24 minute read
CONVERSATION WITH CAMILLE BOURKE
Camille Bourke, partner at Luxembourg law firm Arendt & Medernach, believes Luxembourg has a strong opportunity in the marketing of alternative investment funds DECEMBER 2022 ALTERNATIVE INVESTMENTS
Alternative investment funds raised in Luxembourg are rising, rising, rising. The person who should know is Camille Bourke, partner in the private equity and real estate practice of law firm Arendt & Medernach. She talks to Delano about Luxembourg’s ability to capture the zeitgeist yet again in the field of investment.
Interview JOSEPHINE SHILLITO Photo ROMAIN GAMBA
Luxembourg went from an international hub for Undertakings for Collective Investment in Transferable Securities (Ucits) to now being one of the most attractive places globally to base an alternative investment fund. How? Well, alternative assets have been expanding in Luxembourg for quite a while now. Rewind to 20 years ago, and you had the birth of private equity in Luxembourg. This was thanks in part to the presence of special-purpose vehicles for EU acquisitions domiciled here in Luxembourg for tax reasons. Yet real estate, infrastructure and, most recently, private debt have followed, and now Luxembourg is emerging as a hub to raise pan-European alternative investment funds.
The first benefit was a tax attraction. Is this still the case? Luxembourg is now one of the principal jurisdictions in the world for private assets and, yes, the main reason at first was [the] tax reason. But when regulations like the Alternative Investment Fund Managers Directive (AIFMD) came in 2013, we saw a real ecosystem for infrastructure and service providers pop up, so it became a hub for managers across the world to set up funds. ALTERNATIVE INVESTMENT IN NUMBERS
€962bn Assets under management by regulated alternative funds in Luxembourg
30% The increase in net assets under management in regulated alternative funds in Luxembourg in the past three years
330 Over 330 mancos, 260 AIFMs and 600 registered AIFMs are present in Luxembourg 18/20 Of the top global private equity houses have operations in Luxembourg
20 The world’s 20 largest real estate managers do business from Luxembourg
Source CSSF, Alfi, LPEA, IPE magazine (2018) What sort of changes did you see in Luxembourg post-AIFMD compared to pre-AIFMD? One of the main differences is that preAIFMD, you would see feeder and parallel funds set up in Luxembourg for the European investor that would feed into the main fund that, for example, might be structured in the Cayman Islands. But with the AIFMD came a need for a European AIFM, and you saw the consolidation of structures in Luxembourg. Now, pretty much all US and UK fund managers want to have an AIFM based in Luxembourg.
So the attraction was tax driven and then regs driven? You could say that. The financial regulator in Luxembourg, the CSSF, has been pragmatic, flexible and responsive in terms of its regulation. Then there was Brexit. When Brexit was voted for in 2016 and in the years after, jurisdictions like Ireland, Luxembourg and Germany benefited. What we saw is every private asset--such as private equity, real estate, infrastructure and private debt--head to Luxembourg, while banks positioned in Frankfurt, and hedge funds and collateralised loan obligations went to Ireland. Any worldwide team that had previously had a base in the UK was then considering a European jurisdiction.
What might the future drivers be? Marketing. What we’re seeing now is Luxembourg positioning to attract alternative investment fund marketing teams. This is because UK-based fund managers are facing the issue of raising funds from the UK and into Europe now that they no longer benefit from the passport. The question that Londonbased marketing teams are asking themselves is: ‘How do we reach Europe?’ This is a huge focus of private assets at the moment. To market into Europe, you need to be regulated, you need to be compliant with AIFMD and the Markets in Financial Instruments Directive for the passport--and if you want that passport, you need to be based in the EU. This is a huge opportunity that Luxembourg is positioning itself for.
Luxembourg positioning as a marketing hub for alternative investment funds? Yes. Luxembourg has already positioned itself as a jurisdiction for building an investor base. What we’re seeing is alternative investment fund managers putting a head of marketing in Luxembourg. It doesn’t need to be the main marketing person, but it needs to be someone. Imagine the head of investor relations, for example. Some people are already making this very smart move. This is interesting because formerly the head of marketing would have been in London or Paris.
Aside from the obvious attraction of the European passport, what are the other benefits of having marketing activities in Luxembourg? The sophistication of Luxembourg’s financial services providers, its fund administrators and its depositories are very strong. This ecosystem is already in place and makes it an easy place to which to relocate operations. Then the country itself is becoming more attractive as a place to move to than it was a number of years ago. It’s a great country to live in, it’s a manageable size, for families it’s increasingly an attractive option compared to bigger cities. Some people love the greenery. I see some fund marketing managers already making this very smart move. Then Luxembourg has shown itself to be flexible, responsive, able to adapt to what the alternative investment fund market is expecting.
What expectations might the alternative investment fund market have that differentiate it from other types of fund markets in Luxembourg? We are seeing the slow convergence of regulatory requirements, for example Ucits and AIFMD. There’s a lot of expertise in
Luxembourg in these areas. Risk is also a big thing in private assets. Risk management is more important in this sphere due to the illiquid nature of the assets and their higher returns and therefore risks. Fortunately, all of that risk-management expertise is already in Luxembourg. Then the experience with past and upcoming regulation is important too.
Do you mean Eltif [the European regulations concerning the marketing of alternative investment funds to a wider investor pool]? Yes. There are teams in Luxembourg that already have a strong experience of working closely with the Luxembourg regulator, the CSSF, on Ucits. This means that they will have a strong idea of how the CSSF will approach new rules regarding alternative investment funds. It is becoming important in Luxembourg to share valuable knowledge like this between teams. In Arendt, for example, we have a lot of meetings to share this knowledge between teams. Ucits is very well trusted, and those who have worked with the regulator on Ucits have very important insights for regulatory impacts on alternative funds.
Can you tell me more about Eltif? There’s a huge appetite amongst alternative investment funds to target and raise money from family offices. Eltif [which gives alternative investment funds a regulatory structure through which to market to smaller investors such as family offices and ultra-high-net-worth individuals] gives them a means of doing this across Europe. In fact, there are around 70 Eltifs in Europe, and around 40 of these are in Luxembourg because the interaction with the CSSF on how to interpret Eltif is that good.
Eltif requires a certain liquidity so that smaller investors do not face long lockups of their money. One of the main questions funds are asking is: ‘How liquid is liquid enough?’ We have been able to look at fund redemptions to help us anticipate the regulation and to give us an idea of what the regulators will be looking for.
Luxembourg has put in a lot of effort with the Eltif; lobbying, working hard with the CSSF, there’s been a lot of effort preparing Luxembourg as a country for this.
What used to hold the Eltif back was the uncertainty around it, and Luxembourg
has been keen to eradicate that uncertainty. This is a huge draw for alternative investment fund managers. We already have an idea of what the CSSF will be asking alternative fund managers for in order to class themselves as Eltif, and large fund managers are very attracted to this.
You say Eltif is a big draw of alternative funds to Luxembourg. How would you say it compares to the Long-Term Asset Fund (LTAF) [the UK equivalent]? The LTAF is very attractive for UK-based private clients for UK-based investment. But it’s not finalised yet, and it doesn’t offer that European passport. So if you’re trying to convince a US-based client on where to put their vehicle, convincing them via a UK-based product is difficult. Most US clients will have a Luxembourg vehicle on their checklist. The Luxembourg products have taken over the market.
Can you tell me more about the Luxembourg products that attract alternative investment fund managers? In Luxembourg we have the Special Limited Partnership, an unregulated structure to which you can apply a Raif (Reserved Alternative Investment Fund) or Eltif wrapper. The SLP is really rising in popularity. I’d say it has overtaken alternative structures such as the Specialised Investment Fund (Sif) or the Investment Company in Risk Capital (Sicar) because of its flexibility. As a pan-European way of raising capital, you can’t beat Luxembourg.
You said in the past it was common to have a feeder or parallel fund set up in Luxembourg and the main fund elsewhere. Has this changed? Yes. Not only was there the consolidation after the AIFMD when fund managers began to place their AIFMs in Luxembourg, but the attractiveness now of the investment structures means that the main fund will also be domiciled in Luxembourg. More than €962bn of assets managed by alternative fund managers are based in Luxembourg, showing that it really is becoming a jurisdiction of flagship funds and not just feeders. However, it’s not just a question of volume, it’s a question of sophistication. The service providers are increasingly specialised, increasingly sophisticated, in the sense that this is no longer a back-office place. ALTERNATIVE INVESTMENT FUND STRUCTURES IN LUXEMBOURG
UCI Part II Funds AIFs not governed by a specific product law (such as Sif, Sicar or Raif) nor are they set up in pure company form. Must be authorised by the CSSF.
Sif A specialised investment fund that can invest in all types of assets. Must have appointed an EU AIFM. Limited to ‘well-informed’ investors. Subject to Sif law. Must be authorised by the CSSF.
Sicar An investment vehicle that was designed for investments in private equity or risk capital. Must have appointed an EU AIFM. Limited to ‘well informed’ investors. Subject to Sicar law. Constituted as a corporate entity. Must be authorised by the CSSF.
SLP A corporate form of fund structuring. Contractual flexibility. Can be structured as an AIF or a Raif. Not always subject to CSSF approval.
Raif An investment fund that can invest in all types of assets. Can have external AIFM, but if marketing to EU investors, the AIFM must be EU-domiciled. Limited to ‘well informed’ investors. Subject to Raif law. Not subject to CSSF approval.
Eltif Pan-European regime for AIFs with specific requirements regarding their investment policy, fund portfolio composition and diversification. Open to a wider variety of investors.
WHAT IS THE AIFMD?
The Alternative Investment Fund Managers Directive grants a European passport to the managers of alternative funds. Rapid implementation of the directive has helped Luxembourg to further develop its role as a well-regulated hub for the global alternative investment industry.
Luxembourg chose this moment to overhaul and modernise its limited partnership regime, ensuring maximum compatibility and flexibility under the new AIFMD rules, with a structure more familiar to asset managers from Englishspeaking countries. What can the financial services industry do to support the development of alternative investment? We believe that Luxembourg as a marketing hub is a huge opportunity. What we need to do as an industry is lobby to make it far easier for alternative investment managers to put their teams here. We need to work not just on the expertise, but on the attractiveness of the country to showcase Luxembourg as a place that listens, that is close to the market.
What is the role of law firms like Arendt in this? Law firms have a lot to do here, not just in the field of alternative investment funds, but in many fields. Any alternative investment manager will find law firms in Luxembourg very well equipped to support fundraising into Europe. Their expertise and responsiveness are much better than they used to be, and within Europe, Luxembourg itself is far more respected than it used to be.
Looking forward, I’d say that we’re at the stage of succession planning in legal teams, and we’re finding the new generation of lawyers are proactive and not at all complacent. Luxembourg in the past used to have a reputation for sitting still and allowing business to come forward, but now we’re seeing a closeness to the market, the pragmatism of the CSSF and the sophistication of the service providers really creating a hub. We look forward to it continuing!
Now that the European Council has reached an agreement on Eltif, can you talk me through some of the principal changes and what that might mean for Luxembourg’s financial centre? Now that the European Council has in principle reached an agreement on the Eltif review, we believe that this will result in additional traction for this vehicle. We welcome, more specifically, the possibility for-loan originating Eltifs to use leverage in the same way as other Eltifs; the funds of funds investments limitations that have been removed so that Eltifs will be able to invest in EU funds for this purpose; and more generally, the additional flexibility that has been granted with respect to the product design and definition of eligible assets.
The ongoing boom in private debt in Luxembourg is matched only by its insatiable demand for better services. Gautier Despret of third-party manco IQ-EQ walks us through the unique asset servicing universe that this demanding asset class requires.
Words JOSEPHINE SHILLITO Illustration SALOMÉ JOTTREAU
Private debt has long attracted institutional investors seeking yield, with 40% average growth in assets under management in Luxembourg alone in the 12 months to June 2021, according to fund industry association Alfi. However, with this stellar rise in AUM to €182bn comes increasingly complex demands for asset servicing--from reporting requirements to transaction volume to investor onboarding.
“Because it’s the debt market, it’s the largest spectrum [of services] you can imagine,” said Despret. “When you do debt you can originate, syndicate, do a club, do secondaries, put in place senior secured debt or even unitranche. Then you have leverage, multiple currencies, cashflow reporting and requirements.”
Despret argues that private debt’s requirements and its transaction volume make it a more complicated asset class to service than its alternative asset predecessor, private equity.
But service private debt Luxembourg must. As a financial services centre of excellence in Europe, Luxembourg cannot afford to let the private debt opportunity pass it by as other jurisdictions will be only too happy to become domicile of choice for this growing alternative asset class.
Fortunately, as far as third-party management companies (mancos) go, Luxembourg is “developing extremely well”, said Despret. “But it is facing challenges from the private debt world.”
Institutional investors take a pause One of the first challenges for mancos is the upcoming recession in both the US and Europe, which, according to Despret, will stem the flow of institutional investor capital into private debt funds.
“Private debt has grown constantly but in the past two years we have seen a decrease in fundraising over the first half of each year, followed by a rebound in the second half.” Despret says the finger is being pointed at covid for the decrease in H1 2021, and the invasion of Ukraine for the same slump in H1 2022. “We could see possibly even the same in H1 2023 as we come out of a bad winter in Europe.” The dips illustrate how institutional investors are likely to pause in a traditional, closed-ended, illiquid market like private debt. “So more and more we’re seeing the retailisation of funds,” said Despret. “So more sophisticated high net worth individuals knocking at the door. We’re seeing good products like the European Long-Term Investment Fund (a framework for retail investors to enter into alternative assets). We are seeing
asset managers buying dedicated feeders (funds that channel sophisticated retail investor capital into alternative assets). But retail investors involve challenges.”
The principal challenge being, according to Despret, the mixing of liquid and illiquid strategies in a private debt fund, necessitating a move from closed-ended into open-ended funds.
“We’re talking open-ended funds with ten institutional investors plus one thousand or more retails,” said Despret.
“The reporting requirements are not the same between these two types of investors, and the right technology [is needed] to do reporting distributions.”
Services have developed to cater to this, most notably software solutions that streamline fund administration.
Regulatory challenges Europe-wide regulation of alternative investments aims to harmonise cross-border transactions. However, certain iterations in the Alternative Investment Fund Managers Directive(AIFMD) would restrict the activity of precisely the kind of private debt funds needed to welcome retail investors.
“The [potential restrictions] on AIFMD loan origination are not fixed yet,” said Despret. Previous AIFMD drafts had proposed that if more than 60% of a loan fund contained originated loans, then the fund must be closed-ended. Although it appears as though this stipulation might be relaxed in the regulation’s final iteration, the focus on loan origination will still require the support of mancos.
“You can’t put everything on the secondary market,” said Despret, referring to the importance of originating loans in private debt. “[Therefore] more controls will need to be performed when loans are originated, additional duties and additional checks.”
Environmental and social governance The importance of ESG reporting hangs over all alternative assets, not the least private debt. And to do this properly requires specialists and an entirely new spectrum of specialist services.
“All asset managers have an ESG policy, but building an ESG scorecard that’s robust and coherent, that defines the KPI, collects the data, ensures it’s accurate-that is the challenge,” said Despret. PRIVATE DEBT LANDSCAPE IN LUXEMBOURG
Fund structures 78% of private debt funds are closed-ended 22% of private debt funds are open-ended 45% are debt-originating 55% are debt-participating
The rise of ESG 33% of private debt funds by ESG classification are Article 8 funds, 6% Article 9
Investment strategy 72% of debt funds are focused on direct lending 12% of debt funds are focused on distressed debt 11% of debt funds are focused on mezzanine
Source: Alfi Private Debt Fund Survey 2021
In many cases, private debt funds are accompanied by a private equity sponsor that holds equity in the deal, presenting a new set of challenges to the lender who has to make sure their ESG objectives are in harmony with those of the private equity sponsor. This can sometimes bring the pair into conflict.
“What do you do if it’s not good news? What’s the impact on the valuation of the underlying company--what do you do as the debt holder--ask the corporate to pay more interest?” said Despret.
For third-party mancos, ESG requirements change reporting. “Article 9 is very difficult to put in place in terms of reporting,” said Despret. “Whereas Article 8 says that you will take ESG considerations into account, Article 9 is more of a positive screening.”
According to Despret, funds doing Article 9 currently have their own internal rules on how it is defined. “There’s some subjectivity there, even with the guidelines.”
What is more, Article 9 is a challenge to the lending psychology. “I’m not sure lenders are ready for Article 9 because they are lenders and what is more important to them is the return. It is the financial industry, the first requirement is returns.” All of this presents challenges to mancos to create ESG reporting process suitable for the unique requirements of private debt.
Onboarding a new investor breed Alternative asset classes in general are facing the challenge of onboarding a marked increase of investors. A large and granular base of small-ticket retail investors will gradually join the stalwart handful of big-ticket institutional investors, particularly in private debt.
“Equity markets (shares) are performing poorly so fund managers are often doing diversification strategies with debt to compensate,” said Despret. “The decorrelation of shares with debt--lots of investors are using private debt to mitigate return variation.”
As a result, a new model of investor relations is emerging, whereby the asset manager keeps the institutional investor relationship, but the relationship with the larger retail investor base is held by the investment adviser--often the placement agent or the bank through which the retail investors access the fund.
A number of very different processes will therefore be required both for onboarding and for relationship management. “This is why they outsource more and more, delegate to technology,” said Despret.
There has been an increase in the number of third-party mancos that provide software to streamline the onboarding process for a more fragmented investor base. The technology can speed up the necessary know-your-customer and anti-money-laundering processes that would otherwise stall fundraising if done manually. Then there is the burden of ongoing asset valuation needed in an open-ended fund. Performing this internally or delegating it to an external party requires time-chewing methodology and data modelling as well as administrative and accounting procedures in place.
However, distributed ledger technology has been used by financial services providers to relieve the operational burden on alternative investment managers. A digital shareholder registry and software will have the edge over traditional third-party outsourcing.
“Private debt is the only alternative asset class experiencing constant growth. You see lots of services developing in private debt. We see more and more competition,” said Despret.
A behemoth in the private credit world, Ares works with its borrowers to help create a sustainability agenda and to move their journey forward. Hilary Fitzgibbon, principal in the Ares Credit Group Luxembourg explains.
Words JOSEPHINE SHILLITO
Private debt started in 2008 as an answer to bank retrenchment, but as time goes on, its reach has extended far beyond the purely financial. “Lenders like Ares can provide more than just capital. We can share resources to portfolio companies and sponsors alike to help drive greater ESG integration,” said Fitzgibbon. “Structuring sustainability-linked loans (SLLs) is a way to do this.”
Sustainability-linked loans are a way of incentivising borrowers to comply with ESG targets in a similar way to which performance-related loans might reward the hitting of financial targets. SLLs typically include sustainability targets (STPs). If the borrower reaches these targets, they can benefit from a decrease in the margin that they pay the lender. Conversely, if they fail to meet the STPs, they may instead face a margin uplift. The so-called one or two-way margin ratchet is determined on a case-by-case basis with Ares and designed specifically for the borrower.
Driving a sustainability agenda It is useful, said Fitzgibbon, in an industry that is still in the process of adopting sustainability characteristics. “In our experience of offering sustainability-linked loans and integration of ESG principles, we have observed that about one-fifth of sponsors and just under half of the borrowers we have engaged with do not have a formal ESG plan,” said Fitzgibbon. “That’s where we see opportunity.”
The opportunity, according to Fitzgibbon, extends beyond individual borrowers to developing ESG standards across private credit. “Ares is committed to being a leader in the industry dialogue to develop ESG standards. The global alternative investment manager is chair of the United Nations Principles of Responsible Investment Private Debt Advisory Committee, something that it believes can help shape market standards in this area.”
On top of this, Fitzgibbon points out that the industry body Loan Market Association and the Loan Syndications and Trading Association have published “sustainability-linked loan principles, in which key areas of agreement are that there should be third-party verification on out-
SUSTAINABILITY-LINKED LOANS BY SECTOR
Source Nordea, October 2020
0% 5% 10% 15%
Utilities Transport and logistics Chemicals Industrial – other Food and beverage comes related to STPs and that ESG targets should be material beyond traditional business operations.”
Multiple parties in a deal However, private debt often shares its interest in the underlying borrower with a private equity sponsor. The sponsor will also have ESG criteria, and the trick is to get these to align rather than to burden the borrower, or worse, even create conflicting incentives.
“Ares typically has worked to align incentives with sponsors and borrowers to improve their ESG initiatives,” said Fitzgibbon. “One of these aims is to establish tangible STPs that are aligned with the overall business strategy.”
This also applies to other lenders in the deal--where they occur. The results of this kind of work have been promising. “The industry has increased adoption of sustainability characteristics in private debt funds, and we have seen a convergence around Article 8 [where a financial product promotes environmental and sustainable characteristics] funds,” said Fitzgibbon.
In fact, the industry is beginning to understand that financial performance climbs hand in hand with better ESG. “Nearly 70% of LPs surveyed by the Institutional Limited Partners Association have investment policies that include an ESG approach, with one of the primary motivations being the belief that ESG factors are additive to performance.”
“Luxembourg inputs a great deal into regulation”
Luxembourg has historically maintained a liberal regulatory regime for private debt. Its challenge now is navigating key regulations such as the Alternative Investment Fund Managers Directive and the European Long-Term Investment Fund.
Words JOSEPHINE SHILLITO
With over a third of Europe’s private debt funds domiciled in Luxembourg and the asset class among the fastest growing of alternative assets, the financial centre and its actors are keen to lay the foundations for further growth.
Regulations such as the AIFMD and the Eltif will be crucial in the cross-border functioning of Europe’s private debt market as a whole, says partner at international law firm Linklaters, Martin Mager, so it’s no surprise that Luxembourg has been particularly vocal in ensuring that regulations nurture the asset class.
“Luxembourg is the place to be for alternative funds. And, as a result, the AIFMD and the Eltif reviews show a lot of input from Luxembourg,” said Mager.
AIFMD Of main concern for private debt has been the AIFMD. The alternative investment regulation is designed to protect investors in alternative funds by providing a supervisory framework for the fund manager. However, a recent review by the European Commission proposed aspects that may be damaging to private debt.
“The AIFMD had sought to put in place restrictions on loan origination for alternative investment funds. This would have particularly affected private debt, which originates loans for a diversified range of businesses,” said Mager.
The amendments would have prohibited open-ended funds from originating MARTIN MAGER
Partner at Linklaters Mager is a partner in the Luxembourg investment funds group
more than 60% of their assets. In the case where origination breached that percentage, the funds would have had to become closed-ended.
The Luxembourg investment fund body Alfi and the financial regulator recommended instead that the AIFMD’s “closed-ended” rule were replaced with appropriate liquidity measurements. They also recommended that liquidity measurements replace an AIFMD proposal to hold 5% of the value of any loan they sell as a risk retention requirement.
The European Parliament this year upheld these recommendations. A positive thing for private debt, said Mager, although it still needs to be voted for by the European Council. the industry tried to push for is whether the requirements under the AIFMD would actually be applicable with respect to the Eltif, or if the Eltif product overrides this,” said Mager.
The Eltif is a fund dedicated to longterm, alternative investments that can be distributed on a cross-border basis to both professional and retail investors.
As with the AIFMD, Luxembourg worked hard on making sure the Eltif was suitable for every variety of alternative investment. This included lobbying through working groups set up within Alfi and working closely with the financial regulator to provide stronger guidelines on the framework and structuring of Eltifs.
However, unlike with the AIFMD, the Eltif did not contain any stipulations about loan origination that would have particularly harmed private debt.
“The Eltif is a good regime to set up but not so addressed at loan-originating funds,” said Mager.
Instead, the framework’s problem was more an issue of a general lack of clarity. This has now been resolved by the European Council’s October approval of the “Eltif 2.0”.
“In general, it’s going in the right direction,” said Mager.
Eltif What will be really interesting is how the AIFMD interacts with the Eltif. “What
