Tarek Allouba* reviews changing trends in private equity investments in the MENA region following the global financial crisis and challenges facing both firms and governments The global financial crisis has had a direct and far- reaching impact on the private equity (PE) industry in the Middle East and North Africa (MENA) region, and its effects have probably transformed the industry for years to come. (A private equity investment, in its simplest definition, is an equity investment in a company that is not listed on a stock exchange. The PE industry refers to investment firms [managers] investing other people's money [investors] through pooled investment vehicles [funds] in un-listed companies). The year 2009 witnessed fewer funds being closed, fewer investment deals completed and fewer exits, with almost no exits through the public markets. Expectations are now that fund sizes will shrink from an average of $350 million pre-2008 to $200 million and average deal sizes will drop to $25 million from $50 million. The long-term impact will be a smaller regional industry with fewer firms, as many of the existing managers were first time fund managers who made investments at high valuations during the period from 2004 to 2008, and are unlikely to return the capital they raised from investors. Amidst all the doom and gloom, however, certain trends are emerging that point to a PE industry evolving in ways that will be beneficial to the long-term development goals of countries in the region, including Egypt. The most important of such trends may be the shift in focus to smaller companies in contrast to larger headline-grabbing deals that characterised the industry before the financial crisis. In Egypt, there are thousands of small and mid-cap companies that are in need of growth capital and have difficulty in finding such capital. Many such companies produce goods and services that serve the consumption needs of the domestic market. Egypt has weathered the financial crisis relatively well with GDP growth falling only marginally in comparison to most developed and other developing countries. Domestic demand has continued to grow strongly in such sectors as food and beverages, certain consumer industries as well as services such as healthcare and private education. There will be many opportunities for PE investors in those sectors in 2010 and beyond. The regional PE industry will need to transform to succeed in this changed environment. The days of making easy profits by relying on ever-increasing valuations and cheap credit are a thing of the past. (During the years leading up to the financial crisis, global stock markets and real estate prices were rising which led valuations of private companies to also rise). PE firms are left with two key drivers to create appreciable returns going forward: lower entry valuations; and the ability to add value and effectively contribute to increased profitability in companies they invest in. Value addition is now the central theme in all regional PE conferences, but few existing PE managers are set up to be able to deliver meaningful value. They will now have to find ways to acquire the capability to deliver value to their portfolio companies in areas such as operating efficiency, supply chain management, marketing, financial controls, strengthening management teams, aligning compensation packages to business goals, and corporate governance. Acquiring these capabilities will be a challenge for PE firms and will come at a cost. Firms that succeed in acquiring these capabilities will have a clear advantage over those that don't and will be able to negotiate better entry valuations in companies that value such services. Existing owners of companies will be willing to forgo rich valuations if they are convinced that the prospective PE investors can deliver value in areas such as those mentioned above. This is more likely to happen in the mid-cap growth capital space, where owners will value the ability to access services of a calibre that would normally be available only to larger companies with more substantial resources. The shift from mega deals to investing and adding value to smaller companies is an emerging trend in Middle Eastern private equity that serves the goals of economic development in these countries. These companies (loosely defined here as companies that are not big enough to have easy access to term funding from banks or seek a listing on the main stock exchanges) have the largest potential to stimulate economic growth and create employment. There will likely be a steady volume of mid-cap growth-equity transactions in coming years and less large deals that characterised the industry before the financial crisis. This segment will probably be dominated by local PE firms in each country by virtue of their proximity and knowledge of their markets. Regional governments, keen to stimulate their SME (small and medium sized enterprise) sectors, have started capitalising on and encouraging this trend. Several governments are forming public-private partnerships with PE firms and providing seed capital to SME-focused funds. An example of this in Egypt has been the involvement of the Industrial Modernisation Centre (the IMC falls under the Ministry of Trade and Industry) in several SME industrial funds. Governments are going further by incubating wholly owned vehicles directed at investing in the SME sector. An example of this is the Arab League's recently announced initiative of a $1 billion fund for SMEs financed by member states. A portion of this fund has been earmarked for Egypt, where the government, through GAFI (the General Authority on Finance and Investment), has announced that it will select managers from the private sector to manage a fund to invest in the SME sector. At the other end of the size spectrum, there will be plenty of opportunities for private equity investing in the huge infrastructure development projects that the region will offer. The Middle East is second only to Asia for projected infrastructure spending over the next three years, estimated at $400 billion annually by the Emerging Markets Private Equity Association (EMPEA). Governments in the region are looking to the private equity industry to help in financing these projects. This segment will be dominated by international PE firms and a few large regional firms with the requisite sectoral expertise. Governments in the region have an important role to play to foster the growth of their respective private equity industries. They need to reform regulations to encourage the establishment of local funds that can attract domestic savings. Most PE funds in the region were set up in offshore jurisdictions with well- developed regulatory frameworks, and targeted international investors. Reforming local regulations has become more urgent in the wake of the financial crisis, one of the effects of which has been a sharp fall in foreign investment inflows. Governments also need to structure infrastructure projects with an eye on attracting local and foreign private investment. This is particularly important in countries such as Egypt that do not have large oil surpluses. * The writer is managing director of CI Capital Private Equity.
