El Namaki Opportunity or Threat Sept08 Capital[1]

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business culture october 2008 www.capital-me.com

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By Dr. M S S El Namaki

Opportunityor Threat?Opportunityor Threat?

Private Equityin the Middle East

Private equity is in fashion,despite recent global capital

market volatilities. Theprinciple of opportunistic

leveraged buyout ofbusinesses and rapid and

enhanced sell-out ofrestructured and presumably

healthy companies has caughtfire. The reach and depth areglobal in scale and intensity. A

near $136 billion of privateequity and venture capital

funds, or the equivalent of 0.31percent of the worlds grossdomestic product (GDP), was

invested globally in 2005. Arecord $272 billion was raised,also globally, in the same year.

Total global private equityinvestments over an 8-year

period (1993 to 2005) amountedto $935.06 billion and funds

raised reached $1,312.38 billionover the same period,

according to thePricewaterhouseCoopers

Global Private Equity Report 2006.Private equity performance in the Middle Ealeading to a number of questions. Prime amthose is the claim that private equity potential ifully utilized and that opportunities exceed, bythe demonstrated reach of the players. Firm polio composition and rationale are also raising q

tions.

The PlayersPlayers in the Middle East are few and far betwAbraaj, the UAE operator, seem to be the unded leader. The Abraaj portfolio includes investmin retail, financial services and aircraft maintenbusinesses. Exit decisions related to past acqutions in insurance, financial services, logisticswaste water management.

While greed, ifmanaged, could

be conducive to adynamic andprogressive

private equityindustry, it couldalso turn into anugly whirlwind

that destroys thevery foundationsof the structure.


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business culture october 2008

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Shuaa Asset Management is another player that wasestablished in 2001 and claims near $1 billionassets under management. The companys missionstates that it aims to be the leading Asset Managerby specializing in Arab and Regional EmergingMarkets. We will build on our expertise and longtrack record to create value for our clients andshareholders through innovation, dedicatedresearch and strategic development."Global players are enticed by the areas capital clout

as well. US-based Carlyle Groups Middle East andNorth Africa base, created in 2005, aims at invest-ing in healthy, growing companies in the energy,financial services, healthcare, industrial, infrastruc-ture, and technology and transportation industries.Sovereign wealth funds, quasi-private equity entities,are strong in Middle East countries, especially theGulf states. They command massive resources andhave strong capital clout. Abu Dhabis InvestmentAuthority, or Mubadala, is the largest and QatarInvestment Authority is possibly the smallest andyoungest (established in 2005). Mubadala was cre-ated in 1976 and is the largest sovereign fund onthe globe, with a near $875 billion in assets. Itsinvestments are broad and scattered. It has boughta controlling stake in the Chrysler Building, an icon

of the Manhattan skyline, and is planning to becomeone of the 10 biggest institutional investors inGeneral Electric. Past Mubadala deals included a 5percent stake in Ferrari, 7.5 percent equity in CarlyleGroup and a 4.9 percent capital input in Citigroup.These moves highlight the growing self-confidenceand ambitions of Abu Dhabis sovereign investment

vehicle and the efforts of the emirate todevelop a balanced and diversifiedeconomic growth model.

Middle East sovereignwealth funds have very

recently

played a leading role in helping to recapitalize the fal-tering US banking industry, a risky endeavor intodays volatile capital markets. These investmentsare not really performing. Worse still, they are lead-ing to the question of who owns what and for whatpurpose. Put differently, there are those in theUnited States who are wondering whether govern-ment ownership, especially if it is a Middle Easternforeign government, of specific American assets isa good thing. There is the concern that this could jeopardize interests and undermine traditional capi-tal-market fundamentals of the country.

Middle East Drivers and ProspectsThe private equity industry in the Middle East is shortin terms of history and novel in terms of entry. Theindustry is also modest in terms of global scale.Fund raising jumped from a few hundred million in2004 to $3 billion in 2006, with the first billion-dol-lar fund raised in 2006 and a $2 billion Islamic fundcurrently being raised. Casualties included a singlefund, Rasmala, that was wound up last year. Theindustry claims an average internal rate of return of22 percent and a return to investor of 3.5 times in6 years, according to Altassets, Sept 5, 2007.The industry is driven by two clusters of forces: aconducive cluster and a constraining cluster.Conducive forces stimulate industry growth, expan-

sion and productivity.

Constraining clusters posebarriers to the healthy devel-opments of the sector.

www.capital-me.com

By aligningowner and

managementinterests and

seeking higherproductivity,

[private equity] isfulfilling one of

the basicpremises of

capitalist

thinking.


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Conducive Forces1. Capital market, fund generation and fund flow.Increasing levels of available capital will undoubtedlystimulate industry growth and progression. The fol-lowing chart shows private equity fund raisingbetween 2000 and 2006, and one can only specu-late that with oil prices rising at the recently wit-nessed pace, larger volumes and greater accessare on the horizon.

It is estimated that the private equity industry in theMiddle East had, in 2007, a near $15.3 billion undermanagement.There is also the issue of growth in neighboring mar-kets such as India and even faraway markets suchas China. Both markets provide ample opportunitiesfor Middle Eastern private equity capital to enter andgrow

2. Target acquisitions. There are four types of lucra-tive acquisitions in the Middle East, and together

they represent substantial potential. Ill-managed businesses or businesses that do notconform to common standards of management orperformance. These are commonly observed, espe-cially in the small and medium industry sector, andcould provide a target. Family businesses provide the backbone of thebusiness sector, especially in GCC countries. Theirattraction lies in conservative management cultureand entrenched management approach.

To-be-privatized companies feature across theentire Middle East, although sizable ones are morelikely to be identified in Egypt, Saudi Arabia andSyria. Fragmented industries. There is a high measure offragmentation among industries in the Middle Eastand opportunities for consolidation are numerous.

3. Macro economic climate. Oil price climbs, com-bined with stimulatory economic growth policies,have lead to an average GDP growth of 9.4 percent

and 7.1 percnet (at constant prices, IFM data) in theUAE in 2006 and 2007, respectively. Even tradi-tionally slow growers such as Egypt have shown agrowth of 6.8 percent and 7.4 percent in the sameperiod (at constant prices, IFM data). Projectionsfor the coming years reflect the same positive out-look.The three categories taken together could providefertile ground for the private equity industry in theMiddle East in the medium and longer terms.

Constraining Clusters1. Business culture. Business cultures in most Arabcountries diverge from the typically open culture ofNorth America or some European countries. Someevidence is provided in Geert Hofstedes bookCulture's Consequences: Comparing Values,Behaviors, Institutions and Organizations AcrossNations. The High Power Distance coefficient (PDI)(80) and equally high Uncertainty Avoidance (UAI)(68) coefficient are predominant and induce a

closed business culture. Closed cultures are gener-ally not conducive to the risk-taking spirit of privateequity.2. Track record. Track records of private equityoperators are scarce, if not non-existent, and eventhe oldest practitioner, HSBC, can only trace its his-tory back to 2001. This track record is crucial to anassessment of industry participation and industryexpansion.3. Management talent. A shortage of skilled invest-ment professionals and legislation governing for-eign ownership are regarded as critical in the evo-lution of the private equity industry in the MiddleEast.4. Exit market. Exit volumes are expected toincrease as fund portfolios reach maturity, with

counter acquisitions and IPOs perceived as the mostlikely exit routes. A few initiatives are being under-taken to expand and enhance the exit market.However, trade sales will remain the preferred exitrout. Questions remain with regards to the scale andscope of the exit market.5. Competition. Home-grown private equity firmswill, very likely, be at the forefront of the MiddleEasternmarket. Non-national sovereignwealth fundsand internationally backed private equity firms willpose a threat, however.

The Role of RiskOne can view this question in terms of two variables.The first is the measure of risk involved and thederived risk attitude of the private equity player. And

the second is the extent to which the concept couldmagnify the less than positive dimensions of capital-ist thinking.

Let us start with the risk attitude issue.Private equity is a risk-laden process and the riskattitude of the player is a key force. It is my con-tention that this risk attitude is closely associatedwith two variables: the level of leverage involved inthe transaction and the scope and span of the

restructuring process of the acquired or to-be-acquired business. Leverage could be benchmark-compatible or optimum or above benchmark orbeyond the optimum. An optimum or bench-mark-compatible level of leverage is, largely, a func-tion of the future earnings, the rate of return on totalassets and the cost of leverage as well as theaccepted standards within the industry. To theextent that future earnings are high enough to pro-vide an industry-accepted rate of return, cover the

costs of debt incurred in the process of acquisitionand allow a windfall return to investors, the level isoptimum.On the other hand, the scope and scale of restruc-turing has something to do with the coverage, inten-sity and depth of restructuring. For restructuring tobe comprehensive, it has to have a strategic, finan-cial and organizational dimension. Financial restruc-turing alone, as was practiced in the early days ofleveraged buyout, would very likely not suffice.Financial restructuring backed by a strategicrestructuring and a change in the organizationalparameters of the acquired business could bedescribed as complete and purposeful. So the dis-tinction here is between what we may call limitedor modest restructuring, i.e., restructuring that is

finance-biased, and comprehensive or all-inclu-sive restructuring, or restructuring that extendsover the entire arena, i.e,. finance, strategy andorganization.

Private equity performance in theMiddle East is leading to a number ofquestions. Prime among those is the

claim that private equity potential is notfully utilized and that opportunities

exceed, by far, the demonstrated reachof the players.

Figure 1: Private equity fund-raising in MENA 2000-2006

Source: Zawaya PE Monitor, June 2006, EMPA Private Equity 2006 Fundraising Review, March 2007

The following diagram provides an illustration.

Figure 2: Strategic positions within the private equity industry

Comprehensive(Strategic,organizational,financial)

RiskTolerance

RiskMaximization

Limited(finance-biased) Risk

Minimization

Benchmark orOptimum Level

BeyondBenchmark

RiskSeeking

Restructuring needs of acquired business

Leverage needs of the transaction


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The above diagram illustrates four strategic posi-tions:

Risk seeking, where leverage is beyond bench-mark level and restructuring needs are limited. Risk tolerance, where leverage is placed at bench-mark levels and restructuring is comprehensive. Risk maximizing, where comprehensive restructur-ing needs are combined with excessive leverage. And finally, risk minimizing, where leverage is lim-ited and restructuring is modest.The question now is where the Middle Eastern play-ers are positioned today and where are they likely tobe in the foreseeable future.It is my contention that Middle East private equitypractice, so far, has swayed between risk minimiza-tion and risk tolerance. Acquired businesses such asAramex or Jordan Aircraft Maintenance, for example,required average levels of restructuring and were

acquired within reasonable levels of leverage. This iscommendable, given the realities of the area and theculture. And these are, of course, a few cases thatdo not represent or provide a board conclusionapplicable to the industry in the region as a whole.Future competition and entry into the fray of aggres-sive global players such as Carlyle will, more likelythan not, bring about more risk seeking and risk max-imizing behavior. Those players are known for theiraggressive leverage and fundamental restructuringpractices. Acquisition and turnaround of family firmsbelongs, more likely than not, to the risk maximiza-tioncategorythanany oftheothers.The samewouldapply to the privatization of state enterprises such asthose in the textile sector of Egypt or the telecom-munication sector of Syria, for example.

Turning to private equity and the practice of capital-ism, let us start by stating that capitalism today atleast as Wall Street sees it is a very different, andworse, business than years ago. Greed, which hasalways been a core value of modern-day capitalism,has assumed a more pronounced role than ever. Ithas become a prime driving force in the search ofexcessive gains and exceptional opportunities.Enron in the United States and Ahold in theNetherlands provide ample evidence.

While greed, if managed, could be conducive to adynamic and progressive private equity industry, itcould also turn into an ugly whirlwind that destroysthe very foundations of the structure. In the US, thependulum has swayed to the danger zone. Witnessseveral recent acquisitions such as Freescale andNeiman Marcus. The Freescale takeover was basedon massive leverage at a time when the firms mar-ket was contracting, and the result was a stagger-ing debt burden, collapsing revenues and a serious

management walkout. Neiman Marcus story ismore or less identical.Private equity in the Middle East could sway in eitherdirection and it will all depend on the impact of thenew entrants and the accommodation of the indus-trys foreign culture.

A Question of GreedPrivate equity is the process of leveraged buyout ofopportunity businesses and rapid and enhanced sell-out of restructured and presumably better -perform-ing companies. It is a growth industry that is chang-ing the very fundamentals of capitalism. By aligningowner and management interests and seeking high-er productivity, it is fulfilling one of the basic premis-es of capitalist thinking. The industry is led by key

players in the US that combine the powerful and theendowed.Are Middle East private equity operations an oppor-tunity or a threat? There is evidence supportingboth notions. A combination of abundant funds,numerous acquisition targets, government supportand the very scale of the economies of the areaunderline a robust growth and dominant position.On the other hand, the industry faces structuralconstraints. Prime among those is a closed busi-ness culture, a family-dominant business sector,hesitant government policies and scarce manage-ment talent. Where will that take the industry is aquestion mark. The sheer power of capital, com-bined with volatilities in the international market,may tip the balance in favor of the conducive

forces.However, the issue goes far beyond this straightfor-ward analysis. The core is the extent to which capi-talist greed, an inherent element in capitalism, couldprove to be a boon or a hindrance within the privateequity industry in the Middle East. Greed has led togrim consequences in the present-day US. And pri-vate equity in the Middle East could follow the samepath if foreign new entrants and foreign industry cul-ture takes hold.

Turning to private equity and thepractice of capitalism, let us start by

stating that capitalism today at leastas Wall Street sees it is a very different,

and worse, business than years ago.

Dr. M S S El Namaki teaches and consultson strategic thinking,entrepreneurship and international business.He is past founder and dean of the Maastricht School of Management (MSM), Maastricht, TheNetherlands (1984- 2002). El Namaki hasdeveloped and introduced management degreeprograms into nofewer than 25countries, including theNetherlands, China,Egypt, Brazil, Poland,Canada and Indonesia.He has held executivepositions within Philips(Eindhoven), McKinsey (London and Dar esSalaam) and Time Inc.(Amsterdam). El Namakis book Strategy and Entrepreneurship inArab Countries waspublished in March.

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El Namaki Opportunity or Threat Sept08 Capital[1]