Frontier markets: Middle East - follow the budget surplus for high returns

When the State-owned investment holding company Dubai World asked for an extension on debt repayments last year, it caused major global stock markets to fall as investors worried about the health of the Middle East's economy, writes Richard Hemming.

Underlining the panic was the fact that the region as a whole is heavily weighted towards financial services companies, which represent about 50% of the local stock market indexes.

However, at a time when most governments in the world, especially in Europe, are having problems managing the debt they have accumulated, countries in the Middle East have huge budget surpluses due to their natural resources, namely oil. One of the region's frontier markets, Saudi Arabia, announced a record budget surplus of more than $70 billion last year.

Ian Powell, chairman and senior partner of PriceWaterhouseCoopers, predicts that the Middle East as a whole will invest more than $2,000 billion into infrastructure such as water treatment, roads and healthcare. Saudi Arabia is expected to be one of the main centres of activity with predicted spending of $500 billion in the next few years. "We see Saudi Arabia as a huge opportunity," says Powell.

For family offices looking to gain access to infrastructure, specialist multibillion infrastructure funds are the best option. The bigger institutions that have raised funds for infrastructure projects in the Middle East include Abraaj Capital based in Dubai, Australia's Macquarie Bank, and the IDB Infrastructure Fund managed by Bahrain-based Emerging Markets Partnership, according to research house Preqin.

Another way to gain exposure to the region's businesses is through private equity. According to Jerome Booth, head of research at emerging market specialist Ashmore Investment Management, private equity is the way for families to get the best returns in the region. Private equity companies often invest alongside some of the region's sovereign wealth funds, which in turn represent the interests of the ruling families.

Private equity is preferable to investing in listed companies because the free float, or the share of the companies available to investors, is very small. However, this presents difficulties in exiting investments, as well as difficulties in obtaining clear financial information about a company's operation, but Booth insists that the higher returns of up to 3 percentage points, or 300 basis points, compensates for this.

Other frontier markets in the region include Iraq, although Chris Palmer, head of global markets at asset manager Gartmore, cautions that from an investment perspective it is in its infancy. What investors need to aim for is gaining exposure to its natural resources, as he explains: "There is a stock market there, but it's very small. The best way into the country is therefore via a European or Asian oil company that has assets in the country."

Despite the opportunities in a region flush with funds as a result of record oil prices, after financial disasters such as Dubai and the more recent reverberations surrounding Greece's debt crisis, some frontier market specialists, such as Franck Nicolas, head of global asset allocation at Natixis Asset Management, remain cautious: "We're waiting until the dust settles a bit more," he says.