Is Iraq ripe for private equity investment? The idea of putting a high performing asset class in what is still considered a war zone seems anathema to many. The lengthy investment terms of private equity appear inconsistent in volatile environments, but after a read of the headlines, industry watchers need only look at the deals fund managers have already made and the willingness of investors who partner in country-dedicated funds, or on a deal-by-deal basis, to realize the possibilities of Iraq as the next destination for private equity. In early 2008, news media reported that emerging markets fund manager Mark Mobius was looking for deals for private equity investments in Iraq. Though influential, Mobius will by no means be the first, but rather follows a crew of daring investors and fund managers who have already established operations in this frontier market.
Iraq is not a monolithic conflict and since the 2008 surge, tensions have quieted down somewhat. The Kurdistan Region, in particular, offers much promise for fund managers and investors. According to Scott Ogur of Scimitar, the risks of investing are lower there, yet, “since the region is still in Iraq, most investors apply a risk premium to it that was commensurate with Baghdad.” In his view, this offers a much sought-after investment environment for those with higher appetites for risk or at least deals where “most investors have missed an important nuance, leading them to overstate risk, and therefore depress asset prices.” The perceived risk premiums investors calculate are factored into decision making when looking to generate excess returns.
A headline economy
Rising oil prices on world markets brought a windfall in revenue for Iraq’s 2008 budget, but cautious budgeting means the country will still have a surplus at the end of the year. The increased government riches are complemented by an improving security situation with fewer civilian deaths and many of Iraq’s 18 provinces relatively safe, with violence largely limited to Baghdad, Diyala, Niniveh, and Salah al-Din.
Andrew Eberhart of The Marshall Fund — the first Iraq- dedicated private equity fund and the first to do a deal in the country — believes that “Iraq’s economy needs the fundamentals — food, shelter, and electricity, but the country can also benefit from technology investment that helps meet these needs.” The Marshall Fund has matched Iraqi demand for foreign capital and the increasingly favorable regulatory structures to support capital inflows. Both the federal Iraqi and regional Kurdistan parliament passed investment laws to encourage foreign investment and protect investors through the rule of law, property ownership in certain industries, and favorable tax holidays.
According to Eberhart, “the government is willing and eager to work with outside investors and there is no need to win hearts and minds in the government.” For private equity firms weary of operating in a potentially high-risk environment, the Overseas Private Investment Corporation, an independent arm of the US government, offers insurance against potential political risks, including expropriations, acts of terrorism and war, and political strife.
Eberhart noted that there is large potential outside of the energy sector, as Iraq was and could still be “the breadbasket of the Middle East” with a large amount of arable land and agriculture employing the most Iraqis after the public sector. Snags common to other sectors are also found in agriculture, which has been victim to chronic underinvestment. Following the fall of Saddam Hussein in 2003, the industry dropped, transforming the country from a net exporter to an importer of food. According to Eberhart, “there were crops, but farmers only had access to local markets.” He explained that the vast majority of crops rot on the vine or in storage. “The ability to come in and invest in processing and distribution is enormous.”
Fundraising
The Marshall Fund is currently fundraising from private investors “who understand the very real investment opportunity that exists in Iraq and also feel there is some potential social benefit, an economic development from investment and a way to complement other efforts of regional stability,” according to Eberhart. Limited partners of this sort must share the fund’s vision as it scours for opportunities. Kyle Stelma of Dunia Frontier Consultants noted that fundraising for deals in Iraq is “an interesting environment with a huge upside. There are initial risks but several alternative investment funds have decided to focus solely on Iraq, despite perceived risks.” Stelma estimates the majority of limited partners to be “individuals with one or two institutional investors,” projecting that, “as we see more successful exits and investments, there will be more institutional investors. There are now a number of large Middle Eastern institutional investors getting close to partnering. It’s just a matter of time.” Eberhart believes that while it might still be a bit early for big institutional investors like pension funds, “we expect to see them as we demonstrate success.”
The climate for making deals in Iraq stems the government’s willingness to revive enterprises that have lain fallow for years. Stelma noted that “a number are interested in former state-owned enterprises and the government is privatizing some of them and really trying to make these transactions work.” Iraq dearly needs for financial institutions, construction outfits, and agriculture-related business to lead the country through its post-conflict development.
Ogur’s group, Scimitar, does not use blind pool funds, the typical structure of a private equity fund, having found that they “are not always the best way to align interests of fund managers and investors in the regions where we invest.” Rather, they work with investors on a deal-by-deal basis. With Scimitar’s group of investors, “when we have a deal that meets our investment criteria, we use our own funds to secure and structure the deal, and we then get commitments from our investors.” The group’s investments total a dozen over the past six years, of various sizes ranging between $5-50 million, and have realized about half of its investments. Its Iraqi focus remains in the Kurdish region where contacts run to the top levels, which is an important requisite when working in the region.
Partnering for exits
In terms of exiting investments, the focus remains on selling companies to a strategic buyer. Ogur noticed a number of strategic buyers looking toward Kurdistan as a place to own and operate profitable businesses. “Turkish investors and businesses are extremely interested in Northern Iraq, despite the political tensions that are commonly mentioned between Turkey and the Kurds,” he noted.
Stelma’s has noticed growing interest from Indian, Chinese, and Turkish conglomerates, with growing opportunities for strategic sales. Outside of petrochemicals, regional and international conglomerates are currently the main exit possibilities, although these options will grow as more players enter the market.
Future outlook
The demand for the basics after long periods of neglect under Hussein and over the past five years makes Iraq’s future outlook strong. In an official visit to the US in October 2008, Iraqi Finance Minister Bayan Jabr Solagh emphasized the need for basic infrastructure, particularly water, electricity and housing. The immediate demand for 2.5 million housing units in a population of 28 million means nearly 10% of Iraqis need new homes. This figure alone should make the heads of real estate giants and property developers spin. According to Eberhart, “the government has inherited a lot of businesses from the private sector and Saddam’s private ownership. It embraces capitalism and is anxious to privatize investment. Ministers promote plans for outside investment and there is low or no costs for taking on operations.”
Eberhart also highlighted the strong demand for banking and the financial services sector. Although JP Morgan and HSBC are already in Iraq, the huge room to grow is evident in the lack of free flow of capital and the economy staying cash-based. Financial services could help sustain the already-high consumer market demand, which Eberhart believes could “find opportunities to grow in Iraq after franchise operations demonstrated success.”
Improvements at the macro level mean increased opportunities for foreign investors to remodel many of Iraq’s industries. As the government moves forth with privatizations and plans to stimulate the different industries, private equity is an ideal asset class to restructure and redevelop a potentially dynamic economy.
