The GCC region was once the Cinderella of the global private equity market. Today, it is finding more friends and willing participants. By Nick Kochan.
It may be too soon to be sure that they will all have a ball, indeed current political turbulence may postpone many of the best laid exit plans, but partners have linked arms, and the music has started. The new-found buoyancy has two roots. First, investor confidence in the region’s long-term prospects is growing. Second, local businesses and entrepreneurs, especially the younger ones, look on with interest at global trends and opportunities. They see how private equity allows them to maximise their investments.
Arif Naqvi, the CEO of Abraaj Capital, said: "Young well-educated business leaders are inheriting business empires. These new entrepreneurs have a greater understanding of how to manage in a modern environment. Often their family businesses are sprawling conglomerates, operating in an increasingly competitive and open environment. This is a cause for restructuring the core assets." Private equity partners can assist in this transformation and help the entrepreneur realise value, said Naqvi.
Wider economic buoyancy is the clue to the region's burgeoning private equity sector, says international law firm Walkers. Rod Palmer, managing partner of the Walkers Dubai office, recently said: "A confluence of factors in the region, such as high oil prices, the real estate boom, a marked increase in infrastructure development and privatisations, as well as the stellar returns for PE from the IPO market over a short history, could lead to a tripling of the size of the region's private equity industry over the next five years.
"The Gulf Co-operation Council region (GCC) also seems to be ahead of the curve in a major trend of more rapid fundraising, with funds being fully drawn down after 18 months instead of five years. This allows managers to quickly establish follow-up funds, often much larger than the original. In the first half of 2006, 31 funds were already on the road seeking US$18.2bn, compared with a total of US$5.8bn raised in the Middle East North Africa (MENA) countries between 1994 and 2005," Palmer added.
"It is the potential of the region that is making investors look at regional based investments," says Faisal bin Juma Belhoul, CEO of the Dubai-based Ithmar Capital. This began life managing the investments of the Belhoul family, one of Dubai's leading trade conglomerates. It closed a US$270m fund in early 2006, raising money from other family firms, governments and financial institutions. It has a target internal rate of return of 25%. The fund invested in local water desalination, telecoms and oil and gas.
Larger Middle Eastern players in private equity have sought to play on the global stage. For example, Dubai Investment Capital agreed more than US$3bn of investments in 2005. These included a US$1bn stake in DaimlerChrysler, the US$1.5bn purchase of UK leisure group Madame Tussauds and the US$1.2bn purchase of Doncasters, the UK engineering firm.
These large state investment institutions are also following global trends and placing more money in large emerging markets, such as China and India. The furore that resulted from Dubai Ports' bid and subsequent US$6.8bn acquisition of P&O caused some investors to look leerily on big-ticket Western deals.
The larger Middle Eastern investors increasingly pursue opportunities in local markets. The Gulf Venture Capital Association (GVCA) reports that about US$1bn of equity capital was invested in regional private equity deals in 2005. This was five times the total in 2004. Funds invested as well as funds raised this year are expected to surpass the amounts raised last year. The GVCA forecasts that US$3bn of equity will be put to work this year.
The enthusiasm for opportunities in local markets shown by local investors appears not to be shared by international limited partners. The Emerging Markets
Private Equity Association (EMEA) recently assessed that just 1% of international limited partners are currently 'actively investing' in the Middle East, against 25% in Asia and 14% in Central and Eastern Europe. However, more institutions in Europe and North America are expected to join the market over time to get exposure to the region.
Over the longer term, local economists expect private equity capital to be injected into the region through well-known groups that operate globally, such as Blackstone, Carlyle and Apax Partners. The arrival of secondary buyout deals in the Middle East enabling local firms to pass on portfolio companies to international groups for expansion into world markets is likely to accelerate this trend.
International limited partners will also team up with home-grown private equity groups. For example, when Abraaj Capital closed its second buyout fund last year at US$500m, New York based Citicorp Venture Capital and Wafra Investment Advisory Group supported the fund. This was the largest MENA-focused private equity fund closed to date. Likewise, UK private equity and venture capital company 3i has a strategic partnership with Ithmar Capital.
Abraaj's latest offering tops US$2bn, allowing the firm to join leaders such as Commercial Bank, Dubai Islamic Bank/Dubai Ports World, Gulf One, and Global Investment House in offering billion dollar-plus funds. This Middle Eastern trend mirrors recent developments in the US, where US$6bn is no longer considered a very large fund and multi-partner, multi-billion dollar funds are increasingly common.
Legal and technical structures are advancing and becoming more sophisticated to optimise the use of funds, says Robert Varley, a partner in Walkers' Dubai office. "We are seeing the use of more sophisticated limited partnership structures and a trend away from single closing corporate fund structures," he says. "In addition, real estate funds, which were prevalent not so long ago, are being joined by more and more infrastructure, healthcare, telecommunications and high technology funds. Portfolio diversification has become a driver and local investors are no longer content to stick to the stock markets and real estate sectors.
"A few years ago the market was dominated by ijara-structured funds – funds using leasing strategies – targeting assets in the US and Europe. Political concerns and changing yields saw a period of concentration on the GCC markets. But now we are seeing a new and growing trend for investment in other MENA economies, as those countries embark on the process of deregulation. We expect to see a significant growth in the number of funds investing in Pakistan and India. But local institutions play to their strengths. Only a few high-profile funds are going for global deals at present," says Varley.
Growth in Sharia based funds has spawned a growing number of partnerships between international investors and local institutions. The result is a plethora of Islamic products. Islamic banks that enjoy a strong reputation in other sectors will look to re-deploy their expertise in private equity, making even more capital available. Encouraged by the Middle East's rapid economic growth, some US$2bn–$3bn could be invested by private equity funds in new deals over the next two or three years,
The majority of funds invest in more than one country and many individual investments are themselves cross-border by nature. At the fund investor level, while the bulk of capital for venture capital and private equity funds is raised locally, international investors are also participants, sometimes significantly. Similarly, a proportion of financial institutions invest in international venture capital and private equity funds.
One such is Millenium Private Equity, a leading player in Dubai. This is the private equity arm of Millenium Private Finance corporation, a financial institution registered in the Dubai International Financial Centre focusing on mergers and acquisitions, equity capital markets and private equity. MFC is an affiliate of Millenium Capital Holding, the investment banking arm of Dubai Islamic Bank (DIB). MCH also provides comprehensive debt-related investment banking services through its fully owned subsidiary Millenium Investments.
According to MPE's managing partner Izzet Gunney, MPE expects to raise funds from investors in countries such as the United Arab Emirates, Saudi Arabia, Qatar and Kuwait. He speculates the possibility of raising funds more further afield in North America and Europe.
What of the emerging centres for private equity in the Middle East? Bahrain in particular has caught investors' attention because its regulatory infrastructure is probably more developed than anywhere else in the region. It is also healthily pre-occupied with safeguarding investors' interests. Bahrain not only represents a significant market in itself but is an ideal regional centre for selling investments to the large number of high net-worth individuals resident in the other GCC countries. Bahrain has no income, withholding or capital gains taxes paid by investment companies under existing Bahraini law. No currency or exchange control restrictions are currently in force.
Saudi Arabia's transformation into a modern economy, with modern infrastructure presents highly attractive opportunities to private equity partnerships. This has been spotted by the Saudi Arabia General Investment Authority, for example, which has recently launched the Joussour fund, managed by Swicorp. The fund has gathered some US$500m in commitments and intends to grow to some US$5bn. This will be invested in energy-sensitive projects in Saudi Arabia and in the GCC.
Other significant institutional investors in Saudi Arabia remain the General Organisation of Social Insurance, Kingdom Holdings and the Saudi Development Fund. Some parastatal agencies have also begun backing locally focused private equity funds. Saudis have long been players in the private equity game as limited partners. Virtually any sizeable family office in Riyadh is involved in the industry, often as an LP in global funds.
The boom in GCC real estate has attracted the attention of much private equity-based capital. The real estate market is becoming more sophisticated in terms of financing and debt. Mezzanine debt in financing property deals is now widespread, said Jacques Bernard, managing director of Unicorn Investment Bank. The bank has recently closed its KSA Real Estate Fund 1, a US$52.5m vehicle to invest in residential developments in the northern suburbs of Riyadh, Saudi Arabia. So while the demographics may look good for residential development in Saudi Arabia, Bernard said Bahrain offers the chance for both housing and office development, Oman has opportunities for tourism-based properties, while Qatar is a good environment for warehousing projects. The UAE offers a wide range of investments.
While many US and Europe-based opportunity funds have yet to begin investing in the region, Los Angeles-based private equity real estate firm Colony Capital has made a considerable punt on the area. Muthanna Investment Company is looking at opportunities in Kuwait's highly fragmented full-service and logistics sector. Abdul Aziz al-Marzooq, senior vice-president for investment at Muthanna Investment Company, which focuses on corporate finance activities as well as real estate and equity investments, said "that capital has come looking for a lot of opportunity". Al-Marzooq noted that economic growth in the Middle East was having an effect on the cost of warehousing, an asset class that "is in demand and has yet to be institutionalised".
Unicorn's Bernard noted that, as capital flows into the area, blue chip office space is highly sought after. "Much of the product is not up to international standards," he said. "It doesn't live up to the image they are trying to portray." Bahrain-based Unicorn, after closing its Saudi residential fund late last year, is looking to launch a second fund largely focused on multiple asset classes in the GCC, as well as a 20% allocation to opportunities in Libya, Morocco, Jordan and Turkey.
Unicorn announced in June a link-up with WestLB's London branch for a five-year US$150m musharaka trust sukuk for the Investment Dar Company (TID) of Kuwait. Unicorn said this was the first musharaka sukuk structured with a put option for the investors and a call option for the issuer. The put option allows each certificate holder or investor to exit the transaction after the third year, while the call option allows the issuer the same flexibility at the same date.
The Islamic finance component is also critical to a joint venture with the Abu Dhabi Holding Company in a Bahrain Monetary Authority (BMA) approved Sharia-compliant real estate fund called Gulf Springs. Bernard said: "In terms of real estate, the Middle East and North Africa are one of the most dynamic regions in the world, so great opportunities exist for disciplined and strategic real estate investments and developments."
Unicorn has also received Bahrain Monetary Agency approval to launch a US$150m Sharia-compliant fund to target private equity investments globally. The bank, in conjunction with Standard Bank, recently completed a securitisation on behalf of Kingdom Installment Company of Saudi Arabia. Unicorn was lead manager, Sharia adviser and joint bookrunner.
Archcapita, also headquartered in Bahrain, with offices in Atlanta and London, has also been active in the region. The firm is currently developing a golf resort in Bahrain as part of a joint venture with an investor group that includes the country's pension fund, its Ministry of Finance and National Economy and its General Organisation for Social Insurance.
Sharia compliance and private equity
Private equity appears to offer an attractive route through the complexities of Sharia compliance, especially when funds are invested in an early-stage company or used as seed capital. This is because Sharia scholars regard as partners those lending money to start-up companies rather than as 'creditors' who are detached from the management and risk of the business. The meaning of 'start-up' attracts much discussion behind the scholars' closed doors; what is essential to Sharia compliance is that the funds should be applied to real business rather than simply used as leverage.
One analyst said that venture capital investment allows for greater clarity in decision-making. He said: "You are investing in a company at the early stage of development and the balance sheet has not been infected by the introduction of bonds. From a Sharia point of view, that is the most pure form of investment."
Islamic adherence to the Sharia code inhibits Western investors from accessing much Islamic capital. Sharia is an organic law common to all Muslims, whose practical implications are interpreted by groups of scholars. However, one private equity concern has placed enormous faith on the viability, even buoyancy, of the sector.
Abraaj Capital has entered into a joint venture with Deutsche Bank and Ithmaar Bank to set up a Sharia-compliant alternative assets fund with a US$2bn target. The Infrastructure and Growth Capital Fund (IGCF) will be one of the largest ever raised in the region.
For seven years the Dow Jones and FT has constructed indices for Sharia-compliant funds and companies. The Dow Jones Islamic Market excludes companies if any of the following conditions apply: their ratio of total debt to total assets is the equal to or greater than a third; the ratio of accounts receivable to total assets is equal to or greater than 0.45; or the sum of non-operating interest income plus other 'forbidden' (see later for definitions of this term) divided by revenues accounts for 5% or more of total income.
Sharia law is derived from a number of sources. These include the Quran; the Sunna/Hadiths, the examples and sayings of the prophet Mohammed; the qiyas, which are analytical comparisons; ijtehad, the reasons and logic applied by scholars; and the ijmaa, which is a consensus on issues requiring ijtehad. Sharia prohibits investment in companies that manufacture forbidden – in Arabic haram – products. These include alcohol, pork and tobacco. The entertainment industry – for example, gaming, casinos, hotels and restaurants, and pornography – is also prohibited. Sharia investment principals tend to exclude companies manufacturing weapons and those involved in human cloning or abusive animal testing.
In terms of the financial and banking industries, these investment principles forbid backing endeavours depending heavily on the paying or charging of interest, called in Arabic, riba. Most monotheistic religions have such a prohibition, but Sharia implements it particularly diligently. A belief that money should be made out of real labour and products rather than from the handling of money underpins the distaste for interest.
Insurance companies and any interest-based banks and financial associations are particular targets of the Sharia scholars. Bonds and many other fixed income products are ruled out, as are preferred shares that pay guaranteed dividends. Fixed rates of return are judged to present a distorted view of risk and reward.
The decision that a company or investment is Sharia-compliant is rarely clear-cut. A company that does not generate extensive income may appear to present an attractive investment to a Sharia-compliant Islamic institution, but further examination by Sharia scholars, who are trained in finance as well as religion, may reveal interest rate or currency swaps, commodities market trading or involvement in the financing of customer receivables. These may be deemed 'haram', and the investment prohibited.
Standard investment principles are unlikely to be applied in investment funds using Sharia rules. For example, institutional investment portfolios have fixed income investments as a staple, but these are likely to be prohibited on Sharia grounds.
A venture capital fund can have its own Sharia board to establish principals, first on what investment can be made and second on the type of securities that can be used to finance companies. For example, convertible or preferred stock options are common in venture capital funds but are not acceptable in an Islamic context.
Sharia scholars argue that investments attracting bank loans and other forms of financial leverage lose their Sharia acceptance the more they move away from their early private equity base. The point of unacceptability is argued over by Islamic scholars.
Buyout transactions and recapitalisations obviously involve debt securities, yet there is evidence that even a leveraged buyout in a properly constructed deal, can be accepted by Islamic investors. Some investors view coupon-paying securities as Sharia-compliant as long as the structure is not a straight loan. For example, a company that securitises its cashflow and sells the right to receive a portion of the cashflow would not necessarily contravene Sharia rules. The line between a loan that pays interest and a security that channels cashflow is thin.
A straight loan treats money as a commodity in its own right rather than as a measure of value that has no human utility. On the other hand, a securitised cashflow lays claim to the sale of underlying commodities or services so the receiver of the cashflow is actually receiving his coupon based on the buying or selling of real commodities, rather than as the fee for the rental of an intrinsically valuable currency.
There are three circumstances allowing lending under Sharia law: the lender does not intend to be repaid in full; the lender is simply parking money with the borrower for safekeeping and does not expect interest; or the lender is advancing the money to the borrower and expects to share in the profits and losses. The third case sounds most appropriate to an unsecured coupon-bearing note where the buyer shares in a predetermined cashflow so long as the issue performs at a certain level. Otherwise both the note-holder and the issuer suffer the loss.
Securitisation creates an imbalance between the issuer and the holder of the security as fixed-income payments continue independently of the underlying performance of the assess, unless the business deteriorates seriously. Imbalances in business relations attract opprobrium from Sharia judges. Thus, the Islamically compliant investor prefers the early stage venture capital as the partnership between investment and business is more balanced.
One scholar said: "The basic and foremost characteristic of Islamic financing is that, instead of a fixed rate of interest, it is based on profit and loss-sharing. Islam encourages Muslims to invest their money and to become partners in business instead of becoming creditors.
This encourages entrepreneurship. In turn, entrepreneurs compete to become the agents for the suppliers of financial capital, which in turn will closely scrutinise projects and management teams. The object is that high-risk investments provide a stimulus to the economy and encourage entrepreneurs to maximise their efforts."