Feature

posted 28 Sep 2006 in Volume 9 Issue 5

All points East

The finance world’s relationship with the Middle East has changed dramatically over the past ten years. With booming property sectors, a new stock exchange and increasing interest in private-equity funds, there are also even more opportunities for law firms in the region.

By Kieran Flatt

I only wish we had ramped up the size of our practice here much more quickly,” says Robert Varley, a partner at the Cayman firm Walkers, which has seen stunning growth since opening in Dubai last November. “Every law firm is recruiting here now and the biggest challenge for all of us is finding enough high-quality lawyers to meet client demand,” he continues.

The wealth of the Arabian, or Persian, Gulf region is worth more than a trillion pounds, according to consulting firm Booz Allen & Hamilton. The finance world used to look upon the Gulf as nothing more than a source of cash, but all that has changed over the past ten years. The growth in Shariah-compliant financial services, products and funds has been nothing short of phenomenal. What’s more, until recently this was the only part of the world lacking its own major financial-services hub. Small wonder, then, that the past five years have seen a frenetic race to establish the likes of Bahrain and Dubai as serious players in what must be one of the hottest growth areas of the global market.

Historically, the Lebanese capital, Beirut, was the main financial-services centre in the Middle East – but its glory days ended when the country plunged into civil war in the 1970s and business moved out en masse. Beirut’s loss was Bahrain’s gain. The tiny emirate has since become the world’s pre-eminent location for financial products and services that comply with Shariah – or Koranic – law. Bahrain has long been strategically important for both multinational companies and law firms, many of which cite its well-established regulatory environment as a core strength.

Islamic finance in the capital markets

Until very recently, the Gulf region’s protected equity markets held little appeal for the major players in global finance. For their part, the family-run companies that dominate the economy of the region have historically had little appetite for the high-end services offered by Wall Street. The multi-billion-dollar financing of oil and gas ventures was, and continues to be, largely run by teams operating out of New York, London and Singapore – although even this is beginning to change. It was not until the latter half of the 1990s that Shariah finance really started to take off. The market went into overdrive around 2002, when serious amounts of Arab wealth began to flood back into the Middle East. Islamic finance is now a $260bn-plus international market, serving large Islamic communities stretching from Malaysia and Indonesia to the US. The growth in demand for sukuks – Islamic bonds – has been little short of astonishing. By conservative estimates, assets worth over $500bn are managed according to Shariah principles.

Growth of Dubai

Dubai – the second city of the United Arab Emirates – has witnessed phenomenal growth over the past five years, emerging as a serious challenger to Bahrain’s comfortable hegemony. The latter may hold the trump cards in the Shariah-compliant financing game, as many experts suggest, but never before has so much investment capital flowed into the region and Dubai’s slice of the pie has grown enormously. Consequently, behind-the-scenes competition for business between the Gulf cities has never been so fierce. For the first time ever, major global banks are mounting serious operations in the Gulf – and a new wave of optimism and confidence has spurred an unparalleled boom in construction. The Burj-al-Arab hotel is famous the world over as a symbol of Dubai’s thrusting new economy, but it’s only one among hundreds of ambitious construction projects in a place that’s been aptly, if unkindly, nicknamed ‘Crane City’.

Dubai has scored solid successes with its Media City and Internet City projects, but most ambitious of all its ventures is the Dubai International Financial Centre (DIFC), a free trade zone established in 2004, with about 22-million square feet of purpose-built office space up for grabs. The DIFC permits 100-per-cent foreign ownership of companies listed on its new Stock Exchange (DIFX, which deputed in 2005); offers a zero tax rate on income and profits; and, puts no limits on either foreign-currency exchange or the repatriation of investment capital. The DIFC focuses on seven primary sectors: banking services; capital markets; asset management and fund registration; reinsurance; Islamic finance; business-processing operations; and ancillary service providers.

World-class regulatory framework

To reassure foreign investors, Dubai has created a sophisticated regulatory framework – modelled on those of New York and London, and run by heavyweight regulators hired from the top echelons of their institutions and agencies. Ian Hay-Davidson, formerly chairman of Lloyds of London and Philip Thorpe, ex-managing director of the UK’s Financial Services Authority, have been instrumental in setting up and launching the independent Dubai Financial Services Authority (DFSA). As with any regulatory framework, the proof of its worth will be in the enforcement, but all the right signs are there. One senior lawyer in the region says the DFSA represents an extremely radical departure from the status quo in a region where “market manipulation is part of the scenery along with a certain amount of insider information”.

Is the Gulf area ready for a hyper-efficient regulator? Peter Michelmore, managing partner of Richards Butler’s UAE practice, says confidence in the system will grow over time, as long as the authorities are seen to be serious about enforcement. “If you want to compete in today’s global market you need to understand that you can’t create a world-class regulatory system overnight,” he says. “The regulations need to be seen to be enforced.”

Growing confidence equals ‘gold rush’

Back in 2003, when building works were proceeding at a frenetic pace but few global companies had committed to using the DIFC, many people were sceptical about its prospects. However, the zone is now filling up with major-league banks and a host of other companies at a blistering pace. Merrill Lynch, Mellon Global Investments, Barclays Capital, Lloyds TSB, Credit Suisse, Deutsche Bank, ABN Amro, Goldman Sachs, and most recently, UBS are among the biggest names to be granted operating licenses by the UAE government. The world’s top-30 asset-management companies and scores of leading hedge funds from around the world have also flocked to the DIFC. First Eastern Investment Bank recently became the first Chinese institution to buy into the DIFC, a further boost to the zone’s global ambitions.

Hot on the heels of the banks, many of the world’s major law firms have also opened for business in the DIFC. Capital markets are not the only reason for establishing a strong practice in the emirate, whose booming energy and property markets are also driving the influx. Firms that have recently established or cemented their Dubai practices include Linklaters, Freshfields, DLA Piper, Ashurst, Denton Wilde Sapte, Clyde & Co, Simmons & Simmons, Baker Botts, Akin Gump and Walkers, and this is by no means an exhaustive list. Indeed, as Managing Partner went to press, Richards Butler was opening a brand-new office in Dubai, to complement its long-established Abu Dhabi practice. “It is a natural extension of our practice to serve the wider region,” Michelmore says.

Second time lucky

Dubai has a lot at stake. Previous high-profile ventures such as the Dubai Media City and Dubai Internet City have paid off, bringing prestige and wealth to the emirate and arguably paving the way for the DIFC. However, this is not the UAE’s first attempt to orchestrate a serious financial hub and the early inertia of the DIFC project may have had a lot to do with the lacklustre performance of a similar (albeit slightly less ambitious) scheme to attract global capital to Abu Dhabi. Just six years ago, the UAE’s capital city announced plans to turn the adjacent Saadiyat Island into a major international finance hub with its own stock market.

However, the project failed to gain critical mass and has since been reconceived as an ambitious tourism, retail, general business and residential development. Development of Saadiyat continues apace and it may well turn out to be a commercial success without the banks and hedge funds that it once hoped to attract. Along with a host of building and infrastructural projects in the capital and major developments on three other islands – Al Lulu, Reem and Al Raha – Saadiyat is at the vanguard of a real-estate boom that provides a whole host of opportunities for local and foreign companies alike. At the same time, Abu Dhabi has kept pace with Dubai’s phenomenal growth; it still harbours about 70 per cent of the UAE’s entire wealth – thanks to its immense oil reserves – and if government predictions hold true, its population will have increased from one million in 2000 to 1.8 million by the middle of the next decade.

So what makes the DIFC more likely to succeed than Saadiyat Market? Its leaders are on record as saying that Saadiyat’s downfall was due to its sole focus on banking services, while DIFC’s approach has been to create a robust synergy between international financiers and local companies hungry for global capital. It’s still early days, but the impressive list of banks, institutions and asset-management firms committing to set up shop in the DIFC augurs well for the future. Confidence among leading lawyers is certainly on the rise. “After a bit of a faltering start, the DIFC has increasingly lived up to our expectations,” says Peter Michelmore. “The DIFC is better [than previous IFC initiatives] because it is in Dubai, which is a place that is getting much bigger and more important. It has the dynamics that it needs to succeed. Dubai is increasingly at the centre of things.”

Walkers: The right place at the right time

Caymans-based Walkers was the first offshore firm to set up a fully transactional office in the DIFC. “It’s hard to say whether we got a significant first-mover advantage but we have benefited from an enormous volume of new business,” Varley says. “The original reason for opening here was demand from existing clients. For us it was a question of timing. Setting up in the Gulf a few years ago would have been too early; if we had waited a couple more years business would have moved on – those firms coming in now have to some extent missed the boat. When the IFC was set up it gave us the opportunity to establish our office in a very straightforward, efficient manner – the whole set-up process was much easier than it would otherwise have been.” He says a great advantage of the DIFC is that institutional investors and service providers, like Walkers, are all grouped together in a compact space, so it is easy to meet a great many clients.

Regional rivalry

Where does all this leave Bahrain? Not to be outdone by its neighbour, the island emirate pushed through legislation allowing for 100-per-cent foreign ownership before Dubai and reacted to the establishment of DIFC by announcing a direct rival, the $1.3bn Bahrain Financial Harbour (BFH). The BFH promotes itself as “a complete financial city for the global finance sector, [that] combines business, leisure and residential components and is being developed on a high-profile waterfront site”. Like DIFC, the BFH will be a ‘strategic investment zone’ with liberalised economic conditions to attract the big guns of global finance. By June this year, construction of the BFH was 75 per cent complete.

Can both IFCs co-exist side by side? Perhaps. Varley has no doubt that Bahrain will continue as a major financial centre, irrespective of whether or not BFH takes off. He says that where sukuks are concerned, the two emirates work very well in tandem – the banks in Bahrain supported by lawyers in Dubai. “There’s so much to do in so many areas and everybody is playing to their strengths,” he says.

Leading local players are keen to downplay the competition between the two emirates and point out that each focuses on a different aspect of international finance. While DIFC’s main play is the establishment of a major stock exchange, Bahrain is heavily focused on offshore banking and Islamic finance – but there is already a significant crossover in their activities, one that is unlikely to decrease, according to Michelmore.

Bahrain’s strong point is its well-established reputation as a financial centre. “Looking at it now, there are more banks licensed there – particularly Islamic banks,” he says. “But Dubai has grown dramatically and its infrastructure and communications are increasingly thought of as better [than Bahrain’s]. It’s often said that Dubai, Bahrain and Qatar attract complementary [types of] business but I am not sure that that is absolutely right – they do compete with each other on some levels.” Michelmore adds the DIFX stock exchange is not absolutely pivotal to Dubai’s success as a major financial-services centre. “It’s secondary to the broader role of the DIFC,” he says.

Richards Butler’s practice is slightly more focused on inward investment than outward investment, Michelmore says, but it has netted a substantial number of local clients: local banking institutions and an increasingly large number of trading houses that are beginning to spread their wings beyond the UAE.

Private equity takes off

Offshore law firms, such as Mourant and Walkers, know that they’re onto a good thing. The Middle East’s private-equity market is booming, with rapid growth in both the number and size of funds. Typical private-equity fund structures are consistent with the Shariah principles of sharing in risks and rewards commensurate with capital contributions, making private-equity investments particularly attractive to Islamic investors. Rod Palmer, managing partner of Walkers’ office in Dubai, predicts that the region’s private-equity industry could triple in size over the next five years.

“The Gulf Cooperation Council (GCC) also seems to be ahead of the curve in a major trend of more rapid fundraising, with funds being fully drawn down after 18 months instead of five years,” he says. “This allows managers to quickly establish follow-up funds, often much larger than the original. In the first half of 2006, 31 funds are already on the road seeking $18.2bn, compared to a total of $5.8bn raised in the Middle East-North Africa countries between 1994 and 2005.”

The size of individual funds is also growing. Last year, Abraaj Capital’s $500m buy-out fund was considered large, but its latest offering tops $2bn, allowing the firm to join leaders such as Commercialbank, Dubai Islamic Bank/Dubai Ports World, Gulf One, and Global Investment House in offering billion-dollar-plus funds. This trend mirrors recent developments in the US, where $6bn is no longer considered a very large fund and multi-partner, multi-billion-dollar funds are increasingly common.

Diversification – and origination

“We are seeing the use of more sophisticated limited-partnership structures and a trend away from single-closing corporate-fund structures,” Varley says. “In addition, real-estate funds – which were prevalent not so long ago – are being joined by more and more infrastructure, healthcare, telecommunications and high technology funds. Portfolio diversification has become a driver and local investors are no longer content to stick to the stock markets and real-estate sectors.” Interestingly, he notes that many real-estate funds have been bought up outright – something that is very uncommon in other markets. Such is the demand for ready-made property portfolios.

In parallel with the increasing sophistication of local products, Walkers has noted a marked rise in partnerships between fund managers and global, as well as local, players. Abraaj Capital’s work with Deutsche Bank and Ithmaar Bank to launch a Shariah-compliant alternative assets fund is one example. Crucially, Varley says there has been a growth of origination across the Gulf states.

The geographical focus of private equity is also changing. “A few years ago the market was dominated by ijara-structured funds – funds using leasing strategies – targeting assets in the US and Europe,” Varley says. “Political concerns and changing yields saw a period of concentration on the GCC markets, but now we are seeing a new and growing trend for investment in other [Middle Eastern] economies, as those countries embark on the process of deregulation.” He predicts significant growth in the number of funds investing in Pakistan and India. “But local institutions play to their strengths,” he says. “Only a few high-profile funds are going for global deals at present.”

Walkers has also seen great interest in the region from outside investors, suggesting that outside players will continue to partner with local institutions to produce Islamic products. Meanwhile, Islamic banks that enjoy a strong reputation in other sectors will look to redeploy their expertise in private equity – making even more capital available.

Acid tests

Like most of its peers, Linklaters has followed its major clients, the global investment banks, in opening an office in the DIFC. “I never thought they could get to where they have got to,” says Ewan Cameron, managing partner of Linklaters’ Dubai office. “They have achieved most of their short-term goals and we are now seeing a critical mass of major investment banks coming to town. However the jury is still out on what the banks will actually be doing. The acid test for the DIFC’s medium-term goals is whether those banks start to originate structures from here, rather than just on-selling structures that originate in places like London.”

Another of Cameron’s acid tests is how well the DIFC manages to involve the world’s leading asset-management companies. Yes, the top players are opening offices in Dubai, but to date there has been very little origination. Granted, most of the funds active in Dubai have only been around for a couple of months, so it’s still too early to tell. “Is Dubai going to become a major centre [for asset management] in one year? The answer is no, but over ten years quite possibly, yes,” he says. “That all depends on how well Dubai manages to compete with the established centres such as Ireland, Luxembourg and London.”

Cameron cites the major growth areas for Linklaters’ business in the Gulf as capital markets; M&A; private equity; project finance; and general Islamic finance. He says Linklaters’ Middle East practice strikes a balance between work relating to outward investment – advising the main players in the regional banking industry on global investment matters, for instance – and work on inward investment, which includes helping to finance some of the largest projects in the world, not least the UAE’s construction projects and the multi-billion-dollar railway network being built in Saudi Arabia. Project finance aside, Cameron says his Dubai team is also working on some “massive” IPOs.

Flows of capital, financing trends

The large-scale repatriation of Arab wealth has been widely reported in the media, with a particular focus on high-net-worth individuals withdrawing substantial amounts of investment capital from Western markets, particularly the US, in the years since September 11. 2001. However, several senior lawyers who are well placed to observe any such movements of capital refute the idea of a general trend of Arab money flooding back home. “There has been a lot of talk about that but I am not sure how much capital has actually been repatriated,” Cameron says. His opposite number at Richards Butler, Peter Michelmore, says any inward migration of individuals’ wealth has been balanced with outward investment institutions based in the Gulf. “There is an interesting dichotomy here,” he says. “We have been seeing individual Arab investors withdrawing from the US market but equally, the national institutions have been expanding their investments globally.”

Monetary union

The GCC states – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates – are on track for EU-style monetary union. “I believe that it will and must happen,” Cameron says. “One must not underestimate the political dimensions, but compared to the introduction of the Euro it will be relatively easy to achieve. All the GCC states’ currencies are already pegged to the dollar, which will make the administration much easier. In Europe they had to rebalance their currencies… and it took 15 years.”

Michelmore is also enthusiastic. “Ours has always been a regional practice, for the 30 years that we have been based in Abu Dhabi,” he says. “We already do a lot of cross-border work but [with the single currency in place] it is going to become a lot easier.” He says the UAE is a natural base for law firms, because it is where global corporations tend to site their regional offices, a base from which to service the leaner markets in the region, such as Iran and North/East Africa.

Summary

Cameron points to a major trend in the Gulf: raising money to be deployed locally. “If I were to pick out one major change that I’ve seen over the past few years, that would be it,” he says. “The need for capital in the Gulf has increased exponentially.” With so many grandiose projects and schemes underway, he muses that if the pace of development continues to accelerate, there may one day come a point when the liquidity of the region tightens up and concerns begin to creep in over how it all gets financed. Michelmore is more bullish. “A lot of the capital in the Gulf is self-generated,” he says. “It is the strength of the oil sector that drives the ambition of the states.” One thing is clear, though. There has never been a more exciting time, nor a more lucrative time, to be a lawyer in the Gulf. 