Middle East: Local investment banks fight to survive

Global investment banks in Dubai are downsizing and relocating staff away from the region, but as deal flow continues to evaporate in the Middle East, local investment banks are in an even worse position. Published in Euromoney, November 2011

In late September, Saudi Arabia’s Kingdom Holding and Bahrain’s Batelco pulled out of a $950 million deal to buy a 25% stake in mobile operator Zain Saudi Arabia. The potential buyers simply said the deal was not in the best interests of their shareholders, but it is widely thought to have collapsed because of the target company’s debts of $3.8 billion.

The issues that scuppered the deal might have been specific to it, but the end result was all too familiar. Across the Middle East, there has been a lack of large corporate transactions in recent years, whether in mergers and acquisitions, the bond market or the region’s stock exchanges. For investment bankers, that has translated into the most punishing market conditions many have known in years.

"I’ve been in the region for eight years and the business environment for investment banks, whether they are regional, local or international, is the worst I’ve seen," says Mahdi Mattar, head of research at CAPM Investment, an Abu Dhabi-based investment bank and brokerage house. "We haven’t seen decent transaction volumes in the region since the crisis in 2008."

Firms including Barclays, Credit Suisse, HSBC and Standard Chartered have cut staff in the region in recent months. According to reports last month by Bloomberg quoting anonymous sources, Christopher Laing and Adam Key, head of equity capital markets for Middle East at, respectively, Deutsche Bank and Citi, are both relocating to London from Dubai. Crédit Agricole is moving its Gulf M&A franchise to Paris.

The dismal state of the market means that most investment banks have had to get used to falling fee income and persistent pre-tax losses. Figures from Thomson Reuters stated that the Middle East and Africa generated $1 billion in market fees for banks in the first nine months of the year, down more than 15% from the same period last year. Only the Japanese market has performed worse.

Uneven pain

While all banks are suffering to some extent, the pain has not been evenly spread. The top five fee earners in the region this year have been Deutsche Bank, Morgan Stanley, Citibank, JPMorgan and Goldman Sachs. Local investment banks struggle to compete with these global big-hitters and their international reach. The situation is serious enough to lead some to wonder if many local banks will be able to survive the downturn.

"Since the onslaught of the credit crisis in 2008, regional investment banks have, for the lack of a better description, become a dying breed," says a banker based in Dubai. "Local investment banks are almost non-existent. There are not many deals they can compete for. There’s no volume. It’s a very, very grim prospect."

The reasons for the lack of deals are a mixture of regional and international factors. The most important issue within the Middle East has been the Arab Spring, which has made the political scene volatile and unpredictable. In addition, the sovereign debt crisis in Europe has hurt investor sentiment. But even without those problems, the effects of the regional downturn in 2008/09 have also not been completely dealt with and have continued to cause difficulties.

"The market today is much less active than it was in previous years," says Arul Kandasamy, head of investment banking at Abu Dhabi Commercial Bank. "That has a lot to do with the impact of the economic crisis on the Middle East, it has a lot to do with the Arab Spring and it has a lot to do with the bursting of the real estate bubble, which took up a disproportionate share of investment banking requirements.

"If you’re referring to international bond issuances, which are the bulk of issuances in the region, then clearly the events in Europe and the US have had an impact. But if you look at IPOs on the domestic stock markets, then local factors are more relevant – for example, the Arab Spring and the bursting of the real estate bubble."

These factors have combined to make investors extremely wary. The result can be seen on the region’s moribund stock markets, where trading volumes and the number of IPOs have fallen substantially. Unsurprisingly, brokerage houses – which account for a substantial part of the region’s investment banking sector – have been struggling to make money.

Hibernation

"On the equity markets, which is what most of the investment banks were focusing on, we haven’t seen much activity in the past three years," says Mattar. "The brokerage volumes are very low and at these levels there is no way the brokerage business can be profitable. Some have practically shut down. They still have a couple of employees but they are not doing anything. They are in hibernation mode right now."

The number of transactions on the Qatar Exchange, for example, dropped by more than half between 2008 and 2010, from 4.36 million transactions to 2.1 million. There is little sign of a recovery this year, even though several more brokers are now active on the exchange. It is a similar picture on the stock markets in Abu Dhabi and Dubai in terms of trading volumes, while the number of brokers in the UAE has declined from a peak of 109 in 2008 to less than 50 now.

"When I look at the Arab stock markets since the start of this year, I can’t see a positive performance, with the exception of Iraq," says Nassib Ghobril, head of research at Lebanon’s Byblos Bank. "Investment banking requires investor confidence, a steady flow of deals and a rising stock market, and we haven’t seen any of that so far this year."

The picture is slightly different in Saudi Arabia, where the equity market is more buoyant than most in the region. The value of shares traded in the first nine months of the year was SR776.4 billion ($207 billion), an increase of 32% over the same period in 2010. The number of shares traded was up 34% to almost 35 billion shares and the number of transactions rose by 12% to 17.6 million.

Even so, in early October the Tadawul All Share Index was down almost 8% compared with its level at the start of the year and the number of IPOs has been very limited. In any case, it is a market that is dominated by retail investors and the brokerage arms of large local commercial banks, offering little opportunity for others.

Regional M&A

Regional M&A activity is scarcely any better. The value of deals with a target in the Middle East in the first half of the year was $7 billion, according to Thomson Reuters, a 40% decrease compared with the first half of 2010, when the total was $11.7 billion. Real estate was the most active sector, accounting for a third of the deals by value – helped by the Abu Dhabi government’s decision to help struggling local firm Aldar Properties by buying some of its assets.

Bankers say that there has also been some activity in sectors such as healthcare, hospitality and retail, including some cross-border deals, but nothing of any scale. Asset management has also become more important for many investment banks as they move away from brokerage activities.

Another area of activity is the debt market. Levels dropped sharply in 2009 before recovering in 2010. They have failed to maintain growth this year, but there is still demand from companies wanting to refinance existing debt.

"The vast majority of transactions tend to be refinancing transactions, either through club lending or, in some cases, through the bond market," says Kandasamy. "There’s a lot of activity focused on restructuring where there has been an inability to meet repayments – no ‘new money’ transactions per se."

Some project finance deals have also been completed, but the prices that state-backed sponsors have been able to extract have often been very low. This is partly a function of the trust the market has in certain governments awash with petrodollars. However, low prices also mean there is little return for the banks involved, unless they are able to garner more work from the client in the future.

That approach seems to be what has happened in the Barzan deal in Qatar – a $4.7 billion project being developed by Qatar Petroleum and ExxonMobil. The financing was due to close at the end of September and the expectation at the time in the market was that the deal would be priced at less than 200 basis points above Libor. Some bankers warn that such low pricing is unsustainable for most banks, given their own cost of funding, and that the subsequent and ancillary work might not be sufficient to offset that.

"What is that other business?" asks one senior project finance banker in the region. "Is it going to be the next underpriced deal? I’ve never come across a client who, when they do their second deal, asks for higher pricing. You earn the right to do the next aggressively priced deal at best. At what point are the promises of that other business going to materialize?"

Troubles

Even where there is some deal activity, local banks can find it hard, if not impossible, to compete with the large international banks. This is the case in the bond market, where sponsors generally prefer to opt for banks that can reach a global audience. In recent years, around 70% of bonds have been sold to international investors, according to one investment banker in the region. Most bonds have come from the US and Europe but some have also been sold in Asia.

The preference for hiring international banks to work on these deals was seen most recently in the case of Bahrain’s $1 billion Islamic bond announced in mid-September. It appointed BNP Paribas, Citigroup and Standard Chartered to advise it on the deal.

"The region tries to promote itself to international investors, but the local investment banks don’t have the capacity to market those deals outside the region," says the Dubai-based banker. "On occasion, you may see them as co-arrangers or co-placement agents on a couple of deals here and there, but I don’t know what value these guys bring. The deals that are out there are all big deals that the international banks, for all their troubles, are more than willing to work on because they get paid handsomely on them."

The same problem is also evident in other areas of investment banking business, such as M&A deals involving international companies.

"If you were a typical local investment bank, you would not have the international reach of foreign branches that a global bank would have," says Kandasamy at ADCB. "So, if your client wanted to undertake an M&A deal involving a company in the US or Asia, it is unlikely that a local bank would be able to compete effectively. If a deal were an in-country or in-region M&A deal, or a local or regional currency bond issuance, then I can assure you the local banks are just as good, if not better than, international banks. However, for international bonds, they are less capable as they are less global."

Others agree it is not so much a matter of skill as of scale that is holding back the region’s home-grown institutions.

"Local banks’ balance-sheet size and their limited global reach do not allow them to compete effectively in the underwriting field with international investment banks," says Rajai Ayyash, UAE country manager for BNY Mellon. "Local banks have the expertise, they have the know-how to originate and structure deals, but they can’t do the underwriting."

While such factors are a problem for all local investment banks, those that are standalone operations appear to be finding it harder than those that are part of a larger group.

"As long as you have fee income and deal income and IPOs and so on, you tend to cover your expenses," says Ghobril, who has worked at a number of local investment banks, including Lebanon Invest and Saradar Investment House. "But when the deal flow dries up or declines significantly, then standalone investment banks tend to be more affected than those that are part of bigger groups. It doesn’t mean that others don’t get affected, but it’s just that when you’re a standalone bank you feel it more directly."

Results

The financial results of the region’s largest standalone investment banks make clear the difficulties they are having in the current market.

Dubai-based Shuaa Capital, for example, has consistently lost money on its investment banking activities in recent years. While the bank as a whole managed to post a small profit of AED600,000 ($163,000) for the second quarter of this year, the investment banking division made a loss of AED2.5 million on revenues of AED1.5 million. The division had lost AED8.6 million in 2009 and AED3.2 million in 2010, although it did make a profit in some quarters in those years.

The firm has been trying to bolster its position, most recently with the announcement early last month that it had appointed Michael Philipp to its board of directors. Philipp had previously been chairman and chief executive of Credit Suisse Europe, Middle East and Africa. He plans to expand Shuaa’s advisory and asset management business in Abu Dhabi, Saudi Arabia, and Kuwait.

Other local investment banks are in an even tighter spot. Kuwait’s Global Investment House has been battling with a large amount of debt for several years. As of June 30, it had KD504.8 million ($1.8 billion) in debts. In September, it held a meeting with its creditors to try to persuade them to allow a deferral on repayments, which are due in December, and to waive or defer some covenants attached to its debts. The bank declined to comment on the chances of a deferral being agreed or, if not, if it had the ability to meet the repayments on time.

If the bank can successfully recover the $250 million it says it is owed by the National Bank of Umm Al Qaiwain – a sum that is part of a legal tussle in Dubai – then its position will be strengthened a little, but the bank is still losing money. It made a profit of KD3.3 million from its fee-based business in the first half of this year, but an overall net loss of KD38.7 million for the period.

"It’s a very challenging environment across the world," says Maha Al-Ghunaim, the bank’s chairperson and managing director. "Companies based on a single business model are probably suffering most. If you’re just doing investment banking, then you’ve been doing nothing for the last two years. If you’re just a broker, you’re suffering from the downturn in equity markets. If you’ve diversified, you’ve got a better chance of survival.

"We all realize we have to re-engineer the way we operate. In Qatar, Saudi Arabia and, to an extent, the UAE, [the authorities have] done what needs to be done quickly. They have the highest potential and we’re moving resources to those countries."

Egypt’s EFG-Hermes, another large regional bank, has managed to get involved in some big transactions this year. They include advising Paradise Capital on the sale of its 52% stake in local white-goods maker Olympic Group to Sweden’s Electrolux for $404 million. It has also advised Orascom Telecom on the sale of its 50% stake in Orascom Telecom Tunisia to Qatar Telecom, and Italy’s Wind Telecom on its merger with Russia’s VimpelCom.

Yet the Egyptian market, which accounts for most of its business, will remain an uneasy place to do business for as long as the political situation there remains unresolved. In addition, the bank’s brokerage arm is also heavily exposed to the weak Gulf markets. Compared with its performance in 2010, EFG-Hermes’ investment bank revenues declined 52% in the first quarter of the year and by 7% in the second quarter.

There are numerous smaller institutions in the region that have also been finding the going extremely tough, but Marwan Mikhael, head of research at Lebanese bank Blominvest, says smaller investment banks might have an advantage over their larger peers, although it depends on what markets they are active in.

"If you are a big investment bank and you had a large network, then you have been hit, but if you are a small investment bank then perhaps you will take this opportunity to grow," he says. "We are continuing to grow. If most of your activity was in Saudi Arabia, I don’t think you are hit too badly. However, if most of your activity was in Egypt or Bahrain, then of course you’re hit."

Insights

Qatar’s QInvest has also been growing, opening offices in Turkey and Saudi Arabia this year. Shahzad Shahbaz, its chief executive, says it is working on several cross-border M&A deals along with debt-financing transactions, IPO mandates and private placements of equity.

"If you are a well-established regional, standalone investment bank, you can compete with global banks," he says. "Obviously, a regional bank does not have global distribution or as strong sector expertise, but what we find is global banks want to partner with us because we are closer to the market. We have contacts here and insights, and we have sizeable on-the-ground execution capability, which is still difficult for global banks to duplicate."

That said, the brokerage business is suffering from low volumes and not all the transactions it is working on will close this year. In addition, deals are taking longer to do. "There is clearly not enough business to feed everyone," he adds.

Anwar Abu Sbaitan, CEO of Rasmala Investment Bank, says the market needs a big jolt if it is to pick up any momentum.

"To get confidence back in this market, we need a pivotal event," he says. "It could be a big IPO, allowing the UAE or Qatar to be part of the MSCI, or Saudi Arabia opening up to foreign investors. Imagine if Emirates Airlines goes public, and what a game changer that would be. There is no confidence in the market, so we need a driver to change the negative sentiment that exists today among the regional investors. When that happens, it will entice the international guys to come back as well."

Headcounts

In the meantime, many of the region’s investment banks are getting smaller, cutting their staff numbers to make up for the shortfall in revenues. EFG-Hermes cut its staff costs by 15% in the second quarter alone. Global Investment House cut its operating expenses by 33% in the first half of the year and, overall, has reduced its staff count to 250, from 600 at its peak. Rasmala is down from a peak of around 240 staff to 140.

Shuaa Capital, meanwhile, has been implementing what it calls a "systematic right-sizing programme" this year. What that means is 39 people losing their jobs, or 11% of the company’s staff count, and some AED30 million in costs being taken out of the business.

Perhaps the only bright point for the region’s beleaguered local investment banks is that the downturn in Europe has meant some international banks have also cut back on their operations in the Middle East while they focus on the problems in their home markets, thus reducing the level of competition in the region.

"Many of the companies that came to this region relatively recently and don’t have long-standing roots here have certainly been reassessing their exposure," says Jarmo Kotilaine, chief economist at National Commercial Bank in Riyadh. "In general, the Gulf as a source of revenue has become less important for them than, say, the rapidly growing markets of Asia, so when resources become more scarce, they’ve preferred to focus on the Asian markets."

However, he adds that local banks don’t necessarily have the means to react to this opportunity, as some have never fully recovered from the last crisis when the local real estate sector – which many investment banks were heavily exposed to – collapsed.

"Many of the local investment houses were hit quite hard by the crisis, so they don’t necessarily have the financial or manpower resources to aggressively go into these areas, like project finance or capital markets, as much as they might want to," adds Kotilaine.

"The reality is that many of them have been essentially in retreat since 2008. Many of the big bets that were made by these companies in the middle of the past decade turned sour very quickly. It took them a while to recognise that this was the situation and it wasn’t going to change anytime soon, so they have been in this ongoing, not particularly controlled retreat in some cases."

This year, with the confluence of the Arab Spring and the sovereign debt crisis in Europe, it has become harder for the regional investment banking sector to stage a recovery. Local banks have little option but to try to make the most of the ever-smaller opportunities in the region. The market may be subdued but it is the only market they have, despite some efforts at international expansion.

"The local banks are here to stay because they have no other place to go," says Mattar. "In the near future, I don’t see any bright points. It’s a survival game for investment banks, not a profitability game. It’s a matter of who can survive the downturn."