Caught in a Web

Middle Eastern investors are among the most affluent and active investors in private equity funds. In fact, Middle Eastern fundraising trips have become almost ubiquitous among international senior private equity professionals. Those trips, however, may need to be refocused in light of the recent increase in regulation of marketing activities of private equity and other investment funds by a number of countries in the region. The regulations not only provide rescission rights for investors and regiment the fundraising process, but may also subject private equity firms to significant contractual, civil and criminal exposure.

We outline some of the key regulatory reforms that have been, or are proposed to be, placed on international private equity funds seeking to raise capital in the Middle East. We also describe some of the steps that the industry is taking to establish a dialogue with local regulators with a view to reversing or ameliorating the current reform.

Saudi Arabia: among the first to tighten its grip

Four years ago, the Kingdom of Saudi Arabia initiated the reform bandwagon by enacting its current marketing restrictions. The Saudi regulations left no question as to whether they were intended to apply to foreign investment funds, stating clearly that an investment fund established in a jurisdiction other than Saudi Arabia could no longer be offered on a private placement basis in the Kingdom without consent of its Capital Market Authority (CMA). Although foreign fund sponsors need not themselves be licensed to conduct marketing activities in Saudi Arabia, they must now engage an entity authorised by the CMA in order to have the potential to engage in private-placement fundraising. Such authorised “chaperone” must then seek prior approval from the CMA for each offering and must participate in all aspects of marketing to investors in the Kingdom. In addition, we understand the CMA has suggested that the chaperone must continue to serve as an intermediary between a fund and its Saudi limited partners with respect to capital calls, distributions and financial reports throughout the life of the fund.

While such chaperones may be helpful in protecting retail investors, their use in the placement of fund interests with institutional and other sophisticated investors is likely to add very limited value and raises a number of concerns for both fund sponsors and investors. The chaperone requirement often imposes unnecessary logistical, financial and commercial impediments for both fund managers and prospective investors, perhaps even undermining their longstanding valuable commercial associations and otherwise increasing the cost of capital raising. The requirement also increases a foreign investment fund sponsor’s potential for exposure under the Foreign Corrupt Practices Act and introduces a number of additional procedural requirements upon sponsors who could be held responsible for the activities of their local custodians.

The UAE and Kuwait: following suit

In the past year, the United Arab Emirates and Kuwait have introduced regulations following Saudi Arabia’s lead. The UAE released a draft of its proposed regulations on 6 January 2011, and Kuwait released its final regulations on 13 March 2011, effective immediately. The UAE regulations have not yet come into force. Both regulations appear tailored to protecting retail investors from making uninformed investments in mutual funds and other publicly-offered securities. However, they are drafted so broadly that they apply to private equity funds across the board, without an exemption for private placements to sophisticated investors as in most developed jurisdictions. Because the regulations were not drafted with private equity funds in mind, a number of their requirements impose more than just an additional cost or administrative burden on private equity fund managers and their funds. Rather, they introduce rules which most managers and funds are simply unable to satisfy.

The requirements:

Similar to Saudi Arabia, both Kuwait and the UAE now require foreign investment funds to engage local chaperones to conduct local marketing activities.

In addition, both Kuwait and the UAE have introduced significant reporting requirements to their regimes, many of which are totally impractical for private equity funds in light of the timeframes imposed. The regulations require that private equity funds provide quarterly audited reports to their investors within as early as 15 days after the end of each quarter and yearly audited reports to the government authorities within as early as 30 days after the end of each fiscal year. The Kuwait regulation also demands that each fund manager make available to the Kuwaiti regulator and the public the annual audited financial statements of each investment fund.

The Kuwait regulation requires that an investor pay its entire “unit value” at the time of its subscription to an investment fund.

The Kuwait regulation provides that no investment fund may own more than 10 percent of the securities of any one entity. In addition, employees and officers of a fund manager may not serve on the board of, or hold any position in, any portfolio company. These requirements are fundamentally inconsistent with the private equity buyout and growth capital fund models, which are premised upon seeking control or significant minority positions in portfolio companies and appointing board members, in each case to add value by actively influencing the management and operations of portfolio companies. In addition, an investment fund may not hold more than 10 percent of its net asset value in a single portfolio company. This requirement is obviously more restrictive than many funds’ diversification requirements.

The Kuwait regulation provides that at least one-third of the members of an investment fund’s board of directors must be independent, and approval of the Kuwaiti regulator is required prior to making any change in such board’s membership, which of course is entirely inconsistent with how private equity fund managers generally structure their investment committees.

The UAE regulation requires that a foreign investment fund obtain approval from both the local regulator and the UAE Central Bank prior to conducting any marketing of fund interests in the UAE.
On 12 April 2011, the Kuwaiti regulator released Resolution No. 2, which establishes that foreign investment fund sponsors must pay a fee equal to 1 percent of the total value of the units intended to be marketed in Kuwait. The licensing application fee structure places a substantial financial burden on foreign fund sponsors and is expected to have a significant chilling effect on marketing in Kuwait to the detriment of Kuwait’s competitiveness as a leading financial center in the region (particularly since no other major jurisdiction, to our knowledge, has adopted a similar approach).

A number of advocacy groups and trade organisations have submitted, or are in the process of submitting, comment letters to the regulators in the UAE and Kuwait in reaction to these regulatory changes. Certain Middle Eastern investors (such as some of the sovereign wealth funds) have also inserted themselves in the debate. The primary focus of both groups has been to secure a formal private placement exemption from the regulations, allowing international private equity managers to safely market fund interests to qualified investors in a manner consistent with that permitted by other leading jurisdictions, thereby obviating, for instance, the need for a chaperone in connection with private placements.

Erica Berthou is a partner and Jonathan Adler and Anne-Lise Quach are associates in the New York office of Debevoise & Plimpton. A version of this article originally appeared in the Spring 2011 issue of the Debevoise & Plimpton Private Equity Report.