August 25, 2005
Structuring Private Equity in MENA for Development
Structuring Private Equity in MENA for Development
A few weeks ago I raised the subject of emerging markets private equity in particular in the context of US Gov efforts to utilize the vehicle to further its political / development goals in the Middle East – North Africa region. One of our online world colleagues if you will posed a question to me as to what the “The Lounsbury” approach would be, in the context of my expressed skepticism in regards to the investment vehicle / definition chosen by The Overseas Private Equity Corporation.
Ironically (well not really) at present I am working on materials closely related to just this question, although not really in regards to development – but as much of the private equity activity in region has been international development institution driven there is a clearly overlap. Now, having sent drafts of my materials off for comment I can take a moment to sketch out some preliminary thoughts on the issue that will be the basis for future comment.
First, my assumptions, based on personal experience in the region and in the “sector” if we can call it that. Again, these are my a priori assumptions and principes.
Assumptions and Principals
1. The key financial sector problem faced in the region is proper mediation between “savers” and “investors”
2. Persistent over-liquidity in the classic banking sector (i.e. deposit taking, credit making institutions) and more or less deep cultural reservations regarding recourse to Western style credit institutions (leaving aside the Westernised elite) suggest classic Western style institutions may not be efficient instruments to mediate savings in the “Old Islamic Core.”
3. Persistent over-liquidity, existence of better returns from other activities, suggest market forces are not going to move to financing what we might call the “non-corporate” or non-blue chips due to persistent issues of control.
4. Growth oriented ‘structured’ or properly organized firms – let me call them growth oriented smaller enterprises [GOSE-how’s that for an ugly acronym] – are likely to require equity or equity-like financing – risk capital if you will in older jargon – to be able to access classic bank financing.
5. Angel – ‘Friends, Fools, & Family’ equity financing in the venture model is scarce to non-existent even within family networks. There is little proper equity investing culture meaning risk taking does not appear to be ‘rationally’ structured (i.e. return versus blood based) as a general matter (or rather better there is poor mediation to allow one to use non-blood based networks).
6. Large projects and/or firms operating in the region do not face real capital constraints – the market is broadly liquid and financing for large projects, such infrastructure and major developments is not overly constrained nor expensive. Private capital availability for investment in well structured large scale projects does not pose a serious issue.
7. The most serious financing as well as structuring problem is in terms of ability to transition from “micro-markets” to growth oriented expansion taking advantage of regional or international market opportunities. That is, the relatively smaller firm (non-blue chip) looking to a growth oriented, highly competitive niche (as opposed to the lifestyle business unconcerned with growth, the ‘just get along’ shop model) faces serious financing constraints and usually has to fund itself almost entirely out of own equity, retained earnings – which can be a binding constraint in terms of taking advantage of explosive growth opportunities by taking an innovative or disruptive strategy – be it on cost, cost plus location, ‘real’ innovation, etc. etc.
8. Structured growth oriented financing firms – call them private equity, enterprise funds or whatever – provide a positive model for developing risk oriented domestic capital investment models.
8.1. To provide such models, they need to show they can provide a reasonable return and if part of that return is a ‘development’ return (i.e. some kind of formula rewarding the Fund for development impact) that should be amply justified up front so subsequent investors understand. There should also be a view to achieving at least a few good financial return stand outs in the portfolio to provide poster child promo material
8.2. The model must be institutionalized and as replicable as possible.
9. Operational Issues Goals on returns must be clearly defined and have a rational balance.
9.1. Financial Return versus Development versus Institution Building9.1.1. Investment vehicle must build in that financial rewards managers for successful development oriented investments that fall short otherwise.
9.1.2. A clear and realistic idea on financial returns versus institution building and boosting entrepreneurial activity is needed.184.108.40.206. If pure returns are highlighted, proper incentives and scope of action for fund managers.
220.127.116.11. If institution building (i.e. helping create well run investment vehicles focused on equity and near equity financing of entrepreneurial / growth activities), then clarity is needed on acceptable trade offs. (i.e. whether disclosed to fund managers or not, realistic end goal on financial return versus non-financial return)
9.1.3. If focused on boosting entrepreneurial activity (which contra loose political talk is absolutely not native to the region),18.104.22.168. What level of risk taking is truly acceptable free of political money considerations?22.214.171.124.1. Even if one selects proven managers (i.e. an institution largely already “made”) the extra risk of rolling the dice on start up financing has to be realistically framed. Failure rates will be high, financial return may not be the best pure benchmark (but neither should it be omitted).
126.96.36.199. Real market scope for a combined enterprise center / funding source – call it an entrepreneurship incubator with a funding wrapper.188.8.131.52.1. However incubators are hard to make work. On the other hand if they were “easy” private money would have done it. Proper role for public money in private enterprise may be to boost what may not be immediately commercially viable..
9.2. Realism regarding political constraints on investment scope versus impact.9.2.1. What are the real investment redlines due to politics and are there ways around?
9.2.2. What weight of reporting to justify? Heavier reporting means either (i) higher cost born by funder or (ii) by the fund, which may take certain investment classes (smaller deals, my GOSEs) off the table.
10. Structure has to be localized but with real oversight.
10.1. Plopping money from afar is disastrous.
10.2. Local knowledge is key,
10.3. However local needs oversight in early stages. Mixed team early on to institutionalize good governance likely very necessary.
10.4. Has to be close to the entrepreneurs to finance growth, if that is the objective.
11. Rational formula for meeting operational issues.
11.1. Minimum financial return goals for management company to touch carry.
11.2. However, such financial return goals augmented by ‘points’ to reward management for sustainable development impact even if current exit environment unfavorable. (as in a profitable growth oriented firm but where market sale as in an IPO may not be possible)
11.2.1. Ensures market viability.
11.2.2. Minimized reporting. Reporting is expensive, and “best practices” in developed market inappropriate for developing markets. Extensive reporting likely to create a GIGO effect as well as make smaller firms unfinancable.
11.2.3. Hard choice btw De Novo and Extent vehicles in region.
184.108.40.206. Either way, some thought to instituting good governance and good habits early on. Inside man, or independent may be useful.
11.2.4. Exit Goals and Wind Up Clear.
In a short summary, how The Lounsbury would do a private equity fund for US Gov or anyone else would be:
(i) Negotiate a compensation formula that combines financial return with development kickers in regards to touching carry. Develoment kickers, however, not allowed to overcome commercial failure. Minimum performance goal for aggregate portfolio as well as individual firms. Reward, however, for risk taking.
Example: Investment in privately held plant oil firm producing for export market, aimed at upper end luxury consumption. Say smaller deal, 1-5 million USD range, they grow as expected but on Fund wind up there are not positive exit opportunities. Firm represented positive growth impact for country, created employment and is commercially healthy. Development kicker boosts return in calculation for carry.
Overall goal, lower expected financial return in return for achieving development goals and building an institutional environment.
(ii) Firm ideally partners some international particpation with a domestic firm - unless there is a clear, very high quality domestic partner (rare).
(iii) Focuses on the tough job of financing early stage growth firms. Later stage investments are much less in need of capital, and that capital can be largely found in private sources.
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Why does section 10.2 sound like the proverbial money quote? Like, e.g., "Hire me!"?
10.2. Local knowledge is key
Not that that isn't the seriously proper or wise thing to do.
Posted by: matthew hogan at August 25, 2005 05:29 PM
What's your take on the non-GOSE firms that have been launching IPOs in KSA and UAE? Aabar's the cream of the crop - their prospectus is full of blurb about the oil drilling market without any suggestion of what they plan to do with it, but local investors over-leveraged themselves to the tune of the entire country's GDP to try to buy into the IPO (probably primarily because of the 'names' involved).
Admittedly not in the same vein as the strategic investment concept you're talking about, but while we're talking about finance...
Posted by: yinshuisiyuan at August 25, 2005 09:04 PM
Well, I get a lot of phone calls these days.
Yin...: I don't deal much with the Gulf nowadays so I'm afraid I am quite ignorant as to what the IPO market is looking like from a fundamental stand point. Everyone I know in the financial business seems to be convinced the Gulf market is nutso right now, and needs to cool down. Again, not my market so I only know what I read in the Business Press - what you tell me I presume - although I shall be out in Dubai on business end of next month, perhaps get a sense....
However, reflecting on what it means in the context of GOSE firm financing, as a general matter it strikes me that the hydrocarbon sector has rarely had trouble accessing capital and quite the contrary, often gets more than it deserves in the Gulf. Getting capital to flow to other sectors (and I mean non-hydrocarbon activities, including services or businesses that are not merely tertiary to the hyrdocarbons business) is a problem for lots of reasons.
In my personal opinion, a lot of this is investor bias, or the investing culture.
I'll take the North African IPO market as an example of investing culture trumping fundamentals and even decent technicals in regards to market infrastructure. Looking at the data of the last several IPOs (and only IPOs...) there is a persistent structural problem that arises. All get a nice post listing pop (although the benighted "prudential" rules preventing more than single digit percent price changes end up squeezing out much of the pop as well as liquidity, but the regulators being French trained are scared to death of too much "market turmoil"), and then universally trend downward by about the same percentage as one would expect is the retail buyers unloaded with significant other buying.
In effect, one has an environment where retail buyers simply play a very simple day trader type game, but only on initial buy, on pure speculation of post IPO price increase, whereas the institutionals (effectively mutual funds and some bank buying) sit on static portfolios (that amazingly enough are heavily weighted against equity).
It's strangely mechanical and has fuck all to do with results in general. Bizarre to watch.
Posted by: The Lounsbury at August 26, 2005 06:19 AM