The Abraaj Group The Abraaj Group Closes Second North Africa Fund At US$ 375 Million

Enterprise: Insights from Ahmed Badreldin on 2017 Egypt Outlook

Monday, 9 January 2017 by Enterprise

If you’re looking for investment ideas, you could do far worse than watching what Ahmed Badreldin does next. A partner at emerging markets private equity giant The Abraaj Group, Badreldin oversees the firm’s investments in the Middle East and North Africa and led its push into healthcare (Cleopatra Hospital Company, Integrated Diagnostics Holdings) and education (CIRA’s Future Schools). Abraaj was also an early investor in ride-sharing app (and newly minted unicorn) Careem. Badreldin joined Abraaj from Barclays Capital in London. A mechanical engineer by training, he was earlier with oilfield services outfit Baker Hughes and serves on boards across the MENA region.

2017 will be the year of concern in certain areas. The primary issue for the businesses in which we’ve invested will be wage and cost inflation headwinds, followed fairly closely by uncertainty on the foreign exchange front. We will probably start to see the fruits of the float in the second half of 2017 as the currency begins to strengthen and likely stabilise given the inverted forward curve.

High interest rates will definitely make investment decisions more difficult for some businesses. When you’re looking at deposit interest rates at 19-20% for 18 months offered by some banks, investing in capex and new capacity will demand higher returns compared to simply parking liquidity in a time deposit. And with interest rates high to attract interest from investors in the EGP carry trade, rates are unlikely to come down significantly until you have FX stability.

It’s counterintuitive, but I think we need to ask what happens if interest rates were to be lowered as a form of stimulus. Assume that inflation is running high right now because of the one-time impact of the float. Interest rates aren’t going to be an effective means of transmission in that scenario — and they hit businesses hard. Most businesses are borrowing at a floating rate — the more rates rise, the more they pay. It’s going to make investment decisions more difficult and prompt some hard decisions about how you raise capital.

Inflation and interest rate headwinds are the biggest barriers to an optimistic outlook on the IPO pipeline. Foreign public market investors are keen on Egypt now that the discrepancy between the parallel and official market rates is gone. They believe that from a macro perspective, you can’t afford to miss out on Egypt. But the question is whether it’s going to be cheaper to raise capital from an IPO or via a loan from a bank. If you see the bank funding rate staying high or going higher, it will nudge companies toward an IPO. The flip side, though, is that if you’re a public market investor, you need to believe that you’re going to make more than 20-25% per year to be able to put money into Egyptian stocks against parking them in the carry trade in a bank at 18-20% in a time deposit risk free. This is the biggest headwind for public markets.

And remember: As inflation rises, valuations will have to come down. There’s an inverse relationship between P/E ratio and inflation. If you look at other markets — take Brazil — you’ll see that when the country had high inflation, P/Es were in the low single digits. That’s a key concern.

Is hyperinflation in the cards? It’s certainly true that some economies that have seen inflation rise to 20% have gone on to hit 30%+ if not managed — it’s a vicious cycle, particularly for an import-dependent country that’s just gone through a float. You need to create employment, which means you need the private sector to invest. And if they’re going to invest in new capacity and job creation, they need the funding. That funding can take the form of equity or debt, and the direction will be shaped by the cost of borrowing. If the government sees inflation as a one-time adjustment in response to the float, the way forward may be to reduce interest rates to stimulate investment.

If every company implements a 20% wage rise, we’re going to see inflation next year at 25%. The way we approach it is simple: Wages should go up by no more than high single-digits or low double-digits, and if you need to do more than that, then it needs to come in the form of variable compensation and improved productivity and efficiency. And I think it’s obvious that the wage catch-up needs to be higher for lower wage earners than for those in more senior positions. We’re looking to reward middle and senior management with variable compensation so that there’s an incentive to grow the company rather than just clip the salary.

What sectors will underperform? To start, I would look beyond regulated sectors, which can be problematic in the context of a structural devaluation. Pharma will underperform unless price controls are loosened, particularly with almost all of the raw materials being imported; they need breathing room. Housing and construction could also face some headwinds given erosion of purchasing power and inflation on the raw materials side. Beyond that, look at sectors that have high human capital costs with a heavy wage component and limited ability to market pricing power.

Healthcare services will likely continue to outperform. There may be some inflationary pressure on the wage side, but pricing is market-driven. Pharma will do well if regulation is relaxed and price increases allowed. Margins are being compressed in food, but they’ll catch up given how strong and robust demand is. Power generation and related sectors should do well, as should infrastructure, all on the back of strong fiscal stimulus.

We’ll definitely be investing in healthcare. We see room in healthcare services to consolidate and to invest in medical technology and capacity growth with a focus on patient care and safety. We also see room to invest in capacity growth in education. We would also consider investing in pharma, depending on the opportunities that arise and developments with pricing and regulation.

Our North Africa fund is invested almost equally across Egypt, Tunisia and Morocco with some exposure to Algeria. Egypt certainly has the largest volume of dealflow, though one of the impediments to investing in 2016 was the spread between the parallel market and central bank FX rates. It should be more attractive to deploy capital this year given the float. Last year, Tunisia was our number one market by deal volume, while Egypt was second.

Within private equity in Egypt, there’s a significant discrepancy between the high- and low-volume players. Some are getting great dealflow, others are struggling to find transactions. The question for us hasn’t been dealflow but the fact that in many cases valuations haven’t reflected reality on the ground, particularly when you consider the inflation and supply-demand situation in some sectors. But volume is definitely there in Egypt — it’s one of the few regional economies that has such a diverse number of sectors. That’s a key positive. And the intermediaries, particularly the investment banks, have done a good job sourcing some M&A opportunities, developing transaction ideas and spending time before private equity comes in to prepare sellers. Overall, Egypt is one of the most promising markets for private equity in the region.

The most common questions we’re asked by limited partners: What’s happening with the foreign exchange situation? Where’s the EGP going? Also: What’s going to happen with inflation and its impact on wages and corporate profits?

What haven’t you asked me? You didn’t ask me where things stand in terms of ease of doing business. You hear all of this chatter about how Egypt is difficult and bureaucratic. Our experience — and we have been investing here for over a decade — is that things have been on a positive trajectory, and we honestly can’t say we faced difficulties. The government has really streamlined approval processes, and policy makers are willing to listen and take action to create an enabling framework for investors. Our activity in Egypt is a testimony to this.

The interview was featured in the 2017 Enterprise CEO Poll here