Weighing up money and talent

Much of the global crisis has come about because the credit crunch has robbed private-equity funds of their ability to leverage investments at least in the short-term.

By far, most private-equity money still comes from Europe and the United States. But increasingly, major financial players look to emerging markets like the Middle East for growth. Not surprisingly, they are moving their heavy artillery to places like Dubai in recognition of the new realities in international finance.

Chris Ward, Deloitte's Global Head of Corporate Finance, also serves as head of the firm's Dubai-based financial advisory unit. He has over a quarter-century of experience under his belt on high level merger and acquisitions, business valuations, restructurings and due diligence. Much of that experience has been in private-equity.

In some ways, Ward's arrival last October is a hallmark of Dubai's growing prominence in international finance. With oil prices meandering back up the chart a continued flow of new investment capital, especially in the Gulf, is assured. But the factor that cinches Dubai's future is the ability to attract seasoned talent to effectively deploy these funds.

This experience matters because even in the best of times, half of all merger and acquisitions never achieve the stated objectives and lose money for investors. Nor, these days, can one ignore the uncertainties created by the current crisis.

"Recently, private-equity has taken some hard knocks in the media. Some firms have had investment ratings downgraded and a few bankruptcies have occurred. Returns are down dramatically," says Ward, which is reflected in lower valuations of private-equity firms (some like the Carlyle Group and the Blackstone Group are publicly-traded).

Much of the problem has come about because the credit crunch has robbed private-equity funds of their ability to leverage investments at least in the short-term. Leverage allows an investor to purchase and control a company for less out-of-pocket capital. Or put another way, the amount invested generates a much greater return when leverage is effectively employed. Now, says Ward, "equity is going to have to work harder."

Dr Vadhindran Rao, finance professor at the American University in Dubai, concurs. "Deals will likely use less leverage than pre-crisis levels." Both men also agree that deals will be smaller for the foreseeable future.

The financial crisis also unhinged the private-equity market by wreaking havoc with timing. Unlike investments in shares, private-equity investments typically require a commitment over a period of time - usually three to four years.

Thus private-equity funds are usually designed to bring together investors, find and execute investment deals that offer high returns in this time frame. If everything goes according to plan, investors "exit" on schedule with their profits in hand.

But because the value of many private-equity investments have slumped, funds now need more time to realise returns or are forced to hand over anaemic profits. Worse, an estimated $470 billion (Dh1.7 trillion) in funds has been committed by big investors to private-equity funds.

"Private-equity is now 'overweight'," says Ward. He notes that one high profile European private-equity fund manager cancelled about 40 per cent of their commitments. Some investors are able to off-load their commitments in 'secondaries' transactions - other investors willing to take their position.

And some are forced to live with disappointment. One financial services executive wryly comments that "fund managers are giving lots of foot massages to private-equity investors these days."

But the clouds are lifting. Though mega-deals are scarce, smaller opportunities abound because many private and public companies can be snapped up on the cheap. This creates a smorgasbord of possibilities for private-equity investors to acquire, combine and restructure companies to improve economies of scale, increase market clout and eliminate competition.

Still, finding major deals to satisfy the hungry-man appetites of big investors remains a priority. Ward notes that this is the reason creme de la creme firms such as Kohlberg Kravis & Roberts have turned their attention to growth markets like the Middle East.

But Ward also thinks that the future of big deals will be different than in pre-crisis times.

Previously, says Ward, banks syndicated the debt to execute mega-deals. This "has changed dramatically." In the future, obtaining major finance packages from syndications will be a challenge. Leverage will be used more modestly than before. That means equity could be 'king' in the coming decades.

Ward notes that some private-equity funds are already equity-only though most funds have used leverage as a pivotal component of their investment strategy. This involved avoiding investments in high volatility industries like autos, construction and financial services and investments where leverage's horsepower could be maximised with little added risk.

Increasingly, the slack will be filled by other types of financial institutions, says Ward. One example is GE Capital which last year formed an $8 billion venture with Abu Dhabi-based Mubadala Development Company. Professor Rao agrees. "The gap left by banks may be increasingly filled by sovereign wealth funds and hedge funds."

Large companies in emerging markets are also becoming players. According to a recent Harvard Business Review survey conducted with the World Economic Forum, companies in developing countries initiate an increasing proportion of merger and acquisition deals with developed countries.

Because these companies are dominated by wealthy families and individuals, dilution of shareholdings is of less concern. Without the investing public to worry about, deals can be financed with internal resources and by issuing new equity beyond limits generally accepted in developed economies.

All this adds up to a confluence of money and experience in the Gulf region with Dubai clearly becoming a heavy weight in private-equity investment. Over the long term this will pay off significantly as leaner, better structured companies emerge - companies that are owned and controlled by the Middle East. And these companies will help define international competition as the global economy recovers. "It's remarkable how hands-on private-equity can add value," says Ward. After decades in the business, he should know.

Rod Monger writes on international business, economic and political issues.