10 May 2011, Custody Risk, Risk magazine
Around the table:
CHAIR: MELANIE WHITE, Custody Risk
HERMANN BEYTHAN is partner at Linklaters in Luxembourg. He is a member of several industry committees on investment management and has been involved in upstream private equity structurings, fund of property fund structurings and in specialised investment funds.
GERMAIN BIRGEN is managing director of HSBC Securities Services (Luxembourg)and global head of fund solutions. He is a member of the Association of the Luxembourg Fund Industry (Alfi), chairing the Middle Eastern and Islamic finance Alfi committees.
GEROG LASCH is head of client development, Luxembourg, for BNP Paribas. He joined BNP Paribas Securities Services in 2001 and is in charge of sales managers, relationship managers and client service managers in Luxembourg.
CHARLES MULLER is deputy director general of the Association of the Luxembourg Fund Industry (Alfi). He joined Alfi in 2003 and is responsible for legal affairs, promotion, communications and press relations.
DIDIER PRIME is partner at PricewaterhouseCoopers (PwC) Reviseurs d’Entreprises and a Luxembourg asset management leader. He is responsible for the audit of client portfolios and the development of the asset management practice for PwC Luxembourg.
RÉGIS VEILLET is head of sales and client relationship management at Société Générale Securities Services Luxembourg. He deals with depositary bank, fund administration and transfer agent activities, and client satisfaction, development, cross selling and profit & loss.
Custody Risk: Luxembourg enjoyed high growth in the alternative funds industry in 2010. What factors contributed to the growth and do you think it is sustainable at the same level?
Muller: One of the factors is the increasing popularity of specialised investment funds (Sifs). The number of these types of funds is growing all the time as fund promoters and asset managers realise their advantageous combination of effective supervision, flexibility and rapid time-to-market.
Beythan: The adaptable nature of Luxembourg fund vehicles makes them very appealing for investors. We have a wide variety – including alternative Undertakings for Collections in Transferable Securities (Ucits) Part II funds and Sifs – where investors may invest directly or indirectly, including into master-feeder structures. All of this provides the ability to tailor the funds to the needs of the investor. That – together with a good reputation and being known on the market – is the driver to continued sustainable growth.
Prime: The political and tax stability we have in Luxembourg ensures sustainable growth. Also, more and more hedge fund managers in the US have to find a European solution to meet the regulatory requests of European-based investors. That is why many are investing into alternative Ucits – because it is a good combination.
Veillet: Part of the market comprises family offices that demand regulated products, such as Sifs, in a big way. For example, we recently presented the impending Alternative Investment Fund Managers Directive (AIFMD) to one of our clients that is a family office. We explained the impact this might have on their fund and their reaction was, although it might be more regulation, that it wasn’t bad for them. Even though there would be more constraints, they didn’t see that as a threat, but more as an opportunity that would bring more security to their business.
Luxembourg has a strong source of regulated products that are popular with a certain type of investor.
Lasch: There has also been significant growth in private equity and real estate funds in Luxembourg. This is important to note because it was a space that Luxembourg had not really been in before. Investors are now seeking a regulated space for those products.
Birgen: Is it a one-off or is it a more established trend that the figures grew by 21% last year? As we all know, on the service provider side, the lead time to a fund being launched is quite long, so the figures we saw in 2010 were projects coming to fruition that we probably started in 2009. The reason I am confident about the positive trend, at least in the short term, is our current business pipeline. All of the new projects that are being discussed – the AIFMD as one example – are ones that will keep us growing.
Also, in family offices we are seeing a move from previously favoured private banking services to a regulated structure, which is legally defined, well valuated and easily split among family members. All of these reasons bring increased business into the Sifs business here.
Custody Risk: Luxembourg has become the first jurisdiction to ratify Ucits IV. What first-mover advantage does Luxembourg have and what impact will this have on Luxembourg-based funds and fund management firms over the next two years?
Prime: Ucits IV should be positive for Luxembourg, even if we were afraid before the transposition of the management company passport. Now, asset managers will use Luxembourg because they want to and not because they are obliged to by the regulation. We will see some consolidation across Europe and some fund mergers, but the merged funds should be domiciled in Luxembourg if the objective is cross-border distribution, which will be the objective of more and more asset managers.
Beythan: Having already implemented Ucits IV eliminates ambiguity. Other jurisdictions are still thinking ‘what will we do, how must we adapt to our national legislation?’.
Veillet: The other domiciles are all looking at what we are doing. Ucits IV is a toolbox from which Luxembourg should benefit. The only question mark is how quickly we benefit, because there is still much uncertainty on many potential tax issues. Every single promoter will need to study this according to its specific objectives. On a promoter-by-promoter basis, Ucits IV might have different implications for each of them on their Luxembourg business, but overall Luxembourg should benefit.
Lasch: We firmly believe there are going to be quite a few mergers. We all know mergers still have a tax impact and maybe a tax barrier somewhere but, in the long run, they still make sense because of the economies of scale you will reach out of them. The larger groups are already thinking of how they can reorganise their Ucits fund ranges, and will go through mergers and might have a short-term small tax impact, but once it is done it will be a larger product that they will distribute.
The advantage of implementing Ucits IV in advance of every other country is that we are seen to spearhead the European community in terms of implementing European measures. Effectively, we allow our client base to be quickest to the market with whatever changes they want to make with the new regulation.
In terms of the Key Investor Information Document (Kiid), we are very much advanced compared to other European countries and, again, they see that the Luxembourg community is very much thinking about the future and trying to offer the toolbox so they can serve themselves and start doing something. It’s important clients know it is somewhere they can do things quickly.
Birgen: To be the first mover adds a certain level of risk, but it is best to have the position of being the standard and trend setter rather than the follower.
Muller: I’m a bit flabbergasted by the first-mover advantage discussion. The law comes into effect on July 1. Having the law six months before is normal, we weren’t early. How can you be ready on July 1 if you get the law on June 20? If we talk about legal certainty, it is only normal that you know what is coming your way six months in advance so you can adapt. The other reason for the law to have been passed before December 31, 2010 is there are tax measures in the package that started on January 1 – the tax efficiency package. This includes the reduction to zero of the subscription tax on exchange-traded funds.
Custody Risk: What competitive threats does Luxembourg face regarding Ucits?
Birgen: Some Asian countries wish to have a regional passport or a framework competing with the Ucits branding. If you look at the funds domiciled in Europe, half of net sales are done outside Europe – mainly in Asia and South America. Asia is a very important market for Ucits, and particularly for Luxembourg, as most of the Ucits sold in Asia are domiciled here. If an Asian passport is to become a success across Asia, it may become a threat for Luxembourg. The idea is interesting, but implementation may still take some time.
Lasch: The biggest threat to our future growth are Asian Ucits. However, I believe in a Ucits passport because of the regulatory framework being so different to Asian countries and, today, there is no common economic environment in Asia. It can be the whole of Asia but, for the moment, if we look at the initiatives of the Australian government, which is trying to put Asia-Pacific in that direction, we see more focus on some key countries – Hong Kong, Taiwan, China, Singapore and maybe Japan. These countries are culturally quite close and represent a very large piece of that distribution. You don’t need to have a full Asian passport before getting into the threat zone – it can be quicker. Even the finance ministers have it on the agenda, but it is likely to take at least five years. That leaves us time to implement the European Ucits further and make that idea disappear as Asian fund sponsors, and even governments, find their way in terms of agreeing to supervision with Europe so they don’t challenge a new idea and create a new legal environment.
Birgen: Another threat for Ucits is increased regulation. The increased expenses will have a negative impact on Ucits, making them more expensive, which will impact smaller structures or may just rule these out as no longer viable. Managers who want to access the Ucits market will need very strong business plans. Start-ups will be impossible in that space because a Ucits is expensive, it is a complicated structure and to get it off the ground requires a lot of seed money, expertise and infrastructure. This will keep many managers out of that market.
Veillet: With respect to cost, there is another piece of regulation that might be coming soon concerning the responsibility of the depositary, which could be clarified as soon as next year with Ucits V, and that might impact the way we as custodians assess risk. Our environment is evolving continuously and we need to react and adapt quickly to those evolutions – the greatest threat is for us to become complacent. We have managed Ucits IV well. Two or three years ago everybody was worried about the management company passport, which is not the case anymore. We have to address future regulatory evolutions and challenges from where our growth could come, like in Asia, and not be complacent – look to tomorrow.
Custody Risk: What are Luxembourg’s strengths regarding Ucits vehicles?
Muller: The community working together. Our first aim is to do something together for Luxembourg. Competitors still remain competitors but, in Alfi working groups, the fact that you have PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young sitting around the same table and working towards the same goal is something that brings us forward quickly and efficiently. Then there is our relationship with the government – if we have a problem, we phone the ministry, explain the problem to our contact there and they will react. They know the fund industry alone pays 10% of all taxes in Luxembourg, so it is in their interest that this industry is flourishing.
Prime: Luxembourg is a small country, which enables a quick political decision-making process. In large countries, the decision-making process is long – to find a good person to talk to from a political point of view may take time, but in Luxembourg it is quick and efficient.
Veillet: As a first mover on many related European directives, Luxembourg has developed over the years a cluster of service providers, auditors and other actors working for the fund industry. A lot of knowledge is concentrated here and through this community approach, explained by Charles and Didier, we have the ability to leverage this expertise unbelievably quickly.
Custody Risk: What impact will the AIFMD have on Luxembourg’s alternative fund business? For example, do you think Ucits fund formation managers use less prescriptive vehicles?
Muller: I think these are two different matters – one is retail and the other is institutional. AIFMD will be a lot of work at the European level with European Securities Markets Authority consultations. At the national level, it is not just changing Ucits where you have a fixed framework that you adapt. This is a completely new framework and we will have to adapt our Sifs. Although there are provisions already in line with AIFMD, we will have to look carefully at how we are going to transpose this directive. It is less straightforward than Ucits IV and even Ucits V.
Beythan: An advantage is that the passport will better enable Luxembourg funds to be sold in different jurisdictions. There might be an unintended positive effect of the passport – right now an institutional investor in a certain jurisdiction is not able to buy foreign funds but, once the passport comes, such legislation may be difficult to sustain. I think the market will open from the buy side to become less restricted, as well as from the sell side, because it will be easier to place funds across the borders by way of the passport.
Prime: It will take time before it is fully efficient. In the long run, Luxembourg is in a good position to benefit from AIFMD because of this passport and its skills in distribution, but it will take time. Once it is fully efficient, it is possible that fewer Ucits will be launched, because a lot of Ucits are created for institutional investors. For many institutional investors – insurance companies, for example – the Ucits framework is adapted to them even when they need an alternative investment product, an alternative Ucits.
Veillet: AIFMD is an opportunity for Luxembourg to catch up on hedge funds. The introduction of a passport will allow Luxembourg to put forward its global distribution capabilities and, in addition, we have a good base on which to capitalise – the Sifs product, which is doing very well, and a strong private banking industry.
Birgen: Hopefully it could have an impact on management companies setting up in Luxembourg and attracting talent, particularly with the recent regulation that offers special tax treatment for expatriates coming to the country. This could be an excellent start to getting those people here and physically running these management companies out of Luxembourg.
Lasch: In Luxembourg, in the almost forgotten past, we needed to have fund promoters for every fund, and hence alternative funds, which was a barrier for some of the players in the Sifs world. AIFMD may implement a higher running cost at the very beginning and the smaller structures might not be viable anymore. In the private equity world, you sometimes start with very small assets and I see those players disappearing, which is not necessarily a bad thing. It will attract the more powerful players and those that are the future of our industry.
Birgen: Luxembourg may attract asset managers due to the tax package but also the standard of living, which is quite high. Since Luxembourg is in good financial shape, it is likely to remain this way.
Lasch: On the subject of expats, I believe – as we don’t have great weather or a beach – it is still quite difficult to attract real alternative managers. Certainly, a piece of the governance might come to Luxembourg, and therefore some management companies, but the intellectual asset management – particularly of alternative – is very often situated in very nice areas. Those people are generally not only attracted by tax advantages but mainly by the real standard of living. Unfortunately, there are still other countries in this world that are more attractive in this respect.
Muller: Luxembourg is far less boring than people think. We will certainly be able to attract some, but it is a big step from there to becoming a major asset manager centre. The expat regime that was set up is certainly going to help attract new talent to Luxembourg – and not just asset managers. It will certainly be an advantage to other parts of our business.
Beythan: Talking about quality of life, there is obviously culture – museums and stuff like that – but there are also day-to-day lifestyle aspects, such as: how long it takes to get to the office, how long you spend in traffic jams, do you have schools for your children? All of these soft advantages do exist in Luxembourg and – although this may not be the most evident example or advantage – it is a real-life, daily example.
Custody Risk: What are the biggest challenges for the funds and the alternative funds industry?
Muller: Keeping up the capacity to service – having enough people and the right kind of people to service specialist funds and other funds is going to be a challenge. On costs, we have seen actors in Luxembourg outsource part of their activity to countries in which they can operate more cheaply.
Veillet: An alternative Ucits or a hedge fund might require more, or different, skills than you would need for traditional Ucits. The job market in Luxembourg has recovered from the crisis. We need to make sure we have access to the right skills, and a reasonable quantity of them, to continue to serve those clients and move up the value chain.
Birgen: What is very important on the skills side is covering all areas of the service proposition, including business development. There are several alternative managers coming to Luxembourg to set something up, but they are not fully aware of AIFMD. It is the duty of the service providers to make them aware now so they can prepare how to structure their product. For funds, the biggest challenge will be regulation, and competitiveness is also key. We have mentioned Malta as another jurisdiction that is fully Ucits-compliant. If you set up a Ucits in Malta, it is more cost efficient than in Luxembourg. As such, Malta could be considered a niche for the whole industry. It is not a competitor but a complement for those asset managers who cannot afford Luxembourg as it gives them the possibility of going to another more accessible jurisdiction.
Lasch: An important consideration for both the alternatives and traditional Ucits is cost. As service providers are outsourcing and positioning near-shoring activities into other centres – as European markets are more open between countries – there will be some potential arbitrage between countries, so it is important for Luxembourg to appear as a ‘normal’ cost centre and not a high-cost centre. People are more and more difficult to find and recruit, especially with a certain level of expertise. That counts for the alternative industry because they need a very specific skills set, which is expensive, and you need it for regular fund accounting, custody work and transfer agent work. We are in the old mode of trying to feed Luxembourg from other countries, which we have not spent so much time on over the past two years. We have to create some positive messages for the outside world that Luxembourg is looking for a workforce, in particular for private equity and real estate on the alternative side – skills sets that don’t exist in Luxembourg to a sufficient depth.
Veillet: There is a trend, starting several years ago and now accelerating, of asset managers seeing us more and more as partners than service providers. They expect us to be more proactive, to give advice (although we don’t want to do auditors’ or consultants’ jobs). They are coming for a first-hand view on the issue before going in deeper with the consultants. We need to have the resources and organisation in place to answer those kinds of queries.
A challenge probably coming next year is the responsibility of the depositary. How is it going to be clarified, when will it be implemented, how will it be interpreted locally? We need to address that quickly.
Beythan: Dealing with increased sophistication in regulations and products is a complication. For products, if you take a look at the alternative investment universe – microfinance, private equity, real estate, hedge funds, funds of hedge funds, green power funds, ethical funds, sharia-compliant funds and socially responsible funds – each has specific requirements, and each time it is a different segment of the market with different players and ideas. To cope with limited resources is a problem.
There is a limit to it, which will also be a limit to the industry itself, meaning more sophistication because there will be fewer additional products, and existing products will be increasingly tailor-made with more sophisticated features.
Birgen: We will see further consolidation over the next 12 months, particularly among service providers.
Smaller service providers will struggle with the required investment linked to new regulation and many will probably make a decision to focus on core businesses. For example, I’m not sure that every service provider will still be active in private equity and/or real estate – some will decide to position themselves in that space, or leave it.
Custody Risk: What opportunities do you see for the Luxembourg fund industry over the next year?
Prime: Luxembourg is in a good position to benefit from the regulatory changes and consolidation we can expect in the industry across Europe. The range of products is going to be reorganised and this will benefit Luxembourg. One of the objectives of Ucits IV was to decrease the number of products in Europe – it may succeed but, if we have fewer products in Europe, it’s because some products might be merged with others domiciled in Luxembourg.
Lasch: Attracting Asian players into Luxembourg is a trend at the moment. At first, it was from the very highly sophisticated investment firms, but it is becoming more mainstream. It is important to be in Asia to capture that future flow. Another opportunity is a trend that started with Ucits III and continues with Ucits IV – further product consolidation into Luxembourg, either through mergers or through master feeders with a master in Luxembourg. Both will generate additional flows into the Luxembourg market. The larger players are moving towards a very strong flagship product into Luxembourg, a trend coming from the UK. In the past, the UK has been a very average contributor to the Luxembourg market in terms of promoting it, and it has almost doubled its size in the last two and a half years –partly thanks to Ucits IV and the tax burden in the UK.
Veillet: As a country that came out of the crisis quite well, we are benefiting from a flight to quality and a flight to solidity. We can market our products to emerging market asset managers that are domiciled in Latin America, Asia and the Middle East. A Brazilian asset manager that wants to sell its products in Europe or Asia has many reasons to come to Luxembourg. We need to make sure they know the opportunity is here and I’m sure the Association of the Luxembourg Fund Industry (Alfi) is doing a great job explaining that on its roadshows. Looking at our pipelines, there is a lot of reason to see next year as being a very nice year.
Muller: There is an opportunity to attract asset managers from other parts of the world to Luxembourg. The big American firms have all chosen between Ireland and Luxembourg, but we want to attract those medium-sized as well as smaller American firms that are not in Europe at the moment. Then AIFMD is going to be an opportunity. Also, there are many countries in which Ucits are accepted for distribution, but there are still huge countries, huge markets where Ucits don’t have a footprint. In the four BRIC countries: China has opened up a little bit, but not that much; in Russia and India it is closed; and Brazil is opening slightly for the moment. These are huge economies.
And Australia, there are tremendous opportunities out there. Alfi is working to make Ucits more acceptable over there.
Lasch: Alfi has done a great job of promoting Luxembourg across the world. I think the brand has grown significantly through Alfi and through its tours, and maybe also with Luxembourg for finance support. Effectively, through Alfi we are regularly promoting the Luxembourg product everywhere, and most of the other centres don’t have those types of promotions, hence they disappear. They might be economically strong countries, but the fund industry is only number 200 on the list of whoever is running finance in that area. I think that is one of the very strong points we have here.
Beythan: There are global asset managers, global investors, who look for jurisdiction without any nationalistic interest where you have globalised service providers – auditors, law firms, and so on – all this gives Luxembourg a lot of positives because, in the wake of the crisis, the other jurisdictions may have a certain tendency to be less forthcoming to the non-national players.
Birgen: The number one region from which to attract new managers to Luxembourg should be Asia. Number two should be the Middle East, once this region settles politically, but there are opportunities there. There are some opportunities in the Islamic space where I think we have managed to position ourselves quite strongly. What we see in the pipeline are projects potentially coming to Luxembourg that are considerably bigger in size than what we have seen in the past. These products are developing globally, so I think this is also an opportunity for us.