2010 Outlook for Gulf M&A Financing: Part I
IFR: The first issue I wanted to discuss is the legacy of the global financial crisis on the MENA region. I’ll go on to ask more specifically about regional issues and how they are impacting business. Peter: how has global crisis really impacted this region?
Peter Fort, Morgan Stanley: I think from an M&A perspective in particular, it has changed the landscape pretty dramatically. It is no big secret that a large portion of M&A volume was originated in Dubai and was outbound. Clearly the financial crisis has changed that and what we anticipate going forward is that the make-up of M&A flows will probably change from being primarily outbound to perhaps focused around inter-regional consolidation. There is clearly potential for sell-side activity, too, as a result of continuing restructuring activity and various streamlining of portfolios around the region.
IFR: When you say it has changed the landscape, is lack of confidence the issue?
Peter Fort: Confidence is hard to measure; it has clearly been impacted, but I’m talking purely from the nature of the flows and the nature of the buyers. That has clearly changed fairly dramatically. Last year, you saw Abu Dhabi entities taking up a lot of the outbound M&A flows that Dubai used to get the headlines for. That may very well continue, but I think it is more likely also that M&A activity will become less uni-polar and as I said will include much more inter-regional consolidation which has been an up-and-coming trend for quite a while now.
We do believe that the crisis has potentially provided a catalyst to enable that to happen, whether it is in financial services, in telecoms, within other sectors that really need to be consolidated. Then also, as I mentioned, it has clearly precipitated a level of sell-side activity that we would not have anticipated two years ago.
IFR: If the crisis sets of a process of inter-regional consolidation, that could be good for the region. Could this be a silver lining to the crisis, Ali?
Ali Al-Gwaiz, Riyad Capital: Let me just remind you that Riyad Capital is mostly focused on the local market. We continue to believe that there is great potential in the Saudi market so we follow Riyad Bank’s strategy of focusing their resources and energy on our home market.
If I may just follow up on how the global crisis has affected the Saudi market, just to complement Peter’s thoughts, I believe the Saudi market was impacted on two fronts: the export of petrochemicals, and financial institutions. Obviously with the decline of demand globally, one of the most significant sectors – petrochemicals – was impacted significantly.
On the other hand, financial institutions have less appetite for lending, with the news that some family businesses were impacted by the crisis and the possibility that others might follow suit. It just had a direct impact on financial institutions in Saudi Arabia.
IFR: If I can move to you, Steve. The point about lending capacity in the region is an important one. The Thomson Reuters data for 2009 shows a dramatic reduction in lending, which has been one of the key legacies of the crisis. A lot of banks are out of the game. Do you think that this will change in the near term or will the crisis have a longer-lasting impact on bank lending in the region?
Steve Perry, Standard Chartered: I think there are two sides to this. One is in terms of the way banks have reacted to the crisis. The international banks that were prevalent in the region have retrenched for obvious reasons. I think the original anticipated upsurge in appetite to lend again was going to be this quarter and certainly we’ve seen pricing in Europe being a bit more competitive. The rationale for that is pretty clear: because all the banks had retrenched, there is a lot more competition for business in those home markets now than there was maybe a year ago when banks were finding it difficult to lend at all.
In terms of the region, I think the difficulties we have in this part of the world have arisen as a result of that retrenchment, where there are fewer banks competing. Certainly from our perspective we have always viewed the region as a core hub and having been here over a hundred years, we really wanted to continue assisting our clients. But the local banks have been struggling with dollar funding, as were some of the international banks from a balance sheet perspective, I really don't see a huge pick-up for the next six to 12 months in terms of banks coming back into this market.
I think it will be more a case of banks solidifying their positions in their home markets and then perhaps they will then drift out to the Middle East again. But the region has a lot of opportunity. The way I look at it is out of adversity comes opportunity and that's certainly the way we have looked at it.
IFR: How has what happened last year affected the project pipeline in the Middle East? Ali mentioned petrochemical exports and lower demand. How does that impact projects?
Steve Perry: For Saudi, the impact has not been drastic because they have access to cheap oil and so cheap operating costs, so they can generate decent business and still keep their margins at reasonably levels. I think when you look at the global issues then yes, quite clearly the downturn in commodity prices like naphtha and the by-products has obviously had a big impact, and a lot of mid-range companies have struggled.
You really had to have state-of-the-art equipment and access to low cost feedstock to make it work. So from that perspective the petrochemical sector has been impacted quite badly; oil and gas and power less so. They tend to be more government-sponsored, so the off-takes and the feedstock arrangements are fixed at a set level, so it hasn’t seen as big an impact and certainly projects are still getting done.
IFR: Final question on the theme of the impact of the global crisis to you, Ziad. Throughout the crisis, there has been a lot of focus on the banks. But corporates have clearly been affected by the activities of the banks. Big international banks are reducing the number of core relationships if they don’t work for them on an ancillary business level. How has the crisis impacted you as a CFO of a large corporation?
Ziad Makhzoumi, Arabtec Holding: I think you have to get the background first of all. Because funding is not there, lots of [construction] projects have had to be stopped, rescheduled, re-phased, restructured, or have had their ownership changed in one way or another. So many projects that we were hoping would have been completed this year have probably vanished.
And not just in Dubai. The biggest impact has probably been felt in Dubai, followed by Abu Dhabi. But in Abu Dhabi for different reasons, not because the funding is not there, but because they believe they can get a better deal now. They are more conservative in their views, and they didn’t have the same imperative to build 470 towers in three years and so on. It was a different business model altogether.
Similarly in Qatar. Qatar wanted to emulate Dubai up to a point but they found out maybe that because they did not make decisions as quickly as Dubai maybe they should slow down, so again you see lots of projects in Qatar being rephased, or restructured in one way or another. So it did affect us because the funding for these projects was mainly coming from the banks in the real estate sector and for developers.
But it also affected us when we wanted to move from one market to another. So when we went to Saudi Arabia – we have one of our biggest partners there – banks in Saudi Arabia were saying: “Yes, but you are a Dubai company”. Or they said: “We prefer not to fund private developments any more because there is no bankruptcy law, there is no mortgage law, there are no completion requirements; so unless you put the money into an escrow account but then you can’t use it, therefore we won’t fund it. We can’t give you a performance bond because this is a new company set-up.”
So it has lots of implications, first on cashflow so they are saying, “We don’t believe that the cashflow is going to happen”; second, “We don’t want to take as much risk”, so they reduce risk allocation on developers and so on. So it did affect our business. Our backlog a year and a half ago was about AED45bn. It is still substantial but now it is down to AED28bn. Some of the big projects that you are told are going to happen won’t happen.
IFR: So what have you done?
Ziad Makhzoumi: In October 2008, we wrote to most of the developers and said, “Please be honest with us and tell us if you are going to continue or not”. Some of them were economic with the truth, although if we had sat down and worked with them we would have scheduled a programme that suited them and suited us. Not all misrepresented intentionally; they were hoping that things would get better. But the end result is that projects were stopped, delayed, or rescheduled regionally, except in Saudi Arabia because the requirements in Saudi are different.
In Saudi, you are not building for foreigners to buy second homes to go on holiday. There is a big shortage. You have a high growth rate, you have a bigger population, you have a younger population, so the requirements there are completely different.
IFR: How has that changed the way you engage with your stakeholders? How has it changed your operational approach?
Ziad Makhzoumi: Contracts have different terms now. We have learned a bit. In some cases where we’ve faced an issue, for example, with developers, we’ve said, “The bank will not issue a bond against your down payment because they don’t believe that you are good enough and you are not ready to put all your money into an escrow account”, and so on. So we agreed on cashflow. They pay us in advance and if they don’t pay us, we stop. We changed the way we operate, but at the end of the day, things have to be built. The economy has to keep on going.
IFR: Beyond the global issues we’ve touched on, there have also been some well publicised regional problems in Dubai that have clearly changed the way that people perceive the Gulf. I’d like to focus on some of those. There were a lot of panicked headlines towards the end of last year but there is certainly a difference between the way the international media tells the Gulf story and the realities here on the ground. Are the issues that Dubai and elsewhere in the Gulf face really that challenging? Steve, has it all been overdone?
Steve Perry: I think it all depends where you are looking from. I think if you are sitting in the UK or the US and you hear about a bond that is meant to be repaid and suddenly it is not going to be repaid, that obviously impacts markets in general. I think you could probably say it is not overdone but perhaps a little bit exaggerated. Certainly I know from my friends in the UK, the press has been very negative towards Dubai , which perhaps is a little unfair.
If you are on the ground, I guess you understand a little bit more how things work in practice and although we are all saying transparency needs to improve and perhaps the timing wasn't great, they really had no choice in terms of the actions taken, they repaid the bond and they are going through a process of restructuring Dubai World. You would have thought that by going through a practical process now hopefully at the end of it Dubai will come out a lot stronger.
IFR: Ali, what are your thoughts? Nakheel and Dubai World got huge international press coverage, and there have been other issues. Are these isolated episodes, or are they manifestations of perhaps deeper problems in the region?
Ali Al-Gwaiz: Unfortunately the picture is not very clear. Now we know for sure that there are two important business groups that are facing difficulties. The question is: is this a sign for more to come? The possibility is there and hopefully there will not be many of them, but there will be a few. One positive sign that may suggest that this is not necessarily the case is the fact that banks took large reserves against possible defaults at year-end, 2009. I don’t expect they would want to do this if they had expected more defaults to come because then they would have a reason to wait and do it all at once. But certainly the picture is not clear and the potential is there [for things to get worse].
If I may also just follow up on Steve’s thought about the state of the economy in the relevant GCC countries. I think although GCC countries have a lot of similarities and a lot of issues in common, they are different in some respects. The UAE – Dubai in particular – is at one extreme and at the other is possibly Saudi Arabia, where there isn’t any substantial emphasis on leverage. Real estate, which is the cause of the problem for Dubai, is substantially equity funded [in Saudi Arabia], because of the lack of mortgage laws etc and the mentality of real estate developers. So although there could be difficulties faced by some countries or states, I think one needs to be careful not to generalise and expect it to be the case for most states.
IFR: Good point. Peter, when you are talking to the clients about either investing into the region through the M&A market — what are the concerns and issues that they bring up to you? Can you summarise them into two or three themes?
Peter Fort: At the end of the day, most observers outside of the region tend to not have a very detailed understanding of what is going on here, as Steve mentioned. I think that has a very important implication for how the region is viewed. What happened pre-crisis generally is lack of understanding led to people giving the region the benefit of the doubt on the upside and the general view was, “Lots of oil leads to wealthy governments, leads to support for everything and anything out there, so I don’t need to do any work, I don’t need to do any diligence; I can just invest and everything will be fine”.
That chain of reasoning has changed pretty dramatically. There has been a profound shift to a more careful, diligent, focused view by investors looking at the region. In my mind, that is very healthy because what was happening before frankly was completely unsustainable. Everything from name lending to M&A where people would just come in and say, “I don’t really care because I will probably get taken out at the end of the day”, to bond investors who thought they had GRE guarantees.
All of that has now been replaced by a more careful approach, which has two implications: 1, I think in the medium and long-term it will be beneficial for the region because it will force greater disclosure, more careful evaluation and differentiation of investment opportunities; 2, unfortunately in the short-term it also has the impact of causing investors to slip to the downside and to the extent that the picture is grey, they will slip to black, and that will clearly hurt some of the corporates and other issuers around the region because that means that if they don’t go out with the appropriate disclosure and don’t tell that story carefully in a very consistent manner, they will be sidelined.
IFR: So it is a flight to quality in essence?
Peter Fort: Absolutely.
IFR: Just coming to you on this issue of flight to quality, if I could, Ziad. This could benefit you because I guess a lot of the marginal players in a bubble environment will disappear. Do you see what Peter was saying as a positive?
Ziad Makhzoumi: I don’t know if it is positive. We want the economy to grow and we want people to build tall towers and we want to spend a lot of money on them, so it is not positive in that sense. If you want to build a ten-mile high building, we should be the ones to build it, even if it takes 10 years. Then we can design the best lifts to take you there and so on.
We did look at some opportunities because of what is happening now, where things we looked at in 2008 were valued at AED500m can probably be picked up now for AED150m. The problem is at AED500m, banks were ready to fund it; at AED150m they are not. That is the whole other issue: where do you get the funding?
I’ve been offered many opportunities. Some of even the big players in the region have said: “Come and buy us”, and I say, “At what price?” and they give me a price and I usually laugh. So I think there will be opportunities in a sense for the industry to be re-consolidated. As you said, Peter, I think we will be on more solid, logical, professional grounds as to why deals get done; whether it’s a joint venture, an investment, a project, or a development.
IFR: From an IR perspective, what do you need to do now to take advantage of the opportunities that are coming out of what happened?
Ziad Makhzoumi: I think we are among the best public, publicly communicating companies in the region. IR was my first priority. It doesn’t mean we can’t do it better. I know of others that run it like the CIA in the sense they know exactly what word meant a change in price in a different market. We are not there yet, I don’t think it is needed. Some people love it, that’s fine, but I’m not going to employ 65 people sitting in the south of France analysing what people said and how prices went up.
Anybody who asks for my mobile number, I give it to them. I have shareholders who have 300 shares who call me at 11pm and say, “When are you going to pay a dividend?” Usually I respond politely, but we try to be open. We communicate, we explain. We get our backside kicked occasionally by DFM because they say we give out too much information and they want an explanation. I have no problem with that.
We try to be open and we try to be transparent and I think that has helped us in the sense that it has created opportunities for us. We get people saying, “Can we do something together, either a joint venture, or buy us, or invest in us, or whatever?” Or opportunities that say, “We only want Arabtec to build this new tower in New Delhi because we think you are the best” I personally manage IR with Rial Kamal [Arabtec’s chairman]. Rial and I are really the IR function and we would like to keep it that way.
IFR: Does your open policy benefit you in your dealings with the banks?
Ziad Makhzoumi: I think open and direct communication is very important. That’s why when we do talk to the banks they are more reasonable. When they try to be unreasonable, I can be a bully. Occasionally they say, “Well, we’ll just take the line away”; but they wouldn’t dare. At the end of the day you have to negotiate. There are opportunities and we have to capitalise on those.
We have to work with all stakeholders. We have to work with the regulators; we have to work with the banks. We also work with many private equity houses that come up with deals they want to do with us. I don’t like people going out of business. It is sad for me to see people becoming unemployed, but as a finance guy, it creates fantastic opportunities with valuations that are definitely more affordable now than they were before. The question is, as I said before, is where is the funding coming from?
IFR: Can I ask you, Ali and Steve, about the extent to which you will carry on servicing corporate clients in the region in the current climate? What is your attitude to your corporate relationships? How have you managed them?
Steve Perry: Our philosophy has always been that certainly through the last 18 months we have always supported our core clients. We have taken a prudent step not to go outside of our comfort zone; we like to stick to what we know. We would be cautious about lending to new clients. What we have really been focusing on as a bank is deepening relationships with core clients, so they can rely on us to stand behind them even in times of need. I think that’s been the core to our success over the last two years in that we have carried on lending and carried on supporting core clients. That won’t change. Also I think it helps that our business model is focused on the three core hubs of Middle East, Africa and Asia. That’s obviously helped us to avoid a number of troubles elsewhere.
IFR: At what cost, though, do you continue to support those customers? Anecdotally, the old days of free money in return for ancillary business have gone. How do you price a relationship today?
Steve Perry: I think it is a give and take thing because you have to look at the overall wallet of the client. If it is a big deal and therefore needs to be syndicated, you can't do it at relationship pricing because you have to sell it to other banks. We are still in the game where we are pulling clubs of banks together, so to some degree the client has to take the pain of what the consensus pricing is. But at the end of the day they are still getting the money. It is better than not getting it.
Off the back of that, the banks are happy to provide slightly tighter pricing on the view that they are going to get the rump of the ancillary business. That is really the whole business model at the moment. It is all driven by supply and demand. At the moment there are fewer banks and greater demand for credit, so obviously that dictates pricing and how banks are going to react to their clients.
IFR: Ali, in a Saudi context how does that play out? Are Riyad Bank and Riyad Capital changing your client relationship models?
Ali Al-Gwaiz: From what I know of Riyad Bank, they have not really pulled back on lending as much as some other banks have in Saudi Arabia, so they have still shown appetite to engage in business and help their clients out. But overall we have seen banks that have reduced their lending portfolios by as much as 15% or so, even 20% for at least one bank, so it is fair to judge that overall appetite for lending by financial institutions in Saudi is not great these days.
So we would advise clients to consider issuing sukuks. If you are a publicly traded company in Saudi Arabia, then all the laws are in support of you going to the public market. There is also great appetite for private equity with the emergence of the investment banks and the creation of private equity funds. There are a number of them with substantial resources and they are basically looking for opportunities to employ their capital, as well as pension funds, a large number of newly established insurance companies, and bank treasuries. There is demand for sukuk, but there isn’t enough supply.
The exchange has been expanded to allow for trading of sukuk, but this market is largely inactive for lack of sufficient supply and lack of market-makers.
IFR: Ziad, are you interested in doing Islamic finance issues in the region? Is that something you would consider?
Ziad Makhzoumi: Of course we would, but we also have to see if we fit the profile of sukuk investors. We are in the process of raising a mandatory convertible at the moment and we have always looked at some form of a sukuk. We believe that sukuk, probably on the convertible bond side, is the best way to go forward, but we didn’t have to and we still don’t have to at the moment.
Issuing sukuk is something we looked at, but it wasn’t a requirement. It might become a requirement, or it might not, depending on whether the Aabar deal goes through. [In January, Aabar Investments agreed to acquire 70% of Arabtec Holdings via a mandatory convertible for a total investment of AED 6.4bn.]
If Aabar is investing a large amount of money in us, I don’t think we’ll need any cash for the coming 10 years to be quite honest.
Ali Al-Gwaiz: That makes you a perfect candidate to issue.
Ziad Makhzoumi: I agree with you, the sukuk market is under-utilised. If you are talking access to the sukuk market in Saudi, though, it is different. I can’t see GCC countries having access to the sukuk market in Saudi Arabia because of all the risk that has been associated with the GCC. We would love to, but in our case it could be that we raise sukuk locally for our venture [with the Saudi Binladen group].
Steve Perry: Generally the rationale for doing sukuk, or any Islamic financing, from the bank’s perspective is to replace a conventional instrument which is no longer there. It opens up more pockets for liquidity.
IFR: Let’s focus now on 2010. We’ve talked a lot about the backdrop from last year. We have talked about the issues you face and some of the regional/international issues, so in terms of positioning now for 2010, what are the expectations? What are the business drivers? Where do you see flows coming from and I guess it speaks to how you position your teams as well. I am curious to know how it is going to work this year. Ali, what are your thoughts and ideas for 2010? How are you positioned?
Ali Al-Gwaiz: The investment banking industry in Saudi Arabia is fairly young. It only started in 2004 so it is barely five years old. Many dynamics of the industry keep changing continuously and at a fairly fast pace. We believe that the market is highly competitive now; a bit too competitive. Fees have been compressed to the minimum. We don’t think this will last for long because it is not sustainable in my view.
So we are trying to position ourselves first to deal with the competitive environment in the investment banking industry. Once the dust settles and things stabilise in the market, then we are in a fairly good position. So we are building on our partnerships with investment banks, mainly international banks that are operating in Saudi Arabia. We have a relationship with Standard Chartered in project finance advisory. We work quite often with the likes of Morgan Stanley, participating in deals that they are working on in the market. We are also expanding complementary services which are not widely known in Saudi such as wealth management services, trust services, custody, sell-side research, etc.
IFR: There were a few IPOs last year but it wasn’t a particularly good year for flotations. Is your expectation that in Saudi Arabia you will see more IPOs coming to the market this year?
Ali Al-Gwaiz: We expect more in 2010, definitely not the 50 that has been mentioned in the press. I would expect something in the region of 15 to 20 over the course of the year.
IFR: Do you expect to see much M&A coming out of the Saudi market?
Ali Al-Gwaiz: Certainly, although the regulator is quite careful on which M&A transactions to approve. I think there have been a lot of attempts to do M&A in Saudi between publicly traded companies, but because the laws are fairly fresh, the regulator is quite careful about managing those transactions and on deciding which ones to approve. But I think over time we should see more activities and the regulator should be more comfortable about the process.
IFR: Earlier you mentioned private equity. Will local private equity funds be looking for full takeovers or minority positions? Will these be non-leveraged takeovers? How will the private equity business develop over the next year in Saudi Arabia?
Ali Al-Gwaiz: I think the public market is opening up and there is very large number of companies that want to go public. Many of them realise that an easier and more productive way or process to get there is to partner with a sophisticated investor to take the necessary steps to go to the market. Those sophisticated investors are often private equity funds.
Banks and investment companies that don’t have associations with commercial banks or foreign partners have limited options. They find that raising a private equity fund, whether invested by the owners of the company, or doing it together with high net worth individuals, is a logical way to start their investment banking activities. So those funds have appetite; they have deep pockets, and some of them have achieved substantial success by investing in privately-owned companies, and taking those public and realising substantial returns. I think this model will be duplicated by many small investment companies and will probably revolutionise the market going forward.
IFR: Peter, same question to you in term of business expectations and how you are positioning yourself as a firm.
Peter Fort: I think it is going to be very difficult to predict this year, to be frank, because we are still at a period of a great amount of uncertainty, so it is in some ways very much binary. If the return of confidence that we saw towards the latter half of last year continues, then perhaps we will see more activity. However, I think if the last few weeks are any sign, it is more likely that this is going to be a very volatile year and there are a number of issues that have been papered over last year that will come back to the fore and will need to be dealt with.
IFR: Such as?
Peter Fort: Sovereign debt continues to plague a number of regions and more fundamentally, at a macroeconomic level, the almost impossible balancing acts that the central banks and governments around the world face in exiting from the unprecedented levels of stimulus that have been put in place. In many ways it is a lose-lose proposition because on one hand if the stimulus continues, at some point the bond market will force governments to stop. If governments stop too early, that will potentially cause a double dip recession.
So it is a very difficult tightrope and that will, I think, inform M&A activity because apart from sovereign wealth fund-linked activity (which to some extent is linked to different trends and drivers) actual corporate M&A activity is very much linked to how confident management and boards feel. I think most of our clients that we speak with are still not sure which way it is going to turn out and hence there are a lot of discussions, but not necessarily a lot of specific deal activity that is likely to close any time soon.
Click here for Part two of the Roundtable.