Investment funds in the Middle East
November 2011 | TALKINGPOINT | INVESTMENT FUNDS
FW moderates a discussion covering investment funds in the Middle East between Pervez Akhtar at Freshfields Bruckhaus Deringer and Zeeshan Ahmedani at White & Case LLP.
FW: How would you describe the growth of investment funds in the Middle East? What impact is recent growth having on the emergence of new markets, new opportunities and fund capabilities in the region?
Ahmedani: The MENA investment funds market has grown tremendously over the past decade, notwithstanding the slowdown since last year due to current economic and political challenges, both global and regional. According to many sources, the largest fund managers – in terms of equity raised over the past five years – in Asia are based in the Middle East. The industry has benefited from the region’s large, sophisticated and liquid LP market and the influx of talent from more established markets. The sophisticated LP market has sought to import the global best practices of their Western managers to regional managers, thereby uplifting industry standards locally. On the sponsor side, the arrival of large managers and experienced professionals has had a similar effect on the industry as a whole. Increased sophistication has also led to increased competition, creating incentives to identify new markets in the quest for returns.
Akhtar: In terms of new fund establishments, there has certainly been a reduction in the region over the past 18 months. The monetary value of deals done by existing funds in 2010 also fell further from what was a historic low in 2009. This was largely attributable to the perceived lack of quality assets combined with the fact that asset valuations were felt by many to be out of synch with the economic situation. In addition, private equity firms have increasingly had to concentrate on positioning their existing portfolios and managing risk profiles rather than new transactions with many general partners having a far higher degree of involvement in activities related to the operational management of their portfolio companies and adjusting the models of those businesses to market conditions.
FW: Are sovereign wealth funds active in the Middle East and abroad? What types of investments and sectors do they seem to be targeting?
Akhtar: In the last couple of years sovereign wealth funds (SWFs) have broadly shown an increase in deal volume but there has been a decrease in the value of their individual investments. The principal sectors that have attracted attention have been banking, insurance, commodities, natural gas and petrochemicals, renewable energy, and energy transmission. In terms of the geographic distribution of investments there is an interesting difference between investment patterns of Middle Eastern SWFs and those in Asia. The latter have been understandably active in Asia Pacific but also in North America. This contrasts with the Middle Eastern funds that, while also investing in Asia Pacific, have historically been more active in Europe, and not so active in North America, with the notable exception of the Libyan Investment Authority’s acquisition of Verenex Energy.
Ahmedani: SWFs continue to remain active globally in respect of their investment allocations. Well-established managers with track records continue to do well on the fund raising side, as well as markets and sectors that are perceived to be undervalued, such as real estate markets in the West, or present significant opportunities for return, for instance emerging Asia. Sectors we have seen of late are clean and renewable energy, technology and insurance and re-insurance industries. Regionally, there is still a perception of a general lack of depth across the industry such that the number of attractive managers in the region is proportionately less than in other regions. Many investors look to co-investments, joint ventures and direct investments as a result in order to mitigate this risk.
FW: To what extent has political volatility in the region, coupled with the continued affects of the GFC, had a material impact on the funds industry and the investment outlook?
Ahmedani: Certainly the Arab Spring has slowed growth. Statistics show that overall deal activity in the region has slowed since the onset of the political movements and that outbound investments exceed inbound investments in terms of value, though some of this is attributable to opportunities seized by regional cash-rich investors and companies in global, depressed markets. Not surprisingly, private equity capital raise is still down from pre-GFC highs and recovery has been slowed by the region’s political events. Other parts of the world have benefitted from the regional slowdown. The MENA region, for example, is home to the largest fund manager in Asia but collectively has been outpaced by East Asia in terms of total capital raised.
Akhtar: Political and social unrest throughout 2011 has, unsurprisingly, had a negative impact on MENA markets in the short term, and clearly in those countries directly affected by the unrest. Capital deployment and investments have been put on hold as well as a reduction in activity to raise additional funds. Private equity firms considering exit strategies for some of their investments have also adopted a more cautious approach not helped, for example, by the lack of liquidity of regional stock exchanges and a continued emphasis on the operational management of existing portfolios. There have also been widely divergent views on valuations, particularly those from potential buyers and sellers from outside the region. This has made deals more difficult in the current context, with 2011 seeing the general adoption of a wait and see approach.
FW: Could you provide an overview of the legal principles governing Islamic finance? What are the basics of Shariah-compliant fund structures, and are these becoming more popular?
Ahmedani: Very simply, Islamic finance is based on a number of key principles: actual or constructive possession of assets, mitigation of preventable risk, principles of fairness, certainty, equity and transparency and prohibition of certain industries – certain entertainment, alcohol, pork, defence, and conventional finance and insurance. It is also an asset-based finance with prohibition of interest and certain forms of fixed and preferred returns. Shariah-compliant funds must adhere to these rules not only at the fund level, but also at the investment level, for instance, type of investment, its financial profile and acquisition structure legally and financially. Fund structures themselves are fairly straightforward in most cases as the GP-LP structure fits very neatly in to Shariah. Hedge fund structures can be slightly trickier. Shariah-compliant funds will continue to be popular if they provide investors with access to sectors, regions and strategies that are otherwise unavailable to them. Many managers add a Shariah component to conventional strategies to tap such markets. Shariah products that can provide fixed-income like returns are currently attractive.
Akhtar: The main principle of Islamic finance is to enable investment in a manner which is consistent with Shariah, or Islamic Jurisprudence. Shariah is derived from the Quran and Hadith – the sayings and teachings of the Prophet Muhammad, and religious rulings from Islamic scholars. In summary there are four main prohibitions in Islamic finance which are: (i) riba, the charging of interest; (ii) gharar, uncertainty in contracts; (iii) mayseer, speculation/gambling; and; (iv) particular prohibited activities, for example gambling. The basics of Shariah-compliant fund structures are that such fund investments must comply with certain business activities and they must comply with certain financial ratios. In relation to business activity restrictions, no investment may be made by or on behalf of the fund where the core business and/or major source of revenue is in relation to pork products, tobacco or alcohol, gambling casinos, music, pornography, or conventional financial services. Those financial ratios that must be complied with – including the thresholds – will depend on the requirements of the Shariah scholar and will typically be in relation to total debt, cash and interest bearing securities and accounts receivables. Shariah-compliant fund structures have grown in popularity as such structures enable funds to expand their investor base.
FW: Are the regulatory frameworks governing investment funds evolving across the region? What are some of the significant developments you have seen?
Ahmedani: On the fundraising side, Kuwait has adopted stringent rules regulating the offering of foreign fund interests locally. The UAE has proposed similar regulations. These will bring both jurisdictions in line with markets such as Saudi Arabia, though the practical implementation of the rules is still unclear. The assumption, however, is that regulators across the region will be stricter in regulating such activities than they have in the past. On the sponsor side, both the Qatar Financial Centre (QFC) and the Dubai International Financial Centre (DIFC) have revised and revisited their rules in order to make it easier and more attractive for fund managers to establish funds and/or establish operations there. One emerging trend to watch out for, at least in Qatar, is any attempt at harmonising the rules for the QFC, for QFC funds, and the Qatari Central Bank, for onshore funds.
Akhtar: The most significant developments this year have been the introduction of the new Investment Fund regulations in Kuwait – the New Kuwaiti Funds Law – on 13 March and the publication of draft Investment Fund regulations in the UAE – the ‘Draft UAE Funds Law’ – on 6 January. While the Draft UAE Funds Law has not yet become law, the New Kuwaiti Funds Law is officially in effect. The new laws are in many respects similar to the investment funds regulations of Saudi Arabia which have been in effect and enforced since 2006. It is safe to say that debate about the final form and time table for the Draft UAE Funds Law is ongoing and that uncertainties remain in respect of the implementation and enforcement of the New Kuwaiti Funds Law. At this point in time, we have not noticed any significant change to the practices of investment fund promoters in the region. However, if the New Kuwaiti Funds Law and the Draft UAE Funds Law are implemented as currently drafted and enforced in a similar manner to those in Saudi Arabia, investment fund operators and promoters may have to change their activities significantly.
FW: How important are specialised investment fund professionals to the development of the Middle Eastern market?
Akhtar: As with any industry, specialists with proven track records increase confidence. The funds industry is no exception. This has become particularly important in the context of the recent financial crisis in addition to increasing transparency and industry best practice.
Ahmedani: As a matter of self-preservation, they are very important. In all seriousness, local service providers with global experience across all services have a significant role to play in the continued evolution of the regional market in three distinct ways. Specialised fund professionals can help bridge the gap between markets that may otherwise, figuratively, speak different languages, whether it is the local manager seeking to raise capital from a European pension or an East Asia-based manager looking to place fund interests with local investors. Additionally, as the market matures, investors and managers are going to expect their service providers to be in the same region in order to promote efficiency and mitigate costs. This trend is already visible to a large degree. Finally, true innovation and development locally will come from community synergy and continual exchange of ideas, not just bi-annual conferences. Service providers will play a key role in that.
FW: Drawing on your experience, what knowledge do investors and fund managers need to be successful in this region?
Ahmedani: With some exceptions, the MENA region is still a frontier market. Local economies and the laws and regulations that support those economies are constantly evolving. These cannot be learned in a day or even months. Therefore, knowledge and trust of your counterparty is of paramount importance. They are the key source of transparency where law or market practice may not otherwise provide it. Key relationships with other people on the ground, be it service providers or other industry stakeholders, is highly critical as well. In some cases, the absence of trusted, local relationships may preclude market entry. In other cases, such relationships can create the joint venture a manager needs to leverage ‘first in market’ on the ground presence in to successful upstream and downstream initiatives.
Akhtar: In order for investors and fund managers to be successful in the MENA region they must have a solid understanding of the region itself, not least the business culture and nuances of the individual countries as well as the business constitution of each, that is, the split between public and private sector, the proportion of family-owned businesses etc as well as government budgetary and fiscal policy. There needs to be an appreciation and awareness of short term market volatility and therefore a willingness to have a longer term outlook. There must also be a deep understanding of their chosen market and specific sector(s). Those investors and fund managers that are truly successful have superior knowledge of the companies they invest in and the market opportunities for those companies. Coupled with knowing where and when to invest, is an ability to know when to exit and how to achieve this successfully.
FW: What major trends do you expect to see going into 2012 and beyond? Is there huge potential to be realised by the funds industry in the Middle East?
Akhtar: It is difficult to predict with accuracy but we are likely to see regional governments focus on their domestic projects in infrastructure, healthcare and education and established funds with critical mass increase activity. If we see an increased willingness for countries to open up their economies to more private sector involvement, while this may not impact the funds industry in the short term it may present opportunities in the medium term as a result of the increasing diversity and ease of market entry. Many of the countries in the Middle East, for example Egypt and Saudi Arabia, have solid demographics with many investors feeling confident about their prospects. Turkey is proving increasingly attractive to investors and is likely to continue to do so into 2012, while the UAE is still likely to act as a regional hub for private equity firms and funds.
Ahmedani: Over the near term, do not expect seismic shifts in the industry rivalling the development before the global financial crisis. Political events as well as the current global economic malaise likely will result in a quiet 2012. Over the mid-to-long term, the continued evolution of the MENA funds market will be worth watching, particularly as regional managers need not go very far to tap vast amounts of capital. For a frontier market, the amount of capital raised for the region is staggering. One can imagine the excitement the region will generate once political and economic factors stabilise and if economic liberalisation occurs coupled will greater legal and regulatory robustness.
FW: Fundraising in the MENA region has been decreasing for the past three years. What are the factors behind this? Do you expect this trend to continue?
Ahmedani: The global financial crisis slowed things down and the region is still recovering. Certainly political events in the region have stalled the recovery process, though large managers, niche managers and those whose remit includes, but extends beyond, the MENA region are still raising capital. However, private equity’s steep growth curve has been both a blessing and a curse. In good times, it has been one of the great stories for the region, but in slow times, the lack of a decades-long track record has caused regional and international investors to shy away from allocating capital here. Those investors who are allocating are often pushing joint ventures and private placements rather than traditional private equity, blind pool funds in order to obtain greater governance and transparency. This trend may continue over the near term, but the long term is much more promising.
Akhtar: There has certainly been a reduction in the establishment of new funds across the region. In times of economic uncertainty with nervous investor sentiment, the track record of a fund becomes even more important. This is especially so in emerging markets which tend to be high risk but potentially high return. For Middle East-focused funds that do not have a consistent track record of success or are relatively new, it can be difficult to attract international investors who have options in other markets.
Pervez Akhtar is the managing partner of Freshfields Bruckhaus Deringer in the MENA region and head of the firm’s MENA corporate practice. He specialises in advising both local and international investment funds and private equity houses on their investments throughout the MENA region as well as sovereign wealth funds and government investment vehicles on transactions integral to their strategic investment and economic diversification programmes. He has advised on some of the largest private equity transactions in the MENA region with particular experience of advising on transactions in the finance, energy & utilities and healthcare sectors. He can be contacted on +971 4 5099 100 or by email: firstname.lastname@example.org.
Zeeshan Ahmedani is a partner at White & Case LLP. He is a member of the firm's Investment Funds and India practices. Mr Ahmedani has substantive experience advising managers on the organisation and establishment of US and international private investment funds both onshore and offshore (tax haven) jurisdictions, including hedge funds, private equity funds, real estate funds, distressed debt funds and Shari'ah compliant funds. He represents managers, placement agents and fund sponsors around the world, with equity diverse investment and distribution strategies. He can be contacted on + 971 2 495 0133 or by email: email@example.com.
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