A capital drought

The fledgling private equity industry in the Middle East and North Africa (MENA) has struggled during the global financial meltdown and its aftermath as fundraising has slowed, deals and exits have disappeared and GPs and LPs have re-considered the future of the asset class in the region.

In MENA, like other emerging areas, one of the biggest problems was the rapid rise of new private equity firms that were able to raise cash almost in the blink of an eye.

These firms, without solid track records, made investments at the height of the market and have seen their portfolios suffer in the downturn. They are now struggling to survive with their portfolios in distress and investors suffering burnt fingers.

Also in common with other emerging regions, however, MENA offers good prospects for private equity in future. Because leverage was typically used more modestly than in the West, the industry is likely to recover in MENA before it does in more developed economies.

Indeed, the investment environment today may be the best ever for private equity, according to Ahmed Heikal, chairman of Citadel Capital, a private equity firm based in Cairo, Egypt.

“This is the greatest environment to do deals for a combination of three reasons. One, you have some distressed assets; two, you have distressed sellers; and three, you have governments which have [struggling] balance sheets and have to…get the private sector to do some of the basic infrastructure development that historically governments within this region used to do on their own,” Heikal says.

“It's the greatest environment to do deals but it's a tougher time to raise money to do those deals,” Heikal says. “It's the ultimate paradox that during the best times [to invest] people are shy and risk-averse.”

Like investors everywhere, LPs in MENA private equity funds were hurt in the market downturn and have been hoarding cash in a defensive move to seek protection from volatility.

Along with this retrenchment, MENA LPs are also rethinking the way they invest in the asset class. Many LPs in the Middle East and North Africa are wealthy families that have owned and operated businesses for long periods of time.

With this operating experience, many are considering moves to invest directly or co-invest with funds that can boast long track records of success.

“In a way they see new private equity firms, like HBG, they see us like we're coming onto their turf – the turf they've owned all this time – and they're thinking, why not just do it themselves,” says Zulfi Hydari, co-founder and managing group director of Dubai-based HBG Holdings. “They're thinking of doing it themselves and in the short term, you'll find it'll probably work, but you'll find it's only those families who are significant enough and able to put the resources behind their ambitions who will really be able to generate value from private equity in the region.”

“Others will struggle to find deals and decide to partner up with local firms,” Hydari says. “The trend right now is, ‘we're a family, we've been here forever, we have our networks, we have operating experience because we run our own business, so why pay two and 20? Why pay those fees?’”

Direct investing has always been part of the environment in the Middle East. But after the financial crisis, and the meltdown of investments made by young firms, LPs have been looking more intensely than ever at taking matters into their own hands.

“I would say there will be a fundamental shift in terms of how the private equity model in the Middle East is going to work,” Hydari says.

No matter how LPs ultimately decide is the best way to move forward with private equity, the cold fact is that emerging market LPs have made fewer commitments through the first six months of 2009 than last year.

Firms in the MENA region have raised nine funds with about $1.2 billion in capital, compared to 19 funds raised in 2008 worth about $6.9 billion. It's tough to know which investors are actually part of MENA funds because they are usually low-profile sovereign wealth funds or wealthy families, but “the assumption has been that many within the core investor base took large hits to their portfolios during the worst of the crisis, at least on the developed markets real estate and equities portions on their portfolios”, according to Jennifer Choi, director of research for EMPEA.

Within the MENA region, Egypt dominates the fundraising environment, having attracted $2.3 billion in 2008, compared with Pakistan's $505 million and Saudi Arabia's $470 million. The bulk of investment in the MENA region last year went to the media and telecom sectors, which garnered $1.8 billion. Financial services attracted $659 million of investments, while healthcare brought in $555 million.

Exits have also proven hard to come by in the MENA region. As of May 2009, there were zero exits in the region, compared with 16 in 2008. In July, a consortium led by Ripplewood Holdings sold a 9.33 percent stake in Egypt's Commercial International Bank for $244 million. Ripplewood divested its entire 3.2 percent stake in the bank as part of the deal.

In the distressed environment of today, the MENA region's private equity industry is likely to see major consolidation.

“There was a lot of money thrown at private equity managers and when that happens there is a dilution of quality,” says James Seymour, a managing director with EMP Global, an emerging markets private equity firm based in Washington DC. “Within MENA, I expect to see consolidation but not to the extent I expect it in China, India or even the US. Growth was not as great in MENA.”

“[Young] firms raised a tremendous amount of capital very quickly, and they invested very quickly, and we will see a period of contraction,” Seymour says. “We'll see some other, newer firms who have been more prudent or came a little later in the game who will take advantage of opportunities and grow prudently.”

Certain areas of the MENA region will remain attractive for private equity moving forward, Seymour says.

For example, North Africa will continue to be interesting for oil and gas and related services deals, he says. In Egypt, there have been some compelling financial services investments.

Fundraising has been very tight, Seymour says, and will stay that way for another six months. But a shift will come as LPs decide to do something rather than sit on their cash.

“Up until now [investors] just didn't want to do anything,” Seymour explains. “In the next quarter you'll start seeing investors taking meetings, exploring where they should be allocating time and resources. Toward the second half of next year you'll start to see commitments being made again.”