Ready for a challenge? A survivor's guide to private equity in the MENA region
The main sectors in the region for private equity investment remain those generally perceived as resistant to changes in the economic cycle. ‘Defensive' sectors include healthcare, education, energy and consumer-related businesses. Although some funds remain sector agnostic, whereby a number of key players invest across a wide range of sectors, an increasing number are developing a sector focus in order to create a brand identity and differentiate themselves from other investors. Infrastructure remains an important sector for the region, however investment can be difficult for private equity investors since major projects will be dominated by government owned companies and sovereign players which may exclude private partners.
The majority of MENA countries impose foreign ownership restrictions which typically cap foreign ownership at 49 per cent in various sectors (although there are notable exceptions, such as free zones). For international private equity firms, this can prove to be a challenge as local investment firms may not be subject to such restrictions. Buyouts or change of control transactions are relatively rare and minority investments remain the norm for the region for both local and international private equity firms. A minority stake need not be a passive position. Many investors add value through identifying new business opportunities, advising on mergers and acquisitions and providing access to management talent.
In a number of MENA countries, investors benefit from the ability, under applicable corporate laws, to block certain key decisions provided that a certain minimum percentage of ownership is acquired (typically 25 per cent). However, it is not uncommon for such rights to be expanded and strengthened with contractual protections - typically contained in shareholders' agreement. Inclusion of these rights serves to ensure: (i) involvement in major decisions (board representation and rights of veto); (ii) protection against the equity stake being diluted; (iii) proper distribution of profits; (iv) adequate access to information; and (v) the ability to exit. The reserved matter/negative control rights may include: (i) changes in the company's constitutional documentation; (ii) new issues of share capital (including grant of share options) or debt instruments; (iii) significant changes in nature of the business; (iv) major acquisitions or disposals; (v) capital expenditure or contract commitments in excess of pre-agreed limits; (vi) borrowing limits and security packages; (vii) dividend policy; (viii) appointment and dismissal of key management and auditors; (ix) material dealings with intellectual property and dealings between the company and its shareholders.
Private equity investors may wish to structure their investments off-shore in a jurisdiction where enforcement of their rights may be easier. For foreign and international investors, tax structuring will also be key and consideration should be given to structuring investments through tax treaty jurisdictions to improve their tax position.
In addition, certain tools available to investors in other jurisdictions, such as preference or preferred shares, are not available in most MENA jurisdictions. For example, an investor in a typical deal in the UK or US might hold both ordinary and preferred shares giving significant voting and control rights with a preferential dividend. Share classes would also be used to structure management incentive arrangements such as options and ratchets. As such, investors may opt to structure the deal in an off-shore jurisdiction where shareholding structures are more flexible.
A significant number of funds investing in the region will choose to incorporate in jurisdictions such as the BVI and Cayman Islands, which reflects the relative ease and certainty attached to fund establishment in these jurisdictions in comparision to domiciling funds locally where regulation is less certain or clear (with the exception of Bahrain).
Although the MENA region possesses a number of stock markets, IPOs can be difficult for private-equity players. IPOs are generally priced at par (rather than through a book-building process) and a combination of low liquidity, no secondary listings and a two-year lock-up period for existing shareholders before they can redeem their investment makes a regional IPO an unattractive proposition, for some. In addition, investors are prevented from cashing-out in the short-term, cannot necessarily achieve the pricing they desire.
Secondary buyouts by other private equity firms in the region are also rare. There are a number of reasons for this, including that with minority investments, control cannot be transferred and contractual provisions may be in place (such as rights of first refusal) giving the founding shareholder the ability to prevent a sale to another sponsor. The main exit mechanism, therefore, remains a trade sale.
Private equity investors will generally be constrained by the exit decision of the majority owner and should negotiate specific exit rights and conditions upfront. For example, the investor may negotiate a put option to transfer shares back to a local shareholder for a specific price. Investors should also consider the effect of any drag and tag provisions. A drag right would typically require that on any proposed transfer of shares resulting in a change of control of the company (or other suitable threshold) the transferee(s) have the right to force the minority shareholders to sell their shares on the same terms and conditions to the purchaser. A tag right generally benefits a minority shareholder operating (typically other than where a transferor has exercised a drag along right) on any proposed transfer of a certain percentage of shares so that the minority holders have tag along rights to sell all/the same proportion of their interests to the purchaser.
Generally, speaking distressed businesses in the MENA region do not consider private equity funding and opt to approach banks or friends and family for immediate requirements. Business owners have also been reluctant to revise expectations on asset value and ‘take a hit' on price making deals unattractive for investors. In addition, few ‘distressed' sales in the MENA region are ‘liquidation' sales led by a receiver, liquidator or other administrator. Acquisition of specific assets can also be hindered by licensing and regulatory issues. Buyers and investors should include retention, escrow or other protection mechanisms in such transactions (or achieve an appropriate price discount to account for risk).
What does the future hold for private equity in the region?
Several key drivers will likely impact MENA private equity industry in the short term, including capital market and regulatory reforms (consolidation or integration of regional exchanges to increase market liquidity and streamline trading platforms, clearing and settlement systems and assist with cross-listing of portfolio companies), relaxation of foreign ownership restrictions and the restructuring of family businesses. It is widely reported that only 10 per cent of family business survive to the third generation. The transition between generations involves the challenge of maintaining control and many families may look to partially sell their interests providing opportunities for private equity investors.