Thanks in part to the implementation of the AIFMD and the simultaneous changes in the Luxembourg companies law, and fuelled for a while now by the prospect of Brexit, Luxembourg vehicles for alternative investment funds have been in high demand.
As such, the increase in requests from investors to assist in due diligence on funds – as opposed to setting them up on behalf of the managers – is hardly surprising. It does, however, come with an entirely different perspective.
A fund structure can be fully compliant and tick all the boxes under applicable laws and regulations, but still fall short when it comes to things like adequate governance or the alignment of interests between the manager and the investors. These are ultimately key for investor protection.
“Hardly ever will there be an issue that is purely legal”
The interests of the manager and the investors are traditionally aligned by means of the proverbial carrot and stick; the “carrot” being the entitlement to performance fees or carried interest when the fund does well, and the “stick” being the manager’s investment of own money into the fund.
When asked which of these two tools of alignment is considered the most effective, investors lean towards the manager’s co-investment. They are therefore keen to ensure that the amount that the manager invests in its own fund is substantial (“hurt money”), and that the manager maintains invested throughout the entire term.
As for the performance fees, proper clawback provisions (or, for funds with NAV-based performance fees: a high-water mark) help ensure that the distribution mechanism does exactly what it says on the tin.
Luxembourg tax counsel is well placed to form a view on a fund’s tax structuring papers.
So what about governance then? For the first time since the global financial crisis (GFC), funds are emerging again which only allow investors to remove the manager in the event of cause (e.g. fraud). Market practice requires cause to be determined by a final, non-appealable judgement. As it may take a while to obtain this, the “no-fault divorce” provides a backstop that investors are reluctant to surrender.
If you asked fund investors right after the GFC what in particular had caused losses, one answer was that it was due to “style drift”: managers being allowed to venture off and follow the hype, even if it took them into unfamiliar territory. This has prompted a tightening up of investment guidelines and investment restrictions.
Then there are the tax aspects. Investors will want to assess whether the envisaged amount of tax leakage throughout the structure is actually realistic. Through their general experience in the international tax practice, Luxembourg tax counsel is well placed to form a view on a fund’s tax structuring papers.
All in all, the loopholes in a fund structure are typically in the areas like the ones mentioned; hardly ever will there be an issue that is purely legal.
“Where liquid funds allow you to vote with your feet, governance and alignment are particularly important in alternatives”
The focus on governance and alignment is typical for funds with alternative strategies, and does not apply to retail or liquid funds. Liquid funds allow investors to vote with their feet and redeem their interests at will. Alternative funds are crucially different in this respect, and if you can’t get out whenever you want, you should at least be able to grab control if things are headed in the wrong direction.
This puts open-ended real estate and infrastructure funds in an interesting spot. The possibilities for investors to interfere in the governance are limited, and when push comes to shove, redemptions may be difficult due to the illiquidity of the underlying investments. Yet, these funds are increasingly popular.
“Side letter negotiations are an exciting part of the work”
Cornerstone or seed investors will be able to exert a relatively strong influence; negotiating the fund documentation, including side letters, on their behalf is therefore an exciting part of the work. Fund lawyers can in turn use this negotiation experience to their advantage when setting up new funds for managers.
Ultimately, the popularity of any fund jurisdiction starts and ends with the preference of investors. With investor representation being increasingly handled in Luxembourg, the infrastructure that we can offer to investors is further solidified.