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London Business School

London Business School. November 5, 2009 Prof. Roger Leeds. Clarifying Terminology -“Private Equity,” “Venture Capital,” “Mezzanine Finance,” “Buy-Out,” “Hedge Fund”. “ Private equity ”– Generic term refers to all the above; increasingly imprecise term

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London Business School

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  1. London Business School November 5, 2009 Prof. Roger Leeds

  2. Clarifying Terminology-“Private Equity,” “Venture Capital,” “Mezzanine Finance,” “Buy-Out,” “Hedge Fund” • “Private equity”– Generic term refers to all the above; increasingly imprecise term • Huge range of target firms- from early stage/start-ups to SMEs to multi-billion $ publicly listed companies “going private” • Huge range of PE fund size -from <$10 million to > $15-20 billion • Virtually every sector, from high-tech to manufacturing, services, real estate, banks • Not just equity—various types of debt (LBOs), mezzanine Prof. Roger Leeds, Nov. 2009

  3. PE Common Characteristics • Medium to long-term illiquid financial commitment • Investors usually in legally structured private partnerships (the PE fund) • Fund manager (GP)-sophisticated investors with financial & operating expertise • Illiquidity & concentrated ownership create incentive to enhance firm value (active Investors) • Valuation, terms & conditions result from process of negotiation (except publicly traded companies) • Alignment of interests between investor & management • All of above geared to creating opportunity for exit with substantial returns—dependent on achieving performance enhancements Prof. Roger Leeds, Nov. 2009

  4. Most “Western” Buyouts Don’t Fit Developing Country Profile • TRANSACTIONSIZE: TEND TO BE HUGE (Billions) • CONTROL: MAJORITY OR 100% • PUBLICLY LISTED COMPANIES • HIGHLY LEVERAGED—60-80% DEBT; ASSUMES AVAILABILITY OF RELATIVELY CHEAP DEBT • AUCTIONS & “CLUB DEALS” INCREASINGLY COMMON • FINANCIAL ENGINEERING/RESTRUCTURING RATHER THAN HANDS-ON VALUE CREATION • DEVELOPED FINANCIAL MARKETS TAKEN FOR GRANTED (E.G. EXITS, CREDIT MARKETS) EM PE…A DIFFERENT RISK PROFILE, REQUIRING DIFFERENT SKILL SET… Prof. Roger Leeds, Nov. 2009

  5. EM PE-Different Market, Requiring Different Skill Set • Higher country risks • Macroeconomic volatility • Weak legal protection for investors • Thin domestic debt & equity markets • Limited exit alternatives • Thin professional management class • More challenging due diligence & valuation • Less disclosure requirements/enforcement • Information asymmetries more severe • Accounting and reporting standards less reliable • Sub-standard corporate governance (e.g. transparency & management accountability) Prof. Roger Leeds, Nov. 2009

  6. EM PE Market-Covers Broad Range • Start-ups-early stage (VC) • Established family-run firms seeking to expand & become more competitive • Medium-sized, established companies at pre-IPO stage • Consolidation of independent firms within same sector (“roll-ups”) • Restructuring/ turn-around situations (post-Asia financial crisis) • Privatizations What do all EM PE candidates have in common? Prof. Roger Leeds, Nov. 2009

  7. EM PE Market-Covers Broad Range • Start-ups-early stage (VC) • Established family-run firms seeking to expand & become more competitive • Medium-sized, established companies at pre-IPO stage • Consolidation of independent firms within same sector (“roll-ups”) • Restructuring/ turn-around situations (post-Asia financial crisis) • Privatizations What do all EM PE candidates have in common? Prof. Roger Leeds, Nov. 2009

  8. Victims of Financing Gap • Majority of EM companies have limited or no access to medium/long-term capital • But not due to capital shortage • Many developing countries have savings rates in 30-50% range, compared to 17% in U.S., 15% in England and 23% in Germany • Assets of largest EM institutional investors (pension & mutual funds) substantial & growing , but govt. regs impede PE investing • Government borrowing absorbs large portion of private savings Prof. Roger Leeds, Nov. 2009

  9. Financial Sector Weakness= PE Opportunity Funding Source Access Domestic bank credit (>1 year) Limited Domestic stock market Very Limited Domestic bond market No Govt. programs Yes Int’l equity markets No Int’l credit No Int’l develop. finance (IFC, IIC) Limited Private equity Limited Prof. Roger Leeds, Nov. 2009

  10. Limited Financing Alternatives Enhance PE Opportunity • “Patient Capital”- medium/long-term, illiquid; • Alignment of interests between investor and management; share incentive to enhance firm value; prerequisite for exit • Non-financial value added-incentive & expertise to strengthen corp. governance, financial reporting, access to new markets, etc. • Catalyst-PE strengthens other ingredients for private sector development (e.g.corp. governance, IPO deal flow) Prof. Roger Leeds, Nov. 2009

  11. Inefficiencies Generate PE Opportunity • Successful PE investors (everywhere) identify & capitalize on inefficiencies • Rampant EM inefficiencies a prime explanation for rapid EM PE growth • Companies-weak corp. governance, financial controls, marketing….. • Sectors-over-populated with under-financed companies unable to achieve scale • Countries-anti-competitive regulations, labor law rigidities, taxes • Course focuses on both heightened EM risks and opportunities created by inefficiencies Prof. Roger Leeds, Nov. 2009

  12. Post-Investment Value Enhancement VC Mantra:“The real work begins after money is disbursed.” • More true in EMs-building firm value more difficult • 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 local presence, deep knowledge of indigenous business culture, and cooperative management • “We no longer invest where we do not have eyes and ears permanently on the ground.” Prof. Roger Leeds, Nov. 2009

  13. PE Contribution to Value Enhancement (e.g. earnings growth, multiples expansion) • Financial engineering-B/S restructuring • Identify & negotiate additional funding sources • Recruitment -new management & board members • Leverage industry contacts to identify suppliers, customers, markets • Operational restructuring- gross margin improvement, operating expense reduction • IPO Preparations • Exit preparation Prof. Roger Leeds, Nov. 2009

  14. EM PE Performance: Fundraising & Investment:2003-2008 Prof. Roger Leeds, Nov. 2009

  15. EM PE Fundraising By Region: 2006-2008

  16. Global PE Fundraising: 2001-2008 USD Millions Source: EMPEA, 3i PwC, APER, BVCA, Dealogic, Dow Jones, EVCA, GVCA, KPMG, NVCA, RVCA, SAVCA , Thomson, VELA, Zawya *YTD 2008 figures cover the period starting January 1, 2008 and ending December 9, 2008. Prof. Roger Leeds, Nov. 2009

  17. Global PE Investment: 2001-2008USD Millions Source: EMPEA, 3i PwC, APER, BVCA, Dealogic, Dow Jones, EVCA, GVCA, KPMG, NVCA, RVCA, SAVCA , Thomson, VELA, Zawya*YTD 2008 figures cover the period starting January 1, 2008 and ending December 9, 2008. Prof. Roger Leeds, Nov. 2009

  18. EM PE Returns: Steadily Improving Relative to U.S. & European Funds…Until Late 2008 Cambridge Associates EM PE/VC Index (as of 30 September 2008) Source: Cambridge Associates LLC Proprietary Index: pooled end-to-end returns, net of fees, expenses and carried interest. Prof. Roger Leeds, Nov. 2009 18

  19. Emerging markets still under-penetrated Source: EMPEA estimates. Note: Emerging Asia excludes Japan, Australia, New Zealand. Prof. Roger Leeds, Nov. 2009

  20. PE Fundraising as % of GDP (2007)

  21. PE Fundraising as % of GDP by Region (2007)

  22. The risk premium for EM PE rose from 6.7% in 2008 to 7.2% in the 2009 Survey LPs’ perception of risk premiums required for EM PE funds relative to developed market buyout funds * Categorized as “Pan Africa” in the 2008 survey. LP assessment of risk has gone up for all markets except Brazil; China and India relatively unchanged Prof. Roger Leeds, Nov. 2009 EMPEA/Coller Capital Emerging Markets Private Equity Survey, Global Private Equity Conference May 2009.

  23. EM Attractiveness over Next 12 Months: Country Rankings (LP Survey, March 2009) Prof. Roger Leeds, Nov. 2009 EMPEA/Coller Capital Emerging Markets Private Equity Survey, Global Private Equity Conference May 2009.

  24. Emerging Market Economies Outperforming Developed Countries during Financial Crisis GDP Developed vs. Emerging GDP Emerging Market Regions But performance varies significantly across regions. Prof. Roger Leeds, Nov. 2009 Source: International Monetary Fund, World Economic Outlook Database, April 2009

  25. Financial Crisis Consequences-Some Good News • EM PE industry better positioned to withstand down cycle –deeper, more established than 5 years ago • Financial crises generally lead to lower valuations, less competition, more PE opportunity (e.g. growth capital, restructurings, distressed asset sales) • Historically, PE deals consummated during times of crisis tend to outperform • Long-term perspective-key drivers of EM PE growth during past 5 years have not evaporated! * See reading assignment Prof. Roger Leeds, Nov. 2009

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