A change to just a few lines of Luxembourg’s fund legislation could have very tangible consequences for alternative asset managers. Tabled on 30 July and now before the Finance Committee of parliament, Bill No. 8814 proposes to extend the sub-fund mechanism to certain SCSs and SCSp’s that do not fall within the scope of a Luxembourg product law.

As at 11 September, the text remains at the draft bill stage: it has not yet been passed. However, its content is of particular interest to the alternative funds industry, as it could bridge one of the remaining gaps between unregulated partnerships and vehicles such as the reserved alternative investment fund (Fiar or Raif).

This issue is particularly relevant for private equity, private debt, property and infrastructure: the ability to group several investment portfolios within a single legal structure, whilst legally separating their assets and liabilities.

A limitation of SCSp

The SCSp has become one of the preferred vehicles in the Luxembourg private asset industry, largely due to its high degree of contractual flexibility. However, this flexibility is currently subject to a limitation. An SCS or SCSp that is not governed by Luxembourg law does not benefit from the same legal compartmentalisation mechanism as Fiars, SIFs, Sicars or certain Ucits.

It is possible to establish, by contract, different sub-funds or classes within a partnership. However, the separation of assets and liabilities does not then have the same legal basis in relation to third parties. To benefit from a genuine umbrella structure with several legally separate compartments, promoters may, in particular, make use of a Fiar.

Draft Bill 8814 is specifically intended to remove this restriction. The new Article 28a envisaged in the AIFM Act would allow an SCS or an SCSp qualifying as an AIF to set up one or more sub-funds without having to be governed by Luxembourg product legislation.

One important condition remains: the fund must be managed by an alternative investment fund manager authorised in Luxembourg or in another Member State of the European Union. Structures managed solely by an AIFM registered under the ‘sub-threshold’ regime, as well as those managed by a non-European AIFM, would not benefit from the scheme as it currently stands.

A genuine legal separation

The main innovation lies in the protection afforded to the various sub-funds. Under the proposal, the rights of investors and creditors in relation to a sub-fund would, in principle, be limited to that sub-fund’s assets. The assets of one sub-fund would therefore not be liable for the debts of another, unless otherwise provided for in the constitutive documents. Each sub-fund could also be wound up separately. The winding up of one investment sub-fund would therefore not result in the winding up of the entire SCS or SCSp. The winding up of the vehicle itself would only take place upon the winding up of the last sub-fund.

The mechanism is not unfamiliar in Luxembourg. It largely draws on principles already used in the Fiar and SIF structures. The novelty lies in making these principles accessible to certain partnerships without incorporating them into a product-specific law.

The scheme also permits, subject to certain conditions, a sub-fund to invest in another sub-fund of the same AIF. Safeguards are in place to prevent circular shareholdings.

Fewer vehicles to build

Behind this legal development lies, above all, a question of costs and operational efficiency. An asset manager wishing to offer several strategies, vintages or co-investment opportunities today may find themselves having to set up multiple legal vehicles. In future, some of these strategies could potentially be brought together within a single SCS or SCSp, with each sub-fund having its own portfolio of assets and liabilities.

This change could be of particular interest for co-investments. A private equity manager who regularly offers its investors the opportunity to participate directly in certain transactions could, for example, set up different sub-funds corresponding to different opportunities, rather than systematically establishing a new partnership.

The same logic applies to feeder-type structures, parallel funds and certain multi-strategy platforms. Parliamentary documents highlight, in particular, the case of international parallel structures. A Luxembourg SCSp can be used alongside foreign vehicles which themselves operate with multiple series. Being able to replicate this architecture at the Luxembourg level would therefore simplify the structuring of the platform.

An alternative to Fiar?

This is where the proposal takes on greater strategic importance for the financial centre. Since its introduction in 2016, the Fiar has enjoyed considerable success by combining the absence of direct authorisation of the fund by the CSSF, the mandatory use of an authorised AIFM and a high degree of flexibility in structuring. The ability to create sub-funds is one of its advantages. Bill 8814 would now extend this possibility to certain SCSs and SCSp’s not governed by a product-specific law. However, these structures would not thereby acquire Fiar status.

In particular, they would not be subject, solely by virtue of the new option to compartmentalise, to the specific requirements imposed by the Fiar Act. Depending on the strategy adopted, this may constitute an advantage for vehicles with a highly concentrated portfolio or those designed to hold a single asset.

Co-investments are a good example. A structure designed to carry out a single transaction is ill-suited to a diversification strategy. Being able to place several such transactions in legally separate sub-funds within the same partnership could therefore offer economic benefits.

However, this does not mean that the unregulated SCSp is set to replace the Fiar.

Two different tools

The choice of a vehicle does not depend solely on its legal flexibility. The Fiar now enjoys widespread recognition amongst international investors and has a clearly defined product framework. It also imposes rules concerning, in particular, eligible investors, the organisation of the vehicle and its service providers.

An SCS or SCSp qualifying under the future Article 28a would remain a distinct vehicle. The choice would depend, in particular, on the target client base, the investment strategy, the marketing of the fund, its AIFM, its tax treatment and the expectations of institutional investors.

Nor does the proliferation of sub-funds mean that complexity will disappear. The AIFM must be able to correctly allocate investments, costs and liabilities to each sub-fund and manage any conflicts of interest between sub-funds.

Valuation, accounting and reporting systems must also operate at the level of each sub-fund. The proposal also provides for the option of producing separate annual reports, accompanied by aggregated information relating to the AIF as a whole.

Financing agreements will also be a sensitive issue: the legal separation must be consistent with the guarantees, security interests and rights of recourse negotiated with the creditors.

A new battle for competitiveness

This reform, which appears highly technical, is ultimately part of a well-known strategy in the financial centre: adding new tools without doing away with the old ones. Luxembourg would thus have a new option between a contractually flexible partnership and vehicles governed by a genuine product law.

For private equity or private debt managers operating multiple strategies, co-investments or parallel structures, this option could reduce the number of vehicles required and allow some of the set-up, governance and administration costs to be shared.

It could also enable Luxembourg to better replicate certain structures used in other jurisdictions, particularly in international private equity platforms.

One key caveat remains: nothing has yet changed in the applicable law. Bill 8814 is still listed as ‘tabled’ by parliament, with the last update on 30 July, and has been referred to the Finance Committee. The text may therefore still be subject to change during the parliamentary process.

However, if it is adopted in a form similar to that submitted, Luxembourg-based fund managers will have a new option: to set up several vehicles, to use a multi-compartment Fiar, or to consolidate several legally separate sub-funds within a single SCS or SCSp.