Middle East Private Equity – How Is It Different?

February 23, 2016

Private Equity in MENA is yet to reach full maturity.  Nonetheless, we know from the PE transactions completed to date that there are certain key differences in the terms of such transactions as compared to most Western markets.  These differences arise, principally, for three reasons:

• low tax or zero tax rates (with a few notable exceptions (such as Saudi Arabia) complex structures will not help reduce taxation);
• lack of market practice/precedent; and
• lower levels of legal certainty/enforceability (as a general rule courts in MENA will not grant specific performance or injunctions, and instead limit available remedies to damages awards).

We discuss some of these differences and why they exist.

This article does not discuss foreign ownership restrictions or structures to deal with them because (i) this has been the subject of numerous previous articles and (ii) the appropriate structures (if any are possible) are always fact/country specific.

Key Differences

1.  Bid vehicle structures are simpler and often do not involve establishing a ‘Bidco group’

Holdco’s are not traditionally permitted.  This is, in part, because in many MENA countries the concept of a ‘holding company’ was not widely recognised (companies previously had to have an operational purpose in order for them to be incorporated).  However, this situation is changing – the Dubai International Financial Centre, UAE on-shore, Bahrain and Saudi Arabia are all now allowing holding companies to be established.

Long incorporation processes.  In addition, the incorporation process for companies in MENA can take much longer and be significantly more expensive than in other, more commonly used, jurisdictions (for example the Cayman Islands or Luxembourg).

No need for structural subordination of equity.  Finally (and as discussed below), funding structures in the region are much simpler.  Because junior debt (including interest bearing shareholder loans) is rarely used, tiers of companies are not needed to effect structural subordination.

2.  Shareholder Loan structures or Preferred Shares are not common

In most Western markets, it is usual for bid vehicles to be minimally funded by equity with the majority of funds being provided by way of shareholder loans, allowing interest on such loans to be deducted from the profits of the company, thus minimizing the tax burden of the bid vehicle and allowing sponsors to extract returns in a cash efficient manner.

Because in many MENA countries no (or only a very low rate of) corporation tax is payable, minimising profits through the imposition of interest charges is rarely advantageous.  Furthermore, withholding tax can be assessed on interest payments themselves (for example, in Saudi Arabia for non-residents), often without a corresponding tax credit.

Moreover, many countries do not permit multiple classes of equity (or quasi-equity) and as a result a company can issue only ‘plain-vanilla’ ordinary shares.  Different share classes are, however, permitted in the Dubai International Financial Centre.

3.  Acquisition finance is less readily used/available

In MENA, the use of acquisition finance (though increasing) is less common than in other markets.  The use of acquisition debt is, however, on the rise as know-how of the relevant products increases within the bank market.  Most acquisition debt is ‘unitranche’ senior debt provided by a single lender or a small club of lenders.  The reasons for this include:

• lack of precedent;
• absence of a secondary debt market;
• current liquidity issues/macro-economic factors;
• few participants in the market who are able to ‘price’ different levels of debt;
• the difficulty of putting in place effective security packages to secure debt;  
• the difficulty of enforcing security; and
• the lack of effective insolvency regimes to deal with ‘failed’ investments.

In light of the above, it is no surprise that ‘mezzanine’ financing is still rare in MENA PE deals.  Often, mezzanine finance put in place is akin to expensive, contractually subordinated, senior debt; however as senior debt pricing increases, there are more opportunities for mezzanine financing, and we are seeing a few new money mezzanine financing deals in the region, albeit not for MENA PE yet.

4.  Management stakes – "real" equity vs "phantom" equity

Tax-free regimes.  Generally, individuals pay neither income tax nor capital gains tax in many MENA countries.  As a result, there is no tax advantage for management to hold shares because, unlike in other countries, there is no need to ensure that equity appreciation is taxed at capital gains tax rates, rather than employment income tax rates.

Single class of shares.  In addition (and as mentioned above), many MENA countries do not allow for separate classes of shares and so it is not possible to create a separate class of ‘management shares’.

Enforceability.  Most courts in the MENA region (excluding the Dubai International Financial Centre) are unwilling to force persons to dispose of property and therefore a ‘drag-along’ right is unlikely to be specifically enforced (although we believe this has yet to be tested in court).  Sponsors that issue direct equity to managers could, therefore, find themselves unable to deliver 100% of the shares in a trade sale (unless managers hold equity at a superior off-shore holding company level).

Entrenchment of provisions in constitution.  Finally, in many MENA countries (again, excluding the Dubai International Financial Centre), the constitutional documents of the target must be in a prescribed form and material changes to the form are unlikely to be approved by the relevant regulatory authority.  This means entrenching transfer rights and obligations may be impossible.  Sponsors may, instead, need to rely on contractual rights whose enforceability is uncertain.

In light of the above, management commonly receives ‘phantom’ equity or bonuses as equity incentivisation.  These arrangements are relatively straightforward (for example, an entitlement to a specified percentage of exit proceeds over a hurdle IRR).  The issues that usually are subject to negotiation are not as often fully considered, though they are commonly embedded in the phantom rights given to managers.  Examples of such issues include:

• good/bad leaver (in some cases payment will depend on continuing employment and nothing else);
• drag/tag (not relevant because no equity is held by management); and
• reserved matters/board representation (generally sponsors will not accept any limits on their ability to control operations and will not permit management to have a right to appoint directors).

There is no established market-practice for management ‘rolling-over’ proceeds of sale (although this is legally possible) as few PE exits have taken place where managers have received significant sums and stayed with the business.  The exceptions to this are: i) in relation to secondary buy-outs where management have received significant proceeds – in the small number of transactions where this has been the case, we have generally seen sponsors requiring management to re-invest a material proportion of such sums in the business; and ii) exits taking place by way of IPO – where standard lock-up restrictions generally apply.

5.  Customary PE exit terms are not widely recognised

In most Western markets, PE sellers (if they have a choice) will not give business warranties or sell on any basis other than a ‘locked-box’.  This seller-friendly approach is less common in MENA.

The reasons for this include:

• relatively few PE exit precedents;
• regional trade buyers simply will not accept the risks on a ‘buyer-beware’ basis; and
• lack of trust/understanding/experience of locked-box completion accounts.

In addition, certain SPA terms typically seen in MENA deals are buyer friendly when compared to Western markets.  Such terms include:

• liability caps;
• time limits for raising warranty claims; and
• de-minimis and threshold amounts.

6.  Closing mechanics are more complicated and may require escrow arrangements

Time-consuming processes are often necessary to effectively transfer shares or assets in MENA countries.  The approval of various third parties (such as notaries and economic departments) may be necessary for completion to occur.  In addition, obtaining these approvals will almost always require seller action.

As a result, escrow arrangements, whereby an escrow agent holds the purchase price pending completion of the relevant processes, are often necessary.  Typically, sums in escrow will be released upon the occurrence of the final step in perfecting the transfer of the shares or assets in question.  Often, reputable escrow agents in MENA will not release funds without instructions from both the seller and the buyer.  The consequence is that the seller assumes the execution risk of the buyer failing to give instructions to release funds at the relevant time.