Family offices are by nature conservative, but in recent years they have stepped out of their mold and began to invest in several asset classes including private equity (PE). This change in tack has earned them much profit over the past few years but it has also exposed them to the recent financial turbulence. In the past, family offices have been reluctant to embrace PE because of both cultural and structural preconceived notions about ownership. But these notions have largely been set aside in recent years by the promise of expansion and high return on investments (ROIs).
That said, with valuations at all time lows, it’s no wonder that regional institutional investors remain reluctant to move capital as their primary concern now is to preserve or liquidate their portfolios. This is especially the case for family conglomerates that are reported to own between 70 and 90 percent of all businesses in the GCC and to control assets of around $3 trillion, according to most estimates.
“I think that family conglomerates have been hit very hard and that it will take them time to find their bearings again,” says Yahya Jalil, senior executive officer and head of private equity at The National Investor in Dubai.
Thus regional family conglomerates will increasingly have to look to PE as a source of much needed liquidity in an increasingly illiquid world.
“Finance for some regional family groups will become more of an issue because banking lines may have been withdrawn or reduced and there is an inability to pursue other sources of financing, such as IPOs, due to current market conditions,” says Robert Hall, head of transaction services Middle East & South Asia at KPMG.
In addition to being short of liquidity, many family offices took on business lines during the upturn that were not their core competency. Now that things are on the downturn, many family offices will look to PE to trim the excess weight they put on when there were many businesses, not to mention the opportunity to resolve or preempt family feuds.
“Family groups in the region usually have anywhere from, say, 10 to 30 different lines of business. If they can’t push forward on all of those at the same speed due to lack of financing, they may have to sell some and PE will be the ideal partner to step in and help,” says Hall.
Ammar Al Khudairy, managing director & CEO of Amwal Al- Khaleej Investment Co, adds that “Taking care of succession through PE is definitely one of the core motivating factors and one of the core deal sources for PE firms.”
Although regional family offices may look to PE for funding, they will almost certainly cease to be active PE investors for some time to come.
“[Family conglomerates] can take a wait-and-see approach for a very long time because cash is king. Today, it’s not how much return you can make on your money, it’s whether you can return your money,” says Al Khudairy.
“People are no longer focused on capital growth, they are focused on capital preservation.”
With family offices sitting this one out, the question on everyone’s minds is what will the regional PE industry’s other big slugger, the sovereign wealth funds (SWFs), role be in the current downturn? SWF investment has been largely focused on acquisitions in the Western financial sector, propelling them into the limelight. Over $14 billion were invested by regional SWFs in Western financial intuitions over the course of 2007, of which $7.5 billion (a 4.9 percent stake) was invested in Citigroup by ADIA, Abu Dhabi’s SWF, valued at more than $850 billion. Not to be outdone, the Kuwait Investment Authority, Kuwait’s SWF valued at approximately $250 billion, invested $10 billion in Western financial institutions, including a $3 billion investment in Citigroup and a $2 billion investment in Merrill Lynch. Also in 2008, the Qatar Investment Authority, valued at around $50 billion, invested a further $5 billion in Barclays. According to Thomson Financial, SWF acquisitions in January 2008 accounted for 28 percent of the total merger and acquisition activity in the United States.
The valuations of Gulf SWFs should be regarded as the educated guesses of outsiders rather than firm numbers from accountants inside the institutions.
Indeed, it is the opacity inherent in most aspects of SWFs operations that has been difficult for Western markets to accept. Almost immediately after the SWF investments listed above, commentators and governments began to demand that SWFs more clearly explain their intentions to the world. The hysteria, however, turned out to be short lived when the value of the stocks that the SWFs invested in — namely Citi and Merrill — plummeted and it became evident that the SWFs had bit off more than they could chew.
“These guys [SWFs] are even more traumatized than family offices because they did some very high profile deals and one of the downsides of doing high profile deals is that people keep talking to you about them if they go sour,” says Al-Khudairy. “High profile deals are a double edged sword. I don’t think anyone is going to forget the hosing they took on some of these assets.”
Without a doubt, SWFs will now have to take stock of their losses to figure out the next step. Last month Hussain Al Abdullah, executive director of the QIA, told reporters in Dubai that the fund had lost less than 20 percent of its value in 2008 and that it has decided to suspend buying activity for a total of six months. Many of the other SWFs are also expected to follow suit even though, not surprisingly, they have not advertised it yet.
“In the short term the damage has been so great that [SWFs] want to sit down and take a breather; they are really not thinking of going to their investment committees with anything right now,” explains Al Khudairy.
Whether it’s six months or longer, the region’s SWFs will eventually have to start investing again.
“There is a lot of soul searching going on in the SWFs and many are asking themselves what asset classes they should be investing in,” says Jurgen Heppe, managing director of direct investment at Istithmar World. Once they are done looking in the mirror, the overarching sense is that the SWF petrodollar will begin to look inwards. Western markets are expected to take much longer to recover and they have proven themselves not to be the financial havens of investment they were once heralded to be.
However, for the time being the SWFs are not widely expected to be the silver bullet that will pull the regional PE industry out of its slump, simply because regional governments have other short-term priorities.
“The added impetus for SWFs to invest in PE in the region is the imperative of their host governments to support regional projects and businesses that are close to home, which will help sustain economic productivity in the short term,” says James Tanner, head of placement and relationship management at Investcorp.
Thus there is room for positive developments at the region’s PE firms. “There is likely to be increased pressure on [SWFs] from the rulers to look inwards and to at least make some investment within the region in terms of PE type investments,” says Hall. Others in the industry are even more optimistic about the paradigm shift in the investment outlook for regional SWFs.
“In the medium to long term there is going to be a significant upturn in the amount of money SWFs will be investing within the region,” says Al-Khudairy. “It’s going to be a boom for sure.”
Before PE firms start to queue up at the doors of the region’s SWFs, they would do well to consider the change in focus of sovereign capital and macroeconomic trends. Having established that SWFs will now look to the region to place their vast pools of capital, and knowing that their investments are long term in nature, it is obvious which sectors will benefit.
“A number of sectors in the region have shown resilience and proved countercyclical, such as infrastructure, agriculture, healthcare, and to a certain extent FMCG and telecoms,” says Rami Bazzi, senior executive officer at Injazat Capital.
Heppe adds that “all of the defensive sectors look appealing, however, the reason they are defensive is because they are stable and hence they will not be beneficiaries of a cyclical upturn in the way that other sectors were. Secondly, returns in [defensive] sectors take a long time to mature and that is why the money went elsewhere previously — so they will benefit.”
Never the same again
Whether it’s family offices, SWFs or high net-worth individuals, the nature of institutional investment is undergoing a radical change. The age of short-term flipping is over and investors are looking for areas that will give them solid and reliable returns.
“We cannot assume that there is just a shortage of liquidity and it will pass then we will be back to business as usual when it comes to fundraising,” says Hisham El Khazindar, managing director and co-founder of Citadel Capital.
“Just as this crisis fundamentally affects hedge funds and investment banks it will also affect the PE industry and the way PE fundraises and operates.”
That change will manifest itself in a more sober market that looks more towards expertise than the haphazard investment we have seen in the past three years.
“The market here was growing so quickly and the economy seemed so robust and very few of the people who were raising funds around the region had any sort of track record to run on,” says Benjamin Newland, partner at King & Spalding. “Investors were not investing based on manager performance histories but based on the narrative, connections or the identity of other shareholders and the sponsor [sic].”
As investor’s attitudes change, PE firms must also adjust their pitches and tactics to meet the challenges and new realities of the market.