It is important to remember that until the mid-1990s, when it was overtaken by Europe, the Middle East was second only to the US as the largest source of investment capital for international private equity funds. Middle Eastern governments have long been significant investors in private equity. And according to one estimate, there are more than a dozen family groups in the region who are able to make large commitments of $20m to $25m at a time to private equity funds.
Most of these commitments have been oriented towards the US. Increasingly, Middle Eastern investors are looking for exposure in Europe and Asia as well.
But, as a region, the Middle East itself has not drawn much capital for private equity activity, either from local sources or internationally. Now, a small handful of Western educated private equity professionals with local business acumen are setting up partnerships to target what they describe as compelling opportunities in the region.
The Gulf states have a limited capacity to absorb capital
The biggest private equity player in the Islamic world is the $1.5bn Bahrain-based Islamic Development Bank Infrastructure Fund. Managed by Emerging Markets Partnership (Bahrain), it is 60 per cent owned by Washington-based Emerging Markets Partnership and 40 per cent by Bahrain's Shamil Bank. The fund targets the power, telecommunications, transportation, energy, natural resources, petrochemicals, water and other infrastructure-related sectors in Muslim countries.
Investcorp is another major player in the region. Smaller, country-based funds throughout the Middle East include MECG in Lebanon; United Arab Emirates-based Shuaa Capital; and EFG Hermes Private Equity, which operates out of Egypt.
Generally, Western institutions have been slow to seek investment opportunities in Middle East.
Global banking group HSBC Holdings became the first major international institution to operate a fund in the region when, in March 2003, it closed HSBC Private Equity Middle East on $118m. HSBC had seeded the fund with $33m, and a further $85m was raised from regional institutional investors.
Abraaj Capital, formerly known as Rasmala Private Equity, which bills itself as the only dedicated LBO fund manager in the Middle East, closed its debut fund on $150m at the end of June. The vehicle was largely raised from local high-net worth individuals. The Dubai-based firm's signature deal was the $65m leveraged buyout of Nasdaq-listed Aramex, a Middle Eastern freight and courier company, in early 2002. The deal was not only the first public-to-private deal on the Nasdaq of the year 2002, but also the first ever Nasdaq tender offer by a Middle Eastern buyout firm.
Arif Masood Naqvi, executive vice chairman and chief executive officer of Abraaj Capital, says his firm will invest opportunistically throughout the Middle East, as the region's private market is still too immature to afford investors the luxury of a specific sector focus.
However, signs of development in the region's private equity market are unmistakable. A recent trend to emerge is for Western-educated Arab entrepreneurs who have experience in Western public and private finance returning to the Middle East to launch Western-style investment vehicles.
One example is Amman, Jordan-based Foursan Technology Partners, a venture capital firm established in February 2000 to target emerging growth information technology startups in the Middle East and North Africa. The firm was founded by two Harvard-educated brothers, Leith and Nashat Masri. Leith Masri was previously with diversified financial firm Manara Investment Group and has worked at The Blackstone Group, the Boston Consulting Group, and the Bechtel Group, while his brother Nashat has worked for JP Morgan, where he was a vice president in the investment banking division.
Another pair of US-educated Arab entrepreneurs recently launched a fund targeted at $100m for investment in post-Saddam Iraq. The fund, which was founded two years ago by Yousef Al-Essa, a Harvard Business School graduate, and Mohamed Sarhan, a graduate from Duke School of Law, who previously practiced corporate law in New York with White & Case, will be managed by a firm named Amwal (“money” in Arabic).
Abraaj Capital's Naqvi says he welcomes the entry of new rivals into the market: increased competition boosts the overall size of the market, creating more investment opportunity and expanding the range of exit options. Besides, he adds, how can a firm characterise itself as generating top-quartile returns unless there are at least three other firms operating in a given market?
Early days for musharaka
These private equity initiatives, while welcome, still only draw a small percentage of Islamic capital. “If you look at where most of the money from the Gulf is in terms of choice of investment vehicle, about 80 per cent to 85 per cent is in murabaha [commerce], then it's leasing, then commodities, then mudaraba, which is the mutual funds, then very little left in musharaka, which is venture capital,” an analyst says.
Indeed, while the buying and selling of commodities is a practice that goes back to the dawn of time in the Middle Eastern region, the buying and selling of companies for financial gain is still a rather novel concept. “The Middle Eastern investor, as a rule of thumb, is a proprietary owner,” says Mounir Guen, the founder of London-based private equity placement agent MVision. “They enjoy owning physical assets, whether they're factories, industrial sites or real estate.”
Statistics presented in a recent McKinsey & Co. report bear out this cultural observation. From 1996 to 2001, there were 266 mergers and acquisitions in the Middle East. This comes to 0.11 deals per every US$1bn in annual GDP. In Western Europe, the equivalent ratio is 1.02, according to the report.
The comparative lack of liquidity in the deal market stems in part from religion, which, according to Islam's shari'ah law, favors income-producing assets over income-producing cash and other forbidden forms of liquid securities (see Shari'ah compliant on p.42).
Luckily for the shari'ah-observant investor, the private equity partnership is about the most illiquid form of security available. It gives investors equity stakes in private companies and usually only yield profits when those companies are sold. But convincing local investors that this Western asset class can be applied to the Middle East has been a slow education process.
If drawing Middle Eastern capital to private equity funds is taking time, then convincing Western institutions to invest in funds targeting the region has been even more difficult. Many of these investors do not perceive the region as being a fertile area for private investment. “These are relatively small markets in economies that are very much government controlled, the result of which is that ownership is governed very strictly,” says MVision's Guen, who has spent time raising capital in the region. “The Gulf states have a limited capacity to absorb capital.”
The market will grow rapidly, despite issues of transparency and due diligence
The recent McKinsey & Co. report on the Middle East noted the lack of public market exit options. There is no domestic equivalent to the Nasdaq, the report said, and “there are no capital markets in the region with significant depth and liquidity.” In addition, “leaving aside the local markets, few companies from the region can have any realistic expectation of achieving a flotation on a market in Europe or North America and such a listing might not achieve their aims since being such a small player in such a big market is unlikely to create any interest, analytical coverage or liquidity in the stock (which is likely to hinder the longer-term development of such a company).”
Abraaj's Naqvi says exit opportunities exist for those that understand the Middle Eastern market. He lists a litany of deals that he and his partners completed under their previous incarnation as Cupola Group – deals he says resulted in highly profitable exits through sales to regional companies. In one case, Cupola acquired Bahrain Maritime and Mercantile for $23.6m and later floated it on the Bahrain Stock Exchange in a $30.9m IPO.
Naqvi points out that a number of crossroads have been reached in the Middle East that private equity investors will find attractive – the many large family groups in the region, which control much of the private sector activity, are now undergoing generational change. As this happens, these groups will want to adopt more corporate structures, and private equity may be seen as a “pure” form of partnership capital, but nevertheless one that will help family businesses compete against international companies and against each other.
In addition, while economic reform has been gradual, Naqvi expects large, state-owned conglomerates to represent a “mid-term” opportunity for deals.
David Crosland, the president of Atlanta-based Crescent Capital, a shari'ah-compliant private equity fund that invests the capital of the First Islamic Investment Bank, describes the Middle East as “a very formative market. I think it will grow rapidly, but given how immature the market is, there are issues of transparency and due diligence. The size of the transactions are typically on the small side. And in the event of finding a transaction of proper size, the concern would be the exit opportunities – the public markets are underdeveloped.”
Despite these impediments, Crosland expects private equity in the Middle East “inexorably will become an increasingly attractive market for Western investors.”
The few private equity pioneers that have set up shop in the region are hoping to have established reputations when both investors and business owners wake up to the need for private capital in the Middle East.