Alternative Growth: The Impact of
Emerging Market Private Equity
on Economic Development
Economic development is fundamental to economic growth in emerging
markets. Economic growth is defined as an expansion of Gross
Domestic Product (GDP) or Gross National Product (GNP), where GDP
is a function of capital, labor, land (natural factor endowments) and
entrepreneurship. The difference between GDP and GNP is primarily
technical semantics—GDP is all production on domestic or local soil;
GNP refers to all goods and services produced by nationals, including
expatriates’ production. As a nation multiplies its capital productivity
and capacity through technological advancements, or its labor
productivity through human capital investment, GDP rises. GDP growth
can also be spurred by successful entrepreneurial initiatives.
Of course, increasing gross domestic production implies
increased demand, which must be met by increased supply. GDP
expansion—a rise in demand—can be driven by domestic consumer
consumption, government spending, business investment, export
demand or a combination of these drivers. In an effort to spur GDP
expansion, developing nations form policies designed to encourage at
least one of these growth drivers.
Alternative asset class investments—collectively hedge funds,
private equity, venture capital, credit derivatives and real estate—are a
form of business investment which can be Foreign Direct Investment
(FDI). Today, most alternative asset class investments in developing
nations are FDI made by foreign investors seeking high returns in risky
but high-yield emerging markets. FDI can ignite economic growth.
When fully incorporated into the local economy, Greenfield FDI
or long term ground-up investment, can create jobs, better integrate
local economies into the global market and introduce important
technological advancements to local business. FDI plays a particularly
critical role in emerging markets by injecting capital in markets with a
dearth of domestic savings—which, in part, informs government
spending, business investment and consumer confidence. In Ireland FDI
turned one of Europe’s poorest nations into an important economic
force with highly specialized, developed markets.
Over a 20-year period, from 1984 to 2004, Ireland’s per capita
GNP grew an average nine percent annually. Where GNP per capita was
5,367 in 1984, it rose to 30,726 by 2004. Most of this economic growth
was driven by FDI in Ireland’s information communication technology
industry and in the expansion of the island nation’s export sector. Total
exports in 2004 were 124 billion, up 89.96 percent from 12 billion in
1984 (McDowell, 2006). Yet despite the success of nations such as
Ireland, FDI does not guarantee improvements of GDP.
Instead of re-circulating accumulated wealth into local markets
to stimulate cross-industry growth, foreign-owned Multi-National
Corporations (MNCs) can divest profits to their home country.
Such capital outflows may result in a net loss for the developing
host nation. MNCs are also capable of crowding out local business
and monopolizing the use of local resources. Powerful MNCs with
deep pockets and economies of scale can stamp out rival local
entrepreneurial ventures. Similarly, private equity FDI does not
guarantee economic stimulation in emerging markets.
Critics accuse private equity of using “strip and flip” strategies
to acquire businesses, saddle them with debt, extract high dividend
payouts and undermine labor. Proponents of private equity, such as
Sami, executive board member of Turkey’s leading investment bank,
Ata Invest, argue that private equity adds value to business, thereby
stimulating economic growth. This is because in addition to financial
support, private equity offers financial advice, corporate strategy,
innovative ideas, market access and information (Sami, 2002).
This paper considers both arguments in evaluating the role of
private equity in emerging markets. The term “emerging market” is
used to describe the economies of high-risk countries with nascent
financial markets. In an International Monetary Fund (IMF) working
paper entitled What is an Emerging Market?, Mody argues that
emerging market economies are characterized by “high levels of
risk…higher volatility than advanced industrialized economies…the
absence of a history of foreign investment and their transition to market
economies…” (Mody, 2004).
Measuring the impact of private equity on emerging markets is
important because of the implications for international development. If
private equity has indeed been a stimulus for economic expansion in
developing nations, then this alternative investment asset class should
be more widely adopted and encouraged as a vehicle for economic
development in non-industrialized nations.
This paper summarizes the impact of private equity
investments in the emerging markets of the Middle East, Asia, Latin
America, Africa, East and Central Europe and finds that private equity
can be a catalyst for economic change in developing markets. Private
equity can stimulate growth by encouraging technological and industry
innovation, Greenfield job creation and better corporate governance.
The paper begins by assessing the role of private equity in creating jobs,
developing long-term investments and restructuring corporate
governance. This is followed by an overall analysis of the value added to
developing nations’ economies by private equity transactions.
Definition of Private Equity
Private equity is an alternative asset class investment that can be used
as a means of FDI. Sami explained private equity and its function at a
2002 Massachusetts Institute of Technology (MIT) Entrepreneurship
Center conference, “Venture Capital in Turkey.” Private equity is “capital
to enterprises not quoted on a stock market. Private equity can be used
to develop new products and technologies, to expand working capital,
to make acquisitions, to strengthen balance sheets and to resolve
ownership- management issues” (Sami, 2002). He goes on further to
describe venture capital as a form of private equity specifically
employed in the early stages of business development.
Mezzanine capital funds provide growth capital to mid-sized
portfolio companies for expansion. Private equity is an investment
vehicle that provides a structure whereby limited partners can invest
equity in a managed fund. Limited partners are investors with no
management authority and only limited liability. They share only in
their fund’s profits and liabilities—not those of other funds within the
private equity firm. Typically, limited partners seek large long-term
investments as a means of attaining high returns and diversifying their
holdings. They are prepared to take on risky private equity fund
investments that curtail access to invested capital until the fund’s
underlying assets are exited. In part because of these constraints and
government regulation requirements, limited partners tend to be
university endowments, pension funds and high net-worth individuals.
A fund usually has multiple limited partners. The private equity
firm will set a fundraising target and go “on the road” to attract limited
partner capital. This process can take a few months or years and is
primarily dependent on the firm’s return on investment record and the
fund’s perceived opportunity. Private equity firm managers, known as
general partners, are also expected to make substantial investment in
the fund—ordinarily one to five percent— to demonstrate commitment to
the fund’s performance. General partners have unlimited liability and
receive an annual management fee (two percent of the fund) for making
investment and post-transaction strategic decisions and overseeing day-
to-day fund operations. In addition, general partners receive 20 percent
of the carried interest or fund profit after the fund is exited. Once the
fundraising target is accomplished, the fund is closed to further
investment from limited partners.
After closing the fund, general partners are responsible for
scouting target companies which match the fund’s investment
philosophy. General partners can either purchase targets outright or
acquire an equity stake, together with other investors, in the target
company. General partners perform due diligence on the target
company once interest is expressed in a target company, but before
completing the acquisition transaction.
Due diligence is the process of assessing the target firm’s
financial statements, weighing strengths and weaknesses of the target
company’s business model, evaluating market opportunities, market
trends and projecting strategic fit with the fund’s portfolio of acquired
target companies. In a 2004 Harvard Business Review article, When to
Walk Away From a Deal, Cullinan, Le Roux, and Weddigen summarize
the due diligence process in four key questions: “What are we really
buying? What is the target’s stand-alone value? Where are the
synergies—and the skeletons? What’s our walk-away price?” (Cullinan et
al., 2004). Due diligence is beneficial to both the general partners and
the target company.
For general partners, the process establishes a clear
understanding of the target’s current and potential value, as well as an
appreciation of the health of the target’s balance sheet, which is critical
to the private equity model. Even if the target is not acquired by the
private equity fund, due diligence is valuable to the target company—it
offers management an in-depth analysis of the target company’s strengths
and weaknesses. If due diligence provides enough evidence of the target
firm’s intrinsic and synergistic value, then the next step is acquisition or
“buyout.” A buyout is a partial controlling stake or full acquisition of the
target company. There are two types of buyouts in private equity—
management buyouts (MBO) and leveraged buyouts (LBO).
MBOs are initiated by the management team of the target
company and typically involve management buying out shareholders’
equity and taking the public company private. The primary goal of
MBOs is to align management strategy with ownership interests—this is
achieved by granting management substantial equity post-transaction as
well as seats on the board of directors. MBOs are not confined to
publicly listed companies—management can lead a buyout of a privately
held company. Because most managers do not independently have the
capital to buy out shareholders, and because banks traditionally
consider MBOs too high-risk to finance through debt, managers leading
an MBO turn to private equity funds for buyout capital. Such private
equity general partners will sponsor the buyout transaction by raising
debt and providing equity in exchange for controlling equity rights as
well as strategic control of the target company. Private equity funds issue
buyout capital in the form of a loan or combination loan and equity, in
an effort to balance their investment’s risk. MBO are a form of LBO. For
simplification, this paper uses the term LBO to refer to ordinary LBOs
and MBOs unless otherwise indicated.
A LBO is the acquisition of a target company through a high
debt-to-equity ratio transaction. In LBOs, private equity funds can
sponsor large buyouts because the LBO model is based on a high debt-
to-equity financing structure. The debt-to-equity ratio can be as much
as 90 to 100 percent. Target company’s assets are used as debt collateral,
therefore target companies must have strong balance sheets capable of
supporting high leverage. Private equity companies are attracted to
LBOs because of the minimal equity capital needed to complete sizable
buyout transactions, but LBOs have suffered considerable criticism. LBO
caused controversy in the 1980s as some private equity funds straddled
target companies with 100 percent debt financing, driving target
companies into bankruptcy as cash flows shrank and missed the
minimal times-interest-earned (TIE) ratios to continue operation.
Successful LBOs allow the private equity fund to assume control
of the target company—known as a portfolio company upon acquisition—
aligning investor and management goals. This alignment provides
privately held portfolio companies the space to focus on long-term
competitive strategy without the distraction of fluctuating quarterly
earnings reports. Private equity funds typically have a five to seven year
horizon, after which time the fund is exited for a profit or carried interest.
Private equity funds can exit portfolio companies through
several avenues. The Alternative Assets Network highlights plausible
exit strategies—Initial Public Offering (IPO), a trade sale, selling to
another private equity firm or a company buy-back. Because private
equity funds make their profit in the sale of the target company, exit
strategies are extraordinarily important to general partners and inform
the crux of the initial due diligence process.
Of all exit mechanisms, perhaps the most publicized are IPOs.
An IPO is a procedure by which a private company raises capital by
selling company shares to the public. A private company can only have
one IPO, unless the company subsequently goes private. Once a private
company goes public, it is listed on a public stock exchange, such as
Nasdaq, and must comply to all regulation for public companies. While
IPOs raise substantial sums during periods of high liquidity and stock
booms, IPOs result in expensive fees and complex compliance to
regulation laws such as Sarbanes-Oxley.
Trade sales involve the private equity fund selling the portfolio
company to an existing industry firm (The a-z of private equity, 2007). If
the acquiring industry firm is public, the trade sale will take the
portfolio company public as a subsidiary business unit of the publicly
traded company. Inversely, trade sales to a private industry firm would
keep the company private.
A fund can exit by selling to an existing industry firm, but also
through sales to another private equity fund. If the sale is to another
fund, the acquiring fund will buyout the current investor fund in what is
called a secondary buyout. As fund-to-fund buyouts become more
popular, tertiary buyouts are emerging, attesting to the relative ease of
selling to another private equity fund instead of going public.
Finally, private equity funds can exit through a company
buyback. In this case, the portfolio company spins off the private equity
fund by using its excess cash to buy out the fund’s equity stake.
Company buybacks are more common in venture capital, where the
founding entrepreneur may buy back shares to reassume a position of
primary or sole company controller.
History of Private Equity
The venture capital model of wealthy merchants providing capital for
risky overseas ventures with promises of high returns can be traced as
far back as the Middle Ages, when Italian merchant families sponsored
profitable exploratory expeditions (Banks, 1999). In an in-depth
Washingtonian profile of Carlyle Group’s co-founding partner, David
Rubenstein, Glassman recalls, “Rubenstein likes to say that Christopher
Columbus was the forerunner of the successful private-equity executive.
Columbus insisted on getting reimbursed for all his expenses in
advance. And he negotiated a 10-percent carry from Queen Isabella”
(Glassman, 2006). Private equity as we know it is rooted in this
tradition, but the complex structure of LBOs did not emerge until the
mid-American twentieth century.
Following World War II, three businessmen founded the
American Research and Development Corporation (ARD) in 1946.
ARD was a venture fund established to provide start-up capital and
managerial consultancy to recently discharged military personnel
businesses. In 1959, ARD’s innovative manner of corporate finance was
replicated in the formation of a Small Business Investment Company
(SBIC), an investment vehicle which handled wealthy families’ venture
capital interests. These SBICs raised $464 million over 13 years and
were able to secure debt financing from the Small Business
Administration, but success remained lackluster because of limited
fundraising pools—investors were seldom institutional—and an inability
to attract the best money managers (Wingerd, 1997).
Institutional interest in venture capital-private equity models
began in the early 1960s. Two critical 1970s legislative events solidified
the fate of private equity. Capital gains tax rates were cut and ERISA
(Enactment of the Employee Retirement Income Security Act)
regulations were relaxed, allowing pension funds to shift from
conservative investments, such as government bonds and blue chip
stocks, to more aggressive investment vehicles with higher returns.
In 1965, Bear Sterns undertook its first buyout, led by Jerry Kohlberg—
who later co-founded Kohlberg, Kravis & Roberts (KKR).
LBOs gained momentum in the 1980s. Between 1979 and 1989,
more than 2,000 LBOs valued at over $250 billion occurred. During the
1980s, buyouts were characterized by aggressive leverage financing—
some buyout transactions relied on 100 percent debt financing. The
buyout boom culminated in KKR’s 1989 record-breaking acquisition of
RJR-Nabisco for $25 billion. In the aftermath of the stock market crash
and Black Monday on October 19, 1987, an unprecedented number of
portfolio companies defaulted on loans, undermining the credibility of
LBO models. Private equity activity cooled, but regained impetus on the
strength of the tech boom of the late 1990s. Figures I and II summarize
LBO activity from 1980.
Figure I: Annual LBO and Venture Capital Value, 1980-1998
Annual commitments to private equity, 1980-98 (US$ billion)
Source: The Private Equity Analyst
Figure II: Annual LBO Value, 1995-2007*
* 2007 First Quarter, Source: Dealogic
Emerging Markets Private Equity
In the early 1990s, emerging markets were largely characterized by
family-owned companies with limited access to capital markets and
small lines of credit through traditional bank financing. National
savings pools were small, current accounts were typically in deficit and
capital markets tended to be shallow. Given such constraints on capital
and equity supply, emerging market companies were attracted to private
equity funds as a source of growth capital.
Foreign fund investors were equally keen on emerging market
companies. Target businesses were often undervalued in an atmosphere
of fierce competition for undersupplied capital, implying higher rates of
return on investment and favorable global economic conditions. The
global economy was in a period of growth and relative macroeconomic
stability by the mid 1990s. Inflation and interest rates were down and
policy makers worldwide embraced the wisdom of open markets
without barriers to competition—securing investors’ confidence in
emerging markets’ manageable risk (Leeds and Sunderland, 2003).
Investors also had a robust appetite for risk and they were handsomely
rewarded in the U.S. venture capital tech boom of the mid 1990s, having
acquired significant gains in industrialized financial markets through
private equity investments. The current of globalization aligned
investors with potentially high return investment opportunities while
providing target companies funding and expansion consultancy to gain
competitive prowess in global markets.
From little to no private equity history in previous decades,
emerging markets quickly amassed sizable funds within a short period
of time. According to the authors of Private Equity Investing in Emerging
Markets, private equity funds ballooned in emerging markets. “By the
end of 1999, there were more than 100 Latin America funds, where
virtually none had existed earlier in the decade. Between 1992 and 1997,
the peak years for fund-raising in Latin America, the value of new
private equity capital grew by 114% annually, from just over $100
million to over $5 billion. In the emerging markets of Asia…about 500
funds raised more than $50 billion in new capital between 1992 and