German Asset Management: End of the KAG
A new draft law proposes placing KAGs under a new framework, writes Till Entzian. The industry’s challenge will be to retain the identity and reputation of the Spezialfonds
Spezialfonds had a good year in 2011. They enjoyed inflows of €42.3bn and the net asset volume rose by about 4% to a new high of €813bn. This may fall below the growth rate of 12% achieved in 2010, but it nonetheless shows that institutional business is stable - mutual funds had to contend with outflows of 10%, sinking to €590bn. The second element of institutional asset management business, external Spezialfonds, once again fell in 2011, as in 2010. Assets under management in such vehicles for 2011 amounted to €286bn, a reduction of €21bn year-on-year. However, this reduction has proven to be short-term, with an increase in externally-managed assets to the end of May 2012 to €337bn, exceeding 2009’s €326bn. This year the market for external assets got off to a better start than for Spezialfonds, which had an influx of €19bn by May, increasing total asset volume to 834bn.
Unlike private individuals, institutional investors are not simply able to sit on their assets; despite the financial market turbulence - or, the sovereign debt crisis - and the resulting uncertainties, steady inflows are likely to continue. Unfortunately, the implementation of the AIFM directive into national law is imminent, resulting in new regulation that could make conducting business more difficult. And other numerous EU concepts are in the pipeline, such as European venture capital funds and social entrepreneurship funds.
The draft law intended to implement the directive contains a completely new, and in large part, completely rewritten KAGB, the capital investment law. The KAGB will regulate all vehicles - from the classic securities funds to Spezialfonds, as well as German open-ended real estate funds (GOEFs), right through to the closed-ended vehicles - all in the same vein. To achieve this, the regulation in the various EU Directives will be amalgamated into one new law. The KAGB will not only spell the end of the 2004 investment law (InvG) - unlikely to celebrate a decade on the statute books - but also the KAG.
The draft also displays its eagerness for change with the introduction of new terminology, such as the replacement of the KAG - capital investment company - with ‘external capital management company’, while the classic Spezialfonds will be rebranded as the ‘open-ended domestic special AIF with pre-determined investment conditions’. The reason behind such changes is not always immediately clear.
This creates the avoidable headwind of rebranding for companies with KAG in their name - although those offering closed-ended tax savings vehicles will be delighted, as they will in future also be allowed to call brand themselves as KAGs. This will put any company offering a ‘Wind Fund Number 4’ or a ‘Berlin Fund Number 7’ alongside AGI, DWS, Union and Deka - companies that for 50 years were subject to the full brunt of KAG regulation and supervision by BaFin.
With unequal pairings, it is unfortunately the case that one gains as the other loses. This fate now threatens the KAGs if they are thrown into the same neighbourhood as the grey capital market. It would have been possible, through the retention of existing terminology, to respect tradition and highlight the differences between old and new.
The new terms for KAGs and Spezialfonds are not the only ones. The first paragraph of the draft law contains over 70, often completely new, definitions - with many lifted straight from the AIFM directive and other EU laws. This new terminology is not fully compatible with our legal terminology, meaning each new definition will result in a number of questions that will be discussed, clarified and defined over the coming years.
In contradiction to the legal principle that EU Directives should be transposed word-for-word into national law, the draft law plans for a number of restrictions on business that appear completely unnecessary. One example is the abolition of the open-ended real estate funds and their real estate Spezialfonds equivalent.
With reference to their susceptibility to market risk, these fund types are to be killed off with the stroke of a pen. The fact that daily redemptions have worked without problems for many decades, that there has never been a suspension of redemptions among real estate Spezialfonds or that the suspension of redemptions among mutual funds cannot be seen as equal to capital losses, does not seem to enter the equation when drafting the law. Unfortunately, the draft legislation does not define the word crisis in any precise language. It is usual that real estate holdings cannot be liquidated immediately and this is not indicative of a crisis.
By the same token, if individual funds are bought at the peak of bull markets and as a result have to be written down, affecting valuations, that is also not indicative of problems, just as a decline in market price is not problematic if it affects the market as a whole.
Fault for the high number of closed and partially liquidated open-ended real estate funds lies squarely with the federal government and its decision, in 2008, to guarantee deposits and explicitly not guarantee supposedly unsafe investment funds - causing the first wave of fund closures. This instability was reintroduced by a forced 10% reduction in property asset values last year, sowing significant doubts in investors’ minds.
A further accusation from which the draft law cannot be spared is the timing of its introduction. The guidelines on the redemption of holdings from open-ended real estate funds were only recently changed to reduce the risk of redemptions not being met. These new regulations have not yet had an opportunity to display their usefulness. Therefore, such a fundamental rethink of existing guidelines should only be entertained once the newly introduced legislation has proven to be completely ineffective.
A further example is the ban on closed-ended securities funds. The draft differentiates between open and closed-ended Spezial-AIFs and dictates that open AIFs must invest largely in financial instruments, while closed AIFs should be mostly exposed to alternative asset classes. As a result, all investment strategies that involve redemption by a fixed point must be transferred to an overseas investment structure as quickly as possible.
Also, as the closed AIF investment is limited to a certain range as envisaged by the law; other asset classes (such as cars, art, patent, licence and other rights) must also be invested through overseas vehicles. While the sale of such products would be legal in Germany, such a fund launch would no longer be allowed.
Unlike the real estate Spezialfonds companies whose numbers have increased by four or five each year, the number of securities Spezialfonds companies remains the same - with even some mergers to be reported.
For example, the Credit Suisse Asset Management KAG Frankfurt was transferred to Société Générale Securities Services (SSGS) Deutschland KAG in October 2010 before being merged with SGSS in 2011. Credit Suisse remains responsible for asset management and only transferred administration to SSGS, with UBS following a similar path. However, UBS will retain its KAG licence, with the company signing an outsourcing agreement with SGSS. The developments show that consolidation on the administration side could continue in future.
SEB Master KAG, Frankfurt was sold at the end of last year to Universal Investment, signalling the end of SEB’s attempts to establish an administration platform predominantly for hedge funds. The merger, completed in April this year, is most likely the result of low interest in hedge fund investments since their introduction in 2002. This was the result of return expectations already declining, while many hedge fund strategies could be implemented in regulated structures, as a result of the liberalisation of derivative useage in UCITS.
The ban on open sale and sale through intermediaries (Law 34c GewO-Vermittler) also helped dampen further adoption. According to the draft of the KAGB, hedge funds would be regulated as Spezial-AIFs - as a result, only institutional investors would be allowed to hold them in future.
On the list of Spezialfonds providers, the name DB Capital & Asset Management KAG, Koln appears for the first time, with the city functioning as base for Deutsche Insurance Asset Management (DelAM). This is the new guise for GeneralCologne Re Capital KAG, launched in 1999 and re-branded Oppenheim VAM KAG in 2010. The range of services exclusively targets insurance companies.
Two changes occurred for Investment AGs (listed investment companies): PRISMA Investment AG mit TGV was founded, while Financial Group Investment AG mit TGV returned its licence. The long name will not become simpler under KAGB, with the addition of the term ‘with variable capital’.
A fragmented market
As a result of the break-up of the value chain, caused by the segregation between pure fund administration and pure fund management - and again between the management of internal or external assets - creating a ranking for the industry is no longer straightforward.
Previously, one figure was sufficient to represent the assets of one company; today the information collected by the BVI on Spezialfonds and on third-party assets is broken down into five columns apiece. For clarity, the information is broken down in figure 2 into three columns for each company or group. The middle column lists the classic ‘complete’ service Spezialfonds; on the left are companies providing administration only and on the right are those responsible for portfolio management decisions only.
Comparing the current numbers, from May 2012, with those from last year (dated December 2010), there are several changes to the ranking. Allianz Asset Management Group remains the undisputed number one with a total volume of €416bn.
The company, currently pursuing a two-tiered approach through AGI and PIMCO, is seemingly implementing an in-house separation of portfolios from fund administration. Due to the restructuring, the volume of classic Spezialfonds has fallen to €154bn, while pure administration rose from to €123bn, with portfolio management rising to €132bn.
This has resulted in assets being counted twice, as long as they are managed by one part of the business, with administration being the responsibility of another.
Second is DWS Group, where the classic Spezialfonds still plays an important role, with volumes of €85bn. Pure administration on the other hand only accounts for €10bn, while exclusive fund management has attracted €32bn.
Rounding out the three leading companies is INKA and the other parts of the HSBC Group, who may only report €18bn of traditional Spezialfonds business, but can claim a €70bn share of the administration market and a further €25bn of management. As a result, HSBC/INKA has seen its business increase to €114bn.
Universal Investment meanwhile has almost exclusively targeted administration contracts, with €90bn of their overall €100bn of business stemming from this core area of expertise. The company has increased its service offering from master and service KAGs to include real estate Spezialfonds.
Two further examples of concentration or consolidation within the industry can be found in the administration of portfolios at SGSS, which has nudged up a spot in the ranking due to its master and service KAG inflows, increasing volumes to €34bn. NordLB KAG successfully rose six places in the ranking after its administered assets rose from €5bn to €12bn year on year.
However, success is also possible within the pure portfolio management sphere. LBBW, which concentrates on this field and almost exclusively administer their own mandates, has risen three in the ranking after it saw inflows of €3.4bn, bringing assets to €16bn.
As a direct result of ever larger administration hubs, the number and segmentation of segregated assets has changed further. The end of 2011 saw a 56-fund decline in Spezialfonds to 3,659 due to the termination or merger of mandates, in some cases segmenting them as individual pools within one Spezialfonds. For the first time the number of segmentations, at 3,856, rose above those of segregated assets. At €512bn, segmented Spezialfonds take the larger overall share of the market, ahead of the one manager Spezialfonds with assets of just €300bn.
Structure of Spezialfonds
Reliable information about asset allocation is only available for Spezialfonds. However, as the portfolios under the free investment approach are often administered under the same or similar principles, the Bundesbank’s figures will offer a representative view of the industry.
The trends of the previous years have intensified over the reporting period. Over the period there has been a further increase in foreign bonds - in 2011 only by €4bn to €310bn, with an additional €36bn of inflows in the first five months of 2012. Currently, all inflows are being allocated to foreign paper, with the exposure to domestic bonds stabilising at €95bn over the same period.
Equity remains a fairly insignificant allocation, with €14bn - down from €19bn - invested in domestic equity, while a further €51bn - a €9bn reduction over the previous year - was allocated to overseas equity. The overall equity allocation of the portfolios has, as a result of the re-allocation, declined from 16.4% to 13.7%, declining another 1% by May 2012. The reduction may be market-related, but it also reflects the low risk tolerance of institutional investors.
One of the reasons for the low allocation is certainly the high exposure in 1999, when it stood at 49.4%, resulting in losses for many investors. However, due to the long-term obligations of many institutional investors, the current equity allocation seems too low - but this is unlikely to change, as legislation encourages a short-term view.
The use of sub-funds has also held up, with increases of around €10bn to €63.6bn at the end of last year and further inflows of €6.4bn to May 2012. The advantages of mutual funds are increasingly also recognised by Spezialfonds investors. It is simple to add new markets and asset classes to the mix, with transaction and running costs transparent and low, while liquidation is often easier than through direct investment.
Unfortunately, there is no breakdown of sub-funds within Spezialfonds, so it is often unclear where they are invested, or if they are actively managed, or are ETFs. The volume of ETFs has increased by €4bn, according to Bundesbank statistics, to €30bn at the end of 2011 - with €22bn in equity ETFs and a further €8bn in bond ETFs. This may be good news for domestic investors, but the fact that global assets within ETFs is approaching €1trn demonstrates that Germany is not the investment destination of choice for investment products.
Investment in crisis countries
For a year now, the Bundesbank has published data showing how Spezialfonds are invested, broken down by asset region according to bonds and equity. According to the data from May 2011, Spezialfonds had 16.8% of bonds invested in Cyprus Greece, Iceland, Ireland, Portugal and Spain, with 10.6% invested in equities in these countries. The exposure has since been reduced, standing at 12.4% for bonds and 7.3% for equities at the end of May.
Interestingly, the exposure for Spezialfonds was well above that for mutual funds, where investments in bonds and equity accounted for 11.5% and 3.5%, respectively. Mutual funds also reduced their bond holdings more sharply, lowering the volume of assets invested in these countries by 31% at a time when Spezialfonds only cut exposure by 21.3% year on year.
Further, the data shows that mutual funds lowered their exposure to corporate bonds from €52.3bn to €47.9bn, whereas Spezialfonds increased investment in this asset from €333bn to €377bn over the same period. Both funds also stepped up their sovereign bond investment, while cutting allocations to equity.
The spread of investors has not changed much over 2011 when viewed as a share of overall volume. In particular, the commitments by the largest and most important investor group, insurance companies, has increased once more, measuring €272bn at the end of last year - an increase of €16bn over 12 months, in line with net inflows. Inflows may have declined by nearly half from their peak of €29bn in 2010, but the gains seen last year lay above those of the previous years, 2010 excluded. To the end of May, insurance companies’ share of the market increased by a further €23bn, bringing it to €295bn. It should not be long until the €300bn threshold is crossed.
Pension fund inflows grew from €11bn to €20bn over 2011. As a result, pension vehicles claimed €133bn of the market last December, rising to €144bn at the end of May. While total assets may only be around half of those invested by insurers, inflows from both sectors are at equally high levels.
Credit institutions have been less forthcoming as an investor group. Claiming €9bn of inflows in 2010, this fell by nearly half to €5bn a year later, resulting in their share of Spezialfonds assets declining to €121bn. This could be explained by institutions dissolving their liquid portfolio as they are meet short-term requirements.
Foreign investors seem to have completely lost interest in the German Spezialfonds: €4bn of overseas assets was invested in 2008, while the figure was between €500m and €700m in 2010.
To sum up, although institutional assets have grown throughout the crisis, the biggest threat to the industry remains overwhelming regulation, as well as the new draft KAGB law proposing to reorganise the market by lumping together KAGs with tax optimisation vehicles, while threatening to outlaw German open-ended real estate funds.
Arguing that one or the other change is mandated by EU Directive does not excuse this approach. The industry’s challenge will be to maintain the identity of Spezialfonds cultivated over several decades, but simultaneously retaining investor trust in a new and clearly defined future product. Spezialfonds will likely be able to achieve such a feat as, unlike in the case of real estate Spezialfonds, they will at least be able to maintain their business model.
And as long as the new regulation does not lead to a disruption of business, master KAG business is likely to continue consolidating.
Till Entzian’s annual review follows the tradition started more than 30 years ago by Dr Hans Karl Kandlbinder, the originator of the Spezialfonds concept. IPE has published an English version of this report each year for over 10 years. A German version appeared in August in the Zeitschrift für das gesamte Kreditwesen, published by Fritz Knapp Verlag. Till Entzian is a lawyer based in Frankfurt and advises on Spezialfonds.