10 Tips for Private Equity and Venture Capital Transactions in the Middle East
By Nabil Issa and Osama Audi, King & Spalding
In this article King & Spalding set out some of the common issues faced by parties, particularly PE and VC investors, purchasing Middle East-based companies in the popular healthcare, education and food and beverage sectors with a focus on companies in the Kingdom of Saudi Arabia and the United Arab Emirates (UAE).
1. Purchasers need to understand the regulatory issues relating to their nationality and the sector in which they are investing prior to making such investment.
If a purchaser has any non-GCC national ownership at any level of its equity capital structure, time will need to be spent confirming if the target sector is open to investment (and if investment is limited in the relevant sector whether such limitation applies to non-GCC nationals as well or to nationals of the country in which investment is being undertaken) and the relevant percentage which can be acquired by, as applicable, a ‘non-GCC’ purchaser or a national of a country other than the country in which the activity is being undertaken. For example, in Saudi Arabia a non-GCC investor can directly invest in a hospital with more than 100 beds or in an entity manufacturing medical devices, but cannot directly own a stake in a medical or dental clinic as health care clinics in Saudi Arabia can only be owned by Saudi nationals. In addition, non-GCC national investors can often invest in a business engaged in wholesale or retail sale of goods (including consumer goods) but not if such entity is a registered distributor of such goods. In Saudi Arabia, additional limitations will apply to quite a few other commercial activities including, among others, retail pharmacies, education, logistics, and security services. Even with regulatory hurdles, counsel should be able to explore alternative legal means through which a purchaser can acquire an interest in a target in such sector through alternative legal investment structures such as a fund or sukuk. The structure also may influence the ability to create a robust employee stock option plan, particularly if employees include non-GCC nationals.
2. While fronting arrangements are common, anti-fronting legislation must be complied with nonetheless.
Purchasers should shy away from typical nominee structures that may result in a party running afoul of a relevant anti-fronting law and, depending on the jurisdiction, if reported could face civil or criminal penalties. For example, the stated objective of the UAE Anti-Fronting Law is to prevent non-UAE nationals – whether natural or juristic persons – to practice any economic or professional activity that is not permissible for them to practice in accordance with the law and decrees of the UAE. Despite the existence of such laws in Saudi Arabia and the UAE, some lawyers have advocated for the use of simple side agreements. We are aware that certain lawyers in the UAE often point to the fact that there is actually evidence that the highest courts in the Emirates of Dubai and Abu Dhabi have historically upheld “side” agreements and focused on the economic rather than statutory relationship of the parties. Moreover, the argument has also been repeatedly made that if “side” agreements were invalidated such would result in adversely affecting foreign investment in the UAE and would be contrary to various declarations by the governments at the federal and emirate level that the UAE is encouraging foreign investment. We note, however, that the Union Supreme Court in Abu Dhabi in late 2012 decided that “side” agreements are not valid, and any agreement to vary the economic or other rights of the shareholders in a UAE joint venture should be in the registered articles and/or be recognized by a local notary public and undergo the normal recognition of the licensing authorities in the relevant Emirates. While such case does not have precedential value in creating binding precedent as in a common law jurisdiction, foreign parties need to be mindful that there are examples of the judiciary invalidating such agreements and that such “side” agreements likely violate the antifronting law. Moreover, there are often legal means of achieving economic control. For example, in the Emirate of Abu Dhabi it is possible to have the registered articles provide that the foreign 49% registered owner is entitled to at least 90% of the dividends. Further in Saudi Arabia, the local authorities are regularly prosecuting parties violating the Saudi Arabian Anti-Fronting law and actually reward parties for reporting those engaged in this activity. We also understand that auditors in Saudi Arabia are now required to report the
extent they are aware of not only registered owners but of “beneficial” owners of a business in their filing with the Department of Zakat & Income Taxation. Finally, there are greater demands and a higher level of liability on directors under the new companies laws in Saudi Arabia and the UAE and such directors should carefully review the legality of the ownership of companies and operation of such companies prior to agreeing to act as directors.
3. Term Sheet
Purchasers often wish to enter into a term sheet, memorandum of understanding or offer letter before documenting a complex share purchase agreement and, if applicable, shareholders’ agreement. We find, however, that parties can sometimes gloss over keyterms
at the offer letter stage and, accordingly, do not have a true “meeting of the minds” which can lead to significant resources being expended on a deal that was never truly agreed. For example, we find parties will agree to certain points in a term sheet and not consider
the fact that they may not be enforceable, such as drag/ tag provisions, ability to get certain reserved matters in the registered articles, liability caps, time limits for raising warranty claims, employee stock options, escrow arrangements, acquisitions being subject to financing, etc. By spending more time at the term sheet stage, parties can ensure that there is a clear understanding of the requirements of both purchasers and sellers.
4. Nominee Owners/Third Parties.
As with many other sectors, quite a few healthcare, education and food & beverage transactions involve the participation of either nominee owners or historically passive owners. We often find that when such owners become aware that a private equity group, strategic
investor or fund is keen to acquire the underlying business that such nominees or passive owners suddenly wish to become actively involved and expect to sell their shares at a significant premium. In a UAE or Saudi limited liability company, from a practical perspective,
one shareholder cannot sell without obtaining the written consent of all other shareholders. If one party does not provide written consent they can effectively hold their shares ransom until they feel they are adequately compensated. Thus, a purchaser may wish to negotiate a break-fee if sellers cannot complete a sale due to an uncooperative nominee/ owner. Break-fees often at least include expenditures and some agreed amount to compensate the purchaser for lost time spent on the transaction. Also, indemnities should be carefully crafted to address issues which may arise as a result of a previous nominee owner being deemed to have been in violation of the relevant jurisdiction’s anti-fronting law. Purchasers will often want to ensure they are indemnified for the legal violations as a result of the way in which the previous owner held the asset.
A company that is in negotiations to sell a minority or majority stake to a reputable purchaser may attempt to shop an offer letter to other potential purchasers. Despite confidentiality clauses, the Middle East is a relatively small market and other potential buyers will likely inevitably learn that a stake in a company is for sale. Therefore, it is critical that the concerned buyer negotiate a well drafted exclusivity clause with an enforceable termination or break-fee if sellers breach the exclusivity arrangements. In addition, depending on the governing law used in the offer letter, parties should consider whether a provision requiring parties to negotiate in good faith should be included in the offer letter. We have seen purchasers successfully demand payment of a break-fee when a seller changes its mind or pursue new purchasers. Depending on the governing law and jurisdiction used in the term sheet, the break-fee can be a liquidated damages clause that must be carefully crafted so as to not be interpreted as a punitive penalty clause which may not be enforced.
6. For transactions in Saudi Arabia, the Ministry of Labor’s Saudization program adds complexity and, if ignored, can lead to significant issues.
Since the launch of Saudi Arabia’s Nitiqat Saudization program, labor intensive businesses have faced challenges trying to comply with the program without significantly increasing their overheads. In general, the program categorizes all businesses as either ‘red’, ‘yellow’, ‘green’ or ‘platinum’ depending on the number of Saudi nationals employed by such company and the activity/job description of such
employees with a certificate being issued by the Saudi Ministry of Labor setting out each company’s current status. Depending on the color-coding of a target company, the Ministry of Labor will provide certain incentives or penalties (e.g. residency visa processing and renewals are quicker for ‘platinum’ companies while such services are not permitted for ‘red’ companies). Thus, a purchaser should be prepared to invest in a Saudization program to recruit and train Saudi nationals.
7. Competition approvals may be required for your transaction.
Purchasers should be aware that while competition approvals have been a long-standing feature of M&A/PE transactions in many jurisdictions, the competition approval processes in most regional jurisdictions are relatively new and untested. That being said both
Saudi Arabia and the UAE have competition authorities to which certain transactions must be submitted and approved as a condition to closing.
8. Governing Law and Jurisdiction.
Not infrequently a foreign buyer will agree to arbitration in London to settle any disputes arising under the joint venture, and perhaps will even agree to use English law as the governing law for the shareholders agreement. A foreign shareholder may initially feel elated at this “win,” but the reality may be different. There are only a handful of recent examples of arbitral awards rendered outside of the Gulf Cooperation Council countries ever being enforced in the UAE or Saudi Arabia. It may be preferable for the foreign partner to carefully consider whether to have the arbitration conducted in the English language under the DIFC-LCIA rules at the Dubai International Financial Centre (DIFC). While it is common to have the acquisition documentation governed by one law (e.g. English law) and, to the extent applicable, a shareholders’ agreement governed by another law (e.g. UAE or Saudi law), purchasers should discuss with counsel the benefits and detriments that a particular governing law and jurisdiction can have on their transaction. Parties should also be mindful that the official language of the GCC is Arabic and that should consider adding provisions in the relevant agreement that it will solely appoint a licensed translator in the event such documents require translation.
9. Consider utilizing the DIFC to improve enforcement.
Because the articles of association of limited liability companies incorporated on-shore in the UAE and in Saudi Arabia do not permit much flexibility or customization, purchasers acquiring less than 100% of a target will typically enter into a separate shareholders’
agreement setting out, amongst others, buy-sell provisions, or put and call options, or restrictive covenants of one sort or another. It is important to note, however, that courts in the UAE or Saudi Arabia rarely, if ever, grant specific performance – which is to say that they will not make anyone do anything. Instead they may choose to award money damages for something done or not done, but that raises the question of the quantum of harm done. One common provision in many shareholders’ agreements which deals with “deadlock” in decision making, or serious disputes between shareholders, is to provide for a buy-sell mechanism, whereby one party names a price at which the joint venture interest could be bought or sold. The other party may either buy-out or sell to the first party at the named price. Another common provision is the concept of dilution: if one partner refuses to contribute equity capital as needed, the other partner can
contribute and dilute the interests of the first, possibly removing some voting rights or board representation in the process. Neither of these provisions will work in Saudi Arabia, where any change in shareholding must be consented to by all existing shareholders, all of
whom must appear in front of a notary public to sign amended articles of association that specify the new shareholding. Buyers should consider moving all or part of their acquisition structure to an offshore jurisdiction such as the Cayman Islands or, if the target must be
at least GCC-owned, to the DIFC. We have found that many GCC jurisdictions, including Saudi Arabia, Kuwait and Dubai, view the DIFC as being in the GCC to the extent such entity is GCCowned. Thus, in many cases, it may make sense to establish a joint venture in the DIFC and create an English law joint venture agreement. Such will dramatically improve the ability to enforce put and call options, dilution provisions, have different classes of shares, enforceable employee stock option plants, reserved matters, pledge of shares, etc.
10. Restructuring for eventual exit.
A buyer must carefully consider its structure for making an investment. Buyers should create a structure that will maximize exit options. For example, a party outside of Saudi Arabia that holds shares directly in an unlisted company will be subject to a 20% capital gains tax on exit. By creating another SPV between the buyer and the target company, such capital gains tax can be eliminated resulting in a much lower taxation on exit. A buyer may also wish to agree upfront with the seller and remaining shareholders how an exit will work or the need to convert the company to a joint stock company for an eventual initial public offering.
To protect their rights, investors should retain experienced counsel who understand both Western documentation and local law implications. The region is witnessing an increase in transactions especially in healthcare, education, food and beverage, and real estate/ hospitality transactions. Regional governments are also working to support startups and small business through funding programs and will likely focus on such sectors of employment for nationals for economic diversification and a means to empower the young and increasingly educated populations. We also note that a number of public private partnerships are emerging in the healthcare, education, power, transportation and other sectors throughout the GCC.