Financial crisis and MENA PE?

The events of the last few months have had a tremendous impact on the global private equity industry. For decades, the traditional LBO model was fueled by access to cheap credit, diversification-seeking investors and buoyant stock markets. However, with most banks around the world committing to deleverage, investors shying away from illiquid asset classes and stock markets plummeting, the PE industry in its traditional model faces its most challenging period ever. While private equity in the Middle East and North Africa, or MENA, is certainly no exception, the adverse effects of the crisis have been less severe in the region, and the long-term implications of the crisis are likely to have a positive impact on the ongoing evolution of the sector.

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Initially, the global credit crunch did little to dent the MENA region's economic growth, but as credit continued to tighten in the fall of 2008, the regional outlook dampened. By the winter of 2009, the deepening crisis had caused an exodus of international capital as banks frantically deleveraged. Margin calls on overleveraged local investors exacerbated the sell-off. Local stock markets had lost more than half their market capitalization by year-end 2008.

Yet, while economic growth is likely to slow, the MENA region nevertheless will outpace the rest of the world. Local equity markets may be joined at the hip to Wall Street, but for Main Street, it is another story. In the U.S., people are falling behind on their mortgages and cutting spending, and Japan will export fewer cars to the U.S., but we don't see the same in most of the Middle East thanks to a number of economic drivers, which have helped to lessen the impact of the global economic crisis on the regional economy. In particular, the region enjoys massive petrodollar reserves, enviable demographic drivers, a commitment from local governments to continue to fund critical investments and to pursue expansionary fiscal policies, and a determined reform agenda seeking to liberalize economies and energize the role of the private sector.

This is of course not to say that the crisis has been painless for the region. Despite MENA's notable economic advantages, life is all about relativity, and though the economies will still grow, it will feel painful after the past few years of strong growth. After half a decade of petrodollar-fueled growth and bullish forecasts, the suddenness and depth of the decline is leading to some abrupt adjustments. The price of oil -- the main economic driver of the region -- has dropped significantly following a sharp run-up, and banks' willingness to extend credit has been reduced drastically.

The regional PE industry has not been immune either. Limited partners have seen their net worth go down significantly, so they might not be as keen to make new long-term commitments any more. Declining oil prices also mean there is less surplus capital sloshing around the region, particularly in sovereign wealth funds that have been important investors in PE funds. Many portfolio companies will now require more active management to be steered safely through the crisis. Some of the more expensive acquisitions may even prove to depress future returns of PE portfolios. And very few, if any, exits will take place in 2009. The current state of equity markets is likely to preclude any initial public offerings in the immediate future, and there is little appetite for trade sales.

Nonetheless, the impact of the crisis on MENA's PE sector has been less severe than in more developed markets thanks to the dominant use of unleveraged minority stake deal structures. In the six Gulf Cooperation Council, or GCC, countries -- where most of the regional PE players are based -- family businesses and conglomerates account for 75% of the private sector. These family firms are often unwilling to give up control, even in the case of noncore assets. As a result, a minority-stake deal structure, with related minority protection rights, has emerged as an effective vehicle for gaining exposure to and influence over these family businesses while addressing business owners' desire to retain majority ownership.

Minority-stake deal structures are also more suitable in light of the region's scarce professional business talent. In most MENA family businesses, ownership and management typically overlap, and the value of an established and proven company lies primarily in the know-how and experience of its founding shareholders and managers. Accordingly, a MENA-tailored investment approach typically aims to buy into rather than buy out portfolio companies and seeks to leverage and build on their managerial capabilities through strategic and financial support. As such, minority stake deal structures help ensure the founding shareholders' continued managerial commitment to the future success of the company.

This common use of minority stake structures, and the implied limitations on the use of leverage, saved MENA's private equity sector from much of the adverse effects of the credit crisis on the traditional LBO model in more mature markets. PE investments in MENA are simply not as vulnerable to debt obligations and constraints, and future dealmaking is not as dependent on the availability of credit. In fact, the credit crisis will probably promote an even broader use of minority-stake structures in the foreseeable future.

More importantly, the credit crunch could prove a long-term blessing for local PE firms with the right model. There is, of course, a time lag before private companies fully adjust to the drop in public equity valuations, but many of these growing companies will soon need further capital to finance their growth, and they will become more willing to consider new sources of funding and accept today's valuation levels. In particular, family businesses in the region will likely become more amendable to the idea of using PE money given that banks are tighter on lending and IPOs are closed off in the aftermath of the economic crisis. By the second half of 2009, attractive and compellingly priced opportunities might emerge, and 2010 will probably be an excellent vintage year. In fact, PE firms are already eyeing opportunities in the region, particularly in sectors where valuations have been badly hit while fundamentals remain intact. For example, many investment firms are now looking in sectors that target the region's large and young population, including "hard" infrastructure, such as housing and utilities, as well as "soft" infrastructure, including education and healthcare.

The economic crisis is also expected to shape and accelerate the evolution of MENA's private equity sector into the next stage of development. Specifically, in light of growing competition and a less favorable macroeconomic environment, investment activity in the region is now expected to rapidly evolve from low value-add plays, such as multiples arbitrage and pre-IPO investments, to more advanced value creation plays that require tangible contributions to portfolio companies' strategic direction, operational performance and governance structure.

The private equity sector in MENA is also expected to undergo consolidation and a rapid separation of leaders and laggards in the aftermath of the crisis. Today, the sector remains highly fragmented, with a large number of small funds and newcomers that lack a track record or access to the region's business community. Given today's new economic reality, PE firms that relied on easy capital and the benevolent economic climate will likely be weeded out, and those that overpaid and overborrowed for buyouts may struggle. On the other hand, firms with a strong history of performance, disciplined investment approach and proprietary deal access will likely emerge into leadership and enjoy a highly promising vintage year in the aftermath of the global economic crisis.

Ammar AlKhudairy is a board member, chief executive officer and managing director of Amwal AlKhaleej. Fadi Arbid is an executive vice president and the country head for Saudi Arabia at Amwal AlKhaleej.

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