Exploring AI: An attractive investment opportunity for alternative investment funds?

In the evolving landscape of investment opportunities, asset managers are increasingly turning their gaze to a new investment sector: artificial intelligence (AI).

From an EU perspective, AI systems are characterised by their “capability to infer.” This refers to the process of obtaining the outputs, such as predictions, content, recommendations, or decisions, which can influence physical and virtual environments, and by their capability to derive models or algorithms, or both, from inputs or data.¹ As such, AI entails political, industrial, data protection and financial challenges.

Alternative investment fund managers (AIFMs) managing AI-focused investment funds have therefore to learn to navigate these emerging opportunities and challenges.

AI Investments: A growing opportunity for Luxembourg Investment Funds

Companies using AI mainly operate in strategical industries. This includes renewable energy, engineering, semiconductor, software engineering, healthcare and manufacturing. To understand the implication of alternative investment funds (AIFs), it’s crucial to differentiate between two distinct groups of companies.

On one hand, large and well-established firms have been developing AI-based technologies over the past decade and are pioneers in these industries. These companies are often based in the US and already publicly traded and are no longer at an early stage. They’re primarily focused on securing funds to maintain their competitive advantage and expand their global operations. Investment products like Luxembourg exchange traded funds (ETFs) are well suited to this purpose and have been investing strategically in AI companies for years.

On the other hand, there are small and medium-sized enterprises (SMEs) and early-stage startups developing new AI-based technologies. But they need substantial funding for their launching and then a long period of research and development. Given their growth potential and their promising impact on the real economy and industry, these companies are attractive for the private equity and venture capital sectors.

AI-focused AIFs are increasingly targeting the latter, which can offer significant financial returns while contributing to transforming industries and supporting economic growth. As a strategic location for alternative investment funds, Luxembourg-based AIFs can offer a wide range of financing to these SMEs and startups and are well positioned to contribute to the growth of this sector.

Harnessing AI investment opportunities with Luxembourg Alternative Investment Funds

The Luxembourg regulatory framework offers a versatile toolbox that facilitates the implementation of varied strategies contemplated by AIFMs, including in the AI spectrum.

For instance, the reserved alternative investment funds (RAIFs) regime is one of the structuring options most favoured by AIFMs. Its legal framework offers flexibility, investor protection, and structuring advantages like the possibility of setting up an umbrella structure. However, a 30% risk diversification rule applies, meaning that RAIFs shouldn’t invest more than 30% of their gross assets in any single asset. As the AI industry could be highly concentrated, it’s key to exploit the Luxembourg fund toolbox to assess which structuring option would be best tailored to AI investments. For instance, the diversification rules are not required if the AIF structured as a RAIF also qualifies as an investment company in risk capital (société d’investissement à capital variable – SICAR).

The ELTIF label further represents an opportunity to open up AI-focused AIFs to retail investors, and the latest changes that apply from 10 January 2024 aim to stimulate long-term investments in the real economy.

On the other hand, Luxembourg AIFs’ strategies range across private equity, infrastructure, debt, and multi-strategy funds (steadily growing), which can fit the nature and financing needs of AI underlying entities (Portfolio Companies):

• Debt Investments: These involve acquiring bonds or other debt securities issued by, or originate loans to, the Portfolio Companies. This solution offers more secure returns through interest payment. But the main risk is the possibility of the borrower defaulting on debt repayment, which can result in substantial capital losses for investors and negatively affect the AIF’s performance.
• Equity and Quasi-Equity Investments: Investments might also be in the form of equity (stocks issued by the underlying companies) or quasi-equity (such as convertible bonds). In this enhanced investment ecosystem, funds might choose to play a more active role as equity partners in the governance of Portfolio Companies. This strategy is a shift from the traditional view of investment funds as being only a source of financial input. Instead, it positions these funds as responsible stakeholders actively involved in steering the companies towards growth and operational success.

AI investments: Key challenges for investment fund managers

From the AIFM perspective, many challenges of AI investments lie ahead, notably when the investment is still in the research and development phase. Unlike more conventional assets where valuation can be assessed through pre-established key performance indicators, the risk factor here is higher, particularly for technology-focused companies developing AI software. The non-completion of projects is a major barrier to generating consistent revenue that could reduce expected returns and potentially damage the reputation of the fund and the AIFM.

In addition, the very nature of AI investments includes inherent technological risks such as system breakdowns, theft or hacking. These events can jeopardize a project’s completion, directly affecting the Portfolio Company’s operations and the fund’s return on investment.

Enhanced due diligence by the AIFM before investment decisions is key. And sharing the abort fees in the fund documentation is crucial both for the investors and the AIFM. Market practice tends to require the fund to bear a certain amount (depending on the fund’s size) and the balance charged to the AIFM, but investors might try to minimize this burden at the fund level to induce the AIFM to exercise greater diligence.

Separately, the global interdependence of AI technologies presents a complex matrix of regulatory and geopolitical risks that can significantly affect Portfolio Companies and consequently the AIFs. On the regulatory front, it’s crucial for AIFMs to perform comprehensive regulatory analyses in the countries of their target investments to circumvent potential operational hurdles posed by prospective or existing regulations. Simultaneously, the geopolitical dimension adds another layer of complexity. This intricate global supply chain creates a geopolitical risk in case of tensions, which could lead to severe disruptions in the supply chain, affecting the entire AI market and negatively affecting the financial return at AIF level.

The context in which AI operates underscore the need for asset managers to conduct comprehensive risk assessments and have a deep knowledge of the Portfolio Companies to anticipate and prevent inherent risk lying with AI investments.

AI investments: a requirement for in-depth knowledge

To ensure the viability, development potential, utility, and profitability of Portfolio Companies, it’s essential for asset managers to integrate expert knowledge into the investment process. This integration is often realized by establishing specialized boards or committees in fund structures at AIFM level. Or if the AIF is structured with a portfolio manager, through the appointment by the latter of an investment advisor. These advisory groups are composed of experts from various fields who are selected based on the specific expertise required for the underlying investments. For instance, if the AIF invests in the healthcare industry, these experts might be medical professionals. Although they have no discretionary power over investments – that remains firmly in the hands of the portfolio manager – they play a crucial role in making strategic recommendations, particularly for the due diligence and/ or monitoring process of the investments.

AI investments: What’s next?

The EU has firmly positioned AI as a key area of opportunity, reflected in the substantial funding dedicated to AI-related projects (eg Horizon Europe – the EU flagship research and innovation program with a EUR95.5 billion budget). By aligning their strategies with EU policy objectives and tapping into public-private partnerships – investment funds combining both public and private investors are rising through the alignment of public and private interests – AIFMs can access significant funding and technical expertise to support their investment decisions or the growth of their Portfolio Companies.

The next challenge at EU level will likely be to set a harmonised regulatory framework that offers appropriate protections to those investing in AI while maintaining a sufficient level of flexibility required by these investments. This is in part the purpose of the European Artificial Intelligence Act – the first comprehensive regulation on AI by a major regulator – which aims to regulate the field in a similar way as it has been done with data protection.

With the growth of the AI sector, the ability of AIFMs to adapt their investment due diligence and monitoring to the specifics of AI investments, and to integrate EU regulations, suggests that investments by AIFs in AI have a bright future ahead.

This article was originally published in the Agefi Luxembourg in June 2024 and is reproduced with permission from the publisher.