I. GENERAL RISKS OF INVESTMENTS IN FINANCIAL INSTRUMENTS
1. General risks of investments in financial instruments and other assets
In the investment in financial instruments general risks apply to all asset classes and services relating to the investment in financial instruments. Some of these risks are described below.
2. Cyclical risk
The cyclical risk refers to the risk of losses caused by the investor’s lack of consideration or incorrect consideration of the cyclical economic development in his investment decisions who thereby makes a financial investment at the wrong time or holds or does not sell financial instruments during an unfavourable cyclical phase.
The macroeconomic development of a national economy typically progresses in wave-like movements, the phases of which can be subdivided into sections of upswing, high, downswing and low phase. These cyclical phases and the frequently related interventions by governments and central banks can persist for several years or decades and have significant influence on the value development of various asset classes. Cyclically unfavourable phases can therefore have negative impact on a financial investment over the long term.
The changes of the economic activity in a national economy always have effects, for example, on the price development of securities: prices fluctuate in the rhythm of cyclical upswing and downswing phases of the economy.
Investors should therefore note that investment forms that are recommendable and permit profits in certain cyclical phases are less suitable in another phase and might entail losses.
3. Inflation risk
The inflation risk is the risk of suffering financial losses through currency devaluation. If the inflation – thus, the positive change of prices for goods and services – is higher than the nominal interest accumulation of a monetary investment, this results in a loss of purchasing power in the amount of the difference. In that case, it is referred to as negative real interest. The real interest accumulation can serve as a reference value for a potential loss of purchasing power. If the nominal interest rate of a monetary investment over a given period is 4% and if the inflation during this period is at 2%, this results in a real interest rate of +2% per year. In the event of an inflation of 5%, the real interest accumulation would only amount to -1%, which would equal a loss of purchasing power of 1% per year.
4. Country risk
A foreign state can take influence on movements of capital and the transferability of its currency. If a debtor domiciled in such a country is, despite his own solvency, not able to fulfil an obligation (on time) for this reason, this is referred to as the country or transfer risk. An investor can suffer a financial loss in result of this.
Reasons for intervention in the financial markets and/or transfer limitations in spite of an adequate credit rating can be, e.g. lack of foreign currency, political and social events such as a change of government, strike or conflicts in international relations.
Specific risk factors relating to an investment in a foreign country
Investments, in particular in a foreign country, involves the risk of adverse political developments, including nationalisation, confiscation without fair compensation and acts of terrorism or war and of changes governmental policies. Furthermore, foreign jurisdictions may impose restrictions to prevent capital flight, which could make it difficult or impossible to exchange or repatriate foreign currency. In addition, laws and regulations of foreign countries may impose restrictions or approvals, which would not exist in the investor's country of origin and may require financing and structuring alternatives, which differ significantly from those customarily used in the investor's country of origin. No assurance can be given that a political or economic climate or particular legal or regulatory risk, might not adversely affect an investment. It may be infeasible for various investment vehicles to invest in certain investment structures as they or certain investors or potential investors may be subject to adverse tax, regulatory or other detrimental consequences; this may limit the investment options for the various investment vehicles.
Issuers are generally subject to different accounting, auditing and financial reporting standards in different countries throughout the world. The volume of trading, the volatility of prices and the liquidity of issuers may vary in the markets of the different countries. Hours of business, customs and access to these markets by outside investors may also vary. In addition, the level of government supervision and regulation of the stock exchanges, securities dealers and listed and unlisted companies is different throughout the world. The laws of some countries may limit the ability to invest in securities of certain issuers located in those countries. In addition, there may be a lack of adequate legal recourse for the redress of disputes and in some countries the pursuit of such disputes a highly prejudiced legal system. These risks may be greater in emerging markets.
Investors should be aware that investments in emerging markets may involve, due to the economic and political development process which some of these countries are undergoing, a higher degree of risk which could adversely affect the value of the investments. Among other things, investments in emerging markets involves risks such as the restriction on foreign investments, counterparty risks, higher market volatility and the illiquidity of the companies’ assets depending on the market conditions in certain emerging markets. Moreover, companies may be subject to considerably less state supervision and less differentiated legislation. Their accounting and auditing do not always match the standards utilised in developed markets.
Investments in some emerging countries are also exposed to higher risks in respect of the possession and custody of securities. Ownership of companies is for the most part determined by registration in the books of the company or its registrar. Certificates evidencing the ownership of companies are frequently not held by the custodian bank, any of its correspondents or an efficient central depositary. As a result and due to lack of efficient regulation by government bodies, the investment vehicles may lose the possession of or the registration of shares in companies through fraud, serious fault or negligence.
5. Currency risk
In investments denominated in a currency different from the investor's home currency, the return earned does not exclusively depend on the nominal profit of the investment in the foreign currency. It is also influenced by the development of the exchange rate between foreign currency and home currency. Besides long-term factors such as inflation trends, also medium-term factors such as balance of trade and services indicators, and short-term factors such as current market sentiment or political conflicts can influence a country’s exchange rate. Financial losses can arise for the investor when the foreign currency in which the investment was made is devalued com-pared to the home currency. In that case, the loss from currency valuation can substantially exceed the returns otherwise achieved with the investment and thus lead to a total loss for the investor. Inversely, an advantage for the investor can result if the home currency is devalued.
The prices of financial instruments experience fluctuations in the course of time. The severity of these fluctuations within a certain period is referred to as volatility. Volatility is calculated by means of historical data according to certain statistical methods. The higher the volatility of a financial instrument, the more the price will move up or down. An investment in financial instruments with high volatility is accordingly more risky, as it entails a greater potential of losses.
7. Liquidity risk
The liquidity risk of a monetary investment means the risk for an investor of not being able to sell his securities at any time for prices in line with the market. In general, supply and demand of a market are decisive for the processing of securities transactions. If there are only few and widely differing orders for a security on the market, a market is referred to as being illiquid. In that case, it is not possible to execute purchase or sale orders immediately, or only in part or only at unfavorable conditions. This has the effect that an average-sized sales order commonly leads to noticeable price fluctuations in those cases or that it can only be executed at a significantly lower price level.
8. Cost risk
When buying and selling financial instruments, incidental charges are incurred besides the actual price of the financial instrument. The incidental charges can be divided into three categories. The first category considers costs that are directly tied to the purchase. This includes transaction costs and commissions that are passed on by credit instituts to the client. The second category comprises consequential costs such as depositary expenses. The third category considers costs beyond this, for example, the management fees for shares held in investment funds. The amount of the incidental charges directly affects the realisable return from a financial instrument for an investor. The higher the incidental charges, the higher the return must be to cover the costs.
9. Tax risks
Earnings generated by financial investments are generally subject to taxes and/or levies for the investor. Changes in the tax framework conditions for capital gains can lead to a change of the tax burden and the levies charged. In the case of foreign investments, double taxation may also occur. Taxes and levies therefore reduce the investor's actual return. Moreover, decisions of tax policy can have positive or negative impacts on the overall price development of the capital markets.
10. Risk of credit-financed investments
In some cases, investors can receive additional funding for the financial instrument by borrowing loans or encumbering their financial instruments with the aim of raising the sum invested. This strategy causes a leverage effect of the capital employed and can lead to a significant increase of the risk. This leverage effect becomes even stronger when the credit-financed financial instrument itself has leverage as in the case of options or futures trading. In the event of a decrease of the value of the financial instrument, it might not be possible under certain circumstances to satisfy additional funding obligations for the loan or interest and redemption claims of the loan, and the investor might be forced to make a (partial) sale of the financial instruments. Investors should use exclusively freely available capital for the financial investment, which they do not need for coverage of the running costs of living and current liabilities. Investors should never rely on being able to repay the borrowed credit and interest from the earnings generated by the financial investment, but they should ensure that they can also bear the credit and interest if the financial investment leads to losses or even results in a total loss.
11. Risk of incorrect information
Correct information forms the basis for successful investment decisions. False decisions can be made based on missing, incomplete or incorrect information, and due to an incorrect or belated transfer of information. For this reason, it might be inappropriate under some circumstances to rely on one single source of information when interested in a financial investment, but to obtain further information.
12. Transmission risk
Orders of the investor to purchase or sell financial instruments must contain certain information that is absolutely required so that the investor obtains a right of execution against the securities services enterprise and to avoid misunderstandings. This includes in particular purchase and sale instructions, the number of issues or the nominal amount, and the exact name of the financial instrument.
13. Risk of self-custody of securities
Self-custody of securities carries the risk of the loss of certificates, for example, through fire or theft. Reobtaining the securities certificates that embody the investor's rights may be time- and cost-consuming. Investors who keep their securities in self-custody further-more risk missing important dates and deadlines, so that certain rights from the securities can be claimed only belatedly or not at all anymore.
14. Risk of keeping securities in custody abroad
Securities acquired in foreign countries are frequently kept in the custody of a third party abroad that was selected by the depositary bank. This can entail increased costs, longer delivery periods and complications regarding foreign jurisdictions. Especially in the case of insolvency proceedings or other enforcement measures against the foreign custodian, access to the securities may be limited or even barred.
15. Risk of investments in infrastructure assets
Potential investors should carefully consider the specific risks before investing in infrastructure assets (infrastructure assets are such that cover the basic provision of basic services, facilities and institutions upon which the growth and development of a community depends such as renewable energies, utilities, transport, social infrastructure and communication, and other assets providing social or economic benefits).
The investment in infrastructure assets harbors a high degree of risk. The value of the assets can reduce and increase, and investors may not be able to recover the amount they originally invested, or may not be able to recover any amount at all, upon return or otherwise.
Investments in infrastructure are generally will be subject to the risks inherent to the ownership and operation of the asset concerned, including (i) risks associated with both the domestic and international economic climate; (ii) local energy sector fundamentals; (iii) risks due to dependence on cash flow; (iv) risks and operating problems arising out of the absence of certain construction materials or other resources; (v) changes in availability of financing; (vi) supply shortages; (vii) changes in the tax, infrastructure, environmental and zoning laws and regulations; (viii) various uninsured or uninsurable risks; (iv) natural disasters; (x) the ability to manage and success-fully exit the infrastructure assets; (xi) availability and (xii) costs of debt. With respect to investments in equity or debt securities, the alternative investment funds will in large part be dependent on the ability of third parties to successfully operate the underlying assets. There is no assurance that there will be a ready market for resale of investments because investments in infrastructure assets generally are not liquid.
Infrastructure assets in general
Infrastructure assets can involve risks which broadly stem from issues of geographic or market concentration, the financial instability of third-party sub-contractors and off-takers, government regulation, technical failings, supply, demand and price fluctuations, poor operational performance, project termination and the economic climate, including interest rate fluctuation. These risks may have a material adverse effect on the value of the infrastructure assets.
Infrastructure assets are vulnerable to adverse change in the economic conditions of the jurisdiction in which they are situated, as well as to global economic declines. Since projects in this sector tend to be of a long-term nature, projects which were conceived at a time when conditions were favourable may subsequently be adversely affected by changes in the financial markets, investor sentiment or a more general economic downturn.
Infrastructure companies may be liable for breaches of environmental protection statutes, rules and regulations, or may become bound by environmental liabilities arising in the future in relation to any sites owned or used by such infrastructure companies. The potential liability includes payment of the costs of investigating, monitoring, removal and remediation, as well as fines for non-compliance with the relevant statute, rule or regulation. Compensation may also be payable if liability arises for personal injury, property damage or other private claims which may be brought. Often this liability arises regardless of the state of knowledge of the owner or operator of the property, and regardless of whether or not, for example, it caused the contamination. A liability of this nature may be detrimental to the value of the Infrastructure asset.
Construction and operational risk
The long-term profitability of the Investments will depend on the efficient design, construction, operation and maintenance of underlying infrastructure assets. The construction and operation of such infrastructure assets is often outsourced to third-party contractors, and any potential design or construction defect and/or inefficient operations and maintenance by those external contractors and/or the excess of any subcontractors’ liability caps may reduce returns. If the risks set out above occur, this could have a material adverse effect on the value of the infrastructure asset. Likewise, during the life of an infrastructure asset, components of the infrastructure asset or building will need to be replaced or undergo a major refurbishment. Any cost implication, not otherwise passed down to subcontractors, will generally be borne by the affected infrastructure company, may adversely affect its ability to service its senior debt, and consequently could affect the respective investment vehicle. Other operational risk is associated with the termination of project agreements. Contractual agreements for infrastructure projects including but not limited to public private partnerships (PPP) and private finance initiative (PFI), renewable and conventional power projects, lease structures and acquisition finance frequently give the relevant counterparty and the infrastructure company rights of termination. Termination of the project agreements may significantly affect the borrower’s ability to service its senior debt.
The concessions for certain infrastructure assets are granted by government bodies and are subject to special risks, including the risk that the relevant government bodies will exercise sovereign rights and take actions contrary to the rights of the asset holders under the relevant concession agreement. There can be no assurance that the relevant government bodies will not legislate, impose regulations or taxes, change applicable laws, or act contrary to the law in a way that would materially and adversely affect the business of the asset.
Regional or geographical risk
This risk arises where an infrastructure company's assets are not moveable. Should an event occur, which impairs the performance of an infrastructure company's assets in the geographic location where the infrastructure company operates those assets, the performance of the Infrastructure company may be adversely affected.
Deal flow risk
There may be a lack of investment opportunities offering financial returns in line with the investment objectives of the respective investment vehicle such that the investment vehicle fails to invest the subscription proceeds. This risk may principally appear as a result of a market rally for infrastructure stocks and/or of the competition from other infrastructure investment funds.
Income of the infrastructure company risk
The income earned by the respective investment vehicle from an infrastructure company is made primarily of dividends, interest and capital gains, which can vary widely over the short and long term. Notably, the infrastructure company's income may be affected adversely when prevailing short-term interest rates increase and the infrastructure company is utilising floating rate leverage.
The long-term profitability of an infrastructure company is partly dependent on the timely construction without cost overruns and efficient operation and maintenance of its infrastructure assets. Should an infrastructure company fail to efficiently maintain and operate its assets, the infrastructure company's ability to maintain payments of dividends or interest to investors may be impaired. The destruction or loss of an infrastructure asset may have a major impact on the infrastructure company. Failure by the infrastructure company to carry adequate insurance or to operate the asset appropriately could lead to significant losses.
Changes in law risk
Infrastructure companies and infrastructure assets are generally subject to a highly regulated environment, particularly when they are of a strategic nature, have an impact on the environment, are accessible by the general public, have access to public subsidies or advantageous tax regimes, or are a virtual monopoly. Although infrastructure companies generally protect their assets against changes in applicable laws and regulations, particularly where such changes would be discriminatory, cash flows and investor returns may be materially affected by such changes.
Taxes in underlying jurisdictions
The respective investment vehicle, the investment structures underlying this investment vehicle (including any subsidiaries) and the shareholders may be subject to the income or other tax in jurisdictions in which underlying vehicles are located and/or investments are made. Moreover, withholding tax or branch tax may be imposed on earnings of the respective investment vehicle. In addition, local tax incurred in such jurisdictions by the investment vehicle or a subsidiary may not be creditable to or deductible by the shareholders in their respective jurisdictions.
Strategic asset risk
Infrastructure companies may control significant strategic assets. Strategic assets are assets that have a national or regional profile, and may have monopolistic characteristics. The very nature of these assets could generate additional risk not common in other industry sectors. Given the national or regional profile and/or their irreplaceable nature, strategic assets may constitute a higher risk target for terrorist acts or political actions. Given the essential nature of the products or services provided by infrastructure companies, there is also a higher probability that the services provided by such infrastructure companies will be in constant demand. Should an infrastructure company fail to make such services available and is unable to rectify the poor performance within a reasonable amount of time, there is the risk that performance deductions are applied to the infrastructure company’s revenue stream or that the underlying project contract is terminated, thereby heightening the risk of any potential loss for investors.
Relief events risk
Relief Events, such as interruptions due to poor weather, industrial actions, protestors and trespassers, et al., which prevent performance by the infrastructure company of its obligations at any time and in respect of which the infrastructure company bears the financial risk in terms of increased costs and reduced and/or postponed revenue (but for which it is given relief from termination for failure to provide the full service) may severely affect the returns on investment of the respective investment vehicle, which could result in a default under the related loans held by the investment vehicle.
Distribution risk for equity securities
In the selecting equity securities in which the respective investment vehicles can invest, the respective investment manager may con-sider the infrastructure company's history of making regular periodic distributions (e.g., dividends) to its equity holders. An issuer's history of paying distributions, however, does not guarantee that the issuer will continue to pay dividends in the future. The income distribution associated with equity securities is not guaranteed and will be subordinated to payment obligations of the issuer on its debt and other liabilities. Accordingly, in the event the issuer does not realise sufficient income in a particular period both to service its liabilities and to pay dividends on its equity securities, it may forgo paying dividends on its equity securities and may be subject to a technical event of default and/or an debt acceleration event. In addition, because issuers are not obliged to make periodic distributions to the holders of their equity securities, such distributions or dividends generally may be discontinued at the issuer's discretion. In addition, a component of distributions will represent capital gains. These may be subject not only to the issuer's underlying fundamentals but also to general market conditions.
Documentation and litigation risk
Infrastructure assets are often governed by a complex series of legal documents and contracts. As a result, the risk of a dispute over interpretation or enforceability of the documentation may be higher than for other issuers and assets, including the risk of a dispute with the public authority with which a long term contract has been signed or acting as regulator of the infrastructure assets.
Infrastructure companies can have a narrow client base. Should these clients or counterparties cease to need the services delivered by an infrastructure asset or fail to pay their contractual obligations to the infrastructure company, significant revenues could cease and not be replaceable. This would affect the profitability of the infrastructure company and the value of any securities or other instruments it has issued.
Infrastructure companies may require refinancing of some or all of their debt prior to the end of project’s life in order to repay the project’s obligations as they fall due. Where a project carries a requirement to refinance, there is a risk that such refinancing cannot be secured at the forecasted financing costs or at all. This could have an impact on the timing and/or amounts of distributions or other payments in respect of the infrastructure company’s equity. If refinancing cannot be secured at the forecasted financing costs, the distributions from those projects could be materially reduced. If refinancing cannot be secured at all for one or more of these projects, the relevant project could (subject to limited safeguards in the project documentation) default altogether.
Leverage risk at the infrastructure company level
Infrastructure companies are likely to utilise leverage for the financing of infrastructure assets. Leverage involves risks and special considerations for the respective investment vehicle, including:
- the likelihood of greater volatility of value of the infrastructure companies;
- the risk that fluctuations in interest rates will result in fluctuations in the dividends paid to the investment vehicle or will reduce the return to the investment vehicle;
- the effect of leverage in a declining market, which is likely to cause a greater decline in the NAV of the infrastructure companies than if such infrastructure companies were not leveraged;
- the risk that a breach of covenants provides debtors and/or senior lenders with enforcement and early acceleration rights.
If an infrastructure company requires restructuring due to a force majeure, terrorist attack or armed conflicts, relief event and/or other reasons, there is a risk that such restructuring may not be in the interest of the respective investment vehicle or may not be completed successfully. Any such failure could lead to increased risk and cost to the investment vehicle and result in reduced returns or losses to the shareholders.
Risk relating to force majeure
Events of force majeure, such as social unrest, riots, conflicts, war, floods, earthquakes, lightning, thunderstorms, and typhoons may severely affect the returns on investment of the respective investment vehicle. While the construction and operation of infrastructure assets are generally governed by legal documents and contracts whereby the cash flow losses consequential to force majeure events are essentially allocated to counterparties such as insurers, contractors, operators and public authorities, there exists situations of force majeure where an infrastructure company may experience severe losses, if not bankruptcy. These situations could arise when force majeure risks are only partly allocated to third parties under the applicable contractual arrangements, failure of contractual counterparts to fulfil their obligations due to the situation of force majeure and, more generally, force majeure events which disrupt the economy and stability of a region or country by their magnitude and/or duration.
Terrorist attacks or armed conflicts
Terrorist attacks may harm the investment vehicles investments. There is no assurance that there will not be further terrorist attacks against the countries where infrastructure assets are located, or against the infrastructure assets themselves. These attacks or armed conflicts may directly impact the infrastructure assets underlying the investment vehicles investments or the securities markets in general. Losses resulting from these types of events are uninsurable. More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the financial markets and economy. Adverse economic conditions could harm the value of the infrastructure assets underlying the investments of the respective investment vehicles or the securities markets in general which could harm the investment vehicles financial performance and may result in increased volatility of the value of its investments. Additionally, such events could result in decreased revenues generated by the related assets and could result in increased defaults under the debt instruments held by the investment vehicle.
Infrastructure assets may be subject to numerous statutes, rules and regulations relating to environmental protection. Certain statutes, rules and regulations might require that investments address prior environmental contamination, including soil and groundwater contamination, which results from the spillage of fuel, hazardous materials or other pollutants. Under various environmental statutes, rules and regulations, a current or previous owner or operator of real property may be liable for non-compliance with applicable environmental and health and safety requirements and for the costs of investigation, monitoring, removal or remediation of hazardous materials. These laws often impose liability, whether or not the owner or operator knew of or was responsible for the presence of hazardous materials. The presence of these hazardous materials on a property could also result in personal injury or property damage or similar claims by private parties. Persons who arrange for the disposal or treatment of hazardous materials may also be liable for the costs of removal or remediation of these materials at the disposal or treatment facility, whether or not that facility is or ever was owned or operated by that person. Power companies are subject to numerous environmental laws and regulations in each country in which they operate. Some of the most onerous requirements regulate air emissions of pollutants such as sulphur dioxides, nitrogen oxides, and particulate matter. Emission standards for sulphur dioxides, nitrogen oxides, and particulate matter may be stringent and are likely to become more restrictive over the next several years. Generators may also face new requirements on their emissions of greenhouse gases, specifically including carbon dioxide. The uncertain and ever changing regulatory environment in which generators operate makes it likely both that generators will face increased operating costs in the years ahead and that the relative competitive position of various fuel types and generation technologies will change. Certain possible changes in the environmental laws and regulations applicable to generators could affect the performance of one or more of the investment vehicles investments to an extent that would create a material adverse effect to the respective investment vehicle. The respective investment vehicle may be exposed to substantial risk of loss from environmental claims arising in respect of the infrastructure assets of the investment vehicle, and the loss may exceed the value of such investment. Furthermore, changes in environmental laws or in the environmental condition of an asset of the investment vehicle may create liabilities that did not exist at the time of acquisition of an asset and that could not have been foreseen. For example, new environmental regulations may create costly compliance procedures for infrastructure assets.
In addition, infrastructure assets can have a substantial environmental impact. As a result, community and environmental groups may protest about the development or operation of infrastructure assets, and these protests may induce government action to the detriment of the owner of the infrastructure assets. Ordinary operation or occurrence of an accident with respect to infrastructure assets could cause major environmental damage, which may result in significant financial distress to the particular asset. In addition, the costs of remediating, to the extent possible, the resulting environmental damage, and repairing relations with the affected community, could be significant.
Risk of additional and increased costs of an investment project
The investment activities are generally tied to the risk that the costs related to a concrete investment project according to the investment plan and budget (e.g. production costs, costs of the facilities) are exceeded in consequence of unexpected changes or incomplete or incorrect information that has been considered for the relevant investment decision. If the respective investment vehicle participates in tender procedures for an investment, there is the risk in case the bid is not successful that besides its own costs, the respective investment vehicle also has to bear the costs incurred for third parties in the context of the bidding procedures.
Contract fulfilment risk
The economic result of investment projects of the relevant investment vehicles depends on, among other factors, the respectively involved contractual partners fulfilling their obligations under the contracts entered with them. Breaches of contract by the contractual partners, as well as their bankruptcy, can result in the termination of contracts, which can have the further consequence that investment projects cannot be completed or processed or only at increased cost or with losses.
Projects and companies in the infrastructure sector are often financed with outside capital to a large extent and, for this reason, they are more susceptible to negative interest rate changes, declining cyclical developments, changes in the capital market and higher debt service than projects and companies that are not or only to a very limited extent financed with outside capital. This can entail that the participations held by the respective investment vehicles or investment project in which they participate cannot be completed or they will not be able to finance the future operation and capital requirement. As a consequence, in turn, restrictive financial and operational requirements of the financing banks can be imposed, such as the requirement not to make any disbursements or dividend payments anymore (for the time being). Changes in interest rates might moreover also affect the respective discount rate, which is to be considered in the valuation of the projects and companies. Therefore, this valuation can be exposed to volatility. This can have a negative effect on the prices that can be achieved in a sale of participations. Furthermore, the regulatory authorities often base the determination of the prices they approve of on the respective market interest rates in the case of projects or companies subject to state supervision.
Risk of the availability of outside capital
Besides the availability of equity, it is primarily decisive for the acquisition or refinancing of projects and companies in the infrastructure sector that outside capital can be borrowed to sufficient extent and at appropriate conditions, in order to reach an optimised capital structure. Bottlenecks in the availability of outside capital can cause that investments cannot be made to the extent planned or only at in-creased costs for outside financing. This can lead to negative effects on the results and the financial position of the respective investment vehicles and their ability to meet their liabilities.
Legal and political risks
Infrastructure projects are exposed to political and legal risks in the respective country in which they are established. Especially the risk of uncertainty relating to the future political alignment of a certain country, its involvement in supranational systems, the signing and implementation of international agreements and the risk of a government failure, and disturbance of the general social order and stability of such a country (e.g. conflicts with labour unions, interest representations and public or private organizations, which can potentially lead to strikes, blockades or other actions, which in turn can imperil the planned completion, operation or liquidation of investment projects) is considered a political risk. Legal risks are risks of a potential change of the relevant legal standards of a country, which in turn can have effects on the investment projects. Such risks can entail extensions or delays in the project implementation, discontinuation of a project or additional costs or losses with regard to an investment project. Given the partly substantial public interests that are held in the services, projects and companies in the infrastructure sector, it cannot be ruled out that the attitudes of public instituts acting as issuers of concessions, licenses or leases are being influenced by political motives. Such political interests do not necessarily match those of the participations held and they can therefore entail extensions or delays in the project implementation, discontinuation of a project or additional costs or losses with regard to an investment project.
Insofar as the respective investment vehicles invest in countries where capital controls exist or are being introduced, it cannot be ruled out that based on the existence or introduction of capital controls, a return of investments or a disbursement of earnings from investment projects to Germany may not be possible. This can lead to a drastic deterioration of the financial position of the investment vehicles and impair their capacity to meet their liabilities.
Risk of restrictions and discrimination against foreign investors
The activities of foreign companies in various countries are subject to certain restrictions. Thus, it is frequently the case that the majority of a company that operates in a state-defined key sector, e.g. the energy sector, must be held by a local company (or local companies). Foreign companies may often not hold the majority of voting rights and they are not permitted to exercise negative control rights. The representation of a foreign investor in the administrative board or the management board of a local company must correspond to the portion of the investor’s participation. Emerging countries typically apply restrictions and various measures aiming to prevent the control of strategic sectors and essential means of production by foreign investors or to protect local businesses. The implementation or tightening of such restrictions and protectionist measures in the respective countries cannot be precluded for the future. Such changes can have significant negative effect on the financial position of the investment vehicles and their ability to meet their liabilities.
Subsidies for other technologies
It cannot be ruled out that technologies other than the ones favoured by the respective investment vehicles are supported by the government or other organisations. In these cases, the operation of infrastructure assets and projects can become inefficient, which can have negative effects on the business results.
A large part of the investments in infrastructure assets is made in projects and companies whose business activities are subject to supervision under public law in substantial parts. Such activities frequently depend on concessions and contracts with public administrative authorities or entities of public law, which are generally very complex and which can lead to disputes on interpretation and enforceability. The violation of such contracts or concessions can entail penalty payments or even the loss of the operating permit for the affected infrastructure asset. If the operation of an infrastructure asset requires a concession agreement with a public institution, this concession agreement can entail that the operation of the asset will be subjected to restrictions, which can prevent or limit the possibility of the asset to arrange operations in such a way that the highest possible profit is generated. Concession agreements can also include clauses that favour administrative authorities or public entities more strongly than would be the case between two private parties in ordinary economic contracts. For example, the concession agreement can entitle the authority or the contracting party of public law to terminate the concession agreement on certain conditions (e.g. in the case of minor breaches of investment or maintenance duties) without having to pay an appropriate compensation. The case may also arise that administrative authorities or public entities must be granted the right to change the operating rules at their own discretion. Furthermore, the respective country can pass laws, regulations or decrees that can affect the operation of an asset. This can occur regardless of contractual rights that must be granted to authorities or public entities. Public and state authorities and legal entities have a relatively large margin of discretion for the introduction of regulations and ordinances that can have substantial effects on infrastructure investments. Such decisions and measures can be influenced by political interests and lead to decisions that have a negative impact on the affected companies and their operation. It can moreover not be ruled out that sectors that are not yet subject to supervision under public law on the date when the prospectus is drafted and approved will be regulated in the future. There is also the risk that authorities in countries in which investments can be made will introduce or modify regulations that regulate the permissible fees, prices or other economic parameters with regard to the operation of infrastructure assets.
Information and statements of third parties
In the evaluation of investment possibilities, the respective managers of the investment vehicles consult external experts such as financial, legal and tax advisers, as well as technical consultants and environmental experts. The investment vehicles often base their deci-sion-making processes on estimates, expert opinions and other reports of such consultants without being able to assess independently whether such a report is complete and correct in all cases. In addition, it must be considered that partly subjective evaluations are often included in the conclusions of external consultants.
Investments in Greenfield Projects
Insofar as investments are made in projects that are in the development and/or construction phase (so-called “Greenfield Projects”), the investor bears the risk that the project will not be completed in keeping within the budget, within the planned schedule or according to the agreed specifications. I, the respective investment vehicles can be exposed to the risk of additional costs or losses that may result from the adjustment of the schedule or budget. Greenfield projects are commonly acquired on the basis of certain assumptions with regard to potential demand, market environment, profitability, etc. With regard to the long lead time between the start of the project and its completion, a project evaluated originally as being financially interesting can become a financially unattractive investment as a result of changes in the market, e.g. the investor behaviour, financial markets or the demand for the service.
Risk of price development for commodities
The operation of infrastructure assets, in particular energy generating plants, requires contracts on the supply of the necessary commodities. It may occur that suppliers violate their contracts or that a plant cannot be supplied with sufficient commodities for another reason. In some cases this can lead to the production (of power and heat) being reduced, which in turn can impair the results of the investment company and indirectly impair the results and the financial position of the respective investment vehicles. Moreover, there are regularly no long-term contracts regarding the supply of fuels (with a guarantee of the supply quantity, quality and price). There is also no absolute certainty that the rates of increase of purchase prices for commodities can be compensated by corresponding increases of sales prices.
Construction and operating risks
The long-term profitability of infrastructure assets depends on the efficiency of their design, construction, operation and maintenance. Construction and operation of infrastructure assets is regularly outsourced to external contractors. Possible design or construction defects and/or inefficient operation and inadequate maintenance of assets by such external contractors and/or the exceedance of any liability limits by subcontractors can impair the profitability of infrastructure assets. Insofar as these risks come to bear, this can have a decisively negative effect on the value and profitability of the asset. During the lifetime of an infrastructure asset, the replacement or a general renovation or maintenance of components or buildings or building parts may become necessary. Cost consequences that can-not be passed on to subcontractors have to be borne by the investment company in such cases. The potential termination of project contracts must be regarded as an operating risk. Contracts relating to infrastructure projects, including energy supply contracts, rental and lease agreements, as well as financing agreements usually provide for termination rights of the parties to the contract. The termination of such contracts may substantially impair the operation and profitability of an infrastructure asset.
II. VARIOUS TYPES OF FINANCIAL INVESTMENTS AND THEIR SPECIFIC RISKS
1. Possibilities of investments in financial instruments
There are various types of financial instruments in which the wealth management can invest its clients’ funds. In this brochure, we would like to give an overview of investments in the financial instruments of money market investments, equities, bonds in open and closed-ended investment funds including hedge funds, structured products (for example, certificates) and investment funds. We would also like to introduce the investment possibilities in precious metals and commodities, as well as real estate. In the following sections, the individual investment classes are described and the general and specific risks of an investment in the individual described asset classes is presented.
2. Money market investments
The money market is also known as the market for fixed-term and time deposits. Money market investments consist of short-term receivables with an interest rate and optional maturities of up to one year. The debtor is frequently a bank. A certain minimum amount is usually required for money market investments. The term “money market investments” covers both non- securitised receivables (money market investments in the narrow sense) as well as money market instruments. These instruments include receivables that are issued as a security and usually freely tradable so that they can be sold in the secondary market before they expire.
Specific risks of money market investments
A cluster risk is created in particular in the case of concentration on one or particular debtors. In that case, there is a risk of significantly higher losses in the event of a payment default than in the cases where a carefully diversified portfolio is being used.
A correlation risk can arise especially when an investor is strongly oriented on a bank, thus, for example, if he concentrates his assets largely on account credit balances, money market investments and/or bank shares.
Settlement and custody risk
Settlement risk refers to the risk that the buyer pays the price for a money market instrument in advance but does not receive the money market instrument in consequence of the seller’s insolvency. The custody risk pertains to the risk that the depositary of money market instruments becomes insolvent.
An equity is a security that certifies an investor’s right in a stock corporation. A shareholder is a co-owner of the assets of the stock corporation and thus participates in the economic success and failure of the corporation. Success or failure of the corporation is reflect-ed in a positive or negative price development of the share and in potential dividend payments.
There are various forms of equities that are equipped with different rights. The most important forms are common shares, preferred shares, bearer shares and registered shares. Common shares are equipped with voting rights and the most common type of equities in Germany. By contrast, preference shares are usually not equipped with voting rights. To compensate for the missing voting right, shareholders however receive a preferred treatment, e.g. in the payment of dividends. For a bearer share, it is not necessary to enter the shareholder in a share register. The shareholders can exercise his rights also without the registration. Bearer shares are therefore easier to transfer, which typically improves their tradability. For a registered share the name of the owner is entered in the share register. Without the registration, the rights from the ownership of the share cannot be exercised.
Specific risks of equities
Risk of insolvency
A shareholder is not a creditor but an equity investor and a co-owner of the stock corporation and therefore exposed to all business risks. In the extreme case, i.e. in the case of insolvency of the stock corporation, shareholders will be considered in the distribution of the liquidity proceeds only after satisfaction of all claims of creditors.
Price rate risk
Stock prices are characterised by unpredictable fluctuations. From the shareholder’s perspective, the price rate risk can be differentiated into the general market risk and the company-specific risk. Each for itself and both cumulatively affect the stock price development. The general market risk of a stock refers to the risk of a price change in consequence of the general tendency on the stock market. In this context, the price change is not directly related to the company’s financial situation. All equities are subject to such market risk. The severity can vary. The company-specific risk refers to the risk of a downward price development of a particular company based on factors that pertain directly or indirectly to the company in question. For example, management decisions can be mentioned as such factors. The company-specific risk can thus entail that stock prices develop quite individually contrary to the general trend.
The confidence of market participants in the respective company can also influence the price development. This applies in particular to companies whose shares were only admitted relatively recently to trading at the stock exchange or another organised market; regarding those shares slight changes in the forecasts can already lead to strong price movements. If the portion of freely tradable stocks held by many shareholders (so-called free float) is small, already small purchase and sales contracts can cause a strong effect on the market price and thus lead to higher stock price fluctuations.
In addition, the price development of the stock is determined by the expectations of market participants regarding the specific company and the general market development, and the investment behavior of the market actors. The investment behavior of the market actors can also be influenced by irrational factors such as sentiments, opinions and rumors, irrational considerations and mass psychological behavior such as herd instinct and orientation on particular market actors or other stock exchanges. This can result in the further amplification of existing trends in the market and the detachment from the overall economic situation or that of the company so that the trends no longer reflect those situations.
Dividends refer to the shareholders’ participation in the profit of a company. The divided of a stock is decisively oriented on the earned profit of the company and can rise, fall or be entirely eliminated during a year depending on the financial situation of a company.
Interest rate risk
Along with rising interest rates, it can happen that stock prices – mostly with a certain delay – see a declining development. A reason for this development is, e.g. that companies must now borrow loans at higher interest rates. On the other hand, attractive investment opportunities might arise for investors at the higher interest rate as the case may be.
The investor can estimate the future value development of the stock incorrectly or incorrectly for some of the time even when using single or different analysis techniques (fundamentals analyses or chart analyses) and buy or sell at a time that is inopportune for the investor.
Risk of the loss or change of shareholders’ rights and of a delisting
The rights of the shareholder can be changed or partly or fully cancelled through measures taken by the company, for example, a change of the legal form, mergers, spin-offs or company agreements. In case there is a majority shareholder, minority shareholders can moreover be excluded from the company under certain conditions as part of a squeeze-out. These measures taken by the company can entail that the investor has to sell his shares early with losses and cannot realise the intended investment period in the share. Furthermore, the measures can result in stock price losses for the share. In the event of lost shareholders’ rights, the investor may be entitled to a compensation claim against the company based on legal regulations, but this compensation may value lower than the lost shareholder right.
The company can also decide to revoke the equities’ admission to trading at the stock exchange (delisting). In that case, the equities are tradable only with difficulty and regularly only at significant price discounts compared to the previous stock price. Based on this limited tradability, the announcement of a delisting frequently leads to massive price losses of the affected share.
Risk of low tradability of shares not listed at the stock exchange
Shares that are not traded at a stock exchange carry the risk that the equities cannot be sold immediately.
Bonds refer to a large range of interest-bearing securities, which are also called annuity certificates. Besides the “traditional” bonds, these also include index bonds, debentures and structured bonds. The basic mode of functioning is the same for all bonds. Bonds, in contrast to equities, are issued by (both listed as well as non-listed) companies as well as by public instituts and states (so-called issuers). Bonds may or may not have a so-called investment grade from a rating agency. They do not grant the owner a share right to the issuer but the holder becomes a creditor of the issuer. By the issuance of bonds, an issuer borrows outside capital. Bonds are tradable securities with a nominal amount (amount of debt), an interest rate (coupon) and a defined maturity.
Like for a loan, the issuer undertakes to pay a corresponding interest rate to the investor. The interest payments can be made either at regular intervals during the maturity or cumulatively at the end of the maturity. At the end of the maturity, the investor will furthermore receive repayment for the nominal amount. The amount of the payable interest rate depends on various factors. The most important parameters for the amount of the interest rate are usually the credit rating of the issuer, the maturity of the bond, the underlying currency and the general market interest rate level.
Depending on the method of the interest payment, the bonds can be divided into different groups. If the interest rate is determined for the entire maturity from the outset, it is referred to as “straight bonds”. Bonds are referred to as “floaters” when the interest accrual is linked to a variable reference interest rate and if this interest rate can change during the maturity of the bond. A potential company-specific markup or markdown to the respective reference interest rate is usually oriented on the credit risk of the issuer. A higher interest rate at the same time generally means a higher credit risk. Exactly like equities, bonds can be traded at stock exchanges or over-the-counter.
The earnings that can be achieved by investors by investments in bonds result from the interest accrual on the nominal amount of the bond and from any difference between the purchase and sales price.
Specific risks of bonds
The credit risk refers to the risk of insolvency or illiquidity of the issuer. This includes a potential temporary or final incapacity of the issuer to make timely payment on its interest and/or repayment obligations. In case of doubt, an investor is therefore threatened with a total loss of the capital he has provided. The credit rating of an issuer can be the result of cyclical changes, changes directly at the issuer’s organisation (e.g. economic crisis of a state) or political developments. The credit rating of many issuers is assessed by rating agencies at regular intervals and classified into risk classes. An issuer with low credit rating must normally pay a higher interest rate as compensation for the credit risk to the buyers of the bonds than an issuer with excellent credit rating. For covered bonds, the credit rating primarily depends on the scope and quality of the collateralisation (premium fund) and not exclusively on the credit rating of the issuer.
Inflation risk describes the change of purchasing power of the final repayment and/or the interest income from an investment. If inflation changes during the maturity of an investment in such a ways that it is above the investment interest rate, the effective purchasing power of the investor decreases (negative real interest).
Interest rate risk and price risk
The lead interest rate level set by the central bank has decisive influence on the value of a bond. If the interest rate level rises, for example, the interest income of a bond with fixed interest rate becomes relatively unattractive and the price of the investment drops. A rise of market interest rates thus usually goes hand-in-hand with dropping bond prices. Even if an issuer pays all interest and the nominal amount on final maturity, a loss can therefore result for bond investors when they, for example, sell before final maturity for a price that is below the issue or purchase price of the bond.
Risk of termination
In the terms of issue, the issuer of a bond can reserve a right to premature termination. Bonds are often equipped with such a one-sided right of termination during high-interest phases. When the market interest rate level drops, the risk arises for a creditor that the issuer will exercise its right of termination. This way, the issuer can reduce its liabilities or refinance itself with better conditions by issuance of new bonds. In that case, a reinvestment risk applies to a creditor, as a new investment can be less beneficial due to changed market conditions.
Risk of limited tradability
Bonds that are not traded at a stock exchange carry the risk that the bonds cannot be sold immediately.
Specific risks of fixed income securities
The investment in fixed income securities is tied to the risk that the market interest rate level that applies at the time of the issuance of a security will change. If the market interest rates rise compared to the interest as at the time of the issuance, the prices of fixed income securities will usually fall. If the market interest rate falls instead, the price of fixed income securities will rise. This price development entails that the current yield of the fixed income security roughly equals the current market interest rate. These price fluctuations, how-ever, will commonly have different strengths depending on the (remaining) maturity of the fixed income securities. Fixed income securities with shorter maturities have lower price risks than fixed income securities with longer maturities. In comparison, fixed income securities with shorter maturities usually have lower yields than fixed income securities with longer maturities. Based on their short maturities of at most 397 days, money market instruments tend to have lower price risks. In addition, the interest rates of different interest-based financial instruments denominated in the same currency with comparable remaining maturities can have different developments.
Specific risks of convertible and option bonds
Convertible and option bonds securitise the right to exchange the bond for equities or to acquire equities. The development of the value of convertible and option bonds is therefore dependent on the price development of the stock as the underlying asset. The risks of the value development of the underlying equities can therefore also affect the value development of the convertible and option bond. Option bonds that grant the issuer the right to offer the investor a predefined number of equities for acquisition instead of repayment of a nominal amount (reverse convertibles) are increasingly dependent on the corresponding stock price.
5. Structured products (certificates)
In legal terms, certificates are a kind of debenture to bearer. The buyer is therefore a creditor of the certificate issuer.
Certificates are oriented on a so-called underlying asset, i.e. their value development depends on an underlying value. Underlying can be, for example, commodities but also equities or stock indices such as the DAX. Certificates present an opportunity to pursue complex investment strategies and in doing so, invest in various asset classes.
Certificates do not securitize an ownership or shareholder right but the right to the repayment of a sum of money or to delivery of the underlying asset. The kind and amount of the underlying asset depend on one or more certain parameters (e.g. the value of the underly-ing asset on a key date).
Certificates usually have maturities of multiple years. Depending on the structure of the certificate, there may be a fixed point in time as final maturity. However, frequently so-called “open-ended certificates” are offered, which do not have a limitation on maturity. The issuer may have a right to terminate, which can lead to a premature repayment of the capital invested by the investor.
Certificates are quoted either per unit or as percentages. In case of a unit quotation, only full units can be acquired.
For the issue price, several factors play a role that are defined in the relevant certificate conditions (e.g. the value of the underlying asset). The bank can charge an issue premium in addition to the issue price.
The price of a certificate during its term depends on the development of the respective underlying asset and the chosen structure. Yet, also other aspects such as volatility, currency, dividends/distributions or the interest rate development play a role.
Certificates are traded on and/or off the stock exchange. The issuer or a third party usually provides the purchase or sales prices for the certificate during the entire term. Thus, investors can regularly buy and sell their certificates under normal market conditions.
The certificate is normally repaid in the form of a cash transfer. For some certificates, ,e.g. the relevant stock, the underlying asset may also be delivered on maturity.
The value development of the underlying asset is of decisive importance for the certificate price during the term and for the repayment amount of the certificate. The most important underlying assets are presented briefly below.
Specific risks of structured products (certificates)
Specific risks of all certificate types
The issuer risk is the risk that the certificate issuer is not able during or at the end of the certificate term to fulfill its obligations under the certificate. In that case, the investor bears the risk of a partial or total loss of the invested capital, as he will not receive payment of the yield in the form of interest and/or the repayment amount will not be disbursed to him at the end of the term. Besides the risk of the certificate issuer’s insolvency, there is also risk of bankruptcy of the companies the securities of which are underlying the certificate. In these events, depending on the equipment of the certificate, a complete loss of the invested capital can result for the investor as well.
Price rate risk
Certificates refer to underlying assets that can be subject to value fluctuations. If the price of the underlying changes, the price of the certificate will also change. Falling prices of the underlying can mean steep losses for the investor depending on the terms of the certificate. It might not be possible to compensate price changes in downward direction once an agreed bottom limit (barrier) was reached or fallen below. The investor will then also not profit anymore from any strong price increase of the underlying assets at a later time. An underlying asset with strong price fluctuations therefore represents a higher risk for the investor because bottom threshold values as may be agreed upon can be reached faster.
Besides the value of the underlying asset, still further factors can influence the price development of the certificate. These include changes of the interest rate level, market expectations, dividends retained by the issuer or potential exchange rate risks that occur with certificates in foreign currencies. The certificate price is therefore not reflected precisely in the value development of the underlying during the term. This effect, which cannot be precisely calculated at the outset, is referred to as the correlation risk.
Value loss risk
The settlement or repayment amount at the end of the term is determined according to the value of the underlying asset on the maturity date. Therefore, the settlement amount can also be below the purchase price of the certificate. This can lead to the total loss of the investor’s invested capital. This risk can only be eliminated completely or partly if an investment share protection is agreed. As the investment share protection depends on the issuer’s solvency, the issuer risk must also be noticed here as well.
When purchasing a certificate, investors should consider whether there is a sufficiently liquid secondary market for it and if the issuer or a third party can quote binding prices continuously for the certificate. Although the issuer quotes usually continuously indicative purchase and sales prices for the certificate, it has no legal obligation to do so. Absent demand on the secondary market can cause that a certificate cannot be sold, or not immediately or only with price reductions.
Risk of delivery of the underlying asset
With certificates issued for individual values, it is regularly possible that the underlying asset is delivered. If an underlying asset does not develop as favorably as expected when the certificate was purchased, frequently the underlying asset itself instead of the settlement amount is delivered at the end of the term. In that case, the investor will receive a share, for example. The current market value of the underlying asset can meanwhile be below the purchase price paid by the investor for the certificate. In a partial or extreme case, this can also lead to a total loss of the invested capital for the investor when he wants to sell the underlying asset. If the investor does not sell the underlying, he is subject to the price risks associated with holding the underlying asset, which can entail further losses for the investor if the price of the underlying falls further.
Certificates that refer to underlying assets in foreign currencies can be products with currency hedge and without currency hedge. Certificates with currency hedge are also called quanto certificates. Their currency risk is hedged, which can entail internal costs and hidden fees for the investor. In the case of certificates without currency hedge, currency risks arise on a premature sale as well as on repayment on the maturity date, which must be borne directly by the investor.
Effect of hedging transactions by the issuer on the certificates
The issuer usually fully or partly secures itself against the financial risks related to the certificates by means of hedging transactions in the underlying asset of the certificate. These hedging transactions can influence the price of the underlying asset that is formed by the market and therefore have a negative impact on the value of the certificates or the value of the settlement amount that is due at the end of the term. This can lead to a partial loss of the investor’s invested capital.
Specific risks of certificates based on their structure
Capital loss risk at the end of the term
In the case of bonus certificates and express certificates, a loss of capital can occur at the end of the term when a defined barrier was reached or fallen below during the term. In that case, the investor will receive a disbursement amount equaling the value of the underlying asset on the maturity date. It can be below the purchase price for the certificate. In the extreme case, this can lead to the total loss of the investor’s invested capital.
The certificate price is oriented on the price of the underlying asset but it usually does not reflect it exactly.
If the underlying asset is quoted near the barrier for bonus certificates, this can entail increased price fluctuations of the bonus certificate especially toward the end of the term because even slight changes in the price of the underlying can determine whether or not the bonus will be paid.
In the case of express certificates, the price increase potential is limited to the determined repayment amount. Also the repayment amounts in the event of early maturity are defined in the terms of the issue, so that even strong price movements of the underlying in the beginning or during the term are not reproduced linearly.
Discount certificates do not reflect the value development of the underlying precisely in the normal case either, as their profit opportunity is limited by the cap.
In the case of bonus certificates and express certificates, the tradability of the certificate can be restricted during the term when the underlying asset falls significantly below the barrier. In this event, only the issuer might be available as trading partner.
Specific risks of leveraged certificates
Total loss risk due to knock-out
Leveraged certificates bear a particularly high risk of total loss. If the terms of the certificate provide for the certificate to expire when the knock-out agreement occurs, this results in a total loss of the investor’s invested capital.
Leveraged certificates carry increased loss risks because they are express fluctuations of the underlying asset disproportionately because of the leverage effect, meaning they amplify them.
Effect of incidental costs
For leveraged certificates, the commissions due per transaction in combination with a low order value can lead to cost burdens, which can substantially exceed the value of the leveraged certificates in the extreme case. This can lead to the total loss of the investor’s invested capital.
Liquidity risk before maturity
The possibility to sell certificates on the secondary market is not guaranteed. It is therefore also not guaranteed that a sale of a leveraged certificate will be possible on time before the knock-out threshold is triggered. When the underlying asset nears this threshold, a sale may already not be possible anymore.
Specific risks of commodities certificates
The factors influencing commodities prices are highly complex, so that just a few of these factors will be explained briefly below, which can have effects specifically on commodities prices.
Cartels and regulatory changes
If there are cartels of commodities producers, these will usually influence the commodities prices. The trading with commodities is also usually subject to certain rules of supervisory authorities or exchanges. A change of these rules can affect the price development of the commodity.
Cyclical behaviour of supply and demand
Certain commodities are produced throughout the entire year but only in stronger demand in particular seasons (e.g. energy). Other commodities are in demand throughout the entire year but only produced during a particular season (e.g. agricultural products). This can entail strong price fluctuations.
Direct investment costs
The acquisition of commodities is tied to costs for storage, insurance and taxes. In contrast, no interest or dividends are paid on commodities. This has effects on the total return of commodities and consequently influences the price of a commodities certificate.
Commodities are produced in emerging markets in many cases. This is associated with political risks, e.g. embargos, warlike conflicts or economic and social tensions that can affect the prices of the commodities.
Weather and natural disasters
Unfavourable weather conditions can influence the supply of certain commodities temporarily or even for the whole year. Natural disasters can cause lasting damage on production and extraction facilities. If a supply crisis is caused thereby, this can lead to price fluctuations.
6. Open-ended investment funds
An investment fund enables the collective investment of capital of a large number of investors. Investment funds are offered and managed by a so-called investment management company. It requires a license from the German Federal Financial Supervisory Authority (BaFin). Investment funds and their management in Germany are subject to the regulations of the Capital Investment Act. Compliance with these regulations is monitored by the BaFin.
The investment management company bundles the money of investors in an investment fund in order to invest it for the benefit of the investors according to a defined investment strategy. If an investor acquires shares in an investment fund, he does not become a co-shareholder of the investment management company. The investor’s money will be contributed to the fund assets, which for reasons of investor protection is strictly separated from the assets of the investment management company and kept in custody by a custodian. The fund assets are also not liable for debts of the investment management company.
The investment management company invests the fund assets according to the principle of risk spreading. The minimum level of risk spreading, the assets that may be acquired for the investment fund and the investment limits to be kept are defined in the investment conditions of the investment fund. The investment conditions consider the investment targets and limits that result from the Capital Investment Act.
The assets of the investment fund are kept in custody by a custodian. It will take on certain control and monitoring functions relating to the fund assets.
The terms for the issuance and redemption of fund shares, as well as a description of the investment strategy pursued by the investment fund result from the investment conditions of the investment fund. The investment management company can issue new shares at any time for open-ended investment funds. The investor can consequently generally acquire new fund shares at any time. The investment management company, however, has the possibility to restrict, suspend or entirely discontinue the issuance of fund shares.
In open-ended investment funds, the investors regularly have the possibility to return their fund share according to the regulations in the investment conditions. The investor can liquidate his investment in the investment fund by returning the fund shares held with the investment management company on the respective redemption date for the respectively official redemption price. If the fund shares are traded on the stock market, the investor can also sell his shares on the stock exchange. The investment management company, however, can suspend the redemption of shares of the investment fund if extraordinary circumstances are given, where this appears to be required in consideration of the investors’ interests. During this time, the investor cannot liquidate his investment by returning the fund shares. Furthermore, the investment management company may not issue any new shares during this period.
Both on acquisition as well as on return or sale of fund shares, costs can arise for the investor (e.g. issue premium or redemption dis-count). The value of an individual fund share is calculated by the value of the fund assets divided by the number of issued fund shares. The value of the fund asset is assessed according to a defined valuation method. Stock trading is furthermore available for the pricing of exchange-traded investment funds, whereas the stock price of the fund shares can differ from the redemption price assessed by the investment management company.
The relevant investor information made available about the investment fund, the sales prospectus and the investment conditions contain information about the investment strategy, the running costs (management fee, performance-based remuneration, costs of the depositary, etc.) and further important information regarding the investment fund. Information about the fund’s investment activities also result from the biannual and annual reports published for the investment fund.
Regarding the investor group, it is differentiated between mutual funds and restricted funds. Mutual funds are accessible to all investors, while shares in restricted funds may be acquired only by semi-professional and professional investors.
Foreign funds are not subject to the same conditions as funds issued in the domestic country. Foreign funds that are distributed in Germany, however, require a distribution license that is granted by the BaFin.
Possible selection criteria
The following criteria permit a closer description of an investment fund and they can be helpful in the decision regarding the investment in a fund:
Asset classes of the investment fund
The fund assets can be invested in various asset classes. Stock funds invest the fund assets primarily in equities. Pension funds invest the fund assets primarily in fixed-income securities with varying maturities. Index funds, which are also called exchange traded funds, have the objective of reflecting the value development of a certain index as closely as possible. Umbrella funds invest the fund assets primarily in shares of other open-ended investment funds. Money market funds invest the fund assets primarily in call money and time deposits, as well as in money market instruments and securities with short remaining maturities. Real estate funds primarily invest the fund assets in real estate, rights to real estate and participations in real estate companies.
Investment funds can either concentrate their investments on certain countries or regions or invest worldwide.
Temporal investment horizon
Investment funds can have an unlimited or a fixed term. If the term of the investment fund is limited, it will end on a certain date. After the end of the term, the still remaining fund assets will be liquidated in the interest of the investors and paid out to them.
Repayment or earnings guarantee
The investment management company can issue investment funds with and without guarantee. If a guarantee is granted, the guarantee for the disbursements can apply for a certain term or be given for the repayment of the invested capital or a certain value development of the fund shares.
The earnings of the fund assets can be either paid out regularly (e.g. annually) (distributing funds) or be used for the acquisition of further assets for the fund (reinvestment funds).
The prices of the fund shares can be denominated in euro or a foreign currency.
Special types of open-ended investment funds: Open-ended real estate funds
Open-ended real estate funds invest the investors’ funds in land, buildings and construction projects according to the principle of risk spreading. Regarding the return of the fund shares, open-ended real estate funds have the particularity that the investors must hold their shares generally for at least 24 months. A return period of 12 months applies to the return of the shares. The value of an individual fund share is calculated by the value of the fund assets divided by the number of issued fund shares. The value of the fund assets is assessed here according to a defined valuation method. The assessed real estate values are determinant of the value of fund assets. These are either equivalent of the purchase price of the real property or they are measured by external appraisers. The impartiality of the external appraisers is to be ensured by means of special legal regulations.
Specific risks of an investment in open-ended investment funds
If the investment result of the fund is very positive within a certain period, this success might also depend on the qualification of the acting persons and therefore on the right decisions by the management. The composition of the fund management personnel can change, however. New decision makers might possibly act with less success then.
Issuance and redemption costs
Issue premiums and costs for the management of the fund initially result in higher overall costs for an investor in sum than would be the case if he acquired the assets held in the fund directly. In case of a short holding period, therefore, especially the acquisition of funds with a high issue premium can be more expensive than the acquisition of funds without issue premiums. In addition, redemption costs in the form of redemption discounts can arise when the fund is returned. An issue premium paid on acquisition of shares or a redemption discount paid on the sale of shares can reduce or even cancel out the success of an investment, especially if the investment period is only very short.
Volatility of the fund share value
The fund share value is calculated from the value of the fund assets, divided by the number of shares brought into circulation. The value of the fund assets meanwhile equals the sum of the market values of all assets held in the fund assets, less the sum of the market values of all liabilities of the fund assets. The fund share value is therefore dependent on the value of the assets held in the fund assets and the amount of the liabilities of the fund. The assets held by the fund are subject to market risks that can lead to losses.
In the case of real estate special funds, volatility arises, for example, from differing developments in the real estate markets. Negative value developments are also possible. If the value of these assets falls or if the value of liabilities rises, the fund share value will be reduced.
Risk of negative credit interest rates
The investment management company invests liquid funds at the depositary or other banks on account of the fund. For these bank credit balances, an interest rate is agreed in some cases, which equals the European Interbank Offered Rate (Euribor) less a certain margin. If the Euribor falls below the agreed margin, this results in negative interest on the relevant account. Depending on the development of the interest policy of the European Central Bank, short, medium as well as long-term bank credit balances can reach a negative interest yield.
Risks in securities lending transactions concluded by the fund
If the investment management company grants a loan on account of the fund through securities, it will transfer these to a borrower, who will retransfer securities of the same kind, quantity and quality at the end of the transaction (loan on securities). The investment management company has no possibility to dispose over securities that are lent out for the duration of the transaction. If the security loses value during the period of the transaction and if the investment management company wants to sell the security on the whole, it must cancel the loan transaction and wait for the customary settlement cycle, which can cause a loss risk for the fund.
Risks of repurchase transactions concluded by the fund
If the investment management company sells securities of the fund under repurchase agreements, it sells them and undertakes to repurchase them at the end of the term against the payment of a premium. The repurchase price to be paid by the seller at the end of the term and the premium are set when the transaction is entered into. In case the securities sold under repurchase agreements lose value during the term of the transaction and if the investment management company wants to sell them to limit the losses in value, it can do so only by exercising the right to premature cancellation. The premature cancellation of the transaction can be associated with financial losses of the fund. In addition, it can transpire that the premium to be paid at the end of the term is higher than the earnings, which the investment management company has earned from the reinvestment of the cash funds received as the purchase price payment.
If the investment management company buys securities of the fund under repurchase agreements on account of the fund, it buys them and needs to sell them again at the end of the term. The repurchase price and the premium are set already when the transaction is entered into. The securities bought under the repurchase agreement will then serve as collateral for the provision of liquidity to the contractual partner. Potential value increases of the securities will not be credited to the fund.
Risks relating to the receipt of collateral by the fund
The investment management company receives collateral for foreign exchange transactions, securities lending and repurchase transactions. Derivatives, securities provided for loan or securities sold under repurchase agreements can increase their value. The collateral received might then not be sufficient anymore to cover the right to delivery or retransfer of the investment management company against the counterparty in the full amount.
The investment management company can invest cash collateral on blocked accounts, government bonds of high quality and money market funds with short maturities. The credit institution where the bank credit balance is kept, however, might default. Government bonds and money market funds can develop negatively. At the end of the transaction, the invested collateral might not be available anymore in full amount, even though it has to be returned by the investment management company for the fund in the amount originally granted. In that case, the fund would have to bear the losses suffered in the collateral.
Suspension of share redemption
The investment management company may temporarily suspend the redemption of the shares if extraordinary circumstances are given, which make such suspension necessary in consideration of the investors’ interests. Extraordinary circumstances in this sense may include, e.g. economic or political crises, redemption requests to an exceptional extent as well as the closure of stock exchanges or markets, trading restrictions or other factors that obstruct the determination of the share value. This entails the risk that the shares might not be redeemable at the time desired by the investor due to restricted redemption options. Even if the redemption of share is suspended, the share value may fall; e.g. if the investment management company is forced to sell assets below market value during the suspension of share redemption. The share price after resumption of the share redemption may be lower than the price prior to the suspension of redemption.
The investment management company is moreover obligated to refuse and suspend the redemption of the shares for a limited time in case there is a large number of redemption requests if the liquid funds are no longer sufficient for the payment of the redemption price and to ensure proper management or if the funds are not available immediately. This means that investors will not be able to redeem their shares during this period.
The acquisition of shares is not limited by a maximum investment amount. A large number of redemption requests can impair the fund’s liquidity and require a suspension of the redemption of the shares. In case of a suspension of the share redemption, the share value can fall; e.g. if the investment management company of a real estate fund is forced to sell real properties and real estate companies below the market value during the suspension of share redemption. A temporary suspension can lead to a permanent suspension of the share redemption and liquidation of the fund assets, for example, if the liquidity for the resumption of the share redemption cannot be procured by a sale of real estate. A liquidation of the fund might take a long time, possibly many years. The investor is therefore exposed to the risk that he may not be able to achieve their planned holding period and, as the case may be, that a significant part of the invested capital is unavailable for indefinite period or might be lost entirely.
Change in investment policy or investment conditions
The investment management company may change the investment conditions. This may also affect the rights of the investor. The investment management company may, for example, through a change of the investment conditions modify the fund’s investment policy or increase the costs to be charged against the fund.
Liquidation of the fund
The investment management company has the right to terminate the management of the fund. The investment management company can liquidate the fund completely after terminating the management. The right of disposition over the fund assets will transfer to the custodian after a notice period of six months. There is therefore a risk for the investor that they may not be able to realise the holding period planned by them. When the fund assets are transferred to the custodian, the fund assets may be subject to taxes other than Ger-man income taxes. When the fund shares are written off from the investor’s securities account after the termination of the liquidation procedure, the investor may be charged with income taxes.
Transfer of all assets of the fund to another investment fund (merger)
The investment management company may transfer all assets of the fund to another fund. In that case, the investors can exchange their shares free of charge for shares of the other fund, which is reconcilable with the present investor principle, or redeem his shares without additional costs. The same applies when the investment management company transfers all assets of another fund to this fund. The investor must therefore make another investment decision early in the course of the transfer. Income tax may be payable on the redemption of the share. If shares are exchanged for shares of a fund with comparable investment principles, the investor may be subject to taxes, for example, when the value of the received shares is higher than the value of the old shares at the time of the procurement.
Transfer of the fund to another investment management company
The investment management company may delegate the management of the fund to another investment management company. The fund thus remains unchanged by this as does the investor's standing. However, the investor must decide in the course of the transfer whether he considers the new investment management company to be equally qualified as the previous one. If he does not wish to remain invested in the fund under new management, he must return his shares. Income taxes might be incurred in the process.
Risks relating to the investment in fund shares
The risks of shares in other investment funds that are acquired for the fund (so-called “target funds”) are closely tied to the risks of the assets contained in this target fund and respectively the investment strategies pursued by it. As the fund managers act independent of each other, it can also occur, however, that several target funds pursue the same or contrary investment strategies. This may cause an accumulation of existing risks and potential opportunities may cancel each other out. It is usually not possible for the investment management company to control the management of the target fund. Its investment decisions do not necessarily have to be consistent with the assumptions or expectations of the investment management company. The capital management company will often not know the current composition of the target funds. If the composition does not match its assumptions or expectations, it may react only at a significant delay by returning the target fund shares.
Open-ended investment funds in which the fund acquires shares might furthermore temporarily suspend the redemption of shares. In that case, the investment management company is prevented from selling the shares held in the target fund by returning them to the investment management company or to the depositary of the fund against payout of the redemption price.
Profitability and fulfillment of the investor's investment objectives
It cannot be guaranteed that the investor will achieve the success he desires with his investment. The share value of the fund may fall and lead to losses for the investor. Investors might therefore receive a lower amount in return than the amount originally invested. An issue premium paid on acquisition of shares can furthermore reduce or even cancel out the success of an investment, especially if the investment period is only very short.
Specific risks of open-ended real estate funds
The risks listed below can impair the value development of the fund assets or the assets held in the fund and thereby have a negative effect on the share value and the capital invested by the investor.
Significant risks resulting from the real estate investment, participation in real estate companies and encumbrance with a heritable building right
Real estate investments are subject to risks that may affect the share value by changes in income, expenses and the market value of the properties. This also applies to investments in real estate held by real estate companies. The following examples of risks are not exhaustive.
In addition to changes in the general economic framework conditions, there are risks specific to real estate such as vacancies, rent arrears and rent defaults that may result, e.g. from changes in the location quality or the tenant credit rating. Changes in the location quality can entail that the location is no longer suitable for the chosen use. The building condition can necessitate maintenance expenses that are not always predictable. To limit these risks, the company pursues a high degree of usability of the properties and a tenant structure that includes many industries. Through continuous maintenance and modernisation or restructuring of the properties, their competitiveness is to be preserved and improved respectively.
Risks resulting from fire and storm events as well as natural hazards (flooding, high waters, earthquakes) are internationally covered by insurance policies to the extent that corresponding insurance capacities exist and this is economically reasonable and objectively advisable.
Real estate, especially in metropolitan areas might possibly be exposed to a risk of war and terrorism. Without being directly affected by an act of terrorism, a property might be devalued if the real estate market of the affected region is permanently impaired and the search for tenants is complicated or impossible. Risks of terrorist acts are also covered by insurance policies to the extent that corresponding insurance capacities exist and this is economically reasonable and objectively advisable.
Risks resulting from contaminated sites (such as soil contaminations, asbestos installations) are considered carefully especially on the purchase of real estate (if applicable, by obtaining corresponding expert opinions). In spite of all diligence, however, risks of this nature cannot be ruled out entirely.
For the project development, risks can arise, e.g. due to changes in the construction planning and delays in the issuance of the building permit. Construction cost increases and completion risks are counteracted wherever possible by corresponding agreements with contractual partners and their careful selection. However, it must be pointed out that there are residual risks in this regard as well as that the success of the initial leasing depends on the demand situation at the time of completion.
Real estates can be afflicted with construction defects. These risks can also not be ruled out completely by a careful technical due diligence of the property and, if necessary, obtaining expert opinions already before acquisition.
When acquiring real estate abroad, risks resulting from the location of the properties must be considered (e.g. different legal and tax systems, different interpretation of double taxation agreements, different opinions in the calculation of transfer prices or income accrual and changes in exchange rates). Furthermore, the development of the case law can have negative or positive effects on the real estate investment situations. In the case of foreign properties, the increased management risk and potential technical complications including the transfer risk regarding current income or sales proceeds must also be taken into account. There are exchange rate opportunities and risks for transactions in foreign currencies.
On the sale of a real estate, even if the greatest measure of commercial care is applied, warranty claims of the purchaser or other third parties might be created for which the fund assets are liable.
When acquiring equity interests in real estate companies, risks arising from the legal form of the company, risks in connection with the possible default of shareholders and risks of changes in the tax and company law framework must be taken into account. This applies in particular when real estate companies have their registered office abroad. In addition, it has to be taken into account that, when participations in real estate companies are acquired, these may be burdened with liabilities that are difficult to detect. Lastly, a sufficiently liquid secondary market may be missing in the case of an intended sale of the participation.
Real estate investments can be debt-financed. This is done to achieve a so-called leverage effect (increase of the return on equity by borrowing debt capital at an interest rate below the property’s profit rate) and/or in the case of real estate or real estate companies located in a foreign country (borrowing of loans in the foreign currency of the situs state). The interest on the loan can be claimed as tax deduction provided that the respectively applicable tax laws so permit. If debt financing is utilised, the value changes of the real property will have a stronger effect on the employed equity of the fund assets, e.g. with a 50-percent loan financing, the effect of a reduced value of the real property on the fund capital invested would double compared to a fully equity-based financing.
When a property is encumbered with a heritable building right, there is the risk that the heritable building rights holders will not fulfill his obligations, in particular that he will not pay the interest on the building rights. In this and other cases, a premature lapse of the heritable building right may occur. The investment management company must then find another economic use of the property, which can be difficult in the specific case. This applies analogously in the case of the lapse after the end of the contract. Lastly, the encumbrances of the property with a heritable building right may restrict the fungibility, i.e. the property might not be sold as easily as would be the case without such an encumbrance.
Significant risks resulting from the liquidity investment
Insofar as the open-ended real estate fund holds securities, money market instruments or investment fund shares within the scope of its liquidity investments, it has to be noticed that these investments also carry risks.
Specific risks of open-ended alternative investment funds
The valuations of the various investments of alternative funds can contain uncertainties and evaluating provisions and, if such valuations should prove to be false, this might have negative effects on the net asset value of the shares. All decisions regarding the valuation of assets and liabilities, and the determination of the net asset value are made under the direction and supervision of the respective alternative investment manager. The determination of the net asset is final and binding, and can impact the amount of the management fee and of the performance fee.
Difficulty in the procurement and hedging of suitable investments
The identification, conclusion and realisation of attractive investments is notably competitive from time to time and harbour a certain measure of uncertainty. The respective funds compete for investment opportunities with other investment vehicles such as individual investors, financial instituts (e.g. mortgage banks, pension funds and trusts) and other institutional investors, which may potentially have larger financial and human resources than the funds into which it is invested or they may have better contacts with sellers, creditors and other parties. While the AIFM is in a good position to implement the strategy, there is no certainty that the respective funds will be able to find and make investments that match its target IRR or the value of which is realisable or that it will be able to invest the available capital in full.
There is no certainty for investors when it comes to the measure of diversification of the investments of the respective funds by geo-graphical regions or asset classes. Furthermore, transactions in which the respective AIFM intends to refinance the entire or parts of the invested capital carry the risk that this refinancing cannot be concluded, which might lead to increased risks for the respective fund due to unintended long investments and/or low diversification.
Contingent liabilities on a sale of investments
In combination with the sale of an investment, funds might be obligated to make certain assurances that are quintessential for the sale of investments regarding the business and financial situation of the investment. Funds may also be required to compensate the buyers of such an investment for losses where these assurances are incorrect. Such agreements can result in contingent liabilities for which the respective AIFM can create reserves or deposits in order to be ready for such contingent liabilities or which ultimately have to be financed by the investors before or after the end of the fund term.
Involvement of subsidiaries
Investments of the respective funds can be held either directly or indirectly through subsidiaries. Before an acquisition, a complete due diligence will be made, but in the case of special purpose vehicles, there can be no guarantee that these investments can in fact be sold in the future without problems. Furthermore, while the sale of a special purpose vehicle can result in tax-free sales, in these cases, the seller will frequently aim at achieving a price reduction through negotiations in the amount of the potential tax liability, which remains in the vehicle, should it sell the respective asset in the future.
Missing management authorizations
Investors do not participate in the management of the fund or the underlying fund assets. They therefore also have no opportunity to steer the daily business such as investments and sales decisions of the fund.
Under very specific circumstances that may be described in the general terms and conditions, it is at the sole discretion of the respective AIFM, how it arranges the structuring, negotiation and purchase, financing and potential divestments for the respective funds. Therefore, investors generally cannot themselves estimate the benefits of certain investments before the funds make them. Investors can also not make any investment decisions for the funds and have no opportunity either to evaluate or approve certain assets before the investment.
Management, financing, leasing and sales decisions by the funds and their respective policy with regard to certain other activities including their dividend and business policy are made by the respective AIFM. Insofar as it is permissible based on the legal documentation of the funds and subject to the agreement of the administrative board, these guidelines can be modified respectively at the discretion of the AIFM without the fund investors having a voting right. All such changes might run counter to the investor's interests with regard to the funds.
Regarding the financing of certain investments, the funds can apply hedging techniques to hedge the funds against unfavourable exchange rate and/or interest rate developments. Even though such transactions can reduce certain risks, the transactions might them-selves harbor other risks on their part. Although the funds may profit potentially from the application of such hedging mechanisms, unexpected exchange rate or interest rate risk can also damage the overall performance of the funds.
Collective investments with third parties
The funds can make collective investments with third parties through partnerships, joint ventures or other firms. Under these circumstances, the funds might possibly not hold a controlling participation in certain investments. The risks relating to such an involvement of third parties in an investment also includes the possibility that the third-party shareholder or investor might not be in the financial position to continue the investment or that it suffers default, which would have corresponding negative effects on the investment, or that it pursues economic or business interests or aims that are not consistent with those of the respective fund, or that it adopts measures that are not reconcilable with the investment strategy of the respective fund.
Furthermore, the funds might be liable under certain circumstances for the actions of the third-party shareholders or co-investors. Investments made collectively with third parties in joint ventures or other firms can trigger special profit shares (carried interests) and/or payments to these third parties or co-investors
Effects of changes in public regulations and legal changes
Public authorities at all levels (including the national and EU level) are actively involved in the announcement and enforcement of regulations relating to taxes, land utilisation, zoning, planning restrictions, environmental protection and safety as well as other matters. The adoption and enforcement of such regulations might increase expenses and reduce earnings or profits, and have unfavorable effects on the value of the fund assets.
Every law adopted and its interpretation as well as the legal and regulatory provisions that apply to the respective funds and/or an investment in the respective fund can change during the period of the fund’s existence. In the same way, the accounting practice may change, which can have effects in particular on the way and manner in which the assets in the funds are valued, and/or on the way and manner in which earnings and capital gains of the respective fund are recognised and/or attributed.
There is also uncertainty regarding the future costs of energy and other resources, the reliability of the supply with energy and resources, and regarding the extent and scope of increasing state regulations and market reactions that can soften or increase the energy and resources price changes or the reactions to problems in the availability or market liquidity.
7. Closed-ended investment funds
Closed-ended investment funds are a form of long-term collective capital investment in asset values. In the same way as open-ended investment funds, closed-ended investment funds are offered and managed by investment management companies, which require. Closed-ended investment funds and their management in Germany are subject to the regulations of the Capital Investment Act. Compliance with these regulations is monitored by the German Federal Financial Supervisory Authority BaFin.
A participation in a closed-ended investment fund is acquired through the purchase of shares in a company. It usually has the legal form of an investment limited partnership (“geschlossene Investmentkommanditgesellschaft”). The investor's participation mostly extends over a period of several years.
The participation in a closed-ended investment fund frequently requires a minimum shareholding total. In the acquisition of the share in a closed-ended investment fund, the investor must usually pay a premium (agio). It is calculated at a percentage rate of the investment total. Through the acquisition of a share in a closed-ended investment fund, depending on the legal form of the closed-ended investment funds, the investor becomes a shareholder of an investment limited partnerships or an investment stock corporation with fixed capital in economic terms or in terms of tax or liability regulations. The tax effects of a capital investment in a closed-ended fund can play a significant role for the investor.
In the case of investment limited partnerships, the investor participates as a limited partner. As such, he will be entered in the commercial register. In a so-called public investment limited partnership (“Publikums-Investmentkommanditgesellschaft”), the participation can also be indirect, held by a trustee, who will be entered as limited partner in the commercial register (trustee acting as limited partner) and exercise the investor’s shareholder rights based on a contractual agreement, the trust agreement, in its own name but on account and at the risk of the investors. The trustee acting as limited partner meanwhile is bound by the instructions of the investors in the normal case. In contrast to a direct participation as limited partner, the investor remains largely anonymous here and he will not be entered in the commercial register.
Closed-ended investment funds primarily invest in asset values such as real estate, airplanes, ships, containers, plants for the generation of renewable energies, forestry, forest and agricultural land or shares in companies that are not admitted to trading at a stock ex-change (hereinafter referred to as “Capital Goods"). Closed-ended funds generate earnings from the continuous management of individual or several Capital Goods. At the end of the term, further profits can be achieved by the sale of the Capital Goods. The economic success of investors depends essentially on the success of the management and, if applicable, of the sale of these Capital Goods. The investment management company must assign a custodian for the fund to take on certain control and monitoring functions relating to the fund assets. This includes the review of the ownership structure of the assets of the fund and the monitoring of payment flows.
The capital invested by the investors in the fund company is used as equity of the company for the purchase of Capital Goods and the non-recurrent expenses and fees for the issuance of the fund. In addition, closed-ended funds frequently borrow outside capital. In the case of closed-ended mutual funds, this outside capital must not amount to more than 150% of the equity available for investment purposes, including any not yet paid binding capital commitments.
Differently than in the case of open-ended investment funds, the Capital Good or Goods to be acquired are already determined at least in kind and amount in the case of closed-ended investment funds, so that the amount of the required equity for the acquisition is also al-ready set. Investors can therefore enter the fund only during the so-called placement phase, in the course of which the required equity is procured. If the required equity has been fully procured, normally no participation is possible anymore and the fund is closed. After closing the fund, the Capital Goods are usually being managed. At the end of the fund duration, the assets of the fund will be sold, the sales proceeds will be distributed to the investors after deduction of liabilities and the fund company will be liquidated.
Comprehensive valuation duties apply to closed-ended mutual funds. Both an acquisition valuation as well as a continuous regular valuation are prescribed. The acquisition valuation refers to the acquisition of a concrete asset value. It must be valued prior to the investment by at least one external appraiser. The acquisition price that is paid by the fund for the acquisition of the asset value may exceed the value assessed in the assessment by the appraiser at most by an insignificant measure. In addition, at least once per year, a follow-up valuation of the assets is made.
While the investor in an open-ended investment funds may generally return his shares according to the terms of the investment conditions, shares in closed-ended investment funds can normally not be returned within the fund duration, i.e. not before the start of the liquidation or phase-out period of the investment fund. The investor can only liquidate his participation in the closed-ended investment funds by transferring it to a third party. The transfer of the share, however, frequently requires the approval of the fund company. In addition, no regulated secondary market exists for shares in closed-ended funds. The transferability of the shares to a third party is therefore not assured and frequently possible only at a significant price deduction.
The relevant investor information made available about the investment fund, the sales prospectus and the investment conditions contain information about the concrete structure of the fund, the running costs and further important information regarding the investment fund. Running costs of the fund are, e.g. the fee for the investment management company for the management of the fund, costs of the depositary, costs for the management of the Capital Goods, transaction costs on acquisition and sale of assets, costs for external appraisers, etc. Furthermore, an annual report must be drafted for the investment fund at least once a year.
Closed-ended mutual investment funds can be acquired by all investors. Closed-ended restricted investment funds, in contrast, can be acquired only by professional or semi-professional investors.
Foreign closed-end funds are not subject to the same conditions as funds issued in the domestic country. Foreign closed-end funds that are distributed in Germany, however, require a distribution license that is granted by the Federal Agency for Financial Market Supervision.
Investment possibilities of closed-ended funds
Closed-ended funds are usually characterised by a limited and clearly defined investment project. A detailed description of the fund’s investment objectives is contained in the fund’s investment conditions, which together with the articles of incorporation, the trust agreement if applicable, the declaration of accession, and the sales prospectus are the relevant documents.
Closed-ended infrastructure funds hold participations in infrastructure assets either indirectly through special purpose vehicles or directly. Infrastructure funds can invest both in project developments as well as in finished infrastructure assets. The investors participate in the earnings of the infrastructure assets and/or the sales proceeds of the assets. On a sale of the assets, the sales proceeds are regularly distributed to the investors after deduction of liabilities.
Closed-ended real estate funds usually purchase one or more real property. During the holding period of the real property, the investors participate in the earnings from the management of the property, e.g. its letting. On a sale of the property, the sales proceeds are regularly distributed to the investors after deduction of liabilities.
In closed-ended renewable energies funds, investors participate in the earnings that are generated from the operation of plants to generate electricity, gas or heat from renewable resources such as the sun, wind energy, geothermal energy, biogas or water. When the assets are sold, the investor can participate in the sales proceeds after settlement of the fund’s liabilities depending on the participation offer.
Private equity funds acquire participations in companies, the shares of which are not traded at the stock exchange. The investor participates in the earnings from the company participations and the sales proceeds on the sale of the participations, which will be made usually at the end of the fund duration.
Specific risks of an investment in closed-ended investment funds
Participations in closed-ended funds are, by their nature, business participations. Due to the generally low diversification of the capital invested, which is tied to the investment in one or few asset values, the development of the investor's participation strongly depends on the success of the management and the value development of the investment asset or assets. Depending on the kind of acquired in-vestment asset, its value development can strongly depend on the overall economic developments or the development of a particular market. Industry-specific and asset-related risks, too, can influence the value development of an investment asset in a negative way. There is therefore a risk that the economic development of the participation in the closed-ended fund will not be positive. Thus, a loss of the invested capital up to total loss can be incurred by the investor.
Limited tradability of the participation
The shares in closed-ended investment funds can usually not be returned during the fund duration. An ordinary termination of the participation in the fund company is normally not possible. The investor is only entitled to the statutory right of termination for good cause. Disposition over the invested capital is therefore normally not possible during the fund duration. The investor can only liquidate his participation in the closed-ended investment fund during its term by selling it to a third party. The transfer of the share, however, frequently requires the approval from the fund company. In addition, no regulated secondary market exists that is comparable to a stock exchange for shares in closed-ended funds. There is therefore a risk that due to absent approval from the fund company or lack of demand on the purchaser’s side, a sale of the share will fail or will only be possible after a time delay due to merely low demand on the purchaser’s side and only at substantial deductions from the purchase price compared to the originally invested capital.
Revival of liability
If the investor acquires a participation in an investment limited partnership, he will initially be personally liable as a limited partner for the fund company’s liabilities in the sum of the amount guaranteed that is agreed in the articles of incorporation. The investor’s personal liability, however, will expire as soon as he has paid in his contribution (subscribed amount, if applicable plus an issue premium) to the fund company. Personal liability can revive at a later point in time for the sum up to the agreed amount guaranteed when an investor receives distributions, while his equity participation is reduced to below the amount guaranteed through losses of the fund company or insofar as his equity participation drops to below the amount guaranteed by the disbursement. In the event of a bankruptcy of the fund company, there is a risk that the investor will have to repay the disbursements to the fund company that he has received by way of deposit refund.
If the investor acquires a participation in an investment stock corporation, the risk of a revival of liability in this form does not apply.
Debt financing risk
Closed-ended funds regularly borrow loans (outside capital) for the financing of the planned investment in addition to the equity capital. The loans are usually collateralised by the investment assets. For investors, the additionally employed outside capital has an effect like leverage, which amplifies the relative influence of occurring value fluctuations on the invested equity in both positive as well as negative ways.
In the case of a value loss of the investment asset, the investor’s loss is also dependent on the ratio of equity and outside capital. The higher the portion of outside capital relative to equity, the stronger the impact of an occurring value loss on the loss of invested equity that is allocated to the investor. The debt financing therefore increases the risk for the investor of suffering higher losses. However, it generates opportunities in the same manner through higher relative gains.
Besides the described leverage effect, there is the risk with debt financing that, in the event of a negative development of the current income of the fund, the borrowed loans cannot be serviced or repaid anymore in accordance with the contracts. In that case, the risk applies that the creditor will order foreclosure of the investment assets. This can lead to high losses or even total loss of the invested capital for the investor. If follow-up financing becomes necessary and if this cannot be concluded or only at unfavourable terms, this can also have a negative impact on the bottom line of the fund and the distributions to investors.
Inflation and foreign exchange risk, country risk
Asset values, as well, can be subject to an inflation risk, meaning the risk that the fund will suffer an actual value loss in consequence of monetary devaluation. This can have negative effects on the disbursements to investors. If a closed-ended investment fund is denominated in a foreign currency, earns its relevant income in a foreign currency area or if instead income and expenses or liabilities are entered in different currencies, this can result in a foreign exchange risk for the fund. For example, an appreciation of the euro over foreign currencies can cause a value loss of the foreign asset values that are valued in euro. If the fund company invests abroad or if significant payment flows from foreign debtors are intended, this can result furthermore in a country and intermediary risk. Political instability, lack of foreign currencies or transfer restrictions on cash payments from abroad can have significant effects on the development of the fund.
Risk of default of contractual partners
As part of the concept, sale and management, the fund company enters into contracts with service providers. There is the risk that the contractual partners do not act in accordance with the contract and do not or not adequately fulfill their duties. This can be the case if the credit rating of the contractual partners deteriorates. The default of contractual partners can entail delays in the operation and higher expenses as well as reduced income, which will have negative effects on the disbursements to investors. There is also a risk that the user of the investment asset is unable to fulfill its payment obligations. This can lead to losses in the fund’s income and value. In that case, the investor has the risk of a total loss of the invested capital.
Risk from change in legal and economic framework conditions
There is a risk that the legal and economic framework conditions under which the fund was launched will change unfavorably within the fund duration, which usually extends over multiple years. This also applies to potential tax risks. This can have negative effects on the fund’s earnings and lead to lower distributions to investors.
Bankruptcy of the fund company
As shareholders, the investors bear the risk of bankruptcy of the fund company. Their claims against the fund company in bankruptcy are subordinated to the claims of other creditors of the fund company. The legal regulations on the deposit guarantee do not apply to an investment in a closed-ended fund. Losses of the invested capital must be borne by the investor alone.
Key personnel risk
The successful investment and sale of the fund asset depends in part on the abilities and investment recommendations of the investment manager/AIFM. The investors themselves neither make any decisions on the acquisition, sale or other realisation of an investment nor any other decisions on the business and activity of the fund with the exception of certain situations.
There is no certainty that the experts of the investment manager/AIFM will remain with the investment manager/AIFM during the entire term of the respective fund. The loss of important employees might have significant negative effects on the potential performance of the respective fund. Even though investment managers/AIFM regularly employ experienced teams of qualified experts, the function of key employees will determine the success of the respective fund in the future, and events of death, disability or absent availability of key employees for whatever reasons can impair the performance of the respective funds.
Risk of debt
Alternative investment funds can achieve a leverage effect in connection with its investments by borrowing loans also on the levels of subsidiaries or infrastructure companies. Alternative investment funds can provide guarantees or other appropriate securities for subsidiaries or infrastructure companies in order to achieve such debt. Although the utilisation of debt can improve income and increase the number of investments that can be made, the risk of loss can also significantly rise as well. The utilisation of debt at the level of a subsidiary or infrastructure company entails the risks at alternative investment funds, which normally relate to debt financing including the risk that the cash flow subsidiary will not be sufficient to make the required payments of principal and interest, the risk that debt relating to the real properties cannot be refinanced, and the risk that the conditions of such a refinancing are not as favorable as the conditions of the existing debt financing. Such debt can bear interest at variable interest rates. Variable interest rates result in higher debt servicing obligations when market interest rates rise, which would have negative effects on the subsidiaries or infrastructure companies (and indirectly on the investing alternative investment funds). Alternative investment funds or subsidiaries can enter legal transactions to limit their risk regarding rising interest rates, as they may deem appropriate and cost-efficient, meanwhile legal transactions can be exposed to the risk that the contract partners of such legal transactions cannot fulfill their obligations and that the alternative investment fund (or a subsidiary or infrastructure company) might therefore lose the benefits expected from it, which would lead to negative effects in connection with rising market interest rates.
Specific risks of closed-ended alternative investment funds
These specific risks are equivalent to those of open-end alternative investment funds. It is referred to the corresponding statements in this regard.
8. Precious metals and commodities
Direct and indirect investments can be made in commodities, meaning physical goods. Commodities are divided into four main categories: precious metals (e.g. gold, palladium and platinum), industrial metals (e.g. aluminum, copper), energy (e.g. electricity, oil and gas), agricultural commodities (e.g. wheat and corn). The term “commodities” usually also includes merchandise. Commodities are traded at specialised exchanges or directly between market participants over the counter. This is frequently done by means of largely standardised forward contracts.
Precious metals – gold, silver, platinum and palladium are the most important precious metals. In the demand for precious metals, it is differentiated between physical demand (industry and jewelry trade) and the demand for the purpose of capital investment (investor demand). Physical demand depends primarily on economic growth, while investor demand is primarily determined by interest rate developments, the currency movements (mainly of the US dollar based on the large trading volumes in USD) and the inflation level. Furthermore, gold is considered to be an attractive investment in times of insecure markets, while it should be noted here that gold does not offer complete protection in times of pressure for debt relief either.
Specific risks of investments in commodities and precious metals
Investments in commodities may be subject to big value fluctuations. A counterparty risk in certain investment forms is possible. The prices of the commodities react to interest rate changes and movements on the foreign exchange markets. Investments in futures con-tracts or OTC derivatives can lead to higher margin calls when the derivative has a negative value development. The physical delivery of commodities can entail high costs.
Missing transparency can constitute a problem in certain commodities markets and complicate analysis.
Low market liquidity/Speculative market participants
In commodities markets with low liquidity, speculative trading by just a few market participants can already lead to strong price movements, which feedback on the price development of derivatives of this underlying asset. Liquidity can be very limited in extreme market situations.
Cartels and regulation
Commodities producers are frequently part of organisations or cartels. These regulate the prices at the commodities markets through the supply. Supervisory authorities as well can exert influence on the pricing by means of rule changes. In addition, there are political regulations such as nationalisation or export restrictions.
Risks from natural disasters and cycles
The weather and natural disasters can lead to a change of the supply situation on the commodities markets. Furthermore, especially agricultural commodities are subject to seasonal cycles of supply and demand.
Strong fluctuations in prices of the underlying can also result from embargos, wars, revolutions, etc.
The increase of the price of goods (inflation) can entail a reduction of demand among consumers, especially, e.g. for crude oil. The causes can be the increase of the money supply by central banks (interest rate cuts), reduced velocity of the circulation of money (fall-ing demand for goods, services, loans) or the reduced production as a consequence of failures in the real economy.
The significant, lasting reduction of the price level for goods and services (deflation) can be the consequence of consumption and in-vestment restraint, reduction of public spending, foreign trade developments (global economic crisis), currency revaluations or restrictive monetary policy (significant increase of the interest rate). Here, the demand for commodities can also fall. In contrast, for example, precious metals can experience rising demand.
9. Investments in real estate
It is referred to the instruments of indirect real estate investment under point B.6 (“Open-ended real estate funds"). Besides the indirect investments, there are options to make direct real estate investments.
Based on their value stability, direct investments in real estate are a popular capital investment in general. They are not traded directly at the stock exchange, no daily redemption price is quoted, and a real estate owner does not have to expect similarly high value fluctuations as with equities and other securities. For these reasons, real estate is ideal for pension provisions.
Through rental agreements or borrowing against own real estate assets, a welcomed additional source of income is obtained for retirement. In addition, real estate investments are good for wealth diversification. In real estate investments, frequent restructuring and related profitability losses as in the case of securities accounts are excluded from the outset and a stable return on real estate investments can be expected throughout many years.
Direct investments in real estate come with opportunities and risks like all investments. The purchase of a real estate can be a very profitable investment decision when the location proves to be good over time. The location, purchase price, basic structure of the build-ing, leasability, traffic connections, local and regional economic power and future potentials, economic structure, etc., in particular are decisive here.
Specific risks of direct real estate investments
Real estate markets are often intransparent and presuppose exact knowledge of local conditions. In addition, expertise in the construction trade, management knowledge and specific know-how is required. Here, significant incorrect assessments in the value development of the investment can arise.
Risk of concentration
In a direct investment, based on the total amount tied up in one single investment, no diversification is possible. Given an identical investment sum, a broader diversification and thus a greater risk reduction can be realised in an indirect investment in real estate or with alternative investment forms.
Interest rate risk
Real estate responds similarly as bonds, low interest rates make mortgages more affordable and enable above-average earnings, while high interest rates reduce them.
A direct investment in office buildings, retail properties, industrial properties, residential or special real estate (e.g. hospitals, hotels, logistics properties, etc.) means the purchase of such and therefore requires more capital than an indirect investment, e.g. by means of a real estate fund. At the same time, the risk in the sense of the potential maximum loss is higher than with an indirect investment, alone because exchange-traded real estate funds permit an exit at any time in case of a negative value development.
A real property represents a long-term investment. Nonetheless, the sale of the real property is possible at any time in legal terms. The sales price is determined by the market conditions prevalent at the time of the sale. There is a risk that losses are incurred if the sale is made at an unfavorable point in time or if the search for a buyer takes more time. The value of the real property might therefore not be realised in cash in the short term. In addition, pressure to sell can lead to significant price reductions.
The future development of rents depends on a series of diverse factors and cannot be guaranteed. Throughout the investment period, rent increases are difficult to predict. Unanticipated developments, e.g. changes in the law, changed demands of tenants or structural modifications in an economic area can have positive or negative effects on the rental income.
The value of a rental guarantee always depends on the credit rating of the issuer of the rental guarantee, which might have to be re-searched separately if applicable before the purchase of the real estate. The actually achieved rent after the end of the guarantee period is determined by the market. It can therefore be higher or lower than the guaranteed rent.
Maintenance and renovation costs
For the coverage of renovation or maintenance measures, etc. usually a maintenance cost reserve is created. The amount of the maintenance reserve, however, might not be sufficient as the case may be in order to pay for the higher maintenance costs incurred after 10 to 20 years according to experience. Additional cost allocations to the owner association might therefore be required. When purchasing a condominium apartment second-hand, the minutes of the last meetings of the condominium owners’ association documenting the adopted or upcoming measures must be also reviewed besides conducting a detailed inspection of the apartment and common facilities.
Debt financing costs
If the purchase of a real property requires outside capital, this represents a risk. The price of the property compared to the rental agreements must not be too high; each additional euro of equity lowers the investor’s debt. The loan should be repaid at the latest when the retirement age is reached. Until then, rental income might be lost, asset prices might fall, tax relief eliminated or new real estate taxes might be introduced.
Direct real estate investments cannot be liquidated quickly. If the real estate market comes under pressure because of overcapacities and a fall in prices, the property might be unsaleable. The same applies if there is no demand in consequence of a situation that is hardly promising for the future.