With the rapidly growing economies of the Middle East and North Africa (MENA) requiring greater levels of investment, an increasing number of private equity firms are appearing in the region.
Consider just how quickly the region’s private equity industry has evolved. Five years ago, only a handful of private equity firms targeted the MENA region. Today, over 75 firms, with approximately $10 billion in funds announced or raised in 2006 alone, are active throughout the region.
In mature markets, such as North America and Europe , private equity firms have proven to be effective active owners. Companies that have been acquired by private equity firms have achieved, on average, better risk-adjusted returns than publicly-owned companies in their respective industries. Accordingly, one would expect the development of the MENA private equity industry to have a positive impact.
The role private equity firms have in elevating business performance is particularly important as the region’s economies liberalize, leading to an increase in foreign and intra-regional competition. In order to compete with foreign and other regional companies, MENA-based companies will have to enhance their performance. This is particularly true for companies that were once monopolies and now find themselves in an open market, and companies that are government-owned and subsidized, and now face privatization. For such companies, private equity can serve as a effective catalyst for transformation.
Despite the rapid growth of the MENA private equity industry, it faces a number of challenges. While investors may look to mature markets to extrapolate lessons for the region, MENA-based private equity firms face region-specific challenges. As such, it is critical to understand what private equity firms are, how the region can make its own markets more accessible and attractive to private equity firms, and how the economic landscape will shift as these firms seek further inroads into the region.
Private Equity Firms Seek Value Creation
The private equity industry encompasses a wide range of firms that fundamentally seek to create value, but often in different ways. At the highest level, the industry can be segmented into venture capital firms, which invest in seed through growth stage companies, and buyout firms, which invest in growth through late stage companies. The vast majority of firms, at least in mature markets, are thesis-driven, in that they seek to invest in companies that have specific characteristics, such as industry, location, stage of development, and size.
All firms adopt one or more value creation strategies that are at the core of their investment thesis. As an example, leveraged buyout firms, seek to invest in late stage companies that have stable cash flows and can accommodate additional debt. By levering up such companies, buyout firms effectively lower their cost of capital. In addition, through management incentives and greater operational oversight, they increase returns on capital, thereby earning a greater spread between returns and cost – in effect, value creation. As another example, turnaround buyout firms seek to invest in companies that may be unprofitable due to uncompetitive product lines, poor management, or other causes. By developing a solid turnaround plan, often involving product portfolio, organizational, and financial restructuring, turnaround buyout firms save, what might be otherwise, a dying business.
Private equity firms profit from their investments largely by receiving a share (typically 20%) of the return on their fund’s portfolio return. This “carried interest” is typically received only after the fund’s investors receive a preferred return. In other words, if a minimum amount of value is not created, the private equity firm does not profit. In essence, this ensures strong alignment of incentives between investors and private equity firms in generating value for portfolio companies. It is important to note that private equity firms do also profit from their fund’s management fee (typically 2% of the capital – a substantial amount for large funds) and other fees (e.g., advisory fees) that they receive from their fund and portfolio companies, but these are, for the vast majority of firms, small in comparison to the carried interest.
In addition to having their own incentives aligned with the value of their portfolio companies, private equity firms are also effective at aligning management incentives. In a typical investment, a private equity firm will require management to put their own “skin in the game” by buying a sizable portion of the business. This makes management highly sensitive to the value of the company, and far more keen to making key performance-enhancing decisions. If the company performs well, all investors benefit. Furthermore, with the company shielded from the short-term scrutiny of the capital markets, management can make the types of decisions that have long-term benefits, but might ordinarily be punished by the capital markets and their quarter-to-quarter earnings focus.
Impact on Labor Market is Positive
Private equity firms generally have a positive impact on the labor market. By providing growth capital, private equity firms enable businesses to expand, thereby creating new employment opportunities. In addition, private equity firms tend to invest in improving business practices, thereby contributing to human capital development as employees learn new technologies and skill sets.
In some cases, particularly turnarounds, a private equity firm may engage in workforce downsizing to improve an acquired company’s performance. In the long term, this is beneficial to the labor market as it is far better to have a smaller company than no company, if the business were to fail. Companies that downsize to regain profitability in the short term, position themselves to invest in new avenues for growth that may later require them to increase employment.
Also notable are the indirect effects private equity firms have on the labor market. As private equity firms enlist the services of investment banks, law firms, accounting firms, and other service-oriented businesses, more high-skilled employment opportunities are created in adjacent sectors.
Regulation and Capital Markets Are Critical
The development of the MENA private equity industry depends heavily on the regional regulatory and business environment. In comparison to the private equity industry in mature markets, the MENA private equity industry is small, with just over $25 billion currently under management. In comparison, several deals in Europe and North America (e.g., Equity Office Properties: $38.9B, HCA: $32.7B) each topped $25 billion. Apart from having larger target firms, private equity firms in mature markets have three main advantages that many regional private equity firms lack.
First, private equity firms in Europe and North America have access to a wealth of financial instruments (tradable debt securities, preferred stock) which allow a richer palette of financing options for private equity firms to utilize in structuring deals. As an example, through preferred stock rights, a venture capital firm can minimize downside risk while increasing participation in any upside.
Second, private equity firms in mature markets benefit from greater access to more accurate and detailed market information – the lifeline of the industry – due to greater disclosure and accounting standards. As lack of information increases uncertainty, and consequently perceived risk, it lowers the valuation that private equity firms can place on potential investments, often rendering deals not possible.
Third, private equity firms in mature markets benefit from developed capital markets, enabling them greater opportunities to exit. Private equity firms typically exit through a sale of the investment (trade sale) to another company (40-50% of all investments) or through a public offering (20-30% of all investments). Within the region, the latter exit strategy suffers from a lack of developed capital markets, which are often too illiquid and volatile. As the region’s capital markets develop, in part by attracting greater institutional investors, exiting via an IPO will become a more viable approach.
Challenges Abound, but the Market is Ready
The MENA region may be ripe for private equity firms, but challenges remain. First, the region’s appeal is somewhat compromised by the limited availability of deals and increased competition from other investors, including private investors, investment holding companies, family conglomerates, and government investment agencies. For many private equity firms in the region, the current climate is one of “too much capital chasing too few deals.” This is particularly challenging because private equity funds typically have a pre-defined time limit for investing their funds’ capital. This time pressure could force fund managers to make suboptimal investment decisions.
Second, the increase in the number of firms and funds in the region has crowded the market, effectively making access to capital no longer a distinct advantage. Private equity firms need to better differentiate themselves by having a greater focus in their investment thesis, or by offering a value-add beyond capital, such industry/operating expertise, or access to customers and strategic partners.
For private equity firms that can overcome these challenges, the regional markets offer tremendous opportunities. For companies considering being acquired by private equity firms, there’s never been a better time to be on the “sell side.”