New investments funds and REIT regimes in Saudi Arabia
December 2016 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
The Saudi Arabian economy, while strong and stable relative to other countries in the region, has entered a period of transition. In early 2016, the country’s leadership adopted a national transformation plan – ‘Vision 2030’ the aim of which was to modernise and diversify the economy. In particular, Vision 2030 focuses on increasing employment, particularly in the private sector. There will also likely be continued investment by the private sector in the retail, power, renewables, transport, education and healthcare sectors.
The financial services sector in Saudi Arabia is undergoing a period of transformation. The Capital Market Authority (CMA), which regulates the financial services and asset management industries in Saudi Arabia, has long sought to encourage asset managers and investment banks to grow assets under management by tapping retail markets and international investors. The CMA also wants to encourage managers to develop products which can be accessed by the Saudi public in order to encourage individuals to invest their income in the Saudi domestic market.
As such, throughout 2016 the CMA has released numerous regulations covering the establishment of new corporate vehicles, the IPO process and foreign investment in Saudi Arabia and has promised a complete revamp of existing financial services regulations. Two regulations in particular are pivotal for asset managers looking to raise Saudi Arabia targeted funds: the amended investment fund regulations (the New Funds Regulations) and the real estate investment traded funds instructions (the REIT Regulations).
After a consultation period, the New Funds Regulations were released in May 2016 and became effective on 6 November 2016. The New Funds Regulations govern the formation, offering and operations of all private and public investment funds in Saudi Arabia, except publicly offered real estate funds, which are governed by the Real Estate Investment Funds Regulations. The issuance of the New Funds Regulations was long expected as the CMA had publicly acknowledged for years that new regulations were in progress.
In August 2016, the CMA released draft REIT Regulations, which provide for certain public real estate funds to be listed on the Saudi Arabian Stock Exchange (Tadawul) as real estate investment traded funds (REITFs). These REIT Regulations were initially subject to a consultation period, which ended in late August. The REIT Regulations allow managers to list certain public real estate on the Tadawul; to date, the only listed funds in Saudi Arabia are exchange traded funds. As such, this is an exciting development, as the first REITs are expected to be listed on Tadawul by the end of November 2016.
Both new regulations provide opportunities to investment banks, private equity firms and asset managers to expand their product offerings and access additional investor bases.
Investment funds regulations
In May 2016, the CMA issued draft New Funds Regulations to replace the previous funds regulations issued in 2006 (the 2006 Regulations). These New Funds Regulations became effective on 6 November 2016. The CMA intends the New Fund Regulations to provide clarity and to encourage more managers to launch funds. These regulations have been a long time coming. It has been public knowledge for years that the CMA has intended to revamp the 2006 Regulations in order to codify unwritten practices of the CMA, to address problems of investor protection that arose during the financial downturn and to cover the launch of a diverse range of new funds, many of which were not contemplated by the 2006 Regulations.
The processes for launching a private fund remain essentially unchanged, although the required documentation has been detailed, particularly regarding real estate funds. The process for launching a public fund, which has been opaque in the past, has been expanded, with managers required to prepare an information memorandum, the form of which is set out in the New Funds Regulations. The information memorandum contains much greater disclosure requirements than the 2006 Regulations.
There are a number of other provisions of interest. First, the fund manager may not restrict investors of certain nationalities unless the approval of the CMA is obtained. The CMA has indicated that the only restrictions it will apply will be to restrict those private real estate funds which invest in the cities of Mecca and Medina to Saudi Arabian nationals only. Otherwise, all investment funds would be open to foreign investment, regardless of the underlying investments. This is a significant change as it was often considered a grey area whether foreign investors could invest directly into CMA regulated funds or if such investors would be prohibited or would have to register through a lengthy process with the Saudi Arabian General Investment Authority (SAGIA).
Second, all funds must have an independent custodian; accordingly, the role of the custodian has been expanded so that they control cash flow. Previously, independent custodians were required only for public funds and real estate funds. This new requirement potentially adds significant costs to the fund, though the CMA has determined that the heightened protection for investors outweighs the costs.
Third, administrators, advisers and certain other corporate service providers performing activities in relation to a fund investing in Saudi Arabia must be licensed by the CMA. Previously, many Saudi Arabian managers had outsourced certain functions to advisers and service providers sitting offshore. Such third parties will only now be permitted to provide services to CMA funds if the funds are investing outside of Saudi Arabia.
Fourth, the fund manager and its affiliates are not entitled to vote any units they hold in an investment fund under the new Regulations. Previously, the fund manager was treated equal to other third-party investors in the fund.
Fifth, unitholders are also afforded statutory rights under the New Funds Regulations. Now the manager must obtain the consent of the unitholders prior to making material changes to the fund’s documentation, such as changing the strategy or the risk profile or significantly increasing fees and expenses, which would reasonably be expected to cause the unitholders to reconsider participation in the fund. Further, the fund manager must schedule and hold an annual unitholders meeting. The 2006 Regulations provided no such unitholder protections, nor did it provide for any unitholder meetings.
Finally, the fund manager may be removed by a supermajority vote of the unitholders and the process for replacing the fund manager has been clarified under the New Funds Regulations. The 2006 Regulations, by comparison, were silent on this issue which created a grey area due to the nature of a CMA fund. A CMA fund is a contract between the manager and the investors. It had been widely assumed that if the manager was removed the contract would become void, and as such, the fund would be terminated. The CMA has now introduced the procedure pursuant to which a replacement manager could be introduced and the fund could continue to remain in existence following the removal of the initial manager.
Real estate investment traded funds instructions
The REIT Regulations contemplate the listing of REITFs on the Tadawul and are meant to focus on developed properties that generate periodic income. Such periodic income must at least be on an annual basis. At least 90 percent of the REITF’s net profits must be distributed annually to the unitholders. REITFs must be closed-ended funds with a nominal value per unit of SAR 10. The REITF manager must be a licensed CMA authorised person.
The REITF Regulations permit the underlying assets to have leverage and for the concerned lender to record the property in the name of a subsidiary of such lender. Leveraging, however, should not exceed 50 percent of the total assets value of the REITF. The REITF manager is required to appoint both an independent custodian and a licensed property management company. The custodian is to ensure that it segregates its assets from those belonging to the REITF and from the assets of its other clients. The road show for the REITF is not to exceed 14 days. At least 75 percent of such investments must be in Saudi Arabia in developed assets generating periodic income, resulting in the need to identify 75 percent of the assets prior to launching the REITF. The REIT Regulations require evidence of binding agreements in relation to the pre-identified income generating properties. In our experience, REITFs are initially focusing on various private CMA real estate funds that will utilise the REITF route as an exit.
The REIT Regulations allow for a quarter of such investments to be outside Saudi Arabia. The minimum amount to be raised is SAR 100m and must include at least 50 unitholders from the public. REITFs are not to invest in vacant land, but may invest up to 25 percent of the fund’s assets in real estate development or the redevelopment of properties.
It is widely expected that the REIT Regulations will further spur the real estate market in Saudi Arabia.
Over the last few years the CMA has been focused on issuing new regulations and new products to help spur the domestic market and foreign investment into Saudi Arabia. The issuance of the new Funds Regulations and the REIT Regulations are consistent with these aims. The Fund Regulations provide further clarity to local managers who are seeking to tap domestic and international markets. The REIT Regulations introduce a highly-anticipated new product which provides investors with liquidity and makes it easier for retail investors to participate. Both have been welcomed as they provide clarity and allow for new products to be offered by managers.
James Stull and Nabil A. Issa are partners at King & Spalding. Mr Stull can be contacted on +971 4 377 9929 or by email: firstname.lastname@example.org. Mr Issa can be contacted on +966 11 466 9409 or by email: email@example.com.
© Financier Worldwide
James Stull and Nabil A. Issa
King & Spalding