Private Equity Industry Overview

Zia Ahmed www.ziaahmed.org Private Equity Overview By Zia Ahmed www.ziaahmed.org zia@ziaahmed.org Kuwait Private Equity Overview zia@ziaahmed.org Page 1 of 13 Zia Ahmed www.ziaahmed.org Index Index................................................................................................................................................. 2 Private Equity Industry Overview .............................................................................................. 3 1. THE PRIVATE EQUITY OPPORTUNITY ......................................................................... 3 A. Private Equity - An asset class ...................................................................................... 3 B. Global Fund Raising Activity in 2005 ......................................................................... 4 C. Private Equity in the Region ............................................................................................ 6 D. Importance of Private Equity for the Region............................................................. 6 E. Drivers of growth for Private Equity Industry.......................................................... 7 F. Potential Opportunities .................................................................................................... 9 G. Key Success Factors for PE Investing … ability to source, execute and manage .................................................................................................................................................... 9 H. Private Equity Funds....................................................................................................... 10 I. PE Players in the region looking out............................................................................. 10 J. Still the challenges remain… ..........................................................................................11 2. INVESTMENT STRATEGY ............................................................................................... 12 Exit process ........................................................................................................................... 13 Private Equity Overview zia@ziaahmed.org Page 2 of 13 Zia Ahmed www.ziaahmed.org Private Equity Industry Overview Private equity industry is highly international but is a fairly new phenomenon in the MENA region. With the dramatic change in the market environment, US$5.8bn of private equity funds was raised in MENA between 1994 and 2005, 41% of which were raised in 2005 alone. The rapid growth of the PE industry reflects the potential of this method of finance in the region, in part due to the imperfect match between traditional equity/debt instruments and financing needs of MENA entrepreneurs. If the favorable economic environment is sustained, it is expected that the private equity industry will break the US$10bn barrier in fund raising by 2007. The majority of funds invest in more than one country and many individual investments are themselves cross-border by nature. In the prevailing high liquidity environment in the region, the fiscal and trade surpluses by the GCC economies have resulted in the liberal inflow of wealth in the respective economies. According to market sources, the private liquidity in the MENA (Middle East & North Africa) is in excess of US$2.3tn - of which over US$1.5tn is in GCC countries. Opportunity areas include mid- and downstream oil sector, TMT sector and Retail/ consumer goods sector. Energy Utilities/ Infrastructure with many privatization efforts being initiated in GCC (e.g. projects for power generation, gas distribution, water purification etc) to increase private sector participation. Real Estate sector looks promising with relaxation in ownership allowed by many countries. Health Care sector is likely to witnessed increased private participation in hospitals, pharmacy chains and specialty care projects 1. THE PRIVATE EQUITY OPPORTUNITY A. Private Equity - An asset class Private equity has arrived as a major component of the alternative investment universe and is now broadly accepted as an established asset class within many institutional portfolios. In developed markets such as US and Europe, sums committed to private equity funds have increased dramatically in recent years. Many investors still with little or no existing allocation to private equity are now considering establishing or significantly expanding their private equity programmes. Private equity investments may, in general, be described as investments in unlisted securities through a negotiated process. They typically involve transformational, value added and active strategies that are supported by specialized skill sets. Over the past 20 years, private equity has outperformed the US stock market, both in the long term as well as the short term. During the past two decades there has been a tremendous boom in the private equity industry. The pool of US private equity funds has grown from $5 billion in 1980 to over $800 billion in 2005. Average annual returns for private equity over the past 20 years have averaged 13% compared to 11.7% Private Equity Overview zia@ziaahmed.org Page 3 of 13 Zia Ahmed www.ziaahmed.org for the S&P 500. Private equity has also out performed stocks over shorter, five- and three-year time frames with average annual returns in excess of 20% for the year ended March 2005, according to data from Cambridge Associates. In emerging markets, an estimated $12-13bn has been returned to investors to date in 2005 from funds investing in Asia, Latin America, Central and Eastern Europe, the Middle East and Africa. The divestment total is roughly 1.5 times the capital raised for the asset class in 2004. The Asia Private Equity Review reports an extraordinary performance in terms of net realized capital for the first half of 2005 ($9.7 bn); realized IRRs (mean of 54%); and breadth of exit activity across countries and investment categories. McKinsey study - Key Success Factors - Secure privileged knowledge before committing to investment (insights from the board, from management, and / or a trusted external source) as requiring CEOs to - Institute substantial and focused performance incentives (15-20% of equity), as well invest personally in the venture - Craft better value creating plans and effectively executes them (challenge management, review and renew the plan continuously, measurement) - More time devoted by private equity partners to the initial stages of the deal, in order to better establish strategic priorities and unearthing company’s real source of value - Changing a company’s management early on in the deal (i.e. strengthened management team) B. Global Fund Raising Activity in 2005 A combined US$227bn was closed in 2005 as compared to US$129bn raised in the previous year registering a strong growth of 76%. Over 370 funds across the world held final closings with a combined value of US$227bn. Private Equity Overview zia@ziaahmed.org Page 4 of 13 Zia Ahmed www.ziaahmed.org United States - US accounted for 61% of the total funds raised globally, down from 71% reported in 2004. - The US fundraising total for 2005 reached US$138.3bn, over three times the value raised at the bottom of previous year. the cycle in 2003, and an increase of US$45bn over the - Buyout funds accounted for 40% (2004: 33%) of the number and 62% (2004: 55%) of the capital raised in US in 2005. closing. - Venture Funds raised US$24bn (2004: US$22bn) in commitments with 101 fund Europe - Europe accounted for 33% of the total funds raised in 2005. (2004: 21%). - European PE fundraising reached record levels in 2005 with US$74.9bn raised in 2005 exceeding all analysts’ expectations. 2005 saw banks and pension funds continuing to be the largest source of funding for the industry, providing a total of 57.5% of funds compared to 41% in 2004. - Equity capital invested is expected to exceed EUR43bn for 2005. - Divestments at cost (not exit value) rose from EUR19.6bn in 2004 to EUR24bn in 2005, the highest on record. 2005 saw substantial reduction in write-offs, which represented 5.5% of the total, compared to 9.7% registered in the previous year. - Europe saw its largest ever fund close in 2005 when the fourth offering from CVC Capital raised EUR6bn. in 2005 but accounted - Venture activity showed a modest increase from EUR10.3bn in 2004 to EUR11.4bn for 73% of the total number of deals. Rest of the World - ROW accounted for 6% of the total funds raised in 2005 (2005: 8%). levels of activity. - The emerging private equity markets, particularly China and India generated strong of 200% over the - A recorded US$13.9bn funds were closed during 2005 registering a whopping jump previous year. - Over 80% of the total amount was dedicated to Asian firms. Private Equity Overview zia@ziaahmed.org Page 5 of 13 Zia Ahmed www.ziaahmed.org - The overall picture in Asia is promising as there is enough deal activity in the region to warrant the amount of capital being raised. - India appears to enjoying a mini private equity gold rush currently. - Investors seems to be cautious about China on concerns of regulatory infrastructure, corporate governance and lack of PE experience. C. Private Equity in the Region Private equity funds are beginning to make waves in the Arab world as investors seek to expand limited opportunities to invest the huge sums of capital pouring into the Gulf because of record oil prices. Until recently private equity funds operating out of the oil-rich Gulf states tended to target firms in Europe or the US. This trend is expected to increase as the governments invest annual fiscal surpluses into new projects, and introduce reforms especially privatization and trade liberalization encouraging cross border transactions. According to Gulf Capital research, the regional pool of PE firms currently numbers 36 companies. According to reports, more than 50 private equity funds are operating in the MENA region. There are other shifts in the industry worth noting. Technology funds are quickly losing attractiveness, while energy funds are gaining momentum with $465 million worth, in the process of being closed. Another shift is in the geographic focus of the funds. Prior to 2005, many funds were chasing opportunities in Levant and Egypt. Today, the GCC, with its buoyant economies, is the focus of close to half of the funds being raised. Prior to 2005, country-specific funds raised about $803 million, but this number has declined to $488 million in 2005. Now, funds focusing on the MENA, or one of its sub-regions constitute 85 percent of funds raised. D. Importance of Private Equity for the Region Small and Medium Enterprises Middle East countries, and primarily the GCC countries, will face significant challenges in terms of creating jobs, infrastructure and opportunities for their rapidly growing and young population. This large population base will also need significant investments in health care, education and infrastructure related services which are unlikely to be met entirely from government’s resources. To meet this burgeoning demand, there would undoubted be a massive requirement of considerable private sector participation to help finance and operate these facilities The experience of the OECD countries indicates that the equity market can make a contribution to the development of the SME sector. High growth SMEs, even those with negative cash flows, are particularly well suited to equity finance. In addition, there are special venture capital finance that are particularly Private Equity Overview zia@ziaahmed.org Page 6 of 13 Zia Ahmed www.ziaahmed.org relevant to dynamic SMEs which can make a particularly large contribution to economic diversification and job creation. However, SME sector is dominated by the family controlled business who put in the seed capital in their own new ventures. Although SME is poised to grow at a strong rate as the benefits of strong macroeconomic growth trickles down and more and more look towards entrepreneurship, financing is still limited to loans by the banks which are awashed with liquidity. Private Equity in true senses is still not been taken up in investments in the SME sector and this can be huge growth area for the private equity player to tap the SME sector and find lucrative high return yields in the sector. Diversification of the economies As PE and VC players are ready to take on more risks and invest in new technologies, it will help in improving the sector diversification in the private sector and overall development of the economies. The GCC region especially is overshadowed by the oil economics and the PE firms can help in the growth of manufacturing, services and technology enabled industries. Venture capital, has techniques whereby entrepreneurs, venture capitalists and investors can interact so as to provide equity finance to firms with higher than average growth potential, especially firms having the capability to incorporate new technology and/or business models. Such firms have the potential to make higher than average contributions to structural transformation and employment generation. E. Drivers of growth for Private Equity Industry There are many key factors that will drive the development of the investment banking activities in the region and will be vital to a spurt in listings and IPO activity in Middle East going forward. Ample Liquidity We are in midst of the high liquidity environment in the region. The fiscal and trade surpluses by the GCC economies have resulted in the liberal inflow of wealth in the respective economies. According to market sources, the private liquidity in the MENA (Middle East & North Africa) is in excess of US$2.3tn - of which over US$1.5tn is in GCC countries. Strong on macroeconomics Economically stable and reasonably predictable macro-economic conditions are important to have a thriving business atmosphere where investment capital meets the most eligible investment opportunity. Particularly, strong GDP growth, higher per capita incomes, stable monetary and fiscal policies and free capital flows are crucial to foster an investment climate. Private Equity Overview zia@ziaahmed.org Page 7 of 13 Zia Ahmed www.ziaahmed.org Family/ Group Owned Enterprises Much of the private sector economic activity in the region countries is controlled by large family groups mainly because of their traditional business relationships with the ruling families of the respective countries. These groups are usually heavily diversified across vertical and horizontal lines of their supply chain and also into many unrelated business activities. Moreover, most of these groups are controlled by the family members and they lack a formal corporate or capital structure and frequently do not have access to professional management. In the context of this new economic environment, family owned enterprises will have to reinvent their business models. They need to re-examine their core competencies. To achieve this, they need to consolidate their profitable business segments through M&A and divest those businesses where they struggle. -Supporting the family group as a buyer or an alliance partner in selling-off their non- core businesses. -Providing suitable exit opportunities by identifying suitable regional or international partners related activities Valuing the business and putting a best price tag in various acquisition or divestment thereby instilling value creation opportunities for the shareholders of such businesses. -Providing a framework for target identification, target screening and transaction execution in their core businesses or service areas to help in acquisitions and build a critical mass for the business groups and then acquisitions for the business groups. joining hands together to make such Islamic Investments & Private Equity Islamic banking and finance is no longer a mere exotic niche in the international capital markets. With almost $300 billion in diverse assets and worldwide network of Islamic Financial intermediaries, compound growth rates of 15% and innovative new products such as sukuk and ijara have all made Islamic Banking a subject of interest to the world’s bankers and money managers. The fundamental characteristic of the Islamic finance industry is that it is founded on the principle of profit and loss sharing, rather than that of fixed rates of interest. Islam encourages Muslims to invest their money and become not creditors but partners in business. This encourages entrepreneurs who, having then developed a successful business in partnership with the financier, are then themselves able to supply financial capital and finance further entrepreneurs. This tends to encourage higher-risk investment, stimulates the economy and encourages both the entrepreneurs and the investors. Increased regional trade Private Equity Overview zia@ziaahmed.org Page 8 of 13 Zia Ahmed www.ziaahmed.org Currently the intra-regional trade activities between MENA economies is small as compared to the trading activity levels achieved with US, EU and other Asia-pacific economies. However, with the opening up of borders and sectoral liberalization of key economic segments in the economies will have good potential. Stock markets developments The culture of raising risk capital through IPOs is steadily gathering steam and is gaining acceptance in the Middle East business culture. Developed efficient capital markets are an important precondition for a buoyant VC industry, insofar as public offering is one of the four methods of exit (the other being trade sales, private sales and share purchase). Institutional investments In all MENA countries, other forms of institutional savings such as insurance and collective investment schemes represent low shares of national income. Attracting foreign PE players For MENA regulators, attraction of foreign equity is important insofar as international capital can both augment local financing, provide opportunities for domestic venture funds and investors to undertake larger syndicated deals and gain venture investment management experience. Regulatory Environment Legal and regulatory infrastructure is equally crucial for development of a local PE/VC industry or attraction of foreign equity. The aspects of regulatory environment most relevant to PE firms include transparency, taxation structure, corporate governance framework, and intellectual property legislation. Intellectual property protection is also a key feature of the regulatory environment conductive to VC creation F. Potential Opportunities The existing growth in the economy and capital markets along with the advent of competition as result of the opening up of the economies would mean that the time is ripe for PE activity. We expect a significant PE activity in sectors such as financial services, energy, manufacturing, logistics, real estate and various service industries. Therefore, there is a clear need for PE activities by investment banks in creating such opportunities and assist in sustaining scale and scope efficiencies in the regional economic structure. G. Key Success Factors for PE Investing … ability to source, execute and manage For a successful PE investment, key success factors can be categorized into 3 major categories: Private Equity Overview zia@ziaahmed.org Page 9 of 13 Zia Ahmed www.ziaahmed.org Deal Sourcing: The PE fund managers should have the sourcing capabilities in the market place. They should have developed a strong professional relationship with various stakeholders of the industry, e.g. company executives, major shareholders, advisors and consultants, industry regulators and most importantly, industry competitors, through whom they would have access to the pipeline of “existing” and “likely” transactions in their areas of operation. Deal Execution: The success of the PE fund is primarily dependant upon the ability of the manager to employ specialists, who are deeply experienced in the industry vertical and strategic control over them and also gives them access to complete management information system. Deal Management: The success of a PE fund is heavily dependent upon the fund manager’s experience in the post-acquisition stage phase of the management of portfolio companies in running and growing franchises through organic growth, restructurings and/or acquisitions. H. Private Equity Funds In the last few years, the liquidity in the GCC economies has improved substantially and the capital markets witnessed increased depths, both in terms of the number of listed companies as well as market capitalization. The corporate are witnessing good earnings momentum, which is likely to be sustained on the back of buoyant economy and tremendous business opportunities in the region. In order to smoothen the functioning of the capital markets, the GCC region is witnessing a change in the regulatory framework with the supervisory institutions introducing new capital market laws to improve the investment climate in their respective countries. There are opportunities in the MENA region as well as other emerging market which these funds can utilize and generate good returns. In the MENA region, the IPO and pre-IPO market in Turkey looks promising in 2006 on the back of increasing investor interest by international investors especially in privatization projects. Opportunity areas include utilities/ infrastructure with many privatization efforts being initiated in GCC (e.g. projects for power generation, gas distribution, water purification etc) to increase private sector participation. Real Estate sector looks promising with relaxation in ownership allowed by many countries. Health Care sector in MENA is likely to witnessed increased private participation in hospitals, pharmacy chains and specialty care projects. With a number of family businesses thinking of going public and the governments in the region keen on divesting the stake in the booing market, the pre- I. PE Players in the region looking out The improvement in the macro-economic profile of the GCC region on back of strong petro-dollar surplus has taken liquidity in the economies to unprecedented levels. The financial sector is awash with funds and Private Equity Overview zia@ziaahmed.org Page 10 of 13 Zia Ahmed www.ziaahmed.org corporate are taking advantage of the low interest rate scenario (although rising) to borrow at cheaper rates to fund expansion both regionally as well as internationally. The strong corporate performance has given the financial flexibility to the companies in the region to look for investments outside the region. The investment funds and private equity players are getting strong support from the investors in terms of increased investment in both Islamic as well as conventional funds to fund the deal flow. Apart from looking at the interesting opportunities in the region, the investment companies/corporates are looking at other promising markets outside the MENA region to diversify their investment base/revenues. This is crucial as it will hedge their risk of operating in a single market. J. Still the challenges remain… A unique feature of the Middle-East market, which various data sources have consistently pointed to over the years, is the fact that contribution to value added by companies with a smaller capital base outstrips that of larger capital base companies. This in reality indicates the weight that such corporate structures carry in the local economy. Despite that, however, smaller companies usually face increasing challenges in their operational and financial capabilities. Such challenges center around a tight local market wrought with severe competition, coupled with the resistance to commit financial resources to undertake expansion, marketing, and other operational improvements. To summarize, the local operating environment poses several challenges, listed below in order of significance: 1. Severe competitive pressure and lack of expansion planning 2. Weakness in management and human skill set 3. Public sector dominance 4. Funding and access to capital 5. Underdevelopment of the local capital market and restrictions on financial engineering 6. Listing rules not quite in congruence with the realities of the local business environment and enterprises For a large percentage of these companies, a well-studied strategy is what is ultimately lacking. A few companies, especially those providing complete services, would most likely require a ‘niche strategy’ viz. a manufacturing enterprise that is most likely in need of revisiting its cost structure and asset productivity levels. Another major planning aspect that many of these enterprises lack is that pertaining to succession planning. Succession planning has recently floated to the surface as a serious concern for successful family run businesses. The increased level of awareness of the threats on business continuity posed by the lack of succession planning, together with the heightened confrontation with the challenges described above offers opportunities for a professionally managed investment banking company or buyout firm to step in. Private Equity Overview zia@ziaahmed.org Page 11 of 13 Zia Ahmed www.ziaahmed.org 2. INVESTMENT STRATEGY A typical investment process followed by a fund manager is discussed here. Deal Origination Based on the regional presence of the manager and its relationships in the target countries, the fund manager expects a significant number of direct proposals from companies from across the region. Also, proprietary deal flows are often key to accessing transactions in the target countries. Funds also depend upon transactions received from various intermediaries in the target countries. The intermediaries are usually the leading international / national investment banks in the respective countries with which the manager has already built up professional relationships. Initial business due diligence / Initial Appraisal Identified transactions are evaluated by the manager to determine if the opportunity meets the Fund’s investment criteria and target returns. In addition to the same, the manager will also do a preliminary analysis on the company based on factors such as: Investment Overview / Term Sheet / Information Memorandum An investment overview on the company will be prepared which will cover critical aspects such as: The operating committee of the fund then evaluates the investment overview. If the overview satisfies a majority of the fund operating committee, then a proper and detailed due diligence is conducted on the company. Due diligence, structuring, negotiation and deal execution The manager usually relies upon an in-house due diligence team which undertakes the detailed due diligence on the target company. In instances where there is available expertise or the need is felt for an external consultant/advisor, the in-house due diligence team appoints and co-ordinates with the appointed experts or external due diligence teams. Investment monitoring - Managing for value & value realization Post investment, the manager assists in implementing best practices and also implements measures to prepare the company for realization of value through either a trade sale or subsequent listing. Some of the measures which are usually undertaken at this stage include: • Periodical financial reporting • Audit/governance Private Equity Overview zia@ziaahmed.org Page 12 of 13 Zia Ahmed www.ziaahmed.org • Tax compliance • Synergy and operational improvement realization • Benchmarking company performance against competitors and also internal budgets Exit process The manager and its team needs to have first hand exposure and should have gained significant experience in achieving liquidity for the investments by the Fund. As the fund is focused on investing in companies that are likely to go public / IPO or will be sold through a trade sale, the Manager constantly reviews the progress made by the company towards achieving the same. Exits and target price for exits are discussed by the Manager on a regular basis among its members. The manager in addition to the IPO will also explore other exit options such as trade sale, exercise buy back options if any etc if the invested company is not likely to list during the life of the fund. Private Equity Overview zia@ziaahmed.org Page 13 of 13