If only every great idea could guarantee a swarm of investors knocking at your door. But the harsh reality is that, even after going through all the right motions (from hammering the fantastic idea into a solid business plan and assembling a capable team), entrepreneurs and growth-minded companies customarily face their greatest difficulties in attracting capital. And although nobody doubts that there is a shortage of liquidity in the country, most would-be business tycoons find that start-up money is even scarcer in Lebanon. Simply put, venture capital, for all those who are still asking themselves, refers to any investment in private and unlisted companies. Real venture capital is the investing in start-up and early stage companies. In Europe and North America, venture capital has long reached middle age, with the number of transactions being now levelled out. Once the domain of both little and big players, venture capital has become increasingly dominated by the mega financial institutions, such as global banks, insurance companies and giant pension funds, which all work through specialist business units or subsidiaries. Even in places like Western Europe, it is rare to see successful independent firms, which have been able to raise large amounts of money for venture capital purposes. Although the technology bubble of the late 1990s saw a resurgence of independent venture capital firms, most have now died a violent death or are dominated by the mega financial groups.

In Lebanon, we are light years from achieving what Europe and North America achieved. While the West has used the venture capital tool to grow itself out of recession and debt traps, we in the land of the cedar are still cogitating about the true meaning of venture capital. True, there were some speeches by senior bankers towards the late 1990s to early 2000s, which preached the necessity to establish venture capital funds in Lebanon, but nothing came out of it. Just talk, while our young entrepreneurs are still facing the limited choice of either emigrating to greener pastures or, worse, facing the local banks and their deadly corporate loans. Indeed, at the moment, most private sector firms, whether they are start-ups or established institutions are suffering from expensive over leverage, which is draining most (sometimes more) of their cash flow.

The current situation

Some attempts were made in the mid to latter part of the 1990s to provide the Lebanese economy with a financing alternative to classical banking. The European Union, the European Investment Bank, the World Bank, etc, all provided the local banks with funding to be directed specifically to emerging and start-up companies. These supranational loans were however, always small in size and did not really benefit the end-users (start-ups, etc.) as the banks often misused these funds and allocated them to other sectors. Moreover, the banks never really concentrated their efforts on asking the above mentioned supranational entities for funding to support venture capital, and rather concentrated on asking for funds in order to develop retail and consumer banking.
 

At one stage, some Lebanese financiers and bankers did decide to take the bull by the horn and established independent and proprietary venture capital/private equity funds, such as the Lebanon Fund, launched by Lebanon Invest, which got listed on the Beirut Stock Exchange. Banque Audi also followed the venture capital and private equity path by using its own money to invest in start ups and private equity. These investments were made via a holding company that is still wholly owned by the bank. Middle East Capital Group, another local investment bank also used its capital to carry out some venture capital and private equity investments in Lebanon and the rest of the region. However, these funds never really got 100% engaged in venture capital and rather concentrated on private equity, which is more investments in existing companies that needed to be turned around, restructured or have their operational and strategic direction changed, rather than seed money investments for start-up and early stage companies. Moreover, the cost structure of these funds was always high since the start and significantly affected their performance. Such a lackluster profitability from the part of the venture capital pioneers was a major discouraging factor to other banks and investors, which did not see venture capital as an interesting revenue diversification or investment option.

All these attempts to go into venture capital have been commendable for a small market such as Lebanon, which was just coming out from a twenty years glitch in terms of financial innovation, but is still largely insufficient. For new companies and entire sectors to emerge, boosting as a result the economy, a strong and diversified venture capital industry must be developed and set up. This can only be done with the goodwill and commitment of private Lebanese and Arab investors, which would see a developed venture capital financial sector as one of the ways of boosting the legendary entrepreneurial spirit of the Lebanese, whilst growing the local economy out of a debt and stagnation trap.

Where to go for funding

For the moment, the best way for young entrepreneurs to finance their new venture is to visit their local bank and ask for a Kafalat guaranteed loan. Kafalat is a government-owned sort of insurance company that guarantees bank loans for venture capital purposes. The cost varies from loan to loan, but is generally lower than the cost on a straight loan from the bank to the entrepreneur. It is worth noting however, that few banks would directly lend money to the entrepreneur without a Kafalat guarantee anyway, and given the relatively small size of Kafalat, the number of loans such an institution is ready to guarantee is generally small. Kafalat-guaranteed loans have a ceiling of around $200,000 and automatically exclude new ventures or start-ups needing more than this amount, such as technology oriented ventures, which are capital intensive and need more than $200,000 to build up a solid starting base.

The Islamic Angle

Another funding source for young Lebanese entrepreneurs is Islamic finance. Islamic banks are mostly engaged in financing products such as MUDARABA (trust financing) and MUSHARAKA, (venture capital financing), which are equivalent to participation transactions. MUDARABA is a form of partnership where one side provides only capital and the other only labor and entrepreneurial skills, while MUSHARAKA is a partnership contract where both parties provide capital towards the financing of a project or a venture. Most small and medium size enterprises (SMEs) in the Arab world, more particularly in the Gulf region, are actively seeking to finance their business through capital participation and profit and loss sharing, making Islamic finance in the form of MUSHARAKA or MUDARABA quite attractive.

Most SMEs and start ups in Lebanon and the Middle East can only rely on their weak cash flow to grow organically and cannot have access to outside capital. Their only chance for external capital growth would come in the forms of independent private investments, Islamic banking, or venture capital and private equity funds. While private investors are very selective and only look for investments with established track records (in other words, venture capital is not an option) and venture capital funds do not really exceed the number of fingers on two hands throughout the Arab region, Islamic banking, through its business nature and the SHARI’A rules governing it, is the only serious funding source for start ups and emerging companies.

Basle II compliance

Islamic banks are not yet covered by the new Basel II banking regulations and are subject to a less stringent regulatory regime. Very often, Islamic banks are established under laws specifically designed for them and their regulatory requirements are less detailed and constraining than those with which conventional banks must comply. Such a regulatory environment allows Islamic banks to have a competitive edge over conventional banks, which will soon have to comply with Basel II regulations. The latter make venture capital investments very costly and onerous for conventional banks, which will have to apply a risk weighting of 150% from 2007, the date the new Basel II capital regulations are applied throughout the world. In other words, if a conventional bank invested $1 million worth of assets in venture capital, it would have to set aside at least $120,000 of capital.

With the advent of Basel II, the slim hope of seeing conventional banks getting involved in venture capital is slowly dimming away. However, a whole new market is opening up for Islamic banks, which will be able to diversify and expand their MUSHARAKA and MUDARABA activities, with little competition. For the moment, Islamic banks concentrate mostly on MURABAHA, which is the largest category of development-related financing and the most common form of SHARI’A-compliant short-term financing employed by Islamic financial institutions. It is undertaken by the bank purchasing specific goods at the order of the ultimate buyer and simultaneously selling them to that buyer on a cost-plus basis.

With the venture capital market freeing up from conventional competition, Islamic banks will have the possibility of diversifying their assets and of getting rid of their concentration problem. The latter has been the main characteristic of Islamic banks over the last ten years, and can only be solved with the creation of new markets, such as Lebanon, and the hiring of venture capital experts, whose job will be to boost the MUSHARAKA and MUDARABA parts of the business.

Lebanon is going in the right direction with the establishment of the first Islamic institutions in recent months. What is now needed is for the opening of branches or subsidiaries of large Islamic financial institutions such as Kuwait Finance House, Al Rajhi of Saudi Arabia, Dubai Islamic Bank, etc, in Beirut. Such power houses would have a major positive effect on the local economy and would fill an important gap left by the local conventional banks, which is that of venture capital financing.

Venture capital has worked wonders in the West and has boosted moribund economies to prosperity in less than a decade. The US and Western Europe have rightly relied on the patriotic feelings and national commitment of their institutional and individual investors to fund a nascent venture capital sector. The outcome of such an investment gamble has paid off, as the beneficiaries of venture capital funding have repaid their faith in a major way, as the value of transactions in the buy-out, start-up and early stage markets more than quadrupled in less than ten years in Europe (between 1986 and 1995). What is urgently needed in Lebanon is for our individual investors to emulate their Western peers and place some more faith into the capabilities of their young entrepreneurs. The massive arrival in Lebanon of Islamic banking would provide the institutional investor base for both venture capital and private equity.

(BOX) How do banks finance their own expansion?

The capital needs of banks in Lebanon vary significantly from one bank to another. The twenty largest banks in the country are generally able to attract external capital more easily than their smaller peers, which are struggling to look more attractive to potential capital suitors. The larger banks’ better financial performance, more solid track record and qualitative aspects make it more attractive for a regional individual investor to provide them with fresh capital injections. In recent months, a few large local banks have been able to lure Arab and Lebanese individual investors into their capital, with the most recent example being Banque Libano-Française (BLF), which had to replace its majority shareholder, Crédit Agricole of France, with a regional investor. Replacing a Western financial group with another is virtually impossible at the moment, as the Lebanese market is too small and risky to attract any strategic institutional investor from Europe or North America.

For the smaller banks, which fall below the largest twenty in terms of total assets, raising capital externally is a tall order. Although, some, such as Banque BEMO, have succeeded in recent years, this was only due to a healthy qualitative and quantitative performance, as well as to a clear strategy of maintaining a certain optimum size. Such attributes are always likely to attract external regional investors, who have become increasingly picky in recent years, and who have steered away from the majority of the thirty smaller banks in the country. The latter have not really reached the level of attractiveness required for external capital financing.

However, banks in Lebanon have shown significant resourcefulness as regards to capital raising. Most have relied on the good years in the last decade to grow organically (internally), whilst some have taken advantage of favorable market conditions to carry out Initial Public Offerings (IPOs) and list on the Beirut Stock Exchange (BSE). The current stagnation of local and international equity capital markets for emerging market banks has led some Lebanese banks to resort to issuing preferred shares (a hybrid of debt and equity), in US dollars and carrying a high dividend/interest rate. These issues have been mostly placed with the banks’ customers.

In September the World Bank issued its annual report Doing BUSINESS IN 2005: REMOVING OBSTACLES TO GROWTH, co-sponsored by the International Finance Corporation, the private sector lending arm of the World Bank Group. The report examines investment climates around the world, based on the regulatory performance and reforms undertaken in 145 nations. Comparing data and showcasing examples of best practice, the report demonstrates how governments can create a better business environment, which benefits all firms, as well as society as a whole. EXECUTIVE met with Omar Razzaz, the World Bank’s country manager for Lebanon, to discuss how the country’s business environment fares by international standards, the challenges facing reformers and the advantages offered to investors.
 

The World Bank’s annual DOING BUSINESS IN 2005 report just came out, with more countries and benchmarks than ever before. Governments are coming forth and requesting to be a part of it – what is the value of this report?

This is a yearly report with very critical information, not just on laws and regulations, but on the actual experience of businesses. That’s why it is meaningful. Businesses are not just interested in the legal framework, but how things work on the ground. The report tries to address the type of indicators that really matter to a business: how easy it is to start, how easy it is to operate and how easy it is to close a business. The other side of this report is that it looks at these indicators on a yearly basis, so you can see change all the time. A country that ranks very low but has gone on a pro-active program by the government to improve its business environment will be registered by the report very quickly. That is why the DOING BUSINESS report is increasingly noticed by investors around the world. Where a country ranks is as interesting to them as the pace at which it moves.

How would you assess Lebanon’s business environment based on the findings of the report?

Lebanon has its strengths and weaknesses. Among the strengths, you have the relative ease with which one can get credit and close a business – by regional standards that is. Where Lebanon does not do well is in terms of starting a business: the procedures as of now take 46 days, and the cost of starting a business is 130% of income per capita. This is much higher than in other countries in the region, as well as elsewhere in the world: just look at Latvia, another small country, where the cost is 17%. It has to do with the number of procedures, the time it takes and the uncertainty that’s involved in the process. The solutions are there: if you reduce the steps, if you automate them, if you set up a one-stop shop where investors can come and you give them clear procedures, it would dramatically change the situation. And it can be done fairly quickly: Jordan managed to reduce the time required to set up a business by nine weeks. The one other aspect in which Lebanon doesn’t do very well is the enforcement of contracts. In this area, Lebanon really stands out. It takes 721 days on average to enforce a contract and it involves 39 procedures. This is two or three times longer than even in developing countries. It is very difficult for a business to operate in an environment where you have a contract that you can’t have enforced. And there really is no reason why this has to continue. Lebanon, in terms of its jurisprudence, in terms of its human capital, has some of the best legal institutions in the Arab world. To improve that situation is a matter of will, of putting in the systems, and of training.

Have there been any significant attempts at implementing the necessary reforms to improve the investment climate here?

There have been very important islands of reform in Lebanon. If you look at the area of property registration or the application of VAT on transactions – these are areas that can take a very long time and in Lebanon it has been streamlined. But in the last two years, there hasn’t been a concerted effort by the government to systematically upgrade laws and regulations and undertake reform. This is a major drawback, because with a debt to GDP of almost 180%, the fiscal and monetary policies can only take you so far. They can reduce debt perhaps, and bring it down to 150-160%, but that is still a high level. The only way to reduce the debt is to grow out of it and increase your GDP. So it’s critical for Lebanon to focus on the investment environment to find ways to increase that pace of growth.

But this year, Lebanon witnessed a positive turn in many of its economic indicators: there’s been a sharp increase in export, tourism, construction permits, and bank deposits for instance. The country has experienced its highest GDP growth since 1997. Is this just cyclical growth or will it have a long-term impact, notably on the level of investment?

Our assessment is that this is not short-term. Lebanon has definitely benefited from this situation – it has allowed growth to reach 5% for instance. But the DOING BUSINESS report suggests that if a country moves drastically on reforms, it could add up to 2% on its growth rate. So what the Lebanese economy has done this year is fantastic, but if the country had improved its regulatory procedures for business, it might have added 2% more, thereby growing at 7%. And for Lebanon to deal with its debt problem in a sustainable way, it needs to grow at around 6% to7% every year, and this is achievable. When you look at the composition of the investments and the growth, tourism is fantastic and does create jobs, buying real estate is great. But what you want to see is more Lebanese expatriates and Arabs starting businesses that will create value added, jobs, on a sustainable basis. And for that to happen, you really need to make operating a business a much more straight forward undertaking.

How does this country fare by regional standards? Does it have any comparative advantages to other Arab countries in the eyes of investors?

Lebanon has to think dynamically in terms of its comparative advantage. It shouldn’t necessarily try to reclaim what it had in the 1960s, but rather think in terms of today – an era of information technology, globalization – to figure out its strengths and weaknesses. The most important element that Lebanon has that foreign investors would want is an innate cultural talent for creativity and service. If you look at the industries that are blooming, they are service industries, industries that relate to creativity, advertising, marketing, TV production… I’ve heard that six out of ten commercials in the Arab world are produced in Lebanon. This says something about the human capital in this country. This a multilingual country that is very exposed to information, trends from the West, and its juxtaposition between the Arab world and the West gives it a tremendous advantage in picking up important trends that might be relevant to the area, and modifying them to local tastes. Studies now show that for countries to compete, for countries to succeed, it’s not a matter of capital or resources, it’s a matter of the know-how that exists in a country and the systems that the country has that allow it to utilize that knowledge. The Lebanese have the know-how that is very hard to acquire by formal training. What they lack are the systems. And it’s incredible, because for most countries, the systems are the easy part to acquire. This is something you can buy with money, and a little bit of decision-making and coordination. Yet you find the systems that allow investors to invest money, to register, to get information, to have day-to-day operating procedures that are clear without dealing with a huge amount of red tape, to be the missing part here.

Yet at the same time the World Bank is pushing for educational programs in Lebanon to provide better technical and vocational training?

Here we come to the issue of equal opportunities. Lebanon has a long way to go before it can be proud of offering its population equal opportunities. There is a tremendous human capital in Lebanon, but that doesn’t mean everybody has access to the same quality of education. Those who have access to quality education, to private schools, to private universities, have tremendous talent. But those who are left behind are relegated to competing with unskilled workers, which is a very difficult thing to do in Lebanon given the relatively open borders and the inflow of foreign workers and high standards of living. For the average Lebanese, this is one of the hardest places to live. You can neither do what pays, because you haven’t been equipped, nor can you compete in the unskilled or semi-skilled professions because the standards of living are too high. And that is why vocational training and education are critical.

Speaking of unequal opportunities, is the lack of progress in improving the business environment excluding marginalized groups from participating in the formal economy in Lebanon?

This is very important. The more you deregulate entry for start-up businesses, especially small and medium enterprises, which are the ones that are most employment generating here, the more you create opportunities for employment, formal employment, which gives more protection to workers and has a snowball effect. In contrast, if you have high minimal capital requirements, then many of the businesses will stay in the informal sector. They will not be able to borrow, to expand, to pay taxes, which gets you into a vicious circle of the economy not growing and public finances not improving.

Another problem which Lebanon faces is the fact that it ranks internationally among the top violators of intellectual property rights. To what extent does this act as a deterrent to investors?

To the extent that Lebanon wants to move into the information age and the high-value added economy. In India, about 5000 to 6000 workers in Bangalore are producing about a third of all of India’s foreign exchange earnings, just because of the tremendous growth of the IT industry. Lebanon is so well positioned to enter that area. If it updates and reforms intellectual property rights and puts in the IT infrastructure, it can benefit a lot from it. Many countries make money out of piracy, but that’s not what Lebanon is about. Given Lebanon’s human capital, it needs to make the leap into becoming one of the producers of intellectual property, not one of the countries that live off piracy.

Closely related to this issue is the prospective of Lebanon joining the World Trade Organization (WTO), which the government hopes will happen in 2005. Is the country ready for it?

Lebanese business are ready for it, in the sense that there is a business acumen, an entrepreneurship that allows Lebanese businesses to excel anywhere in the world. My concern is whether Lebanon can bring the cost structure of doing business down. As long as these procedures, which we have been talking about, are prohibitive, as long as the cost of power is the way it is, as long as telecom is so expensive, as long shipment and agro-processing is costly and delayed and inefficient, Lebanese businesses will be greatly disadvantaged. Again, it’s about putting in the systems that will allow businesses to compete. It’s not about the innate ability of Lebanese businesses to compete with European businesses. If anything, I think lowering the barriers will allow for greater innovation.

Lebanon of course, also suffers from its external environment – the instability of the region, which affects investments into MENA as a whole. What impact do you think recent regional developments, most notably the passing of UN Resolution 1559, will have on the country?

These recent events have thrust Lebanon onto the international scene, which means that what the country does or doesn’t do is much more noticed today than it was yesterday. This poses both a challenge and an opportunity for the country. If the next government is a decisive government that takes strong actions on consolidating the freedoms in the country, protecting them, enhancing the transparency and accountability of the government, improving the business environment, taking concrete steps on the macro-economic level to put the country on a more sustainable path towards growth and debt reduction, this is going to be noticed, and noticed very favorably. If it turns out to be a government that is unable to take any serious action towards fundamental social and economic problems, and if it is perceived as even moving back on Lebanon’s uniqueness, which is its freedom, that will be registered as well. We are hopeful and the World Bank will be very active in continuing its support and will work with any government that comes in, to assist it in enhancing Lebanon’s performance and thereby it’s image in the world.