LIST OF ABBREVIATIONS
2 PRIVATE EQUITY
2.2 EARLY-STAGE FINANCING: VENTURE CAPITAL
2.3 LATER STAGE FINANCING: PRIVATE EQUITY AND BUYOUTS
2.4 EXIT STRATEGIES
2.5 AGENCY PROBLEMS IN PRIVATE EQUITY
3 EMERGING MARKETS
3.2 DIFFERENCES AMONG EMERGING MARKETS
3.3 SPECIFIC RISKS
3.4 EMERGING FINANCIAL MARKETS
3.5 EMERGING MARKET CORPORATE GOVERNANCE
4 PRIVATE EQUITY INVESTMENT IN EMERGING MARKETS
4.1 HISTORY AND RECENT DEVELOPMENTS
4.1.1 FROM THE LATE 1980S TO THE 21ST CENTURY
4.1.2 FUNDRAISING IN 2005 AND 2006
4.1.3 DRIVERS OF LIMITED PARTNER INTEREST
4.2 DETERMINANTS OF EMERGING MARKETS PRIVATE EQUITY
4.2.1 MACROECONOMIC ENVIRONMENT
4.2.2 LEGAL FRAMEWORK
4.2.3 CAPITAL MARKETS
4.3 INTRODUCTION OF GOOD CORPORATE GOVERNANCE
4.4 KEY SUCCESS FACTORS
4.4.1 DUE DILIGENCE
4.4.3 INVOLVEMENT AND VALUE CREATION
5 CRITICAL ANALYSIS
5.1 THE INVESTOR’S PERSPECTIVE: RISK AND REWARD
5.2 THE ENTREPRENEUR’S PERSPECTIVE: SOURCE OF EQUITY
6 CONCLUSION AND OUTLOOK
List of Abbreviations
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During the first years of the 21st century Private Equity Investment in Emerging Markets showed strong growth and attracted an increasing number of investors from all over the world. But before the success story started there was a period of disappointing results and unfulfilled expectations among investors who underestimated the difficulties and special requirements of the target countries.
The paper is structured as follows: The second chapter gives a brief definition of Private Equity (PE) and describes different forms of investment and exit options. Chapter three provides an overview about Emerging Markets (EM) and points out some special characteristics. In the fourth chapter the theoretical framework is applied to the reality of Private Equity Investment in Emerging Markets. Chapter five provides a critical analysis of Emerging Markets Private Equity and points out benefits for developing countries. The sixth and last chapter contains a brief conclusion and outlines potential future prospects.
2 Private Equity
Private Equity has been the fastest-growing market for corporate finance over the last years. Nevertheless, it received only little attention in the academic literature, partly due to the nature of the industry which ranks confidentiality the highest and acts in private.1
There is no generally accepted definition of the term “Private Equity”.2 A key issue is the missing clear distinction between Private Equity and Venture Capital (VC) in the literature. While in the U.S. this distinction is often made, Zalan criticizes the fact that in Europe “PE is synonymous with VC”3. This is no longer entirely true: According to the European Venture Capital Association’s (EVCA) general definition for PE, the term describes the provision of equity capital to enterprises not listed on a stock market, while Venture Capital is a subset of Private Equity. A detailed clarification is provided in chapter 2.2. In this paper the EVCA definition is applied. Private Equity is used as a general term which includes Venture Capital as a subset.
Private Equity is the opposite of public equity, i.e. stock and bond markets. The main purpose of PE is the funding of firms which have no access to capital markets yet but reached a stage of growth which requires outside financing or firms which are in financial distress.4 These firms have no possibility to use debt financing, mainly because they cannot offer collaterals. PE is the bridge between internal financing and capital market activity and offers highly structured financial contracts to companies which are informationally opaque.5
The Private Equity market lacks regulation and is associated with high risk profiles and illiquidity.6 PE firms therefore take the role of a financial intermediary and produce information for institutional investors such as pension funds, banks and insurance companies. They use techniques like screening, contracting and monitoring to assess the quality of the companies they invest in, in order to reduce information asymmetries.7
In contrast to other means and vehicles of finance Private Equity has a unique character in terms of the special services PE firms provide. Scholars call it “competent capital” or “smart money” and refer to the integration of investment banking and management consultancy. PE firms not only provide money but also advice regarding risk management, marketing, strategy and networking. This generally also involves a more personal relationship between the PE managers and the entrepreneur of the financed company.8
Contracts in the PE funding process between the investor and the PE firm contain two parties: the limited partner (LP) and the general partner (GP). The limited partner is typically an institutional investor such as a pension fund, insurance company or bank. The general partner is a professional PE fund manager who earns a fixed fee plus a carried interest.9 Since institutional investors lack the skills necessary in the PE industry, they rely on the experience and specific advantages PE firms have acquired. These limited partnerships have finite live spans and typically last for ten years.10 PE funds are classified as closed-end funds and therefore differ from open-end funds like mutual funds.
2.2 Early-Stage Financing: Venture Capital
As already mentioned, the term Venture Capital describes a subset of the more general Private Equity. Venture Capital firms mainly finance new companies and focus on the first phase of the life cycle. VC investments typically have a shorter life span than PE investments.
Apple Computers, Federal Express, Microsoft, Compaq, Oracle, and Sun Microsystems are recent examples for VC funding and enormous growth. Within less than 20 years these companies had become world leaders. Therefore VC is believed to be instrumental in rapidly bringing innovations to the market, creating economic growth and jobs.11
Venture Capital excludes buyout transactions.12 This means that VC investors assist the entrepreneur as a minority stakeholder and do not tend to exchange the existing management. In contrast, Private Equity investments also include buyouts and a take-over of a majority stake in the company (see chapter 2.3).
A study conducted by Millson/Ward showed some differences regarding the importance of management experience in financed companies. While PE managers ranked experienced management the highest and described this aspect as critical, Venture Capitalists were less concerned with the managers’ prior success and more willing to trust inexperienced teams.13 This is unsurprising and highlights that VC fund managers are less risk averse.
Seed financing and start-up financing are more precise terms for different types of VC early-stage funding.14 The role of a VC firm is to take the portfolio company to a stage where other forms of finance are appropriate.15 Seed financing enables the company to take the first steps like product and market research while start-up financing usually sets in when the first stage is completed and the company starts to market its products.16
Early-stage financing means not only one single injection of funds but several rounds of finance. This also allows more control over the management as further financing depends on the fulfilment of contracts.17
A special subset of Venture Capital is angel financing. The term refers to “angel investors” or “business angels”, meaning High Net Worth Individuals spending time and money to finance start-ups and restructuring companies. The major difference between PE or VC and angel financing is the more informal approach of angel investors. It is their intention to make a value-added contribution and spread the knowledge which they acquired during their professional career.18 Angel financing typically takes the form of seed financing.
2.3 Later Stage Financing: Private Equity and Buyouts
Private Equity financing is a general term and can be divided into subcategories. The distinction is mainly based on the financial involvement of an existing or external management team or the debt-equity ratio (leverage).
When a portfolio company moves past the early stage, the need for expansion makes later-stage financing necessary. This type of investment is on the border of Venture Capital and Private Equity.19 Firms in financial distress are also included in this target group. Besides the mere provision of funds as an equity stakeholder of a not publicly listed company buyouts play an important role in the PE industry.
Management buyouts (MBO) and management buyins (MBI) describe the involvement of the management team. By exercising a MBO the existing management team takes control over the company, assisted by external financing through a PE firm. A MBI basically describes the same issue, but in this case an external management team buys the company from the vendor and replaces the current management team. In both cases the PE firm takes a majority stake in the company. The involvement of the management guarantees a higher degree of commitment and entrepreneurial leadership.20
The term leveraged buyout (LBO) describes the PE investment including external debt financing. The debt is collateralised with the assets of the acquired company. This type of investment offers high returns due to the leverage effect – the debt including fixed interest is repaid by the cash flow of the acquired business, the PE investor will receive any remaining surplus. The return is usually realized within three to five years.21
2.4 Exit strategies
For PE firms, the only way to receive a return on their investment is an exit. Companies in an early stage of growth or recovering after financial distress are unlikely to pay dividends to their equity investors.
The timing and the decision how to perform the exit is critical. Close monitoring is required and the interests of the investors and the entrepreneurs have to be in line.22 The most common exit strategies are an Initial Public Offering (IPO), a trade sale or a secondary buyout, which are described in the following. Other, less favoured and common types of exits are buybacks (the entrepreneur repurchases the equity stake from the PE firm) and write-offs or liquidation (the PE firm walks away from the investment with little or no return).
An IPO describes the public listing of a company on the stock exchange. Generally, an IPO is the preferred way to exit a Private Equity investment.23 Nevertheless, this does not mean that the IPO is indeed the most common form of exit strategy. Since the IPO market is characterized by information asymmetries just like the PE market, the offered shares could be underpriced and therefore fail to provide an attractive return to the PE investors.24
Research shows that the involvement of Private Equity has a positive impact on the performance of an IPO compared to the performance of non-PE backed IPOs.25 The engagement of the PE firm helps reducing information asymmetries and has a signalling effect to potential investors.
While the IPO is the most preferred form of exit, the trade sale is the most common way. The term describes a sale to a third party which is usually a company of the same industry or a diversified large corporation. Trade sales provide immediate liquidity to the seller, in contrast to an IPO. However, the objectives of the entrepreneur may not be satisfied.26 The sale to a competitor could lead to a loss of control of the entrepreneur.
A secondary buyout is a sale of a portfolio company from one Private Equity firm to another. Typically it involves a VC firm which wants to realize its early stage investment and a later-stage PE investor. “The secondary market increases transparency, increases understanding of the assets, and raises the level of confidence of investors that they will be able to see liquidity,” says Scott Myers, a Partner at the investment bank Cogent Partners.27
2.5 Agency Problems in Private Equity
There are two sources for agency problems associated with Private Equity: The relationship between the LP and the GP as well as the relationship between the PE firm and the entrepreneur. In order to avoid these problems incentives and monitoring are necessary. Incentives for mutual gains bring the objectives of the PE firm and the entrepreneur in line.28 Monitoring starts with an extensive due diligence, assessing all relevant aspects and figures regarding the investees’ business, and is continued by frequent visits and meetings with the company management and involvement in the board of directors.29
The agency problems between PE firms and LPs are minimized by the short life span of the fund and the possibility to withdraw funds or withhold new funds in later stages.30
1 See Fenn et al. (1995), p. 1.
2 See Zalan (2004), p. 2. Jeng/Wells (2000), p. 243, also include investments in publicly quoted companies in the term ”Private Equity”, which will not be regarded in this paper.
3 See Zalan (2004), p. 2.
4 See Leeds/Sunderland (2003), p. 9.
5 See Berger/Udell (1998), p. 614.
6 See Cumming/Johan (2007), p. 4.
7 See Berger/Udell (1998), p. 614 and Eckstaller/Huber-Jahn (2006), p. 11.
8 See Zalan (2004), p. 4.
9 See Cumming/Johan (2007), p. 5.
10 See Lerner/Schoar (2004), p. 7.
11 See Jeng/Wells (2000), p. 242.
12 See Jeng/Wells (2000), p. 243.
13 See Millson/Ward (2005), p. 79.
14 See Gupta/Sapienza (1992), p. 349 and Eckstaller/Huber-Jahn (2006), p. 22-23.
15 See Wright/Robbie (1998), p. 526.
16 See Jeng/Wells (2000), p. 243.
17 See Wright/Robbie (1998), p. 527.
18 See Wright/Robbie (1998), p. 531. See Lerner (1998) for a more detailed overview about Angel financing.
19 See Jeng/Wells (2000), p. 244-245.
20 See Frien (2004), p. 6.
21 See Olsen/Gagliano (2003), p. 3-4.
22 See Wright/Robbie (1998), p. 549-540.
23 See Jeng/Wells (2000), p. 254.
24 See Berger/Udell (1998), p. 634.
25 See Berger/Udell (1998), p. 634.
26 See Wright/Robbie (1998), p. 551.
27 See EMPEA (2006), p. 7.
28 See Wright/Robbie (1998), p. 533.
29 See Jeng/Wells (2000), p. 247.
30 See Jeng/Wells (2000), p. 253.
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- Private Equity Emerging Markets Alternative Investments International Finance Smart Money BRIC Venture Capital