Open market regime
A complete opening of the German market as a financial centre for hedge funds (which are now regulated by the German Investment Act (Investmentgesetz)) would not have been possible without modifying framework conditions for investments made by insurance companies, which form by far the largest group of institutional investors. Currently, some institutional investors are planning to increase their hedge fund investments fivefold, which will then represent about 3% of their total portfolio.
Against this background and in view of the provisions of the new Investment Act, the revised Regulation on the Investment of the Restricted Assets of Insurance Companies (Investment Regulation, Anlageverordnung) came into force in August 2004. This Regulation stipulates in detail which investments may be made by insurance companies and defines specific limits regarding both the amount and the objects of such investments. The catalogue of permissible investments has now been extended to hedge fund products.
This includes not only investments in hedge funds and funds-of-funds, but also investments in certain hedge fund-linked products, as described in more detail in the circular 7/2004 (VA) issued by the Federal Financial Supervisory Authority (BaFin) in this regard.
Until the amendment of the Investment Regulation came into force, the BaFin allowed such investments only within the limits of what is known as the ‘savings clause’ (Öffnungsklausel), under which insurance companies may invest up to 5% of their restricted assets in financial instruments that are not explicitly referred to as ‘permissible investments’ in the Investment Regulation. This investment limit may be increased to up to 10% with the approval of the BaFin. Since insurance companies have to comply with general investment principles regarding security, profitability and liquidity they only rarely invested in hedge fund products. Moreover, they preferred to use the said savings clause for other types of investments.
Under the new Investment Regulation, up to 5% of the restricted assets of an insurance company may be directly or indirectly invested in hedge funds without making use of the savings clause. The only restriction is that the hedge fund issuer must be domiciled in Germany or another European Economic Area (EEA) country. However, most well-established and recognised hedge funds do not meet this requirement, which therefore excludes many profitable investments in offshore hedge funds. However, investments in hedge funds launched by non EEA-issuers continue to be possible within the limits of the said savings clause.
According to internal estimates made by market participants, the volume of the hedge fund market would increase up to E30bn if only the top 10% of Germany’s 700 insurance companies were to make use of this 5% quota. This would make the overall volume of the German hedge fund market rise to more than E50m over the five years to come.
In principle, up to 5% of the restricted assets of an insurance company may be invested in one particular fund-of-funds and in one broad diversified structured product. Structured products with capital protection do not experience a vitally privileged treatment. Thus, they might become less attractive for larger companies. Whereas smaller companies with less experience in alternative investments are more attracted to this product structure because of its limited risk potential. Due to considerations regarding risk limitation, insurance companies may not invest their restricted assets in more than two single hedge funds of the same issuer or managed by the same funds manager and may not invest more than 1% in one single hedge fund. Investments in single hedge funds investing more than 50% of their assets in other hedge funds are not permitted. In view of the risks potentially involved with hedge fund investments, all direct and indirect investments in such funds are considered to be risk capital investments, the quota of which may not exceed 35% of all investments.
Due to a general lack of long-term experience and the partly high risk potential of single hedge funds, most insurance companies will probably focus their hedge fund investments in funds-of-funds for the time being. The success of a hedge fund investment depends to a considerable degree on the timing of the investment, the choice of the right investment strategy, and the strict implementation of that policy by the fund manager.
High regulatory requirements have been established in particular with respect to a proper due diligence process, manager selection and risk management systems. Such burdensome requirements can only be understood against the enormous losses experienced by German insurance companies caused by the bear markets only some years ago.
For successful hedge fund investments and in order to comply with regulatory requirements, insurance companies must have qualified personnel who must be sufficiently fa-miliar with hedge fund trading strategies and must also be aware of the risks involved in hedge funds operations. Given the complexity of the matter and the risk of a 100% loss of hedge fund investments, it is essential to gather all necessary information required for a prudent investment decision, including details regarding the organisation, management and investment policies of the respective investment companies. Questionnaires drafted for this purpose are available and ensure a standardised due diligence process.
Investment objectives, investment strategies and risk profiles need to be permanently monitored to ensure an effective risk management. Insurance companies are required to ensure that they receive acknowledged risk indicators at regular intervals as well as appropriate evidence of the true value of any single hedge fund or fund-of-funds invested in.
It is permissible for insurance companies to outsource their risk management activities. This shall facilitate hedge fund investments and in particular help smaller insurance companies with less experienced personnel to comply nonetheless with regulatory requirements. However, the potential costs of the establishment of a proper risk measurement and management system for hedge fund investments are considerable and is in practice expected to be a serious regulatory obstacle for insurance companies to invest in hedge fund products.
Appropriate internal rules must be developed to ensure the smooth implementation of the above procedures. These rules must not only be communicated to the BaFin but also the compliance with them must be appropriately supervised. The board of directors and the supervisory board must be informed on the development of hedge fund investments at regular intervals of not more than three months. The BaFin must also be informed on a quarterly basis of any new hedge fund investment as well as the total volume of all investments in such funds.
In a nutshell, the amended Investment Regulation has been welcomed by the market participants as an important step forward on the road to an established German hedge fund market. However, further steps are necessary, in particular with regard to a less burdensome regulatory approach towards hedge fund investments for insurance companies, to accomplish a more sophisticated German hedge fund market.
Zven Zeller is a partner in the Frankfurt office of Clifford Chance