Value of infrastructure deals open to PE investors will reach between $6b-$10b annuallyJEDDAH: Private equity's expansion into fast-growing emerging markets has reshaped the business landscape, and the Middle East and North Africa (MENA) rode this new wave of investor interest. Annual private equity (PE) investments in the region soared from just $148 million in 2004 to top out at $3.8 billion in 2007 prior to the global recession. Now, with economic growth reviving, conditions look promising for PE to pick up where it left off. But bucking the global trend, the industry's momentum in the MENA region appears to have stalled. In 2009, total deal value was just $521 million, its lowest level in five years. Signs of inertia elsewhere in the deal pipeline suggest that new investment activity could remain subdued. Last year, for example, PE firms arranged just six exits-a steep decline from the 17 exits valued at $2.9 billion in 2008. A slump in new fundraising is another indicator that momentum has ebbed. New capital commitments to the Middle East dropped from 10 percent of the total allocated to emerging markets in 2008 to just 5 percent, or $1.1 billion, in 2009. Examining a sample of 10 regional funds, Bain & Company found that, on average, they were able to close at only 55 percent of their original targeted size. Bain's recent interviews with more than 25 limited partners (LPs) found that they are becoming more selective about the regional funds with which they will work. For Middle East-focused funds that are unable to demonstrate a consistent track record of success, it is becoming increasingly difficult to attract investors who have many appealing options in other high-growth markets from which to choose. In a recent ranking of ten emerging markets, LPs ranked the Middle East only ninth, just ahead of Russia and the former Soviet republics. PE firms active across MENA also have their hands full putting to work the money they have already raised. Through the end of 2009, less than half of the $20 billion committed since 2001 had been invested. Much of remaining “dry powder” has been idle for so long that many PE funds are now beyond their planned investment windows. Thus, because they cannot count on using capital gains from successful liquidations of earlier PE investments, investors may be unable-or unwilling-to meet future capital calls. A scarcity of attractive investment opportunities will continue to be a major challenge. Local economies are dominated by family businesses and government-owned enterprises that have long spurned PE acquirers-and in some cases, have become competitors to PE firms. PE investors have struggled to gain traction with owners of family-owned companies, who have been reluctant to sell significant stakes or cede management control. That barrier is unlikely to fall soon. The global economic downturn has left many families dubious about financial assets and preferring to hold on to businesses that generate cash flow. Meanwhile, deep-pocketed government investment companies and sovereign wealth funds, including Mubadala Development Company, Emirates Investment Authority and Invest AD, are beginning to target the same investment opportunities that have traditionally been the domain of PE firms. Their privileged access to deals and longer time horizons make them tough adversaries. This new challenge, on top of the other liabilities weighing on the industry, could compromise many firms' prospects for survival. Bain estimates that approximately one-third of PE firms will not bounce back from the downturn or successfully raise follow-on funds. PE firms can elevate their game and differentiate themselves strategically from their competitors by concentrating on four key areas: Sharpen their sector focus. Specialization in growth sectors such as healthcare, education, logistics, and oil and gas will be an increasing source of competitive advantage for sustaining strong deal flow. These industries boast increasing consumer demand and attractive profit margins, and they have proven to be resilient through the downturn. PE firms will need to build deal teams with industry specialization in order to demonstrate convincingly how they can add value to portfolio companies. Some firms are already beginning to organize investments based on sector themes. Homing in on specific sectors will inevitably limit the number of investment opportunities in any given market. In order to achieve sustainable operating scale, firms may need to broaden their geographic scope to capture opportunities across MENA. Broaden the investment landscape. PE firms can significantly expand their deal flow by looking beyond conventional buyouts and growth-capital investments to consider a wider range of opportunities, including infrastructure, real estate, mezzanine lending and other debt financing. Bain & Company estimates the value of infrastructure deals open to PE investors will reach between $6 billion and $10 billion annually-more than double our estimated value of PE investments in growth capital and buyouts. However, penetrating the relatively few infrastructure deals that are open to PE investors will require distinctive competencies for arranging deals and expertise in financing and managing large projects. Some PE firms are widening their deal options by targeting companies earlier in the development cycle. To the extent that their involvement complements economic development initiatives in the region, they may find willing partners in the public sector. For example, Abraaj Capital recently acquired Riyada Ventures, a Jordanian venture capital firm, to create Riyada Enterprise Development, a new investment platform focused on small and medium-sized enterprises that has already attracted government co-investors. Enhance due diligence and smarter ownership. PE firms need to hone their due diligence processes-disciplines that are especially important in the MENA region, where a high proportion of potential target companies are private and lacking in transparency. Once they close on a deal, PE firms need to work actively with management at their portfolio companies to identify two or three high-priority initiatives that create value. Lay the path for exits. PE leaders begin weighing how they will exit each investment well before the time comes to sell by continuously evaluating market conditions for initial public offerings and identifying potential strategic acquirers. Developing a sound exit strategy is particularly important for foreign PE firms operating in markets like Saudi Arabia, where IPOs are restricted to local investors, the secondary market is thin, and taxes on capital gains can be onerous. Despite recent headwinds, the region's vast wealth and solid growth offer much that should continue to attract PE interest. But it will take greater focus and resourcefulness on the part of PE firms to convert those appealing attributes into winning returns. Jochen Duelli is a partner with Bain & Company and a leader of its Middle East Private Equity practice. Alexander DeMol is a Bain manager, affiliated with its Private Equity practice. Both are based in Dubai. __
