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Comment: Existing regulations for hedge funds and funds of hedge funds should be relaxed in upcoming revision of German Investment Act

Dr Sven Zeller, partner at Clifford Chance, and Patrick Schmidt, associate at Clifford Chance, say that more needs to be done to improve Germany's legal framework for hedge funds.

The total value of all hedge funds worldwide is more than USD 1 trillion, but regulators and investors have little idea of how and where the money is invested. In recent weeks, the calls for international regulations to increase hedge fund transparency have again started to grow louder.

Nevertheless, it needs to be recognised at the national level that capital is shy and will avoid regulation wherever possible. The experiences with public mutual funds (Publikums-Sondervermögen) have shown that concentrating solely on national regulations often leads investment firms to look abroad where the regulatory framework is less stringent. This means that any country introducing strict regulatory provisions is likely to put off both investment firms and investors.

It is therefore very encouraging that the draft of the revised German Investment Act (Investmentgesetz), published on 18 January 2007, did not contain more stringent regulations for hedge funds. However, the liberalisation measures provided for in the aforementioned bill are regarded by those in the industry as purely "cosmetic changes".

The fact that a mere 25 single hedge funds and only 15 funds of hedge funds have been launched in Germany in the three years since the implementation of the German Investment Act, and that the total amount invested in them is considerably less than expected, indicates that the legal framework for hedge funds in Germany needs to be improved to make it more competitive on the international stage.

The investment options eligible for single hedge funds need to be expanded to include real estate, foreign currencies and, above all, non-securitised receivables. The latter would, for instance, allow the implementation of distressed debt strategies.

Another issue which needs to be looked at is the fact that public distribution of shares in single hedge funds remains prohibited under German law. At least, public distribution of shares in single hedge funds to institutional investors should be allowed. Another area to look at would be the restrictions applying to insurance companies with respect to investments in single hedge funds.

The regulations concerning funds of hedge funds also need to be relaxed. German funds of hedge funds may only invest in foreign target funds, if they operate under an investment policy and investment restrictions comparable to those applying to German single hedge funds.

The difficulty lies in the fact that many successful foreign single hedge funds are subject to far fewer restrictions than their German equivalents and obviously see no benefit in voluntarily submitting to German restrictions or meeting the transparency requirements which apply under German tax law. This means that German investors are denied access to a number of successful single hedge funds via regulated funds of hedge funds, which considerably diminishes the attractiveness of German funds of hedge funds. It would therefore make sense to relax the comparability requirement and the tax transparency requirements.

Another sensible move to solve liquidity squeezes for funds of hedge funds would be to allow the postponement of redemption payments. This possibility is provided for in the draft of the revised German Investment Act, but the actual concept does not go far enough. Any such provisions included in a fund's sales documentation have thus far been regarded by the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) as an inadmissible borrowing by the fund of hedge funds.

In the case of particularly extensive applications for the redemption of shares, a fund of hedge funds should be able not to accept all applications for the redemption of shares at such time in order to protect the interests of the other investors. Another issue is the fact that the required warnings concerning the risk of total loss and the requirement of written form do not help to make hedge funds popular with investors.

The risk of a total loss on funds of hedge funds is just as unlikely as it is for other diversified investment undertakings. Reducing red tape by abolishing the requirement of written form when purchasing shares in funds of hedge funds is quite compatible with investor protection.

It can therefore be stated that the introduction of single hedge funds and funds of hedge funds in Germany under the German Investment Modernisation Act (Investmentmodernisierungsgesetz) has been a welcome first step.

The upcoming revision of the German Investment Act should be used as a second step to increase the attractiveness and competitiveness of German hedge funds and funds of hedge funds by relaxing the existing regulations.

(This a translation of an article that was first published in the edition of Handelsblatt dated 26 March 2007)

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