Brexit has unleashed a tsunami of interest in Luxembourg funds, but anyone from the UK picking-up with a local adviser is likely to be confronted by a bewildering matrix of different products (such as UCITS, Part II's, SIFs, SICARs, RAIFs, SVs, Soparfis, ETFs, EuVECAs, EuSEFs, ELTIFs and MMFs) that can take numerous different forms (most commonly, one or more of SICAVs, SICAFs, FCPs, funds, SCAs, SCSs, SCSps, SAs and Sarls) and be listed or listed and traded on a range of different exchanges and markets (such as LxSE or TISE).
This broad spectrum of options in 2018 reflects the rich legal heritage of Luxembourg that makes use of international concepts to accommodate all types of investor. This is a huge plus for industry and an obvious draw for Luxembourg, but, unfortunately, such complexity can also leave UK-based sponsors unsure where to start. This problem can easily be avoided though, if industry sticks to the essentials.
In Luxembourg, as in the UK, it is best to divide funds into the following three categories:
These are classic limited partnerships in a format almost identical to common law jurisdictions, where investor interests are represented by a series of separate capital accounts. These partnerships can either be incorporated (SCS) or unincorporated (SCSp) and whether or not managed by an AIFM, they do not typically make use of a product regime (such as the RAIF). This is because these partnerships are structured in a tax transparent and illiquid manner, and the benefits of a product regime are unclear.
Limited partnerships should be understood as commercial contracts that are freely negotiated between counterparties, namely: sponsors, cornerstone investors and any other founding partners. The parties are usually institutional in nature and, despite well-defined market parameters, each partnership contract tends to become quite bespoke.
Luxembourg is often favoured as a domicile where a limited partnership will operate in the EU (for example, originating loans) or its limited partners comprise EU-based institutions that are more comfortable investing in a passportable product (that may also attach a lower risk-weighting under any applicable investor regulation). In addition, operating in Luxembourg is practical where a partnership makes investments through a number of Luxembourg-based SPVs and in a BEPS context, the extended use of one domicile can be seen as reinforcing the direct tax analysis.
Where Luxembourg is less efficient in an international context, Luxembourg partnerships are often established in parallel or vertical to Delaware, Caribbean or Channel Island vehicles and operated on a pooled or look-through basis. These parallel and vertical structures can achieve significant efficiencies for investors, but some thought has to be given to the proper allocation of costs and voting rights to achieve a fair balance across the different pools.
Partnerships can be structured as undertakings for collective investment (UCIs) in Luxembourg, but it is easier to differentiate them for clarity.
UCIs are best understood as pooled investment vehicles where investor capital is represented by common NAV-based shares or units (as opposed to capital accounts), and can be open or closed end in nature. These vehicles are typically structured as variable capital companies (SICAVs) or contractual schemes (FCPs) and fall under one of the product laws in Luxembourg.
UCIs are funds in a true legal sense. Classically, these were always regulated by the CSSF and fell under the 2010 law as either UCITS or other publically distributed funds (Part II's). SIFs were a special form of lightly-regulated UCI reserved for well informed investors and SICARs were an equivalent form of investment company reserved for investing in risk capital. With the focus now on the regulation of the AIFM, the use of SIFs and SICARs has largely given way to the RAIF (ie, a registered UCI that is managed by an authorised AIFM and not separately regulated by the CSSF) because RAIFs are quicker, easier and cheaper to establish and benefit from the marketing passport and broader EU legal recognition.
Product laws tend to be used where sponsors: (a) are looking specifically for fund features (eg, variable capital, compartments etc); (b) anticipate risk diversification (in accordance with pre-defined parameters); (c) are less concerned about ring-fencing risks (eg, where controlling positions are not held); (d) are looking to create an evergreen vehicle (with a rolling performance fee); and / or (e) anticipate that the fund will be more widely distributed and that liquidity (ie, open end funds) or semi-liquidity (ie, closed end funds operating with a subscription queue) may be required. Fund liquidity requires NAV-based securities that can be purchased / redeemed, traded and / or listed as required.
UCIs are generally tax neutral (ie, taxed on a notional basis) as opposed to tax transparent (where investors look through the fund to the underlying returns in calculating liabilities). Problems can sometimes arise for investors though, where UCIs are structured on a different basis and there is no established international position in relation to the treatment of returns. FCPs, for example, do not benefit from the clear Baker and Garland trust principles that underpin unit trusts in the UK.
Luxembourg tends to dominate the cross-border UCI market in Europe and globally, because, it offers a broad range of very well defined products that are ideal for wealth managers and are supported by very effective infrastructure. Moreover, these UCIs are actively distributed and benefit considerably from the marketing advantages that attach to EU products.
Listed funds are not really funds in a legal sense. These vehicles are public companies (ie, cash shells) that raise money by issuing shares on one or more markets in Europe (such as the LSE, AIM, TISE or LxSE) to spend in accordance with a defined investment policy. They are often evergreen and are sometimes referred to as permanent capital vehicles. Listed funds tend to be closed end but allow for limited subscriptions (by way of share warrants) and buybacks to achieve an element of liquidity, and are domiciled onshore (where appropriate tax exemptions exist) or in a tax neutral jurisdiction (in the Caribbean or the Channel Islands). These companies tend to be unregulated and are operationally very efficient. By operating on a regulated market, they are easier to privately place in practice and secondary trading generally falls outside the scope of the AIFMD.
The absence of tax exemptions or neutrality outside product laws means that these funds are not currently a feature of the Luxembourg market, but this may change in the future if REITs and other similar products are introduced. In practice, this gap in the market is filled by using other products. For example, passively managed funds can be structured as ETFs or securitisation vehicles to achieve tax neutrality in a straightforward manner.
Since 2013, the EU has started introducing a series of special label products to promote investment in specific sectors: (a) the recast EuVECA regulation relates to venture capital funds; (b) the EuSEF regulation covers social enterprises; and (c) the ELTIF regulation attaches to infrastructure, small and medium sized enterprises and real assets. These labels can be pinned-on all forms of AIF and are intended to make fundraising easier. Unlike national product laws though, these labels do not embed special tax incentives. In addition, the EU has also adopted a regulation in relation to money market funds (or MMF) that will start taking effect from July 2018. The use of European labels is an integral part of Capital Markets Union (CMU) and they will grow in importance as CMU develops.
The product matrix in Luxembourg will continue to evolve as the financial centre looks to develop new industries and consolidate its lead in traditional sectors. This is a particularly exciting time and Ogier, for example, is currently helping develop new wrapper technology in the funds sector that could significantly reduce the barriers to UK sponsors looking to do business within Europe for the first time. No matter how nuanced the product matrix becomes though, sponsors should not lose sight of the essentials. Funds represent commercial relationships and fund-structuring is all about translating these relationships faithfully into effective products with a minimum of complexity.
This article first appeared in HFM Week.