Private Equity Financing of high growth companies

1. Private Equity Financing of high growth companies The role of the Government CLEMENTE DEL VALLE World Bank / IFC Capital Markets Advisory Nigeria, March 6 2008

2. Employment in high-growth firms Contributions by different size classes Main Findings OECD The Challenge of growth Source: OECD (2000)

3. High-growth firms and their contribution to job gains Main Findings OECD The Challenge of growth Source: OECD (2000)

4. Private Equity: Definiton VC/PE“medium to long-term finance provided in return for anequity stake in potentially high growth unquoted companies” (BVCA) For the purposes of this study: VC/ PE includes quasi-equity transactions, which rely on hybrid equity/debt instruments involving a stream of dividends dependent on firm performance as returns. Market scope:

5. The role of Private Equity and Venture Capital (VC/PE)Why is VC/PE appropriate? Specialization Pre-investment (focus in the process) Post-investment (focus in the function) • PE/VC firms are very specialized in • selecting investments because • they excell in two process: • Screening process • Due dilligence • After the investment, PE/VC • firms bring: • “Hands-on” co-management • Market savvyness • Contacts for expansion & exit BVCA survey: non-financial contributions to PE-backed companies Typical investment “funnel” of the UK middle-market Source: BVCA, Altassets research, team analysis

6. World: Private Equity Growth - the good news Globally .. and in Emerging Markets Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

7. problem: Equity Gap in VC/PE market “Equity Gap” OECD: Gap affects early stage, innovative firms, untried business models with little collateral. Equity Financing Marketplace – UK Case Long Term; lower liquidity Short Term; higher liquidity Medium liquidity Mezzanine Equities, Fixed Income, Derivatives £50M – UP Private Equity PIPES £2M – £50M £750k – £2M Venture Capital £250k - £750k Angel Investors £10k - £250k £0 - £10k Seed Capital Project Idea Liquid Markets, Mature Shareholder, Competition Corporate Stages Stable Production AIM, OTC Pre- IPO Commercialization Prototype Source: BBAA, UK HMTC & SBS, Stratus Risk Capital, Team analysis.

8. problem: Equity Gap in VC/PE market Emerging markets: large deficiencies across all the supply spectrum of VC/PE Equity Financing Marketplace – EM Long Term; < liquidity Short Term; > liquidity Mezzanine Equities, Fixed Income, Derivatives £50M – UP Private Equity (Global Funds/ limited domestic funds) PIPES “Equity Gap” £2M – £50M £750k – £2M Underdeveloped financing markets Widens the gap… Venture Capital £250k - £750k A.I. £10k - £250k £0 - £10k Seed Capital Project Idea Liquid Markets, Mature Shareholder, Competition Corporate Stages Stable Production Pre- IPO Commercialization Prototype … affecting more stages of business development. Source: BBAA, UK HMTC & SBS, Stratus Risk Capital, Team analysis.

9. Emerging MarketsTartgeting of Government intervention Private Equity Venture Capital Seed & Startup Capital Middle Market: Main Initial Focus? EMs: Government interventions Size Start-up 1 Middle market: Firms well beyond early/start up stage, seeking financing to grow / expand

10. problem: Equity Gap in VC/PE market Emerging markets: large deficiencies across all the supply spectrum of VC/PE • The equity and debt gaps are much larger in the EM’s • PE industry: • Seed & Startup Capital coming primarily from family and friends • and VC: at very low levels • PE: high dependency on foreign capital + Fund management expertise very limited • Financial system constraints: absence of medium/long term credit • But simultaneously: High Saving Rates  how to tap these savings? • Growing interests from governments but still very few cases of structured interventions ( e.g. South Africa, Brazil)

11. Reasons behind the Equity Gap1 - due to sluggish growth in the early development of VC/PE industry Growth concentrated in Asia – NOT elsewhere where industry is at nascent stage Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

12. Reasons behind Equity Gap in VC/PE market 2 - due to migration towards late stage (economies of scale) UK - Total VC/PE Investment, 1990 - 2002 • as PE industry develops & grows, tends to become concentrated on the later stage of marketwhich offers better risk-adjust returns, due to the economies of scale of this activity Relationship between fund size and deal size, 1984 – 2000 UK Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

13. Government Interventions: the importance of private sectorexpertise !VC/PE: a high-risk asset class Return on investment USA, 1980 – 2002 PE/VC Max = 721% 20.0% PE/VC Upper Quartile 16.1% DJ 30 15.0% S&P 500 US Corp Bonds MSCI World Ex US Midcap NYSE Microcap 10.0% Willshire 500 NASDAQ 5.0% PE/VC Median 4.1% 0.0% -5.0% PE/VC Lower Quartile -7.6% -10.0% PE/VC Min = -100% Private Equity Returns by Region vs. Broad Index Returns, as of 12/31/06 Private Equity = High Risk! Source:Lerner (2005), Cambridge Associates, team analysis

14. Government Interventions: the importance of private sectorexpertise !“Persistency”- Success in Private Equity is not Luck, it is Skill. Mc Kinsey finding in Europe: “If your first fund was top quartile, there is a 45% chance your next fund will also be top 25% and a 73% chance it will be top half. A new fund management team has a 16% chance of being in the top quartile. Success in private equity is persistent.” Conor Kehoe, Partner McKinsey & Co., EVCA, June 13, 2001

15. Government Interventions: the importance of investment expertise !Skill is More Valuable in VC/PE than in other asset classes In private equity, the spread between top performers and average performers is large. If you are not with a top fund manager, you would do better investing in bonds.

16. GovernmentInterventions: Typology Business Enabling Environment • Legal, enforcement, obtaining credit, starting a business, IPR, etc. (Taken as a given in OECD / challenging in emerging markets) Stimulate growth of PE/VC industry • Enabling Regulation • Tax framework • Public/Private Investment Programs Other Related Policies • Innovation and industrial policy • Public equity markets • Support VC/PE sector (valuation standards, associations, research, international linkages, etc) Focus of this study

17. GovernmentInterventions:Enabling Regulation • Enabling access to Institutional Investors’ Capital • VC/PE: possibility to tap into a vast pool of national savings • Institutional investors: opportunities for diversification and improved returns. • Supervision of Vehicles and Fund Management • Vehicles, balance between  Protection of public investors Flexibility towards professionals • Licencing  Build Trust in Fund Management • Avoiding overregulation as if it was mutual fund product • Improving protection and rights of VC/PE investors Regulation on minority rights, standards of disclosure and fund management.

18. GovernmentInterventions:Tax framework • Legal Framework Vehicles • Tax pass-through capability = PE/VC funds exempt from corporate tax • Limited liability on the passive investors  Limited Liability Partnership (US, UK)  Closed end investment fund (Brazil, Taiwan, Spain ) • Investment inducing Tax Policy • Low tax rates on capital gains (CGT) US (15%), UK (10-18%), Brazil (15%): • Carried interest = generally 20% of capital gains of PE/VC funds earned by partners Taxed at CGT rate: major stimulus for PE/VC industry

19. GovernmentInterventions:Public/Private Investment Programs • Co-Investment funds, potentially with enhanced returns for Private Investors • Government capital provided as limited partner  management by private sector • Funds of Funds • Government capital provided to PE/VC funds that invest in other PE/VC funds • Quasi-Equity, leveraging VC/PE funds (e.g. SBIC) • Quasi-equity = debt with an upside reward • Government offering long term debt in PE/VC deals (at public debt rates) • Tax break induced programs (e.g. UK’s EIS and VCT) • Tax induced retail investment – directly in companies (EIS), or in trust funds (VCT)

20. Emerging Markets Lessons learned and recommendationsRegulation: Enabling increased private equity activity • Liberalizing investment restrictions on local institutional investors • Pension funds & Insurance Co’s  largest source of capital in OECD • US: legislation change 1979 ERISA  start of explosive growth in PE/VC • Brazil: 2000 Pension funds allowed to invest up to 20% of assets in PE/VC • Brazil: since liberalization: strong growth in PE/VC & IPO’s of PE/VC-backed firms • Supervision • Supervising the professionalism of the manager but not regulating the vehicle (FSA in UK) • Allowing only qualified investors to access VC/PE vehicles [ Brazil ] • Taxation • Investment vehicleswith tax pass-through capability [US LLP or similar • Adjusted frameworks (e.g. trusts, open funds) • differential fiscal treatment of carried interest acknowledges high risk [ US, UK ] • Reducing tax and capital controls on the repatriation of (long-term) capital gains • Brazil (0% rate, no capital controls), South Africa (reducing capital controls)

21. Emerging Markets Lessons learned and recommendationsInvestment Programs: Market-based approach is preferred to direct government equity investments. • The expertise and profit-seeking instincts of professional fund managers are essentialSBIC (US), ECF (UK), Yozma (Israel), IIF (Australia), and Inovar (Brazil): lasting effect on the industry and on the innovative infrastructure • Government as limited partner: harms-length relationship to prevent government involvement in the management and asset allocation of the fund. • VC/PE funds need a minimum critical mass below which they are not viable economically • Hybrid financing instruments - quasi-equity • SMEs do not possess the critical mass to interest larger buyers potential growth rate below that required by VC/PE funds • But low rates of return  continued participation of governments, foundations, IFI’s Successful e.g Business Partners (South Africa) and SEAF (emerging markets). • Asymmetric allocation of returns rewarding more private investors than governmentIncentive not yet explored in most emerging economies. • Requires careful calibration, Good results in US, UK, Australia, Israel ]

22. Emerging Markets Lessons learned and recommendationsInvestment Programs: - Professional fund management capacity and investor expertise - Governance and Evaluation • Professional expertise key to the development of the VC/PE industry. • promoting and funding education and training initiatives at national and international settings (e.g. Inovar program) • inducing the teaming international general partners (e.g. Yozma program) • allocate resources to funds managed by new managers • Avoid government involvement & interference in asset allocation • Capital for Enterprise Board in the UK: staffed by private sector experts manage public-private schemes. • Evaluation of impact & returns, and accountability of private agents managing funds where public resources are invested • UK: involving external professionals and academic experts – monitoring of public resources expenditure & learning • Brazil (Inovar Program): periodic evaluation is required by the Inter-American Development Bank.

23. Emerging Markets Lessons learned and recommendations Final Remarks • Innovation and Education policy  important for early-stage VC • Investments in R&D (US & UK: long established tradition) • Support Entrepeneurship (incl bridge with Universities ) • Early-stage VC Policy ≠ Employment Policy - South Africa VC programs: gains in job creation and Black Empowrment, but inability to create sustainable VC market  Brazil VC program (Inovar): limited resources but multiplicative, lasting effect in VC • Long term political commitment to regulations & programs • Success in UK attributed to consistent bipartisan policies for decades • Inovar project in Brazil (VC)  additional stability factor: presence of MDFI (IDB) • Coordination between agencies • PE/VC policies & programs typical implemented by agencies dependend on different ministeries and levels (loca/state/federal) of government  need for coordination

24. Main Takeaways for Emerging Markets • Evidence of an “equity gap” • PE/VC development fills the gap & boosts growth • Governments have a role in developing the market • Enable appropriate Regulation (incl Taxation) • Build Capacity/Expertise • Attract private funds through Co-investment • Stimulate Innovation (R&D, education) & Entreperneurship

25. Private Equity Financing of high growth companies The role of the Government World Bank / IFC Capital Markets Advisory Nigeria, March 6 2008