If only every great idea could guarantee a swarm of investors knocking at your door. But the harsh reality is that, even after going through all the right motions (from hammering the fantastic idea into a solid business plan and assembling a capable team), entrepreneurs and growth-minded companies customarily face their greatest difficulties in attracting capital. And although nobody doubts that there is a shortage of liquidity in the country, most would-be business tycoons find that start-up money is even scarcer in Lebanon. Simply put, venture capital, for all those who are still asking themselves, refers to any investment in private and unlisted companies. Real venture capital is the investing in start-up and early stage companies. In Europe and North America, venture capital has long reached middle age, with the number of transactions being now levelled out. Once the domain of both little and big players, venture capital has become increasingly dominated by the mega financial institutions, such as global banks, insurance companies and giant pension funds, which all work through specialist business units or subsidiaries. Even in places like Western Europe, it is rare to see successful independent firms, which have been able to raise large amounts of money for venture capital purposes. Although the technology bubble of the late 1990s saw a resurgence of independent venture capital firms, most have now died a violent death or are dominated by the mega financial groups.
In Lebanon, we are light years from achieving what Europe and North America achieved. While the West has used the venture capital tool to grow itself out of recession and debt traps, we in the land of the cedar are still cogitating about the true meaning of venture capital. True, there were some speeches by senior bankers towards the late 1990s to early 2000s, which preached the necessity to establish venture capital funds in Lebanon, but nothing came out of it. Just talk, while our young entrepreneurs are still facing the limited choice of either emigrating to greener pastures or, worse, facing the local banks and their deadly corporate loans. Indeed, at the moment, most private sector firms, whether they are start-ups or established institutions are suffering from expensive over leverage, which is draining most (sometimes more) of their cash flow.
The current situation
Some attempts were made in the mid to latter part of the 1990s to provide the Lebanese economy with a financing alternative to classical banking. The European Union, the European Investment Bank, the World Bank, etc, all provided the local banks with funding to be directed specifically to emerging and start-up companies. These supranational loans were however, always small in size and did not really benefit the end-users (start-ups, etc.) as the banks often misused these funds and allocated them to other sectors. Moreover, the banks never really concentrated their efforts on asking the above mentioned supranational entities for funding to support venture capital, and rather concentrated on asking for funds in order to develop retail and consumer banking.
At one stage, some Lebanese financiers and bankers did decide to take the bull by the horn and established independent and proprietary venture capital/private equity funds, such as the Lebanon Fund, launched by Lebanon Invest, which got listed on the Beirut Stock Exchange. Banque Audi also followed the venture capital and private equity path by using its own money to invest in start ups and private equity. These investments were made via a holding company that is still wholly owned by the bank. Middle East Capital Group, another local investment bank also used its capital to carry out some venture capital and private equity investments in Lebanon and the rest of the region. However, these funds never really got 100% engaged in venture capital and rather concentrated on private equity, which is more investments in existing companies that needed to be turned around, restructured or have their operational and strategic direction changed, rather than seed money investments for start-up and early stage companies. Moreover, the cost structure of these funds was always high since the start and significantly affected their performance. Such a lackluster profitability from the part of the venture capital pioneers was a major discouraging factor to other banks and investors, which did not see venture capital as an interesting revenue diversification or investment option.
All these attempts to go into venture capital have been commendable for a small market such as Lebanon, which was just coming out from a twenty years glitch in terms of financial innovation, but is still largely insufficient. For new companies and entire sectors to emerge, boosting as a result the economy, a strong and diversified venture capital industry must be developed and set up. This can only be done with the goodwill and commitment of private Lebanese and Arab investors, which would see a developed venture capital financial sector as one of the ways of boosting the legendary entrepreneurial spirit of the Lebanese, whilst growing the local economy out of a debt and stagnation trap.
Where to go for funding
For the moment, the best way for young entrepreneurs to finance their new venture is to visit their local bank and ask for a Kafalat guaranteed loan. Kafalat is a government-owned sort of insurance company that guarantees bank loans for venture capital purposes. The cost varies from loan to loan, but is generally lower than the cost on a straight loan from the bank to the entrepreneur. It is worth noting however, that few banks would directly lend money to the entrepreneur without a Kafalat guarantee anyway, and given the relatively small size of Kafalat, the number of loans such an institution is ready to guarantee is generally small. Kafalat-guaranteed loans have a ceiling of around $200,000 and automatically exclude new ventures or start-ups needing more than this amount, such as technology oriented ventures, which are capital intensive and need more than $200,000 to build up a solid starting base.
The Islamic Angle
Another funding source for young Lebanese entrepreneurs is Islamic finance. Islamic banks are mostly engaged in financing products such as MUDARABA (trust financing) and MUSHARAKA, (venture capital financing), which are equivalent to participation transactions. MUDARABA is a form of partnership where one side provides only capital and the other only labor and entrepreneurial skills, while MUSHARAKA is a partnership contract where both parties provide capital towards the financing of a project or a venture. Most small and medium size enterprises (SMEs) in the Arab world, more particularly in the Gulf region, are actively seeking to finance their business through capital participation and profit and loss sharing, making Islamic finance in the form of MUSHARAKA or MUDARABA quite attractive.
Most SMEs and start ups in Lebanon and the Middle East can only rely on their weak cash flow to grow organically and cannot have access to outside capital. Their only chance for external capital growth would come in the forms of independent private investments, Islamic banking, or venture capital and private equity funds. While private investors are very selective and only look for investments with established track records (in other words, venture capital is not an option) and venture capital funds do not really exceed the number of fingers on two hands throughout the Arab region, Islamic banking, through its business nature and the SHARI’A rules governing it, is the only serious funding source for start ups and emerging companies.
Basle II compliance
Islamic banks are not yet covered by the new Basel II banking regulations and are subject to a less stringent regulatory regime. Very often, Islamic banks are established under laws specifically designed for them and their regulatory requirements are less detailed and constraining than those with which conventional banks must comply. Such a regulatory environment allows Islamic banks to have a competitive edge over conventional banks, which will soon have to comply with Basel II regulations. The latter make venture capital investments very costly and onerous for conventional banks, which will have to apply a risk weighting of 150% from 2007, the date the new Basel II capital regulations are applied throughout the world. In other words, if a conventional bank invested $1 million worth of assets in venture capital, it would have to set aside at least $120,000 of capital.
With the advent of Basel II, the slim hope of seeing conventional banks getting involved in venture capital is slowly dimming away. However, a whole new market is opening up for Islamic banks, which will be able to diversify and expand their MUSHARAKA and MUDARABA activities, with little competition. For the moment, Islamic banks concentrate mostly on MURABAHA, which is the largest category of development-related financing and the most common form of SHARI’A-compliant short-term financing employed by Islamic financial institutions. It is undertaken by the bank purchasing specific goods at the order of the ultimate buyer and simultaneously selling them to that buyer on a cost-plus basis.
With the venture capital market freeing up from conventional competition, Islamic banks will have the possibility of diversifying their assets and of getting rid of their concentration problem. The latter has been the main characteristic of Islamic banks over the last ten years, and can only be solved with the creation of new markets, such as Lebanon, and the hiring of venture capital experts, whose job will be to boost the MUSHARAKA and MUDARABA parts of the business.
Lebanon is going in the right direction with the establishment of the first Islamic institutions in recent months. What is now needed is for the opening of branches or subsidiaries of large Islamic financial institutions such as Kuwait Finance House, Al Rajhi of Saudi Arabia, Dubai Islamic Bank, etc, in Beirut. Such power houses would have a major positive effect on the local economy and would fill an important gap left by the local conventional banks, which is that of venture capital financing.
Venture capital has worked wonders in the West and has boosted moribund economies to prosperity in less than a decade. The US and Western Europe have rightly relied on the patriotic feelings and national commitment of their institutional and individual investors to fund a nascent venture capital sector. The outcome of such an investment gamble has paid off, as the beneficiaries of venture capital funding have repaid their faith in a major way, as the value of transactions in the buy-out, start-up and early stage markets more than quadrupled in less than ten years in Europe (between 1986 and 1995). What is urgently needed in Lebanon is for our individual investors to emulate their Western peers and place some more faith into the capabilities of their young entrepreneurs. The massive arrival in Lebanon of Islamic banking would provide the institutional investor base for both venture capital and private equity.
(BOX) How do banks finance their own expansion?
The capital needs of banks in Lebanon vary significantly from one bank to another. The twenty largest banks in the country are generally able to attract external capital more easily than their smaller peers, which are struggling to look more attractive to potential capital suitors. The larger banks’ better financial performance, more solid track record and qualitative aspects make it more attractive for a regional individual investor to provide them with fresh capital injections. In recent months, a few large local banks have been able to lure Arab and Lebanese individual investors into their capital, with the most recent example being Banque Libano-Française (BLF), which had to replace its majority shareholder, Crédit Agricole of France, with a regional investor. Replacing a Western financial group with another is virtually impossible at the moment, as the Lebanese market is too small and risky to attract any strategic institutional investor from Europe or North America.
For the smaller banks, which fall below the largest twenty in terms of total assets, raising capital externally is a tall order. Although, some, such as Banque BEMO, have succeeded in recent years, this was only due to a healthy qualitative and quantitative performance, as well as to a clear strategy of maintaining a certain optimum size. Such attributes are always likely to attract external regional investors, who have become increasingly picky in recent years, and who have steered away from the majority of the thirty smaller banks in the country. The latter have not really reached the level of attractiveness required for external capital financing.
However, banks in Lebanon have shown significant resourcefulness as regards to capital raising. Most have relied on the good years in the last decade to grow organically (internally), whilst some have taken advantage of favorable market conditions to carry out Initial Public Offerings (IPOs) and list on the Beirut Stock Exchange (BSE). The current stagnation of local and international equity capital markets for emerging market banks has led some Lebanese banks to resort to issuing preferred shares (a hybrid of debt and equity), in US dollars and carrying a high dividend/interest rate. These issues have been mostly placed with the banks’ customers.