Dubai International Financial Centre is working on a plan to launch a second-tier market to offer smaller companies the opportunity to tap growth capital, the Centre's chief economist Nasser Saidi said last week. The idea, similar to London Stock Exchange's Alternative Investment Market, is aimed at easing the entry for the region's small and medium-sized companies in the public markets.

The move could come as a big relief to private equity investors who pumped money into the regional firms during the boom years. The initiative comes at a time when venture capital and private equity investing in the region is picking up after a year-long drought.

Private equity investments in the region suffered a decline in 2009, with fund managers raising just $1.1 billion (Dh4.04 billion) compared to a near-record $5.4 billion in 2008. Regional private equity firms raised $1.25 billion in the first quarter of 2010, an 18 per cent per cent increase over total funds raised in 2009, according to the Gulf Venture Capital Association.

For the private equity investing community, the public market exit is an important element in the successful completion of their investment cycle. In early-stage private equity investing, particularly that by Angel Funds (who invest their own money in start-ups) and Venture Capital funds (who invest funds from limited partners), only a few succeed to become profitable businesses. Usually, venture investors make money by selling their share of these successful companies at large multiples. One of the most predictable ways for an investor to exit an investment is to take the company public.

Conventional wisdom says that a VC firm has to expect about half of the companies in its portfolio to fail, a few to earn decent returns and one or two to hit the jackpot in order to make the numbers work. Without a robust market to take companies public, these investments can't be liquid or realise the potential returns. Unlike with an initial public offering (IPO), where the sky is the limit if a company can generate enough buzz, there is a cap on how much an M&A deal is likely to net.

The number of venture capital exits in the US in the second quarter of 2010 shows 15 IPOs by venture-backed companies raised $899 million, while 79 merger and acquisition (M&A) deals raised $4.3 billion. The IPOs had an average value of just about $60 million, while the M&A deals averaged only slightly less at $54 million, demonstrating that IPO exits no longer deliver those sky-high multiples as M&A deals delivered even lower returns.

Preference

Despite the slowdown in the public markets, even late-stage private investors like the typical buyout firms prefer public markets in exits as these historically delivered better returns compared to M&A deals.

For the Middle East private equity investor, an IPO exit is becoming even more important in the context of a drastic decline in M&A activity in recent months. The number of M&A deals targeting the Middle East fell by 38 per cent in the first half of 2010 despite an 86 per cent increase in volume, according to the Zephyr M&A Report for the first half of this year. This simply points to the fact that private equity investors looking for those magic multiples will have nowhere else but public markets to look at.

Although Angel, Venture Capital and Private Equity investors work on different funding formulae, to make their investments liquid and reap higher returns they need to have reliable public market. The key role played by these firms in building grassroots entrepreneurship is undisputed. So the DIFC initiative for a tier-two market makes ample sense. After all, they know very well VCs and PEs are not going to rush in where Angels fear to tread.