In a dynamic region where organic expansion has historically been easily achieved by most companies, the interest in consolidation reflects an increasing recognition of another important driver of business growth. But it also highlights the need to look for new ideas when traditional growth dynamics have been upended by macroeconomic volatility and fiscal reforms.
The pioneers of consolidation in the Gulf are all in the top tier of the regional corporate sector, typically publicly listed companies with high governance standards and a global footprint. While ownership transfers happen even among smaller businesses, these remain very much the exception and are seldom transformative. A number of factors account for this. Most small businesses were set up in the image of a sole founder, and many owners maintain an emotional link to their “life’s work.”
This can be the case even with family businesses that are reluctant to fragment and implicitly admit failure by divesting from one of their holdings. These emotional and cultural considerations, along with underdeveloped private-capital markets, often translate into altogether unrealistic valuation expectations, which risk undermining the financial logic of consolidation.
Instead, the Gulf corporate sector has for decades grown horizontally, to a large extent through the replication of business ideas in sectors with low barriers to entry. In 2017, 48 percent of Dubai small and medium-sized enterprises were services businesses, and 47 percent were in trading, whereas about a third of Bahraini companies were in trade. With the pie getting larger for all, consolidation as a growth formula attracted little attention, as the numerical dominance of very small businesses attests.
Yet internationally, consolidation is an established way of achieving company growth through economies of scale, and the case for it is certainly not limited to the largest companies. The rapid global pace of technological change is raising the bar for success in all sectors.
In the Gulf, the new economic and fiscal realities of slower trend growth and higher input costs have been pushing up the minimum efficient scale for businesses. This process is often further exacerbated by aggressive price competition and margin erosion. Consolidation can bring potential relief, not least by facilitating easier access to capital. This in turn can help unleash productivity gains, new growth drivers, and business-model overhauls.
There are some encouraging signs that the time of consolidation might now be dawning in the Gulf. The more challenging economic backdrop of recent years, notably the shock of COVID-19, has pushed companies to think afresh and increased their receptiveness to new ideas. Cash constraints have pushed some entrepreneurs to sell out to realize value before it is too late. The introduction of value-added tax has pushed up accounting standards, generated more financial data, and thus established a more objective basis for valuations while also underscoring the advantages of scale.
Merger and acquisition is not a guaranteed formula for success. A high percentage of mergers fail even in mature markets because of an inability to realize all the potential savings and synergies, as well as the often thorny challenges of bringing together different corporate cultures.
These risks are likely even greater in the Gulf, where the experience and know-how for implementing consolidation projects are particularly scarce. Just as the performance of many businesses, especially smaller ones, is compromised by the limited availability of the necessary management and financial skills, similar constraints risk complicating attempts to acquire other companies.
Also the kinds of institutions that drive consolidation in mature markets are relatively rare and often unwilling to work with small businesses. In particular, the private equity industry in the Gulf Cooperation Council area is still nascent and often operates with a heavy real-estate bias.
But again, the narrative is evolving. Banks, especially, have the potential to enable further progress in this area. After all, a corporate customer that is transformed, whether through merger and acquisition or otherwise, turns from a problem into an opportunity; a concern capable of renewed growth rather than a potential nonperforming loan.
The case for consolidation in the highly fragmented Gulf corporate sector is compelling and becoming more so. Merger and acquisition offers an important, hitherto underutilized, mechanism for a market economy to heal itself and to reignite growth. While progress is still far from being a foregone conclusion, it now looks as if more and more enabling factors are lining up.
Ultimately, success in popularizing the idea has the potential to create stronger, more dynamic businesses while contributing significantly to making productivity an increasingly important driver of growth and quality employment.
• Jarmo Kotilaine is an economist and strategist focusing on the Gulf region.
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