Private Equity and Real Estate fund sponsors are increasingly pooled into two groups: those that are choosing to run their funds from Luxembourg with the benefit of EU marketing passport; and those that opt for a UK or Channel Island structure and market under the old private placement rules.

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Both jurisdictions offer innovative products and structures which suit nearly all type of investors and fund sponsors. In addition, they are highly regarded for the quality of their service providers, law firms and regulatory environment. Despite the general similarities in operating a fund from an offshore fund hub (Channel Islands) and an onshore fund hub (Luxembourg), some nuances exist in the operational model in each jurisdiction. This article sets out the main differences.

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Regulatory Differences:

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Both Channel Islands and Luxembourg have robust regulatory framework in relation to managing and operating fund structures. Jersey and Guernsey had implemented changes in readiness for the rollout of the Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD) to third countries and was recommended to be approved for equivalence to benefit from the EU-wide marketing passport by European Securities and Markets Authority (ESMA). However since Brexit, there has been diminished drive by ESMA to open up the EU marketing passport to any third country.

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Funds based in Luxembourg which are subject to the full requirements of the AIFMD has the benefit of EU-wide marketing passport, and is therefore perceived to have better investor protections. This means operating under a more regulated and prescriptive regime. For Fund Sponsors usually operating out of Channel Islands, launching their first fund in Luxembourg may take a little getting used to as under AIFMD there are more formalised procedures than requirements in the Channel Islands.

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Primarily, the main difference between the Luxembourg and the Channel Island operational model is the involvement of a regulated (external) Alternative Investment Fund Manager (AIFM) in Luxembourg, whose main functions are portfolio management, risk management and valuation oversight. These functions are mandated by AIFMD. The portfolio management and risk management functions need to be independent of each other and the AIFM may delegate only one of those functions. The AIFM has to formalise internal procedures for portfolio management, implement risk matrices and valuation processes (including drafting a valuation policy) and perform several reportings to the supervisory authority of the Luxembourg financial sector (CSSF) for each Fund on a regular basis. This may sound burdensome in comparison to a Channel Island model where the General Partner takes the decisions for the fund through ordinary board minutes but in practice those differences are only marginal vis a vis the Fund Sponsor as most of the tasks may be undertaken by a third party host AIFM such as Langham Hall in the background. These procedures, processes and documentation must stand up to CSSF audits which they do as standard.

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Taking the investment process as an example, whereas in Channel Islands, the investment adviser will be presenting their recommendation for portfolio management matters (e.g. investment, divestment, financing etc) to the General Partner in a partnership structured fund, in Luxembourg this will be presented to and considered by the AIFM, unless a delegated portfolio manager is appointed in lieu of an investment adviser. The delegated portfolio manager may be the fund sponsor subject to its regulatory permissions to act in such capactity. The General Partner would receive formal notification of the AIFM approval of such action and implements the decision thereafter.

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Funds within the full scope of AIFMD will also require the appointment of a Depositary which will have the main functions of verification of ownership of assets, cashflow monitoring and general oversight of the AIFM and the fund.

There are also detailed and specific provisions to be considered in discharging the risk management function, review of asset valuations, fund operating conditions and remuneration disclosures which have no equivalence in the Channel Island jurisdictions.

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As a consequence of the above, the on-boarding phase between AIFM, Admin and Fund Sponsor does take a slightly longer time to ensure agreement of a Service Level Agreement comprising all relevant processes and procedures for the operations of the Fund.

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Practical Differences:

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Fund set-up – In Luxembourg, the most popular fund structure is the SCSp (special limited partnership) and is similar to the equivalents in the UK and Channel Island jurisdictions. The set-up of the SCSp is fairly simple as it can be done via private deed. However the set-up of the general partner (usually in the form of a S.à r.l. – a limited liability company) is more complicated than in the Channel Islands as the creation of the company is done by notarised deed. As the notary needs to confirm that a minimum share capital of EUR 12,000 has been fully paid up, the company needs to first open a bank account for itself (which at the time is a non-existing company) in order to pay-in the share capital. Fund Sponsors should expect some time for the opening of a bank account as all entities involved in the process are regulated (e.g. bank, the administrator) and require satisfaction of Anti-Money Laundering procedures. The notary has to be engaged and the articles of the company, if in English, will need to be translated into one of Luxembourgish, French or German.

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Timing to market – This may also be slightly slower in Luxembourg as the AIFM needs to register the fund with the CSSF firstly for management and after it receives such confirmation of registration, for marketing purposes in the relevant jurisdiction which it may file for marketing. In the Channel Islands, if using fast track regimes, the regulators can authorise the General Partner and fund in 1 to 10 days (depending on the product).

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For fund sponsors operating out of the UK, the Channel Islands has A more aligned public (bank) holidays than Luxembourg (which also has more bank holidays) and this should be borne in mind when transactions are time critical.

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The above provides the high level overview for fund sponsors between the differences in Luxembourg and in Channel Island for operations of funds. In many cases, there would be various factors taken into considerations to select the right jurisdiction. These may include: location of existing infrastructure and personnel, target investors‘ requirements and preferences for one or the other, route to marketing in a specific jurisdiction in lieu of getting an EU marketing passport, size of fund, tax treatment vis a vis the underlying investments, regulatory considerations, and comparison of the ongoing cost of operations in Luxembourg and Channel Islands.

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Certainly, Luxembourg is generally a more costly place to operate a fund due to AIFMD requirements. However it does have the benefit of ease of marketing across the EU jurisdictions (some of which would otherwise be difficult to penetrate without the EU marketing passport), may be an appropriate jurisdiction for tax efficiency and is a requirement for some investors who prefer on onshore jurisdiction regulated by the AIFMD. Ultimately, what is right for one fund may not be right for another depending on the fund sponsor’s specific objectives.

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However, in terms of the implementation by the fund sponsor in either jurisdictions, there are in practice only nuances in the day-to-day operations and the interactions between the Fund Sponsor and the various service providers if a fund sponsor uses a Host AIFM to undertake the additional regulatory requirements under AIFMD. Langham Hall is in eight jurisdictions including a well established operation across Guernsey and Jersey in the Channel Islands with an office of circa 100 personnel and circa 78 personnel in Luxembourg across a one-stop shop offering Of Administration, Host AIFM and Depositary service lines. We are agnostic in our advice between these jurisdictions and would freely share our experiences in respect of funds we see choosing one over the other.

Following the UK’s departure from the European Union, there has been increased scrutiny on the regulatory permissions for third countries undertaking the activity of marketing to EU based investors. Here we aim to set out the potential routes by which distribution to EU investors may be undertaken.

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It is likely that these discussions will continue to evolve in the coming months as the financial services industry settles on an optimum solution. In the meantime, UK fund sponsors are evaluating their options against an uncertain backdrop because of: (a) the newness of this issue for them; (b) the potential further negotiations between the UK and EU on what equivalence means in the Brexit agreement; and (c) the ongoing political landscape between the EU and the UK which may influence practices and regulations implemented by regulators.

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Brexit has not changed the legal position for non-EU firms in relation to the activity of marketing financial products in the European Union. However, for UK based financial services firms who have traditionally relied on their ability to market in the EU on the basis of the MiFID passport, the loss of regulatory cover now requires careful consideration.

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Non-EU managers that have traditionally relied on UK based personnel to market their funds in Europe are also affected, and this includes placement agents as well as in-house teams. The political agenda surrounding Brexit means that there is more scrutiny by the European Securities and Markets Authority and the EU on the UK as a third country, which in turn affects all third country managers, including those in North America and Asia.

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Broadly then, we see several potential solutions that a fund sponsor may wish to consider when marketing in the EU to ensure compliance with the relevant regulations:

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(i) Engaging an EU-domiciled, MiFID regulated placement agent;

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This is an obvious solution, and most UK based placement agents have resolved their own Brexit issue by either ensuring they (through an EU entity) are themselves registered under MiFID in the EU, or have status as a tied agent (see (v) below) to be able to market in the EU jurisdictions.

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(ii) Having a director of the General Partner (only for limited partnership structures) undertake the marketing activities;

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This is by no means a straightforward solution. However, there are grounds for arguing that the marketing activity undertaken by a director of the General Partner in relation to the partnership they are managing as a director is not a third-party service, and therefore not captured under MiFID. Care should be taken in relation to evidencing the delineation of boundaries in practice when marketing is undertaken in their capacity as a director of the General Partner, or as an employee of the third country entity. In the UK, where there is a concept of financial promotion which is a regulated activity, this is unlikely to be acceptable. However, this is not the case in most EU countries which do not define that specific regulated activity.

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(iii) Secondment of a non-EU based personnel to the EU domiciled AIFM managing the fund, or an EU domiciled MiFID firm with appropriate permissions to undertake marketing;

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This is still a viable route but is under scrutiny. Some regulators have indicated that secondments must be approved by them on a case-by-case basis, and they are looking for robust oversight, risk and control frameworks for the employee, ensuring there is no conflict of interest in the role they are playing. In the case of the CSSF in Luxembourg, they have specifically highlighted the requirement to have a physical presence in the premises of the EU authorised entity, it being understood that travels for professional purposes are accepted. Given that a seconded employee whose main role is to market a Fund would be expected to spend a significant amount of time out of the office meeting potential investors, it is yet to be determined how this is required to play out in practice. This is further complicated in the current situation where the covid-19 pandemic has prevented all but the most necessary cross border travel.

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(iv) Engaging the host AIFM managing the fund to undertake the marketing activity;

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This is similar in principle to the secondment model, in that the regulator will be looking for the same robust oversight, risk and control frameworks for the marketing initiatives, but instead of using a seconded employee, marketing is undertaken by an employee of the EU authorised entity itself. The third country fund sponsor can and will be expected to provide support in the marketing initiatives without breaching the parameters of the operational framework implemented by the host AIFM. The host AIFM will take control of the compliance and risk management of the marketing initiatives, whilst relying on the fund sponsor’s expertise for any commercial considerations and/or insights with respect to the potential investors that they may have greater knowledge of.

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(v) Establishing an EU domiciled subsidiary and applying for tied agent status with a MiFID authorised entity;

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The main advantage of this route is that the marketing initiatives can be done in the name of the fund sponsor’s EU entity, rather than that of a third party. There is the additional work of running a separate legal entity in the EU, including ensuring substance, corporate governance and keeping the company in good standing from a corporate filing, tax and compliance point of view. A modus operandi should also be strictly adhered to, in order to ensure that only personnel properly connected to the EU entity are undertaking the marketing activity.

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(vi) Establishing an EU domiciled subsidiary and applying for MiFID permissions;

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This route has the same considerations as (v) above with the added complication of applying for direct MiFID permissions. From June 2021, the new regulatory capital requirements also commence for MiFID firms, requiring them to retain at least a minimum regulatory capital of €75,000, with potential additional regulatory capital based on its activities and overheads.

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For all of the above scenarios, the third country based personnel may assist with non-regulated activities including pre-marketing (currently regulated on a country by country basis until 2nd August 2021 when the Cross Border Distribution Directive commences), support with corporate advice on fundraising strategy, provision of commercial information, and preparation of fund marketing materials (subject to vetting by the authorised entity undertaking the marketing). Activities such as the potential investor undertaking due diligence on the site of the fund sponsor acting as the investment adviser and/or delegated portfolio manager should also be allowed to take place without need of the authorised entity’s supervision.

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Whichever solution the fund/investment sponsor wishes to explore with the advice of their legal counsel, Langham Hall believes it has a comprehensive robust framework to assist in its practical implementation. We diligently keep up to date and provide a considered review of our processes and procedures to adopt new developments in legislation, practices, and industry opinions.