Private Equity in Emerging Markets:

Learning from Early Experience

(5th Annual Financial Markets & Develop. Conf.,World Bank/IMF/ Brookings Institution)

Roger LeedsJohns Hopkins University (SAIS)

April 15, 2003Washington, DC

3 Premises About PE in Emerging Markets

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

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

3. 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

1Roger Leeds

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 2

Roger Leeds

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

3Roger Leeds

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)

4Roger Leeds

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

5Roger Leeds

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

6Roger Leeds

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

7Roger Leeds

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

8

Roger Leeds

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 large9

Roger Leeds

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.”10

Roger Leeds

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

11Roger Leeds

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 operandiPE Fund Managers Local GovernmentsDFIs Portfolio Companies

12Roger Leeds

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

13Roger Leeds

PE Industry: Work collectively to promote shared objectives

• 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)

14Roger Leeds

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

15

Roger Leeds

DFIs: The game’s over if 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

16Roger Leeds

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 training17

Roger Leeds

Conclusions• 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

18Roger Leeds