I OVERVIEW OF RECENT ACTIVITY
The asset management industry in Pakistan is dominated by open-ended retail mutual funds, which account for over 73 per cent of the total assets under management. Other asset management categories such as discretionary and non-discretionary portfolio management (13.5 per cent), real estate investment trusts (4.5 per cent), modarabas (which are similar to investment funds) (5.5 per cent), private equity funds (0.5 per cent) and pension funds (3 per cent) make the up the remainder of the industry.
Between July 2016 and July 2017, the asset management industry in Pakistan grew by around 30 per cent. However, between July 2017 to May 2018, the sector saw a much more modest increase of 5 per cent, primarily on account of the prevailing political uncertainty and resultant decline in the value of listed equities on the Pakistani Stock Exchange. Over the past eight years, starting from the beginning of this decade, the asset management industry has experienced an average annual growth rate of around 16 per cent per year. From June 2010 to May 2018, the total assets of non-banking finance companies (NBFCs) grew by over 220 per cent. The largest increase was seen in shariah-compliant funds, which experienced growth of 720 per cent, whereas conventional funds saw growth of over 150 per cent.2
As of May 2018, there are 21 asset management companies and investment advisory companies licensed by the Securities and Exchange Commission of Pakistan (SECP) that manage over 190 mutual funds. Of these, 10 asset managers are also licensed to manage pension funds. There are a total of 29 modarabas, five REIT management companies and only three domestically licensed private equity firms. The total size of the asset management industry in Pakistan is around 975 billion rupees. Given the size of Pakistan's economy (around US$300 billion), the asset management sector is quite small in relative terms, showing low penetration levels of asset management companies in the economy.
ii GENERAL INTRODUCTION TO REGULATORY FRAMEWORK
Asset managers in Pakistan are regulated by the SECP, which is a statutory independent body formed under the Securities and Exchange Commission of Pakistan Act, 1997.
The Securities Act, 2015 (Securities Act) regulates the provision of financial services such as acting as a securities manager or securities adviser, and the entities that provide such services. Under the Securities Act, the services provided by a 'securities manager' and 'securities adviser' constitute regulated activities, and entities providing such financial services are required to be licensed by the SECP. A 'securities manager' is defined as a person who manages a portfolio of securities belonging to another person, whether on a discretionary or non-discretionary basis. A 'securities adviser' is defined as a person that provides, inter alia, advice on investing and managing portfolios of securities for another person without holding the property of that person.
In Pakistan, asset management companies fall within a broader category of financial institutions generally known as 'non-banking finance companies'.3
As previously mentioned, modaraba companies are similar to investment funds, but they must invest their capital in a shariah-compliant manner. Modarabas are regulated under a separate law known as the Modaraba Companies and Modaraba (Floatation and Control) Ordinance, 1980 (Modaraba Ordinance).
The SECP has issued further detailed rules and regulations pursuant to Section 282 (A to N), which set out regulatory requirements for NBFCs. These additional rules and regulations include the following:
- NBFC (Establishment and Regulation) Rules 2003 (NBFC Rules);
- Non-Banking Finance Companies and Notified Entities Regulations, 2008 (NBFC Regulations);
- Private Funds Regulations, 2015 (Private Funds Regulations);
- Real Estate Investment Trust Regulations, 2015 (REIT Regulations); and
- Voluntary Pension System Rules, 2005 (VPF Rules).
Furthermore, where a fund is established as a unit trust, the declaration of trust and appointment of trustee is governed by the Trust Act 1882.
The NBFC Rules divide NBFC's into two categories: fund management NBFCs and lending NBFCs.6 A fund management NBFC means an NBFC licensed by the SECP to undertake:
- asset management services or REIT management service;
- pension fund scheme business;
- private equity and venture capital fund management services; or
- investment advisory services.
i Establishment and regulation of NBFCs
The NBFC Rules prescribe the manner of setting up an NBFC and set out their reporting and compliance requirements. An NBFC is licensed by the SECP and is required to renew its licence every three years. A company cannot be issued an NBFC licence if a similar category of licence is held by another group company. An NBFC may not alter its constitutional documents without the approval of the SECP.
The promoters, directors and chief executive of a proposed NBFC must also fulfil the fit and proper criteria laid out by the SECP. The promoters must be issued at least 25 per cent of the paid-up share capital, which shares must be held in a blocked account with the Central Depository Company, and such shares cannot be transferred without the approval of the SECP. The NBFC's chief executive cannot hold a similar position in any other company, except an investment company managed by the NBFC, and any change in the chief executive or the board must be approved by the SECP.
iii Reporting and accounting
An NBFC is required to maintain accurate and up-to-date accounts books, which shall represent a true and fair view of its affairs. and must be prepared in accordance with International Accounting Standards and audited by an auditing firm licensed by the SECP. The NBFC must also adhere to the requirement of submitting quarterly unaudited and annually audited financial statements to the SECP. The asset management company must also appoint an internal auditor, compliance officer and chief accounting officer having the minimum prescribed experience and qualifications. Furthermore, an NBFC is prohibited from removing any of its records or documents from Pakistan without the prior permission of the SECP.
An NBFC is required to obtain annual ratings from a credit rating agency registered with the SECP and publish such rating in its annual report and quarterly reports, as well as the annual and quarterly reports of any funds managed by it.7
v Change of control
A sale of a strategic investment, a sale of shares of a subsidiary or associated company, or any merger or acquisition of an NBFC, requires the prior approval of the SECP.
An NBFC must also comply with the applicable laws and directions relating to money laundering, terrorist financing and other unlawful activities.
The applicable rules and regulations regulate not only the asset manager but also require the fund vehicle itself to be registered with the SECP as a 'notified entity', which is thereafter regulated under the applicable regulatory regime.
iii COMMON ASSET MANAGEMENT STRUCTURES
Under the NBFC Rules, a fund management NBFC can be licensed by the SECP to undertake any of the following activities:
- asset management company services;
- real estate investment trust (REIT) management services;
- pension fund scheme business;
- private equity and venture capital fund management services; and
- investment advisory services.
These licensed activities are not categorised in any order of hierarchy, and a licensee must obtain a separate licence or approval to undertake each particular category of regulated activity.
Asset management services are defined as the business of providing services for the management of collective investment schemes. Investment advisory services mean the services provided for managing discretionary or non-discretionary portfolios for both individual and institutional clients, and include the business of advising others as to the value of securities, or as to the advisability of investing in, purchasing or selling of securities for remuneration. The other regulated activities listed above relate to each type of licence granted by the SECP and are further discussed below.
A collective investment scheme can either be a closed-end scheme or an open-ended scheme. A closed-end scheme is required to specify its maturity period, and must not continuously offer its units or certificates to investors. The holder of a certificate is entitled to receive a proportionate share of the net assets of the closed-end scheme. An open-ended scheme, on the other hand, can offer units based on net asset value on continuous basis without specifying any duration for redemption. The certificate entitles the holder of such units on demand to receive its proportionate share of the net assets of the scheme less any applicable charges on redemption or revocation.
Under the NBFC Regulations, an open-ended scheme can only be established as a unit trust, whereas a closed-end scheme can be established as an investment company as well as a unit trust. Private equity and venture capital funds, pension funds and RIETs are required to be structured as unit trusts. Unlike some other jurisdictions, Pakistan does not have a general partnership law, and accordingly it is not possible to establish a private equity or other fund using the general partnership framework.
In unit trust structures, the appointment of a trustee requires the SECP's prior approval. The trustee and the asset management company are required to be independent entities. A trustee can only be:
- a bank licensed in Pakistan that has a minimum AA- rating;
- a subsidiary of a scheduled bank;
- a foreign bank operating in Pakistan and operating as a trustee internationally;
- a central depository company registered with the SECP;
- an investment finance company that has a minimum AA- rating; or
- such other company as the SECP may specify.
Where a closed-end fund is set up as an investment company, it must take the corporate form of a public limited company. In this case, the asset management company must appoint an independent custodian to hold legal title to the fund assets and enter into an investment management agreement (IMA) with the fund entity (i.e., the investment company). The IMA shall be valid for a period not exceeding 10 years unless its renewal is approved by the shareholders at a general meeting.
iv MAIN SOURCES OF INVESTMENT
The SECP's website only makes sources of investment available for certain categories of funds. As noted above, mutual funds, and in particular open-ended funds, are the dominant category of funds operating in Pakistan.
Local investors are by far the largest source of investment into domestic mutual funds, with only 0.25 per cent of investment coming from foreign sources. Individual investors are the largest single group of investors into such mutual funds, collectively contributing around 32 per cent of investments. Domestic corporates account for around 25 per cent, followed by retirement funds (15 per cent) and fund of funds (8.5 per cent). The remainder is contributed by insurance companies (5 per cent), associated banks and development financial institutions (5 per cent), and other institutional investors.
There are only three domestic private equity funds licensed by the SECP thus far. There are also a number of foreign private equity funds that are active in the Pakistani market. The prominent ones include the three funds established by local or Pakistani-origin business groups in collaboration with the United States Agency for International Development (USAID).
Most private equity funds raise capital through their association with a local business group. Where they raise capital through direct contributions from high-net-worth individuals (HNWI), this is usually due to close business or familial relations with the business group operating the private equity fund. For tax reasons, as a general trend, most investors tend to invest into companies directly instead of using fund structures.
For foreign investors, the UAE and Mauritius tend to be the preferred jurisdictions for setting up offshore funds due to the double tax treaties between Pakistan and these countries.
v KEY TRENDS
The first set of reforms in Pakistan's asset management industry took place in the first decade of this millennium when the SECP introduced a number of new rules and regulations to modernise and regulate the sector. This included the introduction of the NBFC Rules, VPF Rules and NBFC Regulations. In addition, to promote the development of private equity and venture capital funds, new regulations were introduced in 2008 that have now been replaced by the Private Funds Regulations of 2015. In 2015, the SECP also introduced the REIT Regulations.
Pakistan's asset management industry is primarily inward-looking, with virtually no significant investments made by domestic asset managers outside the country, for which the State Bank of Pakistan's approval is required (for the remittance of foreign exchange).
The Pakistani market recently experienced a flurry of activity after a large private equity investor in the country, the UAE-based Abraaj Capital, applied for provisional liquidation and restructuring in the Cayman Islands. This has evinced interest from both domestic and international investors looking to snap up assets that will inevitably need to be sold off by the beleaguered fund.
Most investments by mutual funds in Pakistan tend to be focused on equities (42 per cent), government securities (20 per cent) and term deposits (22 per cent). The recent growth in the sector can be attributed primarily to the rise of Pakistan's stock market. However, as the stock market boom has now largely subsided, we can expect investments to be channelled into other asset classes.
vi SECTORAL REGULATION
i Asset management companies
An asset management licence entitles a manager to manage a collective investment scheme, which can be a closed-end fund or open-end scheme. The NBFC Regulations define a 'collective investment scheme' as a vehicle that enables investors' funds to be pooled together for investment in a 'portfolio of securities, or other financial assets for profits, income or other returns', and where the investors do not have day-to-day management control.
Funds that have been set up under the NBFC Rules as collective investment schemes are typically retail mutual funds. Such funds are required to comply with the prospectus and disclosure requirements under the NBFC Rules, NBFC Regulations and the Securities Act.
The vast majority of collective investment schemes in Pakistan are open-ended mutual funds that are set up as unit trusts. There are only four listed closed-end mutual funds currently established as investment companies.
Marketing and fundraising
The units or shares of a collective investment scheme may be offered for investment to the public and listed on a stock exchange in Pakistan. The shares of a closed-end fund that has been established as an investment company can also be listed (but not if it is established as a unit trust).
A public offer of securities is subject to the provisions of the Securities Act and the NBFC Regulations. These Regulations specify the required disclosures that must be made in the prospectus, which require the SECP's prior approval. The Securities Act contains provisions barring certain types of 'bad actors' from making a public offer of securities, which includes any person that has been declared a defaulter or who has been delisted for violating the listing regulations.
The NBFC Regulations set out detailed requirements and the information that is required to the disclosed in the prospectus or offering document. The prospectus must be signed by the fund's promoters.
In addition, prior to a public offer of the fund's units or shares, the fund must be registered with the SECP as a notified entity, and any public offer underwritten by an underwriter that is approved by the SECP.
Restrictions on investments
Generally, public funds are only entitled to invest in listed securities or tradeable debt instruments. A fund manager requires special permission to be eligible to make overseas investments on behalf of the scheme.
Fund management NBFCs are restricted from undertaking activities permitted to lending NBFCs, or to use the assets of a collective investment scheme to make a loan or advance money to any person. These prohibitions preclude mutual funds from undertaking direct lending activities, although they are not prohibited from investing in debt securities.
An asset management company is prohibited from investing the funds of a collective investment scheme that will vest the management or control of the investee company in the asset management company.
An asset management company can only manage a maximum of three investment funds, but it may be eligible to manage more than three funds subject to fulfilment of certain conditions, including demonstrating a good track record such as the minimum rating of the fund and for itself, and its compliance with the applicable laws.
Redemption, distribution and fees
The NBFC Regulations prescribe maximum limits on the management and other fees that a fund manager is entitled to charge. A collective investment scheme is mandated to distribute at least 90 per cent of its accounting income to the investors from sources other than capital gains and less any expenses. Where a collective investment scheme makes such distribution, it is exempt from any further corporate income tax.
The VPF Rules regulate pension funds and pension fund managers. A pension fund manager under the VPF Rules must either be an asset management company or a life insurance company.
Pension fund schemes in Pakistan may only be structured as a unit trust, and must consist of an equity sub-fund, a debt sub-fund, a money market sub-fund or any other sub-fund allowed by the SECP.
Under the VPF Rules, only Pakistani nationals over the age of 18 are eligible to contribute to and participate in pension funds. The retirement age for participants in a pension fund is any age between 60 and 70, or 25 years since the age of first contribution to a pension fund, whichever is earlier. The age of retirement may be reached in the event of the participant suffering serious physical debilitation or disabilities.
The VPF Rules specify the mandatory benefits that must be paid to participants on retirement. Pension fund managers are restricted from merging, acquiring to taking over management of another pension fund without prior approval from the SECP. Pension fund managers are also prohibited from accepting deposits from other pension funds.
iii Real property
Real estate management companies (RMCs) are regulated by the SECP under the REIT Regulations. These Regulations apply in addition to the NBFC Rules and NBFC Regulations. An RMC is authorised to undertake REIT management services, which are services for the management of a REIT scheme. A REIT scheme must be established as a closed-end fund registered under the REIT Regulations, which is permitted to invest in a single real estate project. The REIT Regulations require a REIT scheme to be listed.
Under the REIT Regulations, there can be two types of REIT funds established to invest in real estate assets: a rental REIT scheme and a development REIT scheme. As the names suggest, a rental REIT is established to invest in industrial, commercial or residential real estate with the purpose of generating rental income. A development REIT is intended to invest in real estate to develop, construct or refurnish such real estate for industrial, commercial or residential purposes.
An RMC cannot offer units of a REIT scheme for subscription to the public unless it has obtained SECP approval. For such approval, an RMC is required, inter alia, to ensure that the real estate is free from all encumbrances, including outstanding debts. The REIT Regulations require RMCs to pay dividends in cash or in the form of bonus units.
An RMC requires the prior approval of the SECP to transfer proposed real estate under the REIT scheme in its management. Furthermore, the real estate must be located within the territorial limits of certain specified cities in Pakistan.8
Although the investment policy of a REIT scheme is restricted to real estate, a REIT scheme is allowed invest any surplus funds in government securities or deposit such funds with a scheduled commercial bank.
iv Private equity
Private funds are governed by the Private Funds Regulations, which sub-divides private funds into two categories: private equity or venture capital funds, and alternative funds.
A private fund is only permitted to be established as a closed end-fund and structured as a unit trust. A private fund is permitted to invest in securities only, limited to the following categories: unlisted companies, listed companies or companies listed on the SME Board if the objective of the investment is to 'turn around' such company; or unlisted companies with the objective of expand their business.
In general, the requirements set out in the NBFC Rules and the NBFC Regulations would apply to private funds and alternative funds to the extent they are not in conflict with the Private Funds Regulations.
Marketing and fundraising
The Private Funds Regulations prohibit a private fund manager from soliciting investments from the public or listing the units of a private fund on a stock exchange. The investments in the private fund must be limited to a maximum of 30 investors who qualify as 'eligible investors'. To be an eligible investor, a person has to offer a minimum investment of 3 million rupees and provide a written confirmation of their understanding of the investment risks. Other than the 'eligible investor' exemption, there are no other safe harbours pursuant to which funds can be offered to sophisticated or institutional investors.
The category of eligible investors is intended to capture qualified institutional buyers, HNWI or sophisticated investors, and exclude retail investors. The criteria for determining eligible investors requires the fund manager to obtain written confirmation from the investor, which ironically may only be possible once the fund has already been marketed to such person.
The Private Funds Regulations set out the minimum disclosures required to be made in the private placement memorandum for a private fund. This includes prescribed language for warnings that must be clearly displayed in the private placement memorandum.
The Private Funds Regulations do not prescribe any specific requirements relating to the management of a private fund. However, when granting approval to the fund manager and when registering the private fund, the SECP will ensure that the fund manager has adequate resources and qualified personnel to be able to undertake the regulated activity of managing a private fund.
Restrictions on investment
Private fund managers are entitled to invest in securities outside Pakistan subject to compliance with the applicable regulatory requirements, which would include gaining permission from the State Bank of Pakistan to allow investment capital to be remitted abroad.
Any change in investment objectives of a private fund require supermajority approval from investors, and an updated private placement memorandum must be submitted to the SECP. Investments with connected persons can only be made on an arm's-length basis and are subject to adequate disclosures.
There is no exemption under the Securities Act or other applicable regulations that allows a foreign sponsor or promoter to register itself, or a foreign offering of securities within Pakistan, with the SECP.
Most foreign private equity fund managers prefer to invest into Pakistan through offshore funds based primarily in the UAE and Mauritius.
The rules and regulations governing NBFCs do not envisage a domestic fund manager managing or operating a foreign fund; nor is it possible for a foreign fund manager to operate and manage a domestic fund in Pakistan.
v Hedge funds
The Private Funds Regulations also regulate what are known as 'alternative funds'. To date, there are no alternative funds registered in Pakistan. An alternative fund is a fund other than a private equity or venture capital fund that is permitted to use leverage or invest in derivates. This category of funds is intended to capture what are commonly known as hedge funds.
An alternative fund can be established in the form of a unit trust only.
Alternative funds are required to disclose in their offering documents details of the derivatives, leverage or other proprietary investment strategies used by them. Such funds are required to demonstrate to the SECP that they have the required expertise for the use of their specific investment strategies, including the use of derivatives.
vi Modaraba companies
In general, a modaraba is an arrangement in which the investor entrusts money to a financial manager who invests the capital on behalf of the investor. Any profits or losses will be shared between them in an agreed manner, whereas the financial manager is also entitled to charge certain management fees for its services.
Under the Modaraba Ordinance, modarabas have separate legal personality, and are entitled to sue and be sued in their own name through the modaraba company. The assets and liabilities of each modaraba must be separate and distinct from those of another modaraba, and also from those of the modaraba company.
The Modaraba Ordinance envisions two types of modarabas: specific purpose modarabas and multi-purpose modarabas. A modaraba can last either for a fixed period or for an indefinite period. Modaraba businesses cannot operate in contravention of the injunctions of Islam, and for this purpose, every modaraba company has to be certified by the religious board constituted under the Modaraba Ordinance. Modaraba Ordinance allows modaraba companies to receive remuneration in the form a fixed percentage of the net annual profits of the modaraba; however, such percentage is capped at a maximum of 10 per cent.
vii TAX LAW
Under the Income Tax Ordinance 2001, any income earned by a mutual fund, so long as not less than 90 per cent of its units at the end of a year are held by the public and not less than 90 per cent of its income of that year is distributed among the unitholders, is exempt from taxation.
Further, under the Income Tax Ordinance 2001, capital gains tax on sales of shares or assets by a private limited company to a private equity and venture capital fund has been capped at 10 per cent. By comparison, capital gains tax of 20 per cent would apply on a sale of shares to a foreign private equity fund. This amendment was introduced in 2007 to encourage the registration of domestic funds by giving them a tax advantage over foreign funds.
For foreign funds registered in Mauritius or the UAE, the capital gains tax is capped at 10 per cent under Pakistan's double tax treaties with both countries. The tax incentive offered to domestic funds at the time of acquisition is likely to be wiped out when the domestic fund liquidates the investment, at which time it would have to pay capital gains tax at a rate of 15 per cent as compared to the 10 per cent capital gains tax applicable under the double tax treaties with Mauritius and the UAE. In addition, dividends payable under these double tax treaties are also capped at 10 per cent, whereas varying rates of withholding tax ranging between 10 to 25 per cent would apply to dividends paid out to domestic investors by local collective investment schemes and private equity funds.
Although the SECP has tried to jump-start the sector through legislative reforms, Pakistan's asset management industry remains relatively miniscule (at US$8 billion) compared with the size of its own economy as well as in comparison with the global asset management industry (which is estimated to be over US$150 trillion). Despite recent and past legislative enactments, the industry lacks depth due to lack of corporatisation and formalisation of the economy, which translates into a dearth of investible assets.
The SECP, however, remains committed to introducing further reforms with the assistance of international agencies such as USAID in order to improve its own understanding of the industry and to help further develop and grow the sector. The recent tax amnesty, coupled with the government's push to widen the tax net, is likely to act as a boon for the sector.
Despite challenges, the sector has seen double digit growth over the past decade, and as the economy grows, the asset management industry is likely to experience further expansion and play an increasingly important role in channelling capital towards productive assets in the economy.
1 Haroon Jan Baryalay and Mian Tariq Hassan are partners at Axis Law Chambers.
2 Source: SECP Monthly Sector Summary May 2018.
3 In addition to asset management companies, etc., NBFCs also include investment banks and investment finance companies, leasing companies and microfinance banks.
4 This Section remains in force despite the repeal of the remaining provisions of the Companies Ordinance.
5 The Companies Ordinance has been repealed by the Companies Act, 2017 (Act XIX of 1997).
6 A lending NBFC is one that is to undertake leasing or housing finance services, or investment finance services or discounting services.
7 Currently, there are two rating agencies licensed by the SECP, namely the JCR-VIS and Pakistan Credit Rating Agency.
8 So far, this is limited to Islamabad, Rawalpindi, Karachi, Lahore, Peshawar and Quetta, or any other city approved by the SECP.