Private Equity in Developing Countries
The past several years have seen a boom in private equity activity in the developing world. This has been fueled largely by institutional investors based in the United States. The reasons for this growth are several. Among them has been the recent rapid growth of many developing nations and the relaxation of curbs on foreign investments in many of these nations. Perhaps equally important has been the recent perception by many institutional investors that the returns from private equity investments in the U.S. are likely to decrease in upcoming years.
While comprehensive data is hard to come by, a few examples may help illustrate these patterns. [No single directory captures private equity activity in the developing world. The Asian data is drawn from Asian Venture Capital Journal, The Guide to Venture Capital in Asia: 1995/1996 Edition, Hong Kong, Asian Venture Capital Journal, 1995; the Latin American data is compiled from the Private Equity Analyst and various stories and studies cited in the "Further Readings" section.] In 1994 alone, private equity funds based in Hong Kong and China raised a total of $3.1 billion in capital. Two-thirds of the capital came from outside Asia, with the single largest source being U.S. institutions. This sum was more than the total raised by professional private equity organizations there since the first fund was raised in Hong Kong in 1981. In 1994 and 1995, Latin American funds raised $1.4 billion. This represented several times the amount that had been raised previously by funds in the region. India, Eastern Europe, South Africa, and Israel are just a few of the other areas where multiple private equity funds have recently been or currently are being raised. In addition, funds based in the U.S. are increasingly investing directly in transactions in the developing world, often in conjunction with these funds.
This essay seeks to identify some of the key challenges and opportunities that private equity investors in developing nations will face. The first section presents a broad overview of some of the key reasons why developing nations are increasingly seen as an attractive investment environment by institutional investors and private equity funds. The note then considers the "private equity cycle." Sections II through IV examine the process from fundraising through investing to exiting, contrasting developing and developed nations. The opportunities that make private equity in developing countries so attractive are highlighted, as well as the potential risks.
It is worth cautioning that this essay only tries to identify broad patterns. This discussion should not blind the reader to the substantial heterogeneity in the private equity industries of various developing countries. A key reason for these differences, of course, is that developing nations differ along many dimensions among themselves. Please bear this caution in mind as you read through this essay.
I. Why Invest in Developing Nations?
In this section, we will discuss two sets of rationales for the growth of private equity activity in the developing world. [According to the World Bank, developing nations are those countries that have either low- or middle-level per capita incomes; have underdeveloped capital markets; and/or are not industrialized. It should be noted, however, that the application of these criteria is somewhat subjective. For instance, Kuwait appears on many lists of developing nations despite its high per capita gross domestic product. The reason for its inclusion lies in the income distribution inequality that exists there, which has not allowed it to reach the general living standards of developed countries.] The first relate to the changes in the developing nations themselves. Many have undertaken radical reforms. External changes--e.g., technological innovations--have also helped make these nations more attractive arenas for investment. The second set relate to the changing conditions in the developed nations. Many institutional investors are skeptical that attractive returns that have recently characterized venture capital and leveraged buy-out investments in many developed nations can be sustained, and are looking for new arenas in which to invest.
The increasing attractiveness of developing nations Much of the interest in private equity investing in developing nations must be attributed to their economic progress over the past decade. A critical impetus to much of this progress, in turn, has been the economic reforms adopted by many of these nations. The pace at which capitalism has rolled through developing economies is breathtaking. It is easy to forget that as recently as a decade ago, only one billion of the world’s citizens were in capitalist economies. Today, three times that number are in economies that are strongly capitalist in orientation. [For a provocative discussion of these changes from a practitioner perspective, see Lucy Conger, "Interview-Garantia launches Brazil Equity Fund", Reuters News Service, September 26, 1995.]
While a detailed discussion of these changes is beyond the scope of this note, it is worth noting a few of these reforms. One of the most substantial macroeconomic shifts was the 1989 Brady Plan. This allowed several Latin American countries to restructure their external debt. The enormous reduction in debt service led to a substantial boost in the economic health of these markets. The successful reform process led to a increase in major investors' confidence in developing nations: as seen, for instance, in the increase in the market prices of these nations' debt.
Other macroeconomic reforms were initiated by the developing nations themselves, though often with the prodding of such international bodies as the International Monetary Fund. One arena for such reforms has been major tax reforms. Many developing countries realized that one way to fuel the economy is by lowering taxes on capital gains, thereby encouraging equity investment and stock market growth. Likewise, in many nations, restrictions on foreign investment--which often prohibited investments in particular industries, stipulated that foreign investors needed to hold a minority stake, or limited the repatriation of profits--have been relaxed. Finally, several developing nations have made great progress in improving their accounting and disclosure standards. These changes have served to lower the costs of investing in these nations, as well as to diminish the information asymmetries that the foreign investors face.
Other drivers of the economic progress of developing nations have been external. An example is the lowering by many developed nations of many tariff and non-tariff barriers to imports from developing nations. Both exports and imports by developing nations more than tripled between 1987 and 1995. [ International Monetary Fund, International Financial Statistics Yearbook, Washington, International Monetary Fund, 1996.] A second example is technological change. Thanks to innovations in information and communication technologies, investors in developed countries--whether corporations or institutions--can better monitor their investments. A substantial decline in inflation-adjusted transportation costs has also made greater trade and investment feasible. These trends have led to spectacular growth in many of the developing nations. While the developed economies grew at an inflation-adjusted annual rate of 1.9% between 1990 and 1994, emerging market economies grew at 5.2%. [Ibid.]
The decreasing attractiveness of developed nations A second critical factor in the growth of private equity investing in developing countries has been the perception of diminishing investment opportunities in the developed nations, particularly the United States. The pool of private equity under management in the U.S. has grown from $4 billion in 1980 to about $125 billion in 1995. This growth has largely been attributable to the relaxation of the formal and informal curbs that limited private and pension funds from investing in private equity.
This growth, many institutional investors argue, has had three deleterious consequences. First, the increase in the size of many private equity funds has led to an alteration in the incentive structure of these funds. In particular, the management fees charged by private equity investors have remained relatively constant, averaging about 2% (typically calculated as a percentage of capital under management). But since the capital managed per partner has increased dramatically, this has meant that these fees have become a significant source of income. Many investors fear that the incentive provided by the share of the profits reserved for the private equity investors has consequently become less effective. Second, many private equity organizations have encountered strong demand when they seek to raise new funds. This allowed them to negotiate partnership agreements without the many covenants that protect investors in these funds. If an institution insisted on the inclusion of a particular form of protection, the venture capitalists could simply exclude them from the transaction. Finally, many institutional investors argue that the current market is characterized by an imbalance between the supply of capital and attractive investments. Many argue that this has led to unjustifiable increases in valuations, or, more colloquially, the phenomenon of "money chasing deals."
These concerns are also leading to institutional investors, particularly in the U.S., to consider more favorably private equity funds specializing elsewhere. One focus has been continental Europe, which has lagged both the U.S. and United Kingdom in the supply of private equity. But the low inflation-adjusted growth rates in many European nations have led many institutions to focus on the developing nations.
Why private equity? In view of the above patterns, it may not be surprising that institutional investors have been have been investing in a broad array of asset classes in developing nations. Institutional holdings of both public equities and corporate and government debt have both increased sharply in recent years. But a particular focus of interest recently has been international private equity funds.
This interest is illustrated by a 1995 survey of 204 of the largest U.S. institutional investors conducted by Goldman Sachs and Frank Russell Capital. It found that international private equity had increased from representing 0.0% of all alternative investments in 1992 to 5.8% in 1995. In a few short years, participation in this asset class (by the institutions that had invested in any alternative assets) went from virtually zero to 51%. Of the remaining firms, more than one-half indicated that they were currently considering investments in international private equity funds. Furthermore, international private equity was the asset class that the institutions identified as the most attractive and with the highest expected future returns. [Goldman, Sachs & Co. and Frank Russell Capital Inc., 1995 Survey of Alternative Investments by Pension Funds, Endowments and Foundations, New York: Goldman, Sachs & Co. and Frank Russell Capital Inc., 1996.]
Institutional investors frequently justify their interest in private equity funds in developing nations by highlighting the similarities to venture capital in the United States. Like venture capital investments, many companies in developing nations are characterized by great uncertainty, difficult-to-value assets, and substantial information asymmetries. In the developing world, a venture capital-like style of investment should consequently yield attractive returns.
II. The Private Equity Cycle: Fundraising
In many respects, private equity in developing and developed countries is similar. In both settings, it can be defined as professional investors who provide equity or equity-linked capital to privately held firms. Another key element is the ongoing involvement of the private equity investor in monitoring and assisting the company. Where private equity in developing countries differs is in its implementation. The next three sections will highlight some of these differences.
Fund structures The fund structure standard in developed countries is the limited partnership. The general partners are the individual venture capitalists (or an investment management firm controlled by these individuals). The general partners are in charge of raising, making, monitoring, and exiting the investments. In return they are paid a management fee plus a share of the profits. The limited partners are prohibited from playing an active role in managing the investments and usually enjoy tax benefits. For instance, taxes are typically paid not at the fund level, but rather by the individual general and limited partners. This enables tax-exempt investors to avoid almost all tax obligations.
This limited partnership structure has served as a model for many private equity funds in developing countries. For instance, all but one of the funds focusing in Latin America have been structured along the lines of U.S.-style limited partnerships. [Lorenzo Weissman, "The Advent of Private Equity in Latin America," The Columbia Journal of World Business, 31 (Spring 1996) 60-68 (this information is on page 68).] A major issue for venture capital funds in Asia, however, has been the general lack of legal structures that allow the establishment of limited partnerships.
Without the ability to form a limited partnership, most Asian venture capital funds are structured as corporations. This corporate structure puts several limitations on the limited partners' ability to insure that the fund will dissolve at the end of a stated period (e.g., ten years). With the corporate structure, it is easier for the general partners to prolong the fund's life. Since the forced liquidation--and the consequent need for general partners to return for additional funds--is one of the most powerful control rights exercised by limited partners, it is not surprising that this has been a major concern.
Capital sources The sources of funds for private equity funds in the developing nations have largely been the same ones who invest in private equity funds based in the United States: pension funds, corporations, insurance companies, and high net worth individuals. To date, U.S.-based organizations have made up the bulk of these investors. European investors are gradually increasing in importance.
Several additional set of parties, however, have played an important role in the raising of private equity funds in developing nations. These have included U.S. foreign aid organizations like the U.S. Agency for International Development (USAID), quasi-governmental corporations like the Overseas Private Investment Corporation (OPIC), and multilateral financial institutions like the International Finance Corporation (IFC). Their role has been two-fold. First, USAID and IFC have invested in funds directly. Rather than serving as traditional limited partners, however, they have typically provided financial support through long-term loans or direct grants. Second, these agencies have provided guarantees to private investors that they will receive some or all of their capital back. OPIC has been particularly aggressive in providing such guarantees.
The track record of these public efforts has been somewhat mixed. A recent internal critique at USAID argued that of all the funds that it had supported over the past two decades, only one--the Latin American Agribusiness Development Corporation (LAAD)--had proven over time to be sustainable. [James W. Fox, "The Venture Capital Mirage: An Assessment of USAID Experience with Equity Investment," Working paper, Center for Development Information and Evaluation, U.S. Agency for International Development, Washington, 1996.] Furthermore, it argued, this fund had become sustainable only by shifting from equity funding to more conventional agribusiness lending.
The critique attributed this poor performance to two factors. First, the government bodies often chose the wrong investors to invest in or guarantee. In many cases, the implementing institution had little or no previous experience as a private equity investor. The funds' ability to attract the right individuals to manage the portfolios was often been limited by government restrictions on the compensation of the investors. A second problem was the excessive constraints on the implementers. Many private equity funds were given very narrow mandates, such as very small businesses, the agricultural sector, and women-owned businesses. Since the number of potential investments was somewhat limited at best, the sustainability of the funds was severely impacted by these restrictions. In other cases, the government bodies conducted lengthy reviews of potential investments, and consequently the funds lost the opportunity to participate in attractive deals. It should be noted, however, it would have been very difficult to obtain attractive returns from private equity investments in most developing nations during the 1970s and 1980s, even under the best of circumstances.
One source that is likely to become an increasingly important source of capital for private equity funds is retirement savings in the developing nations themselves. East Asian nations have very high savings rates, often about 30% of gross domestic product. These high rates partially reflect the younger average age in developing countries, as well as cultural differences. While many of these individual savings are invested informally in the privately held businesses of relatives and friends, little has been directed into institutional private equity funds.
These patterns are likely to change in future years. Leading the way has been Chile, which has privatized much of its retirement savings. Assets in private pension plans have risen to $25 billion—50% of current GDP. Pension funds have already helped to finance privatization programs in Chile, taking equity positions of between 10% and 35% in privatized firms. As the funds have grown, regulators have increasingly widened the fields in which they can invest. Several are considering initiating private equity investment programs. [For a general overview, see Jim Freer, "The Private Pension Path," LatinFinance, (July/August 1995) 34-38; for a specific discussion of future investment plans, see Felipe Sandoval, "CORFO Targets Small and Medium Enterprises," Chile Economic Report, (Summer 1995) 2-9.]
III. The Private Equity Cycle: Investing
The investment process in developing and developed nations is often very different. In this section, we will discuss four aspects of these differences: the types of deals that are considered, the process by which companies are identified and evaluated, the structuring of the investments, and valuation.
Types of investments Private equity funds in developed nations undertake a diverse array of potential transactions. Venture capitalists in the United States usually target high-technology sectors of the economy, while buyout firms focus on more mature firms in a variety of industries which need to restructure or combine. By way of contrast, funds in developing nations generally target already-established firms in traditional industries. (A notable exception is India, where software firms have been successfully attracting investments.)
Typical investments by developing country private equity funds fall into four broad categories. The first are privatizations. The World Bank estimates that 80 countries in recent years have made privatization a primary public-policy concern. More than 7,000 large-scale privatizations have been undertaken, at an annual rate of $25 billion per year. [These statistics are from William L. Megginson, Robert C. Nash, and Matthias van Randenborgh, "The Financial and Operating Performance of Newly Privatized Firms," Journal of Finance, 49 (1994) 403-452 (the information is on page 404).] Many of these newly privatized enterprises are undercapitalized and desperately need to modernize. The simple distribution of shares to employees or others will not solve their need for financing. In many cases, the national capital markets are still not well developed, and access to international markets is limited to the largest firms. Consequently, governments and the private sector are turning to private equity to fill the investment gap.
A second market opportunity has been corporate restructurings. Globalization has implied increased competition for many businesses in developing countries: lower trade barriers and new regulatory frameworks have forced companies to refocus their activities. Furthermore, the transfer of technologies and techniques from developed nations have provided new challenges, which existing management has often not been capable of meeting. Consequently, many private equity investments in developing nations have focused on either (i) purchasing and improving the operations of established firms or business units, or (ii) consolidating smaller businesses to achieve large, more cost-effective enterprises.
The final two categories of private equity investors are largely unique to the developing world. The first of these is investments in strategic alliances. In many cases, major corporations have made strategic investments (acquisitions, joint ventures, and alliances) in developing countries without a detailed knowledge of the business environment or their partners. To address these information gaps, corporations have increasingly welcomed private equity funds as third-party investors. The private equity investor is expected to provide much of the informed monitoring of the local partner that the corporation finds difficult to undertake.
A final class of investment has been infrastructure funds. Most infrastructure projects in the developed world have been financed through the issuance of bonds. In some developing nations, particularly in Asia, private equity funds have financed major projects, such as bridges, docks, and highways.
There are several reasons for the reluctance of private equity investors in developing nations to make the kinds of early-stage, technology-intensive investments that U.S. venture capitalists specialize in. First, of course, in many markets trained technical talent and the necessary infrastructure (e.g., state-of-the-art research laboratories) are scarce. Second, in many nations intellectual property protection is weak, or the enforcement of these rights questionable. Thus, even if one was able to develop a successful product, it is unclear how rapid imitation could be avoided. A third factor is the difficulty in exiting these investments (discussed in more detail below). Finally, many investors argue that investing in a developing country is already a very risky act. To take on additional business risk would be imprudent. Consequently, they concentrate on mature enterprises with established track records.
Deal identification and due diligence The screening of investments is a major focus of private equity funds in developed nations. Typically, a venture capitalist in the U.S. receives several hundred times more proposals than he could invest in. Funds develop broad criteria to quickly select the deals that later on will be subject to in-depth evaluation.
In developing countries, private equity investors have to be more opportunistic, since the number of attractive investments is lower. While deals are identified from the same sources--e.g., other entrepreneurs and business intermediaries like lawyers and accountants--most investors take a much more active strategy. They exploit tight relationships among business and social groups in the region. This often gives them a first-mover advantage over outside investors without such ties.
The criteria employed by private equity investors are similar in developed and developing nations. In interviews, both sets of investors place management as the overriding factor in the success of any venture. Many speak of the need for "chemistry" among venture capitalists and the entrepreneur, and seek to evaluate the management team's commitment, drive, honesty, reputation, and creativity. Other criteria--such as the size of the market, the threat of obsolescence, and the ability to exit the investment--are also similar. In evaluating potential deals, however, private equity investors in developing nations emphasize two sets of risks often not encountered in developed nations. The first of these is country risk. A revolution, for instance, might lead to the nationalization of foreign investments. A more common threat, however, is the potential costs of rent-seeking behavior. The highly regulated infrastructure sector is usually of great concern to investors because politically motivated regulatory changes can directly affect cash flows. Investors need to carefully analyze the institutions and legal framework as well as industry regulations. One very visible example of the potential costs of this behavior was the Enron Dabhol project in India. In this case, the recently elected government of Maharashtra, a state in India, canceled the power plant contract of Enron for the largest proposed foreign investment in India. Accused of bribery and overcharging, Enron agreed to renegotiate the contract even though it claimed already to have spent $300 million on the unfinished plant. [For an overview, see Louis T. Wells, and Courtney Sprague, "Conflict in Maharashtra," Case No. 9-796-147, Graduate School of Business Administration, Harvard University, Boston, 1996.] Working to limit these dangers, however, may be government's concerns about the reputational consequences of such actions: i.e., the potential of their actions to deter future private investment and to invite criticism from multilateral financial organizations.
A second concern is exchange rate risk. While this is hardly unique to developing countries, the Mexican peso devaluation dramatically demonstrated the volatility of these markets. A major devaluation of a developing nation's currency could lead to a sharp drop in the returns enjoyed by its U.S. investors. Ways to mitigate this risk include entering into currency swaps, the purchase of options based on relative currency prices, or the purchase of forward currency. Since the nature and timing of the future payments is usually unknown to private equity investors, however, this poses some real challenges. While hedging tools have attracted increasing interest, their actual use by private equity investors in developing nations appears to be very limited to date.
Deal structuring The choice of financing vehicle also differs between developed and developing markets. Investors in developed nations use a variety of instruments, including common and several classes of preferred stock, debt, and convertible preferred. These financial instruments allow the private equity investors to stage investments, allocate risk, control management, provide incentives to executives, and demarcate ownership.
In many developing countries, private equity investors primarily use plain common stock. This reflects several factors. First, in several countries, especially in Asia, different classes of stock with different voting powers are not permitted. Thus, investors must seek other ways in which to control the firm. These are often of extreme importance, since most of the companies are family owned or controlled. Such control rights allow the venture capitalists to step in during such messy controversies such as a dispute between two sons as to who should succeed the father as president.
While the structure of the investments may differ, shareholder agreements in developed and developing countries are likely to include the same control rights. These include affirmative covenants--such as the investors’ right to access the firm’s premises and records--as well as negative covenants that limit actions that the entrepreneur might take, such as the sale or purchase of significant assets of the firm. While the terms may be similar, their enforceability may vary. The enforceability of these shareholders' agreements depends strongly on the country or region of the investment. For instance, they are usually enforceable in Latin courts, but they may not hold in some Asian courts like China’s.
Pricing Significant differences also appear in the pricing of transactions in developed and developing nations. Reflecting the later stage of most investments, the types of spectacular returns seen in U.S. ventures such as Digital Equipment, Genentech, and Netscape are not often encountered. As William Hambrecht, chairman of the San Francisco-based investment bank Hambrecht & Quist, points out, "Asian investing success in baseball terms is characterized by double and triples, not the occasional home run characteristic of U.S. venture capital." [Wendi Tanaka, "Advising the Asia Investor: Experts Say It May be a Gold Mine, but No Quick Rewards," The San Francisco Examiner, September 20, 1994.]
Venture capitalists’ assessment of the value of a company in a developing nation is often problematic. Challenges abound at many levels. For instance, many developing countries lack timely and accurate macroeconomic and financial information. Sometimes macroeconomic variables published by central banks are manipulated by governments to portray a healthier economy. These uncertainties--combined with political and regulatory risks--may make it extremely difficult to draw up reasonably accurate projections. The uncertainty increases further since most private companies do not even have audited financial statements, especially family-run businesses. Furthermore, accounting principles and practices, although improving, are still very different from Western standards.
IV. The Private Equity Cycle: Exiting
Perhaps the most vexing aspect of venture investing in developing nations has been the difficulty of exit. The fortunes of private equity investors in the developed world have been largely linked to those of the market for initial public offerings (IPOs). Studies of the U.S. market suggest that the most profitable private equity investments have, on average, been disproportionately exited by way of IPOs. In both Europe and the U.S., there has been a strong link between the health of the IPO market and the ability of private equity funds to raise more capital.
Private equity investors in developing countries cannot rely on these offerings. Even in "hot markets" where large foreign capital inflows are occurring, institutional funds are usually concentrated in a few of the largest corporations. Smaller and new firms typically do not attract significant institutional holdings, and have much less liquidity.
An illustration of these claims is India, which saw over 2000 IPOs between January 1991 and April 1995. Despite the volume of IPOs, the public market has not been an attractive avenue for exiting private equity investments. The bulk of these offerings appear to be bought by individual investors, who purchase them at huge discounts (the typical share trades on the day of its offering at 106% above its offering price). After the offering, trading appears to be very thin for most offerings. For instance, 18% of the offerings do not trade on the day immediately after the offering (most of these apparently never trade again). It would be very difficult for a private equity investor to liquidate a substantial stake in a young firm through this mechanism. [Ajay Shah, "The Indian IPO Market: Empirical Facts," Working paper, Centre for Monitoring the Indian Economy, Bombay, 1995.] The situation in many other emerging markets, which lack the infrastructure of settlement procedures, payment systems, custodial or safekeeping facilities, and regulations is even bleaker.
Consequently, private equity investors in developing countries have tended to rely on the sale to portfolio firms to strategic investors. This can be problematic, however, when the number of potential buyers is small. The purchaser can exploit the private equity investor's need to exit the investment, and acquire the company for below its fair value. This is particularly likely to be the case when the firm invests in a strategic alliance: the only feasible purchasers are likely to be the other partners in the alliance.
Several private organizations have tried to develop creative approaches to the exiting problem. Examples include the listing of the shares on an exchange in a developed country, and the acquisition of a similar firm in a developed country (which is subsequently merged with the firm in the developing nation). This is likely to be an area for continued innovation in the years to come.
V. Looking Forward
The future of private equity in the developing world remains highly uncertain. But there are reasons to be optimistic. The growth in interest on the part of U.S. institutional investors suggest that--at least for the next few years--capital should be available. The increasing involvement of leading private equity organizations in investments in developing nations should increase the quality of the deal selection and management. The evolution of institutions such as national securities exchanges, regulatory agencies, banking systems, and capital markets suggest that the difficult problem of exiting investments may be eventually be addressed. Perhaps most persuasively, the types of environments where private equity funds have thrived in the U.S. are quite similar to developing nations: the investors have specialized in financing illiquid, difficult-to-value firms in environments with substantial uncertainty and information asymmetries. In short, it would not be surprising if the private equity industry in developing nations slowly matures, with the investment cycle becoming increasingly similar to that of developed nations.
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Gonzalo Pacanins, MBA '97, prepared this essay under the supervision of Professor Josh Lerner.
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