As rumors swirled last May that state-linked conglomerate Dubai World was in talks to sell a minority stake in DP World, one of the world’s largest port operators, to private equity (PE) firm Abraaj Capital, some fund managers got excited about the possibility of Dubai Inc. relinquishing more pieces of its crown jewels. The sale of myriad assets from struggling businesses would offer cheap investments and revive an industry that has shrunk dramatically. But neither a deal nor the fund managers’ aspirations ever materialized.
The total value of funds raised in the Middle East and North Africa (MENA) region in 2009 plummeted 80% to US$1.1 billion from US$5.4 billion the previous year, according to the annual report from Gulf Venture Capital Association (GVCA), a Bahrain-based nonprofit. The number of deals struck also fell over that period, to 19, and were worth US$561 million, compared with 55 worth US$2.7 billion in 2008.
Until 2007, the region’s nascent PE industry was soaring high on the back of robust oil prices, the capital markets boom, regional economic liberalization and investors keen to try PE investment. As investment banks, financial firms and other companies jumped on the PE bandwagon, valuations of investments soared and grew into asset bubbles that have yet to burst completely, according to some fund managers and analysts.
"People are still thinking things are going to go back to normal and they are going to fly in the region at least; the people who are investing are not so sure," says Imad Ghandour, chairman of GVCA’s information and statistics committee and executive director of PE firm Gulf Capital. "It is a matter of trust. There is enough available liquidity to show some deals are being done."
Cash Now Scarce
Liquidity — or the so-called PE dry powder, referring to uncalled capital in the MENA region — is estimated to be about US$10 billion. Not everyone agrees who is to blame for the paucity of deals. According to a GVCA survey of 25 PE houses in the region conducted in May, 56% of the respondents agreed that higher valuations contributed to a lower deal flow in 2009, while 64% cited investor inability to meet capital calls. Others talked about lack of financing.
Investors shirking capital calls have left fund managers in a quandary. "It is a Catch-22 for many managers," notes Yahya Jalil, director of PE at The National Investor, an investment firm in the United Arab Emirates (UAE). "Over the last two years, liquidity was very scarce and many managers found a good deal but couldn’t call capital for funds nearing the end of their life."
The uncertainty around the level of investment capital is expected to change the shape of the region’s PE industry. Some funds are likely to be extended, cancelled or reduced. Abraaj Capital cut the initial target size of its buyout fund, ABOF IV, to US$2 billion from US$4 billion, while UBS Global Asset Management and UAE-based Invest AD, formerly Abu Dhabi Investment Company, said they had cancelled a joint infrastructure fund that raised US$250 million this year. The liquidity crunch has also meant that many funds are unlikely to close, making it difficult for several PE houses to raise new funds. Of the US$32.6 billion announced between 2005 and 2008, US$14.7 billion, or 45%, have not been raised to date, according to the GVCA report.
The scarcity of cash is not the only reason for lackluster deal-making. Sellers seem to be suffering from "deal fatigue" due to stricter post-financial crisis due diligence required by PE firms. "Sellers get surprised by how much they need to do to get the data room ready for due diligence and then they get exhausted by the whole process," says The National Investor’s Jalil. "During the boom times, the due diligence period was shortened and businesses were coming to buyers with little preparation."
The region’s legal framework and court systems haven’t helped the industry. Fund managers complain about problems in enforcing contracts and taking control of assets in times of trouble, especially since the majority of the region’s funds usually hold minority stakes in businesses. Many family businesses in the region are generally reluctant to relinquish control to investors. Often local foreign ownership restrictions prohibit investors from acquiring a majority stake. The region’s archaic corporate laws, vague bankruptcy rules and fledgling court systems will need an overhaul to help the PE industry regain faith in doing business, experts say. "[Companies] are in distress, but given the legal system, they are not forced to liquidate. There are so many cases of huge debt and the banks banging on their doors … can’t do anything," GVCA’s Ghandour points out.
The change of attitude whipping through the region’s PE sector is not surprising, having grown so rapidly. The total value of funds raised in 2007 reached an all-time high of US$6.4 billion, according to the GVCA. The growth was so fast that PE funds were multiplying more quickly than deals. "People overestimated the size and maturity of the PE market in the region. Firms entered [the market] in a short time frame. There was clear overshooting," according to Ahmed Youssef, a vice president at Booz & Company in Dubai. "While the hundred or so PE firms seem to have survived the shakeout, many of them will unlikely exist in the next few years, at least not in their current form. The number of transactions doesn’t justify these firms to exist as pure PE firms."
The PE fever was so high that several firms snapped up companies in the hopes of spinning them off quickly in initial public offerings or reselling them to take advantage of local investor desire for speedy returns. Investor interest in PE was entwined with the resurgence of the region’s capital markets, where initial public offerings (IPOs) were often oversubscribed hundreds of times. "Everybody wanted to do an IPO and there was huge demand. Even some funds were labeled pre-IPO funds," says the GVCA’s Ghandour.
Not all firms let themselves get sucked into the boom. U.S. PE firm The Carlyle Group opened an office in Dubai in 2007, but didn’t announce any deals in the Gulf region until this year. "At the time, the investment environment was challenging," notes Firas Nasir, managing director of Carlyle’s Dubai office, which covers the Gulf and Levant regions. "Valuations were speculative, driven by a frenzy of investment activity by regional shops and an overestimation of the market opportunity by some business owners. It was not a good time in the cycle and we held back."
This year, Carlyle acquired a 30% stake in Saudi Arabia’s General Lighting Company, the third investment for its US$500 million MENA fund, the company’s first fund for the region. The fund has also invested in two businesses in Turkey. Carlyle, in which the Abu Dhabi government’s premiere investment firm Mubadala Development Company holds a 7.5% stake, hopes to close two or three deals over the next 12 months, Nasir says. "International companies are more active in the Middle East than five years ago as they’ve begun to appreciate the region’s potential and view it as high growth market."
Carlyle isn’t the only company that sees an opportunity in the region’s PE slump. Fund managers and analysts say the crisis will weed out the good from the bad and highlight the need for more scrutiny of investments as the industry demands more due diligence, less risky assets and more long-term strategies.
The industry has already started to exhibit signs of a turnaround. Funds raised a total of US$1 billion in the first quarter of 2010, nearly the equivalent amount raised in all of 2009, according to the GVCA report. Banks are lending again and regional firms are looking at raising smaller funds for smaller deals. With the IPO market clogged and meager sales of investments, more PE firms have turned to growing their existing portfolio of companies. The restructuring of Dubai’s debt-laden state-linked conglomerates could also provide potential deals, but not many investors are holding their breath since the Dubai government may not have the heart to let go of its holdings.
PE firms are also shifting their focus from the pre-crisis rage of buyout and pre-IPO funds to more growth and infrastructure investments tied to MENA’s changing economic and demographic dynamics. About two-thirds of PE firms participating in a survey conducted by Booz and INSEAD in April said their limited partners wanted more funds taking advantage of macroeconomic trends by employing "theme-based" investing. "We are likely to see more transactions that are long term and tied to specific growth themes: A growing, wealthy young population, development of hard and soft infrastructure, and so on,’ according to Booz’s Youssef.
Indeed, the region’s expanding younger generation, growing number of private-public partnerships, succession issues with family businesses and heavy government spending on health care, education and infrastructure will sculpt a different PE industry with an eye on transactions related to consumption versus investment, experts say. Saudi jewelry maker L’azurde is a case in point. Set up in 1980, it sold a 70% stake in 2009 for US$275 million to a consortium that included The National Investor, Saudi Arabia’s Eastgate Capital Group and Bahrain-based Investcorp, the former owner of Gucci and Tiffany.
The sale, which was the biggest announced PE transaction in MENA in 2009, according to the GVCA, signified PE interest in the consumer sector and the growing trend of a family selling a business. Family businesses, the main source of deals in the region, are expected to change tack as they grapple with succession issues, in addition to the weaker and pricier appetite among banks to carry on with ‘name lending’ — that is, a tradition in the region of using the power of personal connections to secure case. ‘Before the crisis, networks and connections used to open doors and get you transactions," Booz’s Youssef notes. "Now they just open doors."