As the economy and investment environment in the region markedly improved over the past several years, Middle East managers and sponsors are more frequently looking to tap capital markets that are outside their traditional bases.
In particular, many asset managers are looking to institutional investors in the United States to raise money and a handful even opened a physical presence in the United States for the sole purpose of fundraising. While certain well-known US groups have been investing in the region for years, most US investors have been hesitant to deploy funds for investment in the Middle East.
While certain elements of this reluctance can be attributed to the concerns of political volatility in the region (whether justified or not), much of it stems from the notion that there is inadequate operational and legal infrastructure in place at the fund management level. However, as Middle East managers address the US investors' key concerns in this regard (which are set forth below), we would not be surprised to see a substantial increase in the flow of funds from the US for investment into the Middle East.
GOVERNANCE, OVERSIGHT AND TRANSPARENCY
Many Middle East managers have been comparatively opaque with their investors and prospects with respect to fees and expenses, management and other investment activities. New regulations regionally have encouraged a shift away from this historical position and are requiring more robust disclosure. Despite these regulatory changes, the market standard still lags dramatically behind best practices suggested by the Institutional Limited Partners Association, widely viewed by investors as a benchmark against which managers are held.
In our experience, US investors at a minimum will expect a developed conflicts policy, with oversight by an investor advisory committee. The US investors do not necessarily need to be on the committee, but having a group of investors overseeing certain actions of the manager would give significant comfort.
Another key consideration is the appointment of independent third party service providers, particularly those with a global presence. The most important is the appointment of an independent auditor to review the financial statements of the investment vehicle. The Big 4 accounting firms have a presence in all the jurisdictions in the region and US investors take comfort in knowing the service providers are reputable. In fairness, it has become the norm in the region to appoint an independent accounting firm to audit the financials of any investment vehicle which is raising third-party capital.
Although not yet market standard, some managers are implementing global best practices and are appointing independent custodians and administrators, in some cases to reassure investors and prospects and, in other cases, due to regulatory mandates. While often viewed only as an added expense, retaining independent, globally recognized service providers gives investors significant security and has been typical in the United States since the fallout in 2008, particularly for hedge funds and similar vehicles.
JURISDICTION
We often hear from US investors that while they see opportunity and would like to invest into the region, particularly with managers who have "boots on the ground", they are uncomfortable with investing into locally domiciled vehicles in the Middle East due to their unfamiliarity with these jurisdictions, the rigidness of the corporate vehicles and relative unpredictability of enforceability.
However, many US institutional investors are familiar with typical offshore jurisdictions and fund structures. A potential solution would be to establish a feeder fund in the Cayman Islands, British Virgin Islands or even Delaware, which, subject to local regulations, could either invest into a master fund domiciled onshore in the Middle East or could potentially invest directly into real estate assets, debt or equity securities in Middle East jurisdictions.
To further improve the enforceability of the structure, the offshore vehicle could invest indirectly through Bahrain or preferably the Dubai International Financial Centre (DIFC) into the underlying assets or securities. Even if the investors still do not have control over the underlying investments or the enforceability of contracts at that level, they will have predictability and certainty as to the rights attaching to the securities they own.
GOVERNING LAW AND VENUE
Similar to the jurisdictional concern, US investors will want subscription, shareholder and/or partnership documents to be governed by a predictable legal regime (such as Delaware, England and Wales or the Cayman Islands) with disputes resolved by arbitration or in a well-established court system. Many US investors are reluctant to submit to local law and local courts, which they believe are unpredictable, lack transparency and will favor the local party.
Even if the contractual arrangements are governed by the laws of Delaware, Cayman Islands or another foreign jurisdiction, if the dispute ends up in a local court, there is a distinct possibility that the judge will simply apply local law, and proceedings will be conducted in Arabic and/or behind closed doors. Therefore, US investors are often adamant that disputes be governed in neutral jurisdictions.
Despite applicable international treaties and conventions, the enforcement record for foreign awards and rulings in Middle East jurisdictions has been inconsistent. An acceptable solution for both the local manager and foreign investor could be contracts governed by English law or DIFC law (which is based on English law) and disputes settled at the DIFC-LCIA Arbitration Centre or in the DIFC courts. These judiciary bodies have short, but consistent, records of enforcing contractual arrangements, and historically, other Middle East countries have respected and enforced Dubai and DIFC legal rulings.
TAX CONSIDERATIONS
Many foreign managers fear US tax repercussions more than the US investors who are actually subject to the regulations of the US Internal Revenue Service (IRS). This is a result of the recent implementation of Foreign Account Tax Compliant Act (FATCA) and the potential withholding of income if a financial institution is non-compliant.
Before prohibiting any US capital in their investment vehicles, a manager should assess what impact FATCA would really have on it and its investments. For a private equity or real estate fund, the repercussions may be minor and easy to address. For a hedge fund or other fund with frequent and high-volume transactions, the implications may be substantial.
Regardless, much of the information that the IRS is requesting may be straightforward to request, collect, organize and disclose. It is important for a manager to speak with its tax advisors and legal counsel before ruling out US investors as the benefits of US capital may far supersede the extra administrative burden.
Once admitted to an investment vehicle, individual tax considerations are key for a US investor as much as or more so than for investors from any other jurisdiction, and US investors may request the following:
(a) Timely and detailed financial reporting so that the investors can make their own individual annual income tax filings with the IRS;
(b) Registration by certain fund vehicles with the IRS and elections by these vehicles to be treated as pass-through entities (which should not have any US tax implications on the fund vehicles themselves); and
(c) Information about non-US portfolio companies so that investors may make certain elections that affect their allocable income; and
(d) Review of the fund documents by US-qualified tax advisors and inclusion of US tax disclosures in offering documents.
Managers must make the decision whether to implement the internal systems and procedures to comply with FATCA and to accommodate investors' individual IRS filings.
FEES
Middle East managers have a reputation of charging higher fees than their counterparts in the United States or Europe. Nevertheless, we have found that US investors are willing to pay a premium to break into what they see as a difficult, but lucrative, region provided the fees are clearly disclosed. The foregoing applies to professional managers, who may have more direct experience in particular local markets than some global competitors. That being said, managers without a distinct track record should consider discounting fees or building up a deal sheet before approaching US institutional investors.
CONCLUSION
Many of the concerns of US investors are actually consistent with the concerns of institutional investors globally, including many based in the Middle East, and could also apply to investments into other emerging and frontier markets. We expect that as local managers continue to seek capital from the United States and other more established jurisdictions, many of the best practices in those jurisdictions will become more commonplace in Middle East funds and other investment vehicles. To stay ahead of the curve and attract Western capital, managers should engage experienced advisors (from both a legal and tax perspective) when structuring their investment vehicles to assist in the adoption and implementation of best practices in the fund documents.
James R. Stull is a senior associate at King & Spalding and has split his career between New York and Dubai. His practice covers a broad range of corporate, finance, and investment matters. He primarily focuses on investment funds, including private equity funds, real estate funds, hedge funds, and Shariah-compliant funds. His practice includes advising local and international clients on the corporate and regulatory aspects of structuring, establishing, offering and liquidating various fund structures, and he has substantial experience with securities regulations in the United States and the GCC.
Zawya 2014
