One year on from the shock revelations that the prominent Saudi conglomerate, AH al-Gosaibi & Brothers, had defaulted on about $1bn of loan repayment obligations, Saudi Arabia’s powerful family-owned business sector is still dealing with the messy aftermath. 

Owners are considering corporatising their family businesses to …access funding through the capital market

Said al-Shaikh, National Commercial Bank

Damaging disclosures about the creditworthiness of one of the kingdom’s largest and well-respected family businesses, followed by related revelations about debt repayment problems encountered by the local Saad Group in May 2009, raised concerns that the entire kingdom’s family business sector could be laden with bad debts.

The forced restructuring of $1.9bn of loans at another Eastern Province family business, the steelmaker Al-Tuwairqi Group, confirmed that Saad and AH al-Gosaibi were not the only examples of corporate overleveraging.

Family dominance

The Saudi corporate sector is dominated by a relatively small network of prominent business leaders. One-third of Saudi listed firms have more than two directors from the same family, and 20 per cent of board seats are held by the same family.

There’s an attitude of ‘let’s do things that avoid embarrassment … in other words, don’t [make the situation public]’”

Saudi senior bank economist

So when massive defaults emerged related to the widespread Gulf practice of ‘name lending’ – in which loans were extended to well-regarded and well-connected individuals without the usual scrutiny and often on the basis of a handshake, allowing Saudi family firms to rack up indebtedness with relative ease – it was not just the two big firms involved that suffered the consequences.

Problems of low transparency levels, ineffective powers of oversight and scrutiny, a culture of excessive secrecy and over-reliance on personal relationships, have combined to shake confidence in a sector that remains the engine of the Saudi non-oil economy, accounting for about half of Saudi gross domestic product.

The penalty has been paid with the drying up of lending to Saudi corporates, aggravating the already painful constriction of liquidity brought about by the global financial crisis. 

Weak financial disclosure levels among Saudi family firms have left lenders in a quandary. “In family businesses, where a lot of money gets passed around in different pockets, people know the cash is somewhere – but the question is, whose pocket is it in today?” says one Saudi-based lawyer.

Closer scrutiny

Not surprisingly, credit growth has collapsed from the 30 per cent averaged in 2007-2008 to less than 10 per cent in 2010. Though bank lending in Saudi Arabia rose by a modest 1.6 per cent in April 2010 to about SR751bn, this is well down on the recent historical average.

Bank claims on the public and private sectors fell by almost 5 per cent in 2009. As the bad corporate debts worked their way through the system, chastened banks were reluctant to continue lending to the private sector, instead parking their cash at the central bank or investing in foreign assets.

There is a positive side, in that the slowdown in credit growth provides firm evidence that lenders are taking a much closer look at the small print of corporate balance sheets, rather than taking promises of creditworthiness on trust – a possible pointer to better practice for the future.

Lenders, particularly international banks who were also caught out by the Saad/AH al-Gosaibi defaults, are now demanding more transparency from their borrowers, especially family firms, insisting on more clarity on how money would be used and greater disclosure as far as financial statements are concerned.

Previously, credit analysis for the corporate sector was anything but rigorous. Saudi family businesses have always been wary about public disclosure of their business activities and corporate governance still ranks well down the pecking order of Saudi family firm priorities.

This is not a problem unique to the kingdom, nor family-owned firms. A 2008 survey of Middle Eastern and North African corporate governance practices by UAE-based corporate governance think-tank Hawkamah, carried out in association with the International Finance Corporation, found no publicly listed company in the region followed best practice guidelines.

This neglect of basic corporate housekeeping may have been excusable when the region’s economies were less developed, and less integrated with the rest of the world. But their increased exposure to the global economy has removed that layer of insulation.   

Furthermore, as Saudi companies mature, they have been forced to cope with increased levels of risk and complexity. Traditional ownership structures are seen as increasingly ill-suited to adapting to this new terrain. Many firms remain vulnerable to disputes related to succession issues, as second and third generations compete to take on the reins of the family business. 

“Owners are considering corporatising their family businesses in order to maintain longevity and at the same time achieve more stability in order to be able to access funding through the capital market or cheaper bank lending,” says Said al-Shaikh, chief economist at the local National Commercial Bank. “Accordingly, they feel they would be growing at a faster rate and I think now there is a realisation among family businesses that this is the way forward. They realise the trend that is taking place in advanced economies, so succession issues are becoming real drivers for that change.”

Yet the economic downturn has also discouraged some family businesses from looking afresh at ownership structures. Formulating long-term succession plans that afford smooth transition of ownership between family generations is a real challenge when market confidence is low.

Still, the net effect the past year’s turbulent events should ultimately prove a force for positive change in Saudi corporate governance standards. There is now a growing consensus that the traditional informal ways of doing business have run their course, and that higher standards of corporate governance are not a luxury, but a necessity if private sector growth is to resume.

Regulatory change

Saudi family businesses have hitherto not been overly pressured by regulators to address corporate governance problems. This is beginning to change, with the authorities viewing the Saudi stock exchange, the Tadawul, as a tool to enable companies to reform.

The Capital Market Authority (CMA) – the main regulatory body for the capital market – implemented new regulatory guidelines on corporate governance for listed companies in 2008. A new corporate law under review in the Majlis al-Shura (Consultative Council), is set to impose further requirements on listed companies and on joint-stock companies to introduce auditing committees that would monitor corporate behaviour and bring to the attention of the board any violations by management.

The UAE’s Hawkamah is encouraging regional regulators to set up specialist departments to monitor the implementation of corporate governance in the entities they are supervising.

The Saudi authorities’ use of the stock market as the most practical tool to raise standards, is founded on the belief that publicly traded companies are by definition better structured than privately owned firms.

Tadawul listings have been viewed as way to raise corporate governance standards simply by having to be more transparent to their shareholders. The CMA has made it clear for a long time that banks, insurance firms, telecoms companies and companies in receipt of government subsidies, such as petrochemicals producers, or those that are either reliant on public resources or handle public wealth, have to abide by higher standards than others. 

Transparency and risk

Along with the Tadawul, the gradual emergence of sukuk and bond markets offers another option for companies to raise money other than through banks, but in a way that would require greater disclosure and transparency than under traditional name-lending.   

However, analysts warn that over-reliance on the capital market to inculcate best corporate practice in the kingdom carries risks.

“It potentially delays the process of listing,” says Jarmo Kotilaine, chief economist at the local NCB Capital. “And second, could delay corporate governance changes in the sense that bank relationships – even though they might gradually be changing – are typically long-standing relationships and are ones where personalities play an important role. So even though they might want to make their relationships more rules-based and start demanding collateral, you aren’t likely to see a dramatic short-term corporate governance revolution.”

More market flotations from family-held enterprises would represent a sign of change, and there are some looking to sell off shares through public offerings. For instance, April saw the successful conclusion of the book-building phase of the sale of 30 per cent of shares in Al-Hassan Ghazi Ibrahim Shaker Company, an air-conditioning supplier and part of the family-owned conglomerate, Al-Muhaidib Group. But further reforms are urgently needed if the Tadawul is to see more family businesses listing.

There is still a view among family business chiefs that the Saad/AH al-Gosaibi crisis was an unfortunate blip, rather than a warning sign that the old ways of doing business have run their course. Though many banks have become more cautious about lending, notes one senior bank economist, for example demanding more collateral, in terms of managing the existing relationships and loans, it has been business as usual. “There’s an attitude of ‘let’s try to do things that avoid embarrassment and unnecessary risks, in other words, don’t bring the situation to the public eye’,” he says.

Many Saudi business leaders are reluctant to scrap a model that has historically delivered strong results for them. Under the current system, controlling shareholders have strong incentives to closely monitor the company and its management, which has a positive impact on the governance of the company, notes Moody’s Investors Service in a comment on family-owned corporates in the GCC issued in 2009.

The innate conservatism of leading Saudi businesses will come under sustained attack as regulators and lenders alike pile on the pressure to boost levels of corporate transparency and disclosure, but old habits die hard in the kingdom.