private equity investing in emerging markets

Journal of Applied Corporate Finance F A L L 2 0 0 3 V O L U M E 1 5 . 4

Private Equity Investing in Emerging Markets by Roger Leeds and Julie Sunderland, Johns Hopkins University

111ACCENTURE JOURNAL OF APPLIED CORPORATE FINANCE

PRIVATE EQUITYINVESTING INEMERGING MARKETS

by Roger Leeds andJulie Sunderland,Johns Hopkins University*

y the mid-1990s, a broad global consen-sus had emerged that the private sector,rather than the state, should be theprimary catalyst for new investment and

expanding number of companies hoping to raisecapital. In addition, many prospective foreign inves-tors were flush with funds, due to the boomingperformance of financial markets and venture capitalfunds in the industrialized countries during the late’90s. Encouraged by improving macroeconomicconditions, the new receptivity of governments toforeign investors, and the prospect of earning highreturns, investors were willing to look at higher-riskinvestments in emerging markets. The factors ofsupply and demand appeared to be in perfectharmony for emerging market funds to succeed.

But the promise of private equity in emergingmarkets has failed to meet expectations. After aninitial proliferation of new funds in the mid-’90s,growth has slowed to a trickle, and few practitionersbelieve that this trend will soon be reversed. Not onlyhave results been disappointing in absolute terms,they are even worse relative to comparable funds inthe U.S. and Europe, where the risks are measurablylower. In an understatement shared by many of hisindustry colleagues, one practitioner candidly noted,“Broadly, the asset class hasn’t returned versusexpectations.”1

The obvious conclusion is that the venturecapital model that worked so successfully first in theU.S. and then in Europe does not travel well toemerging markets. Nearly everyone involved in theearly years assumed that a little tinkering around theedges would suffice to replicate the success achievedby private equity investors in the industrializednations. Development finance institutions, as strongpromoters of private sector development, encour-aged investors to support identical fund structuresand investment approaches even though the regula-tory and legal frameworks did not provide adequate

B

*We wish to thank the private equity fund managers and investors who agreedto be interviewed for this article as well as the participants in the ongoing seminarseries at SAIS on this topic.

1. Quotes and anecdotes cited in this article are taken from interviewsconducted by the authors and from industry sources including Latin AmericanPrivate Equity Analyst, Private Equity Analyst, Private Equity Week, EuropeanVenture Capital Journal, Asia Private Equity Review, and Venture Capital Journal.

development, and many emerging economies weredemonstrating encouraging progress. Growth wasfinally picking up, inflation and interest rates weredeclining, and the political and regulatory environ-ments had shifted in favor of open markets and lowerbarriers to competition. For the private sector strat-egy to succeed, however, the explosive demand forinvestment capital by a burgeoning number ofcompanies had to be satisfied.

Private equity looked like a clear winner, offer-ing many advantages to both the suppliers and usersof investment capital. By “private equity” we meanfinancing for early- and later-stage private compa-nies from third-party investors seeking high returnsbased on both the risk profiles of the companies andthe near-term illiquidity of these investments (ven-ture capital is a form of private equity that generallyapplies to start-ups). As the private sector expanded,an increasing number of firms had to move beyondtheir traditional reliance on “friends and family” forfinancing if they were to continue to grow and becompetitive. By virtue of their size and track record,however, many of these firms had risk profiles thatwere unappealing to banks and securities markets.Notoriously weak domestic equity and credit mar-kets were closed to all but the largest companies, andinternational financial markets were even moreimpenetrable. Private equity offered an attractivemidpoint along the financing spectrum.

Investors were attracted by the severe capitalshortages in many emerging markets, which impliedlow valuations (and hence high returns) for the

112JOURNAL OF APPLIED CORPORATE FINANCE

investor protection. Fund managers used existingprocesses for identifying, analyzing, and valuingtarget companies as well as for structuring deals,despite dramatic differences in accounting standards,corporate governance practices, and exit possibilities.Investors willingly jumped on the bandwagon.

Faced with disappointing early results, how-ever, all participants are being forced to rethink theirapproach. Although the rationale for private equityinvesting in emerging markets remains as compel-ling as ever, the original model must change on everylevel. The funds must become less foreign and morelocal. Emerging market governments must recognizethe indispensable role that private equity can play indeepening and broadening the private sector, andwillingly institute the necessary reforms. Develop-ment finance institutions must fulfill their catalyticrole more effectively by sharing the financial riskwith their private sector counterparts, cajoling andassisting governments to strengthen regulatory envi-ronments, and providing support for creative newapproaches to private equity investing.

A SHORT HISTORY OF EMERGING MARKETPRIVATE EQUITY

Whether in developed or developing countries,a broad range of companies possess risk profiles thatinhibit their ability to raise capital through conven-tional channels such as bank borrowings or publicsecurities issues. Some are too new to have aconvincing track record, others are overburdenedwith debt, and still others have opaque financialstatements. At a certain stage of growth, however,these firms can no longer compete effectively with-out making new investments that are too large andcostly to be financed internally. Private equity fillsthis gap between self-financing and conventionalcapital market activity.

Candidate firms may be entrepreneurial start-ups, more established small and medium-sized firms,or troubled companies that investors perceive asundervalued (such as buyouts). Because the riskassociated with these firms is unusually high, privateequity investors expect financial returns that exceedmore conventional investments—typically 25% ormore. The higher risk levels also spur investors toundertake rigorous due diligence and, once they

have committed capital to a company, to play a farmore active, hands-on oversight role than is thecustom with shareholders of publicly traded firms.Because the shares are rarely listed on public stockexchanges, such investments are illiquid until a buyercan be identified or a public offering allows the privateequity investor to exit with a profitable return.

Some of the most legendary high-growth com-panies in the U.S., including Federal Express, Oracle,Apple Computer, and Intel, were initially financedwith private equity. As these success stories multi-plied and became widely known, large institutionalinvestors like pension funds and insurance compa-nies were drawn to the asset class, fueling theindustry’s explosive growth in the 1980s and 1990s.By the early ’90s, emerging markets seemed likeequally fertile ground for this tested and successfulparadigm. With the unprecedented returns gener-ated from the surge in U.S. equity markets, institu-tional investors were on the lookout for newopportunities. They also began to worry that theenormous increase of capital flowing into U.S. privateequity would outpace the supply of high-return invest-ments. The door opened wide, therefore, for thoseattracted by the prospect of portfolio diversificationand the opportunity to earn exceptional returns.

These developments were reinforced by eventsunfolding in many emerging economies. A resur-gence of growth and new investment opportunitieswas attributed in large measure to a more receptiveattitude toward the private sector generally andforeign investors in particular. Between 1992 and1998, foreign direct investment increased at a com-pound annual growth rate of 19% in Asia, 27% inEastern Europe, and 19% in Latin America.2 Nonethe-less, only a handful of only the largest companieswere capturing these private sources of financing.Governments compounded the problem with theirexcessive reliance on private savings to financepublic sector deficits, crowding out private sectoraccess to capital. In Brazil, for example, a WorldBank report revealed that about 40% of private bankassets in 2000 were invested in government securi-ties. With financing patterns heavily biased in favorof a relatively small number of large firms, thepremise that demand for private equity financingwould be strong was convincing. The case wasfurther buttressed by the presumption of cooperative

2. International Monetary Fund, International Financial Statistics.

113VOLUME 15 NUMBER 4 FALL 2003

local governments, given their commitment to a heavierprivate sector role in the development process.

The Mid-’90s: Optimism and Growth

With so many factors pointing in the rightdirection, emerging market funds proliferated in themid-’90s. By the end of 1999, there were more than100 Latin America funds, where almost none hadexisted earlier in the decade. Between 1992 and1997, 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 $5billion. In the emerging markets of Asia (excludingJapan), about 500 funds raised more than $50 billionin new capital between 1992 and 1999. As thetransition to market economies in Eastern Europetook hold in the mid-’90s, the rapid growth of privateequity told a similar story.3

This private equity expansion was stronglysupported by bilateral development institutions suchas the Overseas Private Investment Corporation andthe U.S. Agency for International Development, aswell as by the multilateral development financeinstitutions that focus on private sector develop-ment, such as the International Finance Corporation(IFC) and the European Bank for Reconstruction andDevelopment. By the end of 1998, these institutionshad committed more than $15 billion to some 220private equity funds. Their participation was criticalin the early years, when private investors werehesitant to commit capital to countries with unfamil-iar local conditions and highly uncertain risk-returntradeoffs. As one fund manager acknowledged,“Having the IFC in our fund as an investor isimportant to assuring other investors.”

In almost every respect, the new breed ofprivate equity funds were clones of their U.S. prede-cessors in terms of fund-raising strategy, organiza-tion structure, investment processing, staffing, andexit strategy. Most funds were headquartered in U.S.or European financial centers, attracted staff trainedby U.S. investment banks, invested in dollars, andexpected to achieve U.S.-style IPO exits. The analyti-cal skills were also the same, as was the step-by-stepprocess of doing a deal: originate transaction oppor-tunities through good market intelligence and word

of mouth, conduct due diligence, build financialmodels that indicate future company performanceand value ranges, negotiate with capital-hungryentrepreneurs, prepare documentation, and closethe deal. As one veteran emerging markets investoracknowledged, “The idea was to adapt the U.S.venture capital model to promote private sectordevelopment in these countries.”

Late ’90s: Unmet Expectations

By the late ’90s, however, the emerging marketprivate equity funds were seriously underperforming.Even though the funds have no obligation to publiclydivulge their results, there is considerable anecdotalevidence that exits are taking longer to materializethan expected, and when they do, returns are notcommensurate with the higher risk levels associatedwith emerging markets. IFC officials, managers of thelargest portfolio of emerging market private equityfunds, have acknowledged that cumulative returnson its investments in private equity funds are insingle digits or lower. One survey of 227 LatinAmerican private equity investments between 1995and mid-2000 indicated that only 15 investments hadbeen exited, or 7% of the total. Performance has beenonly slightly more encouraging in Asia, where capitalmarkets are more developed and liquid. Divestituresin 1998 and 1999 averaged about $2.5 billion per yearin the region, a paltry proportion of the $35 billioninvested between 1992 and 1999.

Of course, many of these first-generation fundshave been in business for only three or four years,far too short a time frame to begin measuring results.Even in the U.S., most funds have a ten-year life anddo not begin generating positive returns until aboutfive years into the cycle. Until mid-2000, emergingmarket funds also bore the unenviable burden ofcomparison to their industrialized country counter-parts at a time when returns in the U.S. and Europewere at historically unprecedented levels. The Na-tional Venture Capital Association reported that theaverage return for all venture funds in the U.S. wasa staggering 146% in 1999, and the five-year averagewas 46%, setting a pretty high—and probably unre-alistic—standard. Defenders also point out thatemerging market funds have been victimized by the

3. The authors compiled and analyzed all of the statistical data in this articleon fund capital flows and performance from Latin American Private Equity Review& Outlook 2000/2001; 2001 Guide to Venture Capital in Asia; European Venture

Capital Association European Private Equity Statistics; VentureSource; OPIC(James C. Brenner, Direct Equity Investment Funds: Public-Private PartnershipExperience, 1999); and IFC documents (Annual Report, 2000).

The promise of private equity in emerging markets has failed to meet expectations….In an understatement shared by many of his industry colleagues, one practitioner

candidly noted, “Broadly, the asset class hasn’t returned versus expectations.”


dollar’s sharp appreciation against most currenciesin Asia and Latin America since the mid-’90s, erodingreal returns to foreign investors.

Still, the conclusion was inescapable that theindustry had performed poorly both in absolute andrelative terms. Private equity investors responded byturning away from emerging markets. Funds raisedin 2002 by Latin American private equity funds wereat the lowest level since 1993, when the industry firstbegan to take off in the region, and Asian funds lastyear also (excluding Japan) had their worst fund-raising year since 1993.4 “After three or four years oflousy returns in Asia, Latin America, and Russia,” onefund manager lamented, “it’s going to be verydifficult to find new money. Investors do not haveany high-profile role models of consistently success-ful funds to demonstrate that this type of investingworks well. The publicity is bad, and getting worse.”An institutional investor in Latin America explained,“Basically, we don’t want to increase our exposurein the region, and only when money starts comingback will we re-invest.”

EXPLAINING UNDERPERFORMANCE

The private equity industry evolved gradually inthe United States over a 30- or 40-year period inresponse to strong demand from cooperative entre-preneurs, a sympathetic public policy environment,a reliable legal system, political and economic stabil-ity, and well-developed financial markets. Thesesuccess factors, however, are demonstrably absentin emerging markets. Three shortcomings in particu-lar highlight the contrast between the two environ-ments and explain why emerging market funds haveunderperformed: low standards of corporate gover-nance in terms of the quality of information requiredto make investment decisions and monitor perfor-mance once investments have been made; theweakness of legal systems in enforcing contracts andprotecting all classes of investors; and the inability ofdomestic equity markets to offer a reasonable pros-pect of exit through the IPO market.

Low Standards of Corporate Governance

The first gaping imbalance in the emergingmarkets private equity equation was the accuracy,

timeliness, and transparency of financial and oper-ating information provided to investors, and thewillingness of managers to subject themselves tosome degree of accountability to outsiders. Even inthe best of circumstances, relationships betweeninvestors and the managers of their portfolio compa-nies are complex and often contentious, but theabsence of sound corporate governance practice hassharply accentuated that tension. Nowhere does thisissue become more problematic than with family-owned firms. Although widespread in all countries,family ownership tends to be even more prevalentin developing countries. The prototype is an en-trepreneur who has built a successful businesswith virtually no capital or shareholders beyondhis or her immediate family and close friends.Absent any accountability to outside sharehold-ers, the interests of the owner and the firm areindistinguishable, and financial accounts are fre-quently intermingled. These traditions of au-tonomy, secrecy, and independence run deepwithin the corporate culture of most developingcountry firms, rarely challenged until the need foroutside capital becomes imperative.

Few entrepreneurs have ever undergone anindependent audit, for example, or adhered tointernational accounting standards that are the pre-requisites for most professional investors. The pro-spective investor is thus at the mercy of theentrepreneur for access to information necessary tomake critical judgments about company perfor-mance and value. The common practice of maintain-ing two or even three sets of accounting records inorder to avoid the tax collector frustrates the duediligence team’s task of gaining an accurate pictureof performance. Opaque bookkeeping and disclo-sure habits also may impede access to other impor-tant information that might alter investor perceptionsof company value, such as environmental liabilitiesor unresolved legal disputes. As one investor noted,“One big problem is skeletons in the closet. Many ofthese great companies have hidden subsidiaries,offshore sales, and other tax avoidance schemes.”Nor is the lure of badly needed capital likely toovercome resistance to outside investors who areinclined to push and prod management to makepainful changes they believe are needed to increasetransparency and enhance company value. It is not

4. Asia Private Equity Review 2002 Year-End Review, and Venture Equity LatinAmerica 2002 Year-End Report.


surprising, therefore, that most fund managers citethe difficulty of assessing the competence andintegrity of the entrepreneur as their most difficulttask during the due diligence phase.

The corporate governance problem does notlessen after the deal is consummated. The investorneeds a regular flow of accurate financial andoperating information in order to monitor companyperformance and participate in major decisions thatare likely to affect future results. Normally, a newlystructured board of directors is established, alongwith a clear set of governance procedures that definerelations between management and the new board.In many emerging markets, however, minorityshareholders encounter a much different reality,where new board members have little leverage toexact the necessary information if managementchooses to circumvent agreements, further under-mining the outside investor’s ability to orchestratean acceptable exit.

Limited Legal Recourse

Weak corporate governance is compoundedwhen legal systems do not offer a reliable outlet forresolving disputes. Carefully constructed and en-forceable legal contracts serve as the bedrock for allfinancial transactions, regardless of the country.Indeed, whether as banks or equity providers,financiers normally have little direct control over thefirms in which they invest and depend heavily on thelegal system to protect their rights.

Early private equity experience in emergingmarkets demonstrates too frequently that regardlessof the soundness of the signed agreements thatdefine the terms and conditions of the relationshipbetween investors and the company, there is mini-mal legal recourse in the event of serious differenceswith management. As one law firm opined aboutLatin America, “...there are significant issues of‘enforceability’ of key contractual rights and statu-tory protection for minority rights, [which] collec-tively act as an unintended disincentive to privateequity investors.”5 The problem often is accentuatedbecause local owners tend to be exceedingly adeptat navigating the ins and outs of the legal system,placing investors at a distinct disadvantage in thejudicial resolution of disputes.

Inadequate shareholder protection has createda severe backlash, with many fund managers alteringtheir investment strategies or pulling out of countriesentirely unless they can gain majority control, allbecause of their painful experience as minorityshareholders. One fund manager acknowledgedthat because of low confidence in local laws andcourts, “It is a fact that we have become more andmore rigid in regards to investment terms.” These arereasonable responses, but they also undermine theexpanded use of private equity as a financing tool.

Dysfunctional Capital Markets

Every aspect of the private equity cycle is drivenby the imperative to orchestrate a profitable exitwithin a certain time frame. In the U.S. and otherdeveloped nations, a well-functioning IPO marketprovides the fundamental underpinning for thesuccess of the entire private equity industry. Withouta credible IPO market, exit options are limited tomanagement buyouts and sales to strategic investorsor later-stage financial investors. According to mostempirical evidence, exits achieved through IPOstend to maximize firm value, relative to the alterna-tives of selling shares to strategic investors or backto the original owners (through managementbuyouts). In the U.S., for example, venture capitalfunds have earned an average annual return of about60% when exit is by IPO, compared to 15% when thesale is to private investors. Yet in Eastern Europe,38% of all private equity exits in 1998 and 1999 weresales to strategic investors, compared to only 3%through IPOs and 16% through secondary offerings.Of the 18 large exits in Latin America between 1998and 2001, only two were IPOs. In Asia, IPO activityhas been somewhat more encouraging, albeit domi-nated by technology companies that have sufferedshare price declines as severe as their counterpartsin the U.S. and Europe.

But equity markets in even the most advancedemerging economies fail to provide a viable outletfor the sale of companies in private equity portfolios.The primary market functions as a vehicle for raisingcapital for only a handful of the largest companies,and secondary market trading is dominated by aneven smaller number of big firms. In Latin America,58% of the average daily trading volume on the major

5. Morrison & Forrester LLP, “The Need For Legal and Regulatory Reforms inArgentina, Brazil, Chile, El Salvador and Mexico to Promote Risk Capital

Investments in Small and Medium Size Enterprises,” Washington, D.C., February2001.

In almost every respect, the new breed of private equity funds were clones of theirU.S. predecessors in terms of fund-raising strategy, organization structure,

investment processing, staffing, and exit strategy. Most funds were headquartered inU.S. or European financial centers, attracted staff trained by U.S. investment banks,

invested in dollars, and expected to achieve U.S.-style IPO exits.


stock exchanges is dominated by the ten largest firmsin each country; the percentage in Asia is onlyslightly lower at 42%.6 In many countries, alreadyweak stock markets are getting worse, leading somemajor companies to delist their shares locally in favorof more established foreign or international ex-changes.7 “You are going to be discouraged,”explained one fund manager, “if you think the onlyway to exit is to go public.”

RETHINKING THE APPROACH

These fundamental shortcomings magnify thereality of a private equity environment that is starklydifferent and more difficult than what practitionerswere accustomed to closer to home. The basicassumptions underlying the U.S. venture capitalapproach are largely missing in emerging markets,with a predictably adverse effect on performance.Results will improve, therefore, only if the fundmanagers align their business model more closelywith emerging market realities.

Go local. Initially, many funds preferred tolocate in the U.S. or Europe, bowing to convenienceand the preferences of Western professional staffs.But just as a vibrant venture capital presence mush-roomed in Silicon Valley in response to the prolifera-tion of new technology clients, fund managersbelatedly are recognizing that a local base of opera-tion is even more necessary when the target compa-nies reside in distant, unfamiliar emerging markets.Generating market intelligence, investigating newinvestment opportunities, conducting due diligence,and maintaining ongoing direct involvement can bemuch more complicated and less effective when theinvestment team literally commutes between thehome office and company headquarters on othercontinents. As one badly burned Latin Americanprivate equity pioneer—who originally located mostof his professional staff in New York—acknowl-edged, “We will no longer do an investment in acountry where we don’t have eyes and ears on theground.” More fund managers now recognize that itmakes sense to hire local professionals who areculturally attuned and have a deeper understandingof the unique circumstances that differentiate emerg-ing markets from countries with more hospitable

investment climates. “You need to have people thatlive there,” explained one fund manager, “have thepassport, and are committed to the community.That is the only way you will gain the criticalintuitive sixth sense about what is going on, whatare the good deals and who are the people youwant to work with.”

Add value. The management role of the privateequity investor in emerging markets is even moreimportant than in developed countries, given theextraordinary challenges of creating a viable exitopportunity. Fund managers must re-think the pro-fessional expertise required for these tasks, recog-nizing that the analytical and negotiating skillsrequired to make an investment are not same asthose required to enhance corporate value duringthe post-investment phase. Initially, the industryrelied too heavily on former investment bankerstrained to “do deals,” collect their fee, and move onto the next transaction. They badly underestimatedthe amount of hands-on time required to monitorportfolio company performance. Attending periodicboard meetings, reading financial reports, and ob-serving performance from afar is not sufficient.Instead, professionals must take on the difficult andtime-consuming tasks of strengthening corporategovernance practices, restructuring management,and positioning the company for a profitable exit.“Value enhancement is becoming the most impor-tant part of this business,” noted one fund manager.“When you sign the deal is when the real work starts,not ends. Finding the right skill set in emergingmarkets is tricky. We need to know how to buildcompany value—to say: ‘Your brother has to go, oryou must sell this subsidiary.’”

More discerning deal selection. After years ofworking with a range of mid-size companies, onefund manager concluded that he could no longerjustify the time, expense, and frustration of investingin traditional family-owned firms, regardless of thesector or historical performance. “It simply is notworth the aggravation and tension,” he explained,“so we are concentrating only on the ‘new economy,’where both the firms and the managers are younger,more flexible, and less likely to have acquired manyof the bad habits that hinder good relations withtraditional family firms.” Funds also are becoming

6. Information on stock market performance is compiled from IFC/Standard& Poor’s Emerging Market Fact Book, 2000.

7. In Latin America, the number of listed firms declined by 2% annuallybetween 1995 and 1999, causing secondary market trading volume also to shrink.In Asia, the number of firms stayed flat in 1998 and declined slightly in 1999.


more proactive in deal selection, rather than waitingfor business proposals to land on their desks or forinvestment bankers to make a pitch on behalf of aclient. Echoing a growing consensus, one managerof a prominent Asian fund observed, “The best dealsare ones we create. In our most successful transac-tion, we proactively approached the company oncewe had decided that we wanted to be in the sector.We looked for an attractive company where wewould not be in a bidding auction.” Good deals mustfit the skill set and industry knowledge of the fundmanager, and offer identifiable opportunities forenhancing value.

Creative exit strategies. “Now, every time welook at a new investment opportunity we rigorouslyassess our exit strategy before deciding whether tomake the investment,” according to one emergingmarkets fund manager. Notwithstanding the inevi-table uncertainties about an event that will not occurfor at least three to five years hence, there isincreasing rigor applied to the exercise of mappingout a viable exit at the outset, whether by an IPO, amanagement buyout, or a strategic investor, andthen ensuring that company management under-stands and commits to the strategy. Are the ownerswilling and able to execute a management buyoutafter a prescribed time period? Or if a strategicinvestor is the preferred alternative, who are thelikely candidates, and what must be achieved bymanagement during the intervening years to attractthese buyers? One practitioner explained his fund’sapproach to attracting a strategic investor: “We try toget into the head of the strategic corporate planner.What’s their strategy? We are starting to think like aconsulting firm, trying to think through industrystrategies, understand industry trends, learn aboutthe key players and whether consolidation is likelyto occur.”

There also must be a greater willingness toexperiment with new, more creative approachestoward exit strategies. One Latin American fund, forexample, launched a mezzanine fund that offersdebt financing with many of the same characteristicsas equity, but provides investors with a greaterassurance of a steady income stream. Another hasbegun to recapitalize some successful portfoliocompanies, which allows the fund to realize somecapital gains while waiting for a more opportunetime to exit. And some are seeking to take control overunderperforming funds, positing that the key to suc-cess is more effective, hands-on fund management.

LOCAL GOVERNMENTS MUST PROMOTEEMERGING MARKET DEVELOPMENT

Given the magnitude of the financing gap thatneeds to be filled, most governments have donesurprisingly little to institute reforms that wouldimprove the environment for private equity, andthey seem indifferent to their own role in attractingprivate investment capital. As global competitionintensifies, local policies, regulations, and businesspractices become increasingly important in attract-ing investment. Private equity investors, ever moresensitive to location-specific problems, are begin-ning to distinguish sharply among countries basedon criteria such as the protection of shareholderrights, tax treatment of capital gains, and securitiesmarkets development.

Protecting shareholder rights. Few reforms aremore important to strengthening investor confi-dence, or more within the control of local govern-ments, than regulations that affect minorityshareholders, such as voting rights and timely andreliable enforcement of shareholder and creditordisputes. More countries must follow the example ofthe Chilean and Brazilian legislatures, which havepassed new laws designed to better protect minorityshareholders. Perhaps more important, reform-ori-ented countries also must demonstrate to investorsthat they are capable of effectively enforcing thesenew laws.

Promoting sound corporate governance stan-dards. An international consensus also is emergingon acceptable standards of corporate governance,another increasingly important benchmark for in-vestors. Countries will be at a distinct advantage withprivate equity investors if they effectively promoteand enforce a set of rules and conventions thatestablish standardized public disclosure and man-agement accountability, including internationallyaccepted accounting practices, independent audits,and defined responsibilities of boards of directors.

Liberalizing investment restrictions for localinstitutional investors. Contrary to conventionalwisdom, the growth of private equity in emergingmarkets is rarely constrained by a shortage of localsources of capital. Many Asian nations, for example,have savings rates that reach 30% of GDP or more,creating a flow of investment capital to pensionfunds, insurance companies, mutual funds, and otherfinancial intermediaries. Until recently, however, mostcountries had placed burdensome restrictions on

Inadequate shareholder protection has created a severe backlash, with many fundmanagers altering their investment strategies or pulling out of countries entirely

unless they can gain majority control, all because of their painful experienceas minority shareholders.


how these institutions could invest, effectively elimi-nating private equity as an option. But some govern-ments are beginning to respond. India recentlyrevamped national regulations governing invest-ment practices and rescinded some taxes in order toencourage a higher level of venture capital investingby overseas firms. Similarly, in 1998 Korea beganto allow pension funds to invest alongside venturecapital funds, and a number of the major LatinAmerican nations also have initiated regulatoryreforms.8

Improving access to public equity markets. Ina statement that resonates for virtually all emergingmarkets, one survey of Latin America concluded thatin order for private equity to realize its potential, “asignificant number of legal and regulatory changeswill need to be implemented” to strengthen localstock exchanges. When public securities marketsfunction well, institutional investors invariablybecome a major source of investment capital forprivate firms.

DEVELOPMENT FINANCE INSTITUTIONS(DFIs) MUST PROVIDE LEADERSHIP

The IFC in particular, as the oldest, largest, andmost experienced of the development finance insti-tutions, has a responsibility to lead the way if thereis to be a private equity rebound. By 2001, it hadinvestments in 142 private equity funds and another45 management companies, with total commitmentsof about $1.7 billion. When resources from otherinvestors are added to IFC-sponsored funds, it canclaim responsibility for channeling approximately $5billion in private equity to firms in developingcountries. But this broad experience has not trans-lated into a track record that is any better than theprivate funds. Understandably disappointed by sub-par performance, some senior IFC decision makershave advocated an institutional retreat from privateequity investing. Such a retreat would send a strik-ingly negative message to governments and privateinvestors alike and do untold damage to the futureof private equity in emerging markets.

Instead, the private-sector-oriented DFIs shouldcapitalize on their deep reservoir of knowledge andpractice to re-energize the industry. They are uniquelyqualified to play this catalytic role because they alone

combine three essential capabilities critical to spur-ring a private equity turnaround: financial resourcesthat are leveraged against private investor funds;credibility with local governments that can be usedto initiate much-needed policy and regulatory re-form; and powerful influence with private investorsthat can be applied to encourage more activeparticipation in private equity.

Financing that attracts additional investors.The very purpose of these development institutionsis to attract additional private investment on thebasis of their own participation. DFIs will be crediblein the eyes of investors and their client governmentsonly if they sustain their financing role. This doesnot suggest that they should throw good moneyafter bad. Instead, they should redouble theirefforts to screen and select competent fund man-agers and then promote strict accountability toachieve solid results.

Assist with policy and regulatory reform. Up tillnow, there has been little evidence that policy reformis a DFI priority, although these institutions areuniquely positioned to exert pressure on govern-ments to undertake necessary reforms. Local officialsview the DFIs as honest brokers who objectivelypromote private sector development, in contrast toprivate fund managers. The DFIs thus have unpar-alleled sway over public sector decision makers, andcan directly influence policy outcomes on suchissues as liberalization of pension fund investmentguidelines or establishing and enforcing interna-tional accounting and auditing standards.

Support creative new initiatives. DFIs shouldplay a stronger leadership role as incubators for newprivate equity initiatives that draw on best practicesfrom other countries. Successful private-public part-nerships in numerous developed countries haveincluded government-sponsored financial incen-tives designed to encourage private sector financingof small and medium-sized companies. Under theU.S. Small Business Investment Corporation pro-gram, for example, specially licensed venture capitalfunds raised more than $1 billion in 2001 in privatecapital markets on competitive terms to invest in pre-IPO companies because the U.S. government guar-anteed a portion of the amount raised. Israel’s Yozmaprogram, launched in the early ’90s, has also hadremarkable success using government funds as seed

8. The Brazilian regulatory authorities, for example, recently liberalized somerestrictions on the amount that pension funds can invest in so-called alternative

asset classes such as private equity. Chile recently raised the amount that pensionfunds can invest in any way they see fit, which represents about $1 billion.


capital to encourage private investors to participatein the initial development of the Israeli venturecapital industry. DFIs should more actively supportlocal governments that launch similar programs,rather than reflexively dismissing any public sectorinitiatives that involve financial incentives for privatesector development.

Training for fund managers. Many of the earlyprivate equity failures were rightly attributed to thepoor quality of fund managers, which is hardlysurprising since few individuals in these countrieshad previous experience in the screening, financing,and overseeing of companies that typically receiveprivate equity. “The principal reason that we are notproviding more funds to private equity,” explaineda senior official at Brazil’s development bank, “is ourinability to identify fund managers with the requisiteexperience.” Yet training for private equity fundmanagers is practically nonexistent. DFIs are in thebest position to assist and encourage the strengthen-ing of indigenous capabilities, perhaps through localtraining of professionals as a condition for theirfinancing of private equity funds.

FUTURE PROSPECTS

Regardless of the country or culture, successfulentrepreneurs share numerous traits, particularlyduring the critical start-up phase of launching a newbusiness—they tend to have an uncompromising,single-minded persistence, a fierce determination toovercome adversity, and unbridled optimism, re-gardless of the odds. Successful private equityinvestors in emerging markets must cultivate asimilar arsenal of personal characteristics, not unlikethe U.S. venture capital pioneers in the ’60s. EarlyU.S. venture capitalists were hard pressed to con-vince skeptical investors to commit capital in high-

risk companies with no track records; they com-plained about inexperienced and secretive entrepre-neurs; and, long before the NASDAQ emerged as anIPO outlet for small companies, they had difficultyeffecting profitable exit opportunities. Then as now,failures outnumbered successes and naysayers hadmore credibility than the innovators and risk-takers.But U.S. venture capitalists rapidly ascended thelearning curve, demonstrating an uncommon capac-ity to make creative adjustments along the way.

The new generation of emerging market privateequity managers must follow a similar trajectory, andnot permit early failures and disappointments toobscure a number of factors that bode well for thefuture. As long as there is an international consensusabout the private sector’s important role in thedevelopment process, alternative financing tech-niques such as private equity must remain on centerstage. Globalization, with its emphasis on openmarkets, lower barriers to trade and investment, andcross-border competition, will reinforce this trend byfostering intense competition among both countriesand firms for scarce financial resources. Some gov-ernments are already responding by passing legisla-tion to better protect the rights of minority shareholdersand by liberalizing onerous tax regulations thatdiscourage foreign investors. This new environmentalso favors so-called new economy companies, withmanagers who are less resistant to third-party inves-tors and more accepting of international standards ofcorporate governance.

Thus, despite some early setbacks, there areencouraging signs that a private equity rebound inemerging markets is not only desirable but plausible.However, the key players must make innovativeadjustments that reflect the realities surrounding thistype of investing. With a different approach, thepromise of private equity will begin to be realized.

ROGER LEEDS

is professor of international finance and director of the Centerfor International Business and Public Policy at the Paul H. NitzeSchool of Advanced International Studies (SAIS) at JohnsHopkins University.

JULIE SUNDERLAND

earned her Masters in International Affairs in 2001 from SAIS andis currently a consultant to fund managers and developmentbanks on emerging market venture capital.

The basic assumptions underlying the U.S. venture capital approach are largelymissing in emerging markets, with a predictably adverse effect on performance.

Results will improve, therefore, only if the fund managers align their business modelmore closely with emerging market realities.

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