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How the German foreign investment act applies to foreign private equity funds

When marketing foreign funds to German investors, one of the first barriers is the foreign investment act (FIA). Alexander Vogts and Benedikt Weiser of Linklaters & Alliance discuss the effects of the act on foreign private equity funds and how such funds can avoid its application.

Introduction

Germany is one of the largest institutional investor markets in Europe and private equity is amongst the most sought after asset classes in the German market. Those accessing the German market must negotiate numerous tax and regulatory hurdles. When marketing foreign funds to German investors, one of the first hurdles is the Foreign Investment Act (Auslandinvestmentgesetz - ‘FIA').

 The FIA provides the framework for marketing foreign funds to the public in Germany and the regulation and approval thereof by the German banking regulator (Bundesaufsichtsamt für das Kreditwesen - ‘BAKred'). It prohibits the public placement in Germany of funds that have neither been approved or fall within the scope of the UCITS-directive. It also sets out the regime applicable to the taxation in Germany of returns from all foreign funds.

The foreign fund tax regime under the FIA is less favourable for investors than domestic German tax law, particularly because certain tax exemptions for capital gains do not apply. The severity of the tax rules applicable under the FIA depends on whether the fund has obtained approval, for public distribution has appointed a tax representative in Germany, or has done neither of these things. In a worst-case scenario, the tax burden of the investors may exceed their income from the fund.

Private equity funds domiciled outside Germany cannot be approved for public distribution because they, inter alia, do not satisfy the FIA's investment restrictions, issue redeemable interests or publish the issue and redemption price of their units on a daily basis.

When marketing foreign private equity funds and funds of funds to German investors, it is therefore important to avoid the application of the FIA if a conventional, tax efficient structure is to be achieved. This article outlines how the FIA applies to foreign private equity funds and funds of funds, and how funds marketed to German investors avoid its application by:

• ensuring their marketing and fund documentation picks up the key requirements of the FIA;

• in the case of fund of funds, carefully selecting investee funds according to the criteria described.

 The article does not deal with structures giving German investors access to foreign funds falling within the scope of the FIA.

1. Scope of application of the FIA

A unit in any fund acquired by a German investor will fall within the scope of the FIA if the fund is:

• governed by foreign law;

• predominantly invested in securities certificated receivables from money loans, deposits or real estate; and

• risk diversified.

The term ‘unit' refers to any participation in a portfolio, regardless of whether the participation is held as a partnership interest, share in a corporation or otherwise. It is generally irrelevant what legal form a foreign fund has and how its assets are legally attributed to its investors.

Funds governed by foreign law

The fund must be governed by law other than German law for the FIA to apply. This will hold true for all funds that do not have their centre of management in Germany.

Establishing a German-based parallel fund structure for German investors has become the market standard solution for the avoidance of FIA by foreign risk diversified private equity, securities and real estate funds seeking to access German investors. However, this raises issues under the FIA which should be borne in mind.

In order to demonstrate that the parallel fund's management is effectively located in Germany, the parallel fund should maintain its own business premises and book-keeping in Germany. Decisions concerning parallel investment in each portfolio company should be taken in Germany on their merits for investors in the German parallel fund.

Where two or more funds invest and divest in parallel pro rata to their respective capitalisations they may, under certain circumstances, be considered to constitute a larger partnership, referred to as a ‘super partnership'. If a German parallel fund were considered to be a partner in a super partnership, the centre of management of the super partnership would almost certainly be abroad, raising the possibility that the FIA might apply. No German court has had the opportunity to rule on this issue and the analysis is not shared by all in the market. Nonetheless, this risk should be mitigated, if possible, by careful structuring of the co-investment relationship between the parallel funds.

Securities held by the foreign fund

The FIA applies to risk diversified foreign funds investing in securities, certificated receivables from money loans, deposits or real estate. Foreign private equity funds typically hold ‘securities' within the meaning of the FIA in portfolio companies.

Under German law the term ‘securities' applies to instruments by which a property right is certificated (verbrieft) in such a way that the exercise of the right requires the ownership of the certificate. According to legal literature, where foreign law governs the interest held (as will regularly be the case in respect of investments in limited partnerships and their investments in portfolio companies), such foreign law is decisive for its characterisation as a security. This leaves the details of the test for the term ‘securities' subject to debate where foreign interests are concerned.

For foreign primary funds, the shares in portfolio companies limited by shares will typically constitute ‘securities' within the meaning of the FIA. This is, however, unclear with respect to interests in foreign partnerships (eg those held by funds of funds), or in private limited companies. The assets of the foreign fund must be predominantly (ie more than 50 per cent) invested in certificated securities and such investment must be for investment purposes (ie not merely ancillary business). For example, the BAKred has held that the creation of liquidity reserves for the purpose of covering contingent liabilities (BAKred Guidance Notes dated 22 May 1985) or the acquisition of certificated securities for the purpose of depositing them with a futures market broker (BAKred Guidance Notes dated 22 May 1985 and 9 January 1992) to be merely ancillary purposes.

Risk diversification

To fall within the scope of the FIA a foreign fund's securities portfolio must be risk diversified. A portfolio is risk diversified if it consists of a multitude of assets (ie combines numerous potential risks of loss with potential opportunities for profits.)

Neither the law itself, nor the rulings of the BAKred provide clear guidance on the number of assets that trigger the application of the FIA. With respect to real estate funds the BAKred has ruled that more than three assets may suffice (BAKred Guidance Note of 13 February 1989). Although this ruling does not apply to securities, one has to acknowledge that more than three assets constitute a risk that the portfolio could be considered risk diversified by both the regulatory and the fiscal authorities.

However, even if the mere number of securities would suggest risk diversification, the FIA does not apply if the foreign fund assumes an active entrepreneurial role in the management of the companies in which it invests, ie it does not hold its assets merely as passive, opportunistic financial investments, but aims at a generation of value by exerting influence over its portfolio corporations.

Activities outside the scope of the FIA are typically indicated by the following three characteristics:

• The fund's investments entitle it to voting rights in its portfolio companies which enable it to exercise a dominating, or at least a significant influence over its portfolio companies, such as in the case of holding companies (BAKred Guidance Note dated 30 August 1990).

• The fund invests in the portfolio companies (even if this is with a minority of shares) with the intention to support their management with advice, networking, financial relations etc, ie by exerting entrepreneurial influence (BAKred Guidance Notes dated 28 August 1991).

• The fund's portfolio consists of long-term investments (at least several years) as opposed to short-term trading of shares.

Buy-out funds will typically take an active entrepreneurial role in their portfolio companies. Venture capital funds vary significantly in their investment style, with investments being structured either with or without an active entrepreneurial role of the fund.

Often the existence of a dominating, or at least a significant influence over the portfolio companies of a fund can only be established by aggregating the interests held by numerous investors in the portfolio company.

The issue regularly arises in connection with funds established in the UK or the Channel Islands because these jurisdictions limit the number of partners in a limited partnership. These funds are therefore structured as a series of parallel limited partnerships with the same general partner and a contractual obligation to invest and divest together pro rata to their relative capitalisation.

Arguably, the aggregation of the shareholdings held by parallel partnerships under common management makes each partnership an active investor for the purposes of the FIA, even if, viewed individually, each parallel fund would not hold a significant participation or have the ability to exercise influence on the portfolio company. This view is based on the argument that the partnerships together are able to exercise a significant influence over the portfolio company.

An analogous scenario arises when a number of co-investors in a portfolio company agree to exercise the rights attaching to their interests together, often in accordance with the will of a lead investor. The argument seeking to attribute entrepreneurial influence to each co-investor may be more difficult to make in the latter case. However, neither the taxation authorities, nor the regulator have had occasion to decide either of these issues.

2. Foreign fund of funds

Fund of funds have become an important product for German investors investing in private equity. Almost all fund of funds on the German market include interests in foreign funds. Some are themselves foreign funds.

German investors investing in a foreign fund of funds encounter the uncertainty mentioned above with regard to the term ‘securities' both at the level of the fund of funds and at the level of their investee funds: An interest in a partnership (fund of funds) does not constitute a security under German commercial law, but may do so under the foreign law governing the partnership. Furthermore, even if the fund of funds is not considered to be investing in securities within the meaning of the FIA, the German tax authorities may allocate securities held by the investee funds to the fund of funds. As a result, the risk that an investment in a fund of funds holding interests in a foreign fund will constitute a unit in a foreign portfolio of securities is difficult to rule out.

The application of the FIA can only be avoided with a high level of comfort by avoiding risk diversification. This, again, involves a two-level analysis:

The fund of funds will commonly not be able to exert a significant influence over the investee funds. It will, however, invest in a number of investee funds, ie considerably more than three, that would most likely constitute risk diversification. If and to the extent the fund of funds is considered to be investing in interests constituting ‘securities', risk diversification can only be negated by looking through to the level of the investee funds.

The investee funds may be able to exert a significant influence over their portfolio companies. Arguably, the qualification of the investee funds should affect the qualification of the fund of funds. A thorough due diligence by the main fund on the investment style of its investee funds could, therefore, exclude the criterion of risk diversification for the entire fund of funds.

The fund of funds and its German investors could only benefit from this approach if there is a ‘look through' from the (risk diversified) level of the fund of funds to the (non diversified) level of the investee funds.

With respect to identifying securities both at the level of the fund of funds and at the level of the investee funds, it was suggested above that the German tax authorities might look through the investee funds and allocate the ‘securities' to the fund of funds. In our view, it would be consistent to also look through the investee funds in determining whether the investment is risk-diversified. At the level of the portfolio companies it would be possible to exclude the application of the FIA by exerting entrepreneurial influence on the portfolio companies by the investee funds pursuant to the criteria laid out above.

However, there is no official confirmation or precedent to confirm this view. It cannot be ruled out that the German tax authorities will focus on the level of the investee fund to determine whether the tests for securities and risk diversification are satisfied.

3. Conclusion

The interpretation and application of the term ‘securities' within the meaning of the FIA lacks certainty. Therefore, it is better to avoid the FIA by ensuring the portfolio held by a foreign fund is not risk diversified. The exertion by a foreign fund of funds of entrepreneurial influence over portfolio companies avoids risk diversification.

Fund of funds can avoid risk diversification by carefully selecting their investee funds according to this principle. While foreign funds of funds may themselves fall within the scope of the FIA, irrespective of the nature of their investee funds, funds of funds domiciled in Germany (possibly as a parallel vehicle) can avoid falling within the scope of the FIA by carefully selecting their foreign investee funds.

Copyright © 2002 Linklaters & Alliance

Alexander Vogt and Benedikt Weiser are solicitors at Linklaters & Alliance.

Linklaters is a global law firm, with integrated practice area teams providing expert legal advice on all areas of commercial law. It works closely with successful businesses all over the world to meet their legal requirements.For more details go to www.Linklaters.com