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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: The Private Equity Industry Europe United States Venture Capital Expansion Capital Venture Capital Buy-outs Private Equity 4 The role of Private Equity and Venture Capital (VC/PE) Why is VC/PE appropriate? Specialization 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 Post-investment (focus in the function) •After the investment, PE/VC firms bring: •“Hands-on” co-management •Market savvyness •Contacts for expansion & exit Typical investment “funnel” of the UK middle-market Source: BVCA, Altassets research, team analysis BVCA survey: non-financial contributions to PE-backed companies 5 World: Private Equity Growth - the good news Globally .. and in Emerging Markets Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005. 6 problem: Equity Gap in VC/PE market OECD: Gap affects early stage, innovative firms, untried business models with little collateral. Equity Financing Marketplace – UK Case Long Term; lower liquidity Medium liquidity Short Term; higher liquidity Equities, Fixed Income, Derivatives Mezzanine Private Equity PIPES £ 50M – UP “Equity Gap” £ 2M – £50M £ 750k – £2M Venture Capital Angel Investors £250k - £750k £10k - £250k £0 - £10k Corporate Stages Seed Capital Project Idea Prototype Commercialization Stable Production Source: BBAA, UK HMTC & SBS, Stratus Risk Capital, Team analysis. Pre- IPO AIM, OTC Liquid Markets, Mature Shareholder, Competition 7 problem: Equity Gap in VC/PE market Emerging markets: large deficiencies across all the supply spectrum of VC/PE Equity Financing Marketplace – EM Long Term; < liquidity Short Term; > liquidity Mezzanine Equities, Fixed Income, Derivatives PIPES £ 50M – UP Private Equity (Global Funds/ limited domestic funds) “Equity Gap” £ 2M – £50M Underdeveloped financing markets Widens the gap… £ 750k – £2M Venture Capital £250k - £750k A.I. £10k - £250k £0 - £10k Corporate Stages Seed Capital 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. 8 Emerging Markets Tartgeting of Government intervention Size Private Equity L M S Venture Capital Seed & Startup Middle Market: Main Initial Focus? Capital EMs: Government interventions early Start-up 1 Expansion/Growth Buy-out Middle Market1 Middle market: Firms well beyond early/start up stage, seeking financing to grow / expand 9 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) 10 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. 11 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 Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005. Relationship between fund size and deal size, 1984 – 2000 UK 12 Government Interventions: the importance of private sector expertise ! VC/PE: a high-risk asset class Private Equity Returns by Region vs. Broad Index Returns, as of 12/31/06 Return on investment USA, 1980 – 2002 PE/VC Max = 721% Index One Year Five Year Ten Year 20.0% PE/VC Upper Quartile 16.1% DJ 30 15.0% S&P 500 Midcap 10.0% US Corp Bonds MSCI World Ex US NYSE Microcap Willshire 500 5.0% NASDAQ PE/VC Median 4.1% 0.0% -5.0% PE/VC Lower Quartile -7.6% -10.0% PE/VC Min = -100% 26.8% 12.8% 6.1% Latin America PE 19.2% 2.3% (2.3%) Asia (ex Japan) PE 18.5% 10.5% 4.9% CEE & Russia PE 53.2% 27.1% 15.3% US PE 25.8% 17.6% 13.8% MSCI Emerging Markets 32.6% 27.0% 9.4% S&P 500 15.8% 6.2% 8.4% Lehman Brothers US Aggregate Bond Index 4.3% 5.1% 6.2% Emerging Markets VC & PE 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 14 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. 15 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) 16 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 – Avoiding overregulation as if it was mutual fund product – Improving protection and rights of VC/PE investors Build Trust in Fund Management Regulation on minority rights, standards of disclosure and fund management. 17 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 18 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) 19 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) 20 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 are essential SBIC (US), ECF (UK), Yozma (Israel), IIF (Australia), and Inovar (Brazil): lasting effect on the industry and on the innovative infrastructure • 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 – But low rates of return continued participation of governments, foundations, IFI’s Successful e.g Business Partners (South Africa) and SEAF (emerging markets). do not possess the critical mass to interest larger buyers potential growth rate below that required by VC/PE funds • 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 ] 21 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. – – – • Avoid government involvement & interference in asset allocation – • 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 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. 22 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 23 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 24 Private Equity Financing of high growth companies The role of the Government World Bank / IFC Capital Markets Advisory Nigeria, March 6 2008