With a new German Investment Act and Investment Tax Act in force since 1 January 2004, a wide variety of new business opportunities have opened up in the German hedge fund sector for foreign players. In fact, the new legislation not only provides a sound legal framework for hedge funds in Germany, it also creates a more level playing field between domestic and foreign players in the asset management business. The focus of this article is on the distribution of foreign hedge funds in Germany. Of course, foreign sponsors can also set up a hedge fund in Germany. However, the benefits of doing so are not obvious since the new legislation aims notto discriminate against foreign funds.
Opportunities for funds of hedge funds (FoHFs)
With the new Investment Act in force, both domestic and foreign funds of hedge funds can be distributed publicly in Germany. In terms of domicile, FoHFs can only be distributed publicly in Germany if they are subject to public supervision in their home state and if the relevant regulatory authorities in the home state are willing to cooperate with the German Financial Services Supervisory Authority (BaFin). If a foreign FoHF does not fulfill the additional criteria for public distribution explained below, it may still be distributed without a public offer in Germany, i.e. via a private placement.
Foreign FoHFs may start the public distribution of their
shares in Germany only after having given prior notice to
the BaFin and if three months have lapsed after the filing
of the notice without the BaFin prohibiting the public distribution.
The notice has to be accompanied by detailed information on
the foreign investment company and its shares as well as its
supervision in the home state. The registration procedure
has proven fairly cumbersome in the past, in particular since
foreign language documents have to be accompanied by a German
translation, but the BaFin is currently revising its procedures
for foreign funds. Apart from the formal requirements, the
BaFin will not allow public distribution unless the foreign
FoHF fulfils similar criteria as a German FoHF:
- the foreign FoHF may only invest in target funds, hold liquid assets (bank deposits or money market instruments) up to 49 % of its NAV and engage in transactions to hedge currency risk;
- no other use of derivatives, short selling or use of leverage may take place at the level of the FoHF. Target funds of course may use these instruments;
- the foreign FoHF may invest in non-regulated target funds, but may not invest in target funds domiciled in jurisdictions that do not cooperate in international efforts to combat money laundering;
- not more than 20 % of the FoHF´s NAV may be invested in a single target fund but the FoHF may acquire all shares of a target fund;
- not more than two target funds may be of the same issuer or manager.
- the target fund`s assets have to be kept in safe custody
by a depositary bank or similar institution Other than these
requirements which apply to both domestic and foreign FoHFs
alike, foreign funds have to appoint a domestic paying agent
and a domestic - not necessarily in-house - representative.
For public distribution, a foreign FoHF has to prepare a
prospectus in German giving prospective investors all relevant
information for their investment decision. In particular,
a prospectus of a FoHF has to include information on:
- the selection criteria for the target funds and their management;
- the extent to which shares of non-regulated target funds may be acquired;
- the extent to which target funds may take up loans and engage in short sales;
- the fee structure of the target funds and the calculation method for the total costs investors have to bear;
- the conditions and the details for redemption of shares and the subsequent repayment.
The fund prospectus also has to contain the following warning statement in a prominent position: "The Minister of Finance warns: Investors in this fund have to be ready and able to bear losses of the invested capital up to a total loss."
The actual distributors of FoHF shares do not necessarily have to be licensed credit institutes or financial services firms. However, they have to comply with the Investment Act´s special requirements for the public distribution of funds, in particular for FoHFs (e.g. written contract requirement for the purchase of FoHFs, risk warning for FoHFs, etc.).
In terms of ongoing reporting requirements, FoHFs have to publish audited annual and semi-annual reports containing, among others, a listing of their - not their target fund´s - assets.
Already widely and critically discussed is the tax reporting requirements foreign FoHFs have to fulfil in order to achieve optimal tax treatment for their investors. It is one of the fundamental aims of the new legislation to tax investments in foreign and domestic funds alike. However the optimal taxation according to the "transparency principle" is one which fund investors are taxed as if they had directly invested in the fund´s assets, presupposes fairly detailed disclosure by the funds of the components of their distributions and deemed distributions both to investors and the official gazette. For FoHF this implies that they need pertinent information from their target funds, which however can be published on an aggregated basis. If funds do not provide information on revenue components that entitle investors to tax benefits, the investors will lose these benefits. If even more information is lacking, investors face punitive taxation.
German institutional investors are able to invest in foreign FoHFs but statutory investment restrictions have to be adhered. For insurance companies these are laid down in an Executive Order which is currently being revised. According to the draft Executive Order, up to 5% of the restricted assets (Deckungsstock) may be allocated to hedge funds domiciled in an EC/EEA member state and to hedge fund related products. Another 5% can be allocated to investments not specifically listed in the catalogue of admissible investments ("opening clause") and thus potentially also in hedge funds. Given the relatively low allocation to hedge funds by German institutional investors so far, this leaves ample leeway for substantial investments in the future.
Opportunities for single hedge funds
a) Distribution in Germany
Single hedge funds may not be distributed publicly in Germany but a private placement of single hedge funds (both domestic and foreign) is possible. There is no restriction whatsoever on the domicile of these single hedge funds since distribution of single hedge funds via private placement does not fall into the scope of the Investment Act. A foreign single hedge fund also does not have to prepare a special fund prospectus for German investors for a private placement. Distribution to German investors by way of a private placement may however only take place via licenced credit institutes or financial services firms.
The borderline between a public distribution and a private placement is still subject to debate at this early stage of the new legislation. Any offer that is directed at an indefinite audience will qualify as a public offer. A private placement basically has to limit the offer to persons with whom the distributor has an existing relationship.
For tax purposes, foreign and domestic single hedge funds are basically treated alike. Again, optimal tax treatment is only achievable if comprehensive information on the composition of the fund`s distributions and deemed distributions is provided.
b) Target funds for German FoHFs
Foreign single hedge funds may also serve as target funds for German FoHFs. German FoHF can invest in single hedge funds irrespective of their domicile unless the target fund is domiciled in a state that does not cooperate in international efforts to combat money laundering. The target fund does not have to be subject to public regulation or supervision. Its assets have to be kept by a depositary bank or a comparable institution, which can be a prime broker.
A foreign single hedge fund manager interested in German
FoHFs as investors has to take into account that German FoHFs
are subject to certain legal requirements which necessitate
information before and during the investment from their target
funds. Before the investment, the target fund has to provide
the following information to the German FoHF:
- most recent annual or semi-annual report;
- contractual terms/corporate charter, fund prospectus or similar documents;
- information on the fund`s organisation, its management, investment policy, risk management and its depository bank or comparable institution;
- information on investment restrictions, liquidity, extent of leverage and short sales.
A German FoHF also has to control its target funds on an
ongoing basis. For this purpose, it has to be furnished on
a regular basis:
- commonly accepted risk measures with the method according to which these measures are calculated;
- confirmation of the target fund`s NAV by the target fund`s depositary bank or comparable institution.
Most importantly, the foreign single hedge fund will be expected to furnish relevant information on the composition of its distributions and deemed distributions so that investors of the FoHF obtain optimal taxation. It is however conceivable that German FoHFs or their service providers develop and provide appropriate systems for prospective target funds in order to facilitate the reporting of relevant tax information to the FoHF.
While several provisions of the new legislation prove problematic, the Investment Modernization Act has significantly improved the legal framework for both domestic and foreign hedge funds operating in Germany. Hedge funds have been set up under the new law and the young but significant German market certainly offers many opportunities for foreign hedge funds as well.