Growing Middle East equity market dealing with major challenges

 

Sustained deployment of funds in quality deals and development of exits and realisation of returns are posing a big challenge to the fast-growing private equity market in the Middle East and North Africa (Mena), according to a new report compiled by Gulf Venture Capital Association (GVCA).

Contradictory regulatory structures and legal framework in the region are among the challenges for this emerging industry in the region cited by the report.

“While the industry progresses from fund raising to the deployment and investment stages, investment managers will experience a new set of challenges.

“In fact, only a few managers have proven their ability to successfully source deals, add value and profitably exit investments. Competition is a challenge not to be taken lightly. Most importantly, investors’ patience over a six to eight year period is yet to be tested in the Mena region,” said Rami Bazzi, a chartered financial analyst at  Injazat Capital.

The stellar growth in private equity since 2005 has continued unabated into 2007, with the wealth created from oil spreading further inside the GCC and into Mena. Improving investment conditions, increased liquidity and mounting international interest in these emerging markets have added to the attractiveness of private equity as a viable regional asset class.

Historically, in the Mena region, funds are raised before the opportunities to invest are found, and it is inevitable and expected that at such an early stage in the development of this market one would expect some capital overhang.

However, privatisation and re-engineering of family businesses have resulted in an increase in investment opportunities. The number of funds actively raising capital declined in 2007, while the number of investment opportunities soared, so the capital overhang is beginning to narrow, the report said.
 

The last three years have seen a boost in the fund raising activity in the region. The number of funds raising capital has more than doubled in this period, with 22 funds reaching at least the first close in 2007, compared to 16 in 2006 and 12 the year before that.

 

In addition, the average fund size raised in 2007 was $274 million (Dh1.06bn), while in 2005 this figure was $204m. Total funds raised in 2007 totalled $6bn, compared to the 2005 total of $2.4bn. Of the 22 funds raising capital in 2007, 14 were announced in 2006 and six in 2007 (two in 2005).

The time for making a close has elongated since 2005. In 2005, it took three to nine months to make a first close. However, by 2007, it took typically six to 18 months to make a first close, but such a time frame is typical in other regions.

The majority of private equity investments in the last decade (66 per cent) were less than $20m in size, while 28 per cent of investments were made in the $21m to $100m bracket. Only 11 of the total 184 PE investments during the past decade have been over the $100m mark.

However, there is an increasing number of funds that are taking a prolonged time to raise their capital. Of the total funds announced in the last two years a total of $6.6bn is still to reach a close since 2006 and $3.2bn since 2007.

The number of funds announced but yet to reach a close declined from 15 in 2006 to seven in 2007. The region is attempting to raise larger funds.

 

The top five funds announced in 2007 represented 70 per cent of the total value of all funds announced that year (compared to 60 per cent in 2006).

As the industry matures and consolidates further, some of the funds announced, mainly by new fund managers, will never reach successful closure. Quoting industry experts, the report doubts that some of the mega fund announcements in 2006 and 2007 will ever come to fruition.

In the Mena region, Egypt has emerged as the preferred destination for private equity investors with $2.3bn being invested in the last decade. The higher level of investments in the past 10 years is mainly due to two investments of more than $500m each, carried out in 2006 and 2007 by Abraaj Capital which accounted for 82 per cent of the total Egyptian investments.

By excluding those two investments of $500m, the UAE was the largest recipient of investments by private equity firms in the last decade, achieving 27 per cent, followed by Saudi Arabia (22 per cent), Jordan and Egypt (nine per cent each) and Bahrain (two per cent).

Investments in the last decade have been focused on basic materials sector (23 per cent of all investments) followed by financial services (16 per cent) and oil and gas (10 per cent) sectors.

Commenting on the returns, the report finds that over the past 10 years, private equity houses have invested an estimated $12bn against which a mere $900m (measured at cost and representing 7.7 per cent of the total investments) have been realised by means of exits.

However, it is worth noting not all exits are reported in the public domain by private equity houses.

As the private equity market is fairly young and most funds are still in the early deployment stage, it is not unexpected that only a few exits have been realised by this stage.

It is expected that the rate of exits is maintained in 2008 as investments made in 2004-2006 reach realisation.Since the private equity is fairly young and most funds are still in the deployment stage, it is not unexpected that only a few exits have been realised by this stage.

Many investments are reaching realisation faster than the planned typical investment horizon of three to five years. The coming few years will reveal if such exits have been realised too soon, and whether better opportunities were found for deploying cash elsewhere.

Recent trends indicate that the most notable sector for the exits of private equity investments in the region has been the financial services sector, which has been driven by one of the most prominent exits in 2007.

This was Abraaj Capital’s sale of its stake in the EFG Hermes Holding for $1.1bn, which alone makes up around 57 per cent of the total exit value to date.

 

 

WHAT THE INDUSTRY SHOULD EXPECT IN THE COMING YEARS

 

The Global Venture Capital Association has highlighted the major challenges for the nascent private equity industry in the region. They are:

 

Enhancing deal flow and concluding larger transactions: The private equity industry has to secure additional deals of larger size. Back in 2004, industry pundits estimated that there would be no more than 10 private equity deals in the GCC and time has proved them wrong.

 

Today, it is difficult to predict how the additional billions raised will be deployed, but trends in the region are all favourable factors for creating more and larger deals.

 

Upgrading the talent pool: The depth and breadth of local talent is limited. The legal, operational and financial nuances of the region make importing new talent from developing economies less effective than previously anticipated.

 

However, local private equity players are successfully marrying local knowledge of doing business with international expertise in structuring and managing deals.

 

Dealing with the entry of global players into the market: Several global private equity players are now operating in the region.

 

The Carlyle Group is now in the fund raising stage for a Mena fund. 3i, CVC, and Deutsche Bank have partnered with regional players. Ripplewood and Actis have made single investments in Egypt. Others are scouting the region for opportunities.

 

Developing multiple exit options and not relying heavily on IPO-only strategy: The strong IPO market, weak private sector, and constraints on foreign direct investment have increased the importance of IPOs as an exit opportunity. However, it is widely expected that IPOs will have a smaller share of exits in the future.

 

Lifting foreign investment restrictions in several GCC countries will also increase the number of sales to international trade buyers.

 

Enhancing the financial engineering of deals: Debt providers in the region are increasing in sophistication and hence, will allow private equity players to structure more sophisticated and better leveraged deals.

 

Banks are developing their acquisition-structured finance expertise. And  in 2007, two private equity players announced that they are raising Mezzanine funds for the region.