At the heart of Luxembourg’s world leading cross-border fund industry are more than 400 management companies (mancos) employing nearly 6,000 people. What are these organisations, how has the concept grown, and have recent events called the model into question?
How to simplify and cut the cost of running and distributing investment funds across borders, while maintaining strong regulatory supervision? That was the challenge faced by European lawmakers at the start of the millennium, and their solution was a hub-and-spoke model centred on mancos (see below). This solution allows fund promoters to centralise technical operations in one EU member state and sell seamlessly across borders. This is a more efficient option than requiring separate organisations in each market.
This structure was formalised by a reform of the Undertakings for Collective Investment in Transferable Securities (Ucits) directive in 2001. Ucits regulates funds mainly destined for a mass, retail market. Ten years later, this structure was extended to alternative strategies that invest in property, private equity, debt, hedge funds and so on. Mancos can be run in-house, as part of the asset management group, or they can be outsourced to a third party which handles these operations for several funds and asset managers. Some mancos specialise in Ucits, others focus just on alternative investments. So called “super mancos” serve both sectors.
Third party advantages
What is the appeal of the third party option? Larger asset managers tend to prefer to run their mancos in-house, often for reasons related to the desire for control or taxation. The outsourced option is seen to be more appropriate for smaller or non-EU asset managers as well as those who wish to focus on core business. In effect, the third party manco delegates the fund’s portfolio management to the asset manager. This gives asset managers a platform from which they can launch and manage their Luxembourg fund without having a physical Luxembourg presence.
Speed to market has been an important factor in the context of UK funds seeking a post-Brexit base in the EU27. Also, it is an ongoing challenge to find and retain scarce human resources, and small mancos can be blown off course if a handful of key people leave. Thus, using a large third party can add resilience. They also might give greater flexibility as investment strategies and regulations change. However, as with every outsourced relationship, the fund is putting a high degree of reliance in a company over which they have no direct control.
Third parties might be a way of adding efficiencies to what is widely seen as a highly fractured market. According to PwC, there were 429 mancos at the end of last year, employing 5,705 people. In figures highlighted at the Association of the Luxembourg Fund Industry conference in March, over half of firms had less than €1bn assets under management, which cumulatively represented just 12% of total assets under management by Luxembourg mancos. At the other end of the spectrum, 39 firms were responsible for two-thirds of the total. Even so, most of these are relatively small operations, managing above €25bn--a significant if not spectacular figure. Only six third party management companies had assets under management in excess of this figure, according to the PwC data.
“The third party manco market is quite competitive and margins are tight,” noted Claude Niedner, a partner with the law firm Arendt & Medernach. He and others see the need for consolidation to boost efficiency. This is happening horizontally with firms taking over competitors or similar players in other markets. Examples include Fundrock’s acquisition of SEB Fund Services to boost its offering to the Nordic market. Also, Hauck & Aufhäuser Fund Services purchased a majority stake in Crossroads Capital Management, a Dublin-based AIFM and Ucits manco.
The search for scale
There have also been vertical mergers, allowing manco services to be offered as part of a full range of services. An example is Apex Luxembourg, which acquired a range of players so that it now has in excess of 500 employees in Luxembourg. Similarly, there was the takeover of Luxembourg Investment Solutions by Sanne, allying alternatives manco expertise with a suite of fund-related and general business services.
“The sweet spot starts at about €30bn as this gives sufficient scale in terms of staffing, presence and specialisation,” said David Rhydderch, president of Apex Group, speaking at the Alfi European Asset Management conference in March. He spoke of a gradual, inevitable process with the biggest players exerting “gravitational pull.” Players like Apex and Fundrock are both backed by private equity investors seeking to grow their businesses with a view to a later sale.
Pierre Weimerskirch, managing director of Luxembourg Investment Solutions, cautioned that acquisitions have to be planned with care, and this involves deep understanding of each firm’s client base. “It’s about the quality, as on-boarding a client with relatively few assets can often require as much work as a much larger portfolio, but with lower profitability,” he noted.
There is also the political challenge of playing in a market that hinges on regulation. For example, a recent blow-up in a UK fund has led some to point to deficiencies in the way the EU fund industry is regulated. Bank of England governor Mark Carney claimed that some investment funds regulated under EU rules are “built on a lie.” The Financial Times suggested the manco structure is “fraught with potential for conflicts of interest.”
This controversy arose after the suspension of the Woodford Equity Income Fund, a UK-based Ucits fund. As a product destined mainly for retail markets, Ucits are forbidden from holding more than 10% of their assets in illiquid securities. This is primarily designed to ensure the liquidity which enables clients to sell their investments when they want.
The Woodford fund invested in non-listed assets below this 10% level. However, disappointing performance led to substantial number of clients selling out of the fund, resulting in this 10% threshold being breached. The fund managers were reluctant to sell their unlisted securities to correct this as these investments had not reached maturity and they wanted to avoid a fire sale. Instead, the fund chose to list these assets on the Guernsey stock exchange. Although technically this brought the fund into line with the letter of Ucits rules, it did little to boost liquidity in reality.
This move did not stem investor concerns, causing clients to redeem their investments in ever greater numbers until ultimately the viability of the fund became threatened. Eventually, on 3 June, with investors selling up at an unsustainable rate, it was decided to suspend redemptions, and in July, this restriction was extended to December. The fund hopes to use this time to rebalance the portfolio without having to offload the illiquid investments at a cut price in a panic sale.
Potential conflict of interest
Part of the controversy stems from the role played by the fund’s third party manco, operated by the Australian firm Link. Questions have been raised in the press whether they did all they could to alert the regulators regarding the listing of the troublesome assets. Critics see this as evidence of the potential for conflicts of interest. While under the law the manco is in charge, the asset manager is de facto in the driving seat as they ultimately choose which third party manco to use. There is an incentive for service providers to not report their client’s legal but suspect behaviour to the regulator.
Niedner sees the potential problem, but thinks that mancos are today already subject to strict conflict of interest rules. Further, there are other examples in business life where clients appoint service providers in order to monitor their activities. “Fund depositaries and external auditors are too required to be independent and monitor the clients who appoint them,” he said. In all these cases, regulators will be aware of the potential concerns, and all these firms know the potential damage that can be caused by a reputational hit.
Clear rules worked
Moreover, the Woodford affair shows that the Ucits rules are clear and have an impact. Reporting requirements demonstrated that the Woodford fund sailed too close to the 10% limit, and ultimately the market punished this behaviour. Indeed, although it did not occur in this case, the third party model provides the potential for a further check on the fund. An in-house manco is probably less likely to blow the whistle. Perhaps the most salient point is that seeking to design regulation that prevents all unethical behaviour is impossible, and could cause unintended negative consequences.
Nevertheless, given the highly competitive third party manco market, the temptation is there to cut corners on corporate governance in the pursuit of market share. “We have terminated contracts with a few clients because we were not happy with their strategy,” noted Weimerskirch. “As a client, you have to ask yourself about the reputation of the third party manager and their clients, and whether you wish to be associated with them in this key business relationship.” Often, it can be more about the feel of any given relationship. “It is for management companies to look at their own risk profile and match with clients with whom they feel culturally aligned,” noted Richard Marshall, head of product and network at Fundrock.
The local regulator has taken steps to ensure that all players understand what is required. The CSSF’s circular 18/698 from last year spells out the rules and best practice. “The circular is useful as it sets out clearly the CSSF’s expectations in relation to manco substance, and thus, it sets a new standard in the European regulatory environment and helps to avoid the potential for a regulatory race to the bottom,” stated Niedner.
More independence or technology?
Some believe potential problems would be minimised further if funds were required to have independent directors on their boards. Being aware of the strategy and policy making of the organisation, and their lack of a direct financial relationship to the fund would encourage these people to call out potentially questionable behaviour. Indeed, from September this year, it has been a requirement for UK-based funds to have two independent directors. Even though there have been informal suggestions from figures at the CSSF that this would be advisable in Luxembourg, it is thought that there are no plans to make this mandatory here in the short term.
IT too can help with data analysis, reporting and due diligence, facilitating profitability in a competitive market. “Those players with robust technology will have an opportunity to be scalable, diversify easily into additional business lines, and perform governance at a high standard while pressure on fees continue,” noted Ross Thomson, head of global implemented solutions at Carne Group. He sees this as an opportunity for third party mancos to attract more in-house managers unwilling to make the necessary IT investment.
What is a manco?
Management companies (mancos) are a key feature of Europe’s hub-and-spoke cross-border fund industry. They are commonly responsible for the web of relationships that link clients to fund investments. The EU requires a manco to be based in just one member state, supervised by the local regulator, with the funds they manage then free to be distributed into multiple markets. The manco is ultimately responsible for overseeing the fund’s operations. After the fund manager has made the investment decisions, the manco puts this into action, working with fund administrators, depositaries and others, while also dealing with auditors and regulators. They then distribute the fund to end investors and their advisors. Mancos can be owned and run in-house, or outsourced to a third party.