February 1, 2012
Interviewed by: David Snow
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“Demonstration Effect”

Private equity markets in emerging economies grow due to good stories and good data.

In the third segment of Privcap’s series about the impact of private equity on emerging markets, Sachin Date of EY, Roger Leeds of Johns Hopkins University’s School of Advanced International Studies (SAIS), and Jeffrey Leonard of the Global Environmental Fund discuss the evidence of private equity’s beneficial effects on development.

Private equity markets in emerging economies grow due to good stories and good data.

In the third segment of Privcap’s series about the impact of private equity on emerging markets, Sachin Date of EY, Roger Leeds of Johns Hopkins University’s School of Advanced International Studies (SAIS), and Jeffrey Leonard of the Global Environmental Fund discuss the evidence of private equity’s beneficial effects on development.

David Snow, Privcap: Gentlemen, thank you for joining Privcap today.  We’re talking about private equity’s impact on the emerging markets. I think it’s very easy to talk in an abstract way growing jobs, making an impact on macro-economic development, but I’d be very interested in hearing some examples that you think provide the case for private equity as a positive, or at least an important impact on emerging markets.

Roger, starting with you, you are the founder and chairman of the Emerging Markets Private Equity Association.  You’ve had the ability to look across many different markets and examples.  I’m wondering if any stand out in your mind as being particularly illustrative of private equity’s impact on an emerging markets’ economy?

Roger Leeds, SAIS, EMPEA: It’s hard to pick one but I’ll try.  I don’t have a favorite emerging markets country, but one of them would have to be Brazil where I have spent quite a bit of time.  I would confess I do have a bias for the middle-market and the role of private equity in value creation in the middle-market.

So I would point out one example and i won’t point out the name of the company or the fund, but I will mention the construction industry in Brazil.  A small company located in Rio, not Sao Paulo that have been providing scaffolding and other equipments.  Low-tech equipment, not high-tech equipment to construction firms starting in Rio then expanding into south-eastern Brazil and then became national.

In almost every growth country, construction is a growth sector and supplying the construction is a growth sector. So, it’s a great fit for private equity. It’s also true that throughout the construction industry there is a tremendous fragmentation.  There is not a lot of consolidation, which again, creates opportunity for private equity.

There is a particular fund that labeled itself an SME fund that spent two or three years nurturing a relationship, developing a trust with the founding members of this construction company that wanted to grow more rapidly.  There was competitive pressure to grow more rapidly and in order to do that, they would need more capital.

Initially, they were very resistant to an outside shareholder and over a period of years, not months, this private equity fund, the founding partner developed a relationship with the family member who ran this company.  To make a long story short, they finally agreed to make a minority investment, provide them with capital that allowed them to accelerate their growth, to acquire some other small, like-minded companies, to expand more rapidly nationally, as you know Brazil is literally as large as the United States with huge construction projects all over the country.  And within three years of making this initial investment, much more quickly than the private equity investor anticipated, they were preparing for an IPO on FBOVESPA, the Brazilian stock exchange, which was enormously successful for everyone.

They raised a tremendous amount of capital for the company.  There was also a secondary offering that allowed the founding members to increase their net worth substantially, to allow the private equity investor to exit with a very attractive return, and it had a tremendous demonstration effect regarding the publicity around it.  So that other like-companies so this as a success story and it raised the profile of medium-sized enterprises in Brazil that they too could do an IPO on the local stock market.

So from start to finish it was a textbook case of success.  They are not always that successful.  I should add that we hear all about the successes.  Nobody likes to talk about failures, nor will I, because it’s hard to find them.  But this was a great, textbook case of success from start to finish.

Snow: And as you say, when you have a success like that, you’re able to turn it into a case study with others that can have a multiplier effect so other entrepreneurs are deciding that private equity is a good option.

Sachin, your firm, Ernst & Young, is a connective tissue between entrepreneurs, business owners and private equity firms.  Can you think of anything that stands out as an example of private equity’s impact either at a macro-level or on a firm level of positive forces brought to bear?

Sachin Date, EY: On a macro-level, as I mentioned, I have seen in India where there is a tremendous need for infrastructure development – power generation, ports, roads.  In all these three sectors I have seen private equity make significant investments and transform the pace at which this infrastructure is developed.  Without private equity, it would take a much long time for this infrastructure to be developed. I’ve seen private equity transform the speed at which this has taken place.

Snow: And is the public aware that private equity capital is at play with helping these assets develop?

Date: Probably not, at this stage, but it almost doesn’t matter.  I think the government is definitely aware that this is happening and is encouraging the private equity players to play.  That’s at a macro-level.  But, at a micro-level there are numerous examples.

One that sticks out in my mind relates to India and the business process of outsourcing, where a major Western company wanted to divest it’s very tiny business process outsourcing in India.  A Western b-fund decided to back this business. Over a ten year period, grew this business by acquisitions, by buying other business process outsourcing both in the West and in India.  They consolidated it and eventually IPO’ing this business on NASDAQ, but it took about ten years.

Contrary to what people think about private equity, being in and out in ten years time, this was a systematic development of a business, creation of a business, value creation, over a long period of time, and that made a big difference.

Jeffery Leonard Global Environmental Fund, EMPEA: A change doesn’t take place over night in many of these kinds of investments.

Snow: Jeff, can you think of any examples from your own firm Global Environment Fund or just any macro-examples that stand out to you?

Leonard: Yes.  We were talking earlier about how private equity can be a substantial bridge in the privatization of or the deregulation of markets that have been traditionally run or occupied by the government, in the government space.

In about 1998 or 1999, we at GEF teamed up with a group in Brazil.  GP Investimentos, I think Rodger sits on their board today, but this was many years ago.  We all saw a substantial opportunity to reinvest and reinvigorate the rail industry, but it had to be a private industry.  We participated in the privatization of assets and began to consolidate railroads in the big population regions of Brazil.

I remember the very first time I was visiting with the business.  First of all, you went into the headquarters and it felt like a government agency. Second of all, we went into the board meeting and said essentially, “Ladies and Gentlemen, I have some bad news. We are going to have a serious train crash – a collision.”  And everybody said, “What do you mean we’re going to?” Basically they said that we have two trains heading toward each other on the same track and we have no way of contacting them.

So the privatization, fast forward a few years – and the engineers were able to spot each other and stop the trains so there wasn’t a serious issue, but that was by luck.  A few years later, yes there was a downsizing at the headquarters of employment, but a substantial amount of the company was being run like a private sector organization.

The rail sector in Brazil was going from 3% to 4% to 5% long haul cargo being hauled to, today probably in the 20’s.  Which is terrific because it avoids additional infrastructure.  Everywhere you went in Brazil there were goods at port not getting out because of the back log of trucks.

So making the economy much more efficient, the organization much more efficient and by the way, benchmarking with American, U.S. long haul railroads, new technologies available and so on, by that time we had the railroad completely automated so that they would never have a collision with two engines on the same track.

So over a long period of time, that asset was finally listed in Brazil.  And I think that was listed at a time when the Brazilian stock market was trading at a 3-4 times PE ratio.  So we had to wait not only a long time for the fruition of the investment and the listing, but we also had to wait a long time for the recovery of the Brazilian markets.

But if you take a 10-year or 8-year hold period for that asset, you will see that all the investors made a good long-term internal rate of return.  And yet Brazil as a country prospered and benefited enormously from a private sector economy.

Snow: I have a bit of an academic question, so maybe we can start with Rodger.  What do we know, so far, about private equity’s impact on emerging markets?  What can we say with confidence, with facts to back it up?  By contrast, what don’t we know that we wish we did?  What is out there?

Leeds: What we do know is that the amount of capital flowing through this asset class to developing countries has grown exponentially.  So if you go back to the Nadar, there was no market and then there was a slight uptick in the late 90’s to 2001 because of underperformance. It was a new industry.  It hit rock bottom then by 2003, there was about $6 billion in current dollars raised for private equity investing in foreign countries.  Just before the financial crisis hit in 2008, 2009 it was $60 billion.  So basically from 2004 to 2008, which is a very short period of time, that’s quite an extraordinary increase in volume of investing.  That in and of itself is a wonderful story of investors gaining confidence in the asset class and these countries.

It had quite a bit of downtick after the crisis, and so did everything else, but it’s coming back smartly.  In the same vein, you had a lot of exits.  So people started to make some money, both the owners and the private equity investors.

What’s the problem?  The problem is the data on private equity in emerging markets today remains, frankly, abysmal.  We don’t know enough about it. As I’ve joked in the past, all we hear about is the good news.  There are no disclosure requirements in private equity.  So when you make an investment in private equity and it doesn’t go well you don’t have to tell anybody.  Or if your fund goes down the tubes, you don’t have to tell anybody.  You just evaporate.

We don’t know a lot about how well the industry is doing relative to who is not doing well. It would be great if somehow we could get more information on that as well.  I think you learn as much from your failures as you do from your success.  Anyone in the business who has really had taken their lumps knows this. That’s really how you learn in this business, but we don’t capitalize on that.   This is an embryonic business.  Even though I cited this tremendous increase in the volume of investing, it’s tiny.  Relative to what it is in the West, it’s tiny relative to the size of these economies.  It has extraordinary upside, but we have a lot to learn.

Date: I completely agree with Rodger.  Over the last five years, both in Europe and in North American, we have spent a lot of time trying to see whether private equity creates value and we have published studies on this. What we are trying to do is replicate that in the emerging markets, together with EMPEA, both in Brazil and India.  And that will start to give us more data points and facts around what is the level of value creation and how is that value being created.

Snow: What kinds of data do you need? Where do you get and are the sources that hold that data willing to give it to you?

Date: We will find out.  I think there is a desire from the industry players to participate, but I think it will need both EMPEA’s and Ernst & Young’s powers of persuasion to make it happen.

Leeds: It’s also micro. You have to go company by company to make that case.

Leonard: Just to pick up on what Roger was saying a minute ago, our failures or the things that don’t go well are often as important, and not to just the managers, I often tell people it’s a very humbling business, but you generally don’t make the same mistakes twice.  You are constantly, over a number of years, narrowing your horizon for mistakes.

But in country, sometimes it’s very important that only private equity can come in and restructure an industry in a way that would be very difficult for local capital or for governments to do.  Sometimes that starts with a reduction of employment in a certain area or wringing out some of the excess, the non-business aspects of formally government company.  There will never be indicators of success there, except survival of the enterprises or thriving of the business sector itself.  Of course today, it’s all about jobs. It’s about jobs in the United States, jobs in Europe, and equally as much in the emerging market companies.  It’s about jobs.

So the biggest thing that governments want to ask and that they come to EMPEA for is tell us whether or not, and how many, jobs private equity creates.  Does it create more than domestic investment and are they sustainable jobs or are jobs being lost as soon as the private equity players exit?

Leeds: That’s why we have to call it a growth capital business.  It’s a different asset class than in the West and the difference is because you’re growing businesses.  You’re not dismantling them, you’re not disaggregating them.  You are making them more efficient, but you’re really in the business of growing businesses.  By definition if you are growing the business one or another, you’re not going to be displacing employment, you will be growing employment – but it goes beyond just the number of jobs. Most of the people that come into the companies that we are investing in in private equity, they are going to get better benefits.  Absolutely, 100% and they had none beforehand.  They will have health insurance, other types of health benefits that they didn’t have in an underground economy or a previous job.  They will get training. At the managerial level they will learn good corporate governance practices, financial accounting, and all these other things.  There is tremendous spin off from this that a private equity investor has a stake in that other types of financiers do not. Their return depends on this.

So, I think there is a tremendous story to tell to governments about this, but we don’t have the data, though.  You’re right.

Snow: I wanted to ask, and maybe this can be the final question, but on a scale of 1-100, where is the private equity emerging markets world on understanding the impact it has on jobs and adding value?  How much further do we have to go?  Maybe starting with Sachin – 1-100, where are we?

Date: 35.  I think we have a long way to go.

Snow:  That’s not bad, it could be 1 or 2.  It sounds like a lot of work has been done.

Date: Yes, but a lot more needs to be done.

Snow: Do you agree?

Leonard: I do agree with that.  I think there is one other aspect of the measuring of private equity, which has to do with the nationalization, the outward facing regionalization. We talk about south-south trade, for example becoming more and more important in the global economy.

From the private equity side, I know that some of our most successful investments, where we’ve had the biggest impact, has been to be able to regionalize a platform.  So, we invested in a company in central Europe that had five locations in one country.  By the time we exited that operation had five countries in 35 locations.

Snow: So it sounds like the three of you will be deeply involved in aggregating and analyzing and disseminating that information.  As you, I hope you come back to Privcap and share it with us.

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