Today, the German federal ministry of finance ("BMF") issued a discussion draft of a law to transpose the Directive on Alternative Investment Fund Managers ("AIFMD" or the "Directive") which includes a draft Capital Investment Act ("KAGB-E").
The KAGB-E is supposed to replace the Investment Act – which currently is only applicable to German open-ended funds that have a specific investment focus – and will become the legal framework for all future German fund structures.
The AIFMD entered into force already on July 21, 2011. By July 22, 2012 it must be transposed into national law. The Directive provides a harmonized European legal framework for fund managers, including private equity fund managers. This includes inter alia, license requirements, minimum capital requirements, depositary requirements, provisions on remuneration systems and disclosure obligations (see client information of July 2, 2011). If the fund is marketed only to professional clients as defined by MiFID the AIFMD further provides a pan-European marketing passport for marketing in the EU.
The KAGB-E transfers the provisions of the Directive and includes them in the system provided by the existing Investment Act. Unfortunately, on some essential issues the discussion draft goes beyond the AIFMD and would – if implemented as it stands – have significant consequences for private equity fund managers in Germany and the fund location Germany as a whole.
The relevant issued of the PE industry are in particular:
- Requirement of full AIFM compliance for managers below the threshold if they manage funds in which private individuals are invested: This includes inter alia, the requirement to have a depositary, license requirement, minimum capital requirement, provisions on remuneration.
- Closed-ended "Specialized Funds" may only invest insignificant amounts in financial instruments: Closed-ended funds that are so called "Specialized Funds", i.e. funds that allow only investors that qualify as "professional clients" under MiFID are required to predominantly invest in assets that do not qualify as financial instruments. Under European law the term "financial instruments" has a very broad meaning and comprises inter alia, interests and shares in domestic and foreign corporations, partnerships or other entities if such interests or shares are comparable to shares in a stock corporation. PE funds invest in shares of stock corporations as well as in shares in foreign corporations and partnerships that qualify as financial instruments and, accordingly, are unable to comply with such product regulation.
- Retail PE funds are only permissible as fund of funds: So called "Retail Funds", i.e. funds that have investors that do not qualify as professional clients pursuant to the MiFID definition, are subject to a product regulation which prohibits direct PE investments.
- It is to be welcomed that generally domestic closed-ended funds can still be established as master feeder structures. Still, it is problematic that the same should be prohibited in relation to foreign closed-ended Retail AIFs.
- The discussion draft introduces a restriction of the admissible legal structures for German funds: Closed-ended funds, whose managers are subject to the KAGB-E, may only be established as investment stock corporations with fixed capital or as investment limited partnerships. With regard to the latter, the draft mandatorily provides that the management must be vested in one or more of the general partners. This may cause troubles to avoid the "deemed business concept" under German tax law.
- No alternative depositaries: The discussion draft does not provide for alternatives to banks as depositaries (i.e. service providers as attorneys at law, auditory, notaries public) – an option that has been provided by the EU legislator to the national legislators. As a consequence, only banks or certain financial service providers may act as depositary for PE funds.
Stricter marketing regulation (abolition of the private placement regime):
- Foreign funds may only be marketed to so called "private individuals" if the manager of the fund and the fund itself are subject to regulatory supervision and appointed a trustworthy and skilled person with registered office or residence in Germany as its representative and certain additional conditions of the Directive have been met. In general, the rules for marketing to private investors (without any distinctions in relation to minimum capital commitments, number of investors etc.) are very extensive.
- As regards the marketing of domestic and EU funds to professional investors the discussion draft adopts the AIFMD provisions without amendments (i.e. the notification procedure, cf. our client information of July 2, 2012).
- With regard to the marketing of third country funds the draft goes beyond what is required under the AIFMD; unregulated private placements will be abolished and the KAGB-E provides new requirements (regulation of the fund and the manager, cooperation agreements, information exchange for tax administration purposes, submission of documents to BaFin).
The aforementioned issues are explained in detail below. At the end it will be shown that most of the changes that are necessary may be implemented quite easily.
I. The different fund categories 4
1. "Open-ended" and "closed-ended" AIFs 5
2. "Retail AIF" and Specialized AIF" 5
II. Licensing requirements and product regulation for closed-ended Retail AIFs 6
III. Product regulation for closed-ended Specialized AIFs 7
IV. Permissible legal forms 8
V. Depositary 9
VI. Marketing / Placement 10
1. Marketing to "private investors" 11
2. Marketing to professional investors 12
VII. Remuneration rules 14
VIII. Grandfathering rules 14
SCOPE FOR IMPROVEMENT 14
I. Semi professional investors 15
II. Product regulation 15
I. The different fund categories
The draft Capital Investment Act comprises provisions on Undertaking for Collective Investment in Transferable Securities (UCITS, hitherto included in the Investment Act) and on Alternative Investment Funds (AIFM) within the meaning of the AIFMD as well as their respective managers.
The discussion draft differentiates between open-ended and closed-ended as well as between Retail and Specialized AIFs and provides for different rules for each category.
Further, the draft differentiates between domestic AIFs, EU AIFs as well as third country AIFs (the latter are referenced as "foreign" AIFs).
1. "Open-ended" and "closed-ended" AIFs
"Open-ended" are AIFs that provide for redemption rights at least once a year. All other AIFs are "closed-ended". Hence, PE funds qualify as closed-ended funds and the below descriptions are limited to such type of funds.
2. Retail AIF" and Specialized AIF"
"Specialized AIFs" are defined as AIFs the interests or shares of which may be held by professional investors only pursuant to a written agreement entered into with the management company of the AIF or pursuant to the founding documents of the AIF. All other AIFs are regarded as "Retails AIFs".
"Professional Investors" are investors that are professional clients pursuant to Annex II of the Directive 2004/39/EC (MiFID) or that may be treated as such upon application. All other investors are defined as "private investors".
"Professional clients" pursuant to MiFID are:
- Institutional investors (including closed-ended funds) as well as
- individuals, who
- received a confirmation of a bank pursuant to which individual has the adequate expertise to be capable of understanding the risks involved in the investment, and
- accepted a written warning about the loss of rights as a consequence of the qualification as professional client and
- at least two of the following three criteria are met
- the person has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarter,
- the size of the client's financial instrument portfolio, defined as including cash deposits and financial instruments exceeds € 500,000 or,
- the person works or has worked in the financial sector for at least one year.
Hence, many high net-worth individuals as well as many private equity professionals, who mostly invest in the funds as well, will not qualify as professional clients because many times they have not worked in the financial sector and/or do not carry out 10 relevant transactions per quarter. Any AIF in which those individuals hold an investment will not qualify as Specialized AIF but as a Retail AIF (cf. § 1 para. 11 KAGB-E).
The following applies to small AIFM and their funds, i.e. AIFs that are managed by AIFM who manage no more than € 500 Mio.1 in unleveraged AIFs that do not provide redemption rights for the first five years: If such AIFs are marketed to "private investors" the full set of provisions for Retail AIFs applies. If such AIFs are marketed only to professional investors, then only a registration requirement for the AIFM applies (§ 44 KAGB-E)
Even though the provision of § 2 para. 4 no. 5 KAGB-E reads that redemption rights may only be provided in the first five years, but this open translation error (see the wording of the AIFMD in Art. 3 para. 2 lit. b)) will surely be cured.
II. Licensing requirements and product regulation for closed-ended Retail AIFs
Pursuant to the draft the qualification as closed-ended Retail AIF has the consequence that a number of considerably stronger restrictions apply, in particular a licensing requirement and product regulations:
- § 225 para. 1 KAGB-E provides an exclusive list of assets that may be held by closed-ended Retail AIFs. Direct PE investments are not included in the list and, accordingly, not permissible. Interests or shares in closed-ended (but not open-ended) Specialized AIFs are generally permissible (but see § 226 KAGB-E below).
- § 225 para. 4 KAGB-E stipulates that the assets held on account of a closed-ended Retail AIF may only be subject to currency risk if value of such assets does not exceed 30 % of the value fo the AIF. That means that a fund of fund structured as a closed-ended Retail AIF may only invest up to 30 % of its capital in US funds.
- Pursuant to § 255 para. 5 KAGB-E assets may be acquired on account of a closed-ended Retail AIF only if they have been valued prior to the acquisition by an external valuer, which may not be the valuer that undertakes the annual valuations, and if the consideration to be paid by the closed-ended Retail AIF does not exceed or only insignificantly exceed such determined value.
- Pursuant to § 226 KAGB-E a closed-ended Retail-AIF may only invest in one asset solely, if the interests or shares in such AIF are only held by such private investors that commit to invest at least € 50,000 and that are so called "semi professionals" as defined by the (planned) EU-regulation on European Venture Capital Funds.
- With regard to closed-ended Retail AIFs the depositary will have extensive rights of prior approval (e.g. for the sale of an asset). That means that a closed-ended Retail Fund of Fund would require the prior approval of the depositary for a secondary transaction of an interest in a sub-fund.
III. Product regulation for closed-ended Specialized AIFs
Even closed-ended Specialized Funds do not escape product regulation: They have to invest predominantly in assets that do not qualify as financial instruments (§ 253 KAGB-E). Pursuant to the discussion draft, this is necessary to distinguish closed-ended funds from open-ended funds. However, this is not convincing. It is understandable that open-ended funds for liquidity management purposes should invest in liquid financial instruments in order to be able to grant redemption rights but not vice-versa. As set out above, many of the investments by private equity funds in portfolio companies are "financial instruments". This kind of product regulation would lead to a totally unjustified limitation of the equity capital available for the Mittelstand.
Pursuant to § 241 KAGB-E short term debt may be incurred but this may be restricted by the BaFin. The same applies to any leverage and to the encumbrance of the assets held by the AIF.
The AIFM should ensure that the interests or shares in the AIF may only be transferred by the investors with the consent of the AIFM. This restriction is contradictory to the provisions that apply to German investors that are subject to the German Insurance Supervisory Act including the investment ordinance thereto. These so-called ISA investors may only invest in closed-ended AIFs if the interest or shares in the AIF are freely transferable (cf. the sample wording of the BaFin VERBAF dated April 2002). Pursuant to this the requirement of a prior consent by the AIFM is prohibited. Pursuant to the discussion draft from the BMF insurance companies and pension funds could not invest in private equity funds anymore! We hope that this is only a drafting error.
IV. Permissible legal forms
The discussion draft introduces a limitation of the permissible legal forms to establish German AIFs: Such AIFs may only be established as closed-ended investment stock corporations with fixed capital or as closed-ended investment limited partnerships (§ 135 KAGB-E). With respect to the limited partnership being the legal form typically used for closed-ended funds the following provisions will be of importance:
A closed-ended investment limited partnership that has not delegated the management of the AIF to a third party (which is not a partner) is seen as an internally managed investment limited partnership and thus is itself regarded as an internal AIFM within the meaning of the AIFMD. Pursuant to the draft act in such cases the management may only be vested in one or more general partners of the partnership. Hence, the structure typically applied in practice in which additionally a limited partner is vested with management authority would be prohibited. Accordingly this structure would cause a higher structuring effort in order to adapt it to private equity funds.
Pursuant to the directive each AIF must have a depositary. In connection with private equity funds, however, the term "depositary" is misleading. In principle, they are supervisors that control the manager (AIFM). With regard to private equity AIFs such supervisor will have the following functions:
- Cash monitoring,
- General oversight control relating to compliance with applicable law, and
- Control that the AIF validly acquired the legal title to its assets.
The EU legislator provided the Member States with the option that – apart from banks and investment firms subject to regulatory supervision – alternatively other service providers (e.g. notaries public or attorneys-at-law), which are subject to special legislation of their profession and may provide sufficient financial guarantees, may be permitted as depositaries. This option has not been exercised in the discussion draft. Pursuant to § 76 para. 2 the depositary function may generally only be carried out by banks or investment firms. It has to be taken into account that the special legislation applicable to the professions that may qualify as alternative depositaries under the AIFMD have not yet been adapted to provide for the depositary functions. Nevertheless, there is no reason to exclude the option a priori because the prerequisites may be incorporated in the respective professional legislation.
V. Marketing / Placement
With regard to the marketing of AIFs by the AIFM the AIFMD provides the marketing passport only for marketing exclusively to professional investors. In that area only, i.e. in relation to the marketing of Specialized Funds in the terminology of the KAGB-E, the national legislator is bound by the provisions of the Directive. The discussion draft transposes these requirements correctly into German law.
In relation to the marketing of Retail AIFs and – with certain restrictions – third country Specialized AIFs the AIFMD does not have any provisions but leaves this to the national legislators. The discussion draft includes the following provisions:
Until today the German law has two sets of rules for marketing: the Securities Prospectus Act (Wertpapierprospektgesetz, "WPPG") and the Investment Products Act (Vermögensanlagengesetz, "VermAnlG", which entered into force only two months ago!). Under current law any marketing that does not fall within the scope of any of those two acts is not subject to any regulation; that applies in particular to private placements.
The discussion draft stipulates that the provisions of the WPPG (as far as applicable) will be applied in addition to the provisions of the KAGB-E, § 262 para. 8 KAGB-E.
In contrast, the discussion draft foresees that the KAGB-E in its scope of application should supersede the VermAnlG (cf. Art. 4 para. 1 of the discussion draft for an Act for the transposition of the AIFMD). That means that placements of AIF should be permissible only in accordance with the provisions of the KAGB-E. The German rules on private placements would be abolished in their entirety (this applies to both, placements to private investors and placements to professional investors).
This goes far beyond what is required under the AIFMD. Pursuant to the Directive marketing under the national private placement regimes would have still been possible in the following cases:
- permanently for the placement of domestic and EU-AIFs by EU AIFMs; and
- until at least 2018 for the placement of third country AIFs by EU AIFMs or third country AIFMs.
On top of that the KAGB-E has a broader definition of "marketing" than the AIFMD: Management is defined as any direct or indirect offer or placement of interests or shares in an AIF as well as the promotion of an AIF or an AIFM. Only with regard to the marketing to professional investors the definition of marketing is being narrowed to comply with the AIFMD (cf. § 262 para. 5 no. 2 lit. d) KAGB-E).
1. Marketing to "private investors"
a) General marketing requirements, disclosure requirements
Already in the marketing to private investors pursuant to § 263 para. 2 KAGB-E) extensive information must be provided: in good time prior to signing the essential investor information sheet, the prospectus, the last financial statements and the last NAV have to be provided without charge. Additional information must be provided in electronic form and as hard copy. The copy of the investment agreement which has to be handed over has to set out subscription or redemption fees, if any.
All AIFMs that market to private investors in Germany are required by § 266 KAGB-E to disclose to their investors information on the illiquid assets, the risk profile and management as well as on the leverage in the fund.
In addition, the updated essential information sheet must be published on the website, § 267 KAGB-E.
b) In particular: Marketing of EU and third country AIFs to private investors
In addition to the general disclosure requirements set out above, EU and third country AIFM when marketing their EU and third country AIFs are subject to further disclosure and information requirements pursuant to § 265 KAGB-E. Such requirements have to be met partially by disclosure on the AIFM's website, partially by public announcement in the German federal gazette or in a financial or daily newspaper (inter alia prospectus, terms of the offering and financial statements
Further, the marketing of EU and third country AIFs to private investors is regulated in §§ 283 et seq. KAGB-E. Both, the third country AIF and the third country AIFM must be subject to effective supervision in their country of residence (irrespective of their size, i.e. including AIFM below the threshold of € 500 m. or € 100 m., respectively). EU and third country AIFM are required to appoint a representative with residence in Germany to perform the compliance functions. Marketing master-feeder-structures will not be permissible whereas in domestic cases a marketing of closed-ended master-feeder-structures is permissible, if marketed only to private investors that qualify as semi professionals.
The marketing has to be based on a prospectus that has to comply with the requirements of § 284 KAGB-E. As far as the fund is subject to the WPPG the provisions of the WPPG must be complied with in parallel.
Any marketing has to be notified to the BaFin, § 286 KAGB-E. Pursuant to para. 1 no. 2 confirmations of the domestic representative and the depositary have to be included. It is unclear whether this stipulates that each third country AIF has to have a depositary, in particular if managed by a small AIFM. If that were the case small third country AIFM would be put in a worse position compared to domestic AIFMs (below the threshold) managing Specialized AIFs only.
2. Marketing to professional investors
Marketing to professional investors is regulated under §§ 287 et seq. KAGB-E. The marketing will be permissible only in the cases provided for, unregulated private placements (cf. § 2 No. 3 VermAnlG) are not relevant anymore.
For the marketing of domestic AIFs and EU AIFs by a domestic AIFM the discussion draft transposes the rules known from the AIFMD, that means that a notification of the AIF to the BaFin plus submission of a set of documents suffices, § 287 KAGB-E.
An EU AIFM is subject to analogous notification requirements in its home Member State and may market them in Germany after transmission of the license for management and marketing by the home Member State authority to the BaFin, § 289 KAGB-E.
For the transitional period pursuant to Art. 67 AIFMD, i.e. until at least July 2015, only two more constellations are permitted for marketing in Germany:
- Domestic and EU feeder AIFs which are managed by a domestic or EU AIFM and the master AIF of which is a third country AIF or is managed by a third country AIFMD, § 295 KAGB-E, and
- Third country AIFs with a third country AIFM, § 296 KAGB-E.
In the context of a third country master EU feeder set-up inter alia a domestic representative and a domestic paying agent must be appointed and the third country master AIF must have the permission to be marketed in Germany. In addition, the domestic or EU AIFM has to submit extensive documentation to BaFin.
For the third country AIF third country AIFM set-up high standards have to be met, in particular, both, the AIF (!) and the AIFM have to be subject to effective investor protection supervision, a double taxation treaty with information exchange clause must exist, a domestic representative for the compliance functions must be appointed and the AIF must comply with the requirements for domestic Specialized AIFs. The marketing has to be notified to BaFin; again, the list of documents that have to be provided leave room for interpretation whether the third country AIF must have a depositary.
Accordingly, for the transition period until at least 2015 marketing any other constellation, including the marketing of a third country AIF by its domestic or EU AIFM is prohibited.
After the transition period such constellations may be marketed applying the provisions of § 287 KAGB-E accordingly (see above), if a cooperation agreement and a double taxation treaty with information exchange clause with the third country exist and all requirements for management pursuant to AIFMD are fulfilled.
VII. Remuneration rules
With regard to remuneration § 37 KAGB-E refers to the Annex of the AIFMD. Such rules will be specified by additional technical standards at EU level, cf. our client information of July 10, 2012.
VIII. Grandfathering rules
The provisions will generally be applicable to all AIFM which manage AIFs that are not fully invested by July 22, 2013.
If an AIFM manages AIFs that are fully invested and AIFs that are not fully invested the provisions will be applicable to the AIFM and the AIFs not fully invested. Nevertheless, the provisions will be applicable to AIFM that manage solely Specialized AIFs only if the assets under management in the AIFs that are not fully invested exceeds the threshold of € 500 m.
The AIFM are required to start implementing the rules from July 22, 2013 and have to submit an application for the license until July 22, 2014 at the latest.
SCOPE FOR IMPROVEMENT
The need for further improvement derives in particular from the two critical issues laid out above, i.e. firstly, that in the definition of the fundamental term "Retail Fund" and "Specialized Fund" the discussion draft includes such funds in the category of Retail Funds that are open to semi professional investors within the meaning of the planned EU regulation on VC funds and, secondly, that the product regulation for closed-ended Specialized Funds provides that such funds have to predominantly invest in assets that are not "financial instruments".
Both issues are not pre-determined by EU law in the AIFMD.
I. Semi professional investors
The AIFMD refers to professional investors as defined by MiFID in the provisions on marketing: The "marketing passport" is only open to AIFs that are solely marketed to professional investors as defined by MiFID. The AIFMD neither requires full application of its rules to small AIFM whose assets under management do not exceed € 500 m. nor the restriction of funds that are open to semi-professional investors to private equity fund of funds and feeder funds.
Some of the improvements that are essential for private equity could be implemented quite easily by defining Specialized Funds as such funds that admit MiFID professional investors AND so called semi-professional investors. Solely the marketing provisions that implement the marketing passport would need to be restricted to funds that admit MiFID professional investors only.
The methodological and systematical differentiation between professional Investors under MiFID and so called semi-professional investors is already included in some parts of the discussion draft. To include this differentiation in the distinction between Retail Funds and Specialized Funds in general, is possible without generally changing the methodology of the Act and essential in order to prevent serious disadvantages for private equity in Germany.
II. Product regulation
The product regulation for closed-ended Retail and Specialized Funds is not prescribed by EU law of the AIFMD.
If, in accordance with the proposal made above, funds that are open to MiFID professional investors and semi-professional Investors would be defined as Specialized Funds and not as Retail Funds, the restriction for closed-ended Retail Funds to fund of fund or feeder structures would not apply. Funds that admit MiFID professional investors and semi-professional investors would continue to be allowed to make direct private equity investments which is badly needed.
Still, as discussed above the discussion draft as well includes a restriction applicable to closed-ended Specialized Funds that would severely restrict private equity investments. The restriction to invest predominantly in such private equity investments that do not qualify as financial instruments excludes a large number of alternative financing instruments without cause.
Hence, with regard to private equity it is necessary that the scope of possible investments for Specialized Funds will be broadened to cover all instruments of business financing, regardless of whether they qualify as financial instruments or not.
Further need for improvement stems from the fact that the draft issued by the BMF today is a "discussion draft" in which some obvious "drafting errors" and systematic inconsistencies have to be corrected. These are essential issues but they can be solved.
We appreciate that the BMF invites the affected parties to discuss prior to starting the parliamentary legislative process. In its scope of application the AIFMD provides for an EU-wide harmonized framework. With regard to private equity the Germany the draft transposition act goes far beyond the scope of the AIFMD. This would lead to a deterioration of the general conditions for private equity in Germany and to a change for the worse in the competition for private equity financing for German businesses. To ensure and support the necessary changes will thus be required not only for the directly affected private equity industry but for attractiveness of the business and industry location Germany as a whole.
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.