Across the region’s private equity landscape, there are a large number of financiers, whose mixture of know-how and ability to gather capital from a solid investor base introduced new ideas of efficiency to some of the region’s most successful firms, including those whose sights are set on becoming regional champions.

When Executive had the chance to sit down with the co-heads of Investcorp’s Gulf Growth Capital (GGC) Fund, Azmat Taufique and Christophe de Mahieu, it reached the crème de la crème of the region’s private equity scene, the philosopher-financiers of the industry.

Investcorp began private equity operations in 1982 in the Gulf, and has since evolved to include a host of other assets. The firm’s latest GGC Fund is a return to its home turf, in an effort to harness the group’s synergy and experience with local partners — an essential ingredient to any regional private equity mix — in spotting deals and acting on those with the best chances for success. The particular focus of the fund is to invest in and improve greenfield projects and buyout opportunities in medium-sized firms, the newest foray of the firm. De Mahieu said the fund has “deployed more than $35 billion of the Gulf’s capital across the world.”

Alignment

With more than $13 billion in assets and an investor base of 1,400, the GGC Fund should not lack deal flow. De Mahieu said that “[Investcorp] combines its distinctive capabilities of raising funds, with its trusted investors in the Gulf and across the world, while bringing its well-established private equity capabilities built over time in the West to make private equity investments in the Gulf and by extension across the Middle East.” According to Taufique the investor base of contacts are not just investors, “but genuine partners in the region,” to whom Investcorp looks “for ideas and for deal flow.”

The relationships with the investor base of partners and profiteers from successful deals are not the only relationships the firm is mindful of. Taufique described the firm’s cooperation with management best when he explained the host of global experience Investcorp brings to the table. Especially as Investcorp is “particularly adept at understanding what the potential conflicts are and mitigating them, creating alignment and structures and working with the teams over a period of time to enhance value that would be of interest to everyone concerned. In this sense, we would like to think that we are better at handling this.”

To enhance investments and ensure that Investcorp can achieve positive results with firms, according to de Mahieu, “there is often an alignment phase with the owner and management of a company before we launch the full due diligence process.” He explained that, “during this alignment phase, we spend a lot of time with the existing owner and management to align ourselves around the vision, the strategy, and the contribution of every party, including Investcorp, to create significantly more value. When alignment is reached, we go into the due diligence. After the due diligence, if the transaction is consummated, we work together, we change the governance, support the management, inject new capital when required and bring our operational capabilities where agreed.”

Foreign capital

Taufique noted the strong regional pull in attracting foreign capital, as seen through the FDI number for Saudi Arabia and the UAE which are both “beyond the charts. And so for a country that has a great capital surplus to attract that sort of foreign investment, there must be something positive going on.”

Within the kingdom, Taufique believes that few associate Saudi Arabia with being one of the fastest reforming economies in the world, because “there are perceptions of other constraints of different kinds, but in terms of the economic structure, there seems to be a momentum for reform, which is being recognized by institutions like the World Bank, but also by private investors.”

Future strategy

Taufique opined that “there are many more possibilities for growth capital equity investing here today as opposed to investing in existing companies and tweaking the edges. And that is the focus of many private equity players now, because that is where the opportunities are, but as things progress, you will find more and more of the region evolving into what you have seen in North America.”

With these dynamics in mind, “as the industry matures, the intermediaries will start playing a more active role as they build their expertise in the region and they build their own relationships,” which, according to Taufique, will “see a bigger flow of deals coming from the intermediaries and that will make the industry more efficient. We know what we do best and that is to invest and enhance value.”

Across the developing world, telecom companies battle to provide populations with the most efficient services. Combining price, service, and convenience, mobile telecom firms and fixed-line businesses are looking for new ways to penetrate these nascent markets and consolidate their share to out-compete rivals. Telecom markets, especially in the developing world, present an interesting case study and a concrete example of how private equity can revamp businesses through their infusions of capital and of knowledge.

Market motions

Vying for market share has created a host of privatizations by governments in the region and has led to a series of mergers and acquisitions within the telecoms, media, and technology (TMT) industries. A. Shabu Qureshi, director at EMP Global, explained that “liberalization points to more opportunities and market efficiencies in the short, medium and long run. It removes the barriers and constraints posed by public ownership. Positive developments brought about by liberalization translate into new services, new opportunities and growth prospects.”

The case for competition is stronger in the developing markets of the Middle East and North Africa (MENA) where penetration rates and convergence are low. This leaves a huge opportunity for private equity firms to assist companies with expansion and improvements to existing models of their corporate governance. Izzet Güney, managing partner at Millennium Private Equity, thinks that TMT private equity deals will target mobile operators “mostly in Africa and South Asia, where you still have countries with only two operators and a low penetration level.”

He attributes the low level of penetration to the existence of several small operators in countries which have escaped the radar of larger conglomerates and who are focused on buying mid-sized to larger operators. The larger firms might penetrate new markets once local telecom operators are “actually larger in size.”

Güney’s experience from one North Africa deal is “to buy one small operation, maybe bring in one or two management executives, maybe on the finance side, maybe on the IT side, maybe on the tech side, and grow the operations from 50,000 subscribers to 200,000 subscribers, at which point in time it becomes a critical mass interesting enough for companies such as Vodacom or MTN.”

For local players, private equity capital offers the chance for a growth-oriented business with a strong possibility for success to become a regional player. While TMT firms are not tip-toeing around owners, they are certainly not hesitant to indicate the points at which efficiency can be improved. According to Güney, “we actually know what they want to see in place before they do an acquisition. They are interested in making sure the numbers are clean, so that is an issue of corporate governance. There is also a critical mass of subscribers, which is extremely important, because dealing with small numbers is not very helpful.”

Instead of working with very small firms, he believes “it’s more effective once you have a critical mass to get discounts on scale in terms of ordering, etc. This area of investment is going to take a large chunk of the fund’s capital.”

For Millennium and other TMT fund managers, the time to act is now and as within the coming year or two the time for investment would have passed. Güney said that, “emerging markets are growing very fast and penetration levels are growing very, very fast. What’s happening now is that the penetration in most of the emerging markets in cities is already quite high.” 

Fixed-line penetration in the Arab World

Restructuring infrastructure

“The infrastructure within mobiles is also another play,” according to Güney, especially for “people who are very conscious of the bottom line and they are trying to figure out ‘how can I squeeze more money’.”

Private equity firms are quite engaged in restructuring the way telecom infrastructure is operated, from changing management and personnel, to specializing in pure telecom by selling off infrastructure to be run by separate entities with more experience and better efficiency.

“Some operators want to just sell a service, sell a phone, one can squeeze some money on the marketing side, maybe some on the acquisition cost, but maybe you should not own the tower” advises Güney, because “the tower is just a building that somebody else could actually run for you much more efficiently. You could lease the space, etc. That would make a lot more sense and that squeezes the costs, so it creates more free cash flow, which is what everybody is moving towards. So infrastructure to us is extremely important.”

Güney believes private equity is best to revamp telecom infrastructure because “they don’t personally have any affinity or love in keeping a tower, for example, in the mobile business. They only look very rationally at where it makes most sense in owning that tower and what the costs associated to it are.”

For telecom operators in love with their towers and network, the idea of de-merging infrastructure from operation is anathema, especially to someone who spent their whole life in telecoms and understanding the sector partly through the physical representations of its infrastructure. Pointing to Western Europe, he shows evidence of people taking issue with demerging their businesses, “but if you go to India, Indian operators are much smarter and they understand exactly where the cost-benefit will be. And they have decided, Reliance, Bharti, Vodafone, and Idea Cellular have all decided that owning a tower doesn’t make sense. Pooling and sharing makes more sense. Let somebody else run that specific area with a specific knowledge while you can concentrate on marketing your services.”

Through demerging and redistributing industry functions, private equity might be able to increase efficiency through investments in telecom’s down-market industries, including logistics and supply-chain management. Rami Bazzi, principal of private equity at Injazat Capital, believes “Telcoms are offering products for which they need support. They need to focus on coming up with the right product, the right service and make sure that they do it right, that they do it profitably. However, they need support on the operational and business side and it is very challenging to get all the support they need built in-house.”

Fixed-line subscriber base in the Arab World

Thumbnail of the telecom sector in KSA

To which telecom markets should private equity move?

According to Millennium’s Güney, there is a “big swath in the middle” of the African continent “where you do have some of the large operators that have a presence there, but not in all the countries. And what you’re hoping for is that area of Africa will grow over time, just like every other emerging market will grow and has grown so far.”

In addition to Africa, South Asia remains a particularly attractive market for private equity capital in telecom operations. In Pakistan and India, particularly, there are a number of fixed mobile operators, while penetration rates remain low. However, the challenges to increasing penetration rates from simple due diligence techniques are not the only consideration.

Because of the nature of the market and its lack of development, “even if you have been able to get a license, maybe there is still not enough frequency available because there are so many operators,” according to Güney. He believes, then, in the “physical restrictions in the ability to have additional players. But other countries exist in Asia where you might have only two operators or three operators and judging from your macroeconomic study of that country, you might have a growth there.”

With a geographic size that dwarfs its neighbors in the Gulf in particular, and the Middle East in general, Saudi Arabia is in the sights of private equity firms who are looking to the kingdom as a potentially excellent market.

With new plans sprouting up to develop the country’s infrastructure, particularly in the transport and communication sectors, as well as down-market industries in the supply chain of goods and services, Saudi Arabia is a slow giant ripe for the introduction of management efficiency.

A slow relaxation of regulations on private equity firms is just one of a series of measures — along with building the social infrastructure of education and healthcare — where the kingdom is thoughtfully giving a thumbs-up to private equity groups looking to enter the market. This is done through obvious contacts with regulatory and other government authorities, but also with the country’s major family firms.

Having spent over a decade in the kingdom, Richard Dallas, managing director of private equity at Gulf Capital, has noticed the difference between the Saudi market and those of its neighboring economies.

Dallas believes that both the UAE and Bahrain “have been leaders in creating regulatory and economic environments that have been inviting and welcoming to foreign investment, particularly the development of the banking and financial services sector.”

Because Saudi Arabia is the biggest market in the Gulf Cooperation Council (GCC) and its economic powerhouse, the economy is “slower, more deliberate and has a regulatory scheme that is changing on a more deliberate basis.”

But the kingdom has already made significant changes. Fadi Arbid, executive vice president for Amwal Al-Khaleej, pointed out that the Saudi government shifted from its traditional policy to spend 60-70% of GDP on defense and infrastructure to the new plan whereby more than 50% of the GDP is being spent on education and healthcare. To prepare the country for an era of declining demand for oil and the possible price drops associated with it.

Wadah Al-Taha, head of strategies at Emaar Financial Services, explained that Saudi regulators “have to set criteria, they have to be careful, then they have to make a move,” attributing the caution to the relative size of the country and the potential for grave errors from a regulatory or economic misstep.

Establishing a castle in the kingdom

Culturally, however, entry into the Saudi market is a new frontier for private equity firms. They must understand how to navigate policies by deciphering them. Firms seeking entry into the Saudi market are also best served by a synergetic partnership with families in the kingdom.

The largest families are mainly sought out for their networking potential and relationships with them are cultivated through a mixture of attracting them to a specific private equity firm as an individual investor or as the owner of a company in which a private equity firm owns a minority stake.

Deliberate, careful motions are not only the way Saudi authorities move but also how new firms proceed as they seek to gain entry into the country. By doing one successful deal with a Saudi firm, a new private equity firm might establish a relationship that generates more deal flow than previously imagined.

Shailesh Dash, senior vice president of alternative investments at Global Investment House, explained that “family-owned businesses in the MENA region are often diversified across vertical and horizontal lines of their supply chain and, accordingly, many family-owned businesses also engage in activities that are unrelated to their primary business. As ownership and control of these family-owned businesses move into future generations, the need to capitalize assets often becomes important, as some of the successors may want to pursue independent interests or liquidate their interest in the business.”

There is a need for liquidity and a “formal capital structure in an increasingly competitive free-market economic environment, which will result in significant merger, acquisition and divestiture activity. We have capitalized on these opportunities and many times have been invited by various families to corporatize them and grow their businesses beyond their countries boundaries and helping these businesses in acquiring economies of scale.”

The help Global Investment House provides to firms comes in several varieties, including “providing liquidity to the family group as a buyer of the group’s non-core businesses or as an investor in the group’s core business, providing suitable exit opportunities by identifying regional or international partners, valuing the business and assisting in various divestment activities to create value for the shareholders of such business, and providing a framework for target identification, target screening and transaction execution to assist in making strategic acquisitions for a family group’s core business.”

KSA public equity issuance ($ million)

According to Richard Dallas, managing director of private equity at Gulf Capital, “they are very guarded and careful about making sure they do everything in an organized fashion, so that they understand the consequences of what they do as much as they can.”

The reasons for this lie not only in the special role played by Saudi authorities as the guardians of the two holiest Muslim sites and the hosts of the hajj. Although these are important factors in a majority-Muslim region such as MENA, and for the significant Muslim populations of South and Southeast Asia, the internal population dynamics are putting pressure on the Saudi state to consider the future of a people whose riches and nobility are to a large part maintained through their natural resources, or down market-related industries. Dallas said, for the authorities “job creation is very, very important. For a long time they have been very focused on providing opportunities to their younger people, so I wouldn’t say they are slower or more resistant to change. I would just say they are more deliberate in what they do. Because if they don’t, quite candidly, they would make a major misstep and I think that this deliberateness will ultimately serve them very well.”

Every major private equity firm gives due consideration to Saudi Arabia. If they do not already have businesses in the country or at least relationships through investors in their firms, regional and global private equity managers are assembling their teams to penetrate this new market. Rasmala Investment Holdings is just one private equity group that received a green light from the Saudi Capital Markets Authority to expand its service in the kingdom.

In addition to its private equity business, Rasmala will be able to operate its mergers and acquisitions and IPO advisory arms. When the group appointed Hamad Mubarak al-Huthaili as the general manager of Rasmala Saudi Arabia, the company’s CEO said that “Saudi Arabia is the largest and most important capital market.”

This appointment hints at the importance of the country’s relationship-driven business culture as al-Huthaili had previously worked for four years at the Saudi Monetary Agency, in addition to other firms in the Saudi financial sector. His experience is likely to provide Rasmala with the sort of inside deal generation necessary to sustain business with key contacts in the kingdom.

A. Shabu Qureshi, director of EMP Global, related his firm’s investment in SIPCHEM, a Saudi diversified petrochemical company. Explaining the market dynamics of the Saudi regulators, he pointed out that “what the Saudi government has done is to allow ARAMCO to controlling the upstream industry, but then to get the private sector involved in downstream investment.”

At the time of the investment, three years ago, EMP took a 23% stake in the company, which then “executed its business plan well, and was able to go for an IPO quickly. It was a very good growth story and a sort of poster child in Saudi Arabia for what the government has been able to achieve by encouraging some degree of privatization, and how some of the dynamic family groups there, in this case the al-Zamil family, have been able to take advantage of this.”

However, Qureshi admitted that “it is a bit of a challenge to penetrate the Saudi market.” He attributes success in Saudi Arabia to the fact that EMP has a “good network of people in Saudi Arabia and we know the government as well as the industrial groups. Also, the Saudi pension funds, including the PIF and the PPA have invested with us, and they have been a very big help to us.”

In addition to EMP’s investment and exit of SIPCHEM, the firm also invested in APPC, a Saudi single purpose petrochemical company manufacturing polypropylene. “It was a greenfield investment where we went in very early and just worked with the company by sitting on the board of directors. The company recently achieved an IPO and is about to begin production. Under the radar, Saudi Arabia has achieved a fair amount of macroeconomic liberalization. And then firms like EMP Global are able to help that along and take advantage of what the government has done.”

Knighthood

Having an institutional backer during its start of operations aimed at the Saudi market was important for EMP, which had the backing of the Jeddah-based Islamic Development Bank, where, according to Qureshi, the firm “had some friends we could rely on for support in the region. The IDB is important for the region as a leading multilateral institution, and we also had the support of two of the Saudi government pension funds.”

In addition to the Saudi pension funds and IDB, EMP “had some prior relationships and our local executives were very familiar with the market and the industrial groups. We don’t go in and punch over our weight. That has over time allowed us to have good relationships. We tend to look at each investment by itself and to add our best professional advice, and not to favor one family group over another. We also look to bring our international relationships to the table if they can be of use to our portfolio companies.”

The bridging of Western models and what some observers affectionately call ‘Bedouin math’ is taking root in the kingdom. Qureshi thinks that “as Western banks and investment banks establish themselves in Saudi Arabia, both parties will benefit. The Western banks will get more familiar with the Saudi market, and that will benefit the Saudi partners and families who will get better access to Western financial technology. Having people on the ground with Western technical skills and knowing how the region does business is helpful for both sides.”

Abe Saad, head of private equity at Rasmala, believes that, “the kingdom is one of the largest markets in the GCC. It hasn’t been treated as it should be on the private equity side, though.

Composition of total estimated value of projects in KSA. Total value $665.42 billion

Most businesses in the region are owned and operated by families. The level of trust between members has also been offered to the extended family. 

This process is hardly the best way to objectively increase efficiency, acquire the best management and talent experts. With new sources of wealth have come new ideas and ways to operate businesses.

By entrusting their operations with a private equity firm, a family-owned enterprise will gain Western-style efficiency, but the challenge comes in interfacing with firms by understanding the concerns of the families still involved directly in business operations. There are several ways to get private equity firms on board without fearing total control by a company.

Thanks to the regulation in most Gulf countries of limiting foreign ownership of firms to 49%, owners can be sure that they will not lose their businesses. However, at the end of the day, owners must become comfortable with one of the firms, or else they will be undercut by the competition.

To balance the issues, family businesses also seek strong relationships with firms, with private equity firms trying to court the favors of family members seeking to do the same. Private equity firms make sure to include the most influential of investors in their institutional and individual backing for investments inside and outside the Middle East and North Africa (MENA) region.

According to Shailesh Dash, senior vice president of Alternative Investment at Global Investment House, family firms “know that competition is coming from regional and foreign companies and if they don’t achieve economies of scale and become big, it will be very difficult for them to have the business survive until the second and third generation. They know these are small markets and a significant amount of success was derived from the fact that these were protected economies and those protections either have gone out or are going out.”

Another industry executive, Romen Mathieu, managing director of Capital Trust Group, explained that, “The most important point of our job, which is specific to our region, and not the same in the Gulf, is that what makes it happen in the end is not the money that we bring, money is everywhere, it is the personal relationship that we manage to build with the shareholders of these companies, the board members and the top employees.”

For Mathieu, courting partners is a personal family-wide effort in itself as his “wife personally knows every wife of every shareholder, every board member, and so on. Building personal relationships are very important because when a problem comes you sit with them and deal with it. Without this personal relationship when a problem occurs you call your lawyer but here it does not work like this.”

Yahya Jalil, senior vice president of private equity at The National Investor (TNI), believed his fund “would capture some of that deal flow at a pre-IPO stage, and then TNI would take those companies public.”

He attributed his firm’s success to its brand name. “Family businesses in the region may not be open to discussing their future financing­/capital raising plans with a private equity player, but these businesses are usually interested in talking to TNI to understand how they can do an IPO. This is because of a history of credibility and a high level of trust that TNI has established for itself in the GCC, which makes entrepreneurs and owner-managers of family businesses comfortable approaching TNI on this.”

Jalil explained that his team works “closely with such businesses to identify their needs, and then, if it makes sense, we will make a private equity direct investment into the business pre-IPO. Once such an investment is made, we work closely with the family business to ready them for IPO.”

Jalil’s process includes instituting corporate governance, legal and structural changes to prepare them for a public joint stock company structure like an IPO, adding depth to the business’ management as well as formulating succession plans for board members, and finally “getting the house in order to ready the business for an IPO.”

Had TNI ignored the relationship-driven way of doing businesses with family firms, the company’s deal flow would sink; but luckily this is not the case for the most successful players who give careful consideration when speaking with family-run firms.

Richard Dallas, managing director of private equity at Gulf Capital, explained the benefits of asymmetrical information and the relationship-driven structure of businesses. He says “people are still modestly uncomfortable with the idea of publishing their results of trade secrets to a variety of people who come and look at them and then the highest bidder wins. I think for some time relationship-based sourcing is going to be an important part of business here, which is very different from, certainly, the United States.”

Yet relationship-based sourcing is looked at positively and is considered a way to tap into proprietary deal flow, which has maintained a strong presence as businesses have moved on in Europe from several generations involved with a firm to the current business environment and the high mobility of upper management personnel within industries.

The trust Dallas’ firm obtains comes from families believing that “we can come in and take strategic investments in businesses, we don’t insist on owning 100%. We like to have the ability to influence the direction of the company, but we will take a strategic minority interest if it’s structured correctly. We bring the ability to help them get ready for an IPO. We could go ahead and regularize their accounting. We can go and upgrade their human resources and get the corporate governance that will be more suitable for a public company. We can affect and put them through that pre-IPO scrub of two to three years of good improvement and the view is that helps them get to the IPO market and enhances their value once they get there. That is one of the things we like to think we bring to the party, the ability to help family companies like that.”

Leaning towards private equity

However, the paradigm gaining popularity is that firms are leaning towards private equity as the means by which they can expand and solidify positions. According to Dallas, “a lot of family companies, by reason of succession or liquidity, whatever motivation there is, they are interested in being available to be public if they choose to be. And bringing an institutional investor like Gulf Capital that operates rigorously in terms of its investment processes, is an aid to doing that. I think that is why a lot of family companies are interested in addressing some of their issues with institutional investors. It’s more than going out and getting three guys with money, its getting smart money that helps you.”

For Dallas, the backdrop for accepting private equity money “varies quite dramatically. Some are very sophisticated, others are more traditional. What we’ve seen in the Gulf family groups own maybe over 100 companies which are all growing and they need capital for expansion and managerial talent.”

In order to keep up with portfolio growth, firms are, according to Dallas, “seeing how they can redeploy their assets and their efforts and maybe sell off some of their non-core companies. They have come to realize they can’t do everything all at once and have to pick and choose where to concentrate their efforts.”

A. Shabu Qureshi, director of EMP Global, explained that the growth in opportunities for acquired firms come from attempts “to work with companies here that are relatively small on a global scale and help them become global companies. We do that with capital, but also by providing an international outlook and relationships with different parts of the world, particularly Asia. Can EMP use its relationships to help take family businesses from this region over to Asia? Here, in the MENA region, it is interesting to an outsider that family groups are involved in such a myriad number of businesses in a pretty small geographic region.”

“To overcome the issue” of ownership attachment, notes Qureshi’s colleague Junaid Jafar, general partner of EMP, “it is important for companies to know what the financial investor is bringing to the table, apart from money — be it good corporate governance, financial engineering, access to new markets, or perhaps a combination of the above.”

Abe Saad, partner at Rasmala, believes his company has the “strength in the sectors that we want to focus on. We know the key players and most of the business done in the region is relationship-based. Typically, let’s say we own a construction business, we know all the key players in the industry in the UAE, in Saudi Arabia, and we have a relationship with them.”

Just talk it out

To increase the quality of their acquisitions of family firms Khaled al-Muhairy, CEO of Evolvence Capital, advocated good communication and local business acumen, paying particular attention to the culture of family businesses. He noticed that “Communication is at its highest level before a limited partner commitment and once you commit, it drops down to zero and I have seen that with 85-90% of the funds here. It’s just that ‘we will be so nice to you until we get your money, then we are done.’”

Al-Muhairy explained that “It is not a matter of returns for investors because he can make the same amount of money somewhere else. I think there are so many elements that make private equity successful. The proof has always been communication. A lot of firms do not communicate properly. You know some of these firms are based in London and will do deals from there. If you believe this age is about communication and voice data, then you will believe it is a must that you are on the ground directly.”

Communicate and trust work together in cementing relationships between families and private equity groups. Mathieu believes “reputation is very important. That is why I don’t think that you will get a single penny from someone that you don’t know. Even if I had a great track record in the internal rate of return (IRR) and I promise you that I will make 20%, you will not give me a penny. We have to build a relationship and trust and by having that trust relationship then you might think that you will try with $1 million or $2 million.”

Since most companies that are ripe for private equity investment are family-oriented companies, Ziad Maalouf, senior vice president of MENA Capital, believes when “you are a family-orientated company your horizon is limited and this is why they see a lot of value added in having a professional private equity fund. So basically, they look for an institutional investor to come and invest in their company to help them institutionalize and streamline their operations in order to expand regionally, and this is what we do.”

Maalouf thinks private equity firms “not only provide capital, but also contribute to the strategic and financial management of the company. We also provide valuable expertise, knowledge, and contacts in the region, leading to operational enhancement and value creation.”

He explained that the role of private equity teams is to help a “successful entrepreneur who has been doing extremely well but does not have the managerial or financial skills to manage his company. So we give him the support that he needs and help him institutionalize the company, but we typically do not get involved in the day-to-day affairs of his business, however, we do actively supervise management through board representation and participation on the relevant committees and allow the entrepreneur to do what he does best, which is generate business.”

Will families accept the new guys?

According to Robert Wages, executive director of the Abu Dhabi Investment Company, acceptance of private equity firms by family firms “varies quite dramatically. Some are very sophisticated, others are more traditional. We have seen in the Gulf family groups, maybe over 100 companies, which are all growing and they need capital for expansion and managerial talent. With all this growth occurring, they are having trouble keeping up with the growth in their portfolio.”

By teaming with a private equity partner, Wages noted, “they are seeing how they can redeploy their assets, their efforts and maybe sell off some of their non-core companies. They have come to realize they can’t do everything all at once and have to pick and choose where to concentrate their efforts. They might consider selling a majority in growth companies, which removes them from the day-to-day management and having the capital is a way for them to participate in the future growth of the business. Therefore, we find that to be a very receptive conversation with family groups in the UAE and in the Gulf.”

Shailesh Dash, of Global Investment House, believes that family firms are responsible for the lack of significant amount of investment in Saudi Arabia, Qatar, and Kuwait, where they are the biggest markets of the Gulf area, but have seen little in the way of investment for infrastructure, oil, and refinery of the region’s natural resources.

Dash said that 85% of all businesses owned in these markets are family-owned, which also own private businesses, making any attempt to work with them “an art in itself.”

Dash believes that “if three years back you came to Kuwait and met any of the CEOs or CFOs of the local banks, when central banks started giving out licenses to Citibank or other foreign banks like BNP Paribas — they would have told you this is only one branch license, we have the local relationship and their business would in no way be impacted. All these local banks are owned by the merchant trading families and have been a source of pride among the various family holdings.”

The current situation, of increased liberalization and more licenses for private companies could not have been predicted. Dash believes the new landscape means “the thought process of these families has changed so much, from being a business that before they would have never thought of selling to a position in which families are now willing to sell. That means, people have really graduated today to think in terms of investment and income. They can derive from it and what is core to their activity and what is not.”

Just as private equity firms seek industry specialization in the long run, family firms are realizing the effects of competition and how businesses must morph from the traditional line of acquiring and gaining stakes in several industries.

For firms involved in trade, banking, and real estate, they “have realized that they are either good in a business or not, therefore before they loose market share and loose value in their non core activities, it is the right time for them to sell a part of their business that they don’t think is going to be good for their business. Alternatively, they have been trying to focus on growing their businesses which they think they have an advantage or which are core to them,” Dash believes.

Regional financial markets have shown their correlation in responding favorably to private equity firms and the efficiency they provide to businesses over a diverse range of sectors. Many firms claim to either be industrially- or geographically-agnostic or pride themselves in their ability to be opportunistic while other firms pride themselves in a specific expertise with one industry or geographic region.

One way to understand the positive market reaction to private equity deals, which are still relatively nascent in the region, is to watch the jump of initial public offerings (IPOs) and the prices at which they are subscribed. IPOs present a way for firms to recapitalize and use their funds to expand or improve operations. Private equity is the key to bringing a firm up to scratch before it launches an IPO.

Looking at the figures, one can notice the jump in IPOs in the region. According to data from Zawya Investor, the total value of IPOs in the Middle East and North Africa (MENA) region, for 2007, reached $14.45 billion, a year-on-year increase of 77%. Among the most attractive markets which played host to these IPOs are Saudi Arabia, which attracted one third of all 66 IPOs in the MENA region, followed by Jordan with 14 in total, and Morocco, whose market hosted 10 of the listings. 

To further break it down by industry, financial services comprised 52% of the IPOs, with real estate ranking second with 11%. According to Zawya Investor, there are over 100 deals in the pipeline, including the second largest public offering in the Gulf, by Saudi Arabia’s Al-Inmaa Bank, for $2.8 billion, as well as Zain Saudi Arabia, which plans to exit the markets and attract $1.86 billion, the third telecom operator to offer the Saudi public its shares. The records set will not stay for long, with Saudi Arabian Mining Company, planning an IPO of up to $9.26 billion.

The type of business going the IPO route is identified as a firm with room for lots of improvement, but that has made a good start. When a private equity company comes in and buys such a firm, after a restructuring period where the management and the board is reflective of a new business philosophy and strategy, the firm is put on a publicly-traded exchange in the form of an IPO. Izzet Güney, managing partner at Millennium Private Equity, believes that IPOs “represent an important exit avenue for the private equity industry alongside the trade sale.” 

Wadah Al-Taha, head of strategies at Emaar Financial Services, explained that “IPOs are quite important now. We have a limited depth in all markets, except Egypt, in the region. The companies are limited, if you keep liquidity pressure coming, then it will affect the limited number of stocks. A lot of people will then lose, especially the small investors.” Al-Taha is “expecting the trading volume of 2008 to exceed $850 billion because of liquidity. So far, since the beginning of the year, UAE markets have traded $120 billion, equal to 22% of the total amount traded last year.”

Al-Taha believes this is a good justification for more IPOs, indicating that “more depth, more diversification into the market is what we need.” Looking forward, Al-Taha said that “in the UAE we will witness 14 new IPOs. In Dubai’s financial sector at least one or two bank IPOs are planned. One with a privatized institution called Emirates Post, which is highly anticipated. We also have a possible IPO in jewelry from Damas, a family-run firm.” 

Another prospect for Al-Taha is the, Saudi-based, National Oil Company which “is the fastest-growing oil service company in the world. It is highly attractive and worth more than $1 billon and is going public in Dubai. An Arab telecom firm specializing in satellite communication is also due for an IPO. The education sector will also be opened in Abu Dhabi.”  

IPO figures can be one explanation for the number of shares trading in local markets, as well as general economic exuberance. However, the figures presented represent a burgeoning market flooded with activity, with room for more. According to figures from the National Bank of Abu Dhabi, the total share traded in local markets by sector from 2000 to 2007 showed a jump from $1.38 billion in 2000 to $554.5 billion in December 2007, an astounding average year-on-year growth and telling of the liquidity available from the most recent boom in the petroleum industry thanks to rising global prices, which brought about a spike in 2004 trading levels, which have yet to calm down.

2007 most important exits

Oversubscription

Pundits point to IPO oversubscription as a source of concern for financial markets, but others are less worried. Güney believes “the term oversubscription has been misused a lot. Usually you have a share price range on offer, so let’s say you have a range between $1 and $2 and you go out and try to do the book building process where you call institutional investors and ask ‘are you interested in shares of ABC? Yes. How much do you want to buy?’ They say ‘OK, I’ll spend $100 million at $1. If you sell it to me at $2, then I will only have $50 million for you.’ The $100 million is the number that everyone remembers.”

Güney points to failings in analysis when industry watchers point to oversubscriptions, believing that instead of simply stating an IPO was oversubscribed, the price at which the IPO was exited is important when examining IPO subscription, since “it could have been oversubscribed ten times at $1, but at $2 maybe not oversubscribed whatsoever. Oversubscription is always a matter of excess liquidity and price point.”

Khaled al-Muhairy, CEO of Evolvence Capital, said that he believes, “there are so many reasons in terms of governance laws, minority protection, so many factors, but I think they really don’t know what to do with these companies. They say ‘OK, we are going to buy these mobiles at six and exit them at nine’.  Exit them where? DIFC? The UAE’s Minister of Economy Sheikha Lubna has 150 applications pending on her table that she doesn’t want to do. She doesn’t want to overrun the market with a higher flow of IPOs.    So people do not realize a very simple equation in private equity, cash in, cash out.”

Understanding private equity as an asset class was the final macroeconomic factor to determine private equity’s future in the region according to Güney. “Today, not many investors in the GCC understand private equity as a unique class of alternative assets, and one that is often uncorrelated with stock market performance. The investors that do understand this used private equity investments to great effect in 2006, when the stock markets in the GCC had ended the year on a sour note, but these investors mitigated their losses because of gains on their private equity portfolios. This awareness is growing, and as it does grow further, I expect private equity will come into its own as an established asset class in the region.”

Many investors around the globe are familiar with ethical funds, and even more so in the Muslim world where Islamic funds, compliant with shari’a rules are common. Among these funds are the Amana Growth Fund, which follows Islamic principles, the Pax World Growth Fund, one of the oldest of “ethical” funds, and the Ariel Fund. On the other side of the spectrum, meet vice funds, which target “sinful” industries, such as alcohol, gambling, defense and tobacco.

According to Matthew Reilly, senior stock analyst with Morningstar, the regulation by government agencies of certain sectors — gambling, alcohol and tobacco — provides them with an indirect advantage. “The interaction between regulatory bodies and industries operating in such areas, through seemingly adversarial, has become more symbiotic in practice,” he wrote in October 2007. Governments are hence relying heavily on such industries that provide them with higher returns via heavy taxation, a reason that might explain ‘vice’ stocks strong overall performance. Reilly believes that the tobacco industry remains largely attractive. The market is seen as an extremely stable oligopoly with a fairly inelastic demand curve.

“In the alcohol sector Diageo, also known as DEO, is an excellent brand as the firm is positioned in more than 180 countries in the world,” underlined Fawzi Sabbagh, senior financial consultant for capital markets at FFA Private Bank. According to Reilly’s report, the company has developed an exclusive distributor base in the Unites States, putting to use its large scale advantage. “The need for regulatory approval from governmental agencies, as well as scale advantages, combine to create wide long lasting moats in industries of questionable social benefit.”

Consequently, does vice constitute the right investment choice for any client? “If I offer you a fund that provides you with long-term capital growth, limited volatility, performance levels that vary between 17% and 18% and a yield-to-date (YTD) of 18%, what will your reaction be? The fund will be invested with 70% in American stocks, 20% in foreign stocks and 5% in bonds and targeting sectors such as information, services and manufacturing,” Sabbagh explained. “However, you will think twice, if you know that your capital will be poured into sectors such as tobacco, alcohol, defense and gambling.”

According to Laurie Roberts, president of USA Mutual funds, investment advisor to the Vice Fund, around $180 million were invested in the fund as of January 31, 2008. She believes that the good performance of the four sectors, namely alcohol, gaming, tobacco and aerospace or defense resides in the steady demand for such products. “These particular sectors are global in nature as people smoke, drink and gamble, while countries around the world defend themselves,” she said.

All of these sectors demonstrate one or more key attributes steering them away from dour returns, mainly a stable demand regardless of economic conditions, potentially high profit margins, a global marketplace dovetailed with natural barriers to new competition such as in the case of the highly regulated tobacco industry. “Global demand within these sectors typically results in low correlation to the U.S. economy. Strong pricing power and low cost of production tend to make the tobacco and alcoholic beverages sectors very profitable,” explained Roberts.

According to the Vice Fund website, specific industries namely alcohol, tobacco, defense and gambling exhibit defensive qualities. “Consumer staples like tobacco and beverages are widely considered to be defensive, because they are generally thought to be uncorrelated with moves in the broad equity market,” it said. The aerospace and defense sector, too, are more directly tied to budgetary cycles than fluctuations in the economy and the stocks of defense contractors are not directly linked to fluctuations in the broader market. The study also estimated that defense stocks had had almost no correlation with the S&P 500 over the last twenty years. “In the defense sector, the outcome of the American presidential elections is essential, as each party views defense spending and taxation very differently,” said Fawaz.

The report issued by the Vice Fund also indicated that there was little correlation between the tobacco sector and the equity market, namely the S&P500. “In light of the recent market hysteria, UBS put out a note last week looking at how the tobacco sector has fared in periods of high volatility. According to UBS, there have been 1,336 days since 1997 when the CBOE Volatility Index, or VIX, an index that measures volatility, has closed above 20; over those days, tobacco stocks gained 12.5%, while the S&P 500 declined 39.2%,”pointed out the report which was published last August.

Regardless of the economic situation, funds that target sectors such as alcohol, gambling, tobacco and defense have show positive returns in spite of adverse market conditions, underscored Fawaz. The Vice Fund achieved strong results in 2007, with the fund up 17.76%. The Fund, a five-Star Overall Morningstar rated fund, among 1,623 large blend funds, had a cumulative return since inception in 2002 of 142.35 % as of the end of 2007. The Overall Morningstar Rating for a fund is derived from a weighted average of the performance figures associated with its three- and five- Morningstar Ratings metrics.

The consultant believes, however, that such funds might pose a moral dilemma for many investors, especially Arab ones. Regardless of the ethical issues at stake, businesses seem to be looking the other way, as profit margins and growth remain the main elements to be put under scrutiny. The recent partnership between Dubai and MGM Mirage, worth $5 billion and aimed at developing casinos, is a perfect illustration of such a trend, despite the official Emirati ban on gambling.

Toward the end of February 2008, stocks dipped and oil prices closed at an all-time high, over $100. Consumer price indices rose and investors worried about their positions following the downward market trend. In such a bearish market, some financiers view fund of funds as a hot investment tool.

In November 2007, funds of funds under management reached $66.2 billion, up from $64.2 billion at the end of the previous quarter and an increase of 21% from Q4 2006. Balanced funds accounted for the majority of funds under management, representing 68% of assets, followed by 18% in equities, according to the Investment Management Association website. Total net sales in this particular class were $1.607 billion, down from $2 billion in Q3 and $1.798 billion year to date.

Funds of funds invest in a diverse range. “They combine the skills of various asset managers within single or multiple asset classes,” said Michel Chikhani head of Asset Management at BLOM Bank. “There are different types of funds of funds,” added Bechara Bardawil, portfolio manager at the bank. They include multi-asset funds of funds (which invest in different asset classes), funds of hedge funds, funds of fixed income funds, funds of equity funds and alternative investment funds (real estate, private equity, etc.). “Ideally, funds of funds manage their holdings towards specific risk and return objectives.”

There are also multi-manager funds, operating in a similar way to other funds of funds but instead of choosing particular funds, they select individual managers who are each responsible for an investment category, explained Fawzi Sabbagh, senior financial consultant in Capital Markets at FFA Private Bank.

According to him, “the main advantage of funds of funds is double diversification, which allows reduced risk, whereas a mutual fund diversifies only across many different stocks. Funds of funds invest in a diversified portfolio, both geographically and among different asset classes, without having to directly invest into dozens of funds.” They also allow overcoming institutional obstacles such as significant minimum investments and enabling smaller investors to access large funds, which have been off-limits to them historically.

High fees

On the other hand, such privileges come with a high fee. Entry fees and charges are, on average, higher in a fund of funds than for individual funds, as top managers tally up their own expenses for the various costs of funds. Charges consist of extra fees and expense ratios, with some funds of funds charging fees at the parent level while carrying high expense ratios. Another disadvantage for funds of funds is liquidity as possible time limitations on the client’s right to redeem shares are prevalent among these funds. “It is more difficult to liquidate your position in a fund of funds than in a regular long fund because they often impose a ‘lock-up’ period of one year, during which you can only cash your shares against payment of a penalty fee,” said Sabbagh.

Now, is paying the extra charges worthwhile? The best funds of funds offer real advantages in both diversification of risk and performance, while others may charge high prices for little returns. In the case of funds of hedge funds, investors will be pouring their money into a range of different products and strategies such as arbitrage, commodity trading, multi-situational and hedging, which may help in reducing the impact of downward market trends. “The manager’s perception of the market will ultimately affect his strategy,” Sabbagh underscored. He emphasized the positive aspects of such funds, which aim at reducing exposure to volatility and risk and seek to preserve capital, regardless of benchmark performance. For BLOM’s Chikhani, other advantages reside in providing robustness in terms of returns and the possibility of relying on the best breed of managers one can get. Bardawil emphasized, however, that in times of crisis, such as the recent subprime meltdown, which led to the current correction, market correlations tend to shoot up. “This implies that within funds investing in the same asset class, the benefit of diversification will not be as effective as in normal times,” said the portfolio manager.

In the opinion of Chikhani, investment in a fund of funds is not necessarily a guarantee of success. “It is vital however to pull the best fund managers together, ones who can boast successful track records over a significant period of time. While some funds are benchmarked and others are absolute-return driven, the essential building block for funds of funds is the common strategy and objectives that bind them together. The big question is that we rarely know which strategy will outperform others in the current economic situation,” he declared.

What selection process should be followed when investing in a fund of funds? “It is a question of trust. You need to have confidence in the fund of funds manager you choose,” said Sabbagh. The financial consultant highlighted the fact that funds of funds remain unregulated for the most part. Some may even be opaque and avoid disclosing losses incurred by shading in future profits over a certain period. Growth of the sector is also estimated on a net basis, excluding funds that went out of business.

Considerations

“It is primordial to verify the manager’s tenure and his track record over a certain period of time,” explained Bardawil. Researching the backgrounds of funds managers and knowing with whom one is investing is an essential process. In Chikhani’s opinion, due diligence of fund managers is indispensable to the selection process. It is also crucial that investors understand the risk level tied to the fund’s investment strategies and ensure that they are suitable to their personal investing goals, risk tolerance, and time horizons. “For a fund of funds to make sense, it needs to provide the same return for lower risk, or a higher return for the same risk; a challenging task for any manager,” concluded Bardawil. Other indicators investors need to look into consider how a fund’s assets are valued, how they are allocated and leveraged, as well as the quality of people on the management team. As FFA’s Sabbagh summed it up, “Diversification, low volatility, guarantee of absolute return and preservation of capital are key elements in any fund of funds.”

Private equity’s microeconomic outlook fuses numerous ideas of industry practice to focus on the quintessential benefit of the industry: value-creation. The re-structuring of firms by private equity players to bring value to them requires a strong team focused on research and pursing only the best deals in the pipeline, while giving consideration to best-practices in revamping businesses. This due diligence is dependent on talent and is important when introducing reforms in corporate governance to acquisitions.

Acquisition acumen

According to experts across the industry, talented professionals with experience in due diligence processes and methods are a necessary addition to any team, but the specific math these due diligence experts employ — from Six Sigma Black Belts to those with a regional understanding — vary considerably. However, they maintain the same ends of making a firm more efficient.

Khaled Al-Muhairy, CEO of Evolvence Capital, thinks that “private equity firms here go to Frankfurt for a conference, and hear buzzwords like value-added. Then they say ‘we bring value-added services to the company’ and they put it in slides seven and nine of a presentation and unfortunately they don’t have a clue what one thing does and what another one means.”

Demonstrating abilities is the best way to gain the favor of regional firms and investors. Looking back at SHUAA Partners’ success in closing their first fund, with the UAE’s leading jewelry retailer Damas, Jamil Brair, senior vice president of the firm, remarked that back in 2005, when the group engaged in fundraising, “raising the money was relatively easy.”

SHUAA Partners’ success has now allowed it to brag about its ability. Briar explained that “raising the money on the back of a transaction that you’ve done is all the easier. After Damas, it was a much more compelling story to investors to show that you did a close on an investment rather than have one slide with Company A or Company B. Having done Damas, I think it took two weeks to raise the money after that.”

Richard Dallas, managing director of Private Equity for Gulf Capital, which prides itself as the first in the MENA region to use Six Sigma due diligence methods, believes “things happen during the course of your ownership and you have to react to it, so it is a very collegial relationship we have with post-acquisition. But fundamentally, I don’t know how to fix supply chains, and that is what another managing director, Magellan Makhlouf, and his group does for a living. And I don’t mean to suggest it’s only supply chains because they are very tactical in what they do.”

Dallas thinks that his firm “is unusual in the Gulf, in getting people together who are committed on a tactical basis to improving the companies. Everybody will tell you they strategically monitor the companies, but I think we are relatively unique in having dedicated internal resources that actually help the company to achieve their operational efficiencies. The other thing Magellan does is manage a series of outside resources that we bring in on a specialist basis. He is involved in the operational aspects of the company.”

Gulf Capital hires due diligence experts from other firms to work on specific deals. “For example, if we are looking in the media area, we will find as a team, somebody who is the guru, who really knows the landscape.” Although Dallas can bring global industry knowledge, his business depends on “localized knowledge to see what opportunities have been foot-printed in the West and how they are going to flow through a new system that is nascent and just building.”

Evolvence Capital’s Al-Muhairy believes that talent acquisition is going above finding skills that are commodities, to hiring people who understand the business climate of the countries in which they work. He views foreign understanding of local markets with disdain saying that, “if he speaks Arabic, it doesn’t mean that he is Arab.”

Changes in company performance since receiving equity or venture capital funds

Executive literacy and innovation

Al-Muhairy advises local players to read, because it makes little difference if someone from a Gulf-based firm attends conferences on Western practices for their MENA business operations without an understanding of regional practices.

He believes “it’s all about reading and understanding. It’s a major issue in this town, reading. You know why they like the newspaper, because it’s short. You give them a ten-page article and they’ll look at the subheadings.”

Maher Hammoud, senior vice president at SHUAA Partners, indicated how the private equity industry has changed from “attracting talents from the investment banking experience. This is understandable given that the focus of these private equity firms have been on raising the funds, screening investments, and executing transactions.”

He continued, “Recently, we started seeing a trend of PE firms attracting talent from the strategy consulting industry. This is a positive trend and a signal that some private equity firms are beginning to add in-house capabilities to manage the post-acquisition stage of their investments and playing a more active role to assist their portfolio companies in building value.”

Innovation is the key to finding new ways to operate and private equity firms pride themselves in their abilities to generate teams whose members compliment the firm’s strategy and the rest of its in-house personnel. For Gulf Capital, Dallas thinks it is “innovative in that we maintain post-acquisition operational resources. And a lot of firms don’t maintain it in house, they outsource it. We like to have people internally, who we can put into the companies as well as draw on outside resources. We are very focused on a value-creation strategy. When we buy a deal, its not ‘oh boy, that is a good punt, I think telecoms is a good go, let’s throw our boat in the river and see if the tide rises.’”

Another private equity guru, The National Investor’s senior vice president of private equity, Yahya Jalil, has organized his division into four research teams to bring in additional deal flow from in-house spotting and assessing. His team is divided by sectors, including healthcare, real-estate and contracting, industrials, chemicals, energy, consumer and retail. 

He explained that “each sector has a dedicated research analyst or team covering it, looking for investment ideas for the fund in that sector on a proactive basis. This allows us to build domain knowledge in these sectors of interest over time, and allows us to make smarter decisions in the future.”

When Jalil initially came on board TNI’s private equity team, after a significant time in Western markets, he knew the ins and outs of the private equity business, and thus “the learning curve for me was really on understanding the region, and deal-making in the region. So I surrounded myself with smart, driven people who could help me on this. My first hire was someone who, while he had not done private equity before, had broad and deep financial services experience in the region.”

Pursing this, he ensured that “each hire I made was to find someone with a skill-set complementary to mine. Today I have people that have (a) deep forensic accounting backgrounds, (b) deep operational backgrounds — they really know how to run a company, and (c) industry specialists in the region. All of these skill sets complement my own background well, and to me, that is what a good private equity team is all about — collecting the right set of specialists.”

The mixture of in-house and external firms in assessing deals in the pipeline has now become standard in MENA private equity, but Jalil wants his team “to have ownership of this part of the process,” including business establishment, due diligence, researching end-markets, and all the core competencies of a private equity firm.

TNI does hire Western firms to help with feasibility studies, but for planned investments the firm “will do the business plan and transaction structuring in-house.” Jalil also believes in “empowering management teams to make decisions,” offering backing while on the board to “a decision related to the operations of the business where we put faith in management of the company to make those decisions.”

Preferred sector of private equity investments since 1998 unskewed ($ million)

Team synergy is important to private equity deals. Dallas explained the organization of Gulf Capital whereby another managing director and his team “become active while we are doing due diligence. They are very active when we do our business diligence as part of the creation of our investment thesis of why we are interested in a company and why we are interested in a sector and, ultimately, why we like that company. He is involved along with his team in doing operational, commercial due diligence.”

Gulf Capital’s division of labor is an attempt to layer pre-acquisition deals. At the technical, tactical level Dallas’ firm examines “how to fix the supply chain, so you could push working capital out of the business or help recruit better human capital into the business.” His team coordinates at the strategic level by examining “where is this firm going? What are the macro trends? What sectors do we want to be in?”

Geographical split of private equity investments since 1998 unskewed ($ million)

Due diligence

Due diligence, the process private equity firms pursue prior to an acquisition to find if investing in a particular company is feasible, has taken hybrid roots in the MENA region. Traditional forecast-based models of the processes — including the new popularity of Six Sigma procedures developed by Motorola — are blending the region’s more Eastern style and approach to deal valuation. They also factor in a certain unquantifiable amount of synergy that a deal will create to nurture future possibilities with a regional partner.

For regional players, the due diligence procedures they learned in the financial capitals of London and New York, along with the ranks they hold — from Green Belt to Black Belt — are of less use than understanding softer due diligence standards, including “the notion of give and take,” which Jalil of TNI has acquired since establishing his base in the GCC and attuning his style to be more market-oriented.

He believes that “if you ask for perfect corporate governance in the region, or corporate governance to North American standards, you will never do a deal in the region. Rather, what I try to do is ask for the really critical things, and maybe give on some of the less critical ones, in the interest of getting a deal done. There are some fund managers in the GCC who have said to me, ‘we don’t do a deal until corporate governance is 100% tied up.’ But then you look at their deals, and there are corporate governance holes so big you could drive a sixteen-wheeler through them.”

For Jalil, “the strongest fund managers in the GCC focus on finding the balance between doing enough diligence to not make a mistake and not going overboard on Six Sigma. This is a fine balance, but one that is paramount for a fund manager to do deals successfully in the region.”

Rami Bazzi, principal at Injazat Capital, explains his firm’s due diligence procedures, consisting of both soft and hard approaches: “The first phase is done in-house, where we assess the opportunity, estimate its fair market value and negotiate the deal structure from a financial and legal perspective. Once we have the board approval, we initiate the hard due diligence process, in which we appoint external advisors to get an independent view on a number of valuation and legal matters. In summary, we do it in-house and conclude it by seeking external expertise.”

Corporate governance

What due diligence often discovers is room for improvement in a firm’s efficiency and with the top-down approach of most private companies, slack in efficiency needs improvement through the management and the board on down. Izzet Güney, managing partner at Millennium Private Equity, attested that “indeed, bringing a high degree of reputation to the table, setting up governance boards, making sure checks and balances are correctly implemented adds value.”

The experience he had with corporate governance improvements prior to his expedition to Dubai in 2006 has taught him that “those steps enable the investor base to truly expand and liquidity in a stock for example is what makes it go high. Bringing the famous other pair of eyes also helps a lot and in many instances, a new investor had the ability to identify issues which needed to be resolved but that existing shareholders overlooked.”

The traditional response to management restructuring has been viewed with suspicion by industry pundits in London and New York, but in the Gulf and in the MENA region in general, there is much improvement to be made bringing firms up to scratch with more sound principles of governance.

Robert Wages, executive director of Private Equity for the Abu Dhabi Investment Company, believes that “there is a willingness and recognition to improve the procedures in corporate governance. However, it starts with the board downward, so if you compose the board properly with people who have the best interests in the company, then you put in place the right reporting and governance procedures from the board who promotes good management practices and the management can carry out the same on down. There is not really resistance, just a lack of familiarity.”

Yahya Jalil’s idea of private equity expertise sums up the nature of the business in which these firms operate. He recounted how someone once told an investor that he made a “lucky” private equity investment, to which the investor retorted: “I find that the harder I study the industry and the company I am investing in, the luckier my investments become.” The same hope is shared by Jalil and his colleagues in private equity teams across the Middle East, North Africa, and globally.

How agnostic and opportunistic are funds?

While some firms claim to be industry and geographically agnostic within the MENA region and pride themselves on the fact, the majority of private equity firms have broad foci on certain sectors. For instance, many firms can categorize themselves as telecoms, media, and technology (TMT) fund managers, infrastructure groups, or down-market activities in the supply chain of one of those two main industries.

Down-market industries provide the cement and bricks to construct not only the glamorous high-rise skylines in the United Arab Emirates, but also the pavement and gravel for roads leading to a burgeoning social infrastructure MENA governments are creating to provide healthcare and educational services for a young, blooming population.

Wages commented on the size of the industry and noted that consolidation is far off in the future, but firms are already beginning to seek out specialization and to build scale in industries for the road ahead. The challenge firms will face when liquidity flows in less abundant amounts is that they will have to start chasing deals with more fervor.

Rami Bazzi, of Injazat Capital, believes “there is a large interest from investors to invest in specific, rather than opportunistic, funds. Industry focused funds tend to have a more defined strategy. They are able to add value to their portfolio companies by building on their industry expertise and market knowledge. Having the right network in one specific industry rather than randomly targeting opportunities in various sectors offers advantages. Overall, the industry will go through consolidation as it grows and matures and as investors become more sophisticated in picking the right fund manager. They will be more focused on track record.”

Bazzi foresees that “as the industry moves from fund raising to the deployment and investment stages, investment managers need to prove their ability to successfully close the cycle, profitably exiting investments. I believe the current industry dynamics will support the emergence of a new set of funds not particularly focused on an industry or a structure such as secondary funds. I expect new players to move in.”

Yahya Jalil, who currently oversees operations of TNI’s Growth Capital Fund I, which has a geographical focus in the MENA plus South Asia (MENASA) region and a strategic focus of late stage businesses and buyouts, is comfortable with the agnostic nature of his fund’s investments, although “a third mechanism for us to do private equity is under development. It would be through a series of industry-specific funds. It’s really taking our sector and industry research-based approach to private equity to the next level.”

For this new venture, the first movement is “likely to be an industrial fund or industrial investment company to take advantage of downstream opportunities in basic materials, chemicals, the oil & gas supply chain, metals, and alternative and traditional energy. The timing on this initiative is in the second half of 2008.”

As private equity becomes more competitive and increasingly based on what you know and how you can add value rather than who you know and the family relationships you have maintained, industry watchers are likely to see more firms heading toward a sector focus and building a competitive business.

Bazzi explained his firm’s new Injazat Technology Fund II will have a targeted size of $100 million in equity and the option of up to an additional $100 million in leverage focused on TMT in MENA. Also, it “will have partial exposure to countries outside MENA on a 75%-to-25% ratio, mainly for strategic purposes whenever the investment compliments our portfolio of companies and would allow us to transfer new technologies to the region.”

According to him, “investments outside MENA will be conducted on an opportunistic basis,” if there is an “appealing investment opportunity that will help transfer technological innovation to the region and some synergy with portfolio companies.” The fund is considering Europe, the US, and Asia as potential markets for investment opportunity. The move to export regional liquidity abroad, especially into developing markets in Africa and Asia, is a move others are following as well. Bazzi believes “investors are increasingly interested in North Africa, specifically in Egypt, Morocco, and Tunisia, as well as Libya,” although “in terms of markets, the GCC presents the highest potential.”

EMP is certainly following this trend and has not restricted itself to any set group of countries, although it has a base in Bahrain. In fact, the relationships they are cultivating are used in development projects in markets lagging behind the Gulf. Junaid Jafar, general partner of EMP, explained that his firm “did not target institutional investors outside of the region” for the group’s Energy Fund but “we intend to do this once we have achieved the first closing of the fund.” Jafar also discussed the geographic mandate of the group’s IDB Infrastructure Fund, which received a green light to work within the 57 member-states of the Organization of Islamic Countries that has a wide reach across North Africa, the Middle East, and far into Asia.

Shailesh Dash, senior vice president of alternative investments at Global Investment House believes MENA is “8-10 years behind in terms of private equity, compared to other emerging markets like India and China. I think this is still a very good market if you have the relations, because the growth rate that will come in the future will determine a lot and the region is just starting to grow and valuations are still in single digits. There will be a significant number of opportunities over the next 7-10 years.”

Izzet Güney, of Millennium Private Equity, thinks that consumerism will indicate the hot sectors in the coming years on which private equity firms can capitalize. According to him, “consumerism is what drives value creation and in the MENA region today, you have millions of kids and young adults all striving to buy stuff, to watch stuff, etc. … This makes communication key. Not only to speak to each other but also advertise, identify and personalize your shopping experiences. This requires a strong economy, not single-industry dependence.”

Real estate private equity funds total value in MENA ($ million)

The macroeconomic changes of the past five years have opened up possibilities for private equity firms to operate in the Middle East and North Africa (MENA) on both a fundraising and investment basis. Industry experts agree that the region is developing and is awash with liquidity, and that it needs regulatory procedures to monitor and tame the activities of new market entrants. 

MENA governments are welcoming private equity capital and expertise through the creation of

an industry-friendly environment through free-trade areas, lenient taxation policies, and strong appetites for imports. Ever mindful of their burgeoning youthful populations, governments in the region are seeking a macroeconomic environment which encourages wealth creation and social mobility.

Rami Bazzi, principal of private equity at Injazat Capital, believes that “over the last four to five years, investors had mainly invested in the equity and real estate markets.” He goes on to attribute the growing popularity of private equity as an asset class to a number of factors, “such as the volatility of the stock markets and the overall enticing business climate.” Regarding the regulatory changes toward protecting minority interests and attracting foreign direct investment (FDI), Bazzi thinks that they are “improving the speed and ease of doing businesses with major efforts that translated into apparent progress.”

The liquidity that has flooded markets should be supervised as excess capital is not a permanent fixture in the region and private equity houses will face increasing competition. According to Junaid Jafar, general partner of EMP, the GCC’s liquidity “impacts what your angle is as an investor — are you a buyout shop, a private equity infrastructure player or a sovereign wealth fund?”  As the private equity game is played out in the region, firms will have to pay attention to specialization. 

2007 Top 5 closed funds

Population as an impetus for change

Governments are increasingly looking to better management practices for their excessive liquidity and have identified ways to improve conditions for their constituents through social infrastructure projects. From schools to hospitals, this new infrastructure will serve the dual purpose of providing services for citizens, while at the same time acting as an engine for white-collar job creation as the services will need staff to man them, nurses to care for patients, doctors to treat illnesses, and teachers to educate the next generation of professionals.

Regional population growth rates show no sign of slowing in the coming decade. Izzet Güney, managing partner of Millennium Private Equity, cited a 25% growth in Dubai’s population on top of similar growth in 2007. “In their development plans, master planner Nakheel is said to envision a Dubai in 2015 which has a population of 10 million. These are astounding levels of population growth, and create the demand for healthcare, education, insurance, and other services.”

According to him, “the nature of the population growth is such that a significant percentage of this increase is expected to come from educated workers/white collar jobs, who consume these services at a much higher rate than the average per capita consumption today. So as the population mix changes, the averages will change too.”

Fadi Arbid, executive vice president of Amwal al-Khaleej, an up-and-coming industry player based in Saudi Arabia and connected with a well-stocked rolodex and portfolio of family firms, looks to demography-driven sectors. Especially in the Saudi market, where under-21 year-olds constitute 70% of the kingdom’s population, noting how “in five years, when oil is no longer at $100 a barrel, you are going to need an educated and healthy population,” necessitating a string of social infrastructure projects.

Governments are trying to build this social infrastructure as soon as possible because of “chronic under-investment in the region, most notably in infrastructure, but also in industry. So we are really trying to play catch-up here. For example in healthcare, the healthcare spending as a percentage of GDP in the GCC is 7-8% lower than in developed markets even today,” according to Bazzi.  Most industry watchers are witnessing the take-off of sectors such as health care and education, which in his estimation, “need more aggressive levels of investment.”

Diversification

Izzet Güney, of Millennium Private Equity, believes there is a drive towards economic diversification in the region and a consequent desire to reduce dependence on the hydrocarbon industries. This creates new sectors of the economy that did not exist five or ten years ago. “In particular, the services industries that are being developed in the UAE for example are relatively nascent and need access to capital to grow.”

EMP’s Junaid Jafar explained his firm’s own experience with macroeconomic winds changing, as they monitor the firms they brought to market by wryly pointing out, “the subprime crisis and global slowdown that have happened over the last couple months haven’t helped.” 

However, because his firm’s investments are in developing markets in Southeast Asia, in addition to others, he remains confident, saying “we should see their valuations slowly start to rise again. Our toll road investment in Malaysia should benefit from the development being undertaken in Johor, especially with its proximity to Singapore. With the announcement of the Iskandar Economic Region and the lack of good roads, we should see a lot of growth and traffic in the region.” For the institutions on board at EMP’s forays abroad, the looming recessionary fears in Western markets have not caught up with developing economies.

EMP’s Energy Fund might not have attracted the same level of popularity from the region’s investors had ideas of diversification not entrenched themselves in the minds of petrodollar financiers. 

According to Jafar, “There are certain regional institutional investors that do not wish to invest in funds that are correlated with the hydrocarbon industry. However, outside the region many institutional investors are looking to gain that kind of exposure. There has been interest in our Energy Fund from institutions as far a field as Finland, Australia and the United States.”

EMP’s experience remains close to the idea of a dual diversification with the West looking to the MENA region as a possible source of returns and safety from less abundant Western markets, while regional investors look elsewhere for other asset classes and sectors into which they can invest their energy riches.  

Founder and managing partner of Ithmar Capital, Faisal Belhoul, noted the interest paid by international firms as they are “aware that the GCC markets are not yet dominated by one single player and are looking to hedge risks and compete in an increasingly globalized market.”

By understanding private equity as an asset class, Middle Eastern investors can diversify their capital from a range of regional deals or natural-resource industries by taking advantage of private equity firms who are willing to court them now, as investors, to generate deal flow down the line. 

Wealthy members of the largest family groups, as well as institutional investors seeking to diversify to other markets in the West or neighboring developing markets in Asia and Africa, would then be cultivated by the fund manager to gain their trust for the future. Then that family firm can assist a nascent private equity player with gaining a toehold in a new market or approval from a new regulatory body. 

In this way, private equity firms are the thoroughfares into other markets, both geographically and by sector, as the region’s investors can become institutional or individual backers of funds in other developing markets less affected by global economic conditions than Western Europe and the United States.

For Bazzi, “government strategies to reduce their oil-income dependency and focus on the development of services have boosted the growth of the economy in general and the private equity sector in particular.” The increasingly favorable macro environment and encouragement of private companies will maintain a strong demand for private equity in the region.

2007 Top 5 announced funds

Employing equity

Research from the United States indicates how the effects of private equity deals in the MENA region differ from the Western experience.  One study shows that regional companies acquired and revamped by a private equity house increased internal employment figures by 17%. 

Private equity transactions 2007

When cited to industry leaders, the response was mixed, and differences exist between industries and within companies, but most agreed that if this number were to be true anywhere, it was certainly in the MENA region where private equity finances expansion plans or movements into other markets, both of which improve employment figures in the long term. The traditional idea of a private equity shark, which cuts jobs for the sake of efficiency, was rebuked in favor of value creation and the need for efficient employees.

Although the details of the figure are not provided and do not explain different experiences, Jafar thought it was “an interesting fact, as normally private equity gets blamed for cutting employment rather than increasing it.” In his own firm’s experience, especially EMP’s infrastructure projects in the MENA region, “there are a couple of greenfield projects in the petrochemicals and power sectors, which have obviously resulted in increased employment in the region or country.”

Yahya Jalil, senior vice president of private equity at The National Investor (TNI), believes “the reason why private equity really has potential to accelerate job creation in the MENA region is because private equity flows are going into non-hydrocarbon sectors, especially knowledge industries, which do require human capital.”

Jalil also indicated that, “private equity managers are just good at creating alignment of incentives through a carrot and stick approach. So the workers that are employed at private equity-backed companies in the region are more likely to be incentivized to maximize the shareholder value of the company in which they work, since there is a strong motivation from the private equity managers to drive high returns.”

Privatization plans in the pipeline or finalized deals have, however, brought the opposite, as government bureaucracies are rife with inefficiencies. According to Jafar, “the only transaction where there has been a significant impact on employment is our telecom investment in Turkey where, post-privatization, there was a cut in the workforce. Originally being a state-owned public monopoly, the company was somewhat overstaffed.”

Firms will have to partner with public bodies as they seek to address the new problems created from privatizations in the economic short run.  For Jafar’s deal in Turkey, his firm worked in collaboration with the Turkish government “as there were local considerations to be addressed.”

If governments can attune the economies for growth in labor-intensive sectors and new infrastructure projects, then it is possible to accommodate the strong demand for job creation. Sheikh Mohammed, ruler of Dubai, saw the need for governments to accommodate firms by setting targets of non-oil sector portions of GDP for Dubai at 70%. Jalil believes the Sheikh’s Vision 2010 “envisions some major steps” toward better labor laws.

Bazzi echoed this view. “I am certain that there is real value creation,” he said. “Judging from our own experience, we have seen growth much higher than that. In certain cases, some companies were increasing their labor force by more than 100% a year for a period of two to three years. On average, for many of our portfolio companies the number is higher than that. I would not be surprised if the region exhibits an average increase of 17% or even higher.”

Private Equity transactions 2007

Private equity transactions 2007

According to Robert Wages, executive director of private equity for the Abu Dhabi Investment Company, “governments don’t necessarily know how to optimize the processes as best they could, but they are heading in the right direction.” He believes the UAE, along with Egypt and Jordan, is “quite serious about privatization” and that the moves towards privatization stem from motives, which range from raising cash for themselves to using privatization as a way of making the economy more efficient. “All economies have a mix of motive. When they are focused on country efficiency, it tends to make transactions work well because commercial consideration is very important.”

Regulations

Private equity players understand the need to work through regulations established in developing countries. The policies are a mixture intended to safeguard the governments as their economies move to another stage, while ensuring that enough air is available to fuel the flame. 

Jafar, whose firm EMP operates in developing countries in the Middle East, as well as Africa and Asia, believes that “having a diverse mandate, both geographically and across industries, you have to know about the regulatory regimes and environments. On the funds side there have been considerable developments in the region.” He attributes success in establishing his fund in Bahrain in large part “to the regulatory developments undertaken by the Central Bank of Bahrain.” For other players, Jafar believes that “regulatory developments such as the formation of the Capital Market Authority (CMA) in Saudi Arabia in 2003 and the Tadawul (Saudi Stock Exchange) or other such developments in the region, provide exit options to many financial and private equity investors.  Five to seven years ago, this would not have been possible.”

Jamil Brair, senior vice president of SHUAA Partners, believes his firm’s first fund succeeded by “learning the particular rules and regulations of the GCC with local sponsors and side agreements and rules that have to do with local ownership. It’s not rocket science, they can get the gist of it from a lawyer or an accountant, but that is when you get to see the complexities of the local markets and the necessity when doing the deal and closing the transactions to be aware of these issues, since it’s not the same elsewhere.”

Brair thinks what “needs to happen is more education about private equity toward target investment companies. And the other is that people should realize there are voluntarily regulations in the industry and the presence of international firms will encourage local players to adopt local financial reporting guidelines and other standards.”

In the future, Ithmar Capital’s Belhoul believes that if inconsistencies in restrictive regulatory regimes can be improved, “the GCC has the potential to become a truly global player in the private equity industry,” and indicated that, “the high proportion of private companies in the region, in comparison to the more significant numbers of public companies in the West, means that private equity in the GCC can perhaps be considered as a main-stream asset class rather than an alternative investment.”

Private equity transactions 2007

The 49% hump

Although improvements are moving forward and there is a “gradual relaxation of foreign ownership requirements, including in the Free Economic Zones, which is again an enabler of new business,” according to TNI’s Jalil, firms must still break the 49% cap on foreign ownership of regional firms. 

The 49% rule is one way for regulators to guard against further liquidity, the market and economic pressures associated with it. By capping the amount of foreign money a firm can use, the regulators are effectively telling regional businesses to use the region’s available liquidity to grow, yet allow for capital from private equity houses because they offer benefits and knowledge of due diligence and corporate governance. 

The 49% ownership limit does not remain a serious impediment to most firms. This is because regional private equity groups advocate for limited stakes in acquired firms to hedge against a losing horse if the investment turns sour, but more importantly because the synergy between firms and family groups is important to future deal flow.

However, for larger firms, like Wages’ Abu Dhabi Investment Company, or firms looking to become major stakeholders as family-firms grow comfortable with the idea of private equity, the current ownership caps are a hamper on the industry’s progress. As he pointed out, “we are looking to be very influential in the company we invest in as we are not sector specific, but we look at all sectors in a market.” 

Jalil said that when the 49% cap will be lifted is “anyone’s guess,” as the spirit is certainly there and reflected in various alternatives and mechanisms to create economic ownership for foreign entities in ventures in the region. “That is what a lot of our business is based on. Partnership with TNI gives international firms access to the regional markets, and since TNI is a regional firm and not subject to foreign ownership caps, we have a lot of latitude pursuing our private equity transactions.”

Wadah Al-Taha, head of strategies at Emaar Financial Services, would “prefer to keep the foreign ownership of all companies at a maximum of 49% but not to exceed it, not now. Not until we get a more mature investment behavior. We are in a stage of growth, not in a stage of mature investment.”

The figures indicated by Al-Taha point to an excited market where investments might provide higher returns from merely the volume traded, especially since January 2008 received trading levels of over $100 billion, which is the equivalent to all trading that had taken place in the market over the last four years.

As advice, Al-Taha cautioned that “we need to provide support and enhance growth and then maybe we can open a little bit wider.  Now the level of growth in UAE markets is not fully supported by a legal environment here. The level of growth is higher than the legal growth would support. I mean, there is a gap now, a legal gap, which is not yet filled.”

Looking forward, he believes that, “in two to three years the market would be more mature for more tools to be listed in the market, including funds and bonds.” Allowing firms into one’s country, does not, however, mean they can do their jobs and create value for acquired firms. Granting the thumbs-up to private equity players and liberalization in general is not the only measure needed by governments to ensure an efficient system. 

According to Güney, of Millennium Capital, “the private equity industry really thrives in an environment in which there is real transparency in the information that companies provide to investors. This is improving in the region, as the GCC attempts to catch up to more global standards on the regulatory front. An adjunct of this is the institution of good corporate governance at the company level, in which we also see a positive movement.”

Abe Saad, partner in Rasmala’s  private equity wing, noted that “you have the World Trade Organization (WTO) regulations being implemented in lots of countries joining the WTO and you need to see more opening up of ownership laws in countries to be able to become competitive.  In the next five to ten years I expect it to happen.”

Liberalization as a condition of access to the WTO is an important point echoed by Ziad Maalouf, senior vice president of MENA Capital, who said that “there is no doubt that the regulatory structures in the MENA region are gradually becoming investment-friendly and the economic liberalization is allowing a greater role for the private sector.  This coupled with the rapid economic growth and the availability of vast capital resources that had previously been channeled to investments abroad, have made the region riper for the expansion of private equity activities.”

Private equity transactions 2007

Legal structure

Once fund managers are able to court the favor of regulators in MENA countries, the regulators must work with the legal system to establish better contractual procedures to govern private equity firms and the deals they make with businesses in the country. 

TNI’s Jalil used the example of “an arbitration body set up by the Government of the UAE to settle business disputes faster. Free Zones such as the Dubai International Financial Center have established their own dispute settlement and arbitration rules.” 

Developing their arbitration systems is a choice that governments can make as a precursor to revamping their judiciary system. Arbitration tends to take less time and allow for new appellate procedures, and thus most industry experts consider it business-friendly, or at least considerably more business-friendly than a bureaucratic court system. 

According to Jalil, arbitration bodies could help develop the “enforcement of intellectual property rights, which is a big enabler of a whole slew of businesses that wouldn’t have been possible before.” Capitalizing on the opportunity to further relationships with foreign firms, regulators are on course to increased, if however gradual, economic liberalization.

Pointing towards a possible compromise between external procedures and local traditions, Richard Dallas, managing director  of private equity at Gulf Capital, explained that “a lot of people decry the whole notion of having elaborate documents, because the courts are slow, but I got news for you, they are slow in the United States as well as really expensive. But the process of negotiating that deal reconciles expectation and risk, I think that is a really important thing to do. And I think that by doing that you are bringing a process that is somewhat foreign to the region.  And that is where we try to make a good interface between investment technology and cultural sensitivity.”

Regulatory relationships

The scuffle with regulators to create the proper environment is a burden shared by private equity players looking to become a mainstay industry in new MENA markets. However, to do so, according to Dallas, “they need to adopt best practices from the West for those pension funds, those endowment investors that feel comfortable with seeing the same investment rigor and the same investment style they see in the West.”

He is not alone when he comments that people “want to invest in a system where after they have done their diligence, they know how it’s going to work, they know the rigor, they know the processes, and they’ve made a bet on the region, a bet on the management team that is putting the money out for them. So I think it is incumbent upon the private equity firms here, if they want to engage the Western world in inward-bound investment private equity to do that.”

Injazat Capital’s Bazzi also noted the rise of foreign capital coming to MENA, one measure which indicates the attractiveness of the region’s markets. Bazzi believes that “there are plenty of opportunities for local and foreign investors. According to the recent Emerging Markets Private Equity Association (EMPEA) survey, limited partners planning to invest in the Middle East increased to 11% in 2007 compared to 5% in 2006 and to 20% in Africa in 2007, compared to 4% in 2006. The improvements in the regulatory system and the development of the overall business climate have been enticing factors to local and international investors. International players are already investing and raising funds in the region.”