Private Equity Comes of Age in the MENA Region
Private equity (PE) in the Middle East has grown remarkably fast. From 2004 to 2008 alone, global PE growth in the Middle East reached 70 percent. Yet despite its rapid ascent, it is an industry that is still trying to find its footing. As limited partners (LP) prepare to make the leap of faith into a market poised for growth, the PE firms that judiciously apply their knowledge and talent stand to capture the benefits. However, such general partners (GP) will need to adapt their practices to local and changing circumstances. To do so, it will be critically important for them to have a deep understanding of the context framing the sector’s evolution during the preceding decade—a three-stage period marked by breakneck expansion and significant but necessary growing pains.
Over the last decade, the state of private equity in the Middle East has gone from virtually nonexistent, to a booming prospect, to an industry facing a shakeout. The sector’s breakneck evolution has made it difficult for investors to obtain a clear picture of the industry’s underlying fundamentals. This being the case, they have been understandably cautious about directing their funds to regional PE firms. This hesitation could come with serious costs for those who miss what is becoming a burgeoning opportunity. The Middle East remains a region of increasing wealth and growing populations that require new and better services. GPs and LPs looking to take advantage of these opportunities can and should equip themselves to better manage this transition. Part of the challenge will be resetting expectations, both for liquidity and returns, as the mirage of easy money dissolves. Additionally, PE firms will have five imperatives in the coming years if they are to attract capital and prove their worth: develop an investment approach based on an investment theme with staying power; tighten up risk management practices; be an active owner; deepen relationships with LPs, especially institutional investors; and build confidence through new fee structures and fund-raising approaches.
Poised for Long-term Growth
The market dynamics in the Middle East—in particular, the pursuit of the same limited opportunities by so many firms—point to a shakeout. Many PE firms operating in the region were founded at the height of the industry’s boom in 2007 and early 2008 as investors poured onto the PE bandwagon. But few knew where to invest. Some invested in real estate and listed equities, and some didn’t invest at all. Their investors will start to lose patience over the next few years as funds reach the end of their terms and exits remain elusive. “In fact, only 3 percent of the aggregate capital across all funds raised from 2000 to 2010 is under liquidation, representing only 15 funds, or about 11 percent of the total number of funds”, said Peter Vayanos, partner, Booz & Company.
Fortunately, the opportunities for those that remain will be substantial, brought on primarily by two factors: sound long-term fundamentals and a management void to fill.
Sound Long-term Fundamentals
The Middle East has a young and promising population that with increasing wealth and increased political stability could constitute a major driver for economic growth and increased demand for products and services. “A survey of 46 PE professionals conducted by Booz & Company and INSEAD in April 2010 confirmed that 73 percent of industry leaders will be looking to tap this demand over the next five years through direct investments in companies,” said Vayanos.
A Management Void to Fill
Family-owned businesses, which play an extremely important role in the Middle East’s economies, offer an equally sizable opportunity for PE firms. The “restless entrepreneurs” who have run many of these family-owned businesses for the past few decades are giving way to a rising second or third generation of family members who see the need to develop more focused strategies and more professional management approaches. In the years ahead, these businesses will look to divest some of their scattered holdings, scale up the businesses they retain, and seek to improve their overall performance. To do so, they need to acquire good management capabilities with a breadth of strategic, financial, and operational knowledge, a scarce resource in the region. “The size of the opportunity is evident from the role that these companies play in GCC economies: They account for roughly 40 percent of the region’s non-oil GDP and 50 percent of private sector employment,” commented Ahmed Youssef, principal, Booz & Company.
Persevering with Caution
Of course, investors looking to participate in the Middle East’s next stage of growth will still need to be cautious: The region’s heady growth over the last decade worked to cover up some critical weaknesses in the PE industry. As these weaknesses come into full view, investors will need to trust that they will be addressed. For starters, significant gaps remain in the region’s legal and regulatory frameworks. Bankruptcy laws, for instance, are still not in place in many countries in the region, leading to confusion when portfolio companies fail. Methods for dealing with closure are not explicitly detailed, and in most cases it is left to the parties to reach agreement with each other.
Other types of laws are equally embryonic. The enforcement of contracts is not always swiftly implemented; the procedural phases of filing, trial, judgment, and enforcement typically take an average of 635 days. “Saudi Arabia ranks 140th out of 183 countries for enforcing contracts, according to the World Bank’s International Finance Corporation. Syria is even more challenged, ranking 176th,” said Youssef. Corporate governance is another area that requires development. The influence of family-owned businesses may hinder corporate disclosure and limits transparency.
New Strategies for a New Era
The shakeout that has already begun among the Middle East’s PE firms will inevitably intensify. Already, small players that could not sustain a competitive advantage are exiting the market. Other companies are renegotiating with LPs on fund terms and trying to rationalize their portfolios. As this pattern continues, PE firms will likely have to shift to the middle of the PE value chain, seeking value creation in the nurturing phase; as opposed to their historical focus on the privileged sourcing stage.
Imperative Number 1: Develop an Investment Approach Based on an Investment Theme with Staying Power
Typical PE funds outside the region focus on specific countries or sectors. However, this approach does not translate to the Middle East, for a number of reasons. First, general PE deal flow in the region has been modest compared to the number of funds. Second, penetration across countries remains low, even with the expected growth of PE investments. Third, large anchor sectors such as energy face stiff competition for investments from PE firms, sovereign wealth funds, and regional governments. For these reasons, focusing on individual nations or sectors might limit PE firms’ ability to scale their assets with superior returns and in a reasonable time frame.
Imperative Number 2: Tighten Up Risk Management Practices
A more mature PE industry will pay more explicit attention to risk management. More than 90 percent of general and limited partners see risk management as a priority in the coming years, according to the Booz & Company/INSEAD survey. Moreover, 86 percent of general partners say they are willing to sacrifice some return in order to lower risk.
Imperative Number 3: Be an Active Owner
If the last couple of years taught us anything about the state of private equity in the Middle East, it is that the time of passive ownership has passed. The gems are still there for the taking—but they are more deeply buried, and only those firms that get their hands dirty will uncover them. The return to fundamentals means PE firms in this rapidly developing region, like PE firms in more mature economies, must play an active role in value creation.
Imperative Number 4: Deepen Relationships with LPs, Especially Institutional Investors
Historically, the majority of LPs in the region were high-net-worth individuals. This trend will endure in the region, because these LPs give access to privileged deals. However, institutional investors now represent a more significant percentage of LPs—an important development for PE firms as they broaden their investor base. Firms should seek to strengthen relationships with institutional investors, whether regional or international, that are looking to make a play in the region. These may include banks, insurance companies, pension funds, and others that have been adding private equity assets in hopes of achieving risk-adjusted returns beyond those possible in public equity markets.
Imperative Number 5: Build Confidence Through New Fee Structures and Fund-raising Approaches
With LPs now placing a greater emphasis on a firm’s track record, the name of the game is confidence. Lowering entry fees will encourage investors to come on board, and give fund managers the opportunity to prove their worth. Among limited partners globally, the standard “2 and 20” fee structure has become a source of increasing dissatisfaction. Investors were particularly unhappy during this latest period, when PE firms were inactive but still collected 2 percent management fees on committed capital.
The rise of private equity in the Middle East has coincided with a period of immense tumult in financial markets worldwide. The region’s PE industry sprang up when equity prices were rising, and many local players enjoyed early success in the form of quick and profitable exits from investment positions. However, that dynamic soon reversed, and in the last few years, there have been more problems than profits in private equity in the Middle East. In finance, there’s no harsher or more humbling teacher than a down market.
Private equity firms in the Middle East are now looking to consolidate the lessons learned over the past few years and invest in the skills and qualities they will need to take advantage of the region’s next stage of growth. Winning will not depend on timing or on external market factors; it will depend on more fundamental sources of value. As firms in the Middle East rebuild, they will need to do the basic things right: Identify sustainable investment ideas, create value within their portfolio companies, reduce their risks, and gain the trust of the best possible investment partners. These are things that will work, and remain important, in good times and bad.