Nicholas Pettifer
Staff writer

With large Middle East private equity houses such as Delta (Two), Dubai International Capital and Istithmar making waves in the west, it is only a matter of time before more regional outfits attempt to do the same.

Admittedly, none of the regional players is actively seeking targets outside of the GCC at present. It seems they are satisfied with competing locally and the market is thriving as a result. For example, in June this year Abraaj Capital bought Egyptian Fertilizers Company for $1.41 billion in a deal that was executed on the Cairo and Alexandria Stock Exchanges. This was the largest private equity transaction ever to take place in the Middle East and north Africa.

But it is almost inevitable that, when they are more established and sophisticated, many more Middle East private equity houses will look overseas. When they do, they will need to prepare themselves well in advance for a number of hurdles. Whether they are political, business or cultural issues, the differences from the local market will require foresight and preparation. Apart from learning how to execute a deal from out of a suitcase, which hurdles should be feared and what can be done to ameliorate them?

Risk of protectionism

This is probably the hardest challenge that novice private equity houses from the Middle East will have to face. Unfortunately, it is also the hardest to detect and plan for. This is because protectionism is not necessarily found in a formal document. Frequently, it is in more subjective areas such as politics and nationalism.

State-linked funds will suffer from protectionism the most. "There is a neurosis in certain parts of Europe and the US on how to regulate sovereign wealth funds," says Bruce Embley, head of Freshfields Bruckhaus Deringer's corporate practice in the Middle East. "They want greater disclosure and often have second thoughts as to which asset classes should be under the control of sovereign funds."

If your target company or its national government does have concerns, then it is essential that you can explain to them that you are not a sovereign wealth fund. And if you are, you need to lobby hard to prove that they should not be worried. In either case, endearing yourself to the management of the target is always a good idea. Whether this includes complying with extra disclosure requirements or not is another matter to consider.

But any government will think of blocking the wrong type of fund going for the wrong type of asset. Even the UK's Chancellor of the Exchequer, Alistair Darling, backed the G7's move to toughen its stance on sovereign wealth funds in October this year.

"What I am clear about is that when a company is not acting in a commercial way or we have reason to believe that it is going to make an investment where there is an issue of national security, then we have powers to take action," he said.

Yet this does not apply to all private equity houses, and Embley thinks that stances could change with time: "Attitude to sovereign wealth funds will evolve as the political landscape does," he says.

This is the fundamental problem with most protectionism at the moment. It is subjective, with no way of predicting where and when problems may arise. The only option is to be prepared from the outset, to be aware of previous political or legal decisions and to have contingency options.

It used to be a lot clearer. Protectionism often came in the form of legislation or regulation. But the European Commission is clamping down on such rules and even in the US the process is not as burdensome as one might expect. The furore over Dubai Ports and CFIUS (Committee on Foreign Investments in the US) suggested that Middle East funds would struggle to buy assets on the other side of the Atlantic.

But CFIUS has not proved to be that challenging a hurdle. "CFIUS is not onerous: if you are organised from the beginning and have nothing to hide, then you will be fine," says Allen & Overy partner Pervez Akhtar. "DP World didn't put people off. They embrace CFIUS and realise that it's just a change from the way things were done in the past."

Debt structures

"Leverage is more complicated in western buyouts. The leverage tends to be higher because prices are generally higher. This means more debt, more structuring and more inter-creditor relationships," says Tom Speechley, executive director in the investments department of Abraaj Capital. "Also returns in this part of the world are more often a function of operational improvements and organic growth rather than financial engineering and leverage, as seen in the west."

This is certainly something that private equity houses from the Middle East will have to grapple with. By all accounts, it is a big step-up to arrange debt and manage leverage on an international scale when used to simpler, local funding in the Middle East. This may prove more of an issue for some regional investment vehicles than would reasonably be expected. One private practice partner reveals that: "A lot of Middle Eastern private equity players don't use debt at all. I find this bizarre."

Again, this hurdle can be overcome by planning. It is essential to have the financing arranged in advance. You need to talk to your banks to make sure that the debt is priced and the money is available. It is crucial to be organised internally, so that the banks' requirements have been considered and their terms are understood.

But Embley warns that it may not be as simple as this for players investing in the west for the first time. "Preferential debt will put you at the top of the tree," he says. "Without the same relationship with large EU or US banks, some new entrants (Middle East or otherwise) may find it harder to obtain debt at the same level or same cost as other players in the market."

Indeed, it will take some time to reach the level of sophistication that the large US private equity houses maintain. Agreed preferential terms, standard form documents and the like are desired, but may prove a long-term aim.

Tax issues

A number of Middle East players operate in a low or zero tax environment, so a cross-border deal in Europe would create challenges. It would certainly take time for an average regional private equity house to understand a structure that incorporated many tax systems. But often time is short. A deal may be lost to rivals if there is too much time spent procrastinating over tax.

"Different tax systems can create real challenges to structure the transaction in the most efficient way," says Embley. "Some Middle Eastern players may not have the same experience of this as others more used to different tax systems."

The key to cracking this issue is to establish an experienced tax team before launching bids in the west. Ensure that you hire the right people that can explain relevant tax systems and the implications they will have on the pricing and structure of your investments.

Consortium building

In a need similar to that of building a relationship with the banks to secure debt, Middle Eastern private equity houses must also be adept at building consortiums for club deals.

Inevitably it will be harder for them to build a consortium with the big European or US players and hedge funds. The western market is made up of deep relationships between private equity houses that create familiarity. As a result, if a consortium needs to be built quickly to tie up a transaction, the risk of going into partnership with competitors is lessened.

This is something that will take time to overcome, and in many ways it is akin to the protectionism issue. Middle East private equity houses will have to prove their intentions and the value of what they have to offer to potential consortium buddies. Whether this proves easier or harder than proving a similar thing to target companies and governments is difficult to predict.

Auction process

"Auctions are not anywhere near as widespread in the Middle East as they are in Europe. The M&A landscape is not as well developed or competitive," says Speechley.

This is a major obstacle for Middle East private equity houses looking to the potential of the west. Auctions are commonplace in the US and Europe, so a thorough understanding of their process is a primary requirement. Otherwise, there is a danger that the transaction is drawn out and eventually lost to a competitor.

"You need to sniff around in round one, enter the data room in round two and look to win the deal in the next round," says Akhtar. "It's like a job interview: endear yourself to the management team, answer its questions, make sure you ask some back and look like a bright boy. You need to be able to take a view on issues, reassure where necessary and get to a point where you can execute."

But Akhtar warns to be careful of representations and warranties. He says that in a western auction, the cap (or amount you can claim back from breaches of pre-contract agreements) can be as low as 5%. If a private equity house from the Middle East is used to a cap of 100%, it needs to be sure that it can handle such a difference. Also, the level of cover for representations and warranties is typically two to three years. In an auction, it is usually only 12 months.

Lessons

The ongoing theme is preparation. Whether it be to hire a tax team, strategise counters to protectionism or build links with western banks, being thorough and organised from the beginning is essential.

Once these issues have been overcome and a house is on to its second or third step in the west, the path becomes easier. For example, only last month Dubai International Capital took another step towards heavyweight status by appointing former heads of BMW, GlaxoSmithKline and Sony to sit on the advisory board of its global strategies equities fund.

Helmut Panke, Jean-Pierre Garnier and Nobuyuki Idei, of those companies respectively, will go a long way to securing a reputation in the market for Dubai International Capital. This is proof that even when you have avoided the pitfalls of breaking into the west, preparation remains the key.