GIM 2008 -
POSTED ON: 01 Apr 2008
RESEARCHERS: Bader Alam, Muhssin El-Yacoubi, Juan Fernando Yoshikay, Brett Holcomb, and Sawan Tivakaran
In response to the U.S. financial crisis, the global investment community has shifted its focus to emerging markets. Major private equity funds, finding themselves with a surplus of capital, are increasingly considering investments in the Middle East, a region with significant capital needs and a strong focus on growth. This paper is a synopsis of research conducted as part of Kellogg’s Global Initiatives in Management program into the dynamics of private equity in the Middle East. The research identified economic and business drivers of private equity’s growth in this region, the major players in the area, and some investing pitfalls. The paper also analyzed the role of Islamic finance in private equity investing.
Middle East Private Equity
Private equity (PE) is defined as “investing in non-publicly held securities through a negotiated process.” As such, the PE industry encompasses leveraged buyout firms, venture capitalists, hedge funds, and sovereign wealth funds, with asset classes ranging from angel and early stage ventures to multibillion-dollar buyouts. This research focuses on PE funds raised in the Middle East to invest in Western markets, as well as funds raised to focus on opportunities in the Middle East, North Africa, and Southern Asia (MENASA). Not surprisingly, much of the capital invested in Middle Eastern PE firms is generated by the petroleum industry, with Gulf Cooperation Council (GCC) countries estimated to have earned $540 billion from 2007 exports alone.
Goldman Sachs estimates that over the next 25 years, the Middle East could generate a $4 to $5 trillion cumulative windfall from extra-normal oil and natural gas revenues. Although such windfalls are not new to the region, regional turmoil and strict regulations on foreign investment combined with low amounts of deal flow and limited exit opportunities, inhibited PE’s growth in prior booms. In recent years the tremendous expansion of liquidity has combined with improvements in regulation and economic liberalization to make Middle Eastern PE investing attractive.
In the Middle East, economic liberalization is most often associated with privatization programs.
The Arab Business Council estimates that fewer than 10% of likely privatizations have been completed, while over 600 enterprises in the Arab world have “high” privatization potential. Given private equity’s desire for strong cash flow businesses that can be leveraged with debt, the PE industry is a natural buyer for newly privatized assets. Private equity’s growing importance in the region can be seen in the fact that in 2007 alone, PE investment in Saudi Arabia was $568 million, compared to $423 million for all investments from 1998 to 2006 combined.
Nevertheless, many obstacles remain. The Middle East and North Africa OECD Investment Programme outlines the following challenges associated with investing in this region:
- the lack of a rigorous and transparent regulatory environment
- the need to educate family-owned enterprises (which make up 75% of the GCC’s private sector) on the dynamics of private equity
- the difficulty Middle Eastern companies have in raising enough financing to reach a level of maturity required by private equity funds
- the petroleum-driven nature of the Middle Eastern economy, which has led to the underdevelopment of other sectors
- the region’s high inflation and unemployment rates
Sovereign wealth funds and traditional private equity funds have the strongest presence in the region.
Sovereign Wealth Funds. Sovereign wealth funds (SWF), in existence since the 1950s, are capitalized by the government and expected to grow to a combined $12 trillion in assets in the next decade. Because of rising oil prices, the six main Gulf states, including Dubai and Saudi Arabia, account for half the world’s SWF assets. In search of diversification, SWF are moving from traditional US Treasury securities to riskier investments, such as stocks. This transformation has not been without controversy, however. Commentators in developed countries worry that SWF investments in local companies may be politically, as opposed to commercially, motivated. The use of SWF funds to recapitalize ailing financial institutions such as Citigroup and UBS raised additional concerns because the SWF themselves are not subject to the regulatory and reporting requirements of traditional banks.
To allay such concerns, SWFs may adopt the tack taken by the Abu Dhabi Development Authority (ADIA), the world’s largest SWF and source of Citigroup’s cash injection. ADIA launched a public relations campaign assuring both overseas and local critics that its wealth would be deployed according to commercial, and not political, criteria. The Abu Dhabi-based Mubadala fund, which does make strategically motivated investments that may benefit the government politically, relabeled itself as an “investment development company,” highlighting the differences between it and ADIA. There are also hybrid funds, such as the Abu Dhabi National Energy Company, which has $20 billion invested or available for investment, and has international stakeholders including US institutional investors.
Traditional PE Funds. PE funds are run by investment professionals and operating managers. Abraaj Capital, for example, operates five funds focusing on the MENASA region, in the areas of buyouts, infrastructure and growth capital, real estate, and special opportunities. Like the region’s SWF, Abraaj’s model is focused more on growth equity than leverage, and the fund’s managers note that one of their key strengths is their local presence.
Middle Eastern PE funds use a range of transaction and capital structures to facilitate investments with both debt and equity instruments. Whereas Western markets rely on conventional debt structures with interest expense payments, many Middle Eastern investors require alternate structures that are compliant with Islamic law (Shari’ah). This movement has been labeled “Islamic Finance.” Islamic Finance is an estimated $750 billion industry growing at up to 20% annually; an increasing number of PE funds have been established to serve investors in this domain. Shari’ah prohibits use of interest, but allows profits, including those achieved through conventional interest-based transactions structured in a Shari’ah-compliant manner:
- Mudaraba (Profit-sharing). In this arrangement, one party pays 100% of the project’s capital, while another covers 100% of the management/work involved. Thus, the provider of capital does not interfere with labor/operations-related decision-making. Financial loss is borne exclusively by the investor; the manager loses the opportunity to earn profits. Thus risk is more widely distributed than in conventional loan structures. In the PE context, providers of capital are called Limited Partners, and managers of capital General Partners. Profits are shared according to an agreed-upon ratio.
- Musharaka (Partnership Financing). This structure is a partnership created for a specific project. All partners provide financing, and profits are shared in proportion to each partner’s equity contribution, similar to a joint venture arrangement.
- Murabaha (Markup Financing). This structure is used for financing assets, working capital, and equipment purchasing requirements. At the request of its client, a financial institution purchases a good or asset from a third party and resells it to the client over a deferred payment term. Before the bank buys the asset, the client and the bank agree to the profit that the bank will make, which is realized over the Murabaha period (the length of the deferred payment term). The financial institution actually acquires title to the asset before reselling it to the client and therefore assumes the risk associated with owning the asset in the interim period.
- Ijara (Leasing). This is similar to a conventional leasing structure, whereby a bank purchases an asset and leases it to a client for a fixed period of time. After the lease term, legal ownership of the asset can pass to the lessee or remain with the bank, depending on the terms.
- Istisna (Pre-production Financing). PE funds use Istisna contracts when investing in commodities or infrastructure-related projects. The contract is used to fix the price and specifications of the commodity in question.
To successfully raise capital from investors requiring Shari’ah compliance, PE fund managers must become very familiar with these transaction structures. Cutting corners is not an option. For example, traditional PE funds seeking to comply with Islamic finance guidelines must form a Shari’ah Board of Scholars, which approves each proposed deal after analyzing the transaction’s adherence to Islamic law. For example, the board may scrutinize the debt-to-total capitalization rate of an investment (no more than 33%) or the percentage of income derived from impermissible sources, such as alcohol and pork (no more than 5% of income). There is variation among schools of Islamic thought on these restrictions.
Middle Eastern PE firms exploit opportunities in the region by specializing in a geographic location (to gain access to privileged deals by building a strong local network) or by applying “concept arbitrage”—investing in global companies identified as having the best practices to succeed in a given target sector in the Middle East. The following industries reflect over 80% of deal flow in the region:
- Infrastructure. Middle Eastern governments are increasingly investing oil-industry surpluses in infrastructure development, building airports, power stations, and telephone networks to support economic expansion. The estimated investment requirement in the region is over $1 trillion for the next decade.
- Real Estate. Population growth continues to drive expansion of the Middle Eastern real estate sector, with Dubai’s population expected to grow at almost 8% annually in the short term. This growth drives the need for new residential and commercial real estate projects, and regional PE firms are investing in these.
- Tourism. Dubai has driven a large portion of regional tourism, offering an “open-skies” air travel policy, unparalleled security measures, and the new concept of the 7-star hotel. Dubai’s target is to host 15 million visitors from the West and more proximal geographies by 2010, requiring the construction of over 100,000 new hotel rooms. As a result, PE firms have started acquiring and investing in hotel chains with proven strategies (e.g., Holiday Inn Express) to replicate their concepts in this region.
- Consumer Retail. While the disposable incomes of the middle class segments of Dubai and other countries are growing at a lower rate than the supply of large shopping malls and other retail outlets in the region, local regulations are helping to protect these stores from foreign competitors. For example, Dubai requires foreign firms to sell their products through local agents, protecting local retailers owned by PE firms.
- Energy. Between 2006 and 2007, 20% of PE deals in this region were in the energy sector. TAQA, an Abu Dhabi SWF, has positioned itself as one of the largest energy conglomerates in the world. Similarly, Dubai’s government launched Dubai Energy in 2005 to evaluate key strategic energy investment opportunities worldwide.
- Industrial. Industrial companies are drawn to the region not only for the low cost of energy but for the increasingly friendly federal policies, including Dubai’s Jebel Ali Free Zone, an area adjacent to the world’s largest manmade port, where foreign firms can establish industrial companies without ceding any ownership to the UAE, pay zero taxes and tariffs, and enjoy tax-free repatriation of profits.
This sector accounts for 16% of total regional investments over the last decade. The UAE is again leading the way, having established the Dubai International Financial Centre in 2004, modeled after major financial hubs New York, London, and Hong Kong. The Centre offers foreign firms the ability to own 100% of assets, no tax on income and profits, and no restriction on profit repatriation, among other incentives.