23 Dec 2010, Christophe Lentschat, Apex Fund Services Luxembourg, Hedge Funds Review
Luxembourg has been associated closely with the development of the Ucits brand since the late 1980s. The Luxembourg Ucits passport is used by investment managers from over 58 countries to distribute their funds on a global basis.
Building on the development of the Ucits funds, Luxembourg has become one of the largest fund domiciles for regulated investment funds. The success of the traditional Ucits has long overshadowed the role of Luxembourg as a domicile for hedge funds.
However, the statistics provided by the Association of Luxembourg Investment Funds (Alfi) indicated there were over 2,000 hedge funds and funds of hedge funds (FoHF) domiciled and/or administered in Luxembourg representing AUM of $190.5 billion, a growth of 182% between June 2005 and June 2008.
The main driver behind this growth has been the financial crisis which caused a shift in attitude among European hedge fund investors. They are now looking more towards regulated products rather than unregulated offshore funds. As a consequence there has been a surge in interest from a number of hedge fund managers for more regulated fund domiciles in an effort to address the change in European investors demand. With a sophisticated but pragmatic legal and regulatory framework, Luxembourg is well positioned to offer solutions to managers who are willing to operate in a more regulated environment on behalf of some of their investors.
As an economically stable European Union (EU) member state with sound public finances, relatively low government debt and deficit levels, Luxembourg also offers the best guarantee for fiscal stability and the limitation of sovereign risk.
Three main vehicles are available for hedge fund managers in Luxembourg: Ucits and part II funds as well as specialised investment funds (SIFs). Selecting the right vehicle usually comes down to finding the right balance between the flexibility required in terms of investments and the range of participating investors.
The growing use of hedge fund types of strategies in a Ucits environment has received much publicity. According to Strategic Insight the universe of alternative investment strategies within Ucits funds is bigger and expanding at a faster rate than commonly believed. By third quarter 2010, €25 billion ($33 billion) of net new flows went to over 1,000 alternative Ucits that follow strategies similar to hedge funds. Assets in these products exceeded €114 billion ($156 billion) as of September 2010.
Luxembourg Ucits hedge funds operate within the framework of the 2002 Law and the Rules of Conduct as defined by circular 07/308 issued by the regulator, Commission de Surveillance du Secteur Financier (CSSF). This circular provides a method for the management of financial risk as well as the use of derivative financial instruments.
For non-sophisticated Ucits funds the use of derivative instruments creates a restriction on the global exposure (commitment approach). The global exposure of Ucits could potentially be doubled by the use of derivative financial instruments. Total Ucits commitments are currently limited by 200%.
In addition there is the possibility for Ucits funds to borrow up to 10% of net assets, as long as these are temporary borrowings and that they are not used for investment purposes. For sophisticated Ucits funds, the use of derivatives is subject to relative and absolute value at risk (VaR) guidelines (internal model) with no limitation on leverage pre-defined by the regulatory framework. Under the guidelines derivative instruments can be used to replicate most hedge fund strategies.
According to the Luxembourg Financial Group, an independent structured product, specialist platform and specialist asset manager, 36% of Ucits hedge funds follow a long/short and equity market neutral strategy while credit accounts for 17%. Other strategies include foreign exchange (7%), managed futures/CTA (5%), global macro (5%), volatility arbitrage (5%) and commodities (%).
The Ucits environment does not allow short selling of securities but a synthetic equivalent can be achieved through the use of derivatives, for example via contracts for difference (CFD). Ucits funds are available to retail investors with no restrictions on minimum investments. The last few years have also seen a tremendous take-up in the setting up of SIFs for an international qualified investors. SIFs are regulated under the Law of February 13, 2007). The objective of the government in replacing the law of July 19, 1991 concerning undertakings for institutional collective investments not sold to the public (UCIs), was to introduce more flexibility in the investment funds industry.
SIFs provide a flexible investment framework but are restricted to sell only to qualified investors. As defined in the law, a qualified investor could be an institutional investor (bank or financial institution), a professional investor or a well-informed investor.
Compared with the undertakings for collective investments (UCI) law, the government has extended the scope of the notion of qualified investors. As defined in the law, an investor is considered “well-informed” if the investor attests in a signed document that he is such and that the amount of the investment is at least €125,000 or an attestation is issued and signed by a bank or any other financial institution confirming the investor is able to understand the SIF’s investment strategy and assess the potential risks.
According to the law the investor is entirely free to decide in which assets the SIF will invest. No restrictions are set regarding the nature of the qualifying assets. The SIF could invest in any financial instrument: real estate property, hedge fund or private equity. In terms of concentration risks, no position should exceed 30% of the total net assets.
All types of hedge fund strategies can fit into a part II fund. The investment restrictions applicable to part II funds are defined by Circular 02/80. Part II funds provide flexibility for the use of short selling and borrowing with or without derivatives. There is no restriction on the type of investors authorized to invest in a Part II fund.
The time taken for setting-up the fund varies depending on the nature of the project. The average is two to four months to obtain CSSF approval for the application of a Ucits fund. For a Part II UCI the average is one to three months from submitting application to obtaining CSSF approval. Under the law no approval by CSSF is required before launching a SIF. However, the standard practice is to wait for the approval before launching. For a Ucits and Part II fund, the filing procedure includes a background check on the promoter (“sponsor”) of the fund and the investment manager.
The promoter initiates the creation of the fund and retains control and responsibility for the structure through the board of directors of the Sicav or the management company of a fonds commun de placement (FCP). The promoter will be a financial institution and able to demonstrate sufficient financial resources.
The CSSF imposes no controls on the promoter or the investment manager for a SIF. All three vehicles need to appoint a custodian that has to be a Luxembourg bank and is responsible for receiving and safe keeping of the SIF’s assets. A Luxembourg-based fund administrator is also needed.
A number of players have set up fund platforms which are structures already approved with a series of predefined partners. A platform’s main benefit is that it provides a ‘plug and play’ solution for setting up a Luxembourg hedge fund.
Platforms considerably reduce the fund’s time to market compared to a stand alone fund. The custodian, fund administrator and the auditors are all predefined at the platform level.
One option available to a hedge manager is to redomicile an existing offshore fund in Luxembourg. During the past five years over 540 fund units totalling €140 billion ($184.94 billion) in assets under management (AUM) have been redomiciled to Luxembourg from offshore and European jurisdictions, according to figures from Alfi.
Luxembourg regulation offers various options enabling foreign companies and funds to relocate and operate in a regulated environment. The most common are: the transfer of the registered office to Luxembourg, merger with a Luxembourg fund or investment company (a Luxembourg fund investment company are both referred to in what follows as the ’Luxembourg entity’) and the contribution by the offshore fund of all assets and liabilities to a Luxembourg entity.
The CSSF requires funds redomiciling to Luxembourg to: ensure the management body of the fund (for example, the board of directors of the general partner) approve the move, prepare the redomiciliation by drafting the fund documents and liaising with the CSSF and hold a general meeting of the shareholders of the fund before a notary in Luxembourg. No ‘contribution in kind’ report is required.
Many hedge fund managers will find it useful to retain an offshore offering to address the demands of some investors or to accommodate confidential or a highly flexible investment policy. Along with this offshore presence, Luxembourg offers a series of different options for hedge fund managers seeking a more regulated environment for some of their products.