With a series of private equity conferences scheduled for the autumn, the expectations from the PE industry in the region are high. However, it remains a difficult region for private equity to do business in. The uncertain economic outlook and the Arab Spring are taking their toll. Added to this is the long-standing difficulty in putting together a viable deal structure.
In this article we discuss some of the key challenges private equity faces in the region, and offer some solutions. Barriers to doing deals include the unrealistic price expectations of sellers, foreign ownership restrictions, inadequate protection for secured lenders, inadequate governance of targets, the difficulty in exiting and the enforcement of legal rights. As a result, in recent times, private equity has often only participated as a minority stakeholder. Most of these barriers can, to some extent, be overcome.
The mismatch in pricing expectations can be dealt with using structured payment mechanisms including earnouts and clawbacks. Whilst the use of these mechanisms is not always acceptable to sellers in the region, they have been used here.
Certain types of businesses operating onshore in some countries in the GCC are allowed to be 100% foreign owned. There are also many free zones in the UAE alone which permit 100% foreign ownership. Companies registered in these zones operate in lucrative industry sectors, including offshore oil and gas services, IT, media, trade, transport, logistics and financial services, subject to the usual restrictions about carrying on business onshore. Additionally, in some GCC countries, correct structuring of investments in onshore businesses can enhance the benefits available to foreign investors. Whilst care needs to be taken to ensure that anti-fronting laws are not breached, these types of structures have been used for many years.
A problem arises if the buyer is seeking bank finance for the acquisition. The legal protection afforded to secured lenders in this region is not at the level seen in the West. Most deals involving secured debt involve the taking of security in offshore jurisdictions, with a "belts and braces" type of approach onshore where the best possible security is taken, recognizing its limitations. The lack of a freely searchable security interests register means that it is often difficult to ascertain whether assets are subject to prior ranking securities. Solutions include vendor finance structures.
One of the concerns is that target companies may have inadequate corporate governance. The board and management structure may not be appropriate for private equity, the internal audit and compliance function may be inadequate, and the quality of documentation for due diligence purposes may be poor. However, there is a heightened awareness of corporate governance in the region. Listed companies are now subject to Western-style corporate governance codes. Government and some local conglomerates have embraced the concept. There are also steps the investor can take to mitigate the risk, including restructuring the target and its management and control functions, and delegating authority to trusted individuals within the target. The use of a trusted manager, local or foreign, with a notarized power of attorney to represent the target in external dealings, helps to contain external risk.
There is also the exit risk, often caused by foreign ownership laws and local corporate law. In many cases the structures used in the West, including exits by IPO, international trade sale, or a dual-track process, simply won't work. The usual exit structures observed regionally include a share sale to local trade buyers or private equity, occasionally IPOs and sometimes a default put option for the private equity investor back to the local shareholder. The solutions are sub-optimal in that the exit options are limited, reducing competition amongst bidders and therefore the exit price. It remains a real problem.
Finally there is the litigation risk. It can be difficult to enforce investor rights through the local courts. However, alternatives are available. Arbitration is becoming increasingly popular, for example DIFC/LCIA arbitration, and there are a growing number of examples of successful enforcement of arbitral awards onshore. Retentions of consideration to be set off against warranty claims can also be used, as can bank guarantees in favor of the buyer to support warranty claims.
It all comes down to the risk profile the investor is prepared to adopt in a region where the rewards can be plentiful but the risk is higher. The judicious use of structures and drafting of documentation can greatly reduce the risks, but never remove them completely. An experienced local partner by your side will help as well.
Hamish Walton
Partner
SJ Berwin (MENA)
© Zawya 2011
