The many hurdles facing global private equity

International private equity has money to spend and the Middle East remains attractive for investment — so why are there so few Middle East transactions involving international private equity?

After all, 2015 was a good year for the major international private equity players. For a fifth consecutive year, distributions exceeded cash calls and the wave of global M&A activity provided a wealth of exit opportunities and new transactions. Limited partners, flush with their distributions from private equity as their best performing asset class, were naturally keen to reinvest funds back into private equity, in turn providing a strong fund raising environment for managers.

This was combined with recent economic changes in the Middle East which served to strengthen the position of the major private equity firms. Regional governments and sovereign investors have scaled back their allocations to private equity, instead consolidating their allocations to private equity among a smaller number of larger funds, naturally favouring the major international players that best weathered the 2008 financial crisis.

Accordingly, major international private equity firms started 2016 with unprecedented levels of ‘dry powder’ (funds available for investment) and a strong mandate to invest. So, with strong demand from international private equity to invest in the Middle East, why are we not seeing more deals involving them in the region?

The Middle East remains an attractive destination for investment. It has a large and young population, strong future growth expectations, expanding GDP and efforts in some jurisdictions to implement economic reforms.

However, international private equity has a number of disadvantages when it comes to investing. The most obvious of these is foreign ownership restrictions, not just restricting legal ownership to a minority position, but also preventing effective holding company structures. And often requiring the introduction of nominee structures and specific country by country transaction structuring.

Couple this with financing complications restricting debt push down, related party approvals and tax issues with cash repatriation in a number of jurisdictions, and what could be a simple multi-jurisdiction transaction in another part of the world suddenly looks like a transaction loaded with complexity and deal risk.

Unsurprisingly, a feature of many of the deals concluded by international private equity in the Middle East have involved consortia with local strategic or financial players who can help navigate some of these complexities and conclude a transaction.

International private equity funds are of course not the only buyers in the Middle East. There is an active local and regional private equity market: active sovereign investors, plus the usual array of deep-pocketed corporates and family conglomerates present in the region.

Valuations thus remain high and as yet do not reflect any weakening consumer demand.

Deal sourcing, a perennial difficulty in the region, combined with a relatively small pool of assets available for investment (Gulf companies are generally reluctant to yield control to outside financial investors) is also keeping valuations high. Given the larger preferred deal size for international private equity, the pool of available assets is further reduced.

Perhaps the biggest difficulty with investing in the current climate is the inherent uncertainty in the region. As the impact of lower oil prices continues to drive changes in the Middle East, governments, currencies and companies are all adapting swiftly and often unpredictably. With so many highly unpredictable variables, financially modelling a pan-regional investment is extremely difficult.

Moreover, regional corporates and conglomerates have a disproportionate advantage over international private equity when it comes to bidding for regional assets. They benefit from lower costs of capital, using their investment grade credit ratings to borrow cheaply from banks.

Gains in regional stock markets have emboldened their share prices and enabled them to offer their shares as currency for acquisitions. The absence of foreign ownership concerns and a general comfort with doing business in the region make deal execution less daunting.

Combined with an ability to pay more and hold assets for longer, they are a formidable competitor to international private equity funds.

So what lies ahead for international private equity in the Middle East? Seismic changes in the legal and regulatory landscape are not expected.

Valuations may adjust slowly, but may be prevented by the high demand for a limited pool of assets. Those already invested in the region may adopt buy and build strategies, a long time feature of private equity investing.

Middle East companies may start to look for more than just a financial investor and see value in blue-chip private equity investors bringing access to other markets to facilitate international expansion.

International private equity will continue to look for opportunities to co-invest with regional players, both financial and strategic. Ultimately, despite the attractiveness of the region, we are unlikely to see much increase in international private equity transactions in the short to medium term.

The writer is Corporate Partner at Baker & McKenzie Habib Al Mulla, UAE.