Luxembourg lays down the law but listens to the launch pad

Good relations between Luxembourg's financial regulator and its hedge funds make for an innovative jurisdiction in which to launch new products

Luxembourg's main appeal as a hedge fund domicile is the increasing popularity of regulated jurisdictions over the traditional offshore location. This is being driven by the increase of institutional money coming into the hedge fund industry, not just in Europe but globally, says Michael Ferguson, a consultant at Ernst & Young in Luxembourg.

Dutch institutions, for example, are, in many cases, making allocations to hedge funds of 5%-10%. Trustees of Dutch pension funds want peace of mind, Ferguson says, and want to make allocations to hedge funds or funds of hedge funds (FoHF) that are onshore and subject to rigorous regulatory oversight.

Once the decision is made to base a fund onshore in Europe, Luxembourg will be a strong contender, Ferguson says, primarily because of its regulatory environment. Successful regulation and the development of a good relationship with the financial institutions in a jurisdiction require a balance of rigour with tolerance of the use of sophisticated techniques and instruments that constitute a hedge funds armoury. "The Commission de Surveillance du Secteur Financier (CSSF - Luxembourg's financial industry regulator) is considered to be firm, but pragmatic," says Ferguson.

CSSF is a well-loved institution in Luxembourg throughout the industry, widely praised as an approachable and flexible body that is willing to listen to the industry it oversees.

open to new ideas

"The regulator really accommodates the hedge fund community's creativity if you can show them what you're doing," says Vincent Beaujeu-Dumontel, marketing and product development manager at Caesis Investor Services.

"We analyse alternative funds on a case-by-case basis," explains Simone Delcourt, director of investment funds at the CSSF. "We have experts in house who analyse them in relation to risk-management procedures, and for whom the alternative product is intended."

It sets parameters within which a fund must operate. "Even if there is a new strategy by a company that has funds in Luxembourg, it must stay within the framework we have in place. It's not that everyone can do what he wants."

If it is an innovative product that has no precedent, the CSSF will not reject it on this basis but will check the fund's infrastructure, the reason behind the strategy and the types of investor it is to be aimed at. All these factors will be considered, though always within the framework it has in place.

"On occasion, we don't accept the products or we say we can accept it only if certain conditions are put in place, or if certain investment policies are changed or modified," she adds.

retail regulation

CSSF's understanding and tolerance of sophisticated portfolio-management strategies is exemplified by its attitude to retail funds, which are allowed to operate in Luxembourg using some of the tools you might normally associate with a hedge fund, albeit a conservative one. The use of derivatives is allowed, giving funds the power to replicate the returns profile of a short-selling strategy. They can employ leverage to varying degrees, depending on the VaR of the portfolio. Funds with moderate to relatively high levels of risk can employ leverage at multiples of up to three or four, while those very low VaR can employ up to eight or nine times leverage in Luxembourg.

It has minimum requirements for any prospective fund manager thinking of domiciling a fund in Luxembourg. "All funds must prove a diversification of risk. They must be experienced people," Delcourt says. "Under the financial institution initiative, an alternative fund must have experience in the field. The organisation of the fund must be structured so the directors and members of the investor committees have at least three to five years' experience in that field, and can prove they have not been responsible for damage to a previous similar fund."

directive diligence

She is insistent that Luxembourg's regulatory system is no less diligent than those in other onshore European locations. "We have to implement the directives that come from the European Union," she notes. "We put in place hurdles to prevent people that may have criminal intentions from launching funds in Luxembourg. We do background checks on anyone initiating a fund here," Delcourt adds. "Once the fund is launched, there are recommendations that have to be observed, and we monitor it through various means we have in place."

There is a new rule slated to be passed in late 2006 that will for the first time establish rules for qualified investors in Luxembourg. No details are confirmed on what the rules will stipulate. It is believed it will abolish most or all of the rules laid out in the 2002 circular, though retaining the principle of risk mitigation through diversification on funds that are made available exclusively to sophisticated investors.

Delcourt says the rule was conceived as a necessary step to modernise the law of 1991, which was designed for institutional investors. It needs to be amended or abolished to put in place a law designed for institutional and qualified investors.

She says the intention of the new rule or guidelines will be to clarify to funds exactly what they must provide to the regulator to allow it to analyse the fund's intended risk-management and investment policies.

supportive sponsors needed

Marc Wenda, business development manager at European Fund Administration, notes one rule in particular has hindered the ability of small hedge funds to domicile in Luxembourg. To domicile without the assistance of a co-sponsor, you must have at least !5m assets. A fund that cannot raise this must take a Luxembourg institution as its promoter, which is financially liable for the fund. Wenda says although banks were initially happy to work with small hedge funds, a general change in their attitude to risk has seen most of the biggest banks in the region pull back from this business, making it very difficult for small funds now to find a sponsor to enable them to domicile in the country. However, Delcourt says, this rule has helped to prevent managers that might put Luxembourg's reputation at risk from entering the market, as has its diligence in conducting background checks.