Friday Letter MENA's positive Darwinism

The shake-out occurring in the Middle East and North African private equity market could be just the dose of reality the fledgling industry needed.

Following hard on the heels of the global economic crisis, the wave of political unrest sweeping through the Middle East and North Africa has buffeted the region's private equity industry.  

The unseasonal storms that swept through the Emirates this week were perhaps a manifestation of the turbulent political and social environment, but just as sunshine follows rain, the upheaval could prove to be the making of the MENA private equity market.  

At the Private Equity International Middle East Forum in Dubai earlier this week, delegates gathered to discuss pressing issues facing the region’s private equity and venture capital community.  

A tentative post-crisis recovery appeared to be on hold, and opinion was divided as to how long a true resurgence would take: 54 percent of delegates polled thought recovery would take less than a year, a reflection perhaps of the optimism and verve that drove such remarkable growth in the years leading up to the downturn.  

Yet the remaining 46 percent of delegates thought a recovery could take anything from 18 months to five years to effect, demonstrating the difficulty of calling what has typically been an opaque market.  

One thing is beyond doubt: the number of managers active in the region has shrunk significantly.  

An experienced MENA-based buyout executive confided that there was perhaps only a handful of MENA-based GPs still active and in any sort of health. Compared to more than a hundred managers to have raised capital pre-crisis, that represents a significant contraction.  

Yet many at the conference welcomed that contraction. Most agreed both GPs and LPs had been guilty of excessive exuberance during the boom years. Indeed, the number of unfinished construction projects littering Dubai suggests that hubris was not limited to the buyout industry. Too much capital had been raised for a relatively immature private equity market, where the pool of potential deals was too shallow to satisfy the dry powder stockpiled by GPs. 

Some international LPs present at the conference took the view that too many firms with no track record, lacking the relevant skills and experience, had been able to raise capital. Yet that could be said of many GPs based elsewhere in the world.  

Contraction could however be the saviour of MENA private equity. Zulfi Hadari, managing director of MENA-based investment group HBG Holdings, argued during one panel discussion that equilibrium had been reached between the number of active managers, the capital at their disposal, and available deal opportunities.  

A majority of delegates polled thought the number of managers would not grow to pre-economic crisis levels within five years, yet a majority did think capital inflows to the region would recover within that time-frame.  

Perhaps the most telling poll result however was that which found 79 percent of delegates thought the so-called ‘Arab Spring’ – the political upheaval and flowering of democracy in the Arab world – would have a negative effect on the region in the short term, but would benefit MENA’s private equity in the longer term.  

The political strife has undoubtedly dampened investors’ ardour in the short-term, and it remains to be seen how long it will take to re-shape the region’s political and social landscape. But MENA’s fundamentals are no less compelling now than they were when investors clamoured to gain access to the region over the last decade. A large, young, and affluent population, favourable tax regimes and a broad range of diverse companies across an equally diverse set of countries make it an attractive target for private equity.  

The few remaining GPs in the region were told by investors at the conference to build on the solid foundations that have seen them weather the storm.  

The prescription read: improve transparency; demonstrate your ability to generate 2x returns over the long term, not just in a bull market; adopt the more attractive fund terms on offer in mature western markets; and don’t cast your net too wide. The last point is perhaps key – many of the managers who have since slipped from view were those who adopted a generalist approach, targeting a range of investments including real estate and infrastructure as well as private equity across a variety of sectors. Just as investors baulk at JAMBOs (‘Just another mid-market buyout fund’), so too do vaguely-defined MENA private equity funds fail to excite.    

For governments in the region, reforming regulatory structures probably ranks a fair way down their list of priorities at present, but concerns need to be addressed at some point. Reducing red-tape, embracing western standards of transparency, and attempting to develop a homogeneous legal and regulatory regime to better facilitate cross-border dealflow within the region are all desirable reforms.  

The MENA region may be subdued at present, but it is not going to slip into obscurity and stand by while other emerging markets steal its thunder. The Arab Spring may yet prove to be the best thing that could have happened.