Private Equity Financing of high growth companies

The role of the Government

CLEMENTE DEL VALLE World Bank / IFC Capital Markets Advisory Nigeria, March 6 2008

Main Findings OECD

The Challenge of growth Employment in high-growth firms

Contributions by different size classes

Source: OECD (2000) 2

Main Findings OECD

The Challenge of growth

High-growth firms and their contribution to job gains Source: OECD (2000) 3

Private Equity: Definiton VC/PE

“medium to long-term finance provided in return for an equity stake in potentially high growth unquoted companies” (BVCA)

For the purposes of this study: VC/ PE includes quasi-equity transactions, which rely on hybrid equity/debt instruments involving a stream of dividends dependent on firm performance as returns. Market scope: Europe United States

Venture Capital

The Private Equity Industry

Expansion Capital Venture Capital Buy-outs Private Equity

4

The role of Private Equity and Venture Capital (VC/PE)

Why is VC/PE appropriate?

Pre-investment (focus in the process)

•

PE/VC firms are very specialized in selecting investments because they excell in two process:

•

Screening process

•

Due dilligence

Specialization

Post-investment (focus in the function)

•

After the investment, PE/VC firms bring:

•

“Hands-on” co-management

•

Market savvyness

•

Contacts for expansion & exit

BVCA survey: non-financial contributions to PE-backed companies Typical investment “funnel” of the UK middle-market 5 Source: BVCA, Altassets research, team analysis

World: Private Equity Growth - the good news

Globally .. and in Emerging Markets

Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

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problem: Equity Gap in VC/PE market

OECD: Gap affects early stage, innovative firms, untried business models with little collateral.

£ 50M – UP Equity Financing Marketplace – UK Case Long Term; lower liquidity Medium liquidity Short Term; higher liquidity Mezzanine Equities, Fixed Income, Derivatives Private Equity “Equity Gap” £ 2M – £50M £ 750k – £2M Venture Capital £250k - £750k Angel Investors £10k - £250k £0 - £

1

0k Corporate Stages Seed Capital Project Idea Prototype Commercialization Stable Production Pre- IPO AIM, OTC Liquid Markets, Mature Shareholder, Competition Source: BBAA, UK HMTC & SBS, Stratus Risk Capital, Team analysis.

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problem: Equity Gap in VC/PE market

Emerging markets: large deficiencies across all the supply spectrum of VC/PE

Underdeveloped financing markets Widens the gap…

£ 50M – UP Equity Financing Marketplace – EM Long Term; < liquidity “Equity Gap” Short Term; > liquidity Mezzanine Equities, Fixed Income, Derivatives Private Equity (Global Funds/ limited domestic funds) £ 2M – £50M £ 750k – £2M Venture Capital £250k - £750k A.I. £10k - £250k £0 - £

1

0k Seed Capital Corporate Stages Project Idea Prototype Commercialization Stable Production Pre- IPO Liquid Markets, Mature Shareholder, Competition

… affecting more stages of business development.

Source: BBAA, UK HMTC & SBS, Stratus Risk Capital, Team analysis.

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Emerging Markets

Tartgeting of Government intervention Size L Private Equity Venture Capital M S Seed & Startup Capital

Start-up

early

Middle Market: Main Initial Focus?

EMs: Government interventions

Expansion/Growth Middle Market1 Buy-out

1 Middle market: Firms well beyond early/start up stage, seeking financing to grow / expand

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problem: Equity Gap in VC/PE market

Emerging markets: large deficiencies across all the supply spectrum of VC/PE

• • • • •

The equity and debt gaps are much larger in the EM’s PE industry

: – Seed & Startup Capital coming primarily from family and friends – and VC: at very low levels – PE: high dependency on foreign capital + Fund management expertise very limited

Financial system constraints: absence of medium/long term credit But simultaneously: High Saving Rates



how to tap these savings?

Growing interests from governments but still very few cases of structured interventions ( e.g. South Africa, Brazil)

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Reasons behind the

Equity Gap

1 - due to sluggish growth in the early development of VC/PE industry

Growth concentrated in Asia – NOT elsewhere where industry is at nascent stage Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

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Reasons behind

Equity Gap in VC/PE market

2 - due to migration towards late stage (economies of scale) •

as PE industry develops & grows, tends to become concentrated on the later stage of market

which offers better risk-adjust returns, due to the economies of scale of this activity UK - Total VC/PE Investment, 1990 - 2002 Relationship between fund size and deal size, 1984 – 2000 UK Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

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Government Interventions: the importance of private sector expertise !

VC/PE:

a

high-risk asset class

Return on investment USA, 1980 – 2002 20.0% DJ 30 15.0% 10.0% S&P 500 Microcap Midcap US Corp Bonds NYSE Willshire 500 5.0% PE/VC Max = 721% NASDAQ PE/VC Upper Quartile 16.1% MSCI World Ex US PE/VC Median 4.1% 0.0% -5.0% -10.0% PE/VC Lower Quartile -7.6% PE/VC Min = -100%

Index

Private Equity Returns by Region vs. Broad Index Returns, as of 12/31/06

One Year Five Year Ten Year Emerging Markets VC & PE Latin America PE Asia (ex Japan) PE CEE & Russia PE US PE

26.8% 19.2% 18.5% 53.2% 25.8%

MSCI Emerging Markets

32.6%

S&P 500 Lehman Brothers US Aggregate Bond Index

15.8% 4.3% 12.8% 2.3% 10.5% 27.1% 17.6% 27.0% 6.2% 5.1% 6.1% (2.3%) 4.9% 15.3% 13.8% 9.4% 8.4% 6.2%

Private Equity = High Risk!

Source:Lerner (2005), Cambridge Associates, team analysis 13

Government Interventions: the importance of private sector expertise !

“Persistency”- Success in Private Equity is not Luck, it is Skill.

Mc Kinsey finding in Europe: “If your first fund was top quartile, there is a 45% chance your next fund will also be top 25% and a 73% chance it will be top half. A new fund management team has a 16% chance of being in the top quartile.

Success in private equity is

persistent

.”

Conor Kehoe, Partner McKinsey & Co., EVCA, June 13, 2001

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Government Interventions: the importance of investment expertise !

Skill is More Valuable in VC/PE than in other asset classes

In private equity, the spread between top performers and average performers is large. If you are not with a top fund manager, you would do better investing in bonds

.

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Government Interventions:

Typology

•

Business Enabling Environment

Legal, enforcement, obtaining credit, starting a business, IPR, etc.

(Taken as a given in OECD / challenging in emerging markets) • • •

Stimulate growth of PE/VC industry

Enabling Regulation Tax framework Public/Private Investment Programs

Focus of this study • • •

Other Related Policies

Innovation and industrial policy Public equity markets Support VC/PE sector (valuation standards, associations, research, international linkages, etc)

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Government Interventions:

Enabling Regulation • Enabling access to Institutional Investors’ Capital – VC/PE: possibility to

tap into a vast pool of national savings

– Institutional investors: opportunities for

diversification and improved returns.

• Supervision of Vehicles and Fund Management – Vehicles, balance between  Protection of public investors  Flexibility towards professionals – Licencing  Build Trust in Fund Management – Avoiding overregulation as if it was mutual fund product – Improving protection and rights of VC/PE investors  Regulation on minority rights, standards of disclosure and fund management.

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Government Interventions:

Tax framework

• Legal Framework Vehicles – – Tax pass-through capability = PE/VC funds exempt from corporate tax Limited liability on the passive investors  Limited Liability Partnership (US, UK)  Closed end investment fund (Brazil, Taiwan, Spain ) • Investment inducing Tax Policy – Low tax rates on capital gains (CGT)  US (15%), UK (10-18%), Brazil (15%): – Carried interest = generally 20% of capital gains of PE/VC funds earned by partners  Taxed at CGT rate: major stimulus for PE/VC industry

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Government Interventions:

Public/Private Investment Programs • Co-Investment funds, potentially with enhanced returns for Private Investors – Government capital provided as limited partner  management by private sector • Funds of Funds – Government capital provided to PE/VC funds that invest in other PE/VC funds • Quasi-Equity, leveraging VC/PE funds (e.g. SBIC) – Quasi-equity = debt with an upside reward – Government offering long term debt in PE/VC deals (at public debt rates) • Tax break induced programs (e.g. UK’s EIS and VCT) – Tax induced retail investment – directly in companies (EIS), or in trust funds (VCT)

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Emerging Markets Lessons learned and recommendations

Regulation:

Enabling increased private equity activity

•

Liberalizing investment restrictions on local institutional investors

– Pension funds & Insurance Co’s  largest source of capital in OECD – US: legislation change 1979 ERISA  start of explosive growth in PE/VC – Brazil: 2000 Pension funds allowed to invest up to 20% of assets in PE/VC – Brazil: since liberalization: strong growth in PE/VC & IPO’s of PE/VC-backed firms •

Supervision

– Supervising the professionalism of the manager but not regulating the vehicle (FSA in UK) – Allowing only qualified investors to access VC/PE vehicles [ Brazil ] •

Taxation

– Investment vehicles with tax pass-through capability [US LLP or similar – Adjusted frameworks (e.g. trusts, open funds) – differential fiscal treatment of carried interest acknowledges high risk [ US, UK ] •

Reducing tax and capital controls on the repatriation of (long-term) capital gains

– Brazil (0% rate, no capital controls), South Africa (reducing capital controls)

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Emerging Markets Lessons learned and recommendations

Investment Programs:

Market-based approach is preferred to direct government equity investments.

• The

expertise and profit-seeking instincts of professional fund managers

SBIC (US), ECF (UK), Yozma (Israel), IIF (Australia), and Inovar (Brazil):  lasting effect on the industry and on the innovative infrastructure are essential • Government as limited partner: harms-length relationship to

prevent government involvement in the management and asset allocation

of the fund. • VC/PE funds need a

minimum critical mass

below which they are not viable economically •

Hybrid financing instruments - quasi-equity

– –

SMEs

do not possess the critical mass to interest larger buyers potential growth rate below that required by VC/PE funds But low rates of return  continued participation of governments, foundations, IFI’s Successful e.g Business Partners (South Africa) and SEAF (emerging markets).

•

Asymmetric allocation of returns

rewarding more private investors than government Incentive

not yet explored in most emerging economies

. – Requires careful calibration, Good results in US, UK, Australia, Israel ]

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Emerging Markets Lessons learned and recommendations

Investment Programs: - Professional fund management capacity and investor expertise

- Governance and Evaluation

•

Professional expertise key to the development of the VC/PE industry.

– promoting and funding education and training initiatives at national and international settings (e.g. Inovar program) – inducing the teaming international general partners (e.g. Yozma program) – allocate resources to funds managed by new managers •

Avoid government involvement & interference in asset allocation

– Capital for Enterprise Board in the UK: staffed by private sector experts manage public-private schemes.

•

Evaluation of impact & returns, and accountability of private agents managing funds where public resources are invested

– UK: involving external professionals and academic experts – monitoring of public resources expenditure & learning – Brazil (Inovar Program): periodic evaluation is required by the Inter-American Development Bank.

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Emerging Markets Lessons learned and recommendations

Final Remarks

•

Innovation and Education policy



important for early-stage VC

– Investments in R&D (US & UK: long established tradition) – Support Entrepeneurship (incl bridge with Universities ) •

Early stage VC Policy ≠ Employment Policy

 South Africa VC programs: gains in job creation and Black Empowrment, but inability to create sustainable VC market  Brazil VC program (Inovar): limited resources but multiplicative, lasting effect in VC •

Long term political commitment to regulations & programs

– Success in UK attributed to consistent bipartisan policies for decades – Inovar project in Brazil (VC)  additional stability factor: presence of MDFI (IDB) •

Coordination between agencies

– PE/VC policies & programs typical implemented by agencies dependend on different ministeries and levels (loca/state/federal) of government  need for coordination

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Main Takeaways for Emerging Markets

• • •

Evidence of an “equity gap” PE/VC development fills the gap & boosts growth

– – – –

Governments have a role in developing the market

Enable appropriate Regulation (incl Taxation) Build Capacity/Expertise Attract private funds through Co-investment Stimulate Innovation (R&D, education) & Entreperneurship

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Private Equity Financing of high growth companies

The role of the Government

World Bank / IFC Capital Markets Advisory Nigeria, March 6 2008