The nascent private equity industry in the Middle East got slammed by the downturn. If it adheres to five core tactics, it could flourish again, says Booz & Co.

By Ahmed Youssef

 Over the last decade, private equity in the Middle East has gone from being virtually nonexistent to become a booming prospect and then an industry facing a shakeout. In 2004 the region was home to about 25 funds with a total of around $3 billion under management; as of this year, roughly 142 funds are managing more than $34.5 billion. (See Chart 1: “Remarkable Growth.”)

The breakneck evolution of private equity (PE) has made it difficult for investors to obtain a clear picture of its fundamentals. They have thus been understandably cautious about directing funds to regional PE firms. In fact, it is now becoming clear that the Middle Eastern region’s heady growth over the last decade masked some critical weaknesses in the PE industry. Some issues are structural: Significant gaps remain in the region’s legal and regulatory frameworks; and corporate governance requires development as closely held family businesses evolve toward greater transparency.

Another challenge is the fact that PE firms in the region are still sitting on about $11 billion of unspent capital—much of it contingent on the performance of previous funds. (See Chart 2: “An Abundance of Dry Powder.”) Even if the zeal for PE investing were to return to the insatiable pace of 2006-2008 (an average of around 70 transactions per year, with an average size of about $30 million), it would take more than five years to deploy all this capital.

Considering that most firms average three to five years until they invest their funds, this mismatch could create significant pressure to invest quickly. The PE market in the Middle East would need to develop much faster in order to absorb the available capital.

Five Imperatives for Private Equity

In order to fulfill its potential and continue attracting global investment dollars, the industry will need to undergo some reform as it consolidates. PE firms that hope to operate in the Middle East should consider five key imperatives.

1. Develop an investment approach based on themes. Focusing on individual nations or sectors, as many firms outside the region do, might limit Mideast-focused PE firms’ pool of opportunities, restricting their ability to scale their assets with superior returns over a reasonable time frame. Theme-based investments, by contrast, are built around economic trends and span numerous countries and sectors. For example, PE firms that focus on the theme of serving a growing and increasingly wealthy population will invest in sectors such as consumer and mortgage finance, real estate management, retail, and restaurants and leisure. (An alternative approach is to raise funds for specific opportunities; while cumbersome, this bespoke option appeals to investors and should be taken into account.)

2. Tighten risk-management practices. PE firms will need to ensure that their portfolios are not overly concentrated. Naturally, this means they should not be heavily skewed toward any single place or sector. However, firms must also ensure that the companies in their portfolio are balanced between different stages of development—i.e., companies that are still in the growth stage and demand cash vs. those that have achieved maturity and generate it. Meeting this target is particularly problematic in the Middle East, where many opportunities are early stage and greenfield. A better balance in the portfolio will hedge against the cyclicality of the business. In terms of individual deals, PE firms will need to practice more rigorous risk management before, during, and after each transaction.

3. Be an active owner. The robust economic growth that preceded the downturn allowed many of the region’s companies to chase top-line growth at the expense of working capital and profitability. Liquidity issues bubbled beneath the surface while the economy was booming, then rose to the top when the recession hit. The same companies are now struggling to get their houses in order. Adopting the appropriate financing approach, anticipating a buildup of operational capabilities, and strengthening relationships with key stakeholders and suppliers will require active oversight by existing PE backers.

4. Deepen relationships with limited partners. Historically, the majority of limited partners (LPs) in the region were high-net-worth individuals. Institutional investors now represent a more significant percentage of LPs—an important development for PE firms as they broaden their investor base. Firms should seek to strengthen relationships with institutional investors—both regional and international—that are looking to make a play in the Middle East. These may include banks, insurance companies, pension funds, and others that have been adding private equity assets in hopes of achieving risk-adjusted returns beyond those possible in public equity markets. Deepening the relationship entails more rigorous relationship management—including continual reporting—as well as better understanding of the risk-return relationship that institutional investors seek.

5. Build confidence through new fee structures. Lowering entry fees will encourage investors to come aboard and will give fund managers the opportunity to prove their worth. Among limited partners globally, the standard “2 and 20” fee structure—in which firms take a management fee of 2 percent of the fund’s net asset value each year and a performance fee of 20 percent of the fund’s profit—has become a source of increasing dissatisfaction. Out of sensitivity to investors’ concern regarding these arrangements, some big PE firms around the world have lowered their management fees on committed but uninvested capital to 1.5 percent (and sometimes less for LPs with large commitments). Regional firms should consider doing the same.

The Middle East’s PE industry sprang up when equity prices were rising. Many local players enjoyed early success in the form of quick and profitable exits from investment positions. That dynamic soon reversed, however.

Today, winning will not depend on timing or external market factors; it will depend on more fundamental sources of value. As firms in the Middle East rebuild, they will need to do the basic things effectively: Identify sustainable investment ideas, create value within their portfolio companies, reduce their risks, and gain the trust of the best-possible investment partners. These are tactics that will work and remain important—in both good times and bad.

Ahmed Youssef is a Partner at Booz & Company with more than 7 years of consulting experience in corporate and investment strategy formulation, business planning, portfolio review, and operating model design.