Category: Top Tips

Information pointers for industry practitioners.

Top Tips When Considering MENA Investments

Introduction

The MENA (Middle East & North Africa) region is often seen as an attractive location for international investments, particularly in relation to establishing manufacturing facilities or general real estate developments.  Whilst the financial rewards can be significant, there are numerous pitfalls for the unwary.  This article highlights 7 of the most important issues any potential investor should consider before entering into any MENA investment.

Rule of Law

Generally, the MENA region operates a Sharia Law based legal system, with many jurisdictions adopting their own Civil Code, which covers specific aspects of the investment and development process.  Some markets have Free Trade Zones, which often operate in isolation using the United Kingdom or other international legal systems (high profile examples include Jebel Ali Free Trade Zone, Qatar Financial Centre and Dubai International Financial Centre), but it is important to note that in most cases when operating under these zones’ rules can come with other restrictions related to project locations, permitted activities, and investment limits.

Irrespective of the above exceptions it is vital investors clearly understand the laws under which their proposed investment will be governed, especially if these rules are markedly different to those in their home country.  Many investors have be caught out by failing to understand that they do not have the same legal protection in the MENA region that they would expect at home.

Linked in part to this point, is the language of the agreements being entered into for the investment.  In the MENA region, virtually all agreements have to be produced in Arabic for local statutory purposes.  Whilst a bi-lingual version of the agreement may be present, it is generally the rule that the Arabic version will take precedence, therefore ensuring the translations are correctly prepared is vital.

Ownership

Many countries in the Gulf have very rigid regulations about the proportion of a development or company an offshore entity can own.  Whilst it is usually advisable for any new investor to identify and work with a local partner, it is critical that the ownership split is understood.  It is frequently the case that an offshore entity is limited to a 49% ownership share in any investment or business.  This means that the controlling interest is held by the local partner / entity.  Although this may not be considered a problem at the outset, in the event of a dispute it can result in decisions being made outside the control of the offshore party.

This particular issue is of major significance if the proportion of investment from the offshore entity is greater than the ultimate shareholdings in the venture.  Similarly, where the local entity provides “equity in kind” (through the provision of land) the true valuation of the overall investment can become rather vague.

Sponsors / Partners / Conflicts of Interest

As noted above, most MENA investments will require some form of local partner to be involved.  Certain countries, Qatar, Kingdom of Saudi Arabia, and Kuwait for example also require a local sponsor in order that any offshore company can legally operate in the local market.  When deciding on a potential partner / sponsor it is important to consider carefully the following types of business arrangement available, before selecting the desired approach:

  • Active Participant

These local businesses are usually experienced in the field being considered for investment and can be highly beneficial to the new investor.  Usually they are looking to expand or enhance their existing position in the marketplace and therefore the new investment is usually complementary the established portfolio.  These partners are usually experienced in working with offshore entities and can quickly identify potential mutually beneficial market opportunities.

Offshore firms should however, be wary of local organisations who are primarily agency outlets, and are simply looking to add another brand to their existing catalogue.  In these cases, the level of ongoing interest might reduce once the deal is concluded.

  • Silent Partner

Many offshore firms like the idea of a local firm simply acting as a registration medium, to ensure local legal compliance, and nothing more.  Whilst this may seem attractive and appear to provide greater autonomy, it is important that under these arrangements the partner involved have the local credibility to support the offshore firm in the event of an issue.  If this is not the case, then in event of a dispute or regulatory matter, the offshore firm will be left to resolve the problem themselves.

Linked with this category are those entities (such as service office providers) who offer company registration services.  These are attractive avenues for consultants and businesses planning a limited entry to a new market, but often the level of commercial registration possible through these entities can severely restrict any future expansion of activities, resulting in additional expenses and delays being incurred.

  • Influential Advocate

One of the most common target partners is what is often defined as being an “influential advocate”.  These advocates are usually, members of the local Ruling Family, local elite, or prominent individuals.  There is no doubt that influence and credibility in the local market can be enhanced through linkage with these categories of individual.  However, since the Arab Spring, most MENA countries have cracked down on corruption and influence peddling.  This means that today, bypassing the statutory processes or procedures is less common and certainly a high-risk business strategy.  Therefore, apart from the passive credibility there is now limited benefit of seeking out influential advocates as a sole market entry strategy.

Despite the above, having a partner who is well connected in the local market is a powerful tool for opening doors and making introductions to enhance business opportunities.  This strategy is still by far the most successful in the MENA region where relationships are the keys to successful business development.

In all cases, offshore investors must be wary of partners who also have a wide range of other businesses.  Often these partners want / insist on their associate companies being involved in the design, delivery, or construction of the investment.  This can result in a conflict of interest as well as loss of control of where the investment monies are being spent.

Ability to Exit Position

Irrespective of the duration of any investment horizon, it is important that the market exit strategy is clearly understood at the outset.  Many MENA markets make investing relatively easy, but are much more restrictive on how investors can remove their money or sell assets.  In the Gulf States for example, whilst they all have active real estate markets, the secondary property market is still in its infancy.  This is partly driven by the constant stream of new developments being launched and partly due to the restrictions on securing mortgages for pre-owned properties.  The result is that whilst a property may have an attractive initial valuation, the asset often cannot command the same value on resale.

Similar issues arise for manufacturing plants and equipment, where the second hand market has yet to fully evolve and therefore finding buyers will often be hard.  A common strategy is to seek out competitors who are looking to consolidate or upgrade existing facilities and use this as a mechanism to off load unwanted assets (provided they are of a suitable standard).

Money Matters – Taxation / Currency / Duties

Securing regular expert tax advice is critical, because the rules are constantly changing across different markets and with the increased globalisation of trade, many dual and free trade agreements are being implemented.  Generally, the main taxation and duty categories encountered will include VAT, Withholding Tax, GST, Customs Duty, and Agency Fees.  It should be remembered that although many MENA markets claim to be “tax free” this usually only applies to certain industries or categories of individual / business.

In terms of currencies, most of the MENA region countries have freely exchangeable currencies, permitting the transfer of funds around the world.  The key exception is Lebanon where local currency transactions are subject to significant limitations (which is why most businesses operate using US Dollars).  Currently the GCC (with the exception of Kuwait) have US Dollar pegged currencies making them more stable from an investor’s point of view.

Economic Viability – Realistic Business Models

Many offshore investments fail because of unrealistic business models prepared using inaccurate local market information.  Whilst local knowledge is critical to the preparation of any business plan, this knowledge has to be tempered with realistic expectations.  In many cases, inflated assessments are prepared due to over optimistic views of how a market will perform or demand volumes.

In general, it is important to understand the overall track record of the market sector being considered.  Gaining knowledge as to why the market is structured and sized the way it is, will give a good indication as to whether the proposed venture will succeed.  Often the reason why a market sector has limited participants is due to the high barriers to entry.  Furthermore, the historic growth in a particular area is still a good indicator future performance.  Historically, it has been rare for the market fundamentals in a particular area, to change significantly in a short time period.

The manufacturing sector is one area where many offshore entities see great potential in the MENA region, and there are certainly great benefits (from a price perspective) by manufacturing close to the end market.  However, the MENA markets also place a significant level of importance on the place of manufacture (as a measure of quality), therefore local manufacturing plants, whilst better from a price point of view, might be viewed as offering an inferior product to the same item produced in Europe or the USA.  This perception is gradually changing but can currently be an influencing factor in the decision making process of potential buyers.  Equally, many internationally backed local manufacturing ventures suffer quality control issues, which too damages brand perceptions.

Price is always a key decision driver and therefore ensuring any proposed product or service is competitive in the local market is key.  Despite the opinion that an offshore delivered service or product is superior, the local market will generally not pay a premium for it unless it is unique or unequalled in similar regional alternatives.  This situation is in part driven by the fact that many international services or products have historically not lived up to the expectations of the local clients (due to the practical difficulties international firms experience when operating in the MENA marketplace).

Mapping Local Competition / Market Landscape

As part of preparing the business plan, it is important to understand clearly, who the local competitors are.  Most MENA markets have local regulations promoting local businesses and products to the extent that they will be given preference in a competitive situation.  This is critical for manufacturing businesses since the pricing model may be very similar to the local competition but market share will be impacted due to local preference requirements.

In the GCC markets in particular, the differentiation between State entities and private sector businesses is also less clear.  This means that in some cases competition in certain market sectors may be dominated by a few State backed players, reducing the ability for new entrants to take a significant market share.

A final consideration is that in some markets the government specifically reserve certain tenders and investment opportunities solely to local entities.  Therefore, whilst the opportunity landscape may seem plentiful, when these restricted areas are removed from the calculation there might be significantly less opportunities available for an offshore entity.

Conclusions

All of the above points are just a sample of the wider considerations any potential MENA investor has to understand before moving into a new country.  In all cases, it is essential that detailed local market research be carried out in advance, so that expectations can be set at the correct level from the start.  This is not only in relation to the potential market size, investment return, but also in relation to the investment window to be considered.  Many organisations have looked to the MENA region as being a “quick” win opportunity, this is not the case, and these firms have long since left the market.  Preparation and planning are the key success strategies adopted by those who have developed sustainable business models for the MENA region.

Top Tips – Construction Bonds

Introduction

Clients in the global construction industry have traditionally insisted on contractors providing construction bonds on most major projects as a means of providing security for performance.  As project values increase, so do the face amounts of these construction bonds, to the point that they now involve a significant expense for the contractor to secure.  These expenses are not only the fees charged by bondsmen, but also the cost of tying up credit lines or working capital.  The demand for construction bonds varies around the world but it is often the public sector clients, which have the most rigid requirements.

Due to the prevalence of construction bonds, it is timely to consider both the different type of bonds used, as well as the five key checks, which need to be performed by any consultant or client upon receiving a bond for a project.

Key Types of Construction Bonds

The following are the main categories of construction bond found on projects around the world, generally in the sequence in which they would arise on a project.  The names of these bonds may vary a little depending upon the jurisdiction, but the function and intent is the most critical aspect to recognise.

  • Tender Bonds

These are typically bonds submitted by a bidder with his tender submission.  They are normally a fixed value (i.e. a value set by the client in the tender documentation) which indirectly reflects a proportion of the expected tender value.  Some government clients establish the value as being similar to the value of any future construction bond.  This strategy enables these bonds can remain valid until the main construction bond is provided by the successful contractor.  Other clients set the value at a more conservative value to cover simply the risk of a potential bidder withdrawing from the tender process.

Ultimately, these bonds are designed to provide the client with financial security / compensation in the event a bidder decides to withdraw his tender (except in the case of a valid / permitted reason) before an award can be made.  Therefore, it is critical that these bonds are unconditional (“On Demand”) so the client can have access to the funds immediately without having to take any other action.

  • Advance Payment Bonds

Another consequence of larger construction projects is the increased demand from both contractors and consultants for advance payments.  These payments are intended to aid the commercial cashflow of the people performing the work or services.  However, they are often seen by clients as being a risk area because payment is being made prior to any services being rendered or construction activities completed.

To balance the client side risks, bonds have become a frequent reciprocal demand in exchange for any advance payment being released.  Usually these bonds are of the same value as the amount advanced.  In some cases, these bonds are gradually diminishing in value (in response to a periodic repayment of the advance payment during the interim payments).  Where the bond value remains fixed it is often the case that the maximum recovery under the bond will be capped at the amount of the advance payment outstanding at the point of any claim.  As is the case with the tender bond above, these bonds are also typically “on demand”.

  • On Demand Bonds

The previous two categories of bond have both made reference to “on demand” bonds.  These bonds are defined as being bonds, which can be presented to the bondsman without having to refer to the other party or providing any reasons for making the call.  Obviously, these types of bond act in a similar way to a cash security and therefore attract a significantly higher premium (cost to the provider) than any other type of bond.  Interestingly, in those parts of the world where these bonds are the most commonly used (the Middle East for example) the cost premium is greatly reduced.  The reason is that in these locations bonds are rarely called and the construction markets are much smaller (i.e. the number of client organisations involved are less numerous) meaning the bondsmen have a closer and more detailed knowledge of the market risks involved.

It is important to note that if a bond has any conditions attached through the wording used, it will automatically fall into the next category of being a “conditional bond”.

  • Performance / Default Bonds (“Conditional Bonds”)

As noted above, the most typical construction bond is one, which has certain conditions attached to it.  These maybe linked to general performance, or to compliance with specific obligations.  In each case, if these stated conditions are met, the bond can be called, usually after a notice / warning period has been initiated.  If the conditions are not met, the bond cannot be touched.  Therefore, these bonds are providing assurance to the client in the event the contractor fails to perform his duties or obligations (usually progressive performance of the works / services).  They are intended to provide the bridging financing for the losses / additional costs incurred by the client if they have to replace the original contractor for the completion of the works.

It is worth noting that in most cases, the amount of loss suffered or additional costs incurred has to be justified prior to any settlement against the bond being reached.  In other words, a client has to incur the actual expenses prior to receiving any recovery against the bond.  This often results in protracted legal action between the parties and in some cases inflates the actual cost impacts involved.

  • Retention Bonds

This final bond category is perhaps still the least common at a global level.  A retention bond is typically provided by contractors in lieu of cash retention being held by the client.  The value of the bond usually matches the total retention value, which was to be held under the contract, and is designed to provide protection for the client should the contractor fail to rectify any defects identified.  The benefit to the contractor is that the cash retention is released immediately (aiding free cashflow).  The risk for the client is that this type of bond often has specific conditions attached to it making access to the money more complicated and resulting in difficulties in financing the necessary rectification works.  The ideal solution is to request an “on demand” bond, but contractors often resist this arrangement wanting to provide a more direct link between the client’s ability to access the money and the actual default.

Checks to be Carried Out when Receiving a Construction Bond

Once the type of bond has been determined and it duly arrives from the submitting party, there are five critical checks, which need to be performed before the original bond (it must be an original document not a copy / email) can be placed in the company safe.

  • Bondsman

Seems obvious, but it is important to ensure that the bond is issued by an organisation who has the necessary authorisation.  Although insurance companies sometimes issue construction bonds, this has to be specifically permitted, most clients insist on a bond coming from a locally registered bank only.

In the case of government clients, they typically have an approved list of banks, which are vetted in advance.  Ensuring compliance with these requirements is important since the financial stability of the bondsman could be critical in the future.

  • Parties

All bonds state the party providing the bond along with the name of the client organisation.  It is important that both parties are correctly recorded (i.e. the names and addresses match those set out in the construction agreement and are registered legal entities).  In the case of Joint Venture (JV) contractors, it is important to ensure the legal entity of the JV actually exists (in project specific JVs the legal formation may take a number of months after formal contract award); otherwise, there may be issues in calling the bond in the future.

  • Value

The value of the bond should be clearly stated in both numbers and words (which match each other).  Where the bond value is calculated based upon a percentage of the awarded contract sum, the calculation should be checked and no rounding or modification of the exact amount should be made.  It is common for bonds to be issued in advance of the final contract sum being established, in these cases the bond should be updated to reflect the final figure agreed by the parties.

In those contracts where the bond value has to be adjusted periodically, in the future to reflect any agreed variations it is important that an accurate track of all changes be maintained.

  • Duration / Validity Period

Depending upon the type of bond involved, the validity period may vary, but typically for main construction work, the bond will be valid for the construction period, maintenance / defects liability period, plus a further 90 days.

Tender bonds are typically issued to cover the tender validity period only.  Similarly, retention bonds are usually valid up to the end of the maintenance / defects liability period.  For these types of bond, it is important to include wording to cover specifically how any delay in issuing the Final Completion Certificate will be handled.

Advance payment bonds are usually valid until the point that the advance payment has been repaid in full, which is often for the complete duration of the contract period.

  • Conditions for Calling Bond

Where the bond is a performance / default one, then the conditions, which have to be satisfied before it can be called, must be clearly defined and met.  Often a contract may have a fixed wording for these types of bonds; in these cases, it is important to ensure the bond submitted matches exactly the requested wording.  These bonds typically require the client to prove that the all the conditions have been met before they can make a claim.

As noted above, any deviation in the bond wording can dramatically change the ability to call the bond in the future.  Therefore, this check is by far the most important of the five identified.

In the case of “on demand” bonds, there are no such conditions and the bond can simply be presented to the bondsman for payment.

Conclusions

The provision of any type of construction bond is now so common it has become increasingly important that both clients and consultants fully understand the nature of the different bonds being provided.  Furthermore, ensuring key basic checks are carried out when the bond is submitted ensures future surprises are avoided.

A final note, as project deadlines are either extended or delayed, it is important that regular reviews are carried out to ensure the validity of the bonds submitted remain in accordance with the contract provisions.  There is no excuse for having a bond expire prematurely.