At the CFA Institute Middle East Investment Conference yesterday, Richard Dallas, managing director of Gulf Capital, described the challenging conditions for private equity (PE) investing in the Middle East and North Africa. Dallas argued that the unprecedented political upheaval and turmoil occurring in parts of the region have resulted in slowing economies, a near-evaporation of foreign direct investment, stagnant or collapsing stock markets, a liquidity drought, and a shortage of debt financing. All of these factors are set against the backdrop of a rising population and high unemployment rates.
As an illustration of the higher risk environment for investors, credit default swap (CDS) spreads have widened for regional sovereigns, particularly for Egypt, Bahrain, Tunisia, Morocco, and Lebanon, Dallas pointed out. While these countries can expect a long period of stabilization following political unrest, he believes that, in general, the Gulf States are following progressive reforms and offer much more attractive long-term fundamentals.
Regional gross domestic product (GDP) growth is expected to slow in the medium term to the 4-5% range, down from 6-8% in the previous decade. This development, along with major political uncertainty, has resulted in a massive decline in private equity transactions from 2007 to 2010 (down 98% in transaction value terms; 75% by transaction volume). In the past five years, fundraising activities have virtually ground to a halt: down 78% from $6.5 billion raised in 2008 to $1.4 billion in 2010.
Since 2004, $15 billion has been invested, versus only $5 billion in exits and distributions, Dallas reported. He noted that a large number of funds are nearing the end of their commitment period, as many have been unable to deploy their funds and build a track record. With around 120 active and announced funds in the region, he thinks the next phase will be one of consolidation, mirroring what happened in Asia in the 1990s (today leading PE players in that region account for the majority of assets under management).
In addition to political risk, which is the main Damoclean sword hanging over limited partners (LPs), Dallas contended that investors are particularly concerned about the limited number of established LPs (and hence the lack of track records), and a scale of investment opportunities that is too small. Compared to PE investments in the United Kingdom, which accounted for 1.13% of 2010 GDP, PE investments in the Middle East and North Africa are well below the global average, at just 0.04% of GDP.
Not surprisingly, major destinations for PE investment in the region roughly correlate to comparative economic growth rates and are as follows: the United Arab Emirates, Egypt, Saudi Arabia, and Kuwait. Favored sectors include real estate, financial services, IT, construction, healthcare, and manufacturing — but Dallas said that investors also see promise in the consumer goods and education sectors. He believes that unlike in other environments around the world, minority deals account for a dominant share of investments.
Dallas argued that growth capital and family businesses are the key for PE in the region, with the latter accounting for more than 90% of commercial activity and non-oil GDP. The region counts more than 5,000 family firms, encompassing more than $500 billion in assets, which employ 70% of the workforce.
Dallas emphasized that structural considerations are critical to PE investing in the region, especially jurisdiction and the enforceability of contracts, along with governance (proper company management, strategic direction, and actual influence). Exit processes are fairly standard in theory, but can be more complex in practice, he said, along with other mechanisms (drag, tag, and demand rights on an initial public offering).
It’s not all gloom and doom, however. Dallas’ advice to investors is to keep their heads low, continue growing portfolio companies, and build a track record of value creation.
He also thinks that it is important to scout carefully for investment targets in what is an undervalued market. As opportunities arise, he counseled, take exits and return money to limited partners as soon as possible (something his firm, Gulf Capital, has done recently with a few investments).
In sharp contrast to other speakers at the conference (Marc Faber for example), Dallas believes that with a good track record the next decade looks promising for the region.