February 21, 2006
Private Equity in the Gulf Region
Speech given by Frederic Sicre, Executive Director on February 21st, 06 at the Gulf Venture Capital Association Forum, Bahrain. Ladies and Gentlemen; Everyone is impressed by the excess liquidity in the region, by the performance of our stock markets, by the growth of property, aviation and tourism sectors and by the overall boom in economy. But we must be reminded that a market that is near its top has only one way left to go, and that place is not where smart money will follow!. This is true for any region or country in the world. The private equity industry has become an important source of funds for start-up firms, middle-market firms, firms in financial distress, and public firms seeking buyout financing. It has delivered strong returns to investors, over 10 per cent per annum over 10 years and longer. But where did this all start? Two major themes emerge when I look at the growth of the private equity business. One is that our industry can ignite activity in nearly any kind of market provided that innovation is welcomed and appropriate regulatory and tax systems are in place. In this case, the innovation was the widespread adoption of the limited partnership. Until the late 1970s, private equity investments were undertaken mainly by wealthy families, industrial corporations and financial institutions that invested directly in issuing firms. Much of the investment since 1980 has been undertaken by professional private equity managers on behalf of institutional investors. The second theme is that start-up companies and established private companies sought alternative sources of finance and strategic assistance and were increasingly attracted to the skills and resources found in typical Private Equity firms. Middle-market companies in the US - companies with annual sales of $25 million to $500 million - became increasingly attractive to private equity investors. Many of these companies were stable, profitable businesses in low-technology manufacturing, distribution, services, and retail industries. They used the private equity market to finance expansion - through new capital expenditures and acquisitions - and to finance changes in capital structure and in ownership.
Public companies on the other hand went private by issuing a combination of debt and private equity to finance their management or leveraged buyout. Between the mid and late 1980s such transactions absorbed most new non-venture private equity capital. Public companies also issued private equity to help them through periods of financial distress and to avoid the registration costs and public disclosures associated with public offerings. During the early 1980s the private equity and venture capital business was still in its infancy in the west. Then things changed drastically. Between 1980 and 1999, the amount of capital under management by the organised private equity market increased from roughly US$5 billion to about US$175 billion. Limited partnerships went from managing less than 50 per cent of private equity investments to managing more than 80 per cent (US Federal Reserve). Then we saw the dot com boom that gave the sector another boost to firmly position it in the major league. Then came the crash………. The subsequent bust was thought by some to signify the end of the road for the sector but today we are as strong as ever. According to the PriceWaterhousecoopers/3i Global Private Equity Study at least US$107 billion of private equity and venture capital was invested globally in 2003 in new start-ups and young companies. This is an increase of 24 per cent on the 2002 level of US$86 billion. Today, there is no major financial institution in the world that does not have its own private equity arm. The simple reason for this is that in the long term, private equity creates value – for investors, for countries and not least for employees in the portfolio. Today in the UK, PE employs directly and indirectly, one in five of the entire workforce. And from the developed world, foreign investment is currently funding a boom in emerging markets private equity fund raising. In 2005, fund raising for the emerging markets were over US$12 billion - more than double that of 2004. As an example, Kohlberg, Kravis and Roberts, the world’s largest private equity player, recently announced its entry into India, with a US$250 million Flextronics deal. This deal is expected to boost telecoms manufacturing in that country. It will create much needed jobs and generate fiscal revenue to the authorities.
A further driver to investing in China, India and Asia is the gradual diminution of risks associated with investing there.. Investors have been encouraged by economic reforms; new legal frameworks; improved regulatory environments; more robust banking and financial infrastructures; and greater emphasis on corporate governance and transparency. The Asian Venture Capital Journal points out that total venture capital and PE invested in Asia has grown from just over US$69bn in 1999 to more than US$106bn in 2004. In the Gulf region, many private equity opportunities are emerging in areas including family groups, who are focusing on rationalising operations; governments undertaking privatisation initiatives or seeking capital partners in infrastructure, energy and water projects; multinational corporations seeking to increase operations, extend their geographies and cement new partnerships. The family groups segment is expected to find most of their solutions in their association with the private equity industry. Why? 1) Faceless Investor/Partner Explain 2) Plat Forming Deals in the region are becoming bigger, the scope of targets is getting broader, boundaries and borders are being broken down and governments are actively engaging the sector in privatisations and in PPP deals. It will cost more than US$750 billion in capital spending in the GCC over the next decade for growing capacity fast enough to match demand for oil. In fact, SAGIA alone announced a US$100billion expansion plan over the next decade. Abraaj Research: The size of the institutional private equity market, alone, reached 2.7 billion dollars in 2005. Now lets have some fund and tally all the announced funds since beginning of 2006- by including the recent Gulf One Bank 10bnUS$ fund–11.5bn $ of funds have been announced since beginning of the year – that’s a 236% increase in Q1 2006 over last year! So where are these funds going to be deployed and what kind of returns do they make? As an example of hot regional deals, let me cite Celtel. It was acquired by MTC Kuwait for US$3.4 billion in one of the biggest corporate deals ever involving a company operating in Sub-Saharan Africa. This deal puts over US$2 billion back to the development and private equity funds who were major Celtel shareholders. Private equity player Zephyr Funds had invested US$24 million and received US$142 million from the Celtel deal.
What may come: As early investors book their profits on the public markets they will also look for alternatives to the stock and property markets, taking a longer term approach to managing wealth. Increased liquidity and high overall economic growth are the two reasons that new investment opportunities are and will continue to be created in the region. The question is how private equity provides a reasonable alternative to investing in stock and property markets. The answer is that PE is the best hedge against market volatility. It could be a bit too early to state that we are near the end of the era of irrational bullishness of the financial markets in the UAE and in some other Gulf countries. But indications towards a gradual but sustained decline in market capitalisations, towards more realistic valuations, are coming in every week. In our business, we tend to be a lot more mathematical and are driven a lot less by sentiment. Seeking long term value has always paid its dividends and I have reason to believe that our business is placed at the beginning of a sustained upward trend. 5 Reasons The first indication of this trend is the speed with which new fund floats are closed due to excess demand. Abraaj’s own US$500 million ABOF II fund, the largest ever in the region, closed a month earlier than expected. High net worth individuals and family groups were joined by private and government institutions in generating collections of more than US$850 million in record time. The second is that the GCC markets are integrating into one entity for all practical investment purposes. Today money can flow from any GCC country to any other as soon as investors sense that there is a great return to be had. The region has understood that the key to global integration is regional integration. The third indication could be the growth of Islamic finance in the region. Its contribution in retaining funds within the region and in avoiding capital flight cannot be underestimated. I am sure that there are no concrete figures about the extent to which the acceptance of Islamic finance has prevented capital flight westwards, but the numbers will be significant.
Today, there are over 120 Islamic equity funds managed by some of the world's top fund management companies, such as Citibank, Deutsche Bank, HSBC, Merrill Lynch and UBS with more than US$6.3 billion under management. A fourth is the incredible value creation opportunities available to us today. Companies from Palestine to Morocco are now seeing their value being unlocked by growth in regional demand, not only in the Gulf but also throughout the region. Suddenly, we find companies like Aramex that were just about surviving a few years ago, come alive and perform way beyond the charts. Aramex Nasdaq Abraaj IPO = Region has solution to it’s challenges. And finally, preliminary results are stunning, attracting attention and more capital to the business. Our own ABOF I, the region's first private equity buyout fund, paid back its investors 100 per cent of their principal within a couple of years. This brings me to the question on the future of the private equity industry in the region. Here are five thoughts: 1. The price of assets will definitely rise. We see this happening across industries and it is not just because of inflation. Continued repatriation of capital from the west and the ongoing high price of oil will leave a lot more money chasing too few value opportunities. 2. We are also going to see inflationary pressure on our greatest asset, our people. The talent that will guide the industry will become more expensive and harder to retain. 3. Global integration will push governments and the industry to comply with increased requirements for transparency and openness. Private equity has not always had a very good reputation – we will need to persuade governments, media, and society that private equity can operate under the imperative of values, that the missions of our respective organizations can be for the general good. Working together with the GVCA to dispel the “Barbarians at the Gate” image will be necessary, if not today, perhaps tomorrow. 4. Private Equity and indeed business throughout the region should embrace the possibilities of Corporate Social Responsibility. If returns are above industry benchmarks, with it comes a responsibility to grow our societies and our communities by being good corporate citizens. Let’s think of our shareholders but let’s not forget our stakeholders.
We tend to forget that the Middle East needs to create 70 million jobs by 2017 just to preserve the current unemployment levels. This represents a 4% per annum employment growth which has never been achieved anywhere in the world before.
5. Another element that may affect our future is the level of M&A activity which could start booming especially in sectors that will eventually face consolidation such as banking. Some 50 regional and international banks serve the needs of a 4.4 million population of the UAE. And more are in the pipeline. Future market conditions will require financial services institutions - from investment banks to insurance companies to retail finance players - to embrace M&A, to stop letting corporate ego get in the way of shareholder value. The approach should allow the long-term release of under-utilised capital. When and if this happens, Private Equity can play an important, neutral and strategic role. Success Criteria: What drives the success of Private Equity, and what will ensure its ongoing success? Three things come to mind: Distribution, an entrepreneurial drive and due diligence. Distribution If a fund does not have a large enough client base how can it raise funds on a continuous basis? How can it keep in touch with the market of opportunity, how can it focus on trade sales? Private Equity is a people business, and only those who are networked throughout this culturally diverse region will succeed. Entrepreneurship It does not take much of that to raise funds in the current environment, but it does take a lot of it to see the opportunities, to take risk adjusted investments and grow the businesses we get involved in. Due diligence, I know we at Abraaj Capital take this process to the point of obsession. We believe that our first priority is to safeguard the funds our investors have trusted us with. Only then can we focus on growing them. Due diligence in my view will be a critical factor differentiating the firms that will remain from those that will not. And may those that fail not ruin the reputation of this growing industry – yet again a risk that GVCA could focus its eyes on. Our industry needs to distance itself from the hot money that enters and exits based on short-term market swings. There is a growing demand from fund managers and from individual investors for better fund monitoring since much of the information is not easily accessible. The more information that is made available, the more likely the industry is to grow and attract additional investors.
In this light, it is an excellent first step to form the GVCA and organise this conference but we need to see much more from the Association and from its members. Sharing experiences alone is not enough; The GVCA must determine an action plan to make sure that it acts as force that can accomplish results, 5 Proposals 1. Become a force for best global practices to be applied by the players in the region. For example in good corporate governance. 2. Encourage governments and family groups to see the industry as a keen, loyal and trusted partner for the development of business and the region. 3. Become the trustee of the industry’s reputation. This might be achieved by creating its own ranking of fund managers or private equity firms. Celebrating successes but sanctioning failures. 4. Act as the incubator for new opportunities, ideas and initiatives. For example, how could the GVCA encourage the high levels of liquidity in this region towards higher levels of investing in North Africa where the economies need to grow in order to create employment. Creating a GVCA / North Africa action committee might be an interesting venture we would be willing to support. 5. Actively engage western markets to engage large western institutions to see the Middle East as a place where good business can take place. Finally, let me thank the Gulf Venture Capital Association for this opportunity to interact with my peers and to provide me with this platform from which, I hope, my upbeat outlook for the sector would have been communicated. Thank you.