An increasing number of hedge fund players recognise the potential in Germany following a relaxation of strict investment laws, but there are good reasons to base any such products in Luxembourg
While the flood of fund registrations that were expected in Germany following the relaxing of the investment tax laws at the start of 2004 has not yet happened, a few providers are making the first steps into the German market.
Some, such as DWS Investments, have already launched products for Germany's various investor groups, and Threadneedle has branched into funds of funds with a Luxembourg-domiciled fund privately placed and awaiting possible approval for retail distribution. Yet it is still unsure if the market will take off, despite the predictions of a German appetite for onshore hedge funds.
David Aldrich, head of securities industry banking in Europe for the fund of hedge funds administrator Bank of New York, says Threadneedle opted to establish a Luxembourg Sicav, which could then be distributed into Germany, rather than simply setting up a German-domiciled nd regulated fund of hedge funds. He cited three reasons for this decision.
"The main reason people are choosing to go to Luxembourg rather than Germany is that there are established hedge fund administrators in Luxembourg (and Dublin). Secondly, a lot of the clients are used to buying Luxembourg-domiciled products. Finally, the service providers in Germany are not set up at all to deal with hedge fund investment, although they all want to be.
"Being a hedge fund administrator is a scale game, involving technology and expertise far beyond the norm for regular long-only products."
Aldrich says that while relatively thin staffing levels at Luxembourg regulator CSSF mean the approval process can take six to 12 weeks, the situation is worse at Germany's regulator, the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), because of the shallow talent pool available to staff the regulation of hedge funds.
Sven Zeller, a partner with lawyers Clifford Chance in Germany, says that while regulators can take time to approve funds, the problem of authorisation often lies with the client. "You can have to restructure some companies or redraft agreements. So, in the background of the FoHF, you can have a lot of changes to the decisions before filing documents with the authorities."
He adds that if all the documents for authorisation are correctly submitted to authorities, you could work on the basis of a four-week turnaround.
A further hitch for applicants can be that, for funds wanting to apply for German retail distribution, they must also be 'seasoned' in their home domicile for three months before application is made to the BaFin.
"You do not get approval from the German regulator," Zeller says, "you only get a letter saying this decision is completed, and then there is a three-month waiting period." Ucits funds need to factor in a two-month period.
"The BaFin sets out what documents are needed for the notification process, and then the CSSF sets out what they need. The core regulator will be the CSSF and the host BaFin which, because it is a non-Ucits fund, checks all the documents twice."
An Irish- or French-domiciled fund also imposes translation requirements for German authorisation, Zeller notes, potentially prolonging authorisation further. But German investors, as a rule, like Luxembourg funds.
"Getting approval in Luxembourg takes a while to get done," concurs Aldrich. "In the summer, all the press was talking about distribution of funds into Germany. The general public did not anticipate how long it would take. Throw another jurisdiction on top of that, such as Luxembourg, and the main requirement for the manager is patience."
Under Germany's updated investment laws, the concept of a depot bank for a retail fund of hedge funds brings with it a level of accountability that does not exist in other jurisdictions' regulations. While Aldrich notes Luxembourg's regulators are happy about custodians taking on this extra level of liability if they so wish, "effectively (under German law), the depot bank becomes ultimately responsible for the performance of all of the parties in the chain."
He explains: "Theoretically, it could be liable for reimbursing investors for wrongly stated net asset values (NAVs) or errors in the investment process. The effectively unlimited liability is much greater than the custodian would normally have for other fund products."
Normally, a custodian will not be responsible for the activities of a sub-custodian, and there is no concept of the investor having to be compensated by someone else in the chain of service providers to, and managers of, the fund.
"As a depot bank you can't say 'It wasn't me'; you have to take the hit," Aldrich says. "Then you may be able to sue people down the line, but it is a very protective environment. That goes further than Luxembourg law and other jurisdictions, so the net result for the administrator and depot bank is you need a longer lead time in negotiating your first transaction."
"When there are only a few people in the marketplace leading the way on this type of product, you go the most obvious route," Aldrich says. "And there are a lot of Swiss institutions and European banks that are very comfortable with Luxembourg and the level of regulation there."
While German institutional investors can access offshore funds, for retail distribution in Germany the vehicle must be an EEA fund, so Luxembourg satisfied this criterion as a domicile as well.
The process of bringing an offshore-domiciled, retail-ready, multi-strategy fund of hedge funds to Germany is further complicated by legal counsel having to gather preliminary, non-binding comments from two regulators on fund documentation and structure before submitting the vehicle for regulatory approval in either jurisdiction.
Aldrich says the process in structuring documentation involves first regarding Germany's regulations and roles and responsibilities under German law, and then seeing how these compare with Luxembourg. Standard contracts for Luxembourg funds are then modified to fit both jurisdictions.
In each country it is crucial to get counsel that understands the regulators' thinking and has a relationship with the regulators, and can interpret CSSF's and BaFin's comments to ensure that both regulators are fully in agreement with both your direction and implementation.
"In Germany, you are doing most of the conversations through the legal counsel, but it is more of an iterative process than a straightforward directional conversation, because the regulator is trying to interpret legislation, which is not particularly clear and in many cases the guidance notes by BaFin are sometimes in minor conflict with the legislation.
"So, interpreting the legislation and the intent of the legislation and also understanding how BaFin intend to interpret the rules themselves is more art than science."
However, the additional work is more than compensated for by other factors of having a Luxembourg domicile for German distribution.
Another alternative would have been simply to produce hedge fund certificates, which have historically been the most popular route - not least for tax reasons, German investors could access hedge funds - based on an existing hedge fund products.
Given that less than e1bn of total investments into hedge funds by Germand - estimated to be around e10bn - have been directly in hedge funds, this may seem the path more trodden and familiar.
Aldrich notes that having established the Luxembourg-domiciled portfolio does not preclude basing certificates off it, while new investment laws also allow all investors to make direct, unstructured investments into funds of hedge funds.
"Institutional investors will not be big buyers of structured products, which are more aimed at high net worth individuals and retail and have higher total expense ratios than simple fund structures," Aldrich says. "The primary goal of this fund was to get institutional distribution and, as a secondary goal, retail distribution, which really requires a regular fund structure."
With the relaxation of investment legislation in Germany, many hedge fund managers are setting up hedge funds in Europe.
However, Luxembourg is still regarded as the premier centre for funds because of its focused ancillary services.
Where BaFin stands on hedge funds
Single hedge funds
• No definition offered, but use of leverage and/or short selling required as characteristic investment strategy.
• Permitted investments include securities, cash/money market instruments, derivatives including cash settled commodity futures, participations, precious metals and investment units.
• Redemptions required at least quarterly with period up to 40 days.
Funds of hedge funds
• No leverage at FoHF level and no short selling.
• Investments only in target hedge funds, bank deposits and money market instruments, only interest rate and currency swaps/options permitted.
• Foreign underlying funds must be comparable to German hedge funds.
• Redemptions required at least quarterly with period up to 100 days.
• Maximum 20% in any one target fund.
• Maximum two funds in any one investment manager or issuer.
• Target funds may not invest in other hedge funds.
• No investment in target funds from states that do not co-operate in fighting money laundering.
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