17

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

18

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

19

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

20

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

21

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

22

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

23

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.

24

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).

25

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

Source: The Private Equity Analyst

Figure II: Annual LBO Value, 1995-2007*

* 2007 First Quarter, Source: Dealogic

Annual commitments to private equity, 1980-98 (US$ billion)

0

10

20

30

40

50

60

70

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

0

200

400

600

$800 billion

'07*'06'05'04'03'02'012000'99'98'97'96'95

26

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

27

1999. As the transition to market economies in Eastern Europe took

hold in the mid-‘90s, the rapid growth of private equity told a similar

story” (Leeds and Sunderland, 2003).

The spurt in investment was further aided by high-risk stakes

taken on by bilateral international development institutions such as the

Overseas Private Investment Corporation, the U.S. Agency for

International Development (USAID), the European Bank for

Reconstruction and Development and the International Finance

Corporation (IFC). Development institutions were often among the first

to test emerging markets because of their primary interest in furthering

international development through the private sector. Investors’

confidence was cajoled by the participation of these development

institutions, whose successful early funds hinted at high potential

returns in emerging markets.

Beginning in the late 1990s and early 2000s, American-style

private equity funds in emerging markets began delivering

disappointing results in comparison to expectations and similar funds in

industrialized regions. Explaining this failure, Leeds and Sunderland

point to emerging markets’ low standards of corporate governance,

limited legal recourse and dysfunctional capital markets (2003). It is

also worth noting that late 1990s fund returns were uncharacteristically

high in the United States and Europe because of the tech-IPO bubble,

providing a skewed and unrealistic measuring stick for emerging

market funds’ performance.

In a 2004 industry survey of 26 investors with an aggregate

$108 billion managed funds, the Emerging Markets Private Equity

Association (EMPEA) reported overall investor dissatisfaction with

emerging market return on investment rates. Reasons cited centered on

weak macroeconomic variables such as currency volatility and market

liquidity, conflicting cultural perceptions on entrepreneurial cooperation

and market access and managerial issues such as high turnover in

target companies, little general partner operational control of portfolio

companies and insufficient risk mitigation strategies (EMPEA, 2004).

But in just three more years, the same EMPEA annual survey conveyed

buoyed investor confidence and optimistic expectations. Figure III

illustrates the upward trend of capital raised for emerging market

private equity funds, underscoring improved investor satisfaction.

Figure III: Emerging Market Private Equity Fundraising,

2003-2005

Source: EMPEA Fundraising Statistics for Emerging Markets Private Equity

By 2007, there was a mood of optimism among general and

limited partners for private equity growth prospects and performance in

emerging markets. A February 2008 EMPEA press release reported a 78

percent year-on-year increase in capital raised from a pool of 204 funds,

from $33 billion in 2006 to $59 billion amassed in 2007. Fund dollars

were still concentrated in emerging Asia, but other regions became

aggressive competitors. In 2007 alone, Central and Eastern Europe saw

a fundraising surge of more than 300 percent, Latin American private

equity funds grew 66 percent from the previous year and the Middle

East 71 percent (Choi, 2008). Emerging market funds were also

dedicated to specific industries—agriculture, technology, infrastructure

and natural resource. Table I highlights the global spread of private

equity dollars.

Recent private equity successes in developing markets are as

much a result of returns to scale on the knowledge curve as they are the

0

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28

29

result of fortuitous timing. International liquidity, low global interest

rates and free cross-border capital movement all encouraged large

fundraising caps and unsurpassed buyout activity. But the learning

curve has been of fundamental importance.

Table I: Private Equity Aggregate Fundraising, 2003-2007

Source: EMPEA, Emerging Markets Private Equity

Initially, partners assumed that the American private equity

venture capital model could be transplanted whole to developing nations,

but soon learned that a dearth of capital markets infrastructure, a lack of

legal constraints and incongruous cultural sensitivities all hindered

successful adoption of the model, undermining expected returns.

Investors were also faced with exit strategy challenges—most

developing nations had shallow capital markets that could not

adequately support IPOs. Responding to such problems, limited and

general partners modified the private equity model over the years,

becoming more adept at handling a different business climate and

culture in emerging markets.

In his article, Private Equity in Emerging Markets,

Gopalakrishnan addresses the need for a different approach in

emerging markets. “Traditional exit is through sale but multinational

companies are pulling out fast. Capital outflow from Asia has been

quick… Even in China, the growth in Foreign Direct Investments is

falling fast. Under these conditions the viable exit option is to sell out to

regional players who have cash” (Gopalakrishnan, 2002). Specifically,

Emerging CEE/ LatAm & Sub-SaharanAsia Russia Caribbean Africa MENA Pan-EM Total

2003 2,200 406 417 350* 116 3,4892004 2,800 1,777 714 545* 618 6,4542005 15,446 2,711 1,272 791 1,915 3,630 25,7652006 19,386 3,272 2,656 2,353 2,946 2,580 33,1932007 28,668 14,629 4,419 2,340 5,027 4,077 59,161

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.

30

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.

Table II: Growing Emerging Market Private Equity Investment,

2003-2005

Source: Business World India

Employment

One of the most contentious debates regarding private equity centers on

The money trail52% 1% 2% 15% 30% 41% 1% 3% 16% 39% 40% 1%* 4% 22% 33%

2003

1 2 3

4

5

2004

1 2 3

4

5

2005

1 2 3

4

5Total funds invested: $115 bn Total funds invested: $110 bn Total funds invested: $280 bn

1 North America

4 Asia Pacific 5 Europe

2 Central & South America 3 Middle East*South America Source: PWC Global Private EquityReport and media reports

31

the question of employment. Specifically, do LBOs create jobs or do they

reduce employment levels in a quest for absolute efficiency?

Historically, the existing limited academic research on this topic focused

on aggregate employment levels before and after LBOs, ignoring zero

marginal change in an acquisition or divestment. Also, studies have

been primarily concerned with LBO employment activity during the late

1970s through 1980s.

After studying 76 LBOs in the 1980s, Kaplan concluded that

LBO target companies reduced employment by a median 12 percent

more than industry wide standards (Kaplan, 1989). In 1987, Lichtenberg

and Siegel published an article supporting Kaplan’s thesis. These

authors concluded from a sample of 131 buyout target firms that

employment levels declined upon the close of a LBO deal (Lichtenberg

and Siegel, 1990).

While this body of research presents empirical data which

frames current discussions, it is important to note that LBO activity has

matured significantly since the 1980s, especially in industrialized

markets. It is also worth noting that the impact of LBOs on job creation

may be particularly difficult to measure in developing markets, where

unemployment is disproportionately high to begin with and where the

maturity and sophistication of LBOs lags similar activities in

industrialized nations. That said, current academic thought on

employment level changes due to LBOs paints a rather complicated

picture.

LBOs can and do create new employment opportunities,

but often simultaneously prune portfolio firms of redundant,

underperforming or inefficient positions. Because portfolio companies

are by definition privately held, and because employees are often

reshuffled post buyout, the destruction of a swath of underperforming

jobs may be quicker and therefore more dramatic than similar

undertakings at publicly listed organizations. In private equity backed

portfolio companies, jobs are only created if they add marginal value to

the portfolio company. In addition, LBO target firms are responsible for

considerable Greenfield job creation.

32

According to The Global Economic Impact of Private Equity

Report 2008, within the first two years of a LBO, the average portfolio firm

creates six percent more Greenfield jobs than the average industry non-

private equity backed firm (Davis et al. 2008). Not surprisingly, research

commissioned by the Private Equity Council supports these findings.

In American Jobs and the Impact of Private Equity Transactions,

Shapiro and Pham argue that private equity companies increase

employment in the United States and abroad. Shapiro and Pham

analyzed 42 large target companies under ownership of eight major

private equity funds. After following the performance of the 42

companies over the period 2002 to 2005, the authors observed initial job

losses after the first buyout transaction, but subsequent gain of job levels

within two years of the transaction. Shapiro and Pham further report

long-term job creation among the sample of 42 companies that

surpassed non-private equity backed companies in similar sectors.

The aggregate worldwide labor force of the sample grew 8.4 percent

from 2002 to 2005. Of the sample population, 76 percent detailed job

gains, while less than 24 percent reduced total employment (Shapiro

and Pham, 2008).

While the data discussed above has an international scope,

Shapiro and Pham concentrate on private equity job creation in the

United States. This leads to an important tangent about private equity

job creation in emerging markets. Policy makers are acutely sensitive to

the geographic location and migration of jobs. Thus, if a private equity

sponsored firm cut 100 redundant jobs in São Paolo and created 1,000

Greenfield jobs in Vietnam, policy makers in Brazil would be tempted to

overlook the 900 percent overall employment gain in an effort to protect

their constituents’ job security. Nonpartisan, international development

bodies are particularly useful here, because of their relative indifference

to region-specific interests that are outweighed by broader, global gains.

The International Finance Corporation (IFC) has been actively

investing in emerging private equity funds for 20 years. Summarizing its

successes from 1998 to 2006, the institution cites a 13.7 percent global

employment growth rate among its private equity funds’ portfolio

33

companies, compared to the global employment growth rate of 1.3

percent. The most impressive rise in job creation is in Central and

Eastern Europe, where portfolio companies’ employment rate grew at a

rate of 16.8 percent over eight years, compared to the regional average

growth rate of 0.3 percent. The following table (Table 3) sums up IFC

funds portfolio companies’ performance, measured against regional

employment growth rates.

Table 3. Company Performance and Employment Growth

Source: IFC News, 2007

Returning to the issue of simultaneous job destruction and

creation leads to the 2008 World Economic Forum Report’s description of

this private equity phenomenon as “creative destruction.” In The Global

Economic Impact of Private Equity Report 2008: Private Equity and

Employment, the authors argue, “especially when taken together, our

results suggest that private equity groups act as catalysts for creative

destruction. Result 1 says that employment falls more rapidly at targets

post-transaction, in line with the view that private equity groups shrink

inefficient, lower value segments of underperforming target firms. We also

find higher employment-weighted establishment exit rates at targets than

at controls in both the full and restricted samples. At the same time,

however, Result 5 says that private equity targets engage in more

Greenfield job creation than controls. This result suggests that private

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

C. & E. EuropeE. Asia & Pacific

S. America & CaribbeanMENA

Sub. Saharan AfricaWorld

16.80%

0.30%

10.40%

0.90%

8.00%

2.40%

7.60%

3.50%

11.70%

2.50%

13.70%

1.60%

Growth of Funds Portfolio Regional Growth

34

equity groups accelerate the expansion of target firm activity in new,

higher value directions. Result 6 says that private equity also accelerates

the pace of acquisitions and divestitures. These results fit the view that

private equity groups act as catalysts for creative destruction activity in

the economy, but more research is needed to fully address this issue”

(Davis et al., 2008). The conclusions of this study highlight the complex

nature of private equity labor relations. Clearly, there is a stark, if

expected, difference between the findings of the World Economic Forum’s

report and research commissioned by the Private Equity Council.

It seems safe to assume that the truth lies somewhere in between.

While private equity is engaged in “creative destruction,”

economic value is realized by industries and national markets—which

gain efficiency and global competitiveness. Of course, this added value

is at the expense of hundreds or thousands of individuals, whose

purchasing power diminishes during structural labor adjustments,

undermining the economic expansionary driver—consumer

consumption. And yet there is also truth to claims of mass job creation

from private equity lobbyists groups such as the Private Equity Council,

even if reported statistics may be skewed by selective data from non-

random samples.

Emerging market fiscal policy makers cannot afford to ignore

the discrepancy in job creation rates between private equity backed

portfolio companies and comparable industry firms. The real challenge

lies in shifting focus from country-specific quantity job creation and loss

cycles to a more integrative global discussion on the qualitative impact

of private equity on emerging market employment growth.

Innovation Investment

Most economists agree that innovation is an imperative driver of

economic development. In his 1956 essay A Contribution to the Theory

of Economic Growth, Solow emphasized the importance of technological

innovation for economic growth. Assuming that capital is subject to

diminishing returns, Solow argued that an economy’s steady rate of

growth depended on the rates of technological progress and labor

35

growth (Solow, 1956). The assumptions and findings of this neoclassical

growth theory led Solow to conclude that in order to grow economies,

governments had to invest in human capital through education and on-

going training, shift resources from low to higher productivity

industries, encourage capital investment, technological progress and

innovation (Government of Canada, 2002). Of these recommendations,

the last is offered as the most important growth driver.

Nowhere else is the economic growth impact of technological

progress and innovation more impressively illustrated than in the four

East Asia Tigers—Taiwan, Singapore, South Korea and Hong Kong.

Following World War II, the four tigers were characterized as emerging

markets, but have since managed to transform themselves into

industrialized regions through 30 years of sustained economic growth.

To understand how staggering economic growth within this

block has been, consider an observation by Sarel, author of

International Monetary Fund (IMF) paper, Growth in East Asia: What

We Can and What We Cannot Infer, “while the average resident of a non-

Asian country in 1990 was 72 percent richer than his parents were in

1960, the corresponding figure for the average Korean is no less than

638 percent” (Sarel, 1996). Sarel presents strong evidence that

technology and innovation have been responsible for East Asia’s

tremendous growth, but also cites data supporting the catalytic qualities

of amassing factors of production—labor and capital. For clarity and

focus, this discussion is only concerned with growth resulting from

innovation and technological progress.

Discussing technological progress and innovation is critical

because of the leapfrog growth these drivers can offer emerging

markets. To compete in a global, high-tech information age economy,

developing nations must use technology as competitive leverage. Again,

Sarel observes, “accordingly, the standard view about the success of the

East Asian countries emphasizes the role of technology in their high

growth rates and focuses on the fast technological catch-up in these

economies. In this view, these economies have succeeded because they

36

learned to use technology faster and more efficiently than their

competitors did” (Sarel, 1996).

Having now established the importance of innovation in

spurring economic development and growth—especially in emerging

markets—does private equity advance technological progress and

innovation? In other words, does private equity activity invest in and

encourage innovation, technology and research and development

(R&D)?

Examining patent filing records of 495 non MBO, LBO private

equity firms from 1983 to 2005, Lerner, Sorensen and Stromberg, offer

the following observations:

• After the LBO transaction, patents belonging to the portfolio

company are more frequently cited, implying more intensive

use of patents post buyout

• Private equity backed portfolio companies’ patent awards have

a higher economic impact after acquisition, even if patent

levels remain fundamentally constant

• After going private, influential innovations are implemented

and pursued in portfolio companies. The authors found this to

be true even when the sample was tested against stringent

controls

• Private equity encourages focused innovation—portfolio

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

37

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

38

39

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.

40

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.

41

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.

42

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

43

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.

44

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