Foreign private equity plays a growing role in the Saudi Arabian market

While the domestic private equity (PE) sphere continues to grow, international players are also paying closer attention to the Saudi market. In April 2015 the US buyout firm TPG Capital inked a deal that gave it majority stake in the family-owned fast food chain Kudu, a transaction which according to earlier reports valued the Saudi Arabian company at between $400m and $500m.

With around 200 outlets in the country, Kudu has built a robust brand in the Kingdom and is therefore positioned to benefit from investment by a group with restaurant chain experience – which in TPG’s case includes an interest in international chain Burger King. Following on from the signing, Kudu has appointed Glen Helton, erstwhile senior vice-president of global operations at Burger King, as its new chief executive, along with a new management team with a mandate to expand the chain’s business.

This deal came on the heels of another significant PE entrance to the Saudi Arabian market by a foreign company. In January 2015, Riyadh-based gourmet confectionery producer and restaurant chain Bateel agreed to a partnership with L Capital Asia, a Singapore-based PE company with a focus on luxury goods that is backed by LVMH Moët Hennessy Louis Vuitton. While details of the exact terms were not available at time of publication, Reuters reported in advance of the deal in early 2015 that Bateel would offload a stake of between 20% and 40%, and that Jadwa Investment has been chosen to advise the company on the sale. With the signing of the agreement, Bateel is positioned to expand beyond its core markets in the Gulf.

Attractive Proposition

It is not difficult to discern what brings companies such as TPG Capital and L Capital Asia to Saudi Arabia. The Kingdom has the largest economy in the region, with a GDP of $746.2bn as of 2014, according to data from the World Bank. Real GDP growth averaged nearly 5.3% between 2010 and 2014, according to the World Bank. GDP growth is forecast to slow in 2015 and 2016, on the back of the decline in oil prices, to around 2.8% and 2.4%, respectively, according to the IMF’s mid-2015 Article IV Consultation.

The Kingdom is also the largest consumer market in the GCC, with an average annual population growth rate of 3.2% between 2004 and 2013, according to Alkhabeer Capital, significantly higher than the global rate of 1.2% seen during the same period. Consultancy A.T. Kearney estimated the Kingdom’s total retail sales reached $103bn in 2014, up 6.4%.

Macroeconomic figures such as these help to explain how the Kingdom ranked 26th among 120 countries on the Venture Capital and PE Country Attractiveness Index for 2015 compiled by EY, up four positions from its 2010 ranking.

Sizeable Potential Gains

For the Kingdom’s businesses, the potential benefits of receiving PE investment and expertise are considerable. The rapid development of the General Lighting Company (GLC) in recent years provides a useful example of what can result from a fruitful partnership of local industry and foreign PE expertise.

In 2007 international alternative asset manager the Carlyle Group established a MENA team to make investments in Turkey, North Africa, the GCC and the northern Mediterranean regions, and in 2010 it picked the Kingdom’s GLC as a “promising concern”, taking a 30% stake in the firm for an undisclosed amount of money. Over the following four years it helped the Saudi company to radically transform its business, which saw it evolve from a domestically focused operation into an international lighting player active in more than 30 markets.

This process involved the GLC making a number of significant acquisitions, including the largest lighting company in Malaysia, Davex, as well as establishing new sales and distribution networks – most notably in key cities in Africa, which allowed the company to expand its sales into a total of 12 African countries. To meet the demands of its enlarged order book the company built a new factory in Riyadh which specialised in high-volume lighting products, bringing its total manufacturing plants to three.

According to figures from the Carlyle Group, production was subsequently doubled to 15m units per year as a result. The GLC’s management structure, meanwhile, was significantly altered as the company focused on attracting new senior talent and professionals to drive further growth.

By 2014, it was time for the Carlyle Group to exit, and with the recovery of investor sentiment since the previous year speculation began to build about a possible initial public offering, with the local press reporting that GIB Capital and legal firm Latham & Watkins had been asked to advise on the offering. However, the Carlyle Group ultimately chose a different exit strategy, deciding instead to sell its 30% stake in GLC to health care, lighting and consumer appliances company Philips for $235m. With the sale of stakes held by two other shareholders – Alliance Holding and Hejailan Group – the Dutch conglomerate now has a 51% stake in GLC.

The successful transaction vindicated the Carlyle Group’s decision to establish a MENA fund, and has gone a long way towards demonstrating the potential for PE both in the Kingdom and the wider region. “Through close collaboration with our partners and GLC’s talented management team Carlyle fostered a number of successful initiatives at the company, expanding geographic presence and enhancing operational capabilities. GLC is one of several investments Carlyle has made in the Middle East and Turkey and we continue to see excellent opportunities in the region,” Firas Nasir, the managing director and co-head of the Carlyle MENA team, said in a press statement at the time of the sale.

Entry Challenges

In terms of PE activity, foreign entities face the same hurdles as their Saudi Arabian counterparts, but are at a distinct disadvantage in one area in particular. The Kingdom’s uncodified legal system and the important role played by personal relationships in business transactions mean that foreign PE fund managers and teams are faced with a challenging entry environment, and one which they may have to tailor their approach to suit. Special measures which may mitigate the problem include establishing a local team to conduct business and investing more time in building relationships with company owners.

In terms of risk limitation, local industry specialists, auditors and legal firms can also play a useful role in the due diligence process, which in the case of smaller concerns may be hampered by the limited amount of financial data.

Negative List & Taxation

At the procedural level there are also a number of concerns for foreign PE firms. Any company with foreign shareholding must obtain a foreign capital investment licence from the Saudi Arabian General Investment Authority, and also ensure that their potential acquisition is not in conflict with the periodically updated “negative list” of activities that are specifically prohibited from being carried out by foreigners.

Foreign PE firms must also be mindful of a differing tax regime to that enjoyed by nationals: while tax on capital gains on a resident company and on income from a permanent establishment in Saudi is generally taxed at 2.5%, for non-Saudis a 20% levy is normally imposed. In addition, management fees are typically taxed at a 20% rate.

Looking to the other side of the equation, Saudi businesses being courted by foreign PE entities need to be assured about the potential value creation that any deal would result in if they are to be persuaded to drop their resistance to non-family control. These tasks are time-consuming and sometimes more costly than might be considered ideal, but when a suitable partnership is made the potential rewards to both parties are indeed considerable.