The second of our on-going series of fund manager roundtables looked at various ways in which fund managers can accommodate the particular quirks of German institutional investors. We have picked out highlights below.
The market opportunity
A combination of experience and what follows might tempt you not to bother structuring your fund to suit BaFin-regulated German pension funds and smaller insurers. The reason not to give up is the size of the prize if you get the structuring right.
We know real estate remains immensely popular across Europe – German institutions alone have more than €200bn invested in property. Less well-known is that, as a group, German pension funds and smaller insurers on today’s figures have the regulatory capacity to double their current allocations to real estate. If your fund meets the 'real estate quota’ criteria, then you are unlikely to hear investors using regulatory exposure limits as a reason not to commit. This contrasts with the position for some other asset classes like private equity, where investors often greet managers with a polite “sorry, we’re full”.
The rules set a range of regulatory exposure limits (‘quotas’), across 18 different asset classes. For example, an investor covered by the rules may not invest more than 15% of its restricted assets in private equity funds, nor more than 25% in real estate, 7.5% in certain debt and other alternative funds and so on.
Fund managers need first to check whether the BaFin rules designed for German pension funds and smaller insurers apply to the investor(s) they are targeting (there are other rules for large insurers, financial institutions and other investor types). Then you must identify the right quota for the fund you are marketing.
When is real estate not real estate?
Correctly labelling your fund as falling in the ‘real estate’ quota for German investors is not as straightforward as it sounds. An asset that generates purely letting income will usually classify as real estate. However, if a target asset that you might view as traditional real estate carries ‘entrepreneurial risk’, it is likely to fall outside the real estate quota. This is the case for assets that generate operating income, as a shopping centre might via its car park, or that bear some risk to the underlying asset, such as turnover rent. If you are aiming for the real estate quota, your investment policy will therefore need to exclude assets that are not ‘real estate’, or you will need to put in place arrangements at asset level to cut out any operating income. Whilst there are sometimes ways to mitigate these issues, the concern is that once you fall foul of the rules, your fund no longer qualifies for the real estate quota.
There are other options
Managers need not give up if they are not prepared to avoid ‘entrepreneurial risk’, as other quotas may also accommodate real estate investments. For example, you can also legitimately frame opportunistic funds within either the ‘private equity’ or the ‘alternatives’ quotas (although remember these are smaller and the race for allocations from them will be more competitive).
In any case, managers need to do the analysis, be ready to explain which quota covers their fund, and provide investors with comfort that their investment policy is tight enough to prevent any deviation.
Tax: ‘business’ is bad for German investors
Certain types of German pension fund can only maintain their tax-exempt status by limiting their investments to certain types of asset and structure. A crucial point for fund managers here is that these limitations effectively prevent exempt investors from putting their money into assets that generate ‘business income’. Fortunately for many real estate funds, letting income is not deemed to be ‘business income’. Unfortunately, earnings from limited partnerships are. There are workarounds if your real estate assets do produce ‘business income’ (using an appropriate feeder vehicle for example), but the first step is to analyse your business plan and identify whether your fund is likely to generate any such troublesome ‘business income’.
German investors will often set up master funds or alternative investment platforms in Germany, and increasingly Luxembourg, for various reasons including to have one entity to make all their investments and appear on their balance sheet (as opposed to lots of individual funds). However, there are also tight criteria on eligible assets for these kinds of structure, in particular if the investor uses a so-called German special fund as an investment platform. These restrictions can be an obstacle when it comes to investments in closed-ended, non-diversified or highly leveraged real estate funds. In order to gain more flexibility, some investors have opted to set up less regulated platforms in Luxembourg which, depending on the specific tax needs, may be designed as a blocker or tax transparent vehicle.