Luxembourg saw a strong year for Islamic finance in 2014, with the launch of its first sovereign Sukuk and its success as a listing location for multiple major issuances including the debut deals from Hong Kong and South Africa. Coming up on the inside to challenge the UK as Europe’s leading location for Islamic finance, the country may be smaller as an overall financial center but has done a sterling job of playing to its own strengths — especially on the funds and domiciliation side. However, as we move into 2015, has this determination really translated into visible action?
The Luxembourg government has made a concerted effort to promote the country as a center for Islamic finance, with a particular focus on attracting Islamic assets as a funds domicile. Domestic law firms have pushed for business while as an offshore center the country has also thrived. Luxembourg is the largest domicile for regulated funds in Europe as well as the global focus for cross-border investment funds, with a share of 75% as of January 2015.
However, despite a positive response from domestic providers, Shariah compliant funds in the country are struggling to achieve size compared to their conventional counterparts. Has the industry shown alacrity or apathy to its opportunistic encouragement?
A positive start
There was no question of the positivity that accompanied the initial burst of activity, with the optimism of the industry and the robustness of the domestic framework outlining a strong future. “First, a start has been made seeing Muslim investors creating platforms in Luxembourg. Service providers are able to apply their expertise in fund structuring to the specific needs of Muslim fund promoters and investors,” said Andreas Heinzmann and Marcus Peter, partners at Luxembourg law firm Bonn Schmitt, speaking with Luxembourg For Finance. “Due to its flexibility the Luxembourg legal framework allows taking into consideration elements that are key to Shariah compliant products. The product range was enlarged by the introduction of the Alternative Investment Fund Managers Directive (AIFMD) legislation.”
The AIF tide
From the 22nd July 2013, managers of alternative investment funds (AIF) authorized under the AIFMD have been able to use a new passport system to market their funds to professional investors across the EU and to manage AIFs domiciled in other member states. With discussions in 2015 to extend this to third countries, this could be of significant assistance to the Islamic funds industry and its growth in Europe.
The European Securities and Markets Authority (ESMA) in November 2014 called for responses on the AIFMD European passport and the marketing of non-EU AIFs in the EU — and whether the passporting regime should be extended to the management of AIFs by non-EU AIFMs — with a decision due to be submitted to the European Commission by the 22nd July 2015. According to the Association of the Luxembourg Funds Industry, more than 235 alternative investment fund managers (AIFM) had already applied for authorization in Luxembourg as of December 2014. Out of these, 175 have already received full approval from the Luxembourg regulator and there are 535 registered below-threshold AIFM already in existence.
However, in its response to ESMA on the 8th January 2015, ALFI warned that an extension to the passporting regime for non-EU mangers could in fact be premature. “The fact that the AIFMD is a manager and not a product directive makes it difficult to capture cross-border situations in which non-EU countries are involved. The latter have their own laws, and managers from those countries usually do not want to comply with an additional set of rules as long as there are alternative solutions.” This could be a specific issue on the Islamic side, with ALFI commenting that: “This is particularly true for smaller players focusing on specific sectors as opposed to global players with a big distribution network.” And while the country is keen to extend the passport regime to third countries in order to export its own funds, this could also need some more work before it becomes a reality: “ALFI thinks that abolishing national private placement regimes (NPPRs) is a prerequisite for an extension of the passport to third countries. A parallel system would cause market distortion by putting EU AIFMs at a clear disadvantage.”
An issue of Sukuk
There have also been some concerns around the treatment of Sukuk under the AIFMD, an issue that the UK has reportedly already clarified. However, Bonn & Schmitt explained that there are still alternative options to Shariah compliant AIFs. For example, a securitization vehicle governed by the Luxembourg Securitization Law of March 2004 is in principle outside the scope of the Luxembourg AIFM Law and can thus be used for the creation of innovative Sukuk structures. However: “When it comes to Sukuk and AIFM, the regulator has not yet issued any specific guidance on this regard,” confirmed Heinzmann.
A new opportunity
Nevertheless, the legislation has the potential to open up the European market to Islamic investors and Luxembourg is determined to take advantage of it, especially in order to leverage its strength on the funds front. “AIFMD was very important in terms of strengthening the asset management market in Europe, and it also helps asset managers originating in Islamic countries who want to sell funds in Europe — or who wanted to come over here and set up their own platform to manage funds in various EU jurisdictions,” Peter explained to IFN.
“AIFMD could be very helpful to them in that regard, and I have seen a number of requests recently. For example, we have an ongoing project with a Singaporean firm that is considering the launch of an AIFM fund platform. They started off with an unregulated fund which has already reached assets under management of EUR80 million (US$92.6 million) and is growing so fast that they want to set up a regulated fund using the AIFMD for when it crosses EUR100 million (US$115.8 million), with the eventual goal of reaching AUM of around EUR700 million (US$811 million). And while the current fund is conventional, they do hope to attract an investor base from an Islamic background and as such might consider a Shariah compliant option in future.”
Holding back
Despite these options, it seems as if a combination of factors, including the uncertainty surrounding AIFMD but extending to a wider horizon, could still be delaying the take-off of the sector, with clients preferring to remain with the familiar rather than explore the unknown despite the expanding variety of options available to them.
“We are very busy with clients at the moment, but to be honest it’s mainly conventional at the moment,” Florence Stainier, a partner within the investment management practice at Luxembourg law firm Arendt & Medernach, told IFN. Although there is still a lot of discussion about Islamic finance, most clients are more interested in creating sub-funds within existing entities rather than launching new structures. “There are not many new additions that are Shariah compliant,” agreed Stainier. “To be honest, we have not seen as much movement in Islamic finance from a regulatory perspective either. There is more activity happening on a non-regulated basis. Also, we expect that Shariah compliant services providers including banks will be able to establish in Luxembourg in a near future.
“From what we can see in the market, there has not been a great movement when it comes to setting up new funds,” Bonn & Schmitt partner Peter confirmed to IFN. “We have see plenty of real estate transactions but that is normal, and has been steady for the last three to five years. When it comes to Shariah compliant funds outside the real estate sector however, we have not seen any major transactions here over the last five or six months, and this is something where the market still needs to do significant knowledge transfer to show the Arabian markets what we can do — there remains a lot of leeway for improvement.”
Struggle for size
Another of the key issues is the perennial issue of raising funds, especially for newcomers to the market. But the problem is the same even for players who have been around for several years. “It is just an additional constraint,” said Stainier. “Raising money is always difficult for a promoter, unless you are a big Fidelity-type player. Everyone struggles at first and Shariah compliant funds are no different. While we have made good progress and the funds are experiencing very good performance, this is not sufficient.”
IFN has heard rumors that several Shariah funds, including a recently launched Sukuk sub-fund from a well-known market player, are struggling to reach critical mass — and this inevitably inhibits new players from entering and restricts organic growth from smaller entrants. However, the big players are still seeing success: and the SEDCO Shariah compliant fund platform in Luxembourg, according to some estimates, currently accounts for almost half the total Shariah assets under management.
Industry promotion
But while some are cautious, other players are more optimistic. “Shariah funds have seen steady growth, and there are a number of projects in the pipeline from the Middle East,” commented Pierre Oberle, senior business development manager for ALFI, speaking exclusively to IFN. “The big international funds were the first to enter the market, as they wanted to diversify. But over the years we have seen a lot of new players.” And although he agrees that the average size remains smaller than conventional, the industry plans to continue its push for growth in 2015.
This includes a planned trip to the Middle East in March 2015 by key stakeholders including ALFI, Luxembourg For Finance, leading law firms and the minister of finance Pierre Gramegna: with the purpose not only to highlight the attractions of Luxembourg as a center for Middle East funds but also to promote Luxembourg funds as a product in their own right. “Our funds sector is a tool for regional funds to expand internationally,” confirmed Oberle.
Lack of interest?
However, while the enthusiasm for Islamic funds might exist on the provider side, some suggest that the lack of interest comes from the investors themselves. “When we go to Dubai, Abu Dhabi, Doha and so on, we do promote and speak about Islamic finance but that doesn’t mean we only access these clients from an Islamic perspective,” explained a Luxembourg-based lawyer. “It’s always good to have, but the vast majority of projects may not necessarily be in line with Shariah compliance. It’s a bit ambiguous — because of course we want to promote Islamic finance and the government wants to do more, but the local investor is just not that interested in the Islamic side.”
Another issue is that the current focus is on promoting regulated funds for the Islamic proposition, and these structures primarily attract mass retail clients, pension funds and so on — markets not necessarily as well developed or in as high demand in the Middle East. “In the first stages, Luxembourg-regulated products created by Middle East initiators are mainly dedicated towards the expat population in the region and they don’t necessarily care about Islamic finance as much,” pointed out Stainier. “Pensions are a key growth point for these funds but so far they barely exist, and Muslim investors don’t even think about looking at these kinds of product. This needs to be investigated — it might explain why the Shariah funds that have been created have been less successful in raising assets.”
Encouraging prospects
Despite the slow growth the long-term prospects remain encouraging for the industry: based in the strong support from the regulators and the growing swell of interest in Islamic finance from continental Europe.
With several Islamic banks expected to launch in the coming year along with a sophomore sovereign Sukuk on the cards which in November last year, minister Gramegna told IFN could use an innovative new asset structure based on investment funds rather than real estate, 2015 has the potential to kickstart a new era for the industry. “Obviously there are some transactions on the market, but there could be significantly more — not only on the funds side but also in terms of debt and financing,” said Heinzmann, partner in the capital markets group at Bonn & Schmitt. “Recently we were asked to provide a quote on a new Shariah compliant project that seems well thought through. However, compared to traditional issuances it is clear that Islamic instruments remains an exotic product. We need to continue to market this as an alternative asset class.”
Pilot projects
One way of doing so might be to demonstrate success through the introduction of pilot projects that give incentives to encourage Islamic investors to access Europe via a Luxembourg platform. “Luxembourg is well-known as the second-largest fund center in the world and conventional players know what we do but this knowledge has not yet arrived to the Islamic world,” reiterated Peter. “There needs to be more promotion in these countries — and what is lacking are pilot projects that complete successfully and can be used as role models for future transactions, so that clients can start to build up trust.”
There are already a number of transactions in the pipeline coming from the Middle East and from Turkey: with a number of ongoing discussions from Turkish banks and clients on both the funds and the financing side, according to IFN sources. “There is a strong market, especially given that we have the European Investment Bank and Investment Fund which support SME and which strongly support Turkey,” agreed Peter. “There is certainly an opportunity here for the set-up of alternative investment funds or SPVs to issue bonds to finance activities in Turkey — and there is no reason why some of these may not be Shariah compliant.”
A couple of projects such as these would increase faith in the market and allow Luxembourg promoters to spread the word or their success in their countries of origin in order to attract more business — following which, according to Peter: “We should then start to see more interest on the Islamic side.”
“Shariah funds remain a niche, but the growth prospects are very positive,” agreed Oberle. Let us hope that 2015 is the year in which they prove their supporters correct.