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— Industry Insight —
What started as an ambitious economic reform program initiated in 2004 with the inception of a new government has resulted in unmatched growth in the Egyptian economy over the past three years. The country's demographics and unique location at the crossroads of three continents, together with a number of crucial regulatory changes have attracted unprecedented levels of foreign direct investment, or FDI, and private equity investment. Against this backdrop, the Egyptian investment landscape has been witness to some of the largest and most lucrative transactions in the region. Although this landscape has a lot in common with regional markets, private equity success in Egypt precludes a copy-and-paste approach of models that have been successful regionally due to some key differences that come into play. Private equity in Egypt requires having an appropriate on-the-ground setup, centering on an intimate familiarity with the legal, business, tax and even social landscape to effectively source, structure, manage and, finally, exit transactions.
Over the past three years, Egypt has witnessed annual gross domestic product growth of 7%, up from 3% in 2003. This growth was driven by reform designed to spur consumption and attract more FDI as a result of improvements in the investment environment, tax reform, and an overhaul of the banking sector. The progression of FDI since the reform is perhaps the best testament to its success. FDI increased from near zero in 2001 to about $12 billion in the 2007-2008 fiscal year. Improvement in the investment environment. As of 2004, efforts to attract investments were rooted in a new desire for increased transparency and a better and more business-friendly environment. The initiative paid off; in 2008 the World Bank ranked Egypt as the top reformer in terms of ease of doing business. Among Egypt's most notable achievements were: halving the time it takes to set up a business; reducing minimum capital requirements to start a business; reducing property registration fees; and setting up one-stop shops for traders at Egyptian ports, which significantly reduced the time to export and time to import. Perhaps the most significant advancement from a private equity perspective was the establishment of the Ministry of Investment, which successfully cut red tape, increased capital market regulations to ensure more transparency, and reduced restrictions on foreign ownership and investments. Realizing that vertical and horizontal integration within an industrial cluster attracts more FDI than an outright tax break or customs exemption (the modus operandi of the past), the government introduced privately managed industrial clusters, such as the textiles cluster in Burg Al Arab, designed to provide an export hub for textiles manufacturers across the entire value chain. Within the textiles industry, the creation of the cluster came at a time when European manufacturers laden with increasing labor and energy costs were shutting down capacity and relocating to production hubs in the Southern Hemisphere. The textiles cluster proved extremely valuable in attracting investments that would have otherwise gone to other locations. While Egypt has always had unique advantages in the textiles sector, the relatively unattractive investment environment of the past prevented investors from entering what would otherwise be an attractive industry. Measures such as the textiles cluster, within a much smoother, investor-friendly environment today present an attractive package to invest in the sector. FDI in the textiles sector has grown by nearly 60% over the past three years. Private equity in particular has recently been active in the textiles sector. Egypt has also engaged in a number of measures aimed at improving corporate governance, with the first guidelines introduced by the Ministry of Investment and the General Authority for Investment and Free Zones. These are to be implemented in joint stock companies listed on the Cairo and Alexandria Stock Exchange, and in companies with bank borrowings. A similar code was issued for public sector entities. Tax reform. The government sponsored a reform of the tax regime that had been in place for many years, resulting in lower stamp duty, customs and income tax rates as well as the introduction of property tax and increased penalties on tax evasion. Perhaps the measure that caught most of the spotlight was the reduction of corporate income tax from a maximum of 42% to 20%. Once again, the government's policy of increasing transparency proved wise: Despite the rate reduction, tax revenue increased 20% for fiscal year 2007-2008 to about $26 billion. Banking sector reform. The Egyptian government completely overhauled the country's banking system, which had by the end of the 1990s amassed 40 billion Egyptian pounds in nonperforming loans. The reform included recapitalization of banks (by raising minimum capital requirements from £E100 million to £E500 million), mandating Basel II capital adequacy requirements (both measures resulting in consolidation of banks from 61 to 41 resilient banks), and liberalizing the exchange rate after the emergence of a significant grey market at the end of the 1990s. The third quarter of 2004 saw unification of the official and unofficial exchange rates and the launch of the foreign exchange interbank market. Another significant leap forward was the privatization of public sector banks, the most notable of which was the sale of 80% of Bank of Alexandria to Intesa Sanpaolo SpA. In the first test brought on by the international financial crisis, Egypt's reformed banking system appears to be adeptly weathering the storm. This stability is in large part attributable to the balance sheet strength that came with minimum capital requirements for banks and the resulting consolidations. Banks also have low exposure to the toxic asset market due to a focus on Egyptian investments and a tendency to stay clear of riskier derivatives. Today's conducive investment environment and resilient banking sector set the stage for new private equity investment seeking to take advantage of what is, despite the financial crisis, an attractive GDP growth rate (4.4% in second quarter 2008 to second quarter 2009), a young and growing population with higher spending and earning power resulting in increasing consumption (on a per capita basis, Egyptian consumption still has significant upside potential compared to regional peers), and the presence of significant untapped opportunities in terms of sectors such as transportation and healthcare. While the Egyptian investment landscape has some commonalities with its regional counterparts, private equity investing in Egypt comes with its own unique limitations, which first-time investors in Egypt should understand, and learn to navigate. Such limitations include human resource, legal and taxation issues, to name a few. Human resource issues. The first is around recruiting new management from a limited pool of high caliber talent. It is imperative for investors to choose not only the winning horses, but also the right jockeys to ride the horses to the finish line. Thus placing emphasis on "management due diligence" is equally important as rigorous company and sector selection. Whereas most acquisition targets in the gulf are managed by the owners, this is not always the case in Egypt. Separating ownership from day-to-day management is beneficial from a corporate governance standpoint in that it eliminates potential conflict surrounding issues such as management change and exit strategy, but it does add an extra layer of due diligence, namely due diligence on both owners and managers or "partners due diligence." Partners' due diligence is of paramount importance given that an unethical local partner could be value destructive to say the least. Thus, the successful equation becomes backing the winning horse (the right company in the right industry), mounted by the right jockey (management). As in the gulf, having the necessary network on the ground to enable private equity investors to discreetly conduct owner and management due diligence parallel to the regular company due diligence is imperative and critical for a successful partnership. Legal issues. Until very recently, the Egyptian legal system did not recognize stock options, a mechanism taken for granted internationally as part of management compensation schemes and well implemented by private equity sponsors. In the absence of the necessary legal framework, investors have in the past had to work around this by creating option-like structures and agreements. Fortunately, this is changing, but it remains untested to a large extent. Taxation issues. Although the Egyptian tax environment has come a long way, certain areas are still not as clear-cut as others with certain structures and entities being subject to varying tax treatments. Examples include: Interest income earned by nonbanks being taxable, thus limiting if not precluding the use of mezzanine financing from structuring transactions; and exemption of listed companies from capital gains tax. As such, obtaining a listing before exiting an investment becomes lucrative. The Egyptian investment landscape has many success stories to boast
about, but there have also been failures. Fortunately, those ventures
that have failed for qualitative reasons could have been avoided had
the investors had the right on-the-ground setup to either thoroughly
check up on a potential partner or management, or to navigate through
some of the choppy waters that can face first-time investors in Egypt. Ammar AlKhudairy is CEO of Amwal AlKhaleej, a private equity firm operating in the Middle East and North Africa region. Noha Khattab is a senior vice president with the firm. |
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