As Mashreq Capital prepares to launch its first hedge fund in the region, John Foster reports on the state of the hedge fund industry in the Middle East
Hedge funds are not a new concept in the Middle East. Over 20 years have passed since Man Investments, one of the world's biggest alternative investment providers, managing more than $58 billion of assets, set up an office in Bahrain.
The Middle East has been good for Man and it currently draws 10 per cent of its total assets under management from the region. Where Man led, others have followed, and there is more than a smattering of the international glitterati of the hedge fund industry coming to the region to find new capital opportunities. It is now not uncommon for the hedge funds, big and small, regularly to visit Saudi Arabia, Bahrain and Dubai on revenue raising raids. There are new players coming into the market at all times such as Alphatraxx, based in Hong Kong, whose chief executive Andrew Sinclair has just finished an extensive tour of the region trying to find new investors for his suite of Asia-Pacific hedge fund of funds. He said that his trip had stimulated a great deal of interest from investors across the spectrum in the region and on the back of this positive result, plans to visit the Middle East regularly.
Despite attracting the interest of foreigners, what seems to be missing in the region is an indigenous hedge fund industry; a hedge fund industry that is based in the region and invests in the region. There are a number of reasons for this. First, as is often the case in the emergence of the financial services industry, there is a lack of understanding and communication. The foreign markets look at the region as one amorphous mass that is fundamentally Arab, Islamic and rich in liquid assets. But there are stark differences between different countries and sub-regions. The way of doing business in the Gulf is different to the way it is done in the Levant. The Levant has different influences and practices to the Maghreb. As such there is a cultural hurdle to navigate and cross-border investment in the region is limited.
Then there are the markets. The exchanges of New York, London and Tokyo, and even the smaller European and South East Asian bourses, are much more developed than the Middle Eastern stock markets. In the Middle East there is little sectoral diversity available: Most of the equity in the region is linked to the oil industry or real estate and, as a result, stock markets are too highly correlated with long term oil price trends and the local property market. If everyone knows what direction the market is going to move there is little arbitrage opportunity, and equities' close correlation with oil prices means that the underlying systemic risk of the markets is comparatively high.
Finally, for hedge fund mangers to do what they do, at least on a simplistic long/short basis, there does not seem to be the investment infrastructure for these types of funds to thrive. The region remains starved of an efficient, rapidly tradable, diversified derivatives market.
Another problem the hedge fund industry has had to deal with in the Middle East is the phenomenal growth of the Islamic investment industry. Shari'ah compliant investment screens out sectors and companies that are unacceptable under Islam. This limits the investment universe of hedge fund mangers. Additionally many of the techniques they use to enhance returns, such as leverage and shorting, are Haram or forbidden.
With these obstacles barring development, it is no surprise that the hedge fund industry has not grown as much in the Middle East as in other emerging markets. The hedge funds are entrenching themselves in the regulation-lite, free-wheeling markets of emerging Asia in a way that they have never been able to do in the Middle East.
But that be about to change with the creation of the DIFC. The DIFC authorised its first hedge fund in August 2006, the Constans Crescent Investment fund by Argent Financial Group, a US-based hedge fund, and other local hedge funds have followed suit.
The DIFC has based its regulatory regime around the UK Financial Service Authority regulations, and this has encouraged the hedge fund industry to set up locally and not send money to be managed in London or New York, or domicile funds in Ireland, the Caymans or Bermuda.
The rise of the DIFC has caused some regional animosity. The DIFC is marketing itself as the premier regional hub of finance, since Beirut was first devastated by civil war 30 years ago. But there are other financial centres in the region, including Bahrain and Qatar, and these two jurisdictions have been scrabbling to catch up with Dubai. This regional competition is good for the hedge fund industry as the various governors fall over themselves to attract members and their assets, and the future looks healthy for hedge funds.
One of the other problems that the region has experienced in terms of hedge funds is brain drain. Traditionally having no local outlet for talent, many of the region's most gifted fund mangers have left the region leading to a diaspora of talent. But they are coming back. Some of the local banks, realising that the region is ripe for harvest, have gone into joint venture arrangements with hedge fund managers to establish their own businesses here.
An example of the local banks trying to beef up their offerings in terms of hedge funds and facing down foreign competition is Mashreqbank. Mashreqbank, the UAE's biggest privately-owned bank entered a joint venture arrangement with Abdul Kadir Hussain in April of last year and created the subsidiary Mashreq Capital.
Abdul, a native Pakistani educated in the US, decided to come to the region and set up the hedge fund in DIFC, as opposed to the Cayman Islands or Ireland, as: "at the DIFC you have a world class regulation system. The product is a global product not just MENA or GCC and the DIFC offers global reach from a regional base," he said.
It is a brave move by Mashreqbank, a bank not really well known outside of the UAE, to start promoting hedge funds in the region. However they are just following the tried and tested local shops for local people marketing strategy. But in setting up this hedge fund, Mashreqbank is taking on the giants of the world hedge fund industry, the Credit Suisses and Merrill Lynches.
Mashreqbank, through Abdul and Mashreq Capital, has its very own little David against the Goliaths of the industry. They have taken on an insider, who can work at a local, Arab, Islamic level. Abdul also knows how the big boys operate, having done his hedge fund apprenticeship with Credit Suisse First Boston, West LB and GE Capital.
Also the smaller players like Mashreq Capital operate at a different level. Whereas the big players have all come into the market to chase the large institutional mandates, and look at it from a top-down perspective the smaller players cannot operate like this.
The Mashreq Capital mode of operation, which should provide a blueprint for the other smaller players in the market, is not to chase the big institutional mandates, nor the ultra high net worth family money in the region, but to operate at the next level. There are many wealthy individuals and families in the middle classes that are financially savvy and want to invest their money in something that is a little more rewarding than a deposit account, or to invest in assets more liquid than real estate. It is to this level that Mashreq Capital is aiming as the large financial institutions like Goldman Sachs or Fidelity are not interested in the relatively small sums of money that are involved in this sector and cannot offer a service to this type of client and make profits at the same time.
The first Mashreq Capital offering is the Emerging Markets Credit Opportunities fund (EMCO). EMCO will invest on both a top-down, or a macroeconomic and bottom-up, or a stock-specific basis. Abdul will initially look at the emerging markets and establish the specific countries that will offer the best returns potential. Once the top-down screen is conducted, the manager then tries to establish the credits in the market that offer the best value.
The fund is not as freewheeling as some of the other hedge funds in the markets. To start with, the mandate of the fund limits its exposure to different individual markets in terms of country concentration, currency concentration and issue size, imposing maximum caps on all of these factors.
The anticipated return of the fund is 10 per cent per annum, and the client will not be liable to pay any performance fees until this minimum target is met. When the 10 per cent threshold is breached, the client then pays the manager 15 per cent of whatever outperformance the manger creates. This threshold is, however, subject to a rising tide mark that resets the outperformance target every year.
The manager has built in downside protection for the fund through the option to use Credit Default Swaps (CDS) from both emerging and mature market indices. The fund has the option of leveraging up to 50 per cent of its net asset value and will take both long and short positions on individual credits.
This will be a pure bond fund where the duration risk will be actively managed on a global macro basis and can access both rated and unrated credits.
Abdul said that, "since I joined Mashreq in April, I have been working on the structuring of this fund. I have managed funds like this before and if you look at the performance of emerging market credit, on a risk-adjusted basis emerging market debt has outperformed US High Grade and US High Yield debt. The picture is the same compared to other markets, so it is very exciting to be setting up a fund like this at this point in the cycle."
He argued that, "Emerging Markets are not going to be emerging forever," citing the example of Russian gas major, Gazprom, which "12 or 13 years ago was a solid junk company, but today is a solid, strong, well-rated, well-run, global energy corporation."
The market offers both opportunities and problems, but Abdul thinks that there has been something of a sea change in the attitudes of investors. Traditionally investors were cautious and the region was a cash deposit based culture, where only the most adventurous investors would invest in equities. However, Abdul pointed out, when the equity markets crashed a lot of investors got burned and equities started to get a bad name.
The adventurous investor is now being attracted to private equity and venture capital, but this could create another problem, as there is a growing concern that there is a bubble rising in this area. It is here that hedge funds can help as they can diversify the risk of concentration. By investing in hedge funds, less money is concentrated in the private equity and venture capital space.
One of the factors that has put investors off hedge funds, both in the Middle East and in Europe, is that hedge funds are perceived as being a lot more risky than vanilla equity funds. Doom-mongers hark back to the spectacular collapse of the US-based hedge fund, Long Term Capital Management (LTCM) in 1998. LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Initially successful, it lost $4.6 billion in less than four months. The fund folded in early 2000. The strategies that it followed were highly complex, the fund cross-held too many other hedge funds, the diversification between asset classes was too small and the core holdings were massively over-leveraged.
In fact, a long-short hedge fund should be less risky than a long-only fund, as with a long only fund you can only make money on backing the winners. With a short selling strategy, you can make money by selling the losers and you can offset the risks of investing in a certain asset, but running a balanced short position against your long-only bet.
But will hedge funds actually work in this region? And will this specific emerging market debt fund work in the Middle East? Jacob Schmidt is the founder and chief executive of Schmidt Research Partners, a London-based hedge fund consultancy.
He thinks that it is an interesting time in the interest-rate cycle, as the spread on emerging market debt has tightened significantly and there will be no more upside in his opinion. Jacob also thinks that with spreads on emerging market credit being 100 to 300 basis points, unless a manager leverages up massively, he will not be able to make a lot of money. Jacob is not excited about emerging market debt at the moment, but notes that Abdul has traded in this space for years, knows his stuff and is right to get into the market with this type of hedge fund right now.
Jacob's overall view of the Middle East hedge fund market is that the region is awash with sophisticated investors, and hedge fund managers have the problem of competing with a lot of other products. "But with Shari'ah compliant investment on the rise, increasing in dollar terms by 10 to 12 per cent annually, it may cause problems for hedge funds by attracting assets away. But if you find the right hedge fund manger, with the right strategy for the region, given the underdeveloped nature of the markets, you could see him consistently return up to 35 per cent a year."
Dr. Brendan Campbell is head of quantitative research for Allenbridge Hedgeinfo a global hedge fund research and ratings firm. Campell thinks that, "the fund's relationship with Mashreqbank is a plus, as banks tend to be concerned with reputation risk and for this reason, they will most likely be vigilant of potential operational risks associated with the fund."
He continued, "The investment terms seem relatively attractive, especially the 10 per cent hurdle rate that the fund must achieve before any performance fee is charged. The manager appears to have the relevant experience appropriate for managing this type of strategy. The leverage limit of 50 per cent of NAV is a sensible precaution. But, one potential concern going forward will likely be the fund's reliance on what it describes as a "stable global interest rate environment." How benign the current interest rate environment is, is a matter of debate.
Abdul has confirmed seed investment for EMCO of $25 million, but has decided to wait until the open-ended fund has confirmed investment of $100 million before unitising it, as at this critical mass, Mashreq Capital hopes to attract large institutional investors in the region. He said that he is ready to make his first investments at $50 million, with leverage. However, leverage is not a key strategy of this product, but having a 50 per cent threshold offers the manager the flexibility to 'juice up' the best ideas in the portfolio, so Abdul argued.
Mashreq Capital is not going to rest on its laurels with the launch of this hedge fund. Abdul already has drawn up plans to launch a suite of Islamic products in 2007. He wants to launch an emerging market Sukuk and also an Islamic hedge fund. He is not sure how they will create the Islamic hedge fund, but is talking to scholars and trying to build a Shari'ah board to help create this product.
Although hedge funds have been in the Middle East for two decades, the region remains a Greenfield site, and the development of a locally run, locally sourced industry can only be welcomed. Whether the experiment works however, is down to the new pioneers explaining their businesses to a notoriously fickle and cautious investor audience.
© Banker Middle East 2007
