In recent years, the Middle Eastern market has witnessed an increasing number of deals, driven by government reforms, economic diversification strategies, and a surge in foreign investments. Determining the right discount rate and Risk-Free Rate and accurately measuring industry risk are critical steps in ensuring successful M&A transactions in the region.

A prime example of this is Abu Dhabi National Oil Company (ADNOC), which entered into a strategic $5.8 billion partnership with Italy’s ENI and Austria’s OMV in its refining and trading businesses in 2019. Given the volatility of the oil and gas sector in the Middle East, ADNOC needed to carefully calculate the discount rate to determine the present value of its refining operations. The deal factored in multiple elements including the Risk-Free Rate, Industry Risk, and Country-Specific Risks.

ADNOC’s success in attracting foreign investment and optimizing its asset portfolio illustrates the importance of accurately determining the discount rate and industry risk, particularly in a complex and evolving market like the Middle East.

Let’s explore how concepts of Discount Rate and Risk-Free Rate can be applied effectively in the region.

Understanding the Relationship Between the Discount Rate and Risk-Free Rate:  

The Risk-Free Rate is a critical component in calculating the discount rate. In the Middle East, the risk-free rate often reflects the yield on local government bonds (such as UAE or Saudi Arabian government securities) and treasury bonds for transactions involving international investors. The discount rate, however, goes beyond this baseline rate, incorporating various risk factors pertinent to the Middle Eastern market.

When valuing a company in the Middle East, the discount rate typically includes:

• Risk-Free Rate: The expected return from an investment with minimal risk of financial loss.
• Market Risk Premium: Additional return required by investors to compensate for exposure to regional market risks.
• Country-Specific Risks: Factors unique to the Middle East, such as political stability, currency volatility, and regulatory changes.
• Industry-Specific Risks: Risks specific to the sector in which the target company operates, which may vary significantly across different countries in the region.

Discount Rate and Risk-Free Rate: Calculating the Discount Rate in the Middle East

Two primary methods are often employed to determine the discount rate and risk-free rate in the Middle East:

• Capital Asset Pricing Model (CAPM): This model helps estimate the cost of equity, starting with the risk-free rate and adding premiums for market and country-specific risks. In a Middle Eastern context, the Risk-Free Rate may be based on local government bonds or adjusted to reflect geopolitical risks. The beta (β) will reflect the volatility of the company or industry relative to both local and international markets.
• Weighted Average Cost of Capital (WACC): WACC calculates the overall discount rate by weighing the cost of equity and the cost of debt according to their proportions in the company’s capital structure. In the Middle East, the cost of debt might be influenced by factors like regional credit ratings, interest rate trends, and the overall economic stability of specific countries.

Measuring Industry Risk in the Middle East: Industry risk in the Middle East is shaped by several regional dynamics, from economic diversification policies (like Saudi Arabia’s Vision 2030, and We the UAE 2031) to rapid technological adoption in sectors such as fintech and healthcare.

Here’s how to assess it:

• Qualitative Factors:
  • Regulatory Environment: Consider regional-specific regulations, such as the UAE’s progressive corporate tax policies or Saudi Arabia’s regulatory reforms to attract foreign investment.
  • Political and Economic Stability: Evaluate how geopolitical events, such as diplomatic relations and regional conflicts, might impact specific industries.
  • Sectoral Growth Trends: Assess government-led initiatives, such as infrastructure development, renewable energy projects, and digital transformation strategies, which may drive growth in specific sectors.
• Quantitative Factors:
  • Beta Coefficient (β): Obtain beta values that reflect the Middle Eastern market dynamics, using a regional benchmark index like the Tadawul All Share Index (TASI) in Saudi Arabia or the Dubai Financial Market General Index (DFMGI).
  • Industry-Specific Data: Use historical data on default rates, credit spreads, and earnings volatility to understand industry-specific risks.
  • Foreign Exchange Risk: Account for currency risks, especially for industries that rely on imports or exports or have exposure to foreign currency transactions.
• Start with the Local Risk-Free Rate: Use the yield on local government bonds as a baseline, adjusting for any geopolitical risks or currency considerations specific to the Middle Eastern market.
• Incorporate Market and Industry Risks: Add the market risk premium, which accounts for the broader market’s volatility, adjusted by the industry beta (β). Factor in specific risks like political instability, regulatory changes, and sector-specific risks that might affect the target company.
• Calculate the Final Discount Rate: Combine these elements using the CAPM or WACC formulas. The final discount rate should accurately reflect both the baseline risk (Rf) and additional risks unique to the Middle Eastern region.

Combining Risk Free Rate and Industry Risk to Find the Discount Rate: With both the Risk-Free Rate (Rf) and industry risk measures in place, here’s how to use them to calculate the appropriate discount rate for an M&A deal in the Middle East:

In the Middle East, while the Risk-Free Rate provides a baseline, comprehensive discount rate and Risk-Free Rate must account for the region’s unique characteristics. Factors such as geopolitical instability, sector-specific risks, and regulatory changes significantly influence investment returns along with discount rate and Risk-Free Rate. By meticulously integrating these elements, investors can navigate the region’s challenges, make informed decisions, and achieve optimal outcomes in M&A negotiations.

MS offers a unique blend of industry expertise and strategic guidance to help to unlock your full potential through M&A. Our services, including valuation and due diligence ensure seamless deal execution and maximum value creation. Let us make the deals work for you.