Awash with petrodollars, the region is reinventing itself through iconic real estate development.
With the Middle East needing to find billions of dollars to fund infrastructure projects, governments are hoping private investors will dip into their pockets.
The Middle East is experiencing a new golden age. Awash with petrodollars, the region is reinventing itself through iconic and ground-breaking real estate developments, opening its arms to welcome foreign investors and residents alike.
It is repositioning itself on the world stage as a hydrocarbon-rich powerhouse that retains its religious and cultural heritage, yet also knows how to have fun. But there is an ominous threat overhanging the region that could derail everything.
The explosive industrial, economic and population growth is putting tremendous pressure on critical infrastructure, such as power, water and wastewater networks. Utility companies are facing an uphill struggle to keep pace with the developers and there is a very real possibility that the region could be hit with a power and water crisis.
Already, industry observers are forecasting that electricity demand will overtake generating capacity in the next couple of years, leaving GCC countries with up to a 35% shortfall in supply by 2010. Without these essential utilities, the Middle East will grind to a halt.
Estimates say the power industry in the Middle East, North Africa and South Asia (MENASA) region needs US $155 billion worth of investments over the next 10 years in order to match consumption growth. The figure for the water and wastewater sector is slightly lower at US $133 billion.
These are huge sums for governments to find, even with their oil-driven budget surpluses. So, increasingly, they are pinning their hopes on private sector capital to relieve some of the burden.
Private sector involvement does not have to be limited to established international utility firms participating in greenfield projects and buying up and expanding divested state-controlled assets.
There are also plenty of financial institutions with potentially millions of dollars to invest, and over the past year their interest in the energy sector has noticeably increased, spurred on in large part by several countries amending laws governing private and foreign asset ownership.
The power sector, in particular, is attracting much attention due to the broad scope of involvement it offers, such as independent (water and) power projects (I(W)PPs), renewable energy schemes and also the potential for electricity and carbon credit trading.
A number of investment banks have set up funds targeting the energy and infrastructure sectors. Among them, Abraaj Capital, which jointly with Deutsche Bank and Ithmaar Bank, has launched a US $2 billion infrastructure and growth capital fund for the MENASA region. The fund will focus on the key areas of power, water, healthcare, education, transportation, petrochemicals and mining.
Abraaj says investment opportunities would include taking controlling stakes in newly privatised companies as well as partnering with international and regional firms in power and water projects. It is already eyeing privatisation opportunities in power sector in Oman, Saudi Arabia, Jordan, India and the UAE.
Similarly, Creative Energy Resources (CER) is an energy investment company that was set up specifically to capitalise on the opportunities in the power sector. It is owned by Saudi private equity vehicle Swicorp Joussur, which provides the capital for CER to develop and acquire projects.
"The idea of CER is that it will be a platform for a regional power company that will own and operate and acquire power plants in the MENASA region and we will be involved in not only conventional thermal power plants, which is what we are starting with, but also we will be looking at investments and projects in alternative energy, such as wind, solar, biomass and so on," explains the company's CEO Shahzad Qasim.
The firm's management team has a wealth of experience in the power industry. Qasim himself developed three IPPs and two IWPPs during his years with energy giant AES. CER recently bought an 18% stake in a 586 MW power plant in Pakistan from GE Capital.
"We aim to invest about US $500 million in equity over the next three to five years," he adds. "The acquisition in Pakistan is the first asset we have acquired. And we are looking at some projects in Turkey, Saudi Arabia, Algeria and Oman.These projects are conventional, either gas or oil fired plants, or hydro projects in Turkey, Pakistan and India."
He says ultimately the company hopes to be able to participate in IPPs: "Governments are creating the framework for the private sector to enter in a big way. The story is the tremendous increase in demand and the resources that will be needed to be deployed to meet that demand. I think is a very exciting story for the power industry and it provides great investment and growth opportunities.
"In the next couple of years, we should be able to pre-qualify for some of the larger projects. Initially, we will probably look to partner with some of the more established players where we bring development and financing expertise. We are also looking at distribution as an opportunity, most likely networks that are set up already and these would really be opportunities for privatisation, we would then expand and invest in them."
Qasim sees investment potential throughout the MENASA region: "It depends on what part of the economic cycle these countries are in, some countries though like Pakistan, India and Bangladesh just by the sheer volume of growth provide great opportunities.
"But countries like Saudi Arabia, for example, even Turkey, they are also there, the growth rates might not be as high on the Indian subcontinent but they have stable governments and less perceived risk, so the idea would be to have a broad exposure and balanced exposure on all markets."
As for private equity companies, due to the nature of their business model, their involvement in the utility sector would most likely be limited to buying majority shareholdings in technical services companies and pre-IPO (initial public offering) plays.
Private equity firm Gulf Capital admits it will only be investing a small part of a US $500-700 million fund that it is currently raising in the utility sector.
The company's energy principle Wassim Assad explains: "As a private equity firm we wouldn't look at providing financing for projects, we always provide equity, so it is a partnership rather than lending money. Our involvement on the utility side will be limited because firstly, the projects are big infrastructure projects that require a huge amount of money, equity and loans to be invested."
"Secondly, the returns on these projects are below the returns that a private equity firm would be looking at. Thirdly, the holding period of these kind of projects is usually long, for instance when you look at being part of an IPP or a water utility provider, this is a long-term investment again with lower returns than what a private equity firm would be looking for," he continues.
"So our interest in that sector would be limited. Most of our fund will be geered to oil and gas. If you look at all the private equity firms in this part of the world on average they look at between 25-35% in terms of return and obviously these infrastructure projects will be in the teens as a percentage of returns," Assad says.
"And always when you look at private equity investment, we enter into an investment with a view to exiting a few years down the road, this is how we monetise our investment and with these kinds of projects it is difficult to do that.
"A liberalisation of markets would help to energise the sector for sure, with less subsidy on the part of the government, but again the size of the projects and the term of the projects will still make it difficult for private equity firms to enter, unless you enter into a vehicle or a company that you know will go public in two or three or four years time and you can monetise a bit of your money at that time. At the end of the day private equity firms look at the returns for investment."
"What would be attractive to us as a private equity firm probably would be the players or market participants who are involved in providing the services to these projects, for instance suppliers of all sorts of equipment, EPC contractors, water treatment and desalination contractors and operators, the same for the power side and renewables eventually, as it is still a very small market in the region here.
These will be the attractive markets for us and again we will have to pick the players that do not require significant investment, I am talking not in the billions of dollars because that would be beyond our interest basically."
As part of that strategy, last year, Gulf Capital bought a 60% stake in water engineering firm Metito. It plans to grow the company through an aggressive business development and acquisition programme before listing Metito on a regional stock exchange by 2010.
District cooling companies are another utility target for investors which promises healthy returns. As with power and water, demand for district cooling is on the rise and the industry is estimated to be worth some US $10-30 billion over the next 10 years.
Last year, Dubai-based GCC Energy Fund bought a 50% stake in joint venture Stellar Energy MENA, which provides cooling and turbine inlet chilling for power plants. Deterrent factor
But according to Paul Navratil from Deloitte & Touche Middle East most investors are still toying at the margins of the utility sector and have yet to get fully involved.
"Right now the thing that we are seeing on the utilities side is the funds and banks and private capital are more getting ready to enter the market than doing actual anything," Navratil says.
"There is still a big distinction between operating capital and financial capital, most of it right now is in the financing part, they are putting their stake in the ground and claiming that they are here. In the oil side, it is completely different, these private equity companies are involved mostly in oil field services, supplying material or services and we are getting a lot of requests to do concrete things.
"From the operational standpoint, they need to partner with people that have access to the right technology, and, more importantly, the human factor. Most of the interest right now from these groups is in renewables and that seems to be the easiest part to penetrate. But with the amount of power plants and the amount of funding needed it is not a surprise they want to get involved."
So what is deterring them?
"The rules aren't there to allow people to define their operational space," Navratil comments. "If someone wants to build a power plant or to offer some kind of service to a utility the pricing mechanisms aren't necessarily set that right now people can understand exactly what the returns are going to be.
For someone coming from Europe or north America it is a completely different ball game because they might be looking to set up a merchant power plant for example or to build something based off a power purchase agreement, this is the typical model, but here the market rules are not yet set up, although I do see that coming."
"There needs to be a market mechanism or market rule to suggest how they can operate in that space, right now it is at best a purely regulatory environment where you might get some type of return fixed but most people know that return is not "competitive" if you compare it to other markets with these types of supply and demand indicators. A fixed return over the lifetime of the investment here will be about 8-10%," he adds.
But Qasim disagrees: "As long as the power offtake prices reflect the reasonable cost of production plus the cost of financing, investment in the power sector will be viable.
In terms of the retail price of electricity being subsidised by various governments that could put into question the viability of the distribution companies, but as long as there are sovereign guarantees behind the power purchase agreements I think we can work around that issue.
While the oil, gas and petrochemicals industries may remain the favoured sector for private equity firms looking to make a fast return, long-term purchase agreements provide predictable revenue streams and make developing, financing and acquiring power facilities a sound investment.
With the region in desperate need of billions of dollars worth of investment in order to keep functioning, governments will be hoping investors can recognise this true potential.
Afterall, with plans to interconnect the Arab and European grids already being discussed, deregulation and free participation in energy spot markets could be just around the corner. So now might well be a good time get hold of some assets.
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