IFR Middle East 2007

IFR Middle East report 2007
21 min read

With huge sums generated by the oil price rise and more competition in some sectors, Middle Eastern companies are increasingly considering mergers and acquisitions. At the same time, regionally based funds are flexing their financial muscles overseas and targeting major companies.

A fledgling M&A market appears to be developing in the Middle East, with significant deals in the financial, telecommunications and oil and gas-related sectors this year. Despite these transactions, the market is still regarded by some advisers as limited by the lack of an appropriate legal framework.

Meanwhile, funds based in the region have been snapping up assets in Europe, the US and Asia. The trend is partly due to the huge sums of petrodollars available for investment and an attempt by Middle East investors to diversify their holdings away from oil. Economic growth in the region has been boosted by a tripling of oil prices in the five years to July and economies such as that of the UAE have been growing at 10% a year.

"We've seen a significant increase in M&A activity because the Middle East is a vibrant economy to invest in, with healthy economic growth and strong oil prices," says Abdullah Shahin, a vice-president at private equity firm Abraaj Capital. He adds that since 9/11 the US has been a less attractive destination for Middle Eastern money, so investors have sought more opportunities in the regional itself.

"There has also been a return of business professionals to the region to set up shop here, as well as increased depth and liquidity in the stock markets and a real estate boom," he says. Shahin adds that many Middle Eastern governments are opening up previously monopolised sectors and focusing less on investment themselves, which is creating more space for private sector investment.

David Nataf, head of ABN AMRO's M&A team in Dubai, says: "There's been an increase in overall volumes and average deal sizes have jumped from double-digit dollar amounts three years ago to triple-digit amounts today. One of the main reasons for that has been that companies are much more comfortable with using debt in M&A."

But some observers are sceptical about the foundations of much of the growth in M&A. Bruce Embley, head of law firm Freshfields Bruckhaus Deringer's corporate practice in the Gulf, says that the regional M&A market is still relatively immature compared with Western standards.

Much of that is because the legal system is less advanced, he says, with banks in some jurisdictions not able to fully rely on the ability to enforce their security and therefore less willing to lend. "That's made it hard to develop a strong local private equity market here because you can't have private equity without debt and that's to some extent limited the development of a wider M&A market," says Embley.

Another obstacle, he says, is continued foreign ownership restrictions in the region, with overseas investors often effectively only allowed in on a joint venture basis, partnering with a local person or firm. "There need to be reforms and things are happening, but gradually, and governments are not always going as far as overseas investors would like," says Embley.

The lack of a takeover regime in many countries is a particular obstacle but things are gradually changing. For example, Saudi Arabia is reforming its takeover rules and that could have an important knock-on effect on the rest of the region. Dubai is also reforming its companies law, which could make M&A easier, although the changes are expected to be less radical than some would like.

Speaking of the toughening of the credit markets in Europe recently, Embley says: "It would be a shame if a shift in the debt markets in Europe ends up restricting debt in markets like the Middle East, just as the environment here is becoming more welcoming. On the other hand, I suspect there will always be debt available for the right deals."

In terms of local M&A, the banking and financial sector has been one of the most active. July saw the announcement of the terms of the merger between Emirates Bank and National Bank of Dubai (NBD), which created the largest bank in the Gulf region by assets. The new company will be called Emirates NBD, have a market capitalisation of some US$11.5bn and assets of around US$45bn. Goldman Sachs is advising the banks on their merger process, which is expected to take 18 to 24 months.

The driver behind the deal was Sheikh Mohammed bin Rashid al-Maktoum, the ruler of Dubai. The Dubai government owns 14% of NBD and 77% of Emirates Bank. The rapid growth of Gulf states, and particularly Dubai, has created the need for bigger banks to help develop the economy. The merger is also seen as a reflection of moves towards consolidation of banking in the region. The UAE, for example, has nearly 50 banks and is regarded as over-banked. Banking in the region is also expected to become more liberalised, thanks to global trade agreements.

These factors are putting pressure on Middle East players to improve efficiencies and become more able to compete with international banks. Some reports estimate that the merged bank will be able to cut costs by 25%–30%. Following the announcement, ratings agency Standard & Poor’s raised its ratings of the two banks to the AA-1 category because of the expected positive result of the merger.

Other deals could follow, with banks such as the government-owned National Bank of Abu Dhabi and Qatar National Bank thought to be looking for acquisitions that will give them the scale to compete effectively in lending to infrastructure projects and providing credit in the region.

The merger was an all share-deal putting Emirates Bank shareholders in control and its senior managers in the major posts. Emirates Bank shareholders will have 66.3% of the new bank, with NBD shareholders owning 33.7%. The Dubai government will own 56% of the combined company.

Other financial transactions have been mooted since the NBD-Emirates Bank merger. In July, International Bank of Qatar offered to buy Bahrain's largest lender, Ahli United Bank, for up to US$6.1bn in cash and stock. International Bank of Qatar is 20% owned by National Bank of Kuwait, which has been looking to expand elsewhere in the region.

But it has been Dubai financial companies that have been at the forefront of banking consolidation. State-controlled Dubai Banking Group took a 32% stake in UAE investment bank Shuaa Capital by acquiring convertible bonds worth US$409m. According to Shuaa, the tie-up will allow it to realise synergies from Dubai Banking Group's commercial operations and from its association with Dubai Holding and Emaar, owners of the bank. Dubai Holding is controlled by Sheikh Mohammed, while Emaar is the richest real estate company in the world.

Meanwhile, in June Dubai Financial, the holding company for Dubai Group, acquired a majority stake in TAIB Bank, a Bahrain-based investment bank. EFG Hermes was financial adviser to Dubai Financial Group.

While these transactions suggest a wider trend, some advisers warn that they cover a still relatively rigid ownership environment. One lawyer points out: "It can be easy for local players to get round the rules on takeovers, but not foreigners. For example, the Emirates Bank deal was created by Sheikh Mohammed and enjoyed a number of waivers from the law. If the purchaser had been a foreign company, I don't think they'd have received the same treatment," he says.

Another investment fund director argues that even though there has been some M&A in sectors like banking, there is still a long way to go and a genuine M&A culture is being held back by the fact that many of the large companies in the region are family-owned. "There are a lot of egos that get involved in any potential deal," he says.

Dawood Ahmedji, an assistant director at Deloitte in the Middle East, says: "M&A in the banking sector is long overdue, particularly in the UAE where there is major overcrowding of participants. However, the complex myriad of common shareholding means that financial motivations are often of secondary concern and not necessarily driving deal activity."

The Middle East's oil and gas industry means that businesses linked to these commodities are often attractive to investors. That is particularly true of Abraaj Capital's acquisition of Egyptian Fertilizers Company (EFC), the largest LBO in the history of the Middle East and North Africa.

The deal, announced in June, involved a US$1.41bn buyout through the firm's infrastructure and growth capital fund and its buyout fund. Abraaj will also take on around US$500m of EFC's debt. Abraaj put US$675m of equity into the deal, while Deutsche Bank, which advised, is syndicating a US$850m loan and will aim to sell US$400m of five-year renewable Islamic bonds, known as sukuk. Dubai Capital Group, Saudi-based Rashed Al Rashed & Sons Group and other regional firms co-invested.

Abdullah Shahin, who led the transaction for Abraaj, says one of the attractions was the low cost of gas in the region, as natural gas is important in the manufacture of fertiliser: "We also think that fertiliser is where cement was five years ago and has very high growth prospects because of economic and population growth as well as expanded production in Europe and the US of biofuels such as ethanol."

He says that EFC has a good management team and a good brand. It has also already begun to expand overseas, with a joint venture in Nigeria. "We see it as a platform for regional expansion," says Shahin.

Abraaj's US$2bn infrastructure fund, the largest such fund ever raised in the Middle East, is Sharia-compliant. This means a team of Islamic scholars must approve investments. Shahin says that, although the firm's other five funds are not Sharia-compliant, it is an asset class that has become more popular. One of the key issues in a Sharia-compliant investment approach is around interest and how that is treated, and referred to, in a transaction.

Abraaj Capital has more than US$4bn of assets under management and is the single largest shareholder in regional investment bank EFG-Hermes. Shahin says that a lot of private equity funds have emerged in the region in recent years, partly because high oil prices have meant there are plenty of opportunities for raising funds. He says: "There are now over 20 funds here, but one of the big challenges is sourcing deals. It's not like the US where 20 PPMs land on your desk every day. We source deals from our network of directors and LPs."

Historically, investors in the Middle East have only really understood the stock market and real estate, says Shahin, adding: "Now they're beginning to understand alternative assets, which have become more available. We've also been seeing increased cross-border activity in the region, with successful companies exhausting growth in their home markets looking to expand elsewhere in the Middle East, or being forced to look elsewhere because their home monopolies are being deregulated."

The M&A market has also been helped, he adds, by the arrival in the last one to two years of many leading investment banks and law firms. Among those banks with expanding local presences are Goldman Sachs, Morgan Stanley and Lehman Brothers.

As for private equity exits, Shahin believes that IPOs have become more viable, despite the market corrections in equities markets in the region. But he believes that strategic sales will continue to be the main exit route, saying: "We’ve exited over 25 companies and the vast majority have been strategic sales."

David Nataf, head of ABN AMRO's M&A team in Dubai, says that one of the big changes in the market in the last three years has been the increasing use of debt in transactions. "Both private equity funds and corporates in the region have become more comfortable with using debt, which was virtually a no-no a few years ago," he says.

Today, while the debt market is under-developed in terms of the kind of innovative instruments used and the sheer debt multiples available, there is increasing use of finance such as mezzanine/second-lien, says Nataf, adding that there is a growing list of lenders in the region willing to offer sukuk bond issues.

Alongside banking and oil and gas-related companies, the third sector that has witnessed significant regional M&A is telecoms. In March, Qatar Telecom (Qtel), majority owned by the Qatar government, agreed to buy a controlling stake in Kuwait's Wataniya Telecom in a deal worth US$3.7bn. The 51% stake taken by Qtel represents the Middle East's largest ever telecoms acquisition, trebles Qtel's subscriber base and expands its presence into new regional markets. The transaction establishes Qtel as the region's fourth largest player after the UAE's Etisalat, Kuwait's MTC and Egypt's Orascom.

Qtel agreed to pay a 48% premium for Wataniya's shares and the Qatar company's stock fell following the announcement on concerns that it had overpaid. But the company's long monopoly in its home market has left it relatively unleveraged. One of the main drivers of the deal was the fact that Qtel is expecting to lose domestic market share later this year when the market is opened to a second operator. The company arranged a US$2bn credit facility in November 2006 to finance its international expansion. It had previously taken stakes in operators in Singapore and Indonesia.

There have been widespread financing packages agreed with Middle East telcos, which are enjoying significant revenue growth thanks to the region's booming economies. Qtel, for example, reported a 53% year-on-year increase in first-quarter revenues and a 15% rise in net profit.

The acquisition is part of a wider consolidation trend in which the region's bigger players seek to digest smaller telcos. Qtel, for example, says it wants to become one of the top 20 telcos globally by 2020. At the beginning of 2007, Saudi Telecom said it was negotiating with local banks to raise US$1.6bn in order to help finance cross-border acquisitions.

Saudi Telecom (STC) has been one of the most active Middle East telcos to invest overseas. In June 2007, it invested US$3.05bn in Maxis Communications, a Malaysian company that owns operators in Malaysia, India and Indonesia. STC lost its home monopoly in 2005 and is facing increasing pressure in its domestic market. It wants 10% of its revenues to come from overseas operations by 2010.

In terms of investment by Middle East-based funds overseas, much of the impetus is an attempt to diversify investors' interests away from oil, combined with the huge revenues from the hike in oil prices. Simon Roderick, a partner at Allen & Overy's Dubai office, says: "There's enormous liquidity in this part of the world and investors are actively seeking to invest offshore." He points out that much of the activity has been led by Dubai but that Abu Dhabi has also become more active through its investment vehicles, as has Qatar.

Deloitte's Dawood Ahmedji says: "One can disaggregate the Middle East private equity into three strands: the quasi-government entities, typically of Dubai and Qatar, chasing trophy assets globally; the traditional buyout houses operating like their Western peers, such as the likes of Arcapita; and finally smaller players predominantly focusing on Middle East and North Africa (MENA) region opportunities."

He adds that the trophy asset acquisition strategy resonates strongly with the Dubai mentality of wanting to have the biggest or the best, saying: "The oil-fuelled liquidity in the Middle East is providing the spending money for an international shopping spree for trophy assets by government investment vehicles."

Some of the state-owned investment authorities have been forming their own private equity funds, such as Dubai International Capital (DIC), and doing deals with other buyout houses. DIC, for example, acquired the theme park group Tussauds in 2005 from buyout house Charterhouse for US$1.5bn. In March 2007, DIC sold the asset to US buyout giant Blackstone for US$1.9bn. DIC retains a 20% stake in Tussauds. It has invested more than US$6bn since 2004, taking stakes in companies such as UK hotel chain Travelodge, DaimlerChrysler and P&O.

With its historic ties to the Middle East the UK has been a popular location for Middle Eastern investors. The US, by contrast, is regarded as slightly less attractive given the political environment since 9/11. This was illustrated last year in the controversy over Dubai Ports World's takeover of P&O. Some US politicians protested at the fact that some ports would be managed by a Middle Eastern company.

What has changed in the approach of Middle Eastern funds is that in the past they tended to be discreet investors, often taking minor stakes and keeping a low profile. Today, the deals being done are much higher profile and often outside the traditional investment areas of banking and property.

While funds such as DIC have been among the most active, there is still huge potential among the Gulf states' government-run investment authorities. The Kuwaiti Investment Authority (KIA), for example, is regarded as the largest investment fund in the world with more than US$500bn of assets.

"If the investment authorities get going they are worth much more than the rest of the private equity funds put together," says one lawyer: "As private equity-type funds they could be very influential indeed."

Some of these investment authorities are already linking with private equity. The Abu Dhabi Investment Authority (ADIA), one of the most powerful institutional investors in the world, was reported to have taken a 40% stake in US buyout house Apollo Management last year.

One of the highest-profile attempted acquisitions has been that of UK supermarket chain Sainsbury by Delta Two, a fund backed by the Qatari royal family. By late July the fund had acquired 25% of the company and in mid-August the Qataris were reportedly negotiating to reduce the proportion of debt in the £10.6bn bid, as a result of the turbulence in debt markets. The Sainsbury board was believed to have asked Delta Two to increase the equity component by about £1bn, from £4.6bn.

Earlier in the year, the Sainsbury family effectively blocked a £10bn (US$20.6bn) takeover of the company by a private equity consortium led by buyout firm CVC. The interest was largely generated by the supermarket chain's substantial freehold property portfolio.

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