The story of the Kingdom’s alternative investment market is one of potential. While Saudi Arabia is a regional leader in mutual fund activity and has led the recent GCC expansion of the segment both in terms of fund classes and volumes, in areas such as private equity (PE) and venture capital (VC), growth has been less brisk. Recent years, however, have seen momentum build, driven by increased private sector interest and the government’s determination to nurture alternative sources of funding for expanding businesses in the Kingdom.
Key Role Of Funds
Investment funds have long played an important and prominent role within the Saudi financial sphere. Until the introduction of swap contracts in 2008, the only way non-resident foreign investors could participate in the Kingdom’s stock exchange was by subscribing to a mutual fund – a policy that helps explain the sustained popularity of the instrument in the country. In 1979 Saudi Arabia became the first country in the GCC to feature a mutual fund, a short-term US dollar-denominated instrument established by National Commercial Bank, sparking an appetite for similar investment vehicles in markets around the Gulf. In regional terms, investment funds did not begin to gather significant momentum until the years approaching 2000. While Kuwait successfully trialled a fund in 1985, Egypt, Bahrain and Oman did not follow suit until 1994, and Lebanon and Jordan did not introduce mutual funds until 1996 and 1997, respectively. By this time, Saudi Arabia had already taken steps to formalise its growing fund industry, establishing the first rules governing mutual fund activity in the Kingdom in 1993.
The attractiveness of mutual funds as an entry point into Saudi capital markets and the regulatory head start the local industry enjoyed over nearby jurisdictions helped establish the country as the regional centre of fund activity it is today. Saudi Arabia is the largest fund domicile in the GCC and the second largest in the MENA region, accounting for $26.2bn of the $79.6bn MENA fund market as of mid-2015, according to Zawya. It is also the most active market in the region; heightened interest in the Saudi market as it prepared to open its doors to foreign investors resulted in a fund flow of $1.5bn in the first half of 2015, compared to second-placed Lebanon’s $72m and Morocco’s negative flow of $234.5m. As the domestic market has grown in size, Saudi banks and asset management companies have broadened their offerings from an initial focus on equity funds to establish the most diverse fund pool in the region.
Public & Private
At the close of 2015, a total of 267 public funds were registered, according to the Capital Market Authority (CMA), offering the investment community exposure to Saudi, regional and international stocks, money markets, bonds, real estate, trade finance and initial public offerings (IPOs). A total of 274 private funds, meanwhile, offered access to similar asset classes, as well as alternative investment instruments, such as hedge and financial derivative funds. The latter segment has shown strong growth in recent years, rising from just nine funds in the first half of 2013 to 26 as of the second half of 2014. Late 2014 and early 2015 also saw growing interest in IPO funds, driven by a buoyant macroeconomic scenario and the imminent opening of the exchange to qualified foreign investors.
A total of 16 IPO funds were established in the Kingdom in 2015, a record rate of growth, which brought the total number to 27. Investor interest is likely to remain strong thanks to enthusiasm from the regulator, which sees IPO funds as a useful means to reduce the price volatility that often follows a public offering in the Kingdom. The regulator has produced draft regulations, which, if implemented, would give IPO funds a greater portion of offered shares in future listings. “The CMA would like to see more IPOs in the coming five years as it is targeting 250 listed companies, and that is why it is helping and approved the IPO funds in the regulatory sense,” Thamer Fahad Al Saeed, head of asset management at Maceen Capital, told OBG. “This will lead to proper pricing coming out of the book-building process, as well as increased institutionalisation of the market.”
However, in the shorter term capital flows have been pushed by economic headwinds into other areas of the fund market. Thanks largely to the effect of low oil prices, defensively orientated debt instrument funds showed the most significant growth in 2015, with public funds of this type rising by 29.5% in value over the year in terms of assets under management (AUM) and private debt instrument funds expanding by 2344.4%.
The Players
Given the size of the Kingdom’s fund market, its key participants are some of the largest and most influential in the wider MENA financial sector. By the second half of 2015, three of the five largest fund managers by AUM were domiciled in Saudi Arabia, led in terms of size by NCB Capital, the investment arm of National Commercial Bank, with around $8.3bn under management.
The company was the second-largest fund manager in the MENA region, marginally behind only Morocco’s Wafa Gestion, while locally based Riyad Capital, with $4.7bn in AUM, and the Samba Capital and Investment Management Company, with $4.1bn, claimed the fourth and fifth spots, respectively. In 2016 each of these large players is offering more than 15 funds, which cover the full range of investment appetite, from high-risk and high-growth portfolios to medium-growth instruments, income equity and small-cap equity funds.
A number of prominent international institutions have secured licences to offer investment services in the country, including Blom Invest of Lebanon, Egypt’s EFG Hermes, Morgan Stanley and HSBC. The opening up of the Saudi Stock Exchange (Tadawul) to foreign investors in 2015 has heightened global interest in the Kingdom’s capital markets and brought yet more international asset management firms to Riyadh, the most significant of which set up business in 2014 as Ashmore Saudi, the local subsidiary of the UK-based emerging market asset management specialist. Despite the presence of 33 asset management companies in the Kingdom as of the last quarter of 2015, according to Marmore Market Intelligence, sector activity remains concentrated at the top, with the five largest firms accounting for 83% of managed assets, with small players having little impact.
Private Equity
While institutional development in the form of a strong exchange and robust regulations has helped grow the Kingdom’s fund market, elsewhere in the alternative investment landscape slower institutional progress has prevented Saudi Arabia from meeting its potential. PE activity remains at an early stage of development relative to the Kingdom’s large and active fund market. A key challenge in this area is the absence of a codified legal system, which has historically resulted in arbitrary judicial decisions that make it more difficult for investors to assess the risk attached to any given transaction. Of particular concern is the lack of bankruptcy legislation required by PE investors should portfolio companies fail. The current legal framework also places minority investors at a disadvantage, as regulations governing preferred shares are absent and governance of takeovers and squeeze outs is unclear.
The large role played by family-owned businesses has also acted as an obstacle to PE activity. Around 95% of the corporate economy is made up of family-owned companies, which have historically been reluctant to cede control to outside interests and have shown a tendency to overvalue their assets when interacting with PE operators – a legacy of the overheated investment environment in the run up to the global financial crisis. This valuation gap was exacerbated in the wake of the crisis as PE firms began to reassess their risk appetite against the backdrop of a more challenging economic environment, particularly in cases where their portfolios were negatively impacted, and they were compelled to hold onto interests longer than expected.
Lastly, PE firms operating in the Kingdom face a shortage of exit opportunities. IPO exits, secondary buyouts and leveraged recapitalisations are relatively rare in the Kingdom, leaving trade sales – a stake sale to other corporate entities – as the only viable exit from PE transactions in most cases.
These factors help explain why, as recently as 2014, the region’s largest economy claimed only 21% of reported PE investment in MENA, while the much smaller economy of the UAE accounted for 55% of the total, according to the MENA Private Equity Association. However, the Kingdom’s PE arena has more recently shown encouraging signs of building momentum, and in the first half of 2015 Saudi Arabia shared the top spot with the UAE for the number of reported PE deals, with four. In the case of family-owned business (FOBs), what was once a barrier to progress is being transformed into an opportunity, as businesses established during the boom of the 1970s and 1980s reach a new level of maturity. “FOBs historically had no need for PE. They had no liquidity pressure, bank funding was easily attained, they could obtain silent investors,” Saad Al Saif, head of PE and investment banking at Jadwa Investment, told OBG. “But now we are onto the third and fourth generation, who want to prolong the life of the family business, make it sustainable.” Sustainability often means company restructuring and increased corporate governance, both of which are well served by taking on a PE shareholder who can help by providing valuable advice as to how these goals can be best achieved.
Legal Framework
The legal system, while still a challenge, is also becoming less of a concern for some PE players. Speaking at the London Business School 14th Middle East Conference held in London in late 2015, Iqbal Khan, CEO of the Dubai-headquartered Fajr Capital, described an improving legal landscape in the Kingdom. “Only recently in Saudi Arabia they have started codifying and collecting the judgements of various judges across the Kingdom. And this database is now made available to judges across Saudi Arabia, so that when they look at a case they can decide on case precedent, and that is leading to faster decision making in the courts and a greater realisation that there is a respect for the rule of law – which was always there but was not codified,” he said.
The increasing appetite for PE transactions means the fledgling industry is beginning to capitalise on the many advantages that the domestic economic landscape offers, such as a stable and resilient economy that has consistently outpaced global growth; political stability, reinforced by the recent uneventful royal succession; and favourable demographics, whereby young people make up 50% of a population which is growing by 2% per annum.
Added to this is the risk-averse stance of the banking sector, which has resulted in just 2% of the aggregate Saudi loan book being directed towards lending to small and medium-sized enterprises (SMEs), compared to a 20% global average, thereby establishing a funding gap that PE is ideally suited to address. Together, these factors mean that Saudi Arabia is likely to play a growing role in the expansion of PE activity in the region.
A survey of industry participants carried out by the MENA Private Equity Association showed that in 2015 respondents saw the Kingdom as the country showing the most promise in terms of future PE transactions, ahead of a stabilising Egypt and the PE-friendly market of the UAE. One of the remaining questions for the industry as it continues to grow rapidly is the issue of funding models.
Fundraising in the Kingdom, as elsewhere in the region, is challenging for many market participants due to the relatively small number of general partners with an adequately robust track record. The Kingdom therefore follows the regional trend, by which investors prefer to subscribe to transactions on a deal-by-deal basis rather than via the blind-pool structure seen in more developed PE markets.
The chief utility of the deal-by-deal approach is that investors are more assured of the growth prospects and corporate governance of the investment target, and are therefore more comfortable with committing significant capital to a transaction. However, increasing governance levels across the corporate sector and a strengthening deal flow powered by a growing number of maturing family businesses in the Kingdom may see the demand for general PE funds grow in importance in the near future. The re
Developing VC
Looking towards the small-cap end of the investment spectrum, VC in Saudi Arabia has somewhat further to travel when compared to its regional neighbours than PE activity. In 2014 the Kingdom accounted for 6% of VC investments in the MENA region and was outstripped by the considerably smaller economies of Lebanon and Jordan, which led the field with 27% and 21%, respectively.
Incubators
The concept of VC is a relatively new one in Saudi Arabia; less than a decade ago there were no angel investors, seed investment vehicles or VC programmes in the country. That all changed in 2007, when the King Abdulaziz City for Science and Technology (KACST) established its Badir Programme for Technology Incubators, a state-led market intervention that established a leading role for the government, which it has maintained to this day.
The programme incorporates two streams of activity, which are open to all technology entrepreneurs from Saudi Arabia with an early-stage technology-based prototype or concept. Its incubators provide a mix of services, such as business consultancy, the provision of office and laboratory space, secretarial and administrative support, and assistance with preparing business plans, financial modelling and pitching. Badir’s other function is to help its clients find funding for further development, which it does by building relationships with existing funding channels in the market, as well as creating new ones. Badir was instrumental in the establishment of an angel investment platform on Saudi Arabia’s west coast.
The Angel Investor Network, known as Sirb, was formally founded as an initiative of KACST in line with the university’s vision to move towards a knowledge-based economy. Launched in May 2012, Sirb aims to bridge the funding gap in the entrepreneurial ecosystem between the ideation stage and the Series A investment stage, and members of its investment network include a range of public and private entities which, in addition to Badir, include King Abdullah University of Science and Technology (KAUST), the Jeddah Chamber of Commerce and Industry, the College of Business Administration and Dar Al Hekma University. While Badir does not provide funding itself, some of its graduates have gone on to receive capital injections from another government initiative, TAQNIA. Founded in 2011, TAQNIA is fully owned by the Public Investment Fund and acts as its technology arm, pursuing industrial opportunities in the Kingdom as joint ventures with global technology players.
The organisation also has an eye for local talent. To further this goal it has established a SR500m ($133.3m) VC fund in partnership with Riyad Capital. Formally launched in January 2016, the fund will focus on opportunities in ICT, energy, sustainability and advanced materials. Interestingly for an investment vehicle in the region, the fund has accepted that many of the seed-stage companies in its domestic portfolio will fail – an acknowledgement of the necessary presence of failure in the entrepreneurial ecosystem, which is a sign of the increasing maturity of the sector. The new fund intends to offset its anticipated losses at home by establishing an international arm in California, from which it will build a foreign portfolio aimed at maintaining profitability while the fund seeks out opportunities in the Saudi market.
Government Initiatives
The government also has a large presence elsewhere in the VC arena. Much of the start-up infrastructure in the country is attached to the university network, and since 2010 KAUST, King Abdulaziz University in Jeddah, King Fahd University of Petroleum and Minerals in Dhahran, and Riyadh’s King Saud University have all established investment arms. Of these, the Riyadh Valley Company has emerged as the most prominent, having started with an initial fund of SR229m ($61.1m), which it has since directed towards investment opportunities in areas such as health and life sciences, ICT, renewables and water resources technology.
The organisation operates as a private company, and the nine firms that make up its current portfolio operate in fields as diverse as water-pump technology, self-service electronic information hubs and dentistry products – some of which, such as the California-based solar start-up Solexel, are based outside the Kingdom. “We have a two-pronged strategy, to invest both abroad and locally. In addition to investments in local technology companies, we have participated in series D round of Solexel in San Francisco, series B round of Green Lord Motors (GLM) an EV startup in Kyoto, Japan and in series B round of Solvoltaics a nano-wire based photovoltaic technology company in Sweden,” Abdelhakim Hammach, managing director of investment at Riyadh Valley Company, told OBG. “RVC aims not only to bolster its fund’s performance but also to bring opportunities of skills and know-how transfer to the Kingdom.” The company has also begun to assume a coordinating role within the domestic VC sector. In October 2015, for example, it organised and hosted the MENA VC and PE Summit at the Burj Rafal Kempinski hotel. The event is an investor platform introducing pre-qualified global investment opportunities to more than 200 pre-screened MENA-based PE and VC investors.
Private Interest
Events like Riyadh Valley Coompany’s summit are important in that they move the sector towards a scenario with more private sector VC players. “To encourage greater involvement from the private sector in the VC segment we need to offer more innovative technologies to make these investments attractive,” Khalid Al Saleh, CEO of Riyadh Valley Company, told OBG. He added that to reduce uncertainty and thereby risk, the proof-of-concept phase must be improved. “Right now it is a gap in the process that we must bridge,” he said.
There are encouraging signs that private sector capital is moving towards the VC arena, especially at the angel and seed investment level. This relatively recent phenomenon started in Riyadh with a small number of high-net-worth individuals who, after starting out as an ad hoc gathering of investors, formalised to become the angel investor Oqal. Founded in 2011, the company had assessed more than 1000 opportunities by 2015, of which more than 120 were chosen as qualifying enterprises and around 20 were invested in – including Uber competitor Careem and online food portal HungerStation. The firm has more recently been joined in the market by Oasis500, the seed investment company that began as a vehicle for IT entrepreneurship in Jordan. In 2014 it announced it was joining forces with Badir to create the Badir-Oasis500 programme, which takes equity stakes in startups in return for seed funding and mentoring. By the close of 2015, the new programme had completed its second training boot camp.
Regional incubator specialists have also shown an increasing interest in the Kingdom, with the most significant market entry in recent years coming from the Jeddah-based Flat6Labs. The accelerator programme forms part of a regional network that has established itself in Cairo, Jeddah, Abu Dhabi and, shortly, Beirut, bringing together more than 200 mentors and hundreds of entrepreneurs involved with over 90 companies, both big and small. By 2016 Flat6Labs had completed 15 cycles, giving successful teams the opportunity to further develop their business models, build prototypes and acquire a diverse array of customers, as well as receive seed funding of between SR50,000 ($13,300) and SR80,000 ($21,300) in exchange for a 15% to 20% stake in the company. Strategic mentorship, office space and a range of services from Flat6Labs partners are also provided.
Corporate Venture
Private sector capital is flowing into the VC market from a number of Saudi Arabia’s largest corporates. One of the most prominent of these is STC Ventures, an independently managed VC fund whose anchor investor is the Saudi Telecom Company. Headquartered in Riyadh, the fund focuses on technology innovation in Saudi Arabia, the GCC, the Levant, North Africa and Turkey. The fund is managed by Iris Capital Management, which has managed investments in excess of $1bn in more than 200 companies since its establishment in Paris in 1986. As seen elsewhere in the global corporate venture market, the small number of corporations in the Kingdom that have established corporate venture arms tend to strategically invest in areas that will allow them to increase sales and profits for their core business. STC Ventures, therefore, focuses on ICT opportunities, while MBC Ventures, the corporate venture arm of the MBC Group, concentrates on media and entertainment start-ups, and Numu Ventures, backed by the Saudi Research and Marketing Group, is a publishing and advertising specialist.
The models used by Saudi corporate venture players to track and manage their remits, however, vary considerably. Some, like STC Ventures, utilise an external manager to help manage their fund, while others, such as MBC Ventures and Numu Ventures, have established internal departments to oversee their funds. MBC has been somewhat quiet lately, having not invested since the spring of 2016. SABIC Ventures and Saudi Aramco Energy Ventures, meanwhile, have created wholly owned subsidiaries to pursue their petrochemical and hydrocarbons-themed corporate venture goals. Other prominent VCs include Al Tayyar and Abdul Latif Jameel Group. Al Tayyar also invested in Careem, based in Dubai.
Outlook
Thanks to the central role the government has played in early-stage investment, its infrastructure has become a useful resource for private sector entities seeking to establish themselves in the domestic market. One of the more interesting questions in the PE field is the extent to which foreign players will be able to gain traction in the Kingdom.
A small number of international firms have achieved some success in the local market, such as the US-based Carlyle Group’s investment and subsequent exit from the General Lighting Company in 2014. Other global brands have worked with regional players to take part in the domestic market, such as the cooperation of Dubai’s Abraaj Group with TPG Invest to secure a stake in Saudi Arabia’s fast food chain Kudu in April 2015. While other global players will also be seeking out investment opportunities, in this environment local knowledge remains essential to the successful execution of PE transactions.
Given Saudi Arabia’s special status within the world of Islam as Custodian of the Two Holy Mosques, it is little surprise that sharia-compliant finance should play a role in the nation’s expanding venture capital (VC) arena. Islamic finance and VC operations are generally seen as a good fit, as the principles of sharia insist on investment in real economic activities. Muslim-majority countries are therefore seeing an increasing amount of wakala (agency), mudaraba (profit-sharing) and musharaka (joint-venture) transactions applied to VC opportunities. According to an analysis of the sector undertaken by Islamic Finance News in 2015, Bahrain, Bosnia, Indonesia and Malaysia all saw significant sharia-compliant private equity (PE) and VC activity in 2015, while Aljazira Capital, Saudi Arabia’s biggest brokerage house, revealed that it is seeking out opportunities in a number of areas within the investment banking and PE arenas in an effort to diversify its income streams as domestic competition increases due to foreign access to the Saudi Stock Exchange.
As is often the case with the Saudi VC market, however, the most significant sharia-compliant activity of late has come from cooperation between the private sector and a quasi-state institution. Alongside Tunisia, the Kingdom is one of two nations chosen by the Islamic Corporation for the Development of the Private Sector (ICD) as locations for a sharia-compliant SME fund. The ICD is part of the Islamic Development Bank Group – the Jeddah-based financing institution founded in 1973, which currently has 56 member countries, all of which are constituents of the Organisation of Islamic Cooperation.
The role of the ICD within the group is to foster private sector investment. “Private sector players are increasingly playing a major role in driving inclusive economic growth through investment, employment and business creation, innovation and knowledge transfer in under-exploited sectors, and other multiplier effects from their operations and activities, which in turn promote economic diversification,” Khaled Al Aboodi, CEO of ICD, told OBG.
In Saudi Arabia the ICD has teamed up with Anfaal Capital and King Abdullah University of Science and Technology to establish a sharia-compliant Saudi Arabia-focused VC fund. Established in 2015, the fund will provide capital to high-tech start-ups and lead early-stage financing rounds aimed at attracting local investors and international venture capitalists. As is usually the case with VC funds, the initiative should also bring further benefits to portfolio companies in the form of strategic advice and operational support.
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