Download Private Equity Financing of High Growth Companies

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)
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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
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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
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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.
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
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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.
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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
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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
Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.
Relationship between fund size and deal size, 1984 – 2000 UK
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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
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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
–
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.
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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 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 ]
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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.
–
–
–
•
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.
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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