The trillion-dollar pipeline in the Mideast no one is talking about

The world is awash in unused investment capital — $2.8 trillion is on the balance sheets of multinationals in the United States and Europe alone — yet the money isn't going to the regions where it is most needed or where it could arguably produce the greatest returns: emerging markets.

Emerging markets private equity has earned 11 percent over the past 10 years after fees, according to advisors Cambridge Associates. Large public equities funds with more than 50 percent of their assets invested in the Middle East and Africa show similar returns, according to Morningstar. Emerging markets are growing at an annual rate of 5.8 percent; the Middle East and North Africa is growing at more than 3 percent annually, according to the World Bank.

Beirut Souks, the shopping, hospitality, entertainment and cultural meeting place in the center of the Lebanese capital
Anwar Amro | Getty Images
Beirut Souks, the shopping, hospitality, entertainment and cultural meeting place in the center of the Lebanese capital

Many things we think of as normal don't make sense. Markets, companies and projects in the developing world have strong investment cases but are overlooked because of concerns over risk. Meanwhile, investors are comfortable putting $11 billion in tech unicorns like Uber, a company that reportedly lost more than $1 billion in the first half of 2016.

When the global stock of capital is $250 trillion and interest rates are at historic lows, we ought to be able to get more investment from the wealthy world into markets that need it most — parts of Africa and Asia, or Libya, or the Palestinian Territory, where I now work. These are markets, often post-conflict, where there is high geopolitical risk — but also great growth.

They are also markets where the difference between the 4 percent growth rate they can produce internally and the 7 percent they could reach with investment is the difference between jobs and stability and chaos.

According to a report by Oxford Economics, global infrastructure spending will be increasing annually, from around $4 trillion today to $9 trillion a year by 2025, and there will be a great need for investment in developing markets in the Arab world.

A broken investment pipeline

The break in the investment pipeline is clear when you look at the way corporations struggle to invest. Capital is flowing where it is easy, not where it is needed. Developing world investment by big multinationals, such as new factories and infrastructure, shrank to $440 billion from $460 billion in 2014–15, according to the U.N. Conference on Trade and Development. Continuing a long-term trend, African foreign direct investment declined 20 percent, to $70 billion from $90 billion, during the same period, also according to UNCTAD.

Instead of investing for the long term, many multinationals rely on financial engineering to increase their stock prices. In 1990 share buybacks and dividend payments represented 38 percent of capital expenditure. Since 2010, the S&P 500 has spent more on share buybacks and dividends — 113 percent — than they have invested. This shift from value creation to value capture is a concern for all those seeking returns from high-growth emerging economies, including individual investors.

Deploying capital where it's needed, not just where it's easy, requires a three-pronged approach:

1. We need to rethink the concepts of risk and return.

Consider this: Uber trades at between 39 and 45 times sales. It is one of 175 unicorns in Silicon Valley. Common sense tells you how hard it will be for private investors at later-stage valuations, or public investors who buy stock after (presumed) IPOs, to make much money.

Meanwhile, it is a struggle to raise, say, a $100 million fund to invest in the power sector in a frontier market. Yet solar power or natural gas projects have clear business models and are often guaranteed by power purchase agreements underwritten by international entities such as the Overseas Private Investment Corp., an independent U.S. government agency. Returns in the mid-teens or above are realistic.

Most investors look at frontier markets broadly through a haze of fear. But the perceived risk of conflict isn't as great as you might think; conflicts are usually geographically limited. The greater risks come from underdeveloped legal and justice systems. Those risks are real but can be managed by having professional, experienced teams on the ground that know how to avoid corruption and advocate for strategic advances in law and regulation.

Abraaj Group is an example of how this can work well. With $10 billion of assets under management, it is the leading private equity investor in emerging markets outside of BRIC countries. Abraaj invests in companies focused on the consumption of the emerging middle classes —everything from restaurant chains to hospitals. It has a loss ratio of less than 2 percent.

2. We need more investable projects.

To attract investment into the Palestinian Territory, for instance, we have to make it easy for potential investors to deploy their capital. It is not sufficient to say, "Solar power is an attractive investment." We have to negotiate with the Palestinian and Israeli authorities, identify and secure the land-use approvals, and ensure power purchase agreements will be backed by international entities.

We have to find motivated investors. In the case of the Palestinian Territory and other markets, they are often found in extended diaspora communities. They have been willing to invest all along but lacked investible opportunities where the risk was managed.

Meanwhile, the need for investment is only going to grow: The cost of the Arab Spring has been estimated at more than $1 trillion, excluding the cost of the war in Syria.

A Palestinian vendor sells gifts and decoration
Mahmud Hams | Getty Images
A Palestinian vendor sells gifts and decoration

3. We need a new kind of public/private investment institution to build equity pipelines to frontier markets.

There are international institutions doing some of this work already, but they mostly finance via debt. In 2014–2015, the International Finance Corp. disbursed on average $9 billion a year: 75 percent loans; 20 percent equity and 5 percent debt securities.

What we're working on in the Palestinian Territory is a new model designed to deliver equity. The organization, Shurook (Arabic for Sunrise), is a nonprofit operated within a United Nations framework. Working with the private sector, we are creating investible projects in four arenas: medium- to large-scale solar power, water treatment, low-cost housing and health care.

An example again is solar power. The West Bank produces no power — more than 95 percent of the 900-megawatt demand is imported from Israel and the balance from Jordan. Shurook identified eight available plots with the right topography and grid accessibility and is in discussions with international finance institutions to mitigate political and operational risk.

As a donor-funded nonprofit, Shurook will not invest; its role is to walk the hard yards of early-stage project development. There are other innovators seeking profit with a purpose in challenging environments. Leap Frog Investments has roughly $1 billion under management invested in 21 portfolio companies in Africa, Asia and Latin America. It teams up with local players to develop and deliver new products and services for the underserved.

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The ROI factor

I believe innovative frontier market institutions can produce annual returns for wealthy individuals, multinationals and institutional investors, in the range of 8 percent to 10 percent over about 10 years, with risk managed to a moderate level. Remember that the Abraaj Group, that private equity firm in growth and frontier markets, has a loss ratio of less than 2 percent.

Moderate returns in unfamiliar and complex environments is not compelling for average investors.

But our task resonates with investors who understand the crucial importance of balanced global growth. The Middle East and Africa in 1990 had a population roughly the size of Europe. By 2050 it is forecast to be four times the size. Unless we find a way to sustainably deploy investment from the private sector at large scale in the countries and sectors that matter, all of our coming generations face a harsher, more chaotic world.

— By Kito de Boer, a Jerusalem-based Dutch national, former senior McKinsey director and diplomat now serving as head of mission of the Office of the Quartet, which includes the U.N., European Union, Russia and United States and mediates between the Israelis and Palestinians. He is also a CNBC-YPO Chief Executive Network member.

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