & Medernach, Luxembourg
  • Henning Swabey, Head of growth, fundcraft

Funds Europe – Would you agree or disagree that the prominence of the Eltif [European Long-Term Investment Fund] will rise considerably in 2023?

Emmanuel Gutton, Alfi – I anticipate a rise in Eltifs in 2024. Today there are 48 Eltifs domiciled in Luxembourg. Alfi performed a survey among our members at the end of last year to understand the direction of travel. We were told at least 25 Eltifs were ready to be launched in Luxembourg as soon as practicable, meaning an immediate increase of 50% of Luxembourg Eltifs. That number may be even higher now. Also, big asset managers have told us they are considering adding Eltifs to the range of investment funds to be launched soon.

Arnaud Bon, Deloitte – The asset management industry is increasingly struggling with cost pressures and volatile performance. Many global asset managers are consequently diversifying into alternative strategies, mainly through acquisition, to support growth further.

With non-institutional investors being increasingly targeted as untapped funding sources for alternative strategies, the revamped Eltif regime is promising. The stars are aligning for a much greater push into the democratisation and, potentially, retailisation of private assets, with Eltifs spearheading this.

Stefan Staedter, Arendt – Eltifs are increasingly perceived as a product for investors, asset managers, and distributors. It is an exciting time despite the economic surroundings. A few years ago, if you mentioned Eltifs to retail investors, as well as families and friends, everyone would be clueless. However, everyone seems to know about Eltifs now and how they may be a good investment.

Gutton – The positive evolution of the Eltif regime is the result of a constructive dialogue between the EU legislator and the industry. Alfi has participated in this dialogue. The EU legislator collected feedback to understand why Eltifs weren’t as successful as what was expected in 2015, and there was a clear intention to adapt the regime to make Eltif a success. The resulting feedback from the industry has been positive.

Sven Rein, Pandoo – Eltifs are the right product as part of the megatrend of the democratisation of assets and investments, although I’m unsure whether Eltifs are moving things in the market. Yes, Eltifs are a vehicle to access new pockets of private investor equity besides institutional money, which investment managers are looking for while setting up new structures. The new Eltif version 2.0 is coming at the right time to accommodate this bigger trend further.

“When structuring a fund and launching a vehicle, digitisation is at the heart of the investor experience as it offers transparency, enables real-time updates and powers operational efficiency.”

Bon – Take a step back. We’ve got the right vehicle and legal and regulatory wrapper with Eltif 2.0. Anticipating where capital can come from, i.e. less sophisticated investors, we should remember there needs to be more education regarding alternatives in the retail and even sophisticated retail markets.

While alternative managers have faced a lot of bad press and bashing in the past, a big challenge for the industry is ensuring we keep a clean image of this industry to channel the retail money. Thus, having the right vehicle is important, but ensuring that the model works and investors understand it will be the main challenge.

Henning Swabey, Fundcraft – Eltifs reflect a trend towards supporting smaller players in the industry. There has been success with other regulatory changes, which is worth noting. For example, the European Venture Capital Fund (EuVECA) has allowed smaller private equity and venture capital managers to efficiently create investment vehicles to support their strategies and goals on behalf of the underlying investors.

Staedter – There is a gap in the retail distribution of alternatives. The Eltif is one solution to this. However, there should be a common effort to explain to the European Commission and other decision-makers that it’s only one tool, and we need to design more tools like this because the demand will grow.

Bon – When we speak about the ‘democratisation’ of the alternative space, we forget it already exists. Still, it’s a national domestic market driven within each country. And in most countries, the right instruments and vehicles are already there. With Eltif, a new cross-border market merging national markets should appear.

Funds Europe – The ‘democratisation’ of private equity refers to making private equity available to a greater range of investors, including smaller pension funds and even retail investors. Could fund administrators and custodians support private equity firms in this ambition, and what challenges would they face?

Swabey – When we’re talking about democratisation or retailisation, we’re talking about a few things, including access to alternative assets but also being able to divest. When structuring a fund and launching a vehicle, digitisation is at the heart of the investor experience as it offers transparency, enables real-time updates and powers operational efficiency. We must also consider the challenges that legacy technology creates, as its maintenance costs and inefficiencies are killing the industry. We can’t support what we’re trying to do in the future if we’re dealing with pre-millennial technology.

Rein – Five years ago, we worked with a client to build up such a ‘democratised’ platform, which has become a big platform now, and we went through all those technological challenges. Digitisation is important to make things more efficient. Yet, we must move to more operational digitalisation, ready to service next-generation funds designed to operate on automated IT platforms. To make something successful, you must understand your client, as your client is building an individual IT platform on their side. You must understand how the client works and the transaction volume and be ready to onboard numerous investors who aren’t institutional investors.

Digitalisation is part of this solution, but you can only digitise some processes. There remains a significant skills gap which needs manual input to resolve. Maybe we’ll have it all digitalised in five years, but it’s being rolled out slower than desired. There is also a lot of transaction flow, many accounts to be opened, and a lot of transfers with which to deal.

Bon – We have two different worlds meeting: the world of traditional asset management – high volume and small tickets; and the world of alternative management – complex investments and structured illiquid investment structures. This comes with technology, operational, distribution and liquidity management challenges. As an industry, we must make sure to tackle these challenges. There is a cost driver to it, too, and EU policymakers are more conscious of that than they used to be. It must be cost-effective. The asset servicing industry needs to build those additional operational and technological building blocks that connect the alternative and the traditional worlds.

Gutton – When you ask what support administrators and custodians can provide, they should have a common understanding of the issues. Of course, depending on the business models of the various set-ups, there might not be a common solution, but understanding the needs of the issues is essential, and making sure they’re looking in the same direction is a must. This is what Luxembourg is used to doing: taking a collective approach to these new developments.

I would insist on the need for asset service providers to have a collective approach: to have a forum to meet, discuss, and agree on the trends, issues, and solutions. We cannot have only one solution. Alfi can help, but there are others besides us, and this is where guidance, Q&As, etc, support the private equity funds.

“We have two different worlds meeting: traditional asset management and alternative management. ”

Rein – We’ve recently been dealing with clients with high IT knowledge since we’re dealing with a different generation of people. They’re also experts in digitalisation, but their fund knowledge lacks the operational administration component. That’s challenging, so that gap must be accommodated. You must educate them on fund servicing, fund governance, regulatory requirements, Luxembourg particularities and necessities to avoid risk.

Swabey – Many digital-savvy venture capital or private equity managers don’t necessarily see the administration industry as being on the ‘sexy’ side, but their business model relies on the infrastructure provided by fund administrators and depositaries. Those driving the ‘democratisation’ of private assets rely 100% on technology to drive automation and scale and need digital infrastructure to ensure real end-to-end efficiency.

I’ve spoken to some global asset managers working with traditional asset services who need help with legacy technology. Yes, in many cases, they also can invest heavily, but they’re stuck using pre-millennial technologies. And so there’s an opportunity to do something new. Someone once told me, “If you want to go far, go together. If you want to go fast, go alone.” There will have to be a need for the leaders of the pack to go fast and together.

Staedter – You usually go with a fully paid-in model when you have retail investors. I have seen a lot of need for adopting a hybrid approach, but this is an operational burden. Dealing with subscriptions, transfers, and redemptions is common in Luxembourg, so I’m very happy to see that the industry wants to find a common solution. It is also important to mention that we need flexibility, but the most flexible sometimes have better checks and balances.

Rein – Being flexible, quick and automated is all good. But remember, here in Luxembourg, we have heavy regulations, and to fail as an investment manager and service provider is a massive fear. So, when we talk about investor onboarding, it’s a sensitive topic to ensure all the checks are in place to avoid any default related to AML [anti-money laundering] and KYC [know your customer] checks. I don’t have to tell you how sensitive our Luxembourg regulator is. So, a lot of education is needed because your client, the investment manager, setting up some platform might need to be more sensitive to the requirements here in Luxembourg.

Bon – We see a number of ‘smart followers’ looking at what products ‘front-runners’ have recently launched successfully. They are moving into this space and trying to avoid past mistakes or improve what has already been set up. When approaching this ‘democratised’ world, we need to help our clients – fund managers – to take a small step back and say, “Hold on – are we doing it right?”

Funds Europe – A key issue in this debate is the illiquidity of the underlying assets. Is it possible to partially tackle the illiquidity issue implicit in the ‘democratisation’ of private equity through a buoyant secondary market?

Bon – We need to be careful when speaking about illiquidity. There is illiquidity at the level of the asset. At the level of the portfolio, there might be a certain level of liquidity, especially with secondaries strategies. And then, of course, liquidity at the level of the product.

Some legal mechanisms, such as gating, are important to protect our industry. Yet, it should not be the starting point of the discussion; the starting point of the discussion should be “how do I manage from an asset/liability management perspective?” and “how do I forecast my liquidity needs with liquidity availabilities, based amongst others on my cash inflows and outflows and the time horizon of each asset?”

I want to mention modelling since it’s crucial here. If you want to model, you want to have historical data sets. Yet, you don’t have an exact match regarding historical data at investor levels. So, you need to use proxies, in normal and stressed conditions, and adjust the model as the market evolves and grows. Finally, managers must be careful about what they are selling – a fund is either open-ended (hence liquid) or closed-ended. When redemptions are at the managers’ discretion – that’s not open-ended. There is an important risk of mis-selling.

Staedter – Gating cannot be the only solution when we speak about liquidity management – you must have in place a type of toolbox which you can adjust to the specific scenario. It is up to the manager to implement an order of priorities regarding the liquidity tools adapted to its product. It’s advisable to keep a certain liquid pocket aside when dealing with retail investor products, and borrowing mechanisms, extended notice periods, matching and the possibility of distributions in kind and gatings may complete this toolbox. However, this remains subject to the discretion of the asset manager.

Rein – It’s about education. When investors decide to invest in a product, transparent information, such as how the fund is managed, must be available. For example, if they invest in an open-ended fund, they must understand it differs from a closed-ended fund. They should also be aware there’s potentially a redemption control mechanism designed found in prospectuses or subscription agreements.

When liquidity control mechanisms are in place, stress testing must be discussed. This should be part of each report. It must be reviewed; it has to be checked over time as market conditions change. We should be talking with our clients and the depositary bank because there are solutions to ease stress moments in which you can bridge the liquidity situation, maybe until you call in the capital to ease the situation. So, it’s about communication, good understanding of the offset mechanism and the effect on the investor and initiator side of service providers.

Bon – Concerning the liquidity pocket, I see two behaviours generally: either managers saying, “We’re keeping a large liquidity bucket,” which negatively impacts your performance, or managers on the other side saying, “We’re going to keep a liquidity pocket as small as possible,” creating more risk of triggering mechanisms which should remain exceptional, such as gating. This is why the modelling component is important.

Staedter – The most important thing is communication. We see it now in the Eltif – an Eltif is closed-ended by nature, but the Eltif Regulation allows for redemptions which make an Eltif semi-liquid without being called ‘open-ended’.

“Theoretically, it was possible to transfer a share from one retail investor to the other, provided the investor was eligible. Now, you will need to involve someone from the distributor side.”

Gutton – Liquidity management tools are highly topical. In the context of the AIFMD [Alternative Investment Fund Managers Directive] review and, in particular, the discussion on loan-originating funds, there is a lot of discussion about the possibility of keeping all loan-originating funds open-ended if the relevant liquidity management tools are in place.

The secondary market is not often used as a day-to-day tool but more opportunistically in a contingency context. Developing the secondary market would allow investors to convert stakes in cash and relieve themselves from future cash outflows.

There are some exciting developments in the Eltif reform. The updated Regulation (Articles 19 and 19(2)) facilitates the development of secondary markets, allowing full or partial matching. Esma [the European Securities and Markets Authority] will develop the relevant technical details at a second stage through regulatory technical standards. These developments will be of interest to follow.

Finally, transactions on the secondary market come at a cost, usually for the seller. Such costs should not be underestimated, and this item should also be part of the education programme.

Staedter – Whenever you use the secondary market, you will need advice from a MiFID [Markets in Financial Instruments Directive] firm, which could be a blocker from the secondary market perspective. Theoretically, it was possible to transfer a share from one retail investor to the other, provided the investor was eligible. Now, you will need to involve someone from the distributor side. In a certain way, it is a new business opportunity for distributors, but this will come at a certain price for investors. Thus, the returns of retail investors could be lower. In a nutshell, this administrative burden makes the secondary market less active than before.

Swabey – There is an important business model in the secondary markets: feeder funds, and they’re a secondary market. You create a pool of assets that invest into other funds, giving you access to them. But if we’re then looking at the pure secondary market or a purer secondary market where you might have an exchange, we see the world of ETFs [exchange-traded funds], where you have the primary market with funds managed, and then you have a series of ‘market makers’, who will then purchase those units, and then will make them available to exchanges, or investors directly.

As far as the secondary is concerned, if I take ETFs as an example, and we come back to costs, any ETF brought on exchange, you typically expect to pay 8 to 16 basis points as a spread for access to those rather than going directly to the market maker. So, there are additional costs. That said, exchanges do bring liquidity in the sense of an opportunity for intraday trading.

“Regarding cryptocurrency funds, I was more bullish last year regarding their future and segment growth. The biggest challenge was finding a depo bank.”

Alternatively, consider nominee or wealth management holdings, in which a wealth manager will buy units in a fund they’ll make available to their underlying clients. Again, a dark pool risk is involved here, so it’s important to understand their cost structures and incentives.

A key success factor for the secondary market is real-time information, transparency, collaboration and digital ‘self-service’. When everything is accessible anytime and anywhere, we get to a buoyant secondary market. Technological advances, including tokenisation, could provide a solution.

Bon – We must watch out for what’s coming from distributed ledger technology (DLT). We’ve seen many proofs of concepts and business cases supported by DLT technology. At the asset level, it could be better. There are a lot of constraints, including tax, registration, and legal.

The benefit of technology is reducing operational burden since it means automating a part of the value chain. On subscriptions and redemption transfers, if we’re speaking about raising funds from a population of investors with limited education of the alternative asset class, we’re asking for a double leap of faith: trust in the underlying strategy (which they do not know very well) and trust in a technology which most hardly understand – or worse, is quickly associated with some recent incidents such as a cryptocurrencies crash or scandals. For DLT to support this democratisation trend, a strong educational effort needs to be made.

Swabey – Investors of all types increasingly want the industry to offer impact to clients to allow end investors to vote with their money if investors like a firm. We’ve seen this with the focus on ESG, but I believe that the ability to ‘vote with your wallet’ will also help educate investors on the power of their investments outside of supporting their financial goals.

Take the example of crowdfunding platforms Crowdcube and Seedrs. There are several platforms where it’s possible to raise retail money for specific purposes, and you can see ‘normal people’ having a lot of interest in access to illiquid investments in brands or causes they believe in.

The concept of impact is in demand; alternative investments offer a unique opportunity to help other companies grow in the real economy. That’s the true benefit of things like Eltifs, and technology will be the key enabler of the retailisation of the alternative asset industry.

Funds Europe – In the Alfi/KPMG ‘Private debt fund survey’, it was said that the tokenisation of investment vehicles and underlying portfolios has started to emerge. Tokenisation will provide a technological advantage to asset managers, reducing loan origination and due diligence costs, increasing liquidity and reducing barriers to entry. What is the panel’s experience or thinking on this matter?

Swabey – Tokenisation/technology is there to help us, and we should leverage it as much as possible as it relates to loan origination., which will always be complex as that’s where the risk is when trying to understand whether to loan money to someone. There are important and challenging questions, of course, such as how creditworthy the borrower is and what kind of collateral they can offer. So, tokenisation won’t necessarily help here, but it will help with due diligence.

It’s a universal truth that it’s increasingly hard to get money from banks, and investors have a strong interest in generating returns on debt rather than equity instruments. Market research indicates that the private debt market will explode. For example, Alfi and KPMG recently wrote an interesting paper that looks to the future. So if there’s strong interest from investors and borrowers, launching a fund is much easier than creating a bank!

Rein – We had private debt funds launched over the last year. So, this was one of the fastest-growing asset classes we have taken in the past. They are replacing banks to some extent. Regarding cryptocurrency funds, I was more bullish last year regarding their future and segment growth. We administer one self-managed fund that grew successfully over the last years. The biggest challenge was finding a depo bank which would be comfortable to service it. We worked on the project for months, but it didn’t conclude because of the difficulties finding a suitable depo bank. That’s why I’m more hesitant regarding Eltif and democratisation products.

“Where we see the fastest development is the tokenisation of private assets. The benefits involve cost reduction, increased liquidity and even a smaller barrier to entry. Although only experimental, we have good reason to think it might work.”

Gutton – Where we see the fastest development is the tokenisation of private assets. The benefits involve cost reduction, increased liquidity and even a smaller barrier to entry. Although only experimental, we have good reason to think it might work. We should be aware of the work on the regulatory side, though. For instance, assessing the appropriate vehicle to hold the assets and/or the authorisation requirements may become core subject matters going forward.

Swabey – Luxembourg has one of the most successful distributed ledger technology providers, FundsDLT, backed by a consortium of strategic investors, including Clearstream, the Luxembourg Stock Exchange and Natixis. There are other distributed ledger technology providers out there who are privately owned or owned by private equity.

In the context of working collectively as an industry and considering the core benefits of distributed ledger technology, I’m talking about the technology which could underpin and provide a shared register, which allows for transparency and potentially greater confidence when you’re doing your due diligence. Through that liquidity, one of the critical aspects is understanding what those providers’ motivations are.

Staedter – I have a certain fund experience in the crypto sphere, and based on my experience in 2018, there were serious discussions among the service providers about the operation models. However, the project did not realise as the service provider could not put in place an operational memorandum which was one of the regulatory condition precedents. If it is contemplated to change this, it would be my understanding that the asset management industry should have a common understanding of the core tasks, associated risks and, ultimately, responsibilities.

Funds Europe – Are there any salient points from the AIFMD review that this panel thinks are important?

Gutton – We expect a Parliamentary vote in mid-February, and then the trilogy discussion will start. I want to mention the topic of loan-originating funds. It’s particularly crucial for Luxembourg, and as an industry, we want to preserve the possibility of generating open-ended funds. Ensuring changes remain targeted is essential, but we’ll see where the trilogue discussion goes. Based on what we’ve seen, competitiveness should also be part of the discussion.

Bon – Luxembourg has been seen as having high regulatory substance and infrastructure standards for many years. Luxembourg strongly inspires certain measures involved in AIFMD II, meaning the playing field levelling is a Luxembourg standard. It should reduce regulatory arbitrage between European countries.

I’m concerned about how the risk retention rule will be implemented for credit funds. Does it mean actual capital injection? Can it be done synthetically? This raises questions concerning the cost of financing on the fund manager’s side.

In some respects, it’s counter-intuitive from the alternative fund manager perspective; they have historically vested interests alongside their investors. There are mechanisms to align interests between fund managers and investors, including carry and co-investments. This risk retention mechanism needs to take the particularities of debt managers’ economic model.

“Luxembourg strongly inspires certain measures involved in AIFMD II, meaning the playing field levelling is a Luxembourg standard.”

Swabey – The review is in line with Luxembourg’s high standards. Yet, the funds industry needs to ensure it’s thinking about its customers and competing based on value-add solutions and helping customers achieve their goals.

Staedter – On loan funds, it will be exciting to see whether the European Commission will apply the AIFMD 2.0 loan fund regime to the Eltif environment because it could be argued that the Eltif Regulation is a special regime with its own framework.

© 2023 funds europe

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