Despite geopolitical turmoil, soaring inflation, rising interest rates and threatened energy shortages, 2022 was a good year in terms of asset growth and market positioning for Luxembourg's fast-growing alternative fund sector.
After the extraordinary global upheaval of the Covid-19 pandemic, investors might have expected a more sedate economic outlook and market performance this year - but it was not to be. With inflation already stoked by increasing input and supply chain costs, Russia's invasion of Ukraine added fuel to the fire and market turbulence.
Alternative funds were not immune to the global economic and political turmoil, nor investors’ frayed nerves, but the Luxembourg industry enjoyed an impressive year during which the appeal of onshore jurisdictions with tried and tested regulatory structures increased. That was not only among institutional investors, but also wealthy individuals who are seeking greater access to alternative strategies to diversify their portfolios and protect them against economic squalls.
On strong foundations
The industry began 2022 on a high. Non-regulated Reserved Alternative Investment Funds, which offer rapid time to market and minimised administrative formalities, were the fastest-growing segment of Luxembourg's fund industry in 2021, with net assets up 84.4% to €290.9bn, according to fund research provider Monterey Insight.
Private equity and venture capital funds reported asset growth of 29.9% to €285bn last year, according to data provider Preqin, the highest growth rate of any asset class in the grand duchy.
Asset managers continue to see strong long-term potential for Luxembourg as an alternatives jurisdiction offering investors the comfort of effective regulatory oversight, particularly in a climate where traditional asset classes and investment strategies have been battered by twin shocks of soaring inflation and interest rate levels not seen in Europe for more than a decade. In the first half of 2022, new Reserved Alternative Investment Fund launches were up by 36% from a year earlier, according to the Luxembourg Trade and Companies Register.
A positive long-term outlook
Longer-term trends continue to be positive for alternative fund providers. Luxembourg has been a prime beneficiary of the European Union's Alternative Investment Fund Managers Directive (AIFMD), which has become a significant factor in the trend in the sector to opt for onshore jurisdictions since its establishment a decade ago.
The grand duchy has also been successful in seeing off attempts by some member states to impose provisions to restrict outsourcing of key functions including portfolio and risk management are no longer included in the planned revision of the AIFMD, which ensures a true cross-border ecosystem remains in place, which is currently wending its way through the EU's legislative process.
The changes also include new rules governing loan-originating funds - a key concern for the Luxembourg industry since more than a third of Europe’s private debt funds are domiciled in the grand duchy. The European Commission's original proposal appeared problematic for the sector, including requiring funds with more than 60% of assets consisting of originated loans to adopt a closed-ended structure and a stipulation that 5% of a loan's value must be retained by the originating fund.
However, the rules have been softened following industry feedback and amendment of the draft legislation by the European Parliament and EU Council. Ensuring that private debt funds remain free to provide loans to European companies is particularly important as banks become ever more conservative about corporate lending because of its impact on their capital requirements.
Extending alternatives to new investors
Changes to the AIFMD are also expected to redefine the concept of a professional investor, extending eligibility to high net worth individuals and family offices making investments above a threshold of €100,000. This is part of a broader shift to extend investment strategies hitherto mostly restricted to institutions.
This is one of the aims of reform of the European Long-Term Investment Fund framework, with revisions agreed by the European Parliament and Council designed to make it easier for non-professional investors to access assets such as infrastructure through ELTIFs - most of which so far are domiciled in Luxembourg.
Accessing a wider range of investors will open up new opportunities for providers of alternative funds who see opportunities in the energy and sustainability transition, as well as the digitalisation of the European economy. It will also throw up new challenges such as extending due diligence compliance obligations to much larger numbers of investors, which is likely to require new systems and processes - albeit a consideration familiar to managers and service providers of UCITS funds.
Embracing sustainability, eschewing greenwashing
That's taking place alongside the tasks facing the fund industry as a whole to comply with the sustainability transparency requirements of the EU's Sustainable Finance Disclosure Regulation and Taxonomy Regulation, which has required a great deal of work in terms of updating fund prospectuses and other documents in the final months of this year.
Sustainability is already a significant issue for private markets. Of a total of $10.3trn in private capital assets under management, 42% ($4.37trn) is managed by firms that say they are committed to ESG principles, according to a report by data provider Preqin in June. The trend is highest in infrastructure investment (64%) and private debt (59%), but somewhat lower for private equity at 34%.
But complying with the detailed SFDR rules and navigating differences in interpretation between national regulators is proving complicated. Uncertainty over whether SFDR article 9 funds must hold exclusively green investments, as opposed to, for example, a minimum of 90%, has prompted several leading international asset managers to downgrade entire fund ranges to the less demanding article 8 classification.
Experienced staff in demand
The complexities of sustainable finance have intensified demand in the fund sector for skilled and experienced employees - especially in Luxembourg, where competition for talented operational and fund management staff is as intense as ever.
Despite the adverse economic environment, this trend may, if anything, intensify in 2023 as alternative asset managers and third-party management companies prepare to meet the challenges of future EU substance requirements under the third Anti-Tax Avoidance Directive (also known as the 'Unshell' directive).
Fund structures may well change, according to KPMG, with consolidation of holding companies and an increase in the number of employees undertaking fund management activities in the grand duchy. L3A contributed to this debate by commissioning a report from Richard Taffler, professor emeritus of finance and accounting at Warwick Business School, and Dr. Shehub Bin Hasan of the University of Reading's Henley Business School, on the business case for creation and use of special purpose vehicles.
There's also the need to accommodate resurgent business activity. Along with the expansion of the private debt sector, private equity dealmaking can be expected to grow as the industry finds ways to deploy its substantial level of dry powder. As 2022 draws to a close, the challenges and opportunities opening up for Luxembourg's alternative investment industry are as exciting, if demanding, as when the year began.