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The impact of the Alternative Investment Fund Managers Directive on Germany will, in some ways, be minimal. Unlike the UK it does not have a thriving hedge or private equity fund industry that would feel the greatest impact from the rules. Yet while most German funds will meet compliance with few problems, the impact will be felt broadly: around 80% of the fund business in Germany will be classed Alternative Investment Funds.
For many German funds regulation is nothing new. “Special funds”, marketed to German institutions, were formerly regulated under the Investment Act but are now governed by the AIFMD. Only the remaining 20% of the market, the UCITS funds, will not be considered AIFM.
On the straight and narrow
Germany has always operated a gold-plated regulatory model: most of the regulations contained in the AIFMD were already in place in Germany, according to Katarina Melvan, managing director at BNY Mellon Service KAG. Indeed, Germany was seen as the model that much of AIFMD sought to emulate.
“The effort required to meet compliance is low compared to what Luxembourg or Ireland will go through,” said Melvan. In other jurisdictions, new requirements for cash monitoring will require a significant effort to comply. In Germany all cash payments, even with a third-party bank, are monitored and pre-approved by a depositary. This means clean cash payments are not paid out automatically, interrupting the straight-through process. Cash instructions are reviewed by the depositary oversight team and only released once all controls and checks have been completed, Melvan said.
Neither is enforcement an issue in Germany. Where some countries in Europe will enforce the rules via monthly spot checks, German businesses are monitored daily with shadow accounting.
But for two types of business in particular, the impact of the AIFMD will be considerable: the closed-ended fund community, a big market in Germany that has until now been completely unregulated; and the depositaries, also known as depot banks, or custodians.
That is disregarding the impact on the investor community. “At first sight it might seem investors will be heavily benefited by the AIFMD – but only at first sight,” said Dietmar Roessler, head of the client segment for asset owners at BNP Paribas Securities Services.
“Nobody doubts that the AIFMD offers investors significant extra protection. But few investors have asked for it, and they are therefore generally cautious to pay the price for it,” Roessler said. “That is going to be the big challenge for both depositaries and fund managers in Germany and across Europe: explaining to their investors that they will have to bear the burden of these extra protections most of them didn’t ask for.”
“Nobody doubts that the AIFMD offers investors significant extra protection. But few investors have asked for it, and they are therefore generally cautious to pay the price for it”
That additional cost might equate to anything from 2bp–10bp on top of existing costs, depending on the complexity of the fund, the underlying asset classes and the markets in which the AIFM invests, said Roessler. To give that context, a vanilla equity fund might traditionally have costs of 2bp.
Among the buyside community, closed-ended funds will by far be the most severely impacted, said Melvan, in line with their hedge fund colleagues in London and Switzerland. Private equity or real estate funds have traditionally fallen outside the remit of the Banking and Investment Acts that regulated most German funds, because they do not trade in securities or derivatives. But under the new rules they will require an AIFMD licence.
It will be difficult and time-consuming for them to meet their new requirements, such as the splitting of the portfolio and risk management functions and the implementation of new reporting procedures.
The rules also forbid funds from outsourcing both their risk and portfolio management functions, which will prove particularly problematic for institutions running white label funds. It is common for managers to act as initiator to a fund, outsourcing the portfolio management decisions to unregulated institutions, but this will not be possible under the AIFMD. Portfolio managers need a licence from a national regulator.
There are more than 1,000 closed-ended funds in Germany, with conservative estimates putting their assets under management at around €200bn, though it may be closer to €300bn. About 80% of them are structured as German limited partnerships. This includes most of the biggest funds, managing around 95% of assets in closed-ended funds, said Carsten Fischer, partner at Dechert. They invest in assets ranging from real estate and private equity to ships and media.
Meanwhile, German funds will also be disadvantaged relative to many other European funds because Germany will abolish its private placement regime in 2013. Many other European states have taken up the option of phasing out regimes gradually until 2018.
This will leave Germany beholden to the European passport regime. A European-based non-UCITS fund can apply for an AIF EU passport in its home jurisdiction and market in Germany and elsewhere without direct approval from BaFin. Discussions about access for non-European non-UCITS funds continue, but it is not clear what access German investors will have to such funds, while investors in the UK and elsewhere import them via private placement.
German authorities believe private placements put investors at risk, so the decision is seen as justified on the grounds of investor protection. But denying German investors access to the broad suite of alternatives products via private placements will cause considerable disruption.
“Alternatives are important for institutional investors, especially as there are so few high performing fixed income products in the market these days,” said Fischer.
Earlier drafts proposed other rules that would have been devastating for Germany. German authorities initially added provisions to the draft rules it will apply in its domestic market to abolish open-ended real estate funds, said Thomas Jesch, counsel at Kaye Scholer in Frankfurt. Many institutional investors are invested in such real estate funds (Spezialfonds), which have been particularly popular since the financial crisis, when liquidity dried up in the real estate market.
The current draft of the German AIFMD Implementation Act now again includes open-ended real estate funds both for retail and for institutional investors, the latter being the real success story among the German fund structures of the last decade, said Jesch.
“Open-ended real estate funds for institutional investors are a German success story. If this was Luxembourg they would have never even considered abolishing them,” said Jesch.
To take a more charitable perspective the episode demonstrates an admirable flexibility and willingness to listen to industry concerns. Yet still, the rules add a regulatory burden to funds, applying to all new launches and existing funds that are open to new investors. For some managers the easiest solution is to close the fund to new investors and carry on under the old regime.
But perhaps the biggest impact of AIFMD in Germany will be felt by the depositaries. AIFMD requires all AIF to use a depositary. “This is an enormous new business opportunity for the community,” said Melvan.
This opportunity comes with strings. Depositaries will have to provide their funds with a restitution guarantee, passing a significant legal risk, that formerly sat with investors, back to them. They must also provide detailed accounts of the risks associated with the business those funds conduct, meaning they must become experts in the legal systems and infrastructure of all the countries its clients do business in, wherever that is in the world.
It amounts to a transformation of the business: a huge new source of business, but with massively increased responsibilities, and significant new legal liabilities.
“The due diligence of the sub-custodian, the oversight, and the control of the evaluation of AIFs, the ownership verification of the assets and the daily cash monitoring cannot be done in the traditional way so a big investment in systems and teams will be required throughout the industry,” said Roessler. The banks will have to bring in professional network management teams and depositary experts to oversee the depositary and custody business, he said.
This is likely to trigger significant consolidation in Germany, which has 47 depot banks, some of them small, local players.
“AIFMD significantly raises the point of critical mass for depositaries, and the majority of such banks in Germany are likely to be below that point,” said Roessler. The investment and the additional requirements will be too big for many of them to be met alone.
The big depositaries benefit from their global networks, meaning less reliance on outsourcing to external, third party sub-custodians around the world, over which they have limited control. Because the depositaries now have to offer the restitution guarantee in case of loss of assets it is an advantage to be able to keep all custody in-house, and not be liable for what happens at external sub-custodians, Roessler said.
The consolidation will be Europe-wide, and the top tier players will be the winners, said Roessler. But the impact will be more marked in Germany, with its abundance of small players.
Although there remain some logistical and interpretation issues requiring further clarification, here again regulators have been flexible. Closed-ended funds investing in assets unsuited to custody, like ships, may use their law firms instead of a depositary, though the larger funds are likely to use a depositary anyway, said Melvan.
Explaining the Sicav route
The implementation of the AIFMD could trigger an expansion of German Sicav (Societe d’Investissement a Capital Variable) structures, as many unregulated funds obtain licences and re-establish themselves as Sicavs.
Luxembourg has about 1,500–1,600 Sicav structures, a number Germany cannot hope to match in the foreseeable future – if ever. But Germany can reasonably hope to have 30 by the end of the year, said Fischer, and at least 100 by the middle of 2014.
Sicavs are popular because of their tax efficiency and transparency: no tax is levied at the fund level, meaning tax only comes at the investor level. They are flexible, for example allowing structures that offer daily liquidity to investors. Most Sicavs will qualify as an AIF under the AIFMD.
At the end of the millennium there was about €800bn in assets under management in Luxembourg Sicavs. In 2004 Germany implemented its own interpretation of the Sicav concept, and so far there have been nearly 30 launches, though six or seven have since disappeared.
“We are going to see more and more institutional investors set up German Sicavs,” said Fischer. It is much easier for institutions to invest in domestic funds than in foreign, Luxembourg funds, he said. And the fees can be lower in Germany, especially on larger funds, because Luxembourg taxes funds between 1bp and 5bp.
But Germany is unlikely to rival Luxembourg’s Sicav business for sheer scale. Those already invested in Luxembourg have little reason to change, while Luxembourg still offers greater flexibility to international investors, where fund documentation can be filed in German, English or French, compared with the rigid requirement for German documentation in Germany.