The Luxembourg fund industry has always been characterised by an environment of investor protection-led regulatory constraints imposed by either European and national legislators, or by increasingly complex and intrusive prudential rules from our domestic financial sector regulator, the CSSF.
The approach taken so far has been to dictate rules around the fund products (so-called "products laws") on one hand, and to impose more or less burdensome licensing requirements on most financial service firms active in the production and distribution of fund products (managers, depositary banks, fund administrators, IT support, distributors and advisors, etc) on the other.
This regulated environment has been beneficial to the development of Luxembourg's role as a global fund domicile by creating a brand for its products (UCITS and SIFs) and a label of quality. The downside, however, has undoubtedly been costs, entry barriers and slowness in the regulatory approval process.
With the implementation in Luxembourg law of the alternative investment funds managers' directive (AIFMD) in July 2013, a further layer of regulation was introduced and international fund promoters, although attracted by the EU distribution passport created by AIFMD feared - rightly so - increased compliance costs and even further delayed approval processes by the CSSF.
The prospect of dual regulations under both the products laws and the new regulation of the managers through AIFMD has accelerated the emergence of new, unregulated investment fund vehicles taking the form of common or special limited partnerships (introduced under Luxembourg law simultaneously with the transposition of AIFMD). These transparent, and thus neutral, fund vehicles would appoint an authorised AIFM (fully subject to the AIFMD), opt-out of the products laws and have access to the European marketing passport to professional investors.
More regulation on the manager has therefore enabled less regulation on the products. Good news!
In reality, the emergence of an unregulated fund products segment was, and remains, an absolute necessity. A double layer of regulation (manager and products) was not sustainable and risked creating a competitive disadvantage for Luxembourg as a domicile compared with its traditional competitors (both onshore and offshore).
Constantly improving the jurisdiction's legal and regulatory infrastructure is key, and the recent initiative from the Luxembourg government to introduce a bill on "RAIFs" (Reserved Alternative Investment Funds) indicates an informed policy commitment to the appropriate direction of travel.
The bill on RAIFs (if enacted, which is likely during the first semester of 2016) introduces the possibility to create, using a variety of contractual and corporate forms - some of which today are still reserved to regulated funds - unregulated alternative investment funds having the same features as regulated vehicles (typically SIFs and SICARs). Such features include variable capital, segregated compartments, multiple classes, easy capital calls and redemption mechanics as well a neutral tax regime. Because the RAIF is managed by an authorised AIFM, indirect supervision of the RAIF is ensured through the regulated AIFM's supervisory oversight making sure the RAIF complies with AIFMD. All other requirements are similar to those of existing regulated AIF like SIFs and SICARs. RAIFs will appoint a Luxembourg based central administration agent, a depositary and an external auditor. Depending upon its investment policy the RAIF will follow SIFs' or SICARs' portfolio diversification requirements and tax regimes. If the RAIF adopts the SIF model it will be subject to an annual subscription tax of 1 basis point on its net assets, where if adopting the SICARs model the RAIF will be fiscally treated as a SICAR.
Having appointed an AIFM (based in the EU) the AIF will have access to the EU marketing passport available to this AIFM under AIFMD. The RAIF may appoint any fully authorised AIFM in any EU country including any such existing resource the promoter may have already available in Europe. If the fund's sponsor has no such presence in Europe it may consider using the services of so-called "third party management companies" (ManCos).These, at that time, are fully authorised AIFMs who provide specialised investment management services (portfolio and/or risk management) to third party sponsors. The Luxembourg market is seeing a growing number of these entities offering their services, typically risk management services, the portfolio management being delegated back to an affiliate of the fund sponsor's group. The long-experience gained by Luxembourg in the UCITS environment (which had a similar model co-existing with the traditional in-house management and research model) is clearly helpful and is enabling the emergence of well-equipped management companies, with capable and experienced directors and officers, tested processes and the relevant technical infrastructure.
Having access to the European institutional and professional investors market certainly must have a value. Although the use of a third party ManCo comes with a cost, the economies realised by avoiding the costs of regulation of the RAIF itself may justify using the third party management company solution. For bigger players, the set-up of its own, proprietary AIFM remains an alternative.
The addition of the RAIF and of unregulated investment vehicles in general to the Luxembourg toolbox of investment vehicles constitutes more than an improvement of Luxembourg legal and financial infrastructure. It potentially places Luxembourg on the same level playing field as offshore jurisdictions like Cayman or the Channel Islands. These jurisdictions have traditionally been and still are able to offer solid and cost-efficient investment platforms. However, they may not yet offer the marketing passport to EU investors. The passport will not be available until such time as the European Commission extends the AIFMD passport to non-EU AIFMs. This is work in progress and unlikely to happen before a number of months if not years in certain jurisdictions. Thus, the use of a third party AIFM may well be an avenue to explore for many promoters.
One likely phenomenon to be anticipated is the transformation of existing regulated structures (SIFs and SICARs) into unregulated Luxembourg limited partnerships or RAIFs once the RAIF legislation is adopted. However, evidently the ambition of the RAIF legislation is to widen the marketability of Luxembourg investment funds products which were handicapped by the requirements of complying with products law. This constraint disappearing, investors and fund sponsors familiar with unregulated or lightly regulated structures may well find attractive the new features introduced in Luxembourg's fund offering. This is likely to appeal to both US managers and also emerging Asian asset managers seeking European investors. They like Cayman funds (rightly so) but may also find useful the Luxembourg version, a combination of both being a perfect design to satisfy both non-EU and EU investors.
Does the emergence of unregulated alternative investment funds in Luxembourg constitute a disrupter? Maybe not but possibly a game changer.
This article first appeared in HFM Week Special Report Luxembourg 2016 in February 2016.
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