The Rise of the Phoenix?

Dubai renews attempts to be new fund hub

AYMAN A. KHALEQ, DUBAI MANAGING PARTNER, and PHILIP R. DOWSETT, SENIOR ASSOCIATE, MORGAN, LEWIS & BOCKIUS LLP

There is no doubting Dubai’s pre-eminence as the jurisdiction of choice and hub of business in the Middle East, albeit it with the caveat that by Dubai, in the case of financial services and funds, the reference is generally to the Dubai International Financial Centre (DIFC), one of Dubai’s free zones. Although Dubai is home to a multitude of free zones (where, among other things, 100% foreign ownership is permitted and there is a long-term 0% tax holiday), the DIFC is arguably Dubai’s flagship of free zones for financial services. In creating the DIFC, Dubai established a free zone with a stand-alone legal structure, premised upon the laws of England and Wales (which looks to and leverages off England’s centuries of legal precedent and extensive legislative framework) and regulatory regime founded upon the rules of the UK’s Financial Conduct Authority’s predecessor, the Financial Services Authority, and governed by its namesake, the Dubai Financial Services Authority (DFSA).

However, notwithstanding the DIFC’s success in nurturing and furthering Dubai’s growth and economic development and providing an infrastructure and jurisdiction promulgating international legal and regulatory standards, for all its accomplishments, one industry and area in which the DIFC has so far achieved only a modest success is the investment funds arena.

The fund industry itself is a huge industry, with assets under management in the European investment fund industry alone at the end of 2013 encroaching on close to €9,000 billion. However, since the DFSA’s collective investment laws were introduced back in 2006, perusal of the DFSA’s public register shows only nine funds are currently registered (another seven have been withdrawn). Given that there is no geographically required nexus between a fund domicile and its investment scope and geography, even if there are perhaps marketing and other jurisdictional benefits that can be availed, the DIFC has inevitably faced strong competition from more established and legacy fund domiciles, such as the Cayman Islands, Jersey, Ireland and Luxembourg. By comparison, as against the DFSA’s nine registered funds, the Cayman Islands Monetary Authority (CIMA), as of the second quarter of 2014, had 11,296 registered mutual funds (and importantly, this figure needs to be taken relative to the fact that many funds operating out of the Cayman Islands are not registered with the Cayman Islands Monetary Authority (CIMA), and therefore not included in this number, so the actual number of Cayman Islands-domiciled funds is probably far greater).

Additionally, Jersey currently has 703 registered funds (all regulated by the Jersey Financial Services Commission), Ireland, as of 31 August 2014, has 5,671 registered funds (regulated by the Central Bank of Ireland) and Luxembourg, as of 31 July 2014, has 3,891 registered funds (regulated by the Commission de Surveillance du Secteur Financier). It is therefore evident that the funds registered in these jurisdictions, even on a stand-alone country basis, dwarf those registered in the DIFC.

In the Cayman Islands, such could be explained by the ability to establish a fund under an exemption, so without any need for registration or regulation (which gives a lot of scope and flexibility). In the other mentioned European jurisdictions, the benefits of domicile include the investor comfort gained by offering a regulated fund together with a streamlined regulation process and an experienced regulator. Ultimately, however, one of the fundamental advantages of each of these jurisdictions is quite simply that they are tried and tested, which is a glass ceiling that the DIFC regime has struggled to contend with.

The DIFC has made concerted efforts to try and capture some of the fund market and bring regionally focused funds to the DIFC, and has, in small part, succeeded. However, its recent overhaul of the DFSA rules relating to the fund regime evidences its resilience to complacency and merely settling for a small footprint, and instead demonstrates its intentions to try to redress the shortcomings in attracting more funds and asset managers. It is widely accepted amongst practitioners, sponsors and investors, and arguably even the DFSA itself, that the collective investment funds regime for professional and more risk-tolerant investors in the DIFC was overly burdensome, expensive and arguably bureaucratic. By way of example, although a DFSA domestic fund can be managed by an external fund manager, the process for registering as a DFSA manager could take many months, as could registering the fund, and once established, there were various onerous DFSA reporting obligations, compliance requirements, and ongoing expenses notably greater than those of other jurisdictions. Enter the “Qualified Investor Fund” (QIF) regime.

The QIF rules were enacted in the DIFC on 21 August 2014, and seek to reduce the regulation of funds targeted primarily at high-net-worth and risk-tolerant investors. The QIF’s key attributes are as follows:

  • Minimum investment of $500,000 per investor is required.
  • Maximum of 50 investors per fund.
  • Available only to “Professional Clients” (as defined in the DFSA rules).
  • There is no longer a requirement to pre-designate the nature of the fund – for example, whether the fund is a real estate fund, Islamic fund, private equity fund, etc. Instead appropriate disclosures in the private placement memorandum are to be made and the specific rules for these funds do not apply to the QIF.
  • Only annual reporting is required (no interim reporting unless a material change to the fund in the meantime).
  • Registration process of 48 hours.

The introduction of the QIF will undoubtedly be welcomed as a milestone in the DIFC’s efforts to address the legacy issues with its fund regime and provide a domicile more accommodating to funds and sponsors. However, the real question is, even with the QIF’s emergence, whether this is sufficient to enable the DIFC to challenge the stronghold of domiciles such as the Cayman Islands, Jersey, Ireland and Luxembourg.

In this regard, there is no denying that the DIFC is playing catch-up and batting in a field with extensive pedigree and history. With all of the complications, risk and considerations that go hand-in-hand with fund structuring, formation and marketing, supplementing these with trying to sell a new domicile to investors is quite possibly a battle that fund managers would rather avoid where there is no real incentive or tangible benefit in doing so. However, to cease the discussion at this point would be to do no justice to the DIFC, and although it is difficult to deny that the DIFC will continue to struggle pound-for-pound on popularity and market acceptance at this stage, the QIF’s introduction, on the face of it, addresses the various drawbacks and issues with the DFSA’s previous fund regime.

By removing these barricades for certain funds it allows the DIFC to compete, prima facie, alongside the other regimes in relation to, for example, annual expenses, reporting obligations, registration process, and regulatory oversight (as versus self-certification). With the DIFC on a level footing at this juncture, although attracting large hedge funds with a global investment geography is going to be an uphill struggle, attracting hedge funds, private equity funds and other funds with a regional focus or focus for Middle Eastern investors, or which desire basing operations from the Middle East, has suddenly become increasingly attractive and marketable. In fact, for Middle Eastern and North African geographically focused funds and investors, the DIFC funds regime can now offer a comparative regime and also advantages, including the following:

  • Tax-free status: the DIFC allows for full repatriation of capital and a 0% tax rate, which is obviously hugely attractive to those investors resident in jurisdictions where they are not subject to tax, and can enable very favourable tax structures to be implemented for investment to benefit all investors. This is, of course, also attractive to asset managers who decide to establish in the DIFC and manage their operations from the DIFC who enjoy the same tax treatment.
  • Benefit of double-taxation and bilateral treaties: although a number of the prominent fund domiciles are party to various double-taxation and bilateral investment treaties, over which the DIFCcan claim no advantage, others are not – the Cayman Islands being a prime example. The DIFC, however, has gone to great lengths to establish understandings with various countries, and a DIFC fund can also benefit from the United Arab Emirates’ (UAE) double-taxation and bilateral investment treaties. Additionally, by virtue of the DFSA’s efforts, DFSA-registered fund managers can claim reciprocal benefits in a number of the DFSA’s recognized jurisdictions.
  • GCC nationality: one unique advantage of a DIFC fund over other regimes, which can be very beneficial for regionally focused funds, is the general recognition of a DIFC entity as a Gulf Cooperation Council (GCC) national, provided 100% of its investors are GCC nationals. This passport entitles the fund to various benefits, including the potential ability to directly invest in certain GCC countries – for example, at present, directly into Saudi Arabia without requiring a Saudi Arabian General Investment Authority (SAGIA) licence (as required for any foreign (non-GCC) investor in Saudi Arabia). Another example is in the UAE the ability for the fund to purchase freehold land outside of a free zone which, although it requires a special exemption at this stage (as granted to Emirates REIT), is a future development and cooperation that, it is understood, the DIFC is looking at seeking to secure for all wholly GCC-owned DIFC entities.
  • Target investors: significant wealth exists throughout the Middle East, wealth that is deployed both nationally, regionally and internationally, with, for example, Abu Dhabi Investment Authority (ADIA) having tens of billions of dollars in international hedge funds. Providing a jurisdiction that can offer the same benefits and regulatory oversight as the more engrained and established jurisdictions, but which has a true nexus to the Middle East, and promotes and raises the profile of the Middle East, could well appeal to many Middle Eastern investors and foster their loyalty and patriotism.

In order to complement the QIF, the DFSA has set out a four to six-week expedited approval process for new fund managers who are managing QIFs, and is currently under consultation to reduce the annual fees of a fund manager from $10,000 to $5,000 which, if approved (and initial indications from the DFSA are positive on this front) would be expected to be introduced in early 2015. Additionally, fund managers from outside of the DIFC can apply for a no-objection to manage a DIFC fund if such are from DIFC-recognized jurisdictions (which includes, among others, European Union Member States, the United Kingdom, Jersey and the United States of America) and other countries in certain circumstances (though in these scenarios the registration process is longer and more convoluted). However, such persons will not be DFSA-regulated, nor will they be able to avail the benefits of the DIFC. Therefore, alongside the QIF regime, the DIFC has also sought to create a favourable fund management landscape to try and appeal to external managers, as well as those seeking to establish in the Middle East and enjoy the benefits that the DIFC provides.

In conclusion, having recognized the various shortcomings of the DIFC fund regime, and studied the approach of worldwide jurisdictions leading the way in terms of fund domiciles, the DIFC has sought to introduce a comparable regime for targeting high-net-worth investors with a greater risk tolerance. It is unlikely that the likes of Ireland and Luxembourg will be nervous of hedge funds suddenly relocating domicile to the DIFC, or the DIFC attracting new global hedge or private equity funds, but then this is presumably not, at least for the time being, an ambition that the DIFC is realistically vying for. However, the DIFC’s vision and advances have signified a great step forward and have served to potentially remove the obstacles that a Middle-East regionally focused sponsor or fund manager would have used previously to excuse domiciling a fund in the DIFC in favour of another jurisdiction. With the introduction of the QIF, a possible genuine contender to the fund market for Middle Eastern and North African-focused funds and investors may have emerged.

As the Middle East’s recovery surges, the DIFC has taken commendable steps to accept the regime’s failings and to remove the blockades from domiciling a fund in the DIFC, laying a formidable groundwork and landscape, but now the success of the QIF and growth of the DIFC fund’s regime is largely in the hands of the sponsors, managers and investors, and now it needs one or two large funds to back the regime and domicile in the DIFC as the next step required to legitimize and propel the status and recognition of the DIFC as a fledging leading fund domicile. Furthermore, in terms of asset managers, the DIFC can offer significant benefits for operations, and in light of the DFSA’s consultation to reduce fees for managers operating QIF funds, if the DIFC as a fund domicile experiences a resurgence, then it is likely that the market for asset managers will grow hand-in-hand.

Ayman A. Khaleq’s practice focuses on structured finance and debt capital market transactions, as well as private placements, with an emphasis on the structuring and documentation of innovative Islamic finance and investment products. Most of his transactions involve advising international and regional clients on legal structures pertaining to debt and equity raising from, as well as on doing business in, the Middle East region.

Philip R. Dowsett’s practice primarily focuses on fund structuring and formation, private investment funds, private equity, venture capital, complex cross-border mergers and acquisitions, takeovers, divestitures, joint ventures, and corporate finance transactions (including Islamic finance). He has experience in a number of jurisdictions, including the United Kingdom, Europe, North and South America, and almost a decade of experience throughout the Middle East.