Market analysis: Mix of debt and equity takes the best of both

Private equity funds have changed their formula and reallocated capital to the consumption side of the economy spanning education, health care and food and beverage, among others.

Private equity investments in companies such Careem are effectively leveraging technology and redefining the market. Victor Besa for The National

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.

Richard Clarke heads the Deal Advisory practice and leads the sovereign wealth fund and private equity sector team for KPMG Lower Gulf.

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