German investment ordinance review - effects on private equity

Q: What is the state of affairs regarding the investment ordinance review in Germany?

A: Bafin, the German regulator, recently submitted a draft of the revised Investment Ordinance to the German Ministry of Finance, and consultations with the insurance industry organization, GDV, are expected to be completed soon. There is a chance that the cabinet will decide on implementation in June, and the new Investment Ordinance could be published as early as August 2010.

Q: What implications will the draft have on the private equity industry that German insurance companies and private equity managers should be aware of?

A: The draft will introduce, abolish and amend a number of restrictions on the way German insurance companies invest for account of their restricted assets. One especially important change, which I refer to as the participation quota, relates to the amount of an insurer's restricted assets that can be invested in unlisted subordinated loans to, or equity participations in, a company. The draft also abolishes the 10% ownership limitation in a company, and instead introduces a new limitation related to investing in a single issuer. Eligibility requirements for holding companies are also changed, which may prove significant for mezzanine and mixed equity-style funds. Finally, the draft introduces a new requirement for limited partnership interests that must be met in order to be considered under the participation quota.

Q: What might change in regards to the participation quota?

A: Previously, German insurers could not invest more than 10% of the restricted assets in subordinated loans to, and equity participations in, companies. The draft raises this participation quota to 15%. Typical private equity limited partnership structures would potentially qualify for the participation quota if the applicable requirements are met.

Q: Could you expand on the new limitation that will replace the 10% ownership threshold? How will this affect the private equity industry?

A: The draft abolishes the restriction barring insurers from acquiring more than a 10% interest in a single company, which I refer to as the investment-related threshold. This restriction is replaced by a special 1% limit on an insurer's restricted assets invested in a single company through listed stock or instruments contemplated under the participation quota, which I refer to as the issuer restriction.

Although the amendment is meant to provide more flexibility, it could pose an issue for smaller insurers, which can also be found within an insurance group acting as one investor, but technically investing via separate entities. However, the draft includes a Grandfathering provision keeping the issuer restriction from being applied to investments made prior to the revision.

As was the case with the investment-related threshold, the issuer restriction will apply on a look-through basis to an insurer's investment in an eligible holding company. It is therefore important to note that the draft also significantly changes the requirements for eligible holding companies.

Q: What are the changes to the eligibility requirements of holding companies?

A: An insurer can invest in a holding company through subordinated loans, listed stock, or other equity participations. Previously, however, the look-through only applied if the holding company invested exclusively in equity participations. The result was that the look-through was not applicable to mezzanine or mixed equity-style funds.

The draft modifies the eligibility of holding companies. The look-through would now apply to holding companies investing in target companies through subordinated loans, listed stock, and other equity participations, if the holding company holds only such assets. Consequently, the look-through could also apply to mezzanine and mixed equity-style funds.

Q: How does the draft change the applicable requirements for limited partnership interests to qualify under the participation quota?

A: Currently, limited partnership interests qualify for the participation quota if they are domiciled in the EEA or an OECD member state, and if certain disclosure, liquidity, and security requirements are met.

The draft would additionally require the target company to "have a business model and enter into entrepreneurial risk," which I refer to as the activity requirement. The draft's reasoning states that a company is not active if its value is generated by the sum of its assets only, as would be the case with open-ended securities funds which merely buy and sell financial investments.

The activity requirement will have significant effects on a private equity fund's eligibility for the participation quota, particularly with a view to private equity real estate funds. BaFin's interpretation of the activity requirement will determine the requirement's impact, and BaFin will likely have large discretion given that German insurance companies generally do not challenge BaFin's rulings.

In the case of holding companies, the activity requirement applies at the level of the investments of the holding companies. Therefore, the determination of whether a company qualifies as a holding company is now not only essential for calculating investment restrictions, but may also be decisive in deciding whether an investment in a fund is eligible for the participation quota at all.

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