Private Equity Financing of high growth companies

The role of the Government

CLEMENTE DEL VALLE World Bank / IFC Capital Markets Advisory Nigeria, March 6 2008

Main Findings OECD

The Challenge of growth

Employment in high-growth firms
Contributions by different size classes

Source: OECD (2000)

Main Findings OECD

The Challenge of growth

High-growth firms and their contribution to job gains

Source: OECD (2000)

Private Equity: Definiton VC/PE

medium to long-term finance provided in return for an equity stake in potentially high growth unquoted companies (BVCA)

For the purposes of this study:

VC/ PE includes quasi-equity transactions, which rely on hybrid equity/debt instruments involving a stream of dividends dependent on firm performance as returns.

Market scope:

The Private Equity Industry

Europe
United States

Venture Capital

Expansion Capital

Buy-outs
Private Equity

Venture Capital

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

Why is VC/PE appropriate?

Specialization
Pre-investment (focus in the process)
PE/VC firms are very specialized in selecting investments because they excell in two process: Screening process Due dilligence

Post-investment (focus in the function)

After the investment, PE/VC firms bring: Hands-on co-management Market savvyness Contacts for expansion & exit

Typical investment funnel of the UK middle-market

BVCA survey: non-financial contributions to PE-backed companies

Source: BVCA, Altassets research, team analysis

World: Private Equity Growth - the good news

Globally

.. and in Emerging Markets

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

problem: Equity Gap in VC/PE market

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

Equity Financing Marketplace UK Case

Long Term; lower liquidity Medium liquidity Short Term; higher liquidity

Mezzanine
50M UP

Equities, Fixed Income, Derivatives PIPES

Liquid Markets, Mature Shareholder, Competition

Private Equity

Equity Gap
2M 50M

750k 2M

Venture Capital Angel Investors

250k - 750k

10k - 250k 0 - 10k

Seed Capital Project Idea Stable Production Pre- IPO AIM, OTC

Corporate Stages

Prototype Commercialization

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

problem: Equity Gap in VC/PE market

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

Equity Financing Marketplace EM

Long Term; < liquidity Mezzanine
50M UP

Short Term; > liquidity

Equities, Fixed Income, Derivatives

Equity Gap
2M 50M

Private Equity (Global Funds/ limited domestic funds)

Underdeveloped financing markets Widens the gap

750k 2M

Venture Capital A.I.

250k - 750k

10k - 250k 0 - 10k

Seed Capital
Project Idea

PIPES

Corporate Stages

Prototype

Commercialization

Stable Production

Pre- IPO

Liquid Markets, Mature Shareholder, Competition

affecting more stages of business development.

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

Emerging Markets

Tartgeting of Government intervention

Size
Private Equity

Venture Capital

Seed & Startup Capital

Middle Market: Main Initial Focus?

EMs: Government interventions

early
Start-up

Expansion/Growth
Middle Market1

Buy-out

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

problem: Equity Gap in VC/PE market

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

The equity and debt gaps are much larger in the EMs PE industry: 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 constraints: absence of medium/long term credit But simultaneously: High Saving Rates how to tap these savings? Growing interests from governments but still very few cases of structured interventions ( e.g. South Africa, Brazil)

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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 at nascent stage

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

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Reasons behind Equity Gap in VC/PE market 2 - due to migration towards late stage (economies of scale)

as PE industry develops & grows, tends to become concentrated on the later stage of market
which offers better risk-adjust returns, due to the economies of scale of this activity
UK - Total VC/PE Investment, 1990 - 2002 Relationship between fund size and deal size, 1984 2000 UK

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

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Government Interventions: the importance of private sector expertise ! VC/PE:

a high-risk asset class

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

Return on investment USA, 1980 2002

20.0%
DJ 30

PE/VC Max = 721%

Index Emerging Markets VC & PE Latin America PE Asia (ex Japan) PE

One Year Five Year Ten Year 26.8% 19.2% 18.5% 53.2% 25.8% 32.6% 15.8% 4.3% 12.8% 2.3% 10.5% 27.1% 17.6% 27.0% 6.2% 5.1% 6.1% (2.3%) 4.9% 15.3% 13.8% 9.4% 8.4% 6.2%

15.0%
S&P 500 Midcap US Corp Bonds NYSE Willshire 500 NASDAQ Microcap

PE/VC Upper Quartile 16.1% MSCI World Ex US

10.0% 5.0%

PE/VC Median 4.1%

CEE & Russia PE US PE MSCI Emerging Markets

0.0%
-5.0% -10.0%

PE/VC Lower Quartile -7.6% PE/VC Min = -100%

S&P 500 Lehman Brothers US Aggregate Bond Index

Private Equity = High Risk!

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

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Government Interventions: the importance of private sector expertise ! Persistency- Success in Private Equity is not Luck, it is Skill.

Mc Kinsey finding in Europe:

If your first fund was top quartile, there is a 45% chance your next fund will also be top 25% and a 73% chance it will be top half. A new fund management 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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Government Interventions: the importance of investment expertise ! Skill is More Valuable in VC/PE than in other asset classes In private equity, the spread between top performers and average performers is large. If you are not with a top fund manager, you would do better investing in bonds.

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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
Focus of this study

Other Related Policies

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

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Government Interventions:
Enabling Regulation

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 investors Regulation on minority rights, standards of disclosure and fund management.

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Government Interventions:

Tax framework

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 partners Taxed at CGT rate: major stimulus for PE/VC industry

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Government Interventions:
Public/Private Investment Programs

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)

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Emerging Markets

Lessons learned and recommendations

Regulation: Enabling increased private equity activity

Liberalizing investment restrictions on local institutional 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

Supervision 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 capital controls on the repatriation of (long-term) capital gains Brazil (0% rate, no capital controls), South Africa (reducing capital controls)
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Emerging Markets

Lessons learned and recommendations

Investment Programs: Market-based approach is preferred to direct government equity investments.

The expertise and profit-seeking instincts of professional fund managers are essential SBIC (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 the management 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 buyers potential growth rate below that required by VC/PE funds

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

Asymmetric allocation of returns rewarding more private investors than government Incentive not yet explored in most emerging economies. Requires careful calibration, Good results in US, UK, Australia, Israel ]
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Emerging Markets

Lessons learned and recommendations

Investment Programs: - Professional fund management capacity and investor expertise - Governance and Evaluation

Professional expertise 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

Avoid government involvement & interference in asset allocation

Capital for Enterprise Board in the UK: staffed by private sector experts manage public-private schemes.

Evaluation of impact & returns, and accountability of private agents managing funds where public 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.

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Emerging Markets

Lessons learned and recommendations

Final Remarks

Innovation and Education policy important for early-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 inability to create sustainable VC market Brazil VC program (Inovar): limited resources but multiplicative, lasting effect in VC

Long term political commitment to regulations & programs

Success in UK attributed to consistent bipartisan policies for decades Inovar project in Brazil (VC) additional stability factor: presence of MDFI (IDB)

Coordination between agencies

PE/VC policies & programs typical implemented by agencies dependend on different ministeries and levels (loca/state/federal) of government need for coordination

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Main Takeaways for Emerging Markets

Evidence of an equity gap PE/VC development fills the gap & boosts growth Governments have a role in developing the market
Enable appropriate Regulation (incl Taxation)

Build Capacity/Expertise
Attract private funds through Co-investment Stimulate Innovation (R&D, education) & Entreperneurship

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Private Equity Financing of high growth companies

The role of the Government

World Bank / IFC Capital Markets Advisory Nigeria, March 6 2008