The Private Equity Review: Luxembourg
i General overview
The Luxembourg asset management industry had another stellar year in 2019. We have seen a massive increase in the number of large private equity managers that have chosen Luxembourg as their European domicile of choice for the establishment of their funds and their alternative investment fund manager (AIFM). Some of the largest private equity firms worldwide have now chosen Luxembourg as their main European hub.
Several factors are contributing to the growth of the Luxembourg private equity industry. One of them is certainly the wide range of Luxembourg vehicles that are appropriate for structuring private equity funds. Most private equity funds that have been established in Luxembourg since 2013 have been established as unregulated vehicles, either as unregulated Luxembourg limited partnerships (LPs) or more recently as reserved alternative investment funds (RAIFs). Between December 2018 and January 2021, the number of RAIFs increased from 561 to 1,361.
Another factor is the convergence of regulatory and tax developments, in particular the Alternative Investment Fund Managers Directive (AIFMD) and the Organisation for Economic Co-operation and Development (OECD) action plan against base erosion and profit shifting (the BEPS Action Plan), which all point in the direction of an increased focus on the operational presence of the manager in the country where the funds and their special purpose vehicles are located.
ii Legal framework for fundraising
Over the years, Luxembourg has developed an amazing toolbox of structuring solutions. Key milestones in that process are as follows:
- March 2004: creation of securitisation undertakings;
- June 2004: adoption of the investment company in risk capital (SICAR), a regulated vehicle specifically designed for investments into private equity;
- 2007: adoption of the specialised investment fund (SIF), a regulated vehicle appropriate for the structuring of any type of alternative investment fund (AIF), including private equity funds;
- 2013: overhaul of the Luxembourg LP regime, with a modernisation of the rules applicable to the common limited partnership (SCS) and the creation of the special limited partnership (SCSp); and
- 2016: creation of the RAIF, a vehicle that is not subject to the direct supervision of the Luxembourg supervisory authority (CSSF) and may be used for the structuring of any type of AIF, including private equity funds.
i Unregulated LPs
Since 2013, the LP (in the form of an SCS or SCSp) has become the vehicle of choice for the structuring of Luxembourg funds investing in illiquid assets, including private equity. The Luxembourg LP regime offers wide structuring flexibility and enables sponsors to tailor the fund structure to fit their specific needs.
The main difference between SCSs and SCSps is that SCSps have no legal personality of their own, in contrast to SCSs, which do. The SCSp is, therefore, similar to an English LP, while the SCS is closer to a Scottish LP or a German KG. From a Luxembourg (legal and tax) standpoint (and for an AIFMD-compliant vehicle), the choice between an SCS and an SCSp has no material impact on how the Luxembourg LP will operate and interact with its partners and counterparties (and does not impact at all on the responsibility of investors, who benefit from limited liability in both structures). This choice is generally driven by investors' preferences. Anglo-American sponsors and investors are generally more familiar with the SCSp structure, which is closer to an English LP.
The SCS and the SCSp are two types of Luxembourg companies. LPs, therefore, do not have a regulatory status, and Luxembourg LPs (SCSs and SCSps) may, therefore, be established either under one of the specific product regimes available (SICAR, SIF or RAIF regimes) or outside those regimes (in which case they are generally referred to as 'unregulated LPs').
The key features of unregulated LPs are very similar to those of English, Scottish or US LPs. This enables Anglo-American sponsors to establish their Luxembourg funds in a format that they, and their investors, are familiar with. They use their standard documentation for the launching of their Luxembourg LP, with limited adjustments only. The unregulated LP may be used for the structuring of funds, feeder funds, parallel funds, co-investment vehicles or carried interest vehicles.
More and more private equity managers are establishing parallel fund structures with two separate funds, one in Luxembourg targeting European investors and the other in another jurisdiction targeting US investors, for instance. The unregulated LP regime offers the flexibility needed to ensure that the Luxembourg fund operates on the basis of the same principles as those that apply to the parallel fund.
Luxembourg LPs benefit from a number of attractive features that may not be available in all other jurisdictions. For instance, in certain jurisdictions, capital returned to limited partners is subject to a risk of clawback in certain circumstances. To limit that risk, limited partners' commitments are structured by way of a combination of a small amount of capital (exposed to the clawback risk) together with a large percentage of a non-interest-bearing loan. In a Luxembourg LP, capital returned to partners by way of distribution of dividends or reimbursement of partnership interests cannot be recalled, unless otherwise provided for in the partnership agreement. Investor commitments in a Luxembourg LP may, therefore, be structured by way of a 100 per cent capital contribution.
As is the case in most jurisdictions with an LP regime, limited partners in a Luxembourg LP may lose their limited liability if they intervene in the management of the LP. However, in Luxembourg this risk only arises if a limited partner carries out acts of external management, which entail an element of representation of the LP towards third parties. The Luxembourg LP regime provides expressly that limited partners are not at risk of losing the benefit of their limited liability if they perform acts that are internal to the LP, such as exercising rights attached to the status of a partner in the LP, providing advice or consultation or controlling the business of the LP.
Unregulated LPs are not subject to the supervision of the CSSF. An unregulated LP may, therefore, be launched without the approval of the CSSF and no regulatory approval is required in relation to any of the steps to be performed during the life of the unregulated LP.
However, this does not mean that all unregulated LPs fall outside regulatory supervision. Unless they benefit from an AIFMD exemption (such as the de minimis exemption for smaller funds or the exemption for AIFs managed by a non-EU manager), unregulated LPs that are AIFs must be managed by an authorised AIFM and are, therefore, indirectly subject to regulatory oversight through their AIFM. This also means that, despite the absence of direct regulatory supervision, an unregulated LP that is managed by an authorised AIFM (whether in Luxembourg or in another EU Member State) fully benefits from the AIFMD marketing passport.
The new Luxembourg LP regime is extremely successful. However, the unregulated LP may not be the most suitable vehicle in all circumstances, as detailed below:
- First, unregulated SCSs and SCSps cannot avail themselves of the umbrella structure, and so cannot create segregated portfolios of assets and liabilities (compartments).
- Second, SCSs and SCSps are not subject to taxation (provided they can be regarded as AIFs or meet certain conditions that have been clarified by the Luxembourg tax authorities by way of Circular LIR No. 14/4 dated 9 January 2015) and a tax-opaque vehicle (with access to certain double taxation treaties) may be more appropriate in certain circumstances.
- Finally, LPs may in certain circumstances qualify as a hybrid entity because of their tax transparency under the European anti-hybrid rules, triggering unfavourable tax consequences. In that respect, the RAIF offers a wider range of legal and corporate forms to meet tax needs while remaining unregulated. In particular, the corporate governance characteristics of the partnership limited by shares (SCA) are very similar to those of the SCS and SCSp, with the main difference being that the SCA is a tax-opaque company. Similarly to the SCS and the SCSp, an SCA is managed by a manager or general partner, and its limited partners may participate in advisory or supervisory boards without being deprived of their limited liability.
The RAIF regime offers a solution to managers who want to avoid a double layer of regulation when setting up AIFs, while at the same time benefiting from the umbrella structure that, until the adoption of the RAIF, was reserved for regulated funds such as SIFs and SICARs. Also, RAIFs may be established either as tax-transparent or tax-opaque vehicles.
The RAIF is reserved for the structuring of funds that appoint a duly authorised AIFM, established in Luxembourg or in any other EU Member State.
RAIFs may be established under different legal forms, including that of a common fund or an investment company incorporated, among other corporate forms, as a public company, an SCA or an SCSp.
RAIFs must in principle comply with the risk-spreading principle, with a maximum concentration ratio in any single investment of 30 per cent. However, RAIFs that have the sole objective of investing in risk capital may be exempted from the risk diversification requirement and benefit from a tax regime that is similar to that applicable to SICARs. The concept of risk capital covers basically all types of private equity and venture capital strategies.
iii Securitisation undertakings
An additional and increasingly popular funding method in Luxembourg is securitisation, by which a Luxembourg securitisation undertaking acquires or purchases risks relating to certain claims, assets or obligations assumed by third parties, and finances the acquisition or purchase by the issue of securities, the return on which is linked to these risks.
Despite certain image problems of securitisation in general after the sub-prime crisis in 2007–2008, there has been a very positive development and steady growth of the Luxembourg securitisation market in the past couple of years. At the beginning of 2021, over 1,400 securitisation vehicles had been registered with the Luxembourg trade and companies register. Furthermore, this number does not accurately reflect the success of the Luxembourg securitisation market as Luxembourg law allows, as further described below, for securitisation vehicles to create several compartments. It has become the funding method of choice for more and more companies that own suitable financial assets.
The Luxembourg Securitisation Act of 22 March 2004, as amended (the Securitisation Act 2004) provides a complete and solid legal framework for the Luxembourg securitisation market and is considered as one of the most favourable and advanced pieces of European legislation for securitisation and structured finance transactions. The robustness and flexibility of this Act is highly appreciated by the international participants using Luxembourg as a hub to set up securitisation undertakings governed by Luxembourg law to access the capital markets.
The Securitisation Act 2004 distinguishes between regulated and unregulated securitisation undertakings. A securitisation undertaking must be authorised by the CSSF and must obtain a licence if it issues securities to the public on a continuous basis. Both regulated and unregulated securitisation undertakings benefit from all the provisions of the Securitisation Act 2004. A securitisation undertaking must mainly be financed by the issue of instruments (be it equity or debt securities) that qualify as securities under their governing law. The Securitisation Act also distinguishes between securitisation companies and securitisation funds that consist of one or more co-ownerships. Until now, the vast majority of securitisation undertakings adopted a corporate form. However, in light of the implementation into Luxembourg tax law of the new interest limitation rule, in accordance with the EU Anti-Tax Avoidance Directive (ATAD 1),2 securitisation funds, which are not corporate income taxpayers, have gained in popularity. Securitisation undertakings may also issue securities in a fiduciary capacity, which is also a useful tool in the context of ATAD 1.
The Securitisation Act 2004 contains no restrictions regarding the claims, assets or obligations that may be securitised. Securitisable assets may relate to domestic or foreign, movable or immovable, future or present, tangible or intangible claims, assets or obligations. It is also accepted that a securitisation undertaking may, under certain conditions, grant loans directly. Very advantageous provisions for the securitisation of claims have been included in the Securitisation Act 2004.
To enable the securitisation of undrawn loans or loans granted by the securitisation undertaking itself, the Luxembourg Act dated 5 April 1993 relating to the financial sector, as amended, exempts these transactions from a banking licence requirement. Furthermore, transactions that fall within the scope of the application of the Securitisation Act 2004 (such as, for example, credit default swaps) do not constitute insurance activities that are subject to Luxembourg insurance legislation.
The Securitisation Act 2004 allows the board of directors of a securitisation company or the management company of a securitisation fund to set up separate ring-fenced compartments. Each compartment forms an independent, separate and distinct part of a securitisation company's estate, or a distinct co-ownership of a securitisation fund, and is segregated from all other compartments of the securitisation undertaking. Investors, irrespective of whether they hold equity or debt securities, will only have recourse to the assets within the compartment to which the securities they hold have been allocated. They have no recourse against the assets making up other compartments. In the relationship between the investors, each compartment is treated as a separate entity (unless otherwise provided for in the relevant issue documentation). The compartment structure is one of the most attractive features of the Securitisation Act 2004, as it allows the use of the same issuance vehicle for numerous transactions without the investors running the risk of being materially adversely affected by other transactions carried out by the securitisation undertaking. The feature allows securitisation transactions to be structured in a very cost-efficient way without burdensome administrative hurdles. There is no risk-spreading requirement for compartments. It is, hence, possible to isolate each asset held by the securitisation undertaking in a separate compartment.
The Securitisation Act 2004 also expressly recognises the validity of limited recourse, subordination, non-seizure and non-petition provisions. Rating agencies are very comfortable with transactions structured under the Securitisation Act 2004 as legal counsel can usually issue clean legal opinions.
The Luxembourg legislature has clearly succeeded in transforming Luxembourg into one of the leading financial hubs for securitisation and structured finance vehicles by producing an attractive legal and tax framework for Luxembourg securitisation vehicles.
iii Tax and regulatory developments
In August 2018, the CSSF released Circular 18/698 on Luxembourg investment fund managers, which provides helpful guidance on the 'substance' and organisational requirements for approval as an AIFM in Luxembourg. Existing AIFMs had until the end of 2019 to adapt to the new rules.
The choice of a vehicle for the structuring of Luxembourg funds has become increasingly driven by tax considerations, in particular in light of the recent implementation (i.e., on 20 December 2019) into Luxembourg tax law of the second EU Anti-Tax Avoidance Directive3 (the ATAD 2 Law).
The ATAD 2 Law contains a set of anti-hybrid rules that draw inspiration from the OECD BEPS Action Plan. The objective of these rules is to neutralise the tax effects of hybrid mismatches arising from different characterisations of a financial instrument or an entity under the laws of two Member States, or of one Member State and a third country. Indeed, the different characterisation of a financial instrument or an entity may, in particular, give rise to a situation of 'deduction without inclusion'. Payments made under a hybrid instrument or by a hybrid entity may be deductible in the country of the payer but may not give rise to an inclusion in the tax base in the country of the payee, nor in any other jurisdiction. The anti-hybrid rules allow the country of the payer to deny the deduction of such payments in a situation of deduction without inclusion.
In the context of Luxembourg funds, a tax-transparent LP may, in a private equity context, be considered tax-opaque by its investors (for instance, under the US check-the-box rules or in accordance with the investors' domestic rules regarding the classification of foreign entities for tax purposes) and thus fall within the definition of a hybrid entity under the ATAD 2 Law. The hybrid nature of the entity is, as such, not sufficient for the rule to apply. Checks would have to be made as to whether such hybridity gives rise to a negative tax effect, such as a situation in which deduction occurs without inclusion of payments made by a Luxembourg company held by the LP to the limited partners, or a situation of double deduction. Similarly, different characterisations of a financial instrument granted by a Luxembourg LP to an underlying Luxembourg company may, in a private equity context, give rise to negative tax effects, whereby the deductibility of the interest under the financial instrument could be denied at the level of the Luxembourg company held by the LP.
These rules will only apply between related or associated parties or in the context of a structured arrangement. An investor might be considered an associated entity in relation to the underlying Luxembourg company, in particular if it holds through the LP a direct or indirect interest of at least 50 per cent or more of the Luxembourg company. For the anti-hybrid rule on financial instruments to apply, the required threshold is reduced to 25 per cent. For the purposes of the associated parties test, one would need to aggregate the interest of investors who are acting together (e.g., investors belonging to the same company group, investors acting in accordance with the wishes of another investor or investors entering into an agreement on voting rights or equity interests). Investors normally invest independently from one another in the LP, they rarely enter into such agreements and they also do not exercise any control over the LP's investments. The ATAD 2 Law therefore provides for a rebuttable presumption according to which any investor in an LP (which qualifies as an investment fund) that holds, directly or indirectly, less than 10 per cent of the LP's interests and which is entitled to receive less than 10 per cent of the LP's profits is not considered as acting together with the other investors. On the basis of an in contrario reading of these provisions, one could argue that where several investors hold more than 10 per cent of the LP's interest or receive more than 10 per cent of the LP's profits, their interests should not automatically be aggregated for the purposes of calculating the relevant thresholds. Such investors must, however, be able to provide evidence that they are not effectively acting together regarding their interests or voting rights in the LP (e.g., they do not exercise any control over the investments realised by the LP and act independently from other investors with respect to their investment in the LP).
Finally, the ATAD 2 Law also sets out a 'reverse hybrid mismatches' rule, which will only apply as from 1 January 2022. This rule targets the hybrid entity as such (i.e., the LP itself), and not the deductibility of interest paid by a Luxembourg company to a hybrid entity. The rule provides that an EU resident entity (which is treated as tax-transparent in its country of residence but as tax-opaque in the country of its non-resident direct or indirect owners) will have to be treated as being tax-opaque in its country of residence. Consequently, it will become subject to tax on its income to the extent that that income is not otherwise taxed under the laws of any other jurisdiction. For this rule to apply, non-resident investors considering the entity as tax opaque would have to hold at least 50 per cent of the entity's interest. The ATAD 2 Law sets out a specific carve-out from this rule for collective investment vehicles, and alternative investment funds may also benefit from the carve-out under certain conditions (the investment fund must be widely held, hold a diversified portfolio of securities and be subject to investor-protection regulation). The 'reverse hybrid mismatches' rule may increasingly become important when choosing the corporate form and regulatory regime of new funds and will be relevant for funds investing into both European and non-European assets.
Asset managers should carefully consider the impact of the ATAD 2 Law on their existing and future fund structures as well as ATAD 2 rules existing in other EU Member States (as the rules may adversely affect the return on investments). There can be no assurance that the rules will be transposed, interpreted and applied by all EU Member States in the same or a similar manner and such differences may, in the presence of target or intermediary holding companies established in other EU Member States, lead to the application of the imported hybrid mismatches rules.
Brexit is likely to be one of the main challenges for the European private equity industry over the next few years. The United Kingdom left the European Union on 31 January 2020 with a transition period lasting until 31 December 2020. During this period, most EU rules will continue to apply to the United Kingdom and negotiations in relation to a trade agreement will take place. The transition period may, before 1 July 2020, be extended once, by up to two years. After the transition period, all UK fund managers will lose the benefits of EU passports, which currently allow them to manage and market their funds on a cross-border basis within the European Union. The counter-attack generally consists of establishing a regulated manager in another EU Member State. This entails building up sufficient substance locally and, in particular, recruiting suitable personnel. When comparing the solutions available in various EU jurisdictions, numerous criteria, such as the existence of a stable and robust regulatory and tax framework, must be taken into account; Luxembourg's status as the leading European fund domicile is a strong argument in its favour. Concentrating funds and their managers in one and the same jurisdiction offers many benefits: the same legal and regulatory framework, and the ability for funds and their managers to share local resources, etc. It is, therefore, no surprise that several leading private equity firms have decided to establish their European hub in Luxembourg.
1 Patrick Mischo, Frank Mausen, Jean-Christian Six and Peter Myners are partners at Allen & Overy.
2 Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market.
3 Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries.