Upload
hanhu
View
217
Download
0
Embed Size (px)
Citation preview
17
Alternative Growth: The Impact ofEmerging Market Private Equity on Economic Development Magogodi Makhene
Introduction
Economic development is fundamental to economic growth in emerging
markets. Economic growth is defined as an expansion of Gross
Domestic Product (GDP) or Gross National Product (GNP), where GDP
is a function of capital, labor, land (natural factor endowments) and
entrepreneurship. The difference between GDP and GNP is primarily
technical semantics—GDP is all production on domestic or local soil;
GNP refers to all goods and services produced by nationals, including
expatriates’ production. As a nation multiplies its capital productivity
and capacity through technological advancements, or its labor
productivity through human capital investment, GDP rises. GDP growth
can also be spurred by successful entrepreneurial initiatives.
Of course, increasing gross domestic production implies
increased demand, which must be met by increased supply. GDP
expansion—a rise in demand—can be driven by domestic consumer
consumption, government spending, business investment, export
demand or a combination of these drivers. In an effort to spur GDP
expansion, developing nations form policies designed to encourage at
least one of these growth drivers.
Alternative asset class investments—collectively hedge funds,
private equity, venture capital, credit derivatives and real estate—are a
form of business investment which can be Foreign Direct Investment
(FDI). Today, most alternative asset class investments in developing
18
nations are FDI made by foreign investors seeking high returns in risky
but high-yield emerging markets. FDI can ignite economic growth.
When fully incorporated into the local economy, Greenfield FDI
or long term ground-up investment, can create jobs, better integrate
local economies into the global market and introduce important
technological advancements to local business. FDI plays a particularly
critical role in emerging markets by injecting capital in markets with a
dearth of domestic savings—which, in part, informs government
spending, business investment and consumer confidence. In Ireland FDI
turned one of Europe’s poorest nations into an important economic
force with highly specialized, developed markets.
Over a 20-year period, from 1984 to 2004, Ireland’s per capita
GNP grew an average nine percent annually. Where GNP per capita was
€5,367 in 1984, it rose to €30,726 by 2004. Most of this economic growth
was driven by FDI in Ireland’s information communication technology
industry and in the expansion of the island nation’s export sector. Total
exports in 2004 were €124 billion, up 89.96 percent from €12 billion in
1984 (McDowell, 2006). Yet despite the success of nations such as
Ireland, FDI does not guarantee improvements of GDP.
Instead of re-circulating accumulated wealth into local markets
to stimulate cross-industry growth, foreign-owned Multi-National
Corporations (MNCs) can divest profits to their home country.
Such capital outflows may result in a net loss for the developing
host nation. MNCs are also capable of crowding out local business
and monopolizing the use of local resources. Powerful MNCs with
deep pockets and economies of scale can stamp out rival local
entrepreneurial ventures. Similarly, private equity FDI does not
guarantee economic stimulation in emerging markets.
Critics accuse private equity of using “strip and flip” strategies
to acquire businesses, saddle them with debt, extract high dividend
payouts and undermine labor. Proponents of private equity, such as
Sami, executive board member of Turkey’s leading investment bank,
Ata Invest, argue that private equity adds value to business, thereby
stimulating economic growth. This is because in addition to financial
19
support, private equity offers financial advice, corporate strategy,
innovative ideas, market access and information (Sami, 2002).
This paper considers both arguments in evaluating the role of
private equity in emerging markets. The term “emerging market” is
used to describe the economies of high-risk countries with nascent
financial markets. In an International Monetary Fund (IMF) working
paper entitled What is an Emerging Market?, Mody argues that
emerging market economies are characterized by “high levels of
risk…higher volatility than advanced industrialized economies…the
absence of a history of foreign investment and their transition to market
economies…” (Mody, 2004).
Measuring the impact of private equity on emerging markets is
important because of the implications for international development. If
private equity has indeed been a stimulus for economic expansion in
developing nations, then this alternative investment asset class should
be more widely adopted and encouraged as a vehicle for economic
development in non-industrialized nations.
This paper summarizes the impact of private equity
investments in the emerging markets of the Middle East, Asia, Latin
America, Africa, East and Central Europe and finds that private equity
can be a catalyst for economic change in developing markets. Private
equity can stimulate growth by encouraging technological and industry
innovation, Greenfield job creation and better corporate governance.
The paper begins by assessing the role of private equity in creating jobs,
developing long-term investments and restructuring corporate
governance. This is followed by an overall analysis of the value added to
developing nations’ economies by private equity transactions.
Definition of Private Equity
Private equity is an alternative asset class investment that can be used
as a means of FDI. Sami explained private equity and its function at a
2002 Massachusetts Institute of Technology (MIT) Entrepreneurship
Center conference, “Venture Capital in Turkey.” Private equity is “capital
to enterprises not quoted on a stock market. Private equity can be used
20
to develop new products and technologies, to expand working capital,
to make acquisitions, to strengthen balance sheets and to resolve
ownership- management issues” (Sami, 2002). He goes on further to
describe venture capital as a form of private equity specifically
employed in the early stages of business development.
Mezzanine capital funds provide growth capital to mid-sized
portfolio companies for expansion. Private equity is an investment
vehicle that provides a structure whereby limited partners can invest
equity in a managed fund. Limited partners are investors with no
management authority and only limited liability. They share only in
their fund’s profits and liabilities—not those of other funds within the
private equity firm. Typically, limited partners seek large long-term
investments as a means of attaining high returns and diversifying their
holdings. They are prepared to take on risky private equity fund
investments that curtail access to invested capital until the fund’s
underlying assets are exited. In part because of these constraints and
government regulation requirements, limited partners tend to be
university endowments, pension funds and high net-worth individuals.
A fund usually has multiple limited partners. The private equity
firm will set a fundraising target and go “on the road” to attract limited
partner capital. This process can take a few months or years and is
primarily dependent on the firm’s return on investment record and the
fund’s perceived opportunity. Private equity firm managers, known as
general partners, are also expected to make substantial investment in
the fund—ordinarily one to five percent— to demonstrate commitment to
the fund’s performance. General partners have unlimited liability and
receive an annual management fee (two percent of the fund) for making
investment and post-transaction strategic decisions and overseeing day-
to-day fund operations. In addition, general partners receive 20 percent
of the carried interest or fund profit after the fund is exited. Once the
fundraising target is accomplished, the fund is closed to further
investment from limited partners.
After closing the fund, general partners are responsible for
scouting target companies which match the fund’s investment
21
philosophy. General partners can either purchase targets outright or
acquire an equity stake, together with other investors, in the target
company. General partners perform due diligence on the target
company once interest is expressed in a target company, but before
completing the acquisition transaction.
Due diligence is the process of assessing the target firm’s
financial statements, weighing strengths and weaknesses of the target
company’s business model, evaluating market opportunities, market
trends and projecting strategic fit with the fund’s portfolio of acquired
target companies. In a 2004 Harvard Business Review article, When to
Walk Away From a Deal, Cullinan, Le Roux, and Weddigen summarize
the due diligence process in four key questions: “What are we really
buying? What is the target’s stand-alone value? Where are the
synergies—and the skeletons? What’s our walk-away price?” (Cullinan et
al., 2004). Due diligence is beneficial to both the general partners and
the target company.
For general partners, the process establishes a clear
understanding of the target’s current and potential value, as well as an
appreciation of the health of the target’s balance sheet, which is critical
to the private equity model. Even if the target is not acquired by the
private equity fund, due diligence is valuable to the target company—it
offers management an in-depth analysis of the target company’s strengths
and weaknesses. If due diligence provides enough evidence of the target
firm’s intrinsic and synergistic value, then the next step is acquisition or
“buyout.” A buyout is a partial controlling stake or full acquisition of the
target company. There are two types of buyouts in private equity—
management buyouts (MBO) and leveraged buyouts (LBO).
MBOs are initiated by the management team of the target
company and typically involve management buying out shareholders’
equity and taking the public company private. The primary goal of
MBOs is to align management strategy with ownership interests—this is
achieved by granting management substantial equity post-transaction as
well as seats on the board of directors. MBOs are not confined to
publicly listed companies—management can lead a buyout of a privately
22
held company. Because most managers do not independently have the
capital to buy out shareholders, and because banks traditionally
consider MBOs too high-risk to finance through debt, managers leading
an MBO turn to private equity funds for buyout capital. Such private
equity general partners will sponsor the buyout transaction by raising
debt and providing equity in exchange for controlling equity rights as
well as strategic control of the target company. Private equity funds issue
buyout capital in the form of a loan or combination loan and equity, in
an effort to balance their investment’s risk. MBO are a form of LBO. For
simplification, this paper uses the term LBO to refer to ordinary LBOs
and MBOs unless otherwise indicated.
A LBO is the acquisition of a target company through a high
debt-to-equity ratio transaction. In LBOs, private equity funds can
sponsor large buyouts because the LBO model is based on a high debt-
to-equity financing structure. The debt-to-equity ratio can be as much
as 90 to 100 percent. Target company’s assets are used as debt collateral,
therefore target companies must have strong balance sheets capable of
supporting high leverage. Private equity companies are attracted to
LBOs because of the minimal equity capital needed to complete sizable
buyout transactions, but LBOs have suffered considerable criticism. LBO
caused controversy in the 1980s as some private equity funds straddled
target companies with 100 percent debt financing, driving target
companies into bankruptcy as cash flows shrank and missed the
minimal times-interest-earned (TIE) ratios to continue operation.
Successful LBOs allow the private equity fund to assume control
of the target company—known as a portfolio company upon acquisition—
aligning investor and management goals. This alignment provides
privately held portfolio companies the space to focus on long-term
competitive strategy without the distraction of fluctuating quarterly
earnings reports. Private equity funds typically have a five to seven year
horizon, after which time the fund is exited for a profit or carried interest.
Private equity funds can exit portfolio companies through
several avenues. The Alternative Assets Network highlights plausible
23
exit strategies—Initial Public Offering (IPO), a trade sale, selling to
another private equity firm or a company buy-back. Because private
equity funds make their profit in the sale of the target company, exit
strategies are extraordinarily important to general partners and inform
the crux of the initial due diligence process.
Of all exit mechanisms, perhaps the most publicized are IPOs.
An IPO is a procedure by which a private company raises capital by
selling company shares to the public. A private company can only have
one IPO, unless the company subsequently goes private. Once a private
company goes public, it is listed on a public stock exchange, such as
Nasdaq, and must comply to all regulation for public companies. While
IPOs raise substantial sums during periods of high liquidity and stock
booms, IPOs result in expensive fees and complex compliance to
regulation laws such as Sarbanes-Oxley.
Trade sales involve the private equity fund selling the portfolio
company to an existing industry firm (The a-z of private equity, 2007). If
the acquiring industry firm is public, the trade sale will take the
portfolio company public as a subsidiary business unit of the publicly
traded company. Inversely, trade sales to a private industry firm would
keep the company private.
A fund can exit by selling to an existing industry firm, but also
through sales to another private equity fund. If the sale is to another
fund, the acquiring fund will buyout the current investor fund in what is
called a secondary buyout. As fund-to-fund buyouts become more
popular, tertiary buyouts are emerging, attesting to the relative ease of
selling to another private equity fund instead of going public.
Finally, private equity funds can exit through a company
buyback. In this case, the portfolio company spins off the private equity
fund by using its excess cash to buy out the fund’s equity stake.
Company buybacks are more common in venture capital, where the
founding entrepreneur may buy back shares to reassume a position of
primary or sole company controller.
24
History of Private Equity
The venture capital model of wealthy merchants providing capital for
risky overseas ventures with promises of high returns can be traced as
far back as the Middle Ages, when Italian merchant families sponsored
profitable exploratory expeditions (Banks, 1999). In an in-depth
Washingtonian profile of Carlyle Group’s co-founding partner, David
Rubenstein, Glassman recalls, “Rubenstein likes to say that Christopher
Columbus was the forerunner of the successful private-equity executive.
Columbus insisted on getting reimbursed for all his expenses in
advance. And he negotiated a 10-percent carry from Queen Isabella”
(Glassman, 2006). Private equity as we know it is rooted in this
tradition, but the complex structure of LBOs did not emerge until the
mid-American twentieth century.
Following World War II, three businessmen founded the
American Research and Development Corporation (ARD) in 1946.
ARD was a venture fund established to provide start-up capital and
managerial consultancy to recently discharged military personnel
businesses. In 1959, ARD’s innovative manner of corporate finance was
replicated in the formation of a Small Business Investment Company
(SBIC), an investment vehicle which handled wealthy families’ venture
capital interests. These SBICs raised $464 million over 13 years and
were able to secure debt financing from the Small Business
Administration, but success remained lackluster because of limited
fundraising pools—investors were seldom institutional—and an inability
to attract the best money managers (Wingerd, 1997).
Institutional interest in venture capital-private equity models
began in the early 1960s. Two critical 1970s legislative events solidified
the fate of private equity. Capital gains tax rates were cut and ERISA
(Enactment of the Employee Retirement Income Security Act)
regulations were relaxed, allowing pension funds to shift from
conservative investments, such as government bonds and blue chip
stocks, to more aggressive investment vehicles with higher returns.
In 1965, Bear Sterns undertook its first buyout, led by Jerry Kohlberg—
who later co-founded Kohlberg, Kravis & Roberts (KKR).
25
LBOs gained momentum in the 1980s. Between 1979 and 1989,
more than 2,000 LBOs valued at over $250 billion occurred. During the
1980s, buyouts were characterized by aggressive leverage financing—
some buyout transactions relied on 100 percent debt financing. The
buyout boom culminated in KKR’s 1989 record-breaking acquisition of
RJR-Nabisco for $25 billion. In the aftermath of the stock market crash
and Black Monday on October 19, 1987, an unprecedented number of
portfolio companies defaulted on loans, undermining the credibility of
LBO models. Private equity activity cooled, but regained impetus on the
strength of the tech boom of the late 1990s. Figures I and II summarize
LBO activity from 1980.
Figure I: Annual LBO and Venture Capital Value, 1980-1998
Source: The Private Equity Analyst
Figure II: Annual LBO Value, 1995-2007*
* 2007 First Quarter, Source: Dealogic
Annual commitments to private equity, 1980-98 (US$ billion)
0
10
20
30
40
50
60
70
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
0
200
400
600
$800 billion
'07*'06'05'04'03'02'012000'99'98'97'96'95
26
Emerging Markets Private Equity
In the early 1990s, emerging markets were largely characterized by
family-owned companies with limited access to capital markets and
small lines of credit through traditional bank financing. National
savings pools were small, current accounts were typically in deficit and
capital markets tended to be shallow. Given such constraints on capital
and equity supply, emerging market companies were attracted to private
equity funds as a source of growth capital.
Foreign fund investors were equally keen on emerging market
companies. Target businesses were often undervalued in an atmosphere
of fierce competition for undersupplied capital, implying higher rates of
return on investment and favorable global economic conditions. The
global economy was in a period of growth and relative macroeconomic
stability by the mid 1990s. Inflation and interest rates were down and
policy makers worldwide embraced the wisdom of open markets
without barriers to competition—securing investors’ confidence in
emerging markets’ manageable risk (Leeds and Sunderland, 2003).
Investors also had a robust appetite for risk and they were handsomely
rewarded in the U.S. venture capital tech boom of the mid 1990s, having
acquired significant gains in industrialized financial markets through
private equity investments. The current of globalization aligned
investors with potentially high return investment opportunities while
providing target companies funding and expansion consultancy to gain
competitive prowess in global markets.
From little to no private equity history in previous decades,
emerging markets quickly amassed sizable funds within a short period
of time. According to the authors of Private Equity Investing in Emerging
Markets, private equity funds ballooned in emerging markets. “By the
end of 1999, there were more than 100 Latin America funds, where
virtually none had existed earlier in the decade. Between 1992 and 1997,
the peak years for fund-raising in Latin America, the value of new
private equity capital grew by 114% annually, from just over $100
million to over $5 billion. In the emerging markets of Asia…about 500
funds raised more than $50 billion in new capital between 1992 and
27
1999. As the transition to market economies in Eastern Europe took
hold in the mid-‘90s, the rapid growth of private equity told a similar
story” (Leeds and Sunderland, 2003).
The spurt in investment was further aided by high-risk stakes
taken on by bilateral international development institutions such as the
Overseas Private Investment Corporation, the U.S. Agency for
International Development (USAID), the European Bank for
Reconstruction and Development and the International Finance
Corporation (IFC). Development institutions were often among the first
to test emerging markets because of their primary interest in furthering
international development through the private sector. Investors’
confidence was cajoled by the participation of these development
institutions, whose successful early funds hinted at high potential
returns in emerging markets.
Beginning in the late 1990s and early 2000s, American-style
private equity funds in emerging markets began delivering
disappointing results in comparison to expectations and similar funds in
industrialized regions. Explaining this failure, Leeds and Sunderland
point to emerging markets’ low standards of corporate governance,
limited legal recourse and dysfunctional capital markets (2003). It is
also worth noting that late 1990s fund returns were uncharacteristically
high in the United States and Europe because of the tech-IPO bubble,
providing a skewed and unrealistic measuring stick for emerging
market funds’ performance.
In a 2004 industry survey of 26 investors with an aggregate
$108 billion managed funds, the Emerging Markets Private Equity
Association (EMPEA) reported overall investor dissatisfaction with
emerging market return on investment rates. Reasons cited centered on
weak macroeconomic variables such as currency volatility and market
liquidity, conflicting cultural perceptions on entrepreneurial cooperation
and market access and managerial issues such as high turnover in
target companies, little general partner operational control of portfolio
companies and insufficient risk mitigation strategies (EMPEA, 2004).
But in just three more years, the same EMPEA annual survey conveyed
buoyed investor confidence and optimistic expectations. Figure III
illustrates the upward trend of capital raised for emerging market
private equity funds, underscoring improved investor satisfaction.
Figure III: Emerging Market Private Equity Fundraising,
2003-2005
Source: EMPEA Fundraising Statistics for Emerging Markets Private Equity
By 2007, there was a mood of optimism among general and
limited partners for private equity growth prospects and performance in
emerging markets. A February 2008 EMPEA press release reported a 78
percent year-on-year increase in capital raised from a pool of 204 funds,
from $33 billion in 2006 to $59 billion amassed in 2007. Fund dollars
were still concentrated in emerging Asia, but other regions became
aggressive competitors. In 2007 alone, Central and Eastern Europe saw
a fundraising surge of more than 300 percent, Latin American private
equity funds grew 66 percent from the previous year and the Middle
East 71 percent (Choi, 2008). Emerging market funds were also
dedicated to specific industries—agriculture, technology, infrastructure
and natural resource. Table I highlights the global spread of private
equity dollars.
Recent private equity successes in developing markets are as
much a result of returns to scale on the knowledge curve as they are the
0
5000
10000
15000
20000
25000
2003 2004 2005
22002800
15446
4061777
2711
417 714 1272350 545
2708
22135
58363373U
S$
Mill
ions
Asi a
C EE /
R us s
i a
L A R
e gi o
n
Afr i c
a+ M
E NA
E M T
o tal
28
29
result of fortuitous timing. International liquidity, low global interest
rates and free cross-border capital movement all encouraged large
fundraising caps and unsurpassed buyout activity. But the learning
curve has been of fundamental importance.
Table I: Private Equity Aggregate Fundraising, 2003-2007
Source: EMPEA, Emerging Markets Private Equity
Initially, partners assumed that the American private equity
venture capital model could be transplanted whole to developing nations,
but soon learned that a dearth of capital markets infrastructure, a lack of
legal constraints and incongruous cultural sensitivities all hindered
successful adoption of the model, undermining expected returns.
Investors were also faced with exit strategy challenges—most
developing nations had shallow capital markets that could not
adequately support IPOs. Responding to such problems, limited and
general partners modified the private equity model over the years,
becoming more adept at handling a different business climate and
culture in emerging markets.
In his article, Private Equity in Emerging Markets,
Gopalakrishnan addresses the need for a different approach in
emerging markets. “Traditional exit is through sale but multinational
companies are pulling out fast. Capital outflow from Asia has been
quick… Even in China, the growth in Foreign Direct Investments is
falling fast. Under these conditions the viable exit option is to sell out to
regional players who have cash” (Gopalakrishnan, 2002). Specifically,
Emerging CEE/ LatAm & Sub-SaharanAsia Russia Caribbean Africa MENA Pan-EM Total
2003 2,200 406 417 350* 116 3,4892004 2,800 1,777 714 545* 618 6,4542005 15,446 2,711 1,272 791 1,915 3,630 25,7652006 19,386 3,272 2,656 2,353 2,946 2,580 33,1932007 28,668 14,629 4,419 2,340 5,027 4,077 59,161
Source: EMPEA estimates. Notes: Emerging Asia excludes funds focused on investments in Japan, Australia, and New Zealand. *Reported together as Africa/Middle East in 2003 and 2004. Detail may not sum to totals due to rounding.
30
private equity partners ascended the emerging market private equity
learning curve by:
• Partnering with local investors and industry leaders to
conduct thorough due diligence on target companies
• Investing prudently and only with highly skilled general
partners. There is a disproportional lag in investment returns
between the top performing managers and those who rank
close behind in second or third position. Much of the initial
disappointing emerging market performance of the mid-1990s
is blamed on a lack of vetted management skill
• Assessing market political and economic volatility risk
diligently, focusing on market-specific impediments to exit
strategies and probable challenges without clumping regions
together to inflate or deflate realistic expected returns
• Focusing on portfolio companies’ strengths, such as cheap
rents and little labor competition, to drive impressive returns.
Table II: Growing Emerging Market Private Equity Investment,
2003-2005
Source: Business World India
Employment
One of the most contentious debates regarding private equity centers on
The money trail52% 1% 2% 15% 30% 41% 1% 3% 16% 39% 40% 1%* 4% 22% 33%
2003
1 2 3
4
5
2004
1 2 3
4
5
2005
1 2 3
4
5Total funds invested: $115 bn Total funds invested: $110 bn Total funds invested: $280 bn
1 North America
4 Asia Pacific 5 Europe
2 Central & South America 3 Middle East*South America Source: PWC Global Private EquityReport and media reports
31
the question of employment. Specifically, do LBOs create jobs or do they
reduce employment levels in a quest for absolute efficiency?
Historically, the existing limited academic research on this topic focused
on aggregate employment levels before and after LBOs, ignoring zero
marginal change in an acquisition or divestment. Also, studies have
been primarily concerned with LBO employment activity during the late
1970s through 1980s.
After studying 76 LBOs in the 1980s, Kaplan concluded that
LBO target companies reduced employment by a median 12 percent
more than industry wide standards (Kaplan, 1989). In 1987, Lichtenberg
and Siegel published an article supporting Kaplan’s thesis. These
authors concluded from a sample of 131 buyout target firms that
employment levels declined upon the close of a LBO deal (Lichtenberg
and Siegel, 1990).
While this body of research presents empirical data which
frames current discussions, it is important to note that LBO activity has
matured significantly since the 1980s, especially in industrialized
markets. It is also worth noting that the impact of LBOs on job creation
may be particularly difficult to measure in developing markets, where
unemployment is disproportionately high to begin with and where the
maturity and sophistication of LBOs lags similar activities in
industrialized nations. That said, current academic thought on
employment level changes due to LBOs paints a rather complicated
picture.
LBOs can and do create new employment opportunities,
but often simultaneously prune portfolio firms of redundant,
underperforming or inefficient positions. Because portfolio companies
are by definition privately held, and because employees are often
reshuffled post buyout, the destruction of a swath of underperforming
jobs may be quicker and therefore more dramatic than similar
undertakings at publicly listed organizations. In private equity backed
portfolio companies, jobs are only created if they add marginal value to
the portfolio company. In addition, LBO target firms are responsible for
considerable Greenfield job creation.
32
According to The Global Economic Impact of Private Equity
Report 2008, within the first two years of a LBO, the average portfolio firm
creates six percent more Greenfield jobs than the average industry non-
private equity backed firm (Davis et al. 2008). Not surprisingly, research
commissioned by the Private Equity Council supports these findings.
In American Jobs and the Impact of Private Equity Transactions,
Shapiro and Pham argue that private equity companies increase
employment in the United States and abroad. Shapiro and Pham
analyzed 42 large target companies under ownership of eight major
private equity funds. After following the performance of the 42
companies over the period 2002 to 2005, the authors observed initial job
losses after the first buyout transaction, but subsequent gain of job levels
within two years of the transaction. Shapiro and Pham further report
long-term job creation among the sample of 42 companies that
surpassed non-private equity backed companies in similar sectors.
The aggregate worldwide labor force of the sample grew 8.4 percent
from 2002 to 2005. Of the sample population, 76 percent detailed job
gains, while less than 24 percent reduced total employment (Shapiro
and Pham, 2008).
While the data discussed above has an international scope,
Shapiro and Pham concentrate on private equity job creation in the
United States. This leads to an important tangent about private equity
job creation in emerging markets. Policy makers are acutely sensitive to
the geographic location and migration of jobs. Thus, if a private equity
sponsored firm cut 100 redundant jobs in São Paolo and created 1,000
Greenfield jobs in Vietnam, policy makers in Brazil would be tempted to
overlook the 900 percent overall employment gain in an effort to protect
their constituents’ job security. Nonpartisan, international development
bodies are particularly useful here, because of their relative indifference
to region-specific interests that are outweighed by broader, global gains.
The International Finance Corporation (IFC) has been actively
investing in emerging private equity funds for 20 years. Summarizing its
successes from 1998 to 2006, the institution cites a 13.7 percent global
employment growth rate among its private equity funds’ portfolio
33
companies, compared to the global employment growth rate of 1.3
percent. The most impressive rise in job creation is in Central and
Eastern Europe, where portfolio companies’ employment rate grew at a
rate of 16.8 percent over eight years, compared to the regional average
growth rate of 0.3 percent. The following table (Table 3) sums up IFC
funds portfolio companies’ performance, measured against regional
employment growth rates.
Table 3. Company Performance and Employment Growth
Source: IFC News, 2007
Returning to the issue of simultaneous job destruction and
creation leads to the 2008 World Economic Forum Report’s description of
this private equity phenomenon as “creative destruction.” In The Global
Economic Impact of Private Equity Report 2008: Private Equity and
Employment, the authors argue, “especially when taken together, our
results suggest that private equity groups act as catalysts for creative
destruction. Result 1 says that employment falls more rapidly at targets
post-transaction, in line with the view that private equity groups shrink
inefficient, lower value segments of underperforming target firms. We also
find higher employment-weighted establishment exit rates at targets than
at controls in both the full and restricted samples. At the same time,
however, Result 5 says that private equity targets engage in more
Greenfield job creation than controls. This result suggests that private
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
C. & E. EuropeE. Asia & Pacific
S. America & CaribbeanMENA
Sub. Saharan AfricaWorld
16.80%
0.30%
10.40%
0.90%
8.00%
2.40%
7.60%
3.50%
11.70%
2.50%
13.70%
1.60%
Growth of Funds Portfolio Regional Growth
34
equity groups accelerate the expansion of target firm activity in new,
higher value directions. Result 6 says that private equity also accelerates
the pace of acquisitions and divestitures. These results fit the view that
private equity groups act as catalysts for creative destruction activity in
the economy, but more research is needed to fully address this issue”
(Davis et al., 2008). The conclusions of this study highlight the complex
nature of private equity labor relations. Clearly, there is a stark, if
expected, difference between the findings of the World Economic Forum’s
report and research commissioned by the Private Equity Council.
It seems safe to assume that the truth lies somewhere in between.
While private equity is engaged in “creative destruction,”
economic value is realized by industries and national markets—which
gain efficiency and global competitiveness. Of course, this added value
is at the expense of hundreds or thousands of individuals, whose
purchasing power diminishes during structural labor adjustments,
undermining the economic expansionary driver—consumer
consumption. And yet there is also truth to claims of mass job creation
from private equity lobbyists groups such as the Private Equity Council,
even if reported statistics may be skewed by selective data from non-
random samples.
Emerging market fiscal policy makers cannot afford to ignore
the discrepancy in job creation rates between private equity backed
portfolio companies and comparable industry firms. The real challenge
lies in shifting focus from country-specific quantity job creation and loss
cycles to a more integrative global discussion on the qualitative impact
of private equity on emerging market employment growth.
Innovation Investment
Most economists agree that innovation is an imperative driver of
economic development. In his 1956 essay A Contribution to the Theory
of Economic Growth, Solow emphasized the importance of technological
innovation for economic growth. Assuming that capital is subject to
diminishing returns, Solow argued that an economy’s steady rate of
growth depended on the rates of technological progress and labor
35
growth (Solow, 1956). The assumptions and findings of this neoclassical
growth theory led Solow to conclude that in order to grow economies,
governments had to invest in human capital through education and on-
going training, shift resources from low to higher productivity
industries, encourage capital investment, technological progress and
innovation (Government of Canada, 2002). Of these recommendations,
the last is offered as the most important growth driver.
Nowhere else is the economic growth impact of technological
progress and innovation more impressively illustrated than in the four
East Asia Tigers—Taiwan, Singapore, South Korea and Hong Kong.
Following World War II, the four tigers were characterized as emerging
markets, but have since managed to transform themselves into
industrialized regions through 30 years of sustained economic growth.
To understand how staggering economic growth within this
block has been, consider an observation by Sarel, author of
International Monetary Fund (IMF) paper, Growth in East Asia: What
We Can and What We Cannot Infer, “while the average resident of a non-
Asian country in 1990 was 72 percent richer than his parents were in
1960, the corresponding figure for the average Korean is no less than
638 percent” (Sarel, 1996). Sarel presents strong evidence that
technology and innovation have been responsible for East Asia’s
tremendous growth, but also cites data supporting the catalytic qualities
of amassing factors of production—labor and capital. For clarity and
focus, this discussion is only concerned with growth resulting from
innovation and technological progress.
Discussing technological progress and innovation is critical
because of the leapfrog growth these drivers can offer emerging
markets. To compete in a global, high-tech information age economy,
developing nations must use technology as competitive leverage. Again,
Sarel observes, “accordingly, the standard view about the success of the
East Asian countries emphasizes the role of technology in their high
growth rates and focuses on the fast technological catch-up in these
economies. In this view, these economies have succeeded because they
36
learned to use technology faster and more efficiently than their
competitors did” (Sarel, 1996).
Having now established the importance of innovation in
spurring economic development and growth—especially in emerging
markets—does private equity advance technological progress and
innovation? In other words, does private equity activity invest in and
encourage innovation, technology and research and development
(R&D)?
Examining patent filing records of 495 non MBO, LBO private
equity firms from 1983 to 2005, Lerner, Sorensen and Stromberg, offer
the following observations:
• After the LBO transaction, patents belonging to the portfolio
company are more frequently cited, implying more intensive
use of patents post buyout
• Private equity backed portfolio companies’ patent awards have
a higher economic impact after acquisition, even if patent
levels remain fundamentally constant
• After going private, influential innovations are implemented
and pursued in portfolio companies. The authors found this to
be true even when the sample was tested against stringent
controls
• Private equity encourages focused innovation—portfolio
companies’ patent applications are more concentrated within
the areas of the firm’s competitive strengths after going private
• Patenting levels after the LBO transaction changed
consistently throughout the sample of 495 companies
These findings, based on primary empirical research summarized in the
authors’ 2008 work, Private Equity and Long Run Investment: The Case
of Innovation, suggest that private equity encourages long-term
innovative strategy.
Corporate Governance
In theory, private equity strengthens corporate governance through the
alignment of ownership and management goals. Walker fleshes out
theory in a 2007 consultative document, Disclosure and Transparency in
Private Equity, “…alignment (of interests) is achieved in private equity
through control exercised by the general partner over the appointment
of the executive and in setting and overseeing implementation of the
strategy of a portfolio company, lines of communications are short and
direct, with effectively no layers to insulate or dilute conductivity
between the general partner and the portfolio company executive team”
(Walker, 2007).
The argument rests on the premise that because management
has an ownership stake in the portfolio company and because
management will be rewarded upon successful exit, managers of a
portfolio company will comply with best business practices, which
promote sound corporate governance, in an effort to multiply the
company’s value before exit. In practice, the end goal of a lucrative exit
can become so enticing, that managers adopt less enviable means—
which compromise sound corporate governance.
In the aftermath of Black Monday in 1987, private equity backed
portfolio companies managing an aggregate $65 million in assets filed
for bankruptcy protection (Kester and Leuhrman, 1995). Congressional
hearings were held to fan out the disaster—many blamed the fallout on
weak private equity institutional governance and a business model with
ample greed but few checks and balances. Of course, private equity
failures were amplified by Wall Street’s hemorrhage from the largest
one day percentage decline in market history—the Dow Jones Industrial
Average took a 22.6 percent dive, the equivalent of 508 points
(Browning, 2007). In this atmosphere, it was easy and sometimes
justified, to blame the LBO structure for internal company
mismanagement.
But in truth, private equity’s functional operations and ultimate
success depend on strong corporate governance. The bankruptcies of
37
1987 attest to this truth—while sound governance does not guarantee
better performance, private equity portfolio companies with sub-par
corporate governance do not survive. If only for self-preservation,
general partners and portfolio managers and are forced by the private
equity model to instill good governance measures such as transparency,
accountability, open communication and trust, ethical business conduct
and a strong corporate culture.
The LBO model differs fundamentally from publicly traded
companies in that the end-goal is an exit. General partners and portfolio
managers must market the portfolio company to potential buyers by
demonstrating value. While distressed sales are common, investors are
unlikely to purchase a company driven to the ground by poor
governance, especially if such failure has tarnished the company’s
brand equity. The exit acts here as a bind or credible commitment,
compelling management to employ business best practice.
The exit’s function as a credible commitment is acutely critical
in developing nations, where business culture is often riddled with
corruption and a tolerance for sub-par governance. Part of the inherent
risk of investing in emerging markets is operating business in an
environment with weak political and socio-economic institutions and
limited legal recourse. Such risk can be partially hedged by employing
sound corporate governance internally, thereby raising industry
standards for acceptable business conduct and encouraging other
businesses to do the same.
A mobile network operator in Africa, Celtel revolutionized the
face of African telecommunications by creating state-of-the-art
infrastructure ground up and through its staunchly ethical corporate
governance, serving as object proof of the possibility for a large
enterprise to profitably and ethically conduct business on a pan-African
level. Celtel’s performance greatly benefited all of its stakeholders—
investors, employees and the communities it served.
In the example of Celtel, management made sound corporate
governance a primary goal, but how does the private equity model
38
39
generally promote good governance? There are two key periods here—
due diligence before closing the deal, and active engagement post buyout.
During the due diligence process, general partners have the
opportunity to vet target companies’ governance, corporate culture and
commitment to business ethics. Even though general partners are not
invested in the company at this point, the target company’s management
team will be eager to address concerns that arise during due diligence
procedural feedback. General partners’ opinion bears tremendous
weight for the target’s management because the partners are potentially
investors (Lim and Sullivan, 2004).
After the buyout, general partners exercise significant leverage
as investors in assisting management to improve the firm’s governance
issues. As private equity managing directors Lim and Sullivan point out,
“corporate governance and private equity” general partners are typically
engaged with portfolio companies’ competitive strategy, exerting direct
influence over customary governance activities such as “validating
management’s business plan, counseling management on making the
board more effective, or improving financial reporting and disclosure—to
unusual undertakings, such as investigating financial irregularities or
assisting management in corporate restructuring or acquisitions” (Lim
and Sullivan, 2004). The authors highlight key governance functions
general partners and portfolio managers must fulfill in private equity
transactions. Their findings are summarized in Figure V.
40
Figure V: How Private Equity Promotes Sound Corporate
Governance
Source: Global Corporate Governance Guide 2004
Private equity managers
Private or public company
Time
Pre-investment
• Evaluate company’sgovernance practices.
• Assess and validatefinancing plan and relatedbusiness proposal.
• Review company’s historyon governance-relatedissues, such as connectedtransactions, conflicts ofinterest, compliance withlaw and regulations, etc.
• Perform third-partybackground check oncompany, management and major shareholders.
• Work with intermediaries and management to ensurefairness and orderliness of investment process.
• Provide feedback tomanagement on governance issues.
Post-investment
• For disclosure purposes:
• Require material company information to beprepared, audited and disclosed for accurateand timely dissemination to shareholders.
• Ensure the accuracy and integrity of financialreporting and internal audit; external audit should bethorough in scope and conducted by a reputable firm.
• Require that management and directors disclose anyrelated transactions or potential conflicts of interest.
• For accountability purposes:
• Develop an effective board to oversee management andcommunicate with shareholders; appointees should havesufficient experience and qualifications; allow for anappropriate number of independent directors; set upaudit, remuneration and nomination committees.
• Introduce formal board proceedings, such as earlycirculation of board agenda, taking of detailed minutes,regular and actively attended board meetings, etc.
• Establish performance-oriented practices and culture,reinforced by performance-linked remuneration system.
• Ensure that the company complies with law,regulations and best practices.
41
Good corporate governance matters—especially in emerging
market private equity. Kester and Leuhrman concur, “…governance
affects how important decisions get made and therefore how efficiently
a company’s resources, including capital, are utilized. Poor governance
can be very costly” (Kester and Leuhrman, 1995).
Conclusion
Private equity, as an alternative asset class business vehicle, provides
interesting opportunities in emerging markets. This paper has examined
the role private equity plays in spurring development by measuring
outcome in terms of employment, technology and innovation investment
and corporate governance.
While there is evidence supporting high levels of private equity
job creation, research presented here suggests that because of creative
destruction, private equity’s aggregate role in eliminating or creating
jobs is indefinite. Private equity is quick to eliminate redundant and
inefficient labor, and there is a trend of creating skill-intensive jobs. In
developing nations, private equity has had tremendous success lifting
employment rates in comparison to regional performance, as reported
in data from the IFC, but there is no unanimous, uniform pattern of the
private equity model creating jobs with none destroyed. In future, a
study investigating cross-border employment trends would be useful in
establishing to what extent private equity actually destroys jobs versus
relocating positions across a border and how such labor shifts affect
emerging market regions. Research considering the quality of private
equity employment in developing nations would also be key and would
offer insight on the value added for recipients of jobs “shipped overseas.”
On the whole, it appears that private equity invests more in R &
D, and the implementation of innovative best business practice than
comparative industry counterparts. Private equity portfolio companies
pursue a more focused technology innovation strategy in an effort to
multiply financial value added to the company. Private equity backed
firms are particularly cognizant of value-adding activity because of
the beneficial impact such value can have on a successful exit.
42
In developing regions, a portfolio firm’s adoption and implementation of
cutting-edge technology and innovation can have life-changing impact
on development and offer a viable means of leapfrogging the
industrialization gap. Illustrating this point fully is Celtel’s introduction
of mobile telephony to isolated markets which have subsequently been
integrated into the global economy. Also, innovation and technology is a
fundamental economic growth driver, and economic growth is a
unanimous emerging market goal.
Sound corporate governance does not guarantee good rates of
return on investment, which inform economic growth, but poorly
managed companies run a higher risk of failure. As such, the private
equity fund model has instituted checks and balances which are
designed to protect shareholders’ wealth. Due diligence, the interactive
oversight of general partners, board selection and the credible
commitment offered by an impending exit—all these procedures ensure
better governance in private equity backed firms. Strong internal
structures are important to attract investment capital, encourage
business longevity and create value for exit. In emerging market
countries with weak institutions, little legal recourse and high risk,
such sound internal governance and discipline is particularly critical.
Companies with good corporate governance serve a social good in
emerging markets because they improve overall risk conditions of
doing business in developing regions.
Throughout the paper, various challenges unique to the private
equity model in developing nations are raised. Due diligence can be
difficult to conduct in emerging markets that don’t have a record of
transparency or where required business regulation and legal recourse
are minimal. The deficiency of viable exit strategies also presents a
unique problem that requires creative thinking. Investors have to
consider exit alternatives to IPOs.
A future consideration is how to exploit the carried interest
wealth generated by private equity models. So far, this paper has
addressed emerging market private equity with the assumption that
because local capital markets are shallow, limited partners for funds
43
investing in developing nations are predominantly Western institutional
investors. Initially, funds may have to rely on foreign institutional
investment, but to multiply the wealth-creation of private equity; funds
must transition to attracting local institutional investment. In most
developing countries, pension funds exist which could form the basis of
pilot funds sponsored by locals and foreigners. There are also examples
of emerging market private equity limited partners, particularly in Asia.
China’s Industrial and Commercial Bank of China has invested in
several funds as a limited partner along foreign investors such as
Goldman Sachs. Shifting to local limited partners would counteract the
FDI risk of capital flight upon exit, and would also directly impact the
institutional investors’ constituents, who might be a university
endowment’s student body or a pension fund’s middle-class employees.
The private equity model has several attributes which make it
an attractive route to wealth acquisition and development. Private equity
invests in highly scalable businesses that have the benefit of directly
impacting the lives of thousands of stakeholders and private equity
encourages entrepreneurial activity—a primary catalyst of economic
growth. But the history of private equity points to a rocky past, riddled
by rock-bottom bankruptcies and disappointments in America’s 1980s.
If LBO failed so dismally in sophisticated markets such as America, how
will they fair in the intrinsically high-risk environments of emerging
markets? As discussed, the answers have so far been complicated, but
preliminary results are encouraging.
Private equity will never be perfect in any market. The key is
capitalizing on the best aspects of the model to create emerging
markets’ missing middle class. To build sustainable long-term growth
and prosperity, emerging markets’ economies have to be underpinned
by a majority middle class with living income, stable jobs, access to
progressive technology and a belief in the soundness of both private
and public institutions. Private equity is a means of creating this missing
middle.
44
References
Banks, E. (1999). The rise and fall of the merchant banks. Kogan Page Ltd.
Browning, E.S. (2007, October 15). Exorcising ghosts of Octobers past.
The Wall Street Journal, pp. C1-C2.
Cattanach, K.A., Kelley, M.F. and Sweeney, G.M. (1999). The Journal of
Private Portfolio Management, 2.
Celtel Africa: Summary of Proposed Investment. (n.d.).
Retrieved on May 1, 2008 from
http://www.ifc.org/IFCExt/spiwebsite1.nsf/0/a88f59c50d22b87785257282006
18c77?OpenDocument.
Celtel Facts. (2008, March 21). Retrieved on May 1, 2008 from
http://edition.cnn.com/2008/BUSINESS/03/20/celtel.facts/index.html.
Cheap money extends credit and risk expands to match. (2007).
The Wall Street Journal. Retrieved April 25, 2008 from
http://online.wsj.com/public/resources/documents/info-Creditchrtbk0708-
06.html.
Choi, J. (2008, February). Emerging markets private equity funds raise $59 billion
in 2007: Record-breaking fundraising pace continues.
Retrieved April 26, 2008 from
http://www.empea.net/research/fundraising2007/EMPEAFundraising_2007_
PressRelease.pdf.
Craig, V. (2002, September). Merchant banking: past and present.
FDIC Banking Review. Retrieved April 4, 2008 from
http://www.fdic.gov/bank/analytical/banking/2001sep/article2.html.
Cullinan, G., Le Roux, J. and Weddigen, R. (April, 2004). When to walk away
from a deal. Harvard Business Review, 82.
Davis, S.J., Haltiwanger, J., Jarmin, R., Lerner, J. and Miranda, J. (2008). The
global economic impact of private equity report 2008: Private equity and
employment. World Economic Forum. Retrieved March 4, 2008 from the
World Economic Forum online.
45
Ewing, J. (2007, September 24). Upwardly mobile in Africa: How basic cell
phones are sparking economic hope and growth in emerging—and even
non-emerging—nations. BusinessWeek. Retrieved May 2, 2008 from
http://www.businessweek.com/magazine/content/07_39/b4051054.htm.
Giddy, I. (2006) The acquisition of Celtel: An African company’s choice:
IPO or sale? [Case Study]. Retrieved May 2, 2008 from
http://pages.stern.nyu.edu/~igiddy/cases/mtc-celtel.htm.
Ibrahim, M. (2006). Celtel: An African success story. IFC Private Equity
Conference, Washington D.C., United States.
Ibrahim, M. (2005, November). Celtel: celebrating the exit. African Venture Capital
Association Conference, Nairobi, Kenya.
Ibrahim, M. (2006, October). Fighting corruption the Celtel way: Lessons from the
front line. Development Outreach. Retrieved May 3, 2008 from
http://www1.worldbank.org/devoutreach/september06/textonly.asp?id=369#
endseven.
Ibrahim, M. (2007). The Mo Ibrahim Foundation. Retrieved May 2, 2008 from
http://www.moibrahimfoundation.org.
Institutional investor views in emerging market private equity. (2004, May).
IFC Global Private Equity Conference, Washington D.C., United States.
International Finance Corporation. (2004, October 5). Celtel international receives
IFC client leadership award. [Press Release]. Retrieved May 3, 2008 from
http://www.ifc.org/ifcext/pressroom/ifcpressroom.nsf/PressRelease?openfor
m&9DFAD3CD44BC049E85256F2400758E27.
International Finance Corporation. (2007, April 26). IFC invests in emerging
market private equity. [Press Release]. Retrieved April 29, 2008 from
http://www.ifc.org/ifcext/media.nsf/Content/Private_Equity_April07.
Glassman, J. (2006, June). Big deals. Washingtonian. Retrieved on April 29, 2008
from http://carlyle.com/News/Fact%20Sheets/item9959.pdf.
Green, R. (2000, May). Irish ICT Clusters. OECD Cluster Focus Group Workshop,
Utrecht, Netherlands.
46
Gopalakrishnan, V. (2002). Private equity in emerging markets. The Monroe Street
Journal.
Government of Canada. (2002, February). Canada’s innovation strategy, achieving
excellence: Investing in people, knowledge and opportunity. Retrieved on
April 30, 2008 from http://www.wd.gc.ca/rpts/research/catalyst/2a_e.asp.
Kaplan, S.N. (1989). The effects of management buyouts on operating
performance and value. Journal of Financial Economics: 24, 217-254.
Kester, C.W. and Leuhrman, A. T. (1995, May/June). Rehabilitating the leveraged
buyout. Harvard Business Review, 73(3): 119-130.
Leeds, R. and Sunderland, J. (2003). Private equity investing in emerging
markets. Journal of Applied Corporate Finance 15.
Lerner, J., Sorensen, M. and Stromberg, P. (2008, February).
Private equity and long run investment: The case of innovation.
World Economic Forum. Retrieved April 30, 2008 from
http://www.weforum.org/en/media/publications/PrivateEquityReports/index.htm.
Lichtenberg, F.R. and Siegel, D. (1990). The effects of leveraged buyouts on
productivity and related aspects of firm behavior. Journal of Financial
Economics, 27:165-194.
Lim, G. and Peter, S. H. (2004). Corporate governance and private equity.
In Metzger, B. (Ed.), Global Corporate Governance Guide 2004.
United Kingdom: Global White Page.
McDowell, A. (2006). Globalization and the knowledge economy: The case
of Ireland. Retrieved March 11, 2008 from
http://www.oecd.org/dataoecd/59/5/37563948.pdf.
MSI cellular adopts celtel name at group level and relaunches celtel brand.
(2004, January 26). Retrieved on May 1, 2008 from
http://allafrica.com/stories/200401260112.html.
Mody, A. (2004, September). What is an emerging market?
IMF Working Paper. Retrieved April 5, 2008 from
http://www.imf.org/external/pubs/ft/wp/2004/wp04177.pdf.
47
Okuttah, M. (2007, June 7). Celtel eyes seamless pan-African mobile network.
Business Daily. Retrieved May 3, 2008 from
http://www.bdafrica.com/index.php?option=com_content&task=view&id=13
41&Itemid=4508.
Our company: Responsible management. (n.d.) Retrieved May 3, 2008 from
http://www.celtel.com/en/our-company/corporate-governance/index.html.
Out of Africa: A new kind of telecoms operator is evolving in Africa and the
Middle East. (2006, December 6). The Economist.
Sadouly, P. (n.d.) Interview with Mo Ibrahim, founder and former chairman of
celtel.
Juene Afrique. Retrieved May 2, 2008 from
http://www.celtel.com/en/our-company/leadership/mo-ibrahim/index.html.
Sami, M. (2002, June). Building value with private equity. MIT Entrepreneurship
Center Venture Capital in Turkey Conference, Istanbul, Turkey.
Sarel, M. (1996). Growth in East Asia: What we can and what we cannot infer.
Retrieved April 30, 2008 from International Monetary Fund website.
Shapiro, R. and Pham, N. (2008, January). American jobs and the impact of
private equity transactions. Sonecon. Retrieved April 28, 2008 from the
Private Equity Council website.
Solow, Robert M. (1956). A contribution to the theory of economic growth.
Quarterly Journal of Economics, 70 (1): 65–94.
The a-z of private equity. (2008, May 5). Telegraph, Retrieved April 15, 2008, from
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/exclusions/
equities/ccequityatoz21.xml.
Walker, D. (2007, July). Disclosure and transparency in private equity.
Retrieved on April 30, 2008 from
http://www.altassets.com/pdfs/walker_consultation_document.pdf.
Wingerd, D.A. (1997, September/October). The private equity market: History and
prospects. Investment Policy, 1: 26-41.