Institutional market poised for take-off
The change of the law in 2004 allowed hedge funds and funds of hedge funds to be launched under German regulations for the first time. Under the German rules, a Master KAG - service company for hedge funds - can take charge not only of the administration of a fund but its launch, registration and ongoing reporting, leaving the fund manager to focus on the investment management, marketing and the distribution.
A key element of reporting is the tax certificate produced by the auditor, which is necessary for a transparent fund in order to allow German investors to be taxed on the underlying gains of the fund, whether income or capital gains, according to their own individual tax rate. But a widespread misunderstanding about the nature of tax transparency and reporting is one of the factors that have delayed the take-off of the German hedge funds sector.
German investors like transparent funds in order to have clean and straightforward tax reporting. However, a tax certificate does not mean that everybody can see the underlying investments in the fund; it just shows the aggregated numbers on the type of earnings, the mix of capital gains or income, the fund has received. It is impossible to detect the strategy followed by the fund from its tax certificate. In the case of funds of hedge funds, the KAG must obtain the certificates from all the underlying funds, and it or the auditor combines these into a single certificate for the fund of funds.
Initially these concerns about confidential investment information were an impediment to fund managers entering the market because many regarded the rules as too onerous. Now, however, leading hedge fund administrators have changed their systems in order to be able produce tax transparency statements for the funds they service in Luxembourg or Ireland.
The issue of tax transparency was not the only hurdle that the hedge fund industry had to overcome in Germany. Another was the poor public image of hedge funds at the time of the debate, now more than a year ago, about whether they were 'locusts' destroying companies and whether they were good for the German economy.
In fact the debate has ultimately been beneficial because it has greatly boosted knowledge of hedge funds and their strategies, and has also helped people to understand the difference between hedge and private equity funds, which were frequently confused in the past. Thanks in large part to extensive coverage in the press, individual and institutional investors in Germany are becoming much more familiar and comfortable with hedge funds. Another obstacle was that insurance companies that wanted to invest in hedge funds had to establish risk-monitoring systems for their investments. This was an expensive procedure, although one that is largely complete, and most experts now believe insurance companies will now start to exploit the relaxation of investment rules in the 2004 legislation that increased their permitted allocation to hedge funds.
A final factor that points to the belated take-off of the hedge fund sector in Germany is that long-only investment may not enjoy as favourable a climate as it did in 2005. In an environment where the blue-chip DAX index gained 20 per cent last year, it was hard to interest investors in hedge funds. But with no guarantee that the equity market will be as irresistible to investors this year, the moment seems to have arrived for German hedge fund investment finally to start fulfilling its potential.
By Jörg Sittman - general manager and chief operating officer of Citigroup Investment Deutschland KAG
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