Dr Sven Zeller, a partner in the Frankfurt office of Clifford Chance, outlines the latest regulations for hedge fund investments by German insurance companies.
A complete opening of Germany as a financial centre for hedge funds (which are now regulated by the German Investment Act (InvG)) would not be possible without modifying framework conditions for investments by insurance companies, which form the largest group of institutional investors.
Currently, institutional investors are planning to increase their hedge fund investments fivefold, which will then represent about 3 per cent of their total investment portfolio.
Against this background and in view of the provisions of the new Investment Act, the revised Regulation on the Investment of the Restricted Assets of Insurance Companies, referred to below as the "Investment Regulation" (Anlageverordnung) came into force in August 2004.
This Regulation stipulates in detail what investments may or may not be made by insurance companies and defines specific limits regarding both the amount and the objects of such investments. Under the Investment Regulation, insurance companies may now invest in hedge fund products to a greater extent than was previously the case.
This includes not only investments in hedge funds and funds-of-funds, but also investments in certain structured products, as described in more detail in the circular 7/2004 (VA) issued by the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) in this regard.
Up to now, the Federal Financial Supervisory Authority allowed such investments only within the limits of what is known as the "savings clause" (Öffnungsklausel), under which insurance companies may invest up to 5 per cent of their restricted assets in financial instruments that are not explicitly referred to as "permissible investments" in the Investment Regulation. This investment limit may be increased to up to 10 per cent with the approval of the Federal Financial Supervisory Authority.
However, up to now insurance companies hardly ever invested in hedge fund products, having to comply with general investment principles regarding security, profitability and liquidity and because insurance companies generally preferred to use the said savings clause for other types of investments.
Under the new Investment Regulation, up to 5 per cent of the restricted assets of an insurance company may be directly or indirectly invested in hedge funds without making use of the savings clause, i.e. without being regarded as part of investments made under that clause. The only qualification to this new rule is that it only applies to hedge funds where the issuer is domiciled within Germany or the European Economic Area (EEA). However, most well-established and renowned hedge funds do not meet this requirement, which excludes many interesting hedge fund investment opportunities.
Investments in hedge funds launched by non EEA-issuers continue to be possible only within the limits of the said savings clause. According to internal estimates made by market participants, the volume of the hedge fund market would increase up to EUR 30 billion if only the top 10 per cent of Germany's 700 insurance companies were to make use of this 5 per cent quota. This would make the overall volume of the German hedge fund market rise to more than EUR 50 million over the five years to come.
In principle, up to 5 per cent of the restricted assets of an insurance company may be invested in one particular funds-of-funds and in one highly diversified investment product. Due to risk limitation considerations, not more than 1 per cent of such assets may be invested in one single hedge fund. Nor may insurance companies invest restricted assets in more than two single hedge funds of the same issuer or managed by the same funds manager. Investments in single hedge funds investing more than 50 per cent of their assets in other hedge funds are also not permissible.
In view of the risks potentially involved in hedge fund investments, all direct and indirect investments in such funds are considered to be risk capital investments, the quota of which may not exceed 35 per cent of all investments. Due to a general lack of long-term experience and the increased risk potential of single hedge funds, most insurance companies will probably focus their hedge fund investments in funds-of-funds for the time being.
The success of a hedge fund investment depends to a considerable degree on the timing of the investment, the choice of the right investment strategy, and the strict implementation of that policy by the fund manager. Consequently, the due diligence, manager selection and risk management requirements are high.
For successful hedge fund investments, insurance companies will have to employ qualified staff who must be sufficiently familiar with hedge fund trading strategies and who must be well aware of the risks involved in hedge funds operations. Given the complexity of the matter and the risk of a 100 per cent loss of hedge fund investments, it is essential to gather any information that may be required for a prudent investment decision, including details regarding the organisation, management and investment policies of the investment companies. Questionnaires drafted for this purpose are available and may be helpful.
The object of investments, the investment strategy and the risk profile need to be permanently monitored to ensure effective risk management. Insurance companies are required to ensure that they receive acknowledged risk indicators at regular intervals as well as appropriate evidence of the true value of any single hedge fund or fund-of-funds they have invested in.
It is permissible for insurance companies to outsource all their risk management activities. Appropriate internal rules must be developed to ensure the smooth implementation of the above procedures. These rules must be communicated to the Federal Financial Supervisory Authority and compliance with them must be appropriately supervised.
The board of directors and the supervisory board must be informed on the development of hedge fund investments at regular intervals of not more than three months. The Federal Financial Supervisory Authority must also be informed on a quarterly basis of any new hedge fund investments as well as the total volume of all investments in such funds.
All in all, and irrespective of the extension of the investment spectrum, the new Investment Regulation represents nothing more than a first step forward as far as hedge fund investments are concerned.
Further steps towards greater liberalisation are to be expected once that both the Supervisory Authority and potential corporate investors have gathered greater experience with investments of this kind.
This is a translation of an article prepared for the newspaper 'Handelsblatt' 'by Dr Sven Zeller, a partner in the Frankfurt office of Clifford Chance, who practises in the banking and capital markets group. His practice has a specific focus on funds, the use of derivatives in fund management and on all customer-related aspects of derivatives and hedge funds. He is an IBA-Member, was lecturer at the European Business-School and published 90 articles in the banking sector.
Dr Zeller was head of the legal department of Union Investment group from 1990 to 1998. In this position he was also a member of the Legal and Tax Committee of the Federation of German Investment Companies (BVI) and lecturer at the Academy of German Cooperatives in Montabaur. Previously, he worked with Deutsche Verkehrs-Bank AG as deputy head of the legal department and head of public relations.