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Asia fund managers and offshore platforms, a pair on a declining curve?

Alternative Universe

Authors: Yves Knel, Cedric Carnoye

Over the past decades, the Asia Pacific region has developed rapidly and become a renowned playground for worldwide investors. The blend of diversified economies, from mature markets such as Australia, Japan and South Korea to developing ones likes South East Asia—combined with relatively less investment constraints—have tempted major investment firms while allowing local players to expand in size.

The region has witnessed a rapidly growing industry driven by greater performances than seen in some of the Western jurisdictions. Asia Pacific ("APAC") Assets Under Management ("AUM") have experienced a sustainable double-digit growth over the past ten years facilitated by a rapidly developing industry in China. In 2018, the AUM in the Asia Pacific Region represented US$19 trillion (increasing from less than 10 trillion 5 years earlier), approximately 20% of the world's AUM. Experts expect the figures to significantly grow over the next five to ten years notwithstanding the slight delay triggered by the situation of COVID-19. Asian investors are cash rich while opportunities for investment seem endless.

So far the AUM rise has been advanced predominantly by large players in the fund industries, with pension funds and insurers being by far the largest investors holding 65% of total Asian assets. However, starting from 2017, the fastest continuous growth has been clearly identified in the alternative and multi-assets strategies. Many new players have come to the market, quickly building track records and being boosted by investors in need of diversification. The Region has observed an increasing demand for such investment diversification from insurers (in China), pension and retirement plans (in Japan, Taiwan and Australia), a maturing appetite from family offices/HNWI (in Hong Kong and South East Asia) and institutional investors broadly. The expected growth of funding from these players is averaging a steady 14% annual increase.

The market has not only allowed local players to evolve but it has also been welcoming to an expanding number of international asset managers, which have established local presences in Asian countries (China, India, Singapore, Hong Kong, etc.) as they aim to foster connections to alternative local investment opportunities. These strategies are expected to continue expanding, driven by diversifying economies, innovative startups and new alternative projects such as opportunities for infrastructure and real estate development as well as the relaxation of local regulations on foreign investments.

Offshore and Asia, a longstanding honeymoon

The development of financial centers, such as Hong Kong and Singapore, has allowed a number of asset managers in the Region to become more global through the establishment of fund management entities in these jurisdictions which offered attractive tax incentives (including on remunerations) and a relatively flexible legal system. More recently, many relative newcomers on the market (including from China, Taiwan and India) have established their bases in these jurisdictions drawing a clear path within the APAC asset management industry. Those who have developed accurate local and regional track records have been increasingly willing to open up their expertise to global investors, predominantly through fund distribution in the APAC and the USA.

In the absence of local cross-border fund regimes and vehicles, offshore jurisdictions were naturally and quickly adopted as popular domiciles in the Region. Preferred by US investors, subject to low levels of regulation, triggering low maintenance costs, allowing for a rapid access to markets and suitably marketed by Anglo-Saxon services firms, the Cayman Limited Partnership quickly imposed itself as the right candidate for the region, particularly in the alternative sector. Ten years ago, large fund domiciles such as Luxembourg offered a suite of solutions which could not compete as they neither satisfied nor matched local needs (being too expensive or simply too complex). The choice of an offshore limited partnership, managed from Hong Kong, Singapore or another jurisdiction, did not raise any concern among the APAC asset management's industry until recently. The well-established offshore partnership structure offering a low tax impact on management fees and carried interest was anticipated to last indefinitely.

Tax and regulatory reshuffles

Initiated by the OECD, new measures, trends and initiatives are now popping up all over the world. Tax authorities and regulators across jurisdictions appear to be moving at speed in a common direction triggering some real game changing shifts in the asset management industry.

In Europe, the AIFMD, BEPS/ATAD, jurisdictional blacklisting and other measures aiming at providing increased transparency and fair tax treatments are currently reshaping the environment of the fund industry (especially in the field of alternative asset management). Fund managers have now entered a cycle of reconsiderations focused on identifying ways of implementing sustainable fund platforms, not only limited to the distribution vehicle but also including the underlying investment and financing structures. In this context, the new regulatory and tax framework has pushed certain jurisdictions to rethink the solutions currently offered and to come up with innovative proposals offering fund promoters more flexibility, lower costs and a shorter time to market. Some have turned out to be an immediate success; examples include the RAIF in Luxembourg, which has been implemented 700 times within its first three years of existence, averaging almost one setup per business day and the new Luxembourg Special Partnership (SCSp) which has been widely engaged (there having been almost 2000 new setups within the last three years). With regulatory and tax measures converging, Europe has seen its alternative investment industry consolidate its fund platforms (fund vehicles, managers and special purpose vehicles) in a maximum of two jurisdictions.

In the meantime, new economic substance requirements laws encouraged by the OECD are kicking off offshore, raising questions across the entire industry. The implementation and maintenance of platforms is expected to become more cumbersome and costly going forward. To take an example, as of 7 August 2020, the new Private Fund Law in the Cayman Islands will require private close-ended funds to register with the Cayman Island Monetary Authority. Within the sector, it is anticipated that new measures will increase maintenance costs due to the annual payment of a mandatory fee. A new local filing obligation enforced by the same law will require Cayman auditors from now on to sign off on the fund's audit reports, which will likely also increase annual costs.

Simultaneously, carried interest and management fee structures surrounding offshore platforms have gradually been increasingly challenged as regards their low effective rates of taxation. Jurisdictions such Hong Kong and Singapore hosting most of the key individuals are now asking for their fair share of tax. Questions are raised in the Region as to whether such arrangements implemented today would still be sustainable in the near future rendering the five to seven year lifetime of a platform increasingly uncertain.

Moreover, the introduction of BEPS derived measures has made it more difficult to obtain tax benefits for acquisition structures involving offshore entities, which usually do not have a large treaty network. Worse still, certain countries are currently levying penalties (e.g. through a non-deductibility, withholding tax, reporting and similar) on payments made to certain jurisdictions, and especially as regards countries included on a blacklist. Not only payments are at risk but also some rules have been introduced at investor level to tackle investments in offshore jurisdictions. For example, Belgium has even launched its own legislation called the "Cayman tax".

As mentioned, in parallel, Asian asset managers have begun to further expand their research for investors. Beyond the APAC region and the USA, they now lean towards Europe for marketing their strategic funds looking for large investment tickets from institutional investors and even, in some cases, partnering with European GP's on specific investment strategies (belt and road driven funds in China for example).

European investors are responding positively to this initiative globally. Looking at diversifying their portfolio, we have seen a clear increase in the number of structures set up by local asset managers, ready to accommodate the European flow. Indeed, since reputational risk has become a core criterion for European investors, Asian Managers are adapting their platform to the demand of this new wave of cash inflow. In the alternative sector, the number of European fund structures, mainly established in Luxembourg, has increased over the past 2 to 3 years.

Recently, we have even identified some European asset managers that require their Asian investors not to invest through any offshore platform, directly compelling them to interpose an unregulated European partnership as direct investor in their platform. Offshore vehicles within a list of LP's seems to become problematic for the reputations of European managers.

Asia's asset management hubs are becoming fully aware of this "onshorisation" of the fund industry and initiatives (new vehicles, law, distribution passports, and so forth) have been blooming on the market which is slowly detaching from its offshore dependence. As far as solutions are concerned, the two major hubs which focus on the cross-border fund industry, namely Hong Kong and Singapore, are in parallel developing their own cornerstone fund vehicles aiming at convincing regional players to move these offshore funds onshore, strategies on which both jurisdictions have indirectly been relying for many years in order to develop their local economies. Their offers come out in 2020 but may still take time to be accepted by investors and managers on a global level.

No one solution fits all

Regulatory frameworks and new tax measures focused on the alternative investment management have set a clear path towards the “onshorisation” of the fund industry.

Since the advent of the AIFMD in Europe, the offering of the major world cross border fund center has evolved significantly, proposing flexible solutions adapted to the needs of Asian Managers, being quick to market and compatible with most of the existing fund platform models.

The RAIF and the new Luxembourg Special Partnership are clearly tailor-made for the Asian market. Both clearly propose adaptable solutions, which may be either set up as a single platform that works for every player no matter the investment and/or investor, or be established as a vehicle compatible with multiple (existing) structures.

For example, we have seen "Western" asset managers relying on a single Luxembourg platform for its global reach in terms of distribution (including within Europe) combined with an Asia- based underlying investment and financing structure for their pan-Asian asset strategy. Such a model offers perfect compatibility with a worldwide distribution provided by the Luxembourg fund vehicle combined to a regional platform usually established in Hong Kong for Chinese investment strategy or Singapore for pan-Asian strategies and has proven to be a robust and flexible investment platform from a fund marketing and tax perspective.

Furthermore, we have identified a growing appetite from Japanese or Australian asset managers for platforms which would not only accommodate their local accounting and tax rules but also allow these managers to re-centralize their focus on their initial core business: portfolio management. With its wide range of vehicles and variety of legal forms available, Luxembourg is able to accommodate most needs of investors. For example, the Japanese actors may have a clear preference for the "unit" of an FCP since it provides for easier accounting valuations in their books. Another notable consideration is that in certain cases, regulation turns out to be advantageous for fund managers. Since the AIFMD and related fund product regulations require some activities such as decision making, portfolio and/or risk management (one of them can be delegated but the AIFM nevertheless remains responsible) or even tasks such as fund administration, custody and NAV calculation to be undertaken locally, this can usually make the fact-checking process both smoother and faster within the fund manager's team resulting in a greater opportunity for them to focus on their core business, that is to say, fund raising and portfolio management. It should also be mentioned that there is a convergence between regulatory and tax substance requirements.

Finally, venture capitals greatly appreciate the possibility in Luxembourg to establish vehicles that are fully dedicated to their activities like the Luxembourg SICAR. Indeed, a fund platform set up under the form of a corporation would eventually grant access to the broad Luxembourg treaty network and its advantages in terms of capital gain allocation while offering a tax neutral fund platform to investors across the world.

The future will be…onshore

With the world of funds increasingly moving onshore, asset managers are looking for answers that are functional, flexible and tailor-made to their needs. In Asia, the recent introduction of the economic substance rules in offshore jurisdictions has clearly accelerated this transition. Fund managers are looking to their next move. Where should they implement their platform for the next five to seven years? The option of taking their platform to a less familiar environment might prove to be risky and difficult.

With its experience of more than 30 years within the fund industry ecosystem and thanks to its large offering of vehicles proven to be suitable, Luxembourg is playing well on the smooth transition and compatibility cards, offering solutions that can be adapted to the needs of asset managers as well as those of promoters and investors. A Luxembourg Special Limited Partnership with equivalent features to its offshore twin would complement an existing platform and clearly broaden its distribution area. For asset managers with a pan-Asian strategy and presence, a Luxembourg vehicle with an Asian investment platform could be a perfect fit from the perspective of the investors, as well as operational and tax requirements.

Having US$5 trillion of assets under management, Luxembourg is the largest fund domicile for cross-border funds. Its infrastructure in this environment is safe and mature. Certain Asian managers have long preferred the comfort of offshore jurisdictions but the always-increasing quest of investors for less reputational risk and more robust (tax) structures have shed light on this small country from an Asian eye. There is no doubt that with its longstanding existence in the industry and the offering of innovative solutions such as the Special Limited Partnership and the RAIF, Luxembourg will have a key role to play in the “onshorisation” of the Asian Alternative Fund industry, perhaps as the sole domicile, perhaps as complementary solution to newly developed regimes in the region.

*Preqin data until 2018

Alternative Universe

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