Cashing in

The popularity of the Dana Gas IPO with Saudi Arabian investors should not come as a huge surprise. People in the Kingdom have seen the local index hit 17 000 points – double its value two years ago. And 2004 was no lean year for capital markets in Saudi Arabia. Elsewhere in the region too, stock markets have risen sharply in the last two years, although some markets are going through a correction phase.

Investor interest in the region is at an all time high and private equity has emerged as a new option for companies seeking growth capital in the region. Abraaj Capital, a leading PE firm in the region, has recently closed a US$500-million fund. It manages over $1 billion in assets. Shuaa Partners, the PE arm of another reputed investment firm, Shuaa Capital, closed a $200-million fund.

According to estimates by Abraaj Capital, there are 27 PE players in the region that had a total of $2.3 billion under management by 2004. Last year, the private market grew by over 100%, adding another US$2.7 billion.

Banks too are changing their ways, albeit very slowly. Traditionally, only large projects with a solid asset base were financed. However, a few are now beginning to look beyond asset-based financing.

“There is shift to cash-flow based financing,” says Abe Saad, managing director of Shuaa Partners. He adds that the shift is slow and selective with only a handful of banks comfortable with the idea of lending money without having enough assets as collateral. “It takes a different mindset to fund cash flows instead of lending against assets,” says Arif Masood Naqvi, executive vice-chairman and chief executive officer of Abraaj Capital.

Even taking account of the slow nature of this shift, it is still a big step forward when it comes to funding in the Middle East. The chief sources of capital in the past were wealthy families and high net worth individuals (HNWIs). As a result, options for CEOs in the Middle East seeking growth capital have widened.

Today, a company that has a solid track record, can go for an IPO or raise money from PE investors. CEOs no longer have to rely solely on having access to HNWIs. However the second option was often simpler. As money was raised from several individual investors, no single individual held sway over the company. The relationship worked more on a basis of trust
than modern governance systems. All of this gelled well with the culture in the region.

New options bring their own set of issues and challenges. Some of these are a consequence of the culture, others the result of underdeveloped capital markets. For instance, in Saudi Arabia, only 77 companies are listed. Many other exchanges in the region have poor liquidity. Few stocks are traded regularly.

Control, or the fear of loss of control, is another issue. Transparency and corporate governance practices also need to be put in place if a CEO wants to take a company public,
or raise money from PE investors. Yet, for companies that have come some way, stock markets offer a great way to create value for their investors and even build their brand name. It is natural that such companies would want to capitalise on the current mood in the region.

But the decision to go public is not a simple one. And it should not be taken overnight just because markets are buoyant. “The management needs to have a certain maturity. It’s a huge responsibility. These things take time and they can’t be learnt overnight,” says Saad. He points out that, in many companies, the family takes decisions, over lunch or evening meals. “You can’t do that once you are listed. They have to go through a learning process about decision-making. They have to be careful about what you can say and what you can’t. It can impact your stock price,” he adds.

So for CEOs in the Middle East who have got used to the fast-paced development of businesses in the region, the question is an obvious one. How long does it take to get ready for an IPO?

For Bahrain-based Jawad Group, preparations began five years ago. It recently took Jawad Fashions public. “The preparation for IPO went through stages. We are talking about five years. A lot of things have to be put in place. You can’t go public overnight. We did some restructuring three years back. A special purpose vehicle was created – it is this that is being taken public. So we have three years of actual results to show,” says Faisal Jawad, chief executive officer of Jawad Group.

For Jawad, IPO was the second stage in raising capital for expansion. Earlier, in January 2005, the company had brought in a PE investor. It had given a 30% stake over to the third party. “It was all part of what we wanted to do in the future [the IPO]. As we went public we were issuing new shares and the investor too was selling part of his stake. It also helps in increasing the comfort level of the public – if they see others have backed the company,” Jawad says.

So why go public at all, especially when the Middle East has one of the highest concentrations of HNWIs anywhere in the world?

“What option you choose depends on the purpose for which you are raising money,” says Jawad. “There were several reasons for our IPO and the obvious one was to finance growth. But we also wanted to create value for our shareholders. Having a wider base of shareholders also helps raise the awareness of your brand,” he adds.

While going public was undoubtedly a tough decision for the family owned Jawad Group, the other key choice was where to list. Bahrain, which has not seen many IPOs, had the appetite. It also had the bonus of being home territory but Dubai has more depth and liquidity. Being a Bahraini company, Jawad Fashions has listed in Bahrain but Jawad is aware that the local stock exchange is not as evolved as Dubai’s where he eventually intends to list.

Chief executives that see an IPO as a quick way to raise cash should also be aware that there are costs attached to listing. The process itself can cost anywhere between 3% to 5% of the money being raised.

Investment bankers also need to be paid and the issue has to be promoted. Above all, during the run-up to the listing – for a period of at least three months – the senior management should be completely dedicated to the project. Therefore, CEOs looking at the listing option need to ask whether they have reached the level of maturity where so much of the top management’s time can be spared.

Besides, norms at certain exchanges tend to impact control. “If you list on Dubai Financial Market (DFM), then you need to put 55% of your company up for sale. Some have issues with that. There is a risk of losing control. Of course, there is the DIFX which allows a minimum of float of 25%,” says Saad.

However, listing has its advantages for companies with mature systems and a profitable track record. It raises the profile of the business, which in turn helps it attract better talent and create brand awareness. If it does well on the stock market, the company can also use its stock as acquisition currency.

Abraaj Capital’s Naqvi cautions against getting too excited by stock markets. “I think this whole euphoria over IPO markets is overblown.

How many companies have actually listed? Ten or 20? That’s a drop in the ocean if you look at the region as
a whole,” he says.

Booming stock markets may not have added depth but they have certainly brought in new PE players. Traditionally, there has been a bias against PE as it comes with strings attached and its investors seek a far more active role as well as an often substantial say in the key decisions of the company.

“Many family-owned businesses have been reluctant to part with absolute control they have enjoyed thus far. Culturally too, taking money from a stranger is considered somewhat of a taboo,” says Walid Musallam, president and chief executive of Middle East Capital Group, a Lebanon-based merchant and investment banking firm.

PE investors look for opportunities that deliver healthy internal rates of return, usually in excess of 25%. Abraaj Capital, for example, claims an IRR of in excess of 30% on its first buyout fund.

Companies in mature profitable industries such as chemicals, retail, logistics and power with high entry barriers and a good distribution infrastructure are considered attractive.

Businesses with cyclical cash flows are avoided. And of course, everyone wants strong, highly motivated management teams.
The advantages to having a PE investor on board are numerous for CEOs. Markets look more favourably towards companies that have raised capital from these investors in earlier rounds so it is generally easier for these companies to go for an IPO.

There are obvious reasons for this. Professional investors such as PE players demand a much higher level of corporate governance.

“Most family-owned businesses, which have taken the decision to take the business to the next level, have to be realistic about what they can and can’t do. They have to open their books…go in for due diligence,” says Saad.

PE partners rigorously monitor companies on various levels and as a result, create a comfort zone for investors, as they feel reassured when they see the experts backing a particular business. Furthermore, companies with funding usually end up learning to build systems that can accurately predict the financial future– a competency that is a must for any chief executive wishing to take a firm IPO.

In fact, most investment bankers warn against rushing to markets without adequate preparation. If you can’t forecast your immediate future, you are better off staying away from stock markets. Otherwise, the stock is likely to get hammered, or might just not receive an adequate level of funding.

While stock markets may not work for all CEOs looking to raise capital, PE is ideal for those that have a proven business model. There is a predictable revenue stream and the management is seeking to take the company to the next level. This could involve entering new markets or an expansion plan that requires substantial capital.

Usually, PE investors are very good at maximising shareholder value. They are also good at ensuring transparency and prudent financial management.

This makes them ideal partners for any CEO running several businesses, and also who may want to partially exit some of these.

It’s a market ripe for growth, according to Naqvi, especially for family businesses where heirs are looking to break up conglomerates to ensure they each receive their own part of the business to run. He cites the example of Europe, where family businesses went through a wave of corporatisation in the 1980s and 90s in tandem with PE investors. Currently, stock market stipulations, which require companies to list 50% of their equity, is a major barrier to such deals as owners are wary of losing control.

Globally, data monitoring the performance of PE capital has
shown that companies that went public after taking PE funding delivered an average return of 29%, while those without it posted only 15%.

The downside to taking money from PE firms is that their final objective is always to find an exit route and so they may force choices, such as selling a majority stake to a strategic investor who may want to take over the management.
But Naqvi, whose firm has made 22 exits in the past 10 years, says promoters should not worry. “We never had any problem. You need to have a clear understanding of the goals right from the beginning,” he says.

In the absence of a serious venture capital industry, or plentiful support from conservative banks, PE could become a major growth driver in the region.

Finally, if a company has a decent asset base, or a history of positive cash flows, debt is always an option and can be the best choice from an owner’s point of view.

While banks nowadays also insist on a certain level of transparency, the demands are nowhere as tough as those that stock markets or PE investors make. Unless things go horribly wrong, banks usually do not intervene in the day-to-day running of the company.

Currently, only international banks provide loans on the basis of cash flows. But the situation, for companies in some countries, is slightly more encouraging. “Banks in Morocco and Jordan do lend to young companies. Saudi Arabia too has created an institution which provides up to 75% of start-up capital,” says Naqvi.

Perhaps the most important benefit of debt financing is the fact that owners do not need to dilute their shareholding in the company.

For CEOs looking for funding, neither debt, PE nor an IPO stand out from the crowd as the best way to go. In reality, a company will take different routes to raising money at different stages of its growth. Each of these measures demands a certain level of preparedness.

Servicing debt requires free cash flow. PE demands robust growth and transparency. And stock markets hate unpredictability.

The choice must ultimately depend upon a company’s readiness to meet expectations and to what level it sets its risk strategy.||**||