London Business School November 5, 2009 Prof. Roger Leeds

London Business School

November 5, 2009Prof. Roger Leeds

Clarifying Terminology-“Private Equity,” “Venture Capital,” “Mezzanine Finance,” “Buy-Out,” “Hedge Fund”

• “Private equity”– Generic term refers to all the above; increasingly imprecise term– Huge range of target firms- from early

stage/start-ups to SMEs to multi-billion $ publicly listed companies “going private”

– Huge range of PE fund size -from <$10 million to > $15-20 billion

– Virtually every sector, from high-tech to manufacturing, services, real estate, banks

– Not just equity—various types of debt (LBOs), mezzanine

Prof. Roger Leeds, Nov. 2009

PE Common Characteristics

• Medium to long-term illiquid financial commitment • Investors usually in legally structured private

partnerships (the PE fund)• Fund manager (GP)-sophisticated investors with

financial & operating expertise• Illiquidity & concentrated ownership create incentive

to enhance firm value (active Investors)• Valuation, terms & conditions result from process of

negotiation (except publicly traded companies)• Alignment of interests between investor & management• All of above geared to creating opportunity for exit with

substantial returns—dependent on achieving performance enhancements


Most “Western” Buyouts Don’t Fit Developing Country Profile

• TRANSACTION SIZE: TEND TO BE HUGE (Billions)• CONTROL: MAJORITY OR 100%• PUBLICLY LISTED COMPANIES • HIGHLY LEVERAGED—60-80% DEBT; ASSUMES

AVAILABILITY OF RELATIVELY CHEAP DEBT • AUCTIONS & “CLUB DEALS” INCREASINGLY COMMON• FINANCIAL ENGINEERING/RESTRUCTURING RATHER

THAN HANDS-ON VALUE CREATION • DEVELOPED FINANCIAL MARKETS TAKEN FOR GRANTED

(E.G. EXITS, CREDIT MARKETS)EM PE…A DIFFERENT RISK PROFILE, REQUIRING

DIFFERENT SKILL SET…


EM PE-Different Market, Requiring Different Skill Set

• Higher country risks– Macroeconomic volatility– Weak legal protection for investors– Thin domestic debt & equity markets– Limited exit alternatives– Thin professional management class

• More challenging due diligence & valuation– Less disclosure requirements/enforcement– Information asymmetries more severe– Accounting and reporting standards less reliable– Sub-standard corporate governance (e.g. transparency

& management accountability)


EM PE Market-Covers Broad Range

• Start-ups-early stage (VC)• Established family-run firms seeking to expand &

become more competitive• Medium-sized, established companies at pre-IPO stage• Consolidation of independent firms within same sector

(“roll-ups”)• Restructuring/ turn-around situations (post-Asia

financial crisis)• Privatizations

What do all EM PE candidates have in common?


EM PE Market-Covers Broad Range

• Start-ups-early stage (VC)• Established family-run firms seeking to expand &

become more competitive• Medium-sized, established companies at pre-IPO stage• Consolidation of independent firms within same sector

(“roll-ups”)• Restructuring/ turn-around situations (post-Asia

financial crisis)• Privatizations

What do all EM PE candidates have in common?


Victims of Financing Gap

• Majority of EM companies have limited or no access to medium/long-term capital

• But not due to capital shortage– Many developing countries have savings rates in 30-

50% range, compared to 17% in U.S., 15% in England and 23% in Germany

– Assets of largest EM institutional investors (pension & mutual funds) substantial & growing , but govt. regs impede PE investing

– Government borrowing absorbs large portion of private savings


Financial Sector Weakness= PE Opportunity

Funding Source Access Domestic bank credit (>1 year) LimitedDomestic stock market Very Limited

Domestic bond market No Govt. programs Yes Int’l equity markets NoInt’l credit NoInt’l develop. finance (IFC, IIC) LimitedPrivate equity Limited


Limited Financing Alternatives Enhance PE Opportunity

• “Patient Capital”- medium/long-term, illiquid;• Alignment of interests between investor and

management; share incentive to enhance firm value; prerequisite for exit

• Non-financial value added-incentive & expertise to strengthen corp. governance, financial reporting, access to new markets, etc.

• Catalyst-PE strengthens other ingredients for private sector development (e.g.corp. governance, IPO deal flow)


Inefficiencies Generate PE Opportunity• Successful PE investors (everywhere) identify &

capitalize on inefficiencies• Rampant EM inefficiencies a prime explanation

for rapid EM PE growth– Companies-weak corp. governance, financial controls,

marketing…..– Sectors-over-populated with under-financed

companies unable to achieve scale– Countries-anti-competitive regulations, labor law

rigidities, taxes• Course focuses on both heightened EM risks and

opportunities created by inefficiencies


Post-Investment Value EnhancementVC Mantra: “The real work begins after money is

disbursed.” • More true in EMs-building firm value more difficult• Skill set required to make an investment very different

than to enhance firm value– Investment bankers – do deal, collect fee, move to

next deal; no operating experience• Post-investment success requires local presence, deep

knowledge of indigenous business culture, and cooperative management – “We no longer invest where we do not have eyes

and ears permanently on the ground.”


PE Contribution to Value Enhancement (e.g. earnings growth, multiples expansion)

• Financial engineering-B/S restructuring• Identify & negotiate additional funding

sources• Recruitment -new management & board

members• Leverage industry contacts to identify

suppliers, customers, markets• Operational restructuring- gross margin

improvement, operating expense reduction• IPO Preparations• Exit preparation


EM PE Performance: Fundraising & Investment:2003-2008


EM PE Fundraising By Region: 2006-2008

Year 2001 2002 2003 2004 2005 2006 2007 YTD 2008*

Western Europe 35,611 28,868 34,037 37,230 85,026 108,000 152,000 NA

US 110,000 68,200 49,300 92,000 151,800 252,000 291,000 NA

Asia (incl. JANZ) 7,064 3,221 4,801 7,651 18,269 25,828 34,734 NA

Asia (ex-JANZ) 5,192 1,093 2,200 2,785 15,446 19,386 28,668 37,088

Latin America 624 407 417 714 1,272 2,656 4,419 3,975

CEE/CIS 575 530 406 1,777 2,711 3,272 14,629 5,364

Africa 92 151 741 1,380 791 2,353 2,340 2,592

Middle East 78 1,050 680 320 1,915 2,946 5,027 6,380

Multi-Region N/A N/A 116 618 3,630 2,580 4,077 8,092

Emerging Markets 6,561 3,231 3,489 6,545 25,765 33,193 59,160 63,491

Global 154,044 102,427 90,498 141,690 265,414 399,635 508,226 NA

Global PE Fundraising: 2001-2008 USD Millions

Source: EMPEA, 3i PwC, APER, BVCA, Dealogic, Dow Jones, EVCA, GVCA, KPMG, NVCA, RVCA, SAVCA , Thomson, VELA, Zawya *YTD 2008 figures cover the period starting January 1, 2008 and ending December 9, 2008.


Global PE Investment: 2001-2008USD Millions

Source: EMPEA, 3i PwC, APER, BVCA, Dealogic, Dow Jones, EVCA, GVCA, KPMG, NVCA, RVCA, SAVCA , Thomson, VELA, Zawya*YTD 2008 figures cover the period starting January 1, 2008 and ending December 9, 2008.

Year 2001 2002 2003 2004 2005 2006 2007 YTD 2008*

Western Europe 41,000 32,476 34,100 43,400 67,393 113,775 132,608 NA

US 58,000 41,399 59,200 43,500 22,738 215,000 444,390 NA

Asia (incl. JANZ) 11,200 9,119 17,600 11,799 16,559 50,683 41,506 NA

Asia (ex-JANZ) 2,000 250 4,528 4,316 7,692 22,468 30,370 20,570

Latin America 996 734 822 607 1,069 4,263 8,017 6,177

CEE/CIS 317 377 676 986 842 2,603 4,426 4,189

Africa NA NA NA 1,300 1,659 850 4,200 2,731

Middle East NA NA NA 176 724 5,195 3,500 796

Emerging Markets 3,313 1,361 6,026 7,385 11,986 35,379 50,513 34,463

Global 111,513 84,105 112,398 101,768 110,984 392,369 638,647 NA


EM PE Returns: Steadily Improving Relative to U.S. & European Funds…Until Late 2008

Index One YearThree Year

Five Year

Ten Year

Emerging Markets VC & PE ( 7.18) 17.31 19.71 8.30

Asia (ex Japan) PE (8.65) 11.63 13.75 6.88

CEE & Russia PE 0.41 34.45 39.97 19.87

Latin America & Caribbean PE 9.35 23.83 18.02 0.95

MSCI Emerging Markets (33.01) 8.69 19.05 14.77

US VC (0.9) 10.16 10.7 40.18

US PE (5.55) 13.29 19.01 11.81

Western Europe PE (14.76) 28.51 29.53 21.15

S&P 500 (21.98) 0.22 5.17 3.06


Cambridge Associates EM PE/VC Index (as of 30 September 2008)

Source: Cambridge Associates LLC Proprietary Index: pooled end-to-end returns, net of fees, expenses and carried interest.

1818

Emerging markets still under-penetrated

Source: EMPEA estimates. Note: Emerging Asia excludes Japan, Australia, New Zealand.


PE Fundraising as % of GDP (2007)

PE Fundraising as % of GDP by Region (2007)

The risk premium for EM PE rose from 6.7% in 2008 to 7.2% in the 2009 Survey

2009 2008Change in

Risk Premium

China 6.4% 6.3% 0.1%

India 6.4% 6.1% 0.3%

Brazil 6.4% 6.9% -0.5%

CEE (inc Turkey) 6.4% 5.0% 1.4%

South Africa 7.0% 6.4% 0.6%

Other Emerging Asia 7.3% N/A N/A

Middle East 7.3% 6.5% 0.8%

Latin America (ex Brazil) 7.5% 6.7% 0.8%

North Africa* 8.0% 6.7% 1.3%

Russia/CIS 8.4% 6.9% 1.5%

Sub-Saharan Africa (ex S. Africa)* 8.4% 6.7% 1.7%

LPs’ perception of risk premiums required for EM PE funds relative to developed market buyout funds

* Categorized as “Pan Africa” in the 2008 survey.

EMPEA/Coller Capital Emerging Markets Private Equity Survey, Global Private Equity Conference May 2009.

LP assessment of risk has gone up for all markets except Brazil; China and India relatively unchanged


EM Attractiveness over Next 12 Months: Country Rankings (LP Survey, March 2009)

2009 Survey

2008 Survey

Change

China 1 1 0

Brazil 2 4 + 2

India 3 2 - 1

Central & Eastern Europe 4 3 - 1

Latin America (ex Brazil) 5 7 + 2

Africa (ex South Africa) 6 5 - 1

South Africa 7 9 + 2

Middle East 8 8 0

Russia/CIS 9 6 -3

EMPEA/Coller Capital Emerging Markets Private Equity Survey, Global Private Equity Conference May 2009.


GDP

Source: International Monetary Fund, World Economic Outlook Database, April 2009

Developed vs. Emerging

Emerging Market Regions

GDP

But performance varies significantly across regions.

Emerging Market Economies Outperforming Developed Countries during Financial Crisis


Financial Crisis Consequences-Some Good News• EM PE industry better positioned to withstand

down cycle –deeper, more established than 5 years ago

• Financial crises generally lead to lower valuations, less competition, more PE opportunity (e.g. growth capital, restructurings, distressed asset sales)• Historically, PE deals consummated during times

of crisis tend to outperform• Long-term perspective-key drivers of EM PE

growth during past 5 years have not evaporated!* See reading assignment


Documents

London Business School November 5, 2009 Prof. Roger Leeds