Despite the financial downturn of the last few years, there is still plenty of money in the world looking for a home to call its own. Perhaps understandably, many investors are cautious about stashing that cash in the Middle East. But to ignore the region altogether could mean missing out on prime investment opportunities.
Investors’ fears may be soothed by a better understanding of the current state of private equity in the region, where the last decade saw breakneck growth followed by near whiplash-inducing collapse. A recent study by Booz & Company and INSEAD shows that up until 2000, only eight funds existed in the Middle East, with an average $37 million under management. But the region’s economic development and liberalization created opportunities and encouraged the Gulf’s sovereign wealth funds and wealthy families to look for investments closer to home.
By 2004, the region had 26 funds. The subsequent increase in the price of oil between 2004 and 2008 stimulated capital formation, quadrupling the number of funds to more than 100. The amount of money raised jumped from less than $500 million in 2004 to about $10 billion in 2008.
That heady growth obscured some critical weaknesses in the Middle East’s nascent private equity market — weaknesses that were exposed once the global economic downturn put a halt to new fund creation in the first half of 2008.
For one, most fund managers had limited experience and track records. Private-equity firms did not have to get deeply involved in their investee companies as much of the money made during this period resulted from rapid arbitrage opportunities — holding periods were very short, in many instances under a year. Furthermore, significant gaps existed in the region’s legal and regulatory frameworks; in many countries, laws related to issues such as bankruptcy or the delisting of companies were still either nonexistent or, conversely, too rigid. Several Middle Eastern countries are addressing these gaps and some reforms have been made, but still there is room for improvement.
A shorter leap of faith
Now that the euphoria is over, many potential investors are seizing on these shortcomings as reason to think twice about committing funds, but they should be viewing the consolidation of businesses and industries through a different lens — as growing pains in a private equity market that is still immature by almost any standard. Investors looking to make a play in the region will still need to make a leap of faith, but that leap isn’t as wide or unnerving as it once was thanks to a number of factors lining up in the region’s favor.
First, the Middle East is still a region of increasing wealth and a growing population that needs new and better services. Health care service providers, retailers and consumer finance companies are among those sitting in the sweet spot, especially for private equity firms. Another huge opportunity looms in the region’s infrastructure development. The richest countries are investing billions in large-scale projects and private money will be needed to supplement the public spending and support the creation of enabling industries, such as materials and equipment, construction services and financing.
Furthermore, the family-owned businesses that account for roughly 40 percent of the region’s non-oil economy are more open to working with outside firms. Money was so abundant before that there was no need for equity financing to fund their businesses, many of which spread themselves too thin over multiple sectors. With access to capital now drying up, they are looking to shed non-core operations or introduce strategic investors to help manage them because they lack the requisite talent and capital.
Finally, there is bound to be less competition for these emerging opportunities. Most funds were established in 2007 and 2008, when investors were concerned about missing the ride and were not exercising due diligence. Investors have since wised-up, and they are going to be short on patience when those funds fail to show results over the next two years, accelerating their demise.
Do the due diligence
Investors looking to take advantage of these opportunities can and should equip themselves to better manage this transition. Part of the challenge will be resetting expectations, both for liquidity and returns; they will also need to understand and manage their limited partnership agreements. Exits will take longer, more debt may be required, and returns will need to be risk-adjusted for market opacity and regulatory changes.
The absence of market and industry information will necessarily shift investors’ focus to the strength or weakness of the management team. Questions investors should be asking during due diligence include: How much experience does the team have of operating in the region? What are their credentials in the industry of focus? How strong are its governance policies? Does its network and capabilities align with its investment philosophy? The answers to these questions will help investors gain enough confidence to take the leap of faith with a given team or seek out a more suitable partner.
Certainly, the easy money is gone in the Middle East private equity market — or it soon will be. But the sector is maturing rapidly, and its coming of age will spell plenty of opportunities for those who do their homework. Realizing attractive returns in this market will not depend on timing or external market factors but on recognizing fundamental risk-adjusted value.
