ALFI Private Assets Conference

Luxembourg strengthens role as European private assets hub in challenging economic times

Amid an international environment characterised by lacklustre economic growth, international conflict and geopolitical tensions, and an uncertain policy outlook in Europe, Luxembourg has strengthened its position as Europe’s foremost centre for cross-border private asset funds over the past year, especially in the fast-growing private debt sector, according to speakers at ALFI’s Private Assets Conference 2023. Held at conference and exhibition centre LuxExpo, The Box in Luxembourg on November 28 and 29, the event attracted 550 signed-up participants.

To a large extent, private equity and venture capital, real estate and infrastructure and private debt funds have maintained their appeal to international investors amid elevated levels of inflation and ongoing tight monetary policy, reflected in the unwinding of central bank asset purchasing programmes and a rise in interest rates to a level not seen for a generation. “We’ve seen better days,” acknowledged ALFI chairman Jean-Marc Goy. “These are challenging times for the investment management industry, but not everything is bleak.”

He noted that despite the drop in Luxembourg’s regulated fund assets from €5.9 trillion at the end of 2021 to €5.0 trillion at the end of October, the Grand Duchy remains Europe’s largest domicile and the global leader for cross-border fund distribution; the continent’s main hub for SFDR article 8 and 9 sustainable funds, with 34% and 51% of the market respectively; home to 59 out of a total of 95 European Long-Term Investment Funds, and to 61.8% of Europe-focused alternative fund assets, up from 15.6% in 2010.

The past year has seen Luxembourg receive a solid mutual evaluation report from the Financial Action Task Force (FATF, or GAFI - Groupe d'action financière), and adopt legislation in July modernising the country’s regulatory framework for investment funds. Noting that the financial industry accounts for 15% of national employment, 20% of tax receipts and 25% of GDP, Mr Goy urged the new government to exempt active exchange-traded funds from the subscription tax on fund assets, like index-tracking passive ETFs, in order to capitalise on a new market segment that is growing rapidly in the United States.

Pragmatic approach to ELTIF 2.0 authorisation

The EU’s revised ELTIF Regulation should overcome barriers to retail investment in long-term assets and broaden the range of potential investments, according to Marco Zwick, head of fund supervision at financial regulator CSSF. He promised a pragmatic, “almost automatic” approach to authorisation of new ELTIF products queued up ready for the application of the new rules on 10 January 2024.

Mr Zwick also expressed hope that the legislation’s regulatory technical standards, which remain the subject of debate between EU institutions and member states, should encompass principle-based regulation rather than defined limits that might kill off the product before it gets started.

He told conference participants that the FATF evaluation recognised the quality of Luxembourg’s efforts both to put in place effective anti-money laundering controls and their implementation by the financial industry, although he believes the international body’s verdict was less glowing than it might have been because the assessment also considered AML controls in non-financial sectors such as real estate agents and jewellery dealers.

The next major area of regulation that firms must consider will be the EU’s Digital Operational Resilience Act, for which regulatory technical standards will be published early next year and which will apply from the beginning of 2025. Mr Zwick noted that of around 100 companies surveyed, only 11 have completed or even started mapping of their infrastructure requirements.

Infrastructure assets increased in value by 8.2% last year, by contrast with losses of more than 15% each for global equities and bonds, according to Rosa Villalobos, head of the Luxembourg office of Macquarie Infrastructure and Real Assets. However, she said that fundraising was taking longer – infrastructure funds raised just $11bn in the first half of this year, compared with $175.8bn throughout the whole of 2022, although another $45.6bn has come in since June.

A megatrend in its infancy

Volker Kraft, managing partner at ECE Real Estate Partners, said fundraising has slowed to its lowest level in the past 10 years, although he noted that this was in part due to the denominator effect – real estate and infrastructure have grown to an outsized share of many institutional investors’ portfolios because of the falling value of liquid assets.

Anthony Guerra, who leads Blackstone’s head of private wealth efforts in France and Benelux points to a significant regional shift in individual investors’ allocation to private markets. This has come about through the development and launch of semi-liquid funds, broadening access and attracting a wider range of investors to private markets. “It’s a megatrend, one that is still is in its infancy, the wealth market is estimated at $50 trillion globally, so as democratisation and innovation continue, we expect the allocation to private markets to grow further” he said.

Attracting private individuals will inevitably entail a rethink of minimum investment limits, according to ArcanoPartners director Marta Hervas. She says it will call for structures allowing them to invest amounts starting as low as €10,000, although individual investors will need to understand the characteristics and restrictions of the products, especially regarding liquidity.

Sustainability is also an increasingly important aspect of investment decision-making, with 39% of institutions surveyed by Preqin reporting that they would consider turning down investments of ESG grounds. Gwen Colin, ESG director at Vauban Capital Partners, notes that the long-term nature of many private market assets means that some of them may still be in portfolios by the 2050 target date for net zero greenhouse gas emissions; investors will increasingly demand audited sustainability data rather than self-reporting.

The global buyout market today is hemmed in on two sides, reported Benedikt Hoefelmayr of Munich-based private equity data analytics platform Cepres: on one hand from investor pressure for returns amid an IPO market that has dried up and sale transactions have slowed, and on the other from the rising cost of debt. However, he says that after a series of good years for many portfolio companies, general partners have been able to reduce their debt levels.

Lurking danger of Pillar 2 minimum taxation

Andrea Vathje, a senior representative of Scope Fund Analysis, says the revision of the EU’s ELTIF Regulation has created a hybrid regime in between closed-ended funds and the UCITS rules, with a shift to semi-liquidity, a reduction in a fund’s minimum investment in real assets from 70% to 55% and a corresponding increase in permissible liquid assets, and a decrease in the minimum number of investments from 10 to five. On the client side, there is no longer a €10,000 minimum investment and the wealth check has been abolished. Ms Vathje expects many new products to be launched next year, with most of those aimed at retail investors domiciled in Luxembourg.

Although investment funds are intended to fall outside the scope of the Pillar 2 OECD-sponsored global minimum corporate tax rules, there could be exceptions, warned ATOZ tax partner Andreas Medler. If a management company was large enough to breach the €750m annual turnover threshold, it could drag in funds they service, although few Luxembourg ManCos would reach the threshold. Equally, investors with a large enough share of a fund to consolidate it, such as insurers, could do the same; as could theoretically a fund portfolio company exceeding the turnover limit.

Liquidity management tools have become an increasing focus of regulators in the years since the global financial crisis after a succession of economic shocks and temporary dislocations exposed liquidity mismatches in open-ended funds. Luxembourg’s CSSF has been an early pioneer of encouraging the incorporation of mechanisms such as redemption gates and swing pricing into funds’ offering documents, and their role is now being formalised in parallel initiatives by IOSCO and the European Securities and Markets Authority.

IOSCO’s recommendations have fed into the upcoming revisions to the Alternative Investment Fund Managers Directive, but industry members see a particular importance for liquidity management tools in the new breed of semi-liquid ELTIFs. “It is a trade-off between avoiding having to manage or delay redemptions, and the need to treat all investors fairly,” said Invesco Real Estate Management general manager Fabrice Coste. BlackRock Fund Management Company managing director Geoff Radcliffe noted: “The CSSF wants ELTIFs to be as flexible as possible and to avoid prescriptive rules on liquidity mechanisms.”

Prudence in democratisation

Amid widespread enthusiasm across the alternative investment sector about the democratisation of private markets through semi-liquid funds, Linklaters counsel Hermann Beythan struck a note of caution: “Be prudent!” In the retail – or at least non-professional – market, he says, asset managers face the risk not only of regulatory sanctions but even criminal proceedings, and the much greater possibility that investors may seek to sidestep redemption restrictions by claiming mis-selling.

Soraya Kamel, global head of business development at Allfunds Alternative Solutions, said asset managers must work with distributors to ensure they understand the product and educate private bankers who are used to more liquid investments about how tools such as redemption gates might be applied.

Providing greater liquidity than is normally available in private market funds carries a cost, noted Olivier Garin, senior sales director of Carlisle Management Company: “There is an extra need for liquidity, of up to 20%, to ensure the ability to meet redemptions. That means missed opportunities and an impact on performance.”

Panellists pointed to the constant tension involved in bridging the gap between institutional and individual investors, even though ‘retail’ is a misnomer; essentially democratisation involved targeting high net worth individuals and families, and to some extent the mass affluent. Beyond clients of private bankers and family offices, Mr Garin said, there is a wider range of potentially suitable investors – for instance, entrepreneurs who have seen their companies through an IPO might well have the experience and appetite for venture capital investment.

Investors of all kinds are increasingly demanding more granular data on their assets, which can be a logical outgrowth of increasing automation of fund accounting processes, but a development that still needs human supervision, according to Stuart Tait, a director of UK analytics and reporting provider Accelex Technology. He remains unsure about the role to be played by digital ledger technology, but is convinced of the potential of generative artificial intelligence: “It will get better, smarter and faster, and very quickly.”

Decoupling funding costs from inflation

Morgan Stanley portfolio manager and research analyst Anton Heese identifies three key macroeconomic issues that will impact markets over the next few years. First, he said, inflation is now coming down more quickly than expected – just as its rapid rise surprised economists – and central banks will start lowering interest rates next year, but not quickly, and not far: “They will return to a neutral stance, not an accommodative one.”

As a result, he expects funding costs to remain structurally higher than during the period from 2005 to 2021, casting doubt on the future of investment models based on leverage but boosting returns from ‘normal assets’. And Mr Heese warned that the economy will remain patchy, with manufacturing struggling – in large part due to last year’s surge in energy prices – while services perform significantly better, concluding: “Selection of assets will remain important.”

Camille Seillès, secretary-general of the Luxembourg Bankers’ Association, had reassuring news for fund industry members concerned that the sometimes slow and burdensome process of opening bank accounts for alternative funds is becoming a reputational problem for Luxembourg. The ABBL has already canvassed member institutions to identify interest in serving fund clients, and clarification with the CSSF of customer due diligence requirements as well as employing AI in KYC screening will speed up onboarding procedures and free up resources from “document chasing”.

Automation and the mutualisation of processes common to the industry as a whole are also seen as one answer to skill shortages in key asset serving fields. Alan Dundon, president of industry group L3A, argues that more advanced technology can fuel faster growth for the sector, alongside existing solutions such as outsourcing of work to other jurisdictions. This will become more important if as Preqin forecasts, global private fund assets grow by 50% to $24trn over the next five years. He said: “The trend is toward bigger and more complex funds, and it will entail consolidation among service providers.”

AI is expected to play a major part in that process, while helping to address issues such as wide variations in data collection practices in the private markets sector, although Cara Browne, head of relationship management and product oversight at EQT fund management, said that while there are obvious efficiency gains in offer in areas such as corporate secretarial functions, quality checking represents an important challenge.

The capabilities of AI in an area involving large volumes of text, such as screening of legal documents, are already evident. Allianz Capital Partners head of private markets operations Helge Baur says that while using it in decision-making raises the regulatory and ethical issues (“What boundaries should AI have”), documentation represents low-hanging fruit. Here, it can provide much greater efficiency combined with higher quality. He advocates enabling the workforce to try it out and let use cases evolve – generations Z and Y will come up with new ideas.”

The long, dark night of the conducting officer

What keeps conducting officers up at night? The answers vary, but many of them feature anti-money-laundering controls – especially as the advance of retailisation in the private assets sector opens up the prospect of customer due diligence being extended from a small number of limited partners to hundreds or even thousands of individual investors.

Alain Delobbe, managing director of Alter Domus Luxembourg, highlights the operational challenge posed by the larger number of investors in open-ended funds, but also the critical importance of valuation in ensuring that all investors are treated fairly.

The conducting officer of the European arm of Salt Lake City-based Bridge Investment Group, Jennifer Walker, says that in order not to lose potential investors, the onboarding process must be rapid and efficient, not requiring endlessly going back to the would-be client with more questions.

Smaller-ticket investors are also getting into closed-ended funds, according to JTC (Luxembourg) funds director Derek Russell, who observes that the €125,000 minimum investment is no longer the barrier it once was. He told conference delegates: “My AML/KYC team can’t grow fast enough to keep up with all the new business.”

However, the panellists were less concerned than other industry members about the human resources available in the Grand Duchy. Ms Walker argues that Luxembourg is swimming in talent – “It’s retention that’s critical” – while Mr Russell believes the country is now more attractive to experienced employees and is less vulnerable to losing people to rival financial centres such as London and Dublin.

New products, new markets

The conference offered a showcase to two new pieces of research on Luxembourg’s alternative fund sector. A survey conducted by ALFI in collaboration with leading Luxembourg consulting firms finds that assets under management at Luxembourg-domiciled real estate funds declined by just 1% during the first three quarters of 2023, a creditable outcome given the difficult economic environment facing the sector. The number of funds covered has doubled over the past five years and was up by 12% year on year to 706.

Deloitte General Services senior manager Anne-Sophie Le Bris says the survey highlights a shift away from the specialised investment fund regime (now 30% of the total) toward indirectly-regulated reserved alternative investment fund structures (31%) for property investment, while 59% of all structures are limited partnerships; more than half of all funds followed a multi-sector investment strategy.

Meanwhile, the aggregate net assets of private debt funds rose by 51% to €404bn over the 12 months to the end of June, according to a survey by ALFI and KPMG Luxembourg of 12 depositaries that service 1,495 funds or sub-funds. KPMG tax and advisory partner Julien Bieber says regulated funds still account for 55% of the market, but the proportion that are indirectly supervised has grown from 40% to 45% since 2020. Over the same period the share of assets of SIFs investing in private debt has declined from 67% to 38%, while that of RAIFs has grown from 28% to 53%.

The final session of the conference was an illuminating, irreverent and at times emotional look back over the past 16 years at ALFI, through the eyes of CEO Camille Thommes, who is passing the baton to Serge Weyland at the end of the year. When he took up the post in 2007, Mr Thommes told Antoine Kremer, ALFI’s head of European affairs, Luxembourg’s fund assets under management stood at just €2 billion – soon to drop by a quarter under the impact of the looming global financial crisis, although not for long.

It was also a time for new initiatives that would sow the seeds for future growth: the launch of specialised investment funds in 2007, and six years later the introduction of the EU’s AIFMD, accompanied by the hugely successful creation of Luxembourg’s special limited partnership. At the same time ALFI was extending the global character of the country’s fund industry, dispatching roadshows to open up new markets not only across Europe but in Asia and Latin America.

Said Mr Thommes: “These trips involved extremely hard work on the part of our highly professional events team, created bonds with members of the industry extending well beyond professional relationships, and won ALFI a reputation worldwide as a source of funds expertise. He concluded: “Today we cannot rest on our laurels. We must remain agile, and hope the political classes continue to value our contribution to the economy.”

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