January 1, 2012
Interviewed by: David Snow
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Development Equity

Among the ingredients necessary to help an economy mature and grow, private equity is increasingly essential. Yet, understanding of private equity’s impact on emerging markets is still developing.

In the first of a three-part series, 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, share insights on private equity’s role in helping emerging economies develop.

Among the ingredients necessary to help an economy mature and grow, private equity is increasingly essential. Yet, understanding of private equity’s impact on emerging markets is still developing.

In the first of a three-part series, 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, share insights on private equity’s role in helping emerging economies develop.

David Snow, Privcap: So gentlemen, thank you for being here today. We are talking about private equity in the emerging markets, what is the impact of private equity on the development of the emerging markets, and certainly, the three of you are experts at the talk. And we’re very pleased to have you here today.

Maybe let’s start with Jeff Leonard. Jeff, an emerging market economy needs certain building blocks in place in order to prosper and thrive. What are – speaking from a macroeconomic level first, what are some of those building blocks that need to be in place in order for an economy to progress?

Jeffrey Leonard, Global Environment Fund; EMPEA: Well, let me speak from my 25 to 30 years of experience now working in emerging markets and say that I’ve gone through an evolution myself that has culminated in investing with private equity as these markets themselves have gone through an evolution. You need an infrastructure. You need open markets. You need education. You need a transition from an agrarian economy into an industrializing economy.

And in many respects, I think all of us here at this table have seen a great transition. So when we started Global Environment Fund in 1990, I remember I was asked to be the head of research for a developing country, third-world, as we called it in those days, organization that did a lot of work on the development side, the official development assistance and so on. And I drew on a napkin for the gentleman who asked me to head that organization a curve of crossing lines, which showed official development assistance as the major inflows of capital and during that time in the previous years and the rising influence of private equity.

And it was my thesis at that time, and I think probably all of us who are in the business today, that private equity would dwarf in importance public official development assistance over the years, so that really is the genesis of the last couple of decades. If you look at the 1990s, in emerging markets in the private equity, a lot of the flows were for infrastructure and privatization.

And so there were a lot of things to privatize. Old utilities are privatized state-owned assets.  You had a lot of the former Soviet Union assets being privatized, the beginnings of privatization in China and so on. And now, in the last decade and over the years it’s become more and more like private equity serves the role in Europe and the United States where you really are helping to make the whole industrial and manufacturing and business sectors more efficient by using private equity to acquire assets and build them to consolidate markets and to take advantage of new market opportunities.

Snow: And Roger, picking up on what Jeff was saying, as you have observed the development of many different economies over the years, what have you seen as being very important building blocks that need to be in place in order for these economies to move forward?

Roger Leeds, SAIS, EMPEA: I don’t wanna be too academic, but if you went to Development Economics 101, the ultimate objective of all this is to grow an economy, and by doing so, you’re going to reduce poverty, create a rising middle class, and all the other things we expect from economic growth.

And that requires first – not first and foremost, but it definitely needs a financial sector, institutions, markets, regulations that allow you, as we say in the classroom, to mobilize savings whether domestic or foreign, intermediate it through the financial system into productive investment. And that’s really what a financial system is meant to do.

My observation has been that even when you take the more successful developing countries over the last quarter century, like a Brazil or like a China, the lagging sector, notwithstanding all the growth and all the success they have had has been the financial sector. The financial sector for a variety of reasons in most of these countries has lagged behind the other sectors in terms of growth and development, and that’s still the case to a large extent throughout the developing world.

And that, in and of itself, creates the private equity opportunity. The fact that it is so hard for worthy companies of any size, small, medium, large to raise medium and long-term capital – not short-term capital because that’s a different sort of – but medium and long-term capital they can use to invest and grow their businesses, it’s really tough. It’s really tough still, even in a Brazil or a China, as large as they are and as fast-growing as they are.

And this is the great opportunity for private equity to fill that financing gap.

Snow: Sashin, do you agree?  Your team has boots on the ground all over the emerging markets, and I’m wondering if you’ve seen the impediments to capital reaching the business owners and the entrepreneurs you work with?

Sashin Date, EY: Absolutely. I couldn’t agree more with the point. And we’ve done some research in India, in particular, where we’ve seen that over the last five years, private equity has provided double the amount of capital that the equity markets have been able to provide to Indian corporates to grow. So I think private equity is absolutely essential in terms of helping the companies through the growth phase, largely because the equity markets are not developed enough, don’t have enough depth, to be able to cope with the growth companies that an emerging economy needs.

Leeds: If I could just add one thing, David. Not only is that true of the equity markets, but it’s even worse for debt. So a company that doesn’t have access to public equity markets is not going to get probably access to medium and long-term debt, which we take for granted in the West. Banks in most of these countries don’t bank in terms of providing medium and long-term loans to companies.  They’re too focused on consumer credit and on government credit. And so again, this is another part of this tremendous gap that really impedes the overall private sector of financing.

Leonard: And in some ways, I’ve seen the influx of foreign private equity or international private equity as part of the democratization of capital, access to capital, in many markets. If you look at India, traditionally, new businesses have been formed and access to capital has come through the large, traditional families. And what you have today in India because of the, just, tremendous changes in the way capital is flowing into the country and the whole region is that new entrepreneurs have access to capital, new businesses are developed.

And then you’re seeing new billionaires, a new generation of billionaires instead of a perpetuation of the old generation of billionaires in that market. And it’s happened in many other markets around the world.

Date: And if I can add, in places like India, it’s happened with not just international private equity. There’s a thriving domestic private equity industry that’s probably sprung up over the last ten years that is helping that growth.

Snow: You say that it takes a while for the public capital markets to develop in some of these developing countries, and in the meantime, private equity has a role to play. But that said, there is still a regulatory framework in which private equity exists in a lot of these countries. Can you talk a bit about what you have found in the successful regulatory frameworks that encourage the right kind of private equity activity and maybe frameworks that you’ve seen that have actually discouraged business growth because they’ve maybe been not the right structure for private equity, starting with anyone?

Leeds: I think the big shift, at least in some of the more middle-income countries, is now they are beginning to encourage local institutional investors to allocate some of their capital to private equity. This is very encouraging, and I think that if you fast-forward five or ten years, this is going to be a trend that’s going to pick up momentum. And it’s a very good sign because these countries are not very efficient in the way they allocate capital.

And so, if you can get more of this domestic savings in a place like China, for example, where there’s these huge pools of inefficient capital, into private equity, 1, 2, 3, 4 percent of that would be just massive in terms of being a stimulus to this industry. And I think that the regulatory framework in countries like this is beginning to encourage us, just as it did by the way, in this country 30 years ago.

Venture capital and private equity took off in this country in 1980 as a result of a change in regulation that allowed pension funds as prudent investors to put more of their capital in the alternative assets like private equity.

Leonard: And that’s happening up and down, and particularly, Latin America right now where they’re releasing that. The really interesting thing about it is a lot of that is it’s a convergence of knowledge. You see a lot of regulators from those countries coming to the United States understanding our pension system and the European ones. And they’ve learned the notion of prudent investors and regulation, and so, it’s a tremendous learning experience.

You asked the question earlier, David, about the balance between foreign and local capital flows, and I think the foreign capital flows often provide the stimulus, the learning, the benchmarking that can help change the local market, as you were saying about the Indian market.

Snow: Jeff, as the current chairman of the Emerging Markets Private Equity Association, and Roger, as the former and founding chairman of EMPEA, you must have spent a lot of time talking to regulators in some of these countries and maybe educating them or responding to inquiries that they had for you. What kinds of conversations were those? And what types of information were they seeking out about private equity and the right regulatory structure?

Leonard: I think that beyond what I’ve just said – and Jeff said about encouraging more flows of domestic capital into the industry, I think the other big issue is corporate governance and transparency at the company level. Again, I think this is where private equity has so much to contribute because private equity people are very hands-on. They have a tremendous set of aligned incentives with managers.

And I think that increasingly, public officials in many of these countries recognize that private equity can strengthen corporate governance all across the board when it invests and creates a demonstration effect because corporate governance, frankly, in many of these countries is atrocious, transparency, disclosure, accounting standards, and so forth. But private equity investors won’t tolerate that, and so, when they come into a company, this has to change.

And I think that increasingly you see public officials in these countries as envisaging this as a benefit. Now maybe that’s not exactly regulatory, per se, but many of these countries now are tightening disclosure laws, corporate governance standards, and so forth, and I think that’s a great sign. This is not something that happens quickly or overnight but is a trend, I certainly see it. I talk about this with public officials all over the world.

Date: Adding to that, I mean, over the last three or four years, we’ve seen a significant amount of regulation both in Europe and in the US, around private equity. So the ultimate investment firm directive that came out in the EU, the Dodd-Frank regulation here in the US. I think that, both of those moves, are being very keenly observed by the regulators, by government in the emerging markets.

And as those get implemented on both sides of the Atlantic, I think we will see that some of that regulation gets picked up by the emerging economies and get implemented and try and bring some regulation to private equity, albeit, they understand that there can’t be too much of regulation because that will then stifle the industry.

Leonard: Now, as the new chairman of EMPEA, I would say the issues are evolving along the lines that you’re saying is that the concerns about private equity to some extent are being raised are those that you hear in the international and press in the United States and Europe about big buyout issues or leverage, and so on. And most of the investment capital that we’re seeing from the members of EMPEA, anyway, and these markets is real growth capital.

And I think the regulators understand that, that they need inflows of growth capital.  They need the job creation aspect of it, the enterprise formation, the international benchmarking. And so, they spend a fair amount of time with EMPEA now trying to solicit and elicit from EMPEA case studies about that, ideas that help them fight the ideological war, shall we say, sometimes when you hear about these issues?

And I remember in one country in particular where we had an investment, and I sat across from a government official who went on for quite a while about that she didn’t like capitalism, she didn’t like foreign investment capital, she didn’t see the need for private sector involvement in the particular sectors that we were investing in, and then, she leaned across the table. And she said – after maybe 30 minutes of that – and she said, “But our country and our sector needs your investment because your investments are the only bridge between the third economy and the first economy for people who don’t have jobs today.”

So I think there’s that conflicting feeling or politics that we all sense in certain of these markets that they look to us to help them address.

Leeds: I think, just building on what Jeff said, the message I always bring to the floor when I talk to government officials is that private equity and emerging markets is a fundamentally different asset class than it is in the West for the reasons that Jeff just mentioned.  It’s not the same asset class, and once that message is understood, I think the dialogue changes very dramatically. And they just have to understand that this is not a buyout business, primarily. Someday, it may be, but it’s primarily a growth capital business. It’s a positive force for private sector development. And I think all the evidence points in that direction.

But you’ve got to be an evangelist for this type of a message and get it out because it is very badly misunderstood in a lot of places, not only there, but here. Because all the headlines speak about veracious buyouts, the buyout, strip it, sell it type of mentality, and that’s not the same thing as the business we’re in.

Date: And in that respect, the private equity industry has done a good job in emerging markets because they have chosen to invest in sectors such as power generation, roads, ports, basic assets that they completely shy away from in the developing world.  But they have found ways to invest in those sort of assets in the developing world, and that has probably started to change the perception of what the private equity can do in the developing world.

Snow: It’s funny.  It’s almost like in the developed world in the US, there’s almost this sense from the public and from the politicians, private equity, we’d like less of that.  Whereas, in the emerging markets where there’s less of a history of private equity, there seems to be less hostility and in fact, a real desire to have more of it.

Leonard: Well, they need the capital. They need the enterprise formation. They know they need to create the jobs, and they need the infrastructure and in countries where there isn’t an established public finance aspect. And the nice thing about doing some of these infrastructure or big power and other utility type investments in some of these markets is that there’s an oxymoron here. It’s kind of a growth utility involved.

It’s going to be, ultimately, a regulated industry, but you’re adding customers from 1 million customers to 5 million customers in a growth mode that can get you the kinds of returns from a private equity perspective that you wouldn’t get investing in those basic utility sectors, necessarily, in the United States or Europe.

Leeds: I also think the opportunity in comparing and contrasting with the West is that one of the reasons these countries are quote, unquote underdeveloped is because almost every sector you look at within the private sector is fragmented. Lots and lots of small and medium-sized businesses that get to a certain stage, and then they hit a brick wall because they can’t get the financing to consolidate and to gain scale.

And this is a great private equity play almost everywhere, whether it’s construction materials or retail or agri-business or so forth. And so, you see so much of private equity in these countries in contrast to the West being consolidations of some sort, taking advantage, capitalizing on the inefficiencies that have long existed in these countries, and this is good for the countries and it’s good for the private equity investor.

Leonard: Just to make one interesting contrast. I remember in the 1960s and in the early 1970s in Europe there was this real fear of American investors and American corporations. Remember the French were all concerned, the Americanization of France from American companies. But what’s happening is Roger indicated earlier as the financial markets are growing up alongside our private equity investments, we’re in private equity long-term investors.

Our whole period is often five to eight or more years. Sometimes we don’t admit how long it is, and so there’s a long period during which the capital markets have been maturing over the past decade or two, so that you actually can see your exit strategy in a lot of these countries.

And I think of South Africa or India or Brazil or China as great indicators of this. You’re generally or often exiting by selling to domestic local entities, so what you’re doing is you’re building out with international capital a whole new industry or a whole new set of infrastructures or access to international markets in a sector, and then you’re leaving behind to local players who couldn’t have built it themselves a domestically run business.  It’s not leaving behind Americans or Europeans sitting in Johannesburg or San Paulo running the business.

Snow: I want to ask one final question on this topic, and that has to do with something that Roger alluded to, the balance between external international, big capital coming into the country and the development of local, either GPs or local sources of investment capital. Are some of these emerging market governments having a hard time balancing attracting in the external capital while also fostering the development of indigenous private equity managers?

Leonard: I haven’t seen this as a government issue. I think this will work itself out over time. Certainly, I would expect it certainly in the middle-income countries as you’re going to have more and more domestic capital. It depends on how much savings you have in an economy, what the intermediation process and what kind of institutions you have, the pension funds and so forth. But I don’t see this as an issue that governments are going to control.

There will continue to be, especially in the middle-income countries, a flow of foreign capital into these countries for deals, and I think this is very, very good. But I haven’t seen – and maybe my colleagues feel differently – that governments have resisted this in any way or have encouraged one or the other.  It’s not an either/or proposition in my view yet.

Date: No. I completely agree. I don’t think that governments have tried to influence it. I think as Jeff said earlier, these governments need the capital and I think both domestic and international players both have a role to play in the development of the private equity industry. And I think that that’s happening.

Leeds: The one place where there’s a slight exception to this, of course, is China, which is – it’s not exactly a level playing field. And the way it’s unfolding at the moment, there is certainly preferential treatment given to wholly Chinese funds. The regulatory structure for foreign capital and domestic capital is different.

How this plays out over time, I don’t think anybody really knows, but they are preferring or leaning in the direction – not at the expense of foreign firms – but there’s room for both. But the regulatory framework is certainly favoring the local players right now, but I think that will change over time.

Snow: Well, gentlemen, this is a fascinating topic. I think we can pause for now, but thank you so much for joining Privcap today.

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