Pri­vate eq­uity and mez­za­nine fi­nance

This mix of debt and eq­uity takes the best of both

The National - News - Business - - The Markets - Richard Clarke Richard Clarke heads the Deal Ad­vi­sory prac­tice and leads the sov­er­eign wealth fund and pri­vate eq­uity sec­tor team for KPMG Lower Gulf

The pri­vate eq­uity in­dus­try in the Mid­dle East and North Africa has wit­nessed in its short life sig­nif­i­cant de­vel­op­ments and chal­lenges other re­gions wit­ness over decades. The nascent in­dus­try of the early 2000s had just started to spread its wings when the fi­nan­cial cri­sis of 2008 struck global mar­kets and de­railed many of the world’s eco­nomic growth en­gines.

Barely on its path to re­cov­ery, the in­dus­try suf­fered another blow in 2010-11 with the out­break of the Arab Spring. While these de­vel­op­ments could have un­der­mined the pri­vate eq­uity in­dus­try, through the years they have shaped it to be­come more ma­ture and re­silient.

Not very long ago pri­vate eq­uity funds fo­cused on the Mena re­gion flocked to sec­tors as­so­ci­ated with oil and gas given the re­gion’s high de­pen­dence on the sec­tor. But the oil price decline since 2014 has forced them to seek al­pha in other in­dus­tries. Be­tween 2014 and 2015 alone, in­vest­ment value in the oil and gas sec­tor had de­clined by more than half. PE funds have since changed their for­mula and re­al­lo­cated cap­i­tal to the con­sump­tion side of the econ­omy span­ning ed­u­ca­tion, health care and food and bev­er­age, among oth­ers.

Even in these al­ter­na­tive sec­tors, an in­ter­est­ing trend ob­served is that the in­vest­ment is not lim­ited to com­pa­nies of­fer­ing con­ven­tional ser­vices. It tran­scends to busi­nesses that are ef­fec­tively lever­ag­ing tech­nol­ogy and re­defin­ing the mar­ket. Take the ex­am­ple of ride hailing app Ca­reem and dis­count voucher app En­ter­tainer.

The dy­nam­ics of the in­dus­try are chang­ing with lim­ited part­ners (LPs) shift­ing away from the tra­di­tional ap­proach of in­vest­ing in blind pool funds to ex­pect­ing higher in­volve­ment in the de­ci­sion making process tra­di­tion­ally left to gen­eral part­ners (GPs). These trends have per­haps brought mez­za­nine fi­nanc­ing into fo­cus for pri­vate eq­uity funds. Mez­za­nine fi­nanc­ing is a mix of debt and eq­uity that, in the event of a de­fault, has a lesser claim to the bor­rower’s as­sets than se­nior debt does; like a mez­za­nine, it lies be­tween two lev­els.

While some per­ceive it is as an ex­pen­sive fi­nanc­ing model, this al­ter­nate source of funds tak­ing some of the best el­e­ments of debt and eq­uity can prove to be help­ful for in­vest­ments in the Mena re­gion, which has a high con­cen­tra­tion of fam­ily busi­nesses and en­trepreneurs. With mez­za­nine fi­nanc­ing, fam­ily busi­nesses can raise funds with­out the con­cern of di­lu­tion. En­trepreneurs, many of whom have boot­strapped their busi­nesses, typ­i­cally find it dif­fi­cult to se­cure bank loans. The oil price decline and the en­su­ing liq­uid­ity crunch have made se­cur­ing credit even more dif­fi­cult. Mez­za­nine funds can pro­vide them a lease of life while al­low­ing them to fully reap the ben­e­fits of their eq­uity growth.

While for in­vestors with mez­za­nine be­ing a ju­nior level of debt they can en­joy a higher rate of re­turn as well as reg­u­lar in­ter­est pay­ments or even par­tial eq­uity up­side. In this world of chas­ing yield, this is a great op­tion.

In the face of low in­ter­est rates and skit­tish eq­uity mar­kets, mez­za­nine fund­ing in pri­vate busi­nesses is gain­ing pop­u­lar­ity as an al­ter­nate in­vest­ment op­tion, though it re­mains in its in­fancy. In the first six months of 2016, the mez­za­nine funds of Gulf Cap­i­tal and NBK Cap­i­tal Part­ners were to­gether re­spon­si­ble for 79 per cent of the cap­i­tal raised for funds con­cen­trated in the re­gion.

Over­all, there are many fac­tors that tip the scales in favour of pri­vate eq­uity growth in the Mena re­gion. A favourable de­mo­graphic (with more than 20 per cent of Mena’s pop­u­la­tion be­tween 15 and 24 years old, the largest con­cen­tra­tion of young work­ing age pop­u­la­tion), an in­creas­ing pop­u­la­tion of en­trepreneurs in the busi­ness mix and the con­sen­sus es­ti­mate of an im­prove­ment in GDP for the en­tire re­gion of up to 3.6 per cent in 2018 are all rea­sons to in­vest in the re­gion.

We are look­ing at a ma­ture, dy­namic and evolv­ing mar­ket ready to ab­sorb pri­vate eq­uity in­vest­ments.

The oil price decline has forced pri­vate eq­uity firms to seek al­pha in non-oil in­dus­tries

Vic­tor Besa for The Na­tional

Pri­vate eq­uity in­vest­ment is not lim­ited to con­ven­tional com­pa­nies. Apps such as Ca­reem, above, also re­cieve fund­ing.

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