Lucrative relationships

The Middle East has long played a significant role as a provider of capital to international private equity firms. Indeed, before European investors discovered the asset class in the latter half of the 1990s, it was the second most important destination for private equity fundraisers worldwide, behind the United States.

Among the Western practitioners who know the region well is Antoine Dréan, managing partner at placement agent Triago. ?When I started the business 10 years ago, almost a third of the capital we raised came straight from the Middle East,? says Dréan, who early in his career built up a network of personal relationships within the region's investment community. ?Ten years down the line and the Middle East is of relatively small value to us. Today it represents 5 to 10 per cent of our total funds raised.?

Fellow placement agent Lance Whitehead, managing director of Cygnus Capital and former fundraiser for Dresdner Kleinwort Capital and Wasserstein Perella, has a similar view. He recalls that no less than 50 per cent of the capital raised for Wasserstein Perella's 1997 US Equity Partners Fund came from the Middle East. ?Today, it would be realistic to expect 10 per cent of a fund,? he says with reference to his most recent mandate, Kleinwort Capital Partners IV.

But although Europe has now eclipsed the region as a source of institutional capital, Middle Eastern money has continued to move steadily into private equity in recent years. No exact statistics are available, but practitioners estimate that there are around 50 institutional investors actively contributing to the asset class, and that over the past ten years amounts raised in the region have in fact increased from around €1bn per annum in the early 1990s to over €3bn in 2002.

The Middle East's involvement in the asset class goes back as far as the late 1970s, when wealthy individuals started to take an interest in the small but growing investment community on the back of the oil boom. Today, there are some 300 such high-net-worth individuals participating, with merchant families and local banks also playing an important role. However, by far the most important contributors to the asset class are the investment authorities. Attracting attention from private equity firms since the 1980s, these government-run organisations were set up to manage excess cash flow from oil proceeds. Among the authorities that are most active in private equity are the Abu Dhabi Investment Authority and the Kuwait Investment Authority, which between them are thought to account for almost a third of total private equity commitments from the Middle East. With large quantities of money to invest, these groups have been known to commit up to $100m per individual fund investment.

New investors
There are also signs that other types of investors are beginning to take an interest in the asset class. The most telling change could come from pension schemes, which are for the first time looking to become more visible in private equity. At Aberdeen Murray Johnstone Private Equity, director of investor relations Vicky Mudford, who has been fundraising in the Middle East since 1997 and makes three to four trips to the region a year, says: ?Government legislation in certain jurisdictions has restricted pension funds from investing outside the market in the past and that is being eased slowly. The ones who aren't doing anything [in the asset class yet] are treading carefully and are likely to go down the funds of funds route.?

In the banking sector, Islamic banks are also attracting attention. ?A lot of individuals will channel their money into Islamic savings banks over the next few years,? says one investor. ?One way or another this money will have to find a way of being invested. Private equity is likely to be a beneficiary.?

Such positive trends notwithstanding, there are obvious uncertainties facing those interested in the region, particularly US firms. Many practitioners believe a war in the region could accelerate the withdrawal of Middle Eastern capital from the US, which may have a knock-on effect on private equity partnerships. Some even predict a complete halt of commitments from Middle East investors into the asset class, depending on political developments going forward.

Others are less pessimistic. Harry Alverson, managing director of investor relations at The Carlyle Group, who has lived in Bahrain and was once responsible for Chase Manhattan's European and Middle Eastern institutional and private corporate investment clients business, says: ?Press reports have exaggerated the extent of this trend. Private equity is a long term investment and this is a short term phenomenon that may effect liquid securities and cash investments, but it is not really effecting private equity nor is it likely to.?

Fewer hurdles
Among the region's attractions to international fundraisers is that there are surprisingly few restrictions facing Middle Eastern investors when considering investment in Western funds. More relevant are issues relating to Islamic law, Shari'ah, including screening, liquidity management and purification. However, depending in part on the degree to which a potential investor requires a general partner to comply with Shari'ah principles, it is possible for a private equity fund to accommodate these when agreeing terms and conditions with the investor (see box).

Potential regulatory hurdles that often arise in other jurisdictions such as fiscal obstacles and restrictive securities laws have been of surprisingly little cause for concern to fundraisers in the Middle East. ?From a general partner's point of view, in some respects it is easier to do business in the Middle East than elsewhere in Europe,? notes Chézard Ameer, a private equity lawyer at international law firm Debevoise & Plimpton.

General partners and placement agents should nevertheless be aware of the cultural obstacles they may face, particularly when coming to the Middle East for the first time. GPs often find it difficult to get close to institutions that are looking to do business in the asset class. Personal relationship building is therefore key to any fundraising effort, and ideally supported by either native contacts or practitioners who have lived and worked in the region for a long time. ?Middle East investors have over the years become more astute and selective, but once you have won their trust you are halfway to a successful business,? says Lance Whitehead, who spent four years living in the region.

Such relationships, short of political developments making it harder for Middle Eastern investors and Western practitioners to do business with each other going forward, seem certain to remain fruitful. The region will remain an important partner for private equity, as existing investors continue to diversify their asset allocation abroad and new institutions prepare to enter the asset class for the first time. For general partners to ignore the region as a potential source of capital would be a mistake. That said, Middle Eastern investors are certainly no easier to convince than their Western counterparts. Fundraisers struggling to place product in Europe or the US will not be given an easy ride in the Middle East either.

Who's active?
The six member countries of the Gulf Corporation Council (GCC) – Kuwait, Saudi Arabia, Bahrain, Oman, Qatar and the United Arab Emirates – have built strong reputations as providers of capital to the international private equity industry. Also active in the asset class are institutions based in Egypt and Lebanon, whereas investors in Syria and Jordan have had little, if any, involvement so far.

Investment authorities
Investment authorities advise governments on best practice policies regarding investment abroad. As a general rule, these bodies seek investment in larger, well-established private equity partnerships and invest across the spectrum of investment strategies, ranging from buyouts to secondaries. Considered the most sophisticated investment vehicle of its type in the region is the Kuwait Investment Authority, thought to allocate around 10 per cent of its income to private equity each year. Other key players include Abu Dhabi Investment Authority, the Oman State General Reserve Funds and the Gulf Investment Corporation, a pan-regional organisation which manages assets on behalf of several governments.

Private investors
The most important group of private investors are so-called merchant families, whose wealth is predicated on long-established links with ruling families. Typically these families are not directly involved in the oil business, but act as principal suppliers of goods to governments, local contractors and foreign firms. Included in this category, which comprises some 35 families, are the Kanoo Group, whose roots are in Bahrain, and the Olayan Group in Saudi Arabia. Around 300 high net worth individuals are also known to be participating in the asset class.

Several local banks, such as Bank Muscat, National Bank of Kuwait, BMB Commercial Bank and Saudi American Bank are beginning to offer private equity investment to their clients. The same banks have also been committing funds from their balance sheets, usually within the range of $10m to $20m per private equity fund.

The Shari'ah: what fundraisers should know about Islamic law. By Chézard Ameer.
The forging of new relationships with Middle Eastern investors (beyond those with the region's merchant families and investment houses which have, for some time, been investors in the asset class) has brought with it new and complex issues of culture, commerce and religion, which GPs have had to accommodate.

For example, GPs have found that it generally takes longer to secure firm commitments from Middle Eastern investors than from their European or US counterparts. This is due, in part, to the greater emphasis that investors in the region place on personal contact and establishing trust in business dealing, as well as the need to educate certain investors whose experience has been mainly with open-ended mutual funds.

However, GPs commonly encounter the most difficult issues when seeking to admit Islamic or Shari'ah investors into their funds. These investors conduct their commercial activities (as well as all other aspects of their lives) in accordance with the body of Islamic jurisprudence known as Shari'ah law. The Shari'ah prohibits, inter alia, the charging or paying of interest (riba), investment in certain forbidden (haram) industries such as armaments, gaming and alcohol, contractual uncertainty (gharar) and the guarantee of a fixed return on investment.

Not all Islamic investors require the same degree of compliance with Shari'ah law, and the extent of the modifications which a GP will have to make to its fund documentation will depend on the degree of compliance necessitated by any given investor. However, in general, where a GP wishes to admit an Islamic investor into its fund, it will have to adopt a Shari'ah compliant investment policy, which will include some, if not all, of the following restrictions being incorporated into the fund documentation:

  • ? no investment in haram industries;
  • ? no investment in interest-bearing instruments such as convertible debt securities;
  • ? no investment in financial products such as options or futures (i.e., no hedging); and
  • ? no investment in companies which do not meet specific financial parameters in relation to debt to equity ratios, interest income and accounts receivable.
  • Fund documentation may also require modification to prevent the GP from charging interest on monies due but unpaid in relation to investors' drawdown obligations, in relation to certain profit and loss allocations and the preferred return or hurdle rate. For certain investors, there will also be a need to address issues in relation to the exercise by the fund of redemption rights and liquidation preferences attaching to preference shares, which may not be acceptable in a form familiar to western investors.

    Additionally, investment in LBO funds poses particular problems for Islamic investors since the use of debt to finance investments made by such funds usually involves riba, which is forbidden under the Shari'ah. It is, however, possible to use financial engineering to structure around this by using a lease financing arrangement (ijara wa iktina) to replicate the use of debt, whilst adhering to the precepts of Shari'ah law. This is, however, quite a complicated arrangement and may not be a viable option for many GPs since it would generally lead to increased funding costs and a somewhat lengthier transaction process.

    Significantly, certain investors may insist also on the establishment of a Shari'ah Committee in relation to the fund, which would consist of Islamic scholars appointed by such investors and which would advise the GP in relation to Shari'ah compliance. A thorny issue in the negotiation process with such investors is whether the Shari'ah Committee should have the power to prevent the GP from making investments that are not Shari'ah compliant. This raises fundamental issues for the GP as it relates to its control of the investment process and also may not be acceptable to other non-Islamic investors in the fund since such a restriction may lead the GP to forego making what would otherwise have been a profitable, albeit non-Shari'ah compliant, investment. One solution that we have used as a compromise in such circumstances is to allow Islamic investors to opt out of investments which the Shari'ah Committee regards as being non-compliant. However, this raises complex issues with respect to carving out such investments from the fund's normal distribution waterfall and the treatment of the realisation proceeds in relation to such investments in investors' capital accounts.

    Not all Islamic investors will have the same requirements and not all GPs will want to make concessions, particularly where Islamic investors do not represent a significant investor group. However, with estimates of Islamic capital available for investment being upwards of $80bn, and with many Islamic investors looking for a new home for capital withdrawn from the US in the aftermath of September 11, European GPs are increasingly likely to at least make themselves aware of the concerns of Islamic investors.

    Chézard Ameer is a member of the Private Equity Funds group of Debevoise & Plimpton.