By Tim Rogmans
Despite political turbulence, Middle Eastern markets provide great opportunities for international investors. The region’s advantages include its location at the crossroads of three continents, vast energy reserves and rapidly growing populations. Political risk is the main factor making multinational companies stay away from the region or limiting their involvement in licensing and franchising deals. This article outlines ways in which companies can enter and grow in the region, while managing political risk.
Middle Eastern Megatrends
The Middle East is experiencing a number of fundamental shifts, each with a great impact on foreign investors. Although every industry sector will have its own specific developments shaping its future, here is a brief overview of the eight trends that are transforming the region’s overall business environment:
1. Political instability and improving business regulations. The sources of political instability in the region are wide-ranging and generally well known. Foreign investors looking at the region will quickly think of the Israeli – Palestinian conflict, the Arab Spring, the conflict in Syria and Lebanon, the aftermath of the Iraq war and the tensions over Iran’s nuclear programme. What is perhaps less known is that many countries in the region, particularly the Gulf countries, have been making steady progress in improving the business environment through the introduction of new investor friendly legislation. As a result, the UAE and Qatar both rank in the top 10 most competitive nations according to IMD’s World Competitiveness rankings. Both political instability and increasing openness to foreign investors look set to continue for the foreseeable future.
2. Energy resources. The recent shale gas boom in the United States, softening energy prices and rapidly increasing energy use inside the Middle East, have served as a warning for governments who rely heavily on energy exports to balance their budgets. However, energy reserves still provide a massive cushion for government spending in Saudi Arabia, Kuwait, Qatar, and the UAE, underpinning growth in spending on education, healthcare, infrastructure as well as the energy sector itself. In these countries, energy reserves are projected to last at least another 50 years at current production rates.
3. The rise of women. Although many obstacles remain to the professional advancement of women in the Middle East, women now represent the majority of students enrolled in higher education in the region. They are making up an increasing proportion of the workforce and, at least in some countries, are rising to levels of seniority in government and business unheard of just ten years ago.
4. Turning East. Trade and investment links between the Middle East and other emerging markets are growing far more rapidly than with Europe and North America. The reinvigoration of links with Asia has been referred to as The New Silk Road, reviving trade routes that existed centuries ago. At the same time, the region is becoming a transit hub for the rapidly growing business links between Asia, Africa and Latin America.
5. Regional integration. Although regional integration is not developing rapidly at the political level, it is happening in many other areas of relevance to investors. Intraregional migration (especially from the Levant region to the GCC countries), Free Trade Agreements, improving transport and communication links, the emergence of a regional media market and the regional expansion of companies in a variety of sectors, all contribute to greater economic integration in the region.
6. Value based consumption. Middle Eastern consumers are increasingly purchasing according to their values and beliefs, leading to rapid growth in Islamic Finance and to a slow but robust emergence of more environmentally friendly practices in industries such as food, construction and transport.
7. Demographics. The region’s population is projected to grow by over 80% over the next four decades. The influx of young people into the workforce and continuing urbanisation will put great pressure on societies to provide jobs and adequate living conditions.
8. The rise of Middle East multinationals. Foreign investors are facing increasingly tough competition as local companies expand internationally across the region and beyond. They have become serious competitors in a range of industries, including in air transport (e.g. Emirates, Etihad, Qatar Airways), logistics (Agility, Aramex, DP World), tourism (Jumeirah), telecommunications (Etisalat, Orascom), petrochemicals (SABIC) as well as in finance and construction. Middle East multinationals benefit from a lack of legacy, enabling them to adopt best practices quickly, low cost labour, low taxes and a favourable location for transport, tourism and energy intensive industries.
Companies looking to enter the region will need to consider the impact on their business of these and other trends. For most industries, the general picture that emerges is one of rapidly growing markets coupled with high political risk. Within this context companies will need to define their entry strategies, starting with which markets to enter and which entry mode to use.
The choice of which countries to enter in a region is first of all determined by the attraction of a particular market. Reliable market data can be hard to obtain in countries where the collection of statistics by government agencies is still under development. As a result, companies are forced to rely on macro level data followed by custom research in order to assess the attractiveness of specific product and geographic markets.
Once attractive markets are identified, other factors come into play. Case studies of successful investors in the region have pointed to infrastructure and quality of life as being major elements in the investment location decisions of multinationals. As most investors have regional ambitions and look for one hub location from which to coordinate all activities in the region, the availability of airport facilities and international flights are important considerations. In this regard, Dubai has long ago overtaken Bahrain’s lead, while Abu Dhabi, Doha and Istanbul are also expanding quickly. Other infrastructure considerations include a country’s availability of quality housing and office space and the quality and cost of telecommunications. Quality of life is another important decision-making element, as investors will often rely on expatriate managers and workers that need to be attracted to relocate to the region with their families. The availability of international schools, safety and entertainment options are important factors in making location choices. The key for investors is to choose a location that is not only appropriate for a particular manager who may be heading the region for a limited time, but whether a pool of talent can easily be attracted to live and work in the chosen location.
Taxation and cost of business considerations always play a role in location decision-making and in the Middle East the picture is more complicated than it appears at first. Most Gulf countries operate a ‘no tax’ policy, making them look attractive at first sight. However, investors need to do a careful analysis of the total cost of running a business, including rent, various license fees, import duties and telecommunications. In some countries with protected telecom operators, the cost of telecommunications can exceed that of office rent.
Probably the most important location choice determinant for investors in the region is the quality of a country’s institutions and level of political risk. A whole industry of ranking and rating providers has emerged to assist managers in their assessment of the institutional and political environment. Although the ratings can be a useful starting point, investors need to carry out their own analysis of the risk factors that will have the greatest impact on their particular investment project. A country with a high level of overall political risk may still provide great opportunities in specific regions and industry sectors, with Erbil in Iraq providing a good example of a booming region in an unstable country.
In the end, companies may decide to locate in countries that are adjacent to the most attractive markets and serve these markets remotely. Although this can be a sensible entry strategy, the pressure to have an operation in the country of the client is increasing rapidly. Suitcase bankers and other remote operators are only tolerated if they bring something truly unique to the table.
Entry Mode Options
The usual entry mode options for investors include exporting, licensing/franchising, joint ventures and wholly owned subsidiaries. These entry modes differ in their level of commitment to a market, the level of control they offer and the investment required. Traditional theory suggests that multinationals start with a low commitment entry mode such as licensing or franchising and gradually move to greater levels of ownership and control as they develop the requisite local knowledge. In practice, many investors have discovered that if they enter a market through a partnership agreement, it is very difficult to adapt the terms of the arrangement in the light of changing circumstances. The need to change ownership structure can arise as companies find that legislative changes allow them to have a greater ownership stake than before or that the partnership has outlived its usefulness as local knowledge has been built up. Legislative changes which relax foreign ownership restrictions are continuously being implemented and offer new opportunities to investors. The expansion of free zones in which foreign investors can maintain 100% ownership is another mechanism used to attract investment.
Therefore, the motive for entering into partnerships should be for more lasting reasons than the need for local knowledge or to satisfy a local ownership requirement. In practice, local knowledge and contacts can be built up without giving up an equity stake in the business, by hiring local staff and potentially through the use of consultants. Durable partnerships are based on a true bundling of complementary capabilities that goes beyond local expertise and contacts. The retail sector is an example where many durable partnerships have been established successfully, as the foreign retailer provides the brand, product and retail concept and the local operator secures access to mall space, quality staff and efficient operations.
Another reason for a strong involvement in Middle East operations is to ensure compliance with the US Foreign Corrupt Practices Act and the UK Briberies Act extends, which apply to all companies with operations in either the US or UK. These laws make it imperative that the foreign investor represents itself to host country governments and does not subcontract this activity to local agents.
The usual establishment choices of greenfield investment versus mergers and acquisitions apply in the Middle East. Acquisitions provide greater speed than greenfield projects, but are accompanied by several challenges. First, finding acquisition targets and determining their value can be difficult in countries with relatively small stock markets and few reporting requirements for private companies. In terms of valuation, given the relatively undeveloped M&A market, there are unlikely to be similar transactions against which a valuation can be benchmarked, requiring investors to analyse carefully what benefits and future cash flows an acquisition will bring. Integration challenges arise especially when acquiring family owned companies with a great dependence on the founder/owner. The relationships this person holds with key customers, suppliers and authorities must be transferred smoothly. One way to achieve this can be to start with a minority stake and agree up front the conditions for a full acquisition later on.
When implementing their strategies, successful investors have shown a deep commitment to the region, regardless of any short term setbacks. One way to demonstrate commitment is through the recruitment of local staff. Particularly in the Gulf countries, many multinationals underutilise the opportunities to employ local managers. In a time of increasing pressure for workforce nationalisation and a growing supply of well-educated young people across the region, it makes sense to build local knowledge and cultural awareness through local staff.
In terms of risk management, companies considering investment in the region should not wait for some wishful landscape of political stability to arise. Instead, investors need to analyse which political risks matter most to their business and tailor their projects and risk mitigation strategies accordingly. Successful investors realise that risky environments can lead to high returns and even provide valuable options to expand an investment once initial success has been achieved.
Once an investment has been made and the external environment takes a turn for the worse, companies need to think twice before closing down an operation. Local stakeholders tend to remember who stuck with them during difficult times. Authorities look unfavourably towards foreign companies looking to re-enter after a retreat, as Citibank found out in Saudi Arabia after it closed its operations in 2004 and re-applied for a license several years later. Companies may scale down their operations during difficult times, but a continuous presence will result in increased customer loyalty and better stakeholder relations all round.
About the Author
Dr. Tim Rogmansis an Assistant Professor at the College of Business at Zayed University in Dubai. He previously worked in the UK, the Netherlands and France as a strategy consultant for LEK Consulting and Gemini Consulting, and as a senior manager with Atradius Credit Insurance. In the Middle East, he has worked as Department Chairman at the Rafik Hariri University in Lebanon and as Director of Zayed University’s Executive Education activity. He is the author of the book The Emerging Markets of the Middle East: Strategies for Entry and Growth.