The growing need for alternative sources of credit financing in the Middle East
In Western Europe, the US or even parts of the Far East, private equity investments are made with a combination of equity and debt. Thisdebt financing will either be in the form of a loan (senior bank debt, or mezzanine or subordinated debt) or by using the capital markets, such as high yield bonds. In some cases, both instruments are combined.
In the MENA region, on the other hand, PE investments are typically fully equitised, such that only their fund investors’ money is invested, not a combination of debt and equity.
As for mid-sized corporates, regional banks still apply lending practices based on the value of the company’s underlying assets over which they can take security (usually a mortgage) when sizing a loan. As such, regional banks tend to give limited options to companies wishing to grow once they have reached an arbitrary loan to value lending limit.
Regional banks that do have the capital to lend to PE or corporates will typically prefer to finance their home clients rather than those from abroad, even within the GCC.
International banks, meanwhile, started a pronounced retrenchment to their home markets in 2008/2009 and with the exception of a few names, are now adopting a wait and see approach and only extending selective facilities to governmental agencies. Forthcoming Basel III capital requirements, meanwhile, are likely to restrict banks’ appetite further still.
Why is this the case and why does it matter?
There are some peripheral reasons for this situation like the lack of tax shield in the region that makes debt less attractive here than in countries with higher levels of interest taxation.
However, in our view the main constraint on PE and mid-size corporate financing is not due to the lack of demand but more the limited supply of sophisticated lenders. This is because when either of these clients seek expansion finance in the form of an acquisition or a capex plan from lenders, these will need to take a view on future cash flows rather than rely mostly on the present situation of the borrower.This approach is not widespread enough in the region and so the banks are likely to decline to finance.
The route to success for lenders, we believe, is to quantify the future financial benefits of the proposed expansion plan and then carry out confirmatory due diligence on the borrower’s financial and commercial prospects.In short, ascertain whether the growth plan generates enough additional free cash flow to repay the loan or bond under a realistic scenario (cash flow approach) rather than determine whether a mortgage on assets will give the lender sufficient asset coverage (asset approach).
Why does this matter? Put simply, less sophisticated asset lending approaches are holding back regional entrepreneurs’ growth and making PE investments less profitable than they could be.
For example, a strong corporate with few tangible assets available to mortgage but with high margins and limited debt will struggle to borrow from regional banks despite being potentially a good investment. Similarly, a corporate seeking to invest in earnings-enhancing capex that does not involve making assets available to pledge to banks will find limited appetite from regional banks.A cash flow lender would look favourably at these investments.
For PE, an investment mixing debt with equity will generate a much better IRR than one using only equity. This should matter to fund investors.
Gulf Capital Credit Partners has just launcheda new Abu Dhabi-based $300 million regional credit fund focusing on bringing much needed liquidity to PE and faster growing companies. Investments from this fund will be carried out using the more sophisticated cash flow investing approach described above. Investments will therefore be tailored to the specific needs of borrowers and PE financial sponsors.
The fund will also be able to invest on longer maturities than those seen in the market currently and be able to lend in loan or bond form across the MENA and Turkey region.Investments will cover a wide spectrum from traditional senior debt through subordinated debt such as mezzanine and extend to preferred equity, if needed.Investors in the credit fund will get the benefit of attractive, income generating yields with downside protection.
Ultimately, the MENA finance industry will mature and more innovative and sophisticated financing solutions will be developed to meet the growing financing needs of both corporates and PE firms. This is line with the development of the regional private equity industry and in line with trends seen in other emerging markets such as Asia.
Christopher Baines and Walid Cherif are the Managing Directors and Co-Heads of Gulf Credit Partners.
© Banker Middle East 2011