Islamic Private Equity

Arab Economic Forum

May 2006

By: Khaled Hassan Rashed

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Private equity provides long-term, committed share capital, to help private (unlisted) companies to grow and succeed. It can be used to develop new products and technologies, to expand working capital, to make

acquisitions or to strengthen a company’s balance sheet.

What is Private Equity (PE)?

Key Elements

Investments in unquoted companies

Equity Capital by nature Targeted at companies with

growth potential Medium to long term investment

Categories

Buyouts Venture Capital Growth Capital

Angel Investing Mezzanine Capital

Source: Abraaj Capital Analysis

Exit

Consolidation

Maturity

Expansion

Early Stage

Buyout

Venture Capital

Private equity investment helps in nurturing young companies throughout various stages of growth as per the diagram below:

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PE Has Outperformed the Other Asset Classes Over the Last 20 Years

Current Industry Size

• The current regional PE industry size is less than USD 2.0 billion;

• The regional allocation to PE ranges from 0-5% with only a fraction in the region.

Value for investors

• Investors can achieve supernormal returns on their PE investment in the region.

Choice of Fund • Investors should choose funds with a credible performance track record and a strong management team.

0

10

20

30

40

50

60

70

80

901st Quartile Venture

1st Quartile Buyouts

US Large Stocks

First Quartile PE firms have consistently and significantly outperformed the US large

stocks for 20 years

Source: Venture Economics

4Sources: Start Consult Analysis

Screening & Selection Screening & Selection

Deal Sourcing

Deal Sourcing

Investor RelationsInvestor Relations

Industry expertise and credibility

Networking

Communication & presentation

Trust building

Responsiveness

Industry analysis

Market intelligence

Contact management

Data gathering

Structured problem solving

Communication

Industry analysis

Company analysis

Financial analysis & modeling

Process management

Organization & corporate governance

Process & operations

Management accounting

Private Equity Value Chain

ExitExit Portfolio Management Portfolio

Management

Legal structuring

Financial structuring

Documentation

Process management

Structuring & Execution

Structuring & Execution

Legal structuring

Organizational structuring

Financial structuring

Documentation

Process management

Core Skills

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Potential for Private Equity value creation

Low degree of

intervention

High degree of

intervention

required

Passive ownership

Financial engineering/leverage

Financial engineering/conglomerate break-up

Strategic re-positioning of single company

Consolidation through ‘bolt-on’ acquisitions

•Leverage management incentive systems and influence through board representation to create value in portfolio company

•Across industries, owner-driven companies with strong but non-incentivised management

•Acquire under-valued company to generate value through leverage as well as arbitrage between entry and exit multiples

•Companies with potential strategic buyers

• Industries with stable cash flows and heavy assets

•Create arbitrage by divesting separate divisions of conglomerate to distinct strategic buyers and reducing the conglomerate discount

•Expat-owned mid-sized conglomerates due to higher trader mentality and financial pressures

• Improve market value through new strategic focus, re-branding and improving key operational levers

•Companies with under-utilized products and/or strong market position across industries

•Acquire platform company and expand/diversify by acquiring similar companies through leveraged build-up

•Most industries with private ownership fragmented

•Focus on high potential company to serve as platform

OpportunityLevers

Source: Abraaj Capital Analysis

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Islamic Private Equity

Shari’a Principles: The diagram below illustrates the Shari’a principles guiding investments:

Musharaka-

shared risk &

reward

Real goods &

services

Non speculative

Ethical*

33% leverage

cap

Interest free

Alignment of

interests

Equity

investment

The

Principles

* Investments in financial services, tobacco, breweries and cinemas are examples of non acceptable industries to investment in according to Shari’a ethical guidelines.

Source: Abraaj Capital Analysis

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0

20

40

60

80

100

120

140

160

180

<19941994 1995 1996 1997 1998 1999 2000 2001 Feb.2006

- Islamic financial institutions worldwide has risen from 1 in 1975 to over 300 in more than 75 countries. - Islamic financial institutions worldwide has risen from 1 in 1975 to over 300 in more than 75 countries.

- Total assets and financial investments of the world’s Islamic banks are estimated to stand at US$ 262 billion and - Total assets and financial investments of the world’s Islamic banks are estimated to stand at US$ 262 billion and over US$ 400 billion respectively. They are estimated to grow at a rate of 15% annually over the coming years. over US$ 400 billion respectively. They are estimated to grow at a rate of 15% annually over the coming years.

- The Islamic equity- The Islamic equity funds worldwide total assets is currently estimated over US$ 5 billion and is growing at rate of funds worldwide total assets is currently estimated over US$ 5 billion and is growing at rate of 12-15% annually.12-15% annually.

Source: www.failaka.com , Abraaj Research Database & Zawya

Growth in Number of Islamic FundsGrowth in Number of Islamic Funds

Islamic Finance has slowly ventured into the Private Equity industry despite the significant growth in the industry as a whole.

The Islamic Space is still missing out on several high return areas due to limitations that can easily be overcome by creative structuring and innovation. PE is one such area.

Islamic Finance & Private Equity Industry

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Islamic Banking Assets & Global Sukuk

Total Global Islamic Banking Assets - (US$ billion)

80

190

262

500

1996 2000 2003 2005

CAGR 38%

Islamic Banking Assets in GCC - (US$ billion)

33

38

46

2002 2003 2004

CAGR 18%

Global Sukuk Issuances - (US$ billion)

2

7

10

8

2003 2004 2005 YTD 2006

CAGR 129%

Islamic Debt by Country (Feb 05-Feb 06) - (US$ million)

61 80 134 200500

42504710

Source: Islamic Finance News Feb 2006, Mckinsey, E&Y

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Private Equity is a natural fit for Islamic Investments

Source: Abraaj Capital Analysis

All IndustriesAll Industries

Equity InvestmentEquity Investment

PE ConceptPE Concept

Partnership- shared risk & reward

Partnership- shared risk & reward

Long Term ValueLong Term Value

Alignment of Interests

Alignment of Interests

Islamic PE ConceptIslamic PE Concept

Shari’a Compliant IndustriesShari’a Compliant Industries

Equity InvestmentEquity Investment

Musharaka- shared risk & reward

Musharaka- shared risk & reward

Long Term ValueLong Term Value

Alignment of Interests

Alignment of Interests

Favorable

Unfavorable

Natural FitNatural Fit

10

Sources: Start Consult Analysis

Screening & Selection Screening & Selection

Deal Sourcing

Deal Sourcing

Investor RelationsInvestor Relations

Industry expertise and credibility

Networking

Communication & presentation

Trust building

Responsiveness

Industry analysis

Market intelligence

Contact management

Data gathering

Structured problem solving

Communication

Industry analysis

Company analysis

Financial analysis & modeling

Process management

Organization & corporate governance

Process & operations

Management accounting

Islamic Private Equity Value Chain

ExitExit Portfolio Management Portfolio

Management

Legal structuring

Financial structuring

Documentation

Process management

Structuring & Execution

Structuring & Execution

Legal structuring

Organizational structuring

Financial structuring

Documentation

Process management

Core Skills

Adhering to Shari’a Principles

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The Fund Structure

Limited PartnerPE Firm

Partnership

(the Fund)

Investments

$$$$

Mgm

t. Agreement

Mgm

t. Agreement

Mgm

t. Fees, Carried Interest - closed-end fund with a finite life ScreeningScreening

Due DiligenceDue Diligence

Post Acquisition MgmtPost Acquisition Mgmt

ExitExit

Source: Abraaj Capital Analysis

The private equity & Islamic private equity fund structure are essentially the same, however the Islamic PE funds will be Shari’a complaint such as type of investments, industry, etc.

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Islamic Private Equity Value Proposition

Islamic investors should apply the model of private equity firms whose strategy evolves around taking majority stakes in privately held companies engaged in the real economy. This will enable them to maintain control, which

ensures the company’s adherence to Shari’a principles.

Better value proposition compared to other assets classes in terms of:

Value Proposition

• Performance

• Diversification

• Higher long term returns

• Price stability

• Lucrative investment opportunities

• Sharing risks & rewards

Source: Abraaj Capital Analysis

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Islamic Private Equity Issues

Governed by Shari’a principles, the parameters set for Islamic Private Equity investors will cause:

• Increase in research costs compared to conventional counterparts.

Islamic PE Issues

• Specialized skill set needed to screen, evaluate, negotiate, execute, manage and create value, sourcing commercially viable deals that are Shari’a compliant and structuring them

accordingly is a very exhaustive task.

• Holding a majority control in companies to ensure their compliance to Shari’a principles on a continuous basis and maintaining a diversified portfolio become a challenge for Islamic

investors with small amounts of capital to invest.

To address the issues above, the concept of creating Islamic Investment Funds was cleared in accordance with the definition and parameters set by the Accounting and Auditing Organization of the Islamic Financial

Institutions.

Source: Abraaj Capital Analysis

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Perception

Breadth of Products

Fee Structure

Distribution Channels

Marketing challenges faced by Islamic Funds

The number of Islamic products and innovative Islamic structures is very limited compared to conventional products.

Islamic product providers charge premiums due to the added complexity of structures, added layers of screening, higher research costs and scarcity of products.

Direct marketing efforts are lacking and the industry is dependent on a pull strategy.

Client Education

& Spread of

Awareness

by Scholars

Innovation

Competitive Fee structures

Push Strategy

Perceived to be restricted to Muslims Viewed as a complex form of conventional finance Regarded as Emotional Behavior Perceived to yield lower returns Association with Terrorism

Source: Abraaj Capital Analysis

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Lack of Information

Human Capital

Structures

Limited investment opportunities

Control

Investment challenges faced by Islamic Funds

Research originated by Islamic product providers is very scarce and updated industry data is very difficult to find.

There’s a limited pool of skilled talent in the industry due to limited education.

Acquisition finance and mezzanine instruments are not available.

The pool of available investments is limited by Shariáh screening requirements.

In house research,In house research,

research housesresearch houses

Training &Training &

focus on top focus on top

talent recruitmenttalent recruitment

Innovative Innovative structuringstructuring

Due to the requirements of ongoing Shariáh compliance monitoring, a majority stake is mandatory, further limiting investment opportunities.

Source: Abraaj Capital Analysis

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Opportunity CommentsKey Segment

Divestment

Partnerships

Family Groups

• Groups may divest their business due to generational issues, strategic focus or to diversify shareholder base. PE groups can provide them with viable exits

with minimum risk to the reputation of the family. In addition, PE groups can resolve succession and ego issues

• Groups could also partner with PE funds to benefit from their value creation discipline, corporate governance, compliance, etc

Corporate Refocus

Distressed Sale

Multinationals

• Companies may sell their non-core business for strategic reasons such as concentration on core businesses or region

• Alternatively they may need to sell part of or all their business for financial reasons or to raise capital for organic and acquisitive growth

Sector Liberalization

Privatization

Sector Liberalization/Privatization

• A number of industries are affected by liberalization and lowering of entry and exit barriers which provide investment opportunity

• There is a paradigm shift in the mindset of regional governments from an ownership role towards regulatory role to promote the

privatization of state-owned enterprises to attract foreign investment, greater efficiencies and higher returns

ConsolidationSmall/Medium Enterprises (SMEs)

• Fragmented nature of industries and regulatory changes such as WTO and GATT are likely to fuel consolidation

• Credible management looking for opportunities to own a stake in their business

Management Buy-outs

Regional Private Equity Opportunity..

Source: Abraaj Capital Analysis

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Sector Opportunities

Power & Energy

Print Media

Financial Services

Insurance

Pharmaceuticals

Privatization of power assets and new IPP projects currently in progress in a number of countries including Jordan, Algeria, Oman and Pakistan

Directories businesses among the most successful business models worldwide

Regional market is underdeveloped and has potential for significant growth and value extraction

Financial Planning slated for high growth, driven by mature investor base and rapidly increasing demand for FP products. Exchange houses presenting another opportunity

Large sector with approximately US$ 3 billion premium revenues in GCC alone, with growth rates over 5% per annum across the region

High growth due to low historical penetration and lowered pricing

Availability of privatisation and acquisition targets with strong brands and significant market share

Telecom

India, a major supplier of bulk drugs worldwide has various consolidation and pre-IPO opportunities.

Growth opportunities for small ME companies particularly in Jordan, UAE and Saudi Arabia

Main sectors that offer substantial value creation potential

Source: Abraaj Capital Analysis

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Thank You