“Good things come to those who wait,” said the American lawyer and statesman Abraham Lincoln —who, we suspect—doesn’t need much of an introduction. For fund managers, it seems the time has come to open alternative funds to retailisation —and what an exciting opportunity it is.
In this blog, we walk you through the basics of Alternative Investment Funds (AIFs) —what they are, how they work and who’s holding them— and explain why alternative funds are being opened to retailisation and what that means for fund managers and —potentially— for you.
An introduction to Alternative Investment Funds
Alternative Investment Funds are called this because they don’t fall into one of the conventional investment categories, such as stocks, bonds, and cash. AIFs refer to all investment funds that aren’t covered by the EU Directive on Undertakings for the Collective Investment in Transferable Securities (UCITS) and instead fall under the Alternative Investment Fund Manager Directive (AIFMD). This includes hedge funds, infrastructure, venture capital, private equity, private debt and real estate funds.
Moreover, they entail a long-term investment horizon, that is, the lifecycle of these funds is usually quite long —for instance, infrastructure funds can last as much as 30 years.
Due to their complex nature, more nascent regulation, and higher degree of risk, most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals —pension funds, family offices, insurance companies. This is because, very often, AIFs require a minimum commitment amount that starts at several million euros, which obviously not everyone can afford.
Another characteristic of alternative investment funds is that they are typically closed-ended. This means that they don’t continuously offer their shares for sale, but instead sell a fixed number of shares, or rather commitments, at one time.
That explains why the group of investors —which is usually a small group of 10 to 25 investors— tends to remain the same throughout that fund’s life. The opposite happens with a UCITS fund, in the traditional asset management world, where anyone can invest in it and enter or leave it at any point in time, even daily. As a result, the investor base constantly changes.
But let’s walk you through an AIF lifecycle. The initial phase is usually called fundraising —when the fund manager brings in the investors, signs them up for the fund, and gathers the (typically uncalled) capital from each one of them to build up the total sum of the fund.
Next, the fund manager will invest the total capital in companies or real estate and develop them over time. At the end of the fund’s life, he or she will sell those companies or real estate, so that the investors get their money back, hopefully with an added value.
While the nature of institutional investors has always existed, and it’s here to stay, now alternative investment fund managers want to open the gates to a huge pool of capital —that includes you and the whole world out there— which they traditionally haven’t tapped into yet.
In other words, the idea is to sell AIFs to individuals, mainly starting with high-net-worth individuals and private banking clients —people who have got a few million in their bank accounts, and by that we mean entry tickets between 50 and 100 thousand euro.
Now that’s affordable for a whole lot more people. And that’s where the opening up part of those funds comes from, or, as some refer to the happening, the “democratisation of alternatives”.
Why it’s time to open alternative funds to retailisation
Let’s be honest. As an individual, you are probably not really keen on locking yourself into an AIF for 10 years —that’s really a long time and so much can change over that period. So, you want to be able to enter a fund and, if for some reason you need capital —say, you want to buy a property or pay your kids’ university studies— get it back smoothly.
We totally understand that you probably don’t have the luxury—and simply might not want— to wait seven or more years until the fund’s lifecycle comes to an end. Hence, for this to work, these types of funds need to be open-ended in nature, which comes with several operational challenges —but more on that later.
To put it bluntly, opening alternative funds to retailisation would allow alternative investment fund managers to tap into new sources of capital —something that they are constantly looking for to set up new funds and grow. Even though it might complicate things in terms of operations, the sheer amount of capital they can potentially collect is vast —and worth it.
But here comes the first challenge: alternative assets aren’t listed on a stock exchange, and thus there’s no free market information in terms of the value of those assets, so how can they be easily traded? If this is all Greek to you, don’t worry. Ας κάνουμε ένα βήμα πίσω (or “let’s take a step back”).
Net asset value, explained
The net asset value (NAV) is the value of any investment fund. For example, in a traditional UCITS fund that’s buying stocks —say Apple or Mercedes shares— one only needs to sum up all those investments, deduct any liabilities and, voilà, one gets the NAV.
This is important because, in an open-end fund, shares must be priced daily, based on their current NAV, so fund managers can smoothly sell them directly to investors as well as redeem them.
On the other hand, since alternative investment funds are typically closed-ended, fund managers tend to calculate the NAV on a quarterly basis. They then relay that information to the investors —which is more like “good to know” information, since they can’t really opt out of the fund whenever they wish to.
Thus, going down the retailisation route means that the NAV of alternative funds will have to be recalculated more often —most likely every month instead of every quarter— so that individuals like you can trade on more frequently.
Attaining the NAV in alternatives
The challenge is that the net asset value in alternatives can be quite difficult to calculate. Taking the example of our beautiful building, Crystal Park, how much do you think it’s worth right now? Well, ask three different people, and you will get three different answers.
It goes without saying, there are valuation experts who can calculate the building’s value, but the crux of the matter is that if you go, for instance, to Bloomberg, you won’t find how much Crystal Park is worth there.
As fund managers will have to inform investors every month, and as accurately as possible, about the value of the different assets because of retailisation, this valuation exercise is becoming increasingly critical. But it bears its own challenges.
Coming back to the example of Crystal Park, let’s imagine you decide to buy a fund, which only includes our building. If there’s a miscalculation in its valuation in the month you went in, you might have paid too much and lost capital. Of course, as an investor, you can bring legal charges against the fund manager for mis-selling that fund to you —not to mention the regulatory consequences it can bring. However, clearly that’s a risk the latter doesn’t want to take.
The operational challenges… and solutions
We keep our promises, so we will now dig into the operational aspect. What fund managers will ask themselves is, “How will I suddenly manage working with thousands, or ten of thousands, of investors, instead of 10 or 25? I know it’s not ideal, but before I could simply use an Excel spreadsheet. What happens now?”
As Kai Braun, Alternatives Advisory Leader at PwC Luxembourg, told us, fund managers will need different systems, will have to validate their data differently, and look after their investors differently. The latter is mainly because they are individuals who might require a different reporting than institutional investors.
But there are solutions too. The major distributors or private banks could manage the end-investor relationship. This way, the alternative investment fund manager would work with, let’s say, 20 distributors —which is what they are typically used to in terms of number of investors— and then the distributors or banks would focus on managing the relationship with investors. Sounds good, right?
Ever heard of tokenisation?
Technology will certainly play an essential role in the retailisation of the alternative assets industry, and from that perspective distributed ledger technology (DLT), including blockchain, could become a key enabler as it opens the door to private asset tokenisation.
To tell us more about the matter, we spoke with Thomas Campione, Blockchain and Crypto-assets Leader at PwC Luxembourg. He explained that tokenisation is a process through which any kind of assets, tangible or not, are issued or converted into a digital form that is stored on and transferred over a blockchain infrastructure.
The benefits of a token-based model and a distributed infrastructure will be particularly significant for the asset management industry. More precisely, tokenisation capitalises on the technology underpinning the broader digital assets universe and therefore benefits from similar features.
These include, among others, a limitless fractional ownership —removing the minimum entry ticket inherent to alternative vehicles—, a continuous trading at global scale and on a peer-to-peer basis —removing the notion of lock-up and allowing enhanced transferability between investors—, and programmability features embedded at individual token level —for example, creating significant opportunities for the automation of compliance rules.
At macro level, tokenisation can also offer sizable efficiency gains in the asset management value chain given the register’s self-maintained, append-only and distributed features in a DLT context. These features directly impact basic, yet burdensome, considerations, such as the shareholders’ register update or data reconciliations between parties, which become irrelevant in this setting.
In addition, the upcoming development of secondary markets for tokenised financial instruments in the European Union (EU) could also bring liquidity to private assets, a feature that retail investors particularly value in the traditional UCITs industry.
While the list of benefits doesn’t stop there, tokenisation is certainly not a magic bullet and its practical implications, as well as its operational considerations, can’t be ignored. In addition, we need to acknowledge the complexity of the underlying technology combined with new considerations impacting the legacy environment.
Even if it may be so, market participants want to be mindful of the huge potential of illiquid asset tokenisation —whose global market is expected to reach more than €15tn by 2030— and start preparing accordingly.
Undoubtedly, these are exciting times for the alternatives world, filled with opportunities for innovation to thrive around it. Technology will very likely make opening alternative funds to retailisation easier going forward by helping overcome many of the current operational challenges.
A status update and the Luxembourg case
As we mentioned, the opening of alternative funds to retailisation has been around for a while, but it’s been gaining traction since the last three to five years, with some funds already getting their feet wet.
Indeed, this trend is taking place all over the world, including in the United States and Europe. And we know very well that if it’s happening in the Old Continent, everything points towards Luxembourg because that’s where many of the alternative fund managers sit.
In the Grand Duchy, alternative fund managers are very much open to retailisation. Kai also told us that if he were to guess, there are probably around 20 to 25 open-ended retailisation type of alternative funds that have already been set up in the last few years or are about to be setup, which is quite a positive number.
There’s nowhere better than Luxembourg for this trend to thrive because of its position in the UCITS sphere —more precisely, number one in Europe. Besides, the country has the know-how on dealing with individual investors, particularly when it comes to transfer agency and AML matters, and it has the right fund products as well.
Let’s get regulatory…but only a little
Another key challenge is the very choice of fund structure that can be used to address the needs and preferences of this new investor segment. That said, there are several options, but we are going to focus on two.
The undertakings for collective investment (UCI) Part II fund is a fund set up under Part II of the Luxembourg Law of 17 December 2010, which applies to AIFs that aren’t covered by a specific product law. The Part II fund is able to invest in all types of assets and, theoretically, allows any type of investor to invest in alternative investment funds.
There’s also the European Long-Term Investment Fund (ELTIF), which facilitates infrastructure investments and can be marketed to all types of investors across the EU. The ELTIF law is currently being revamped, which will probably result in an increased demand for this type of fund as it will make it more attractive and allow, through a passport, to sell fund shares throughout Europe to individuals.
Thanks for the info, but what now?
At PwC Luxembourg, Kai’s team can support fund managers who aren’t used to working in an open-ended environment. They will walk them through and help them implement the necessary operational changes. Moreover, his team can help fund managers in selecting the right partners —that is, the fund administration, transfer agency, among others.
Last, but not least, even though the passport in ELTIFs might be on the horizon, the UCI Part II is still quite fragmented even within the EU, and so, if fund managers are using it, they will probably need some support in navigating through the regulatory requirements in the different jurisdictions.
In addition, Thomas’s team can support alternative asset managers end-to-end in their tokenisation journey, starting from strategy definition, to product review, the selection of stakeholders and technological providers, to the entire operationalisation of the process.
We started this blog entry with a quote from Abraham Lincoln (“Good things come to those who wait”), but did you know there’s more to it? We purposefully left the rest to the end, which goes like this: “…but only the things left by those who hustle.”
The Luxembourgish fund industry is well equipped and placed to pave the way for this opportunity. There are, of course, some challenges to overcome, mainly operational, but the good news is that there are solutions as well —some may not be viable yet, but that’s the beauty of innovation. To get there, we can think of two things: taking baby steps and some hustling too.
*A gate provision refers to a statement in a fund’s offering documents that establishes the fund manager’s right to limit or halt redemptions. Gate provisions are intended to stop a run on a fund, particularly when the assets a fund holds are illiquid and difficult to turn to cash for redemption in a timely manner. Source: Investopedia.
What we think
I’m quite excited about the opening of alternative funds to retailisation and the innovation that can happen around it. If alternative fund managers want to go for open-ended funds, which have some differences compared to the institutional world, they need to look into their internal operations, but they might also have to reconsider their setup with external parties.
Asset tokenisation offers massive opportunities to both issuers and investors. It can remove much of the existing friction in terms of product affordability, accessibility/investability and create the conditions for bringing liquidity to inherently illiquid assets. This shift however, implies the value chain’s transformation as we know it today —and any such change isn’t without challenge for incumbents. That said, I’m very optimistic about the industry’s ability to embrace technology and transform itself to maintain business relevance.