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September 15, 2016

Another non-traded private fund bites the dust?

A peculiarity of the German investment landscape is the so-called „geschlossener Fonds“. Although it sounds similar, it has nothing to do with closed-end funds in the UK or the US. The sale of „geschlossene Fonds“ to private investors is illegal in most European countries, including the UK and France and for very good reasons. In our opinion, they are simply toxic. Though they can be bought in Germany if you are an expat living here, we believe you should avoid them at all costs.

This week another one of these non-traded private funds was making headlines. 2600 German retail investors put around $200m into a fund called DS-Fonds Nr. 129 that owns one Airbus A380, leased to Singapore Airlines. Now Singapore Airlines has announced that they will not extend the leasing period. The most likey scenario is that investors will nurse heavy losses. We will briefly explain what went wrong with this fund and why investors should stay away from this type of product.

So what exactly is a „geschlossener Fonds“?

„Geschlossener Fonds“ is a type of investment fund that raises money for a specific investment such as a plane, property, container ships or solar energy parks. After the money is raised, the fund is ‚closed‘, i.e. it has no liquidity. You cannot trade in-or-out of the fund, meaning you are locked up for a very long period of time. These funds typically have investment periods of >10 years. Besides a lack of liquidity, there are other major problems as we see it:

  • Very lightly regulated compared to public mutual funds
  • Very high commission around 10-20%, leading to a significant conlict of interest
  • Most issuing firms are small and have next to no track record
  • The prospectus is simply too complicated for most individual investors to understand.

If this sounds ridiculuous to you, you are not alone. If this sounds extraordinary to you, than you are not familiar with the German regulatory landscape…

Back to basics: What are sound investment rules?

There are several fundamental investment rules that every investor should follow. Unfortunately, these private placements run foul of all of these in our opinion:

1. To reduce risk, you must diversify

The easiest way to reduce risk is to diversify by investing in a wide variety of assets. However, these private placements usually only invest in one single asset. In this case, a plane. Unfortunately, the Airbus A380 turned out to be a commercial failure and in 2015, not even one single new plane was sold. Therefore the resale value is highly uncertain.

2. Never invest in illiquid assets 

Circumstances can change. This applies to your own personal situation as well as to the business that you are investing in. But with these private placements, it is virtually impossible to sell them because there is no secondary market. If the business outlook deteriorates, you are basically stuck with it.

3. If you really must invest in an illiquid asset, make sure you get an illiquidity premium

At the time of the launch of this fund, a 10 year German government bond yielded 4.5%. An investment-grade corporate bond around 6%. To compensate for the risk, the fund should have offered a return around 10% in our opinion. However, there was no way to calculate that expected return, because the resale value of a new plane 10 years hence was virtually unknowable.

4. Never buy risky assets on credit

Nobody in his right mind would buy stocks on credit. But these these private placements are profligate users of credit. They also invest in companies, similar to stocks, but they are nearly always using leverage, thus increasing the risk profile dramatically.

5. Dividends are not returns

With the use of leverage, the fund can manufacture any kind of pay-out it likes. But most retail investors confuse pay-out with returns.

 

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