Private equity, but not as we know it

Over the last decade the private equity juggernaut has motored on in the US and Western Europe, leaving pretty much the rest of the world blinking in its wake. According to Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School, who specialises in studying the evolution and impact of private equity and venture capital (VC), in 1990 private equity and VC funds raised in the US and Western Europe accounted for less than 70 per cent of the world's total ? and today that figure is more like 95 per cent. Ironically, Lerner says the average rate of growth in the developing world between 1990 and 1999 was an inflation-adjusted 5.8 per cent compared to 1.9 per cent in the developed world, suggesting that those emerging markets should have been attractive places to invest.

Lerner and professor Antoinette Schoar of the Sloan School of Management at MIT were curious as to why private equity has not taken off in developing economies where there are big information gaps, lots of uncertainty and difficulties in the valuation of assets – just the things upon which venture capital and private equity thrives. ?If private equity is a good solution in Silicon Valley, why are there difficulties in Sao Paolo?? asks Lerner.

Little research
One of the biggest barriers to private equity investment in developing countries is the scarcity of information about how the markets work. ?Virtually no work has been done on private equity in developing country settings apart from some case studies by Harvard and some other business schools,? says Lerner. ?There is clearly an important set of issues in terms of understanding to what extent the private equity model can and does work in those places.?

The starting point for Lerner and Schoar has been to examine the influence that the legal environment in different countries has had on the structure of private equity transactions, as well as the actual contractual relationships that govern them. Through this they hope to gain a clearer understanding of the challenges that private equity investors face in emerging markets.

Lerner and Schoar have just completed the preliminary phase of a study called Private Equity in the Developing World: the Determinants of Transaction Structures&#42. ?Private equity in different countries varies, but in fairly predictable ways,? says Lerner. ?We hope to provide a framework for understanding the economies where you will see substantial differences from the US/European model.? The ultimate goal is what Lerner calls a ?foundational contribution? – the authors aim to produce a clear set of guiding principles for what private equity strategies may work best in developing country settings.

Another important output from the study is to provide guidance on the formulation of public policy on private equity development in developing countries. The ability of institutions like Harvard University to provide sound guidance in this area has been affected by a lack of hard data to present to government officials and agency representatives who are unwilling to rely on anecdotes and intuition.

As a first step, Lerner and Schoar have analysed a sample of the private equity transaction structures used in the developing world to see how they differ from those used in countries like the US. The investigation is based on documentation from 167 transactions collected from 23 diverse private equity groups ranging from global firms that are active in the developing world, to high profile national and regional funds, to smaller, local specialists who are typically based in a single country.

Persistent diversity
Lerner considers many of the findings already made to be significant. In particular, both authors are surprised by the persistent diversity of private equity deal structures. ?We are used to seeing differences in the US,? says Lerner. ?Some groups use participating preferred shares, some just use straight convertible preferred shares – and there are lots of graduations in between. But if the US spectrum is light pink to red, we have seen the full rainbow in developing countries.? This structural diversity exists even in investments by large international private equity groups, which may use different deal templates in the same geographic market, although the degree of diversity is shrinking. The fact that these firms do not employ a ?one size fits all' approach shows that they adapt – by necessity – to conditions in particular national markets. ?If we believe that there is a connection between transaction structure and success, this may be an important determinant of the evolution of various markets,? says Lerner.

While deal structures may vary considerably throughout the developing world, several common themes do emerge. Two key factors are whether the country's legal system is common or civil in origin and how well developed the system is.

In countries with civil law, or less well-developed legal systems, there are fewer engineered or complex transactions and a greater reliance on common stock. There is also more emphasis on exercising control through larger equity stakes on account of the difficulty in enforcing special provisions and property rights.

One thing the study highlights is the increased sophistication of private equity groups in developing markets since the early 1990s. ?Often the limited partners would say that they had two bad investments in an emerging market in 1995 so they won't invest again,? says Lerner. ?Many of the attitudes seem to reflect a lack of awareness that there has been a lot of evolution in these markets over time.? There are some particularly bright spots. Central and Eastern Europe stands out in terms of the pace of evolution that has taken place. ?There has been real change in terms of structuring there compared with the other regions, where it has been slower,? says Lerner.

So does this study explain the lack of private equity growth and performance in developing countries? Not yet. ?It's an important step in trying to understand these markets and what's going on there,? says Lerner. The answers may be more apparent after the next stage of Lerner and Roach's analysis, which will examine the relative successes and failures of the sample transactions and offer some possible explanations for them. They expect to have a completed working paper by the end of the year: Private Equity International will be reporting on this too.

Key findings
? Unlike in the US, where the use of convertible preferred securities is ubiquitous in private equity, substantially different securities are employed in developing nations. More than one-half of the sample transactions employed common stock, and a subset employed instruments that are essentially debt. Private equity investor rights that are standard in the United States, such as anti-dilution provisions, are encountered far less frequently.

? The choice of security employed appears to be driven by the setting of the firm and the nature of the private equity group. Investments in common law nations and by UK and US private equity groups are far less likely to use common stock or straight debt, and more likely to employ preferred stock.

? In nations where the rule of law is less established, private equity groups are less likely to utilise preferred securities. They are likely, however, to have a majority of the firm's equity and to make the size of their equity stakes contingent on the performance of the company.

? Larger financing sizes and higher deal valuations are seen in nations with a common law tradition.

? Transactions in common law nations are generally associated with more contractual protections for the private equity group.

? The composition of boards of directors differs little from that seen in the US. Common law countries have more substantial representation of founders and managers on boards, which suggest that board structure may serve as a substitute for contractual protections.

? In emerging markets – where stock markets provide much less liquidity – there is a much greater reliance on trade sales and even large-scale dividend payments as exit strategies.