Public equity drought is also a challenge for private equity

15 September 2010

Gulf stock markets are still underperforming, which is bad news for private equity firms

Despite signs of recovery across the GCC, the region’s equity markets are still going nowhere. Trading generally is modest and only two of the seven GCC markets are up on the year: Qatar by 8 per cent and Saudi Arabia by only 3 per cent.

Equities globally have still not recovered from the shock of 2008, though there was a rebound in 2009. Equity markets in most advanced economies have performed poorly since the start of 2010.

The global financial crisis of 2008 showed that GCC stock markets tended to reflect global trends. It undermined the argument that those wishing to reduce portfolio risk could do so by investing in the companies of the region. This is one reason why the economic buoyancy in the GCC as a whole has not translated into significant positive trends in shares. Then there is the ‘casino’ nature of equities in the region. For many, buying shares is about making a quick profit, not investing for the long-term. Long-term institution investors shy away from markets where speculators rule.

Gulf companies seeking long-term finance have limited options. Banks remain reluctant to lend. Islamic institutions have been hit badly by the downturn and there are fears that for the sector not all the problems are fully known.

Then there is private equity. The idea of cutting out stock markets and going directly to investors for finance was highly appealing in the middle of the last decade, when private equity firms became the new masters of the finance universe. Their rise was partly driven by the conclusion that equity markets were not the most efficient means of raising capital. Clever people working at private equity firms claimed they could spot hidden value in companies that capital markets could not see.

Investors, instead of relying on executive managers and non-executive directors, were represented directly by directors, report to private equity firms and determined to get the best possible returns. The clinching factor was the use of leveraged finance, a simple process of multiplying your money by providing as little as – and sometimes even less than – 10 per cent of the finance needed to buy a firm and raising the rest from banks.

The approach was simple. The companies bought were to be made more efficient by their need to service the debt used to buy them, though some saw this was tantamount to paying someone to rob you. Talented chief executive officers with a stake in the firm they managed were put in place to drive performance, revenues and profits. After about five years, during which time debt would have been paid off and profits lifted, the company would either be floated or sold directly to a new buyer. The aim was to get twice as much for a business as was paid in the first place.

The attractions of this approach are simply mathematical. A company bought for $100 million using 10 per cent equity and 90 per cent debt and sold five years later for $200 million would deliver a gross return of 900 per cent over that period, even if none of the debt were paid off. Before 2008, a number of transactions did deliver on this scale. Private equity investors became notorious: Both fabulously rich and feared as predators. Initially dismissive of critics, the industry was eventually forced to defend their practices. Their claims to helping economies grow were occasionally believed.

The new conditions applying after 2008 have dealt a double blow to private equity. Confidence in the capacity of firms outside high-growth sectors to deliver superior profits has been shaken, though not destroyed. The idea that a simple transfer of talent at the top of firms acquired by private equity and the pressure of debt service would do the trick has proven to be false. Banks have simply not been willing to provide loans on the leverage ratios seen before the crash. Investors in some private equity funds have seen their money evaporate. Private equity is no longer the flavour of the month.

The story in the Gulf reflects the larger pattern. The first firm considered to be a private equity investor in the region is Bahrain-based Investcorp, which carried out some of the world’s most high-profile acquisitions in the 1980s. For years, the firm was acting largely on its own and undertook little investment in the Gulf. The start of the great Gulf boom in 2003 attracted the industry’s attention. New firms – possibly almost 50 – were created to finance corporate expansions without resort to the public markets.

But the industry never took off in the region. The main reason is that many potential investors are high net-worth individuals rather than individuals and that the public markets have been too unstable to confidently conduct initial public offerings (IPOs) since Gulf markets crashed in 2006. There has been only one recorded private equity exit since the end of 2008.

The poor performance of Gulf public equity markets will add to private equity’s woe. It is estimated that only about $1 billion was raised in 2009 for transactions in the region and it is unlikely this figure will have been higher in 2010. Some firms already have more money than they can use: About $10 billion has been put at the disposal of private equity firms in the Middle East. Only part of it has been invested.

Despite these trends, Gulf businesses generally are showing few signs of financial distress, though there is less private investment in capital assets than there was. The fact is that the government is conducting most big-ticket capital formations. GCC businesses are increasingly focusing on services. The impression is that many Gulf companies have developed the capacity to grow without the need for conventional finance. The banking and finance industry will have to do more to convince people otherwise.

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