Private Equity Financing of high growth companies

CLEMENTE DEL VALLEWorld Bank / IFC Capital Markets AdvisoryNigeria, March 6 2008

The role of the Government

2

Main Findings OECD

The Challenge of growth

Employment in high-growth firmsContributions by different size classes

Source: OECD (2000)

3

Main Findings OECD

The Challenge of growth

High-growth firms and their contribution to job gains

Source: OECD (2000)

4

Private Equity: Definiton VC/PE

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

The Private Equity Industry

Europe Venture Capital Expansion Capital Buy-outs

United States Venture Capital Private Equity

VC/ PE includes quasi-equity transactions, which rely on hybrid

equity/debt instruments involving a stream of dividends

dependent on firm performance as returns.

For the purposes of this study:

Market scope:

5

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

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 BVCA survey: non-financial contributions to PE-backed companies

Source: BVCA, Altassets research, team analysis

Specialization

6Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

World: Private Equity Growth - the good news

Globally

.. and in Emerging Markets

7

problem: Equity Gap in VC/PE market

Short Term; higher liquidityLong Term; lower liquidity

Equities, Fixed Income, Derivatives

Project Idea Prototype Stable

ProductionCommercialization

Angel Investors

CorporateStages

SeedCapital£0 - £10k

£250k - £750k

£ 750k – £2M

£ 2M – £50M

£10k - £250k

£ 50M – UP

Pre- IPO Liquid Markets, Mature Shareholder, Competition

Venture Capital

Equity Financing Marketplace – UK Case

Mezzanine

Private Equity

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

“Equity Gap”

PIP

ES

AIM, OTC

Medium liquidity

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

8

Short Term; > liquidityLong Term; < liquidity

Equities, Fixed Income, Derivatives

Project Idea Prototype Stable

ProductionCommercialization

A.I.

CorporateStages

SeedCapital£0 - £10k

£250k - £750k

£ 750k – £2M

£ 2M – £50M

£10k - £250k

£ 50M – UP

Pre- IPO Liquid Markets, Mature Shareholder, Competition

Equity Financing Marketplace – EM

Mezzanine

Private Equity

(Global Funds/ limited domestic funds)

Underdeveloped financing marketsWidens the gap…

… affecting more stages of business development.

PIP

ES

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

Venture Capital

“Equity Gap”

problem: Equity Gap in VC/PE market

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

9

Seed & Startup

Capital

Venture Capital

Size

Start-up

Private Equity

EMs: Government interventions

Emerging Markets

Tartgeting of Government intervention

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

Middle Market: Main Initial Focus?

L

M

S

early Expansion/GrowthMiddle Market1

Buy-out

10

• 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)

problem: Equity Gap in VC/PE market

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

11Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

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

12Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

UK - Total VC/PE Investment, 1990 - 2002 Relationship between fund size and deal size, 1984 – 2000 UK

• as PE industry develops & grows, tends to become concentrated on the later stage of marketwhich offers better risk-adjust returns, due to the economies of scale of this activity

Reasons behind Equity Gap in VC/PE market

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

13

Government Interventions: the importance of private sector expertise !

VC/PE: a high-risk asset class

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

0.0%

-5.0%

-10.0%

10.0%

5.0%

15.0%

20.0%

DJ 30

S&P 500

Microcap

Midcap

Willshire 500

US Corp Bonds

NYSE

NASDAQ

MSCI World Ex US

PE/VC Lower Quartile

-7.6%

PE/VC Median4.1%

PE/VC Upper Quartile16.1%

PE/VC Min = -100%

PE/VC Max = 721%Return on investment USA, 1980 – 2002

Private Equity = High Risk!

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

Index One Year Five Year Ten Year

Emerging Markets VC & PE 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%

14

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

15

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.

Government Interventions: the importance of investment expertise !

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

16

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

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

Focus of this study

17

• 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.

Government Interventions:

Enabling Regulation

18

• 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

Government Interventions:

Tax framework

19

• 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)

Government Interventions:

Public/Private Investment Programs

20

• 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)

Emerging Markets Lessons learned and recommendations

Regulation: Enabling increased private equity activity

21

• The expertise and profit-seeking instincts of professional fund managers are essentialSBIC (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 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 ]

Emerging Markets Lessons learned and recommendations

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

22

• 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.

Emerging Markets Lessons learned and recommendations

Investment Programs: - Professional fund management capacity and investor expertise - Governance and Evaluation

23

• 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

Emerging Markets Lessons learned and recommendations

Final Remarks

24

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

Private Equity Financing of high growth companies

World Bank / IFC Capital Markets AdvisoryNigeria, March 6 2008

The role of the Government