A draft proposal to allow German institutional and retail investors to invest directly in hedge funds and funds of funds could open the floodgates to between €50 billion and €100 billion ($57.6 billion to $115.1 billion) in new hedge fund capital, according to various estimates.
The draft of changes to the rules governing German and foreign investment funds and taxation of those funds is working its way through the Ministry of Finance. Although changes are likely as the political process unfolds, approval of the new rules is expected late this year. If that happens, German investors will be able to invest directly in hedge funds and funds of funds, starting Jan. 1.
Demand is expected to be strong, said market observers, based on current interest in derivatives that allow German investors to indirectly buy into hedge fund performance. Currently German institutional and retail investors have roughly €5 billion invested in notes and certificates that track the performance of hedge fund indexes and hedge funds of funds, said Antonello Russo, who looks after German hedge fund managers within Deutsche Bank AG's Equity Prime Services group in London.
"If (the proposal) does pass, it will be a huge potential source of demand for hedge funds" worldwide, said Christopher Alan Zook, chairman and chief investment officer of CAZ Investments LP, a Houston hedge fund of funds.
"There is pent-up demand, no question," said Andy Good, vice president of hedge fund sales for Driehaus Capital Management Inc., Chicago. "Several folks from our firm were in Germany a few weeks ago, primarily to discuss our traditional long-only product. But in a couple of the meetings, the people present expressed interest in our hedge fund products."
Investor demand is a big reason the Finance Ministry has proposed the changes, said Jeff Tarrant, president and chief executive officer of New York-based hedge fund of funds Protege Partners LLC.
Today's German investment laws were drawn up 30 years ago to protect German investors from people like Bernie Cornfeld and his Investors Overseas Services, which made some of its investors-turned-salesmen rich but ruined other investors when equity markets tanked in the 1970s. German regulatory authorities quickly drafted new laws governing foreign investment companies operating in Germany and German investors themselves. The laws basically said that if German investors placed money with investment firms not registered with German regulators, any returns were heavily taxed, Mr. Tarrant said.
This was OK for the most part because German pension funds were generally cautious investors. Equities did not become a significant part of their portfolios until the mid-1990s, just in time to catch the very end of the runup.
As a result, German investors have been clobbered the past few years.
"The German investors have been looking for a long time at new alternatives to invest directly into hedge funds," Mr. Russo said.
But even the proposed rules are restrictive by U.S. standards. Single-manager hedge funds could be sold only to institutional investors, while funds of funds could be sold to anyone. However, any single-manager hedge funds being sold directly to investors, or that are a part of a fund of funds, would have to offer complete position-level transparency and report daily net asset values to the German regulatory authorities, said James R. Hedges, president of Naples, Fla.-based LJH Global Investments LLC, a hedge fund advisory firm.
"The universe of hedge fund managers that provide that is extremely small," Mr. Hedges said. "What will end up happening is that German investors will not end up getting access to the broad universe of hedge fund managers, but to a narrow subset that will meet the regulatory requirements."