Uwe Bärenz Attorney at Law and Partner at P+P Pöllath + Partners, Berlin 2 Uwe Bärenz P+P Pöllath + Partners Structuring of Investment Managed Accounts Over the last few years, German institutional investors have increasingly made use of alternative investments in their asset management. Due to the continuing low interest rate period, the asset classes have gained a consistent popularity among institutional investors. Especially insurance companies, pension funds and professional pension schemes are attracted by above-average potential returns and long-term projected cash flows. Many investors initially tapped such assets through investments in specialized funds of funds. With an increasing reliance on the asset classes, the involvement of specialized portfolio managers to invest in directly investing target funds, to make coinvestments and direct investments obtains priority for a wider group of insti- Typical Access to Alternative Investments Own organization / expenses / responsibility / risk target funds direct investments funds of funds managed accounts 32 Portfolio management
Structuring of Investment Managed Accounts tutional investors. In addition to private equity participations, debt participations, primarily asset class-related debt instruments (e.g., infrastructure debt) are requested as well. The organization of these investments requires structures facilitating continuous cooperation and accommodating the specific requirements of the investors. Requirements and range of services The requirements of German investors for investment structures inter alia includes tax requirements (shielding or transparency) and the eligibility under insurance supervisory law (eligibility for restricted assets) as well as the eligibility under investment law (eligibility for special investment funds). Furthermore, aspects such as the limitation of liability, the legal control over the contractual relationships and reasonable administrative expenses are of key importance. First of all, the determination of the requirements to be fulfilled by the portfolio manager depends on the range of services the investors request from the portfolio manager. Apart from that, the requirements interact with the structure chosen by the investor. While in the past the legal relationships between investor and portfolio manager were often limited to advisory services, the assumption of management and administrative functions has partially been facilitated by the regulatory developments. Identification Due Diligence Recommendation Negotiation Decision Management Advice / Placement Portfolio Management Risk Management / Administration 33
Uwe Bärenz P+P Pöllath + Partners Structural Alternatives In addition to the direct investment (own balance sheet), particularly the use of regulated investment funds (special alternative investment funds) as well as selfmanaged or third-party-managed holding companies (investment platforms) Structural Alternatives (Domestic) Investor Investor Investor D Advice Management GmbH KG Special AIF KVG Management Foreign Countries Target Funds Structural Alternatives (Foreign Countries) D Investor PPN Investor Investor Investor Notes Management/ Advice Luxemburg Lux S.à r.l. Lux S.A./S.C.A. SIF Management/ Advice Lux S.C.S-SIF/SLP Securitization S.à r.l. PPN Management- S.à r.l. 34 Target Funds
Structuring of Investment Managed Accounts come into consideration for institutional investors. Consequently, the prerequisites to be considered in the course of the structuring are correspondingly different. The structuring of the investment managed account is additionally determined by both the structure and regulation of the portfolio manager (EU manager with or without AIFM authorization, third-country manager), the number of investors (one or more investors / group entities) as well as by the character of the portfolio investment (i.a. AIF interests vs. direct investments). n Direct investments (own balance sheet) Direct investments are only taken into consideration, if the related consequences do not affect the regulatory and tax status of the investor. In this connection, the following criteria are relevant when considering this alternative. n No loss of tax exemption status due to income from trade or business; n Direct obligations to file tax returns and pay tax in foreign countries; n Fulfillment of the conditions to participate in the restricted assets (requirement of having a registered seat in the EEA/OECD; free transferability; limitation of liability, with respect to AIF interests, in future also regulation of the target fund manager, if applicable 1 ). n Use of Special AIFs The market-leading investment fund managers in Germany perceived the trend to make investments in target funds by using regulated investment funds ( Special AIFs ) and have invested in professionals and structural resources in order to be able to support the implementation of such investments. From a legal point of view, the examination is shifted from the investor to the Special AIF which now has to secure the eligibility of any investment. Whereas the investor is basically subject to requirements under insurance supervisory law in addition to the tax requirements, the Special AIF is also subject to requirements under investment law. 1 Cf. ministerial draft bill of the German Federal Ministry of Finance to amend the German Ordinance on the Investment of Restricted Assets of Insurance Undertakings dated May 23, 2014. 35
Uwe Bärenz P+P Pöllath + Partners n Legal requirements Most notably, investments in alternative investment funds may qualify as securities or interests in portfolio companies. Uncertainties arise from the planned adjustments of the German Ordinance on the Investment of Restricted Assets of Insurance Undertakings 1 intending to limit the eligibility of interests in Special AIFs for the guaranteed assets dependent on the Special AIF limiting its investment strategy to investments eligible for acquisition by UCITS. In this event, the Special AIF would only be entitled to acquire interests in portfolio companies if the interests in the target fund qualify as securities (cf. Sec. 193 para.1 no.7 of the German Capital Investment Act (Kapitalanlagegesetzbuch, KAGB)). A range of additional structural measures (e.g., feeder, securitization) as well as legal adjustments (transferability) may be required in order to fulfill these preconditions. Otherwise, the entire Special AIF has to be allocated to the basket Other AIF which is limited to the 7.5% of the restricted assets of an insurance company 1. n Tax restrictions While in the past, only the general tax consequences and the eligibility under investment law had to be considered, the changes in the investment tax law (the AIFM Tax Adaption Law ) also implied additional limitations. The AIFM Tax Adaption Law has proved problematic for investors invested via Special AIFs regarding their investments in private equity, infrastructure, hedge funds and similar alternative investment funds (AIFs). Consequently, some experts voiced the opinion that such investments may in the future only be realized with the help of securitization structures. In the meantime, the financial administration commented on single issues and questions relevant for Special AIFs; consequently a certain easing of the situation occurred. In this respect, investors investing through Special AIFs rely on the tax exempt status of such Special AIFs. To date, this tax exemption was simultaneously effected with the compliance of the Special AIF with supervisory law. However, with the coming into force of the AIFM Tax Adaption Act, this automatic effect 36 1 Cf. ministerial draft bill of the German Federal Ministry of Finance to amend the German Ordinance on the Investment of Restricted Assets of Insurance Undertakings dated May 23, 2014.
Structuring of Investment Managed Accounts was cleared. While previous Special AIFs within the meaning of the Investment Act under supervisory law may normally be continued to be managed as open domestic Special AIF with fixed investment conditions, their future tax treatment now depends on the compliance with certain investment restrictions introduced for tax purposes. In future, such investment restrictions have to be complied with in connection with the assessment of the investment strategy of a Special AIF and afterwards for each of its portfolio investments. n Eligibility for Restricted Assets Direct alternative investments of regulated investors under insurance supervisory law (i.e. in addition to insurers also e.g. pension funds and pension schemes) in this respect underlying the provisions of the German Ordinance on the Investment of Restricted Assets of Insurance Undertakings are currently subject to uncertainties. The fact that the Ordinance has not been amended simultaneously with the implementation of the AIFM Guideline into the German legislation is the reason for the foregoing. Consequently, provisions of the former version which will also prevail regarding the previous investment legislation of the Investment Ordinance in its present version become ineffective or misleading. Furthermore, it may not be taken as granted that the regulated investors may further invest to the extent permitted in the past after a change of the provisions. The following table shows the intended changes: Exhibit AnlVcurrent version AnlVplanned* Notes Private Equity (Non-AIF) No. 13 No. 13 a no changes (look-through?) Private Equity (AIF) No. 13 No. 13 b AIF legislation in accordance with OECD full member, AIFM seat EAA/OECD, public supervision, licensed manager, look-through re funds of funds, no VC/SV Mezzanine (AIF) N0. 13 N0. 13 b same as private equity ( other equity equivalent instruments ) * Ministerial draft bill of the German Federal Ministry of Finance dated May 27, 2014 37
Uwe Bärenz P+P Pöllath + Partners Infrastructure (AIF) N0. 13 (No. 13 b)? No. 17 not sure, if no. 13 b still applicable Real Estate (AIF) No. 13/ No. 14 c No. 14 c EU-AIF AIFM seat EAA, public supervision, licensed manager Loans to companies (Non-AIF) No. 4 c companies, seat EAA/OECD at least speculative grade rating (motive: granting of loans to infrastructure companies [infrastructure company = company as defined by no. 13 a]; high yield company loans ) Loans to companies (AIF) No. 15 (max. 30%) No. 17 EU-AIF, public supervision, manager consent UCITS Funds No. 15-17 No. 15 no changes UCITS Special AIF No. 15-17 No. 16 limitation to UCITS assets, look-through re target funds (conflict when making investments in closed funds, if share = security as defined by Sec. 193(1) No. 7 Capital Investment Act?) Other AIF No. 17 only for other AIF, which are not registered in accordance with no. 13 b, 14 c, 15 and 16 (EU-AIF; AIFM seat EAA, public supervision, licensed manager, no look-through) Subsidiaries (e.g. platform) Para. 4 No. 3 Para. 4 No. 3 passive investment without operative influence on business or current project development (motive: infrastructure companies) (issue: active management by shareholder) n Re-Packaging as alternative for direct investments Due to the current uncertainties both in the tax and regulatory field, investment structures are discussed which shall on the one hand enable a complete participation in opportunities and risks of a direct investment and on the other hand minimize certain regulatory or tax risks. 38 Structures where the investor is entitled to repayment of his capital contribution and interest payments depending on the economic development of a reference figure are most suitable for this purpose. This reference figure may e.g. be the investment in a closed AIF. The shares in such a closed AIF may be held by
Structuring of Investment Managed Accounts the issuer of the instruments to be acquired by the investor. Also, such instruments may be constructed as a certificate, derivative, profit participation note or subordinated claim. Securitizing structures may be a solution for a continued holding of an existing portfolio if direct investments are not longer feasible (e.g. for Special AIFs which can hold certain investments in closed funds only until 2016 due to the transition provisions of the AIFM Tax Adaption Law). In case investments are intended to be held within securitizing structures requiring an active management (e.g. CLO), it is possible that the securitizing company invests in an additional vehicle holding the reference portfolio. Such additional vehicle may be a (regulated) fund vehicle as well as a common company. The use of securitizing structures may not be effected without risks or disadvantages. Although popular products basically reflect the same economic chances and risks as the respective reference product, the structure differs from a direct investment in an AIF. In economic terms, re-packaging entails additional expenses, consequently resulting in lower profits. In legal terms, a securitization company is an additional contractual partner, different from the actual fund vehicle, where additional default and control risks have in each case to be considered or eliminated. In addition, the tax or supervisory authorities may challenge such companies. n Use of established investment structures Due to the aforementioned disadvantages and risks of a securitization, established structures for direct investments in AIF via Special AIFs may also in future be the more advantageous investment decisions. With respect to the current uncertainties in insurance supervisory legislation, a direct investment via a Special AIF may currently be more practicable than an indirect investment. First relevant questions of doubt are cleared from a tax view for certain typical constellations by the letter of the German Federal Ministry of Finance dated June 4, 2014 regarding interpretation questions to the investment act in the version of the AIFM Tax Adaption Law. 39
Uwe Bärenz P+P Pöllath + Partners Investments in AIF, whose interests qualify as securities under investment law, consequently remain eligible assets for Special AIFs. If the interests in the AIF are not listed, their ratio in the entire portfolio of the Special AIFs is limited to 20% of the net asset value of the Special AIF. This corresponds to the current legal situation for supervisory and tax purposes. Several products in the market, especially in the area of funds of funds comply already today with such prerequisites for a classification as securities. In case of investments in AIF, whose interests are not securities, the legal form has to be examined: n In the past, it was not clear whether interests in limited partnerships were eligible for Special AIFs without jeopardizing the tax exemption of the Special AIF. The German Federal Ministry of Finance now answered this question in the affirmative. However, such investments must be limited to 10% of the Special AIF ( trash quote ). n Investments in AIF in the form of corporations shall basically be allowed up to 20% of the net asset value of the Special AIF. However, the percentage in the AIF being structured as a corporation must not exceed 10% or more of such a corporation. n Own or self-governing holding companies Numerous institutional investors use their own investment platforms in order to accommodate their legal and tax needs on the level of the investment platform instead of complying on the level of each and every single investment. 40 The treatment of holding companies depends on the qualification of such under the Capital Investment Act (Kapitalanlagegesetzbuch; KAGB). In case the holding company is not qualified as investment fund, it may be advantageous for insurance supervisory purposes, because in the past the German Federal Financial Supervisory Agency (Bundesanstalt für Finanzdienstleistungsaufsicht; BaFin) did not look through holding companies (e.g. location of registered seat of target funds). With respect to the intended changes of the German Ordinance on the
Structuring of Investment Managed Accounts Investment of Restricted Assets of Insurance Undertakings (look-through regarding private equity funds of funds) however, it is highly arguable whether this also continues to apply in the future. Furthermore, it has not yet been clarified whether investments in infrastructure target funds will in future also be treated as private equity target funds or if the intended 7.5% rate has to be applied exclusively. Especially with regard to the prerequisites in connection with the requirement of having a registered seat in the EEA, this would also constitute a limitation vis-àvis the broader scope (OECD) in case of private equity target funds. However, it is helpful that the expression holding is no longer regarded so strictly anymore. Investments in group companies shall also be possible if such investments of the holding are not limited to investments in companies, but e.g. also other AIF or loan claims, provided that the investor conducts himself passively and does not influence the operative business of the holding company. uwe.baerenz@pplaw.com 41