Germany: The German "Part II Fund": Maximum Flexibility For Mutual Funds And A New Opportunity For German Market Entry

The relatively recent so-called 'Other Fund' (also known as the German Part II Fund) was incorporated into the German Investment Act ("InvG") at the end of 2007. The creation of a new type of mutual fund for those funds pursuing innovative investment strategies, such as private equity, loan, commodity and precious metals strategies, with more flexible investment opportunities and limits, had become necessary due to the increased focus of German investors on other European fund domiciles, in particular Luxembourg.

German investment law now provides for a mutual non-UCITS fund, offering the same degree of flexibility as the market standard Luxembourg Part II fund¹. The Other Fund allows, for instance, innovative investment strategies in shares and bonds in addition to investments in raw materials, complex derivatives and hedge fund "light" strategies.

Furthermore, the Other Fund is a very efficient wrapper for offshore investment fund products that are marketed in Germany. Many foreign fund initiators have, to date, chosen a Luxembourg Part I (UCITS) or Part II fund as a fund wrapper for their continental European (including German) offerings, and the Luxembourg Part II fund has become a popular wrapper and/or feeder structure in particular for complex offshore products.

Because certain types of German institutional investor, such as insurance companies and pension funds, may be subject to restrictions on investments in shares in a Luxembourg Part II fund, the Other Fund may be the better alternative for a German market entry solution.

The Other Fund allows, for instance, innovative investment strategies in shares and bonds in addition to investments in raw materials, complex derivatives and hedge fund "light" strategies.

The Luxembourg Part II Fund as a Benchmark

Many international fund promoters have, in the past, chosen Luxembourg Part II funds as wrappers or feeders for their non-UCITS mutual funds. The principal reason driving this choice was the flexibility offered by the Luxembourg Part II fund with regard to eligible assets and investment restrictions. For example, when selecting underlying assets, the Luxembourg Part II fund is not limited to those classes of investment permitted by the UCITS Directive, but merely has to comply with a per issuer limit of 20% of the fund's net asset value to satisfy diversification requirements. One of the principal issues of the Luxembourg Part II fund centres on its ability to be admitted to public distribution in Germany and elsewhere in Europe. For the admission to public distribution in Germany, a notification letter has to be submitted to the German Federal Financial Supervisory Authority ("BaFin"). Public distribution can usually not begin sooner than three months after receipt of the complete fund documentation by the BaFin. This notification process can result in a substantial cost burden and time delay for the fund concerned, as significant changes may have to be made to the fund documentation (e.g., the sales prospectus), the fund structure and strategy as a consequence of the BaFin approval process. The admission to public distribution in Germany is frequently not granted immediately because the investment strategy of the Luxembourg Part II fund has not been set out with sufficient detail in the sales prospectus.

In addition, a significant number of German institutional investors are not allowed to invest into this structure because of mandatory (i.e., legal or regulatory) or voluntary restrictions. Against this background, fund promoters may wish to consider more closely the Other Fund if they intend to issue a non-UCITS mutual fund that is to be distributed first and foremost in Germany, both publicly and/or privately.

The German Other Fund – the Hidden Champion

With the introduction of the Other Fund, the InvG not only provides a match to the flexibility of the Luxembourg Part II fund, but in some respects offers a more suitable alternative. The legal framework allows a wide range of eligible assets and consequently makes the Other Fund attractive for a wide range of mutual fund strategies.

The Other Fund is a very efficient wrapper for offshore investment fund products that are marketed in Germany.

Other Funds may first of all invest in all assets that are permitted to be invested in by a UCITS fund. Consequently, the Other Fund can acquire securities, money market instruments, bank balances, investment shares and derivatives (as defined in the UCITS Directive). The starting point is that there are no investment restrictions for these assets, although the Other Funds are subject to the principle of risk diversification, which provides that at least four assets must be acquired and held at any one time. Other Funds are also able to pursue a more flexible investment approach because:

• The ability to invest in derivatives is significantly extended in comparison to UCITS funds – Other Funds can invest up to 30% of their assets in those derivatives that are not derived from securities, money market instruments, investment shares, approved financial indices, interest rates, exchange rates or currencies, and can acquire, for instance, derivatives using commodities, precious metals or raw materials as the underlying instrument.
• They can acquire shares in other domestic or foreign funds — in addition to shares in a UCITS fund, up to 30% of the Other Fund's net asset value may be invested in non-UCITS mutual funds and/or in hedge funds. The acquisition of shares in foreign (offshore and onshore) hedge funds is also permissible.

Moreover, an Other Fund may to a limited extent pursue a private equity strategy by acquiring classic company interests in a variety of different legal forms (with no restriction on the nature and purpose of the target company), so that it is possible not only to invest in domestic and foreign partnerships and joint stock companies but also in companies having other legal forms, provided that the market value can be determined. The acquisition of company interests is limited to 20% of the net asset value at the time of acquisition, with a per target company limit of 5%.

In addition, Other Funds have the ability to acquire precious metals up to 30% of the fund's net asset value. While it is not possible to issue the Other Fund as a mutual fund that exclusively invests in physical precious metals, the Other Fund can be issued as a mutual fund that is practically a pure precious metal fund because alongside the 30% invested in physical precious metals and derivatives based on precious metals, the remaining 70% can be invested in securities issued by companies in the precious metals sector (e.g., mine operators), in precious metal index derivatives and certificates convertible into precious metals. The investment restriction for precious metals does not apply to Other Funds created as institutional buyer funds (i.e., German "Spezialfonds"), the shares of which may not be acquired by natural persons. As a result, it is possible to design institutional Other Funds as pure precious metal funds (100% investments in physical precious metals and/or precious metal derivatives) if the fund targets the right investor base.

Other Funds may also invest directly in non-securitized loan receivables (i.e., loans that are not in the legal form of a security), enabling them to participate in loans of all kinds (e.g., real estate loans, infrastructure loans, corporate financing loans, micro-financing and consumer loans), which includes participating in the financing of companies that do not issue securities themselves and can therefore not be acquired by means of shares or bonds. The Other Fund consequently enjoys wider-ranging investment opportunities than hedge funds do from a German regulatory perspective (which prohibits the direct acquisition of non-securitized loan receivables).

The ability of the Other Fund to acquire non-securitized loan receivables is limited because of a 30% investment restriction, similar to the restriction applying to the acquisition of precious metals and derivatives. However, the Other Fund can also be structured as a micro-finance fund. This type of fund typically acquires non-securitized loan receivables granted by micro-finance institutions in developing and threshold countries to small businesses in the form of small and micro loans. As a micro-finance fund, the Other Fund can invest up to 75% of its net asset value in nonsecuritized loan receivables of a micro-finance institution (a draft amendment currently being considered would increase this limit to 95%).

The legal framework allows a wide range of eligible assets and consequently makes the Other Fund attractive for a wide range of mutual fund strategies.

Other Funds are to a certain extent allowed to take out short-term loans to bridge liquidity squeezes, and for investments. While the limit for UCITS funds is 10% of the net asset value of the fund, Other Funds may take out short-term loans of up to 20% in aggregate of the net asset value ('short-term' in this context is presumed to mean a credit period of up to one year, although there is some uncertainty about the exact period).

A further benefit of the Other Fund worth highlighting relates to the issuance and redemption of fund units. It is possible to deviate from the obligation to redeem fund units at any time so that the fund structure of an Other Fund can be similar in effect to a closedended fund (although at least one redemption must be permitted each year). This would allow the investment management company or the investment stock corporation (essentially the German equivalent to the Luxembourg SICAV) to benefit from more efficient portfolio management, as the actual redemption can take place at a later point in time when fund units of a high aggregate value are surrendered. The amount that is required to be surrendered before a redemption right is triggered has to be set out in the fund documentation.

The Other Fund is finding particular favour in the form of loan, micro-finance and precious metal funds.

Conclusion

Other Funds bear the "made and regulated in Germany" quality seal and offer a flexible, costefficient, as well as internationally competitive, fund category for investment in innovative investment products. The Other Fund is finding particular favour in the form of loan, micro-finance and precious metal funds. For fund initiators intending to issue a mutual fund that does not (need to) comply with the UCITS Directive but that will be distributed first and foremost in Germany, the Other Fund may be a more suitable solution than the Luxembourg Part II fund.

Footnotes

1. Investment funds not complying with the UCITS Directive and intended for public sale to private investors are regulated in Luxembourg under Part II of the Law of 17 December 2010 relating to undertakings for collective investment; therefore the term "Part II fund" is used in this article.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.