In our Client Memo of December 2, 2011, we reported on the adoption of the "Act Reforming the Laws on Intermediaries for Financial Investments and on Investment Products" ("Act"). One important change the Act brings about is the extended scope of the notion of "financial instruments" in the German Banking Act ("KWG"): As of June 1, 2012, also interests in closed-ended funds will qualify as financial instruments.

Over the last weeks, evidence has increased that this change of law, in the view of the German Federal Supervisory Authority ("BaFin"), could trigger a licensing requirement pursuant to the KWG for private equity (fund-of-)funds or their managers. This position of BaFin, which has as yet only been uttered in non-published statements, is outlined below.

I. Starting Point

As interests in closed-end funds will be treated as financial instruments as from June 1, 2012, certain activities regarding fund interests can trigger a licensing requirement under the KWG. A possible field of application are fund-of-funds, which invest in other closed-end funds (i.e., in financial instruments under the new law). The management of a fund-of-funds concerns the licensing requirements for investment management and financial portfolio management. The Act contains an exemption in this field (Sec. 2(6) sentence 1 no. 20 KWG-new), the scope of which is, however, unclear.

II. Investment Management

BaFin assumes that funds which invest in interests in other funds will typically fall under the rules for "investment management" (Sec. 1 (1a) sentence 2 No. 11 KWG), and will therefore generally require a license for rendering financial services pursuant to Sec. 32(1) KWG. BaFin mostly speaks of "secondary market funds" in this context. It must be assumed that the same will apply to funds-of-funds, regardless of whether they make primary investments in target funds or acquire interests on the secondary market.

Investment management is defined in the KWG as the acquisition and disposal of financial instruments with investment discretion on behalf of a community of private individual persons. Therefore, at least blind pools primarily targeting private individual investors would be concerned.

BaFin apparently takes the view that such funds cannot rely on the newly inserted exemption in Sec. 2(6) sentence 1 no. 20 KWG. The wording of the exemption requires that an undertaking must render services on behalf of initiators or issuers of investment products". According to BaFin, this is not the case for the funds concerned, as they act "for the investors".

Additionally, it appears that the private equity exemption, which BaFin currently applies in connection with investment management, will not apply to funds-of-funds.

It is yet an open question whether BaFin would apply a licensing requirement at the level of each individual "secondary market fund"/fund-of-funds, or whether the licensing requirement would (only) concern the relevant fund manager (e.g., general partner or managing limited partner). Pursuant to an already existing exemption in the KWG, it might be sufficient if a fund's parent company has been granted the respective license.

III. Financial Portfolio Management

Additionally, BaFin takes the view that it depends on the individual case whether financial portfolio management (Sec. 1(1a) sentence 2 No. 3 KWG)

could be triggered. In case that BaFin will actually assume this position in the future, it can no longer be excluded that even directly investing private equity funds might fall under a licensing requirement pursuant to Sec. 32 para. 1 KWG. There are, however, no concrete indications for this at the moment.

IV. Outlook, Further Process

The position of BaFin outlined above raises significant questions of doubt concerning both the rationale of the new Act and the compatibility with the AIFM-Directive which is to be transposed into German law by July 2013 (and which will also introduce licensing requirements for the management).

In case BaFin will uphold its position, the initiators concerned will have time to file an application for the required license until the end of 2012. As far as foreseeable today, German funds-of-funds would be concerned if they follow blind-pool strategies and are marketed to private individual investors as primary target group. But also foreign blind pool funds-of-funds might be affected, as licensing requirements might be triggered even on a cross-border basis if the fund is actively marketed to German-based private individual investors. However, whether a license will actually be required will depend on the individual circumstances.

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.