Middle East and India: Private equity, public gain

The founder of one of the world's leading private equity managers was recently quoted as saying that private equity may be moving from a 'golden age' to a 'purgatory age', with a humorous tone. While this may be somewhat the case in the West, private equity is booming in the Middle East. It is one of the fastest-growing sources for business funding in the region, thanks to surging oil prices, a local real estate boom, the growing sophistication of Middle Eastern investors and Western institutions seeking new emerging markets. Industries and infrastructure are rapidly privatising and, according to a September 2007 report from the Middle East Economic Digest, there is an estimated $1.5trn (£750bn) of infrastructure and industrial projects currently planned or underway in the Gulf Cooperation Countries (GCC). According to Zawya, a Middle East business information provider, private equity funds devoted to investing in the Middle East and northern Africa grew from $316m (£158m) in 2004 to $5.2bn (£2.6bn) in 2006. Private equity funds formed in the Middle East with commitments of more than $1bn (£500m), and even $2bn (£1bn) when targeting the Middle East, North Africa and South Asia region, are now part of the fundraising landscape with a broadened investor base that includes European and US capital.

A number of crossroads have been reached in the Middle East that private equity investors will find attractive. First, real GDP growth in many Middle Eastern countries is exceeding 5% and GCC economies are among the fastest-growing in the world. Second, Middle Eastern countries, including the GCC, have undertaken to liberalise their economies and are starting to deregulate a growing number of industries. Third, there is a growing number of mid-market owners willing to embrace external expertise and accept private capital in order to expand their businesses while family groups are wishing to exit and cash in on their lifetime's work. Fourth, Middle Eastern businesses are slowly becoming accustomed to transparency and due diligence requests and are adopting more transparent corporate structures (although they still need to improve their management information systems and corporate governance practices). Finally, exit strategies are increasing. A public market listing is now viable in the Middle East due to the creation of the Dubai International Financial Exchange (DIFX) - which recently acquired a 20% stake in Nasdaq - which should create regional capital markets with enough depth and liquidity in the forthcoming years for successful exits. There is also a growing segment of readily available buyers such as trade buyers and secondary buyers; for example other private equity buyers such as deep-pocketed local sovereign wealth funds, local and international private equity funds.

Private equity funds are divided into two broad categories in the Middle East: venture funds and buy-out funds. Venture funds invest in early-stage or expanding businesses that have generally limited access to other sources of funding. Buy-out or leveraged buy-out funds tend to invest in more mature businesses, usually taking a controlling interest and leveraging their equity investment with third-party debt. Leveraged buy-outs in the Middle East have not generally used the very high leverage ratios known to Western leveraged buy-out (LBO) financings closed in the last three years. Although both private equity funds and corporates in the Middle East have become more comfortable with using debt, many Middle Eastern funds are just buy-out funds which use little or no leverage and seek to achieve their returns by focusing on underlying profitability growth of the companies they invest in. These funds have still generated attractive returns which are comparable to Western LBO fund returns.

The main opportunities in the Middle East for private equity funds are infrastructure assets, including greenfield projects, privatisations, private companies and real estate. Unlike in the West, there are very few public companies to acquire. Most Middle Eastern private equity funds operate on a cross-border basis on the fundraising side as well as on the investment side. In addition, private equity, in particular venture capital funds, lends itself nicely to Shariah-compliant investing where investors benefit from the growth of companies as partners rather than creditors. Many local asset managers and a growing number of Western asset managers are offering Shariah-compliant alternative assets funds. Shariah-compliant funds are increasingly attractive to Western investors for several reasons, including the search for portfolio diversification, ethical investing and a more limited exposure to debt.

The private equity market has been supported by the arrival in the GCC in the last three years of many leading international investment banks and law firms. With respect to fund structures, the vehicle of choice in the Middle East will generally be a limited partnership established in the Cayman Islands, the British Virgin Islands (BVI) and Bermuda, although private equity funds may also be structured as companies or unit trusts and the Channel Islands remain popular jurisdictions. The legal regimes of the Cayman Islands, Bermuda and the British Virgin Islands, based on English common law, are investor-friendly and offer light but firm regulations with international standards. International and Middle Eastern private equity managers and investors are satisfied with the corporate governance features of entities established in these jurisdictions. Entities formed in the Cayman Islands, BVI and Bermuda are being used at the fund formation and portfolio acquisition level as well as the co-investment side for both Shariah and conventionally structured transactions. Fund formation can be done in as little as one or two business days. In a typical closed-ended private equity fund formed in these jurisdictions, there is generally no requirement for a local custodian or administrator, nor is there a requirement to prepare or file a prospectus (although it is customary to provide investors with an offering memorandum). Segregated account companies (SACs) can also be used by funds to provide a level of protection of the assets of one account from the liabilities of another. Within the greater funds industry, the ability to use a SAC is particularly useful for fund managers wishing to establish master-feeder fund structures, structures providing for multiple classes of shares or any structures where the statutory segregation of assets is desired. When shareholder agreements are being used, they will be consistent with what one would expect in an English law or New York law governed agreement. Negotiated terms will include transfer restrictions, board representations, certain veto rights, tag-along rights, drag-along rights and an initial public offering exit clause. Such provisions must accord with the relevant entity's constitutional documents.

Most Middle Eastern countries still have complex operating and legal environments, interventionist attitudes towards private enterprise and underdeveloped financial markets, but there is a willingness to reform and the GCC countries are leading the way. Other Middle Eastern countries such as Egypt and Jordan are slowly adopting business-friendly regulations and encouraging private sector investments. Private equity is now recognised in the Middle East as an important alternative asset class. While GCC sovereign wealth funds have been recently making the top business news headlines, leading global private equity fund managers have been quietly establishing a presence or a local partnership in the region principally to tap into local capital, while a growing number of such managers, such as HSBC, Colony Capital and The Carlyle Group, are setting up funds targeting regional investments. On the other hand, local private equity fund managers have acquired a depth and sophistication perhaps inconceivable a mere decade ago and are taking advantage of their local connections. Some are starting to develop an impressive track record. It remains to be seen whether the best deals will be won by the local players or the increasing number of Western private equity firms targeting the Middle East.

Fawaz Elmalki is an associate in the Dubai office of Conyers Dill & Pearman.