Monday, April 5, 2010

UAE: traditional banking and venture capital in a knowledge based economy

I have been doing some reflecting lately on the economic development choices available to the UAE as a country and further at the emirate level. The necessity for diversification from oil driven economy has been stated multiple times and while it may be true for most of the countries in the GCC including the Abu Dhabi emirate for others like Dubai and all of the Northern Emirates the name of the game has always been trading. Needless to say, diversification remains a fundamental aspect for these economies in spite of the fact that the driver is different.

As recently pointed out in an interview Dr. Fabio Scacciavillani, director of Macroeconomics and Statistics at the Dubai International Financial Centre: “Advanced sectors in the twenty-first century will be based less on the combination of labor and machinery and more on the values of ideas and the business acumen required to translate them into commercially viable operations”.

The UAE has therefore embarked in the development of high value add industries which are knowledge driven other than heavy industries that are driven by availability of raw materials and cheap labor. In the global economy it has become almost impossible to compete with Chinese and Indian manufacturing costs. Some might argue that some of the external costs associated with bureaucracy, language barriers and relatively unfavorable foreign investment laws in these countries create a more even playing field still the ground to cover from cost-structure perspective remains significant.

The development of a knowledge based economy relies on few key ingredients, the most important of which is obviously “knowledge” both created throughout a solid educational system as well as imported via hiring of a highly specialized work force. Further, the legal system needs to provide the necessary framework and certainties to encourage risk taking and entrepreneurship as well as protect the ownership of intellectual property: probably the single most important asset in a typical knowledge based economy.

While “intellectual property” management and the educational systems would certainly deserve their own article and analysis, for this posting I would like to focus my attention on the type of banking system required to support the knowledge based economy of the future. Access to start up capital is a vital component for the development of a strong economy, but traditional lending seems ill equipped to provide the right valuation to knowledge-based start up. In fact traditional lending is still based on the valuation of tangible assets, in fact often times entrepreneurs need to provide collateral unrelated to their business venture to be able to get its appropriate financing. In other words, visionary entrepreneurial attitude doesn’t score high with loan officers and credit committees. The latter focus mainly on calculating risks privileging residual equity in case of bankruptcy instead than calculating project risk based upon a market based analysis and business potential.
In a high risk entrepreneurial environment the rules of traditional lending just don’t match market needs. And that is where government bodies with their regulatory powers, banks and equity funds will need to step in to fill the gap by growing a more sophisticated and structure venture capital industry. Venture capital firms provide much needed equity for innovative start ups, not loans. VC firms compensate for the higher risks by taking an ownership stake in the enterprise and dividing equity rounds based upon project milestones often taking a tangible role in the direction or development of the project.

If GCC banks want to meet the demands of a growing and more specialized knowledge based economy they must outfit themselves with experts with the capabilities and experience to analyze, evaluate and rate business plans in order to maximize returns for the bank and in turn provide entrepreneurs with much needed startup capital. As part of this model financial institutions playing in this field must also formulate clear exit strategies that would allow start ups to transition to traditional, and less onerous, debt upon reaching of their maturity stage and in turn allow the equity providers to cash in after the initial and more risky incubation process is over.

So, while banks and lending institutions face the challenge to modernize and meet the challenges brought about by knowledge based economy, regulatory and government bodies on the other have the difficult task to create the transparency laws and mechanisms required for the markets to operates and flourish, and that includes among others: adoption of shared accounting rules, enforcement of penalties for any wrong doing, creation or enhancement of investor friendly procedures.

The UAE government both at the federal and emirate level has taken significant steps already to meet the challenges on hand. It would be great for many entrepreneurs and visionaries in a variety of industries if the banking systems would quickly follow suit providing the equity partnership that is required by them. Any delay would turn into an opportunity for the many venture capital firms in the US and Europe that could step in matching knowledge and processes with capital existing in the GCC. That would be a lost opportunity for lenders already operating in this region.