Over the last few years, financial institutions offering Islamic products have taken a number of important steps to keep pace with developments in the global private equity and venture capital industry. As private equity and venture capital investments become increasingly sophisticated and innovative and seek new pools of investors, including Islamic investors, growth in Islamic private equity and venture capital funds can be expected to mushroom.
Shariah precepts encourage risk taking by prohibiting guaranteed and fixed income returns on investment (whether interest-based or interest-like). Venture capital and private equity funds that do not utilise conventional leverage instruments are ideal tools for making investments in a Shariah-compliant manner. Another appropriate tool is early-stage investments in start-up companies, because investors have considerable scope to negotiate the structure and conditions of their investment to ensure Shariah compliance. An indication of the acceptance of these vehicles for making Islamic investments is the number of conventional private equity and venture capital funds that have passed Shariah compliance tests with only minor adjustments made to the investment policies of the funds themselves.
The fundamental characteristic of the Islamic finance industry is that it is founded on the principle of profit and loss sharing, rather than that of fixed rates of interest. Islam encourages Muslims to invest their money and become not creditors but partners in business. This encourages entrepreneurs who, having then developed a successful business in partnership with the financier, are then themselves able to supply financial capital and finance further entrepreneurs. This tends to encourage higher risk investment, stimulates the economy and encourages both the entrepreneurs and the investors. The returns generated are then reinvested and continue the cycle. This sounds remarkably like the principles that drive the private equity industry and may serve to demonstrate that the private equity fund industry may have a significant future in an Islamic context.
High net worth individuals (HNWIs) in the Middle East currently control assets worth over an estimated US$1.1 trillion, while globally their wealth is estimated to reach US$44.4 trillion by 2010. In 2004–05, Saudi Arabia’s HNWI wealth grew by 13.5% and the UAE’s grew by 11.8%. In addition, it is fair to say that overall private equity is replacing hedge funds in the portfolios of HNWIs.
While in the Middle East only about 20% of the Arab population currently use Islamic finance products, this is changing, and at a rapid pace. The market is already growing by 12-20% annually, depending on the region. Within the next decade, 50-60% of the world’s total savings is estimated to be Shariah compliant.
Islamic banking and finance is no longer merely an exotic niche in the international capital markets. With some US$300 billion in diverse assets and a worldwide network of Islamic financial intermediaries, compound growth rates of 15% and innovative new products such as Sukuk and Ijarah have all made Islamic banking a subject of interest to the world’s bankers and money managers.
One of the major constraints to western financial institutions and private equity groups, in particular, to accessing capital reserves in the Middle East has been the limitations imposed by principles of the Shariah, which steer capital flows away from investments considered to be haram.
High Liquidity Drives Equity
In the Middle East and North Africa (MENA) region in general and the GCC in particular, private equity has continued its robust growth in 2006 and 2007 on the fundraising front, as well as fund sizes. It goes without saying that liquidity arising from the oil price surge is the prime motivator. The governments’ initiatives via privatisations, together with the promotion of private equity financing by fund managers and investment firms were no less important. The liquidity flush has been responsible in the rehabilitation or total “makeover” of their economies.
The GCC countries have also realised the importance of involving the private sector in this restructuring, so privatisation has played a pivotal part in the process. It is expected that the privatisation pipeline in the MENA region will reach US$900 billion, with approximately 147 privatisation transactions either announced or planned in the next ten years.
The diversification of their economic bases has most importantly led the GCC countries on a race to become the “financial capital of the GCC,” thus easing regulations in terms of foreign interest in the regional financial sector. This has provided the right catalyst for the GCC economies to embark on restructuring their financial sectors, hence new regulations were imposed, financial systems were upgraded to allow for new financial instruments and myriad financial companies have launched their products in the region.
These recent trends in the GCC have had a positive spill-over effect on the MENA region. MENA countries have adopted “openness” in their economic and financial sectors, which gave cash-rich private equity managers the incentive to seek investment opportunities within the region.
In the first six months of this year, total fund sizes touched the US$9 billion mark, compared to US$14 billion for the whole of 2006; the amount was merely US$78 million five years ago. Not only has the number of funds increased, but also the sizes – four funds exceeded US$1 billion last year, with a combined size of US$4 billion, whereas this year until June, three funds exceeding US$1 billion mark totalled US$5.5 billion.
The private equity industry in the MENA region does not only seek investment opportunities in the region. Private equity managers have also been tracing absolute returns worldwide, given the maturity of the US and UK markets, and the ample of opportunities in Asia, particularly China and India. It is also important to mention that private equity in the MENA region is a relatively new phenomenon compared with the US and Europe, hence the reluctance of family-owned business to sell their interest in companies is still widespread. It is only recently that individuals came to grips with the concept and advantages of floating their equities in the market – or “going public” – and the advantages this has.
Egypt was the focus of private equity managers domiciled in MENA, accounting for 61.6% of total deals in 2006-2007. The rest went to UAE (15.3%), Saudi Arabia (10.3%), Bahrain (4.3%), Kuwait (2.1%), Jordan (1.3%) and others.
The high returns (if successful) from private equity investments are to compensate investors for the length of time they are without their money – a lifespan of five to seven years is common international practice in private equity investment.
Sectorally, the basic materials sector took the largest – 19.6% – share of the private equity pie, followed closely by the travel and tourism sector with 18.8% and another 16.4% for real estate. Financial services were a favourite too with a 13.2% share, with the largest being Dubai International Capital’s US$1 billion bid for HSBC (UK).
The impact of private equity on infrastructure has been dramatic in recent years. Infrastructure, with its steady, dependable cash flows, long-term investment horizons and low correlation to other alternative asset classes, is proving increasingly attractive to funds and institutional investors seeking to diversify their investment portfolios.
Private equity fund managers in the MENA region have been developing an appetite for the real estate market in the region. The real estate market in the GCC presented itself as a lucrative investment opportunity for private equity players, made possible by the relaxation of the property ownership rules and regulations in many GCC countries. To date this year, real estate private equity funds amounted to US$700 million, versus US$993 million for the whole of 2006, and this is estimated to further increase with the emergence of new private equity funds taking advantage of the property boom.
With the GCC equities market languishing, the alternative asset classes have gained prominence among investors. Lower investment returns from publicly-traded stocks in the region, along with low interest rates, have pushed big investors to look for other options, and private equity is trying to bridge the gap.
Small and medium-sized enterprises (SME) have been flourishing in the region. However, many of them are undervalued and poor at marketing themselves to investors. Private equity buyout funds’ role would be in taking strategic stakes in those start-up private companies, helping (or maybe changing) management and helping to improve the valuation, whether through an IPO after taking a company private or through a sale to a strategic buyer.
The private company can share international best practices with the strategic investor (in this case the buyout fund), improve corporate governance and lessen agency problems. Moreover, the strategic investor provides a solid, flexible capital base to meet future growth and development plans. We believe that the region presents excellent opportunities in the mid-deal sizes ranging from US$50 million to US$150 million.
Much of the private sector economic activity in the region is controlled by large family groups which are usually heavily diversified across the vertical and horizontal lines of their supply chain and also into many unrelated business activities. Buyout firms have undergone a paradigm shift as they have moved to purchase companies with undervalued assets, and after they restructure and enhance their performance they search for the best exit strategy for their stake in the company so that they achieve the highest returns for their investors.
Private equity, especially buyout funds, are still in their early stages of development in the region, however they present a strong case for portfolio diversification and asset allocation. Given the current economic strength in the MENA region, and particularly the GCC economies, buyout funds are in a great position to reap the rewards of growing economies and liberalising financial sectors.
Equities as the Way Forward
Popular exit strategies for private equity managers are IPOs, divesting the stakes to other asset managers or individuals, and through mergers and acquisitions. In the MENA region, very few private equity transactions have been exited: the 2006 annual report by GVCA and KPMG on MENA private equity indicates that only 5% (US$300 million) of deals made since 1998 have been realised on exit.
With a large number of private equities approaching maturity, private equity managers will be looking at the highest returns feasible for their investments. Returns realised from exited investments have been encouraging so far in the MENA region, underpinned by the vibrant IPO market, where demand for new offerings by local and regional investors continues to outstrip supply, and all IPOs have been oversubscribed by several times.
It is expected that the charged IPO momentum in the GCC will proceed, albeit not with the same vigour as experienced in 2005. Nevertheless, the general trend indicates that equities from IPOs are the way forward for private equities in the GCC and MENA regions.
This article first appeared in Islamic Finance news (Volume 4, Issue 31).