Luxembourg turns up the heat in search for new business

As large European banks and financial houses establish more hedge fund products they are turning increasingly to Luxembourg. In turn the country is aggressively promoting what it has to offer and is in the process of tweaking laws to make it more streamlined for hedge funds using short-selling techniques to domicile in the Grand Duchy.

Furthermore this report discovered the Isle of Man and Guernsey have been quietly attracting more hedge funds while growth in the Cayman Islands, BVI, Bermuda and the Bahamas has been steady. Luxembourg is shaping up to be the leading domicile for European hedge funds, particularly fund of funds.

Although more up-to-date statistics are being sorted out by leading authorities, some initial reports reveal the growth has been staggering.

At the end of 2000, e50bn was held in fund of funds and e9bn in a range of funds including venture capital, real estate, leveraged and futures and options funds. Hedge funds were included in both classes. At the end of 1998, e10bn were held in fund of funds and just e5bn in the other categories. Standard & Poor's data on offshore hedge funds also shows a growth in hedge funds in Luxembourg. Despite the fact its universe of offshore hedge funds is very small (showing 23 overall) it is still reveals some trends.

S&P has details of eight hedge funds setting up in Luxembourg in 2001 including those by Darier Hentsch & Cie, Credit Suisse and Sinopia while two funds were established in Bermuda and the BVI; four were set up both in The Cayman Islands and Guernsey; and the Isle of Man attracted three funds. Luxembourg has been particularly successful in attracting Continental European-based managers.

However, the country has some hurdles to overcome going forward. Despite its good financial reputation, the country is still regarded as expensive although Luxembourg-based providers deny this drawing attention to the weaker euro compared to sterling.

Another big issue the country is trying to solve is the ease of which managers can establish funds which use short-selling strategies. Currently, if hedge funds want to short they have to apply to the regulator on a case-by- case basis.

Changing the rules

Last month [February], a committee from ALFI (the Luxembourg Investment Fund Association) met with the regulator, the CSSF (Commission de Surveillance du Secteur Financier) to discuss how new laws could help promoters attract more hedge funds to the country.

On 28 February, ALFI's Jean-Jacques Picard reported: 'On the basis of the working paper discussed with the regulator, ALFI will work out a draft circular defining a framework for hedge funds. This will be made without any time pressure and without a clearly defined schedule. The aim is to have a strict regulation that guarantees the highest level of investor protection as well as high quality products, service providers and supervision. Let us say that we focus on quality and security rather than exaggerated flexibility.'

ALFI marketing committee member Henry Kelly explains: 'There are no detailed rules in terms of short selling and we want to change this to make the process more streamlined. 'However, there is already a perfectly satisfactory regulatory environment in Luxembourg to enable fund promoters to set up and administer hedge fund structures.'

Alternative investment funds are established under part II of the Law of 30 March 1988 (non-UCITS funds). Since 1991, CSSF Circular 91/75 has enabled the launch of fund products using alternative investment strategies: derivatives, financing leverage, real estate investment, venture capital funds and funds of hedge funds.

However, Kelly says: 'Fund promoters would benefit from a more explicit regulatory framework covering, for example, short selling and certain aspects of prospectus disclosure in respect of hedge funds. Proposals in this regard have been developed by ALFI for discussion with the CSSF.'

The decline of Ucits funds

He admits that Luxembourg is trying to attract alternative investment business more actively than in the past. This is because the growth rate for UCITs (currently the cornerstone of the Luxembourg fund industry) is likely to be less in coming years than for hedge funds.

Kelly says: 'The 1990s constituted a period of exceptional returns for many investors in mutual funds that held long positions in equity and bond markets. The Luxembourg fund industry benefited significantly from this favourable investment environment with the compound annual growth rate in fund assets rising by an average annual rate of 28% over the decade.

'But after the exhilarating experience of the 1990s, many traditional investors have experienced disappointing returns over the past two years. Many UCITs funds have fallen heavily in value and investors are seeking alternatives.'

Growth in hedge funds

Currently the size of the hedge fund industry in Luxembourg, including fund of funds, represents less than 10% of all assets domiciled in the Grand Duchy.

Kelly says: 'Apart from a more explicit regulatory environment for hedge funds, there is an opportunity for further development of expertise in Luxembourg to administer these products. A sound capability to administer these products in Luxembourg already exists, but for those fund administrators that recognise the potential growth of this sector the rewards promise to be great. In order for the Luxembourg industry to profit from the expected continuing boom in these products, there is the need to get the marketing message across to international fund promoters and their legal advisers that Luxembourg is an attractive domicile for these products with a large pool of local expertise, central location and excellent financial and regulatory reputation.'

Greg Swart believes roughly 60% of all new hedge funds are being established in the Cayman Islands. He is chairman of the Cayman Islands Fund Association as well as manager of Goldman Sachsš 40-man administration operation, on the island. The biggest recent change in regulation has come in the form of the The Securities Investment Business Law 2002, due to be in operation this year.

New licencing in the Caymans

Many of the aspects of the new rules are being ironed out by the local government and Cayman Island Monetary Authority (CIMA), however, essentially it is designed to make anyone with a securities investment business to hold a licence in the Cayman Islands. There will also be requirements for those who engage in security dealings to be fit and proper, competent, solvent, honest, have appropriate references and be properly experienced.

For the first time a new policy change will require Cayman Island-based professionals to 'sign-off' audits for the first time. This comes into effect in July 2002.

Swart says it will no longer be possible for people to operate a purely brass plate service where all the accounting and administration work is done overseas. He says the new audit sign-off policy will mean a local officer will be responsible to the local regulator.

So, if things go wrong, the regulator will be able to receive the information it needs quickly and take action. Action, depending on which laws the fund is regulated by, could come in the form of suspension of licenses, fines and/or in extreme cases prison sentences.

Swart says there has been a mixed reaction to the new rules by the local industry. He comments that some other offshore centres are now marketing themselves as an easier alternative. However, Swart says in the long-term these tougher regulations will help to prevent fraud. He says: 'When a hedge fund has a liquidity problem and suspends redemptions, then it becomes an issue for the regulator and one of CIMA's big problems is difficulty in accessing information. This new policy is designed to combat this.'

Commenting on the recent suspension of Fortis in The Bahamas, he says offshore jurisdictions are becoming tougher in order to improve their reputation.

He says: 'If one operator in the Caymans does the wrong thing, the whole island is tarnished and we as an industry are working together to prevent this.'

In addition, he notes investors are doing more thorough due diligence. Swart says: 'We have a group of investors touring our operation every two weeks and some of those got burnt in the past including Manhattan. This is a much more stringent approach to even two years ago when people were less inclined to do a site visit. If one person does not do their job, then it ruins it for everybody.'

The Isle of Man's experienced investor legislation passed in 1999 to attract hedge funds to domicile on the island is having the desired effect. At the financial services centre, Sarah Kelly reports 71 funds have been established under the 'experienced investor' category since the laws came into effect. And just under half of those funds are hedge funds. A handy website at lists them and contact details.

From Dublin, Hilary Griffey, a partner at law firm Kilroys, says the growth in hedge funds listing on the Irish Stock Exchange has been phenomenal over the past 12 months. She adds: 'Domiciling hedge fund products in Ireland is still relatively rare but it has increased. The growth has mainly come from institutions with operations already established in Ireland rather than boutique hedge fund managers.'

Roseanne Kelly, head of investment fund listing on the Irish Stock Exchange, says there are about 400 hedge funds with appointed prime brokers listed on the exchange plus many more alternative products which include funds of hedge funds.

She says the listing of hedge funds grew by 50% in 2001 on the previous year. 'European institutions are particularly keen to invest in listed funds as opposed to unlisted funds,' says Kelly. In addition, she added there were more alternative fund of fund products being listed. In excess of 21 hedge funds are domiciled in Dublin.

In the Caribbean, many of the smaller jurisdictions have been fine-tuning regulations over the past year. Aware that if scandals continue to haunt their islands they are at a very real risk of losing business to overseas centres such as Luxembourg, Dublin, the Isle of Man, Guernsey and Jersey.

Locals report that regulators are being increasingly vigilant to make sure everyone is doing their job properly, because the whole centre will suffer for the actions of one rogue accountant.

The harshest disciplinary action taken against an administrator of recent times was by the Securities Commission of the Bahamas.

It issued a disciplinary order in January 2001 ' after a previous notice dated 20 October, 2000 ' against Fortis Fund Services (Bahamas) which was formerly trading as Meespierson Fund Services (Bahamas) in regard to the administration of the Oracle Fund.

Fortis originally alerted the regulator to Oracle-related irregularities but, after an investigation by commission, the regulator took the view that Fortis had not taken proper action early enough.

The subsequent notice has been a major embarrassment for the global administrator. The regulator undertook a complete review of the Bahamas operation and it required all compliance reports to be submitted to the regulator on a monthly basis. However, despite rumours, Fortis never lost its license to operate in The Bahamas and actually gained new business in 2001.

Sources inside the company revealed new procedures had been established to limit the likelihood of a similar situation occurring.

The commission formerly lifted all conditions relative to the notice on September 24, 2001 satisfied it had fulfilled all necessary requirements of an original order.

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