Business is largely a family affair throughout the Middle East and North Africa (MENA) region. Operating successfully in this environment requires private equity (PE) firms to master the art of making family owners comfortable with selling a stake in their enterprises and working with new partners.
“This is how you get the deals,” says Fadi Arbid, CEO of Amwal AlKhaleej, a leading Middle East-focused private equity and alternative investment firm and the first to be headquartered in Saudi Arabia. “The families come directly to the fund or its local LPs (limited partners) rather than through an investment bank.” It also is common for limited partners to come forward with proposed transactions, he says.
Making deals is far easier for locally based firms with established contacts and limited partners who are known and respected by attractive deal prospects. Deals are often proprietary — made directly between firms and companies without intermediaries — and based on knowledge and contacts within the market, says Hani Ashkar, partner at PricewaterhouseCoopers in Riyadh, the Saudi Arabian capital. “If you are not based in the kingdom, it is difficult to get early sight on deals.”
This reliance on family and personal ties is typical of emerging markets in contrast to more developed ones. “In Europe and the U.S., most deals are intermediated by investment banks,” says Stephen M. Sammut, a senior fellow and lecturer on entrepreneurship at Wharton Entrepreneurial Programs. “In many emerging markets, however, there is still proprietary deal flow, and funds are fewer in number and particular to a country,” he says. “In the Middle East, PE derives from Middle East sources.” That stands in contrast with some other emerging markets. In India, for example, most PE investments are sourced from outside the region.
Structuring the Deal
The diamonds in the rough that PE firms hunt for are family businesses that have yet to reach their full potential and are looking for help to unlock value. A typical PE play in Saudi Arabia might be to find a family business that wants to expand and provide it with the capital, financial expertise and cross-border contacts to do so.
Well-connected firms can approach deals from several directions. Another strategy is to find a family conglomerate and sell off an underperforming business and work with the owner to extract value from the remaining assets. Still another way is to pick out three or four companies and bolt them together to create economies of scale or perform a value chain integration, whether vertical or horizontal.
PE firms can bring expertise to even the most well-established companies, says Amwal senior vice president Hani Halawani. Firms can tap into their international networks and introduce acquired companies to new markets and prospective acquisitions of their own, for example. That was the case when Amwal used its local knowledge and business network to help Damas, its United Arab Emirates (UAE)-based jewelry company, expand into the Saudi market.
Amwal was set up in Riyadh in 2004 by a group of regional investors who have helped the firm build its pipeline in the initial stages. Amwal now has offices in Dubai and Cairo and has positioned itself as an experienced regional alternative assets investor with an indigenous team and a proven track record.
The home-grown Middle East PE industry is still young, having emerged only in the last 10 years and the vast majority of funds were established in just the last five years. More generally, the Middle East saw less than 2% of emerging-market PE investments in 2001, according to a survey by Booz & Co. and INSEAD. By 2008, the Middle East share of such investments had jumped to 10%.
That rapid growth slowed sharply during the 2009 global recession. Middle East PE funds raised just US$1.1 billion in 2009, marking an 80% drop from the US$5.4 billion that had flowed into funds in 2008. But despite the recent rounds of turmoil in the Arab world, the region could now be poised for a comeback for alternative investments including PE as investors see growth in emerging markets. “If you put aside the volatility, the trend is in favor of emerging markets and is not likely to reverse abruptly,” says Wharton’s Sammut.
Deals Remain Scarce
Deals themselves remain scarce, however. “The region doesn’t suffer from lack of capital,” notes N. Bulent Gultekin, a professor of finance at Wharton and a former central bank governor of Turkey. “It is a structural issue that companies are not usually for sale.”
This is true despite the fact that bank lending virtually dried up during the recession, forcing family-owned companies to look elsewhere for funds. But instead of taking in partners, the companies turned to friends and family to meet short-term cash needs.
The lack of bank financing has thus failed to produce a slew of PE investment opportunities. In 2009, “there were few deals and very few distressed deals if any,” says Amwal CEO Arbid. “The market thought that after the crisis we would see a lot of turn-around transactions, but we haven’t seen it. Businesses need finance but valuations are not what they [the business owners] want them to be,” he adds. “It’s not the case that family businesses are keener now to talk to a PE investor. If, as a fund, you want to take a controlling stake, you need to overpay.”
Indeed, the gap between seller and buyer price expectations that widened at the outset of the recession persists. Business owners have been slow to adjust to new market realities and PE firms remain wary of a further dip in asset values. “The biggest issue has been the disconnect in valuations,” says Bassam Yammine, managing director and co-chief executive officer of Credit Suisse in the Middle East. “Sellers need to be realistic and realize that the valuations achieved at the peak of the market will not come back” anytime soon, he says. “It’s also surprising that you don’t see more distressed [sales]. Most businesses are family-owned and there is sentimental value. It is going to take a few PE successes to change their minds.”
Families with succession issues could give PE firms a friendlier welcome. This appears increasingly likely as a wave of generational changeovers gets under way in the region, making family businesses more open to help from investors.
To get a foot in the door, funds have typically had to acquiesce to an owner-manager’s unwillingness to give up control. Nearly three quarters of all PE deals in the region in 2008 were for stakes of 49% or less, according to the Gulf Venture Capital Association (GVCA).
Keeping the business founder on board with his networks and industry knowledge can bring substantial benefits, especially in markets that are powered by contacts and reputation, and that have a shortage of managerial talent. Family participation continues to be needed after the entry of the PE firm, “since in many cases management and ownership are intertwined,” says Amwal’s Halawani.
This marks another contrast between emerging markets like the Middle East and more developed economies. “It remains the preference of many of these families [in emerging countries] to maintain total control,” says Wharton’s Sammut. “Generally, we don’t see the same in the West. By now, you would have thought that there would be a trend [among families] to be more comfortable selling their positions, but that doesn’t seem to have happened.”
However, a minority stake is not necessarily a passive position, says Arbid, who notes that funds can still be deeply involved in creating value. Among other things, they can identify new markets, optimize the company’s capital structure, advise on mergers and acquisitions and act as a conduit to bring in state-of-the-art management talent.
Tale of Two Markets
Egypt and Saudi Arabia, the two markets with the most investment potential, take different approaches to dealing with PE investors — and Egypt is seen as the far easier place to do business. PE funds and advisers generally agree that taking a small and passive minority stake can be particularly risky in Saudi Arabia, and the downside can outweigh the advantages. The days of acquiring modest positions, riding rising asset prices and flipping the investment to generate impressive returns are clearly over. Investors point out that Saudi Arabian corporate law remains under development and offers little protection for minority stakeholders. “If you only have a minority stake, then the extent of the change you can instigate is limited,’ says Ashkar of PricewaterhouseCoopers.
This makes choosing a good local partner crucial. PE firms conduct careful reputational checks and legal due diligence prior to buying a stake in a Saudi company, and often insist on representation on the boards and executive and audit committees of their portfolio companies. In addition, a firm with its own sources of business intelligence can provide comfort to limited partners that may be jittery about the investment environment.
PE firms are now starting to adopt new strategies for Saudi investments. “The traditional model of minority interest hasn’t allowed investors to drive up value in their portfolio companies,” says Ashkar. “The recent trend over the past 18 months is for a majority stake,” he notes, “or at least the ability to have the final say on the key strategic and operational decisions.” Yet garnering a majority interest is easier said than done. Evidence still shows very few, if any, majority PE deals reaching completion, according to Amwal experts. Even the Carlyle Group, which typically specializes in majority buy-outs, had to adjust to the region’s preferences and closed a minority deal in Saudi Arabia after the financial crisis in 2010.
Egypt’s corporate legal environment is based on English law and is seen as more predictable than Saudi Arabia’s. “In Egypt, there is a long history of legal interpretation and the courts are more developed,” says Amwal’s Halawani. “A legal document is much more enforceable.” It’s also easier to make larger investments in Egypt, he says, and target companies are more educated about the benefits of taking on a PE investor.
Credit is also easier to obtain in Egypt since its banks are among the most familiar in the region with PE deals and have a history of financing them. By contrast, “non-recourse acquisition financing is almost impossible in Saudi unless there is a large sponsor,” says Halawani, referring to loans that are repaid from the cash flow of a project. In Egypt, “leverage is not impossible. Banks know how to do it and there are more exotic transactions. You see PE deals in Egypt include LBOs [leveraged buyouts], takeovers, management buyouts, minority investments and private placements. And that’s a feature of a more mature PE market.”
Leveraged financing has been far less prevalent in the region as a whole than in the United States and Europe. “As a consequence, the [global financial] downturn has had a much more profound impact in the United States” than in the Middle East, says Wharton’s Sammut, because the nature of the deals is different. “In the Gulf, local money has been an important source of capital and will continue to be so.”
Investors that have used debt to finance PE deals have usually been international funds that have borrowed from outside the region. While local financing was easier before the global credit crunch, banks with liquidity have begun to participate in more PE transactions, says Yammine of Credit Suisse, and several mezzanine funds are starting up in the region. Mezzanine financing, a hybrid of equity and debt, gives lenders the right to an ownership stake if the debt is not repaid on time.
This Way to the Exit
Few PE firms have cashed out of Middle East investments to date, since deals are still relatively young in the region. Of the 218 investments made by regional PE funds since 2004, only 14 had reached exit — defined broadly to include selling shares to other companies — by 2009, according to GVCA. The financial crisis has halted any significant divestments since then.
The lack of exits is also tied to the fact that there have been relatively few PE deals in the region to begin with because of the length of time it can take to consummate a transaction. Buyers and sellers may take 12 to 18 months to work out details that include negotiating the price, completing due diligence and complying with any conditions, says Ashkar. “Investors walk away from a lot of deals,” he says. “It takes a long time and that limits the number of investments a year.”
For example, “Saudi Arabia is quite new in PE and there simply have not been that many completed PE deals in the kingdom,” notes Ashkar. “So in terms of exits, there has only been a small handful. They tend to be trade sales [to other companies] or sales to other PE funds, with a small number of IPO exits being prepared.”
Many firms also acquired their stakes at the peak of the market and are reluctant to sell at current prices. “It’s not so profitable to divest,” says Credit Suisse’s Yammine. “There have been a couple of strategic sales and more players will try to consolidate. The PE preference these days will be to do a trade sale rather than an IPO.”
In surveying investment and exit strategies across the region, Amwal’s Halawani says the difficulty of operating in Saudi Arabia, the single largest market, actually provides a compelling reason to do business in that country. “The number of alternative investment firms there is small and the number of opportunities is great,” says Halawani, pointing out advantages. “It is an under-exploited market and there is still room for alternative investment players especially those who do not restrict themselves to a specific asset class or a single model. There is government spending in a number of sectors, which is generating employment and opportunities, and the kingdom is reforming rapidly,” he adds. “The landscape is starting from a low level of development and offers many investment opportunities. It’s rich soil and there is a lot of money that wants to be deployed.”