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The Promise & Challenge of Private Equity Financing for Developing Country Entrepreneurs

By Gulam Samdani, PhD,
Sep 10, 2005

The Economist, in a recent special report, had termed Private Equity as the 'New Kings of Capitalism."    Indeed, Private Equity's role in fueling today's entrepreneurial successes is unparalleled.

In other words, if money makes the world go around, private equity is the "smart money" that makes it go the extra mile to create and capture more economic value.

It's not just for tech startups anymore

The US has been the nerve center of private equity financing, contributing to the growth and success of many of its global brands. Today, private equity is a "mature" industry in the US and many of the key players are looking for growth through new business models, e.g., transitioning from an early-stage/startup fund to a later-stage investor, and expansion in new geographies, e.g., Europe and Asia.

In contrast to the traditional VC funds leading up to the burst of the dot-com and telecom bubble in 2000 - 2001, Bain Capital continued to perform magnificently. Today, it is expanding aggressively outside the US. Could Bain Capital and others lead the charge in bringing their highly successful modus operandi to Asia?

Perhaps the burning question is this: Is this world of high finance (i.e., private equity) completely out of reach of entrepreneurs in developing countries? Well, we do not think so. However, given the different financing options and sourcing possibilities potentially available to those rare entrepreneurs with patently bankable ideas, they'll need to be savvy enough not to get stuck with the short end of the bargaining stick during deal structuring. (a followup article next month will talk about six key facets of private equity financing)

Private equity for economic development

By most accounts, interest has been quickening recently in fostering private equity investments in developing countries. This is also in line with a representative resolution adopted at the UN-sponsored meetings of the world's heads of state, finance ministers and NGOs in Monterrey, Mexico, in January 2002, stating in part that: "We will support new public/private sector financing mechanisms, both debt and equity, for developing countries and countries with economies in transition, to benefit in particular small entrepreneurs and small- and medium-size enterprises and infrastructure." Indeed, it is now an established fact that productive entrepreneurial activity is a primary driver of economic growth (see Exhibit 1).

As a follow-up to the above resolution, an action proposal was also tabled at the meeting, to the effect that: "The international development community should designate a significant component of its aid program to risk [i.e., entrepreneurial] ventures and work with local public entities, using similar programs as the Small Business Administration (SBA) in the US, in the emerging economies to implement such programs. To do so, an international fund can be set up and allocated on a regional basis among four or five regions, e.g., Latin America, South Asia, the Middle East, and Africa. The fund can enter into a "master agreement" with one or more private managers with proven skills…To be successful, the international community should benefit from the experience of VC [venture capital] and other capitalists by attracting such managers to help install managerial skills into such companies and to make this work along the way VC managers work."

Evolution of private equity in the US

Private equity in the United States, especially of the traditional VC type, did not really begin to take off until a couple of little-known events came together, the first being the advent of modern portfolio theory, which dictated that large pools of capital could enhance their returns by diversifying their investments over a variety of asset classes. Clearly, investments solely or primarily into early-stage ventures might be deemed too risky for a traditionally conservative pension fund manager (see Exhibit 2).

Exhibit 2 - COST OF CAPITAL IS A FUNCTION OF RISK, WHICH VARIES WITH THE STAGES OF A VENTURE’S LIFE CYCLE Source: Virtual Change Catalysts (VC2), Copyright 2005

However, the portfolio theorists revealed that, if the manager were to take the discrete pools of capital and allocate certain percentage to bonds, another percentage to publicly traded stock, and the remainder to so-called alternative investments, e.g., real estate and private equity (i.e., buyouts and VCs), superior returns would result, all other things being equal. Coincidentally, as the modern portfolio theory was gaining in popularity as an asset management imperative, the US Department of Labor enacted in 1979 the Plan Asset Regulation, which released pension fund managers from strict application of the so-called "prudent man rule" and protected them from liability if they were to invest capital in professionally managed VC and LBO funds.

These two factors - modern portfolio theory and the Plan Asset Regulation - converged with the fact that most US states and municipalities shifted in the post World War II period from pay-as-you-go backing of their retirement obligations to fully funded pension funds. As a result, the pension funds, both private and public, swelled into the trillions of dollars, managed by competitive professionals who used modern portfolio theory to maximize their results. The rest, as the saying goes, is history.

Making globalization a two-way street

Recent research findings suggest that private equity firms with good local connections and deep market insights account for the bulk of recent investments in the developing world. Indeed, these firms may succeed in catalyzing the globalization of mid-size Western firms by expediting the global resourcing process (more commonly associated with the politically charged label of "offshoring").

For example, while Fortune 500 companies have the scale and international scope to move operations and sourcing to Asian countries, many midsize US and European companies are held back by their lack of access and expertise in the region. Although they possess substantial brand value, sales channels and intellectual property, many of them are struggling to keep up with the Asian competition.

This offers an opportunity for private equity groups to invest in these midsize companies and inject the management talent to help them shift operations and sourcing to Asia, which can lead to substantial cost reductions, especially in labor-intensive operations. Because there is little competition to invest in these midsize firms, these deals represent a tremendous untapped opportunity for the global private equity firms. What's more, the private equity firms should be able to recoup their investment and "cash out" several years down the road by selling these companies to their Asian rivals looking to expand overseas.

Given the likely eagerness of the Asian trade buyers to penetrate the "up markets" in the US and Europe, astute sellers stand a good chance to be able to strike win-win deals. Thus, the private equity firms could turn globalization into a two-way street where the Western multinational corporations expand to Asia on their own while the Asian heavyweights buy their way into the Western markets, thanks to the inevitable exit strategies of the private equity players over the next five to ten years.

Paving the road to prosperity

It is well known in the investor community that in order to start, let alone flourish, private equity needs a relatively stable government, independent judiciary, constitutional guarantees of free inquiry and the ownership of property.

Absent these institutional frameworks, private equity is unlikely to prosper because, by its nature, the process involves high-risk/high-return investing by the providers of both financial capital and the so-called "sweat equity" (by those entrepreneurs who invest their talents at suboptimal pay in anticipation of significant returns via appreciation of their equity holdings).

To position the developing countries as a preferred destination for private equity investments, they'll need to cast aside the mindset of the proverbial elephants who continue to be tethered to the "baby stakes" even after they have grown up. As the story goes, when the elephants were small, they tried to pull off the small stakes and invariably failed; so they grow up believing that the stakes are unshakable and never try again! We must keep in mind that what's at stake (pun intended!) here is the future prosperity, if not the viability, of many developing countries and that we'll have to go for what we're fully capable of, and not limit ourselves by what we have been in the past.

To this end, we need to commit ourselves to the resolve that nothing short of a fundamental rethink of regulatory reforms and resetting of our entrepreneurial aspirations will do. Country-branding campaigns perhaps somewhat perversely anchored on the theme - "past performance is not a predictor of future results" - could also help remake the image of many of these countries to the outside world. Clearly, these countries have a long way to go, but as the saying goes, the journey of a thousand miles must begin with the first step - and then the next, and the next…

Creating a business-savvy entrepreneurial culture

The World Bank recently published "Doing Business in 2005: Removing Obstacles to Growth," its second in a series of annual reports investigating the scope and manner of regulations that enhance business activity and those that constrain it. Designed for easy comparison of regulatory performance across 145 countries, two types of indicators have been constructed - measures of actual regulations (e.g., the number of procedures to register a business or an index of employment law rigidity), and measures of regulatory outcomes (e.g., the time and cost to register a business, enforce a contract, or go through bankruptcy). Overall, the developing countries offer a mixed picture in terms of business environment (see Exhibit 3).

According to the study, on average, it takes a business in a wealthy nation 6 procedures, 8% of income per capita, and 27 days to get started; in a poor or lower-middle income economy, the same process takes 11 procedures, 122% of income per capita, and 59 days. The report also shows that poor regulation of bankruptcy can cause business loans to dry up. For example, in 50 such countries, creditors can expect to recover less than 20 cents on the dollar when a business goes bankrupt (compared to Japan where the recovery rate is 92.4 cents on the dollar).

The good news is that the payoffs from regulatory reform can be large. The report estimates that an improvement from the bottom to the top quartile of countries in business-friendliness is associated with an additional 2.2 percentage points in annual economic growth. The payoff comes because businesses waste less time and money on unnecessary regulation and devote more resources to producing and marketing their goods and services while governments spend less on ineffective regulation and more on social services.

In addition to regulatory reforms, new initiatives are needed to create a business-savvy entrepreneurial culture. Business plan competitions can encourage development of entrepreneurship not only in developing new businesses but also improving/rescuing underperforming/dying businesses - with the rigor of a business plan that contains financial performance targets and specifics on milestones to be achieved by certain dates. Such competitions could be an extension of university programs in business and entrepreneurship.

However, they can also be organized as a national effort, e.g., the initiative in Malaysia where the nationwide competition is organized by a consulting firm, a stock exchange and a nonprofit business organization, with the support of the government and many others (e.g., Microsoft, Telekom Malaysia, Korn/Ferry International, and the national media companies). The cosponsoring firms donate consultants/mentors to teams entering the competition to coach them on planning and execution. About 450 business plans were submitted in the 2001 competition, with another 250 in the 2002 contest.

In the first phase (running for two months) of the three-phase competition in Malaysia, the teams are judged on the basis of the scoping of the business opportunity, with the first 10 teams receiving RM2,000 (about US$525). In the 2nd phase (running nearly for four months), the winners are based on the draft of the business plan with a special focus on competitive analysis and marketing strategy, with the top 10 each receiving RM2,000. In the final phase, the winners with a detailed business plan are awarded the first prize (with RM25,000) and other prizes scaled down until fourth through tenth each receiving RM2,500.

Turning the trickle of 'smart money' into a torrent

As competition for the great money-making deals intensifies in the world's developed economies, the major private equity firms are confronted with the reality that their domestic growth options are limited. As a result, many are now looking abroad and stepping up their efforts to invest in developing countries. If the current trend continues, it offers the developing countries in Asia and Africa a window of opportunity to position themselves as attractive places to invest in and thus capitalize on the private equity bonanza outlined above.

Indeed, it appears that private equity investments have just begun to trickle in Bangladesh, for example, since the country emerged on the private equity investment destination list in 2003, reportedly drawing $154 million from two renowned development financing organizations. Finance experts believe that emerging market investors are finding the private equity route to investment to be an efficient one. It overcomes the problem of illiquidity in many developing economies' stock markets for large-scale equity investment.

This hands-on style of active ownership of private equity (also known as "smart money") investors - as opposed to the arm's length relationship of public equity (often pejoratively dubbed "dumb money") and other traditional/institutional portfolio investors - allows greater control on aspects of corporate governance, which is increasingly a matter of great concern for investors in developing countries. Many Western private equity firms believe their contributions have been much more than financial - they seek to be a constructive and value-adding participants, whether by bringing international opportunities and technology to local business, helping to identify new forms of finance, instilling best-practice corporate governance, or supporting good management practices that are increasingly valued and recognized by the broader financial community.

"Adventure Capital"

An interesting case example of an innovative risk capital fund supporting private sector development is the Afghanistan Renewal Fund (AFR) with target capitalization of $30-$50 million. If all goes well, Afghanistan may soon have its first VC fund that will invest in fledgling construction, food, textiles and furniture manufacturing companies as this country emerges from more than two decades of conflict.

Pierre Van Hoeylandt, the German-born founder of AFR, who helped advise the Afghan government while working at the international top management consultancy McKinsey & Company, is betting that the risks posed by a war-torn country that lacks extensive paved roads, power and water supplies can be outweighed by the Afghanistan reconstruction effort. According to press reports, some $4.4 billion of aid was earmarked for 2004 alone, about equal to the country's gross domestic product (GDP). Given the challenges it faces, some have dubbed this VC-style investment as "adventure capital." Indeed, the value propositions of private equity go beyond the financial returns (see Exhibit 4).

Needless to say, interests of the poverty-stricken majority in developing countries will be ill-served if we allow the possible torrent of "smart money" investors to breed financial - and by proxy, political - tyrants only. If structured appropriately, however, private equity investments supporting targeted entrepreneurial initiatives could go a long way toward planting the seeds of hope at the grass-roots level and letting "a thousand flowers bloom" in all the developing regions of the world.

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About the author

Mr. Gulam Samdani, PhD, is one of the thought leaders at Virtual Change Catalysts (VC2), a non-profit and for-benefit organization dedicated to developing and transferring best management practices and innovations from anywhere in the world to where they could make the most difference today.

He is also an industry expert in advanced materials, biotechnology and chemicals at the New Jersey, USA office of McKinsey & Company, an international top management consulting firm. He welcomes constructive comments from Dinar Standard readers and can be reached at samdani@aya.yale.edu via e-mail.

This article has been adapted with permission from The Executive Times.

Key Learnings: Private Equity's role in fueling today's entrepreneurial successes is unparalleled. It plays a disproportionate role in catalyzing wealth creation by entrepreneurial individuals as well as nations. As competition for the great money-making deals intensifies in the world's developed economies, the major private equity firms are confronted with the reality that their domestic growth options are limited. As a result, many are now looking abroad and stepping up their efforts to invest in developing countries. The hands-on style of active ownership of private equity investors - as opposed to the arm's length relationship of public equity investors - allows greater control on aspects of corporate governance, which enables the investors to be a constructive and value-adding participant.