German Asset Management: Defiant growth in the face of hostile legislation
Germany’s Spezialfonds have survived the latest legislative challenge of incorporation within the legislation implementing AIFMD, writes Till Entzian. They remain institutional investors’ preferred vehicle with record inflows in 2012 and AUM that should soon cross the €1trn mark
Boasting net inflows of €72bn over 2012, German Spezialfonds outdid 2010’s record of €69.4bn. Assets under management rose to €945bn, the fourth consecutive time a new record has been set. The figure increases to €1.3trn when the €326bn in assets managed outside Spezialfonds are included.
The Kapitalanlagegesetzbuch (KAGB), the legislation enacted on 22 July 2013 to transpose the European Union’s Alternative Investment Fund Manager Directive (AIFMD) into domestic law, will change relatively little for the traditional Spezialfonds investor. But the term ‘special segregated assets’ (Spezial-Sondervermögen) now encompasses a number of other vehicles; if the German Federal Ministry of Finance (BMF) had succeeded in its initial ambition, the Spezialfonds would have been done away with due to the widening of this scope. But the industry was succeessful in the creation of a further fund category, guaranteeing the existence of the Spezialfonds for now.
The new terminology of ‘open domestic special alternative investment fund (AIF) with fixed terms of investment’ may be correct within the new legislation’s framework, even if it does not roll off the tongue as easily.
Spezialfonds are deemed ‘open’, as investors are entitled to exchange their holdings in return for the actual market value, whereas a fund is now deemed ‘closed’ if the opportunity to redeem shareholdings is granted less than once a year. The KAGB now explicitly makes the distinction between open and closed vehicles, instead of previous legislation, which historically assumed a fund was open. Closed investment vehicles were only introduced in 2002.
The term ‘domestic’ is also a newly drawn distinction. However, as a result of the passport system allowing for cross-border activity, even funds governed by non-German legislation can be deemed ‘domestic’ and can be launched by non-German asset managers – as demonstrated by Luxembourg-domiciled mutual funds. Such cross-border activity is also permissible for Spezialfonds and non-UCITS vehicles aimed at institutional clients. As a result of the new approach, firms based in Luxembourg or elsewhere could offer Special-AIFs in compliance with local law. It remains to be seen if this will allow for an easier distribution of domestic asset management services in these countries.
Redefining the permissible client base
The reference to ‘special’ in Spezialfonds is an allusion to the restrictions concerning those who can invest in the funds. The first funds targeted squarely at one or a few institutional clients came about in the 1960s and 70s, back then still called ‘individual funds’ (Individualfonds) as they were launched for and catered to individual client requirements. In 1990, the legal definition of Spezialfonds was introduced – a fund limited to investment from 10 legal entities. The threshold was slowly increased over the years and lives on in the shape of a theoretical, tax-related limit of 100 investors, but the majority of Spezialfonds to this day only cater to a single investor.
The KABG legislation redefines the types of clients a Spezialfonds can attract and limits them to ‘professional’ and ‘semi-professional’ investors – with the former term defined by the Markets in Financial Instruments Directive (MIFID) as clients including financial institutions and sovereigns. Other investors may be categorised as professional, but must meet certain criteria – resulting in the manager needing to assess the investor’s professional understanding of the matter and the volume of business proposed – and a minimum investment of €500,000.
This may not be a problem for most Spezialfonds investors, as they are professionals anyway, but the introduction of the semi-professional category was important for foundations, church endowment funds and other such investors unable to prove their requisite professional qualifications and unlikely to complete over 10 transactions a quarter.
Allowing for investments from semi-professional investors also greatly expands the potential client base of Spezialfonds. The investment threshold is set at €200,000 if it has been documented that the investor is aware of the associated risk and the asset manager is sure that the investor has the requisite expertise, experience and knowledge to make informed, independent decisions, and that the sum invested is appropriate. This potentially broadens the client base to include individuals with at least €200,000 to invest – previously individuals were excluded to avoid the creation of ‘millionaires funds’.
Opening Spezialfonds to individuals also puts the vehicle on equal footing with the Luxembourg Special Investment Fund (SIF), created in 2007 as a direct competitor to the German fund. The SIF has seen significant success and, to date, the number of vehicles is over 1,500, growing by 111 in 2012 and a further 20 in the first quarter of 2013. Unfortunately, little is known about the vehicle’s actual investor base.
It is unlikely that Spezialfonds will be heavily marketed at individuals in future, as it currently remains unclear to what extent asset managers will be expected to take responsibility for investors. Most importantly, individuals will not profit from the tax advantages of the Spezialfonds and their presence would actually affect the tax advantages of institutional investors within the same fund.
Down the well-trodden path
Spezialfonds only qualify as alternative investment funds (AIFs) because, since the first legal definition of the Spezialfonds was published in 1990 and due to relatively trivial details, they were not categorised as UCITS funds. The practical differences between Spezialfonds and mutual funds are limited to disclosure guidelines (if the investors are identifiable, unit prices need not be published in a journal of record) and sale (a Spezialfonds is not offered to an open investor base). Furthermore, both investment and regulatory restrictions were identical until 2004. A little goodwill could have easily deemed at least ‘regulatory conforming’ Spezialfonds, those in line with the UCITS sales and tax regime, as regulated funds rather than AIFs, but clearly that was not the goal.
The term ‘with fixed conditions of investment’ is meant to spell out that traditional Spezialfonds are concerned, those that balance risk and comply with the investment restrictions as laid down in existing investment legislation.
Finally, the legislation also allows all existing funds to continue in their current form and new ones to be launched. In this context, Spezialfonds may also continue to be marketed if they restrict themselves to the assets permitted in funds that conform to the regulation.
This means the Spezialfonds vehicle may continue to be referenced within other regulation – such as that governing investments of insurance companies. Spezialfonds also benefit from rules designed to facilitate consolidation in annual reports and accounts.
The fact that the Spezialfonds survived the upheaval largely unscathed is to the credit of German fund management association BVI. If the federal and state working groups responsible for overhauling tax legislation for investment assets had succeeded in forcing the funds to comply with the Investment-KG legislation, or if the finance ministry had decided that Spezialfonds were superfluous and required no separate regulation, this could have been the last of the Kandlbinder reports. As experience from the past few years demonstrates, the fight must continue on both regulatory and tax levels with undiminished vigour if the industry does not wish to fall victim to an ill-considered stroke of the pen. The next dark clouds looming on the horizon are the discussions surrounding shadow banking and the financial transaction tax.
The regulator’s uncritical use of the term ‘credit intermediation’ sows the seeds of potential disaster for Spezialfonds. Intermediation in itself means simply to impart or transfer something. And in fact funds do pass on the assets of investors when acquiring corporate bonds – meaning that investment funds could correctly be viewed as financial intermediaries in such instances. As a result of this superficial perception, investment funds risk running foul of the shadow banking debate and could be faced with costly capital requirements. Initial considerations have affected money market funds with fixed share prices, but the differences to other funds are a matter for discussion – meaning that, in the long run, all investment funds may be affected.
The actual goal of the shadow banking discussion is to curb the use of non-regulatory structures that bypass banking regulation – for which certain leveraged investment vehicles, such as private equity, venture capital and hedge funds – are cited as examples. As these vehicles are not subject to any capital requirements, third party investors are said to be subject to higher risks.
Unconditional redemption demands
A bank retains default risk, creating a situation in which further tensions can develop within the system. Deposit holders have an unconditional right to redeem their holdings, meaning banks must carry default risk and protect against such a scenario with capital buffers.
Investment funds, meanwhile, share every risk with investors, even the default risk of assets held within the portfolio. The investor, as one of the co-owners of the fund’s portfolio, is in the same situation as if he had simply acquired the bonds directly. In contrast with banks, private equity and hedge funds extend no credit to investors, meaning they cannot fail to meet their obligations towards them.
Redemption requests also need only be met if the fund is in possession of sufficient liquidity. This fact may have only become apparent when problems were first encountered with German open-ended real estate funds and asset-backed securities but it has always been the case. Regulators are also fully aware of this, and banks and insurers investing in investment funds face a variety of solvency, large exposure and liquidity rules allowing Spezialfonds-related risks to be treated as ‘directly accepted’.
Wave of regulation
Various political interests have seen the creation of a range of institutions whose bread and butter is the drafting and publication of regulations, guidelines, questions and answers. These include European institutions such as ESMA, EIOPA, and the ECB, as well as international bodies such as the Basel Commission, the FSB and IOSCO.
These and other organisations will continue to formulate regulations that will either directly impact the investment industry or otherwise affect important participants such as banks and insurance companies.
Many of these rules also only require the same common sense and ‘prudent man’ diligence that one would, in any case, expect of market participants. But these in themselves sensible regulations increase costs and demand the time and attention of those involved in documentation and processes that would otherwise be better spent on more important matters.
There have, furthermore, been rules that seem to have been dreamt up by officials without any prior practical experience in the industry. As sensible as these rules might appear when taken at face value, in fact they create further work and do not benefit either the financial system or individual investors. One such example is that when funds merge, investors must be sent a (costly) letter, even when the situation has not changed for the investor, financially speaking.
Another such example is the way in which the AIFMD has affected the regulation of Spezialfonds. For investors, the regulation has no specific disadvantages – except that the capabilities of the KAG could be put to better use. Investors will, in future, be sent sales documents and other leaflets that are of little use and they will no longer be able to easily access overseas managers deciding against AIFMD compliance. This is contrasted with the potential for greater security, better returns and increased stability of the financial system.
The ambition of the AIFMD and its transposition into German law through the KAGB is to portray the sovereign debt crisis as a crisis of financial markets – and thereby to regulate the guilty more strictly. This approach recalls the Chinese general who executed his quartermaster for telling him there were insufficient rations. It is not a question of if the new regulation is sensible – its impact on private equity and hedge funds, Spezialfonds and GOEFs is immaterial if you follow our general’s train of thought – what matters is that they make for excellent scapegoats.
The next looming danger, the financial transaction tax (FTT), serves the same purpose of attributing responsibility for the crisis to apparently more suitable scapegoats. This approach willfully ignores that the cost will not be met by the credit institutions it targets, but will simply be passed on to the end-client. Only activities conducted on behalf of the company itself will be affected as intended by the law, their volume tiny compared with customer-facing activities. The tax will have a significantly harder impact than intended on those who were not intended to fall within its scope.
Expensive transaction tax
Based on current proposals, each securities transaction would incur a 0.4% cost (0.1% for each sell or buy order from counterparties). The first problem the approach would pose for many asset managers would be a fall in transactions within the portfolio, resulting in knock-on effects for many investment strategies. The drop in turnover would hit brokers and trading platforms, not to mention that high-risk investments may see their sale delayed despite a noticeable decline in value. Market participants would quickly start expressing a wish to leave the region affected by the tax and several escape routes are offered by current European investment regulation.
For example, domestic and non-domestic funds can simply be merged, or domestic funds converted into feeder funds exclusively investing in a master fund (1) outside the reach of the tax. In both cases, re-investments can be made that are unaffected by the tax – demonstrating that not only can the impact be minimised, but that finance ministries will soon find that the cost of introducing and collecting the tax vastly outstrips its income. The revenue from France’s FTT will just about equal the take from Germany’s municipal dog tax.
There is still hope that this poisoned chalice will pass market participants and investors by. For constitutional reasons the current German proposal requires the tax obligation to be met in the domicile of the company undertaking the trading while the French approach takes into account the origin of the issuer. This will hardly result in a unified European approach.
Market participants have remained focused on their core activities of selling and servicing institutions as well as executing asset management and administration duties despite the recent turbulent market environment. Figure 1 shows the assets managed by Spezialfonds and other investment funds. For ease of understanding, both have been included on a single chart as they cover institutional mandates.
In figure 2, we differentiate between those purely administering assets (master and service KAGs), pure asset management (external managers and advisers, extending to risk management) and all-in-one service offerings. But it should be noted that some assets are counted twice where they are outsourced.
The first nine places are unchanged in comparison with 2012, with Allianz Global Investors leading the ranking and responsible for €471bn. A third of all assets, €154bn, are claimed by second-ranking Deutsche Asset & Wealth Management, under which brands such as DB Advisors and DWS Investments continue to reside. Universal-Investment narrowly comes in third with €133bn investments, ahead of Generali with €130bn. LBBW, meanwhile, has made it into the top ten by increasing total assets to €45bn and rising three places, forcing MEAG’s €42bn into the eleventh spot Bayern Invest has also moved up two spots thanks to its €25bn in traditional Spezialfonds, €7bn in asset management and a further €9bn in assets within its KAG administering business. Last year’s overview omitted the company’s administered assets.
While the real estate Spezialfonds (GOEF) market may be seeing a fair amount of change – with six new companies entering and one leaving – general securities Spezialfonds can only report three new start-ups – Fidus Capital, Opinova Investment and Enercon, based in the East Frisian islands, a first for German investment management. It is also noteworthy that WestLB Mellon Asset Management has been re-christened Meriten Investment Management, following BNY Mellon’s 2012 buyout of former co-owner Portigon.
The market is dominated by the top four companies, accounting for over half of all assets under administration, resulting in the remaining 21 firms sharing what remains. Asset management is even more highly concentrated and the three largest firms account for over half the market. Looking at the mutual fund universe, where Allianz claims a 47.8% AUM share, it is not unreasonable to think that a further consolidation of the institutional market could occur.
The number of Spezialfonds has continued to decline over the course of 2012, although their numbers only fell by 44 to 3,615, and the overall pace of decline seems less rapid than in the past. The previous six years averaged 140 fewer funds per annum. This contrasts with the ever-rising number of segments within Spezialfonds, now up by 338 to 4,149 at the end of December. It appears that there is not only a split in the value chain, with new launches being segments within existing funds, but it would also point to an ever larger number of more specialised mandates. This greater segmentation allows smaller, niche providers to claim their share of the spoils on offer.
Since 2009 the Bundesbank has differentiated equities and bonds not only between domestic and foreign issuers but also between euro-zone and countries outside the single currency. The sudden increase in the volume of assets in Spezialfonds in 2009 is the result of a change in the way they were represented in the statistics – now not only covering securities assets, but also mixed assets and other special assets other than retail assets.
Particularly noticeable is a dynamic increase in the usage of target funds. Whereas a decade ago only 1% of Spezialfonds assets were invested in such vehicles, by 2012 this had risen to around a fifth of total AUM. Furthermore, ETFs will continue to play a role as an affordable means of allocating to the market. Interestingly, however, the Dach-Spezialfonds (funds of funds) only account for around €44bn of the €171bn invested in target funds.
Equity exposure increased only marginally over the course of 2012, but non euro-zone equities are attracting greater interest than domestic or euro-zone equities. The importance of domestic bonds is slowly but steadily in decline, while euro-zone and non-euro-zone bonds are increasingly on the rise – particularly noteworthy after a slight decline in this asset class in 2011.
Rise in exposure to euro-crisis countries
Exposure to the euro-zone’s troubled countries, Cyprus, Greece, Ireland, Italy, Portugal and Spain, is also on the rise. The graph does not distinguish between asset classes.
Spezialfonds previously lowered their exposure to these countries from over 18% in the autumn of 2009 to just 10.3% over the summer of 2012. After the much-feared doomsday event did not occur, trust in equity markets seems to have grown. Regardless of the reasons behind it, fixed income Spezialfonds have increased their exposure to the three countries to 12.4%.
In contrast to the above increase, investment in the three other crisis-stricken countries of Portugal, Greece and Cyprus remains unremarkable. Portuguese holdings (€2bn) are a third of their 2009 value, while Cypriot investments halved to just €160m over the same period. Greece investments particularly suffered, down to €100m from €8bn in 2009.
Such reductions did not occur within mutual funds, which are not traditionally investors in the above-mentioned countries.
This year also holds few surprises as far as investors are concerned. Bundesbank figures, now capturing a greater range of investors, show that insurance companies remain the largest and most important investor grouping within the industry.
It should also be highlighted that with €95bn, life insurers account for less than a third of the €332bn in total insurance assets within the funds. The lesser importance of life insurers is even more visible when examining net inflows, where these investors only accounted for around €6bn, or around a sixth of all inflows. Where banks allocated a further €3bn in 2011, their net inflows fell to €360m, and they account for €130bn of overall assets.
Other new categories introduced by the Bundesbank, such as national, state and municipal governments, and banks and insurance auxiliaries, did not show noticeable net inflows. Regardless of these groups, however, increasing interest in Spezialfonds should make 2013 the fifth consecutive year of record assets under management. More importantly, it should also be the year when the industry crosses a very important milestone – the €1trn threshold.
1- Difference: A master fund is an investment fund in which a feeder fund, exploiting a loophole in the risk diversification guidelines, can commit the entirety of the investment. A master KAG is a KAG that manages the administration of most segmented Spezialfonds, while the asset management is undertaken by external managers or consultants.