Middle East emerges as a private equity centre

Asiamoney, July 2008

The Middle East has emerged as the fourth world centre for private equity after North America, Europe and Asia.

The numbers are indisputable. A study by the Gulf Venture Capital Association, KPMG and research group Zawya put the total funds raised in the region in the three years to the end of 2007 at US$13.4 billion, from 76 separate funds. Everything is climbing: the $6 billion raised in 2007 is more than double the $2.4 billion of 2005; the number of funds closed in 2007 – 22 – is up by a similar degree, from 12 in 2005; and the average fund size is climbing too, from US$204 million in 2005 to US$274 million in 2007. Last year saw the first billion dollar private equity deal in the region (Abraaj Capital’s $1.41 billion purchase of Egyptian Fertilizers) and the raising of the first billion dollar fund (Abraaj again, with its Infrastructure and Growth Capital Fund).

But it’s not just the figures. Everywhere you look you see new entrants coming in. Abraaj’s name keeps cropping up because it was a first mover (see box): when it set up in its current form in 2001, it had the market to itself. But these days there is competition from local funds, from the direct investment of local banks, from increasing international attention, and from the growing wealth (and newfound willingness to invest locally) of the vast sovereign wealth funds in the region.

What’s the attraction? One obvious reason is the oil price. There is great and growing wealth here at both an institutional and an individual level, and it needs to go somewhere. For any business seeking to get started or grow, liquidity is abundant – and that can’t be said for many world markets today. In particular, the region needs infrastructure. “After more than a decade of underinvestment, the Middle East is going through a huge construction phase, with more than a trillion dollars worth of projects underway,” says Imad Ghandour, principal in the investment team at Gulf Capital, a private equity specialist in Abu Dhabi. “All sectors related to real estate and infrastructure are booming. Soon after, a consumption cycle will begin, supported by an efficient economy liberated from the public sector and significantly higher disposable incomes.”

On top of that, there are interesting demographic changes taking place. According to Faisal Belhoul, the managing partner of Dubai-based Ithmar Capital, over 90% of all commercial activity and non-oil-related GDP in the Gulf is controlled by family firms. He says there are 5000 of these family firms with combined assets of more than US$500 billion, employing 70% of the region’s workforce.

Traditionally, this has been an impediment to investment: people don’t want to sell. But there is also a sense that things are beginning to change. “Often you’ll find that one or two generations of a family build up a business, but when it comes to the next generation, they don’t necessarily want to take it on,” says one private banker in Dubai. That creates an opportunity: either businesses consider listing for the first time in order to give family members an exit if they want it; or it gives private equity players a way in.

“It’s changing for a lot of reasons, not just the generational lead,” says Chuck Pieper, vice chairman of Credit Suisse Alternative Investments, speaking to Asiamoney between company visits in Abu Dhabi. “As many of the families have acquired a portfolio of interests over time, they’re finding that the cash requirement for growing a broad base is larger than the ability they have to generate it. We were reviewing a deal today with three different arms of a family company, and within each of them, two or three different businesses: a mini-conglomerate. They would like to monetise some of them to get the cash required to build others.”

Ghandour adds: “Family businesses eyeing an IPO understand that private equity is a good intermediary step towards public listing, as it proves to the wider investor audience that the company is ready for outsiders and at the same time it infuses new expertise into the company.”

One could also argue that the thinness of Gulf stock markets supports private equity. Many markets in the region – in the UAE and Qatar, for example – are barely a decade old. Saudi Arabia, by a distance the most powerful economic force in the region, has only 123 stocks listed on its stock exchange. In a market like that, with very few small caps to speak of, the stage is set for pre-IPO investment, by private equity or venture capital firms.

And, locally, the financial services sector is growing in sophistication by the day. And it’s here, on the ground, that the broadening of the field is taking place. As local banks have announced their latest results, the words “private equity” are cropping up ever more frequently.

For example, take a look at the 2007 results announcements from Bahrain’s banks, all of them announced in the last few months. Investcorp, which focuses on alternative investments, recorded strong growth in both its private equity and Gulf growth capital businesses. Unicorn Investment Bank completed an initial $150 million capital raising for the Unicorn Strategic Acquisition Fund, which it hopes will become a $1 billion fund in due course. (One of its existing funds, Unicorn Global Private Equity Fund I, bought 55% of Gulf Strategic Partners, a Bahraini engineering services firm, in March to go with four previous investments.) Ithmaar Bank achieved a $200 million first close on its Aldar Private Equity Fund in November. Capivest, formerly known as Khaleej Finance & Investment, confirmed a private equity fund worth $110 million focusing on India. Gulf Finance House told its February AGM that its focus for expansion is on asset management and private equity. And other banks are active as acquirers in their own right, whether as principal finance or to build their franchises; an example is Ahli United Bank, which bought 35% of Oman’s Alliance Housing Bank in 2007.

Several of these banks are relatively new themselves. Ithmaar (not to be confused with Dubai’s Ithmar Capital) is only in its second full year of operation as an investment bank but has embraced the private equity opportunity as a strategic business, launching funds not only for the Gulf but the world. “We take a global view of private equity opportunities,” says Andrew Pocock, who heads the bank’s private equity team; examples have included an investment program for Australia, stakes in  funds investing in China (Ithmaar owns 20% of CITIC International Asset Management), and funds related to Africa, Latin America and CIS’s energy sector.

Big new funds are springing up all the time. Kuwait’s Global Investment House, Dubai Islamic Bank and Millennium Capital (part of Dubai Islamic) announced in March the Global DIB Millennium Islamic Buyout Fund, a private equity vehicle targeting $500 million of commitments, which will invest in buyouts of Shariah-compliant companies. The fund followed an earlier Global Buyout Fund, which had an initial close in November 2007 after raising $550 million and has already committed more than one third of it. Global itself says it manages around $1.6 billion in private equity; at the fund’s launch, Global’s executive vice president, Omar El-Quqa, said: “We believe strongly that this asset class will dominate the region in the coming years as it is well-suited for the region’s macroeconomic factors, such as sustained economic growth, implementation of reforms that facilitate foreign direct investment, and an increased willingness of governments to privatize state-owned entities in a variety of sectors.”

Internationally, too, groups have taken notice of the possibilities in the Middle East. In November 2006, Carlyle Group announced it had established a team for the Middle East and North Africa (MENA) region, headed by Walid Musallam. It was quite a coup: one of Musallam’s previous roles was chief executive officer of the Abu Dhabi Investment Company, a multi-billion dollar investment group backed by the Emirate itself (he’s also worked at Lehman Brothers and the IFC). Firas Nasir subsequently joined from UBS and is based in Dubai; other key hires include Hassan El-Khatib,  a managing partner of EFG-Hermes Private Equity, part of the leading investment bank in the Middle East. Carlyle has yet to make public any investments by its new MENA Buyout Fund, nor its size.

Carlyle is the foreign private equity name everyone talks about in the Middle East, but others are building up too. 3i is invested in a fund from Dubai’s Ithmar Capital, and in a Bahrain-based infrastructure fund run by Manara Equity Partners. Both Ripplewood and Actis have made purchases in Egypt. Blackstone worked alongside Dubai International Capital on the Merlin Entertainments/Tussauds merger in 2007.

Among the foreign investment banks, the clearest sign of renewed enthusiasm comes with their recent movements of personnel. David Law was until recently head of the financial sponsors group internationally (that is, outside the US) for Morgan Stanley, with close relationships with major private equity firms; in February he was appointed chairman of investing banking for Middle East and North Africa out of Dubai, supposedly with a mandate to target sovereign wealth funds. In April, Lehman Brothers created a new role of global head of sovereign wealth funds in Dubai, to be filled by Makram Azar, previously head of the media, consumer and retail investment banking business in Europe and the Middle East.

Aside from the seniority, there are interesting tie-ups too. Credit Suisse announced in March that it would create a strategic alliance with Gulf Capital. “Even when oil was at $20 or 40 a barrel, we thought the Middle East had a lot of potential for private equity,” recalls Chuck Pieper, vice chairman of Credit Suisse Alternative Investments. “It was still early on, but it was developing a real infrastructure that was not just about carbon exports of oil or gas, but real businesses developing here. We spent a couple of years looking for partners.” Gulf Capital proved a good fit: of the four managing partners, one used to work at DLJ (now part of Credit Suisse) and the other had worked for Pieper during his time at GE. The partners have been reported to be raising a fund of around $750 million.

Pieper thinks the time is right for international institutions to play a bigger role. “Something in the order of $12 billion of private equity has been raised for the Middle East and the vast majority of that is done with local firms,” he says. “Less than 20% has been from international names.”

But there is a big difference between the amount of money ready to be invested and the amount of money that actually is. And there’s an even bigger difference between the amount that is invested and the amount that comes out again in exits.

The KPMG report says $13.4 billion has been raised for private equity in the last three years – but only $12 billion has been invested in the last 10. Also, during all that time, just $900 million has been realised in exits: just 7.7% of total investments. And that’s a dramatic improvement: of the 49 investments sold in the last decade, 36 were in 2006 and 2007, although not all exits are reported publicly.

“With a few conspicuous exceptions, there has to date been a lot more success in raising investment capital than in deploying that investment capital,” says Pocock at Ithmaar, “and one consequence of this is that returns are being constrained by the prices being paid.” There are western-style deals occasionally – the Abraaj purchase of Egyptian Fertiliser is one – but “what you find is a lot of the private equity is actually going into what are, in effect, start-up businesses. You get a relatively high level of green field investment, which can mean quite a long lead time before you start generating cash. In pure green field, at least in capital intensive industries, you’re probably not talking about cash generation for three to four years and dividends for five.” That, in turn, leads to a longer holding period than is traditionally seen in the west. “We’re looking at a project now which probably won’t close until next year, and then the equity is drawn down over the next three. That approach is still going to give investors an attractive return, but they have to have confidence and be willing to allocate capital to Ithmaar’s fund for the duration.”

Pieper notes a key difference between the Middle East and other emerging markets, notably China. “You’d probably say 90% of the exits in China are IPOs,” he says. “I would bet in the Middle East we will see at least half of the exits being strategic acquirers.”

There are other challenges for private equity too. It’s true that the nature of family business is changing, but it’s still very much there, and change takes time. “The economic backdrop that makes for a very active private equity market like in the US and Europe generally speaking does not exist in the Gulf,” says Pocock. “One of the reasons for that is that a lot of the enterprises here are family-owned, and while many have made a lot of progress in corporatizing themselves, some are still run in their old-fashioned form as a sole proprietorship or family partnership. In these cases there’s a reluctance, particularly if the patriarch remains alive, to dispose of any division, no matter how poorly it may be performing.”

And it creates some doubtful arrangements too. In May, The National Investor, an Abu Dhabi-based investment group, calculated that 75% of businesses in the GCC region have at least two board members from the same family. In Kuwait, one family can occupy the whole of a board, and in Saudi Arabia, 75%.

And underpinning any boom market is a perennial challenge: people. Pieper says he spends one third of his time on people matters. “The whole private equity industry is people dependent,” he says.

“Many individuals and institutions seeking to enter this business underestimate the issues involved,” says Pocock. “There is a significant shortage, not of able people, not of talented people, but appropriately experienced people trying to make their way in this business.”

BOX ONE: SOVEREIGNS

As everyone knows, the really big money in the Middle East is with the sovereign wealth funds. Nobody knows the precise figures, but the Abu Dhabi Investment Authority may have as much as $1 trillion under management. Of the estimated $3 trillion in sovereign funds internationally, probably almost half is run out of the Gulf. A recent report by Private Equity Intelligence estimated that 60% of the world’s sovereigns are invested in private equity, with between $120 and $150 billion committed to the sector, so if the Gulf accounts for about half that figure, it’s clear there are some huge funds to be deployed – and the money just keeps coming out of the ground.

Traditionally, though, the sovereigns have focused on investments outside the Gulf, in order to diversify. The investments that get the most coverage are, for example, Saudi Arabia’s Prince Alwaleed or Abu Dhabi’s ADIA buying chunks of Citigroup, or the Kuwait Investment Authority taking holdings in DaimlerChrysler and Merrill Lynch.

But recently, sovereigns have started to show a willingness to invest in the region as well, if not in their own name then through subsidiaries, or for other groups mandated or supported by the state. Take Dubai Holdings, owned by Dubai’s ruler, Sheikh Mohammed bin Rashid Al Maktoum. Its financial services holding company arm, Dubai Group, was launched in 2000 and holds a wide range of direct and indirect investments worldwide. These include American, European and Asian interests, but also stakes in numerous Middle East groups such as EFG-Hermes, Global Investments House, TAIB Bank in Bahrain, Dubai Bank, and Emirates Cement Company. Dubai Investments is a separate entity again, the largest investment holding company listed in the UAE; it has a private equity and venture capital division called M’Sharie, whose investments include a range of local companies from rubber to driving centres, cooling machinery and lab technology. Also in Dubai is Ithmar Capital, another GCC-focused private equity fund. Its first two funds raised $70 million and $250 million respectively, and a third raising later this year is rumoured to be targeting as much as a billion dollars. While not part of a sovereign, its partners in its funds do include sovereign wealth funds, as well as international funds and institutions, among them 3i. An example of a recent investment was Panceltica, a Qatar-based provider of fast track housing, in which Ithmar was a pre-IPO investor.

Ninety minutes up the road in Abu Dhabi, ADIA, the heavyweight of sovereign funds, does not invest locally. But Abu Dhabi Investment Company, a sister company of sorts to ADIA, includes a private equity division focused on the MENA region. It is, for example, developing the Queen Alia Airport project in Amman, Jordan. Then there’s Mubadala Development Company, a wholly owned investment vehicle of the Abu Dhabi government, established in 2002. Mubadala’s mandate is to establish new companies and acquire strategic holdings in existing ones, locally and overseas. While some of its holdings are in the West – most notably, stakes in Ferrari and Carlyle – most are in the Gulf, such as stakes in Abu Dhabi Ship Building, Emirates Aluminium and a host of healthcare businesses. (Mubadala is not the only example of this interesting twist of Gulf funds owning stakes in American private equity firms: ADIA has a stake in Walden Capital.)

Still, many in the industry do not see sovereigns as direct competitors. “In reality, the private equity houses competing for deals are less than a dozen,” says Imad Ghandour at Gulf Capital. “Sovereign wealth funds usually have a different agenda compared to private equity firms, and rarely compete head to head with private equity houses.”

 BOX: ABRAAJ

Abraaj Capital is enjoying the benefits of being a first mover. While other funds and enterprises grapple for opportunities, Abraaj has around US$5.25 billion under management already, across five funds.

“We had the advantage of being the early birds,” says Omar Lodhi, executive director at Abraaj in Dubai. “We entered this space as principals in 1995, and in our formal structure as Abraaj in 2001, when nobody knew what private equity was, leave alone sensing any opportunity. We’ve grown in tandem with the opportunities around us in the region.”

From the outset, Abraaj has not limited itself to the Gulf, but to a region it calls Menasa, for Middle East, North Africa and South Asia. “That’s some 1.8 billion people, $3.2 billion in GDP, and a region that has historically had a lot of cultural and economic ties that are now being rekindled,” he says. Taking this approach benefits from the synergies between resource rich and population light countries in the GCC, and those with the reverse demographics in south Asia and Africa. Much of the region is also now benefiting from an agenda of business reform.

With its scale, Abraaj tends to appear on the landmark private equity deals in the region, such as the acquisition and exit of Aramex International, and the region’s biggest ever private equity-led buyout, the purchase of Egyptian Fertilizers. Other deals, worth at least $100 million apiece, have included investments in Acibadem Healthcare Services in Turkey, Air Arabia in the UAE, and GEMS Schools across the region. Access is helped by a remarkable roster of shareholders and executives, among them Saudi Arabia’s Sheikh Abdulrahman Ali Al Turki, Kuwait’s Public Institution for Social Security, the Qatar Pension Fund, Citicorp, and numerous other regional business or political figures. “They’re all very influential institutions and people who permeate the fabric of society, of business and corporates and government within the region,” says Lodhi. “They are extremely useful throughout the value chain of private equity we practise, in terms of deal sourcing, post-acquisition management, and helping companies grow.”

Apart from being one of the few businesses around to be able to demonstrate a full-cycle track record, Abraaj really now stands out for its size. “The need for larger funds arises because corporates around us now are growing,” he says. “Aramex when we bought them were $70 million, and when we exited, $300 million. Today they’re close to a billion. That’s the kind of growth we are seeing in this region.”