Private equity investments are inherently complex. The issues related to sourcing, implementing, managing and exiting these investments are compounded in emerging economies, where capital markets are often shallow and underdeveloped, regulatory and legal frameworks can be patchy or haphazardly enforced, and company owners are often reluctant to sell. These aspects are even more pronounced in the frontier markets — those with less liquidity, and lower market capitalizations than more developed emerging economies — that characterize most of the Middle East and North Africa (MENA) region.
Nonetheless, private equity became an increasingly popular subset of the asset class in emerging and frontier markets over the past few years. The Emerging Market Private Equity Association estimates that the U.S. dollar amount raised by funds that specialized in developing markets rose from $6.6 billion in 2001 to $66.5 billion in 2008. That boosted the funds’ share of all money raised for private equity investments from about 4% in 2001 to about 14% in 2008. MENA-focused funds alone raised almost $16 billion from 2005 to 2010.
For those interested in the region’s private equity potential, it is essential to recognize the unique challenges that private equity firms face in the MENA region and to know how to cope with them. This article combines insights from Wharton and Amwal AlKhaleej, a leading Middle East-focused private equity and alternative investment firm and the first to be headquartered in Saudi Arabia, and from other industry experts about these barriers and the ways to navigate them.
“Everyone is excited about the potential of the Middle East,” says Chadi Hourani, partner at Hourani & Associates, a regional law firm that has worked closely with Amwal AlKhaleej. Yet “there are so many interplaying factors in the Middle East that can complicate investments: family politics, government politics, economics and regulations. The key is knowing how to overcome them.”
Find a Willing Seller
First of all, finding viable investments is often far trickier in the MENA region than in more developed markets. Apart from large, state-owned enterprises — which are only rarely privatized in the Gulf, usually through the initial public offering of a minority stake to nationals — the vast majority of companies in the MENA region are family-owned. These are predominantly wealthy, well-established merchant dynasties that are often reluctant to sell even minority stakes to private equity firms.
“You need to find a company owner that is willing to sell, which can prove difficult in some parts of the world where sentiment can come into play,” says Stephen M. Sammut, a senior fellow and lecturer on entrepreneurship at Wharton. “Being predatory is normal and accepted in developed markets, but not so much in regions like the Middle East.”
The global financial crisis was widely expected to trigger a rash of distressed sales, but they have largely failed to materialize. “On one hand, after such a crisis you would have expected more distressed sales, but we haven’t really seen any,” says Bassam Yammine, co-chief executive of Credit Suisse Middle East. “Many family groups were affected in the wake of the crisis, but banks in the region normally enable them to hold on while they regroup.”
The region’s lack of transparency and generally weak corporate governance are further obstacles to finding deals. “You have a layer of companies that look like great investments, but they are just so haphazardly run, audited and structured that a private equity firm won’t touch them,” Hourani says. “There are actually very few that are of a quality that a private equity firm could contemplate an investment [in]. A lot of companies need more house cleaning than a private equity firm is willing to do, which limits the number of companies that are viable investments.”
Listed companies, which are at least somewhat transparent, are also difficult investment avenues. Apart from Egypt, which enjoys a regulatory architecture similar to that of the western world, there is little regulatory support for prospective buyers. This makes hostile takeover bids of listed companies almost impossible. Saudi Arabia has introduced some helpful regulations, but they remain untested. The rest of the Gulf lacks squeeze-out provisions that would allow buyers who take a substantial stake to gain control of a company.
Virtually all private equity firms thus set their sights on privately held companies. “There are no squeeze-out provisions, and it’s virtually impossible to take a company private in the strict western definition,” says Fadi Arbid, chief executive officer of Amwal AlKhaleej. “You can take sizeable ownership in public markets and try to take control, but even that can be complicated as each of your moves will be overly scrutinized by the regulator. You will need to create value while working around these hurdles, but this is a tedious task.”
MENA countries also typically have stringent foreign ownership limits. While Egypt has no such restrictions and has benefited from the resulting foreign direct investment windfall, many countries in the region cap the foreign ownership stake at 49% in most sectors. This is more of a challenge for international private equity firms, since most regional firms are locally incorporated and are not prevented from taking larger stakes. Nevertheless, minority investments are the rule across the region for both international and local firms.
Once a potential investment has been found, private equity firms must structure the investment carefully. Private equity firms often seek additional safety through customized investment agreements, says Samer Sarraf, senior vice president at Amwal AlKhaleej, since the legal environment in many of the MENA countries remains underdeveloped. “In private companies, it can actually be easier to protect your shareholder rights through tailored legal agreements that deal with almost all eventualities,” notes Sarraf.
Yet even carefully worded documentation is no guarantee if the relationship between a minority and majority shareholder ruptures. For example, many firms insert put options as mechanisms to ensure exits if a listing or trade sale proves difficult. Such options give the firms the right to sell acquired securities at a specified price. But enforcement can be challenging in some Gulf jurisdictions, where courts are often unfamiliar with complex financial and legal structures and can be more inspired by sharia — or Islamic law — than by western commercial codes. “Time will tell if these structures are acceptable and durable,” says Hourani.
Many MENA countries have in recent years overhauled their bureaucracies, commercial laws and regulations to make themselves more business-friendly. While this has earned them relatively high positions in the World Bank’s ease of doing business rankings, the region nonetheless remains a difficult environment in which to operate.
This is particularly true in Saudi Arabia, the largest MENA economy. The government has tasked the Saudi Arabian General Investment Authority to encourage foreign businesses to set up in the kingdom, and has helped make Saudi Arabia the world’s 11th easiest country to do business in, according to the World Bank’s 2011 “Doing Business” report. However, experts say the reality is often very different. “There is still a lot of red tape,” says Amwal’s Arbid. “For example, in theory it is supposed to take just a few days to set up a new company with foreign ownership, but in practice it does take much longer than one would like.”
The Value of a “Godfather”
Yet well-connected local private equity firms are often well-placed to surmount such obstacles. “Private equity is a very social and local industry, particularly in emerging markets like the Middle East,” says N. Bulent Gultekin, a professor of finance at Wharton and a former central bank governor of Turkey. “You really have to be a local firm” with a team of locals on the ground “and be socially integrated into the corporate fabric of the country.” Most local private equity firms have influential board members and MENA limited partners that are usually well-connected merchant families. These partners are often far more active than investors in western markets, and frequently lend a hand in sourcing deals, advising on investments and even on exits. “Having a ‘godfather’ – a professional, respectable family — on the board or involved in some way, always helps to open doors,” agrees Arbid. “A lot of companies we look at don’t necessarily need money, but connections — people who can make introductions and open doors and markets.”
Many PE investee companies need support at the management level as well. However, the ability to recruit capable and effective management is complicated by two factors, according to executives at Amwal. First, since most of these companies are family owned, ownership and management are often intertwined, which makes introducing a new management team to take over from the family owner a sensitive topic. Second, and this is particularly true in Saudi Arabia, managerial talent is scarce in the region, therefore making the identification of a new management team with sector expertise, local knowledge, a proven track record and the right skill set a major challenge for PE firms.
Finally, exits are often not as smooth as in developed markets. The MENA region has a plethora of stock markets — the United Arab Emirates (UAE) alone has three bourses. But initial public offerings, the primary exit strategy, can be difficult for private-equity players. “Retail investors dominate the market, and protecting them is the paramount guiding principle of the regulators, which it should be,” says Arbid. “But that means the capital markets aren’t always as conducive to private equity as we’d like.”
IPO exits are particularly complicated in the UAE, according to Sarraf: “Nasdaq Dubai [the emirate’s international exchange] is fine, but the liquidity is low, and on the Abu Dhabi Stock Exchange and the Dubai Financial Market the flotation rules aren’t conducive to private equity,” Sarraf says. “Only primary listings are allowed, so you can’t exit via a secondary listing, and there is a two-year lock-up period for existing shareholders” before they can sell or redeem their shares.”
Moreover, he adds, “IPOs are priced at par, rather than through a book-building process” that takes bids to determine the price of an offer before it goes on sale. “This means that investors can’t cash out immediately, can’t get the price they want, and companies that list have bloated, inefficient cash piles on their balance sheet while the lock-up period is in effect. Reforms of the capital markets regulations are needed, but have been slow.”
Pledges of Reform
Countries across the MENA region have pledged to reform their capital-market regulations and there have been some positive developments. Saudi Arabia’s Capital Markets Authority has revamped its listing rules, which now include an element of book building, though pricing is often set low by the regulator to protect retail investors. Kuwait has recently established its first ever Capital Markets Authority, and Oman has recently seen its first book-building IPO, for Nawras, the country’s second-largest telecommunications company. Yet overall regulatory reform has been slow and piecemeal in the region, and staffing and enforcement of existing rules can be patchy. “All the regulators are pretty young, and have not been able to keep up with developments or don’t have the resources or expertise to do so,” says Hourani.
One clear exception is Egypt. Although Egypt’s economy and stock market have been rattled by the revolution that ousted former president Hosni Mubarak in February, the country’s regulatory architecture remains one of the most developed in the MENA region. Egypt’s stock market is arguably the best-regulated in the region, and the newly formed Financial Supervisory Authority (FSA) has set out to tighten regulation of listed companies and financial intermediaries even further.
Publicized reforms include tighter regulation of insider trading and financial disclosure, with penalties ranging from hefty fines and imprisonment to suspension from doing business. In 2009, some of Egypt’s largest financial intermediaries were suspended for up to a month at a time.
Reversals of trades have also become common practice. This has caused investors to sustain heavy losses over and above penalties levied for insider trading. The FSA is also tackling reporting requirements, and Egypt has started implementing — albeit gradually — a corporate governance code.
Beefing up regulations and corporate governance should be a priority for the region, say experts at Wharton. “Improving the regulatory frameworks would help investor confidence. It can and should be done as soon as possible,” says Raphael (Raffi) Amit, a Wharton professor of management and entrepreneurship. “One of the region’s main weaknesses is the laxer regulations and corporate governance. Tightening up those aspects would help a lot.”
Investor Activity Picks Up…But….
Local private equity firms can do little about the broader macroeconomic picture in the MENA region, which has been more challenging than expected. The recent surge of political turmoil across much of the Arab world has also wrong-footed many investors and could dampen economic growth as companies shelve investments.
However, expansive government spending has buttressed growth rates in many countries and the region’s economy is still expanding at a faster rate than developed markets. This has enabled the profits of listed companies in the region to start to recover from the depths of the trough in 2008 to 2009. Companies representing about 90% of the Gulf’s overall stock market capitalization reported profits of $43.1 billion in 2010, for example, a 25% gain over the year-ago period, according to research by Markaz, a Kuwaiti investment house. What is more, signs now point to growing investor activity in the region. Trade sales in which private equity firms sell their stake to other companies are picking up, and demand for IPOs, which had been dormant during the financial crisis, appears to be recovering gradually. “I expect to see more and more trade sales and initial public offerings over the next few years as conditions improve,” says Credit Suisse’s Yammine. “We are also going to see more cross-border synergy-driven acquisitions.”
Nevertheless, Amwal executives caution that the investment landscape has been changing over time. For example, factors which prior to 2008 enticed investors to focus on private equity, such as the remarkable growth of regional capital markets, have, in the aftermath of the financial crisis, given way to new realities. These include the following: a large pool of capital chasing limited number of deals; limited exit avenues; a fading of the presumed entry/exit multiple arbitrage; and, more recently, the political instability that has engulfed the region, and which is leading investors to favor more liquid asset classes over private equity until the region’s political and economic outlook improve.