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THE NASCENT HEDGE FUND MARKET IN ITALY AND GERMANY
 
By Hugo Cox, a London-based independent financial writer. The Italian hedge fund market has reason to celebrate

The Italian hedge fund market has reason to celebrate. Spurred by a series of tax incentives, just two and a half years after the first ?fondi di speculativi? was launched, the Italian market is worth over ?3 billion. As multi-managers proliferate, stimulated by an increasingly heterogeneous market and recent regulatory relaxation, the first single managers are appearing. In the meantime, awareness among institutional investors is growing as the range of products on offer increase. Some believe that Italy?s new private pension funds could lead the market into its next stage of development.

In Germany, stringent regulation has made access to hedge funds virtually impossible. Both short selling and leverage are prohibited to registered funds. Punitive tax treatment discourages investors from non-registered funds. Any profits in these so-called ?black? funds are taxed at 90%. If the fund fails to make a profit then the investor must pay 10% of his holding as tax. It is hardly surprising, then, that German interest in the hedge funds has so far been limited, with only five German-based managers presently offering domestic funds. But from January 2004, a new investment act is set to change the landscape entirely.

Italy

In Italy, two early fiscal drivers established the fledgling industry, while a third regulatory change has fired recent growth. First regulator Bank of Italy replaced the punitive ?progressive tax? ? over 40% for many investors ? with the standard mutual fund tax rate of 12.5%. Subsequently two windows of tax armistice on repatriated money were declared. Established this and last year, the armistice windows dropped tax on the repatriated money to 2.5%. An estimated ?60 billion of new money flowed back into Italy, with a good deal destined for hedge funds. The third and final stimulus came in the form of regulatory relaxation: in May, the Italian Treasury Ministry doubled the maximum number of investors permitted for each fund to 200, while simultaneously halving their minimum investment to ?500,000.

The table below lists the major hedge fund managers in Italy today. As one would expect from a young market, the lion?s share of assets is in funds of funds. Of the 59 registered funds 53 ? with around ? 4.5 billion in assets - are multi-managers. The remaining six single manager funds contain around ? 200 million. Notable is the lead taken by the smaller independent asset managers. One has to go to fifth in table ? and a modest 7.6% market share - to find the first Italian bank ? Banca Intesa ? who own Nextra SGR. ?Size is no particular advantage in this industry,? explains Paulo Basilico of market leader Kairos Sgr, pointing to the fact that the traditional retail distribution power enjoyed by the large banks does not extend to High Net Worth Individuals (HNWIs), who are in Italy the largest market sector.

Italian Hedge Fund Companies

Assets under mgmt.

(? million)

Market share

Kairos A.I. Sgr*

617.0

15.2%

Ersel Hedge Sgr*

549.9

11.6%

Duemme Hedge Sgr

470.7

11.6%

Pioneer A.I. Management Sgr

331.9

8.2%

Nextra A.I. Sgr*

306.6

7.6%

Aletti Gestielle Alternative Sgr

303.5

7.5%

Akros HFR A.I. Sgr

247.9

6.1%

Cr?dit Agricole A.I.P.G. Sgr

186.8

4.6%

Hedge Invest Sgr

185.9

4.6%

Mps A.I. Sgr

158.1

3.9%

Private Wealth Management Sgr

146.0

3.6%

JP Morgan Alternative A.M.

114.5

2.8%

Bipielle A.I. Sgr

101.6

2.5%

Euromobiliare A.I. Sgr

66.9

1.6%

Sanpaolo IMI A.I. Sgr

66.2

1.6%

Obiettivo Sgr*

66.1

1.6%

Bim A.I. Sgr

54.5

1.3%

Morgan Stanley Sgr

41.8

1.0%

Albertini Syz I.A. Sgr

29.0

0.7%

Zenit A.I. Sgr

11.5

0.3%

* Those SGRs are also offering single manager funds.

A notable feature is the prevalence of foreign managers in advising the new Italian funds of funds. A survey by Italian consultants Mondohedge found that 55% of firms (in terms of asset under management) made use of foreign advisors in setting up funds. Popular choices, according to Deborah Ceo of Mondohedge include Tremont Capital and Ivy Asset Management from the US, and Union Bancaire Priv?e, and Bucephale Investment from Switzerland. Paulo Basilico believes that the influence of foreign advisors risks commoditizing the new industry. ?There is a risk that a larger number of easily assembled funds focusing on a smaller number of key single managers will kill performance?. But as long as the single manager market remains small, the foreign advisors look set to continue with their major role.

A second feature of the Italian industry is the dearth of single manager products. A total of nine single funds are presently available, from just four managers. A lack of demand and a scarcity of talent appear the main reasons. In the first case, Edoardo Ugolini of Nextra SGR believes that the high minimum investment - ?500,000 - is restricting demand for the new funds: ?It is unlikely an average investor of ?1.5 million net worth would want to give over a third of his portfolio to a high risk single manager. Potential investors into the single funds tend to have ?5 million upwards, and there are not so many of these?. The second problem is on the supply side: it is hard to attract talented managers. ?We don?t have the same volume of proprietary trading desks you can pick mangers from,? explains Max Veniziani of Goldman Sachs, who supply Prime Brokerage services to Intesa BCI on its Nextra range. ?And it?s hard to tempt managers away from multi-billion Euro mutual funds to run a new single manager hedge fund of ?10 million?.

Difficult environment for foreign entrants

Another impediment to future growth could come from the difficulty foreign managers have in establishing a presence in Italy. In the first case setting up an office there takes longer and is more costly than in most European domiciles. In the UK, for example, regulator Financial Services Authority provide fund registrations within about four months; in Italy registration of the manager takes three months, and approval of the fund takes a further four. In Italy it is also more expensive. The initial application requires a ?1 million capital advance, and associated costs are usually much higher.

Regulatory constraints also affect the freedom with which Prime Brokers can operate. A legal uncertainty concerning the status of funds held off-shore means that Prime Brokers must either partner with a local bank who acts as custodian, or obtain a custody license themselves. Goldman Sachs followed the first route partnering with Intesa BCI on their Nextra range. Deutsche Bank, on the other hand, operate under license already and keep funds for Deutsche Asset Management in their Italian branch in Milan. The consequence is clearly a narrower selection of Prime Brokers, with implications for cost and quality.

The future: retail and pension funds

While troublesome for foreign managers used to the ease of the offshore environment, the Italian regulations do not at present appear to be a serious impediment to the growth of the new industry. Whether this growth continues may depend on the reaction of two so-far untapped markets: pension funds and the retail investor. For the retail investor, larger institutions are pushing guaranteed products to the regulator, who is so far resisting. Last year, the industry association of SGR?s (hedge fund managers) unsuccessfully sought permission for new guaranteed funds with lower minimum investments. According to Paulo Barbieri of manager Banca Akros, the main reason for the regulator?s attitude stems, ironically, from the likely popularity of the new funds. ?The average size of the existing funds is ?20 ? ?70 million,? he explains. ?Given the size of the retail market, the structured products based on these funds will be much larger. ?The regulator is concerned that these products could begin to affect performance of funds to which they?re linked?.

The case of pension funds is more promising. All pension funds established before 1999 ? the majority ? are entitled to invest. Several pension fund bodies have gone on record recently in favor of allocations to alternative investment managers. ?The high level of regulatory control should be appealing to them,? explains Eduardo Ugolini of Nextra, ?the requirement of Prime Brokers for daily reporting of position information entails an attractive level of transparency?. In addition pension funds should warm to the twin pillars of scrutiny provided by manager and Prime Broker. ?A large risk management team provides additional scrutiny,? continues Ugolini, ?this works over and above that provided by the Prime Brokerage and will appeal to institutional investors.? If and when they begin to allocate to hedge funds ? inevitably first through funds of funds ? the money looks likely to come from their investments in property. Italian pension funds on average allocate 25% of their assets to property. A large slice compared to the US average of 5%.

Germany

The key points of the new legislation are summarized below

Single manager hedge funds

  • Must be established under German law: domiciled and registered in Germany.
  • Maximum investor number is 30.
  • Individuals (literally ?natural persons?) prohibited from investing directly.
  • Maximum 30% of portfolio invested in companies not listed on a stock exchange.
  • May not invest in commodities.

Funds of hedge funds

  • No minimum investment
  • Must be established under German law if or based in EU, EEU or other countries approved by Ministry of Finance.
  • For capital preservation funds may not invest:

More than 49% of capital in banks or money market instruments

More than 20% of capital in a single fund

More than 40% in funds with the same strategy

More than 30% in companies not listed on a stock exchange

In more than 2 funds run by the same manager

In other FoFs that themselves invest more than 30% in other hedge funds

  • For investor transparency funds must:

Disclose terms and conditions concerning investment strategy, leverage/ short-selling and exposure to foreign / unregulated funds.

Provide all material data regarding the Target Fund?s investment. This must include risk management, investment restrictions and extent of leverage and short selling.

Ensure compliance of target manager with that manager?s respective investment strategy via obligatory weekly risk ratio report and asset value provided by administrator or depository bank.

Source: Wilmer Cutler and Pickering

In Germany, insurance companies and not pension funds will be the main institutional targets for the new funds. German law and the tradition of different professions managing their funds in isolation, means the pension market is relatively fragmented. Insurance companies already allocate between 1% and 2% to hedge funds. But most of the high-risk portion of portfolios goes to private equity and real estate. The profile of the high net worth investor is similar, with a greater readiness in many cases to consider single manager funds. However access for these investors must be via special purpose vehicles since the act prohibits individuals from investing into single managers on their own.

The German retail investor is on the face of it well placed to create strong demand for the new products. They appear sophisticated and well disposed to those with hedge fund exposure. For example, in 2001 Deutsche Asset Management launched Xavex HedgeFirst, a structured note linked to the performance of a basket of foreign-based single manager hedge funds. With the help of Deutsche?s impressive distribution network the new product raised over ?3 billion.

But the success of Xavex had little to do with either the sophistication of the investor or the hedge fund element. ?The broad mass of German retail investors hasn?t heard about hedge funds so far but with the new investment modernization act this will change soon,? explains Rolf Dreiseidler of BAI, the German association of the alternative investment industryAt present, in fact, those certificates with a hedge fund element represent a very small slice of the market. Finally, it seems unlikely that the average investor into Xavex understood the complex hedge fund element of the product. For when Deutsche prepared a version for the UK market, its complexity attracted criticism from investor bodies and brokers alike, including a harsh review in the Financial Times. There, without, the guarantee portion, the note raised only ?55 million.

How managers are placing themselves

According to Dreiseidler, asset managers are pursuing one of two strategies in anticipation of the new legislation. ?The first group are the innovators working on concepts to release at the beginning of January; the second are waiting to see how the market develops?. Principal among those who will be launching products in January are those large asset managers who can draw on existing hedge fund experience. Among the principal German brands, Deutsche has a hedge fund group based in New York and according to Thomas Richter, head of European Communications at Deutsche?s retail arm DWS, ?are working hard to develop products that fit specifically the German market?. Commerzbank, too, will draw on the expertise of Jupiter Asset Management, the London-based managers they acquired in 2002. Finally Dresdner is leveraging the experience of investment banking arm DRKW, which manages products for their clients elsewhere in Europe and the US.

Managers following the alternative ?wait-and-see? route include those German brands without existing hedge fund experience. Many, as with the Italian industry, are forging links with foreign advisors and establishing tester funds abroad. Union Investment - a leading example - has a total of ?115 billion funds under management, with a small ?100 million in hedge funds. They have teamed up with Swiss Partners on their first multi-manager product, which launched in Luxembourg at the beginning of this year.

Despite their differing approaches, both Deutsche and Union must struggle with the dearth of talented hedge fund managers available in Germany. The scarcity of proprietary trading desks means that many of the best managers are working abroad, where most institutional money is managed. The business of attracting new managers is made harder by the punitive top-level 56% tax bracket. Compare this with the special tax treatment enjoyed by foreign managers working in London, and one can see how that it will be hard to attract top caliber managers.

A more lasting threat to the new industry is posed by the tough new reporting and disclosure requirements. It is feared these could scare off the best international funds entirely from accepting investments from new German funds of funds. The problem lies in the level of disclosure multi-managers must provide in order to avoid the old punitive tax. New funds must provide the regulator with detailed information not only about themselves, but also about the managers they are investing into. This ranges from the amounts and components of each distribution to detailed accounts of each portfolio, including short positions. It raises questions of confidentiality that may discourage many first choice managers.

This problem may not be insoluble because the new Act may well change before becoming law. The Bundestag, Germany?s second legislative chamber must approve the act, and it could change the disclosure requirements. Supporting this is the fact that industry has thus far enjoyed the ear of the regulator. ?The initial act was drawn up in close consultation with our members,? explains Dreiseidler, ?and we are continuing our efforts to establish a competitive regulatory framework for the Alternative Investment industry in Germany?. But the Christian Democrat opposition enjoy a majority in the second house. And rival lobby groups oppose liberalization. The action of the second chamber will be a key component in how the new market develops. u

 
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