Asset servicers in the Mena region exist for local managers that want to expand internationally, and for international managers that want access to the Gulf and surrounding area. Here they talk about the problems faced by managers in the region and the challenges, such as automation, that asset servicers face in order to help clients. (part 2)
Dimitri Arlando (head of business development, State Street)
Glyn Gibbs (head of business developent, HSBC Securities Serivces)
James Martinson (SVP, Maples Finance)
Craig Roberts (chief executive officer, Apex Fund Services, Dubai)
Michael Slater (senior vice president, Northern Trust)
Thomas Sams (business development director, Citi)
Funds Global: Will the regulators be key to driving outsourcing within the specific regions? Or will it be the fund managers themselves wanting best practice within their business?
Roberts: A bit of both. For example, Qatar and the UAE are putting directives through to split the custody function from the fund manager, but the managers have already also been implementing this to a certain degree. They have asked to be seen to be taking best practice seriously and are now getting support for it from the regulators. But that is an area where outsourcing will benefit from the regulators’ approach, but then there are other areas, such as middle-office functions, that managers are prepared to look to outsourciong for best practice without being directed by the regulator.
Gibbs: As we all know, competition within the custodian and administration services area has increased exponentially over the past two years, particularly within this region. If we were having this conversation three years ago, I would have probably been the only person around the table, because that was the reality at that time. Now there are more alternatives for fund managers and if you’re a regulator that’s a good thing, particularly if you want to drive the separation and independence of certain service support activities. To do this the market needs service provider options to drive competition in order for pricing and other efficiencies to be gained. So it’s going to be a combination of factors that will gradually, over the next couple of years, begin to come together that enable authorities to drive that process.
Sams: I have one particular prospect where the management board recognises that they do a lot of the custody and administration servicing in-house and now they are looking for an external solution. The board has mandated that by mid-2011 they must have their internal structure sorted out and a third-party provider in place. With an external provider in place, they won’t have to worry about someone coming in and accusing them of a Madoff-type situation.
Martinson: Both regulators and investors are driving the overall move to more of an independent outsourcing model. While regulators in the region are prescribing the minimum standards for outsourcing, independence, transparency and accountability, it is the investors that are the other main driving force. Increasingly, we’re seeing investors demand the administration to be separate from the manager’s operations, the brokerage and custody and managers are responding swiftly and positively, so it’s a collective effort on the part of regulators, investors, managers and the service providers that service this demand.
Funds Global: When we first came out to the Mena region, many local fund managers had weekly NAVs while now they want daily NAVs. In your experience, are the locally based fund managers becoming more sophisticated in what they require from you? And are they willing to pick up the cost for more sophisticated services?
Roberts: There are many services you can offer a client and then many times their incentive fizzles out as soon as you tell them how much it will cost. There are a few add-ons that we can roll into our offering. But if one told them, ‘look it’s going to cost you this much’, then that would be different. But now they are asking more sophisticated questions and for more formal options than what they were before. They’re coming at it from a higher level of sophistication where they know what answers to expect and what they want from you. They know what they want to do and that allows you to come up with a tailored and effective solution for them.
Arlando: From the fund’s perspective, cost is an important factor. There’s so much competition within the funds world itself that fund managers can be reluctant to pay for additional services, which, although can be a great marketing tool for them, ultimately make their funds more costly relative to their competitors.
Sams: Due to developments over the last two and half to three years, the market is driving down costs. We’re all very fierce competitors, which is a good thing. Competition is helping the market mature and the funds receive more services at a more acceptable price. We’re not giving away things for free yet, but it is a different market than it was three years ago.
Funds Global: Craig mentioned that the cost being driven down has been partly a result of regulation and partly by the client. Can you say exactly which type of client has been driving this? Is it the Arab private bank or multi-managers driving this kind of outsourcing?
Roberts: The newer managers have much more incentive to do that and have a fresher look at outsourcing. We’re also seeing a change of occupation for some managers. They go from one management firm to another, and its in this transition period, when they’re just beginning their new role, that they can make initiatives such as outsourcing work, or at least put it before the board as this is a value-add. So you’re beginning to see a couple of more established institutions now looking at outsourcing differently, and it’s happening more because there has been a change of guard which has come in with a new approach.
Funds Global: With all the abilities you’ve got, do you feel underused here? You have all these things to bring to the table but the fact is there isn’t a great deal of demand for everything.
Martinson: You tend to spend more time working more closely with investment managers on things that you wouldn’t necessarily work on in the North American and European markets where you would be more focused on automation, straight-through processing and a variety of other services that come back to middle-office services. On the other hand, here you really are working with the manager through an education and development process. From explaining the service you’re providing and then working through how to structure communication with their investors that enhances the manager’s relationship with their investors and how to adopt best practice at all levels. So it’s really a collaborative partnership evolving in the region, which takes a lot of time, but it’s time spent differently to time spent in other regions and it’s equally rewarding.
Funds Global: The Madoff story did reach the Middle East, right? Everyone knows who Madoff is?
Arlando: Yes. It drives the point home to them. After Madoff and the crisis I found that there was a lot of education, not only about funds but even around custody. We had to reeducate people about what custody is. Sadly, or to our benefit, because of what happened a lot of people understood custody as being prime brokerage with rehypothecation where assets actually come onto one’s balance sheet. We had to sit and explain that that is not what true custody is, but rather it’s about holding assets in trust on behalf of an underlying client.
Gibbs: And they ask whether you’re going to charge them as there is still great reluctance to pay for the service when assets can be left with brokers for free. Thus a lot of conversation takes place concerning the risks and hidden costs that arise as a result
Arlando: That’s where the regulation change happening in Saudi, in the UAE and in Qatar can make a difference. Fund managers will no longer be able to use their brokers to hold assets and will have to find custodians.
Sams: When I speak about our products I like talking about securities lending because it’s interesting, it’s something a little more fun to talk about than standard custody or administration – it’s entertaining and generates interesting questions. However, it’s not here yet as there isn’t the need for it. The region is focused on the nuts and bolts and the building blocks of investor services.
That’s not to say that change isn’t happening. But it takes time. What is clear is that people are using the market downturn and the slow down in volumes to think about how they can strengthen their offering, be it from a service provider perspective or by introducing new services and outsourcing more.
Roberts: Particular to the custodian aspect, is that you only can hold some securities in the region on a nominee basis. It’s not meant to, but funds are holding on a nominee basis and could be putting a large risk on that particular position. There is an unlikely chance that something could go wrong and that’s generally accepted as an associated risk. So you have to bear in mind that you’re coming into an environment where they will accept practices like that.
Funds Global: In Europe, custody laws are becoming increasingly tighter under the proposed AFIM [Alternative Investment Fund Managers] directive, which people say will filter through to Ucits as well, making liability on your businesses in Europe very onerous. Do you think that the Mena markets will catch on to this and increase liability here as well?
Sams: The region is just now focusing on a true custody service where assets are ringfenced from brokers with a third-party institution. Over time the Middle East will go in the same direction as Europe, but you have to remember that the industry here is at a different stage and does on occasion move much more slowly.
Funds Global: How are asset-servicing firms coping with the Islamic finance segment of the funds world and what are its particular challenges?
Martinson: It depends on what your definition of a fund is. There are numerous Islamic finance products that we service globally and some of those Islamic finance products contribute significantly to the global financial markets. There is a very extensive Sukuk market in the region and a lot of the established businesses in the UAE specifically use that market to raise funds. We see a lot of the private equity funds that are Sharia-compliant, which have their intricacies. With hedge funds, we don’t really see the same proportion of Sharia-compliant funds which is a factor attributed to the typical investment strategies and the use of leverage. Ultimately, from a service provider perspective, it’s our prerogative to ensure structures are administered in accordance with their constitutional documents and once the documents are final and formally approved as Sharia compliant it’s seamless. A more recent development is towards focused ‘Sharia-friendly’ products, which are not necessarily Sharia-compliant. So they don’t necessarily go through the formal process, but they are acceptable investments to people with a focus on Sharia products, which is a demonstration of the importance of Islamic finance to investors and managers alike.
Gibbs: It depends which country you’re in as well. For example, if you’re in Saudi Arabia the demand for Islamic funds is higher than in other parts of the Gulf. It also depends on the asset manager involved. If it is an Islamic bank, then it’s naturally going to have Sharia-compliant funds. As you drive down Sheikh Zayed Road [the main road in Dubai; home to most of the Emirate’s skyscrapers] the names of the banks along the roadside shows that there are a lot of Islamic banks. When it comes to servicing, it depends on the funds themselves. Sometimes there are commodity-based specific Islamic structures set up by certain managers to make sure that the underlying investments are orientated around capital gains rather than investment returns. Additionally, these are less structurally complex than Sukuk and equity funds and we certainly view this as an expanding segment of the market.
Funds Global: Will there ever be a dedicated centre for Islamic finance?
Roberts: I don’t know whether it’s necessary for there to be a Sharia centre, as long as every financial centre can understand and communicate what’s required. The issue is about applying a consistent set of principles and understanding across the different countries. That will make things a lot easier.
Martinson: There are different interpretations of what Sharia compliance constitutes and that’s the challenge, especially in the fund context. You would need to qualify what is absolutely not allowed and what is actually permissible to a certain extent. So you do have an element of subjectivity, which complicates matters and makes the fund documentation more complex than that for a conventional fund. So documentation remains key. Asia is still a dominant market in Islamic finance, but you’re seeing all these different centres around the world trying to establish themselves as Islamic finance centres. So you’re really looking at a global financial industry that’s emerging from this trend rather than it being focused on a specific geographical location.
Gibbs: The centre for Saudi Sharia-compliant funds is Saudi Arabia, the centre for Qatari Sharia-compliant funds is Qatar, and the centre for Bahraini Sharia-compliant funds is Bahrain because that’s a matter of regulation. There has been talk about Luxembourg trying to establish itself as the centre for Sharia-compliant funds but that would probably be more for Ucits-compliant funds where it competes against Dublin primarily. Luxembourg would not be competing against funds regulated in Bahrain or in Saudi, for example.
Sams: You have to remember that you don’t have to be Muslim to invest in Islamic products. During the crisis there was a lot of empirical evidence showing that these funds were quite resilient to some of the things that were going on globally. There is a growing trend where fund managers would launch an Islamic product that’s not necessarily targeted to the UAE and the Emiratee population.
Roberts: A private equity fund would be a classic example of where the nature of the asset is Sharia compliant and you can put very few restrictions on how you operate the fund so the fund can be Sharia compliant, yet still retain the risk profile of a conventional fund.
Gibbs: I had one manager advise that all they manufacture are Islamic funds because they can distribute such funds to everybody. In contrast they can’t distribute a non-Islamic fund to the Muslim community so it just makes sense for them to go the Islamic route.
Sams: As a core fund administrator or a core custodian to Islamic entities, yes there is documentation with specific requirements, but the actual operation of the fund is not difficult for us. Islamic finance is a very ‘en vogue’ subject and I receive calls from around the globe from clients and prospects interested in learning more on the subject. But, while there are some very significant Islamic finance fund nuances and requirements, such as the provision of a Sharia board, the customisation required to make an operation compliant will not turn it on its head.
Slater: An Islamic fund is managed by a manager that has a specific mandate and that’s where a lot of the regulatory issues play out. The Sharia board has to invest in the right stocks, so there are a few nuances that the funds industry is going to have to work through, like the purification of dividends and the like.
Funds Global: As Mena-based fund managers increasingly look to market their investment management expertise beyond the Mena region and into Europe and the US, which international domiciles will capture this business?
Sams: Dublin and Luxembourg are certainly at the top of that list. This is because Western investors have a certain comfort with the structure that a Dublin and a Luxembourg fund bring to the table. As mentioned earlier, there is an education process in doing that, given the costs that surround it. But increasingly we have existing and prospective clients that are very interested in capturing the European investor. They believe, as we all do, that the Middle East will recover making it a good value proposition to certain European investors.
Fund providers want to make sure their client base is comfortable with the structures on offer. We’re all very ambitious and having the best business practises of a well-known service provider as support allows investors to say, ‘yes I know that name, they have the global consistency and local market expertise I need’. This can mitigate a lot of the concerns that a European investor may have about this part of the world or about a smaller investment manager that’s not a household name. By using Dublin or Luxembourg along with a large international administrator and custodian you can tick the geographical due diligence boxes that are core to the decision-making process when investing into a new region.
Roberts: The analogy’s similar to that of the Sharia versus conventional product. A Ucits product allows you to access a wider range, maybe your local market plus the European and the Asian markets. If you can take advantage of that and you’re prepared to risk increasing costs and can deal with the possible restrictions in the region, then Ucits may be an option. You must remember that a Ucits fund may apply significant restrictions on how you can actually implement your strategy. But if everything lines up and if you can afford it then it opens up a wider market. We have recently opened our office in Luxembourg and have the ability to service regional managers with Luxembourg funds from our local offices – this is being well received by our clients. But we’re still in the very early stages of education around what managers need to do and what their objectives are around Ucits.
Martinson: Exactly, it really depends on what you’re trying to achieve and which investors you’re targeting. For the retail market, there’s a mutual understanding between managers and investors of what’s gained by using a Ucits structure domiciled in Luxembourg or Ireland. If you’re talking about qualified investors in a fund offering shares on a private placement basis, then it’s a completely different scenario that needs to be analysed. European centres have done a very good job of marketing some of their structures in the Mena region and particularly Ucits structures. However, this may not necessarily be appropriate for the types of funds that we’re seeing emanating from the region, where you typically have high net worth individuals and institutions providing the seed capital for these funds that are not focusing on the retail sector. It’s more of a private placement scenario here. In the alternatives sector, Luxembourg and Ireland shouldn’t be discounted either because they do offer structures other than Ucits that may be more appropriate to the types of investors the managers are trying to attract. You can get quite far along with somebody wanting to establish a Ucits structure in Europe and then they realise that they cannot bear the costs or the restrictions. This would ultimately lead them back to some of the tried and tested jurisdictions like Cayman where there is a good fit with their investor profile and investment objectives.
Gibbs: Many regional and local asset managers are ambitious and would like to attract funds from high-net-worth individuals and institutions around Europe and maybe the US. The fundamental challenge faced is that while most of the asset managers are very familiar to everybody around this table, they’re probably not so recognisable to the large investors outside the Middle East. So the first hurdle they face is persuading those cash-rich institutions to have the confidence to invest through them. To do this they have to demonstrate that they’ve got the processes, controls and procedures to run that money in a professional manner.
In the region there are only a handful of names that have the international reputation to carry that off, or have a track record of investment success over an extended period of time. For example, a local entity that launched an international regulated fund in early 2009 aimed at just this investor base has recently announced that it was closing the fund to third-party investors having not attracted sufficient external inflows to justify the overhead. It’s a lot harder than people think and there are a lot more components to it. The Ucits domicile does offer certain reassurance because of the tighter regulations, but there’s more to it than just that, and that’s the problem. This comes back to the point we talked about earlier regarding cost. It depends on how long you are willing to bear that cost, while your fund builds a track record and you prove your processes over a two-, three-, four- or five-year time horizon. And all this would be going on while institutional investors look at your firm and get comfortable with it. Particularly when the local players choose to go to into the Ucits environment and their Mena fund is competing with the likes of Franklin Templeton, Schroders and ING, firms that are internationally recognised.
Slater: You’re right there are some that are going to succeed but not a great number.You will probably see more JVs [joint ventures] or alliances, where the local managers have specific mandates inside a Western asset manager, providing the Sharia, the Saudi or some other local specific component. I don’t think a large number of local players are going to go to Luxembourg or Dublin to set up Ucits funds; they’ll find there’s no money there.
Martinson: Ultimately the jurisdiction has to be a good fit with the strategy and the investor base. Managers in this region are increasingly partnering and forming joint ventures with European and North American firms because typically the investment banks in the region have the investor contacts with high levels of liquidity but they still need global exposure in the asset management industry. So European and North American firms are looking to access that liquidity and local asset management firms and investment banks are looking to partner with them to get their names out there and grow their global reach.
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