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Private Equity in Emerging Markets: Learning from Early Experience (5 th Annual Financial Markets & Develop. Conf., World Bank/IMF/ Brookings Institution). Roger Leeds Johns Hopkins University (SAIS) April 15, 2003 Washington, DC. 3 Premises About PE in Emerging Markets.

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Private Equity in

Emerging Markets:

Learning from Early Experience

(5th Annual Financial Markets & Develop. Conf.,

World Bank/IMF/ Brookings Institution)

Roger Leeds

Johns Hopkins University (SAIS)

April 15, 2003

Washington, DC

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3 Premises About PE in Emerging Markets

  • 1st generation PE funds, with few exceptions, have not met expectations of all stakeholders (M. Barth)

  • Principle explanation for poor performance -- unrealistic assumption that VC model from U.S. could be successfully exported to EMs

  • Case for PE in EMs as compelling as ever, but model must be adjusted on almost every level in order for revitalize asset class credibility


Roger Leeds

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The Rationale For PE in Emerging Markets is Compelling

  • A broad global consensus -- private sector development (PSD) in EMs highly desirable

  • Disconnect, however, between advocacy of PSD and financing of PSD

  • Result has been sharp bifurcation of private sector-- most firms have limited access to capital :

    • Banks don’t bank except for lending to govt. & largest, most creditworthy firms

    • Domestic securities markets either non-existent or only open to largest companies

    • International markets a non-starter except for very largest….

  • PE has potential to bridge gap for vast middle market between family & friends, and public markets


    Roger Leeds

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PE in Emerging Markets: Unmet Expectations

  • PE performance leaves no room for ambiguity: cash returned relative to amount invested, and timing of disbursements

  • PE exit data closely held, but anecdotal evidence (e.g., IFC) confirms industry consensus that EM returns well below expectations & taking longer to be realized

  • Litmus test for all PE funds: ability to attract follow-on funding

    • 2002– PE fund raising for L. Am. & Asia (ex-Japan) at lowest levels since 1993; no better in other regions


Roger Leeds

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Relevance of U.S. VC Model

  • Key factors for VC success in U.S. & Europe are largely absent in EMs:

    • Macroeconomic stability

    • Receptive private sector policy environment

    • Confidence-inducing legal framework

    • Well-established corporate governance, accounting & financial reporting standards

    • Professional management culture at level of both the firm and PE fund

    • Active & cooperative post-investment role

    • Functioning financial markets (debt & equity)


Roger Leeds

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Macroeconomic Conditions

  • Model has succeeded primarily in countries w/ macroeconomic stability, sustained growth & stable currencies

  • Macroeconomic instability compounds inherent risks of PE because:

    • Investments illiquid

    • Projecting future performance more precarious (e.g. valuation)

  • Aftermath of Asia crisis & Latin American currency crises, for example, had long-term negative consequences for PE investors


Roger Leeds

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Private Sector Policy Environment

  • Model depends on willingness of private savers to make PE allocation

  • Strong, well-organized industry advocacy also helps (e.g., NVCA, EVCA)

  • Domestic savings adequate in many EMs, but few incentives for private savers to invest/lend

    • Too dependent on foreign funding

  • Large, creditworthy companies ( regular access to capital) have no incentive to promote PE

  • No effective industry associations to apply collective pressure on policy makers


Roger Leeds

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Legal Framework

  • Model’s success takes for granted existence of effective legal framework

  • “Significant issues of ‘enforceability’ of key contractual rights & statutory protection for minority rights collectively act as unintended disincentive to PE investors.”(L. Am. Attorney)

  • PE investors in EMs generally are poorly protected in fundamentally important areas:

    • Bankruptcy law

    • Minority shareholder rights

    • Disclosure requirements

    • Enforceability of shareholder agreements


Roger Leeds

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Corporate Governance

  • CG = (i) accurate, timely, transparent flow of operating and financial information, & (ii) management willingness for degree of accountability by “outsiders”

  • CG far more important than with publicly listed firms, especially in EMs, because

    • investments illiquid for longer time

    • limited legal recourse

    • information asymmetries more acute

  • An alien concept to most EM candidates for PE

  • McKinsey study—investors willing to pay up to 30% premium for well governed EM firms


Roger Leeds

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Professional Management

  • Model thrives on good management

    • “I invest in management, not ideas.”

      – Eugene Kleiner, Venture Capitalist

  • Family-owned firms predominate in most EMs

  • Secrecy is deeply embedded in management culture-- intermingling of financial interests of owner & firm are commonplace

    • No need/desire for independent audits

    • No pressure from independent directors

    • Tax evasion well-established method of financing growth

  • Everything works well until financing needs become too large


Roger Leeds

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Post-Investment Role

  • VC Mantra: “The real work begins after the money is disbursed.”

    • Even more true in EMs, where building firm value far more difficult

  • PE skill set required to make an investment very different than to enhance firm value

    • Investment bankers—do deal, collect fee, move to next deal; no operating experience

  • Post-investment success requires permanent local presence & deep knowledge of indigenous business culture

    • “We no longer invest where we do not have eyes and ears permanently on the ground.”


Roger Leeds

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Functioning Financial Markets

  • Competitive firms everywhere require access to both debt & equity

    • Schumpeter: “He can only become an entrepreneur by first becoming a debtor.”

  • Unlisted companies (PE market) in EMs over-dependent on equity -- weak banking sectors

    • Creates inefficient firm capital structure

    • Negative impact on IRR

  • Functioning IPO market is the most important success factor for entire PE industry

    • In U.S. VC firms earned 60% average IRR with IPO exits, vs. about 15% with strategic sales

  • Exit via IPO in EMs usually not an option


Roger Leeds

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Learning From Experience: Needs To Change?

  • Broad consensus– U.S. VC model has not traveled well to EMs

    • Contrary to expectations, similarities do not outweigh differences

  • Early PE performance indicates that all stakeholders must/are adjusting their modus operandi

    PE Fund Managers Local Governments

    DFIs Portfolio Companies


Roger Leeds

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PE Fund Managers: Align business model more closely w/ EM realities

  • Permanent local presence & professional staff are an imperative

  • Premium on skills training for professional staff

  • Professionals w/ operating experience to concentrate on post-investment role

    • Willingness & ability to build firm value

  • More proactive deal origination

    • “The best deals are ones we create.”

  • Tighter shareholder agreements w/ more explicit minority rights

  • Rigorous & realistic assessment of exit strategy before finalizing investment


Roger Leeds

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PE Industry: Work collectively to promote shared objectives realities

  • Establish reliable global standards for valuation & financial reporting geared to private equity in EMs

    • fund certification

  • Mobilize broad industry support to pressure EM govts. on PE-specific policy reform

  • Organize practitioner training to overcome acute shortage of EM-based private equity professionals w/ requisite skills (e.g., EVCA Institute)

  • Create mechanisms for more knowledge sharing & best practices (information clearinghouse)


Roger Leeds

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Local govts: actively support policy reforms to increase PE investing

  • Awareness that limited access to capital for huge middle market severely undermines PSD public policy objective

  • Market forces alone will not close financing gap

    • Follow OECD country examples—range of incentives

  • PE can help bridge the gap, but only if govts. actively promote essential policy reforms

    • Protect minority shareholder rights

    • Promote sound corporate governance practices

    • Liberalize restrictions on institutional investors

    • Facilitate access to public equity markets

    • Financial incentives for domestic PE investors


Roger Leeds

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DFIs: The game’s over investingif they retreat!

  • IFC has largest PE portfolio in EMs (invested in >140 PE funds); catalyst for channeling >$5billion of PE to EM firms

  • IFC track record no better (or worse) than most other PE funds, leading some staff to advocate withdrawal

  • In absence of active IFC involvement (i.e. risk sharing), why should domestic govts., other DFIs, & private investors support PE?

  • Traditionally sets the standard--must play leadership role to re-energize industry


Roger Leeds

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DFIs: Capitalize on traditional strengths as catalyst for PSD

  • Finance new PE funds when demonstrable evidence that creating additionality

    • Use leverage to attract quality private investors

    • Rigorous fund manager screening & monitoring

  • More aggressive, tougher promoter of local govt. policy reform (e.g. conditionality)

  • Serve as incubator for creative new thinking on PE investing in EMs (e.g. transferring best practices)

  • Actively support fund manager training


Roger Leeds

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Conclusions PSD

  • Original rationale for PE in EMs as compelling as ever

    • PSD won’t happen in absence of more diversified funding sources

    • Private sector bifurcated--most firms limited or no access to capital

    • Market inefficiencies breed PE opportunities (theoretically!)

  • Reasons for PE underperformance well understood and adjustments being made

  • Some countries beginning to recognize PE potential & undertaking important reforms (e.g. Brazil, India)

  • Keep a realistic perspective-- even U.S. model evolved slowly, amidst much trial & error

  • Investors will slowly return to fund managers who have demonstrable track record

    • Huge spread between performance of best & rest


Roger Leeds