private equity financing of high growth companies[1]

7/30/2019 Private Equity Financing of High Growth Companies[1]

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Private Equity Financing of high growth companies

CLEMENTE DEL VALLEWorld Bank / IFC Capital Markets AdvisoryNigeria, March 6 2008

The role of the Government


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Main Findings OECD

The Challenge of growth

Employment in high-growth firmsContributions by different size classes

Source: OECD (2000)


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Main Findings OECD

The Challenge of growth

High-growth firms and their contribution to job gains

Source: OECD (2000)


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Private Equity: Definiton VC/PE

medium to long -term f inance prov ided in return for an equity stake in potentially high growth unquoted companies (BVCA)

The Private Equity Industry

Europe Venture Capital Expansion Capital Buy-outs

United States Venture Capital Private Equity

VC/ PE includes quasi-equity transactions, which rely on hybrid

equity/debt instruments involving a stream of dividends

dependent on firm performance as returns.

For the purposes of this study:

Market scope:


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The role of Private Equity and Venture Capital (VC/PE)

Why is VC/PE approp riate?

Pre-investment (focus in the process)

PE/VC firms are very spec ialized in se lect ing investments because they excel l in two pro cess :

Screening process

Due di l l igence

Post-investment (focus in the function)

After the inv estm ent, PE/VC f i rms b r ing :

Hands - on co -management

Market savvyness

Contacts for expansion & exi t

Typical investment funnel of the UK middle -market BVCA survey: non-financial contributions to PE-backed companies

Source: BVCA, Altassets research, team ana lysis

Specialization


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6Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

World: Private Equity Growth - the good news

Globally

. . and in Em erging Markets


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problem: Equity Gap in VC/PE market

Short Term; higher liquidityLong Term; lower liquidity

Equities, FixedIncome, Derivatives

ProjectIdea Prototype

StableProduction

Commercialization

AngelInvestors

CorporateStages

SeedCapital 0 - 10k

250k - 750k

750k 2M

2M 50M

10k - 250k

50M UP

Pre- IPO Liquid Markets, MatureShareholder, Competition

Venture Capital

Equity Financing Marketplace UK Case

Mezzanine

Private Equity

Source: BBAA, UK HMTC & SBS, Stratus Risk Capital, Team analysis.

Equity Gap P I P E S

AIM, OTC

Medium liquidity

OECD: Gap affects early stage, innovative firms, untried business models with little collateral.


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Short Term; > liquidityLong Term; < liquidity

Equities, FixedIncome, Derivatives

ProjectIdea Prototype

StableProduction

Commercialization

A.I.

CorporateStages

SeedCapital 0 - 10k

250k - 750k

750k 2M

2M 50M

10k - 250k

50M UP

Pre- IPO Liquid Markets, MatureShareholder, Competition

Equity Financing Marketplace EM

Mezzanine

PrivateEquity

(Global Funds/limited domestic funds)

Underdeveloped f inancing markets Widens the gap

affecting more stages of bus iness deve lopment .

P I P E S

Source: BBAA, UK HMTC & SBS, Stratus Risk Capital, Team analysis.

VentureCapital

Equity Gap


Emerging markets: large deficiencies across all the supply spectrum of VC/PE


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Seed &Startup

Capital

VentureCapital

Size

Start-up

PrivateEquity

EMs: Government in tervent ions

Emerging Markets

Tartgeting of Government intervention

1 Middle market: Firms well beyond early/start up stage, seeking financing to grow / expand

Middle Market: Main Initial Focus ?

L

M

S

early Expansion/Growth Middle Market1

Buy-out


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The equity and debt gaps are much larger in the EMs

PE indu stry :

Seed & Startup Capital coming primarily from family and friends

and VC: at very low levels PE: high dependency on foreign capital + Fund management expertise very

limited

Financial system con straints : absence of medium/long term credi t

But s im ultaneous ly: High Saving Rates how to tap these savings?

Growing interests f rom governm ents but s t i l l very few cases of s t ructured interventio ns ( e.g. South A frica, Brazil)


Emerging markets: large deficiencies across all the supply spectrum of VC/PE


11/2511Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

Reasons behind the Equity Gap

1 - due to sluggish growth in the early development of VC/PE industry

Growth concentrated in Asia NOT elsewhere where industry is a t nascent s tage


12/2512Source: HM Treasury & SBS Report: Bridging the finance gap, 2004; Lerner 2005.

UK - Total VC/PE Investment, 1990 - 2002 Relationship between fund size and deal size, 1984 2000 UK

as PE industry develops & gro ws, tends to become conc entrated on the later s tage of market which offers better risk-adjust returns, due to the economies of scale of this activity

Reasons behind Equity Gap in VC/PE market

2 - due to migration towards late stage (economies of scale)


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Government Interventions: the importance of private sector expertise !

VC/PE: a hig h-r isk asset c lass

Source:Lerner (2005), Cambridge Associates, team analysis

0.0%

-5.0%

-10.0%

10.0%

5.0%

15.0%

20.0%

DJ 30

S&P 5 00

Microcap

Midcap

Willshire 500

US Corp Bonds

NYSE

NASDAQ

MSCI WorldEx US

PE/VC Lower Quartile

-7.6%

PE/VC Median4.1%

PE/VC Upper Quartile

16.1%

PE/VC Min = -100%

PE/VC Max = 721%Return on investment USA, 1980 2002

Private Equity = High Risk!

Private Equity Returns by Region vs.Broad Index Returns, as of 12/31/06

Index One Year Five Year Ten Year

Emerging Markets VC & PE 26.8% 12.8% 6.1%

Latin America PE 19.2% 2.3% (2.3%)

Asia (ex Japan) PE 18.5% 10.5% 4.9%

CEE & Russia PE 53.2% 27.1% 15.3%

US PE 25.8% 17.6% 13.8%

MSCI Emerging Markets 32.6% 27.0% 9.4%

S&P 500 15.8% 6.2% 8.4%

Lehman Brothers US AggregateBond Index

4.3% 5.1% 6.2%


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Government Interventions: the importance of private sector expertise !

Persistency - Succ ess in Private Equ ity is no t Luc k, it is Ski l l .

Mc Kinsey finding in Europe:

If your first fund was top quartile, there is a 45% chance your next fundwill also be top 25% and a 73% chance it will be top half. A new fundmanagement team has a 16% chance of being in the top quartile.Success in private equity is persistent .

Conor Kehoe, Partner McKinsey & Co., EVCA, June 13, 2001


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In private equity, the spread between top performers andaverage performers is large.If you are not with a top fund manager, you would do better investing in bonds .

Government Interventions: the importance of investment expertise !

Skil l is Mo re Valuable in VC/PE than in oth er asset c lasses


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Government Interventions:

Typology

Business Enabling Environment Legal, enforcement, obtaining credit, starting a business, IPR, etc.

(Taken as a given in OECD / challenging in emerging markets)

Stimulate growth of PE/VC industry Enabling Regulation Tax framework Public/Private Investment Programs

Other Related Policies Innovation and industrial policy Public equity markets Support VC/PE sector (valuation standards, associations, research, international linkages, etc)

Focus of this study


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Enabling access to Institutional Investors Capital VC/PE: possibility to tap into a vast pool of national savings Institutional investors: opportunities for diversification and improved returns.

Supervision of Vehicles and Fund Management Vehicles, balance between Protection of public investors

Flexibility towards professionals

Licencing Build Trust in Fund Management

Avoiding overregulation as if it was mutual fund product

Improving protection and rights of VC/PE investorsRegulation on minority rights, standards of disclosure and fund management.


Enabling Regulation


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Legal Framework Vehicles

Tax pass-through capability = PE/VC funds exempt from corporate tax

Limited liability on the passive investors

Limited Liability Partnership (US, UK)

Closed end investment fund (Brazil, Taiwan, Spain )

Investment inducing Tax Policy

Low tax rates on capital gains (CGT)

US (15%), UK (10-18%), Brazil (15%):

Carried interest = generally 20% of capital gains of PE/VC funds earned by partnersTaxed at CGT rate: major stimulus for PE/VC industry


Tax framework


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Co-Investment funds, potentially with enhanced returns for Private Investors Government capital provided as limited partner management by private sector

Funds of Funds Government capital provided to PE/VC funds that invest in other PE/VC funds

Quasi-Equity, leveraging VC/PE funds (e.g. SBIC) Quasi-equity = debt with an upside reward Government offering long term debt in PE/VC deals (at public debt rates)

Tax break induced programs (e.g. UKs EIS and VCT) Tax induced retail investment directly in companies (EIS), or in trust funds (VCT)


Public/Private Investment Programs

E i M k L l d d d i


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Liberal iz ing investment res t r ic t ions on local inst i tut ional investors Pension funds & Insurance Cos largest source of capital in OECD

US: legislation change 1979 ERISA start of explosive growth in PE/VC

Brazil: 2000 Pension funds allowed to invest up to 20% of assets in PE/VC

Brazil: since liberalization: strong growth in PE/VC & IPOs of PE/VC -backed firms

Supervis ion Supervising the professionalism of the manager but not regulating the vehicle (FSA in UK) Allowing only qualified investors to access VC/PE vehicles [ Brazil ]

Taxation

Investment vehicles with tax pass-through capability [US LLP or similar

Adjusted frameworks (e.g. trusts, open funds)

differential fiscal treatment of carried interest acknowledges high risk [ US, UK ]

Reducing tax and capi tal contro ls on the repatr iat ion of ( long-term) capi tal gains Brazil (0% rate, no capital controls), South Africa (reducing capital controls)

Emerging Markets Lessons learned and recommendations

Regulation:Enabling inc reased p r ivate equi ty act ivi ty

E i M k t L l d d d ti


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The expertise and profit-seeking instincts of professional fund managers are essentialSBIC (US), ECF (UK), Yozma (Israel), IIF (Australia), and Inovar (Brazil):lasting effect on the industry and on the innovative infrastructure

Government as limited partner: harms-length relationship to prevent government involvement in themanagement and asset allocation of the fund.

VC/PE funds need a minimum critical mass below which they are not viable economically

Hybrid financing instruments - quasi-equity

SMEs do not possess the critical mass to interest larger buyerspotential growth rate below that required by VC/PE funds

But low rates of return continued participation of governments, foundations, IFIs Successfule.g Business Partners (South Africa) and SEAF (emerging markets).

Asymmetric allocation of returns rewarding more private investors than governmentIncentive not yet explored in most emerging economies .

Requires careful calibration, Good results in US, UK, Australia, Israel ]


Investment Programs:Market-based approach is p referred to direct gov ernment equi ty inv estments .



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Professional expert ise key to the development of the VC/PE industry. promoting and funding education and training initiatives at national and international settings (e.g.

Inovar program) inducing the teaming international general partners (e.g. Yozma program) allocate resources to funds managed by new managers

Avo id governm ent involvement & in terference in asset a l locat ion Capital for Enterprise Board in the UK: staffed by private sector experts manage public-private

schemes.

Evaluat ion of im pact & returns, and accou ntabi l i ty of pr ivate agents managing fun ds where pub l ic resources are invested UK: involving external professionals and academic experts monitoring of public resources

expenditure & learning Brazil (Inovar Program): periodic evaluation is required by the Inter-American Development Bank.


Investment Programs:- Professional fund m anagement capaci ty and investor expert ise - Govern ance and Evaluation



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Inno vat ion and Educat ion pol icy imp ortant for ear ly-stage VC Investments in R&D (US & UK: long established tradition) Support Entrepeneurship (incl bridge with Universities )

Early- stage VC Policy Employment Policy

- South Africa VC programs: gains in job creation and Black Empowrment, but inabilityto create sustainable VC marketBrazil VC program (Inovar): limited resources but multiplicative, lasting effect in VC

Lon g term po l i t ica l com mitm ent to regula t ions & prog rams Success in UK attributed to consistent bipartisan policies for decades

Inovar project in Brazil (VC) additional stability factor: presence of MDFI (IDB)

Coord inat ion between agencies PE/VC policies & programs typical implemented by agencies dependend on different

ministeries and levels (loca/state/federal) of government need for coordination


Final Remarks


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Main Takeaways for Emerging Markets

Evidence of an equity gap

PE/VC developm ent f il ls the gap & bo os ts grow th

Governm ents have a role in developin g the m arket

Enable appro priate Regulat ion (incl Taxat ion)

Bu ild Capaci ty/Expert ise

Attrac t pr ivate funds throug h Co-inves tment

Stimu late Inn ov at ion (R&D, educ at ion) & En treperneurship


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Private Equity Financing of high growth companies

World Bank / IFC Capital Markets AdvisoryNigeria, March 6 2008

The role of the Government

private equity financing of high growth companies[1]

Documents