3. Germany- a new hedge fund market
Local regulations have until 2003 been a major constraint to launch hedge funds in Germany, and have prevented German investors from directly investing in non-German funds.
To satisfy the increasing demand for total return products, most of the German market participants have developed structured products linked to hedge funds. Hedge fund certificates have been sold to retail investors as well.
Germany's finance minister Hans Eichel in March 2003 announced a new German Investment Act that came into force early in 2004, covering:
* The regulation of German and non-German hedge funds;
* The sale and marketing of German and non-German hedge funds;
* Changes to the tax treatment of non German funds;
* Additional opportunities for traditional mutual funds (for instance the possibility of acquiring leverage and short market exposure via derivatives);
In the new Investment Act (Investmentmodernisierungsgesetz) hedge funds are explicitly defined as a separate asset class. They are funds with:
- Additional risks that comply with the principle of risk diversification;
- No limits regarding the choice of assets that are permitted under the German Investment Act;
- Possibility of short sales or unlimited leverage.
German hedge funds must use a depository bank, which must also be located in Germany, or a "comparable institution". Among other things, the depository bank is the guarantor of the investors' interests. There can be Single Hedge Funds or Funds of Hedge Funds.
As the German market will still be a thoroughly regulated one, the repackaging techniques developed by investment banks to distribute non-German hedge funds (i.e. certificates) may remain important.
Also, given the reporting and transparency requirements, I expect that those "foreign" hedge funds, which want to attract German investors, will set up parallel vehicles, next to their flagship fund, compliant with the German regulations and tax reporting.
Consequently, there will be opportunities for managed account platforms, as long as they support compliance with German tax reporting rules.
German Single Hedge Funds
German single hedge can be set up as Investmentaktiengesellschaft (similar to SICAV) or as "Publikums-Sondervermögen" without public offering (pooled assets with no legal personality, managed by an investment management company or KAG). Units of these funds will in this case be available to private investors and institution but only via private placement. There will be no minimum investment requirement for single hedge funds.
Units of German and non-German single hedge funds can be distributed to private investors. The most likely choices for the legal domiciliation of a non German fund targeting German investors may be Luxembourg, Ireland, Jersey (they comply with the requirement of keeping their assets in safe custody with a "comparable institution" to a German Depotbank).
The portfolio management can be outsourced. A German institution could set up the framework for an on-shore hedge fund, and its management could be contracted out to an established "off-shore" manager.
If certain reporting requirements are satisfied by the hedge fund, the tax treatment of German investors will be favourable.
The role of the prime broker needs to be revisited and adapted to the German regulatory framework. Traditionally, in order to fulfil its functions, a Prime Broker traditionally acts as custodian of hedge funds' assets. Consequently the requirement that Germany-domiciled hedge funds use a depository bank (also domiciled in Germany) needs to be reconciled with the presence of a prime broker.
Deutsche Bank is in a position to offer prime brokerage services to German hedge funds in line with the German framework. Deutsche Bank's solution combines the presence of a prime broker and a depository bank under a model denominated "direct nomination": the investment manager appoints the depository bank, and then appoints the custodian (i.e. the Prime Broker). This segregates clearly the responsibilities of the depository bank for monitoring from those of the Prime Broker/Custodian for clearing, settling, safekeeping, equity financing, securities lending services.
This model has been implemented for the first equity based German domiciled hedge fund that is currently awaiting approval by the authorities.
German Funds of Hedge Funds
To reflect the principle of risk diversification, a German fund of hedge funds will have to invest in at least five different target funds. It will, therefore, not be permitted to invest in a single target fund only (no master feeder funds).
Units of German funds of hedge funds may be distributed to private investors, and publicly marketed.
German funds of hedge funds will be prohibited to short sale or leverage themselves
There will presumably be no restrictions on the registered domicile of an eligible target fund. A German regulated fund of hedge funds will be permitted to in invest in non-regulated target funds, but target funds have certain reporting duties to the fund of funds manager.
Most likely the "target" funds will need to keep their assets in safe custody with a depotbank or "comparable institution".
Funds of hedge funds will not be allowed to invest in more than two hedge funds by the same issuer or fund manager.
Non-German funds of hedge funds may be registered for public distribution in Germany. Otherwise, foreign funds of hedge funds can be distributed by private placement, and can achieve a favourable tax treatment subject to similar reporting duties as for non-German single funds.
The Insurance sector reform act
The Insurance Sector regulation will be reformed to bring it in line with the provisions of the new Investment Act.
One of the most important expected changes is the possibility to invest up to 5% of their "committed capital" in Hedge Funds. This creates an important new group of hedge fund investors.
The German investment reform act may bring about a significant contribution to the growth of the European hedge fund market, hopefully releasing the potential of a very important market.
The launch of single strategy funds in Germany is expected to grow in a steady fashion, following a period of market adaptation to the new rules. Nevertheless, the German market may well become the second largest in Europe next to London.
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