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Financial infrastructure and investor appetite converge to drive Middle East fund growth

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Once considered a relative backwater by the global hedge fund industry, the Middle East is starting to attract increasing attention thanks to a combination of factors, including the surge of wealth

Once considered a relative backwater by the global hedge fund industry, the Middle East is starting to attract increasing attention thanks to a combination of factors, including the surge of wealth created by the oil price boom over the past few years, the increasing sophistication of local financial markets and the efforts to develop a world-class financial services infrastructure in jurisdictions such as Dubai, Qatar and Bahrain.

Having already seen strong growth in areas such as private equity, the region is now seeing the emergence of local financial institutions that are looking to offer their clients a wider spread of alternative investments, as volatile markets and concern about the concentration of individual and institutional assets in real estate prompt a new appreciation of the benefits of financial diversification.

Although the growing enthusiasm for investments that comply with Islam’s Shariah law poses problems for the hedge fund industry, with its strictures against the receipt or payment of interest and against the short selling of borrowed assets, a number of asset managers have already developed products that they say have been certified as Shariah-compliant by their Islamic advisers.

And more broadly Western managers are increasingly developing hedge fund products that invest across the Middle East and North Africa. Amid general enthusiasm for the outsize returns offered in recent years by emerging markets, they are attracting interest both from local investors and from clients elsewhere in the world for which the region offers not only excellent recent performance but little or no correlation with the other asset classes in which they invest.

The latest big name asset manager to enter the fray is US firm BlackRock, which at the end of last year built on its existing investment experience in the region by launching a Middle East and North Africa hedge fund. BlackRock, for which its USD6bn in hedge fund assets are a relatively small share of its total of USD1.3trn under management, is aiming to attract up to USD250m for the new fund by the middle of this year.

BlackRock is following in the footsteps of multi-manager specialist GAM, which recently launched a fund that has up to 90 per cent of assets invested in the Middle East. ‘The level of interest from clients has quite surprised us, not only from the Western world but from within the region,’ says group head of institutional and fund distribution Craig Wallis. ‘It’s a new approach for local investors, buying a fund that invests in the region rather than investing in a particular project.’

The vigorous development of the region’s financial markets owes at least something to the change in its economic fortunes over the past decade, and to the efforts now underway throughout the Gulf to create an attractive environment for the financial sector. These initiatives aim not only to facilitate the financing of petroleum-related and other infrastructure projects but to encourage the development of the financial industry as an economic diversifier in its own right.

For much of the past couple of decades Bahrain has been the region’s most important financial hub, and the centre of most of its indigenous alternative investment activity. According to Abdul Rahman Al Baker, executive director of the Central Bank of Bahrain, the country is home to more than 57 hedge funds, with total assets of USD2.6bn – approximately a quarter of the USD10bn in assets held by Bahrain-registered mutual funds.

Bahrain was the birthplace in 1982 of Investcorp, probably the region’s highest-profile home-grown alternative asset manager. Today the group has added offices in London and New York and has a total of more than USD13bn in assets under management worldwide in private equity and venture capital, hedge funds and real estate investment.

Last June Bahrain introduced new collective investment scheme regulations that offer a more flexible choice of vehicles for structuring hedge and other alternative funds. The new rulebook introduced three categories of funds, retail, expert and exempt, of which the latter two offer streamlined regulatory requirements for funds with more sophisticated investment strategies and investor profiles.
 
Expert funds may only be offered to expert investors (defined as individuals or families as well as companies, partnerships and trusts with investible financial assets of at least USD100,000, public and international bodies) and have a minimum investment of USD10,000. They are subject to fewer restrictions than retail funds, notably in terms of risk concentration rules and asset classes; expert funds may invest in real estate, commodities and unlisted securities and offer funds of hedge funds.
 
Exempt funds are largely unregulated and need only to register with the central bank. They are open to accredited investors, defined as individuals, families, companies, partnerships and trusts with investible financial assets of at least USD1m as well as national and international institutions and state investment organisations, and carry a minimum initial investment of USD1m. Exempt funds are not subject to any investment policy restrictions and registration approval is promised within 15 calendar days of the receipt of applications.

The new regulations also liberalised Bahrain’s rules regarding recognition of funds domiciled in other jurisdictions. Funds established in recognised jurisdictions including Bermuda, the Cayman Islands, Guernsey, Jersey, Ireland, the Isle of Man, Luxembourg and Singapore, as well as European Economic Area members and the US, are now required only to register with the central bank rather than go through a full authorisation process.

‘The extended list of recognised jurisdictions gives us a clear edge over some of our competitors by opening the market and encouraging all aspects of the industry as well as increasing the offering available in the region,’ says Jane Dellar, managing director of Bahrain Financial Services Development, the promotional body for the country’s financial industry. And speaking at a regional hedge fund conference last year, Al Baker said he expected Bahrain to attract more alternative funds business, noting that for all its high international profile, Dubai had only one registered hedge fund.

But Bahrain’s neighbour and rival, which has spared no effort to make the Dubai International Financial Centre the jurisdiction of choice for financial services groups looking to tap into the new-found wealth of the Gulf, is ready to compete vigorously for alternative investment business as well. Last July the Dubai Financial Services Authority set out its stall by publishing a set of principles designed to guide the operation of hedge fund managers based in the emirate’s international financial marketplace.

The publication of the hedge fund code, coming a year after the introduction of the DIFC’s collective investment funds regime, is one of the steps aimed at giving Dubai a solid foundation from which to offer alternative funds alongside a comprehensive range of other financial products. The authorities are keen to stress the strength of the jurisdiction’s regulatory structure rather than follow other offshore jurisdictions in making supervision as light as possible.

At present there are just a handful of funds domiciled within the DIFC, although the centre is also home to asset managers whose funds are domiciled in other jurisdictions. But other parts of Dubai’s wide-ranging industry infrastructure are also gearing up to provide an environment attractive to hedge funds and other alternative products. For example, the Dubai International Financial Exchange, while still finding its feet as a trading venue – its biggest draw is the shares of global port operator DP World – has become the first exchange in the Middle East to list structured products alongside equities, fixed-income offerings and sukuk.

‘We believe that a lot of what we are doing will be of interest to hedge funds in particular, partly because equities and structured products are set to get bigger, but because also next year we will become the first exchange in the region to list equity derivatives,’ says Mark Fisher, head of corporate communications at the DIFX. ‘At the moment some institutions based here access derivatives via the OTC market because there’s no equity derivatives exchange.’

A number of managers based in Dubai are already offering alternative products to both local and foreign investors, such as Rasmala Investments, which has launched a range of conventional and Shariah-compliant funds of funds covering both tradition and alternative assets and strategies. Chief executive Eric Swats notes that this is a relatively new focus for the DIFC, but he does not doubt that it will eventually enjoy the same success it is achieving in other areas of the financial industry.

‘The Dubai International Financial Centre and its collective investment scheme rules are relatively new, even in the framework of the DIFC,’ he says. ‘They were only issued in 2006, and it’s still very early days for funds to be established here. We understand there’s a lot of interest, and a number of funds have certainly been domiciled in the DIFC, but it is only now starting to gain traction. And Dubai is competing against the Cayman Islands, the BVI, the Channel Islands, the Isle of Man and all the other offshore tax-free jurisdictions.’

So far, he suggests, Dubai has mainly attracted asset managers that are looking to distribute their products in the Middle East. ‘The jurisdiction has been very successful in attracting marketing people,’ Swats says. ‘The next stage is to get people to think about domiciling their funds and managing their assets in this jurisdiction. That may be a more difficult challenge than getting marketing people out here at a time of an oil boom, but it will happen, there’s no doubt about that.’

His conviction is shared by Mark Weller, managing director for Europe, the Middle East, Africa and Asia with PerTrac Financial Solutions, provider of the PerTrac Analytical Platform, who says the firm already enjoys strong demand from major investors in the region. ‘We’re been focusing on the investor side of the marketplace for a long time and established some very significant clients in the region,’ he says ‘These include some of the biggest sovereign wealth funds, which are now putting a lot of their money to work in the alternative investment space.

‘The amount of wealth being generated in the Middle East by rising oil prices is creating even more opportunities. There are also regulatory changes in markets such as Dubai that are encouraging the development of the alternatives space. The DIFC has created a legal infrastructure to establish relatively unregulated funds, and there are now service providers to support that business. Now it’s just a question of fund providers setting up there, and we’re convinced it will come because there is so much wealth on the investor side.’

PerTrac is hoping to see a broad range of interest in the region for its newest product, a portfolio management system geared toward funds of funds and large investors that was developed in partnership with London-based emerging markets hedge fund manager Caliburn Capital Partners. Says president and chief executive Gerry Mintz: ‘The new product is likely to garner a lot of interest in the Middle East because it’s particularly geared toward investors, especially some of the larger clients.’

Fisher notes that a hunger for diversification is growing with the expansion of oil wealth, which stands to boost the appetite for alternatives among both institutions and private investors in the Middle East. ‘This region has got a lot richer very quickly, and even in Dubai there is a limit to the amount of real estate people inside and outside the region can invest in,’ he says.

‘People want the capital markets to develop to increase the number of options to park their money. There have been a lot of IPOs over the past year, and we believe there will be a huge institutional appetite for vehicles like structured products and derivatives, especially derivatives based on stocks from the region. It may take longer for demand to build among smaller private investors who are less familiar with some of these sophisticated investment offerings.’

Swats says a number of factors are set to drive the momentum of growth in the industry for the foreseeable future. ‘The volume of managed funds as a proportion of the market capitalisation of this region is much lower than in many other emerging markets, and we expect it to rise,’ he says. ‘There’s a good tailwind in this region for managing money in this region for local clients.

‘Secondly, hardly an international investor currently has a basis point here. However, this region will find a space within the indices, and all emerging market and equity market investors will increasingly find the Middle East of interest because of the boom from high oil prices, the great investment returns available, and the problems facing other markets, whether in emerging economies or the industrialised countries.’

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