Overseas interest powers Luxembourg’s financial sector, says RBS International

With an increasing number of US funds choosing to domicile in Luxembourg, RBS International’s Ian Harcourt examines the benefits of doing business in the country.

This article is sponsored by RBS International

Ian Harcourt
Ian Harcourt

US financial institutions were some of the first international players to utilise Luxembourg as a place for business following the first Undertakings for Collective Investment in Transferable Securities directive in the 1980s. This represented a significant step change for US institutions, enabling them to effectively undertake many of their European asset management activities from a single location within the EU.

Over the following decades, the US rose to become the largest international player in Luxembourg. The country is now home to 10 US banking groups – BBH, JPMorgan, Citibank, Goldman Sachs, John Deere, Northern Trust, PayPal, State Street, the Bank of New York and US Bank. US financial institutions collectively represent around 21 percent of the €5 trillion of assets currently under management.

All but one of the top 30 US-based asset management groups as measured by Luxembourg for Finance also have a presence in Luxembourg, while 23 of the world’s largest 56 investment managers that have operations in Luxembourg are of US origin. Additionally, Luxembourg is home to a cluster of fintech enterprises with US ownership, including Airbnb and Amazon Pay.

Emerging trends

Over the past few years, we have observed a shift in both appetite and strategy within this market, accelerated by Brexit and covid-19. While the pandemic gave many institutions time to reconsider and re-evaluate their strategies, the largest top-performing global managers continued their fundraising activities unabated. This led to significant growth in the size of their funds on the back of strong investor-led demand, with an increasing number of mega funds valued at over €1 billion.

However, smaller mid-market funds haven’t benefited from the same type of investor-led demand, which indicates that there is still a reliance on meeting with investors physically.

As many predicted, Brexit acted as a catalyst for the redomiciling of institutions to Luxembourg, re-enforcing the country’s importance as a growing global financial hub. Its location in the heart of Western Europe is an ideal one from which to observe the development of subtler trends, many of which highlight how some sponsors are reimagining the future of global capital flows and investor expectations. More general trends, such as fund managers pivoting their funds to increase global reach and attractiveness to investors, can also be witnessed from this prime location.

We have also seen some movement within Europe, as previously domestic European funds relocated from their home countries to Luxembourg, capitalising on the opportunity to diversify both their investor base and, often, their fund offering. We have already seen several Nordic alternative investment funds following this pattern, for instance.

US following suit

An even more exciting development has been the increase in US-based fund managers evaluating the pros and cons of moving funds from the US to Luxembourg.

US funds often have entities incorporated in the state of Delaware or the Cayman Islands in order to meet the needs of their investors, GPs and sponsors. However, even prior to the onset of the pandemic, there had been a glacial shift away from these traditional centres towards the greater global reach offered by a European location.

For many years, funds based in the US have sought to diversify their investor base, both in the name of good practice and because preferred return expectations are significantly lower in certain parts of Europe and Asia, where specific investors simply need to deploy capital. There isn’t a major fund today that doesn’t have non-US investors and, as the US seems to have avoided the curse of negative rates, we can expect this trend to continue.

Home from home: all but one of the top 30 US-based asset management groups as measured by Luxembourg for Finance have a presence in Luxembourg

ESG considerations

The pandemic has also helped to focus people’s minds on the importance of ESG – in particular, the role that private investment can play in helping to solve society’s greatest challenges, such as the climate crisis.

As the second-largest fund domicile in the world, Luxembourg can offer a comparable framework for establishing alternative funds within a single country, with the added benefit of a consistent, stable and transparent regulatory framework which has ESG high on its agenda.

ESG data metrics will be key for sponsors in assessing long-term performance and sustainability, with new performance indicators scrutinised by investors, regulators and society alike. The sponsors who can best master their data will be deemed more resilient, and will therefore be rewarded when it comes to their fundraisings.

The drivers of investor value are increasing and becoming more diverse. As yet, no standardised approach has emerged, and how sponsors react to this new challenge will be an important differentiator.

A global stepping stone

US fund managers have for many years established feeder funds in Luxembourg, predominantly to attract European – often German – investment into the US. Luxembourg also remains the domicile of choice for global funds. However, there is now a growing realisation that this small country in the middle of the EU can be used as a strategic stepping stone to attract a more diverse global investor base, such as from Asia-Pacific and further afield.

Asia’s growing presence bears so much significance that Luxembourg has issued licences to at least 12 Chinese banks so far, according to data from the Commission de Surveillance du Secteur Financier.

Furthermore, at the beginning of this year, KPMG’s Asia arm noted in its Private Equity Trends for 2021 report that, based on Preqin data, it expected “dry powder allocated to the region to continue to outgrow the US and EMEA in 2021”.

It also reported that “Asia-Pacific’s PE/VC dry powder market share now represents 25 percent of the global total, above Europe (19 percent)”. As the Asia-Pacific market grows, so will the need for Asia-Pacific-based investors to diversify their investment portfolios.

Legislation and regulation

While US funds find clear appeal in opening shop on the other side of the Atlantic, the varying legislation across different markets has always proven a difficult nut to crack. However, we are seeing a fair amount of interest on the part of US funds attempting to expand into Europe.

The Alternative Investment Fund Managers Directive, introduced in 2011, was a game changer for the European funds market. It imposed an EU-wide framework on hedge, private equity and real estate funds, with greater regulation and compliance requirements. The directive was also implemented to increase investor protection.

In August, most of the provisions of the EU Cross-Border Distribution of Funds legislation came into effect. The CBDF legislation is designed to reduce barriers to cross-border marketing and the sale of funds.

While harmonisation – in particular, the introduction of an EU-wide definition of ‘pre-marketing’ – will be welcomed by AIFMs based in the EU, the new rules present some new challenges for fund sponsors seeking to access EU investors. For example, US-based funds will need to appoint an EU-based AIFM to market their funds to European investors.

The purpose of the pre-marketing rules for EU AIFMs is to introduce consistency in the EU with regards to what counts as marketing under the AIFMD marketing passport. This process can only be carried out if a passporting notification to the relevant member state regulator is made.

Looking to the future, a revised AIFMD (AIFMD II) is expected to strengthen the rules and expand the legislation’s scope to include smaller AIFMs. This would increase the need for real EU fund products and marketing passports, rather than relying on private placement to market funds.

The potential for growth

It’s reasonable to estimate that financial and investment services in Luxembourg have a growth rate of 5-10 percent, with more significant double-digit growth in the alternative investment fund markets.

The structures and services that Luxembourg currently has in place will flex to accommodate more business, and we are likely to see new technologies – particularly from the fintech sector – facilitating this growth. Going forward, technology will help to alleviate the need to grow the workforce in proportion to the economy, as many of today’s manual services will be automated. One particular area to benefit from this will be depositary services.

RBS International’s institutional banking services include fund finance, liquidity and risk management, and depositary services (through separate legal entities). We offer these services to institutional customers located in all of our operational jurisdictions, which include Jersey, Guernsey, London, Luxembourg, Gibraltar and the Isle of Man.

Ian Harcourt is RBS International’s country head and head of institutional banking in Luxembourg