Private Equity in Emerging Markets: Learning from Early Experience (5 th Annual Financial Markets & Develop. Conf.

1. 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

2. 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 1 Roger Leeds

3. 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

4. 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 3 Roger Leeds

5. 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) 4 Roger Leeds

6. 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 5 Roger Leeds

7. 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 6 Roger Leeds

8. 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 7 Roger Leeds

9. 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

10. 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 9 Roger Leeds

11. 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

12. 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 11 Roger Leeds

13. 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 12 Roger Leeds

14. 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 13 Roger Leeds

15. 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) 14 Roger Leeds

16. 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

17. 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 16 Roger Leeds

18. 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 17 Roger Leeds

19. 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 18 Roger Leeds