Gulf private equity focus is on growth capital

Companies in the region have reached a size that they now need to restructure away from centralised control of a typical family-run business, according to Bain, a global consulting firm that advises business clients on strategy, operations, organisation and mergers and acquisitions.

One of its areas of expertise is private equity, which accounts now for a quarter of Bain’s business and has enjoyed a 12-fold increase since 1997.

Bain began operating in the Middle East in 1993 and has completed 60 projects in the Gulf . Many of its top executives were in the UAE this month to mark the official opening of its regional headquarters at the Dubai International Finance Centre (DIFC). These included the managing directors for worldwide and regional operations.

Following are excerpts from a double-header interview:

What has been the effect of the credit crisis on the global private equity industry?

ELLIS: In the first half of 2007, the availability of low-cost and low-term debt – in other words covenant-light debt with very few restrictions – created an unsustainable bubble of major acquisitions of very large companies, primarily through the access to cheap debt. That has gone in the US market, but there’s still a reasonable amount of activity going on underneath the surface.

There’s no question that markets are not providing the same type of debt financing and therefore it’s much more challenging for private equity companies, which are having to be more creative and with less leverage. Private equity is going back to the basics and the truth is there’s a lot of activity in the industry, with a huge amount of un-invested capital. Even with lower levels of leverage, this money will be put to use eventually.

As the credit markets begin to ease we will see activity ramp back up fairly quickly. These private equity funds are generally long-term investors and they see this cycle as an opportunity – equity values have dropped and the cost of buying companies has fallen.

How significant is the so-called shift of capital from East to West?

ELLIS: Sovereign wealth funds have around $3 trillion deployed in the global economy today. This number has grown dramatically in the last five to seven years, the petrodollar has been the primary driver, but the trade surpluses of the likes of India and China are also a significant part.

Depending on what you believe will happen to the oil price and global growth rates, that number might even be $12trn by 2013. If you take that level of capital, three-quarters of which is probably going to come for the East rather than the West, that is a tectonic shift in global capital markets.

What will that mean for the global economy?

ELLIS: I believe the global capital markets will continue to become more global, that the forces of globalisation will continue to bring down the legal, regulatory and political barriers to cross border investment.

Western companies and economies are going to have to become more comfortable with direct investment coming from other countries and regions. Hopefully we can get over the fears of political interests.
The markets in general have historically proven pretty good at finding a level of equilibrium and to overcome some of these political concerns.

It will definitely have some effect on the private equity industry. The large pension funds are starting to act a lot like SWFs and that’s going to put pressure on the LBO (leveraged buy-out) and private equity business to be more differentiated and better at what they do.

SWFs will have to figure out how to be sophisticated investors because it’s going to be a competitive market.

How will your firm be affected by these trends?

ELLIS: These changes play right into the core of our business. Private equity is a major piece of what we do. We have been advising private equity clients for the past 20 years and are by far the world leader in doing so, so we are in a wonderful position to help everybody in what could grow to be more than $10trn of capital coming into the market, all the way from SWFs to the small middle-market private equity funds in India.

This will mean that people will want to know how to complete the entire process, from deal sourcing and screening to diligence, improving the value of the company and exit. They are going to want to figure out how to optimise that to maximise value and that’s what we know how to do.

So we think this will be hugely beneficial for our business and all players at every end of the spectrum will have an enormous need to be more competitive.

How will the increasing prominence of sovereign wealth funds affect private equity?

ELLIS: The traditional private equity fund has a three- to seven-year window in which they operate because that it how its fund structure is set up. A typical SWF has time horizons that are defined potentially in decades or generations and this affords some real flexibility in the way the asset portfolio is managed in terms of entry and exit.

As these forces converge, it will be interesting to see what happens. SWFs, which have traditionally been asset allocators rather than direct investors, will probably to shorten their time horizons, while traditional private equity firms will have to extend their timeframe so they can compete for these other deals. There are early signs in the United States that the next generation of private equity funds will be evergreen funds that don’t actually have a specific timeframe for when investors will get their money back.

How significant are the activities of private equity in the Gulf ?

PEAN: In Europe and the United States, private equity took advantage of the fact that there were a lot of companies that were inefficient.
Here, most of the businesses are still either family or government owned and these families don’t feel the need to sell. If you ask them to do so, they say ‘selling the business is like killing off my children’.
Families don’t want to sell unless they have to. Funds have been hoping for the past 10 to 15 years that succession would bring these businesses to private equity. This is happening, but the speed has been much slower than anticipated because the regional economy has been doing very well.

In the Gulf, private equity is not so focused on buyouts, but has spent a lot of effort on growth capital, taking minority stakes in companies to help them become more efficient and expand into new markets.
Private equity is also more biased towards infrastructure investment and real estate because of the relative lack of buyout opportunities.
Going forward, the buyout market will increase because all those family firms will have to focus on fewer business channels and go regional. They won’t be able to retain 25 businesses, but will have to concentrate on five or six and some businesses will then be for sale. It will be a slow process.

ELLIS: When the market is as buoyant as it is here today, it tends to wipe away many of the incentives for sellers. Willing sellers drive private equity. When there’s not a motivation to sell it makes it much harder to find the types of deals private equity has traditionally found attractive. The increasing importance of private equity is changing the way companies think about cross border merger and acquisitions, globalisation and entering new markets.

They are using this infrastructure expansion as a way to drive it and many of the global private equity players are aggressively expanding their global footprint because they believe one of their selling points is support they can provide for the globalisation of a company they acquire. This is the next generation of evolution for the traditional private equity funds. They are going to have to find a way to differentiate themselves. They can’t just create value through financing.

They have to create value by operating better, by bringing in expertise. It can’t just be an underwriting game because there’s just too much capital out there. With big pension funds, soverieng wealth funds and limited partnerships getting into direct investment, PE will be forced to raise their game to another level to win deals.

What are exit strategies for private firms operating in the Gulf?

PEAN: With an infrastructure project, a fund can add value by helping to structure the investment. They can bring all the partners together – the financing, the operator and so on – acquire the licence and other legal requirements and, once the whole structure is complete, you sell for a premium to a long term investor such as a pension fund. Although the percentage return may not be so high, the whole deal is completed in a short space of time, that’s how some fund have been making money.

Bain has a 15-year track record in the Middle East. So what does your work entail?

PEAN: The bulk of the work we have done is to review companies’ portfolio strategies. The companies in the region are highly diversified, which has been a way for them to manage risk, but as borders tumble they have recognised they need to strengthen their position on fewer businesses, so we help them to select the right ones.

We help them restructure their organisations to do that. Most companies are from a family background, with a typical control and command structure and once they reach a certain size they need to institutionalise their organisation. Without adequate planning and control structures, these firms will struggle to survive in today’s global market.

How does your work in the Middle East differ from the other regions you operate in?

PEAN: One of the most exciting things about working in this region is that every project is about growth and the trick is to help our clients understand where they can build a competitive advantage – companies can grow, but if they don’t have the capabilities to manage this they will fail.

Because of the WTO (World Trade Organisation), which is opening borders for both imports and exports, a lot of Gulf companies are recognising they have to take a regional or even global scale. We are helping them to move from being a national leader, to be a regional or maybe even global leader.

Private equity firms are diverting more of their attention to emerging markets where the use of debt is much less prevalent. Access to capital is not a problem, but the market is still inefficient, the lack of availability of information and a lack of transparency makes it a challenge to underwrite deals. But if you’re working alongside a local firm you have a better chance of piercing the somewhat opaque nature of a lot of these firms. That’s likely to be another trend we will see in this region.

PROFILE: Steve Ellis, Worldwide Managing Director of Bain and Company

Steve Ellis is the worldwide managing director of Bain and Company, having joined the firm in 1993. He has previously worked in a wide range of industries including telecoms, IT, financial services, private equity and real estate and also holds an MBA from the Stanford Graduate School of Business.

PROFILE: Jean-Marie Pean, Middle East Managing Director of Bain and Company

Jean-Marie Pean is the managing director for Bain and Company Middle East and has been advising clients in the region for more than 15 years. He specialises in developing strategies for conglomerates and family-owned businesses and has worked at Bain for 25 years, becoming a partner in 1988.