The German Federal Financial Services Authority
(Bundesanstalt für Finanzdienstleistungsaufsicht
– BaFin) published a draft circular concerning investments of
German regulated pension funds for consultation on Dec. 21, 2016
(consultation 16/2016, reference VA 25-I 3201-2016/0002, Internet:
kon_1616_kapitalanlagerundschreiben_va.html). The draft addresses the regulator's views on important aspects of the German Investment Ordinance (Anlageverordnung) which contains the material regulatory rules for investments of German pension funds.
The draft is of particular importance for investments of affected investors in alternative investment funds, i.a., as it contains concretions with regard to the investment procedure. According to the draft, investments in funds require scrutiny with regard to the qualification for the guarantee assets (Sicherungsvermögen) as well as to legal risks prior to the acquisition and during the entire term (based on at least quarterly reports) and a reasonable documentation.
This client information provides a brief overview of the new systematic of the German Investment Ordinance concerning investments in alternative investment funds and discusses material statements of the circular.
In summary, the draft provides alterations for investments in alternative investment funds for affected investors as follows. Some of the statements of the draft contain alterations the reach of which is surprising and it is questionable whether the consequences that can be derived from the draft are all within the regulator's intention of the regulator. We will try to play a part in the consultation via the appropriate organizations in order to further a reasonable drafting of the circular.
- Investments even in private equity funds which invest directly are only eligible for the so-called participation quota if the funds do not employ leverage. Private equity funds using leverage can only be acquired outside the regulatory escape clause (Öffnungsklausel) if they are EEA funds managed by EEA managers.
- Investments in real estate funds are only eligible for the real estate quota if the leverage employed within the structure is limited.
- The draft substantially provides that investments in debt funds can only be made within a new quota for alternative investments (7.5% of the investor's guarantee assets). In consequence, investments in US debt funds would only be eligible under the regulatory escape clause.
- Investments through open-ended special funds which are frequently used by German institutional investors are intended to be subject to regulatory restrictions beyond those applying under German investment fund regulation. Participations of special funds in closed-ended funds would no longer be possible according to the draft.
- The regulator intends to significantly restrict options to invest in funds in accordance with the rules applying to alternative investments as compared to the text of the ordinance. Even funds-of-funds would not be allowed to invest in funds managed by US managers or other non-EEA managers according to the current wording of the draft.
- The draft requires an assessment of the creditworthiness of each asset on the basis of a look-through approach irrespectively of the type of investment fund in which the investor invests.
- Investments in closed-ended funds investing directly are to be limited to 1% of the guarantee assets in any case. These funds would no longer be eligible for a look-through approach in this respect.
- The draft is of significant importance for investors as well as for alternative investment fund managers since the German investment ordinance had undergone significant changes in adjustment to the new German investment code (Kapitalanlagegesetzbuch) in particular for investments in alternative investment funds. Whereas the German investment ordinance had not contained fund-specific rules regarding alternative investment funds until March 2015 the ordinance since then has contained provisions concerning basically all kinds of investments in alternative investment funds. The new circular is supposed to contain statements regarding the regulator's interpretation of those provisions.
- The new German Investment Ordinance for purposes of the eligibility of participations in closed-end funds and their attribution to certain diversification quotas distinguishes between private equity funds, real estate funds and funds constituting alternative investments.
- Participations in private equity funds are relevant for the so-called risk quota (35% of the guarantee assets) as well as the participation quota (15% of the guarantee assets). The quota applying to real estate funds is 25% of the guarantee assets for funds belonging to the alternative investments the applicable quota is only 7.5%.
- The attribution to a fund type is not only relevant for the question which quota applies, but different qualitative requirements apply to those different fund types (e.g. concerning the jurisdiction of the fund vehicle and the manager or the manager's level of regulation). The draft circular contains important statements regarding this distinction.
- The new German investment ordinance contains a separate catalogue number regarding investments via German special funds which are of significant importance for German institutional investors. The draft circular contains important additional requirements regarding these special funds beyond the applicable investment fund regulations.
III. Material Aspects
1. Private Equity Funds
The draft provides restrictions regarding the eligibility of participations in private equity funds for the guarantee assets. In addition to restrictions already contained in the materials regarding derivative instruments and liquidity the draft circular limits borrowing to 10 %. This statement is not covered by the text of the ordinance and constitutes a tightening of the current administrative practice. Until now, restrictions regarding leverage for undertakings only applied at the level of holding companies the only purpose of which is to hold equity or equity-like instruments. The statutory documents of a typical private equity fund will usually not contain such restriction. This is in particular true for funds investing directly, but will also apply to many funds-of-funds. Rather, the fund documents of many private equity funds provide for a higher level of borrowing (even if such borrowings are normally only on a short term basis). If the regulator keeps its position investments in many private equity funds will no longer be possible within the participation quota, but only within the quota for alternative investments. Due to the different geographic requirements for those quotas, participations in affected funds would only be eligible in case of EEA vehicles with EEA managers. As regards private equity funds, the participation quota would almost become useless.
2. Closed and Real Estate Funds
The draft contains an important statement for real estate funds concerning the practically important questions to which extent these funds may borrow from an insurance regulatory perspective. According to the draft, leverage is limited to 60% of the gross value of the real estate assets held by the fund. In addition, short term borrowing is allowed up to 30% of the net asset value of the fund. If investors invest through a real estate fund-of-funds, borrowings at the level of the fund-of-funds have to be limited to 30% of the net asset value and may only be entered into on a short term basis.
3. Debt Funds
The draft circular is much more restrictive than the text of the German investment ordinance with regard to credit funds. Whereas according to the wording of the ordinance funds within the private equity basket may invest in instruments of corporate finance instruments of any kind the draft circular only allows investments in equity, subordinated debt and profit participation rights. Private equity funds are only considered to be allowed to acquire equity in other businesses which may include debt origination. If the regulator does not change its view debt funds will only be eligible for investments by affected investors under the quota for alternative investments. In addition, investors would be excluded from investments managed by US managers or other non-EEA managers (except for investments within the regulatory escape clause).
4. Special Funds
The draft contains requirements for special funds which go way beyond what is required under German investment fund regulation. These requirements are based on rules regarding a certain type of German mutual funds. They are in substance in line with prior insurance regulatory requirements for special funds. Under these rules special funds which are intended to be eligible for affected regulators may only invest 30% of their assets in loans. Investments in open-ended target funds which belong to the quota for alternative investments have to be limited to 49% of the net asset value. Participations in target funds are only considered to be eligible if they are open-ended and could also be held directly as part of the guarantee assets. This is a material obstacle for alternative investments which frequently are based on special fund structures. If the statements in the draft remain unchanged in this respect participations of open-end special funds in closed-end target funds would no longer be possible under applicable insurance supervisory law.
5. Alternative Investments
Though investments in alternative investment funds are attributable to the quota for alternative investments (7.5% of the guarantee assets) the draft provides that any investment made through a fund belonging to the alternative investments in another fund (target fund) needs to qualify as an asset which is directly eligible for the guarantee assets. This includes in principal the requirement that the target fund is an EEA vehicle managed by an EEA manager. The only exception is investments in fund-of-hedge funds where the target funds may be non-EEA-funds. This exception is only considered to apply for pure fund-of-hedge funds within the meaning of German investment funds regulations. Such interpretation would have a significant impact on the investment options for German regulated investors since even target funds held via EEA fund-of-funds structures would be limited to fund vehicles and managers from the EEA within the alternative investment basket.
6. Principle of Security
The German investment ordinance requires that the insurance regulatory principle of secure investments also applies to all assets indirectly held via an investment fund. This would mean that investors would have to monitor portfolios of the funds in which they are invested with regard to the creditworthiness of each single asset and in particular to identify assets having a speculative grade rating or a sub-speculative grade rating in order to be in a position to take appropriate measures in that respect. This is in line with the current administrative practice for open-end investment funds. The amendments of the German investment funds regulatory law and, in consequence, of the German Investment Ordinance have given rise to an extension of the scope of this administrative practice to funds which are subject to their own quota (in particular private equity funds and funds belonging to the alternative investments). In our view, due to the attribution of those investments to the respective quotas no monitoring of the creditworthiness of assets on a look-through basis should be necessary.
7. Holding Privilege
Participations in the same company or in the same closed-end fund may in principal not exceed 1% of the guarantee assets. Until now a so-called holding privilege applies to companies whose only purpose is to hold equity or equity-like assets. According to the draft, this would no longer apply to funds investing directly, but only to funds-of-funds.
The regulator has asked for comments regarding the draft by the end of January. We will try to play part in the consultation via the appropriate organizations in order to further a reasonable drafting of the circular. If you have any comments or questions regarding the above please do not hesitate to contact one of the attorneys set forth below.
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.