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The ‘Alternatives Circular’ in Luxembourg Back  
Luxembourg’s Alternatives Circular provides a regulated alternative product while allowing the Grand Duchy to retain its competitive edge writes Didier Prime.
Luxembourg is the second largest financial centre for investment funds in the world. It has prospered primarily due to its regulated culture, which provides clear rules for investor protection. As such, Luxembourg has decided to provide the same regulated environment to hedge funds, requiring clear restrictions on the type and extent of allowable investments as well as approving appropriate promoters aimed at developing such products.
Regulated alternative products are not a common concept in the hedge fund world where there are often little or no quantitative investment restrictions in the prospectus.

As institutions, retail and private banking clients are beginning to increase their exposure to alternative products, the concepts of transparency, risk management and investor protection are emerging as key selection criteria.
In the current Luxembourg market, there are two broad categories of hedge funds that are readily available:
• Funds investing mainly in derivatives and subject to a specific and flexible set of provisions (Chapter I of Circular 91/75);
• Funds investing in transferable securities and following alternative investment strategies by the use of leverage and short sales.

The first category, consisting of hedge funds investing mainly in derivatives, have been permitted since 1991 and have proved to be successful while benefiting from a flexible regulatory framework. This category of funds must follow investment restrictions expressed in terms of margin deposits allowing the fund to have leverage at several times the funds Net Asset Value (NAV).

In the past, concerning the second category of hedge funds, Luxembourg regulations did not provide a specific set of provisions to establish funds that would fall under this category. The issuance of the Alternatives Circular provides regulations for this category of funds.

The newly-issued Alternatives Circular: CSSF 2002/80
The Circular CSSF 2002/80 (‘The Alternatives Circular’) is an important development for the Luxembourg investment fund industry. The Circular allows the Luxembourg fund industry to compete with other jurisdictions while aiming to provide a ‘regulated’ alternative product that continues to promote the positive reputation of the Luxembourg financial centre.

The Alternatives Circular will also speed up the approval process for funds following alternative investment strategies as the following issues have now been clarified:
• How to appoint a prime broker for a Luxembourg domiciled fund?
• What are the limits governing borrowings for investment purposes?
• To what extent is it possible to combine leverage through borrowings and short selling?
• What are the rules for funds of hedge funds?
• How to use derivatives for funds governed by this new circular?
In general, it is still recommended that a new promoter meet with the Regulator to explain the project, the investment strategy, the distribution network and the investors targeted.

However, it is no longer necessary to discuss the investment restrictions for short selling and borrowings or to detail the investment strategy, as the new Circular is flexible enough to accommodate the most widely used alternative strategies.

Use of a prime broker
The use of a prime broker is clearly foreseen in the Alternatives Circular. In order to secure the financing of leverage provided by the prime broker, it is possible to transfer ownership of assets of the fund to the prime broker for an amount exceeding the debt of the fund to the prime broker by 20 per cent of the market value of the assets. This is important for prime brokers as market fluctuations may reduce the value of assets transferred.

Restrictions on short selling and long positions
Most of the investment restrictions of the Circular are based on gross assets and not on net assets. Therefore, the use of leverage does not result in an exaggerated number of lines in the portfolio.

For the long portfolio, the fund cannot invest more that 20 per cent of its assets in any one issuer. On the ‘short side’, the proceeds from short selling applicable to any one issuer cannot exceed 10 per cent of the assets.

Furthermore, there is a stop loss limit when a short sale results in an unrealised loss representing 5 per cent of the assets. But this stop loss on short selling does not apply to a fund following a market neutral or relative value strategy.

The amount of allowable leverage is restricted through limits on borrowings based on net assets. In principle, a fund should not borrow more than 200 per cent of net assets if it follows a directional strategy. For market neutral or relative value strategies for which short positions are covered by long positions, this limit is raised to 400 per cent of net assets.

However, if additional leverage is needed for a specific strategy (fixed income arbitrage for example), the CSSF has been open to such discussions.

The Circular allows for the use of any kind of derivatives: futures, forwards, options, interest rate swaps, equity swaps - the list is not limited.

The constraints on the use of derivatives are driven by the principle of risk spreading. The idea is to allow the investment manager to achieve with derivatives the same exposure he/she can get with securities and borrowings.

As the use of derivatives may increase the level of leverage mentioned in the borrowings section, the prospectus must indicate a maximum level of leverage resulting from the combination of borrowings and derivatives.

The Circular is flexible enough to allow the investment manager to achieve his investment objective through the use of borrowing and short selling or with derivatives or with a combination of both.

The Circular also foresees the possibilities to use securities lending and repo/reverse repo transactions.

Investments in hedge funds
The rules concerning funds of hedge funds are clarified and simplified. Investment in underlying hedge funds cannot exceed 20 per cent of net assets, whatever the domicile of those underlying funds. In addition, it is possible to hold up to 100 per cent of the shares/units issued by the underlying funds.

The use of leverage is allowed. Furthermore, creating a feeder is possible under certain conditions as described in the Circular.

The Alternatives Circular is flexible enough to accommodate most of the investment strategies developed by hedge fund managers while aiming to protect the reputation of the Luxembourg financial centre through selective investment restrictions.

The Circular will clearly help fund promoters speed up the approval process when launching new products. However, the objective is not to compete with non-regulated domiciles where it will always be easier and faster to launch such products.

New types of alternative investors who are interested by non-correlated returns, such as institutional investors, pension plans and others, may find a Luxembourg alternative product to be the alternative that meets their investing criteria.

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