Bloomberg Businessweek Interview – The Path to Growth
Karim Souaid, Managing Partner at Growthgate Capital, on the prospects for the company’s investments over the next few years and the challenges of being a direct equity investor in the Middle East
- How is the ongoing slump affecting the market for acquisitions in the PE industry?
At times of economic slow down and of financial markets’ volatility, owners of privately held companies tend to hold back on any sale plans awaiting better conditions to ameliorate their value proposition, and hence their prices. This in turn reduces the number of targets willing to close deals with any potential acquirer including PE firms. Only businesses that operate in non-cyclical sectors (such as food for instance) will witness a vigorous momentum, as one can observe with the flurry of regional M&A activity in this space.
2. What are Growthgate’s acquisition plans in the short and mid-term?
Growthgate tends to become very active at such turbulent times. At the beginning of 2016, we have completed one of our largest transactions to date, in the modern retail sector in North Africa, the details of which will soon be disclosed. We also are actively pursuing, during the course of this year, exit paths for a number of our investee companies that operate in non-cyclical sectors, and that are attracting a number of strategic suitors.
3. What is the value of assets under management? How much dry powder does it have and what does it plan to do with it?
As of December 31, 2015, Growthgate had circa. $1.7bn of assets under management, and a shareholders’ equity of circa. $400m, it being a specialized investment firm with permanent capital, and not a mere fund. Dry powder, at any time, does not exceed 15% of our total capital, since we nimbly invest, and reinvest the proceeds of previous exits after distributing super-dividends to shareholders. Our track-record shows that we experienced no ‘capital hang over’ meaning that due to our active deal flow, all available funds are aptly re-allocated thus, avoiding any capital inefficiencies.
4. How have and will plunging oil prices continue to affect the market for raising finances? What expectations do you have for the future of the market and its implication on your business?
At present there is a perfect storm in regional markets translated into low oil prices, severe budget deficits, public spending contraction, and political turmoil. All such factors affect capital providers –debt and equity alike- and severely impact any capital raising plans for companies as well as for PE firms. Whilst the impact will be significant, it also will be temporary since all said factors will not coexist permanently in the long run. If any component of such factors changes, the picture for capital raising will be enhanced.
5. How sensitive are Growthgate’s future funding plans to the shrinking of sovereign wealth funds and tightening liquidity in the region?
As a principle. regional SWFs do not invest in the region or along with regional PE firms. Their strategy is to invest funds generated from oil revenues into a wide range of non-oil related assets. Their mission is to preserve value for future generations and thus, there is a strong tendency to look beyond the region and into more developed markets. To ensure funding needs, Growthgate is following a trend in global PE that is moving away from funds and rigid LP structures towards co-investing. Co-investing is akin to syndication in commercial banking where larger deals, risk diversification, and reduced fees bring together a lead partner (Growthgate in this case) with a host of other like-minded institutions, PE firms or investors’ groups.
6. Has there been any progress in fostering transparency in the industry, especially in terms of available opportunities, over the last few years? How does this affect Growthgate’s growth rate?
The region has a culture of opacity. Even public companies do not disclose the same level of data as one would expect from listed entities. While companies and their executives have embraced more transparency measures than in prior years, this remains a work in progress. We are hoping with the introduction of IFRS by 2017, that many companies will be disclosing more elaborate data about their operations. However, every investment requires a great deal of due diligence, but that is also true of other emerging markets. I guess the silver lining is that we do not leave anything to chance, so we drill the data, mine the facts, and that in turn, offers us greater insights into the businesses we are pursuing.
7. How does the ME Private Equity business compare to the rest of the world in terms of taking on debt and tax implications?
Debt is seldom available for PE transactions in the ME, and when compared to developed markets any debt financing is, when available, short to medium term in nature. Global PE firms have been used to leveraging their acquisitions to the hilt (4x to 5x EBITDA) with willing capital providers who come in different shapes and forms: banks, financing institutions, mezzanine lenders, hedge funds, commercial paper, preferred and convertible instruments etc. This arsenal of financing tools is virtually non-existent in the ME. Little debt, and no taxes are the defining traits of PE investing in the ME.
8. How do rates of return on assets in MEA compare with the rest of the world?
Returns depend on the nature of the business (normal growth vs. vertiginous growth) and the capitalization structure (highly leveraged vs. lightly leveraged). PE firms in the ME invest in ‘old economy’ businesses since high tech/VC type companies are far and few in between. As a result, returns on invested capital in ME companies, over a 5-year period, tend to be 2x to 2.5x on a fully unlevered basis. That translates into circa. 18% to 20% IRR. In comparison, leverage for PE-backed deals in developed markets and the nature of certain high growth companies (Internet based, high tech, social media, etc.) could offer higher returns, but only the top quartile bulge bracket PE firms have been able to achieve such levels.
9. How does Growthgate determine the performance fees it charges its funding partners? How do successful exits in a depressed market affect the prospect of raising performance fees?
Growthgate follows the classic 2% – 20% fee structure applicable across the PE industry. Naturally, performance fees, the so-called carried interests, are severely affected when an exit sale realizes lesser returns. If shareholders make less returns we also receive lesser rewards. That is the rule of the game. But, PE managers tend to wait for better market conditions and higher valuations in order to complete an exit and realize greater returns for all interested parties. A slow down affects exits as much as it does entries, and whilst many investee companies can be quickly sold at competitive or ‘fire sale’ prices, no PE manager would entertain such idea in order to preserve value and hope to realize it, for its investors as much as for itself.
10. Can you share details (maturity, exit strategy) of the assets Growthgate has under its ownership currently?
We have already conducted 3 exits in 2013 and 2014, out of a portfolio of 8 investee companies, and have in 2016, replenished one additional new entry. So we are at a total of 6 fully invested companies. I would venture and say that: 3 out of 6 are ripe for an exit between Q3 2016 and Q1 2017, 2 out of 6 are destined for exit in Q4 2017/Q1 2018; and1 is a newly invested company and we do not see any maturity for an exit prior to 3 years minimum.
11. Why does Growthgate insist on enterprise values under $200m and not outright ownership?
Our niche market is the middle market which consists of companies that are valued (pre-money) at $100m to $200m. This segment offers the widest spectrum of platform companies that meet our investment criteria: owned by the first or second generation founders, lightly leveraged, commanding a leading position in their domestic markets, and with a scalable business model. Said companies are regional champions in the making, and we, as active partners, offer to inject growth equity capital and to assist in realizing their expansion plans. Such plans invariably include organic growth as well as inorganic growth/acquisitions initiatives to accelerate the value-creation process. We seek sizable minority stakes (25% and up to 49%) because we believe that keeping founders-managers at the helm of operations ensures maximum commitment, continued drive for growth and sustainable economic well-being of said companies. If the majority owners do well, we would benefit as much. Also, a minority stake avoids paying a premium for control which invariably leads to overpayment, and lesser returns at exit.
12. How do you minimize the risk of conflicts stemming from operational involvement and steering company decisions despite minority stakes in the companies?
We do not get involved in day-to-day operations since we are generalists and not specialist PE managers as we do not focus on one sector or sub-sector of activities. Besides, if the principle is to partner with ethical, able and experienced owners-managers you’d better leave them run the daily operations without undue interference. At the outset, we agree with the founders-managers on a list of Reserved Matters over which we would have to reach mandatory consensus before they become binding. Such matters are few and are not in the normal course of business such as: M&A, sale of assets, indebtedness beyond a certain threshold, issuance of new securities, changes in senior management, and most importantly exit routes and timings.
13. With how successful PE firms have been in the region, how carefully do they have to negotiate to avoid paying premiums on the perceived value of a company?
Any PE firm in the ME or in developed market that intend to buy a majority of any business will have to pay a premium. There is no avoidance of this axiomatic reality only different levels of premiums. A seller would not part with control without compensation in real terms and not in future promises. So, PE firms would have to make their own calculations on whether –despite paying such a premium- the investment would still realize the required returns in few years’ time. This requires an intimate knowledge of the investee company, its sector and its prospects and also, an inherent experience within the PE firm to translate those plans into financial realities.
