A crisis of confidence

The economic crisis has eaten into short-term prospects for private equity in the MENA region, with many GPs putting investment activity on hold. But confidence in the region has merely been dimmed, not extinguished. Jenny Blinch reports.

Having witnessed the economic crisis wreak havoc in the US and Europe, GPs in the Middle East and North Africa (MENA) are nowtrying to gauge its impact on their home turf.

“One has to think about how the credit crisis will unravel in the region – will there be any of the spectacular failures that we've seen in the US and Europe? These are things that are unknown and will have a direct impact on our industry,” says one Dubai based GP, who asked not to be named.

In the face of such uncertainty, the private equity community in the region is split between those who are bedding in for the long haul, anticipating the worst, and those who persist in seeing theMENA region, or at least the GCC, as relatively sheltered from the crisis.

The latter can take the latest International Monetary Fund (IMF) World Economic Outlook as a source of comfort. In a recent update to its November 2008 Outlook, the IMF amended its prediction for growth in the Middle East downwards from 5.3 percent to 3.9 percent. However, even with this downgrade, the region stands out as one of the few predicted to see any growth this year at all; the same update saw the IMF adjust its expectations for world economic growth from just over 2 percent to 0.5 percent – the lowest rate sinceWorldWar II.

Tom Speechley, an executive director in the investment team at Abraaj Capital, puts it in the following terms: “If you look at the global context, it's obviously pretty bleak. And sitting here, what you cannot do is say that the region is unaffected. But the most important question is to what extent it's affected the real economies, because that's more fundamental to a private equity house. In terms of the real economies, there will be slower growth during 2009, but there will still be growth. And the overall prospects for the real economies are very good given the region's fundamentals – demographics, hydrocarbons and ongoing reform.”

However, there are those who see any optimism in the region as misguided. One Dubai-based lawyer comments: “People haven't really come to terms with what's happening here. Certainly the government hasn't and it's incredible to read in the local press the level of denial at what's happening.”

Whether or not there is a lag in terms of reality sinking in, the signs of strain have certainly begun to show in the financial sector.

In December, Kuwait's Global Investment House defaulted on a $200 million loan from a syndicate of investors led by German bank WestLB, causing shock ripples throughout the financial community.

Widespread jobs cuts have also been seen, pre-empting tougher times to come. SHUAA Capital said in December it planned to cut 9 percent of its Dubai workforce, predominately culling from back- and mid-office operations, in a bid to reduce “overcapacity”.

Private equity teams too have felt the pinch. At Bahrain-headquartered Investcorp, 90 jobs were lost from its Bahrain, London and New York offices in a cost-cutting exercise across its business lines of private equity, real estate, hedge funds and technology. Further job losses came in January as Dubai World-owned investment firm Istithmar World slashed 13 jobs, equivalent to 10 percent of its workforce, citing current external market conditions and a strategy to align resources in line with business requirements for 2009.

More private equity-related bad news came in January for Investcorp, when global ratings agency Standard & Poors (S&P) announced it was downgrading the bank's credit rating from'BBB/A-2“ to ”BB+/B'. S&P cited concerns over the extent of Investcorp's private equity, real estate and hedge fund exposures in the face of “global deleveraging, falling equity and real estate prices, and tight credit”.

Arcapita too saw its rating slashed from “BBB/A-2” to “BB+/B” by S&P, a move triggered by the bank's weak liquidity profile, “narrow” business diversification, high leverage and the potential for its private equity and real estate portfolios to decline in value in current market conditions.

Says Amjad Ahmad, senior managing director – alternative investments, NBK Capital, a subsidiary of the Bank of Kuwait: “My view is that we have seen huge destruction of wealth in the last six months which will have an impact on every aspect of the economy and will result in structural changes in the banking and finance industries. This meltdown is not like the dotcom bust or the Asian financial crisis, but more broad-based with far reaching implications. I believe it will be a two to three year process before we return to solid GDP growth.”

Within this context, it seems even those GPs still upbeat on the prospects for 2009 have paused for consideration.

Anis Bibi, executive partner at SHUAA Partners, the private equity arm of SHUAA Capital, explains: “For a lot of people in private equity, they have not seen deteriorations of this scale before in their professional careers and I think caution is something that can't be overemphasised.”

Benjamin Newland, a corporate partner at Dubai-based King & Spalding LLP, comments: “Even those [GPs] who say they are optimistic and will invest are also saying they're going to take it easy for the first quarter and just look after their portfolio companies.”

The shift to placing the emphasis on portfolio companies rather than deal making is not, however, only due to uncertainty about what the crisis might bring next. It is also a reaction to the damage the crisis has already done. As one Dubai-based GP puts it, “anyone who says they don't have a portfolio problem is lying.”

Dubai International Capital's (DIC) recent management reshuffle within its international private equity division, which invests in large buyouts and secondaries in Europe andNorthAmerica, might be indicative of this change of mindset in the region from bullish deal-doing to bearish introspection.

Announced in February, the reshuffle saw dealmakers Sylvain Denis, CEO, and Alan Hyslop, managing director, preparing to leave the firm, They will be replaced by portfolio managers David Smoot, who took the CEO role, and Eric Kump, managing director, who was appointed head of the European operations.

A spokesman for DIC said at the time the switchover reflected a complete change of focus within the private equity division of the firm. As a result of the economic crisis, he said, the emphasis was now on “the return of equity, not the return on equity”.

“Our focus in private equity is to manage the assets we've got – in thismarket of falling valuations and so much uncertainty, we are not focused on making new acquisitions,” he said.

“What we need for the next year, maybe two or three, is a different approach focusing on portfolio companies. This requires a slightly different skill set to the team we have now.”

While deal activity has dropped off the radar at the moment, there is a large proportion of MENA-focused GPs that expect it to pick up as 2009 advances.

This optimism was captured by consultancy firmDeloitte, which put out its second “MENA Private Equity Confidence Survey” in January, following consultation with 30 global GPs in November and December 2008.

Asked about their expectations for investment activity in the MENA private equity market to over the next 12 months, 47 percent anticipated an increase, 40 percent a decrease, and 13 percent said it would stay the same. Compared against the results to the same question in the first MENA Confidence survey, carried out in the first half of 2008, the results highlight a massive erosion of confidence: in that survey not one person anticipated a decrease over the following 12 months, and a whopping 94 percent expected activity to grow. Taken on their own, however, the results indicate sustained optimism among the region's GPs: essentially, a majority of 60 percent are predicting investment activity levels will at least stay the same this year.

There is, in theory at least, plenty of dry powder available. Estimates vary on the number of private equity firms active in the region (most pitching it somewhere between 80 and 100), but according to statistics from the Emerging Markets Private Equity Association (EMPEA) just over $19 billion has been raised for deployment in the MENA region since 2001, with around $2.9 billion, $5 billion and $5.9 billion raised in 2006, 2007, and 2008 respectively. EMPEA gives the total amount invested in the region since 2001 as $14.7 billion, leaving a good $4 billion apparently still to be invested. In a region where the average deal size is £35 million, that money would go a long way.

As elsewhere in the world, the current economic climate has meant the region's banks have effectively shut their doors to new business and the IPO route is a nonstarter. With these more traditional financing routes closed off to companies, a Dubaibased source explains why some GPs anticipate a good year “from a selfish private equity perspective”: “Corporates that are still well positioned, that need access to growth capital, will find it very difficult to access either the debt or the public equity markets, so as a consequence we think private equity's very well positioned to take advantage of this unique proposition and invest in companies that are still high quality, despite the difficult times, and do so at relatively attractive price multiples.”

Certainly it will be interesting to see if the scarcity of other sources of financing helps the MENA region, where private equity is still a nascent industry, warm to the asset class. Previous PEI Asia articles on MENA private equity have highlighted the reservations that still surrounds it in a wealthy region where most businesses are familyowned and there are strongly ingrained codes of conduct when it comes to the borrowing of money.

The traditional source of funding for Middle Eastern businesses has been bank loans. Ironically, the very same lack of available lending that in theory might push private equity up the agenda might also cause untold problems to GPs' existing portfolios.

NBK Capital's Ahmad explains: “The fact the banks are not lending now is much more to the detriment of portfolio companies than acquisition finance. If a portfolio company is not getting the adequate level of leverage it will struggle to finance initiatives or in some cases to merely survive.”

In terms of deal-doing, some have commented that lack of leverage does not matter to a region where the predominant investment type has always been development capital. Certainly a comparison of the two Deloitte MENA Private Equity Confidence Surveys shows the shuttering of the debt markets has had little impact on predictions of the type of transaction likely to bemost popular over the next 12months: buyouts dropped a small amount (from 17 to 12 percent), pre-IPO, venture and PIPE saw small rises (13 to 15 percent, 2 to 5 percent, and 2 to 8 percent respectively), but development capital maintained a strong majority (dipping slightly from 64 to 60 percent).

Others though point out that a buyout industry was beginning to build momentum pre-crisis. Evidence of this is the number of buyout funds dedicated to the region. In fact MENASA-focusedAbraaj is currently in the process of raising its third buyout fund, which held a first close on $3 billion in October last year. Once closed, it will be the largest private equity fund ever amassed for the region.

Some are sceptical about the prospects for buyout funds in current conditions. King & Spalding's Newland says: “Before the economic crisis, private equity was gaining a lot of acceptance here as an asset class. The family-owned conglomerates were slowly but surely getting more accustomed to the idea of, say, spinning off a part of their business and allowing in private equity investors. [GPs] were thinking more about taking controlling interests and even using leverage, but then the debt markets just shut down and now people are not even able to talk to banks about getting lending – there's just no financing available.”

Those funds captive to or sponsored by one of the big regional banks might be in a better position to secure leverage for buyout deals, but otherwise it would seem the growth of the region's buyout market has, for now, been stalled.

With the emphasis on growth investments then, many GPs in the MENA region are biding their time, waiting for prices to come down.

Since stock markets across the region have come down between 30 percent and 60 percent in the past few months, there is obvious downward pressure on valuations in the private sector. However, as has been seen in markets across the world, the sellers have yet to budge; a situation one GP described as a “gap that has yet to be bridged”.

With uncertainty hanging over company earnings across the board this year, there is also hesitance on the part of GPs themselves to make a call on valuations, for fear of seeing their investment slammed by what-ever unpleasant surprises the crisis may still throw up.

Nonetheless, some good deal opportunities are still filtering through, as Tamer Bazzari, deputy CEO, Rasmala, explains:“We see a lot of deal flow coming from businesses requiring funding for business on hand or for expansion, which theymay not be able to get bank financing for. We also see distressed sales of businesses at very attractive prices.”

He continues: “We see many opportunities coming from Egypt, Turkey and the UAE. Sectors that could attract private equity funding include education, healthcare, manufacturing, infrastructure, and oil and gas.”

When talking about opportunities within the GCC, private equity firms – like other investors – look to take the lead from their cash and oil rich governments.

As one GP says: “I want to tell you that education and healthcare are important sectors for us, but every single private equity firm says the same thing because they are areas that we know the government and private enterprise want to improve in this region.”

With the GCC predicted to avoid recession, the deep pockets of the governments in this area of the Middle East are being dipped into to prop up ailing sectors and cushion the region from a deeper crisisinflicted blow.

Real estate and infrastructure, which in Dubai especially have been key plays for investors in recent years, have taken a pummelling in the crisis: real estate values have dropped up to 25 percent and the market has all but dried up. With these sectors so crucial to the health of the economy, the governments have moved to up their budget spend in this area, as Bazzari explains: “Many companies represented in the economy are real estate related. This includes construction material manufacturing and services. We see large budgets being announced by governments in the GCC, which indicate that the infrastructure investments made by these governments should help some of the businesses supplying such projects survive and even grow.”

The GCC's powerhouse, Saudi Arabia, is also being looked to with increasing interest by the region's GPs. In terms of “untapped opportunities”, it represents a particularly tempting one, accounting for 80 percent of the GCC's economies.

Private equity has yet to make much headway in the country, known for its conservatism, but that does not deter those looking at it purely in terms of its potential. Says lawyer Newland: “It isn't the easiest place to do business – it's definitely harder to do deals there – but the economy is too big, the population is too big and too young, and there are too many resources there for it not to happen.”

With an abundance ofmaterial and natural wealth in the region, governments only too willing to bolstering flagging sectors, and vast untapped territories like Saudi Arabia, it is easy to see why even themost bearish ofGPs now is still bullish about the long term.

Looking ahead, Bazzari comments: “In the long term, we believe acquisition financing will become available, valuations will stabilise, and interest in private equity investment in theMENA regionwill rise. We think this is an industry in its infancy in theMENA region and it will develop over the next few years.”

His view is reflected in the Deloitte Confidence Survey. Asked to rate their longterm optimism in the sustainability of private equity in the MENA region on a scale of one to 10, the average response came in at 8.2 – a notch up even from the 8.1 average of the first Confidence Survey, carried out in far more optimistic times. Conversation with local GPs affirms this: the crisis may well stall the growth of private equity in the region this year, but it has done nothing to dent its practitioners' belief in its durability.

As the downturn starts to make itself felt in the private equity industry in the Middle East, North Africa and South Asia (MENASA), an ominous word that crops up time and time again is “consolidation”.

Its meaning, however, has been left somewhat open to interpretation.

“[There is] consolidation in the form of mergers and then there's consolidation which means a smaller number of players in the market three years down the road,” says Anis Bibi, executive partner at SHUAA Partners. “The latter is what people ought to be referring to.”

From small-scale beginnings a decade ago, the private equity industry in the region has grown exponentially year on year, and estimates on the number of players now active in the region vary between 80 and 100, and the amount of capital available for deployment is frequently cited anecdotally as being in the region of $10 billion.

For Yayha Jalil, senior executive officer, private equity, at Abu Dhabi and Dubai based The National Investor (TNI), this represents a clear-cut case of capital overhang: “During 2008 – a good year – the volume of transaction activity was $1.4 billion, representing 14% capital deployment per year on a conservative basis. The issue is that many of the MENASA region private equity funds have five to seven year lives, and were predicated on the fund being fully deployed in three years, leaving two to four for exits. But if you are deploying 14 percent of your capital a year, you need seven years to do it, leaving no time for exits. 2009 and 2010 are also likely to be much slower years than 2008 in terms of capital deployment, and the deployment rate in the region may fall to half of 2008, i.e. 7 percent. The conclusion is: too much money chasing too few deals.”

While not everyone agrees there is a capital overhang – the figure of $10 billion of available capital is a widely disputed one and some see there being an excess of capital only at the bigger end of the deal spectrum – there is nonetheless a consensus view that the economic crisis will implement a process of attrition among the region's GP base.

Comments one Dubai-based observer: ”There's going to be a shake-out, but I don't think that it's because there are too many private equity funds in the region – it's because there are too many bad ones.

“At the height of the boom back in early 2008, the funding available to private equity sponsors and investment banks was like funding for internet companies at the height of the internet bubble – a lot of people who had no business running a fund were attracting absurd amounts of capital.”

The mostly local LP base is also experiencing cashflow problems due to its heavy real estate overweight, leading some to question not only future fundraising (see page 28), but also the capital already committed to private equity.

Says Amjad Ahmad, senior managing director – alternative investments, NBK Capital: “I would question whether all the capital that has been committed is still available if GPs decide to draw down.

“It depends on the LP base – if a GP has more of a retail base, then it is a concern. If it is more institutional, then the GP is in a much better position.”

There are already reports of some GPs struggling. Such is the youth of the private equity industry in the region that many firms have no track record to speak of and – with their LP base also struggling to hold its head above water – they are falling victim to the vicious circle summarised by Tamer Bazzari, deputy CEO, Rasmala: “Many firms are having difficulty raising funds. Their LPs are not able to fund drawdowns of existing commitments, making it difficult to do deals. The underlying business outlook is unclear, making it difficult to invest as valuations keep going down. Their track record has been hurt with the drop in the market and their holdings have large unrealised losses. We have already seen several management teams looking to move and many funds requiring assistance.”

This situation is only likely to worsen over the next two years, as Jalil points out: “Because deal volumes are actually going to decline substantially in 2009 and stay low in 2010 compared to 2008 levels, I expect several of the private equity funds and principal investment groups in the region will fall by the wayside, as investors see they are unable to source and execute private equity deals in the region.”

While some might see the economic crisis as a particularly nasty virus, picking off the weak and young from amongst the region's burgeoning GP community before they've had the time to grow, others accept it more philosophically.

Says SHUAA Partners' Bibi: “If [a shake out] happens in the region, it's just another sign of the industry maturing. All we're doing is following trends which have been demonstrated and experienced in other more mature markets, and when downturns happen, the same way a traditional asset manager may not survive, the same can happen to private equity players.”