January 1, 2012
Interviewed by: David Snow
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Fostering Private Capital

Needing more private capital, many developing countries must figure out how to nurture and build a local private capital market and its beneficial ecosystem.

In “Fostering Private Capital,” the second in a three-part Privcap 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 how advocates for private capital have successfully spurred development of this asset class in their home markets.

Needing more private capital, many developing countries must figure out how to nurture and build a local private capital market and its beneficial ecosystem.

In “Fostering Private Capital,” the second in a three-part Privcap 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 how advocates for private capital have successfully spurred development of this asset class in their home markets.

David Snow, Privcap: We’re going to be talking about the impact of private equity on emerging markets, and specifically, I’d like to talk about how to foster the development of a private capital ecosystem in a developing country, and it’s something that all of you have thought a lot about and fought very hard to help bring along.

Maybe we could start with a question for Sachin from Ernst & Young.  When a country or when advocates for private capital within a country have decided that they need to push for the further development for the better framework for private capital within their home country, who have tended to be the best groups to further that effort?  Has it been sort of private equity associations? Has it been international groups?  Has it been possibly the government development agencies? In your experience, who has been most effective?

Sachin Date, EY: My experience over the last five to ten years would say that actually, it’s been the financial intermediaries, the professional services firms, together with the help of the industry associations in most geographies that have played a significant part in fostering the developing of private capital, private equity, in these markets.  And they are the ones who have encouraged and opened the eyes of the entrepreneurs, the family businesses, to the possibility of a different source of financing.

Snow: So they’re sort of the connective tissue between the business owners and the providers of capital and are able to explain both sides to each other?

Date: Yes.

Snow: How about in your experience, Roger?

Roger Leeds, SAIS, EMPEA: I have to first give it some historical perspective, and if you go back, say, 15 years, which isn’t a very long time, the asset class today is unrecognizable from what it was then.  If you had gone to any – name your country – 15 years ago or even 10 years ago and talked about private equity, you would have had a lot of blank stares whether it was the company owners or the financiers locally.

What drove the industry – I’m talking about private equity in emerging markets – initially was foreign capital, foreign expertise, either Westerners or foreigners who had spent time in a Western financial institution.  Governments, it wasn’t even on their radar screen, which is probably good.

Initially, the industry grew as a result from a demonstration effect. People started to invest.  Some people started to make a lot of money. They made headlines, and that was – and more and more capital started to flow in.  Also, these economies in the 2000s started to do much, much better. So the macroeconomics situation stabilized for many of these countries, and growth began to pick up.

All of these factors came together, coupled with liquidity around the world, which was looking for new outlets, and I think that confluence of factors.  So I don’t think it was governments. I think it was a natural process and some successes in the last, say, decade or so.  If we look out five or ten more years from now, it will be unrecognizable from what it is today in many respects.

Jeffrey Leonard, Global Environment Fund; EMPEA: So, Roger, let me build on that because you were one of the founders, the real creators of the Emerging Markets Private Equity Association, along with a few people from IFC and a few American and European general partners. In that day, it was the GPs were largely from Europe and the United States, and they were almost themselves conduits of recycling funds from, say, Western pension institutions, and so on, into emerging markets.  When EMPEA started, that’s what it was.

Today, as I’ve taken over in chairmanship in 2011, EMPEA has 300 members, most of whom are in Latin America, Asia, Africa, and Central Europe. So there’s been this explosion of local GPs, and those local GPs are doing the same thing as the international GPs previously did.  A lot of them are raising money in Europe and the United States.

But they’re almost more and more blending that capital they raised with local capital.  And so the asset class has become much more full and much more global, and it’s not unidirectional anymore. The flows of capital, the flows of people, the flows of ideas are in all directions today.

Leeds: The exciting thing is that this was unimaginable a decade ago, unimaginable that EMPEA is emblematic of this and would have a membership as diverse and as broad-based as it is today.  We couldn’t have even begun to envisage this.

Leonard: EMPEA was largely formed in about 1998, before the actual formation, when a group of us would sit around in Washington –as the emerging market asset class was melting down – Russia, Latin America, Asia, we found out everything was correlated on the downside in those days.  And we sat around, and we said, “Gee, is this really an asset class?  Will we ever make money in it?  Will we ever come out of these doldrums?”  Then we had a new definition of emerging markets.  Remember, Roger?

They’re markets from which you could not emerge in an emergency because that raises the issue that Roger brought up earlier about liquidity. So the change today is these markets are much more liquid. There’s much more domestic and local capital and financial centers that can orchestrate exits, even in a downtown.

If you look at the 2008 to 2010 downturn, we all saw that some of the most liquid places, some of the best places to be long-term investors actually and the markets that recovered first were outside of the United States and Europe.

Leeds: I would say the one, again, exception to all these generalizations is China, where the government was much more out front as one of the catalysts, not the only, but a major catalyst for developing the private equity. I think they were very visionary.  This is a real oxymoron, but there were state-owned venture capital funds in China 10 years ago, 12 years ago. They have directed money in this way.  They’ve seen it as a conduit for capital getting into SMEs.

I don’t want to congratulate them too much, but the government, contrary to almost every other country, has been in the forefront of developing the private equity industry, sometimes well, sometimes not so well.  But it certainly has played a very prominent role relative to just about any other developing country I can think of.

Snow: Almost every country in the world has a private equity association called different things, you know, Russian, Brazilian has ABVCAP.  What does a successful, national private equity association look like?  What does it do, and how do you measure its success, keeping in mind that EMPEA sort of rides above the many national organizations, but what have you seen as signs that a national private equity association is working?

Leonard: One of the signs is that it’s kind of in the form of a pyramid.  That is, there are a small number of international GPs that are beacons in the market, have been there, and so on. But there’s a growing number throughout, as you get down through the pyramid, of local, large-sized PE groups, middle-sized growth capital, and then even venture-capital-type groups involved because then, you’re playing at all levels of the capital structure of enterprise formation all the way to turnaround. Then you’re benchmarking with the international classes, but at the same time, capital is flowing into the local markets.

Leeds: The main role is to raise the level of awareness and understanding of the asset class amongst all the stakeholders from the companies themselves to the providers of capital to the service providers and, not unimportantly, to the government.

Just to give you one anecdote, you mentioned the Brazilian venture capitals – Private Equity and Venture Capital Association.  I went down there to speak about five or six years ago to their annual meeting, and you could have held that meeting in a closet, a few dozen people, got no publicity.  But last year or the year before when I was down there to speak, there were 400 people from all over the world that came to the Brazilian Private Equity Association –

Snow: They’re all trying to hire the locals, right?

Leeds: Exactly. It was so wonderful to see this, and it shows the role that the local association can play in mobilizing interesting, getting publicity, and bringing together – networking and bringing together various stakeholders to build the asset class.

The same thing has happened obviously in China and India.  You’ve seen this happen, so now we have an African Private Equity and Venture Capital Association, the South Africa Venture Capital Association, very, very strong.  These are real catalysts for the development of the industry by raising this level of awareness and understanding, doing research, bringing people together.

Date: And explain the benefits that private equity can bring to the local economies, and I think that’s a very important role that they have to play.

Snow: Let’s dig into that. Two of the constituents that these private equity associations are targeting are government regulators, policymakers, and then the local investment institutions. When speaking to the government regulators and the policymakers, what are the benefits that are brought out first, as far as the impact that private equity can have on a local economy?

Date: The ability to provide capital to businesses, entrepreneurs, families, that would not be available to them through either the debt financing or the equity markets or any other form, and that can accelerate the development of a business, thereby creating jobs and bringing prosperity, which is what every single government in emerging market is after.

That is the main role that private equity has to play. The role of the private equity association, the local association has to be to make sure that that story does get out and bring those case studies. Those good examples are well publicized.

Snow: Right, and be told again and again over a multi-year period.

Leeds: I would add one thing to that recipe, and that is that private equity is sharply distinguished from all other types of financing for private companies in that it is basically focused on value creation.  It’s the only type of investment where you’re not passive, where you’re an active participant with management in building value in a company.  And by building value, you’re creating jobs; you’re doing a lot of other things.

This is what governments have to understand and why they should be supporting this.  This is not like other types of financing.  And the private equity investor, we all know, has an incentive, a built-in incentive, to build that value because that’s the only way they make money.  And it’s that incentive and that value-creation theme, which I like to emphasize, and I think that these industry associations, it’s at the top of their agenda to make that case.

Date: Just one other thing to add:  If economy wants to have a good, stable equity market, then I think having the private equity investor as the intermediate step for a business before it goes to the public market is absolutely critical because private equity, because of the hands-on nature of developing these businesses, is able to inject all the things that we talk about, good corporate governance, good systems, all the things that you need to have a good and stable equity market. So any government that is interested in having a strong equity market must want to encourage private equity as the intermediate step.

Leonard: In addition to that, more and more we see around the world, if you’re in international private equity, you have to bring more than money; you have to bring more than capital to the equation.  So, like Roger said, you need to be a hands-on, active investor.  But you need to bring the access to capital, the knowledge of markets, the knowledge of business models, perhaps the ability to bring in people who have the organizational and management capacity, who can train and develop because that becomes the beacon that forms whole new industries in countries.

We invested in Africa in 2000 – 1999, 2000 in the forest products/lumber industry.  It was an industry that was being largely divested. Capital was being extracted from the industry. Old milling assets, lumber assets that had been put in place in the 1950s and ’60s were just going downhill, and mills were being closed.

But, by coming in, bringing new technology, new techniques, new access to international markets, which had stagnated in this region, we were able to not only build an asset that prospered itself, but suddenly, all the other owner companies were seeking private equity investment and were reinvesting in their capital stock, and the industry itself came to thrive again.  And that’s a clear example where private equity combined − domestic and international equity combined together can reinvigorate even a dying industry.

Snow: It’s interesting.  The case can be made for − let’s say, government or policymakers that would like to see the development of their public markets, the case can be made that, far from being a competitor to the public markets, that private equity is actually the lining up and priming companies to go public in a more compliant manner with a corporate governance.

Leeds: Absolutely.  It’s the private equity folks who are going to bring them up to standard where they can list, where they can get their corporate governance, their financial reporting, their accounting, and so forth, at a level that will allow them to be sufficiently transparent that they can list.

Snow: Let’s talk about something that’s very important, which is the development of the local investors as sources of capital for private equity.  The classic model of development for private equity in the emerging markets is that there’s a local GP.  Oftentimes, he’s been educated in the West and in the US or Europe, and then the first fund is raised with Western sources of capital. It’s the local investors who are often the last to come into these local private equity funds. How has EMPEA, how have some of these advocates for private equity in these developing countries been educating the investors? What has worked and what has not worked?

Leonard: It’s still going on.  That education is still going on. Some markets there is more domestic capital available and some you have to structure off-shore and on-shore vehicles separately for various reasons. In some countries the pension funds are loosened to provide more and more capital. It’s a mixed bag still, but there’s not question that the private equity model is now not just a form of recycling funds from the advanced countries like Europe and the United States into the so-called ‘developing countries.’

Snow: What is preventing a local pension fund from investing in private equity? Is it strictly regulatory or is it just lack of information about the asset class?

Leonard: It’s both. It certainly has been regulatory in many cases or just prudence. The definition of prudence being zero. Now it’s a small portion or small percentage as we see in the United States and in Europe of very large pension funds put into private equity can have a major impact. Both on returns for the long-term investor, but also on the private economy.

Leeds: There is an issue, however, in the larger countries where domestic pension funds and other LPs are coming into private equity with increasing amounts of money.  They have not yet learned, if I may use that word, to behave in the same way that LPs behave in the West.

Why does an LP invest in a private equity fund? Why doesn’t an LP, which is basically an asset manager, with a huge pool of capital go direct to invest in these companies? Because you find it more efficient to go through a fund where you have expertise and it’s a much better way of allocating your time and resources.  That’s the theory, anyway. That theory has not arrived with the same force yet in most developing countries. What you have as a result is the LPs want to be more hands-on. They want to sit on investment committees. They don’t have yet, in a degree, the confidence in the GP and they want to monitor and be involved more than what GPs are comfortable with, which is understandable. They have not embraced the limited part of the partnership.

I think that will change over time, but it’s been difficult for many countries. I think of China, Brazil, and a lot of countries where LPs are very active to an extent where it makes GPs, understandably, uncomfortable.

Leonard: In some cases they may also have a developmental mandate that may push them to want to invest in a manner that isn’t just for financial return. For real, true general partner private equity players, it’s very difficult to manage differential expectations from your limited partners.  We’ve seen situations where local, domestic, quasi-government organizations may come in and do something that is not for full return and that certainly changes your risk profile.  That also changes your other limited partner, fiduciary responsibilities.

Date: Another thing that will lead to the development of the domestic LP will be, using India as an example, we are starting to see big Indian family businesses set up their own GPs. What that will then create is the ripple effect which will allow others to come in and start investing as LPs.

Leonard: I wanted to comment on one other, less spoken about the effect of the availability of private equity capital and international flows. It is helped to nurture and stimulate further this returning diaspora of people from, say, countries like India, Brazil, or China where you have Western educated individuals who were working either ina business or in a financial institution here in those markets coming back to their respective, national countries of original with a desire to create an interprise.  In India or in China, you really couldn’t get access to capital.

Now we see in India, an engineer returning from having run a group within an engineering facility in the United States or Europe who has a business plan in mind. And it’s been private equity – no other source of capital because these are individuals who are professional engineers.  They are not associated with the large institutions in India and the same for China. We see that many of the venture capitalists who have returned to China today are Chinese American individuals who made money in the old Silicon Valley tech-boom in the United States.  So they go back and they’ve created venture capital firms that are mirrors of the firms that they worked with in Silicon Valley. Those are really positive trends.

Snow: Well it’s certainly a powerful story to our policy makers – if you’d like to reverse the brain-drain, private equity can be a very powerful magnate.

I’d like to finish with one final topic and maybe we can start with Sachin.  One final constituent group that needs to be eduated, although it sounds like they are more and more aware, are the business owners, the operators, the entrepreneurs themselves.  With your boots on the ground team spread out through Europe, Africa, India – I’m wondering if you can talk about the level of awareness and the outreach that’s necessary to get these entrepreneurs familiar with private equity, familiar with alignment of interest and all the things that private equity brings with it.

Date: I think it’s an evolving process.  It has started to happen over the past five years, although I don’t think it’s a finished process.  There is still a lot of work that needs to be done as far as educating the entrepreneurs and the family businesses about the benefits of private equity.  Inevitably they will see the loss of control, intrusion from a shareholder that wants to be hands on as negative until they reall experience it or they know someone who has experienced it and then they will know that they will change their mind.  But that sort of thing doesn’t happen overnight, it needs some good examples, good case studies that will bring that to life.

Leeds: I would agree.  I think that if you go back a few years, before private equity had any reputation in these countries, you had to start with the ABC’s of private equity when you went in to see a company. You had to go back over and over again to explain the benefits.  But a word that I think about in terms of private equity that is not very commonly used in the world of finance is empathy. Unless a private equity investor understands this trepediation that the founder, the family owner has of a company intruding on his or her business, they will not be successful.  You have to create a partnership of trust.  That takes an enormous amount of trust and empathy in understanding why the founder or the owner wants your money, but he doesn’t want you.  And overcoming that resistance which is very natural, very understandable, developing that trust it’s not going to be a successful transaction.

Leonard: Roger, I couldn’t agree more with you.  I much of my time making sure that wherever we are operating, that our teams are sitting down with the entrepreneurs and not just signing a document or having lawyers negotiate an agreement, but really helping them understand the good and the bad.  The opportunity and the obligation that comes with prvaite equity.  For example, in many contries the notion of liquidity is just not here.  The family owns the business they want to own the business forever.  Well that’s great for them perhaps if they use the private equity capital to grow the business even further, but then what about htat agreement of liquidity?

It’s not just a matter of signing an agreement. It’s a matter of really impressing upon them.  Sometimes we’ve had family groups or the CEO, head of the family business come to the  United States or talk to other CEOs so they really understand that issue.  It has to be a great partnership.  It can’t be about control.  It does have to be about agreements of your road map to the long-term.

Snow:  Well this is a fascinating topic, I think we should pause for now.  We will certainly return ot the topic of private equity;s impact on the emerging markets, but thank you for joining Privcap today.

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