6 November 2006
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Driven by Dubai's increasing strength in the global capital markets, the first three quarters of 2006 were strong for investment funds in the Middle East. Experts agree that the fourth quarter shows no sign of slowing, in part due to the role of foreign investors, diversification of funds and the use of an increasingly broad range of investment vehicles.
One of the most obvious indications that Middle East funds are having a strong year is the fact that the size of the individual funds is growing. Last year the $500m (£264.05m) buyout fund of Abraaj Capital, one of the leading private equity house in the region, was considered large. Abraaj's latest offering tops $2bn (£1.06bn) allowing the company to join leaders such as Commercialbank, Dubai Islamic Bank, Dubai Ports World, Gulf One Investment Bank and Global Investment House in offering $1bn (£530m)-plus funds, and there are several equally large funds currently being planned by other finance houses and managers.
The private equity market seems to be leading the charge because typical fund structures are consistent with sharia principles of sharing in risks and rewards commensurate with capital contributions, making private equity investments particularly attractive to Islamic investors.
The first Dubai International Financial Centre (DIFC) domiciled and managed by a hedge fund was launched in late August by Argent Financial Group. That fund is regional in scope, but is not sharia-compliant. However, Amiri Capital, a UK-based Islamic investment manager, has predicted that the $1.3tr (£686.54bn) global hedge fund industry will have a viable $50bn (£26.41bn) niche market in Islamic funds within the next three years. Asset managers have been trying to develop Islamically acceptable strategies that will replicate the return basis of hedge funds, while still adhering to the principles of Islamic law. It is expected that the ongoing development of sharia-compliant hedge fund structures will improve their acceptance by Islamic investors. There has also been a noticeable increase in the marketing of conventional hedge funds in the region.
Not only is the size of regional investment funds increasing, with more opportunities for a broader range of funds on the horizon, the complexity of those funds is also on the rise. The trend towards the use of more sophisticated limited partnership structures and away from single closing corporate fund structures for private equity has accelerated. In addition, there is more sector diversification. Instead of primarily investing in the stock market and real estate, capital is also being raised to invest into projects related to infrastructure, healthcare, telecommunications and high technology.
Another key driver is interest in the region from outside investors, suggesting that outside players will continue to partner with local institutions to produce Islamic products, and Islamic banks that enjoy strong reputations in other sectors will look to redeploy their expertise in private equity, making even more capital available.
In the last quarter in particular there has been increasing interest from a number of the top global private equity and hedge fund managers seeking to partner with local institutions to tap the market's liquidity. There seems to be a range of alternative structures for partnering in launching both Islamic and non-Islamic products, including new standalone products, white labelling by local institutions of existing products managed outside the region, as well as local institutions entering into sub-advisory mandates with global asset managers.
The Dubai Financial Services Authority (DFSA) is reviewing public comments about allowing the use of prime brokers by hedge funds. Under current regulations, hedge funds in Dubai cannot appoint prime brokers because Dubai's securities regulations state that a fund cannot commingle investments or collateralise them through a third party. All investments must be held by the fund itself. The proposed amendments would allow hedge fund operators to appoint prime brokers, subject to safeguards and regulations to prevent problems that arise with the commingling of accounts. This change would move the Dubai model closer to those of other markets.
Foreign entities are seizing on the expanding opportunities. On 25 September, Henyep Investment became the first UK-based specialist foreign exchange and derivatives trading firm to be granted a licence by the DFSA to operate from the DIFC. On 14 September, banking giant UBS announced that the DFSA has awarded it a license to open an office in the DIFC. Many law firms and financial institutions have already set up offices in Bahrain and Dubai, and many more, such as Henyep and UBS, continue to follow suit.
On home turf
The enthusiasm for professionally managed funds investing in the emerging markets of the Middle East, North Africa and South Asia is sometimes taken to indicate a reluctance to invest in more traditional geographical centres. Some observers have seen a political aspect to this.
Certainly there may be a natural preference for investing on 'home turf', but the simple truth is that yields in the Middle East/North Africa region (Mena) markets have been spectacular during the period of the observed trend for repatriation since the terror attacks on 11 September 2001. As the markets mature, it becomes easier to see that local investors are applying exactly the same criteria as any other sensible investor: they are looking for the best balance of risk and return and using local knowledge, especially that of the Gulf-based asset managers, to give them an edge.
As recently as a few years ago, the market funds focused on the US and Europe. Political concerns and changing yields saw a period of concentration on the Gulf Cooperation Council (GCC) markets, but now we are seeing a new and growing trend for investment in other Mena economies as those countries embark on the process of deregulation. For example, we expect to see a significant growth in the number of funds investing in Pakistan and India. In August, Kuvera Capital Partners, a long/short equity hedge fund manager focused on India, gained approval from the DFSA to operate out of the DIFC, so money continues to flow both ways. But local institutions often stay focused on the local market and known entities. The number of funds looking for global deals remains in the minority.
Earlier in the year a confluence of factors in the region, such as high oil prices, the real estate boom, a marked increase in infrastructure development and privatisations, as well as the stellar returns for private equity from the IPO market over a short history, contributed to spectacular growth in the region's private equity. However, in the past few months GCC investors and managers seem to have broadened their horizons from local real estate and IPO speculation. Offshore funds set up from the GCC are now much closer to the profile of London-originated funds. Private equity and funds of funds have replaced real estate as the dominant types of funds.
There is still much interest in well-managed real estate funds, of course, and while some have presented the recent equity market corrections as a setback, these corrections have in fact driven a move to more sophistication on the part of investors and managers. People are paying more attention to the track record of the managers and are thinking much more about managing risk. We are seeing a far greater number of multijurisdictional funds.
The GCC market is maturing at an astonishing rate, with no slowdown in sight. With more money to spend from both local and foreign investors, and more types of financial vehicles to structure deals, we expect the strength of 2006 to be just the beginning.
Robert Varley is a partner at Walkers