Abraaj’s flawed operating model

A lot has been written recently about Abraaj Capital, the private equity company based in the Dubai International Financial Center. The current focus is around Abraaj’s actions with regards to the potential co-mingling of client funds with its own operating funds. News is updated on a relatively frequent basis about the subject and there is clearly a lot to learn on many fronts. However, it is too early to do a full post-mortem as investigations and legal cases have not come to a conclusion. But there are some things that can be gleaned that could be instructive for investors. The aim of this post is not to judge Abraaj, the courts will do that. The aim is to try to see if there are lessons that can be used by investors to better manage their portfolios.

Abraaj’s Origins

I first met Arif Naqvi when the name of his company was Cupola, some time in 1998 or 1999. The context was the acquisition by Cupola of Inchscape, famous for its ownership of the Spinneys supermarkets amongst other things.  I’ll use an article on Abraaj’s history by Forbes, published in November 2015, to reinforce the story that I was presented but the conclusions are mine alone.

The first puzzling issue for me, and a story that I have repeatedly heard in terms of other companies seeking investments, was that Cupola was founded using a small amount of savings. The Forbes article indicates that it was USD 50,000. There are several warning bells when I heard the origins story. Setting up a business in the region is not as simple as getting a commercial license. The complexities, and financial costs, increase when the license is for a regulated business such as investment advisory, Cupola’s original business line. The lawyer fees alone would eat up such a frugal amount. Then there’s the minimal organisational structure that regulators would require, e.g. at a minimum a compliance officer, a risk officer and employees proficient in investment advisory. At that time, and to a large extent today as well, a commercial license will not be issued without a fully fitted out office. If you add all of this up, USD 50,000 of equity seems inadequate.

The rags to riches business story of a couple of guys in a garage is not impossible. But in 1994, in the UAE, this could not be done. Also, the couple of guys in a garage success stories, think Apple, Dell, etc., created products that were sold in an unregulated market. That is a far cry from asking people to give you their companies to sell and asking investors to invest in those companies. Being clear about the source of funds is not only to ensure that the money is legal, but also to ensure that it was there. The gap between expenditure and revenue/equity is one of the main issues Abraaj is facing today. The warning signs were clear decades ago.

Abraaj’s Operating Model: Private Equity or Investment Banking?

The next part of the story that was not clear was the first big deal that Cupola executed. The actual quote from the Forbes article is “In [Naqvi’s] first deal he raised $8 million for a duty-free-kiosk business and received an $800,000 advisory fee.” And there it is, the reminder that Cupola was an investment bank. The underlying fee income was a 10% fee of equity raised. There are two issue here. The first is that Cupola, Abraaj’s roots, is investment banking. The second is that they charged 10% to raise equity which is considered extremely high for an established investment bank let alone a startup. The idea that Abraaj’s deep DNA is that of transaction based investment banking rather than value accretive private equity is spectacularly shown in its deal regarding EFG Hermes in 2006.

At that time, EFG Hermes was a large, Egyptian based investment bank. EFG was also dual listed in Cairo and London. Abraaj bought 25% for a consideration of USD 505 million of the company in late 2006 and sold the stake for circa 118% profit in late 2007. Here are the warning flags. The first is size. According to this article Abraaj had USD 1.5 billion of assets under management. So that deal would represent 33% of assets under management. Now, there might have been co-investors and leverage not included in the news article’s USD 1.5 billion number but nevertheless, that is an astounding percentage of the portfolio in a single position. This goes beyond concentration risk. Different asset managers set different limits to what percentage of a portfolio is concentrated in a single asset, with numbers ranging between 2% and 10% in my experience. The concentration in the EFG position does not seem to make sense.

The second and third warning signs are related. What is a private equity firm doing investing in a listed company? There are many valid reasons to do so, usually having to do with either merging the asset with other companies, or delisting and doing something that creates value with it. However, since the holding period was about a year, the third warning sign, how can Abraaj have done anything to create any value? Private equity firms usually quote average three to seven year holding periods, and the reality is often longer. What PE firm can add any value in a single year? As they say in the investment industry, there was no alpha, just beta. Did Abraaj do anything unethical? Unless they breached their concentration limits, the answer is no. Did Abraaj make a phenomenal amount of money? Considering that the Egyptian markets where up about 50% during the same period, then yes, that was quite a stock pick. Did Abraaj take tremendous risk? Unless Abraaj had secured a sale before taking on the position, then the answer is yes, Abraaj took on a tremendous amount of risk in that trade. So what is the conclusion? Abraaj made a lot of money by taking on tremendous risk outside of its state core activity: private equity. That is a serious warning flag. The company is not behaving as advertised, but perhaps the tremendous amount of money made kept investors quiet.

Managing a PE Firm’s Operating Business

There is a lot here that indicates not a pure equity firm, but more of a merchant bank, doing deals and entering into transactions to take fees or get basic market exposure. Why does this matter? It could answer something that has been puzzling me. I do not understand the sizes of the co-mingling of funds. The first news broke about four investors investigating circa USD 200 million missing from the fund. Later news came out that these funds were returned, but there was news of a possible shortfall in another fund. Most recently the UAE businessman Hamid Jafar has alleged that Arif Naqvi took out a short-term loan from him of USD 300 million late last year to be repaid early this year. Let us assume that this indicates that there is about a USD 300 million hole in the operational budget, otherwise why would Abraaj need so much money so quickly? I do not want to get into whether something illegal or unethical happened, I just want to talk about why would there be a USD 300 million shortfall in operations.

First, USD 300 million is a huge number. The asset management firm should normally never need that much money for operations. Second, remember that PE funds usually charge a flat 2% on funds deployed. Let us assume that the funds deployed is USD 6 billion. This would generate USD 120 million in guaranteed annual management fee income, excluding any performance income. There is something seriously flawed for an asset management firm to get into this position. All fees relating to an actual deal or fund are charged to that deal / fund. What’s left is general and administrative expenses with the biggest components being salaries and rents. There is no infrastructure expenditure, no building factories. Just people and offices. How is USD 120 million not enough? More importantly, if USD 120 million is not enough, how do you allow the shortfall to reach USD 300 million, or 250% of your annual management fee income?

Whilst people argue about was co-mingling funds right or wrong, or was KPMG right or Deloitte right, or are Arif Naqvi’s statements that investors have misunderstood the situation and are over-reacting, my basic question remains: How do you end up with a USD 300 million hole in your operational budget? You do not go to a high net-worth individual for a USD 300 million short-term bridge loan if there isn’t a problem. The main response from Abraaj at this time seems to be that there is a delay in selling assets in Pakistan and that this has caused a cash short-fall. But the funds form such a sale belong to investors with a potential performance fee to Abraaj. If the problem is the performance fee, usually 20% of profits, then Abraaj has not managed the asset-liability mismatch between income and expenses. There is something profoundly unsettling about taking on a USD 300 million liability in the expectation of a deal consummating by a certain time and generating fees to cover such a large liability. If, on the other hand, Abraaj is itself an investor and looking for a return of its funds to cover the liability then this is a worse issue, as using your balance sheet for expenses is not good business.

Then there is the issue that it is the management firm that is borrowing, as opposed to the more usual situation of the funds or the portfolio companies borrowing. It doesn’t make sense.

Was Abraaj a Pure PE Firm?

So what can we conclude? The current public debate is between the idea of Abraaj being a bad corporate citizen and misbehaving versus Abraaj is being attacked, or at the least weakened, by people who are ignorant or might even have personal grudges. The courts will decide that. But I do have a third theory. Abraaj was not built and run as a private equity company. It was a well promoted and opportunistic financial services firm run by people who depend on their ability to close transactions and ignore the institutionalisation of the company under proper corporate governance. Such a characterisation is consistent with some of Abraaj’s deals and subsequent actions.

What are the lessons? The main one is that when looking at an investment opportunity, think about how you can test that what is being presented is indeed what is happening. A circa 118% return in a single year is luck, regardless of who is making the trade. Talk focussing on specific trade performance rather than portfolio performance is another question mark. Financials of the management company begin to make sense under this light, to ensure that there is no financial pressures on management. But most of all, has the company being acting in a manner consistent with its business description? If you let yourself be blinded by returns and miss that the story presented has flags indicating an opportunistic merchant bank involved in trades and deals rather than value creation, then you might get a shock later down the line.

I hope that everyone receives a good outcome in this case. But let’s try to learn.