Leverage is at the heart of almost every buyout, which means money is borrowed against the assets of the acquisition target and used to fund the transaction. Interest payments on the debt are offset against tax and this alone helps enhance the overall profits in a deal, never mind any improvement in the performance of the underlying asset itself.
What to do then if you are an investor looking for the superior returns leveraged buyouts can deliver, but your religion forbids you from earning money from interest?
This is the bind many wealthy Muslim investors find themselves in. Under Shari'ah law, the Islamic code of conduct, they may not pay or receive interest on loans. If they want to invest in private equity regardless, one potential partner is Arcapita, a Bahrain-based merchant bank, which opened for business in 1997 as First Islamic Investment Bank. Renamed Arcapita in 2005, the group provides alternative investments that are compliant with Shari'ah law. Additional offices exist in London and Atlanta.
Arcapita has four business lines: corporate investments in the US and Europe; real estate in the US, Europe, the Arabian Gulf and Asia; asset-backed investments in the US and Europe; and venture capital in the US. At the level of equity investors, money is ring-fenced and insulated from the interest bearing debt provided by the lending banks.
John Madden, a principal in the firm's 30-strong London office, says: ?We take the deals, restructure the finances and make them compliant with Islam. Then we distribute them to high net worth individuals in the Gulf.?
To date about 1,400 investors have put their money to work with Arcapita. The firm itself invests in its deals, typically keeping approximately 10 percent of each investment on its books. The firm's management will account for a further 4 to 8 percent, depending on the deal. Madden says: ?You're expected to take your full allocation.?
But before anyone invests, Arcapita has to find an appropriate deal. Madden says: ?First the business must be islamically acceptable. We do not invest in defence, alcohol, tobacco, media or gambling for example.?
Every deal is approved by a formally appointed, standing board of Shari'ah law experts. Madden says: ?The structures are approved and moderated by the board, which focuses on appropriateness of the business and the structure. If it does not like the deal, we drop it.?
Arcapita's Shari'ah compliance is essential to every deal, but its executives play down the impact it has on the deals it does. Madden says: ?The financial structuring is slightly different. It is not alright to lend money in return for an interest payment. It is alright to lend an asset and for that to be paid for. The documentation however is standard. So if you are a lending bank, it will look just the same.?
And after almost a decade in business, it is almost a given that Arcapita's deals are Shari'ah compliant. Other than that Madden says: ?We have always kept our business free of any religious or political agenda.?
The firm cites its investment in Cypress Communications, a US local telecom carrier and a strategic industry in the US, as a prime example of its apolitical motives. During the acquisition of Cypress, the guidelines of the Committee on Foreign Investment in the United States (CFIUS) required Arcapita to provide significant disclosure on its business, its management team, and its shareholders. Madden says: ?At the end of this major process, we were admitted as investors without a single issue.?
If anything, the nature of its funding has more of an impact on the way Arcapita selects its deals. The firm does not have a traditional fund, choosing instead to raise money on a deal-by-deal basis from high-net-worth individuals from the member states of the Council for Co-operation in the Arabian Gulf (GCC), i.e. Saudi Arabia, Kuwait, Bahrain, Qatar, the United Arab Emirates, and the Sultanate of Oman.
Madden, who on some deals accompanies the firm's 15-strong marketing team on roadshows to potential backers, says: ?We focus more on growth. It is a better pitch to our investors: ?here's the growth story? is more appealing than ?here's the financial engineering story?.?
The firm's own story is also about growth. To date Arcapita has completed 22 corporate investments worth more than $2.8 billion in the US and Europe. It has exited five of them generating an average internal rate of return in excess of 20 percent.
Arcapita's deals are growing also. Most of its investments have been near the $100 million mark. In June this year it won the fiercely contested auction for Paroc, a Swedish insulation manufacturer and at €620m its biggest investment to date.
Madden says: ?Part of the appeal is that it is a stable business with dominant market shares in the Scandinavian markets, with a real growth opportunity in the Baltic states and in Russia. It has good downside protection. In the East there is a lack of quality housing stock and a consequent need to renovate existing stock or to construct new buildings.?
Arcapita was not the only potential purchaser able to see the opportunity. At the time a source close to the firm told PEI Asia's sister website PEO that as many as 60 bidders had contested the first round of the Lazard-run auction.
Madden says: ?It was competitive. We were a bit more user-friendly. We wanted to advance it along a certain timeline and we worked hard to get that done.?
Once a deal is signed, Arcapita underwrites it using its balance sheet of $2.4 billion and additional credit lines. Madden says: ?Unlike private equity companies that run a fund model, we couldn't do five deals simultaneously. There has to be some sequencing. As soon as a deal closes we aim to syndicate it to our investors within a couple of months.?
The bank keeps a proportion of the deal itself and staff are also expected to invest alongside. Madden says there are 1,400 total investors, who come into various transactions with between $250,000 and $500,000 on average. Some investors even come in on every deal with $1 million. He says: ?Investor appetite has gone up tremendously. We could do bigger deals.?
Investcorp, another Bahrain-based private equity investor, has a similar approach to syndicating deals to a Middle Eastern investor base.
Clearly the flexibility of Arcapita's funding cuts both ways. A rival private equity manager says: ?They are only ever as good as their last deal. In every deal there will be investors coming in for the first and potentially only time and for those Arcapita have to get every deal right. There is no portfolio effect to smooth over the failures.? He concedes that long-term investors with the bank are likely to be more forgiving.
This type of funding can also be more time-consuming, he says. ?You are constantly on the road and if deal-doers have to get involved it can be a distraction. But these days any firm that only talks to its investors when it is fundraising is not going to raise a fund. It is an ongoing dialogue so the gap between Arcapita and a traditional set up is narrowing.?
Certainly Arcapita is moving further into the mainstream of private equity in terms of its handling of portfolio companies. It is preaching the mantra of operational, not just financial commitment to its investments.
Madden says: ?We also have five people who look at nothing but the companies within our portfolio. They are experienced and well connected, and can draw on extensive networks to help companies develop their strategies for growth.?
In some cases the firm can do more than build a team and guide companies strategy. It can provide practical help developing the business. With Roxar, an oil and gas technology supplier it bought in February this year, Arcapita has used its investor base to help introduce the company to the Gulf states, a crucial market where the company had only a small exposure.
Its investment in Cirrus Design, a manufacturer of single-engine aircraft and a supplier to stars such as Angelina Jolie, came as the company was on its eighth round of venture capital financing.
Madden says: ?We cleaned out the entire capital structure. The business had a three-year back-log of planes and it had no ability to deliver that order. We hired a new chief financial officer, a new head of manufacturing and a new sales person. We built a new management team.?
It is not clear whether Jolie was one of the customers stuck in the back-log of orders and whether Arcapita helped her into the clouds.
But Arcapita has its feet firmly on the ground as its profits and profile grow with ever more visible deals.
Bahrain (136 employees)
London (30 employees)
Atlanta (31 employees)
Charles Ogburn, head of corporate
Asim Zafir, head of real estate and assetbased
Henry Thompson, legal and general
Charles Griffith, portfolio management,
Ryiad Al Saie, investment placement,
Hisham Abdulla, investment placement,
Khalid Al Jassim, investment placement,
Mohamed Nooruddin, investment placement
and general manager, Bahrain
Mounzer Nasr, corporate investment,
Muhannad Abdulhasan, real estate
John Huntz, Arcapita Ventures, Atlanta
Mohammed Chowdury, financial management,
C. MacLaine Kenan, real estate