Dr. Gunter Reiff
“Key investor information will soon be replaced by basic information sheets according to the PRIIPs Regulation!” – This headline could be read regularly in newsletters from law firms or in articles in trade magazines in recent years. However, the “soon” date of the changeover has been postponed again and again. On 1 January 2023, however, the time will finally come: From this date, private investors who want to acquire units in a closed-end mutual fund and semi-professional investors who want to acquire units in a closed-end special AIF must receive basic information sheets designed in accordance with the requirements of the PRIIPs Regulation before making their investment decision. In contrast, key investor information pursuant to § 270 KAGB is no longer to be handed out.
Since the effective date refers to the date of distribution of the units and not to the date of authorisation for distribution, new key information documents must also be prepared for closed-ended investment funds that were already in distribution before 1 January 2023.
The content and form of the key information documents is regulated in great detail by Delegated Regulation (EU) 2017/653, which was substantially modified last year by Delegated Regulation (EU) 2021/2268. The annexes to the regulation contain model templates and precise specifications as to which headings and which information must be included in the key information document. An essential component of the basic information sheets are key figures that are to enable the comparability of different financial instruments. Since these ratios will sometimes show surprising values for closed-ended investment funds and require explanation, they will be explained in the following in overview.
The overall risk indicator
Up to now, the specific risks of a closed-ended investment fund have been described in detail and individually in the key investor information. In the future, the risks will essentially be clarified by the “overall risk indicator” in the key information sheets. The overall risk indicator is a number between 1 and 7, whereby 1 represents the lowest risk and 7 the highest risk.
The overall risk indicator is calculated according to the specifications in Annex II of Delegated Regulation (EU) 2017/653. According to this, a market risk value and a credit risk value must first be determined. The overall risk indicator is then determined from the combination of the two risk values according to a table.
The market risk value is past-oriented and is based on the past volatility of the financial instrument. The prerequisite for calculating the market risk value is therefore that historical prices for the financial instrument are available. In the case of closed-ended investment funds, such prices are regularly not available. For such financial instruments, item 8 of Annex II of Delegated Regulation (EU) 2017/653 stipulates that the market risk value is 6. The table for determining the overall risk indicator shows that with a market risk value of 6, the overall risk indicator is always 6, regardless of the credit risk value.
For closed-end investment funds, this means that their overall risk indicator will regularly be 6, regardless of which asset class is invested in and whether the investment fund is risk-mixed or not. The overall risk indicator of 6 for closed-ended investment funds does not contain any statement on the specific risk of a fund. It is merely a consequence of the structure of the closed-end investment fund, which does not allow any recourse to prices from the past.
Distributors must make clear to potential investors that the overall risk indicator, which is particularly emphasised in the key information document, is only determined on the basis of a specific calculation methodology and does not contain any substantive statement about the risk of the respective closed-ended investment fund.
Performance scenarios
As in the key investor information, performance scenarios must also be stated in the key investor information document. In principle, four scenarios should be presented: an optimistic scenario, a medium scenario, a pessimistic scenario and a stress scenario. In the stress scenario, significant unfavourable effects on the product are to be presented, which are not covered in the pessimistic scenario. Like the determination of the market risk value, the scenarios are calculated on the basis of the previous development of the financial instrument.
For financial instruments where past price performance is not available, “a reasonably possible and conservative best estimate is provided. (…) Scenarios shall be selected to provide a balanced representation of the possible outcomes of the product under both favourable and unfavourable conditions, but only scenarios that can reasonably be expected shall be shown. The scenarios shall not be selected in such a way as to unduly emphasise favourable outcomes compared to unfavourable outcomes.” (paragraph 31 of Annex III to Delegated Regulation (EU) 2017/653). Fortunately, no stress scenario is required for financial instruments where the scenarios are estimated and not calculated.
The scenarios must be printed in the order pessimistic scenario, middle scenario and optimistic scenario.
As a result, three performance trends based on forecast calculations and taking into account different developments of the key performance factors are also presented in the basic information sheets as previously in the key investor information.
Annual average return
A new metric compared to the key investor information is the “annual average return” to be calculated for each scenario. The average return is calculated in accordance with point 44 of Annex III of the Delegated Regulation (EU) 2017/563 by taking the xth root of the quotient of the projected total returns (numerator) and the initial deposit amount (denominator), where x corresponds to the projected term in years. This determines the interest rate at which the investment amount must be invested in order to reach the amount of the total returns, taking compound interest into account.
The effects of the calculation methodology are illustrated by the following numerical example:
Issue price including front-end load: 105 %
Annual distribution: 4 %
Repayment after 10 years: 100 %
In total, the investor achieves 140% total returns after ten years. The average interest is calculated by taking the tenth root from 140/105 and subtracting 1. This results in an interest rate of 2.91 % p.a.
A closed-ended investment fund which, according to the perception of distributors and investors, is to be assessed as a “solid four-percenter” will thus show an average return of less than 3 % p.a. in the basic information sheets.
Reduction in yield due to costs (Reduction in Yield)
The methodology for calculating the reduction in yield due to costs will also lead to surprising results. Two payment series are formed for this purpose. One payment series corresponds to the incoming payments and projected outgoing payments, taking into account the costs. In the other payment series, the incoming payments are reduced by all costs incurred during the term and the outgoing payments are set at the forecast amount. For both payment series, an interest rate is determined according to the internal rate of return method. The difference between these interest rates corresponds to the “reduction in yield”. (Paragraph 70 ff. of Annex VI of Delegated Regulation (EU) 2017/563)
Continuing the above example, let us now assume the following fee structure:
Initial fees: Issue surcharge + 8
Ongoing fees: 0.6 % p.a.
First, the IRR yield for the projected payment series is determined, taking costs into account.
It amounts to 3.4 % p.a.
The payment series modified by the costs is then drawn up. The total costs are 13% initial costs and a cumulative 6% ongoing costs, for a total of 19%. These costs are deducted from the issue price, so that a deposit of 86% and payouts of 4% each form the modified payment series. The IRR yield of this payment series is 5.89 % p.a..
The yield reduction due to costs to be stated in the basic information sheet amounts to 5.89% less 3.4% and thus 2.49%.
The combination of the average return and the reduction in return due to costs can give investors the impression that almost half of the economic success of the investment is eaten up by costs.
Conclusion
The new key figures in the basic information sheets according to the PRIIPs Regulation are surprising and require a great deal of explanation. In particular, the information on the average return and the reduction in yield can unsettle investors. Distributors and corporations should therefore familiarise themselves with these ratios, their calculation methodology and interpretation at an early stage so that they do not get any nasty surprises in January 2023.
We have written off the loan to P&H in the SFD. However, it has no effect there for tax purposes, as § 8b KStG stipulates that write-offs on shareholder loans may not reduce profits.
We have experienced a great deal of uncertainty in our discussions with potential investors.