What Future for Luxembourg Funds Managed by UK-Based Managers

Introduction

Most sponsors of Luxembourg funds have sought to create a robust structure that would survive Brexit with options to switch, to the extent necessary, a UK-based manager for an onshore alternative investment fund manager (AIFM) to manage the Luxembourg fund, but this solution is often considered as the last resort by most managers.

Whilst a new flexible deadline to 31 October 2019 was recently obtained by the UK, it remains possible that Brexit may occur sooner, maybe even within a few weeks, depending on the outcome of the UK government’s attempts to obtain approval of the withdrawal agreement with the UK Parliament.

The revocation of Article 50 notice is now considered as an option favoured by a large minority, but it does not attract currently much consideration, and a “no-deal" Brexit remains a default possibility, with the UK government hoping to obtain a majority in the UK Parliament to support the withdrawal agreement.

If the withdrawal agreement was approved by the UK Parliament, Brexit would occur prior to 31 October 2019 and UK managers would benefit from the transitional period that will operate from the Brexit date until 31 December 2020, during which period all of the relevant EU directives will remain applicable in the UK and all the UK-based AIFMs will continue to benefit from the existing passporting arrangements. The transitional period, however, is part of the withdrawal agreement and in principle, there is no other transitional arrangement agreed upon between the EU and the UK with respect to Brexit.

Against this backdrop, the Grand Duchy of Luxembourg adopted a flexible approach to ensure the continuation of business even in the case of a hard Brexit scenario and therefore provide UK-based managers managing Luxembourg funds more certainty for the middle term.

The following key drivers should be considered by UK-based managers when assessing their current Brexit strategy.

1. The Grand Duchy of Luxembourg chose flexbility in favour of UK-based managers.

Uncertainty as to what the regulatory environment will look like following the Brexit negotiations does impact many Luxembourg alternative investment funds (AIFs) currently managed by authorised UK-based AIFMs. The Grand Duchy of Luxembourg adopted a series of measures to attempt to secure a soft landing for those funds managed by UK-based managers even in the case of a hard Brexit, signalling that the Grand Duchy will remain open for business with the UK:

• on 26 March 2019, the Luxembourg Parliament adopted the law n°7401 (part of the first of a series of Brexit-related laws in connection with the financial sector) where UK-based managers benefit from a form of EU passport for UK financial service providers currently operating in Luxembourg (e.g., by managing a Luxembourg fund) and a grandfathering period of 21 months (in line with EU contingency plans); and
• on 28 March 2019, the Luxembourg Parliament adopted the law n°7426 providing transitional measures for UCITS and SIFs (and therefore RAIFs) addressing (i) the risks of potential passive breaches of these funds’ investment limits that might arise once the UK leaves the EU and (ii) marketing UK funds in Luxembourg after the occurrence of Brexit, regardless of whether such exit is taking place with or without the withdrawal agreement.

Under that law:

• UCITs and part II funds managed by a Luxembourg manager with delegation or outsourcing to the UK benefit from a grandfathering period to adapt the fund investment policies’ governance to the Luxembourg compliance regime as soon as possible and within 12 months from the Brexit date to mitigate potential adverse impacts from markets on investors;
• UK UCITs marketed to Luxembourg clients benefit from a 12-month grandfathering period after which they might not be eligible anymore as UCITS for retail investors; and
• UK UCITs managed by an EU manager shall be authorised to market in Luxembourg, provided that the manager has an AIFM license as these funds will be de facto AIFs from the occurrence of Brexit.

2. Can a UK-based AIFM manage Luxembourg fund post-Brexit?

Yes, in accordance with current transitional measures and Luxembourg local law. Luxembourg funds which are managed by a UK-based AIFM and which will not fundraise by the time Brexit occurs would not suffer any changes to their existing governance because of Brexit. Opting for no change to the UK-based AIFM is therefore an option to consider, which is viable to the extent that the UK-based AIFM expects to have substantially completed its marketing activities in relation to the Luxembourg AIF before the occurrence of Brexit, so that any activity undertaken post-Brexit would not be “marketing” under the AIFMD.

The UK will become a “third country” under the AIFMD and therefore, the AIFMD will no longer apply to the UK This is on the basis that the AIFMD applies to AIFMs rather than the AIFs themselves. At the time that the AIFMD came into force, it was anticipated that management of EU AIFs by “third country” AIFMs would be regulated under the AIFMD by virtue of Article 37, which was drafted to regulate the authorisation of non-EU AIFMs intending to manage and/or market AIFs in the EU in accordance with Articles 39 or 40 (i.e. “third-country passporting”). However, it is unlikely that any progress will be made in the near- to medium-term future on third-country passporting.

For so long as no such progress is made, the management of a Luxembourg AIF by a non-EU manager is a matter of Luxembourg law. Luxembourg was and remains today much more open than many other EU countries and has not, to date, “gold plated” the AIFMD. In Luxembourg, currently, non-EU managers may manage Luxembourg AIFs. This is also confirmed by law n°7401.

If the law were to change, however, we would expect firms to be given reasonable time to comply given that the change would affect not only UK managers raising new funds, but managers of long-established funds and funds managed by other third-country managers, such as those in the United States.

3. Can a UK-based AIFM market a Luxembourg fund under the passport post-Brexit in the case of no deal?

No. This is because there is no “third country” passport; a Luxembourg fund managed by a UK-based AIFM after the occurrence of Brexit will no longer be able to benefit from the AIFM’s passport and should therefore comply with (i) the national private placement regimes (NPPRs) in the respective member states in which the UK AIFM wishes to market the Luxembourg AIF and (ii) the conditions set out under Article 42 of the AIFMD, subject in each case to the grandfathering periods granted in law n°7426 of 28 March 2019, referred to in Section 1 above, and keeping in mind that the Luxembourg regulator has a cooperation agreement in place with the FCA in the UK, which will facilitate the process under Article 42 of the AIFMD.

As a result, UK-based managers may have to consider alternative solutions if (i) the legal regime of the NPPRs is complex and/or (ii) if the targeted jurisdictions have gold-plated the conditions set out under Article 42 of the AIFMD and/or their regulators do not have a cooperation agreement in place with the FCA.

There are, in such case, two options: to set up an AIFM onshore or appoint a third-party AIFM. In most cases, managers opt to set up their AIFM in Luxembourg. The alternatives to Luxembourg are usually Ireland and The Netherlands, but in our experience, Luxembourg is chosen over those jurisdictions for numerous reasons, including the expedient approach of the regulator, deep market knowledge and experience of local providers, taxation and the legal certainty) It is worth noting, however, that the authorisation process takes time. The other solution, considered by smaller funds to address costs, substance, and regulatory compliance or by other funds in light of timing considerations, is to switch to a professional of the financial sector (usually based in Luxembourg) that will act as AIFM for the Luxembourg AIF. This last option is quicker than setting up a new AIFM, but the newly appointed AIFM will need to get comfortable with the existing fund documents and its appointment may have an impact on ongoing operational processes, though most funds documents agreed since the Brexit vote of June 2016 tackle expressly the costs to be borne by the AIF for any changes to be made to the AIFM due to Brexit.

4. What structural changes to consider with a switch of AIFM?

Article 20 of the AIFMD requires that AIFMs that intend to delegate to third parties must notify their home member state before the delegation arrangements become effective and certain conditions are met. One of these conditions in relation to the delegation of portfolio management is that there must be a cooperation agreement between the competent authority of the home member state of the AIFM and the supervisory authority of the entity who is to carry out the delegated services, and this is now current for Luxembourg. For the avoidance of doubt, no delegation arrangement may remove substance from the Luxembourg-based AIFM delegating portfolio management functions to a UK-based manager: Article 82 of the AIFMD level 2 regulation provides that this would occur if the delegation was made “to an extent that exceeds by a substantial margin the investment management functions performed by the AIFM itself.” In making this assessment, the Luxembourg regulator assessed the delegation structure as a whole, taking into account a number of qualitative criteria, including the types of tasks delegated versus those retained and the materiality and importance of those activities. The Luxembourg regulator, the CSSF, issued a Circular 18/698 on 23 August 2018 which, inter alia, sets out guidance on substance requirements and the specific conditions applicable to delegation of each type of function by Luxembourg AIFMs, including clarification on portfolio management in connection with the guidance above.

The alternative to the delegation is to opt for the UK AIFMs to become the investment adviser to the new EU AIFM, providing certain investment advisory services in respect of the Luxembourg AIF.