Daniel Richards, Ogier examines Luxembourg's fund industry from UCITS to Specialised Investment Funds.
Asset class – Hedge
As a founder member of the European Union benefiting fully from free movement of capital and freedom of establishment within the EU, Luxembourg is also one of the largest global financial centres, benefiting from flexible and attractive legal, regulatory and tax regimes and a significant concentration of professional service providers to the financial services industry.
Luxembourg ranks as the largest EU fund domicile jurisdiction and the second largest fund domicile jurisdiction globally. After more than 30 years of development, total net assets under management of Luxembourg undertakings for collective investment and specialised investment funds stood at €2.157 trillion as at January 2012. These assets under management are held in 2,450 undertakings for collective investment, including UCITS, introduced in 1988, and approximately 1,400 specialised investment funds, introduced in 2007.
Approximately 75 per cent of internationally distributed UCITS are domiciled in Luxembourg.
Luxembourg’s solid track record of stability has enabled it to meet the challenges arising in global markets since 2008 with a Triple A credit rating, low levels of sovereign debt and one of the highest per capita GDP globally. This economic and political stability, allied to the legal, regulatory and fiscal attributes of its investment funds industry has resulted in Luxembourg’s position as a premier-ranking fund domicile.
Over the last five years, Luxembourg regulated fund products have been increasingly used by managers pursuing complex, alternative strategies in a complementary fashion to structures in traditional hedge fund domiciles. This has enabled managers to respond to regulatory change and an increasingly broad range of investor preferences with diversification in both product ranges and distribution networks. Complex UCITS in particular have played a key role in this.
Principal Luxembourg hedge fund vehicles
There are two principal, regulated Luxembourg fund vehicles which may be used for complex, alternative strategies, as follows:
Both UCITS and SIF are regulatory classifications. They describe regulated fund products which can be structured in various legal forms, with tax efficient outcomes following from such selection. A summary of the vehicles commonly used as complex UCITS and SIF for hedge-type strategies and the corresponding tax treatment is set out below.
As regulated products, both UCITS and SIF are subject to the prior authorisation and ongoing supervision of the Commission de Surveillance du Secteur Financier (CSSF), the Luxembourg regulatory authority. In discharge of its duties, the CSSF is charged with maintaining investor protection and the stability of Luxembourg’s financial services industry.
In addition to complex UCITS and SIF, complex alternative funds pursuing an equities-only strategy and with the aim of influencing the management of portfolio companies may be structured as “investment vehicles in risk capital” (SICAR).
Choice of fund vehicle
The regulatory frameworks for both UCITS and SIF result in identical basic fund structures (as shown below). As tax outcomes are also broadly similar, selection of regulatory product will be driven by a balancing of the following factors:
Between complex UCITS and SIF (and similarly SICAR), the fundamental balance lies between greater distribution benefits for UCITS but less prescription as to investment policy, portfolio composition, leverage, risk-spreading and operational matters for SIF.
Originally set up to implement EU single market principles in financial services, UCITS may be distributed to all categories of investors within the EU, without regulatory restriction as to investor eligibility.
With the introduction of UCITS IV in Luxembourg in 2011, the process in practice of such distribution to EU investors has been significantly stream-lined with the effective time-to-market from the decision to distribution reduced from two months to ten working days.
The process commences with submission of a notification pack to CSSF including the following:
All documents other than the KIID may be in English.
CSSF verifies that the notification pack is complete, transmits details to its equivalent regulators in the recipient investors’ jurisdictions within ten working days and informs the manager. On receipt of that notification, the manager may start distribution to potential investors in those jurisdictions.
Regulators in the host jurisdictions will then review within five working days. The manager is responsible for identifying and complying with any applicable local requirements. In practice this is addressed through use of established distributors, although legal responsibility for compliance remains with the manager.
Although UCITS may lawfully be offered to all categories of EU investors, managers may apply fund-specific eligibility criteria in the prospectus if appropriate. For example, funds may be offered only to institutional investors and / or an appropriate minimum investment threshold may be set, for example US$50,000 / 100,000/ one million, provided such criteria are objective.
In addition to geographic distribution advantages within the EU, UCITS also benefit from advantageous treatment in institutional investors’ asset allocation rules. UCITS are also extensively used for distribution to investors in many non-EU markets due to the perceived advantage of their bench-marked brand recognition.
UCITS fall outside the scope of AIFMD and the balance of factors which makes them attractive to managers of complex alternative funds is therefore unaffected by it.
In contrast, SIF are available only to eligible investors comprising: institutional; professional; self-certifying sophisticated private investors with a minimum investment of €125,000; investors certified as sophisticated by a regulated intermediary (no minimum investment required); and carried interest investors acting in the management of the SIF.
Distribution of unlisted SIF outside of Luxembourg is currently determined by national private placement regimes. SIF will become subject to an AIFMD overlay as AIFMD is implemented, and are anticipated to be an early beneficiary of EU AIFMD passporting, following the UCITS model.
Bench-marked brand recognition for Luxembourg SIF in non-EU markets is developing but is at an earlier stage of development than for UCITS.
Neither UCITS nor SIF carry any minimum or maximum requirements as to investor numbers, and may be constituted as single-investor or dedicated funds.
Investment policy & portfolio composition
SIF have greater flexibility in regulatory requirements as to investment policy and portfolio composition. On condition of adequate disclosure in offer documents, there are no restrictions on asset class, investment policy or permitted investment-holding instruments applicable to SIF.
In contrast, UCITS portfolio composition is more restricted in scope, being limited to: transferable securities; derivatives based on eligible underlying assets (including currencies, commodities and interest rates); bonds and money market instruments; cash at bank; certain eligible structured finance products; and other collective investment undertakings.
Transferable securities are (broadly) negotiable securities listed on a regulated, liquid market with regular, accurate price information which are compatible with the UCITS’ investment policy and risk management framework.
Derivatives (referencing eligible underlying investments) must be either listed on a regulated market or be over-the-counter products issued by eligible counterparties with reliable fair-value valuation. Please note, this is a summary only of a technical area.
SIF are not subject to regulatory limitations on leverage policy.
In contrast, UCITS are substantially prohibited from entering into borrowing. However, UCITS may enter into securities lending, sale and repurchase transactions relating to transferable securities or money market instruments, in each case for the purpose of risk spreading, cost-mitigation or for additional income or capital generation, in accordance with the fund’s overall risk profile. Detailed rules apply in relation to counterparty risk, concentration risk, eligible collateral and valuation.
Managers of Luxembourg UCITS have in practice lawfully applied such techniques and appropriate derivatives strategies to deliver the value multiplier effects of leverage without being hindered by the prohibition on borrowing and yet respecting borrowing constraints.
SIF are subject to a broad portfolio risk-spreading requirement. Although not specified in the SIF Law, CSSF policy requires that SIF apply investment restrictions so that no single investment represents more than 30 per cent of the SIF’s total net assets.
For SIF, this applies also to short selling in that it cannot result in the SIF holding uncovered securities of the same type issued by the same issuer representing more than 30 per cent of the SIF total net assets. This general position is subject to any other temporary restrictions on short selling in force from time to time. When entering into derivative instruments, SIF must ensure comparable risk-spreading through appropriate diversification of the underlying assets.
Exemptions apply in relation to (a) securities issued or guaranteed by an OECD Member State (or by its local authorities) or by certain supranational bodies and/or (b) investments in portfolio funds which are themselves subject to risk-spreading requirements at least comparable to those of SIFs. Other exemptions to the risk-spreading requirements may be available on a case-by-case basis.
UCITS are subject to more detailed risk-spreading / portfolio diversification requirements than the broad 30 per cent rule applicable SIFs.
Notwithstanding this, managers have found such requirements to be consistent with their strategies in practice and for UCITS’ distribution advantages to outweigh compliance with these regulatory requirements.
Physical short-selling is not permitted by UCITS. However, synthetic strategies utilising derivative investments of similar effect may lawfully be applied, subject to any other temporary restrictions on short-selling of general application in force from time to time.
Preferred level of regulation
In summary, the distribution advantages of UCITS do bring an enhanced level of regulation. In contrast, SIF enjoy a less prescriptive regulatory environment but without the full investor distribution benefits of UCITS.
The optimum outcome will be determined in each individual case on an assessment of the balance of these factors.
Complex UCITS and SIF pursuing hedge strategies are principally set up as either:
An FCP is an undivided pool of assets, co-owned by investors directly. FCP have no separate legal personality and are managed by a separate, regulated management company. This management company acts in the name and on behalf of the FCP, in the interests of unit-holders. The FCP is similar to the English law unit trust and US mutual fund.
Unit-holders have limited liability, restricted to their agreed level of contribution. Their minimum legal rights are generally more limited than those of shareholders. Subject to any case-specific provisions in an FCP’s management regulations (similar in function to constitutional documents), unit-holder rights will commonly be limited to approval of annual accounts and to changes to the offer document or management regulations. When used for hedge-type strategies, FCP will be constituted on an open-ended basis.
An FCP is deemed to be a Luxembourg fund if its management company has its statutory seat in Luxembourg.
SICAV are open-ended, variable capital investment vehicles. They are generally constituted as public limited companies (sociétés anonymes). Having a variable capital means their issued share capital is always, automatically equal to their net asset value, without formality, vote or amendment. Although other fund vehicles are legally possible for both UCITS and SIF, such vehicles are not commonly used to pursue hedge-type strategies.
Both UCITS and SIF may be constituted as either single asset-pool funds or with multiple, segregated compartments. Such compartments provide ring-fenced asset (and liability) pools and are the mechanism of choice for umbrella multi-strategy and/or multi-currency funds. There are no restrictions as to currency selection.
Both UCITS and SIF have a general market capitalisation requirement of €1,250,000, with the following additional requirements: this general minimum capital must be subscribed for within six months of CSSF authorisation for UCITS, with €300,000 being paid up as at authorisation for UCITS structured as self-managed SICAV; for SIF this general market capitalisation requirement must be subscribed within 12 months of CSSF authorisation and be five per cent fully paid up.
Provided this minimum capitalisation requirement continues to be met, there are no restrictions regarding dividends or distributions for either UCITS or SIF, whether structured as FCP or as SICAV (save any that may be applied in the constitutional documents on a fund-specific basis).
Both UCITS and SIF assets are valued at fair value, determined in accordance with applicable accounting standards pursuant to the constitutional documents and confirmed by their independent auditor.
Detailed additional rules apply for UCITS as to the valuation of certain assets, the responsibilities of UCITS management companies, the frequency of NAV calculation (which must be at least twice monthly), independent third party verification of NAV calculation and risk management review.
Required Luxembourg service-providers
Both UCITS and SIF which are structured as FCP must appoint a regulated Luxembourg Management Company (ManCo). If structured as SICAV, a ManCo may be appointed (but is not obligatory). If a ManCo is not appointed, the SICAV (whether UCITS or SIF) will be self-managed. If so, the SICAV must also comply with ManCo regulatory requirements.
All UCITS and SIF must appoint Luxembourg regulated central fund administration, registrar and transfer agent service providers and CSSF approved auditors.
SIF must appoint a Luxembourg regulated custodian approved by the CSSF, whose responsibilities are to verify title to portfolio assets at acquisition and to provide periodic monitoring of the continuing ownership of the portfolio by the SIF and the related portfolio funds-flows. This does not necessarily extend to safe-keeping of title documents.
For UCITS, this portfolio and fund-flow supervisory monitoring is carried out by the UCITS’ depositary which must therefore also apply such monitoring oversight to dealing by the UCITS’ prime broker. The depositary’s appointment must be approved by CSSF. Depositaries must be Luxembourg regulated credit institutions or branches of EU regulated banks.
UCITS offer documents must contain prescribed information as to the fund and its service providers. UCITS must also use a pro-forma key investor information document providing an abridged summary for investors.
In contrast, there are no prescribed content requirements for SIF offer documents other than the general requirement to include all information necessary for investors to make informed judgements of the investment proposition and of the risks attaching to it. The key elements of offer documents must be updated (as required) prior to any future closings involving new investors.
In practice, where managers utilise complementary fund vehicles in other jurisdictions, UCITS and SIF offer documents may be issued to investors in substantially similar (and familiar) formats, with only limited adjustment often being required to meet local regulatory requirements.
UCITS must provide detailed audited annual reports and unaudited semi-annual reports to investors and CSSF, financial information is also submitted monthly to CSSF.
For SIF the minimum required investor reporting takes the form of the annual report, there is no obligation to publish semi-annual reports, to submit monthly financial information to CSSF or to prepare consolidated financial statements, although more frequent investor liaison may be adopted if considered appropriate.
Stock exchange listing
Both UCITS and SIF units may be stock exchange listed on meeting the applicable exchange admission and ongoing requirements. Ensuring compatibility between free transferability requirements of the relevant exchange and applicable eligible investor requirements is required.
Such listing may assist distribution either in relation to: non-EU investors; institutional asset allocation requirements; or, for SIF prior to AIFMD overlay, to utilise the EU Prospectus Directive passport for cross-border distribution (implemented in Luxembourg in 2005).
Commensurate with the sophisticated nature of SIF investors, the regulatory approach to authorisation and ongoing supervision is less extensive than that applicable to UCITS.
The application will include regulatory approval of the offer document and constitutional documents. For both UCITS and SIF, directors (and ManCo director and shareholders) must also be approved as being of good standing with appropriate experience, as must the selection of Luxembourg regulated custodian, fund administrator, transfer and registrar agent and auditor. CSSF may also request any other information or documents considered relevant from time to time.
For UCITS, CSSF also applies a promoter policy review and approval including financial statements. In contrast, for SIF no separate promoter review / authorisation is applied.
UCITS have detailed compliance responsibilities in relation to risk management including as to: organisational separation from portfolio investment management; valuation methodologies; and global risk exposure limits.
In line with anticipated AIFMD requirements, since March 2012 SIF are required to implement adequate risk management systems and organisational arrangements to prevent conflicts of interest.
CSSF authorisation for SIF may take three to six weeks depending on investment policy and strategy. Complex UCITS authorisation commonly takes approximately the same time. On authorisation, UCITS and SIF may then conduct their first closing.
Any appointment of new directors, change of custodian or amendment of constitutional documents requires CSSF prior approval.
FCP are generally transparent for Luxembourg tax, SICAV are generally opaque.
UCITS and SIF are both exempt from Luxembourg direct taxation. UCITS are subject to an annual subscription tax calculated at 0.05 per cent per annum of the net asset value, calculated and payable on a quarterly basis, although this may be reduced to 0.01 per cent (or exempted) in certain circumstances. SIF are subject to an equivalent annual subscription tax of 0.01 per cent. There is a negligible applicable capital duty.
UCITS and SIF both are exempt from Luxembourg income tax, municipal business tax and net wealth tax. Distributions / dividends by UCITS and SIF to investors and payment of unit redemption monies are not subject to Luxembourg withholding tax (subject to the EU Savings Tax Directive).
Both UCITS and SIF (however structured) effectively qualify as taxable persons for VAT purposes. Management and administration services provided to UCITS and SIF are VAT exempt. Depositary, audit, and professional advisory services applied to UCITS and SIF are however subject to VAT.
For efficient structuring, UCITS and SIF may hold portfolio investments via intermediate holding companies, depending on the geographic location of the portfolio.
Investors’ tax treatment depends on many individual factors including the place of such investor’s residency. Investors should seek specific, independent tax advice.
This briefing provides a summary only of the current law and practice in Luxembourg at the date of writing and is subject to change therein. It does not purport to be comprehensive and does not constitute legal or tax advice for reliance purposes. Specific, professional advice should be sought on each occasion.
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