Weighing Middle Eastern risk

“I cannot teach anybody anything, I can only make them think.” Socrates, the Greek philosopher said it originally in circa 400 B.C., but it is a phrase that Arif Masood Naqvi, chief executive officer of Dubai-headquartered buyout firm Abraaj Capital, thinks apt when considering the state of the private equity market in the Middle East.

“Do as I do and as I say” could equally be a motto for the man who enthusiastically advocates private equity as a financing tool. Naqvi, whose firm runs the largest buyout funds in the region with $150 million (€125 million) in committed capital, has just commissioned a report entitled Private Equity: A catalyst for economic growth in the Middle East region, a document that calls for more activity and greater competition in the Middle Eastern private equity business.

Naqvi's belief in encouraging people to think about the industry as a catalyst for growth is a view echoed by a number of practitioners in this nascent marketplace. Despite the disturbing political problems that have overshadowed the region in recent years – the war in Iraq, the ongoing conflict in Palestine and recent unrest in Saudi Arabia – those closest to the marketplace believe that there are a number of factors that could impact positively on the overall economic climate and, specifically, the private equity marketplace, which has shown significant growth in the last few years.

The report commissioned by Abraaj and produced by consultancy firm, Start Consult, estimates that institutional private equity in the Middle East region has grown from approximately $200 million in 1998 to in excess of $700 to 800 million in 2002 in terms of funds raised.

For financial investors, access to capital isn't a problem. Due to a number of reasons, the Middle East region is a capital-rich environment these days. Although observers offer differing opinions as to the amount of, and rate at which, Arab capital is flowing back to the region following the events of 9/11, they are unanimous in agreeing that the Middle East is enjoying significant liquidity at the present time.

Not only is capital returning from abroad but, equally importantly, cash generated in the region that traditionally would have gone to overseas markets is staying put. Oil prices are high, real estate is booming and stock markets, though still relatively immature, are showing increasing signs of buoyancy.

Other factors at work include the much-discussed opportunities arising from consolidation of the many family-owned businesses in the region (though most observers agree this is more of a theoretical private equity opportunity, rather than a reflection of current reality); privatisations of state-owned enterprises; development of public markets as bona fide exit routes and the creation of new initiatives like the Dubai International Financial Centre (DIFC).

Local investors who previously looked to overseas markets to invest in private equity are increasingly focusing their attention on opportunities within the Middle East. The still relatively small pool of incumbent general partners in the region – following a difficult period for investment during the war in Iraq – now see an opportunity to put to work some of the excess capital in the region and, in the process, make the most of a window that may not stay open overly long.

So who are the players that can take advantage? Abraaj Capital has recently launched a real estate private equity fund with a target of $100 million, dedicated to the Middle East and North Africa (MENA) and subcontinent region on top of the $150 million that it already manages through two funds – the $116 million Abraaj buyout fund and the $34 million Special Opportunities fund.

The buyout fund is fully committed at this stage, and Naqvi anticipates that the firm will go back to the marketplace “later this year.” The fund recently achieved a significant exit, selling its stake in the Oman National Investment Corporation to Shuaa Capital and realising an IRR of 84 percent. According to Naqvi, the firm is also preparing an initial public offering (IPO) of, a global transportation solutions company of Middle Eastern origin.

Another firm likely to be taking advantage of the surplus of capital in the region is Shuaa Capital, formerly the Arabian General Investment Corporation, which together with Capital Trust Group launched the $54 million Middle East and North America Direct Investment Fund (MENAVEST) in 1998. With that fund 75 percent committed, according to senior associate Ahmed Ozalp, it is anticipated that Shuaa will also look to raise new capital later this year.

The $118m HSBC Private Equity Middle East fund is distinctive in the region, being the first fund launched by an international bank to invest in the Middle East. Focusing exclusively on GCC-oriented businesses – the Gulf Cooperation Council comprises the countries of Bahrain, Kuwait, Qatar, Oman, Saudi Arabia and the United Arab Emirates – the fund, which closed in December 2002, is made up of $85 million received from government investment organisations, other banks and major family groups and $33 million dollars invested alongside by HSBC. Although the fund has only made one investment to date, early in 2003, co-director David Knights believes that after a difficult political, “wait and see” year in 2003, 2004 “will be a good investment year” and anticipates making a number of investments in the remaining half of the year.

In Dubai, Evolvence Capital, a financial services firm focusing on the alternative investment markets headed up by co-founder and chief executive officer Khaled Al- Muhairy, sponsors and advises the largest fund dedicated solely to opportunities within the power/energy sector in the Middle East, the $300 million BTU fund.

Outside of the GCC states, other local firms are also raising money, albeit on a lesser scale. In Jordan, cousins Leith and Nashat Masri founded the Foursan Group in 2000 and are currently raising the $50 million Jordan Fund, which Foursan will manage along with Deutsche Bank and Atlas Investment Group. The fund, which includes a $20 million commitment from the Jordanian government, has just completed its first investment, a $3 million commitment to Xpress Telecommunications, the inaugural digital radio and mobile services operator in Jordan.

In Lebanon, the Middle East Capital Group (MECG), a ([A-z]+)-based private equity and merchantbanking firm, closed its $20 million Lebanon Real Estate Development Fund in December 2003. The fund will focus on generating capital gains in upper end residential real estate opportunities in the greater Beirut area.

So where are these local players looking to invest and where are the key private equity destinations of the future? Speak to anyone with any knowledge of the Middle East marketplace and the area of opportunity that is the family-owned private business will undoubtedly be mentioned. With a significant proportion of businesses held by families across the region, it is easy to see why this area is often seen and cited as an opportunity for the private equity industry to develop and exploit.

However, the consensus among the majority of people interviewed for this article was that the idea, while sound in principle and undoubtedly a source of future potential deal flow, hasn't yet produced a significant amount of private equity activity.

Abraaj's Naqvi for one, believes that talk of consistent family business deal flow is slightly misplaced: “I haven't seen a recent major transaction in that area, despite everyone talking about it – major family business groups just aren't fully ready yet to take the plunge.” Despite the fact that the Middle East has a reputation as being the cradle of trade, with a tradition of selling/bartering going back more than 3,000 years, the concept of disposing of privately-owned businesses is still relatively alien.

Concurs HSBC's Knights: “A question I used to hear a lot, and still do occasionally, which summed up the problem was: “If the business is any good, why are you selling it?”” This lack of appreciation of the traditional private equity concept of judging a business by what it might be worth to a purchaser – preferring to rely on hard and fast (and sometimes inappropriate) accounting valuations – has meant that some deals “just don't get done,” Knights concludes.

That said, most observers also agree that gradually, this situation will change as unwieldy family businesses are consolidated, asset portfolios are rationalised and a clearer division is drawn between the management and ownership of private enterprises over the next number of years. As succession issues come to the fore, the result should mean increased opportunities for private equity investors to ape the success of investing in family businesses previously evidenced in regions such as Western Europe.

According to some observers, the oft-cited abundance of privatisation opportunities of state-owned enterprises in the region is also somewhat exaggerated, as “closed” sectors like energy and power offer limited scope for investment. However, the majority of players in the marketplace are upbeat about the potential of this avenue for providing future private equity investment opportunities.

As a sign that the market is changing and that governments are opening up to the idea of selling off publicly held companies, observers point to the recent sale of the Saudi Telecommunications Company (STC). In December 2002, the government of the Kingdom of Saudi Arabia (KSA) sold 30 percent (60 million shares) of its shares in STC through an IPO that was 3.5 times oversubscribed. Two-thirds of the shares were made available to KSA citizens and the rest were bought by two public pension funds. The sale generated approximately $4 billion for the KSA government, which is committed to a broad privatisation plan, including introducing competition in the wireless market by 2004 and the fixed line sector by 2008.

Arif Naqvi believes that privatisations represent a key area of opportunity for the Middle East. With a backlog of privatisations, representing perhaps as many as 600+ companies and hundreds of billions of dollars, Naqvi believes that private equity will be a key driver and beneficiary of that opportunity. Leith Masri, cofounder of the Foursan Group, shares this view: “Privatisation is a good source of deal flow [within the region], dependent on individual markets. In Jordan, the process is generally transparent and open.”

While some firms have demonstrated an impressive track record in getting local stock market flotations away – of 17 Abraaj Capital divestments in the last nine years, a significant proportion have been IPOs according to Naqvi, and others too are bullish about the prospect: “If you have a well-structured, well-priced deal, there is usually little problem in achieving an IPO,” says David Knights – public offerings are not the easiest exit route within the marketplace for most private equity transactions.

According to Leith Masri, “exits are tough. The capital markets are less mature than elsewhere although Jordan's situation is improving with good returns and strong liquidity.” This increased liquidity in the region is benefiting not just Jordan but stock exchanges across the Middle East, although much remains to be done before the region can produce viable, competitive public equity markets.

The traditional reasons why a company might seek to do an IPO, principally to raise more money for funding the business, don't necessarily apply in a region that one observer described as “awash with capital.” However, companies that are able to raise capital through sources other than public markets, may miss out on additional benefits that come with floating, including improved corporate governance, developing succession strategies and learning how to structure businesses for the future.

According to the recent study on market conditions in the Middle East by Abraaj, the market capitalisation of the combined GCC stock markets in mid-2003 was only 12 percent of the London Stock Exchange and just two percent of the New York Stock Exchange. Bank lending currently accounts for over 70 percent of the financing of trade and business expansion and the total market capitalisation of stock markets in the MENA countries, at around $200 billion, amounts to just over 40 percent of their combined GDP.

The inherent problems relate not just to lack of size, but also to concentration of stocks on those exchanges. The Saudi stock exchange – the largest in the region, making up 56 percent of the total market capitalisation of GCC states – has 70 companies listed on it. However 60 percent of the market capitalisation comes from just five of those 70 listed companies. In Qatar, a much smaller market, the situation is even more acute, with more than 70 percent concentration in the top five stocks.

Dr Florence Eid, assistant professor of economics and finance at the American University of Beirut, who has researched the Middle Eastern private equity marketplace extensively for the World Bank, believes that the current relative immaturity of the region's stock markets makes this a propitious time for private equity: “Exiting via IPO onto a dormant stock market is not the only option. Private equity players are creating different exit options by nurturing and developing businesses, making them more competitive and exiting via different types of trade sales. At the same time, that process [of developing and growing credible private companies] could help the public equity markets grow by providing strong candidates to populate those markets, contributing to creating a robust economy.”

One important development for the region in this area is the formation of the Dubai International Financial Centre, including a new international finance exchange, announced in February 2002 and comprising six pillars of activity: banking services, capital markets, asset management, reinsurance, Islamic finance and back office operations (see box on page 68).

Khaled Al-Muhairy at Evolvence Capital welcomes the advent of the new financial centre: “With a world class exchange operating in the DIFC, we will see more private equity funds being set up in the DIFC, which will encourage entrepreneurs to give shape to profitable ideas. This in turn enhances the region by allowing seed capital to flourish, encouraging private equity investment and increasing stock market capital.”

… family groups and businesses are doing well; the region is very liquid; oil prices are high; stock markets are robust; real estate is on the up – economically, it is a boom time for the region

Jonathan Woods

Other investors in the region welcome the concept of having a local, significant stock exchange in the region, but are cautious about the immediate impact the DIFC will have on the private equity market. Knights says: “I'm not sure if it will have a dramatic effect from day one, but it will be good for the long term. The most important thing will be the introduction of the exchange, which should encourage more businesses to operate and list there and stimulate more exit activity.”

The political instability of the region has been well documented and has largely deterred investors from Europe and the US, who otherwise might have been keen to scope out opportunities in what clearly appears to be an emerging market. However, the sentiment among market practitioners is that this can work to the advantage of those players already committed to investing in the region: “Where others see risk, we see opportunity,” says Naqvi.

Jonathan Woods, chief operating officer of MECG, believes that a number of factors mean that private equity can provide attractive, alternative investment opportunities in the region going forward: “The irony is that while the political situation is perceived as being very turbulent, family groups and businesses are doing well; the region is very liquid; oil prices are high; stock markets are robust; real estate is on the up – economically, it is a boom time for the region.”

The increased liquidity in the region, improving stock market conditions and a slow move towards liberalisation of economic, taxation and regulatory structures means that there is a significant opportunity for private equity to play a major role in changing the financial landscape of the region. That should give private equity practitioners, both in the region and further afield, pause for thought.

The Middle East region faces a potentially massive population explosion over the next number of years that is likely to have a significant impact on the macro-economic landscape. A number of market observers believe that the nascent private equity market in the region could have an important role to play in creating jobs, opportunity and a more stable financial future for the region.

The total population of the GCC and Levant region (the countries along the eastern shore of the Mediterranean, including Lebanon, Jordan, Syria and Iraq) is approximately 41 million, with Saudi Arabia constituting 54 percent of that total. Over the last decade, the population of the region has grown at a rate of 3 percent and it is projected that the population will double to almost 73 million by 2025.

Concurrent with these statistics is the fact that the GCC/Levant region has one of the highest unemployment levels of any developing or developed region in the world. The understated official unemployment rate in the region is approximately 12 percent. However, among the age group of 18-24 year olds, unemployment is reckoned to be as high as 30 percent.

According to projected statistics contained in the Start Consult report on the Middle East, commissioned by Abraaj Capital, just to maintain current levels of unemployment, approximately 7 to 9 million jobs will need to be created in the region by the year 2020.

This sobering statistic has ramifications across the whole of the regional economic infrastructure and for the region to be able to deal with that challenge, a host of fundamental changes must occur – from the reduction of the dominant role played by governments in all aspects of economic activity to the need to dramatically increase levels of education attendance (enrolment currently stands at less than 85 percent at primary school level, less than 50 percent at secondary level and less than 15 percent entering tertiary level education).

So where does private equity come into this? According to Dr Florence Eid, the industry is in a unique position to limit the damage of “brain drain” to Europe/US and create employment within the Middle East. In a survey she carried out for the World Bank, the major private equity players in the region rated lack of local business entrepreneurial knowledge as one of the major problems.

Eid believes that if the educational sector can respond in the right way, developing young people's commercial acumen and entrepreneurial skills, the private equity marketplace can only benefit: “The first time job seekers [those between 18 and 24] are the potential first time entrepreneurs of the future and face unemployment rates as high as 35 percent. They need to be encouraged to take risks and get into business because even if they fail at first, they still acquire the skills and culture which are key to long-term business success and can help develop a competitive, entrepreneurial economy.”

If the private equity industry can be seen to be successful in the region and a best-practice business culture adopted, then the attendant new jobs – not just for investment professionals, but all the spin-off roles associated with successful investee companies – will help go some way to addressing future unemployment issues for the region.

Ambitious plans for a new International financial centre to operate in Dubai, agreed two years ago, are currently being implemented

The Dubai International Financial Centre (DIFC) was launched in February 2002 to create a financial marketplace to operate in the gap not covered by the international financial centres of London, New York and Hong Kong. The decree of the federal cabinet of the United Arab Emirates establishing the DIFC as a financial free zone was approved in July 2003.

Conceived by the government of Dubai, with 50,000 jobs expected to be generated by 2007, the DIFC's remit is to create a regional capital market with world-class regulations and standards. It aims to offer participants an attractive investment environment, including 100 percent foreign ownership, zero rate of tax and the freedom to repatriate capital and profits without restrictions.

Comprising 45 buildings on a 110-acre site in the main centre of Dubai valued at $1 billion, the DIFC will contain office, residential, retail and hotel accommodation. The DIFC will be governed and regulated by international laws; the working language of the DIFC will be English and the trading currency will be US dollars.

His Highness Sheikh Mohammed Bin Rashid Al Maktoum, crown prince of Dubai, serves as president of the DIFC. Naser Nabulsi is the chief executive officer and Anis Al Jallaf is chairman of the board of directors.

The DIFC is made up of three core divisions:

  • • DIFC Development Authority: the holding company for the DIFC;
  • • Dubai International Financial Exchange (DIFX): a liquid and transparent electronic market, trading equities, bonds and derivatives within the DIFC; and
  • • DIFC Land Company: the financial district from where DIFC licensees will operate (currently under construction and expected to be completed within the next 3 to 4 years).
  • Activities within the DIFC will be regulated by the Dubai Financial Services Authority (DFSA). The laws governing the DIFC, including regulatory, companies and markets regulations are available online (www.dfsa.ae) along with the DFSA rulebook.

    The DIFC will initially comprise six core sectors of activity:

  • • Banking services;
  • • Capital markets;
  • • Asset management and fund registration;
  • • Reinsurance;
  • • Islamic finance; and
  • • Back office operations.
  • DIFX
    The DIFX has been created to provide a larger and more liquid securities market than exists in any of the region's national exchanges. The fully electronic marketplace will trade a range of securities including:

  • • equities
  • • bonds
  • • funds (index funds and unit investment trusts)
  • • Islamic compliant (Sharia) structured products
  • • derivatives (futures, options etc)
  • • commodities (oil, gold etc)
  • • indices
  • • alternative risk products.
  • With bank lending currently accounting for over 70 percent of the financing of trade and business expansion and the total market capitalisation of stock markets in the Middle East and African (MENA) countries being around $200 billion (approximately 40 percent of combined GDP), the first international exchange to be launched in the 21st century appears well poised to provide a viable public exchange.

    The centre hopes not only to facilitate forthcoming privatisations in the region and accelerate the rate of initial public offerings, but should provide impetus for programmes of deregulation and market liberalisation throughout the region. The DIFX is scheduled to open for trading in the second quarter of 2005.