luxembourg

Fund service providers create fictitious companies with cryptic names for the business.

(Photo: images new-horizons.eu/ddp)

Zurich They are among the riskiest interest-bearing securities in the market: subordinated debt from developers of real estate projects. Interest rates remained exceptionally high at 15 percent, even in recent years without interest. There are no ratings. Terms are flexible from 12 to 36 months. And liquidity is low given the lack of a secondary market.

investment vehicle as the Verius real estate financing fund, which entered into crisisInvesting in such debt instruments are also high risk products. The fund attracted, before it was frozen, an annual return of eight to ten percent and two distributions a year.

However, insurance companies and pension funds subject to the Insurance Supervision Law may not invest the funds entrusted to them, the so-called collateral assets, directly in said funds. “In the judgment of the Bafin not suitable to cover the collateral assets”, write the Deloitte experts, for example.

However, financial lawyers and engineers have found a way to make investments in Verius funds and comparable investment vehicles possible. The magic word is “credit improvement.” Ironically, the German financial regulator Bafin is said to have approved these credit-enhancing constructs, according to industry circles.

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The consequences could be fatal: In the worst case, pension funds that have invested in Verius through credit enhancement structures may have to postpone their own annual financial statements.

companies mailbox in luxembourg

“Credit enhancement” works like this: The fund’s service provider sets up a special-purpose vehicle between the fund and investors. This company, usually with a cryptic name and registered office in Luxembourg, has the sole task of buying fund shares. In the case of the Verius fund, it is Securo Pro Lux SA based in Munsbach, Luxembourg. It issues fixed income securities, to which investors subscribe. The special purpose vehicle uses the money raised to buy shares in the fund.

graphic

Credit enhancement is achieved when the SPV transfers only a portion of the fund’s distributions to the bond investor. Case in point: the Verius fund recently distributed between seven and eight percent a year to investors. However, Securo Pro Lux only pays its bond investors a fixed interest rate of 1.25 percent.

Securo Pro Lux retains the difference and thus creates a kind of buffer. From this buffer, the special purpose entity can pay the coupon interest and face value of its own bond even if there are no fund-level distributions.

Consequently, the cushion is greater if the investment goes back a long time. For example, if a company only invested in the fund one year ago through Securo Pro Lux, only one year’s interest is available as a cushion. As a result, no more than 90 percent of face value would be hedged. The Verius fund’s Securo Pro Lux bond has a triple B rating less than Creditreform, just one notch above junk status.

questionable motivation

The result: the structured bond has a good credit rating, so pension funds and insurers can invest without problems. And this despite the fact that the underlying fund invests in unrated interest rate securities of the highest risk class and would therefore be taboo for many professional investors.

The motivation behind this is to circumvent regulatory quotas. You can, but you need to be aware of reputational risks. Senior manager of a large private markets investment provider

The outstanding volume of these bonds with the special guarantee of the Verius funds exceeds 800 million euros. This means that most investors invest in the Verius fund through this indirect route.

Many professional investors also got involved in the Stratos real estate fund, which was also frozen, exclusively through this supposedly safe diversion. In many cases, so-called alternative investments are also configured in this way, for example in individual infrastructure projects. Industry experts estimate that German insurers and pension funds may have invested billions in such structures.

However, the structures are controversial among asset managers. A senior manager at a large private market investment provider says: “The motivation behind this is to circumvent regulatory quotas. You can do it, but you have to be aware of the reputational risks.”

The Verius crisis is now revealing the risks of these constructions: the fact that Hauck & Aufhäuser has suspended the calculation of the fund’s share value is also causing chaos among the creditors of the Securo bonds. Because the price of this bond can no longer be calculated, as confirmed by market participants.

The pension funds and insurers that hold the bonds are under pressure. Many of the large German insurance companies are reportedly among them. The Schleswig-Holstein tax advisor pension plan disclosed investments in the Securo bond in the 2021 financial report.

If the Verius fund’s value calculation remains suspended any longer, they could be forced to postpone their own financial statements. So it’s no surprise that those in the know report that everyone involved is nervous.

More: A real estate fund worth billions is under pressure again

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