Reviving the Private Equity Story

Private equity should be a thriving asset class in the Gulf. Not only does it appeal to many investors because of its Shariah-compliant (with some significant but avoidable exceptions) nature but it also provides a highly attractive means to buy into some of the most compelling growth stories in the region. After all, the Gulf has by now a solid track record of macroeconomic stability, a dynamic demographic situation, and enormous convergence potential in most sectors, which is furthermore supported by a firm commitment on the part of the regional governments to economic diversification.

Fostering the growth of private companies with expansion plans should be one of the most obvious and attractive opportunities in this environment. In practice, however, PE has struggled to establish traction, in spite of solid progress especially in 2006-2007. Moreover, it has been hit hard by the global downturn, a vulnerability made worse by the nascent state of the PE/VC sector in the Gulf. According to the latest annual report of the Gulf Venture Capital Association (GVCA), private equity fund managers in the Middle East managed to raise ‘only’ USD1.06bn in 2009, as compared to an all-time record of USD5.4bn in 2009. Private equity investments plummeted by almost 80 per cent - from USD2.72bn in 2008 to USD561mn a year later.

In spite of the setbacks, the outlook for regional PE is showing signs of improving. Fund raising during 1Q2010 recovered sharply to USD1.25bn while the GVCA poll of Middle Eastern PE professionals in May, found that 72 per cent expected brighter prospects for the sector, as opposed to 50 per cent in 2008. The ravages of the crisis have inevitably resulted in some natural selection among market participants, leaving the industry presumably more resilient. The outlook further benefits from an impressive war chest of some USD10bn of uninvested funds.

Although a great deal of work awaits the PE sector, the basic value proposition is extremely attractive, with the basic growth/diversification story further amplified by opportunities offered through corporate consolidation and restructuring in an increasingly contested market place. One the main benefits of private equity investment is the fresh, focused look at management and governance that PE investors bring with them and which in turn has a critical bearing on the value generated by the investment. As desirable and necessary as this process is, it is ultimately depends on relatively easy and cost-effective access to the right skill sets needed to bring about such transformations. Moreover, the PE investor needs to have the power to seek these changes. A number of challenges exist on both counts in the GCC region.

The regional management culture is not underpinned by a long tradition of widely available management education, active professional associations, or the promotion of corporate governance codes by regulators and independent entities. In spite of significant positive changes in recent years, management excellence typically still relies critically on the skills and aptitudes of individuals and the governance practices adopted by individual companies of their own initiative. The end-result is a corporate landscape where management and governance standards remain highly uneven but where also the resources for easily improving the situation are relatively scarce. At the same time, the corporate culture in many cases still frowns on the kind of loss of control that bringing in PE might involve. Instead of viewing the arrival of a PE partner as an opportunity, many are inclined to take as an ‘admission of failure.’ Under the circumstances, it is not always clear how tied the hands of PE investors end up being.

The progress made by PE investors on the management and governance of companies represents an important pioneering function whose significance goes far beyond the private returns generated for the investors. These efforts can contribute in important ways to the rise of regional management standards by producing success stories which, when publicized, may prompt others to question and overhaul their own practices. The growing volume of restructuring efforts will also over time create a growing cadre of ‘turn-around specialists’ whose skills will be applicable across the economy. These ‘positive externalities’ are critically importance for the continued sustainable growth of the GCC region.

The formative years of the GCC PE industry have inevitably left the sector with a great deal of unfinished business. The most immediate challenge, of course, is mobilize the funds that have been raised for PE investments while ensuring that the recipient companies do bolster their management and strategy and reach a point that offers a natural and profitable exit strategy for PE investors. In spite of the multitude of opportunities, there are still considerable practical challenges in terms of properly assessing the nature of the opportunities and risks they represent.

Secondly, the crisis has understandably left the industry in a defensive mindset with a relatively narrow sectoral footprint, mainly led by healthcare, transport, education, and utilities. While these are all compelling long-term growth stories, the need for private capital and management innovation is acute across the economy. Hence, efforts will need to be redoubled to broaden the presence of PE.

Lastly, the venture capital segment of the industry has barely begun to realize its potential in a region that desperately needs to foster entrepreneurship and to make it easier for creative GCC residents to set up companies on their own. Without fully unleashing the creative power of entrepreneurship, the regional economies will struggle to productively employ their growing populations.

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