The need to tap into increasingly globalized sources of capital is prompting more asset managers to create fund structures that comply with the European Union’s Alternative Investment Fund Managers Directive. That tendency is boosting the popularity of fund domiciles such as Luxembourg and leading managers to outsource more of their fund administration functions, argues Dirk Holz, head of origination and business development for private capital services at RBC Investor & Treasury Services.
PERE: What are the leading domiciles for private equity real estate investment today?
Dirk Holz: For institutional capital there are two big hubs: Delaware, Cayman Islands and Bermuda for North American, Asian and Middle Eastern investors; or Luxembourg if managers want to attract European investment which goes into AIFMD-compliant structures. However, it is not usually a matter of one entity sitting in a single jurisdiction. A strategy may utilize five, or even more structures leveraged through different jurisdictions. For example, parallel structures that consist of non-AIFMD compliant funds based in Delaware, the Cayman Islands and Bermuda, and AIFMD-compliant funds that enable managers to access all kinds of global institutional investors in an efficient way. When choosing where their funds will be domiciled, asset managers have to look at where the properties are located and then structure the holding entities or feeders to provide tax-efficient up-streaming of the rental income or capital gains from sale proceeds. For that, Delaware, the Cayman Islands and Bermuda are still among the leading domiciles. They give a lot of flexibility from a structuring perspective and the regulatory burden is quite mild. Together they cover the majority of the global institutional money that flows into private capital strategies including real estate.
Five years ago, the majority of structures would have been domiciled in Delaware or the Cayman Islands. However, the introduction of AIFMD and other regulatory changes have driven a shift toward Luxembourg, but Delaware and the Cayman Islands will remain popular because two-thirds of the top global fundraisers in the real estate space continue to be US-based and they are still mainly raising US-based money.
PERE: How is regulation influencing domiciliation decisions?
DH: AIFMD has been a game-changer. If managers want to attract European money they have to create an AIFMD-compliant structure for the investment capital coming in. Usually that structure is not directly investing in the properties but investing in special purpose vehicles located where the assets are. For instance, if a European institution wants to invest in the US it may do so through a Luxembourg fund that invests into a Delaware structure, which then owns properties in the US.
Since the implementation of AIFMD in July 2013, the UK, Ireland and Luxembourg have emerged as the three leading jurisdictions covered by the regime. After the Brexit vote in 2016, a lot of asset managers questioned the UK as the right location for their fund management structures given the uncertainty over EU passporting rights. There is still an interesting angle for creating Irish-domiciled funds, especially if they are investing in domestic real estate through Qualifying Investor Alternative Investment Fund and Irish Collective Asset-management Vehicle structures. However, there is a clear trend emerging which favors Luxembourg at this stage.
We have observed a trend toward creating parallel structures in different jurisdictions. That is quite a smart way to operate if you want to attract European money, but you still have a lot of US or Middle Eastern investors. You set up a Delaware-Caymans structure together with a parallel fund that is AIFMD compliant and those two structures co-invest into the properties.
As of today, a lot of North American asset managers in the real estate space are not AIFMD compliant and are still doing distributions via the national private placement regime. However, in 2018-19 the European Commission will take a decision on whether to prolong NPPR or close down that option, so it may not be a long-term sustainable solution.
PERE: How are managers addressing the administrative burdens of operating across different jurisdictions?
DH: There is a strong connection between domiciliation, regulation and the drive towards outsourcing. The big private equity houses that manage their assets through the Cayman Islands, Delaware and Bermuda have more confidence their in-house teams can handle those domiciles, which are fairly straightforward in terms of regulation and require less reporting or regulatory follow-up.
“There is a clear trend emerging which favors Luxembourg as a PERE fund hub. The majority of institutional funds launched in Europe are going into Luxembourg-based structures”
Now, however, with the introduction of AIFMD-compliant funds they are tasked with additional reporting to the relevant regulatory bodies in Luxembourg, the UK or Ireland and need to set up a reporting function with specific local knowledge on the accounting side. There is a clear trend emerging among the US players entering EU jurisdictions to outsource the middle office and administrative component so they can focus on their core competencies.
This trend started for the European asset managers a few years ago following AIFMD implementation. What we’re seeing now is those managers are asking whether they should outsource their accounting needs for Delaware, the Cayman Islands and Bermuda funds. For managers operating in both Europe and the US that means they can put their working capital into the investment side instead of spending it on running the administration, which as well as being a challenge isn’t really a value-add activity for them.
PERE: Which jurisdictions are likely to gain popularity in the medium term?
DH: In the next five to 10 years it seems as though Luxembourg is extremely well positioned because of the regulatory regime. Over the last 12 to 18 months the biggest private equity fund managers have all set up management structures in Luxembourg and they are now starting to create AIFMD-compliant funds, most of them Reserved Alternative Investment Funds. Luxembourg also has a limited partnership regime, which is extremely flexible and very similar to those in the UK and US. Moreover, some big institutional investors, particularly pension funds and insurers, feel more comfortable investing in an AIFMD-compliant structure with greater regulatory oversight. It provides greater protection for their investors, even if the regulatory costs are a bit higher.
No one knows yet what will happen as a result of Brexit, and whether the UK will still have access through the AIFMD passporting regime to the European Union market, or if it will have its own regulations. Jersey and Guernsey are linked closely to the UK but they are independent from it, so they may be able to negotiate a separate third-party passporting regime into the European Union. If so, they could play a very important role especially for UK-based asset managers that want to raise money from outside the UK.
In Asia, there is a trend towards opening up fund structures in the real estate space to attract international investors. They will have to make this work from a regulatory and tax-efficiency perspective, but in five to 10 years there could be a market in some of the region’s jurisdictions.
This article is sponsored by RBC. It appeared in the Regulation and Fund Domiciles supplement with the May 2018 issue of PERE.