Private Equity Performance in the Gulf Cooperation Council Countries: an Empirical Analysis

PRIVATE EQUITY PERFORMANCE IN THE GULF COOPERATION COUNCIL COUNTRIES: AN EMPIRICAL ANALYSIS

‘A thesis submitted to the University of Manchester for the degree of Doctor of Business Administration (DBA) in the Alliance Manchester Business School’

2019

AHMAD KHAMIS

ALLIANCE MANCHESTER BUSINESS SCHOOL

ACKNOWLEDGMENT

People face many challenges in their professional and personal lives. Only those who endure difficulties and who are passionate about achieving their goals can make it till the end. For me, this research work would not have been possible without the unlimited support and love extended by my parents, who always urged me to excel and look for better paths. This support and encouragement did not stop even when I was working hard on developing my research, which has given me extra energy to devote to contributing to the body of knowledge within my expertise in private equity. I am especially indebted to my father and mother, who both are my role model in life, who worked very hard in order to invest in the education of their children, which was the greatest investment made in their life, not the stock markets!

I would also like to thank my wife, who stood by my side and made several sacrifices just to make sure I was on track with the progress for my DBA. Her support to me has been endless, and I will never forget how many nights she stayed awake to help me stay engaged in my work.

I am also thankful to the management of my previous employer, Global Investment House, which supported me when I decided to pursue my DBA and granted me a “free” study leave when I was required to attend the workshops at Alliance Manchester Business School.

I am grateful to my supervisors, Brahim Saadouni and AbdulKadir Mohamed, with whom I have been working together for almost 5 years. They have provided me extensive professional guidance and have taught me a great deal about scientific research.

TABLE OF CONTENTS

1. Introduction ……………………………………………………………………….. 8 1.1 Motivation of Research ………………………………………………………… 8 1.2 Purpose of Study, Problem Statement and Research Gap ……………………... 11 1.3 Limitations When Carrying Out This Research ……………………………….. 11 2. A General Overview on Private Equity …………………………………………. 16 2.1 Private Equity as an Asset Class ………………………………………………. 16 2.2 Private Equity Firms …………………………………………………………... 17 2.3 Structure of Private Equity Funds ……………………………………………... 19 2.4 Private Equity Investment Funds ……………………………………………… 20 2.5 Private Equity Fee Types ……………………………………………………… 21 2.5.1 Management Fees ………………………………………………………. 22 2.5.2 Incentive Fees …………………………………………………………... 23 2.5.3 Other Ancillary Fees ……………………………………………………. 24 2.6 Private Equity Investments ……………………………………………………. 25 2.7 Private Equity Market Synopsis ………………………………………………. 27 2.8 Private Equity Characteristics …………………………………………………. 30 2.8.1 Liquidity ………………………………………………………………… 30 2.8.2 Time Horizon …………………………………………………………… 31 2.8.3 Category of Investors …………………………………………………… 31 3. Background ……………………………………………………………………….. 33 3.1 Private Equity Industry Dynamics by Region ………………………………… 33 3.1.1 Private Equity in the US ………………………………………………... 35 3.1.1.1 Introduction ………………………………………………………. 35 3.1.1.2 US Fundraising …………………………………………………... 35 3.1.1.3 Exit Deals ………………………………………………………… 37 3.1.2 Private Equity in Europe ………………………………………………... 40 3.1.2.1 Introduction ………………………………………………………. 40 3.1.2.2 Europe Fundraising ………………………………………………. 40 3.1.2.3 Exit Deals ………………………………………………………… 42 3.1.3 Private Equity in Emerging Markets …………………………………… 44 3.1.3.1 Introduction ………………………………………………………. 44 3.1.3.2 Emerging Markets Fundraising ………………………………….. 44 3.1.3.3. Investor Preferences ……………………………………………... 45 3.1.4 Private Equity in the GCC Region ……………………………………… 47 3.1.4.1 The Importance of the PE Industry for GCC Investors …………... 47 3.1.4.2 Legal Framework ………………………………………………… 51 3.1.4.3 Private Equity Deal Flow in the GCC …………………………… 55 3.2 Islamic Private Equity in the GCC ……………………………………………. 55 3.2.1 Islamic Private Equity Market in the GCC ……………………………... 59 3.2.2 Islamic Private Equity Firms …………………………………………… 61 3.2.3 Islamic Private Equity Structures ………………………………………. 62 3.2.3.1 Mudarabah ……………………………………………………….. 62 3.2.3.2 Musharakah ………………………………………………………. 63

3.3 Structural Differences Between PE in the GCC and Other Regions ………….. 64 3.3.1 Composition of LPs …………………………………………………….. 65 3.3.2 The Importance of Relationships ……………………………………….. 66 3.3.3 Regulatory Environment ………………………………………………... 68 3.3.4 Exit Options for Private Equity ………………………………………… 74 3.3.4.1 IPO Exits …………………………………………………………. 76 3.3.4.2 Trade Sale ………………………………………………………... 78 3.3.4.3 Secondary Sales ………………………………………………….. 79 3.3.4.4 Buy-backs ………………………………………………………... 80 3.3.5 PE Funds’ Structures …………………………………………………… 81 3.3.5.1 The United States ………………………………………………… 81 3.3.5.2 The GCC …………………………………………………………. 82 3.3.5.2.1 Co-Investment Rights ……………………………………... 84 3.3.5.2.2 Deal-by-Deal Fundraising …………………………………. 84 3.3.5.2.3 Pledge Funds ………………………………………………. 85 4. Literature Review ………………………………………………………………… 87 4.1 Private Equity Literature ………………………………………………………. 87 4.2 Summary of Literature ……………………………………………………….... 98 4.3 Determinants of the IRR and Hypotheses ……………………………………. 99 5. Data and Methodology ………………………………………………………….... 104 5.1 Data & Sample Description …………………………………………………… 104 5.2 Methodology …………………………………………………………………... 108 6. Empirical Results …………………………………………………………………. 110 6.1 Univariate Analysis ……………………………………………………………. 110 6.2 Multivariate Analysis ………………………………………………………….. 112 6.2.1 Simple Correlations …………………………………………………….. 112 6.2.2 Regressions ……………………………………………………………... 118 7. Findings and Conclusions ………………………………………………………... 128 7.1 Research Findings ……………………………………………………………... 128 7.2 Contribution to the Body of Knowledge ………………………………………. 132 7.3 Future Areas for Research …………………………………………………….. 134

LIST OF TABLES

Table 1 – Global PE Fund Raising (2004-2014) ………………...………...………...... 28 Table 2 – Private Equity Activity by Region (2004-2014) ……………………………...... 34 Table 3 – US PE Fund Raising (2004-2014) ……………………………………………… 35 Table 4 – US PE Activity (2004-2014) …………………………………………………… 36 Table 5 – US PE Deals by Size & Value of Sectoral PE Investment (2004-2014) …...…... 37 Table 6 – US PE-backed Exit Activity (2004-2014) ……………………………………… 38 Table 7 – European PE Fund Raising (2004-2014) ……………………………………….. 40 Table 8 – European PE Activity (2004-2014) …………………………………………….. 40 Table 9 – European PE Deals by Size & Value of Sectoral PE Investment (2004-2014) … 41

Table 10 – European PE-backed Exit Activity (2004-2014) …...…………………………. 43 Table 11 – Emerging Markets PE Fund Raising (2004-2014) …………...……..………… 45 Table 12 – GCC PE Activity (2004-2014) ...……………….....………………...………… 49 Table 13 – GCC Major PE Funds Raised (2004-2014) ...………………....………………. 51 Table 14 – Private Equity in Comparison with other Modes of Capital in the GCC ……... 54 Table 15 – Structural Differences between PE in the GCC and Other Regions ………….. 64 Table 16 – Capital Market Authorities in the GCC ……………………………………….. 69 Table 17 – IPOs in the GCC Region (2004-2014) ………………………………………... 77 Table 18 – Sample Description …………………………………………………………… 106 Table 19 – Investment Returns by Exit Channel ………………………………………….. 107 Table 20 – Investment Returns & Average Holding Period by Investment Year ………… 108 Table 21 – Definitions of Variables Used in the Empirical Analysis …………………….. 108 Table 22 – Descriptive Statistics ………………………………………………………….. 111 Table 23 – Sample Correlations for Independent Variables ………………………………. 113 Table 24 – Main Regression Model ………………………………………………………. 114 Table 25 – Regression Analysis …………………………………………………………... 115 Table 26 – Extended Regression Model ……………………………………...…………… 117 Table 27 – Shariah-compliant PE Investments vs. Conventional Investments …………… 120 Table 28 – Shariah-compliant PE Fund Structure vs. Institutional PE Structure ….....…… 121 Table 29 – PE Fund Type versus Direct Institutional PE Investments ..……………..…… 122 Table 30 – Ownership Structure & Returns ………………………………………………. 125 Table 31 – Age of Investee Companies (Maturity) and IRR ……………………………… 126 Table 32 – Test of Mean Difference Between Matured & Un-matured Companies ……… 126

The final word count is: 49,598

ABSTRACT

Private equity (PE) in the Gulf Cooperation Council (GCC) region1 is a new asset class that has been informally structured and formalized towards the beginning of the last decade (early 2000). New private equity firms were established with more generic private equity funds established in 2002 and 2003. No publicly available private equity performance data are available that shed light on how the GCC region compares to other regions in the world, thus creating a gap in the body of knowledge for private equity in academia. This thesis explores the performance of private equity General Partners (“GPs”) domiciled in the GCC over the 10-year period from 2004-2014. Our data collection entailed proprietarily collecting 306 PE portfolio companies directly from general partners in the GCC, as there is an absence of any compulsory reporting requirements for PE investments. We performed a multiple regression analysis to examine the relationship between the Internal Rate of Return (IRR) as a dependent variable and the independent variables of investment ticket size, sector of investment, location of investment, investment-holding period, Shariah-compliant and conventional investments, and legal type of investments. We analysed the performance of private equity General Partners represented by the IRR, and our results show that only the investment holding period is statistically significant. We also compare the performance of the private equity portfolio to the S&P GCC Composite Total Return Index over the period of 2004-2014, and we find that the private equity portfolio underperformed the index by an average of 2.37% per annum. Overall, our findings show that private equity, as an asset class in the GCC region does not provide higher investment returns than public equities. These findings can be used as a basis to explore other areas relating to the private equity industry in the GCC region, such as examining if there is any relationship between PE performance and the possession of GCC experience by investment managers with the GPs, or if there is any relationship between the incentive structure of GPs and the performance of PE.

1 The GCC region comprises 6 countries: Saudi Arabia, United Arab Emirates, Kuwait, Oman, Bahrain, and Qatar.

DECLARATION

I declare that no portion of the work referred to in the thesis has been submitted in support of an application for another degree or qualification of this or any other university or other institute of learning;

The author of this thesis (including any appendices and/or schedules to this thesis) owns certain copyright or related rights in it (the “Copyright”) and he has given The University of Manchester certain rights to use such Copyright, including for administrative purposes.

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1. INTRODUCTION

The Private Equity industry in the GCC region is nascent, with no empirical studies available regarding its performance, competitive framework, legal aspects, regulations, general partners (GPs), limited partners (LPs), composition, and any other PE-related measures. However, there are few non-academic research papers and articles that were published on the subject yet lack depth, comprehensiveness, and comprehension due to several issues such as survival bias, selection bias, and reporting bias. Therefore, I depend on the academic research on PE available in the US, Europe, and some emerging markets (which are few) to build the case for the PE industry in the GCC. I have also relied on some regional non-academic research papers such as that published by Marmore (2016)2. Furthermore, the levels of informational depth in these market research reports are not comprehensive enough to build a case for PE in the GCC region, as it is mainly based on perceptions and theoretical inputs with incomplete data. Therefore, there would be some dependency on such GCC-related PE market reports in the relevant contexts in this research.

1.1 Motivation of Research

Private equity not only experienced significant growth globally, especially in the beginning of the twenty-first century, but also emerged as a new organized asset class in the Gulf Cooperation Council (GCC) region due to the increased investor appetite for more investment diversification. Internationally, private equity houses gained more influence and attention from corporations as well as High Networth Individuals (HNWIs) and Sovereign Wealth Funds (SWFs) as lucrative destinations for investment (Metrick and Yasuda, 2010). According to Ernst and Young (2017), global private equity firms’ fundraising activity reached its peak in 2008 with US$634 billion, and the number of private equity funds launched hit 1,090 PE funds in the same year.

2 Marmore (2016). Private Equity in GCC: Still in its Infancy.

The GCC region witnessed the establishment of the first PE firms in 2002: The Abraaj Group in the United Arab Emirates and Global Capital Management in Kuwait. More PE companies started their operations in the GCC after 2004 in an attempt to benefit from portfolio diversification as well as the anticipated high returns from PE investments similar to the performance of private equity funds generated by global PE funds (Moskowitz and Vissing- Jørgensen, 2002). Following the global financial crisis in 2008, exits within the GCC region have been delayed, performance has been negatively impacted, and portfolio restructuring took place, putting extra pressure on investment returns and affecting the attractiveness of private equity as an asset class (Setser and Ziemba, 2009). To the best of my knowledge, no empirical research has been conducted related to the PE industry in the GCC region. Furthermore, the PE industry in the GCC is not subject to any regulations; therefore, this research will be of value to investors and regulators in the GCC countries, as it will provide an empirical evidence on the performance of PE which will help investors in their investment allocation decisions. In addition, it will provide regulators with a better understanding of PE as an asset class in the GCC and how it compares to a public market index such as the S&P GCC Composite Total Return Index which may lead to setting up certain regulations pertaining the PE industry in the GCC. Furthermore, the findings of this research will be beneficial, as this study provides an empirical introduction that will help in understanding the private equity industry in the GCC in general, which is characterized by a lack of data or public insights such as the performance of private equity investments.

I have collected proprietary data directly from private equity investment managers in the GCC, which is a challenging task, as these data are not available to academia or the public. Private equity data are confidential and private equity investment managers do not publish such data as the industry is not regulated and there are no disclosure requirements. I have worked in the PE industry in the GCC for over a decade and I have built a strong network with PE managers and PE investors, which have helped me in collecting proprietary data for this research project, which would neither be available to anyone nor be easy to collect. The networking effect is key when it comes to data collection and I have signed Non-Disclosure Agreements (“NDAs”) with those PE investment managers whom I collected data from. Furthermore, I believe the sample that I collected is not subject to survival, selection or reporting bias as I got access to all portfolio

10 companies under the PE funds under investigation (or PE investments in the case of corporate PE houses). It is worth mentioning that the reports that I accessed are shared directly with LPs, and thus nothing is hidden or eliminated, and I reported all such data collected in my sample. I focus on analysing such a dataset to examine the performance of private equity in the GCC and compare it to a general public index, such as the S&P GCC Composite Total Return Index exhibiting unique findings. In addition, I have also examined the performance of Shariah- compliant PE investments versus conventional PE investments and I find that there is no difference in the mean returns between Shariah-compliant and conventional PE investments. Our results (Table 26) show that Shariah-compliant PE investments do not have an impact on the IRR when they exist in a PE portfolio, and there is no difference in the mean returns between Islamic and conventional PE investments in the GCC, as both results are statistically insignificant. Our analysis and examination to the PE industry in the GCC region can help investors in their asset allocation decision-making process and regulators in acquiring more in-depth analysis of the PE industry, which may help them in their regulation-related efforts.

1. Investors – the emergent PE industry in the GCC lacks history and a track record, which imposes challenges on investors to understand the risk/return trade-off of this asset class. There has been no academic research on the GCC PE industry in terms of analysing the performance of PE General Partners (hereafter GPs or Investment Managers), who are investing in the GCC region, thus making any asset allocation decision for investors a challenge. Typically, the PE investment cycle can take up to 12 years (Kaplan and Strömberg, 2009), and thus there is no literature available about investment returns (IRR) that private equity investments would typically generate in the GCC and what the practical exit mechanisms would be when analysing PE investment opportunities and the associated divestment routes. This makes investors’ investment allocation choices difficult, whether for a sovereign wealth fund, corporate investor, or a high networth individual.

2. Regulators – although private equity investments are private in nature, the PE industry is well regulated in the US and Europe, serving to increase more disclosure and better transparency for both General Partners and Limited Partners (hereafter LPs or Investors).

Such regulations mainly relate to competition, in which the Federal Trade Commission’s Bureau of Competition in the US and the European Commission in Europe take part in regulating acquisitions or in India where Foreign Direct Investment Law prevails when an acquisition happens, even for private companies. Thus all private equity firms are bound by the legislations of takeovers (Stowell, 2017). Such regulations are prevalent in the US and Europe, because the PE industry is more matured with a long track record, unlike the GCC region where there are regulations related to listed equities through the recent establishment of capital markets authorities as a means of regulating stock market trading. Therefore, PE funds are not examined as a whole as other investment products are, such as mutual funds or listed equity investments, in addition to the fact that there are no disclosure requirements in private equity (Marmore, 2016). As a result, this research will give regulators a more holistic view on the performance of PE investments in the GCC, with the expectation that this may lead to the introduction of some regulations relating to the PE industry in the GCC.

1.2 Purpose of Study, Problem Statement, and Research Gap

The confidential nature of private equity transactions in relation to deal commercial terms and the absence of reporting and disclosure requirements pose challenges in fully understanding performance metrics. In addition, since reporting is voluntary and many international PE firms tend to report some data on performance, such reporting is subject to over-performance and survival bias (in terms of excluding non-performing assets) (Kaplan and Strömberg, 2009). In the GCC region, this reporting is non-existent, as private equity funds launched in the GCC since 2002 have not had their divestment cycles completely materialized, especially after the global financial crisis of 2008, which prolonged almost all PE funds’ lives beyond their initial existence (Marmore, 2016).

At the current stage of research, the increased liquidity in the GCC in the last decade, as a result of high oil prices coupled with improved credit markets, have contributed to the recent attention to private equity, which have helped in the buildup of such asset classes in the GCC region (Marmore, 2016). However, there are still unanswered questions about the PE industry in the

GCC region, and more importantly regarding the return performance of PE investments and how they compare to other asset classes, such as public equities whose returns are known to investors and policy makers. In addition, several empirical studies have been carried out in the US and Europe on the performance of private equity investments based on disclosures made by General Partners, providing real insights into private equity investment returns.

The primary objective of this research is to investigate the drivers of private equity in the GCC region in terms of performance, size of investments, fundraising activity, legal structures, exit routes, its competitiveness, and the level of PE regulation. In addition, it aims to provide valuable insights for PE investors as they devise strategies for their portfolio asset allocation. Furthermore, it will also help regulators to better understand the PE industry from different angles, such as regarding performance, activity, and associated challenges, which may be useful for them in the introduction of some regulations related to the PE industry in the GCC region such as considering minimum investment ticket sizes based on the type of investors and the level of investor sophistication (i.e retail versus corporate investors), or introducing regulations relating to holding PE investments beyond their tenure and how the PE funds’ underlying assets would be distributed to investors in such case. This research examines the performance of the private equity industry in the GCC and also examines the determinants of the IRR.

This study is exploratory in nature and aims to fill the existing gap in understanding the private equity business functionality as well as the returns associated with such an asset class. It therefore addresses multiple audiences such as academia, potential and existing PE investors, corporate family offices, sovereign wealth funds, financing institutions, regulators, capital market authorities, stock exchanges, and legal and management consultants. Thus, this research makes several key main contributions to the body of knowledge in the field of private equity:

1. It provides a thorough understanding of the private equity industry in the GCC region in terms of its drivers, performance, legal structures, regulations, the role of investment managers or GPs, types and suitability of investors, and the contractual arrangements within a PE structure. In addition, it highlights the compensation structure in a PE setup and how it is different from any other asset class.

2. It examines the relationship between private equity investment IRRs and investment geographies, sectoral diversity, type of investments (Shariah-compliance vs. non Shariah- compliance), investment holding periods, size of PE investments, legal structure of investing vehicles, ownership structure, maturity of portfolio companies (age), GDP growth and the 2008 financial crisis. In addition, it provides detailed performance analysis about private equity in the GCC region from the perspective of the investment size, location, sector, legal type, Shariah-compliance, investment holding periods, ownership structure, maturity of portfolio companies (age), GDP growth and the 2008 financial crisis adding more awareness and providing new findings. This is a big gap in the PE literature due to disclosure limitations and the developing nature of the PE industry in the GCC region. Furthermore, it compares the performance of Shariah- compliant investments (“Islamic”) versus conventional investments, and Shariah- compliant PE Funds to Shariah-compliant Institutional PE, which may be helpful to investors seeking investment diversity and to other investors when they make their investment allocation decisions. In addition, it helps in building the literature to highlight the differences in returns between Islamic and conventional PE investments. It also helps build the literature to highlight the differences in returns between Islamic and conventional PE investments.

3. It compares the competitiveness of the private equity investment returns with those of the S&P GCC Composite Total Return Index, which would help investors gain insights on their asset allocation strategies as a means of achieving return maximization within a given sought-after risk-return profile.

4. In focusing on the GCC region, which is an immature region for PE, this research provides researchers with important findings in relation to the determinants of the IRR and the relative performance of private equity in the GCC to the public market, and this compares to global PE relative performance.

5. It provides detailed analysis about PE in the GCC region from the perspective of how well the performance of PE firms is in terms of sector and geography, thus adding further insights and providing unique findings.

6. It reports the findings relating to the performance of PE funds versus the performance of Direct Institutional PE Investing and provides insights which may help investors in their investment allocation decisions as to which investment vehicle performs better.

1.3 Limitations When Carrying Out This Research

When collecting data on private equity for the purpose of this research, there were some challenges in obtaining such private data due to several reasons. One of the main reasons is the paucity of PE data in general in the GCC region due to the embryonic nature of the PE industry, and also the fact that such data are confidential and not easily accessible or sharable by GPs or LPs. In addition, there are no compulsory disclosure requirements for PE performance metrics especially in the absence of regulated bodies for the private equity industry in the GCC, making performance reporting voluntary (if ever existed) with high-level information available publicly without much informational depth. Having mentioned that, and due to my experience in the PE industry since its beginnings in the GCC, and as a result of the strong network that I have amongst the PE community in the GCC with GPs and LPs, I was able to collect a sample of 306 PE portfolio companies with full details on every and each investment, which could have not been obtained without my direct involvement in the PE industry in the GCC region.

There are naturally certain limitations that cannot be controlled when conducting research that may have affected the methodology, scope of work and conclusions of my results. Below is a list of some of these factors:

1. Sample Size

Although PE in the GCC region is still a developing industry with a limited number of established GP houses, I managed to get a sample of 306 portfolio companies for the period from

2004-2014, which can be good enough to build basic and first-time conclusions around PE performance given that the size of the industry is not very big now relative to the international markets. Data collection would remain a challenge for PE investments as long as there is no regulatory body that would organize the flow of information and the disclosure requirements, otherwise the acquisition of such confidential data will continue to be a major limitation.

2. Timing of Study & Market Conditions

Given that the emergence of the first private equity players domiciled in the GCC region started in the beginning of the twenty first century, the data that we have can be considered as the first wave of such PE confidential data. This research explores the period when the actual PE investment cycle started to happen in the GCC region from as early as 2004 till 2014. It is worth mentioning that this 10-year cycle had the 2008 global financial crisis hitting and the GCC region was not an exception, which may have impacted the performance with external factors that would have not been there had the financial crisis not been there. Naturally, this would make carrying a follow-up research beyond 2014 something of more interest so as to cover a longer period and avoid any bias that may have been created due to the 2008 global financial crisis.

3. Access to Literature

The other important limitation that I faced while carrying out this research is the fact that there are no empirical studies that were carried out exploring the PE performance in the GCC before, which has resulted in an exploratory approach towards the identification of the independent variables which were basically stemming from studies conducted in regions different than the GCC such as the US and Europe. For the GCC, I identified a gap in the literature whereby there are no academic studies analysing the PE performance and the factors affecting the IRR in the GCC, which is critical to both investors and regulators. Thus, access to relevant literature was also a limitation when carrying out this research.

2. A GENERAL OVERVIEW ON PRIVATE EQUITY

2.1 Private Equity as an Asset Class

Private equity as an asset class emerged in the late 1960s and gained prominence after the late 1980s, when the growth of technology and modern asset management techniques were the prime reasons for the rising popularity of private equity. Investors became more informed and looked beyond traditional portfolio investments in search for better returns. This led to the growth of alternative investments and the rise of private equity as an asset class.

Private equity is a long-term equity investment in private assets that are not publicly traded in a stock exchange, which includes venture capital (VC) and buyout transactions (Cendrowski, Petro, Martin and Wadecki, 2012). Private equity can also be defined as any non-public, private investment made by a given institution, corporate, individuals of high net worth, sovereign wealth funds, or other corporate PE fund investor in either private or public companies (Fenn, Liang and Prowse, 1998). Venture Economics (EVCA, 2004) defines private equity as venture investments made in the form of buyouts and mezzanine structures. From a practical perspective, private equity is usually split into three main categories: (i) venture capital, (ii) growth capital, and (iii) buyouts depending on the stage of the investment cycle. It is, however, very common in the global investment community to define private equity as any equity investment in any private company for the purpose of growth, unlocking hidden value within investee companies, as well as performance improvement in preparation for exiting such investments and returning the investment cost and profits to investors.

The private equity cycle has several funding stages depending on the asset’s growth phase. There are mainly three stages of private equity investment: venture capital being an early-stage investment, growth capital being a growth-stage investment, and buyout being a matured-stage investment that may include a debt component such as the case of leveraged buyouts (Achleitner, 2002). However, there may be other classifications for private equity depending on the market at which this asset class is present. For example, in the US, private equity is treated as a different asset class from venture capital because the venture capital market is more matured and has

17 hundreds of specialized players in it with unique investment criteria (Gottschalg and Phalippou (2007) and Ljungqvist, Richardson and Wolfenzon (2008)). On the other hand, private equity is sometimes used interchangeably with buyouts due to some commonalities in their investment criteria and having the same private equity investors investing in both asset classes under the theme of private equity (Jones and Rhodes-Kropf (2003) and Kaplan and Strömberg (2009)).

In Europe, venture capital and buyouts are viewed as private equity and are usually treated as a single asset class (Marti and Balboa 2001). This may be due to the fact that the venture capital industry in Europe is still in its early stages when compared to the US, but today it is maturing with more specialized VC players joining the club (EVCA (2007) and Hege, Palomino and Schwienbacher (2008)).

In the case of venture capital investing, private equity investors would normally invest in minority stakes unlike buyouts in which they invest in majority stakes with significant control (Kaplan and Strömberg, 2009).

Throughout this dissertation, the term private equity will refer to the growth capital stage of the cycle, which includes buyouts as well. Hence, the venture capital component is excluded for the purpose of the research undertaken and because of the embryonic nature of the VC industry in the GCC. For this reason, our data collected does not include any venture capital deals, as it is purely focused on private equity growth capital. Furthermore, the industry size for venture capital in the GCC is very small, and it only has a couple of exits so far such as the sale of souq.com to Amazon.

2.2 Private Equity Firms

Private equity firms are in essence financial intermediaries between investors who are looking for considerable investment returns and private assets. Such investors seek capital to expand their operations, achieve greater financial performance, and enhance their valuations (Achleitner, 2002). Funding provided by private equity firms is vital, especially for startups and non-public small- and medium-sized enterprises that are in need for financing (Fenn, Liang and Prowse,

1998). Private equity firms are in general more specialized, depending on the growth stage of the opportunities they invest in, whether venture capital, growth capital, or buyouts (Kaplan and Strömberg, 2009). Furthermore, the use of debt is sometimes prevalent for large private equity houses, especially when they conduct transactions in the form of leveraged buyouts, in which part of the acquisition cost is financed by debt in addition to an equity component as a means of enhancing investment returns.

The legal structure of private equity firms is usually set up in the form of limited liability companies or in some cases as partnerships. The private equity funds that are launched by those private equity firms are usually structured as General Partner (GP)/Limited Partners (LP) structures. The General Partner is the private equity firm being the investment manager of the private equity fund, and Limited Partners, which are the investors subscribing in those private equity funds. In recent years, some international private equity firms have listed their shares on some stock exchanges such as The Blackstone Group L.P.(BX:US), KKR & Co. L.P. (KKR:US), Apollo Global Management LLC (APO:US), and the Carlyle Group (CG:US).

As per Kaplan and Strömberg (2009), private equity GPs have their own investment team, which includes professionals in the transaction services or deal sourcing vertical and others who are responsible for post-acquisition value addition and performance enhancements. Furthermore, the average number of investment professionals in private equity GPs is usually less than 13. However, from a practical perspective and due to the fact that the number of newly launched private equity funds has increased as well as the larger sizes of such funds, the average number has increased drastically, reflecting more focus on a hands-on approach in PE portfolio management. Typically, those investment professionals handle fundraising, deal flow pipeline, transaction structuring, investment management, and exit planning. In most cases, some of the duties of private equity firms are outsourced to advisers such as financial consultants carrying out financial, operational, and legal due diligence, and as portfolio companies get closer to an exit event, sale advisers are usually appointed for either private sale or IPO filing (Fenn, Liang and Prowse, 1998).

In return for managing the private equity portfolio, private equity firms usually receive placement fees, management fees (being the compensation paid by LPs to the GP), and carried interest or success fees, which is compensation paid based on the realized returns above the hurdle rate (Wright and Robbie, 1998).

The GP usually commits 1% to 2% of the fund size, and the remaining is invested by the LPs. In addition, GPs tend to use excessive leverage to fund their deals in order to maximize returns to LPs, hence increasing the risk associated with those investments, since GPs have a carried interest incentive that is mainly linked to the performance upon investment exit realization (Sahlmann, 1990). It is argued that the interests of the GP and LPs are not aligned due to the difference in investment commitment between the two (GPs usually invest up to 2% of the PE fund size) (Fenn, Liang and Prowse (1998) and Kaplan and Strömberg (2009).

2.3 Structure of Private Equity Funds

The main structure of a private equity fund is the GP/LP structure, which is highlighted in the below graph:

Private Equity Firm

Limited Partners (LPs) General Partner (GP)

1. Management Fees 2. Incentive Fees Capital & Profit 98%-99% Stake 3. Capital & Profit 1%-2% Stake Repayment Repayment

Limited Partnership

Investment Portfolio Asset 1, Asset 2, Asset 3, Asset…, Asset n Source: Müller (2008), Gilligan, John and Mike Wright (2008) and Baker and Smith (1998)

The private equity fund is the special purpose vehicle (SPV) for which the funds are raised from investors, which is also referred to as a Limited Partnership. The investment manager or the private equity firm is called the General Partner (GP) and the investors in the fund are called Limited Partners (LPs). The GP usually contributes around 1-2% of the size of the private equity fund, whereas the remaining 98-99% is subscribed by investors or Limited Partners, who are usually institutional investors, family offices, SWFs and HNWIs, as well as corporate investors. There is a Limited Partnership agreement which is signed between the GP and LPs detailing the contractual relationship between the two from all fund management perspectives, such as capital commitments, capital drawdowns, management fees, carried interest, investment holding period, fund investment strategy, exit strategy, and many other contractual clauses (Gompers and Lerner, 1996).

Private equity funds are investment vehicles created by GPs to form a pool of funds raised from different investors (LPs) to make investments in private companies in different growth stages. Such private equity funds are usually strategy focused and/or geography focused and are considered “black boxes” due to the fact that investment opportunities are not known at the time of investment. In such cases, investors make a commitment to invest a certain amount of capital in such private equity funds, in which investment managers have the responsibility of sourcing, acquiring, and managing such investments, with the ultimate objective of divesting them and making the promised investment returns to investors. GPs are incentivized through a combination of fees such as one-time placement fees, annual management fees, and carried interest or profit sharing at the time of full fund exit. Investors generally invest in private equity funds in order to earn a higher return via investing in a diversified pool of high-potential private companies managed by a team of investment experts (Metrick and Yasuda, 2010).

2.4 Private Equity Investment Funds

Private equity funds are closed-ended structures with a lifespan that ranges between 7-12 years with extension options depending on the strategy and the geography of the fund being established. They are closed-ended in the sense that investors cannot ask for redemption and are

21 locked in until an exit scenario happens but get paid occasionally once one or more portfolio companies exit through dividend payouts/capital paybacks. Investment funds have three important time frames: the fundraising period (usually 12-18 months), the investment period (usually up to 5 years), and the exit period (up to 7 years following the investment period (Kaplan and Strömberg, 2009). The fundraising period is the period during which the investment manager initiates its roadshow by meeting potential investors and getting commitments into the fund (withdrawn in stages whenever there is a capital call) (Metrick and Yasuda, 2010). The investment period is the period during which the sourcing of transactions and the deployment of capital take place by the transaction team within the investment management. Once an investment is made, the value creation process kicks in as a means of enhancing the performance of portfolio companies in preparation for exit (Kaplan and Strömberg, 2009).

2.5 Private Equity Fee Types

Investing in private equity funds is usually bound by certain terms and conditions that are unique to the private equity industry and are set forth in long and intricate legal documentation. Limited Partners, who provide capital for private equity funds, must sign such legal documents, which highlight the risks involved and the distribution of compensation when making such an investment, and the legal framework that govern the relationship between Limited Partners and General Partners (Kaplan and Schoar, 2005). Private equity funds have specific set of fees that are earned by General Partners for the placement, management, supervision, and divestment of funds contributed by Limited Partners through an exit. Gross returns achieved through divestment would be diluted in a GP/LP structure due to the fees charged by the General Partner in return for the investment management services offered by the General Partner to the Limited Partners. Some fee categories are prevalent in private equity, such as placement fees, management fees, incentive fees (carried interest), and ancillary fees such as fund administration fees (Marmore, 2016).

2.5.1 Management Fees

General Partners earn a management fee for the efforts expended for the management of the funds contributed by Limited Partners in terms of the sourcing of investment opportunities, capital deployment, and value creation and is usually is a fixed percentage charged on the capital raised. There are different schools of thoughts for calculating the management fees depending on several factors, such as market norms, economic fundamentals of the region of investment, and the track record of General Partners. Management fees usually range between 1.5%-2.0% and could be based on either the (i) capital commitment, (ii) capital called, or even (iii) capital deployed including debt (Robinson and Sensoy, 2013).

In the case of management fees being charged on capital committed by Limited Partners, GPs are then rewarded more even though the capital is not all called or even invested. However, when the management fees are based on the capital called, GPs receive their fees even if the capital is not deployed in investment opportunities but rather still being invested in bank deposits. In both cases, there is a considerable amount of risk that GPs are earning their management fees and yet are not able to deploy the capital in rewarding investment opportunities, thus increasing the risk of non-deployment and reducing the net return to Limited Partners. Today, it has become the norm for GPs to invest in all of their newly launched private equity funds along with their LPs as a means of interest alignment and charge fees on either called or invested capital (Robinson and Sensoy, 2013).

The management fees structure used to be a percentage of capital committed by Limited Partners to the extent of 2-3% (Fenn, Liang and Prowse, 1998). However, there was a change in the way in which management fees were calculated in the 1990s, to become a percentage of invested capital. The justification behind this change was that Limited Partners pressurized GPs to lower the management fees due to the perception that the efforts extended by GPs are actually higher in the earlier years when the investments are being made, and thus once all funds are deployed, only then should GPs be allowed to take management fees based on invested capital. Furthermore, in the case of committed capital, they would be earning management fees on

23 capital that is yet to be invested, which is either in LPs bank accounts or is yet to be called (Fenn, Liang and Prowse, 1998).

2.5.2 Incentive Fees

The incentive fee that is earned by General Partners is called a “carried interest”, which is a percentage of profits achieved above the hurdle rate of return promised to Limited Partners, in which the typical structure is 80/20. In other words, once the General Partner achieves the promised minimum IRR (hurdle rate) to Limited Partners (which usually ranges between 8%- 12%), any excess return above the hurdle rate is split between the Limited Partners (80%) and the General Partner (20%) (Robinson and Sensoy, 2013). In most cases, the carried interest is earned on a fund level, meaning once the private equity fund closes and all investments are exited, the IRR for the fund is calculated and the carried interest is measured and paid. However, in some rare cases, General Partners earn a carried interest on a deal-by-deal basis, but what the General Partner earns stays in the bank until full fund exit occurs, and the overall IRR for the fund is calculated. In this case, a “claw back” is usually introduced in the GP/LP agreement. If the overall fund underperforms towards the end of its life, and the total carried interest earned by the General Partner at the time of full exit is more than what it should be eligible for after making overall adjustments, then the General Partner should pay back the difference to the Limited Partners in order to ensure the achievement of promised returns (Robinson and Sensoy, 2013).

General Partners receive not only management fees, but also “carried interest” or an incentive fee which is highly dependent on the fund’s performance, in which case GPs share part of the gains (usually 20%) above a hurdle rate promised to investors (usually a range between 6-12%) (Kaplan and Strömberg (2009) and Metrick and Yasuda (2010)). For GPs, approximately one third of their overall compensation comes from carried interest (Gilligan et al. 2008). The private equity industry has established a norm whereby the carried interest is split 20:80; meaning 20% goes to the GP and 80% goes to the LPs, once the agreed upon IRR or the hurdle rate is achieved, beyond which the share of profits starts counting for GPs. This allocation has changed over time and there are several profit sharing allocations depending on different geographies and

24 funds strategies (Fenn, Liang and Prowse, 1998). For example, for Real Estate PE funds, the hurdle rate ranges between 6-8%, with carried interest split being 10-15%, as is the case with some PE houses in Kuwait, UAE, and Saudi Arabia.

The profit sharing waterfall in private equity differs between Europe and the US. In Europe, the carried interest is only earned once the fund life is exhausted, the fund is liquidated and the profits and fund-level IRR are calculated, and it is more favorable towards LPs. Once the fund’s hurdle rate is achieved, GPs take their share of profits above the hurdle by the agreed-upon split – in most cases, 20% to GPs and 80% to LPs (Schell, 2017). However, the US profit-sharing waterfall and hurdle rates are calculated on a deal-by-deal basis (in most cases), with a clawback clause which favors GPs to a larger extent. In this case, GPs take their carried interest after achieving the hurdle rate on a deal-by-deal basis without having to wait until the fund is fully exited and before knowing the overall fund’s IRR to which the final carried interest is calculated and paid. The clawback clause is a protection for LPs in the case that GPs don’t achieve the hurdle rate promised to LPs and thus must return the difference from the previously earned carried interest to compensate LPs for the underperformance on an overall fund return (Metrick and Yasuda, 2010).

2.5.3 Other Ancillary Fees

Private equity General Partners tend to earn other fees from portfolio companies such as board sitting fees, various committee sitting fees, and finance arrangement fees. In some cases, some LPs bargain the application of such fees with a demand to reduce management fees or waiver of other administrative fees (Marmore, 2016). General Partners also tend to charge LPs placement fees on the capital raised, which usually ranges from 0.5% to 2%. These fees are either paid directly to the General Partners or if there is an investment bank placing the fund, then the fees go to the investment bank as introductory or placement fees. In some cases, fees are waived (Marmore, 2016).

In the GCC region, private equity General Partners still follow the classical 2/20 model, whereby they charge a 2% management fee on capital called and earn a 20% carried interest above the

25 hurdle rate (usually up to 12%). It is worth mentioning that, after the global financial crisis of 2008, General Partners in the GCC faced increasing pressure from Limited Partner to reduce their fees; however, they in fact witnessed a slight improvement in their bargaining power to resist investors’ demands, contrary to what happened in the more developed countries. This is due to the lack of investment options and the poor performance of public equities performance in the GCC, which all led to the stickiness of the 2/20 formula (Marmore, 2016).

The typical structure of any private equity investment happens in such a way that a vehicle or a fund is established which would not only raise funds from LPs but also take leverage in order to conduct such investment. In recent years, a new trend has also emerged regarding the structure of private equity deals whereby private equity firms come together and join efforts to make joint investments in the form of club deals, usually when the transaction size is big, which has never before been the case (Officer, Ozbas, and Sensoy, 2010). This is due to the fact that the investment strategy of some of these private equity firms require certain expertise which might not be available within those private equity firms, and thus co-investing becomes the alternative to solo-investing. In such cases, there is usually a lead investor who will manage the due diligence process and the structuring of the deal during which other co-investors may be allocated to other strategic roles (Fenn, Liang and Prowse, 1998).

2.6 Private Equity Investments

Investments made by private equity firms are routed through private equity funds, which are closed-ended with a limited life of approximately 7-12 years, in which the investment period is usually 5 years followed by a value creation period (investment holding period) of around 5-7 years, within which the portfolio is sold and the proceeds are returned to LPs (Kaplan and Strömberg, 2009). The PE fund investors are mostly pension funds, individuals of high net worth, and institutions who have a long-term investment mandate, committing a certain amount of equity capital to the fund (Fenn, Liang and Prowse, 1998). The capital deployed by private equity funds into individual portfolio companies is usually used to fund its growth, create strategic synergies, and initiate value creation tasks that would eventually enhance the performance of those portfolio companies (Grabenwarter and Weidig, 2005). In some cases, and

26 depending on the strategy of the PE fund, capital may be used for turnaround cases or distressed asset financing when there is a strong case for such investment (Grabenwarter and Weidig, 2005).

General Partners follow a systematic approach when they make their investment decisions. The process starts with deal sourcing in which investment opportunities are sourced directly by PE professionals using their network or through investment bankers who have access to both sell- side and buy-side deal flow from their clients. Once investment opportunities are received by the PE team, comprehensive operational, financial, and legal due diligence and deal structure planning are carried out based on which the initial decision to go ahead with the investment is made by the PE fund’s investment committee. Upon the deal’s conclusion, the post-investment phase starts when the experienced PE team starts its value addition initiatives in transforming the portfolio company into a growth engine as a means of achieving the projected business plan and simultaneously positioning the portfolio company for a profitable exit (Kaplan and Strömberg, 2009).

PE Investment Process

Pre-Investment Period Post-Investment Period

Deal Sourcing Structuring Value Creation Exit

Kaplan and Strömberg (2009) & Fenn, Liang and Prowse (1998)

It is worth noting that the most critical component in the PE investment process is the ability of GPs to generate investment opportunities that meet their funds’ investment criteria due to the fact that there is generally a shortage of qualified PE deals in the market, and competition amongst private equity firms is very tough. Thus, a private equity firm with a strong business network would naturally have better deal access than those firms with less network power (Gompers and Lerner, 2000). It is also common in the private equity industry to see nine out of every ten deals rejected, on average. Furthermore, when investment bankers introduce the deals to private equity firms, they run an auction process requiring all GPs to submit a non-binding letter of intent

27 highlighting the key terms before GPs are allowed to proceed further with the deal (Fenn, Liang and Prowse, 1998).

Once the non-binding offer is accepted by the selling shareholders of the target company, a more detailed process is initiated whereby GPs are allowed to start detailed financial, operational, and legal due diligence. If GPs confirm their interest in pursuing the deal, then this will be communicated with the selling shareholders to move ahead with deal structuring and sale and purchase agreement (SPA) drafting (Kaplan and Strömberg, 2009). The deal negotiation then occurs, highlighting all the major clauses to be incorporated in the SPA such as valuation, stake offering, deal structure, control level, management team compensation, role and incentives, authority matrix, and other critical clauses of importance to both parties (Fenn, Liang and Prowse, 1998). When the investment is closed, the role of private equity firms becomes crucial in terms of active monitoring on the board and committee levels and also in driving all the strategic and operational initiatives that aim to improve the financial performance of the investee company. In addition, GPs also initiate exit planning strategies, which need to be well defined and executed within the timeline allocated for such a purpose either through IPO or trade sale (Wright and Robbie, 1998).

2.7 Private Equity Market Synopsis

Private equity investors look for companies that are undervalued or even firms that underperform in comparison to their peers in the same industry group. Once they have invested, they tend to focus on improving the corporate governance and operational efficiencies. The turnaround of these underperforming assets yields higher returns for the PE firms. Traditionally, these PE investments were accessible to institutions and wealthy individuals who are able to undertake large investments. Wealthy individuals also prefer PE investments, as they have historically generated higher returns compared to public equity investments. Unlike public equity, private equity offers the opportunity to acquire controlling stakes, enabling firms to impact the strategic direction of investee companies and the decision making of such companies. Hence, HNWIs and institutional investors who intend to actively take part in the managerial affairs of the investee companies in which they invest prefer private equity investments. In the US and Europe,

28 regulations have been favorable for PE in terms of tax considerations, making it an attractive asset class for larger investments. These factors helped in the growth of PE investments in the past decade.

One of the main characteristics of the GCC private equity industry is the fact that the participation of individuals of high net worth as well as that of family offices is very high amongst LPs, making the PE in the GCC a unique industry when compared to other international PE markets. In addition, several PE investments carried out by GPs are effectively sourced by those family-oriented LPs, who are indeed influential LPs depending on their wide business network and connections in addition to their own reputation when sourcing PE deals (Strategy &, 2010). As per the 2010 INSEAD – Booz & Company survey regarding the prevalent mix within LPs in PE funds’ investors, institutional investors headed the list followed by HNWIs as the second type of investors. In 2009, there were around 400,000 HNWIs and more than 3,600 UHNWIs in the greater Middle East region, the majority of which are from the GCC (Strategy &, 2010).

During the period 2004-2014, a total of 9,505 private equity funds were established globally, raising approximately US$ 4.5 trillion. The best performing years in terms of PE activity were 2007 and 2008, with an average fundraising of US$ 625 billion per year and an average number of new PE funds of 1,103 funds. Global PE fundraising activities retracted to its growth path in 2011 after recording a level of US$ 291 billion in 2009. In 2013-2014, the fundraising from PE remained largely unchanged, yet the number of deals executed declined. Europe and Asia witnessed a decrease in the number of deals, though the value of the deals increased by an annual average of 28% in 2016. The Asia Pacific saw a decline of 25% in terms of deals value in 2016 compared to 2015, mainly due to the macroeconomic uncertainties surrounding China.

Table 1 Panel A: Global PE Fund Raising (2004–2014) Year Commitments (in US$ bn) No. of Funds 2004 188.2 574 2005 324.3 777 2006 492.4 987 2007 616.7 1,117 Table to be continued next page…

Table 1 continued… 2008 633.8 1,090 2009 291.4 693 2010 267.5 727 2011 305.6 820 2012 356.2 882 2013 501.4 959 2014 489.3 879 Source: Ernst and Young 2017, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, Preqin Private Equity Online

Panel B: Geographic Distribution of Global PE Fund Raising (2004–2014) Amounts in USD bn 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 USA 90.3 142.4 185.0 272.1 180.8 120.8 71.6 89.2 106.9 198.9 197.1 Europe 30.6 81.1 126.0 89.7 90.0 21.0 24.7 47.7 28.7 61.2 50.6 Emerging Markets 53.0 49.0 64.0 71.0 75.0 32.0 54.0 87.0 68.0 55.0 79.0 GCC 0.2 3.1 0.8 4.4 8.1 0.6 1.4 0.1 0.3 0.9 2.3 Other 14.2 48.7 116.6 179.6 279.9 117.1 115.7 81.6 152.4 185.4 160.2 Global Fund Raising 188.2 324.3 492.4 616.7 633.8 291.4 267.5 305.6 356.2 356.2 489.3 Source: Ernst and Young 2017, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, Preqin Private Equity Online

Cash available for investing (known as dry powder) has increased over the period of 2013-2016, due to improved fundraising, which saw gains in buyout, growth, real estate, and venture capital funds. Funds in buyout reached US$ 525 billion in 2016, which is about 11% higher when compared to 2015. Taking into account all fund types, it is estimated that dry powder is accumulated to reach US$ 1.4 trillion. Assets focused on the rapidly growing Asian market have more than doubled, making Asia the fastest growing market for dry powder (Ernst and Young, 2017).

The growth of PE as an asset class has been cyclical over the past five decades and differed widely in various regions across sectors depending on the requirement for funding. North America and Europe have been the forerunners in the development of PE funding, while the GCC region is still in its nascent stages.

Technology (encompassing software, hardware, the Internet, and semiconductors) has been the favorite sector for PE investors worldwide. The sector received US$ 64.9 billion investments from private equity in 2016, 20.4% higher than those of 2015. Software accounted for 70% of the aggregate investments in technology. There were 19 deals worth more US$ 1 billion each in

30 the tech space announced by PE firms in 2016. Strikingly, PE investments gushed more into technology companies that hold a strong brand name, yet have recently lost significant market share to the new operators. Further, PE deals executed in the global Utilities sector increased significantly from US$ 4.5 billion in 2015 to over US$ 50 billion in 2016 (a growth of 1,024%). Electricity generation companies were the cynosures of 2016 with major deals being completed in the U.S and Europe. Two of the year’s largest deals, US$ 14.5 billion sale of National Grid’s gas distribution business to a consortium that included Macquarie, China Investment Corporation and Qatar Investment Authority; and the US$ 12.4 billion sale of Ausgrid to IFM Investors Pty Ltd., increased the share of utilities sector from 1.4% in 2015 to 15.9% in 2016. This is followed by the Healthcare sector increasing from US$16.3 billion to over US$ 31 billion in 2016 (a growth of 93%). Other sectors which have seen a growth of over 20% in 2016 compared to 2015 include Resources and Materials sector growing from US$ 15.8 billion to US$ 23.0 billion. Technology had a share of 20.4% of all the PE deals executed during the year 2016, followed by Utilities at 15.9%, Consumer Goods at 11%, and Healthcare at 9.8% (Ernst and Young, 2017).

2.8 Private Equity Characteristics

2.8.1 Liquidity

Different assets have different liquidity profiles, and private equity has always been considered a relatively illiquid asset due to its long-term holding period nature and the fact that the fund structure is a closed-ended type with no redemption rights. However, unlike many other illiquid assets, the underlying portfolio is usually cash-generating with annual dividends that makes periodic distribution to LPs a norm. In addition, when any of the underlying portfolio companies is sold, the proceeds are usually also distributed to LPs, with rarely a re-investment clause in the fund structure. When this is compared to public equities or public equity funds, these can be traded daily, and there are usually immediate redemption clauses based on NAV of such funds (Franzoni, Nowak and Phalippou, 2012). In private equity investments, investors could yield profits only towards the end of the PE fund’s life and most probably after the whole portfolio is sold, which can usually take up to 10-12 years, depending on the life of the fund. In a survey carried out by SEI Private Equity (2013) among more than 212 private equity managers,

31 consultants, and investors participating, it was revealed that respondents felt that liquidity of private equity as an asset class has improved over the years. This can be attributed to the changing dynamics of the PE industry across the years due to a change in the profile of LPs, and the emergence of institutional investors served predominantly as a key component of LPs with slightly different liquidity preferences and the need for more frequent cash distributions over the life of the PE fund as well as the push for more reporting transparency. Furthermore, the respondents believed that the sale of private equity investments in secondary markets has become much more achievable than before, as they considered liquidity to have been improved when compared to the early days of private equity. The survey also reveals that 58% of the LPs have transacted in the secondary markets, which highlights the changes happening in exit routes and prospects. However, with these developments, private equity is still considered a less liquid asset class targeting long-term investors with long-term investment and divestment horizons.

2.8.2 Time Horizon

PE investments have in general an investment period of 5 years followed by a value creation time frame of approximately 5-7 years, during which the underlying PE fund portfolio can be sold and the proceeds can be paid back to LPs (Kaplan and Strömberg, 2009). This is the largest investment-divestment horizon amongst other asset classes if liquidity is taken into consideration. When this is compared to 10-, 20-, or even 50-year bonds, the period seems to be higher, but since a liquidity event can occur when trading bonds before their maturity, thus providing immediate liquidity, PE is the champion in terms of time horizon lock-up (Kaplan and Strömberg, 2009). Private equity has been popular in the US and Europe before it has emerged in the GCC region, and thus in the US and Europe, LPs have borne the PE illiquidity risk in return for high returns offered by private equity investments.

2.8.3 Category of Investors

Given the long-term nature of PE investments and the fact that such an asset class is relatively illiquid, the risk profile of LPs investing in PE is different, with usually high tolerance to risk as well as a higher ticket size per LP (Kaplan and Strömberg, 2009). Therefore, the majority of

32 private equity LPs are governmental sovereign wealth funds, pension funds, individuals of high net worth, institutional investors, and recently more family offices. The asset allocation strategy for these LPs is diversified, with PE having an important allocation that can go up to 20%. For example, the Abu Dhabi Investment Council allocated up to 8% of its portfolio in private equity (Marmore, 2016).

3. BACKGROUND

3.1 Private Equity Industry Dynamics by Region

This section highlights the industry dynamics for the PE industry for four main regions: the United States, Europe, emerging markets, and the GCC market. We shed light on the PE industry statistics and how each geography performs in relation to the other. The table below highlights the descriptive numbers for the three main regions: the US, Europe, and the GCC region.

Table 2: Private Equity Activity by Region (2004-2014) 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Panel A – United States PE Funds Raised (US$ bn) 90 142 185 272 180 120 71 89 107 199 197 No. of PE Funds Closed 161 252 269 311 262 161 159 189 202 293 318 PE Deal Count 1,686 2,032 2,810 3,499 2,743 1,858 2,705 3,068 3,467 3,354 4,162 PE Deal Value (US$ bn) 126 174 512 889 359 167 350 422 472 514 660 PE Exit Count 413 644 757 929 649 437 826 917 1,120 1,041 1,299 PE Exit Value (US$ bn) 113 180 166 234 115 65 147 171 227 220 314 Panel B – Europe PE Funds Raised (US$ bn) 32 85 132 94 94 22 26 50 30 64 53 No. of PE Funds Closed 76 113 192 187 155 114 107 114 100 108 98 PE Deal Count 765 1,023 1,967 2,692 2,391 1,597 2,244 2,575 2,420 2,530 2,952 PE Deal Value (US$ bn) 95 152 299 375 226 101 198 232 222 250 348 PE Exit Count 433 563 667 781 687 498 707 927 835 1,046 1,136 PE Exit Value (US$ bn) 24 35 39 32 17 14 24 37 26 41 46 Panel C – GCC Region PE Funds Raised (US$ mn) 214 2,930 1,304 5,516 7,078 329 1,157 95 153 17 1,421 No. of PE Funds Closed 2 12 7 19 12 2 4 2 3 1 9 Amount Raised via IPOs (US$ mn) 673 5,407 6,482 12,043 11,226 1,035 2,031 796 1,685 1,608 9,698 No. of IPOs 7 17 19 34 22 11 12 9 9 10 14 Source: Zawya, MENA PE Association, Pitchbook, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, Preqin Private Equity Online Definitions: PE Funds Raised – this represents the total amount raised by GPs from LPs for the PE Funds established and is usually a committed capital that will be drawn down from LPs at every capital call from GPs. No. of PE Funds Closed – this represents the number of the PE Funds where the announced capital has been collected from LPs. PE Deal Count – this is the number of PE investments executed by GPs. PE Deal Value – this represents the total value of PE deals executed / acquired by GPs for their respective PE Funds managed by them. PE Exit Count – this is the number of PE exits made by GPs providing a liquidity event for LPs. PE Exit Value – this represents the total value of divestment proceeds resulting of the exit of the portfolio companies. PE Deal Count & Value and Exit Count & Value for the GCC region is not available due to the private nature of such data. We provided data for IPO such as number of IPOs, amount raised as a result of IPOs.

3.1.1 Private Equity in the US

3.1.1.1 Introduction

Private equity activity in the US market reached its peak in 2007, with deal values and number of deals reaching US$ 889 billion and 3,499 deals, respectively. The global financial crisis in 2008 brought with it a sharp decline both in terms of the number of deals and value of transactions, making 2009 the year with the least number of deals and the lowest deal values in the last decade. Deal values dropped by 81% in a span of two years (2007 to 2009). The PE market in the US started picking up after the financial crisis, more specifically in 2010, and witnessed buoyed activity between 2014 and 2016, with the number of deals exceeding 12,000 during this period. Despite the increase in the number of deals, the average value per deal has not reached the heights of 2007, with deal values averaging US$ 653 billion per year. This is due to the fact that 2007 had 43 deals that individually exceeded the value of US$ 2.5 billion by deal size. In contrast, after 2007, no year saw more than 20 deals of this magnitude.

3.1.1.2 US Fundraising

The total amount of PE funds raised from 2004-2104 was approximately US$ 1.7 trillion, distributed over 2,577 PE funds with an average PE fund size of approximately US$ 659 million per PE fund.

Table 3 US PE Fund Raising (2004–2014) Fundraising 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Capital Raised ($ bn) 90.3 142.4 185.0 272.1 180.8 120.8 71.6 89.2 106.9 198.9 197.1 No. of Funds Closed 161 252 269 311 262 161 159 189 202 293 318 Source: PitchBook, Zawya, MENA PE Association, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, Preqin Private Equity Online

The fundraising activity in the US reached more than US$ 272 billion in 2007, distributed over 311 PE funds. However, following the 2008 financial crisis, the fundraising activity was negatively impacted and dropped to US$ 180.8 billion in 2008, decreasing further to US$ 120.8

36 billion in 2009 and US$ 89.2 billion in 2010. The average amount of PE funds raised in the US in 2013 and 2014 was around US$ 198 billion. In addition, the number of PE funds increased after the investors’ confidence began to be rebuilt in 2009. Notably, the capital raised in 2013 nearly doubled in value when compared to that of the year 2012, and has maintained that level afterwards. In 2016, several big PE funds launches have taken place in the US, with significant amounts of fundraising such as Advent International raising US$ 13 billion PE fund, TPG Capital with a US$ 10.5 billion PE fund, Leonard Green launching a US$ 9.6 billion PE fund, and Apax Partners launching a US$ 9 billion PE fund.

Table 4 US PE Activity (2004-2014) 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Panel A – Capital Invested & Number of PE Deals Capital ($bn) 455.1 487.4 511.6 889.5 359.4 167.3 349.7 422.3 472.1 514.2 659.8 No. of Deals 2,455 2,611 2,810 3,499 2,743 1,858 2,705 3,068 3,467 3,354 4,162 Panel B – Quarterly Activity – Capital Invested & Number of PE Deals Q1 Q2 Q3 Q4 Capital No. of Capital No. of Capital No. of Capital No. of

(US$ bn) Deals (US$ bn) Deals (US$ bn) Deals (US$ bn) Deals 2004 118.3 711 115.2 691 105.6 567 116.0 486 2005 126.7 611 135.1 593 111.6 588 114.1 819 2006 131.9 731 125.5 746 117.3 710 136.8 623 2007 180.1 865 249.6 1,100 257.0 961 202.8 573 2008 173.2 792 101.6 731 56.2 757 28.4 363 2009 39.2 402 40.6 471 37.5 464 50.1 521 2010 70.1 661 78.4 619 83.2 609 118.0 816 2011 104.6 794 98.9 738 93.6 727 125.3 809 2012 98.1 872 96.5 757 96.9 737 180.6 1,101 2013 99.8 810 114.5 725 123.7 865 176.3 954 2014 156.6 1,085 154.6 934 175.1 1,047 173.5 1,096 Source: PitchBook, Zawya, MENA PE Association, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, Preqin Private Equity Online Definitions: Capital – Capital Invested by GPs in portfolio companies. No. of Deals – is the number of PE transactions executed by GPs.

From 2014 to 2016, PE activity, such as fundraising, and the number of deals have been stagnant with an average capital investment of US$ 653.6 and an average number of 4,081 deals per year over the same period.

Smaller deals with size lesser than US$ 25 million contribute to more than 30% of the total number of deals executed every year. However, deals between US$ 100 million and US$ 500

37 million contributed a major portion in terms of total deal values, accounting for 30% of the deals in 2016.

Table 5 Number of US PE Deals by Deal Size and Value of Sectoral PE Investment (2004-2014) Deal Size 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Panel A – Number of Deals Categorized by Size Under US$25 mn 824 936 1,054 1,310 1,251 1,048 1,246 1,403 1,464 1,525 1,774 US$25-US$100 mn 753 761 796 931 823 470 602 726 915 752 921 US$100-US$500 mn 691 703 736 925 538 276 630 734 826 840 1,106 US$500-US$1 bn 142 161 168 231 93 46 196 169 216 194 293 US$1-US$2.5 bn 27 31 35 59 28 11 23 25 37 29 55 +US$2.5 bn 18 19 22 43 10 7 8 11 9 14 13 Panel B – Value of PE Deals Categorized by Sector (US$ bn) Materials / Resources 7.1 12.6 11.8 14.1 13.2 2.6 4.9 7.5 11.0 16.8 15.3 IT 51.2 56.8 49.1 50.3 39.9 21.1 24.7 20.3 40.2 53.2 43.5 Healthcare 35.5 37.0 39.1 40.1 25.8 16.7 22.2 45.5 31.6 16.3 48.3 Financial Services 25.1 27.2 35.0 41.2 31.1 10.0 13.5 7.4 32.1 22.7 42.5 Energy 18.9 23.1 41.6 31.4 25.2 17.3 24.2 41.5 23.0 27.2 49.2 B2C 35.1 43.6 39.1 39.8 32.1 20.1 27.3 14.8 46.9 48.5 52.8 B2B 36.9 40.2 49.2 46.0 41.3 23.3 30.1 34.3 41.7 34.9 62.1 Other Sectors 245.1 246.9 246.7 626.6 150.8 56.2 202.6 250.9 254.5 294.5 345.9 Source: PitchBook, Zawya, MENA PE Association, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, Preqin Private Equity Online Other Sectors – this represents the PE investments made by GPs in any other sector not mentioned in the table.

There was a considerable increase in the number of PE firms investing in large PE deals in the period from 2004-2007, which dropped after 2008. In 2014, the number of deals increased from 43 deals with a value greater than US$ 1 billion in 2013 to 68 deals with a value of US$ 68 billion in 2014 (a growth of 58%). In terms of deal value, the healthcare sector has seen considerable growth over the period (2015-2016), becoming the most active sector in 2016. If 2016 was a good year for healthcare, then in 2015, the IT sector dwarfed other sectors, with deal values exceeding US$ 100 billion. Materials and Resources has been the sector which has seen minimal PE activity over the years, with deals totaling only to US$ 87 billion between 2010 and 2016.

3.1.1.3 Exit Deals

Exit activity in the US for PE-backed companies has grown steadily from 2004 to 2014, increasing from US$ 113 billion in 2004 to US$ 314 billion in 2014, with a significant drop in 2009 following the 2008 financial crisis. There were 437 investment exits with a total exit value

38 of US$ 65 billion in 2009, as compared to 147 investment exits with a total exit value of US$ 147 billion in 2010. The growth in exit activity continued until 2014, with a total of 1,299 investment exits demonstrating a total exit value of US$ 314 billion. In addition, the number of IPOs for PE-backed companies rebounded in 2017, in which 13 PE-backed companies made their debut on public stock exchanges during the first quarter of 2017. This is the highest of any quarter since the second quarter of 2015, in which 18 IPOs took place. Three out of the 13 IPOs were from the Oil and Gas industry, which has seen an upturn in equity since crude prices began to stabilize during the end of 2016. If equity valuations continue to grow with more PE firms seeking exit through IPOs, there could be more liquidity in the PE market.

Table 6 US PE-backed Exit Activity (2004–2014) 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Panel A – Exit Activity Exit Value (US$ bn) 113 180 166 234 115 65 147 171 227 220 314 No. of Exits 413 634 757 929 649 437 826 917 1,120 1,041 1,299 Panel B – Exit Activity through Exit Channel (No. of Exits) Q1 Q2 Q3 Q4 CA IPO SB CA IPO SB CA IPO SB CA IPO SB 2004 61 6 35 66 7 31 63 10 39 62 11 22 2005 78 7 44 82 11 51 111 8 56 103 6 77 2006 119 11 73 124 8 65 121 9 63 127 10 27 2007 132 16 85 136 11 93 128 13 90 143 14 68 2008 147 15 81 131 14 88 51 3 29 43 6 41 2009 47 12 38 55 9 43 63 13 44 71 9 33 2010 92 8 42 131 10 73 135 9 73 133 11 109 2011 116 11 71 127 13 82 129 10 85 141 9 123 2012 167 18 91 135 10 105 126 14 101 172 6 175 2013 120 12 84 126 18 76 122 12 121 173 26 151 2014 160 17 116 150 26 122 179 13 147 196 23 150 Source: PitchBook, Zawya, MENA PE Association, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, Preqin Private Equity Online Definitions; CA – means Corporate Acquisition; IPO – means Initial Public Offering; and SB – means Secondary Buyout

Another emerging trend over the past 10 years is the rise of secondary buyouts. In 2004, there were a total of 127 exits through a secondary buyout compared to 535 in 2014, a growth of more than 3 times over the 10-year period. Secondary buyouts have never exceeded the number of corporate acquisitions in any quarter. Generally, exits through private transactions were more preferred to GPs than through IPOs over the same period.

The private equity activity in the US increased significantly in recent years, with several multi- billion dollar acquisitions occurring in 2016, such as the acquisition of EMC by Dell with a deal worth US$ 60 billion, Keurig Green Mountain by JAB Holding with a deal worth US$ 14.2, and MultiPlan by Hellman and Friedman for US$ 7.4 billion.

3.1.2 Private Equity in Europe

3.1.2.1 Introduction

Europe has seen a promising activity in private equity from the start of the millennium as the single currency created an integrated debt and equity market buoying the private equity activity in the European union.

3.1.2.2 Europe Fundraising

The total amount of PE funds raised from 2004-2014 was € 587 billion spread across 1,364 PE funds, with an average PE fund size of € 430 million per PE fund. Similar to the global market trend, both fundraising activity and the number of PE funds launched dropped drastically. However, the fundraising activity was negatively impacted after 2006, dropping from € 114 billion in 2006 to € 80.8 billion in 2007 and stabilizing in 2008 at € 81.1 billion. However, following the 2008 financial crisis, fundraising activity significantly fell to € 18.9 billion (a drop of more than 77%).

Table 7 European PE Fund Raising (2004–2014) Fundraising 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Capital Raised (€ bn) 27.5 73.1 113.5 80.8 81.1 18.9 22.3 43.0 25.8 55.1 45.6 No. of Funds Closed 76 113 192 187 155 114 107 114 100 108 98 Source: PitchBook, Zawya, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, PricewaterhouseCoopers, InvestEurope, Preqin Private Equity Online

In addition, the number of European PE funds launched after they peaked in 2007 with 187 PE funds, falling thereafter and stabilizing at an average of 102 funds in the period of 2012-2014.

Table 8 European PE Activity (2004-2014) 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Panel A – Capital Invested & Number of PE Deals Capital (€ bn) 95.3 151.9 298.9 374.7 225.7 101.5 198.0 231.9 222.4 249.8 348.3 No. of Deals 765 1,023 1,967 2,692 2,391 1,597 2,244 2,575 2,420 2,530 2,952

Table to be continued next page…

Table 8 continued… Panel B – Quarterly Activity – Capital Invested & Number of PE Deals Q1 Q2 Q3 Q4 Capital No. of Capital No. of Capital No. of Capital No. of

(€ bn) Deals (€ bn) Deals (€ bn) Deals (€ bn) Deals 2004 23.8 181 21.5 213 19.8 176 30.2 195 2005 33.6 247 38.9 312 37.9 265 41.5 199 2006 48.7 347 86.5 613 83.7 544 80.0 463 2007 79.3 552 103.7 713 105.4 722 86.3 705 2008 90.3 707 65.1 742 38.9 521 31.4 421 2009 22.5 387 25.8 345 29.3 417 23.9 448 2010 30.5 478 49.0 515 59.3 589 59.2 662 2011 68.3 644 61.4 671 53.4 667 48.8 593 2012 52.4 613 57.7 612 60.8 587 61.0 608 2013 66.8 633 73.5 676 60.2 651 49.3 570 2014 79.4 658 94.6 789 81.2 736 93.1 769 Source: PitchBook, Zawya, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, PricewaterhouseCoopers, InvestEurope, Preqin Private Equity Online

The PE investment activity in Europe has grown steadily and significantly from € 95 billion in 2004 to over € 348 billion in 2014, exhibiting more than 3 times increased growth during that period. Although there was a drop in PE investments following the 2008 financial crisis, the PE market picked up quickly and grew from a PE investment size of € 101 billion in 2009 to € 198 billion in 2010, which represents nearly two-fold growth, with PE deals increasing from 1,597 deals in 2009 to 2,244 deals in 2010 (a growth of 40.5%).

Similar to the US markets, buyout deals are the most popular investment type in Europe. The number of buyout deals experienced a 10.3% growth in 2016 as compared to 2015, as it increased from 1,128 deals in 2015 to 1,244 deals in 2016. The BREXIT vote and other concerns such as the US presidential election at the time stymied activity in the market.

Table 9 Number of European PE Deals by Region & Value of Sectoral PE Investment (2004-2014) Deal Size 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Panel A – Number of PE Deals Categorized by Region UK & Ireland 161 215 413 565 502 335 471 541 508 531 620 France 145 194 374 511 454 303 426 489 460 481 561 Germany 107 143 275 377 335 224 314 361 339 354 413 Nordics 99 133 256 350 311 208 292 335 315 329 384 Benelux 77 102 197 269 239 160 224 258 242 253 295 Italy 54 72 138 188 167 112 157 180 169 177 207 Others 122 164 315 431 383 256 359 412 387 405 472 Table to be continued next page…

Table 9 continued… Panel B – Value of PE Deals Categorized by Sector (€ bn) Industrials 14.3 22.8 44.8 56.2 33.9 15.2 29.7 34.8 33.4 37.5 52.2 TMT 12.4 19.7 38.9 48.7 29.3 13.2 25.7 30.1 28.9 32.5 45.3 Consumer 11.5 18.4 36.2 45.4 27.3 12.3 24.0 28.1 26.9 30.3 42.2 Energy & Utilities 11.2 17.9 35.2 44.1 26.6 12.0 23.3 27.3 26.2 29.4 41.0 Financial Services 8.7 13.9 27.3 34.2 20.6 9.3 18.1 21.1 20.3 22.8 31.8 Business Services 7.6 12.2 23.9 30.0 18.1 8.1 15.8 18.6 17.8 20.0 27.9 Leisure 6.9 10.9 21.5 27.0 16.3 7.3 14.3 16.7 16.0 18.0 25.1 Pharma and Biotech 6.6 10.5 20.6 25.9 15.6 7.0 13.7 16.0 15.3 17.2 24.0 Real Estate 6.3 10.1 19.9 25.0 15.0 6.8 13.2 15.4 14.8 16.6 23.2 Transportation 3.9 6.2 12.3 15.4 9.3 4.2 8.1 9.5 9.1 10.2 14.3 Construction 2.8 4.4 8.7 10.9 6.5 2.9 5.7 6.7 6.4 7.2 10.1 Agriculture 2.1 3.3 6.6 8.2 5.0 2.2 4.4 5.1 4.9 5.5 7.7 Defense 1.0 1.5 3.0 3.7 2.3 1.0 2.0 2.3 2.2 2.5 3.5 Source: PitchBook, Zawya, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, PricewaterhouseCoopers, InvestEurope, Preqin Private Equity Online Benelux include Belgium, Netherlands and Luxemburg

The UK and Ireland had the maximum share of PE deals in Europe for the period from 2004- 2014. While the UK and Ireland accounted for an annual average of 21% of the number of PE deals, the average share in terms of value of such deals was around 31%. Furthermore, PE investment activity was relatively strong in both France and Germany, whose share of the total number of PE investments was 19% and 14%, respectively. Collectively, around 54% of the PE deals in Europe were in UK and Ireland, France, and Germany.

The Industrials and Chemicals sector has been the most active sector, with an annual average share of 15% of the total investments made in Europe, while other sectors such as the Technology, Media, and Telecom (TMT) had an annual average share of 13%, followed by the Consumers and Energy sectors at 12% each.

3.1.2.3 Exit Deals

Exit activity in Europe for PE-backed companies has grown steadily from 2004 to 2014, increasing from € 20.6 billion in 2004 to € 39.6 billion in 2014, with a significant drop in 2008 following the 2008 financial crisis. The number of exits in Europe grew from 433 exits in 2004 to 1,136 exits in 2014, growing at a compounded annual growth rate of 10.1% between 2004 and 2014; however, the exit deals value grew only at 6.7% during the same period. There were 433 investment exits with a total exit value of € 20.6 billion in 2004, as compared to 1,136

43 investment exits with a total exit value of € 39.6 billion in 2014. Following the drop in exit activity after the 2008 financial crisis, the growth in exit activity picked up in 2010 and continued its upward trend until 2014. As for the exit type, approximately 49% of exits for the period of 2004-2014 were through corporate acquisitions, followed by 33% through secondary buyouts and 18% through IPOs.

Table 10 European PE-backed Exit Activity (2004–2014) 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Panel A – Exit Activity Exit Value (€ bn) 20.6 30.1 33.5 27.5 14.6 12.0 20.6 31.8 22.4 35.3 39.6 No. of Exits 433 563 667 781 687 498 707 927 835 1,046 1,136 Panel B – Exit Activity through Exit Channel (No. of Exits) Q1 Q2 Q3 Q4 CA IPO SB CA IPO SB CA IPO SB CA IPO SB 2004 55 20 37 62 23 41 51 19 34 45 16 30 2005 72 26 48 80 29 54 66 24 45 58 21 39 2006 85 31 57 95 35 64 78 29 53 69 25 46 2007 99 37 67 111 41 75 92 34 62 80 30 54 2008 88 32 59 98 36 66 81 30 54 71 26 48 2009 63 23 43 71 26 48 59 22 39 51 19 35 2010 90 33 61 100 37 68 83 31 56 73 27 49 2011 118 43 80 132 48 89 109 40 73 95 35 64 2012 106 39 72 119 44 80 98 36 66 86 32 58 2013 133 49 90 149 55 100 123 45 83 108 40 72 2014 145 53 97 161 59 109 134 49 90 117 43 79 Source: PitchBook, Zawya, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, PricewaterhouseCoopers, InvestEurope, Preqin Private Equity Online Definitions; CA – means Corporate Acquisition; IPO – means Initial Public Offering; and SB – means Secondary Buyout

3.1.3 Private Equity in Emerging Markets

3.1.3.1 Introduction

Following the global financial crisis, Emerging Markets (EMs)3 were considered the beacons of global growth stories, as a result of investors limiting their consideration to Europe and the US who have started to invest in the equity markets in these regions.

At the onset of the global financial crisis, the amount of capital secured by emerging market funds decreased from US$ 63 billion through 245 funds during 2008 to US$ 26 billion through 196 funds in 2009. However, in 2010 and 2011, fundraising recovered quickly, with 335 emerging markets focusing on fundraising of US$ 69 billion. India and China were the sweet spots for many institutional investors in 2010 and 2011, as these countries were resilient to the 2008 global financial crisis while the developed economies were struggling to redirect their economy on the path of recovery. Emerging markets presented a unique opportunity for investors, as businesses in these economies needed capital to grow, while the untapped potential of the market offered higher returns in comparison to the developed markets. In addition, many investors saw the opportunity for impact investing in emerging markets.

3.1.3.2 Emerging Markets Fundraising

The total amount of PE funds raised from 2004-2014 was US$ 687 billion spread across 3,769 PE funds, with an average PE fund size of US$ 182 million per PE fund. Fundraising activity in emerging markets dropped drastically in 2009 to US$ 32 billion from US$ 75 billion in 2008 as a result of the 2008 financial crisis. However, the greatest fundraising activity happened in 2014 at US$ 79 billion, exhibiting investors’ confidence in emerging markets to a level that was not achieved anytime during the period of 2004-2014. However, there was a decrease in PE activity following 2014, which was mainly due to the poor inflow from commodity-reliant economies of

3 ‘Emerging Markets’ includes all countries in Africa, Asia (excluding Hong Kong, Japan and Singapore), Central & Eastern Europe, Latin America (South and Central America, the Caribbean) and the Middle East (excluding Israel).

45 the Middle East, Latin American, and Russia. The concern of economic slowdown in China was also another reason for the declining number of deals after 2015.

Table 11 Emerging Markets PE Fund Raising (2004–2014) Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Panel A – Fund Raising Activity No. of Funds 246 312 308 359 320 291 368 482 399 354 330 Capital Raised ($ bn) 53 49 64 71 75 32 54 87 68 55 79 Panel B – Dry Powder Dry Powder ($ bn) 13 15 29 40 46 45 58 82 80 94 82 Panel C – Size of Emerging Markets’ PE as a Proportion of Global PE Deals Contribution (%) 9% 8% 10% 12% 15% 6% 11% 17% 13% 10% 17% Source: PitchBook, Zawya, European PE and VC Association, Global Private Equity Report 2014, Bain & Company, PricewaterhouseCoopers, InvestEurope, Preqin Private Equity Online Dry Powder – is the capital held un-invested with GPs but available for investment.

Emerging markets have been quite different from the European and the US markets in the type of funds that have been raised. In advanced markets, buyouts dominate, while in emerging markets, venture capital and growth funds are preferred. During 2008 and the first half of 2016, growth and venture capital deals accounted for 73% and 55%, while buyout funds had a share of 12% and 32% of the total number of deals and funds raised, respectively.

3.1.3.3 Investor Preferences

Corporate investors and banks accounted for 19% of the investor pool in emerging markets from 2004-2014, a striking difference from the investor base in advanced markets that mainly comprise pension funds, sovereign wealth funds, endowment plans and wealth managers (Preqin, 2017). Investors’ preference differs from region to region and among the countries in the emerging markets category, Asia (excluding China and India) followed by China and India are the most favored destinations. China and India are preferred by 42% of the investors surveyed by Preqin while South America, the next preferred destination has patronage of 10% of the investors. There is an evident skewness in investor preference towards different regions in emerging markets (Preqin, 2017).

Not only do more than 40% of investors prefer Asia for their investments, but also 50% of the investors are located in emerging markets in Asia. This indicates a clear inclination among

46 investors towards their home markets while choosing their investment options. Following the Asian investors are those from the Middle Eastern region, who accounted for 17% of the investors from the emerging markets. Investors from the Middle East started investing in emerging markets as their preferred destinations only after the global financial crisis in 2008, since the US and Europe became unattractive in terms of the returns they offered. Emerging markets have gained prominence as a favored destination for PE in the past decade. It has also become the source of capital with the raise of pension funds, insurance companies, and other institutional investors looking for alternative investment options (Preqin, 2017).

3.1.4 Private Equity in the GCC Region

3.1.4.1 The Importance of the PE Industry for GCC Investors

The PE industry in the GCC has gained greater importance for investors since the beginning of the twenty-first century. Historically, sovereign wealth funds, family offices, high net worth individuals have always been investing in the US and European private equity industry as a means of diversifying their investment exposure. The growing interest in the GCC region started when the abundance of cash started flowing in a big way following the rise in oil prices and more specifically post the Iraq War in 2003, which has helped the GCC countries build cash piles. This has caused, in parallel, more private sector participation in the GCC governments’ investment in their own infrastructure leading to more companies being established in different sectors to cater to the positive economic growth witnessed then. This has created a wave of investment companies and private equity GPs being established with the mandate to invest in local stock markets as well as private opportunities. The scale of company listings and liquidity levels have grown considerably since 2003 and investment companies started investing heavily in both private and public companies. GCC governments and private offices have started allocating investment funds to invest in their own markets without having an idea of the typical investment returns that would be generated due to lack of data and track record. Not only that, but even international fund managers started looking at the GCC region as a diversity-resort for their investments in developing economies where they believed it is a high-risk but high return markets, leading to more foreign direct investments in the GCC region due to young demographics and rising consumer and business demands in these societies, which have high GDP/capita. However, when it comes to the PE industry, several value bubbles have burst during the euphoric years (e.g. the 2008 global financial crisis) which have affected the path of PE in the region. In addition, although the PE industry has undergone several shake-ups following the 2008 global financial crisis, it remains as one of the leading verticals in the GCC asset management industry. In both Saudi Arabia and the UAE, the strong performance of PE-backed listed companies have generated more confidence in the industry to gain more momentum about the industry’s capabilities to generate good investment returns. And with the local financial

48 markets – especially in the UAE and Saudi Arabia – posting strong performances, investors are slowly gaining confidence about the region’s capability to generate returns. Dr. Karim El Solh, CEO of the Abu Dhabi-based PE firm Gulf Capital, says that “the GCC’s private equity activity has stabilized and is picking-up again post the financial crisis and had limited or no impact from the ongoing Arab Spring.” According to Dr. Solh, defensive sectors such as the food & beverage, healthcare, logistics and education with underserved demand are currently the most attractive for regional PE managers. PE experts agree that countries like Saudi Arabia and the UAE are the natural picks, where young populations and higher incomes present attractive long-term playfields. Khaled Abou Zahr, founder of the Private Equity Forum, noted: "The potentials of private equity investments in the Middle East and North Africa are enormous, and so are the challenges. But also it is important to highlight how the market is currently progressing in order to address current roadblocks that hinder success. The release of the report brings to our attention that the PE market is evolving and there are efforts from various sectors that attempt to shape its future in the region. The regional landscape is definitely changing and regional businesses are opening up to PE investors as revealed by the findings of the report." (Orient Planet Research, 2017).

The GCC private equity industry is poised for a significant growth, as attested by the International Monetary Fund which mentioned that the greater MENA region is headed to become the third’s fastest growing region by 2022 (Orient Planet Research, 2017).

Nidal Abou Zaki, Managing Director, Orient Planet Group, said: "A number of factors are making the region highly attractive to PE investors, including the regional governments' strong initiatives to strengthen local entrepreneurship and promote small- and medium-sized enterprises. In addition, the region's young demographics, increasing wealth, and recent important economic reforms are making it highly attractive to PE investors whose investments can help drive development and advance MENA's position in the global stage" (Orient Planet Research, 2017). The report found that the UAE and Saudi Arabia received the majority of private equity investments in 2014 with more than 75% of investments by value. Due to the various initiatives taken by the GCC governments to diversify their economies away from petro- dollars, investment in new cities (such as Silk City in Kuwait, Dubai Harbour City, King

Abdullah Economic City in KSA, and many others) has emerged necessitating the creation of full economic infrastructure that would make almost all sectors of the economy vibrant such healthcare, education, real estate, food & beverage, logistics and other sectors. This would require the private sector participation and the need for more private equity moneymaking such asset class a great area to explore (Orient Planet Research, 2017).

Unlike North America or Europe, private equity in the GCC region became popular only towards the beginning of the year 2000. The GCC region was perceived more as a source of capital rather than a destination for PE investments. The lack of openness to foreign investors, regulatory bottlenecks, family-owned business structures, and poor ease of doing business rankings were some of the impending factors for the growth of the industry. The legal and regulatory framework in most countries of the GCC region remains nascent and characterized by stringent ownership restrictions, weak bankruptcy laws, and high setup costs stifling the business climate and entrepreneurial ventures. The industry went through a quiet phase after the global financial crisis in 2008. The amount raised from the deals decreased significantly from US$ 8,084 million in 2008 to US$ 569 million in 2009. In 2014, PE investments recovered from the crisis, yet deal values still remain way below the pre-crisis levels. Following the global financial crisis, fundraising had become anemic. Despite the sizeable amount of dry powder accumulated over the boom years, deals had stalled as acquisition finance became more expensive and difficult to obtain (Marmore 2016).

Table 12 GCC PE Activity (2004–2014) 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Panel A – GCC Fund Raising Activity Capital Raised ($ mn) 214 3,143 831 4,358 8,084 569 1,427 129 289 937 2,351 No. of Funds Closed 2 11 4 15 21 3 5 4 7 4 11 Panel B – GCC Fund Raising Activity by Investment Focus Buyout Balanced Infrastructure Growth Real Estate VC Others 2004 - - - - 214 - - 2005 1,694 27 981 267 100 - 75 2006 253 - 272 - - - 306 2007 2,962 533 - 663 - - 200 2008 4,963 1,520 630 - 559 55 357 2009 - - 250 319 - - - 2010 545 - 500 282 100 - - 2011 20 - - 66 - - 43 2012 35 - - 102 143 10 - Table to be continued next page…

Table 12 continued… 2013 35 - - 682 - - 221 2014 38 160 750 1,060 321 22 - Panel C – GCC Fund Raising Activity by Investment Focus in Aggregate (2004-2014) Size (US$ mn) No. of Funds Average Size (US$ mn) Buyout 10,544 31 340 Balanced 2,240 9 249 Infrastructure 3,383 6 564 Growth 3,815 18 212 Real Estate 1,436 11 131 VC 87 4 22 Others 1,202 7 172 Source: Zawya, Marmore, Global Private Equity Report 2014, Bain & Company, PricewaterhouseCoopers, Preqin Private Equity Online Definitions: Buyout Funds – are funds with the mandate of acquiring a controlling stake in every company they invest in. Balanced Funds – are funds with the mandate of investing in PE as well as fixed income (bonds). Infrastructure Funds – are funds with the mandate to invest in private companies focused on infrastructural projects. Growth Capital Funds – are funds with the mandate to invest in companies in the growth stage. Real Estate Funds – are funds with the mandate to invest in private real estate companies or vehicles. VC Funds – are venture capital funds with the mandate to invest in companies in the early stage of growth. Others – Mezzanine, Pre-IPO, Secondary Investments & Distressed Funds

From 2009-2013, the diminished ability to raise funds by the PE firms in the GCC region could be partly attributed to the changing focus of those PE firms in the GCC region towards exploring exit opportunities for the investments already made during the boom years. With most of the funds raised in 2007 and 2008 nearing their end of investment cycle (5-7 years), the focus has visibly shifted in securing exits and to return funds to investors. Private equity fund closure continued to slow until 2013, which witnessed the closure of a lone venture capital fund. However, in the latter half of the year, NBK Capital launched a fund (NBK Capital Equity Partners Fund II) and experienced a successful first close of US$ 217 million. The fund raised US$ 310 million in capital and achieved its final closure in October 2014. Strong demand from institutional investors and family offices led to a resurgence in 2014, which witnessed more closures and funds being raised than in the last three years combined (2011-2013).

The real estate sector was preferred by most investors with five funds, valued at a combined US$ 460 million, closing in 2014. The pick of the funds was the GCC Equity Partner III, a US$ 750 million fund managed by Gulf Capital. The investors in the GCC Equity Partners Fund III include a significant number of regional and international Limited Partners, comprising sovereign wealth funds, pension funds, endowments, funds of funds, insurance companies,

51 family offices, and other institutional clients. Close to 60 percent of external investors are from the US, Europe, and the Far East, highlighting the appeal of the GCC region to global investors (Marmore, 2016). In 2015, activity in both private equity and venture capital activity relatively stagnated, as the decrease in oil prices deterred investors across the board from allocating more funds to private equity. Only two funds were closed in 2015, including the Riyad Taqnia Fund, by Riyad Capital, which raised US$ 120 million.

Table 13 GCC Major PE Funds Raised in (2004–2014) Year Fund Name Fund Manager Size (US$mn) 2004 Direct Investment Fund Global Investment House 100 2004 Abraaj Buyout Fund I Abraaj Group 116 2005 Global Opportunistic Fund 1 Global Investment House 550 2005 Abraaj Buyout Fund II Abraaj Group 500 2005 Global Opportunistic Fund II Global Investment House 360 2006 Global Buyout Fund Global Investment House 615 2006 NBK Capital Equity Partners Fund I NBK Capital Partners 250 2007 Infrastructure and Growth Capital Fund Abraaj Group 2,000 2007 Gulf Capital Syndicate I Gulf Capital 145 2008 Global MENA Financial Assets Fund Global Investment House 500 2008 Gulf Capital Equity Partners Fund II Gulf Capital 533 2013 NBK Capital Equity Partners Fund II NBK Capital Partners 310 2014 Gulf Capital Equity Partner Fund III Gulf Capital 750 2014 IDB Infrastructure Fund II ASMA Capital 750 2014 The Saudi SME Fund Malaz Capital 160 Source: Zawya, Marmore & Preqin Private Equity Online

3.1.4.1 Legal Framework

The legal and regulatory framework in most countries of the GCC region remains nascent and characterized by stringent ownership restrictions, weak bankruptcy laws, and high setup costs. Such a scenario stifles the business climate and entrepreneurial ventures. In recent years, the GCC countries have undertaken initiatives to overhaul their bureaucracies to provide a business- friendly environment. For instance, Saudi Arabian government established Saudi Arabian General Investment Authority (SAGIA) to oversee the investment affairs in the kingdom, including foreign investments.

However, the financial markets in the GCC region remain largely underdeveloped. Bank assets form a major part of financing, debt securities are usually not preferred, and stock markets command low market capitalization in comparison to the size of economy. Stock market capitalization and debt securities, as a percentage of GDP, stand at a mere 44% and 64% for MENA region in comparison to the world average of 73% and 137%, respectively (IMF, 2014). Thus, it is clearly evident that bank finance has been the preferred choice of firms in the GCC.

State-owned enterprises which constitute most of the economic activity in the GCC region are rarely privatized, such as Al Kharafi National Group Holding of Kuwait, which belongs to the Al Kharafi Family, and Moosa Abdul Rahman Holding, which is owned by the Abdul Rahman Family in Oman. Even under the privatization initiative, only minority stakes in these enterprises are floated in the stock exchange, which is usually reserved for and subscribed to by the nationals of the respective GCC country. A recent example is the listing of the Mezzan Holding in Kuwait Stock Market in 2015, which is owned by the Al Wazzan Family Group in Kuwait, who only sold 30% to the public and retained 70% control. Apart from the state enterprises, family-owned businesses form the majority of companies in the GCC region. Family business houses are wealthy, well established, and often reluctant to sell their stakes to private equity firms. In contrast, given their intimate knowledge of the region, deep pockets due to surplus capital, solid business relationships, and unparalleled connection networks, they pose stiff competition for the regional PE players (Marmore, 2016).

Traditionally, for family businesses, ownership and control are not distinctly outlined. Private equity investors have a difficult time convincing the owners of family businesses that their company’s assets are not their personal property and that sharing management responsibility and decision making, adopting innovative and sound management practices, and corporate governance can only propel the business forward and is by no means a sign of conceding power. The difficulty of investing in order to obtain anything more than a minority stake will continue to undermine private-equity General Partners’ control over the scope and speed of post-acquisition plans, which limits their capacity to create value. Unaware of the benefits of having PE investors, business owners are reluctant to surrender their shares and control to PE firms or implement structural changes. Improvements to corporate governance have also been slow in their

53 development, which is sought out by PE firms and required to prepare those investee companies for exit (Marmore, 2016).

The level of inquiry and the associated investigative process may seem invasive to business houses in the GCC region, which are usually conservative in nature. The fear of such repercussions often leads PE firms only to scratch the surface during its research. Gaining access to reliable information is a significant hindrance. The GCC region’s lack of transparency and weak corporate governance are further obstacles in finding and establishing deals (Marmore, 2016).

The challenge in conducting thorough due diligence is compounded by the fact that very limited information is publicly available. Most private equity firms often resort to conducting discreet inquiries with company, industry, and government sources in order to supplement the information which may be available in the public domain. Only then can the private equity firm gain an understanding of a target (Marmore, 2016).

Furthermore, managerial talent is scarce in the GCC region, making the identification of new management teams with sector expertise, local knowledge, a proven track record, and the right skills a major challenge for PE firms. This difficulty in finding skilled management teams in the GCC region hinders the implementation of the buy and build model. This is especially true in sectors such as healthcare and technology. In addition, since most of these companies are family owned, ownership and management are often intertwined, which makes introducing a new management team to take leadership from the family owners a sensitive issue (Marmore, 2016).

Most of the SMEs and startup companies find it hard to obtain adequate financing from banks that have stringent collateral requirements, including personal guarantees. Lack of funding sources for early-stage investments acts as a hindrance for entrepreneurs and cause for concern for SMEs. As companies look to grow and expand, private equity can emerge as an alternative funding method (Marmore, 2016).

This is especially warranted in the case of the GCC, which seeks to diversify its economy by encouraging and stimulating several nascent sectors. The GCC banking sector, which is already overburdened with liquidity and issues related to Non Performing Assets (NPAs), is wary of funding such risky projects. Private equity funding also helps promoters avoid the public financing route and scrutiny by regulators, which is much preferred by several family-oriented businesses. However, it is important to note that private equity is more than just a mode of capital and often brings about significant value by establishing credibility to the venture and by setting a price benchmark.

Table 14 Private Equity in Comparison with other Modes of Capital in the GCC PE vs. Debt - Private equity involves a capital commitment from long term investors or LPs, who are looking for value appreciation and high exit returns with no promised dividend distribution and thus no visibility over capital return frequency. Further, private equity has less covenants and restriction (Kaplan and Strömberg, 2009). - Debt involves regular interest payments according to a pre-agreed schedule with several covenants in the debt agreement (Kaplan and Strömberg, 2009).

PE vs. Equity - Listed equities are bound by regulations and disclosure requirements. Raising funds through IPO or rights issue is a lengthy exercise and involves the supervision of capital market authorities. - Private equity capital can be raised relatively quickly and at a relatively lower cost than listed equities due to the fact that it is not bound by regulatory body, but rather an agreement between the buyer and the seller.

Standalone PE - Private equity represents the best option for both start-up companies as well as for raising growth capital for companies with the perception that it achieves high investor returns.

Source: Zawya, Marmore & Preqin Private Equity Online

3.1.4.3 Private Equity Deal Flow in the GCC

The majority of family businesses in the GCC region are currently managed by second- generation family members, and about 20% are being managed by third-generation members. The resulting rise in the number of shareholders leads to complex decision-making processes. In fact, more than 80% of family businesses fail to survive in the third generation (Fakhro, Kahaleh, Lahoud, and Lerner, 2011), because the wealth gets split between heirs who have different business orientation. Such family firms could be prime targets for private equity firms. The diversified portfolio of these conglomerates may require restructuring, as they need to shed some of their non-core assets and re-align their focus on core assets and competency. For example, the American Group in Kuwait was sold to the Dubai-based Mohamed Alabbar in an all-cash deal in 2016. In the case of listed companies, most regulatory authorities in the GCC region do not have squeeze-out provisions (in which minority shareholders are obligated to sell their ownership in a public company through a fair cash deal to majority shareholders), thus prohibiting bidders who take a substantial stake from gaining control of the company. This restricts GCC PE firms from acquiring privately held companies rather than listed ones.

Economic growth in the GCC region has largely remained positive, aided by vast hydrocarbon reserves and increasingly favorable demographics. These factors lead to a strong appetite among investments and expansion amongst the companies in the region. Of late, high oil prices have improved the economic outlook for the GCC region and the persistent spending by GCC government, and a spate of reforms augur a good long-term outlook for the region.

3.2 Islamic Private Equity in the GCC

Islamic finance is generally defined as a finance activity that is bound by the teachings of Islam stemming from the Holy Book of Quran and the Sunnah or practice of the Prophet Mohamad Peace Be Upon Him (Iqbal and Mirakhor, 2011). Islamic finance in its existing organized structure started in the beginning of 1980s, where the focus was mainly on the provision of commercial banking services especially when it comes to financing activities such as commodity

56 finance, trade finance and real estate finance to some extent. There are several forms of Islamic finance such as Murabahah (cost plus profit), Mudarabah (profit and loss sharing), Musharaka (joint venture), and Ijara (leasing) (Iqbal and Mirakhor, 2011).

The GCC government are becoming more supportive for Islamic finance and the establishment of Islamic Banks and Islamic Insurance Companies (Takaful). For example, the Central Bank of Bahrain has a special unit that deals with all Islamic financial institutions from license issuance, monitoring and even operational direction. There are now proven and tested Islamic investment structures and in-place regulations that support Islamic Finance in the GCC. In addition, several GCC governments have big investments in Islamic financial institutions such as the Abu Dhabi based Al Hilal Bank which is completely owned by the government of Abu Dhabi, the Kuwait- based Kuwait Finance House which is owned by the Kuwaiti Government, and many more in other GCC countries. Therefore, the GCC governments’ involvement gives the Islamic Finance segment fundamental credibility towards local, regional and international investors.

In the GCC region, the concept of Shariah-compliant (or “Islamic”) private equity was not a known term, and there were only international private equity investments from GCC investors into the US and European private equity markets mainly from LPs such as sovereign wealth funds and family offices. The last decade witnessed the emergence of private equity as an asset class in the GCC region in its modern status with an increasing demand for Shariah-compliant structured private equity products. As a result of the wealth buildup in the GCC by sovereign wealth funds and other institutional investors, their appetite for regional private equity has also increased as a means of investment diversification. In addition, the establishment of pure-play Shariah-compliant investment companies in the GCC region in the last decade, their investment criterion is only to invest in Shariah-compliant products. Institutional investors are increasingly diversifying their investment allocation to include Shariah-compliant private equity transactions by investing in private equity deals that are Shariah-compliant directly or through co-investment opportunities offered by PE funds in the GCC market (Marmore, 2016).

It is hard to determine the beginning of Islamic PE investments, as financial transactions used to take place since the 14th century based on the teachings of Islam (Islamic Fiqh). There were no

57 institutions or bodies exclusively dedicated to form Islamic vehicles to carry out such financial transactions in the same manner it is being done today. The Islamic Finance industry in general emerged in the early 1970s, when Islamic banks started to open its gates as dedicated Islamic financial intermediaries, after which more Islamic modes of funding started appearing (Iqbal and Mirakhor, 2011).

In recent years, PE as an asset class attracted the attention of a considerable audience in the GCC such as sovereign wealth funds, high net worth individuals, family offices and other pure-play direct investment companies. Those investors have been investing in international PE markets for the past 20 years and Islamic PE was always an avenue of interest for investors who prefer investing in Shariah-compliant investments. However, Islamic PE is still not matured with less regulations both on the structure side as well as the supervisory side.

Islamic PE involves the pooling of different investors, who may be high net worth individual, corporates and family offices. Historically, investors who only invest in Shariah-compliant investments held piles of cash in Islamic bonds or fixed deposits or investments in real estate as safe haven for their wealth as a means preserving their wealth.

The Shariah-compliant private equity industry in the GCC region has grown over the past 10 years due to an increasing interest from investors in the GCC region to do investments only in Islamicly-acceptable industries and business models. However, till date, there are no regulations governing the set-up of Shariah-compliant PE funds in a typical GP/LP structure as most investments are carried out directly by institutional Shariah-compliant investment companies or by high net worth individual investing directly in Mutual Islamic Funds or Islamic Equity Funds that only target companies which are Shariah-compliant.

Shariah-compliant PE funds (either through PE funds or institutional PE structures) provide financing to a range of investments that would be accessible to each investor independently through pooling with other investors leading to risk diversification. For Shariah-compliant PE, investment destinations must be in sectors that are classified Halal (permissible and not against

58 the teachings of Islam), therefore posing some restrictions on such investments when compared to conventional ones (Iqbal and Mirakhor, 2011).

In contrast with conventional PE funds, even with the prevalence of the GP/LP structure in Shariah-compliant PE, such Shariah-compliant investment proposals must obtain the approval of Shariah Supervisory Board before making any investment decision. The process of committing to a Shariah-compliant investment must go through the following process (Iqbal and Mirakhor, 2011):

• Once the initial investment appetite for a PE opportunity appears through PE transaction teams or the executive committees of the PE fund, this investment opportunity gets reviewed by the Shariah Supervisory Board to get the clearance of compatibility with Shariah principles; • The opportunity will then be passed back to the PE transaction team to take it forward with further operational, financial and business due diligence; • Once cleared by the transaction team, the final structure of the investment will have to go through the Shariah Supervisory Board again to get the final approval on the opportunity and the investment structure. • Periodic reviews on performance of each and every PE investment are carried out by the Shariah Supervisory Board to ensure continued compliance until exit takes place.

One of the main differences between the structure of Shariah-compliant structure and conventional one is the presence of the Shariah Supervisory Board. For Shariah-compliant PE, the Shariah Supervisory Board is an independent committee containing at least three scholars who specialize in Islamic jurisprudence (Fiqh al Muamalat) as well as in financial law. The Shariah Supervisory Board must check whether the selected investments are in accordance with the principles of Shariah or not. The Board is also responsible to review all the stages of the PE investments to ensure their compliance (Iqbal and Mirakhor, 2011).

The following list summarizes the major industries which are known to be clearly non Shariah- compliant:

- Any opportunities relating to pork products, drugs, tobacco, alcohol and in general any activity related to intoxicant products; - Pornography or obscenity in any form; - Gambling, casinos, lotteries; and - Some non-compliant financial activities which are based on interest, speculation and insurance.

Shariah-compliant PE industry faces some challenges when compared to conventional one in the sense that all activities that are run by the executive committee of the GP must be Shariah- compliant. The legal documentation for all such PE funds must be drafted in accordance with the Shariah principles from the perspective of content, restrictions, promises, funding structure, and the sharing of risks and rewards. For instance, any capital guaranteed returns are not legally in accordance with the Shariah principles and thus LPs must be aware that the value at exit would reflect the then fair market value.

Islamic private equity is a booming industry and endeavors to meet the demand of both Muslims and non-Muslims all over the world. However, the industry is still immature and there are some difficulties in implementing PE in general in the GCC due to the absence of any regulations and the immaturity of such asset class.

3.2.1 Islamic Private Equity Market in the GCC

Islamic private equity industry in the GCC region is a growing one and is driven by several factors, which are expected to contribute to its progress. Investors’ appetite towards Shariah- compliant investing increased significantly over the past 10 years. The Global Islamic Assets Under Management (AUM) is estimated at US$ 60.2 billion in 2014, and several Shariah- compliant companies have been established in all the countries in the GCC (MIFC, 2015). There is a big demand for Shariah-compliant investment opportunities in the GCC region with an improved investor awareness about the benefits of diversification. In addition, there is a large pool of family offices, who only invest in Shariah-compliant opportunities as they aspire to follow the guidelines of Islam even when it comes to investing. Further, non-Muslim investors

60 also look at Shariah-compliant investments as a growing segment that could add value to their portfolios. This is because both types of PE investors perceive this segment as a favorable one which could offer investment returns that are at least comparable to those returns offered by classical PE investments, resulting in a higher demand for Islamic PE investments (Marmore, 2016).

Some people in the GCC region want their businesses or investments to be all Shariah-compliant in line with their ideological beliefs, and would rather not make any investment in conventional businesses even if the returns are more favorable. Several family offices in the GCC region have a very strict criterion in investment, where every investment has to be Shariah-compliant even though their investment vehicles are not legally Shariah-compliant. An example of this is Al Bisher Family Office from Kuwait and Al Thuwaini Family Office from the UAE who follow the same principle; they only invest in Shariah-compliant PE opportunities. These family offices have become more sophisticated as they do not only ask about returns and strategy when they are being pitched for investment, but also they started investing in PE based on a co-investment model, whereby they want to know the technical details of every new investment made by the PE fund before committing to an investment and are becoming more selective. This model makes them invest in PE opportunities along with the GPs in a co-investment framework rather than investing as an LP in PE Funds.

In principle, conventional private equity financing is very similar to Islamic finance in the sense that there is a sharing of risks and rewards with investors and portfolio companies, but with the main difference that the deal structure has to be Shariah-compliant with some caveats relating to leverage use, sector restrictions and other important features.

- Sector Restrictions

Shariah-compliant finance permits the investment in all sectors that are beneficial and are of value to the economy, where employment opportunities are created and the eco-system is improved without committing any violations to the Islamic law. However, there are certain restrictions for investment in some sectors, which are against the principles of the Islamic

Shariah such as tobacco, wine, gambling, and casinos in addition to others. Furthermore, any business that involves interest taking or usery (Riba) is strictly prohibited under the Islamic law. Infrastructure sector, including ports, roads, educational entities, healthcare facilities, and telecom, is one of the sectors that are well-suited for Islamic private equity with the condition that it abides but the Islamic law.

- Use of Leverage

Under the Shariah rules, the use of leverage is allowed through various Islamic structures such as Murabaha (cost plus profit) or Musharaka (joint venture). Other leverage structures are allowed and are accredited by some Islamic Scholars such as the Dow Jones Islamic Market Index Criteria (DJIMIC), which specifies the Shariah-compliance criteria for any investment (Khatkhatay and Nisar, 2008). For example, DJIMIC stipulates that for an investment to be considered Shariah-compliant, the Debt to Market Cap ratio must be less than 33%, Liquid Assets to Market Cap ratio must be less than 33% and also Receivables to Market Cap ratio must be less than 33%. Further, Islamic debt must be backed by real assets. For Islamic private equity, this means that both GPs and portfolio companies are bound by the guidelines of the Shariah law in order to be classified as Shariah-compliant. It is worth mentioning that making PE investments in conventional companies which meet the criteria of DJIMIC is considered Shariah-compliant, even though the constitutional documents of such portfolio companies do not specifically mention it is a Shariah-compliant company by their Articles of Association. In such case, such investments are screened by independent Shariah committees to confirm its compliance with the Shariah law (Khatkhatay and Nisar, 2008).

3.2.2 Islamic Private Equity Firms

In the GCC region, there are 3 different type of PE investment companies; (i) conventional PE companies, which launch purely conventional PE funds or do direct PE in conventional non- Shariah-compliant companies such as Abraaj Group in the UAE; (ii) PE investment companies that offer both conventional and Shariah-compliant PE products such as Kuwait Financial Centre in Kuwait and Gulf Capital in the UAE; and (iii) Islamic PE companies which offer only Islamic

62 products including PE funds such as Al Dar Investment in Kuwait and Al Rajhi Capital in Saudi Arabia. The relationship between conventional private equity firms and Islamic private equity firms has evolved since the emergence of the PE industry in the GCC region in the last decade through some co-investment opportunities. In addition, several international PE companies (such as KKR and The Carlyle Group from the US) now partner with GCC Islamic PE firms (such as Jadwa Investments in Saudi Arabia) in order to form joint PE investments whereby the international PE companies benefit from the access to PE finance and exposure to investment opportunities in the GGC region, and where such Islamic PE firms in the GCC benefit from the experience and best practice of those international PE players.

3.2.3 Islamic Private Equity Structures

In essence, private equity fits well within the principles of Islamic Finance from the perspective of it aim and approach and the fact that it focuses on value creation and tangible economy. Private equity investors take an active role in the companies that they invest in with the objective of sharing the rewards upon exit. In other words, the GPs and LPs have an aligned interest; LPs to make good investment returns, and GPs to make good incentive fees. There are two main forms of Islamic private equity investment structures that are followed by GPs focusing on Islamic private equity.

3.2.3.1 Mudarabah – it is a Shariah-compliant contract between two or more parties, whereby one party provides money or capital as a contribution (capital owner), and the other party provides its efforts as a contribution (agent) to undertake a specific agreed-upon task or business (Rahman, 2018). This is the same principle as a GP and a LP; whereby the LPs provide capital to be invested, and where GPs manage the investment and divestment cycle without committing any capital from the GP’s side into the Islamic private equity fund. Therefore, Mudarabah is one form of Shariah- compliant private equity structures, which is being followed by pure-play Islamic private equity houses.

3.2.3.2 Musharakah – it is a Shariah-compliant contract (means Sharing in Arabic) between at least two parties, but usually several parties, whereby each party commits a capital into an investment partnership or joint venture, at an agreed entry valuation among all investing parties. All the investors in the Musharakah share profits and losses as per their shareholding. Musharakah is frequently used in the purchase of real estate properties and this has extended into private equity recently. Therefore, Musharakah is another form of Shariah-compliant private equity structures, whereby the GP commits an amount of money to the PE Fund along with LPs forming together the Islamic private equity fund and where the GP sets clearly its right to the discretionary management of the PE Fund in return for management and incentive fees. The only difference between Mudarabah and Musharakah in Islamic private equity is the capital contribution of GPs in a Musharakah and not in a Mudarabah (Shah, 2015).

Therefore, private equity in it purest form is in line with what Shariah principles allow. This is why the restrictions imposed by the Shariah-law in Islamic private equity do not relate to the investment approach or modus-operandi, rather it relates to sector restrictions and the use of leverage making the structuring of an Islamic private equity deal straightforward and understandable by investors.

In conventional private equity deals, leverage is a fundamental component in any deal funding. In Islamic private equity, leverage can still be used, however, with certain limitations as set out by DJIMIC framework, which is followed closely by Shariah committees in the GCC when classifying investments as a Shariah-compliant or not. Furthermore, debt can be provided away from the DJIMIC framework without incurring any interest if it takes the Murabaha structure. A Murabaha structure is a Shariah-compliant financing structure where the financing happens over two stages with two separate agreements. In the first step, the lending financial institution buys a commodity or a service that the client is offering in one agreement, and in the second step the client agrees to buy that service back from the financial institution at a different price (cost plus profit) in a separate agreement. In this case, the Murabah contract does not involve interest and is not considered an interest-bearing loan and thus is fully Shariah-compliant (Hanif, 2014).

In short, there are major differences between the structure of Shariah-compliant private equity versus conventional private equity relating to the legal structure of private equity investments, sector restrictions and the use of leverage. This may lead to an increased appetite by GCC investors when investing in private equity due to Islamic PE competitiveness due to the lower leverage and the improved corporate transparency.

3.3 Structural Differences Between PE in the GCC and Other Regions

There are key structural differences between the GCC private equity industry and that of the United States and Europe. The GCC PE infrastructure is still being developed, with an absence of a track record and historical performance. In addition, the size of the GCC PE industry is relatively small when compared to the more mature US or European PE industries. The table below highlights the main fundamental differences in the private equity’s modus-operandi for the three regions (details will follow).

Table 15 Structural Differences between Private Equity in the GCC and Other Regions Particular US & Europe GCC Composition of LPs Public & private pension Sovereign wealth funds, funds, endowments & family offices and foundations, financial institutional investors as well institutions, insurance as high networth individuals. companies, and increasingly family offices. Role of LPs & LPs in the US and Europe are A large proportion of Relationships usually more passive and have businesses in the GCC are no role in the PE investment family-owned. Family- management subtleties. oriented LPs play a critical role in deal sourcing for GPs, due to their robust and closed trusted networks giving them a comparative advantage when identifying investment targets. Regulatory Environment Private equity is a regulated Private equity industry in the industry and has a standalone, GCC is only subject to well established and corporate laws of Limited comprehensive rules and Partnerships, if they are regulations that serve to structured so. Moreover, the

Table to be continued next page…

increase disclosures and industry professes self- transparency of funds and regulation where disclosures investment managers alike. are usually made between General Partners and Limited Partners. Most of the data regarding private equity is derived from voluntary disclosures made by the funds to industry associations. PE Exit Options IPOs have always been and The most common exit type still the preferred exit channel by private equity firms in the for most PE funds. GCC region is the sale of portfolio companies to other corporate investors, institutional investors or family offices. PE Funds’ Structure Private equity funds are Private equity funds are generally structured as structured as Limited Limited Partnerships (LPs) or Partnerships incorporated in as limited liability companies the Cayman Islands mainly. (LLCs), and the capital is Such jurisdictions offer typically raised in private transparent common law, placements as per the exempt tax structures and an prevailing securities law enforceable legal system for requirements. all investors. All investors invest at the fund holding level which becomes the investment vehicle to make all fund investments.

3.3.1 Composition of LPs

Private equity funds typically obtain their funding from institutional investors such as pension funds, insurance companies, banks, and government institutions. Well-informed individuals of high net worth and wealthy family offices also partake in private equity funds. The private equity market in U.S remains robust. Capital raising has increased year after year, while investors have either maintained or increased their allocations to private equity. Deployment of the capital has also progressed at a steady pace, despite valuation concerns. The primary sources of funding for private equity funds in the US include public and private pension funds, endowments and foundations, financial institutions, insurance companies, and family offices. Family offices have increased their asset allocation to private equity in recent years. They now target 30% allocation

– almost double that of their peers. In sharp contrast, for banks and other financial institutions, the overall share of capital invested in private equity has dropped in recent years, mostly due to Volcker Rule regulations, which is a federal regulation preventing banks from carrying out certain investment activities from their own balance sheet and limiting their ownership percentages in private equity and hedge funds (Preqin, 2017). Principle investors in the United Kingdom include pension funds and sovereign wealth funds, while participation by corporate investors or private individuals remains low. Private equity market and deal flow have remained relatively stable on the back of Brexit concerns. PE firms have concentrated more on exits on account of buoyant stock market and low interest rates. New deals are hard to source in the current environment (Reuters, 2016).

In the GCC, the private equity market has been very challenging especially after the global financial crisis of 2008, resulting in a persistent drop in oil prices leading to diminishing government spending. Sovereign wealth funds, family offices, institutional investors, and individuals of high net worth constitute the majority of private equity investors. Deal activity and fundraising after the 2008 financial crisis also dropped drastically, resulting in less funds being raised, slower investment activity, and very minimal initial public offerings. However, the GCC region experienced 2.3% economic growth in 2016 which is expected to increase to 2.4% in 2017 and is expected to pass 3% in 2018 and 2019, driven by the anticipated economic reforms post 2017, high oil prices and the increase in GCC governments’ budget spending on infrastructural projects (World Bank, 2017).

3.3.2 The Importance of Relationships

Conducting business in the GCC region leads to professional relationships and business connections. This can be partially attributed to the fact that a large proportion of businesses in the GCC are family owned, and those families have diversified portfolios in various sectors. In addition, even amongst the GCC families, strong ties are formed in general, resulting in ease of doing business between those families. It is worth mentioning here that family businesses represent around 40% of the GCC’s non-oil GDP and more than 50% of private sector employment (Strategy &, 2010). It is also estimated that family businesses constitute

67 approximately 75% of the private sector in the GCC and recruit circa 70% of the workforce (Economic Intelligence Unit, 2009). Most of these businesses are unstructured in nature, lack corporate governance and have control issues. Furthermore, the developing nascent regulatory environment in the GCC poses more concerns making family-owned business a challenging target for GPs or PE investors in general.

One of the differentiating features of PE in the GCC region for the family businesses is the role played by family-oriented LPs in deal sourcing for GPs, unlike the scenario with other global PE LPs. LPs from big family groups in the GCC, who are investors in regional private equity funds, play a vital role in deal sourcing due to their robust and closed trusted networks giving them a comparative advantage when identifying investment targets. For example, Mohamed Al Abbar Enterprise in the UAE launched a PE fund of US$200 million in 2017 targeting medium-sized companies, and it started investing in different companies before fully raising the target size of the fund. Furthermore, as a result of the emergence of GCC PE investment houses and GPs in the past decade, local LPs and family offices have had more exposure and have shown great experience when investing in PE, mainly due to family offices’ exposure to international PE investing before the evolution of the PE industry in the GCC (Strategy &, 2010). Therefore, the role of LPs in the GCC region is more critical for deal flow for private equity managers, unlike other regions such as the US and Europe, where LPs are usually more passive and have no role in the PE investment management subtleties. INSEAD-Booz & Company (2010) ran a survey in 2010 where all survey respondents from LPs confirmed that they expect that all acquisitions to be made in private equity are to be sourced privately and through connections and relationships. In addition, LPs highlighted the importance of building strategic alliances and business partnerships in succeeding when investing in private equity.

In spite of this being a unique attribute to the GCC region, it also raises some questions as to whether there are concerns of conflict of interest over the selection of private equity targets (Strategy &, 2010). This raises other concerns such as the lack of adequate due diligence on PE deals sourced by family-oriented LPs rather than being sourced at arm’s length by GPs. This could be another area for research once a good understanding of the dynamics of the PE industry in the GCC region is established. Additionally, deals sourced by family-oriented LPs could be

68 generally prone to unrealistic exhaustive valuation expectations leading to high entry multiples, which was the case before the 2008 financial crisis, which lead to a significant slowdown in the PE industry in the GCC following the crisis (Financial Times, 2010). Moreover, the GCC region’s banks have had a blatant preference towards lending on a popular-name basis rather than a collateral basis. A good example which had significant business implications in the GCC market is what was known as The Saad-Algosaibi Affair, in which significant amounts of debt instruments worth US$22 billion were circulating without any real collateral or proper scrutiny, depending merely on name-based lending resulting in a big default (Economist, 2015). Nevertheless, the picture has completely changed after the 2008 financial crisis in which banks became stricter and extra conservative and transitioned towards being more normalized with performance-based lending with additional security cushions. As a result, GPs in the GCC, who lack a strong reputation in terms of track record, would find it challenging today to bank on LPs’ reputation for either deal sourcing or fundraising (Strategy&, 2010).

3.3.3 Regulatory Environment

In the United States and the United Kingdom, private equity is a regulated industry and has standalone, well-established and comprehensive rules and regulations that serve to increase disclosures and transparency of funds and investment managers alike. For instance, PE funds should notify the regulator when a significant stake is obtained or disposed of in private companies. Regulations and requirements related to acquisition of control of unlisted companies, pertaining to communication and disclosures and establishment of safeguards against erosion of capital are established. However, in most other countries, private equity is largely regulated within the framework of existing regulations of the state. For instance, in India, private equity investment from abroad is considered Foreign Direct Investment (FDI), which is subject to regulations on foreign capital such as sectoral caps and a lock-in period. Similarly, private equity firms that execute mergers and acquisitions are bound by the rules of takeover legislation (Stowell, 2017). In addition, banks and financial institutions’ contribution in the total capital invested in the PE industry in the US shrank drastically in 2017 due to new restrictive regulations such as the Volcker Rule (Preqin, 2017).

In the GCC, given that most investors in private equity are institutional investors or high net worth individuals, who are unlike retail investors considered to be sophisticated, PE funds are not scrutinized to a greater degree as other investment products are, such as mutual funds or listed equity investments. In most jurisdictions, they are only subject to corporate laws of Limited Partnership if they are structured so. Moreover, the industry professes self-regulation in which disclosures are usually made between General Partners and Limited Partners. Most of the data regarding private equity is derived from voluntary disclosures made by the funds to industry associations. On the downside, such a practice incentivizes firms to only report successful activities leading to the creation of a survival and performance biases by not reporting dead or written-off investments.

Independent capital market regulatory authorities in most GCC countries were set up during different years and are still developing the reforms required to keep up with the market developments and regional needs. For instance, the book building process for an IPO is hardly the norm in the GCC capital markets. As most of the stock market participants are retail in nature, the standard practice in the GCC region is to float a company at a fixed price, set by the regulator, based on company’s actual and forecasted financials. Such a mechanism might discourage companies that seek a fair value for their shares from the market. The table below highlights the establishment year of the regulatory bodies in the GCC countries.

Table 16 Capital Market Authorities Country Regulator Inception Kuwait Capital Market Authority 2010 Bahrain Division of Central Bank of Bahrain 2007 Qatar Qatar Financial Market Authority 2005 Saudi Arabia Capital Market Authority 2003 UAE Securities and Commodities Authority 2000 Oman Oman Market Authority 1998 Source: Relevant Capital Market Authority in each country

Capital market laws and financial regulations are being revamped in an attempt to increase transparency, ensure accountability, and encourage foreign investment. However, regulations governing structures such as preferred shares, takeover regimes, and squeeze-out clauses that protect minority investors are still absent in most countries. Several reforms have also taken

70 place in the GCC region relating to real estate ownership reforms in the UAE as well as increasing ownership stakes for foreign investors in Saudi Arabia yielding positive investors’ appetite such as private equity investors targeting these newly-reformed sectors. This will not only ease the way businesses are done in the GCC but also will improve investors’ confidence in such economies. Nevertheless, the regulatory and legal environment in the GCC still lacks critical reforms similar to those of developed economies such as the US and European Union countries. In addition, the GCC region does not abide by one single set of jurisdiction rules, as each one of the six-member states has its own rules and regulations as stipulated by the commercial law or even the companies’ laws (Marmore, 2016).

Stemming from the concept of consumer protection and as a means of avoiding monopolistic incidents, the UAE issued some laws that would supposedly maintain a competitive landscape for both investors and consumers. For example, Competition Law, which is a federal law issued in 2012, aims to regulate any anti-competitive behaviour in the UAE applying not only to companies carrying out commercial activities in the UAE but also to companies operating outside the UAE but whose activities impact the competition inside the UAE. In the case of acquisitions such as a contemplated PE transaction, such law requires GPs to apply for a merger clearance from the Ministry of Economy should they decide to acquire a company that may result in an anti-competitive scenario and create a dominant position in one industry or affect the level of competition in the market in that industry. The criteria for anti-competitive acts include when the new merged entity has a total market share above 40% of the total industry, thus hindering competition and fair play (Steyn, 2012).

In Dubai International Financial Centre (DIFC), a legal structure such as investment partnerships is usually used for PE investors to carry out their acquisitions. GPs in this structure are authorized by the Dubai Financial Services Authority (DFSA) to act as the PE fund manager. Two main types of funds PE GPs are allowed to create and are authorized in DIFC: (i) public funds and (ii) exempt funds. The exempt funds are only open to clients with a minimum subscription of US$500,000 and such fund is not permitted to have more than 100 investors (DFSA, 2014). Further improvement in such regulation was introduced in 2014 by the DFSA introducing Qualified Investor Funds (QIF), whose cost is lower than the exempt funds having

71 less regulation and targeting mainly well-informed investors such as high networth individuals and family offices (DFSA, 2014).

In the UAE, free-trade zones are special areas where full foreign ownership is permitted by foreign investors with special tax and custom treatment with the aim of encouraging foreign direct investments and are governed by their own rules and regulation under the respective authority. This had a positive impact on GPs’ appetite to invest in companies with a free-zone domicile avoiding ownership and control restrictions, (Gulf News, 2017).

While there are no direct regulatory reforms affecting the PE industry in the Kingdom of Saudi Arabia (KSA), there have been numerous reforms as part of the broad capital market reforms, designed to improve market conditions in the Kingdom. KSA’s Capital Market Authority (CMA) recently approved the direct entry of foreign institutional investors in the Saudi’s stock market marking the largest regulatory reform in the history of the stock market. This would generate increased investment interest by private equity firms in the GCC and from abroad. This may lead to an improvement in corporate governance and streamlined and clear exit prospects. The Saudi Arabian General Investment Authority (SAGIA) has introduced a ‘fast track service’ that guarantees decision on licensing applications for businesses within five working days, proved that all the required documentations are submitted on time. This would help in quicker business setup, more transparent processes and enhanced governance for foreign investors in the Kingdom. Additionally, the new Arbitration Law introduced in 2012 in Saudi Arabia would make foreign investors more confident when carrying out their business activities as it is based on international best practices (Alkhabeer Capital, 2014).

In the case of squeeze-out provisions, different GCC countries have different regulations governing it. In Qatar, squeeze out is allowed and is subject to a Ministerial decree, whereas in the UAE and more specifically for NASDAQ Dubai listed companies, it is allowed given that the bidder has already acquired 90% or more of the target company or has unconditionally committed to acquire 90% of the target company (Linklaters, 2011).

UAE, Kuwait and Bahrain issued decrees allowing them to accept new investors only after going through proper Know Your Customer (KYC) verification process. Further, such funds which are being marketed must undergo a thorough registration process via a locally licensed entity. In the UAE, Abu Dhabi Investment Authority (ADIA) has become one of the world’s most active investors in alternative assets (i.e. private equity, hedge funds and real estate funds). The availability of patient capital, characterized by long holding periods, made such sovereign wealth funds increase their fund commitments in private equity in local and international private equity funds. Not only in the UAE, but also Kuwait sovereign wealth funds have always been active in PE investing and more recently more active investment is being carried out by Saudi Arabia and Qatar. The UAE recently amended its laws to allow fund managers to promote funds to local SWFs and other institutional investors. Saudi Arabia, traditionally the most restrictive jurisdiction for raising funds in the region, is consulting on changing its laws, potentially allowing marketing to SWFs and other institutional investors (Alkhabeer Capital, 2014).

Although the GCC region enjoys an attractive tax environment, it however lacks a rigid and structured legal operating framework for investors’ protection such as bankruptcy laws, corporate governance practices or foreign ownership and control dynamics and thus the need for major reforms. The regulatory environment in the GCC has failed to move in alignment with the prevailing economic growth, especially following the 2008 financial crisis, given that in other regions in the world, the scope and pace of economic reforms have accelerated to meet both international best practices and local market conditions. Thus, there are still many gaps within the regulatory framework that needs to be reformed in order to meet the expectations of private equity investors as well as foreign investors (Strategy &, 2010). The absence of bankruptcy laws in the GCC has always been a hindrance towards having a fully functioning ecosystem supporting entrepreneurs and making it easier for private equity players to take an active part in the development of this asset class. This is due to the GCC countries’ attention on protecting creditors in the first place, focusing on asset liquidation as a means of debt recovery rather than granting an opportunity for investors to restructure their businesses and debts (Markaz, 2013). However, some reforms have recently been initiated by the UAE and Kuwait revamping their bankruptcy laws and introducing insolvency codes aimed at helping investors restructure their debts under courts’ protection, contrary to what was prevalent such as liquidation and business

73 shut down. These measures would constitute a boost to the ecosystem encouraging entrepreneurs and investors to pursue growth mandates, invest more and take growth debt without being fearful of unwanted consequences (Mabin and Al Rasheed, 2017). Nevertheless, and due to the contemporary nature of such bankruptcy laws in the GCC, which have not been heavily tested, financial lenders such as banks are still reluctant to loan to investors as this constitutes an added burden towards the non-performing loans that are sitting on their balance sheets and thus even such laws are positive for investors, they are not for lenders as long as the governments’ backing is lacking. Furthermore, in the case of minority shareholders owning small stakes in companies, they are still at a big disadvantage as regulations governing preferred shares, takeovers and squeeze-out provisions are either unclear or absent altogether. If this is compared to more developed countries such as the US, the existence of a sound legal bankruptcy system gives extreme relief to private equity investors in case of any portfolio company failing and thus providing the opportunity to restructure debts and ensuring business continuity (Markaz, 2013). While the GCC region is at an advantage from the perspective of tax systems in place, which is very much in favour of private equity investors, it still needs to perform better in the areas that interest private equity players such as investor protection, bankruptcy laws, and law enforceability.

The GCC region is characterized by a relationship-driven market for private equity investors with deal flow contribution from LPs, due to the family-driven nature of the businesses. The due diligence process is usually lacking in terms of corporate disclosures and quality of earnings resulting in less transparency, and deterring foreign institutional investors from committing funds into the region. In spite of the limited progress towards market liberalization in some of the GCC economies, the role of governments in instilling governance frameworks and formalizing investor protection rules is very critical to make the GCC an investor-friendly destination (Strategy &, 2010).

Corporate governance in the GCC region has been inadequate. It is not uncommon for private firms not to follow an accurate bookkeeping framework and not to have been audited or questioned by external stakeholders. More than 45% of small and medium enterprises in their mature cycle do not adopt standard accounting practices. These companies tend to employ small

74 local accounting firms that do not abide by recognized international financial reporting standards and are prone to agreeing to reporting figures that business owners want to show. This erects significant challenges for private equity investors trying to run a full comprehensive business, financial and legal due diligence on target companies especially in the absence of a government- backed corporate governance framework (Dubai SME, 2011).

3.3.4 Exit Options for Private Equity

The PE investment activity in the GCC started as early as 2000, and it continued its growth until it peaked in 2007, after which the ramifications of the 2008 financial crisis have negatively affected the investment and exit activity. Given the nascent nature of the PE industry in the GCC and the fact that PE investments started happening in 2000, the majority of exits also started occurring between 2010-2014, as the typical tenure of PE funds is 7-10 years in the GCC. However, several planned exits have been delayed due to a negative performance of those investments as a result of the 2008 financial crisis. As a result, GPs extended the life of their PE funds to additional 3-5 years to carry out restructuring plans, thus prolonging exit plans. GPs, however, managed to exit some portfolio companies prior to the 2008 financial crisis with the aggregate value of exits in 2008 reaching US$ 1.2 billion. During the first 3 quarters of 2008, a surge in capital inflow into the GCC region took place with valuation multiples, such as price-to- earnings ratio, reaching new record highs and affecting exit valuations and divestment proceeds. The reality is that such valuations were driven by positive market sentiment and abundance of cash rather than enhanced operational efficiencies and business scalability (Miniaoui, Syani and Chaibi, 2015).

There are several factors which have affected the number of exits in the GCC region by GPs. Capital markets are still inefficient, illiquid, and immature; the relatively new and underdeveloped private equity industry; scarcity of leverage for acquisition finance; and most importantly, a primitive culture of aggressive M&A for regional corporate investors buying from private equity GPs (Charfeddine and Khediri, 2016).

The most common exit type by private equity firms in the GCC region is the sale of portfolio companies to other corporate investors, institutional investors, or family offices away from the stock market, because sellers tend to have more bargaining power exercising a stronger negotiation stance over buyers who have the cash but lack a healthy flow of good investment opportunities (Marmore, 2016). In addition, buyers must choose more strategic acquisitions, thus completing their value chain in some cases or pursue inorganic acquisitions to build stronger balance sheets for a later exits through an IPO, or even diversify their product offering and achieve more synergy. Furthermore, regional investment banks played a major role in initiating a bidding process over assets with good performance and a positive track record, leading to bidding wars through a formal auction process. Such corporate divestures could consume a significant amount of owners’ and management’s time and several rounds of tough negotiations before a transaction is concluded (Marmore, 2016).

The other exit type in the GCC is secondary buyouts, which is less prevalent. Secondary buyouts are another type of exit for private equity GPs, which usually happens when an existing private equity GP sells some of its portfolio companies to another emerging or new private equity fund, with the former fund being in the winding up stage and the latter being a newly established PE fund. However, given the early age of the PE industry in the GCC region, this is expected to happen heavily in the next round of PE exits in the GCC region as more PE funds start entering the maturity stage while new PE funds are being set up (Marmore, 2016).

Contrary to the more developed markets such as the US and the UK where IPOs have always been and are still the preferred exit channel for most PE funds, PE exits through initial public offering for GPs in the GCC have not been an active route. This has mainly contributed to the underperformance of capital markets over the past decade and the dropping valuation levels driven by a mix of geopolitical instability and weakening economic fundamentals as a result of declining oil prices. In addition, IPO procedures in the GCC region are not investor friendly because of the stringent lock-up period rules making pre-IPO investors subject to lock-up periods ranging from 6-24 months, depending on the individual GCC countries’ stock markets regulations (e.g., in Kuwait it is 24 months). This is intended to prevent excessive selling by earlier investors and to avoid shares dumping, which could adversely affect stock valuations

76 immediately after the portfolio company’s shares go public and due to the low levels of liquidity, which could also accelerate such price fluctuations. Furthermore, the viability of exits through IPOs is highly determined by the then-prevailing market conditions and investors’ sentiment. Given that the GCC region’s stock markets are characterized by informational inefficiency (Al Janabi, Hatemi-J and Irandoust, 2010), stock prices upon IPOs may significantly fluctuate, leading to value impairments or a significant increase. Price fluctuations are also impacted to a large extent by the concerned company’s performance in relation to financial and operational milestones being met. If for GPs the investment has decreased in value, the available options become limited. GPs could either sell their stake at a loss to another investor, hold for a much longer period with more risks on board, or attempt insolvent liquidation if the portfolio company’s performance deteriorates (Al Janabi, Hatemi-J and Irandoust, 2010).

3.3.4.1 IPO Exits

The GCC capital markets are still underdeveloped, characterized by market informational inefficiencies (Zein and Grigorievna, 2016). This is why, in light of the existing regulations surrounding the IPO market in different GCC countries, managing initial public offerings is a challenging task, posing several obstacles for private equity firms when contemplating their portfolios’ exit prospects. Company size limitations, minimum capital requirements, bureaucratic filing process, investor lock-up periods, minimum profitability thresholds, and high filing costs are some of the bottlenecks that private equity managers face when preparing their portfolios for exit through IPOs (Zein and Grigorievna, 2016). IPO regulations have not progressed well to enable investors to explore such routes as the key channels when making their PE investments. Initially, the inexistence of a capital market central authority in each of the GCC countries was one of the problems faced by investors when filing for an IPO, due to the subjectivity prevalent in accepting such IPO applications by authorities. In addition, and as a result of the GCC countries depending through high oil prices, the region witnessed a period of high valuations and higher number of retail investors participation, leading to higher market volatility (Zein and Grigorievna, 2016). Hence, there were periods with high level of IPO activity as seen in 2007 (34 IPOs) and periods of low activity such as year 2016 (4 IPOs).

Table 17 IPOs in GCC Region (2004–2014) Amount Raised (US$mn) No. of IPOs 2004 380 12 2005 1,800 21 2006 6,482 19 2007 12,043 34 2008 11,226 22 2009 1,035 11 2010 2,031 12 2011 796 9 2012 1,685 9 2013 702 9 2014 10,892 17 Source: Zawya

The number of IPOs in the GCC region decreased both by value and volume following the 2008 global financial crisis, affecting investors’ appetite for more investments and fearing risk after the global equity collapse in 2008. From 2009 to 2013, a mere US$ 7.15bn was raised in the primary capital markets of the GCC representing 60% of the size of the IPO activity witnessed in 2007, which was the year with highest number of IPOs in terms of volume and value. Furthermore, amongst the IPOs that took place, only a minimal portion was an exit by private equity investors whose portfolio companies had to execute complete turnaround and restructuring. The other challenge for private equity firms in the GCC region is the fact that liquidity levels are low, adding more difficulty to selling through IPO and limiting the options to a prolonged sale process that can take up to 12-18 months, as liquidating a large number of shares would diverge the stock selling price from the fair value of the sold stock. The stock market liquidity in the GCC region fell significantly on the back of the deteriorating market conditions following the 2008 financial crisis, as the predominant retail investors were in the mode of loss accumulation accompanied by lack of buyers. Furthermore, bank lending reduced considerably due to the blatant tendency of banks to squeeze their lending activities and to focus on recovering as much as possible of the non-performing loans and dues from defaulters and semi-defaulters who went into loan restructuring initiatives (Markaz, 2013).

3.3.4.2 Trade Sale

Private equity managers also pursue a trade sale as a more appealing exit route in the GCC region, whereby a portfolio company is sold to another strategic buyer or a corporate buyer who sees synergies to complement their exiting businesses across the value chain for the sector they are operating in. For such strategic or corporate buyers, such acquisitions from private equity- sponsored assets may put them on a better competitive edge, provide them with improved growth prospects, or accelerate their inorganic growth. From the private equity managers’ perspective, such acquisition justifications by strategic buyers provide them with better bargaining power, while usually requesting a premium to sell their private equity portfolios (Wright, Robbie, Romanet, Thompson, Joachimsson, Bruining and Herst (1994) and Kaplan and Schoar (2005)).

Trade sale in the GCC region can be categorized into two main buyers’ groups: regional players and international players. Regional players who buy PE portfolio companies are usually family businesses or conglomerates looking to expand within the GCC region and gain more market share, consolidate their position in the market, and diversify their holdings as a means of total risk mitigation (Zein and Grigorievna, 2016).

On the other hand, international corporates who are keen to expand their businesses globally view the GCC region as a lucrative destination due to its strong economic fundamentals underpinned by its dependency on oil wealth, coupled with the young and growing population. Such international firms usually target consumer-driven sectors such as healthcare, food and beverage, education, and retail in order to benefit from the demographic advantages of the GCC region. Furthermore, the rising wealth in the GCC region has also appealed to international players, positively impacting their investment allocation decisions toward the financial services industry, such as wealth management and investment banking services. For example, the behemoth Blackstone Group bought a stake in the Dubai-based GEMS Education Group (Blackstone, 2014). Further examples include the recent acquisition of Dubai-based Souq.com by Amazon (TechCrunch, 2017), the partial sale of Metiti Holdings to Mitsubishi Corporation and Mitsubishi Heavy Industries, and the exit by Younata Group to its stake in Kalium Group to the

79 giant healthcare services provider AVIVO Group in the UAE, which reflects how highly the GCC region is perceived in terms of growth potential (Marmore, 2016).

In most cases, trade sale occurs when the whole company is sold, or all of the investor’s stake is divested, thus effecting full exits and, in the majority of cases, for a cash consideration. However, in some cases, the sale is executed through shares in the acquiring company, which might be listed, providing an exit window for the private equity investors (Cumming and Macintosh, 2003). Typically, the purchaser for the PE investor’s stake is a strategic acquirer who seeks synergies or vertical or horizontal integration with the acquired company (Cumming and Macintosh, 2003). There is also an evidence that strategic buyers for PE portfolio companies tend to pay a premium in order to acquire such companies due to the perceived synergies that can be accomplished and the anticipated long-term benefit that can be attained by investing in such companies (Harris, Jenkinson and Kaplan, 2014). Nonetheless, not all strategic acquisitions are merely executed due to synergies; such acquisitions can also be made to eliminate competition or to build business empires (Gompers and Lerner, 2004). In some cases, the decision to buy certain portfolio companies by strategic buyers from PE players is to complement the acquirer’s product offerings, or acquire a technology that would support the development of products or services in order to offer complete business lines. This is way better than developing the product or the technology required to enhance their offering thus saving time and efforts, albeit through a high acquisition premium. The acquirer’s willingness to pay a certain acquisition premium is highly dependent on the level and magnitude of the expected synergies from the acquisition (Bienz, 2004).

3.3.4.3 Secondary Sales

Secondary sales are a very common exit route for which a full exit happens and equity stakes exchange hands with the acquirer, which is usually a strategic buyer or another private equity or buyout fund. In the secondary sales situation, only the private equity investor sells its stake, whereas other shareholders and the management team members who also own stakes do not. In addition, since not all shareholders sell their stakes in a secondary sale, the acquirer does not necessarily take full control of the business, depending on the stake sold by the private equity

80 owner (Cumming and Macintosh, 2003). Transaction synergies are not essential or are achieved to a lesser extent due to the fact that the acquirers do not typically own the whole business and thus are unable to fully integrate the acquired company with their own businesses to the existence of other shareholders who may have different agendas, business plans, and strategies. As such, secondary sales, unlike trade sales, do not offer much price premium upon exit and thus generate a lower return than those achieved by trade sales (Bienz, 2004). A new trend in private equity, which is growing especially in the GCC region, is a secondary buyout, in which a company is sold from a financial investor to another financial investor. Private equity funds in this case would be the financial investor buying the offered stake in a buy-and-hold model. Such a phenomenon is growing in the GCC region, fuelled by the growing number of portfolio companies held by private equity funds.

3.3.4.4 Buy-backs

Private equity managers sometimes invest in companies or partner with companies’ founders based on promising business plans. In such cases in which the business founders are so optimistic about the future performance of their companies, private equity managers tend to insert a “put option” or a “buy-back” option at a predetermined exit IRR, which will be triggered if such promised performance is not achieved, thus impacting the ability of private equity managers to exit at a lucrative rate. If this clause is triggered, the stake bought by private equity managers is sold back to the founders of the business or the previous investors from which the stake is bought at the predetermined exit IRR. This exit route for private equity managers usually occurs when the entry valuation is not very competitive and is on par with listed comparable companies. In addition, this route can also be pursued by private equity managers for divesting portfolio companies with limited access (Cumming and Macintosh, 2003).

The GCC capital markets are generally fragmented and are driven by small retail investors. This has changed lately, as the GCC stock markets are being developed and capital market authorities have taken a more active regulatory role in supervising listed companies’ actions. Such regulations have made listed companies more institutionalized with the implementation of corporate governance frameworks such as the establishment of board committees, the

81 appointment of independent board members, and the segregation of duties between the CEO position and the Chairman position. In addition, more regulations have been implemented in the GCC, such as the imposition of lock-up periods. For instance, the Saudi Arabian Stock Market (Tadawul), which is the largest stock market in the GCC region, imposes a 6-month lock-up period on all early shareholders, blocking the ability of the original shareholders to liquidate upon listing. Furthermore, the Saudi Capital Market Authority must also approve all share sales. In addition, in the United Arab Emirates, the capital market authority has a rule that companies going for listing their shares in the stock market have to list at least 55% of their shares through new share issuance rather than secondary shares, meaning that any investor with a minority shareholding cannot exit their investment upon IPO, thus leaving aside the 2-year lock-up period for founding shareholders (Strategy &, 2010). For private equity, there is no regulatory body, and there are no such regulations governing the activities of PE firms. Only when PE portfolio companies get listed on stock markets do they become subject to capital market authorities’ regulations.

3.3.5 PE Funds’ Structure

Private equity firms in the GCC region use different fund structures when they raise money from investors or LPs in order to effect discretionary investment and management decisions of their PE portfolio companies. This is due to the existence of foreign ownership limitations for all investment vehicles created in the GCC with the imposition of the 51/49 minimum local ownership structure (i.e. foreign investors are allowed to own a maximum of 49% of any locally established entity leaving majority ownership with local investors). Therefore, GPs resort to establishing such investment vehicles outside the local territories of the GCC countries. In the below section, I highlight the legal structure for PE funds in the US before elaborating on that of the GCC region in order to provide a meaningful benchmark.

3.3.5.1 The United States

In the US, private equity funds are generally structured as Limited Partnerships (LPs) or as limited liability companies (LLCs), and the capital is typically raised in private placements as per

82 the federal securities law requirements (Light, 2015). There are several benefits in structuring PE funds as either LPs or LLCs in the US. Both LPs and LLCs are not subject to corporate income tax and thus are “pass-through vehicles.” In other words, all profits or losses of such structures are passed through to Limited Partners or investors and are taxed at the Limited Partners’ level (Light, 2015). Furthermore, LPs and LLCs are normally flexible vehicles in the sense that they allow standard statutory provisions to be modified as per the preferences of GPs and LPs. Thus, they are not subject to strict regulations and therefore allow both LPs and GPs to have negotiable structures and customized legal clauses (Light, 2015). All investors in the LP or LLC structure have a limited liability to their capital commitment and share of the PE fund asset portfolio only, and thus they are not personally subject to the liabilities of the LP or the LLC vehicle, all of which is subject to the applicable laws and regulations (Light, 2015).

In addition, in the US, private equity funds are formed as Delaware Limited Partnerships or Delaware Limited Liability Companies for several reasons, such as the fact that investors are more familiar and more comfortable with such a jurisdiction, as it generally became an industry norm in which Limited Partners prefer not to change, due to its investor-friendly structure (Metrick and Yasuda, 2010). Moreover, Delaware has its own specialized courts for the various businesses operating out of it, resulting in relevant exposure and expertise in relation to business, economic, and governance issues. In addition, Delaware has been rapidly developing a robust common law practice governing LPs and LLCs for private equity players, and the region is now considered one of the most sophisticated in the US with broad contract flexibilities (Metrick and Yasuda, 2010). The administrative process in Delaware is not expensive and relatively smooth, with plenty of entities offering business and legal services with great efficiency (Metrick and Yasuda, 2010). Other structures that are also investor friendly and better serve private equity firms desiring to invest outside the US are Cayman Islands, Luxembourg, or British Virgin Islands LP structures, which are tax exempt and are well structured with strong and very enforceable legal systems (Metrick and Yasuda, 2010).

3.3.5.2 The GCC

In the US and Europe, private equity firms usually acquire stakes in companies through tax- efficient structures and use leverage on the funds’ level accordingly. The GCC, however, exhibits a zero-tax system with immature and a nascent regulatory framework with undeveloped legal system with many unenforceable rights for PE players, such as ownership rights and control concerns for non-GCC owners (Marmore, 2016). Furthermore, private equity funds are structured as Limited Partnerships incorporated in the Cayman Islands mainly, or in some cases in the British Virgin Islands (BVI). Such jurisdictions offer transparent common law, exempt tax structures, and an enforceable legal system for all investors. All investors or Limited Partners come in at the fund-holding level, which becomes the investment vehicle to make all fund investments (Tomlinson, 2010).

Several factors are taken into consideration by General Partners before establishing the private equity fund structure which may be imposed by certain laws within the Cayman Islands or BVI structures, such as licensing requirements, minimum capital requirements, minimum number of shareholders, fund control mechanism, classes of shares, ownership transfer restrictions, exit visibility, and other important matters (Tomlinson, 2010). In the GCC, non-GCC entities have some control restrictions, such as a maximum ownership of 49% of any local entity, and thus the creation of a Cayman Islands or BVI structure would provide a better alternative for Limited Partners with no ownership restrictions. In this case, all local GCC investments may end up with majority ownership of foreigners, regardless of where investments are made within the GCC through the introduction of Nominee Agreements, with local lawyers who hold a certain stake in the investee companies to enable the 49% restriction with the back-to-back agreement that the beneficial ownership is the PE fund. This development within the PE industry in the GCC occurred as more and more LPs became concerned over ownership restrictions, and therefore foreign investors can be the indirect owners of a PE fund investing in the GCC.

Furthermore, almost all private equity deals are executed via equity investment with very limited leverage on the PE fund level posing restrictions on the investment ticket size. The significant

84 majority of private equity deals are investments in companies with minority stakes due to the fact that almost 85% of businesses in the GCC region are family owned, and thus family offices do not compromise on the loss of control (Marmore, 2016). As such, private equity firms are considered an additional source of funding to be used for more business expansions and as a means of acquisition financing. For this reason, General Partners devise their PE investment strategies to have a diversified risk profile by investing across several midcap portfolios in different sectors and seek minority protection rights in the sales and purchase agreements such as tag along, drag along, right of first refusal, and sometimes a put option in addition to other important clauses (Tomlinson, 2010).

It has become common for General Partners to seek other sources of funding at the transaction level rather than at the fund level, when a transaction is partially financed through debt as a means of enhancing investment returns to LPs. Although mezzanine financing carries a high interest rate, it is a new funding source for General Partners making investments and is generally provided by investment houses in the GCC (Tomlinson, 2010). Mezzanine funding can be structured in different ways depending on the preference of General Partners and the strategy of debt providers in either a straight debt or a convertible debt with pre-agreed terms and conditions. Currently, there are several major mezzanine debt providers in the GCC, such as Gulf Capital in Abu Dhabi and Integrated Alternative Finance Company in Dubai International Financial Centre in addition to Global Investment House in Kuwait, among other small players in the GCC (Marmore, 2016).

In the GCC, and mainly following the 2008 global financial crisis, PE fundraising activity witnessed a slowdown, although the economic prospects for the GCC were still strong. The lack of fund managers who possess a robust track record, due to the embryonic nature of the PE industry in the GCC and the low risk appetite for investors in the GCC, have resulted in less investment in PE funds. PE funds from 2008 and previous have undergone several life extensions and portfolio restructurings with partial exits. This has lead private equity General Partners to impose certain clauses in a more customized manner in the sale and purchase agreements with business promoters, such as a guaranteed sale in the form of a put option in case no IPO or trade sale happens. However, the enforceability of such clauses in the GCC are

85 challenging, and courts may not endorse or enforce such structures (Tomlinson, 2010; Marmore, 2016). As a result of changing the investment appetite of Limited Partners in the GCC towards the structure of PE investment into more transparent structures, several structures were enabled in order to make PE investment more attractive to Limited Partners.

3.3.5.2.1 Co-Investment Rights

Limited Partners in the GCC invested in a PE phase that can be referred to as “blind pool” PE investing, where their contribution of capital was made through one commitment in a PE fund that has a certain strategy regardless of the opportunities, which will be generated by General Partners in the investment period. Limited Partners then started asking for more visibility regarding the available investment opportunities and thus the emergence of co-investment rights in the GCC PE industry. Such Limited Partners opting for such co-investment rights would commit to a minority investment along with the General Partners in any given deal with the same terms and conditions rather than investing in a PE fund. Such cooperation would enable Limited Partners to build a more transparent and performance-based relationship with General Partners, thus exposing them to the General Partner’s style of management and commitment level without necessitating a long-term blind-pool commitment. Several negotiation rounds usually take place between the General Partner and investors in a co-investment structure until mutually acceptable terms are reached (Braun, Jenkinson and Stoff, 2017).

3.3.5.2.2 Deal-by-Deal Fundraising

When the General Partner lacks the exposure and track record needed, they resort to a deal-by- deal fundraising structure, in which the General Partner sources, structures, and offers investment opportunities to potential investors in an investor-friendly arrangement. This allows those General Partners to build a track record and establish relationships with investors in preparation for a more formalized future relationship in the form of GP/LP PE fund structures. Execution in this type of structures is highly uncertain, and General Partners would require a significant amount of time to source and deploy the funds raised and plan their next fundraising effort. In addition, General Partners would incur all of the costs associated with the sourcing of

86 deals and bear all the due diligence costs before offering them to potential investors to raise funds (Caselli and Negri, 2018).

3.3.5.2.3 Pledge Fund

When investors make soft commitments toward pledge funds, they can opt out of contribution to any given investment, and such funds are only drawn down from them if they give approval to General Partners. This is unlike traditional PE structures in which the commitment is hard or there is a legal obligation to transfer their capital contribution when the capital call is made by the General Partner. This structure is rare in the GCC, but it may be common in corporate PE structures rather than PE fund structures when a PE investment company offers the deals sourced by its investment team to its clients, and only those who show interest would transfer their capital contributions for such investment to be made. Therefore, pledge funds do not have a formal legal structure, such as an investment vehicle for each investment, but rather investors invest directly in portfolio companies along with the investment company (McCahery, and Vermeulen, 2013).

4. LITERATURE REVIEW

The literature on the performance of PE industry in the GCC region is limited. This is mainly due to the paucity of data. Most of the empirical studies tend to use the data from a number of data sources such as Venture Economics, which is highly dependent on both GPs and LPs in the provision of data; different single LPs; Preqin, which relies on public information and filings; and Cambridge Associates, which relies on the data provided by different GPs. There are several sources of bias in the datasets used in prior studies. For example, survival bias and best performers’ bias could result in an incomplete set of information with sample unrepresentativeness and thus sometimes conflicting results.

4.1 Private Equity Literature

Kaplan and Schoar (2005) studies the performance of private equity funds in relation to the S&P 500 and found that the average net-of-fees private equity returns are almost equal to the S&P 500 Index returns. The authors use a sample of 1,090 funds covering the period 1980-1997 from Venture Economics (based on voluntary reporting by both general and Limited Partners), where not all funds had realized IRRs, and thus were unable to calculate with reliability and accuracy the performance for all funds. Kaplan and Schoar (2005) find that there is a potential bias in the results including selection bias as well as the inability to control for differences in market risk.

Phalippou and Gottschalg (2007) argue that the reported outperformance of PE investments relative to S&P 500 in prior studies is overstated. They use a sample of 1,328 mature private equity funds and eliminate all residual non-exited investments from the dataset to avoid any exaggeration in investments’ valuations, as these values tend to be significant. Furthermore, prior studies used datasets that demonstrated performance bias, as they included only better performing funds. Following these adjustments, Phalippou and Gottschalg (2007) find that the average private equity fund performance net of fees is 3% lower than that of the S&P 500 per year.

Conroy and Harris (2007) find that the average net returns to investors in private equity have not been nearly as attractive on a risk-adjusted basis as many have conceived. They use a sample of 1,750 private equity funds covering a 20-year period, sourced from National Venture Capital Association. They report that the average return of these private equity funds was higher than the S&P 500 by 3.1% and also higher than the NASDAQ by 1.7%, net of fees. Risks are often understated and returns are overstated, triggering an over-optimistic asset valuation of PE firms. Their results show that the average returns in private equity may not be sufficient to justify the illiquidity and costs associated with adding the asset class to one’s portfolio. They also state that successful investors in PE companies are those who have the ability not only to identify superior PE firms but also have access to the right funds.

Phalippou (2007) states that the performance of PE funds is generally overstated and should be evaluated using appropriately weighted profitability indices, since measures such as average IRRs inflate fund performance. The author finds that the average net-of-fees performance was lower than that of the S&P 500 by 3% per year. He also finds that the performance of PE funds is predictable to a certain extent.

Robinson and Sensoy (2011) used a sample of 837 private equity funds from 1984-2010 to investigate the performance of PE compared to the public equities’ returns represented by the S&P 500, by looking at the quarterly cash flows of these funds. They find that, on average, buyout funds outperformed the S&P 500 by 18% net of fees over the life of the fund. In addition, they find that venture capital funds also outperformed the S&P 500 index by 3%. The authors report that the private equity funds sample (buyout and venture capital funds together) outperformed public equities’ returns by about 15% over the life of the fund.

Kinlaw, Kritzman and Mao (2015) uses a proprietary database of private equity returns to measure the excess return of private equity relative to public equity covering a period of approximately 18 years. The excess returns from private equity investments were decomposed into two components: an asset class alpha and an illiquidity premium. They report that the decomposition of the private equity excess return into an asset class alpha and an illiquidity premium affects the optimal composition of a portfolio. Their findings show that the sector

89 weights of private equity funds do predict the future performance of public equity sectors within both large- and small-cap. They also report that private equity is less attractive than all liquid asset classes, because it offers a smaller premium to compensate for its illiquidity.

Mozes and Fiore (2012) highlight that buyout funds generate returns with a risk–reward profile superior to that of public equities. They find that peak periods in private equity investments coincide with rallying the public equity market. Venture and buyout funds tend to outperform public equity markets at different times; however, a mixture of venture and buyout funds may provide more consistent outperformance of public equity markets than buyout funds alone.

Harris, Jenkinson and Kaplan (2014) studied the performance of 1,400 US buyout and VC funds and find that buyout funds have outperformed public markets, particularly the S&P 500, in the last three decades. On the other hand, venture capital funds outperformed public markets substantially until the late 1990s, but have underperformed since. The estimates also imply that each dollar invested in the average buyout fund returned at least 20% more than S&P 500 returns. They also report that the vintage year performance for buyout and VC funds decrease with the amount of aggregate capital committed to the relevant asset class for performance relative to public markets. Although it is natural to benchmark private equity returns against public markets, investing in a portfolio of private equity funds across vintage years inevitably involves uncertainties and potential costs related to the long-term commitment of capital, uncertainty of cash flows, and the liquidity of holdings that differ from those in public markets.

Minardi, Ferrari and Tavares (2013) investigate whether private equity-backed IPOs performed better in the long run compared to non-private equity-backed IPOs. They examined the one-year cumulative abnormal returns (CAR) of 108 Brazilian IPOs from 2004 to 2008, including 42 PE backed IPOs. Their study shows that PE-backed IPOs perform better in the long term than non- PE-backed IPOs in the issuing period between 2004 and 2006, as PE-backed IPOs had an average one-year CAR equal to 13.72%, while the non-PE-backed IPOs had -3.23%. They conclude that PE investments, despite not being immune to economic crises, work as a quality certification for companies going public in Brazil, at least for the one year buy-and-hold horizon.

Kiehelä and Falkenbach (2015) analyse the performance of European private equity real estate funds using timed cash flow data over the 1998–2009 period. They point out that the average performance of the sector during the study period is significantly lowered by the relatively high number of crisis-era funds. The fund valuations were found to be conservative, as they underestimate the future distributions by nearly 20%, thereby affecting the performance. During the sample period, PE Real Estate funds were also found to be significantly underperforming when compared to the public market. In addition, fund manager fees are quite high for these funds, and therefore the actual returns the LPs realize from the funds are significantly lower than what the investments return.

Alcock, Baum, Colley, and Steiner (2013) examine the performance of a large sample of global private equity real estate investment funds, with special attention to the role of leverage as well as managerial skill in making leverage choices. Their results indicate that the incentive is higher for PE real estate fund managers who demonstrate their investment skills to improve fund performance than the ones who achieve it by modifying leverage levels. In addition, fund performance was found to be almost directly proportional to the return on the underlying real estate market, implying that fund managers effectively track the performance of their target markets. Finally, they conclude that leverage cannot be viewed as a long-term strategy to enhance performance, and in the short term, managers do not seem to add significantly to fund excess returns by timing leverage choices to the expected market environment.

Focusing on the private equity industry in Brazil, Minardi, Kanitz and Bassani (2014) report that 72% of the PE firms were operating for 5 years or more, indicating that the industry was maturing in Brazil. Over the last 20 years, the average gross return for the sample was 22% (with a median of 23%). Brazilian funds outperformed the US PE funds during the vintage years from 1998 to 2008. The authors’ findings reveal that the performance of the Brazilian PE funds can be attributed to: 1) the Brazilian economic boom between 2004 and 2012, 2) the limited competition for deals in Brazil at that time, and 3) the fact that Brazilian PE and VC managers are becoming more experienced, thus driving better performance.

After examining a sample of 131 industry-focused European and US buyout funds raised between 1997 and 2006, Cornelius, Juttmann, and de Veer (2009) report that most of the funds were relatively diversified across industries. However, the capital deployed was not equal across different industries. In several cases, a significant share of the fund’s capital—in some extreme cases even more than 50%—was invested in one sector. The higher concentration of buyout funds in few sectors suggests that many GPs are specialized in a limited number of industries. In terms of performance, it has been observed that US venture capital industry firms with concentrated portfolios managed by specialists in one particular industry tend to outperform generalist firms (Gompers and Lerner, 2004).

Missankov, van Dyk, Van Biljon, Hayes, and Van der Veen (2008) analyze a sample of South African private equity funds. They report that South African private equities outperformed other traditional asset classes in the country. PE investments had less or no correlation with the other asset classes, thus offering diversification benefits for the investors. It was noted that PE funds had a higher cost of investing, yet the premium offered was sumptuous enough for investors to compensate for the investing cost. Schmidt (2006) examines the IRR of the US private equity funds over time and the benefits of including PE in a portfolio. A time period analysis shows that, only in the late 1990s did the overall PE market perform extremely well in terms of mean IRR. He claims that there is higher performance variation within funds in the earlier stage categories, while the performance variance is considerably less when the funds mature. Based on statistical simulations, it was reported that the optimal mixed-asset portfolio weightings for PE were in the range of 3% and 65%.

According to Lamm Jr. and Ghaleb-Harter (2001), the perception that successful private equity investments can provide both exceptional returns and enhanced portfolio diversification remains widespread in the investment community. Zhu, Davis, Kinniry, and Wicas (2004) analyze a sample of private equity returns to understand the diversification benefits offered by PE as suggested by Lamm Jr. and Ghaleb-Harter (2001). Their findings suggest that PE is not an alternate asset class, but is just a unique component of the overall equity markets. The difference in returns between private and public equity will largely depend on the estimation of NAVs of residual holdings and liquidity of public shares. Cumming and Zambelli (2013) investigated the

92 impact of excessive regulation on PE returns and firm performance. They found that strict regulations negatively affected the supply of capital and reduce PE returns. The findings also show that the likelihood of exit by IPO was also affected.

Harris, Jenkinson and Kaplan (2012) analyse the performance of US private equity funds (both buyouts and venture capital) using data sourced from Burgiss, collecting data from over 200 institutional investors (LPs). The authors compare the cash flow returns of both buyout and venture capital investments to the returns generated by public markets. They also compare the returns obtained using the Burgiss dataset for those returns, which were obtained using other datasets such as Venture Economics, Preqin, and Cambridge Associates. They find that buyout funds demonstrate better performance compared to what was reported by other studies in terms of over-performing public equities. They apply this to the concerns over the biases inherited in the data provided by Venture Economics, Preqin, and Cambridge Associates. They find that the average US buyout fund returns surpass that of the S&P for most vintage years by 20% to 27% over the life of the buyout funds under study and over 3% per year. When they analyse venture capital funds, they find that venture capital funds achieved higher returns than public equities in the 1990s, but lower returns in the 2000s. One major concern for using such a dataset is the high probability of selection bias. The authors also find that buyout funds have not only over- performed public equities in the 1980s and 1990s, but also in the 2000s, a result which is also supported when using datasets other than Burgiss such as Preqin and Cambridge Associates. When they used the Venture Economics dataset, which has a more downward bias, the result remained the same: the average buyout fund outperformed the public equities returns. Overall, they report that the average buyout fund yields at least 20% higher returns than the returns realised through public market equities, and that venture capital funds’ returns were significantly higher than those of public market equities in the 1990s, but lower in the 2000s.

Moskowitz and Vissing-Jørgensen (2002) study the performance of all private equity investments made in the US in the period 1989 to 1998 based on data collected from the Flow of Funds Accounts (FFA), National Income and Product Accounts (NIPA) as well as from the Survey of Consumer Finances (SCF) databases. They examine the return of private equity investment by aggregating all the PE deals in a value-weighted index. They find that on average,

93 the returns of all private equity deals are not different from that of the public markets in the US for the same period. They extend their analysis to highlight that the success rate for PE investments is only 34%. They also report that if founders continue working in their companies post a private equity investment, then the probability of achieving exit success becomes higher. In addition, the authors try to assess the risk aversion coefficients for private equity investors when deploying money in private equity deals and find that investors with a relative risk aversion coefficient of two should ask for a minimum excess return of 10% over a US public market index and those with a coefficient of three should ask for at least 20% excess return over a US public market index. The authors find that when other elements of risks are modeled in private equity returns, the net return for private equity investments become lower than public markets on a risk-adjusted basis.

Lopez de Silanes, Phalippou, and Gottschalg (2011) examined the performance of a global private equity portfolio consisting of 7,453 PE investments worldwide in 81 countries by 254 private equity firms over the period 1971-2005. The authors find that median IRR for this portfolio is 21% and that there is a 10% bankruptcy rate and almost 25% of the portfolio has an IRR of more than 50%. They also find a significant negative relationship between investment holding period and the IRR performance for those private equity investments and that PE investments in emerging markets underperform those in the US and Europe. When the authors tested the relationship between the size of private equity investment ticket size and the performance, they report that small PE investment tickets tend to outperform those PE investments with larger investment ticket sizes.

Jegadeesh, Kräussl, and Pollet (2009) used a sample of 24 publicly traded PE funds of funds listed on the London Stock Exchange and Europe to examine the risk-adjusted returns of PE investments. These funds of funds have the mandate to invest in unlisted private equity funds as limited partners and not directly in private equity transactions. The authors report that those PE funds of funds are able to earn an abnormal return of 1% per year compared to the public market. Further, the authors also examine the performance of listed private equity funds by using another sample of 129 publicly traded PE funds and find that those funds earn zero to negative abnormal returns compared to the public market. The difference between PE funds of funds and listed PE

94 funds is that the latter does not have a second layer of management fees earned by the managers of the PE funds of funds. The authors extended their analysis to report that there exists a statistical positive relationship between PE fund returns and gross domestic product (GDP) and a negative statistical relationship between PE fund returns and credit spreads.

Guo, Hotchkiss, and Song (2011) analyse the performance of 192 leveraged public-private buyouts in the US from the period 1990-2006. The authors compared the performance of those buyout when the acquisition was first made with the performance post the acquisition until the exit. They compared the price paid upon investment with the price exited (either through IPO or private sale) and they report a risk-adjusted return of 40.9% for the portfolio.

Chung (2012) examine the private equity performance persistence when new consecutive private equity funds are launched by GPs. He uses fund-level data sourced from Preqin with a sample size of 2,250 buyout funds and 4,588 venture capital funds where only 888 buyout funds and 1,157 venture capital funds disclose their performance. He finds that persistence in the performance of private equity funds does not last with the following PE funds’ launches managed by the same GPs. The author also reports that current PE fund performance is significantly and positively correlated with the first follow-on PE fund but not with the second or third follow-on PE funds. Chung (2012) also reports that the performance of private equity funds converges in the long run as the statistical significance between current PE funds and their first follow-on PE funds is not large, and that PE returns tend to improve for the worst-performing PE funds in their follow-on PE funds, thus making the overall difference in PE returns insignificant over the long run. The author also studies the impact of capital flow into better performing PE funds and find that the more capital flow into current good performing PE funds tend to negatively impact the performance of future PE funds, and that the longer the time between any two PE funds the lesser the PE performance persistence.

Fang, Ivashina, and Lerner (2015) used a proprietary and confidential dataset of private equity investments sourced directly from seven large private equity institutions in the US over a 20-year period from 1991 to 2011 in order to examine the performance of the private equity industry in the US. The authors find that direct private equity investments achieve a better performance than

95 public market indices especially for buyout transactions, and that private equity investments made in the 1990s perform better than those made after 2000. In addition, they report that standalone co-investments tend to underperform private equity funds which they co-invest with which is mainly due to selection problems (i.e. co-investors can only invest in private equity deals that are made available to them by PE firms, which are usually large in size and are beyond PE firms investment capacity). Furthermore, direct private equity investments carried out by PE investors alone tend to outperform fund-level PE investments.

When a private equity investment is made, the vehicle for such an investment, which is usually a private equity fund, becomes a temporary owner leading to a temporary governance structure (Rappaport, 1989; Kaplan, 1991). The investment holding period for PE investments varies from one geography to another and from one period to another. Kaplan and Strömberg (2009) find that the average investment-holding period for individual private equity investments is around 4-5 years before an exit takes place. In another study, Strӧmberg (2008) analyses 21,000 LBOs globally from year 1970 to 2008 and finds that the average investment holding period for such buyout transactions is 4.1 years for exited buyouts. In addition, he reports that a mere 42% of PE-backed buyouts exited within 5 years from the time of investment. Strӧmberg (2008) highlights in his study that deals involving large enterprise values tend to execute exits more successfully than smaller ones and those which are public-to-private deals. Furthermore, more experienced PE managers were more likely to conclude successful exits than less experienced PE managers.

Ljungqvist and Richardson (2003) report that the availability of PE deals and the competition from other PE funds for those deals affect the performance of private equity investments. Furthermore, the authors analyse the PE activity for the period from 1981 to 2001 by studying a sample of 3,800 PE portfolio companies and concluded that the average investment holding period was 3.6 years before an exit event takes place. The sample was gathered from large institutional LPs. However, this might seem a shorter average compared to the results arrived by Strӧmberg (2008) reporting the average at 4.1 years. Schmidt et al. (2010) ran a similar analysis by analysing a sample of 672 PE transactions (out of which 538 are in the US and 134 are in Europe) for the period of 1990-2005, reporting an average investment holding period of 4.1 years

96 as well. Furthermore, the author reveals that 75% of the sample had exited with an average holding period of 5.5 years. The sample used by Schmidt et al. (2010) only reported exited investments along with write-offs, which could result in bias in the results. Furthermore, Ljungqvist and Richardson (2003) report that private equity funds generated a 6% excess return over that of the S&P 500, which was mainly attributed to the good skills of its fund managers. The authors also find that the risk-adjusted return for PE funds remains higher than that of the S&P 500, even after modeling risk. In addition, when they analyse the portfolio diversification strategies of PE fund managers, they report that the flow of funds and the size of the private equity fund are important factors affecting the performance of PE investments.

A recent analysis was also carried out by Jenkinson and Sousa (2015) for a sample of 1,022 private equity exits (only IPOs and trade sale) with an exit value of more than US$ 50 million in Europe. They conclude that the investment holding period averaged slightly over 4 years and that an exit tends to happen approximately 6 years into the tenure of the private equity fund. More importantly, they reported that the average investment holding period was prolonged following the 2008 financial crisis without assessing the reasons behind it. Moreover, Valkama et al. (2013) analyse a sample of 321 buyout transactions in the UK from 1995-2004 and find that the average investment holding period is 3.6 years, with a negative correlation between IRR and the investment holding period length.

As reported by Preqin (2017), private equity investment holding periods have expanded from an average of 4.5 years for the exits happening in the period of 2006-2009 to more than 6 years for the exits occurring in 2014. In Europe, for exits happening in 2013 and 2014, the average investment holding period was 6.1 and 6.2 years, respectively, being comparatively much more than the earlier studies’ average of 4 years. In addition, around 36% of the portfolios which had been exited in 2014 were actually held for more than 7 years in those PE portfolio holdings.

Lopez-de-Silanes, Phalippou and Gottschalg (2015) analyses 11,704 PE investments carried out by 334 PE firms over the period from 1973 to 2005 and report that 10% of the PE portfolio is a write-off, and 25% of the PE portfolio generates an IRR greater than 50%. Furthermore, they find that performance does not seem to be scalable and sustainable as more PE investments are

97 added to the existing PE portfolio, where such PE portfolio tends to underperform with scalability. They also find that diseconomies of scale are linked to PE firms’ organizational structure where more independent and less hierarchical PE firms tend to have lesser diseconomies of scale. They conclude that PE firms, although having PE management skills to perform, tend to fail when they scale their PE investment activities to manager bigger PE portfolios.

Bernstein, Lerner, Sørensen and Strömberg (2016) examine the relationship between the PE- backed investments and the growth rate of productivity and employment. They use a sample of 14,300 PE transactions carried out by 13,100 firms over the period from 1986 to 2007. They find no evidence that PE backed companies achieve higher growth rates in productivity and employment than those companies which are not backed by PE. Furthermore, they also do not find an evidence that PE backed companies are less volatile in the face of economic shocks or industry cycles.

Braun, Jenkinson and Stoff (2017) examine the persistence of PE return of PE GPs using the cash flow dataset on 13,523 PE portfolio companies carried out by 865 PE funds. They find that the persistence of GPs in generating stable or increasing IRR has significantly dropped for the PE deals that have been fully exited, as the sectors in which the GPs invested in tends to mature and become more competitive. They conclude that PE would eventually have more normalized returns which are in line with what the industry offers and would follow the pattern of other assets classes. Thus, there is no evidence that PE past performance is a good indicator of future PE performance. However, in another study conducted by Korteweg and Sørensen (2016) who analysed the performance of 842 PE funds carried out by 433 firms over the period of 1069 and 2001, find that PE performance is persistent with PE firms consistently achieving high (or low) IRR.

Ang, Chen, Goetzmann and Phallipou (2018) examine the performance of 2,331 PE funds over the period from 1994 to 2015 and report that PE returns are cyclical depending on the type of PE funds (VC or Buyout) which is consistent with the understanding that capital market segmentation contributes to PE returns. They use the quarterly cash flow data from LPs and

98 construct return indices for PE as a whole and for VC and buyout separately and find that the estimated PE returns are more volatile than those of the standard market indices.

For the GCC region, there are no empirical studies analysing the performance of the PE industry for the following reasons: (i) the short track record of the PE industry in the GCC (less than 15 years old), (ii) the paucity of data, and (iii) the absence of a regulatory body and reporting requirements for PE. Therefore, I try to fill this gap in the literature by analysing the PE industry in the GCC and its performance, which will make a positive contribution to the body of knowledge. Furthermore, this research will highlight the performance of Islamic PE versus conventional PE, thus providing insights into Islamic PE performance in the GCC region. It is worth noting that the estimated size of Global Islamic Assets Under Management (AUM) is estimated at US$ 60.2 billion in 2014 (MIFC 2015). Furthermore, this research will also highlight the relative performance of PE in the GCC compared to the S&P GCC Composite Total Return Index, thus providing comparative performance analysis to exiting and potential PE investors in the GCC as well as academia and the global PE literature.

4.2 Summary of Literature

The PE industry in the GCC is still nascent with no empirical studies covering the industry’s performance dynamics and how it compares to public markets. Furthermore, there are no literature on the performance of Shariah-compliant PE neither globally nor regionally as Islamic PE is still an emerging specialty within PE. The available literature on PE is mostly from global markets such as the US and Europe due to the maturity of such markets in terms of having multiple diversified PE cycles across different industries and geographies. When we review PE performance against public markets, we find that the results are mixed depending on sample size and composition, and time period covered. Ljungqvist and Richardson (2003), Conroy and Harris (2007), Missankov, van Dyk, Van Biljon, Hayes, and Van der Veen (2008), Robinson and Sensoy (2011), Mozes and Fiore (2012), Harris, Jenkinson and Kaplan (2014), Fang, Ivashina, and Lerner (2015) and Braun, Jenkinson and Stoff (2017) find that PE investment returns tend to generate an IRR higher than that of a comparable public market index. On the contrary, Phalippou and Gottschalg (2007) and Kiehelä and Falkenbach (2015) find that PE investment

99 retunrs are lower than those achieved by a comparable public market index, where as Moskowitz and Vissing-Jørgensen (2002) and Kaplan and Schoar (2005) report that PE returns are almost equal to those of a public market index.

4.3 Determinants of the IRR and Hypotheses

In this section, I present a set of hypotheses on the determinants of the IRR for PE investments in the GCC region based on the available literature on global PE as well as the perception of GPs or PE practitioners in the GCC region, which suggest that these variables can explain the PE investment returns represented by the IRR. The first six independent variables are used in constructing six different hypotheses relating to the impact of these variables on the IRR (the Main Regression Model). The reason for selecting these six independent variables as part of this examination is that these variables are major components in the decision making process when opting to make PE investments or when launching new PE products, and that these factors have been considered in the global PE literature. We then extend our analysis by adding 4 more independent variables relating to market conditions, industry, global financial crisis and ownership structure in PE companies in order to have more robust analyses (the Extended Regression Model). It is worth mentioning that these ten independent variables have been examined empirically by researchers to explore the performance of PE in the global PE markets, yet not for the GCC.

1. Investment Size (FZ)

Caselli, Garcia-Appendini, and Ippolito (2009) argue that the IRR is positively related to the size of the investment ticket made by GPs and that the returns achieved by large European PE transactions tend to outperform those achieved by small transactions and that the larger the investment ticket size, the higher the investment return. In this study, we test the hypothesis of Caselli, Garcia-Appendini, and Ippolito by analysing the sample we have. Hypothesis 1 is therefore that the PE investment size (FS) has a significant impact on the performance of private equity investments.

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2. Sector-Specific Investments (SI)

Bernstein, Lerner, Sorensen, and Strömberg (2016) argue that there is no proof that sectors with a PE backing can perform better than others which are not. In the GCC region, there is a perception that certain sectors such as the real estate sector can be more stable and predictable when compared to other sectors with a certain level of return visibility (GulfNews, 2015). However, this is a theory that was established purely based on experience accumulated over time. In addition, following the 2008 financial crisis, the financial services industry was hit significantly, making investors reduce their exposure to this sector significantly. We therefore test the hypothesis of Bernstein, Lerner, Sorensen, and Strömberg (2016) that the performance of sectors backed by PE investments show no difference than sectors without PE backing, and therefore, Hypothesis 2 is that sector-specific PE investments (SI) have a significant influence on the performance of private equity investments.

3. Investment Holding Period (HP)

Valkama, Maula, Nikoskelainen, and Wright (2013) argue that there is a significantly negative correlation between IRR achieved by PE investments in the UK and the length of the investment holding period. In other words, the longer the investment holding period, the lower the IRR. However, in the GCC region, there is no historical data or studies which have assessed such a relationship, and thus we would like to test Hypothesis 3, which states that the PE investment holding period (HP) is a significant factor affecting the performance of PE investments.

4. Shariah-complaint Investments (SC)

The GCC region has not yet seen the establishment of pure Shariah-compliant private equity funds. However, some institutional investors have invested in Shariah-compliant transactions as a result of their investment strategy or legal corporate structure. Some studies have analysed the performance of Islamic mutual funds compared to conventional ones. Merdad, Hassan, and Alhenawi (2010) find that Islamic mutual funds tend to underperform compared to conventional ones. Therefore, this research would be the first to analyse whether Shariah-compliant private

101 equity investments have better returns than those which are conventional and whether they impact the portfolio IRR or not. Furthermore, there is a perception by some GCC investors that Islamic products including private equity would generate better returns than conventional private equity and only invest in Shariah-compliant PE funds, although there is less exposure to such Islamic PE investments in the GCC. Therefore, we test Hypothesis 4, which states that Shariah- compliant PE investments (SC) affect the performance of the overall private equity investment portfolio.

5. Investment Location (LO)

For the GPs in the GCC, investments made are mainly located in the GCC countries with some diversification outside the region, depending on each PE fund’s strategy or corporate direction for institutional PE firms. However, it is not clear whether there is any correlation between investment returns and the geography of investment. This is important for the GCC private equity managers, as there are country-specific equity funds whose strategy is to invest in the public equity markets of certain countries, but that has not yet been seen in private equity, and thus providing insights on that can help GPs better draw their investment strategies and focus for their new PE funds. Thus, we test Hypothesis 5 that the geographic location of PE investments (LO) is a major factor in determining the performance of private equity investments.

6. Investment Vehicle (LG)

The GCC region still has institutional investment firms that engage in several investments in different asset classes, with a private equity investment mandate. Furthermore, there are PE firms specializing only in PE investments through a GP/LP structure in order to make their investments. We try to assess whether the legal type of the investing vehicles in private equity transactions has any impact on the IRR returns. Therefore, Hypothesis 6 states that the type of investing vehicle (Institutional PE or Fund Structure) (LG) is a major factor in deciding the performance of private equity investments.

7. Ownership Structure in PE Portfolio (OW)

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Private equity funds have been gaining momentum in the GCC since the beginning of the twenty first century with the establishment of specialized PE firms such as the Abraaj Group and Global Investment House. Private equity GPs have invested over the past decade in different companies in different sectors in different geographies with minority and majority stakes. Battistin, Bortoluzzi, Buttignon, and Vedovato (2017) find that PE-backed companies tend to outperform for high growth companies when the PE shareholding is between 75-100% (super majority), for which the relationship is positive. This means that when super majority ownership exists in PE portfolio performance, the IRR is higher when compared to other financial investors. This may be contributed to the full control of GPs and the fact that special experienced teams have been deployed in such portfolio companies with a mandate to accelerate growth and enhance shareholders’ value without facing any friction from other shareholders. They also find that minority shareholding (less than 50%) for non-banking PE portfolio companies has a negative effect on performance. This may be due to the limited role of GPs in driving the strategic direction of such portfolio companies. We therefore test the hypothesis that PE ownership structure has a significant impact on the performance of private equity investments.

8. GDP Growth (GDP)

GDP growth in a given economy is an important economic factor affecting every segment in the economy, as a country’s economic performance is judged by several factors for which GDP growth is one of them as well as employment and inflation rates. Phalippou and Zollo (2005) find that the relationship between PE funds’ performance and GDP growth is positive; the higher the GDP growth rate the higher the PE funds’ performance. This in effect means that when the economic cycle is trending upwards, businesses tend to invest more in technology, hiring better management teams, training and development for talent as well as going for more inorganic growth through acquisitions, which may ultimately lead to better growth prospects. Furthermore, they find that there is no evidence that GDP growth has an impact on PE portfolio companies with a negative IRR, meaning that any underperformance of PE portfolio companies is not a direct result of GDP growth movement. We therefore test the hypothesis that the average GDP growth has a significant impact on performance of private equity investments.

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9. PE Portfolio Maturity Level (AGE)

Private equity GPs invest in different companies with different maturity levels depending on PE funds’ strategy. PE firms have certain investment criteria for investing in companies with varying maturities (or age), which may need to have a proven profitability track record or a certain number of years since establishment. In general, companies that are established (more matured) tend to have a normal growth rate that may be in line with the macroeconomic growth, whereas growth companies (younger or startup ones) have a more aggressive growth trend that can yield higher returns albeit with higher risk. Dimov and De Clercq (2006) explore the relationship between the age of PE portfolio companies and the IRR and find that it is a negative one; meaning that the older the portfolio company the lower the IRR. For our purpose, we test the hypothesis that the maturity level of PE portfolio companies has an impact on the performance of private equity investments.

10. The 2008 Financial Crisis (FC)

The 2008 financial crisis had a significant impact on the global economy affecting almost every country whether developed or developing but with varying scale. Wilson, Wright, Siegel, and Scholes (2012) examined the impact of the 2008 financial crisis on PE-backed buyouts based on thousands of PE transactions in the UK. They find that PE-backed portfolio companies achieved higher returns before and during the financial crisis when compared to other companies which are not backed by private equity. Furthermore, they find that those PE-backed portfolio companies achieved 3-5% higher profitability, and both revenues and employment growth rates were positive compared to companies which are not backed by private equity. Therefore, they find an evidence that companies backed by private equity capital tend to add value to portfolio companies by helping them overcome any adverse economic shocks. For our sample (covering the period from 2004 to 2014), we test the hypothesis that the 2008 financial crisis had a significant impact on the performance of private equity investment portfolio.

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5. DATA AND METHODOLOGY

5.1 Data and Sample Description

In general, private equity transactions tend be confidential with no mandatory disclosure requirements and no regulatory body. In the GCC, it is challenging to collect date relating to private equity as the industry is still infant with no track record, and data is confidential and extremely hard to collect. Being a PE practitioner in the GCC from the early days, I had the opportunity to work in one of the largest PE houses in the GCC. This has provided me exposure to a large number of PE deals and has helped me build strong business relationships and networks amongst the PE community in the GCC. In addition, PE houses sometimes tend to co- invest, thus increasing the number of deals that are reviewed in the GCC. Moreover, I have established a strong relationship with major GPs and LPs such as family offices, institutional investors, and SWFs, from whom I was able to collect data by signing several Non-Disclosure Agreements (NDAs). Due to the infancy of the PE industry in the GCC and the fact that the complete PE investment and divestment cycles have not been fully materialized, empirical researchers have not yet performed any empirical studies on PE in the GCC region, as what is available in the market is a high-level review on the PE industry, including public data only, such as new fund announcements, some investments, and exit news. Therefore, it is difficult for any researchers to carry out an empirical analysis to report the findings on the performance of PE in the GCC. This makes the only way to collect data relating to PE in the GCC region through networks and connections within the PE community, who would provide data on a confidential basis with the objective of better understanding the PE industry and its performance.

I have collected a sample of 306 private equity portfolio companies from General Partners and Investment Managers operating in the GCC region, leveraging on the strong business network that I have in the GCC. The dataset covers the period from 2004 to 2014 by GCC domiciled investment managers, which are proprietary in nature and are a mixture of PE funds’ portfolios and corporate investors focusing on PE. The sample includes data on 38 Private Equity funds (11 PE funds with GP/LP structure and 27 Institutional PE firms). Furthermore, the sample has 306

105 portfolio companies classified by type, domicile, portfolio size, Shariah compliance, location of investment, portfolio sector, investment value, investment holding period, investment vehicle (fund or firm), money multiple, IRR, and exit type. The sample I considered for this research covers a size of almost US$ 4 billion. It is worth mentioning that not all of the investments made have been exited especially for the funds raised after 2008, due to the long-term nature of private equity. The description of the sample is highlighted in the tables below. In addition, the proprietary data that has been collected does not have any survival, selection or reporting bias as I have got access to all PE funds’ data from both GPs and corporate PE houses with whom I have signed NDAs. This makes the dataset more reflective, contrary to the various biases that have been reported in international PE empirical studies.

From the dataset, GPs domiciled in the GCC invested in 15 countries with the top 5 destinations being all GCC countries (excluding Bahrain). The top 5 countries in the GCC represent 85% of the deal volume, which took place in Saudi Arabia (30%), Kuwait (25%), United Arab Emirates (21%), Oman (5%), and Qatar (4%), with a total of 260 transactions. The 6 GCC countries (adding Bahrain to them) together had a total of 87.6% of the deal volume. This reveals that such capital pools were heavily focused on the GCC market as an investment destination with some flexibility to invest small portions of the capital in other opportunistic deals outside the GCC. GPs in the GCC generally give themselves the flexibility to invest up to 20-25% of the PE fund size outside the GCC, provided that such investment opportunities are lucrative. For example, the Global Opportunistic Fund II managed by Global Investment House had a flexibility of 20% investment outside the target region.

In terms of capital allocation and exit prospects for the 15 destinations, the top five best performing investment destinations were all non-GCC investment destination except Oman, with China being the top performer with an average annual return of 8.8% (2 investments made in China), followed by Oman with an average annual return of 7.4% (14 investments). Saudi Arabia had the highest number of investments, with 93 transactions, yet it is ranked number 7 in terms of performance with an average annual return of 2.1%. The UAE had 64 transactions but with an average annual return of 2.5% and the sixth-ranked destination in terms of performance. Kuwait, which had the second largest number of transactions of 78 deals was ranked 12 out of 15 in terms

106 of the average annual returns with 0.3%. The below table highlights the investment returns of the sample categorized by the investment destination, sector, and type (Islamic vs. Conventional).

Table 18 Sample Description Panel A – Investment Returns by Country Country Money Multiple Annualized Return Country Money Multiple Annualized Return China 1.9 8.8% Turkey 1.2 1.6% Oman 1.7 7.4% Egypt 1.1 0.6% Jordan 1.4 4.0% Qatar 1.1 0.6% Lebanon 1.4 3.5% Kuwait 1.0 0.3% India 1.3 2.8% Malaysia 1.0 0.0% UAE 1.2 2.5% Pakistan 0.9 -1.2% KSA 1.2 2.1% Bahrain 0.8 -1.5% UK 1.2 1.6% Panel B – Investment Returns by Sector Money Multiple Annualized Return Energy 1.4 4.2% Financial Services 1.4 3.8% Real Estate 1.4 3.5% Food & Beverage 1.3 3.4% Logistics 1.3 2.8% Healthcare 1.2 2.1% Education 1.2 1.5% Manufacturing 1.1 0.7% Other 1.1 0.5% Utilities 0.9 -1.3% Media 0.8 -2.4% Retail 0.5 -4.7% Panel C – Investment Returns by Type Conventional 1.20 2.03% Shariah-Compliant 1.12 1.14%

I follow the Fama and French industry classification and divide my sample into 12 main industries. From the sample, it is evident that the best returns were generated by investments made in the energy sector, yielding an average annual return of 4.2%, followed by the financial services sector with 3.8%, followed by the real estate sector with 3.5%. This clearly reflects that these 3 sectors were booming in the GCC region, supported by high oil prices driving the energy sector, a lucrative transformation in the financial services sector. In addition, the real estate sector in the GCC has always been perceived as a safe haven that would not underperform at any stage of the business or economic cycle, as perceived by leading real estate investors such as

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Hussain Sajwani from DAMAC Group (UAE), Khalaf Al Habtoor from Al Habtoor Real Estate Group (UAE) and Abdulaziz Al Nafisi from Al Salhia real Estate in Kuwait (GulfNews, 2015).

Within the sample, 86 companies (28%) were Shariah compliant, with a total investment amount of US$814 million and an average annual investment return of 1.13%. When this is compared to the conventional portfolio within the sample (220 companies with total investment amount of US$3.18 billion), the conventional portfolio outperformed the Shariah-compliant one by generating an average annual investment return of 2.04%, with an outperformance of 0.91%. This is underperformance is similar to the trend found when comparing Islamic Mutual Funds’ performance with conventional ones (Merdad, Hassan and Alhenawi, 2010).

Analysis of the data by exit channels revealed that 137 transactions (45%) were exited through sale in the stock market, and 106 trade sales (35%) with 39 investments (13%) were still held at fair market value by the end of 2014, with a total of 24 investment write-offs, representing 8% of the sample. It is worth observing here that investment returns generated by exits through sales in the stock market yielded the highest annual returns at 4.7%, followed by trade sales with 3.2% and investments held at fair market value nearly kept at cost.

Table 19 Investment Returns by Exit Channel No. of Sample Portfolios 306 Annual Return No. of Full Exits 243 Stock Market 137 4.7% Trade Sale 106 3.2% Investments Held at FMV 39 0.2% No. of Write-Offs 24 N/A

The average investment holding period for the sample portfolio (whether it is exited or held at FMV) is 3.6 years. However, for the 243 full exits, the average investment holding period is 4.0 years. Kaplan and Strömberg (2009) found that the average investment holding period for individual private equity investments is around 4-5 years, while Strӧmberg (2008) in another study and Schmidt et al. (2010) concluded that the average investment holding period is 4.1 years for exited buyouts. Ljungqvist and Richardson (2003) concluded that the average PE investment holding period was 3.6 years.

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Table 20 Investment Returns & Average Holding Period by Investment Year Year No. of Investment Amount Exit Amount Avg. Holding Period Annualized Investments (US$ mn) (US$ mn) (Years) Return 2004 30 165.5 395.8 4.4 31.8% 2005 49 325.4 470.9 4.7 9.6% 2006 61 468.1 506.6 4.3 1.9% 2007 68 1,321.1 1,576.9 4.7 4.2% 2008 44 1,128.0 1,035.4 4.6 -1.8% 2009 19 145.4 190.9 4.3 7.4% 2010 20 251.9 296.7 3.6 5.0% 2011 10 164.1 224.1 3.0 12.2% 2012 4 19.7 32.0 2.0 31.0% 2013 1 3.4 3.6 1.0 3.8% 2014 - - - - - Total 306 3,993 4,733 3.6 - Annualized Returns are based on the average holding period for the respective investment year regardless of size and not based on the overall portfolio.

5.2 Methodology

The PE industry in the GCC is relatively new when compared to those of the US and Europe. The primary aim of our study is to examine the factors affecting the performance of PE investments in the GCC region and also compare such performance to the S&P GCC Composite Total Return Index. The literature on the performance of PE investments in the GCC region is not available due to the infancy of PE as an asset class. The analysis of the global PE performance literature suggests that the PE investment performance can be explained by several variables. A listing of these independent variables and their definitions are highlighted in Table 21 below, and are used in our empirical analysis.

Table 21 Definitions of variable used in the empirical analysis Dependent Variable The Internal Rate of Return (IRR) – IRR is the performance metric used by private equity firms to assess their portfolio’s performance, which takes into account the value of investment, timing of investment, holding period and exit value. It is one of the methods that are used to calculate the investment rate of return, which makes the net present value of all future cash flows equal to zero. Table continues next page

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Independent Variable > Investment Size (FZ) – A measure of the dollar value size of the investment made and paid for in cash by GPs. > Sector-Specific Investments (SI) – PE investments were classified into 12 sectors adopted from Fama-French industry classification as highlighted in Table 18. > Investment Holding Period (HP) – A measure of the length in years, at which the PE investment is held before it is exited. > Shariah-complaint Investments (SC) – A dummy taking the value of 1 if the investment is a Shariah-compliant investment and zero otherwise. > Investment Location (LO) – A variable that highlights the countries in which the investment is made, as highlighted in Table 18. > Investment Vehicle (LG) – A dummy taking the value of 1 if the investment vehicle is a Fund, and zero otherwise. > STAKE^ is the ownership percentage in portfolio companies owned by PE investors when they make their PE investments. > GDP_GROWTH^ is a measure of the GDP growth in the GCC region being a dummy variable taking the value of 1 if it is greater than 5%, or 0 otherwise. > MATURITY_LEVEL^ is a measure of the age of portfolio companies being a dummy variable taking the value of 1 if it is greater than 10 years, or 0 otherwise. > FINANCIAL_CRISIS^ is a measure of the impact of the 2008 global financial crisis on PE performance being a dummy variable taking the value of 1 if an investment or exit is made in 2008 or 2009, or 0 otherwise. This table highlights the definitions of all the variables used in the regression analysis for the sample data.

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6. EMPIRICAL RESULTS

We start in Table 22 with the descriptive statistics for our sample of 306 PE investments for the period 2004-2014 and the sample structure. This is followed by a multivariate analysis of the performance of the PE investments. Table 23 presents the correlations between the independent variables of the analysis to investigate for potential Collinearity among the independent variables. Finally, we present in Table 24 the results of the regression analyses in order to examine the effects of the independent variables on the IRR.

6.1 Univariate Analysis

Table 22 presents the descriptive statistics for a sample of 306 private equity investments made by GPs domiciled in the GCC region and covers the period from 2004 to 2014. The total investment value invested by those private equity managers amounted to US$3.993 billion during the 10-year period, with a total exit value of US$4.733 billion (divestment proceeds including those carried at fair market value). The annualized money multiple return for the sample portfolio is 1.85% per year. This takes into consideration both the fully exited portfolio as well as investments still held available for sale. Furthermore, the average investment ticket size for the sample is US$ 13.05 million, with the biggest investment ticket being as high as US$ 300 million, and the smallest investment ticket being as low as US$ 100,000, making the range a very wide one. In addition, the average exit value is US$ 15.47 million, with the maximum and minimum exit values being US$ 359.50 million and a write-off (zero value) respectively over the same period. Moreover, the average investment holding period for the sample is 4.35 years over the period from 2004-2014.

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Table 22 Descriptive Statistics Panel A – Sample Structure Period Covered 2004-2014 No. of Portfolio Companies 306 Investment Value (US$ mn) 3,993 Exit Value (US$ mn) 4,733 Money Multiple (10 Years) 1.18x Annual Money Multiple 1.85% Panel B – Descriptive Statistics Mean Median S.D Min Max Investment Size 13.05 4.56 26.86 0.10 300.00 Exit Value 15.47 5.58 32.87 0.00 359.50 Holding Period 4.35 4.00 1.98 0.00 10.00 Money Multiple 1.18 1.44 1.76 0.00 24.00 Definitions: No. of Portfolio Companies – this is the total number of portfolio (investee) companies where GPs have invested their money in. This is a combination of fund investment and direct institutional investment, and a mix of Shariah-compliant and conventional investments. Investment Value – this is the total actual amount invested in cash in these 306 portfolio companies over the period 2004-2014. Exit Value – this is the sum of the cash proceeds resulting from the sale of portfolio companies for the fully exited companies and the unrealized value of un-exited investments still held at fair market value (FMV) in 2014 (the cut-off date). Money Multiple – this is the investment multiple after the Exit Value is realized which is calculated as the exit value divided by the investment value. Annual Money Multiple – this is the Money Multiple divided by the number of years under consideration (i.e. 10 years), which will give the average annual investment return for the sample portfolio. Holding Period – is the number of years an investment is held before it is exited from the time of making the investment. S.D. – is the standard deviation.

When the overall returns generated by the sample data are compared to the S&P GCC Composite Total Return Index over the same period (2004-2014), it can be seen that the index has outperformed the PE returns generated over the same period of time by approximately 2.37%. So from the two datasets, we find that PE as an asset class in the GCC does not seem to provide higher investment returns than public equities.

Index Name 1 Year 3 Years 5 Years 10 Years S&P GCC Composite Total Returns Index -2.20% 1.70% 8.62% 4.22% Source: S&P Dow Jones Indices as at end of 2014 (Viewed on 8 January 2015)

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6.2 Multivariate Analysis

By using a sample of 306 PE investments made by private equity investors in the GCC region, we consider Multiple Regression Analysis as the analytical tool to examine the impact of these independent variables on the IRR as a dependent variable. Hence, the following two models are examined (Main Model & Extended Model), and the regression model results are highlighted in Table 24.

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&: (4<-) + &=(>4?) + &'@((/) + 5 (2)

6.2.1 Simple Correlations

Table 23 exhibits simple correlations between the independent variables for the sample of PE investments in the GCC region carried out by GCC-domiciled private equity investors. We note that the correlation between most of the independent variables are small and do not raise multicollinearity concerns. However, there is one relatively high correlation of 56% between the legal structure of the investment vehicle (i.e. fund or institutional) and the size of the investment ticket, which is likely to create multicollinearity amongst independent variables. We have therefore calculated the VIF, and we find that it is less than 5 for all of the independent variables. We conclude that there is no multicollinearity amongst the independent variables, and thus we can carry out the multiple regression analysis. The results of such regression are highlighted in Table 24.

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Table 23 Sample Correlations for Independent Variables FS SI HP SC LO LG OW GDP AGE FC FS 1 SI 0.135 1 HP 0.025 0.104 1 SC -0.083 -0.219 0.061 1 LO 0.359 0.012 -0.192 -0.265 1 LG 0.437 0.070 -0.071 -0.055 0.440 1 OW 0.362 0.021 0.034 -0.048 0.186 0.181 1 GDP -0.024 -0.089 -0.336 -0.016 0.031 -0.026 -0.042 1 AGE 0.160 0.097 0.043 -0.188 0.091 0.086 0.091 -0.115 1 FC 0.120 0.033 -0.224 0.004 -0.006 0.018 0.019 0.095 0.102 1 FS is measure of the dollar value size of the investment made and paid for in cash by GPs. We use the logarithm of investment ticket as it is usually more normally distributed and makes more intuitive sense rather than having absolute investment values. SI is the sectoral investment destination for the PE investments which were classified into 12 sectors adopted from Fama-French industry classification as highlighted in Table 18. HP is a measure of the length in years, at which the PE investment is held before it is exited. SC is a dummy taking the value of 1 if the investment is a Shariah-compliant investment and zero otherwise. LO is a variable that highlights the countries in which the investment is made, as highlighted in Table 18. LG is a dummy taking the value of 1 if the investment vehicle is a Fund, and zero otherwise. OW is the ownership percentage in portfolio companies owned by PE investors when they make their PE investments. GDP is a measure of the GDP growth in the GCC region being a dummy variable taking the value of 1 if it is greater than 1, or 0 otherwise. AGE is a measure of the age of portfolio companies being a dummy variable taking the value of 1 if it is greater than 10 years, or 0 otherwise. FC is a measure of the impact of the 2008 global financial crisis on PE performance being a dummy variable taking the value of 1 if an investment or exit is made in 2008 or 2009, or 0 otherwise. (According to the U.S. National Bureau of Economic Research (the official arbiter of U.S. recessions) the recession began in December 2007 and ended in June 2009, and thus extended over eighteen months.) VIF for the independent variables is less than 5 and thus there is no multicollinearity amongst the independent variables.

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Table 24 Main Regression Model Coefficients Standard Error T-test p-value Intercept 0.52325 0.06557 7.97998 0.00000 INVESTMENT_SIZE -0.03985 0.01845 -2.16010** 0.03156** SECTOR_INVESTMENT 0.00486 0.00587 0.82794 0.40837 HOLDING_PERIOD -0.08331 0.01012 -8.22866** 0.00000** SHARIAH_COMPLIANCE 0.06670 0.04576 1.45757 0.14601 LOCATION_INVESTMENT -0.00869 0.00756 -1.14949 0.25127 LEGAL_STRUCTURE 0.05880 0.05068 1.16017 0.24690 Regression Statistics Multiple R 0.45470 R Square 0.20675 Adjusted R Square 0.19083 Standard Error 0.33777 Observations 306 F-ratio for regression 12.98861 This table reports the results of the regression analysis for all independent variables for a sample of 306 PE investments over the period 2004-2014. Regression Model: (i) Dependent Variable: Exit IRR; (ii) Independent Variables: INVESTMENT_SIZE is measure of the dollar value size of the investment made and paid for in cash by GPs. We use the logarithm of investment ticket as it is usually more normally distributed and makes more intuitive sense rather than having absolute investment values. SECTOR_INVESTMENT is the sectoral investment destination for the PE investments which were classified into 12 sectors adopted from Fama-French industry classification as highlighted in Table 18. HOLDING_PERIOD is a measure of the length in years, at which the PE investment is held before it is exited. SHARIAH_COMPLIANCE is a dummy taking the value of 1 if the investment is a Shariah-compliant investment and zero otherwise. LOCATION_INVESTMENT is a variable that highlights the countries in which the investment is made, as highlighted in Table 18. LEGAL_STRUCTURE is a dummy taking the value of 1 if the investment vehicle is a Fund, and zero otherwise. **Level of significance reported at the 5% level.

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Table 25 Regression Analysis Panel A – Model 1 Coefficients Standard Error T-test p-value Intercept 0.54273 0.06117 8.87201 0.00000 INVESTMENT_SIZE -0.04010 0.01843 -2.17542** 0.03038** HOLDING_PERIOD -0.08232 0.01005 -8.19253** 0.00000** SHARIAH_COMPLIANCE 0.05817 0.04456 1.30538 0.19276 LOCATION_INVESTMENT -0.00887 0.00756 -1.17412 0.24128 LEGAL_STRUCTURE 0.06185 0.05052 1.22434 0.22178 Regression Statistics Multiple R 0.45270 R Square 0.20493 Adjusted R Square 0.19168 Standard Error 0.33759 Observations 306 F-ratio for regression 15.46545 Panel B – Model 2 Coefficients Standard Error T-test p-value Intercept 0.50974 0.05438 9.37443 0.00000 INVESTMENT_SIZE -0.04326 0.01825 -2.37030** 0.01840** HOLDING_PERIOD -0.07996 0.00985 -8.11649** 0.00000** SHARIAH_COMPLIANCE 0.07125 0.04317 1.65024 0.09994 LEGAL_STRUCTURE 0.04759 0.04907 0.96987 0.33289 Regression Statistics Multiple R 0.44864 R Square 0.20128 Adjusted R Square 0.19067 Standard Error 0.33780 Observations 306 F-ratio for regression 18.96333 We use a stepwise regression, where in each step, an independent variable is eliminated from the set of independent variables one at each time in order to get the best fitting and statistically significant model. This table reports the results of the regression analysis for all independent variables for a sample of 306 PE investments over the period 2004-2014. Regression Model: (i) Dependent Variable: Exit IRR; (ii) Independent Variables: INVESTMENT_SIZE is measure of the dollar value size of the investment made and paid for in cash by GPs. We use the logarithm of investment ticket as it is usually more normally distributed and makes more intuitive sense rather than having absolute investment values. SECTOR_INVESTMENT is the sectoral investment destination for the PE investments which were classified into 12 sectors adopted from Fama-French industry classification as highlighted in Table 18. HOLDING_PERIOD is a measure of the length in years, at which the PE investment is held before it is exited. SHARIAH_COMPLIANCE is a dummy taking the value of 1 if the investment is a Shariah-compliant investment and zero otherwise. LOCATION_INVESTMENT is a variable that highlights the countries in which the investment is made, as highlighted in Table 18. LEGAL_STRUCTURE is a dummy taking the value of 1 if the investment vehicle is a Fund, and zero otherwise. **Level of significance reported at the 5% level.

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Regression Analysis (Continued) Panel C – Model 3 Coefficients Standard Error T-test p-value Intercept 0.51376 0.05421 9.47683 0.00000 INVESTMENT_SIZE -0.03325 0.01505 -2.20894** 0.02793** HOLDING_PERIOD -0.08083 0.00981 -8.23825** 0.00000** SHARIAH_COMPLIANCE 0.07089 0.04317 1.64228 0.10157 Regression Statistics Multiple R 0.44585 R Square 0.19878 Adjusted R Square 0.19083 Standard Error 0.33777 Observations 306 F-ratio for regression 24.97579 Panel D – Model 4 Coefficients Standard Error T-test p-value Intercept 0.53256 0.05314 10.02202 0.00000 INVESTMENT_SIZE -0.03518 0.01505 -2.33736** 0.02007** HOLDING_PERIOD -0.07983 0.00982 -8.12924** 0.00000** Regression Statistics Multiple R 0.43775 R Square 0.19163 Adjusted R Square 0.18629 Standard Error 0.33871 Observations 306 F-ratio for regression 35.91400 We use a stepwise regression, where in each step, an independent variable is eliminated from the set of independent variables one at each time in order to get the best fitting and statistically significant model. This table reports the results of the regression analysis for all independent variables for a sample of 306 PE investments over the period 2004-2014. Regression Model: (i) Dependent Variable: Exit IRR; (ii) Independent Variables: INVESTMENT_SIZE is measure of the dollar value size of the investment made and paid for in cash by GPs. We use the logarithm of investment ticket as it is usually more normally distributed and makes more intuitive sense rather than having absolute investment values. SECTOR_INVESTMENT is the sectoral investment destination for the PE investments which were classified into 12 sectors adopted from Fama-French industry classification as highlighted in Table 18. HOLDING_PERIOD is a measure of the length in years, at which the PE investment is held before it is exited. SHARIAH_COMPLIANCE is a dummy taking the value of 1 if the investment is a Shariah-compliant investment and zero otherwise. LOCATION_INVESTMENT is a variable that highlights the countries in which the investment is made, as highlighted in Table 18. LEGAL_STRUCTURE is a dummy taking the value of 1 if the investment vehicle is a Fund, and zero otherwise. **Level of significance reported at the 5% level.

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Table 26 Extended Regression Model Panel E – Model 5 Coefficients Standard Error T-test p-value INTERCEPT 2.15063 0.43592 4.93348 0.00000 INVESTMENT_SIZE -0.00355 0.00459 -0.77496 0.43898 HOLDING_PERIOD -0.14626 0.05689 -2.57089** 0.01063** SHARIAH_COMPLIANCE 0.36825 0.24129 1.52616 0.12804 LOCATION_INVESTMENT -0.05818 0.03932 -1.47969 0.14002 LEGAL_STRUCTURE 0.33227 0.24791 1.34027 0.18119 STAKE_%^ -0.18408 0.60702 -0.30325 0.76191 GDP_GROWTH^ 0.06010 0.21439 -0.28032 0.77943 MATURITY_LEVEL^ -0.05875 0.21687 -0.27089 0.78666 FINANCIAL_CRISIS^ -0.18440 0.23790 -0.77514 0.43888 REGRESSION STATISTICS Multiple R 0.45470 R Square 0.27899 Adjusted R Square 0.26071 Standard Error 1.74947 Observations 306 F-ratio for Regression 13.54667 We added 4 more independent variables to the Model to to reduce the probability of having an omitted variable bias. This table reports the results of the regression analysis for all the 10 independent variables for a sample of 306 PE investments over the period 2004-2014. Regression Model: (i) Dependent Variable: Exit IRR; (ii) Independent Variables: INVESTMENT_SIZE is measure of the dollar value size of the investment made and paid for in cash by GPs. We use the logarithm of investment ticket as it is usually more normally distributed and makes more intuitive sense rather than having absolute investment values. SECTOR_INVESTMENT is the sectoral investment destination for the PE investments which were classified into 12 sectors adopted from Fama-French industry classification as highlighted in Table 18. HOLDING_PERIOD is a measure of the length in years, at which the PE investment is held before it is exited. SHARIAH_COMPLIANCE is a dummy taking the value of 1 if the investment is a Shariah-compliant investment and zero otherwise. LOCATION_INVESTMENT is a variable that highlights the countries in which the investment is made, as highlighted in Table 18. LEGAL_STRUCTURE is a dummy taking the value of 1 if the investment vehicle is a Fund, and zero otherwise. We have extended our regression model to include 4 additional independent variables as follows: STAKE^ is the ownership percentage in portfolio companies owned by PE investors when they make their PE investments. GDP_GROWTH^ is a measure of the GDP growth in the GCC region being a dummy variable taking the value of 1 if it is greater than 5%, or 0 otherwise. MATURITY_LEVEL^ is a measure of the age of portfolio companies being a dummy variable taking the value of 1 if it is greater than 10 years, or 0 otherwise. FINANCIAL_CRISIS^ is a measure of the impact of the 2008 global financial crisis on PE performance being a dummy variable taking the value of 1 if an investment or exit is made in 2008 or 2009, or 0 otherwise. (According to the U.S. National Bureau of Economic Research (the official arbiter of U.S. recessions) the recession began in December 2007 and ended in June 2009, and thus extended over eighteen months.)**Level of significance reported at the 5% level.

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6.2.2 Regressions

Main Regression Model

Table 24 shows the results for the Main Regression Model incorporating the six independent variables with an adjusted R-squared of 19%, and the regression shows no evidence of multicollinearity (VIF<5). However, only Model 4 is statistically significant at the 5% significance level with an adjusted R-squared of 18.6% with the size of PE investment and investment holding period being statistically significant with negative relationships with the IRR (Table 25).

The results in Table 25 show that there is a statistically significant relationship between the PE investment ticket size and the IRR, and that the size of the PE investment is relevant when explaining the IRR for a PE portfolio at the 5% significance level. This is consistent with the findings of Caselli, Garcia-Appendini, and Ippolito (2009), who demonstrate a statistically significant relationship, but inconsistent with the positive relationship, as our sample exhibits a negative relationship. Our findings show that there is a statistically significant negative relationship between the size of the PE investment ticket and the IRR, which means that the lower the investment ticket size from PE investors, the higher the IRR. From a practical perspective of a PE practitioner in the GCC, when the investment size is small, the typical case is that PE investors are minority shareholders, whereas the founders of the business are the major shareholders, thus there is a big incentive for business founders to enhance the performance of their business in order to gain better valuations at future rounds of funding. However, when the investment ticket size by PE investors is large, the acquired stake is typically a majority stake, as PE investors tend to have more control than business founders, who may not be incentivized enough to drive the positive performance of the business due to several control restrictions imposed by PE investors on them. Furthermore, when the investment ticket size is large, business founders could cash out some of their holdings on a secondary sale, thus reducing their shareholding with less incentive to work as hard as when they were in control. Other possible reasons to explain such a negative relationship is the case in which the investment is made as a

119 private rights issue in order to cover a large capital expenditure for highly capitalized companies, in which the positive returns on such investments are very long-term (>10 years) and are beyond the exit window of PE investors. There could be other reasons explaining such a relationship, which is beyond the scope of this research.

Considering Hypothesis 2, the regression results show that sector-specific PE investments do not affect the IRR of a portfolio of PE investments, and thus we conclude that there is no statistically significant relationship between sector focus and performance at the 5% significance level. This is in line with the findings of Bernstein, Lerner, Sorensen, and Strömberg (2016), who argue that there is no empirical evidence that certain sectors backed by PE have a significant impact on private equity investments performance. In the context of the GCC region, although there are some sector-specific PE funds launched in the GCC (such as PE real estate funds or PE infrastructure funds), there is no evidence that such sector-specific PE funds demonstrate different performance than other sectors backed by private equity firms. Therefore, we conclude that PE sector specialization may not be a good investment strategy for private equity firms in the GCC region and may not also provide any competitive advantage over other generic private equity funds or investments. As a result, the findings relating to the GCC region are consistent with those of Bernstein, Lerner, Sorensen, and Strömberg (2016), and thus the GCC region is not different.

We test Hypothesis 3 and find a statistically significant negative relationship between the investment holding period and the IRR. This is consistent with the results found by Valkama, Maula, Nikoskelainen, and Wright (2013), which covers the UK market. This means that the shorter the investment holding period, the higher the IRR. From a practical perspective, the investment characteristics of private equity investments, the financing structure (i.e. use of leverage), and the prevailing macroeconomic conditions may play an important role in prolonging or shortening the investment holding period. For our sample, PE investments exited before the 2008 financial crisis had relatively shorter investment holding periods (average 2 years) and higher IRRs, and those who endured the crisis had longer investment holding periods (average 5 years) and lower IRRs. Therefore, we conclude that the investment holding period is a significant factor affecting the IRR.

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Regarding Hypothesis 4, when we analyse the impact of PE-backed Shariah-compliant investments on the IRR, we do not find a statistically significant relationship. For PE investors, this means that allocating funds only to Islamic PE funds has no strategic advantage over those which are conventional PE funds. In addition, for PE GPs, launching specialized Shariah- compliant PE funds would not make any strategic value addition, except to admit investors who are only Shariah-compliant investors, thus widening the investors’ base. Furthermore, we try to extend our analysis further by testing the mean difference between Shariah-compliant and conventional PE investments to check if there is any difference in mean returns (Table 27). We find that the results are not significant, and we conclude that there is no difference in the mean returns between Shariah-compliant and conventional PE investments. Therefore, our results show that Shariah-compliant PE investments do not have an impact on the IRR when they exist in a PE portfolio, and there is no difference in the mean returns between Islamic and conventional PE investments in the GCC, as both results are statistically insignificant. Shariah- compliant investment returns underperform conventional PE investments in terms of IRR. This can be attributed to several factors such as GPs being restricted in using leverage as a tool to enhance the performance and lessen the reliance on equity capital at the level of portfolio companies. Other reasons may include the limited number of Shariah-compliant investment opportunities, which make the chances of GPs deploying PE capital lower than those offered by conventional PE opportunities. Furthermore, GPs investing in Shariah-compliant opportunities may be more inclined to deploy the capital even if the rewards are not as high as what they offer in reality just to avoid situations of earning no management fees for the un-deployed capital.

Table 27 Shariah-compliant PE Investments compared with Conventional Investments Shariah-Compliant Conventional No. of Observations 86 220 Investment Value (US$ mn) 814.25 3,178.43 Exit Value (US$ mn) 906.66 3,826.18 Investment Money Multiple (Mean) 1.13% 2.04% T-test -0.73319 p-value (one tail) 0.23200 (>0.05) p-value (two tail) 0.46400 (>0.05) This table reports the results of the test for the mean variance for the Shariah-compliant investments versus the Conventional investments.

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We extend our analysis to test the mean difference in returns for Shariah-Compliant investments carried out through different legal structures; (i) a PE Fund structure; and (ii) an Institutional PE structure. The economic rational behind this is to compare the mean investment returns of a portfolio of Shariah-Complaint investments through a focused management approach via direct investing by institutions versus the mean investment returns of those conducted as part of a well- structured GP/LP PE Fund with an investment pool with Shariah and non-Shariah investments. We find that the Institutional PE structure achieves an average of 5.2% mean return compared to a negative 0.6% mean return for PE Funds structure. However, such differences in mean investment returns are not statistically significant. The economic justification for such results may be explained by the fact that direct investing by companies into specific Shariah-Compliant investments makes investment managers more focused in attempting to enhance the performance of such investee companies, which is directly linked to their short-term annual compensation structure contrary to the long-term nature of PE Funds’ structure. Other reasoning may be that those institutional PE investors are Shariah-complaint investment companies who are specialized only in Islamic investments.

Table 28 Shariah-compliant PE Fund Structure vs. Institutional PE Structure PE Fund Institutional PE Total No. of Observations 27 59 86 Investment Value (US$ mn) 571.2 243.06 814.25 Exit Value (US$ mn) 536.45 370.21 906.66 Investment Money Multiple (Mean) -0.6% 5.2% 1.13% Average Investment Size (US$ mn) 21.16 4.12 9.47 T-test 0.16 p-value 0.44 (>0.05) This table reports the results of the test for the mean variance for the Shariah-compliant investments made through Institutional PE and PE Funds

When assessing whether PE investment location has any impact on the IRR (Hypothesis 5), our results show no statistical significance between PE investment location and the IRR. This provides insights to PE investment managers in the GCC that launching country-specific PE funds would not provide them with improved IRR when compared to generic PE funds. Furthermore, PE managers in the GCC tend to launch generic PE funds in which the fund prospectus allows flexibility in investing in different GCC countries by putting capital caps (i.e. maximum investment allowance) on country investment allocation as a means of country-

122 specific risk diversification. We therefore conclude that the location of PE investments is not a factor in determining the performance of private equity investments.

We test Hypothesis 6, which states that the PE investing vehicle does not have any effect on the performance of private equity investment or the IRR. In addition, we test the mean difference in return for PE Fund investing versus direct institutional investing. Our analysis from the regression shows that there is no statistically significant relationship between the PE investing vehicle and the IRR. In other words, whether the PE investment is done through a PE Fund structure or a direct corporate PE firm, there is no significant impact on the IRR. However, when we test the mean difference of returns between the PE Fund structure and the institutional direct PE investment, the results are significant (Table 29) and we conclude that the mean investment returns achieved by PE funds are different from those achieved by institutional private equity investment, but none of them have a significant impact on the IRR.

Table 29 PE Fund Type versus Direct Institutional PE Investments PE Fund Direct Institutional PE No. of Observations 82 224 Investment Value (US$ mn) 3,141.14 851.55 Exit Value (US$ mn) 3,567.30 1,165.55 Investment Money Multiple (Mean) 1.36% 3.69% T-test -1.88819** p-value (one tail) 0.02997**(<0.05) p-value (two tail) 0.04995**(<0.05) This table reports the results of the test for the mean variance for the PE Fund Type versus the Direct Institutional PE Investment.

Extended Regression Model

In our Extended Regression Model, we added 4 more independent variables which are (i) stake ownership in PE portfolio companies; (ii) average GDP growth in the GCC region; (iii) maturity level of portfolio companies (age); and (iv) the impact of the 2008 global financial crisis. We added more variables that may have an impact on the IRR to provide a more robust model and avoid any omitted variable bias.

We test the hypothesis 7 that PE ownership structure has a significant impact on the performance of private equity investments. We find that the relationship between the ownership structure in

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PE companies and the IRR negative; as the PE ownership stake increases, the IRR decreases. However, such relationship is not significant and we conclude that the ownership stake in PE portfolio companies does not have an impact on the IRR. Our results are contrary to the findings of Battistin, Bortoluzzi, Buttignon, and Vedovato (2017) who report that PE-backed companies tend to outperform for high growth companies when the PE shareholding is higher and when PE investors have a minority stake in portfolio companies, the relationship becomes negative and the performance deteriorates.

In order to assess the different brackets of the ownership structure and its impact on the IRR, we have collected data on the investment ownership structure of GPs in all portfolio companies. 68% of the sample were investments made in companies with up to 30% ownership structure (little or no influence), followed by 18% in companies with control (>50%) and around 14% in companies with some influence (between 30% and 50%). The mean returns generated by GPs in those investments where there is little or no control yielded an average of 3.34% annual investment return, followed by those investments with some influence with an annual investment return of 1.17%, with the least investment returns being generated by those where the GPs had a control at an annual investment return of less than 1% (Table 30). Below are possible explanations for such results:

- When GPs commit to investment opportunities with little or no influence, the management team or the founders of the business are hard-focused on driving performance, creating efficiencies, scaling operations and achieving growth. Founders’ interest in this case is much aligned to grow the business, enhance dividends, and maximize valuation of their own companies. In such cases, there are little confrontation between founders and GPs as their powers are diluted. This also explains why the mean average returns on such investments for GPs are the highest amongst the three ownership brackets at 3.34%. Even though the relationship between the IRR and the ownership bracket of (0-30%) is positive due to more founders’ involvement in the business and their solid experience, we find that the relationship between the IRR and the ownership structure at the ownership bracket from (0-30%) is positive yet statistically insignificant and is one that cannot be generalized.

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- When there is some influence by GPs in the management of the PE portfolio companies either through a representation in the board or through other board committees, there can always be a chance of disagreement on business vision, operational approach, expansion plans, budgets and other matters between GPs and founders. This can hinder the smooth operations of the company, under which the founders of the company would be distracted from focusing on the macro vision undermining their abilities to achieve or grow. In addition, a conflict of interest may arise as a result of GPs wanting to exit as soon as possible to achieve quick returns, which can always be blocked by the founders who believe in the long-terms prospects of their business via measured and sustained growth. This is how we can explain the lower mean average investment return of 1.17% (compared to 3.34% with less or no influence from GPs) and the negative relationship between IRR and the ownership structure when there is some influence by GPs. Thus, such relationship is negative and statistically significant at the (30-50%) ownership brackets by GPs.

- When GPs opt for control when investing in PE opportunities, control moves to GPs in terms of steering the vision and the operations of the company as well as the financial structure. In such cases, the founders, if not fully exited, would retain minority stakes which will impact their decision making ability to exert an influence. The experience of the management team may be much better than those of the GPs in this specific industry and thus the performance of such controlled portfolio companies may be negatively impacted. Furthermore, the management team may not be incentivized enough to put more efforts as there is less alignment of interest once they become diluted (unless there is an attractive mechanism put forward by the GPs – which is not always be the case in the GCC). The mean average returns achieved by GPs for their majority-controlled portfolio companies, we find that the returns are the lowest amongst the three brackets at less than 1%. This may be due to the less experienced management team put by GPs, inappropriate financial structures (e.g. heavy use of debt) or non-focus by GPs as they have a pool of other investments to take care of. We find that the relationship between the IRR and the more controlled ownership structure to be positive but not statistically

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significant.

Table 30 Ownership Structure & Returns Up to 30% >30%-50% More than 50% (little or no influence) (some influence) (control) No. of Observations 209 44 53 Investment Value (US$ mn) 1,533 387 2,073 Exit Value (US$ mn) 2,046 432 2,255 Annual Money Multiple 3.34% 1.17% 0.88% Coefficient 0.20 -6.75 0.68 T-test 0.10 -2.17 0.37 p-value 0.92 (>0.05) 0.04 (<0.05)** 0.71 (>0.05) This table reports the results of the test for the mean variance for ownership structure and the impact on the IRR.

We then test hypothesis 8 that GDP growth movement has an impact on private equity returns. We find that the relationship is positive, the higher the GDP growth rate, the higher the IRR – a 1% change in the GDP growth rate will have a 0.06 unit change in IRR. However, and although the relationship is positive, it is not significant at the 5% significance level and we conclude that GDP growth does not have a significant impact on the IRR. This is contrary to the findings of Phalippou and Zollo (2005) who find that the relationship between PE funds’ performance and GDP growth is positive; the higher the GDP growth rate the higher the PE funds’ performance. The justification for such conclusion is the fact that the 6 GCC countries have different economic strengths, which cannot be generalized across the GCC as one region; what might work for Kuwait may not necessarily work for Oman or Bahrain due to varying breakeven points in their budgets (surplus or deficit). The varying level of individual government spending spending amongst the 6 GCC countries is different and therefore the investment returns vary from one country to another.

We test hypothesis 9 that the age of investee portfolio companies has an impact on the IRR. We find that the relationship is negative meaning that the more mature (older) PE portfolio companies are, the lower the IRR, and the younger PE portfolio companies are the higher the IRR, which is in line with the findings of Dimov and De Clercq (2006) who find a similar relationship. However, our results are not statistically significant, we further analyse the relationship between the age of the PE portfolio companies (maturity) and the IRR to explore if there is any relationship between the variables.

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From our sample, there are 194 companies which are less than 10 years old (63% of the sample) and 112 which are more than 10 years old (37%). It seems that the mean average investment returns are slightly higher for more matured companies (1.92%) than the returns for the less matured companies (1.79%). When we test the significance of the results, we do not find a statistically significant relationship between the maturity of the PE portfolio companies and the IRR.

Table 31 Age of Investee Companies (Maturity) and IRR Age <10 Years Age >=10 Years Total Portfolio No. of Observations 194 112 306 Investment Value (US$ mn) 1,900 2,092 3,993 Exit Value (US$ mn) 2,240 2,493 4,733 Investment Money Multiple (Mean) 1.79% 1.92% 1.85% Coefficient -0.15 T-test -0.73 p-value 0.47 (>0.05)

We extend the analysis to test the mean difference of returns between the more and the less matured companies for our sample, and we find that the mean difference between the two groups is statistically insignificant and that the mean investment returns are not different. This means that whether companies are matured or not, this has no impact on the performance, which means that there are other factors which are more economically important in explaining the IRR and the differences in returns amongst different PE portfolio companies.

Table 32 Test of Mean Difference Between Matured & Un-matured Companies Age <10 Years Age >=10 Years No. of Observations 194 112 Investment Value (US$ mn) 1,900 2,092 Exit Value (US$ mn) 2,240 2,493 Investment Money Multiple (Mean) 1.79% 1.92% T-test 0.73 p-value 0.23 (>0.05)

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We move on to test the last hypothesis (hypothesis 10) that the 2008 global financial crisis had an impact on the performance of PE portfolio companies. We explore the relationship between the prevalence of the 2008 global financial crisis at the time of investment in new PE portfolio companies or exit of existing PE portfolio and the IRR and find that the impact of the 2008 global financial crisis is not significant and that the ramifications of the financial crisis did not have an impact on the performance of PE investments exited or invested in during 2008-2009.

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7. FINDINGS AND CONCLUSIONS

7.1 Research Findings

The purpose of this research was to examine the performance of private equity investments in the GCC region, and compare their performance to that of public equities. In addition, one of themes that emerged from the analysis of the PE data collected was also to examine the performance of Shariah-compliant private equity investments in comparison to conventional private equity investments. Furthermore, the analysis of my research was extended to also analyse the performance of direct PE Funds’ investments versus direct institutional private equity investments.

In the GCC region, non-publicly-traded transactions are confidential in nature with the absence of any mandatory disclosure requirements from any regulatory authority. Therefore, collecting data on private equity transactions tends to be extremely laborious because business owners do not prefer to share their companies’ financial information to any third parties. Since I worked, and still working, as a private equity professional in the GCC region for the past 15 years, I had the opportunity to work with several GPs and LPs on both fundraising and PE investments. This helped me in building strong business networks in the GCC region which gave me the opportunity to get a privileged access to such private financial data about PE transactions. I proprietarily collected PE data from General Partners and investment managers in the GCC, with whom I have signed several Non-Disclosure Agreements (NDAs). Therefore, it is difficult for any researcher to carry out an empirical analysis on the performance of private equity investments in the GCC.

I have collected a sample of 306 private equity portfolio companies from General Partners and Investment Managers operating in the GCC region, leveraging on the strong business network that I have built in the GCC. The dataset covers the period from 2004 to 2014 by GCC domiciled investment managers which is proprietary in nature, and is a mixture of PE funds’ portfolios and corporate investors focusing on private equity investing. The sample includes data on 38 Private Equity funds (11 PE funds with GP/LP structure, and 27 Institutional PE firms). Further, the sample has the 306 portfolio companies classified by type, domicile, portfolio size, whether Shariah-compliant or not, location of investment,

129 portfolio sector, investment value, investment holding period, investment vehicle (fund or firm), money multiple, IRR and exit type.

I ran a multiple regression analysis by using the IRR as the dependent variable, and six other variables as independent variables which include the PE investment size, investment sector, investment holding period, Shariah-compliance investments, location of investments and the legal structure of the investing vehicle. I initially began by checking if there is any multicollinearity between the independent variables and concluded that there was not any multicollinearity concerns amongst the independent variables and thus I continued with carrying out the multiple regression analysis.

My findings show that the relationship between the IRR and the PE investment ticket size is statistically significant at the 5% significance level with negative correlation. This means that the lower the PE investment ticket size the higher the IRR. This is consistent with the findings of Caselli, Garcia-Appendini and Ippolito (2009), where there is a statistically significant relationship, but inconsistent with the positive relationship as our sample exhibits a negative relationship. From a practical perspective, when the investment ticket size is small, the typical case is that PE investors are minority shareholders whereas the founders of the business are the major shareholders, thus there is a big incentive for business founders to enhance the performance of their business in order to gain better valuations at future rounds of funding. However, when the investment ticket size by PE investors is large, this is when the acquired stake is typically a majority stake, as PE investors tend to have more control than business founders, who may not be incentivized enough to drive the positive performance of the business due to several control restrictions imposed by PE investors on them. Further, when the investment ticket size is big, it could be the case where business founders cash out some of their holdings in a secondary sale, thus reducing their shareholding with less incentive to work as hard as when they were in control. Other reasons to possibly explain such negative relationship is the case when the investment is made as a private rights issue in order to cover a large capital expenditure for highly-capitalized companies, where the positive returns on such investments are very long-term (>10 years) and are beyond the exit window of PE investors.

In addition, I also find a statistically significant relationship between the IRR and the investment holding period but such relationship is also negative. In other words, the shorter

130 the investment holding period the higher the IRR. This is consistent with the results found by Valkama, Maula, Nikoskelainen and Wright (2013) and by Lopez de Silanes, Phalippou, and Gottschalg (2011). This means that the shorter the investment holding period, the higher the IRR. From a practical perspective, the investment characteristics of private equity investments, the financing structure (i.e. use of leverage) and the prevailing macroeconomic conditions may play an important role in prolonging or shortening the investment holding period. For our sample, PE investments exited before the 2008 financial crisis had relatively shorter investment holding periods (average 2 years) and higher IRRs and those who lived the crisis had longer investment holding periods (average 5 years) and lower IRRs. Therefore, we conclude that the investment holding period is a significant factor affecting the IRR.

The results also show that sector-specific PE investments do not affect the IRR of a portfolio of PE investments, and that there is no statistically significant relationship between sector focus and performance. This is in line with the findings of Bernstein, Lerner, Sorensen and Strömberg (2016), who argue that there is no empirical evidence that certain sectors backed by PE have significant impact on private equity investments performance.

Furthermore, the analysis shows that there no statistically significant relationship between the IRR and PE-backed Shariah-compliant investments. For PE investors, this means that allocating funds only to Islamic PE funds has no strategic advantage over those which are conventional PE funds. I extended the analysis to see if there is any difference in returns between Shariah-compliant investments and conventional investments and the results are not significant which means that there is no difference in the mean returns between Shariah- compliant and conventional PE investments.

When assessing whether PE investment location has any impact on the IRR, the results show no statistical significance between PE investment location and the IRR, which means that launching country-specific PE funds would not provide PE investors with improved IRRs when compared to investment in generic PE funds.

I also examined if there is any impact on the investment IRRs if the investing vehicle is different (PR Fund vs. Direct Institutional Investment) and the analysis from the regression shows that there is no statistically significant relationship between the PE investing vehicle and the IRR. In addition, I also tested the mean difference in return for PE Fund investing

131 versus direct institutional investing and the results were significant. I conclude that the mean investment returns achieved by PE Funds are different from those achieved by institutional private equity investment, but none of them have a significant impact on the IRR.

When then extend the Main Regression Model into the Extended Regression Model (Table 26) by adding four more independent variables. These variables are (1) stake ownership in PE portfolio companies; (2) GDP growth in the GCC region; (3) Age of PE portfolio companies (Maturity); and (4) The 2008 global financial crisis impact. When the model was extended, only the investment holding period appeared to be statistically significant and relevant in explaining the performance of PE investments in the GCC. The additional 4 independent factors were not statistically significant in explaining the IRR.

We find that there is no significant relationship between the PE stake ownership structure and the IRR. However, when testing the mean variance between 3 different control brackets, we find that the relationship is negative and statistically significant at the (30-50%) ownership brackets by GPs (Table 30).

We also find no significant relationship between the GCC’s GDP growth rate, the maturity level of PE portfolio companies, the impact of the 2008 global financial crisis and the IRR.

To assess whether PE investments in the GCC region offer a better investment return than public equities, we compared the annualized investment return of PE investments for the period 2004-2014 to the S&P GCC Composite Total Return Index for the same period, and the analysis shows that private equity investment returns tends to underperform those of the S&P GCC Composite Total Return Index by 2.37%. This is consistent with the results of Phalippou and Gottschalg (2007), who find that the average private equity fund performance is 3% lower than that of the S&P 500. However, our results are inconsistent with the majority of the studies assessing the performance of PE, which analyse PE compared to public markets such as Moskowitz and Vissing-Jørgensen (2002) and Kaplan and Schoar (2005), who find that the performance of their PE sample is approximately the same as the public markets. In addition, our results are also inconsistent with the findings of Ljungqvist and Richardson (2003), Conroy & Harris (2007), Jegadeesh, Kräussl, and Pollet (2009), Robinson and Sensoy (2011), Harris, Jenkinson and Kaplan (2012), Mozes & Fiore (2012)

132 and Harris, Jenkinson and Kaplan (2014) who all find that private equity investments outperformed the public market.

My findings have several implications to the private equity industry in the GCC region as they can help investors to have a better understanding on the performance of private equity in order to be able to have more informative asset allocation decisions. In addition, regulators can have in-depth insights about the private equity industry in the GCC region, which may help them in setting up more educated regulations relating to the private equity industry as a whole. When it comes to academia, this research reveals new findings about the performance of the private equity asset class in the GCC region and how it compares to the public market, which will help in complementing the literature on the global private equity industry by having new literature on the GCC region, thus enriching the academic body of knowledge.

7.2 Contribution to the Body of Knowledge

This study aims to fill the existing gap in understanding the private equity industry in the GCC region, as well as examining the investment returns of private equity investments and how they compare to the public equity markets. In addition, it analyses the performance of Shariah-compliant private equity in comparison to conventional private equity shedding more light on a grey area that has not been researched before. Further, our research addresses multiple audiences such as academia, potential and existing private equity investors, corporate family offices, sovereign wealth funds, financing institutions, regulators, capital market authorities, stock exchanges, legal and management consultants, in addition to other stakeholders. Thus, this research makes key main contributions to the body of knowledge in the filed of private equity.

1. It provides a thorough understanding of the private equity industry in the GCC region in terms of its drivers, performance, legal structures, regulations, the role of investment managers or GPs, type and suitability of investors and the contractual arrangements within a PE structure. In addition, it highlights the compensation structure in a PE setup, and how it is different from any other asset class.

2. It examines the relationship between private equity investment IRRs and investment geographies, sectoral diversity, type of investments, investment holding periods, size

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of PE investments, legal structure of investing vehicles, PE stake ownership in portfolio companies, GDP growth, maturity level of PE portfolio companies and the ramifications of the 2008 global financial crisis. In addition, it provides detailed performance analysis about private equity in the GCC region from the perspective of the various independent variables. This is a big gap in the PE literature due to disclosure limitations and the developing nature of the PE industry in the GCC region.

3. It compares the competitiveness of the private equity investment returns with those of S&P GCC Composite Total Return Index, which would help investors gain insights when it comes to their asset allocation strategies as a means of achieving return maximization within a given targeted risk-return profile.

5. It compares the performance of Shariah-compliant investments (“Islamic”) versus conventional investments, which may be helpful to investors seeking investment diversity and to other investors when they make their investment allocation decisions. Furthermore, it analyses the performance of Islamic PE in terms of the investing vehicle whether it is a fund or a direct institutional investment. Further, it helps in building the literature to highlight the differences in returns between Islamic and conventional PE investments.

6. It compares the the performance of PE Funds versus the performance of Direct Institutional PE Investing and provides insights, which may help investors in their investment decisions as to which investment vehicle performs better.

7. It assesses the performance of PE in the GCC with different PE ownership structures and provides a detailed reasoning for any performance differences thus shedding more light on the relationship between IRR and the ownership structure.

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7.3 Future Areas for Research

While the GCC region lacks any academic research on the performance of the private equity industry, this thesis constitutes a building block towards establishing a fully-transparent framework that describes this asset class in some detail. Although this research examined the performance of the private equity industry in the GCC region and provided important insights on how it performs relative to S&P GCC Composite Total Return Index, there are some future areas, which can be studied in order to shed more light on the other attributes of the GCC private equity industry such as:

• PE deal sourcing channels for private equity managers in the GCC, and the role of family-oriented LPs in generating deal flow and whether there exists any conflict of interest or selection bias towards those deals. • The effect of leadership in private equity firms on the performance of private equity portfolios, and whether a GCC experience would have an impact on the returns achieved by those PE firms. • The compensation structure of GPs and whether differences in such structure would impact the overall portfolio performance.

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