23 Feb 23
Luxembourg's Outlook for 2023
2023 is expected to present a number of challenges amid tough market conditions across the globe. In spite of these there are a several opportunities for companies structuring their operations through Luxembourg – a location which remains one of the most highly sought-after for structuring transactions.
2022 was an eventful year with major changes to the global political and economic landscape, resulting in a rapid increase in inflation and a growing energy and supply chain crisis. Russia’s invasion of Ukraine in early February 2022 sent shockwaves across the globe, increasing pressure on supply chains, driving up costs for many goods and also raising questions of energy supply and security.
In Luxembourg, to combat the global inflation, the government has introduced a temporary reduction to the VAT rates by 1%, applicable from 1 January 2023. Two indexations, one in February and the second in April 2023, will likely increase domestic prices.
That said, there are also a number of more promising economic indicators on the horizon. According to the OECD’s economic projections, economic growth in Luxembourg is forecast to slow down to 1.5% in 2023, before a period of gradual recovery in 2024. Headline inflation in the euro zone has been in steady decline since October 2022, although core prices have yet to exhibit a decrease.
In a bid to control persistently high and rising inflation, central banks in nearly every major economy have enacted interest rate increases in an attempt to dampen the effect of rising inflation. In February, the European Central Bank raised interest rates by a further 0.5%, bringing the main lending rate to 3%. Interest rates are expected to increase further, with a peak of 3.25-3.5% projected in Q3 2023. Rising interest rates present a unique opportunity to asset managers to enter the space of traditional markets where previously they have not had high enough rates of returns.
In recent years, the private equity industry in Luxembourg saw unprecedented levels of activity fuelled by easily accessible credit. Fast forward to the second half of 2022 and dealmakers were contending with significantly less attractive market conditions. Despite this slowdown, deal activity remains above pre-pandemic levels even whilst adjusting to tighter conditions and a clear pivot towards lower risk across asset classes.
The spectre of weakened economic growth has had a clear impact on credit markets and, in particular on leveraged financing conditions with the cost of capital increasing. It is therefore likely that much of 2023 will follow a similar trend to the second half of 2022, with relatively greater activity in the middle-market.
When it comes to fundraising, PE managers are finding that capital is starting to taper off. Inflation and lower appetites for risk are making investors far more discerning about where and to whom they allocate their capital leading to longer fundraising cycles. It is also favouring managers with extensive track records and with whom limited partners have existing relationships. In turn, this will likely further concentrate capital, a trend that had emerged pre-pandemic and which shows few signs of abating.
The slowdown has extended to venture capital with investors taking a more selective approach to investments although this does not necessarily mean investors are starting to back away from venture capital deals. Fund managers will hope that their funds perform better by taking advantage of lower valuations. The venture capital outlook in Luxembourg is strong for 2023 especially for long-term opportunities during the late-stage phase which would pose less risk to investors.
Higher interest expenses, labour costs and weakening margins will continue to stress leveraged loans, collateralised loan obligations (CLO) and other structured credit products that hold them. In response to increased default expectations and liability spreads that have widened considerably, new structured credit deals will likely be planned more conservatively over the next six to twelve months.
Last year, the CSSF published several long-awaited circulars and guidelines, among them Circular 22/806 on outsourcing arrangements to provide a transparent, homogeneous and harmonised national framework in the matter. Circular 22/811 on UCI Administrators takes into consideration legal and regulatory developments, changes in the IT environment and evolutions in the market. These updates provided further clarifications and strengthen Luxembourg’s already sound governance framework.
Also, in 2022 Luxembourg’s long-awaited new securitisation regime was adopted bringing more flexibility and opportunities including active management of debt portfolios thereby opening the door to CLOs. These changes have further increased the attractiveness of the Luxembourg financial services industry. The next step for Luxembourg is to actively market these changes to the law to encourage issuers to consider Luxembourg as a destination of choice for such structures.
The Luxembourg legislative elections will take place in October 2023, and it will be interesting to see what will be provided by the incumbent government and what priorities and path are taken by the new government. Several EU Directives are currently going through the Luxembourg transposition process, e.g., the Cross-border Mobility Directive and DAC7. In addition, the EU Directive on ensuring a global minimum level of taxation for multinational groups in the Union (Pillar Two Directive) and Public Country-by-Country Reporting will have to be implemented in domestic law by 31 December 2023.
There are a number of relevant legislative changes making their way through the EU adoption process. The new Listing Act will further develop the EU’s Capital Market Union (CMU) to make EU clearing services more attractive and resilient and help to promote cross-border investments to alleviate the administrative burden for companies of all sizes, in particular to facilitate SME's access to the EU public capital markets. Furthermore, to protect and strengthen the EU’s AML/CFT framework, the EU Commission has adopted an action plan, referred to as the “EU Single Rulebook on AML/CFT” which is foreseen to be applicable by the end of 2025. The proposed regulation would be directly applicable and replace the minimum rules of the EU AML Directives currently in force. This would mean unifying and strengthening the market practice in the matter by having clear expectations, consistency and a harmonisation of requirements across all member states.
With ESG rising up the priority ranks for investors and fund managers alike, we expect momentum to continue to build with respect to the industry’s approach to environment, social impact and governance considerations.
One factor that will play a role is the Sustainable Financial Disclosures Regulation (SFDR) and its regulatory technical standards which entered into force on 1 January 2023. This will help integrate appropriate disclosure in communications to investors and better inform decision making.
The CSSF published a frequently asked questions guide on the application of SFDR which applies to alternative investment fund managers (AIFMs), managers of a qualifying venture capital fund (EuVECA) and managers of a qualifying social entrepreneurship fund (EuSEF)..
With the European Parliament adopting the new EU law on gender balance on corporate boards towards the end of 2022, and members states having two years to transpose its provisions into national law, we may already see a shift in board composition toward gender diversity and ESG performance in 2023.
Cafico International is an independent service provider with a proven track record of providing excellent service and flexibility that only an independent provider can give. Our client-centric approach helps us work with our clients to understand their changing needs in relation to the day to day management of their Luxembourg fund and corporate vehicles.