GFH private equity model — Traditional vs Islamic
Most of GFH’s deals were private equity which comprised never less than 70% of its revenue. It should have been abundantly clear to management that any annual failure in the bank’s private equity business would directly result in the failure of GFH.
Therefore, in order to comprehend the fall of GFH, it is important to understand the basic mechanism of private equity, as well as the adaptation of private equity used by GFH.
According to International Financial Services London (IFSL), “Private equity is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. This also includes public companies that are delisted as part of the transaction.”
The fund-raising process begins when private equity houses establish a special purpose vehicle (a fund), then raises capital from institutional investors, such as pension funds, and high net worth individuals. These investors are collectively referred to as limited partners (LPs); although GFH did not necessarily use the GP/LP structure, it was essentially the same).
The year in which the capital is raised and invested for a given transaction is known as that transaction‘s “vintage” year. Once set up, a fund is generally closed to new investment. A private equity firm’s track record on previous funds will drive its ability to raise capital for future funds. The general partners (GPs) — the private equity firms — invest this capital according to a business plan approved by the LPs in the process of raising the money. To increase the impact of the investment in a target company or real estate project the GP often borrows from banks and other lenders on behalf of the fund.
Once the value adding process has finished and the private equity firm believes that it has increased the business’ efficiencies — usually in five to seven years — the GP seeks an exit to realize returns on the investments made by the LPs. The main exit routes include trades sales, repurchase, refinancing and flotation on a public exchange.
Most private equity firms, set up as private partnerships, charge the investors an initial purchase fee equal to 1.5% to 2% of assets committed, and then an annual management fee of about the same amount, which is supposed to be used to finance operations of the private equity firm (salaries, office rent and other day to day costs).
Typically, a private equity house will seek an overall return in terms of an annual internal rate of return (IRR), calculated over the life of the investment, of above 20% per annum for the LP investors. Although the return will depend on the risk of the investment, generally the higher the risk the higher the return that is expected. It is important to note that private equity is almost always totally illiquid as capital is usually locked up for the five- to seven-year period, but it is not unusual for investments to be locked up for 10 years until there is an exit.
Historically, and in retrospect we know why, private equity firms in the US and elsewhere occasionally delivered profits of 15% to 25% per year to their investors. What was often unsaid, however, was the frequency of failure in the industry. A study by Bain & Co revealed that “40% of private equity deals fail to earn returns that even cover their original acquisition costs….” Sophisticated investors know this. They will seek private equity firms that have a solid track record, and they will diversify their investments among funds at one private equity firm, and then among several private equity firms.
Very sophisticated institutional investors will also maintain minimal amounts of total private equity investments. According to one report, global private equity was equal to only 1.2% of all private wealth under management.
A private equity firm itself will also try to achieve diversification. It will spread its talent and resources among several funds in various industries, plus, as is often the case, it will branch into other lines of business to reduce total reliance solely on private equity (such as at Investcorp, also in Bahrain). This will facilitate dispersion of risk and spread the financial failure of a venture over the total investment held by the fund and ultimately over all the individual investors.
Hence, there is very little structural distinction between conventional private equity funds (CPEF) and Islamic private equity funds (IPEF). Similar to CPEF, IPEF will invest in the underlying target companies and will upon the future exit incur losses or gain profits, which are passed on to investors. They also charge identical purchase commissions and management fees, and they always add a performance fee to the final return if profits are above some minimum threshold. The performance fee is generally 15% to 20% of the total return to investors above, say, 5%. The point here is that the CPEF does not achieve a major payout until it successfully exits an investment. The objectives of the CPEF (or GP), in other words, is closely aligned with the objectives of LP investors.
IPEF can be distinguished from CPEF in several ways, such as investment techniques excluding the use of conventional debt for buyouts or conventional project debt (although Islamic credit facilities can and are substituted for conventional debt). One substantial difference is the inclusion of a Shariah supervisory board (SSB), one of whose several functions is to list eliminating criteria used for short listing target companies.
Understanding the conventional private equity model helps us understand the modifications of this model used by GFH. In general, GFH pioneered in the GCC region the addition of a large upfront fee, a relatively large amount of money at the time GFH made its private equity investment on behalf of LP investors. This is unique and, to our knowledge, unprecedented in the private equity industry anywhere.
GFH would normally find a target investment, most often a greenfield real estate project but also companies or pools of real estate in Europe or North America. It was then taken under GFH’s control, either through direct acquisition of the asset on GFH’s balance sheet, or control of the project through an SPV created by GFH.
GFH would then create a fund offering memorandum and send its sales force out to meet LP investors. Happy with the investment prospectus the investors would then transfer money to GFH. A new SPV created by GFH, or the previous SPV, would then transfer majority ownership of the asset to the LP investors.
Until this point the process was in line with industry standards. However, it appears that GFH would charge a “premium“ to LP investors. Say, for example, GFH bought a mid-sized American company for US$10 per share. It would then sell a majority of its position to the LP investors for US$15 per share, making an immediate 50% profit on its investment. Sometimes this was done in an all-cash transaction, sometimes in a combination of cash and the “Income from receiving shares in companies in which the bank invested, in lieu of cash” (as stated in the accounts). This extra bonus became commonly known as the “premium”.
In effect, LP investors for real estate projects and other private equity investments were charged the exit fee, or performance fee, in advance, a pre-exit fee. The GFH model for charging the performance fee in advance became widely emulated throughout the GCC region, used by peer firms Arcapita, Addax, GBCorp and others. This was to our knowledge unique in the world industry of private equity. It seems to be an extremely profitable strategy as the GPs (GFH in our case) made enormous profits on an investment using LP money before a successful exit. Oddly enough, all of GFH’s investments with LPs also carried a performance fee, which would, if the investment was successful, truly deliver enormous profits to GFH.
This kind of lopsided fee structure was obscured in part because of the very favorable market conditions that existed during the boom years of late 2002 through 2007, when asset prices were inflating everywhere, but in particular in real estate. However, it would only take a modest crisis to expose the unequal application of GFH’s fees. With a recession and deflating asset values GFH would ultimately have to disclose substantial capital loss to its investors. And, that is precisely what has happened.
During the boom years GFH launched a series of private equity and real estate projects. In the table we can see the annual income from investment banking activities, which were by far the vast majority of revenue at GFH. Income is broken into two line items, cash and shares, both received as fees for GFH activities. Since GFH exited very few investments during this time period we can assume that nearly all the revenue was from buying assets, not managing or selling them. Interestingly, GFH chose to accept a large volume of revenue in the form of shares in the SPVs it created.
But GFH became highly exposed when the crisis hit. Its private equity business ground to a halt. Income from investment banking services collapsed, from a high of US$453 million in 2008 to a low of $49 million just the next year. Clearly, GFH was unable to sustain revenue in its core line of business. It was fully exposed to a single business line — private equity — and its revenue was dependent on LP investors continuing to accept the concept of the premium, which apparently they did not.
As one would predict, actual management fees were a small minority of GFH’s revenue model. The line item “Placement, arrangement & management fees“ was once as high as 12% of total revenue, but otherwise only in the mid to low single-digit percentage range. Clearly GFH was not a sustainable enterprise without constant deal flow and buying assets with LP investor money.
Implementing Murabahah with private equity
Our analysis shows that the GFH investment model implemented was not quite private equity. The form may be private equity but the substance was not. GFH was undoubtedly engaged in the purchase and sale of assets, although it appears the large majority of its revenue was from purchasing or acquiring assets with LP investor funds, not exiting investments.
Therefore, we like to theorize that GFH may have implemented a modified version of Murabahah in its private equity deals. A traditional Murabahah transaction under Shariah law must meet the conditions of a valid sale. Also, it is a requisite that the seller informs the buyer of the cost price of the subject matter and any additional cost and profit (which is pre-agreed) it is intends to charge.
The only difference in GFH’s Murabahah model was that it did not disclose the profits it was charging on the projects to LP investors but rather valued them in a way that included profits and sold them to the LP investors through a fund.
Hence, the pricing model used by GFH to price its deals can be linked to the type of model one would find in a Murabahah transaction. Indeed, this technique is flawed and its implication can be directly seen on the current financial condition of GFH.
MSc investment banking and Islamic finance
Email:
[email protected]
Email:
[email protected]
Email:
[email protected]