To give German investors exposure to hedge funds, currently, structured products are used, with hedge-fund linked certificates being the most popular route. One can expect that certificates will remain the most attractive route relative to a direct investment in hedge funds unless those funds comply with specific tax publication and notification requirements.

The greatest appetite for hedge fund exposure is currently with life insurance companies and various pension schemes.

Public marketing
and private placement
Under regulatory laws, public marketing of hedge funds other than funds-of-hedge-funds is not permitted in Germany, and even a public marketing of funds-of-hedge-funds is unrealistic since the permission of the regulator BaFin (Bundesanstalt für Finanzdienstleistungs-aufsicht) will be virtually impossible to obtain. Private placement of all types of hedge funds is permissible in Germany. The current practice is quite liberal as it accepts an offering to all parties with which a relationship with a focus on asset management exists whether or not such party is a qualified investor or a private individual. The upcoming regime will see an explicit permission to market to qualified investors but also the power for BaFin to define the limits of public marketing.

Public marketing of certificates and other structured products is permissible. If marketed publicly in a securities format, a security prospectus will be needed unless the minimum investment is EUR 50k or more. For private placement, no prospectus will be needed.

Licenses for the distribution channel and prospectus issues
German distribution channels need a financial services license to market securities. Units in hedge funds (and certificates and other structured products) usually qualify as such securities and so the distribution channel will need that license, which is one of the reasons for non-German funds to dislike certificates.

A remedy to the need of a financial services license might be to (further) wrap the certificate in a limited partnership stake. Partnership stakes may be publicly offered without a financial services license (only a license easy to obtain from the local municipality will be needed). A sales prospectus will be needed unless the minimum investment is EUR 200,000 or higher.

Regulated Investors
The greatest appetite for hedge fund exposure is currently with life insurance companies and various pension schemes including German mutual funds through which these investors often invest.
However, insurance companies and certain pension schemes (in particular Pensions-kassen and Versorgungswerke) may only invest in hedge funds if they are comparable to German hedge funds which condition is usually not fulfilled. The use of structured products helps to overcome the issue. Typically, a principal-protected certificate or Schuldschein (a German-specific loan instrument in a format close to a security) is used to give those investors exposure to hedge funds.

The quota of their net assets that insurance companies are permitted to invest in hedge funds (including structured products giving hedge fund exposure) is likely to be raised to 10 percent under the upcoming regulatory changes.
A practical problem is the requirement that insurance companies must establish a risk-monitoring entity to be permitted to invest in hedge funds. In light of the costs incurred by risk-monitoring, quite large investment amounts are needed to benefit from economies-of-scale effects. It is yet unclear whether the requirement of an own risk-monitoring entity will be waived by the regulator.

With regard to German mutual funds wishing to invest in hedge funds, the situation might significantly improve, since CESR tends to take a more liberal view which will extend to German UCITS funds which until now cannot have hedge fund exposure. Given that many insurance companies and pension schemes invest through so-called special funds, the more liberal regime for those funds should permit them to increase their hedge fund exposure.

Taxation
The tax regime poses a significant obstacle to German investors wishing to get direct exposure to hedge funds.

The tax regime poses a significant obstacle to German investors wishing to get direct exposure to hedge funds.

In essence, non-German and German funds are classified trifold:

• Funds fully complying with German tax reporting and publication requirements qualify as ‘transparent’ or ‘white’ funds which, in essence, puts the investor in a tax position as if directly holding the fund’s assets.
  
  
• If a fund does not comply with all but at least some of the reporting and publication requirements, it will qualify as ‘semi-transparent’ or ‘grey,’ with the consequence that investors cannot avail themselves of tax benefits but also no tax penalties apply at investor level.
  
  
• Non-German hedge funds typically do not comply with reporting and publication requirements at all, in which case they qualify as ‘non-transparent’ or ‘black’ funds, exposing the investor to an unfavourable tax regime (also referred to as ‘penalty taxation’).

As a consequence, a direct investment in non-German hedge funds (unless complying with tax reporting and publication) is only possible for tax-exempt investors (such as Pensions-kassen, Versorgungswerke and some foundations) if the regulatory conditions are met. With regard to taxable investors, a structured product or other appropriate wrapper will be needed to shield from unfavourable tax consequences. Under a decree, it is clarified that hedge-fund linked certificates are not treated as hedge funds.

Under the upcoming tax reform, the speculative gain exemption for private individual investors will expire. However, hedge-fund linked certificates held by an investor through a fund will benefit from grandfathering if acquired by 31 December 2008 at the latest.

Private Equity Funds
Up to now, the situation for private equity funds was pretty much identical to the regime for hedge funds, albeit the Federal Ministry of Finance has exempted some of them from the investment taxation. However, under the upcoming regulatory reform, private equity funds are likely to be fully (or at least to a much larger extent) exempted from the specific investment taxation regime.
This will mean that public marketing will be permissible and the ‘penalty’ taxation should usually not occur. For regulated investors, an EEA wrapper (such as a partnership domiciled within the EEA) should be sufficient to make the investment eligible.