When you talk to German end investors, such as insurance companies, pension funds and family offices, they often speak very positively about the new Investment Act.
But when it comes to the heart of the matter, you will find the answers as to where the real added value of the new law is hard to give. It looks as if institutional investors are still afraid of reputational risk on the one side, and that they have to bear in mind on the other side the restrictions imposed by the executive order based on the Federal Insurance Supervision Act.
Critics say that in reality German investors are kept away from 80% of the hedge fund universe because the foreign players are not willing to fulfil the transparency requirements imposed by the German law or to go an extra mile for the German market. But let´s start with the good news.
In July the Bundesrat has voted for the new executive order based on the Federal Insurance Supervision Act, which is the relevant law for asset allocation. Thus institutional investors are now allowed to invest more in hedge funds or related products. They can now invest 5% of their restricted assets via a new quantitative clause designed especially for hedge funds.
Additionally they still have the opportunity to allocate money via the opening clause in the past. A lot of institutions have invested less than 0.5% in hedge funds in the past. But because of the high transparency requirements and the threat of punitive taxation they tend not to invest directly into single hedge funds.
Investors will allocate money directly into a single fund, if the fund fits the tax requirements imposed by the German law. The Investment AG and the GmbH are practical examples of constructions that worked already in the past. Copernicus Beteiligungs AG and arsago ACM GmbH are among the very few examples.
But with the new investment regime a new classification of funds has been introduced. There are the investment funds – the UCITS funds and the non UCITS funds. In addition, there is the Investment Stock Corporation – the Investment AG – which can have variable and fixed capital and finally, the investment funds with additional risks – hedge funds.
But because of the high transparency requirements and the threat of punitive taxation, institutions tend not to invest directly into hedge funds. The punitive taxation implies that the revenues of a non-transparent fund – a black fund – have to be calculated on the higher of (1) 6% of the last redemption price of the calendar year or (2) all distributions plus 70% of the increase in value between the first and the last redemption price of the calendar year. Thus a black fund is only accessible in a tax efficient way when it is connected with a certificate – certificates are tax-free after 12 months for private investors – or a structured note, when the investment comes out of Germany.
If the investment is done through a foreign arm of the company a black fund is accessible in any way. But that was not the intention of the new law. So this point has unfortunately not really changed.
Investors are complaining about this point and are worried that they could not get access to the better hedge funds because of the high transparency requirements. These funds are not willing to build up a structure for Germany even if the pockets of the German insurance companies seem to be among the deepest worldwide.
In the near future the German market will see a lot of managed account platforms emerging but without the better hedge funds who are afraid of revealing some of their business secrets.
The German market is still considered to be immature. Institutions are told from their advisers that it is better to go through FoHFs. So they have less risk – which means obviously a reduced opportunity to have exceptional returns. Investing this way they have somebody picking the funds and controlling them during the investment period.
As the first German products have an ambitious fee structure, investors tend to have a closer look at foreign FoHFs. But now the problem begins once again. The investor could only enjoy favourable tax treatment if the foreign FoHF delivers for every distribution or deemed distribution detailed information in German regarding the amount and the components of the distribution. As foreign FoHF are investing in target funds that are not fulfilling these requirements, they have a problem. What are the transparency requirements? There are transparency requirements related to the regulatory as well as to the taxation side so that the target fund could be controlled before and during the investment.
The target fund has to deliver the last annual or semi annual-report. Additionally the contractual terms/ corporate charter, fund prospectus or similar documents has to be handed in. The manager must provide information on the fund’s organisation, it management, investment policy, risk management and its depositary bank. Finally there must be information on investment restrictions, liquidity, extent of leverage and short sales.
During the investment period the fund has to provide commonly accepted risk measures, with the methodology according to which these measures are calculated being explained to the German FoHF. There must be confirmation of the target funds’ NAV by the target funds’ depositary bank or comparable institution.
The fund has to provide the overall amount of retained income and gains after costs, calculated on the basis of cash flow accounting. The fund has to show capital gains from disposing of securities as well as from derivative transactions. The investor has to see the dividend income and the capital gains from disposing of shares in companies. Finally, the taxable foreign income from tax credits in Germany is granted as well as the amount of credited tax. Investors will be taxed like investors in a non-transparent fund if one or more of the target funds are not able to furnish this data.
There is no gold rush yet in Germany. The law has a slight tone of protectionism. The German mutual fund industry is obliged to show the dividend income and is afraid to loose even more competitiveness. It would have been better to consult an investor, before defining what investor protection means. Keeping investors away from 80% of the hedge fund universe will certainly induce allocating more money into lesser investments at the expense of investors’ overall assets.
Investors are worrying that they will not gain access to the best hedge funds because of the high transparency requirements that these hedge funds might not be prepared to come up with. Thus in the near future the German market will see a lot of managed account platforms emerging.
Marcus Frederich is managing director, Hedge Pensions, based in Cologne