When Germany liberalised its rules governing hedge funds and taxation of their income at the beginning of 2004 the initiative was hailed in some quarters as a new dawn for the sector. If Germany, with its tradition of conservatism in investment choices and reputation for pernickety rule-making, could embrace hedge funds and funds of hedge funds, the argument went, the rest of Europe and other markets around the world would surely soon be following suit.
With two related pieces of legislation, the German Investment Act and the Investment Tax Act, the authorities sought to put in place the conditions to encourage the growth of a domestic hedge funds industry. At the same time they made it easier for funds to attract customers by increasing the extent to which institutional investors such as insurance companies could invest in hedge funds, and even set in place rules that would allow retail investors to invest in funds of hedge funds.
The Investment Act authorised the establishment of hedge funds either as part of an investment company, known in Germany as a KAG, which provides administration services to the funds set up under its aegis, or in the form of an investment stock corporation, an open-ended fund vehicle modelled on the Luxembourg Sicav that has lower regulatory, reporting and capital requirements than a KAG.
The German reforms were hailed at the time as part of a widespread opening of European markets to hedge funds, also embracing countries such as France and Italy, especially because one of the key features of the legislation was that domestic hedge funds and funds of funds were placed on the same tax basis as foreign funds, as long as the latter followed the same rules in areas such as tax transparency and investment restrictions.
There was speculation that with the floodgates opened, as much as EUR8bn might flow into German hedge funds in the first year following market liberalisation. But in fact, the total was less than EUR1bn, and more than 80 per cent of the total was attracted by funds of funds set up according to the German rules but across the border in Luxembourg. Even now, the sector's total assets amount to just EUR2.3bn It must be said that the political and economic environment was far from ideal. During last year's general election campaign, Franz Muntefering, at the time secretarygeneral of the ruling Social Democratic Party, famously described hedge funds as 'locusts' after investors in Deutsche Börse, the company that runs the Frankfurt Stock Exchange, thwarted its efforts to acquire the London Stock Exchange as well as ousting the failed merger's architects, chief executive Werner Seifert and chairman Rolf Breuer.
Meanwhile there was also concern about the practical impact of the 2004 reforms. Foreign hedge managers complained that despite liberalisation of the establishment and marketing of hedge funds, they were hamstrung by rules requiring that hedge funds and funds of funds provide transparency regarding the source of income, such as dividend income or capital gains, of any distribution to investors or 'deemed distributions', revenues received by the fund but not distributed.
If funds meet the full information requirements set out by the Investment Tax Act, their investors will be taxed as though they had invested directly in the assets held by the fund, or in the case of a fund of funds, in the assets held by the underlying target funds. By contrast, for investors in funds that are not transparent, taxable income is defined as all distributions received plus 70 per cent of any increase between the first and last redemption prices of the calendar year, or six per cent of the final redemption price of the year, whichever is the higher.
It was initially assumed that most hedge fund managers would be unwilling to provide the kind of information required by the tax authorities because it would rip away the confidentiality of their investment strategies. Promoters such as Pioneer Alternative Investments started to design fund of fund products based on their own families of single-manager hedge funds on the basis that this was the only way to guarantee transparency of the underlying target funds. At the same time, the greater ability of investors such as insurers to invest in hedge funds appeared to be meaningless because of the additional risk monitoring efforts they would have to put in place. Says Werner Goricki, hedge funds director at investment consultants Feri Trust: 'Insurers [were] publicly questioning why they should spent 50 per cent of their time on investments that might make up just three per cent of their portfolio.'
However, despite the slow start to domestic hedge funds business, the association of German fund managers (BVI) never lost faith in the ultimate development of the sector. 'The first year of implementation of the new investment law may have been slow, but it is important that the hedge fund industry grows steadily, through a process of education of private and institutional investors alike,' BVI spokesman Frank Bock said at the time. 'Eventually we believe that allocations to hedge funds will be in double digits.'
More than two and a half years after the legislation came into force, it's looking as though the confidence of the association may be justified. While there is no sign yet of a flood of investment into German hedge funds and funds of funds from either private or institutional investors, market participants say the vital development is that the barriers to both providers and investors are demonstrably coming down.
One of those barriers is the psychological one. 'The mistrust of hedge funds is disappearing,' says Jörg Sittman, general manager and chief operating officer of Citigroup Investment Deutschland KAG, one of the leading third-party service providers for hedge funds. 'There's no longer discussion about Deutsche Börse, which has other problems, and in the meantime the economy is doing better and the government is benefiting from an unexpected increase in tax income. As a result of all these things people feel more relaxed about hedge funds than a year ago.'
At another level, one of the most important realisations has been that tax transparency does not require managers to provide details of their strategy, which means they are much more likely to be willing to comply with the German rules. Says Sittman: 'There has been a misunderstanding. A tax certificate does not mean that everybody knows all the underlying investments in the fund. It just shows the aggregated tax numbers on what kind of gains and income the fund has received. You really cannot see the strategy behind it.'
In order for fund of hedge fund investors to benefit fully from advantageous tax treatment, tax transparency information must be provided by all underlying funds; for those that do not, taxation is governed by the formula applicable to non-transparent funds. Says Sittman: 'You have to get the tax numbers from the underlying target funds, and then the auditor, or we as the KAG, combine all the different certificates into a single certificate for the fund of funds.' A number of providers are setting up facilities to help funds to achieve the required tax transparency. One has been created by HSBC in partnership with hedge fund administration software provider Advent Geneva, with advice from Pricewaterhouse Coopers; completed last November, it now provides tax transparency to around 25 hedge funds, mostly serviced in the US and Ireland, that are in the main targeting investment from German-domiciled funds of hedge funds.
According to Claude Noesen, client relationship manager with HSBC Alternative Fund Services in Luxembourg, the group was wary from the outset of the excessive expectations that accompanied the opening of the German market and always viewed its involvement, including the creation of a structure to service German-domiciled hedge funds, as a long-term project.
'We always knew that it would be slow, but we still decided to move in into the market,' he says. 'It looks better now, as we see signs that a number of large traditional investment houses are starting to add alternatives to their offering. On the single manager side the issue is getting people to leave the banks. It's not like in New York, where talented traders will suddenly decide to start their own hedge funds. There have always been good traders, good arbitrageurs in Germany, but to get them out there is very difficult.'
One conclusion that many market participants have reached is that setting up a hedge fund using a Master KAG that handles administration for all the funds belonging to the structure, leaving the manager to focus on investment management, marketing and distribution, is preferable to using a standalone investment company.
Says Sittman: 'Without a Master KAG, if you want to set up a new fund you have to go through the whole procedure of setting up a fresh legal entity. There are currently only two in the market, and it is very expensive because it is a highly regulated entity with a full licence, board of directors and auditors, just for one fund. The Master KAG is the fastest and cheapest way to set up a fund because overheads and costs such as audit are shared across more than one fund.'
Citigroup estimates that German investment in hedge funds is fairly evenly divided between retail investors, high net worth individuals and families, and institutions, but it is in the latter market that potential for growth is greatest. Says Sittman: 'The interest of insurers is increasing, but their problem is that under the law governing insurance companies, they can only invest up to one per cent of their capital in one single hedge fund, and up to five per cent in a fund of funds.
'However, this might change at the beginning of next year. There are proposals to increase these levels, because institutions have to beef up their risk control systems. They are less keen on the effort required to do due diligence if the investment is only one per cent, so they want to invest bigger amounts into one fund. Still, Allianz, Germany's biggest insurance company, has certainly invested in hedge funds already.' Sittman argues that for many institutional investors an allocation to hedge funds is only a matter of time. He says: 'On the institutional side people have now looked into the funds. They always need about six months to look at the track record, do due diligence, and then they start to undertake all the internal approvals that they need before they can invest. So the second half of the year is looking good, and once there is a change in the law and the insurance companies can invest more, it will give the market a further push.'
Noesen says that while institutions are 'right at the beginning of the curve' toward investing in hedge funds, they are already enthusiastic investors in other types of alternatives. 'Germany is very big on private equity and property funds,' he says. 'That's why it's strange that there was such a bad feeling about hedge funds. In Germany, they put container ships into funds, wind farms, movies, things that can be a lot riskier than hedge funds. They put everything into funds.' There is already evidence that momentum is building, he argues. 'We are now seeing a lot more demand, including from institutions we were talking to two or three years ago when people thought [hedge funds] was an easy game. It turned out not to be the case, but it is promising that some of these names have popped up again. We used to have something like EUR250m [under administration] a few months ago, but now we are approaching the EUR1bn mark. This will increase as the insurance industry and pensions funds in Germany open up to alternative investments.'
Another change that market participants would like to see is a lifting of restrictions on borrowing by funds of hedge funds. This is designed to prevent them using leverage but its effect is to deny them liquidity to deal with eventualities such as redemptions. Says Noesen: 'Some of the rules are extremely cumbersome, such as the inability of funds of funds in Germany to have a liquidity line to help in cases like redemptions. 'That's something that makes funds of hedge funds nearly impossible, and results in most fund of fund structures being created through managed account platforms instead. However, it is hoped that this will change when they review the legislation at the end of this year or beginning of next year. If the clause is changed, funds of hedge funds would be able to take credit lines, not for leverage but for liquidity purposes. That would be very good for the market.'
Growth of direct retail investment, however, is being held back by competition from investment certificates, structured products that provide a guarantee wrapped around funds of hedge funds. 'This is already a huge market in Germany, and is now worth more than EUR20bn,' Noesen says.
Says Sittman: 'Certificates have an advantage compared with hedge funds that after 12 months their income is tax-free, but their disadvantage is that they are very expensive because of the structuring costs in the fees, and they are not very transparent. As people become more involved in hedge funds they are starting to see that they have to pay for the structuring of the certificates. This is persuading some people to invest directly in the funds, because they have lower costs.' In addition, he says, institutional investors have to consider have issuer risk, for example if they place 50 per cent of their investment in certificates from a single large issuer. But neither that nor the structuring costs are likely to make much difference in the retail market. Says Noesen: 'Certificates may not very efficient and their charges may be high, but they are an established product, and people like them. Remember that Germans still had savings books when the rest of the world had long discarded them.'