Hedge fund managers see a host of investment opportunities opening in Germany, where a deep-rooted reluctance to reform the economy and hostility toward foreign capital are slowly but steadily diminishing.
Hedge funds are looking at investment areas including stocks, particularly manufacturers, and unprofitable loans sitting on the books of German banks.
Hedge fund managers say Germany is beginning to realise that structural and labour market reforms are vital if the country wants to keep its position as one of the world's biggest economies, although the changes are still mainly psychological.
A recent agreement in Germany's construction industry for a longer working week with no extra pay and lower minimum holiday entitlements is a sign of changing attitudes.
"Germany is already on the road to recovery," said Ton Tjia, London-based hedge fund manager at Olympus Capital.
"When things start changing in Germany, it's a safe bet they will keep changing ... Productivity has risen."
Germany is Europe's largest economy, but the market capitalisation of its listed stocks is around 490 billion euros ($596 billion), compared with the 1.8 trillion euro valuation of all listed stocks in Britain, also one of Europe's biggest economies.
"The reason is most of the financing is still done through bank loans," said Nicolas Campiche, manager of selection services at Pictet Asset Management.
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However, hedge funds expect firms to start using the stock market to raise capital and say cross holdings of shares are likely to be unwound and companies to be listed. These changes will boost liquidity, interest in German stocks and merger and acquisition activity.
A recent M&A example, which would have been nearly impossible a few years ago, is Italian Bank Unicredito's bid to take over Germany's HVB in what would be Europe's biggest cross-border bank merger to date.
Fund managers, meanwhile, see recent German government calls for tighter controls on hedge funds as a tactic to divert attention from economic setbacks ahead of an expected election in September.
One area of interest for hedge funds is German manufacturers, which were forced to slash costs to keep their exports competitive after the euro started to rise in June 2001 to record levels above $1.36 in December 2004.
The process was painful, but the dollar has recovered this year, and that should help boost profit margins, especially in the manufacture of capital goods, where Germany has a reputation for excellence.
"There are interesting investment opportunities in Germany," Tjia said. "Look at manufacturing, especially capital goods."
Hedge funds are also eyeing auto makers including Volkswagen despite its recent bribery scandal.
Under the so-called Volkswagen law from 1960 that makes a hostile take-over of the company difficult, no shareholder can exercise more than 20 percent of voting rights in the firm.
"Pro-marketeers are trying to get rid of this law," said Christoph Avenarius, a senior hedge fund analyst at Credit Suisse Alternative Investments in Zurich.
"I'm confident they will succeed sooner or later, because the emotional attachment is not as strong now as it was previously."
Weak balance sheets and moves to modernise and strengthen capital standards via the Basel II Accord means many bank loans have been or will have to be sold at a discount to book value.
"The idea is to buy the debt at a discounted rate because the bank has overestimated the default rate," said John Godden, European managing director of HFR Asset Management.
"Hedge funds could try to take over a company ... But it would depend on how the debt was constructed."
Hedge fund managers who think discounts are bigger then they should be and are looking for yield have already snapped up a lot of bank debt. But the process isn't over, they say.
"It's potentially a huge market," Campiche said. "The bank debt market is absolutely enormous, and hedge funds are looking very actively at trying to get exposure to debt in Germany."
However, bank debt can be difficult to exploit because unwilling sellers have hindered the development of a market.
Some hedge fund analysts say a lot of German bank debt is already held by hedge funds and that they are not sure whether the strategy, with the exception of property loans, is still viable.
"The property market is still rather depressed," Avenarius said. "That's where some of the bad debt is looming ... a consequence of investments made after reunification, subsidised by the state."
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