New land of opportunity for hedge funds?

James Norris
Originally published in the December 2005 issue

Hard on the heels of their successful Asian and Chinese businesses, the Cayman Islands offshore legal firm has decided to open an office in Dubai. James Norris speaks to the managing partner Rod Palmer.

When it comes to ambition, the Dubai International Finance Centre doesn't do things by halves: it is setting itself up as no less than the leading onshore capital market in the strategic time zone that sits half-way between London and Hong Kong. And, as part of this ambition, the DIFC is also aiming "to position itself as the natural home in the region for the hedge fund industry."

Dr Omar Bin Sulaiman, the director-general of the Dubai International Financial Centre Authority, says "the Middle East region is witnessing a phenomenal growth with unprecedented opportunities for all." For example, the financial services sector's double digit growth is expected to continue unabated. Around $1.8bn was raised through initial public offerings in 2004, a figure that is expected to double by the end of 2005.

Already, the leading names in financial services, accountancy and law have obtained, or are in the process of obtaining, a licence to operate from the DIFC. From this month, too, the DIFC will be able to count Walkers, the leading Cayman Islands-based offshore law firm, among its licensees.

Rod Palmer, Walkers' managing partner based in Dubai, says: "one of the underlying growth drivers of our business is being able to advise our clients in the same time zone." The new office in Dubai follows their success in attracting business from Asia and China. He adds: "The driver for this business is to complete our offer of global legal offshore advice to our clients in their time zones."

At a more practical level, he says, "while we're based in the Caymans, there will always be a time lag between taking instructions and being able to sit down with the client, face to face. You can provide a better service and better structure the financial product by being in the region, especially where the product has an Islamic-finance element."

As listed on the DIFC website, the attractions of doing business from Dubai are many. They include zero per cent tax rate on income and profits, a wide network of double taxation treaties, no restrictions on foreign exchange, freedom to repatriate all capital andprofits, high standards of rules and regulations and brand new office accommodation.

Palmer, however, prefers to point to "a maturing of the financial services sector in Dubai", which he says was "accelerated by the flight of capital out of the US back into this region post-911. A number of our principal clients are operating here, including a number of financial institutions and UK law firms."

The main challenge of basing an investment business in Dubai is the trend towards Sharia law-compliant financial instruments. As Palmer explains: "One of the problems with traditional long-short hedge funds is that under Sharia law you cannot sell what you do not own, which is an issue for those shorting stocks. This is what has held back the development of the traditionally structured hedge funds market in the Gulf Cooperation Council region."

One way round this problem is the arbun concept, which has been developed as a 'workaround' that replicates an economic outcome similar to shorting. Palmer says: "The best way to describe this is as a down-payment. You pay a percentage of the purchase price. It has a future transaction date, and if the price goes down, you forfeit the down payment and you don't fulfil the contract. Otherwise it would be cheaper to buy something cheaper on the market."

A second challenge is that stocks investing in alcohol, tobacco, gambling and financial institutions are all prohibited. Again, the challenge is being met by investment managers, who use filters on their trading platforms. Some traders are building platforms based on a database of approved stocks that will enable all trades to be automatically Sharia-compliant.

The third challenge concerns leverage. Palmer says: "the problem here is that borrowing is not permitted. We can't leverage hedge funds in the traditional manner because money cannot be accepted to lend against money. The workaround solution to this is the murabaha contract, which is used for long positions in hedge funds."

Payment of interest, or riba, is also prohibited, making even the regular bond non-compliant. Here, the sukuk, the Islamic bond, is the answer, providing Walkers with one of its main lines of business. In 2005, 60 sukuks were issued in the region, with a total aggregate worth of more than $10bn. A measure of its success can be gauged by the fact that in 2000, when they were first introduced, just three sukuks were issued with a total value of $336m.

The unpredictable element in this situation is that Islamic scholars can disagree on whether a particular investment vehicle is Sharia-compliant, and to what degree. However, not all Walker's clients are purists. And, as Palmer says: "Our role is not to advise on Sharia law. We advise on Cayman Islands law, but having a familiarity with Islamic finance we can come up with a solution as to how we can use a Cayman Islands or British Virgin Islands-registered vehicle to put a product together."