The unwinding of global capital markets has been a multiple whammy for regional players. Private equity portfolio valuations have been severely depressed, exits have been compromised by closed initial public offering (IPO) markets and the trade sale route has become virtually impossible. Prospective corporate buyers are more cautious in turbulent times, not least as their leveraged buying power diminishes with their own share price. The net result is that private equity investors have been hit the world over: the Middle East has been no exception.

The regional houses most active in this field have been affected in different ways (see table 1). While most have seen exit strategies impacted, only those with liquidity issues have seen their balance sheets badly damaged. Even here, the negative impact has been varied. With one notable exception, profits at all have been hit, but the difference between declining profits and the recording of losses is stark. The latter has led to the severe erosion of the capital bases of some regional investment banks (see table 1). Such erosion is not sustainable.

Most deeply troubled has been BIB. An inability to exit profitably from private equity investments has led to a liquidity crunch so severe that a number of bankers have been expressing doubts about whether BIB will survive its current crisis. From the numerical perspective, the situation is fairly simple. A form of unofficial standstill has been adhered to by creditors involved in three outstanding medium-term loans, totalling $227.5 million, and a further group of creditors with short-term exposure to the bank.

Nine-month interim results unveiled in late November showed a balance sheet with assets of $492 million and shareholders' equity sliced down to $12 million on the back of further heavy losses. The fire sale of BIB's corporate bond portfolio - staged as a result of immediate liquidity pressures - led to a loss of more than $80 million. Further negative pressure came from almost $52 million of provisioning taken in the third quarter for private equity exposures in the UK, France and South East Asia.

BIB chief executive Robin McIllvenny has been dynamic in negotiations with creditors and has drawn up a compelling plan for BIB's recovery. Credit Suisse First Boston and Norton Rose have been appointed as advisers. The long-term strategy - once creditors have been paid and the balance sheet mended - is for BIB to focus on real estate and regional corporate finance activities, areas in which it has been particularly successful in the past. The first stage proposed is a rights issue aiming at raising up to $50 million of fresh capital. An extraordinary shareholders' meeting (EGM) has been called for 11 December to seek approval for the issue.

'This is an absolutely crucial meeting,' says a member of one of the two steering groups of creditors. 'So far, none of the creditors have started legal action, but the assumption is that, if the EGM decides against a capital increase, the creditors will pull the plug and it will get really ugly.'

'Even if they go for the capital increase, this is still very delicate and some of the creditors might want to take what they can get now, diminished as it might be, rather than wait to see what emerges at the end of a long restructuring process.'

One of the key players at the potentially decisive EGM will be BIB's largest single shareholder, Sheikh Mubarak bin Jaber al-Ahmad al-Sabah, the son of the emir of Kuwait, who controls about 16 per cent of BIB's equity and has a seat on the bank's board.

The situation may become more complicated still with potential legal turmoil over priority of payments in the event of the bank going into administration. Current Bahrain Monetary Agency (BMA - central bank) law dictates that all depositors, regardless of the size of the deposit, are treated equally and that the claims of depositors rank ahead of those of lenders. 'A lot of those with exposure to BIB are asking 'when is a short-term lender a depositor?' and vice versa,' says a creditor. 'This could get really messy.'

Whatever the fate of BIB, a recent comment by the bank's chairman, Faisal al-Marzook, makes clear reading: 'The risks of a leveraged private equity strategy have been clearly exposed.'

BMB Investment Bank is also aware of the risks but has been considerably more adept at navigating the storm (see interview on page 28). It too has had its capital base eroded on the back of losses in 2000 and 2001, but the introduction of more sophisticated controls and some restructuring of the bank's business model has seen a sustained period of interim profits. In addition, BMB has been able to stage profitable exits from private equity positions this year and, as chief executive Albert Kittaneh tells MEED, the underlying strength of its private equity portfolio remains strong.

On an operational basis, BMB is clearly back in business, but liquidity concerns linger. A $75 million, three-year syndicated loan matures on 23 December and negotiations with the lenders are yet to be concluded. Unlike BIB, BMB has consistently been adept at organising alternative financing sources to ease any potential liquidity concerns. Last summer, it secured a 14-year, $20 million subordinated loan from key shareholders and, in late October, the board approved plans for a $20 million capital increase. In the context of firmer financials, such moves stand as the difference between a liquidity squeeze and a crunch.

BMB has also been careful to preserve its reputation. Its own losses in 2000 and 2001 were painful but it was adept in passing on as little of this pain as possible to its clients, many of whom have seen their investments in BMB products outperform international markets. Relationships forged in difficult times will provide solid foundations for future growth.

When it comes to reputations, few financial institutions in the Middle East are better regarded than the father of regional investment banking, Investcorp. It, too, has been negatively affected by difficult global markets. Profits have declined from the high-tide mark of 1999 and this year look set to decline further. However, Investcorp has never posted a loss and its capital base continues to grow. In fact, so strong is its franchise in the region that in late November it launched a massive $700 million rights issue, a testament to its confidence.

Much of this strength comes from the size and robustness of Investcorp's balance sheet: greater scale and access to long-term funding limit liquidity pressures and negate the need for forced sales in adverse markets. In addition, Investcorp has been adept at developing diversified and stable revenue streams. Direct private equity transactions, on which the bank's reputation was founded, have been complemented by a fast growing asset management business and extensive corporate and real estate investment. Investcorp's management may not have enjoyed the past three years much, but the bank remains in good health, its market position is secure and it is well placed to profit from any future upturn in global markets.

BIB, BMB and Investcorp have had different experiences over the past two years, but the real maverick is First Islamic Investment Bank. It is the youngest of the quartet - it was founded in 1997 with $100 million of capital - but is set this year to be the most profitable of all four, with its earnings even overtaking those of Investcorp. Unquoted First Islamic does not post interim results, but bank executives suggest full-year profits will be in line with, or better than, the $33 million generated in 2001.

While First Islamic retains its interest in mid-market direct private equity investment in the US, much of its ongoing success is based on a string of real estate transactions concluded over the past 18 months.

'We've continued to be in the market with private equity and real estate transactions and the international downturn has really not affected us,' says Mohammed Nooruddin, First Islamic's executive director for investment placement. 'What matters are the fundamentals of the deal. Perhaps some exits have been delayed, and at the moment we are doing more real estate than private equity, but our core business has not been hit.'

For all their differences, most of the quartet of investment banks will be facing the same litmus test over the coming weeks and months. The question of access to reasonably priced medium-term finance will not only shape the immediate future of some of the banks, but also their long-term strategies.

As BIB seeks a restructuring of its liabilities, participants in its three outstanding medium-term loans will have a vital say in proceedings. BMB is currently seeking the refinancing of its own medium-term loan. Early next year, First Islamic is planning to tap the market for more than $100 million of three-to-five-year money. Just as BMB is hoping lenders will not punish it for BIB's difficulties, so First Islamic will be hoping its own outstanding performance is taken into account.

The important lesson is that each of the banks has had a different experience so potential lenders and investors should avoid generalisations about the health of the sector. As table 2 shows, the international rating agencies have been able to make distinctions: Investcorp's ratings remain unaltered while both BIB and BMB have been sharply downgraded.

Equally important is the reality that regional appetite for private equity may be a little diminished but it has not gone away. As one Gulf investment banker says: 'Markets rise, markets fall. The important thing is to know when and how to make money. This is not always as easy as some people think.'