The event organisers of SuperReturn Middle East 2012, in recognition of the challenging fundraising environment facing fund managers, both locally and internationally, dedicated an entire summit day to fundraising and LP/GP relations.
When the Institutional Limited Partners Association (ILPA) issued its Private Equity Principles in 2009, and its more toned down version two in 2011, there was concern amongst some fund managers that investors would begin to use the principles as a "checklist", which could result in significant changes to fund terms and protracted investor negotiations. Indeed, some fund managers claim they have structured their funds to be 100% ILPA-compliant solely with a view to forestalling such negotiations.
What will therefore be reassuring to fund managers is that major institutional investors confirmed that the "principles can be useful if used in a holistic fashion but were not used as a check box" and that the principles were "not used as a decider on whether to invest".
What is perhaps less reassuring is the stance taken by some investors on the question of transparency. One LP commented that they expected key issues to be communicated in advance of the LP advisory committee (LPAC) meeting - they didn't want to "attend an LPAC meeting and find anything on the agenda that would be a surprise". If funds are going to see an increased shift in the role of the LPAC, with fund managers engaging in advanced dialogue with LPAC members, operational costs will necessarily increase and investors who are not represented on the LPAC may take issue with selected advanced disclosure to some investors but not all, and brings into question the role of the LPAC.
Direct Investing
Another potential concern for those fund managers seeking to raise capital from the Middle East is the new trend amongst some Middle Eastern investors, especially family offices, of a preference for direct investments or co-investments over blind pool funds. This is, in part, driven by their dislike of paying management fees on undrawn commitments.
In addition, in relation to those funds where part of the management fee is recycled to pay the fund manager's co-investment, some investors regard this recycling as confirmation that the management fee levels are excessive and are over and above what is required to cover the fund manager's expenses.
However, there are obvious potential issues with the direct investment model, especially if investors do not have the infrastructure to successfully execute, manage and exit investments. Monte Brem of Stepstone Global commented: "In order to make direct investments globally, limited partners must be willing to have local offices in the markets they invest in and pay their investment professionals market level compensation. Very few limited partners are able to do this. Because of this the vast majority of limited partners' expansion into direct investment will end very badly."
Differing Strategies
What is clear is that the financial downturn and the Arab Spring have resulted in a shift change in the Middle Eastern private equity landscape resulting in local fund managers adopting different strategies.
Fund managers with established track records are continuing with the standard 2 and 20 model, focusing their attention on attracting international and institutional investors and the development finance institutions, who recognize the attraction and advantages of investing with established local fund managers offering investment opportunities in their local markets.
The second type of fund manager, especially those with a limited track record, have taken on board investor concerns regarding the management fee structure and are raising funds where the management fee is payable only on invested capital instead of the standard 2% with a step down following the end of the investment period, but with the potential upside of a higher carried interest.
Then there is the third type of fund manager, especially those without an established track record, who have either abandoned or delayed their fund raising and have instead focused on deal by deal financing for investments and co-investments. Most of these, no doubt, hope to build a track record in the new world order, and then seed a new fund with these direct investments, or seek to attract investors from their co-investing pool of partners. The direct investment strategy is providing both fund managers and investors the opportunity to work closely together, and a successful track record may persuade some co-investors to invest in any future fund the fund manager may raise.
However, the obvious risk is that if investors have become accustomed to not paying management fees, they are unlikely to return to the standard fund model without some serious concessions by the fund manager which could result in a whole new set of terms.
It remains to be seen which strategy will win favor and, more importantly, whether the changing terms in Middle Eastern funds will set new standards for funds internationally. On the whole, the blind pool fund model does continue to offer advantages.
In the short term, it may have to compete with direct investments and managed accounts, but in the long term it is likely to remain the dominant model - even if the terms do continue to evolve.
Bilkis Ismail is employed as counsel by SJ Berwin (MENA) LLP and is part of the international funds team. She advises on the structuring and formation of private funds including Shariah-compliant funds and co-investment schemes.
This is the second and concluding instalment of her two-part series on the Changing Face of MENA Private Equity. You can access the first part here.
Zawya 2012
