Lebanon is being blessed with another proposed law, and several serious voices are intonating praise of the type of a minor doxology to the deities of capital. The new private equity draft law is designed to boost the – currently lacking – ability of fund operators to incorporate commercial entities that are best suited as establishments offering private equity and venture capital avenues. These establishments have hitherto been forced to function with difficulty because they had to rely on holding companies or other conventional formats instead of incorporation as firms with a general partner/limited partner structure.
Mohamed Alem, managing partner of the law firm Alem & Associates in Beirut, explains to Executive how and why his firm has approached the project of drafting the law. “Lebanon is not known to have an infrastructure on the legal level that encourages the creation of Lebanon-based private equity funds,” he says. “The purpose [of introducing the law] is to allow room in Lebanese legislation to permit the structuring of private equity funds, which are typically funds structures, obviously companies, in which you have a general partner and limited partners.”
According to Alem, Lebanon’s dated Code of Commerce, or legal framework for corporations and businesses offering the well-known société anonyme Libanais (sal) or société à responsabilité limitée (sarl) company forms, is not optimally suited to the tasks of giving investors enough minority shareholder protection, the fund managers the flexibility to make decisions, and provide the whole corporate structure with what he describes as “tax transparency”. This is an extremely important issue to address, he says, as for companies using the private equity funds structure “there should be no penalization from a tax point of view.”
Whereas the common formats of incorporation such as sal and sarl according to the central bank both limit shareholder liability to their capital contribution, they also give shareholders duties and rights that allow them to influence corporate decisions on the board level. Converse to that, the European continental format of the société en commandite simple (known as SECS or SCS in francophone countries and as KG in German speaking ones) distinguishes two classes of participants in the company, which according to Alem corresponds to the general partner/limited partner structure commonly used by private equity companies.
In private equity (PE) parlance, the general partner (GP) of a fund is the decision maker regarding the investments and manager of day-to-day operations. The limited partners (LPs), on the other hand, supply the fund with its ammunition – the cash needed for investments – and have certain expectations, namely to make a healthy return on their money.
The law is being commissioned by the Office of the President of the Council of Ministers – the prime minister’s bureau. The main driver behind the initiative is Lebanon for Entrepreneurs (LFE), a nonprofit organization that was established in 2013 and that, in the words of its managing director Abdallah Jabbour, supports legal reform and other measures that would be beneficial to the business community, with special emphasis on entrepreneurs and members of the Lebanese diaspora. “We started with 16 laws on our list in 2014, three of which we were able to pass successfully. We have been drafting several laws in conjunction with the prime minister’s office and advocating for adoption of some laws that have been sitting in various drawers,” Jabbour says.
The Lebanese private equity draft law will benefit the country’s economic community and more specifically, the group of financial actors that spend their time with the structuring and operations of private equity and venture capital funds. This funds industry is a highly skilled and specialized profession, with a handful of practitioners who contribute to wealth creation – firstly their own.
Confidence in confidence
What makes this a macro-economically interesting discussion is the disproportionately large growth of entrepreneurial companies that are taken forward by PE and VC funds. This is also the argument of Firas Safieddine, executive board member of the Capital Markets Authority. “As regulator we believe that the private equity law is a requirement to complete the ecosystem as regards to equity and capital markets,” he tells Executive.
Under this mandate, the CMA became a stakeholder in reviewing and assessing the draft law, which according to Safieddine was “beautifully written” but would need a further round of drafting and review. He expects that the law, once it is passed, would deliver a component to make the Lebanese scene more inviting for investors.
[pullquote]Firas Safeddine, executive board member of the Capital Markets Authority, expects that the law, once it is passed, would deliver a component to make the Lebanese scene more inviting for investors.[/pullquote]
He also admits that it is an “ambitious undertaking” to attract investment funds to base their operation in Lebanon, but chooses to see the cup as having room. “Optimistically, the private equity law is a major step forward in terms of creating more confidence in the market,” he says.
Building the ecosystem from a legal point of view will not only require the PE law but “many laws that need to be addressed and attended to,” he says, naming the bankruptcy law as an example for other needed legislations.
Since Lebanon does not have a setup where such funds could be incorporated, the law would close this gap, and the CMA would further contribute to building trust and developing capital markets. “We will be proving very soon that the CMA is a major source of confidence,” he states.
Safieddine’s belief extends beyond the PE law into a trust of being able to remedy a more fundamental disequilibrium: as general agreement goes, banking dwarves the financial markets, and he emphasizes that capital markets are so tiny in Lebanon that they are “negligible”. That needs to change and he points to the case of the United States’ post-recession recovery after 2008/9 as an indicator that equity-based economies recover more quickly from economic weaknesses. “We are heading towards shifting our economy from a debt-based banking reliant economy towards capital markets, an equity-based economy.”
Whereas Safieddine claims to have read studies that show how equity markets and growth of GDP are correlated one-to-one, the story according to other studies is more complicated and it is an open question if debt or equity are suitable as magic keys for economic growth. Post the Great Recession, academic opinions and empirical indications are against one-key solutions and more tending towards combinations, meaning that the financial secrets to best-possible growth scenarios will likely be different for different countries and economies.
The Bank for International Settlements (BIS) indicated as much in a research paper two years ago, finding wide diversity. “First, financial structure differs considerably between countries. The relative importance of banking ranges from less than 20% in the United States to over 60% in Austria, Hungary and New Zealand. Second, financial structure is not static. Market-based intermediation has gained ground over the past two decades,” it said in a paper published in March 2014.
Noting that market-based financial intermediation tends to increase as per-capita GDP rises, the BIS paper found that some industries in emerging markets tend to benefit from capital markets while others – like small firms and sectors with tangible and transferable capital (such as agriculture), as well as those where output is easier to pledge as collateral (such as construction), are more amenable to bank debt finance.
[pullquote]Recessions in countries with bank-oriented systems are three times more severe than in those with a market-oriented financial structure[/pullquote]
“The results of this paper confirm the widely accepted view that both banks and markets are very important for economic growth,” it said. “We also find that banks provide services which differ from those offered by financial markets and that such services prove to be particularly beneficial for less developed countries […] Finally, our evidence suggests that banks and markets differ considerably in their moderating effects on business cycle fluctuations. Banks are more likely to supply loans during a ‘normal’ downturn, thus smoothing the impact of the recession. But their shock-absorbing capacity is impaired when the downturn is associated with a financial crisis. In this case, recessions in countries with bank-oriented systems are three times more severe than in those with a market-oriented financial structure.”
A few hurdles yet to clear
Given the near two decade-long dormancy of the Beirut Stock Exchange in combination with the dominant role of bank debt in the domestic market, plus the inertia in the political and legislative class, it seems moot to debate whether the Lebanese migration toward capital markets will be a “shift” with rapidity, as the CMA’s Safieddine contends, or slow and gradual, or even more hesitant and not actually tangible, as some economists suspect. But the drafting of the PE law has already been remarkable, says Alem. Besides helping local companies, which previously had no choice but to take on debt, to tap into capital markets, the law in future “can attract foreign private equity managers to base themselves in Lebanon because of the modern legal framework,” he says.
The draft law for private equity was accomplished by a team at Alem & Associates that comprised two partners and two associates. By researching existing laws in Luxembourg and France and by adapting the draft from suitable European codes – a job that required about 240 hours of legal research and writing and was supported by three PE companies as sponsors which LFE could mobilize – the team developed a draft law that is at the forefront of such legislation for the entire Middle East and writs forth the pioneering business legislation in the same tradition by which Lebanon introduced the offshore corporate structure in 1983, Alem says.
LFE’s Jabbour agrees, emphasizing there is “no modern law for private equity funds in any country of the Middle East. If our law passes, it will be the most modern one in the region.” According to him, adopting such a law comes with positive implications not only for tech-oriented funds and investors in the knowledge economy but also for real estate funds and any area where separation of investors and managers of funds is desirable.
He acknowledges the pitfalls of acceptance by Parliament, such as the fact that no law of any sort is passed when the assembly does not gather. But once that barrier is removed, the private equity draft law stands a good chance of being adopted, he says. “Usually, passing a law faces little opposition when it does not affect the vested interests of politicians or groups,” he reasons. A combination of proper advocacy (he doesn’t like to use the word ‘lobbying’) and the absence of vested interests will help the draft pass into law at one (not yet determined) point, he hopes.
“We need a law that is flexible, that follows global standards and makes any investor feel comfortable,” he emphasizes.