Since the liquidity crisis gripped the GCC there has been a significant drop in regional M&A activity. This is the same worldwide, but the drop-off in M&A activity within the GCC and across the Middle East as a whole has been even more drastic. According to data compiled by M&A intelligence provider Mergermarket, the value of M&A activity across the Middle East for the first half of 2009 was off a staggering 86% compared to the corresponding period in 2008.
Elsewhere, the overall slow-down in M&A activity has been partially counter-balanced by a significant increase in distressed M&A. However that is yet to happen in the GCC, notwithstanding that many of the conditions which cause distressed deals to happen are prevalent in the GCC (and particularly in sectors exposed to real estate).
The lack of distressed M&A activity is perpetuating the valuation gap which exists between buyers and sellers and in turn magnifying and prolonging the slowdown in activity.
Andrew Lewis, Partner in the Middle East Corporate Finance group of International law practice Norton Rose (Middle East) LLP explains that M&A activity in the Middle East may soon increase.
So why isn’t distressed M&A flourishing in the GCC?
In addition to the generic factors which are slowing down M&A activity throughout the world, such as the lack of liquidity for buyers to leverage purchases, there are a number of GCC-specific factors which are amplifying the slowdown. For example:
- The GCC has lagged the West into the downturn, so economic distress is a more recent phenomenon. This lag is compounded by seller reluctance in the region to revise their expectations as to the value of their assets and take a “hit” on price.
- Bankruptcy regimes in the GCC are underdeveloped and untested, so while many companies are failing to pay their debts as they fall due almost no formal bankruptcies are occurring.
- More broadly, creditor rights in GCC jurisdictions are less certain and options to force assets to be realised to pay debts (whether via bankruptcy applications or other enforcement actions) are limited. To the extent they exist, they do not offer a timely solution and in many cases, a solution which comes to late is no solution at all.
- As a result, there is less pressure on distressed companies in this region to sell and take a hit on value.
- Alternative buyer strategies such as buying existing distressed debt or providing new debt as a step to ownership which are common in the West and can force a reluctant seller’s hand are usually too risky in the GCC because of uncertain creditor rights.
- Leverage is not only tight, but hardly ever available on a non-recourse basis (partly due to the weaker rights of secured creditors). This can make it difficult for a buyer to make a deal work, particularly a private equity buyer whose model relies on leverage.
- Regulatory hurdles are a barrier to quick deals and distressed deals often have to be quick or else the attractive buying opportunity will pass and significant value will be lost.
By way of illustration of a number of the above factors, consider the example of a Dubai property development which is, say, 80 per cent complete, where the developer has run out of money and the contractors have, or are about to, exit the site. The prospects of the developer obtaining further finance to get the project back on track are close to non-existent as the value of the building on completion has dropped and is less than the existing debt and the cost to complete exceeds the balance payable under sale contracts. The cost to complete is increasing daily as it becomes more and more difficult to remobilise contractors and existing electrical and other works deteriorate. The value of existing sale contracts are also diminishing as delays strengthen purchaser claims that they have been prejudiced and can cancel, (whether relying on express sunset dates or not).
In similar circumstances in the West, often the only realistic hope to reactivate and complete the project quickly is if a secured creditor or other creditors force the sale of the property at a discount to existing cost so the project is viable for a new owner/developer. This might be achieved through a mortgagee sale, appointment of a receiver or liquidator or forcing the developer to take this action voluntarily to avoid inevitable enforcement action. However this is not happening in Dubai, largely because creditor rights are less certain and enforcement action cannot be taken immediately without regulatory sanction. So instead a stalemate persists and the prospects of the development ever completing steadily diminish.
But M&A activity will return
However the above factors are delaying deals in the GCC rather than avoiding the need for deals to be done. Many businesses have no way forward without a cash injection from a new source and can't stand still forever. Ultimately they must accept the new valuation environment and either sell or attract new external capital to survive.
When this happens, and whether the floodgates open or activity accelerates more gradually, remain to be seen. However factors like the very extremity of the slowdown and the evident build-up of pressure on many ailing companies to realise cash from assets, suggest that there is a high level of pent-up activity to be released such that we can expect a pick-up of activity after the summer.
In a survey conducted by Norton Rose at the start of 2009* to determine the key business challenges and opportunities for 2009, 50 per cent of Middle East respondents planned to do at least one deal in 2009, signalling that a number of companies were planning to take advantage of the market environment to expand their business, plans that may re-surface in the coming months.
There are signs of liquidity and buyer interest returning, but most importantly there are signs that many potential sellers are beginning to accept the new valuation realities (often through necessity).
Assuming this is correct, it is reasonable to assume that the best buying opportunities for a long time will be available in the near future.
*About the survey
Norton Rose Group, in conjunction with the Economist Intelligence Unit, surveyed 925 respondents at CEO or executive level, in November 2008 to determine the key business challenges and opportunities for 2009. The regional breakdown of respondents is 23 per cent Asia Pacific, 33 per cent Europe, 20 per cent North America and 24 per cent Middle East and rest of world.
How will distressed M&A be different in the GCC?
While there are many generic facets of distressed M&A which apply equally in the GCC as elsewhere, there are also particular nuances in the GCC environment which will differentiate the distressed M&A which takes place in the GCC from similar activity in other jurisdictions. Some of the key differences are discussed below: Few, if any of the ‘distressed’ sales will be ‘liquidation’ sales, similar to those which occur in the West and are led overtly by a receiver, liquidator or other statutory administrator.
While the weight of debt and creditor pressure may be a significant factor in forcing a distressed seller to sell and accept the current valuation environment, this will be less evident and the time frames within which a sale must be completed will be less clear cut.
- Many of the strategic options available to buyers of distressed assets in the West, such as acquiring fulcrum debt rights and manipulating those rights to ultimately acquire control or key assets and/or manipulating a seller’s insolvency, will not apply to the same extent and, where they do, will apply more subtly.
- Buyers will generally have less reliable information on which to assess the risk associated with a distressed purchase opportunity, (less public information is available and the accounting and other information available from the records of the distressed seller is often less reliable). Accordingly the risk discount which should be applied to any distressed purchase should be higher to take account of the additional risk and there is a stronger case for payment mechanisms which provide some protection against the risk of unknowns (eg. escrow or retention mechanisms).
- It is always challenging in a distressed situation to obtain worthwhile warranty protection from the seller or related parties who have the financial wherewithal to meet any claim. The problem is compounded in the GCC where the legal process and precedent to enforce a warranty claim is less certain and less expeditious. Accordingly, warranty protection may only be of value if an appropriate portion of the purchase price is set aside in a escrow account to meet warranty claims or a similar self-help remedy is available.
- Buyers of distressed assets invariably prefer to purchase assets rather than shares to avoid exposure to unknown liabilities. However it is more difficult to complete an asset purchase expeditiously within the GCC because of licensing and other regulatory issues.
- Where communication with all key stakeholders associated with the distressed seller is important for any distressed purchase anywhere in the world, it is even more critical in the GCC where continued support by key stakeholders (whether they be employees, suppliers, customers, banks will continue providing support, regulators or other) is even more critical.
- Acquisitions of control of a distressed company will more often take the form of an injection of new equity and/or a merger, rather than a simple acquisition. There are a number of reasons for this, including:
- Sellers can avoid crystallising their full loss and the transaction can be presented in a more positive light to the market (i.e. a successful capital raising rather than a ‘fire sale’).
- All of the cash invested by the buyer/investor is invested in the target without any cash leakage to the current owners (and where to pay both may not be viable in the current climate).
- By deferring any exit payment to the current owners and keeping their interests aligned to those of the buyer/investor, the risks associated with unreliable information are mitigated to some extent (and they might be further mitigated by including mechanisms which have the effect of adjusting ownership proportions in the target if warranties are breached and/or subsequent trading is worse than anticipated).
Whilst M&A activity in the GCC has been sluggish (at best) over the first half of 2009 this is largely due to lag factors and particular nuances of the local environment which are slowing activity and most particularly distressed activity. However in many cases these factors are delaying deals rather than negating the rationale or need for deals to be done.
There are signs that pent up activity is about to be released. This will create exciting opportunities for buyers, but there are risks they must be wary of. In addition to risks which apply for any distressed purchase anywhere in the world, there are particular local risks (particularly risks associated with information reliability, regulatory issues and inadequate legal recourse for warranty and other breaches).
These risks and other local factors will impact on the types of deals which are done and the types of protections which buyers or investors should seek. We can expect to see more ownership changes being effected through mergers or majority investments rather than simple acquisitions. Buyers and investors should consider inclusion of retention, escrow or other mechanisms to protect against the heightened risks which apply (or seek an additional price discount to take full account of those risks).