12/11/2009 Author: Gwyn Roberts

Germany's turning point

Despite a new centre-right coalition in government, Germany's current stance on alternatives is one of well-established suspicion and stand-offishness. But with growing interest in the Ucits space, and the prospect of EU regulation calming investor nerves, could it be time for hedge funds to make inroads into the heart of Europe?

In 2009, politics became as confusing and counterintuitive as the markets. This year, the paternalistic BBC allowed a fascist party airtime; free-market fanatics have eviscerated bankers’ bonuses; even America looks set to gain a publicly funded healthcare system. If these are strange days, perhaps the ultimate demonstration of our topsy-turvy times arrived last month, when the re-election of Germany’s Chancellor Merkel defied the conventional logic that governments cannot survive recessions.

Swept to power, Merkel’s impressive victory also demonstrated that, post-2008, the fiscal attitudes of the European right and left have blurred. With the Chancellor now heading Germany’s first centre-right administration in 11 years, political cliché should paint a clear picture of the nation’s nascent hedge fund industry in the ascendance. Instead, there is little joy among Germany’s small cadre of managers. The country’s alternatives canvas remains smudged by confusing tax structures, wider European politicking and even the emergence of a domestic hedge fund scandal, in the shape of K1.  

Yet, in another counterintuitive twist, change could be afoot. While the taint of an alleged $300m fraud is bound to bother hedge fund-phobic German pension funds and insurance companies, the need to diversify and the
current popularity of absolute return-style Ucits III products could outweigh inbuilt Teutonic reluctance to allocate. It’s an attitudinal shift that Stefan Heieck and Frank Siebrecht, who both managed Absolute Capital’s Germany Fund, are gambling on as they prepare to launch a new product for German investors.  

“The new government that came in place in September is corporate-friendly and that is something we need in Germany,” said Jacobse. “That will give a boost to the economy.”

Hedge funds are also seen as potentially useful in a country where institutional portfolios are inadequately diversified. According to Feri Rating & Research, only 23% currently invest in alternatives, but more than half are planning to. Even traditionally conservative German foundations – last year the charitable Hertie Foundation announced plans to increase its allocation from 1.5% to 5% – have expressed an interest in the space, although the pace seems painfully sclerotic.  

Clearly, manager and investor will is in place, but politically the situation remains complicated. Gone is Franz Müntefering, the Social Democrat who branded hedge funds as locusts in 2006; he and his party pushed out of joint-power by the new more economically liberal Christian Democrat-Liberal coalition. If this were America, fans of deregulation (and schadenfreude) would be celebrating. Instead, Germany’s Bundestag remains a tough nut to crack.

Given its staunchly fought-for position as Europe’s only gross exporter – the China of the West – Germany has never been a natural home for the hedge fund sector. Now that Merkel has returned to power, relieved of the burden of a Social Democratic partner, she is still in no mood to liberalise the German economic scene. The new German government may lower taxes at home, but is unlikely to embrace wider free market reforms. While on the international stage the Chancellor will still stand side by side with a hawkish French premier, who favours strict financial legislation and the introduction of the draft AIFM Directive in its original draconian format.

“A few managers may be excited, but why will anything change here?” questions Jochen Kindermann, a lawyer with Simmons & Simmons’ Frankfurt office. “There is no guarantee that the new government will do anything to encourage a larger hedge fund sector. At this point we just don’t know what will happen.”   

And if the new German government – despite its changed political hue – is unresponsive to hedge funds, German financial institutions are similarly nervous. Last month, HFMWeek revealed that Commerzbank was leaving the hedge fund space. Prior to that, Allianz had sounded a similar retreat.

However, for every retiree there is a new entry. Frank Dornseifer of the Bundesverband Alternative Investments (BAI), Germany’s Aima equivalent, reports German hedge fund numbers to be static and stable with an average of 40, while investors, according to Kindermann, are clamouring to access the market as they attempt to diversify investment portfolios that ground to a halt during last year’s dislocation.

Obvious early interest hasn’t quite translated as a hedge fund boom. At a recent educational event held by the administration company iFina at Frankfurt‘s Deutsche Borse, the attendance was poor. “You should have seen Zurich‘s event yesterday,” said the firm’s Derek Adler, “we expected there to be more interest from Frankfurt.”
Hamstrung by cumbersome investment limits, hedge funds still see Germany as a difficult play. “There is some interest, but it is very small,” says a Deutsche Borse source. “German institutional investors can only place 5% in hedge funds, plus they’re too conservative – why would German hedge funds want to set up, or foreign hedge funds want to register, when it’s so tough? We are still far away from a real industry.”

It’s clearly not just in-built antipathy or the locust-factor hurting the sector. In the shape of 2004’s Investment Modernisation Act (IMA), the then-German government – including Merkel and the Social Democrats – tried to create an environment where homegrown hedge funds could thrive and foreign funds could trade with impunity. However, a well-meaning attempt to foster a domestic hedge fund industry has been hampered by the stipulations of the same year’s German Investor Tax Act and its allergic reaction to anything deemed opaque.

Germany’s tax transparency – in many ways a precursor to the AIFM – has hurt the sector. Rigid and flawed, it demands transparency, asset segregation and liquidity. Meaning, during the hedge fund boom years, Germany was the only location where growth was pegged back from a high of 42 funds in 2005 to 41 in 2008.

Non-transparent funds, those that don’t comply with the tax act’s reporting requirements, are also subject to a punitive tax rate of 6%, a figure that is calculated on redemption valuations. According to Dornseifer, it is a situation that turns off investors, as well as German hedge funds and foreign funds, which frequently have to recalibrate fees and jump through excessive reporting hoops to stop investors being penalised. Little wonder that the homegrown market has stalled in 2009 with just €1bn ($1.5bn) in AuM.

In the past there has been a convenient solution. Traditionally those who wanted to avoid these requirements have invested in hedge fund certificates, a form of structured product traditionally distributed by domestic banks. If Germany only has €1bn ($1.5bn) in homegrown hedge funds, more than €20-25bn ($30-37.5bn) sits in these in structured products. However, with opaque vehicles undergoing a period of unpopularity – particularly in light of K1 – investors are looking to go direct and hedge funds are heeding the call, despite the restrictions. Man has enjoyed a good deal of success in Germany, while Dornseifer says Paulson has been meeting national tax reporting requirements for the past year – saving investors the pain of the punitive levy – and is enjoying some success. And where Paulson leads, others are sure to follow, despite ongoing perception problems.

“Much of this is because of the offshore nature of service providers for foreign hedge funds,” says Dornseifer. Believing the attitude to be detrimental to investors and their opportunities, the BAI is currently trying to build bridges between managers and investors by bringing interests together via a series of educational events.

It will be a challenging exercise, Dornseifer concedes. With some banks reconsidering their role as funds of hedge funds managers (FoHFs), investors are still nervous. “The current quota [the 5% limit for institutional investors] is small, but many are reluctant to even dedicate that,” he says. And despite the departure of the Social Democrats, there are still plenty in Merkel’s ruling coalition who continue to regard managers as locust-like, and were openly jubilant when many took a hit on Volkswagen shares this year.

Imperfect regulation can be changed, but vaulting historical unease requires more than just a change in government. Investors need to build up knowledge and trust before investing, while the German hedge fund sector is so new that no one really has the track record to pull in allocations. Foreign hedge funds are on the scene, but few are willing to make the extra reporting effort for a maximum allocation of 5% – although BaFin, the German financial regulator, is reportedly considering raising the allocation maximum to 10%, as more investors begin to express an interest.

And, in the most counter-intuitive twist of all, interest could be crystallised by the arrival of the AIFM Directive. “We must think beyond this, beyond regulation that is just for the benefit of the local industry, but that will also benefit the global industry,” says Dornseifer, referring to the passport element of AIFM, before stating that other aspects are so detrimental that the fallout will be just as damaging in Germany as the rest of the world’s hedge fund industry.
Kindermann says the draft in its current form is unworkable, but also sees how it could perhaps thaw the attitudes of German investors and even politicians. By introducing Europe-wide legislation it could actually serve to correct harmful misconceptions about the industry.  

“The current Directive is not workable, but parts of it are so close to current German regulation that when a reworked version finally appears, it might be the stamp of approval that pushes investors and managers,” he says. With structured products also out of favour, Germany investors – arch Europhiles and arch-federalists – may also be drawn in by the increasing use of Ucits III as a vehicle for hedge fund-style products.

“Once again, our regulation is similar”, says Dornseifer, “but it’s a real case of German investors buying into a framework that has a Europe-wide stamp of approval. It is highly standardised, but German investors like highly standardised.”  

Most importantly, it would also mean an end to the ban on marketing. Altering a distribution model that is split between secretive homegrown hedge funds and opaque structured products.

Five years after the IMA, the current Ucits-mania could be the catalyst that the German hedge fund sector needs. However, while domestic regulation remains the real barrier, it is a German political solution, rather than an EU concept, that stands in the way of a homegrown industry. And with Merkel reluctant to provide the sort of tax parity that exists in the UK and US, the German hedge fund industry will remain underdeveloped, just when its national investors need it the most. A counterintuitive move, indeed