When US fund managers tap into the European investor market, they frequently offer prospective European investors the option to commit to a Luxembourg fund vehicle. EU investors generally prefer to commit to such a fund vehicle rather than an offshore vehicle, because of “smell test” reasons.
It is not only EU fund raising that often comes with a Luxembourg angle. When US fund managers target European assets, they will encounter that this often also comes with a Luxembourg angle in the form of a Luxembourg acquisition structure.
As the title suggests, this article is dedicated to the US market, but conclusions apply similarly to fund managers based in other countries.
The drivers for a Luxembourg acquisition structur
European targets are typically acquired through European holding structures. Such structures are frequently organized as (multiple layers of) Luxembourg private limited liability companies. Luxembourg companies can accommodate the various commercial needs of lenders, joint venture partners, co-investors and/or senior executives. Hence, Luxembourg is not only high on the shortlist for capital raising, but also for entities acquiring EU targets.
US fund managers prefer to concentrate their European presence in one and the same European jurisdiction. If a Luxembourg fund vehicle is used to accommodate European investors, it increases the likelihood that Luxembourg (rather than another European jurisdiction) is also used to host the acquisition structure for any EU targets.
The height of the insourcing threshold – fund management vs holding structure functions
When a US fund manager has decided to take the step to set foot in Luxembourg, it should decide on how to manage its Luxembourg fund vehicle(s) and/or how to service the Luxembourg holding structures.
The threshold that makes it economically viable to insource the management functions of a Luxembourg fund vehicle is substantially higher than the threshold for insourcing the functions relevant for the holding structures.
US fund managers typically only set up Luxembourg fund management organizations if they have at least some USD 3-5 bn asset under management (AUM) through Luxembourg fund vehicles. When such AUM level is reached, it can be economically viable to launch an in-house authorized Luxembourg AIFM to manage the Luxembourg funds (rather than relying on an external Luxembourg ‘host AIFM’).
On the other hand, US fund managers tend to insource functions relating to their Luxembourg holding structures in a much earlier stage, because that type of insourcing is less costly and easier to set-up compared to insourcing fund management functions.
Insourcing holding structure functions: the tipping point
Luxembourg holding companies require maintenance when it comes to e.g., their funding, investments, cash flows, exits, financial statements and certain filings. To accommodate these needs, the US fund manager hires, as a default solution, local corporate service providers without hiring its own Luxembourg staff.
However, when US fund managers get critical mass in terms of Luxembourg holding companies, they may favor insourcing some of those functions. The tipping point is typically some 15 – 20 Luxembourg holding companies, of which some 8 -12 are EU target facing.
Insourcing holding structure functions: what are the key drivers?
Insourcing often reduces the overall maintenance costs of the holding structures. Perhaps surprisingly, the cost savings are frequently not the main driver for insourcing. A key consideration for insourcing is generally the need to avail of local experts equipped to navigate the patchwork of European rules, but also to have a team active in the same time zone and in proximity of the European service providers. In other words, US fund managers aim to get a better grip on their Luxembourg holding structures (and European targets) by building up their own local team familiar with navigating the European market.
Local Luxembourg physical footprint – tax lawyers refer to it as substance – has another added benefit. It generally strengthens the entitlement to tax benefits (e.g., reduced withholding or capital gain taxes) in the countries where the European targets are located. A tax efficient structure improves the fund’s overall performance.
Insourcing holding structure functions: the resources needed in Luxembourg
Insourcing means organizing Luxembourg local footprint. That footprint encompasses office space, office infrastructure and Luxembourg staff. A Luxembourg in-house team typically starts off with 2-3 full-time employees.
The in-house team is usually grown gradually on an as-needed-basis and continues to rely on certain specialized support from Luxembourg corporate secretarial service providers. During the early stages of building up the Luxembourg presence, the functions shortlisted for insourcing are accounting, corporate secretarial services, coordination of legal and tax matters, and certain compliance matters. Asset oversight functions are sometimes added in a later stage.
Organizing the insourced functions “under the fund”
The most basic model is to allocate the Luxembourg resources over the Luxembourg holding companies directly facing the European targets. Such allocation can be accommodated through a combination of sub-lease agreements for office space and so-called global employment contracts (“GEC”). Under a GEC, a single staff member is employed by multiple Luxembourg holding companies (but not more than 15) that are affiliated.
Another model, which is implemented when the footprint in Luxembourg matures, is to pool the Luxembourg resources together in a master holding company (“MasterCo”) that is owned by the fund and owns, directly or indirectly, the holding companies that face the targets. In such a set-up, the office space and staff is concentrated in the MasterCo. The MasterCo services the investment-facing holding entities. For both these models GECs and subleases may be used to accommodate the substance needs of the investment-facing entities.
The main commercial downside of the above models, where the Luxembourg footprint is organized “under the fund”, is that the Luxembourg team is ultimately controlled by the investment fund and not by the fund manager. Once the fund terminates, the Luxembourg holding companies and MasterCo must also be liquidated, which disrupts the operations in Luxembourg. Agreements that were entered into by the relevant Luxembourg entities may need to be terminated before being able to liquidate the relevant entities, which may delay the overall termination of the fund.
Organizing the insourced functions “next to the fund”
To overcome the potential concerns expressed in the above section, some US fund managers set up a Luxembourg service company (“ServiceCo”) that is controlled by the US fund manager (and not the fund). The staff, office space and office infrastructure are pooled in the ServiceCo. The ServiceCo provides services, under a service contract, to Luxembourg holding entities controlled by one or more Luxembourg funds. The ServiceCo can thus remain in existence even if one of the funds together with its holding companies is rolled-up.
A ServiceCo set-up should be carefully designed to ensure that it does not trigger the need for a Luxembourg financial services license as that would trigger a range of complexities. Such a license would be triggered if a ServiceCo provides administrative services in combination with making its address available (i.e., the companies have their registered office at the ServiceCo’s address) to holding companies “outside the group”. There is generally no need for a financial services license if administrative services and an address are exclusively provided to “group companies”. Unfortunately, there is insufficient clarity on whether a ServiceCo (controlled by the investment fund manager) and the holding companies (controlled by the investment fund) are considered as part of the same group for purposes of the financial license.
In any event, it is only the combination of administrative services plus a registered address that triggers need for a financial service license. If a holding company has its registered address elsewhere or has concluded a sub-lease with ServiceCo for dedicated office space within ServiceCo’s premises, ServiceCo should not be considered as providing a registered address and the financial services license should not be required.
While services provided by the ServiceCo may not require a financial service license, a ServiceCo does require a Luxembourg business license because it is considered to perform business services “outside the group” for purposes of that license (i.e., the sponsor chain and the fund(s) are not considered to be within the same group). The business license, which is essentially a backstop to secure that the ServiceCo is fit for the tasks it will undertake, is easy to obtain for a fit and proper Luxembourg organization.
Insourcing functions “under the fund” or “next to fund”: tax considerations
When considering how to organize the insourced Luxembourg resources, the tax angle should be given ample consideration. For an entity that receives foreign-source income (e.g. dividends, interest or capital gains on foreign shares), substance is typically a must-have from a source country perspective to secure tax benefits (reduced withholding or non-resident taxes). Whether the Luxembourg substance suffices for that purpose, ultimately depends on the relevant source country’s view.
As discussed above, there are three models to organize the Luxembourg footprint of Luxembourg funds and its holding companies: (i) substance in the Luxembourg investment-facing entities, (ii) pooling of substance in a Luxembourg entity that is owned by the fund (i.e., a MasterCo) and (iii) pooling of substance in a Luxembourg entity that is owned by an entity in the US fund manager group (i.e., a ServiceCo).
Certain source countries take a holistic approach to substance and do not demand that the substance is present in the entities that receive the foreign income or capital gains. Instead, they can get comfortable if the substance is present higher in the holding chain or in any group entity in the jurisdiction where the holding companies are located. They may thus sympathize with the model whereby the holding companies enter into a mere service agreement relationship with a MasterCo or ServiceCo. Those countries recognize the business rationale behind the MasterCo and ServiceCo models: the business simply does often not require that all holding companies have their own dedicated office space, staff and infrastructure. This holistic view is only embraced by certain source countries. For countries that take a more restrictive approach, substance in the investment-facing entities through GECs and sub-lease agreements concluded with a MasterCo or ServiceCo can be considered.
A pending draft European tax directive that aims to deny tax benefits to holding companies that are low on substance (the so-called ‘unshell’ or ATAD 3 directive) sympathizes with the MasterCo model as it recognizes that substance higher in the holding chain and in the same Member State should count towards the tax substance of the direct and indirect subsidiaries in the same country. Under the current draft of the directive, it is unclear whether the footprint offered by a ServiceCo is sufficient to stay outside the scope of the directive. The draft directive does recognize that outsourcing the administration of day-to-day operations, while retaining decision making on significant functions, is not problematic. It is unclear how a ServiceCo model should be organized to secure that sufficient decision making is retained by the Luxembourg holding companies. When the directive will enter into effect (and in which form) is still very much uncertain.
ServiceCo model: who assumes the costs and benefits?
From a commercial perspective, it is key to verify whether the costs invoiced by a ServiceCo to the holding companies should ultimately be for the account of the fund manager (e.g., through an offset on the management fee) or the investors (no management fee offset).
By default, the maintenance costs of intermediate holding entities are for the account of the investors if they are due to third party providers or arise because those entities avail of their own corporate secretarial resources. The question who should bear those costs is typically less clear if those costs are invoiced by a ServiceCo controlled by the fund manager. To avoid confusion with investors (they may think they “pay double”, namely the regular fund management fee plus the fees due to the ServiceCo), clarity in the fund documentation is key.
When (prospective) investors inquire about the ServiceCo in the structure, they should be made aware that a ServiceCo generally reduces the overall cost level of the holding structures (running costs but also tax costs). Insourced services are typically more cost efficient than outsourced services and the fees paid to the ServiceCo would not be in addition to the fees for outsourced service fees but would replace these. In other words, investors are normally better off if functions are insourced.
As soon as US fund manager have critical mass in Luxembourg when it comes to the holding structures under the funds they manage, it may be beneficial to hire own teams in Luxembourg responsible for the maintenance of these holding structures.
There are different models to insource those functions. Which model is the best fit depends on a variety of legal, regulatory, tax and business (outlook) factors, which should all be carefully navigated and balanced.
The authors thank the following colleagues of Loyens & Loeff Luxembourg for their contributions: Adrien Pierre (financial regulatory), Farah Sophia Jeraj (employment and litigation law), Benjamin Hitzges (investment management), Jordan Kaselow (law) and Keira Mebrek (personal income tax).