The Future of Domestic Capital Markets in Developing Countries

Panel Summary: The Role of Private Equity in the Development of Capital Markets

 The Role of Private Equity in the Development of Capital Markets Michael Barth, chair of the panel and chief executive officer of the Netherlands Development Finance Company, initiated discussion by defining private equity as a medium- to long-term financial commitment in equity or quasi-equity in illiquid securities with the expectation that future performance of the company will generate both profits and an opportunity to divest with substantial returns. Private equity serves an important role in filling the financial gap between small companies, with sales generally of $15 million a year or less, and large, publicly tradable companies, with $250 million in annual revenue or more. Managers of private equity funds seek to expand a business by injecting not only finance but also business expertise and savvy. As a demonstration of how critical the second aspect is, Barth cited a study where 70 percent of private equity recipients in the United Kingdom stated that private equity managers had made substantial contributions through advice to their companies. National macroeconomic impacts from private equity funding may include professionalization of the corporate sector and growth in employment and exports. Given its niche in transforming small domestic companies into internationally competitive businesses, this type of financing has the potential to build stronger, more balanced financial sectors. While financial flows to the developing world have shrunk dramatically over the past few years, the fraction of those flows in foreign direct invest-   ment has continued to grow, reaching roughly 60 percent of the volume of flows in 1999, where it has remained since. However, private equity indexes in every developing region show a drop-off in both funds raised and investment over the past two years. Latin America and Russia suffered a massive decline in inflows over that time, while Asia and Central Europe fared better, with only modest decreases. In contrast to public equity and fixed-income funds, the quality of private equity funds varies greatly. From 1980 to 1995, annual returns from the upper quartile of private equity funds exceeded returns from the bottom quartile of funds by 15 percent, while similar spreads were a modest 2.3 percent for equity funds and a scant 1 percent for fixed-income funds. A similar comparison of European private equity funds from 1993 to 1999 found a 25.2 percent differential between top and bottom quartiles. What can be learned from these tremendous disparities in performance? Barth drew several conclusions. For one, management has a striking impact on the performance of private equity funds. Private equity operations must be adapted to local environments, as opposed to taking a one-model-fitsall approach. Such investment should be considered a craft requiring diligence and dedication in the pursuit of acceptable returns, not a commodity that requires no more work than cutting a deal and a check. From a strategic side, firms must plan how they will divest in the future when making decisions to invest in the present, something that the past generation of equity investors may not have done. Managers must also incorporate into their investment planning and strategies the issues of the local environment—specifically poor investor protection and corporate governance laws—and not forget that they are operating in less sophisticated capital markets than the ones they are used to in the developed world. Roger Leeds of Johns Hopkins School of Advanced International Studies offered an analysis of the numerous ways in which emerging-market private equity differs from venture capital investment in the United States and Europe, the role private equity can and should play in developing countries, why it fills an important hole in the financial infrastructure in these nations, and what adaptations can be made to bolster its success. He began by sketching the recent history of private equity in emerging markets. In the mid-1990s, spurred by the booming success of venture capital funds in the developed world, investors began to apply the venture capital model, with few modifications, to previously untapped developing markets. They initiated private equity funds in these riskier markets, but    the returns were abysmal, particularly compared with investment in Europe and the United States. As a result of this, private equity is now a relatively discredited asset class that must be revamped to restore its standing among investors. As a clear demonstration of this lack of confidence, institutional investors that participated in the initial round of financing are not returning with a second wave...