The sharp reversal of economic fortunes in the Gulf has sent all private equity (PE) houses back to the drawing board to redesign their investment strategy. Some are optimistic the Gulf will bounce back quickly, while conservative investors predict this recession will be deep and long and are waiting for the recession tornado to vanish so they can pick up from the carnage good companies at attractive valuations. The bulk of PE houses, however, are focusing on a selected number of defensive sectors to invest in, with the consensus being that education, healthcare, and fast moving consumer goods and related industries will survive the downturn.
Starting with education, this article is the first of a three-part series — which will also run in March and April issues of Executive — covering the dynamics of investing in each of these defensive sectors:
Back to school
Education is one of the largest global industries, yet one of the most fragmented. It is estimated that the global market size for education services is $2.5 trillion and it is ranked amongst the top three industries depending on how you count. Yet, it is one of the least represented sectors amongst listed companies. The largest education company by market cap is Apollo in the US, with a market cap of only around $7-10 billion. Just a handful of companies have revenues exceeding the billion-dollar mark.
Yet education takes a significant chunk of household and government expenditures. In Saudi Arabia, the education and vocational training budget comes second after defense, with more than a quarter of the budget allocated to it. In most societies, household spending on education is only exceeded by accommodation expenses. Furthermore, governments are offering subsidies to investors, and many are privatizing their educational system. This means an even larger pie for private sector operators.
The education sector is divided into several subsectors. The largest and the most fragmented is K-12, or primary and secondary education. Adult education and vocational training come second. Other notable sub-sectors are early childhood education (pre-school) and testing (e.g. GMAT, SAT, TOEFEL, etc).
Cash is king
From an investment point of view, education has very interesting characteristics. It has stable and predictable cash flows: students pay upfront for the service, and once a student enters a school or a university, he is likely to stay there until graduation. In the GCC, population growth and rising incomes imply continued growth in demand, and most likely shortage of supply.
Parents (clients) have limited price influence on tuition and thus tuitions increases are ahead of inflation and margins remain healthy and stable. In the GCC, for example, it is very common to have net margins of 25-35 percent.
The main challenges for institutions are the upfront investment in real estate and recruiting good teachers. Schools and universities, in particular, need a significant investment in purpose-built facilities, and investors have to balance the economics of being close to the urban demand centers and the escalating cost of land as you get closer to such centers. The other challenge is recruiting quality teachers in the wake of a shrinking global population of teachers but a growing population of students. Symptoms of teacher shortage are already evident, resulting in escalating costs.
Given the attractive investment characteristics of education and limited number of investment opportunities, listed educational institutions usually trade in the 20-30 times their earnings. This creates a significant arbitrage opportunity for investors who build new schools and eventually sell them at high valuations.
PE houses are not flocking to education for one main reason: opportunities are scarce. Yet the most creative PE players were able to enter the sector early, and will probably cash out handsomely, even in turbulent times!
Imad Ghandour is head of Statistics and Information Committee, Gulf Venture Capital Association and board member, Maarif Education
and Training Holding Co, Saudi Arabia