This article is sponsored by Alter Domus.
Investors in European real estate have been faced with a bewildering flurry of new regulations in recent years, with the UK’s departure from the EU further clouding the fund domiciliation and structuring picture. But as the dust settles on Brexit, it is becoming clear that Luxembourg is not the only domicile in contention, while the UK still has a prominent place on a growing menu of options for managers setting up funds to deploy capital in Europe and beyond, say Patrick McCullagh, managing director, sales for Europe and North America, and Matthew Molton, country executive for the UK, at fund administrator Alter Domus.
What are the main drivers for the UK private real estate market right now?
Patrick McCullagh: The volume of investors coming into the market is growing. The introduction of the Long Term Asset Fund (LTAF) last November has opened up the sector to more high-net-worth individuals and family offices, and also the defined contribution pension schemes, which are the principal target market for the new investment structure. Due to their requirement to match assets with liabilities, the long-term returns available via traditional bond and equity funds are not sufficient for these investors, while the timescales of traditional closed ended private real estate funds do not work, either.
The LTAF is an open-ended fund structure, but one designed for the alternatives market where asset liquidity is an issue.
We are also seeing pension managers, including local government pension schemes, pooling multiple smaller pension funds to increase their firepower and access the big private real estate funds.
Matthew Molton: A lot of larger managers are partnering with smaller specialist operators or developers on strategies that aim to aggregate portfolios for subsequent sale to institutional investors, particularly in the logistics and residential sectors. In the listed market we have recently seen the initial investments on the IPSX, the new specialist stock exchange for real estate, which allows unitization of individual assets for the first time.
What are the principal factors influencing domiciliation and structuring for UK real estate funds and managers?
PMC: In the recent past, if you were a manager looking to attract EU investors, there was a widespread perception that you had to go down the Luxembourg route, both in terms of having an Alternative Investment Fund Manager (AIFM) management company platform, and also having your fund domiciled in Luxembourg. Questions are now being raised about whether that is always the right answer, however.
The European alternative is Ireland, which is proving increasingly popular, and there are other options utilizing the national private placement regimes (NPPR), so that the fund could be domiciled in the Channel Islands, Delaware, Cayman or the UK. We are seeing some law firms beginning to advise their clients that NPPR can be a good way to go, depending on the tax treatment that they need and the regulation to which they are subject.
Proposed new “substance” rules intended to apply to European holding companies under the anti-tax avoidance Directive III (ATAD III) are expected to make typical European structures more onerous and costly to run, given the directive’s requirements to employ local operational staff, rent real premises, rather than just a brass plate, and initiate local banking arrangements. Nevertheless, Luxembourg will continue to benefit from a strong flow of capital where managers are looking to raise money from European investors. We see a lot of UK and US managers setting up parallel funds in Luxembourg to access capital from countries like Germany and France, where investors tend to be more comfortable with a Luxembourg structure.
MM: We are seeing an increased desire for managers to structure their investments via the jurisdiction in which their main management and decision-makers are located. That is good news for the UK market because so many large private equity real estate asset managers are based in London.
The UK government has demonstrated a favorable attitude toward the alternatives industry and is looking at making the products available more attractive for structuring investments. The introduction in April of the Qualifying Asset Holding Companies (QAHCs) regime has been a key element of that.
Meanwhile, recent changes to the REIT rules on the real estate side have reduced the administrative burden associated with them. When you couple those developments with the factors that have always made the UK attractive to investment – the language, the legal and regulatory system, the talent pool and infrastructure available to manage large, complex funds – that means that we are seeing increased activity from investors structuring holding companies and portfolio investments through the UK.
Why have the introduction of QAHCs and changes to the REIT rules been significant?
MM: These changes are two key initiatives as part of the UK government’s strategy to make the UK more attractive for the structuring of alternative investment funds.
The qualifying asset holding company (QAHC) regime is primarily aimed at the private equity market, although it also offers real estate managers another potential structuring option. It is a regulatory change designed to bring in a tax-efficient holding vehicle to compete with the entities available in territories like Luxembourg and Ireland.
Similar to REIT status, instead of being a new type of vehicle, it is a tax classification that you can apply for HM Revenue and Customs to grant to an existing company. It does away with the tax disadvantages associated with legacy UK holding company structures, mainly by introducing the concept that having a holding company for an investment asset should not create an additional level of taxation between the investment itself and the investor.
Its key features are a broad capital gains tax exemption, exemption from requirements to withhold UK tax from payments on interest, potential to deduct interest on profit-related debt instruments, and the ability to repatriate funds in the form of capital via a share buyback. The changes make the structuring of private equity investments through the UK more appealing regardless of the location of the asset.
Two principal changes have been made to the REIT regime. Firstly, the listing requirement has been removed where REITs are at least 70 percent owned by institutional investors. Secondly, the penalty tax charge for holders of excessive rights, which previously applied to any corporate entity owning 10 percent or more of the REIT, will now not apply to shareholders who are entitled to received PIDs gross, which will include UK corporate shareholders (such as UK resident companies, PAIFs, UK Lifecos, UK REITs, etc) and charities.
QAHCs and the revised REIT regime have been welcomed by the industry, and with early uptake looking good, it is likely they will encourage the increased use of UK-based holding companies for fund structuring. That fits neatly with the desire among managers to use management companies in their own jurisdiction, consistent with the requirements to show “substance” under ATAD III.
How can fund administrators help UK and European managers respond to the regulatory challenges that they face?
PMC: There is a complex matrix of regulations coming together that will affect how fund domiciles will be selected in future, including ATAD III, DAC6, AIFMD and the European Securities and Markets Authority (ESMA) review of clients’ sustainability preferences. To access the European market, managers need an entry platform to market their fund and take on investors, a domicile for their fund in Europe, and to fulfill various other regulatory requirements.
We believe it is a big advantage to be able to get those things from one service provider on one platform. For example, Alter Domus can look after an organization from the day it decides to apply for very basic pre-marketing registration all the way through to when it raises the fund, sets up the structure, onboards the investors and starts making investments.
MM: There is a real desire from investors, which is often unmet at the moment, for more transparency of data and timely reporting from funds. As well as traditional performance data, many investors now want to measure the ESG characteristics of their funds, which necessitates gathering information like energy consumption and carbon emissions from real estate portfolios, and diversity and inclusion data from within portfolio companies.
A lot of managers lack the infrastructure and resources to respond. They can look to build a bigger team, invest in technology, or outsource to administrators like us to bridge that gap. Fund administrators can bring to bear technology and resources that enable access to the granular data needed to answer investor queries.
Another challenge has been an increased requirement for transfer pricing services, where two related parties need advice on setting an appropriate rate for a transaction that is not being determined in commercial markets. A transfer pricing team will carry out benchmarking exercises, whereby they make reference to recently completed similar transactions in the open market, to impute the appropriate rate for the transaction in question. The purpose is to satisfy tax authorities that there has been no manipulation of the tax regime in order to benefit unduly the company or fund in question.
Tighter regulation of base erosion and profit shifting has led to a greater need for institutional investors and fund managers to appoint an independent third party to carry out robust and well-documented transfer pricing studies. Administrators like ourselves are in a strong position to provide those services because we already have access to fund data.