Opportunities and Risks of Closed-End Funds for Private and Corporate Investors

Table of Contents

Abstract

List of Abbreviations

List of Tables

List of Figures

1 Introduction

2 Problem Definition

3 Objectives

4 Methodology

5 Theoretical Part
5.1 Definition
5.2 Conception Design of Closed-End Funds
5.3 Holding Structure
5.4 Specific Types of Closed-End Funds

6 Current Development of the Closed-End Fund Market in Germany

7 Risks of Closed-End Funds

8 Opportunities of Closed-End Funds

9 Business Case: Analysis of the WealthCap Immobilien Deutschland 35 “Ten Towers München” Fund

10 Conclusion

Bibliography

Online Sources

Abstract

Capital markets provide many investment opportunities, but CEFs offer the possibility of high returns and attractive alternative investments. The fund subjects can vary and so many categories have been established during the last decades. Today, investments in real estates, ships, renewable energy, planes, and other divisions are open for private and corporate investors. The main challenge for the investor is to understand the product, which is essential for an investment decision. The conception and operative stage of a fund is complex and sophisticated why many investors keep distance to these type of investments. The previous market development has shown that there are many risks and opportunities given which have to be considered. An evaluation of these aspects is crucial to the investment success and should be clearly observed. The legislator has standardized the information system of CEFs to offer the possibility of well-arranged information which is intelligible to all. Summing up, an investor has to identify the main risks and opportunities of a CEF investment and then to evaluate the possible return consistent with his portfolio strategy.

List of Abbreviations

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List of Tables

Table 1: Current Data of the German CEF Market

Table 2: Investment and Cost Structure of the Ten Towers Fund

List of Figures

Figure 1: Fragmentation of German Assets in 2012

Figure 2: Life Cycle of CEFs

Figure 3: Basic Structure of a CEF

Figure 4: Types of CEFs

Figure 5: Investment Diversification of Private and Institutional Investors

Figure 6: Legal Structure of the WealthCap Ten Towers München Fund

Figure 7: Position Plan of the Ten Towers Office Block

1 Introduction

Since years, Closed-End funds have been an alternative investment for many private and business investors, but since the financial crisis in 2007 the demand for financial alternatives like CEFs declined drastically. The German market gives a good appraisement of the current trust of investors in alternative investments. A recent study of the BVR identified that German citizens hold assets over 4.9 trillion Euros and most of them are invested in checkable deposits and private insurances.^[1] Figure 1 gives an overview of the fragmentation of German assets in 2012.

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Figure 1: Fragmentation of German Assets in 2012^[2]

This uncertainty reflects in the amount of invested money in alternative investments. In 2012, the industry was able to collect only 4.5 billion Euros, which is up to 0.09 % of the total assets available.^[3] One reason for this development could be the lack of knowledge and followed mistaken investments. People may have not understood or still do not understand the structure and peculiarity of CEFs and with that the opportunities and especially the risks of such investments.^[4] The distinctive feature of CEFs is that the investor becomes an entrepreneur and the involvement equates a business hazard, similar to a stock purchase with the risk of a total loss.^[5] However, the structure possibility and investment opportunity of CEFs are very sophisticated and manifold, that is why alternative investments are subjected to the liability concerning information contained in brochures, in Germany. This means that the prospecting of CEFs has been standardized, due to simplify the understanding of the subject for investors. On the one hand, alternative investments themselves are good occasions to diversify assets and to get admission to specified funds and projects all over the world. On the other hand, corporations get the possibility to collect equity for huge projects.

2 Problem Definition

Alternative investments are very complex products and difficult to understand for investors and even companies which are searching for private equity. There exists a multitude of design-possibilities and legal requirements which significantly sophisticates the issue and makes an examination indispensable. A good advice from an investment adviser should be helpful, but the conflicting interests are huge and may lead to immoral suggestions. An acquirement of basic knowledge is always the best advice to face the complexity of such investment products.

3 Objectives

The objective of this paper is to analyze the structure and main characteristics of CEFs, due to give a standardized scheme for investors to evaluate alternative investments by themselves. Additionally this work paper should clean prejudices up and create an objective acceptance of CEFs as financial instruments for investors but also for companies. In order to not exceed the scope this work paper will focus on the German funds market.

4 Methodology

This work paper will start with a theoretical part, to explain the main characteristics of CEFs and their organizational structure. The following step will deliver a summarized overview of the German CEF market and its development, before going over to the opportunities and risks of alternative investments. A business case will explain the conception but also the opportunities and risk of such an investment by a practical case study. The conclusion should bring the paper down to a round figure and sum up the results.

5 Theoretical Part

The theoretical part of this paper will deliver a definition of the investment instrument CEF and give an overview of its main characteristics. Additional, a conception analysis will define the conception workflow and uncover the standard structure and organization form of these alternative investments. Due to the complexity of the issue, a segmentation of the specific types of CEFs will simplify the understanding of this topic.

5.1 Definition

Generally, CEFs are issued to realize and finance projects. Closed-end funds bundle capital from many investors and facilitate them to participate on huge projects with a manageable risk. On the other hand, these alternative investments enable the realization of diverse projects. Up to now, there exists no general definition of CEFs, but some figures could be analyzed which describe the investment very close. First of all it should be defined in which fund-objects the investment will go. Afterwards, the total capital volume of the fund is published; which means that the equity and the liabilities are calculated and fixed. The next step is to authorize a brochure whose structure is exactly defined by the German BaFin. And it has to be noticed that CEFs have a fixed duration time and usually it is not possible to leave the investment during the timeframe, excluded by the secondary market. These figures should help identifying CEFs, but as already mentioned it is not necessary to fulfill these aspects. Some funds do not clearly define in which objects the investor invests, rather an investment region or a geographical market is named.^[6] One main characteristic trait is the corporate organization of the funds which is almost the same, namely the German GmbH & Co. KG, which explains a limited partnership with a limited liability company as general partner. In fact, the investor becomes a limited partner of the company, liable to a fixed amount, which means that the private investor converts to an entrepreneur with all the risks and opportunities given.^[7] As a KG consists of a partner with unlimited liability and a partner liable to a fixed amount, the GmbH and Co. KG erodes the possibility of unlimited liability by replacing the partner with unlimited liability by a close corporation with limited liabilities. The reason for this reorganization is to limit the liability to a minimum, and this is one cause why risky projects are not financed by banks, but rather by private investors with the financial instrument CEF.^[8]

5.2 Conception Design of Closed-End Funds

Before a CEF is going public, diverse steps have to be fulfilled by the initiator, which is visualized in figure 2.

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Figure 2: Life Cycle of CEFs^[9]

First of all a conception of the whole investment is necessary. In this step it will be fixed which investment subject should be taken as a basis or in which project the investment should go. The initiator is installing a kind of business plan to arise the total capital needed, with a cost and profit projection and a preview of planned equity and liabilities. In the next step, the organization form of the alternative investment is getting founded. In Germany, as already mentioned it is mostly the GmbH & Co. KG, to minimize liability risks. Before going into the stage of capital procurement the investment company has to public a sales brochure conformable to the standards of IDW S4, which afterwards will be verified by the BaFin. Due to this, the initiator is liable to disadvantages if the brochure is not complete or if it has wrong information, which can lead to a disadvantage for the investor^[10]. This process is continued by the capital procurement or the placement of the financial product. On the one hand, the initiator has to collect debt capital from banks and on the other hand he has to collect equity from private or corporate investors. The placement is one of the most important steps of the roll out, because if there is not enough equity placed the project will not get any financing from banks. Having collected all capital needed, the project can turn into the operating stage and the fund subject can be bought or build, depending on the subject. From this point on, the investment earns an income which can be distributed to the investors or used to cover current costs. The last stage of a CEF is the closing stage. After a clearly defined time the project will be closed and the fund subject sold. The cause is to quit the investment and to pay out the investors. Generally the run-time of an investment is about 7 – 25 years, depending on the fund subject.^[11]

5.3 Holding Structure

The holding structure of a CEF varies between each different conception of the investment. Usually, it can be noticed that a basic structure is almost given like figure 3 shows. The main agent is the initiator; he launches and administrates the fund and he is responsible for the conception design discussed in the last sub-chapter. The initiator acts in the front and also in the background and accompanies the project from the conception to its closure. The next party is the fund company, which describes the fund itself. In fact, the fund company is a design organization which is assigned to conduct a specific project, like buying and leasing real estates. Additional, the fund company manages the organization together with the initiator and the partner with unlimited liability, who is almost the same person. The sales-force is responsible for the placement and capital collection of the CEF. Financial advisors sale limited partnership shares to their private and corporate customers and receive a fee for this transaction. The investors convert to a limited partner and an entrepreneur and bring the equity into the fund company. Banks give debt capital to the fund company to achieve the calculated capital. The investor can appear as a direct limited partner or as a trust maker. To reduce complexity and administration, it is common that a trust collects the capital from the investors and acts for them during the fund period. Alternatively, every investor has to register as a limited partner in the commercial register, which would cause additional costs and a high administration.^[12]

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Figure 3: Basic Structure of a CEF, own description

This basic structure gives an overview of the participants of CEF-project. In addition to this structure, other service providers like certified accountants, tax advisors or consultants act in the background whenever it is necessary.

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^[1] N.a. (2012), www.handelsblatt.de: Wie die Deutschen ihr Geld anlegen.

^[2] Ibid.

^[3] Reents (2013), www.welt.de: Anleger flüchten in Scharen aus geschlossenen Fonds.

^[4] Schultz (2011), p.17.

^[5] Voigtmann (2010), p. 122.

^[6] Pelikan (2007), pp. 11 – 12.

^[7] Voigtmann (2010), p. 122.

^[8] Klatte (1991), pp. 2 – 5.

^[9] Schieferstein (n/a), www.fondsvermittlung24.de: Welche Lebenszyklen haben geschlossene Fonds?

^[10] Lüdicke & Arndt (2007), p. 143.

^[11] Betz (1997), pp. 35 – 36.

^[12] Pelikan (2007), pp. 27 – 30.