Emerging markets and private equity: The past, present, and future

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Emerging markets and private equity The past,
present, and future

• Josh Lerner
• Harvard Business School

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Venture capital is increasingly global
2006
1996
Source 1996 National Venture Capital
Association, European Venture Capital
Association, Asian Venture Capital Journal, and
various national venture capital associations
2006 Ernst Young.
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as is private equity
1970-2000
2001-2007
Source Stromberg 2008.
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But two inconvenient truths

• The returns from private equity in emerging
  nations have been disappointing.
• Each prior boom has ended in disappointment.

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Truth 1

• Analysis of Harvard/MIT PE database
• Performance data from 2373 funds as of 2007.
• Compiled from Private Equity Performance Monitor,
  on-line disclosures by limited partners, and
  personal contracts.
• Closed from 1980s to mid-2000s
• Coverage better beginning in early 1990s.

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Truth 1 (continued)

• Look at net IRR by funds in developed and
  developing world
• Define developing as everything outside U.S.,
  Canada, Western Europe, Japan, Australia and New
  Zealand.
• Base classification on which nation had most
  private equity investment from fund, not stated
  goal.
• Obtain investment data from SDC/VentureXpert.

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Average IRRs
Really problematic fund selection!
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Truth 2

• Private equity is a boom-and-bust industry.
• But particularly extreme in developing world.
• Cycle of boom-and-bust has been seen many times
  before.

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Latin American private equity fundraising,
1989-2002
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China/Hong Kong private equity investments,
1992-2002
Source Asian Venture Capital Journal and
authors calculations.
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The big question

• Will this emerging market VCPE boom be different?
• Yes!
• Most other developing market private equity booms
  have coincided with booms in developed nation PE
  activity.
• This time is the opposite
• Profound downturn in U.S., European markets.
• Mounting regulatory pressures.
• But emerging market VCPE groups must work to
  avoid fate of those in earlier booms.

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The developed nation challenge A profound
market cycle

• Recent fund influx was not the first boom
• Private pension funds in 1980s.
• Public pension funds in 1990s.
• Global investors in 2000s.
• But certainly the largest shift.
• What will be consequences for private equity in
  developed nations?

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U.S. private equity fundraising, 1969-2007
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New fund commitments as of stock market,
1980-2007
Source Venture Economics and Asset Alternatives.
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Evidence re pricing

• Inflows into private equity affect pricing.
• Basic pattern
• Doubling of funds inflows raise prices by 7-21.
• More dramatic effects in more concentrated
  sectors.
• Increased valuations do not reflect shifts in
  transaction quality!
• Gompers-Lerner 2000.

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Evidence re activity

• Buyout groups dramatically accelerate investment
  activity
• When debt becomes cheaper.
• When equity market valuations rise.
• Ljungqvist, Richardson, and Wolfenzon 2007.

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Implications for returns

• More activity at higher prices leads to downturns
  in returns.
• 2x to 4x more dramatic an effect in buyouts than
  VC.
• One possible reason
• Correlation of entry with credit market cycles.
• Leads to dramatic increase in velocity of
  activity.
• Once withdrawal of credit, cascading
  bankruptcies e.g., 1990-91.
• Hard not to see history repeating itself

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Ratio of enterprise value to EBITDA, 1980-2007H1
Source Kaplan and Stein 1993 for 1980s data
Standard Poors thereafter. 1980s data is for
large buyouts only.
1981 deals include those in 1980 2006 those in
first half of 2007.
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Coverage ratios in large buyouts
(EBITDA/interest), 1980-2007H1
Source Kaplan and Stein 1993 Guo, Hotchkiss,
and Song 2007
1981 deals include those in 1980 1996, those
between 1990 and 1996 2006, the first half of
2007. Does not include required principal
repayments.
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Implications

• While debt availablity will eventually return,
  expect sustained downturn.
• Today, we see private equity groups reshaping
  themselves in substantial ways
• Smaller deals.
• More growth equity, PIPEs, etc.
• More creative deals
• E.g., debt repurchases.
• More focus on developing world.

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The developed nation challenge Regulatory
pressures
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Numerous examples

• Lone Star raids in Korea.
• Horde of locusts speech in Germany.
• Tax policy proposals
• Treatment of carried interest in U.S. and U.K.
• Tax deductibility in Denmark.
• U.S. DOJ clubbing investigation.
• Union activity in Europe and U.S.

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The key reason

• Private equity has existed in a regulatory
  bubble
• 40 Act exception in U.S., similar elsewhere
• Reflected modest importance of these
  partnerships.
• As importance has grown, growing scrutiny,
  pressure inevitable.

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Compounding factor

• Industry has been traditionally very secretive.
• And most policymakers dont understand!
• While limited efforts to addresse.g., Private
  Equity Council in U.S.not the most sympathetic
  parties.
• Even though evidence suggests
• Infrequency of bankruptcy, quick flips.
• Facilitation of long-run investment.
• Minimal employment losses.

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Implications

• In past, these criticisms blew overas in 1989.
• Industry will be able to work around some
  thingse.g., taxes?
• But my vote is that collectively, these will have
  a profound impact!
• Negative effects likely to fall substantially on
  largest buyout-focused groups.
• Will again accelerate shift to emerging markets.

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The challenge

• Good news The focus on emerging VCPE markets is
  likely to continue.
• But bad news Past booms have seen many problems
  in emerging market VCPE groups.
• Developing market groups can limit these
  challenges by pro-active steps
• Managing rate of growth.
• Incorporating global best practices.
• Relentless focus on building people in
  organization.

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• Josh Lerner
• Rock Center for Entrepreneurship
• Harvard Business School
• Boston, MA 02163 USA
• 617-495-6065
• josh _at_ hbs.edu
• www.people.hbs.edu/jlerner