Prior to the global recession, emerging markets saw considerable growth in private equity activity. Significant investment capital was poured into - and in some cases, poured out of - these markets. While this was a phenomenon seen across all emerging markets, nowhere was this more true than in the Middle East, and in the oil-rich countries of the Arabian Gulf in particular. As a result of the global financial crisis, however, the froth has come off the markets. Dubai and its debt woes have stood in as proxy for all emerging markets in the minds of many investors, and substantial negative press coverage has some believing that the party is permanently over. Some private equity managers with close connections to emerging markets believe otherwise, and some have gone so far as to state that the next few years will represent the best buying opportunity in a decade. As outlined below, we tend towards the latter point of view, though we also believe that the risk of a "double dip" recession in emerging markets remains and that it is more important than ever to understand the unique risks posed by emerging market investing, and the legal terms and structures available to mitigate those risks.
Until the turn of the century, both sovereign and private investment capital in emerging markets, including the Middle East, was most often deployed in passive investments in international funds or in real estate. Over the last decade, however, emerging market investor appetite for more direct investment increased, and the years before the financial crisis saw a rapid rise in the number of emerging market private equity funds, particularly in the Gulf Cooperation Council countries (the United Arab Emirates, Saudi Arabia, Bahrain, Qatar, Kuwait and Oman), created to make direct investments. According to the Gulf Venture Capital Association, the number of regional private equity fund closings went from five in 2003, to 17 in 2005, to 28 in 2007. Cumulative private equity assets under management in the GCC saw a similar spike, from $4.8 billion in 2005 to $19.6 billion in 2008.
Originally, the remit of many of the new GCC funds was to invest in the GCC. As more capital flooded the industry in the last years of the decade, however, and as the volume of available deals showed no proportionate increase, some of the funds exhibited "scope creep" and began searching for investments in North Africa, India, Pakistan and even further east into Asia and west into Europe. This was not enough, however, to keep valuations from rising. Available deals drew numerous potential buyers, and with (1) the tremendous optimism generated by spiralling oil prices and robust GDP growth and (2) price-to-earnings ratios in the public equity markets reaching into the high 20s (the Saudi Arabian stock market price-to-earnings ratio peaked in 2006 above 40), seller expectations and ultimately prices became inflated, when judged by historical standards.
For a time there was a view that many emerging markets were going to be insulated from the global recession - the so-called "decoupling" of emerging and developed economies - but this proved not to be the case. The GCC and Dubai in particular, but also other emerging markets such as Russia and Southeast Asia, were hit hard. First , the real estate bubble in many emerging markets burst, and this had knock-on effects in other industries, including services and retail industries. Second , with the onset of the financial crisis, Western banks stopped lending into emerging markets, which meant a shut down of virtually all acquisition financing. Third , a sharp drop in the price of oil - to a level below that at which many emerging market governments were able to balance their budgets - led to a reduction in available investment dollars, and, as importantly, a decline in positive investor sentiment. Finally, the $10 billion dollar embezzlement scandal in Saudi Arabia relating to the Saad Group and the Algosaibi family conglomerate, followed by Dubai World's threatened default on the $3.6 billion sukuk, or Islamic bond, by its subsidiary Nakheel, caused serious concerns about transparency and accountability not only in the GCC but also in emerging markets beyond the Gulf.
In spite of these shocks there are already signs of renewed life in the emerging market private equity industry, and in the GCC specifically. Anecdotal evidence suggests, for example, that fund sponsors and managers are in the process of raising a significant amount of new capital for investing in the GCC, particularly in Saudi Arabia, and a small number of private equity investments have been completed in the GCC over the last six months.It is too early to tell if the new fundraising activity will be wholly successful, but there are reasons for hope. The rising prices of oil and other natural resources are beginning to restore investor optimism, and the GCC governments' commitment to increase or sustain their investments in infrastructure, education and healthcare will help propel their economies forward. As important are the preliminary signs that governments will seriously address systemic issues such as corruption and a lack of transparency, and will also continue on the path toward greater economic liberalization and rule-of-law reforms.
There also appears to be some sentiment among investors that a market bottom has been reached, but a few points bear mentioning in that respect. First, fewer-than-expected "distressed" deals have surfaced. While many companies in emerging markets are troubled financially, their lenders have either been unable to enforce their rights due to the difficulty in obtaining security interests and in dealing with the local court system, or reluctant to enforce their rights as they didn't want to end up owning assets in, for example, Saudi Arabia or Russia, which for an international bank can be difficult. Consequently, banks have been more willing to work around defaults rather than take over equity. The severity of this issue may be masked to some extent by banks' reluctance to write down assets in emerging markets to their true current value.
Second, aside from distressed deals, emerging markets transactions have not generally seen the dramatic shift in favour of buyers that many predicted. Deals may not be as overtly "seller friendly" as they were two years ago, but our experience is that the movement has been toward the middle rather than to the "buyer friendly" side. This is largely attributable to a continued scarcity of attractive investment opportunities, and to a continued overhang of un-invested capital. The most common complaint heard from many private equity investors in emerging markets is still the lack of good deals, and, more importantly, good deals with reasonable pricing expectations.
Third, for the transactions that have occurred and that are now being contemplated, buyers are engaging in an analysis of legal risk that was rarely encountered during the boom years. As a result, we expect that certain investment terms and structures will emerge with increasing frequency. Many of these are by no means new, but they are being seen more frequently and often for different purposes.
Earn-outs. These are being used more frequently by buyers to reduce the risk of overpaying for a business in the event that various assumptions as to future performance do not work out. Although attractive for this reason, earn-outs are invariably complex and the detail is often difficult to agree upon. It is important to consider whether an earn-out is actually workable in the context of the particular deal and whether it may have any unintended consequences on the operation of the business going forward.
Joint ventures. Joint ventures are increasing in popularity and in some emerging markets, particularly in parts of the Middle East and Asia, are the only way to make investments. They can be used by buyers to delay paying the full purchase price at completion (effectively, a form of seller financing), as well as a mechanism for sellers to participate in future upside. In many respects, joint ventures that include a buyout mechanism can be viewed as an extreme form of earn-out. In a cash-constrained deal market, with limited financing available, this type of structure can allow buyers to consolidate and gain control of a business, while allowing sellers ultimately to achieve the sale price they desire.
More clearly defined materiality and Material Adverse Effect provisions . Not surprising given that, in today's economy, the health of a business can take a turn for the worse very quickly, many purchasers are requiring more certainty with respect to their exit rights in transactions, especially where there is a significant period of time between signing and completion. Historically, buyers have relied on general concepts such as "materiality" in seller warranties, and ill-defined terms such as "material adverse effect" in the completion conditions, but these have had very limited success in creating a pre-completion "out" for buyers, even in exceptional circumstances. As a result, we are advising clients to consider defining in the purchase agreement with much greater specificity what exactly would constitute a "material" change, and also to work carefully through any exceptions as they relate to the specific transaction and local market.
Reverse break fees . Because debt financing is scarce, where an acquisition is dependent on leverage, buyers would like to provide that if they are unable to complete the transaction due to lack of debt financing, they can be released from the deal upon payment to the seller of a "reverse break fee." Although reverse break fees can take a variety of forms and often require the buyer to jump through various hoops before being permitted to exercise the reverse break fee option, these arrangements clearly reflect the increased closing risk associated with reliance on external financing.
As part of the enhanced risk analysis, and in order to negotiate the terms and structures described above, buyers are placing a much greater reliance on detailed due diligence to uncover potential liabilities in targets and to verify valuation models. In addition, as governmental regulation and enforcement increase, well-advised buyers are looking more closely at regulatory compliance prior to acquisitions, as opposed to relying on cleaning up compliance issues post-completion. In particular in emerging markets, due diligence with respect to corruption, money laundering and bribery issues are increasingly becoming hot topics.
Emerging markets investing requires additional commitment to understand the markets and comes with greater risk exposure, and a risk premium must be adequately priced into such investments. Many emerging markets investors believe that, for companies that have survived the financial crisis, growth rates are likely to be higher than in developed economies.We believe that by using the right financial and legal tools to assess, price and mitigate risk - the cornerstone of successful emerging market investing - intrepid emerging markets investors are likely to be the first to find the light at the end of the global financial crisis.
Published February 1, 2010.
