Comment: Hedge fund Investing in post-modernisation Germany 2004 – Open for Business?

Six months have gone by since the German government passed its investment modernisation law, which became effective on January 1st, 2004.

These past months have been dominated by adjustments between what had been intended by the legislative, what had been communicated by the regulators, what the local ‘matadors’ would have liked to see and what the institutional investors really require.

However, there are still a few obstacles to overcome: According to Frank Herring, partner in the international law firm Norton Rose, the German banking regulator is very keen to promote the establishment of a German hedge fund industry, showing a practical approach whenever the law is unclear or requires amendments.

But on the tax side, many firms still struggle with the onerous tax transparency requirements. Says Herring: “Many large hedge fund managers have decided to comply with the requirements, others have decided to circumvent them. But unless and until a large number of foreign hedge funds become fully tax transparent, German investors will not have many funds to choose from.”

Currently, a group of tax advisers and fund administrators is working on a solution to help hedge fund managers to comply with the German requirements.

It does not denigrate the potential success of the new legislation if one describes the year to date as one of confusion and learning for all parties involved. The new law was birthed before local market players and authorities were able to fully assimilate the required practical experiences and constraints of hedge fund investing.

The main brake to rapid implementation was the asymmetry between intended improvements for German institutions investing in hedge funds and, on the other side, laggard tax laws, such as the prohibitive foreign investment act, that also had to be adapted.

At this time the situation could be described as follows: German authorities have a genuine interest and ambition to assist the local financial market in positioning itself with the international hedge fund scene. Also they have recognised that hedge fund investments could alleviate some of the problems big capital pools such as the life insurers and pension funds face in their asset liability management. What is required to get there is shaping up and should be finalized in June in a new ‘Rundschreiben’ [circular] to the industry.

The regulator has also understood that it must keep the hedge fund approval process within an internationally competitive time frame, say three months, in order to prevent players from migrating to other geographies. To put some ‘meat to the bone’, the regulatory body has already approved one hedge fund and one fund of funds. Even though these first approvals where given to local players, namely Lupus Alpha with a single strategy equity derivatives hedge fund and DWS with a diversified fund of hedge funds approach, one could genuinely read some serious commitment into this move.
Our understanding at this point is that the ‘missing’ or incomplete ruling on the exact tax treatment of hedge funds with respect to tax transparency is leading towards something that looks very similar to the K1 tax reporting requirements in the US.

We are aware of at least one international hedge fund group that has already the tax reporting requirements in place to comply with German law. Our conclusion: it doesn’t appear to be overly difficult.

Talking of which, many foreign hedge fund groups have now spent some time scoping their potential for institutional investors on the ground with, at best, mixed results. The ‘gold rush’ that drove their hopes to Germany for a ‘quick buck’ has certainly not materialized. There is no quick money to be made here.

This is not only because of a, still, clumsy regulatory environment, but definitely because of an investor base who take their time to explore and understand; before channelling their efforts according to reasonably framed expectations.

 Picking up on DWS’s stated ambition a few months ago of raising some EUR 1 billion fast, it now looks as if, despite their status as the biggest local player (or because of it), money is flowing into their new fund of funds on a drip by drip basis only.

Is it that investors have learned from past experiences where they rushed into the Neuer Markt or into the initially massively successful (from an asset gathering perspective) Xavex Hedge Select Hedge Fund certificate? Interestingly enough, investors have since redeemed around 50% of the initial EUR 1.6 billion from the Xavex hedge fund product – reflecting some on-boarded learning as to what to buy, when and certainly at what cost.

Germany is probably not a ‘sprinters’ market, but rather a cautious and enduring ‘marathon’. Institutional investors in Germany want access to best of breed and will iteratively work their way there, hand in hand with the authorities, to ensure they are not paying for cheap and/or nasty compromises.

More specifications as to the application of the law are expected from the authorities in June.
Florian Hach, ehedge AG, Frankfurt