Like most other industries, the private equity industry follows a typical cycle consisting of several phases that exhibit typical characteristics. Each phase, however, may vary across markets and over time in its duration and magnitude reflecting different extrinsic and intrinsic factors. The following is a high-level description of private equity cycle and a number of observations on where this industry stands at this point in time in the MENA region.
The private equity cycle starts to gain momentum by a booming economy and increased prospected investment, which create an attractive environment for investors’ interest in this asset class. This phase exhibits high level of fund raising activity and the entry of new private equity firms into the picture. This is also the phase where some funds are able to achieve high returns without significant involvement in their investee companies and/or simple financial engineering.
The region started entering this phase over the past few years with high level of fund raising activity taking place in 2005-06 and the entry of new players into the market. We remain, however, at an early stage since private equity, as an asset class in its current form and scale, is relatively new to the region and when compared to the enormous scale of investment opportunities driven by robust regional economies, market liberalization initiatives, privatization programs, generational succession of family-controlled businesses that are open to divestments/ inviting of external capital, and expansion aspirations of local/ regional firms that are seeking growth capital. This favorable climate is further accentuated by the notable development of capital markets, which is a critical venue for exits.
With time, the market is expected to move into a phase where too much money starts to chase after a declining number of good investments. This is likely to bid up valuations leading to lower returns on investment.
The next phase is where private equity firms can differentiate themselves through a more selective/ patient investment approach and, more importantly, by taking on more challenging investments that require significant involvement in the investee companies and focusing on strategy-based value add. This is the phase when we can expect to see funds that pursue disciplined investment strategies (e.g., buy-out, sector-focus) stand-out and outperform the less-focused opportunistic funds.
Some of the PE firms in the region have already started moving in this direction. This can be observed as several new funds have started positioning themselves as buy-out and/or sector focused funds. In parallel, many of these firms started attracting talent from the management consulting industry to build post-acquisition capabilities with the aim of creating strategy-based value-add in their investee companies. The interesting question here is whether the buy-out funds have arrived too soon to the market and the extent to which they will be able to successfully implement their investment strategies in the next 1-2 years and overcome the perceived reluctance of many enterprises in relinquishing control, especially since such enterprises have access to other private equity investors that are willing to provide capital against minority stakes.
Moving forward along the cycle we can expect to see that the average return of private equity investments decline, and the exit of the less-focused private equity firms. As a result, investors’ interest in private equity as an asset class is held back. The interesting question is see how fast we will arrive to this phase and what will happen to the smaller/ less established firms in the region.
As the private equity investment activity slows down, competition is expected to soften, gradually leading to lower valuations and ultimately to higher returns. This, combined with favorable economic environment, is a prelude to complete the private equity cycle and start to gain momentum once again under favorable market environment.
Overall, the private equity industry started to establish itself as an important and visible asset class in the region. So far, the growth has been spectacular in terms of fund raising and in attracting talent. The challenge now is to see a growing number of good investments taking place, successful exits/ divestments, good returns on investments, and the maturity of this industry in terms of a more active involvement of PE firms in their investee companies and their ability to attract more local and international institutional/ sophisticated investors. Furthermore, it would be interesting to see how fast and how accentuated each phase of the private equity cycle will be in this part of the world over the coming years.
Maher Hammoud is Senior Vice President at SHUAA Partners
