Private Equity Investment in the Middle East: Deal Structures and Issues

Transcription

1 International In-house Counsel Journal Vol. 3, No. 9, Autumn 2009, Private Equity Investment in the Middle East: Deal Structures and Issues MARK SALTZBURG General Counsel, Abu Dhabi Investment House (ADIH), UAE I. Introduction Private equity investments are structured differently in the Middle East than in other regions of the world. Traditionally, the Middle East has been a source of capital for a number of private equity firms outside the region, particularly prominent US based private equity firms that focus in part on going private leveraged buy-outs of publicly traded companies. In recent experience, a number of private equity investment managers have established investment advisory operations in the Middle East itself. Also, while the investment strategy of such managers can be international in scope, in many cases they have invested heavily in the region due to the high level of expected returns based on robust local economic growth. This article focuses on deal structure issues in connection with the formation of Middle Eastern based private equity funds and in connection with execution of their transactions. As a matter of definition, the term private equity is used in this article to refer to investments in investment fund companies that have shares that are not listed on an exchange and are not redeemable on demand and that tend to invest for the long-term in illiquid assets or securities. The features of Middle East market practices, corporate law, property law and securities law combine to make such private equity deals fundamentally different than in other jurisdictions. This article provides a guide to the practitioner in understanding critical issues regarding fund and deal structure where there is a close nexus to the Middle East, particularly in connection with Gulf Cooperation Council countries, deriving from one or more factors such as the location of the fund manager, the source of capital or the location of the target asset. II. Capital Raising Process Private equity funds based in the Middle East tend not to be large, blind pools of undrawn capital that are subject to capital calls on investors by the fund manager once the manager has identified in its discretion a suitable asset. In contrast to the role implied by such structures, many Middle Eastern investors tend to be highly hands on and nondeferential to the expertise of the fund manager. Typically, the investors want to review the target asset before committing to invest in a private equity fund. International In-house Counsel Journal ISSN print/issn online

2 1394 Mark Saltzburg Thus, numerous Middle Eastern based private equity funds tend to be special purpose entities formed for the express purpose of housing a particular asset. An investor will be less diversified but will have more control over the investment made. Where there are only a few investors in the fund and they conduct extensive legal and financial due diligence, the private equity fund manager operates at the outset in a role similar to an investment bank working as a broker to bring the transaction to the investors. The market practice of investment fund formation on a deal by deal basis has significant implications for the fund manager. The investment manager will not spend a year or more raising the capital commitments for a private equity fund as might be common in another market. Thus, an investment fund manager typically must identify a target asset, prepare offering memoranda materials for a special purpose fund to invest in the target asset, raise the capital and then close the transaction. As a result, many funds are not well positioned to participate in an auction for an asset or where speed to closing is an important factor. Also, further delays will be experienced where leverage is used because, prior to making debt funding commitments, banks will want to see the equity capital in place. In addition, letters of intent play an important role in the process. Because the deal by deal fund-raising process means such Middle East private equity funds cannot execute until funded, it becomes important to provide for exclusive dealing for a period of time in the letter of intent. If exclusivity is achieved or deal-jumping by a rival bidder is not a concern, letters of intent may also be seen to have publicity and marketing value for the private equity manager and provide the substance for press releases. III. Investment Fund Structure While in some cases the private equity management company may be organized as a Middle East company, in many cases the fund company into which investors invest will be organized as an offshore vehicle. In connection with Gulf Cooperation Council based fund managers (in United Arab Emirates, Saudi Arabia, Oman, Qatar, Kuwait or Bahrain), it is common to use Cayman Islands corporations. This choice of entity is a product of several factors including speed of formation, tax, level of restrictions on transfer, capital requirements and level of development of the law and legal systems. First, entities can be formed very quickly in such offshore jurisdictions upon filing of charter documents. It may take substantially longer to form a company in a Gulf Cooperation Council state due to the ministerial approvals required. Second, tax-free offshore jurisdictions are tax efficient and mean that the corporate entity can be used because double taxation of dividends is not an issue. Many complicated issues related to partnership tax and capital accounts are avoided in this manner. Where significant anchor investors are involved and demand rights to protect their investment, the agreement among investors will be enshrined in a shareholder agreement due to the corporate form and not a partnership agreement and possibly also at the charter level for the corporation. Third, restrictions on transfer of shares are an impediment to using Gulf Cooperation Council entities. In many cases, there are nationality requirements for shareholders or there may be ministerial approvals required in connection with a change in the shareholder register.

3 Private Equity 1395 Fourth, capital requirements in offshore jurisdictions are minimal whereas Gulf Cooperation Council countries may require a substantial initial equity capital investment merely to form a company. Fifth, in connection with a jurisdiction such as Cayman Islands, the well developed nature of the corporate law and the perceived credibility and impartiality of a court system founded on the United Kingdom common law system are also important factors in choice of entity. IV. Investment Management Fees In Gulf Cooperation Council based private equity funds, as discussed above, the investment fund may be an offshore corporation and the investment management company may be a Gulf Cooperation Council company. The document linking the two entities will be the investment management agreement which will set forth the fees to be paid to the investment manager. In addition, in connection with the offering of shares in the investment fund, a private placement memoranda, even if not required under regional securities laws, will be used to disclose all material aspects of the fund and to avoid any potential anti-fraud rule violation claims by any investor. The private placement memoranda will also set out the investment management fees. Because of the special purpose nature of the fund with its segregated asset, the offering memoranda will often provide a more detailed description of the business or asset to be invested in as compared to the offering memoranda of a blind pool fund where the document may be deliberately vague to maximize flexibility in investment strategy. A commonly used fee arrangement on an international basis in hedge funds and private equity funds is a "2 and 20" structure. In this structure as it is generally used in the Middle East, the manager receives an annual fee of two percent of the equity capital contributed to the fund (i.e. the management fee ). It should be noted that since the management fee is based on the equity capital contributed to the fund, it is different than in a hedge fund structure whether the fee may be paid on assets under management. Thus, the management fee will not increase over the life of the fund even if assets under management increase as a result of mark to market or trading gains. Under the 2 and 20 type structure, the manager also receives a 20% share of annual profits (often referred to as a "performance fee" or in real estate deals as a "promote fee.") Frequently, this performance fee structure is also subject to a "hurdle rate," whereby the performance of the fund must exceed the hurdle rate before the performance fee may be paid to the manager. In Gulf Cooperation Council based private equity funds, this type of performance fee arrangement is used except that, given the use of special purpose entities to hold single assets, it is typical that the 20% "performance fee" will be paid cumulatively based on the internal rate of return over the life of the fund rather than paid on an annual basis based on annual return. This is appropriate given that in some cases the sole cash flow or liquidity event may be upon exit of the investment in the asset. The performance fees based on internal rate of return typically do not feature a high water mark sometimes present in connection with annual performance fees where prior year losses must be made up before performance fees based on profits will be paid.

4 1396 Mark Saltzburg Further, in a common Gulf Cooperation Council based private equity fund, the investor typically may be charged a placement fee in the range of one to three percent of assets in connection with the initial investment. This front-end loaded charge will be paid only once by the investor and will not be a recurring charge such as the annual management fee. While this general collection of fees (management, performance and placement fees) may appear relatively standard, the investment manager in a Gulf Cooperation Council fund may generate other earnings as a result of the founder and organizer aspects of its role as fund manager. In many cases, the hurdle rate is very high such as at a 20% level and thus a manager cannot rely on exceeding the hurdle rate to generate performance fees. While this high hurdle rate may look extremely attractive from the point of view of the outside investor, private equity managers in Gulf Cooperation Council funds frequently may be less concerned with earnings from investment management and performance fees than from an initial "mark up" earned from a sale of the target asset to the fund. In many cases, the target asset will be acquired first by the fund manager or an affiliate and then sold at a premium to the private equity fund managed by the manager. Thus, the investment manager will earn a large part of its compensation through a mark up earned by buying the asset and selling it at a higher price to the fund after a very short holding period. This, however, does not excuse the responsibility of the investment manager to produce projected returns for the investor. In many cases, private placement memoranda for such funds disclose the intention to achieve target returns of a 30% internal rate of return. In addition, the investment manager will frequently co-invest cash from its own balance sheet alongside the outside investors. While the high hurdle rates, the performance fee incentives and the "skin in the game" through co-investments of the investment manager do much to align the interests of the manager with those of outside investors in producing absolute returns, outside investors will bear some unique risk related to the degree to which there may be room left for future price appreciation of the asset if the intended exit strategy is the sale of the asset for capital gain at the end of the life of the fund. V. Issues Unique to Favored Private Equity Asset Classes In jurisdictions other than the Middle East, there are a number of types of investment categories in which private equity funds may invest. Frequently, such funds invest in taking private companies that are publicly traded. They may also make venture capital investments in newly established companies that provide new technologies, products or services. They may also invest in acquiring controlling or minority stakes in private companies in a wide variety of sectors. In the Middle East, particularly in the Gulf Cooperation Council countries, many of these strategies are not viable for funds investing in targets within the region. In the case of publicly traded companies, there are a limited number of listings on regional exchanges and in many cases the most commonly traded firms are affiliated with a government. Many regional companies are family-controlled and do not want to give up control by listing on an exchange. For similar reasons, while many industries could benefit from economies of scale, the mergers and acquisitions market is also limited by sellers reluctant to divest a family business. Regarding venture capital investment, much of this investment is focused on technology companies and the number of firms originating new technologies in the region is limited.

5 Private Equity 1397 The one asset class, however, that has been attractive frequently to investors in Middle East based private equity funds has been real estate. While Middle Eastern investors certainly have been active in acquiring real estate assets internationally, in recent experience, real estate in the Middle East itself has proved an attractive investment for Middle East private equity funds. Reasons for this include population growth trends in the region, the rate of economic growth, the preference for tangible "bricks and mortar" type assets and the ability to better monitor property management services based on the proximity to regional real estate. The nature of real estate in the Middle East drives elements of deal structure in private equity investments. Certain countries, particularly in the Gulf Cooperation Council, have nationality restrictions regarding ownership of real estate. This frequently cannot be satisfied by formation of a local business entity because the rules often trace up the chain of ownership to the shareholder level. It is possible to create a deal structure to comply with local law while completing the desired transaction, but this frequently requires using derivative type instruments where the total return generated by the asset is transferred to another party. Typically, these financial structures may be deemed enforceable by local counsel but there are risks given the limited body of legal precedent addressing the issue. The key point is that while investors in Middle East private equity funds may like the idea of investing in something with tangible value, the structure of the investment due to property law restrictions is such that frequently they are actually invested in derivative instruments with real estate as the underlying asset. VI. Exit Strategies Middle East focused private equity funds also face different options for monetizing their investments as compared to other funds. Typical methods of producing a return to investors for any private equity fund as a general matter would include taking an asset or portfolio of assets in the fund public in an initial public offering, selling an asset to another buyer or operating an asset to generate net profits that can be distributed to investors as dividends. The life span of the common Middle East based private equity fund may rule out the option of running the business or operating an asset to generate distributions as the principle source of return. The typical fund is for a two or thee year period as compared to longer term five or ten year term funds found in other markets. This means that the bulk of the internal rate of return will be achieved not through annual cash flows but from terminal value in a sale. The options for sale of the asset, however, may be limited also because an initial public offering may not be a good option. As discussed above, the deal by deal formation of special purpose entities may mean the fund (and its sole asset) may be too small to form the basis for a public company. In addition, the public offering process common to regional stock exchanges may not generate the type of valuation that would produce the type of returns sought by private equity investors. On many exchanges, there is no book building process to evaluate demand to price the shares but rather the price is determined in connection with valuation analysis agreed upon with a regulator. This procedure carries risk that if the offering is underpriced, it may be deemed a success in secondary trading as there will be oversubscription for the shares and likely a large increase in first day trading but at the expense of the company having left money on the table. Furthermore, regulators frequently limit the number of public offerings in a certain

6 1398 Mark Saltzburg time period, so the manager may lose control of the timing of the offering as a result of the queuing process to go public. Also, securities offerings may be comparatively riskier on Middle East exchanges for issuers because investment banks in the region generally do not underwrite shares on a firm commitment basis. It may be possible to structure an all or nothing best efforts offering, however, to avoid problems related to incomplete divestment of the intended portion of the business. One aspect of the process that is positive for Middle Eastern issuers is that underwriting fees are substantially less than in other markets. The short life span of the common Middle East based private equity fund also creates another problem with divestment through a public offering of securities. In most cases, investors will want to see the company have a productive use for the funds raised in the offering, with a greater portion of the funds raised going to the company through the issue of new shares than to the selling shareholders through their divestment of existing shares. Thus, in most private equity investments, a complete exit through an initial public offering is rare. Commonly, a private equity fund will divest part of its stake in an initial public offering to create a market to value the shares and then may later sell more of its stake after establishment of this secondary market. In the typical Middle East private equity fund with a term of two to three years, this becomes difficult to do. VII. Conclusion The basic framework of a Middle East based private equity fund and its investment strategy are similar to that of other private equity funds. In order to be an effective counsel in connection with such deals, however, it is critical for the practitioner to understand the unique aspects of fund structure, management fees, issues related to the type of asset and methods of achieving return on investment of private equity funds in the Middle East. Mark W. Saltzburg Al Nahyan Camp, B-2, Unit 101; Abu Dhabi, UAE; P ; marks14@hotmail.com The Abu Dhabi Investment House (ADIH) journey has begun. Since establishment in 2005, ADIH has continued to grow. We attract the highest-caliber staff across the board and our investment and financial expertise have proven their ability as we deliver beyond expectations. ADIH has opened representative offices both in Bahrain and Geneva.