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Middle East Private Equity

by Executive Staff

 

Over the last decade, the state of private equity (PE) in the Middle East has gone from virtually nonexistent, to a booming prospect, to an industry facing a shakeup. In 2004, the region was home to just 26 funds, with a total of $3 billion under management; in 2010, 142 funds manage $34.5 billion.

The sector’s breakneck evolution has made it difficult for investors to get a clear picture of the industry’s underlying fundamentals, and they therefore have been understandably cautious about directing their funds to regional PE firms.

In fact, it is now becoming clear that the region’s heady growth over the last decade worked to cover up some critical weaknesses in the PE industry. Some issues are structural: Significant gaps remain in the region’s legal and regulatory frameworks and corporate governance requires development, as the influence of family-owned businesses may hinder corporate disclosure and limit transparency. Another challenge is the fact that PE firms in the region are still sitting on about $11 billion of unspent capital — much of which is contingent on the performance of previous funds.

Even if the appetite for PE investing were to return to the insatiable pace of 2006–2008 (around 70 transactions per year, with an average size of $30 million), it would take more than five years to deploy all of this capital. Considering that most firms average three to five years until they invest their funds, the mismatch could create significant pressure to invest quickly. The PE market in the Middle East would need to develop much faster in order to absorb the available capital.

In order to fulfill its potential and continue attracting global investment dollars, the industry will need to undergo some reform as it consolidates. PE firms that hope to operate in the Middle East should consider five key imperatives.

·         Develop an investment approach based on themes with staying power. Focusing on individual nations or sectors, as many firms outside the region do, might limit Middle East-focused PE firms’ pool of opportunities, thus restricting their ability to scale their assets with superior returns and in a reasonable time frame. Theme-based investments, by contrast, are built around economic trends and span numerous countries and sectors. For example, PE firms that focus on the theme of serving a growing and increasingly wealthy population will invest in sectors such as consumer and mortgage finance, real estate management, retail, and restaurants and leisure.

·         Tighten up risk management practices. PE firms will need to ensure that their portfolios are not over-concentrated. Naturally, this means that they should not be heavily skewed toward any single geography or sector. However, firms must also ensure that the companies in their portfolios are balanced between different stages of their development — i.e., between companies still in the growth stage that demand cash, and those that have achieved maturity and generate cash. Meeting this target is particularly problematic in the region, where many opportunities are at an early or greenfield stage. A better balance in the portfolio will create a hedge against the cyclicality of the business. In terms of individual deals, PE firms will need to practice more rigorous risk management before, during, and after each transaction.

 

·         Be an active owner. The robust economic growth that preceded the downturn allowed many companies in the region to chase top-line growth at the expense of working capital and profitability. Liquidity issues bubbled beneath the surface while the economy was booming, but rose to the top when the recession hit. These same companies are now struggling to get their house in order. Adopting the appropriate financing approach, anticipating a buildup of operational capabilities and strengthening relationships with key stakeholders and suppliers will require active oversight by existing PE backers, as leading firms KKR and Blackstone have demonstrated.

·         Deepen relationships with limited partners (LPs), especially institutional investors. Historically, the majority of LPs in the region were high-net-worth individuals. However, institutional investors now represent a more significant percentage of LPs — an important development for PE firms as they broaden their investor base. Firms should seek to strengthen relationships with institutional investors, whether regional or international, which are looking to make a play in the region. These may include banks, insurance companies, pension funds and others that have been adding private equity assets in hopes of achieving risk-adjusted returns beyond those possible in public equity markets. Deepening the relationship entails more rigorous relationship management, including continual reporting, and better understanding of the risk-return relationship that institutional investors seek. 

·         Build confidence through new fee structures and fund-raising approaches. Lowering entry fees will encourage investors to come on board and give fund managers the opportunity to prove their worth. Among limited partners globally, the standard “2 and 20” fee structure — in which firms take a management fee of 2 percent of the fund’s net asset value each year and a performance fee of 20 percent of the fund’s profit — has become a source of increasing dissatisfaction. Sensitive to investors’ concerns regarding these arrangements, some big PE firms around the world have lowered their management fees on committed but uninvested capital to 1.5 percent (and sometimes lower for LPs with large commitments); regional firms should consider doing the same. Another peculiarity is fundraising for specific opportunities — while cumbersome, this bespoke option appeals to investors and should be taken into account.

The region’s PE industry sprang up when equity prices were rising, and many local players enjoyed early success in the form of quick and profitable exits from investment positions. However, that dynamic soon reversed. Today, winning will not depend on timing or on external market factors; it will depend on more fundamental sources of value. As firms in the Middle East rebuild, they will need to do the basic things right: Identify sustainable investment ideas, create value within their portfolio companies, reduce their risks, and gain the trust of the best possible investment partners. These are things that will work, and remain important, in good times and in bad.

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