Profit & loss

August 28, 2001, will live long in the memory at Investcorp, the Bahrain-based investment bank. On that day CityReach, a British web-hosting venture, went into administration - less than a year after Investcorp had sunk some $80 million into the company. The following day, the world's financial media mourned the loss of one of the technology boom's brightest hopes.

Investcorp, meanwhile, mourned the loss of a significant chunk of its $80 million investment. The process was clearly a painful one; within days, a press release heralding the deal had been wiped from Investcorp's website.

Time flies. It was a very different story just 51 weeks earlier. "We are delighted to lead this important round of financing for CityReach," said Investcorp's Philippe Costeletos on September 4, 2000. "The data-center market offers significant opportunities for growth and we are particularly impressed with the management team of CityReach."

To be fair to Investcorp, it was in good company when it backed CityReach. Co-investors included JP Morgan Partners, the venture capital wing of the US investment bank, and Paul Allen, the co-founder of Microsoft, through his Vulcan Ventures fund. In total, CityReach had raised $354 million in funding over two years. But by the end of August, creditors were literally knocking on its doors. One British furniture company was reportedly seen physically recovering its stock from CityReach's London offices, and KPMG had been called in as administrator.

For Investcorp, the CityReach affair came at a bad time. In 2000, the bank's profits plunged 44 percent, to $70 million, after it was forced to write-off a hefty $304 million when Burnham, an American firm, went into administration. Investcorp bought into the company, which specialized in computer transportation, in 1988. But as computers became more durable, demand for Burnham's services dried up. Investcorp tried to transform Burnham, but by 2000 had already set aside $191 million in provisions against the investment. By the time the plug was eventually pulled, that figure had risen to $304 million.

The Burnham incident followed a number of lesser blows the previous year. In 1999, Investcorp wrote-off its investments in Mondi and sold Breguet, Chaumet and Ebel at a loss. The combined effect left Investcorp with reserves for investments, after the Burnham write-off, of just $54 million, or 4.2 percent of gross investments - against 19 percent in 1999.
Rebuilding these reserves will inevitably place pressure on Investcorp's bottom line over the coming years. Staff are already feeling the pinch - compensation fell from $109 million in 1999 to $70 million last year.

So is Investcorp a company in crisis? Far from it, say analysts. Investcorp has certainly suffered in recent years. But market conditions have been truly awful, and some argue that the company has weathered the storm better than most. "Investcorp is investing in technology and obviously some of these investments will go sour," says Adel Satel, an analyst with Moody's Investors Service. "These are investments that will hurt the bottom line of Investcorp but certainly not its solvency level."

Chase Manhattan. Investcorp was formed in 1982 by Nemir Kirdar, a former Wall Street investment banker. Kirdar, a member of a prominent Iraqi family, turned his commercial attentions to the United States in the 1950s when the Iraqi royal family was ousted. After moving to New York, Kirdar was recruited by Chase Manhattan, the American bank, and during the 1970s established Chase's presence in Bahrain, as the bank looked to cash in on the Gulf's newfound oil wealth.

Kirdar soon spotted a niche. Almost overnight, the oil boom had created a new, super-rich elite in the Gulf that was crying out for investment advice and opportunities. Meanwhile, Kirdar's experience in New York meant that he knew all about the growing American appetite for private equity deals. Investcorp was created in 1982 to act as a bridge between the two - since then it has channeled $19 billion of mainly Gulf money into North American and European investments. There have been some turkeys, such as Burnham and CityReach. But Investcorp boasts a loyal and growing franchise of investors who put their faith in Kirdar's judgement, and his bank has backed far more winners than losers. "Overall, it has a good record in corporate investment," says Satel.

Take Leica Geosystems. Investcorp made its initial investment in October 1998 as part of a management buyout at the Swiss firm, which makes global positioning and laser measuring systems. In 2000, the company was successfully floated on the Swiss stock exchange - the IPO was 10 times oversubscribed - and Investcorp sold its stake later that year for a total of $221 million - a rate of return of 78 percent.

What's more, Investcorp achieved this with the full backing and support of the company - unlike some corporate raiders who make enemies whenever they go through ruthless asset-stripping. "We have been privileged to work closely with Investcorp over the past two years," says Hans Hess, Leica's CEO. "Through our close working relationship, we have achieved strong results."

Typical of Investcorp's whole-hearted approach is the fact that Philip Yea, an Investcorp management committee member, remained a member of Leica's board of directors. "As a financial investor, the decision to sell our remaining shares is entirely a function of our own business policies," says Yea. "I look forward to continuing to serve the company as a director, as it pursues its objectives."

Investcorp's is an unorthodox business model, but it is certainly a strong one. First, its breadth means that all Investcorp's eggs are never in one basket. "They have a well-diversified portfolio," says Satel. "They did not go into technology big-time. My view is that they have taken a prudent approach." Even in 1999 and early 2000, when technology hysteria was at its peak, Investcorp refused to commit more than 20 percent of its funds to the tech sector. Its judicious use of hedge funds for liquidity management also helps.

Second, Investcorp's franchise is in many ways the envy of the private equity world. Nowhere is business loyalty stronger than in the Gulf, and Investcorp has generated enormous amounts of goodwill through its Bahrain-based placement team. "They knew how to place deals in the Gulf," says Satel. "They knew their source market, and they knew how and where to invest."

Convincing the second generation of the Gulf's wealthy elite has been a challenge - most of them have business degrees from prominent American universities. But so far, they are staying on board.

Third, and perhaps most importantly, Investcorp has embraced sophisticated risk management techniques. "These are proving their worth now that we are in a downturn," Satel points out. "But there are limitations to these models." Investcorp identifies five key areas of risk: portfolio company and real estate investment risk; asset management business risk; liquidity risk; market risk; and credit risk. "In order to quantify and help manage these risks, we have built a team of dedicated and specialized professionals and developed advanced risk management processes and systems, applying Value-at-Risk and stress testing methodology," says Investcorp.
Few question the validity of this approach. "Risk management in the world has taken important steps forward - new computers, new economic models, new financial models," says Satel. "Investcorp has taken full advantage of these changes."

For all these reasons, clients and analysts are happy with the performance of Investcorp's management in recent years. Kirdar has played a crucial role, but retirement looms for the iconic president and CEO. It is testament to the strength of the management team that he has assembled that few observers worry for the group's future once control has passed from the founder. Indeed, it was precisely for this reason that Kirdar refrained from using his own name when he established the company 19 years ago.

However, it would be wrong to think that the future will be all smooth sailing. Investcorp's business model is inherently a risky one, despite its admirable efforts to mitigate those risks. It may have performed reasonably well in the downturn so far, but it is not out of the woods yet.

"We have not seen how far the capital markets can come down," warns Satel. "We have seen in recent times new investments turning bad. There are a few investments where we don't expect to see significant capital gain. There is certainly a risk that some companies cannot be exited properly, or will not provide the returns that were expected when they were acquired ... Exiting will be difficult."

This is dangerous for two reasons. First, it will hit Investcorp's bottom line, but this is not the main threat. Second, and more importantly, it threatens what is perhaps Investcorp's greatest asset: its reputation. "A few bad investments will affect capitalization," Satel says. "But more important is reputation risk. That is what Investcorp can lose - if the customer base loses trust.

Hard times. "Investcorp has to beat the indices," Satel continues. "Investcorp customers are used to returns of around 15 percent or 17 percent, but the chances of that happening depends on the value of equities, and we have seen a bear market for a long time. If that goes on there may be problems. Managing expectations is all-important. If they manage to do that, even in a downturn, they will be okay - so long as investors know that is the best they can expect."

On balance, few would bet against Investcorp weathering the current storm. "Investcorp has a sound balance sheet structure that would allow it to sustain long periods of no exits and therefore resist pressure to exit," says Satel. For this reason, the threat of widespread desertion by Investcorp's previously loyal clients is small. "That is not happening today nor do we expect it to happen."

Kirdar certainly remains bullish. "The fact that profits in 2000 were down from 1999 is largely due to the unusual turmoil in the financial markets, which prevented us from completing as many exits as we had planned," he told investors in his latest annual report. "Recent macro and micro economic conditions, particularly the drying up of acquisition financing, made the sale of assets at acceptable multiples unusually difficult.

Furthermore, we decided this year to write off our total investment in Burnham, a company that proved to be impossible to turn around. Without just one of these two unusual events, Investcorp would certainly have had its 16th record year." Net income for the full-year ending March 31, 2001, was up 19 percent from full year 2000, at $83.2 million.

Clearly, deals such as CityReach will not help Investcorp in the short term. But taking even a two-year time horizon, a return to record profits is far more likely than not. "Massive market failures could be damaging," says Satel. "But management is aware of that, and that's what makes Investcorp so strong."