17 Alternative Growth: The Impact of Emerging Market Private Equity on Economic Development Magogodi Makhene Introduction 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
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Alternative Growth: The Impact ofEmerging Market Private Equity on Economic Development Magogodi Makhene
Introduction
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
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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
Source: EMPEA estimates. Notes: Emerging Asia excludes funds focused on investments in Japan, Australia, and New Zealand. *Reported together as Africa/Middle East in 2003 and 2004. Detail may not sum to totals due to rounding.
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private equity partners ascended the emerging market private equity
learning curve by:
• Partnering with local investors and industry leaders to
conduct thorough due diligence on target companies
• Investing prudently and only with highly skilled general
partners. There is a disproportional lag in investment returns
between the top performing managers and those who rank
close behind in second or third position. Much of the initial
disappointing emerging market performance of the mid-1990s
is blamed on a lack of vetted management skill
• Assessing market political and economic volatility risk
diligently, focusing on market-specific impediments to exit
strategies and probable challenges without clumping regions
together to inflate or deflate realistic expected returns
• Focusing on portfolio companies’ strengths, such as cheap
rents and little labor competition, to drive impressive returns.
companies’ patent applications are more concentrated within
the areas of the firm’s competitive strengths after going private
• Patenting levels after the LBO transaction changed
consistently throughout the sample of 495 companies
These findings, based on primary empirical research summarized in the
authors’ 2008 work, Private Equity and Long Run Investment: The Case
of Innovation, suggest that private equity encourages long-term
innovative strategy.
Corporate Governance
In theory, private equity strengthens corporate governance through the
alignment of ownership and management goals. Walker fleshes out
theory in a 2007 consultative document, Disclosure and Transparency in
Private Equity, “…alignment (of interests) is achieved in private equity
through control exercised by the general partner over the appointment
of the executive and in setting and overseeing implementation of the
strategy of a portfolio company, lines of communications are short and
direct, with effectively no layers to insulate or dilute conductivity
between the general partner and the portfolio company executive team”
(Walker, 2007).
The argument rests on the premise that because management
has an ownership stake in the portfolio company and because
management will be rewarded upon successful exit, managers of a
portfolio company will comply with best business practices, which
promote sound corporate governance, in an effort to multiply the
company’s value before exit. In practice, the end goal of a lucrative exit
can become so enticing, that managers adopt less enviable means—
which compromise sound corporate governance.
In the aftermath of Black Monday in 1987, private equity backed
portfolio companies managing an aggregate $65 million in assets filed
for bankruptcy protection (Kester and Leuhrman, 1995). Congressional
hearings were held to fan out the disaster—many blamed the fallout on
weak private equity institutional governance and a business model with
ample greed but few checks and balances. Of course, private equity
failures were amplified by Wall Street’s hemorrhage from the largest
one day percentage decline in market history—the Dow Jones Industrial
Average took a 22.6 percent dive, the equivalent of 508 points
(Browning, 2007). In this atmosphere, it was easy and sometimes
justified, to blame the LBO structure for internal company
mismanagement.
But in truth, private equity’s functional operations and ultimate
success depend on strong corporate governance. The bankruptcies of
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1987 attest to this truth—while sound governance does not guarantee
better performance, private equity portfolio companies with sub-par
corporate governance do not survive. If only for self-preservation,
general partners and portfolio managers and are forced by the private
equity model to instill good governance measures such as transparency,
accountability, open communication and trust, ethical business conduct
and a strong corporate culture.
The LBO model differs fundamentally from publicly traded
companies in that the end-goal is an exit. General partners and portfolio
managers must market the portfolio company to potential buyers by
demonstrating value. While distressed sales are common, investors are
unlikely to purchase a company driven to the ground by poor
governance, especially if such failure has tarnished the company’s
brand equity. The exit acts here as a bind or credible commitment,
compelling management to employ business best practice.
The exit’s function as a credible commitment is acutely critical
in developing nations, where business culture is often riddled with
corruption and a tolerance for sub-par governance. Part of the inherent
risk of investing in emerging markets is operating business in an
environment with weak political and socio-economic institutions and
limited legal recourse. Such risk can be partially hedged by employing
sound corporate governance internally, thereby raising industry
standards for acceptable business conduct and encouraging other
businesses to do the same.
A mobile network operator in Africa, Celtel revolutionized the
face of African telecommunications by creating state-of-the-art
infrastructure ground up and through its staunchly ethical corporate
governance, serving as object proof of the possibility for a large
enterprise to profitably and ethically conduct business on a pan-African
level. Celtel’s performance greatly benefited all of its stakeholders—
investors, employees and the communities it served.
In the example of Celtel, management made sound corporate
governance a primary goal, but how does the private equity model
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generally promote good governance? There are two key periods here—
due diligence before closing the deal, and active engagement post buyout.
During the due diligence process, general partners have the
opportunity to vet target companies’ governance, corporate culture and
commitment to business ethics. Even though general partners are not
invested in the company at this point, the target company’s management
team will be eager to address concerns that arise during due diligence
procedural feedback. General partners’ opinion bears tremendous
weight for the target’s management because the partners are potentially
investors (Lim and Sullivan, 2004).
After the buyout, general partners exercise significant leverage
as investors in assisting management to improve the firm’s governance
issues. As private equity managing directors Lim and Sullivan point out,
“corporate governance and private equity” general partners are typically
engaged with portfolio companies’ competitive strategy, exerting direct
influence over customary governance activities such as “validating
management’s business plan, counseling management on making the
board more effective, or improving financial reporting and disclosure—to
unusual undertakings, such as investigating financial irregularities or
assisting management in corporate restructuring or acquisitions” (Lim
and Sullivan, 2004). The authors highlight key governance functions
general partners and portfolio managers must fulfill in private equity
transactions. Their findings are summarized in Figure V.
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Figure V: How Private Equity Promotes Sound Corporate
Governance
Source: Global Corporate Governance Guide 2004
Private equity managers
Private or public company
Time
Pre-investment
• Evaluate company’sgovernance practices.
• Assess and validatefinancing plan and relatedbusiness proposal.
• Review company’s historyon governance-relatedissues, such as connectedtransactions, conflicts ofinterest, compliance withlaw and regulations, etc.
• Perform third-partybackground check oncompany, management and major shareholders.
• Work with intermediaries and management to ensurefairness and orderliness of investment process.
• Provide feedback tomanagement on governance issues.
Post-investment
• For disclosure purposes:
• Require material company information to beprepared, audited and disclosed for accurateand timely dissemination to shareholders.
• Ensure the accuracy and integrity of financialreporting and internal audit; external audit should bethorough in scope and conducted by a reputable firm.
• Require that management and directors disclose anyrelated transactions or potential conflicts of interest.
• For accountability purposes:
• Develop an effective board to oversee management andcommunicate with shareholders; appointees should havesufficient experience and qualifications; allow for anappropriate number of independent directors; set upaudit, remuneration and nomination committees.
• Introduce formal board proceedings, such as earlycirculation of board agenda, taking of detailed minutes,regular and actively attended board meetings, etc.
• Establish performance-oriented practices and culture,reinforced by performance-linked remuneration system.
• Ensure that the company complies with law,regulations and best practices.
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Good corporate governance matters—especially in emerging
market private equity. Kester and Leuhrman concur, “…governance
affects how important decisions get made and therefore how efficiently
a company’s resources, including capital, are utilized. Poor governance
can be very costly” (Kester and Leuhrman, 1995).
Conclusion
Private equity, as an alternative asset class business vehicle, provides
interesting opportunities in emerging markets. This paper has examined
the role private equity plays in spurring development by measuring
outcome in terms of employment, technology and innovation investment
and corporate governance.
While there is evidence supporting high levels of private equity
job creation, research presented here suggests that because of creative
destruction, private equity’s aggregate role in eliminating or creating
jobs is indefinite. Private equity is quick to eliminate redundant and
inefficient labor, and there is a trend of creating skill-intensive jobs. In
developing nations, private equity has had tremendous success lifting
employment rates in comparison to regional performance, as reported
in data from the IFC, but there is no unanimous, uniform pattern of the
private equity model creating jobs with none destroyed. In future, a
study investigating cross-border employment trends would be useful in
establishing to what extent private equity actually destroys jobs versus
relocating positions across a border and how such labor shifts affect
emerging market regions. Research considering the quality of private
equity employment in developing nations would also be key and would
offer insight on the value added for recipients of jobs “shipped overseas.”
On the whole, it appears that private equity invests more in R &
D, and the implementation of innovative best business practice than
comparative industry counterparts. Private equity portfolio companies
pursue a more focused technology innovation strategy in an effort to
multiply financial value added to the company. Private equity backed
firms are particularly cognizant of value-adding activity because of
the beneficial impact such value can have on a successful exit.
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In developing regions, a portfolio firm’s adoption and implementation of
cutting-edge technology and innovation can have life-changing impact
on development and offer a viable means of leapfrogging the
industrialization gap. Illustrating this point fully is Celtel’s introduction
of mobile telephony to isolated markets which have subsequently been
integrated into the global economy. Also, innovation and technology is a
fundamental economic growth driver, and economic growth is a
unanimous emerging market goal.
Sound corporate governance does not guarantee good rates of
return on investment, which inform economic growth, but poorly
managed companies run a higher risk of failure. As such, the private
equity fund model has instituted checks and balances which are
designed to protect shareholders’ wealth. Due diligence, the interactive
oversight of general partners, board selection and the credible
commitment offered by an impending exit—all these procedures ensure
better governance in private equity backed firms. Strong internal
structures are important to attract investment capital, encourage
business longevity and create value for exit. In emerging market
countries with weak institutions, little legal recourse and high risk,
such sound internal governance and discipline is particularly critical.
Companies with good corporate governance serve a social good in
emerging markets because they improve overall risk conditions of
doing business in developing regions.
Throughout the paper, various challenges unique to the private
equity model in developing nations are raised. Due diligence can be
difficult to conduct in emerging markets that don’t have a record of
transparency or where required business regulation and legal recourse
are minimal. The deficiency of viable exit strategies also presents a
unique problem that requires creative thinking. Investors have to
consider exit alternatives to IPOs.
A future consideration is how to exploit the carried interest
wealth generated by private equity models. So far, this paper has
addressed emerging market private equity with the assumption that
because local capital markets are shallow, limited partners for funds
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investing in developing nations are predominantly Western institutional
investors. Initially, funds may have to rely on foreign institutional
investment, but to multiply the wealth-creation of private equity; funds
must transition to attracting local institutional investment. In most
developing countries, pension funds exist which could form the basis of
pilot funds sponsored by locals and foreigners. There are also examples
of emerging market private equity limited partners, particularly in Asia.
China’s Industrial and Commercial Bank of China has invested in
several funds as a limited partner along foreign investors such as
Goldman Sachs. Shifting to local limited partners would counteract the
FDI risk of capital flight upon exit, and would also directly impact the
institutional investors’ constituents, who might be a university
endowment’s student body or a pension fund’s middle-class employees.
The private equity model has several attributes which make it
an attractive route to wealth acquisition and development. Private equity
invests in highly scalable businesses that have the benefit of directly
impacting the lives of thousands of stakeholders and private equity
encourages entrepreneurial activity—a primary catalyst of economic
growth. But the history of private equity points to a rocky past, riddled
by rock-bottom bankruptcies and disappointments in America’s 1980s.
If LBO failed so dismally in sophisticated markets such as America, how
will they fair in the intrinsically high-risk environments of emerging
markets? As discussed, the answers have so far been complicated, but
preliminary results are encouraging.
Private equity will never be perfect in any market. The key is
capitalizing on the best aspects of the model to create emerging
markets’ missing middle class. To build sustainable long-term growth
and prosperity, emerging markets’ economies have to be underpinned
by a majority middle class with living income, stable jobs, access to
progressive technology and a belief in the soundness of both private
and public institutions. Private equity is a means of creating this missing
middle.
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References
Banks, E. (1999). The rise and fall of the merchant banks. Kogan Page Ltd.
Browning, E.S. (2007, October 15). Exorcising ghosts of Octobers past.
The Wall Street Journal, pp. C1-C2.
Cattanach, K.A., Kelley, M.F. and Sweeney, G.M. (1999). The Journal of
Private Portfolio Management, 2.
Celtel Africa: Summary of Proposed Investment. (n.d.).