WINNING STRATEGIES FOR PRIVATE EQUITIES IN SPAIN. Learning from the US

Transcription

1 WINNING STRATEGIES FOR PRIVATE EQUITIES IN SPAIN Learning from the US Jose A. Marco Venture Capital & Private Equity Harvard Business School Boston, May 2002 Available at

2 Table of Contents ACKNOWLEDGEMENTS... 3 EXECUTIVE SUMMARY... 5 INTRODUCTION... 9 CHAPTER 1. THE PRIVATE EQUITY CYCLE IN SPAIN FUNDRAISING INVESTING EXITING CURRENT STRATEGIES AND PLAYERS CHAPTER 2. LOOKING FORWARD: INDUSTRY DYNAMICS AND KEY CHALLENGES.. 17 PRIVATE EQUITY DYNAMICS FUNDRAISING INVESTING EXITING CHAPTER 3. WINNING STRATEGIES FOR PRIVATE EQUITIES IN SPAIN COMPETING FOR INDUSTRY FORESIGHT CRAFTING STRATEGIC ARCHITECTURE: BUILDING GATEWAYS FOR THE FUTURE INTANGIBLE ASSETS...23 FUNDRAISING INVESTING EXITING BIBLIOGRAPHY ABOUT THE AUTHOR

3 Acknowledgements This paper draws on several people; without them, the results would not have been possible. First, Josh Lerner, professor of Venture Capital and Private Equity at Harvard Business School. Second, Jose Marti from Universidad Complutense de Madrid and many private equity professionals from 3i Spain, Corpfin Capital, Excel Partners and Mercapital Servicios Financieros. Finally, the conversations with many professionals of the private equity industry, throughout my involvement both in the Venture Capital and Principal Investment Club of the Massachusetts Institute of Technology (MIT) and the MIT venture capital & principal investment conferences, have also shaped my knowledge of the US private equity industry. I owe all of them a great deal of thanks. 3

4 With new corporate structures, evolving markets and increased need for investment in many companies, industries and countries, there will be excellent investment opportunity for those who successfully build the expertise to manage Europe s complexities Edward Gilhuly, managing director of Kohlberg, Kravis, Roberts & Co., London. Before I served as a consultant to Kennedy, I had believed, like most academics, that the process of decision-making was largely intellectual and all one had to do was to walk into the President s office and convince him of the correctness of one s view. This perspective I soon realized is as dangerously immature as it is widely held Henry Kissinger, Secretary of State of the United States 4

5 Executive Summary This paper aims to propose a set of strategies for private equities in Spain by (1) analyzing the current status of the industry, (2) identifying its main challenges and (3) adapting successful strategies used by US private equities. Current status of the private equity industry in Spain The status of the private equity cycle can be disaggregated in three parts: fundraising, investing and exiting. Fundraising. Two major features distinguish the composition of funds raised by Spanish private equity firms from those of the US: (1) type of investors, with Spanish funds having a lower relative weight of pension funds and academic institutions and a higher weight of banks, (2) type of investments, with Spanish funds investing 15% in venture capital and with over 65% in expansion investments as compared with the 20% and over 40% respectively in US funds. The structure of the fundraising market in Spain is highly concentrated in a few players; one firm has had a share of the fundraising market of over 30% during the last three years and the first five firms hold a share of over 60%. Moreover, while US private equity firms obtain a substantial portion of their funds from national investors, Spanish private equity firms obtain more than 50% of their funds from international investors. Investing. Compared with the US, where established proprietary deal flow is the major source of deals, intermediary deal flow plays a significant role for deal origination in Spain. The financial instruments used to protect private equity investments significantly differ from the US, with the 80% of the investments in the Madrid region using common stock, and not preferred stock. However, Spanish firms, to limit their equity downside, use other features such as covenants, supermajority provisions and vesting restrictions of key employee shares. The major valuation technique used is comparable transactions. Discounted cash flows are used sometimes as a quality check. Other techniques used in the US, such as adjusted present value or real option valuation, are used occasionally. Winner takes all economies apply in both countries: a solid track record in the past allows firms to raise and manage relatively larger funds. The concentration in managed capital by Spanish private equity firms is higher than that of the US. While the top 5% of Spanish groups controls 63% of the funds, the 5% of US groups controls 42.5% of the funds. Exiting. Private equity exits in the Spanish market are more difficult than those of US and other European countries (UK and Germany). Two main reasons explain the limited exit market: (1) a narrow IPO market due to the small size of the Spanish economy and suspicion of public ownership and (2) a not strong equity culture. Traditional exits are acquisitions by multinational corporations, management buyouts, and repurchases by the original shareholders. This is an important limitation for the development of a strong private equity market as the type of exit highly influences the return of the investment: an IPO exit provides an average IRR of 29%, while a private exit provides an average IRR of 10%. Mapping of Spanish private equity firms by investment per company. One differentiation point among private equity firms in Spain is the size of investment per company. Exhibit 1 shows 5

6 how the main firms have consistently maintained or changed, relative to market changes, their strategy over time; that is, increases or decreases in the average investment per company. Each private equity firm is positioned in exhibit 1 by considering the average investment per company in their past investments and the average investment per company in their current portfolio. Only one firm positions itself as the private equity that has consistently made the largest investments per company (Mercapital). However, another firm has entered into the segment of large investments (Secuoya/SCH). Other private equities (DrK and Vista/SCH) have changed their strategy from relatively larger investments per company to smaller investments per company. Finally, the rest of the main private equities, while they have increased their investments per company, the average investment per company has increased even more and then they remain consistent with their strategy of investing relatively small amounts per company. EXHIBIT 1 PAST AND CURRENT SIZE OF INVESTMENT PER COMPANY IN SPAIN Past investment per company (Euro M.) Vista / SCH New strategy : smaller investment per company DrK Capital Consistent strategy : smaller investment per company (many players) 3 Nmas1 Ibersuizas 3i Excel Corpfin AC Desarrollo Caja Madrid Barings MCH Activa Mercapital Consistent strategy : large investment per company (only one player) New entrant : large investment per company Secuoya / SCH Current investment per company (Euro M.) Source. Adapted from Ranking (2001). Note: data from international firms such as The Carlyle Group, Apax and CVC was not available. Note: dotted lines represent the weighted (by capital invested) average of investment per company. 6 Looking forward: industry dynamics and key challenges Industry dynamics. There are three major constrains that limit the supply of funds of the Spanish market: (1) limited track record of many private equities, (2) not very favorable regulatory climate for international investors, but only for national investors and (3) reduced awareness of the private equity industry. On the demand side, there are also three major constrains that limit the demand of funds: (1) relatively non-very favorable regulatory environment for new and mature firms, (2) limited entrepreneurial culture with higher risk aversion than other European countries (e.g. UK

7 and Germany) and (3) weak IPO market and limited size of the Spanish economy. Though the constrains in the supply of funds can be overcome with time and policy changes, those of the demand of funds are more structural and difficult to change and therefore represent a real constrain for potential development. Fundraising. Spanish private equities face several fundraising challenges that can restrain future supply for private investment opportunities. The major challenges, connatural with the level of development of the industry, are: (1) first-time fundraising, (2) access to capital and (3) access to talent. Investing. The major challenges Spanish private equities face in the investment phase are related to the ability to (1) generate and retain proprietary deal flow, (2) minimize price inflation in deals (3) simultaneously maintain focus and scope, (4) develop a rigorous criteria to evaluate investments over time (5) manage risk and rewards. Exiting. The Spanish market is mainly characterized by a small IPO-market and a limited number of strategic buyers based in Spain, forcing many private equities to buy locally and sell internationally. Furthermore, the size of the Spanish economy makes more difficult to quickly grow and scale start-ups and mature companies. If high growth prospects want to be achieved, companies must expand into Europe and that implies dealing with different cultures and regulation, then increasing to some extent the complexity of growth management. The size factor in Spain has two main implications: (1) mature firms are more attractive than young firms and (2) limited partners should expect larger maturity periods before exits or accept lower IRRs than those of their comparables in the US. Winning strategies As the Spanish public market is getting efficient, private equity is raising its profile as the next way to get abnormal positive returns. Given this trend, Spanish private equities must position in this winner-takes all industry. This smart money has the opportunity to exploit several discontinuities in technology, lifestyle, regulation, demographics, industry consolidation and globalization, serving as the financial and strategic fuel for growth in Spanish private markets. These are the trends that the US has been exploiting during the last decade. The key success factors have evolved during the 90 s from the ability to raise funds and structure and exit deals to the ability to attract proprietary deal flow and create post-deal value. The strategic architecture for private equities in Spain is presented as a portfolio strategy (exhibit 2). It defines a strategic matrix of areas to compete (fundraising, investing and exiting) and strategies to use (intangible assets, big bets, real options, no-regrets moves and safety nets) across the private equity cycle. The portfolio of strategies is structured in four building blocks: big bets, real options, no-regrets moves and safety nets. Big bets are major commitments to a course of action that may payoff handsomely in some situations but produce dismal results in others. Real options are investments that are made to learn more or create flexibility. No-regrets moves make sense no matter what eventually happens. Finally, safety nets are options specifically designed to protect a company against a big bet going bad. 7

8 EXHIBIT 2 PORTFOLIO STRATEGY FOR SPANISH PRIVATE EQUITY FIRMS Intangible Assets Big Bet Real Options Fundraising Investing Exiting Talent / Brand / Human networks Differentiate the private Simultaneously maintain Invest in larger private equity to limited focus and scope: companies partners through the - Small size development of industry - Family owned foresight - Restructurings Attract new types of investors: - Investments office of successful entrepreneurs - Universities - Pension funds - Industries Capture the full value potential: - DCF - APV - Venture capital method - Real options Gear up for national and international listing Safety Nets & No- Regrets Moves Source: Author. Develop creative fund structures that align GPs and LPs incentives Set a market-based corporate governance system Overcome the suspicion of public ownership 8

9 Introduction History. The beginning of the private equity industry in Spain is around the mid 80 s, compared with the mid 40 s 1 of the US and the 60 s in Europe. The rationale for this delay in Europe, and in Spain, can be found 2 in the underdeveloped stock markets, the importance of financial institutions (bank lending), the higher barriers for entrepreneurs (bureaucracy, regulations and culture) and the tax policy on private equity firms. The role of foreign investors, combined with the deregulation and privatization of some industries, and the economic and financial integration of European markets, favored the development of European private equity during the last quarter of the previous century. Objective. The purpose of this paper is to identify successful strategies that US private equities use, and adapt them to Spanish firms. These strategies do not aim to close the gap between Spain and the US but they provide some high-level thinking to reduce it. The gap will probably never be closed because there are some structural differences in the culture and the economy that cannot be changed. Spanish private equities, as well as using financial leverage, can use the leverage of ideas, the ideas from the US and the rest of Europe, and adapt them to the Spanish economy and company-specific contexts. Gary Hamel defines what I have tried to do in this paper the goal of competition for industry foresight is, at one level, simple: to build the best possible assumption about the future and thereby develop the prescience needed to proactively shape industry evolution. Competition for industry foresight is essentially competition to establish one s company as the intellectual leader in terms of influence over the direction and shape of industry transformation. Industry foresight gives a company the potential to get to the future first and stake out a leadership position. The trick is to see the future before it arrives. However, as Hamel also says all the foresight in the world, if not matched by a capacity to execute, counts for little. Finally, industry foresight is the product of many people s vision and though I interviewed several of the main private equities in Spain, other important private equities have not been interviewed. Structure. The paper is structured as follows. The next section analyzes the private equity cycle in Spain, decomposing the value chain in fundraising, investing and exiting. Chapter 2 describes the future dynamics of the Spanish private equity industry using the five-forces model. Furthermore, it identifies the major challenges faced by private equities in each part of the private equity cycle. Finally, chapter 3 discusses several strategies (for fundraising, investing and exiting private equity investments in Spain) to build gateways for the future. It proposes a portfolio strategy using a strategic matrix of areas to compete (fundraising, investing and exiting) and strategies to use (intangible assets, big bets, real options, no-regrets moves and safety nets). Note. This paper has been done part-time for a course of Venture Capital & Private Equity at Harvard Business School. All errors are solely from the author and he can be reached at his EFL jose.marco@sloan.mit.edu. 1 In 1946, the president of the Massachusetts Institute of Technology (MIT, Karl Compton, and a professor of Harvard Business School, Georges Doriot, founded the first venture capital firm, American Research and Development (ARD). 2 Marti, J. (2001b). 9

10 Chapter 1. The Private Equity Cycle in Spain The private equity cycle is analyzed by disaggregating its value chain in three main parts: fundraising, investing and exiting. A comparison of the status of private equity in Spain versus that in the US is made at each stage. Fundraising Two major features that distinguish the composition of the funds raised by Spanish private equity firms from those of US are the type of investors and the type of investments.. Type of investor. Exhibit 3 shows the profile of the funds analyzed by type of investor. There are two major differences. First, the higher relative weight of pension funds and academic institutions in US firms. Second, the lower relative weight of banks in US firms. Some practical implications for the fundraising strategy of private equity firms in Spain are highlighted in chapter 3. EXHIBIT 3 TYPES OF INVESTORS IN PRIVATE EQUITY FIRMS IN THE US AND SPAIN % 60% 50% 40% 30% Spain US 20% 10% 0% Banks Pension funds Academic institutions Individuals others Source: Marti Pellon, J. (2001a) and Lerner and Hardymon (2002). Type of investment. Another comparison is the focus of the funds raised in the US and Spain (exhibit 4). On the one hand, US funds focus is 20% venture capital and 80% private equity. On the other hand, Spanish funds invest less than 15% in venture capital and 85% in private equity. It could be argued that there are some venture capital opportunities still no exploited. However, interviews conducted with Spanish private equity managers highlight two facts that limit this opportunity: (1) small size of the Spanish market and then, slower growth than that required for a VC-backed start-up firm, and (2) moderated entrepreneurial culture in Spain. 10

11 EXHIBIT 4 TYPES OF INVESTMENTS OF US AND SPANISH PRIVATE EQUITY FIRMS % investment EEUU Spain 0 Buyout Expansion Later Stage Seed Early Stage Other Source: Marti Pellon, J. (2002) and Lerner and Hardymon (2002). Fund structures. Spanish private equities do not significantly differ in their fund structure from those of US private equities. They set a minimum size of investment per limited partner (LP) and a minimum and maximum size for the fund, limiting also the life of the fund. Sometimes LPs are concerned that if the size of the fund becomes too large, GPs will not perform well. This is not surprising as the majority of LPs are international banks, foreign institutional investors and pension funds. Some GPs, given their reputation in the Spanish market, can negotiate broad mandates of investment without narrowing the investments to a specific set of industries or stages. Investing Deal sourcing and selection. Intermediaries, whether investment banks or small corporate finance boutiques are the major sources of deals. This intermediary deal flow contrasts with the established proprietary deal flow of many US private equity firms. For small deals, the process is relationship-based and the competition is not very intense. However, for large deals, given their limited number in Spain, the competition is high and many times a bidding system is used. The due diligence is very similar to the US, though some firms outsource many of the process, even the business due diligence. As in the US, many firms consider that the due diligence of the team is the most important factor and that the rest of the issues, such as market and business models should just meet a minimum. Deal structuring. One major difference in the structure of transactions between the US and Spain is the use of preferred stock. In the US, many of the private equity and venture capital transactions include any form of preferred stock, whether redeemable preferred, convertible preferred or participating convertible preferred. However, in Spain, almost 80% of the transactions are structured with common stock (exhibit 5). One reason argued for this limited use is that preferred shares are not a tradition in the Spanish business law. Moreover, preferred stock 11

12 is more critical where the probability of liquidation is higher, that is, in early stage investments and in highly leveraged companies with a high probability of entering a bankruptcy process. However, as exhibit 4 shows, venture capital investments in Spain were slightly higher than 10% in the boom period, and then, the need for preferred stock is less than in the US. Other features to limit the equity downside of Spanish private equity firms are used; among them are, vesting restrictions of key employee shares, covenants and supermajority provisions. Though these last features protect venture capital s equity, they are not perfectly efficient. None of these features, but preferred stock, guarantees a liquidation preference over common stock, thus being venture capital equity as risky as other common equity. EXHIBIT 5 FINANCIAL INSTRUMENTS USED BY PRIVATE EQUITIES IN THE MADRID REGION % 80% 70% 60% 50% 40% 30% 20% 10% 0% Capital Mezzanine Non secured debt Secured debt Quasicapital Source: Marti, J. (2002). Valuation. The major valuation technique used is comparable transactions, whether public or private. Discounted cash flows are used occasionally and as a quality check of the relative valuation. A discussion of other valuations techniques can be found in chapter 3. Exiting Private equity exits in the Spanish market are more difficult than those of the US and many other European countries (UK and Germany). Two main reasons explain the limited exit market: (1) a narrow IPO market due to the small size of Spain and suspicion of public ownership and (2) a not strong equity culture. Traditional exits are acquisitions by multinational corporations, management buyouts and repurchases by the original shareholders. This is an important limitation for the development of a strong private equity market as the type of exit highly influences the return of the investment: an IPO exit provides an average IRR of 29%, while a private exit provides an average IRR of 10% 3. 3 Lerner, J. and Hardymon, F. (2002) and author. 12

13 The not yet mature Spanish private equity market has been able to provide high IRRs during the last decade. Two of the first private equity players, Mercapital and Excel Partners, have been able to achieve returns over the US average of 20%. Mercapital, with 22 divestments, has achieved an IRR of 37% 4 while Excel Partners has obtained an IRR of 42% 5 for its two first funds. As the number of players increases and potential targets learn from market inefficiencies and operational and strategic improvements, the returns will align with those of the US, or even lower due to the limited available exits in the Spanish market. Current Strategies and Players Some of the strategies 6 that Spanish private equities use to compete are related with (1) the ability to influence the value chain through market power and (2) the ability to specialize in a particular size of investment per company. Spanish private equities can be classified within these two areas. Ability to influence the value chain through market power. Fundraising. A few firms have raised the majority of the funds in Spain during the last two years (exhibit 6). One firm, Mercapital, has a share in the fundraising market of nearly 30% and the first five firms hold a share of over 60%. This market share, concentrated in a handful of players, allows a significant power compared to the rest of Spanish firms as well as a signal of credibility of these players through its past performance, especially for those who are purely independent players. As others fund sizes are not very large 7, the top ten firms can have privileged access to leading investment banks or corporate finance boutiques. Furthermore, the relative difference between the first player, Mercapital, with 926 million euro of managed capital, and the second player, 3i Spain, with 673 million euro, allows the first one to position itself as the Spanish independent player with the option to do larger deals. Exhibit 7 shows how quickly the market has developed in Spain. While the largest player, Mercapital, holds a significant market share and maintains a large difference with the second largest fundraiser, its share in the fundraising market has decreased. Investing. The concentration in funds managed is higher than that of the US. While the top 5% of Spanish groups controls 63% of the funds (exhibit 8), the same top 5% of US groups controls 42.5% 8 of the funds. Winner-takes all applies to both countries: a solid track record in the past allows firms to raise and manage relatively larger funds. As an experience based business, the ability to generate consistent deal flow, attract the best intermediaries and obtain above average returns can create a positive self-reinforcing cycle difficult to break. 4 Public website accessed February 25, Public website accessed February 25, The analysis is not complete. It only focuses on quantifiable strategies and does not include performance as it is not public. The author limits his job to show the different current strategies. 7 Inversiones Ibersuizas is the tenth Spanish player by assets managed with an amount of less than 150 million euro. 8 HBS Case N Year

14 EXHIBIT 6 SHARE IN THE FUNDRAISING MARKET OF SPANISH PRIVATE EQUITY FIRMS % 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Mercapital Vista/SCH Secuoya/SCH Excel Activa Source: Ranking (2001). Note: data from international firms such as CVC, 3i, Apax and The Carlyle Group was not available. EXHIBIT 7 SHARE IN THE FUNDRAISING MARKET OF SPANISH PRIVATE EQUITY FIRMS. SINCE CONCEPTION TO % 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Mercapital Nmas1 Vista/SCH Caja Madrid Corpfin Barings Source: Adapted from Ranking (2001). Note: data from international firms such as 3i, Apax, The Carlyle Group and CVC was not available. It only considers current top largest private equity firms in Spain. 14

15 EXHIBIT 8 FUNDS MANAGED BY THE TOP 5 SPANISH PRIVATE EQUITY FIRMS % 20% 15% 10% 5% 0% Mercapital 3i Vista/SCH Secuoya/SCH Excel Source. Ranking (2001). Note: data from international firms such as Apax, The Carlyle Group and CVC was not available. Exiting. The large share of Mercapital in the exiting market is a consequence of its long history, (founded in 1985, it is one of the oldest firms in Spain) and its large funds raised. The fact that Mercapital, together with two players, Nmas1 and Vista/SCH, hold a share of nearly 85% (exhibit 9) in the exiting market, better position them to raise additional funds. A recent study 9 shows that the divestment activity in the past has a positive and significant impact on fundraising 10. EXHIBIT 9 SHARE IN THE EXITING MARKET OF SPANISH PRIVATE EQUITY FIRMS. SINCE CONCEPTION TO 2001 AT COST. 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Mercapital Nmas1 Vista/SCH Caja Madrid Corpfin Barings Source. Ranking (2001). Note: data from European firms such as The Carlyle Group and CVC was not available. 9 Marti, J. and Balboa, M. (2002). 15

16 Ability to specialize in a particular size of investment per company. One way of differentiation of private equity firms in Spain is by the size of investment per company. Exhibit 10 shows how the main firms have consistently maintained or changed, relative to market changes, their strategy over time; that is, increases or decreases in the average investment per company. Each private equity firm is positioned in exhibit 10 by considering the average investment per company in its past investments and the average investment per company in its current portfolio. If these firms are classified on the criteria of whether they are above or below the weighted average of current or past investment per company, a change 11 or consistency 12 of the strategy can be analyzed. Only one firm positions itself as the private equity that has consistently made the largest investments per company (Mercapital). However, another firm has entered into the segment of large investments (Secuoya/SCH). Other private equities (DrK and Vista/SCH) have changed their strategy from relatively larger investments per company to smaller investments per company. Finally, the rest of the main private equities, while they have increased their investments per company, the average investment per company has increased even more and then they remain consistent with their strategy of investing relatively small amounts per company. EXHIBIT 10 PAST AND CURRENT SIZE OF INVESTMENT PER COMPANY IN SPAIN Past investment per company (Euro M.) Vista / SCH New strategy : smaller investment per company DrK Capital Consistent strategy : smaller investment per company (many players) 3 Nmas1 Ibersuizas 3i Excel Corpfin AC Desarrollo Caja Madrid Barings MCH Activa Mercapital Consistent strategy : large investment per company (only one player) New entrant : large investment per company Secuoya / SCH Current investment per company (Euro M.) Source. Adapted from Ranking (2001). Note: data from international firms such as The Carlyle Group, Apax and CVC was not available. Note: dotted lines represent the weighted (by capital invested) average of investment per company. 10 Some other factors such as the ability to make profitable investments and manage large funds also have a significant impact in the fundraising activity. 11 In the past larger (smaller) investments per company and now smaller (larger) investments per company. 16

17 Chapter 2. Looking Forward: Industry Dynamics and Key Challenges This chapter addresses the future dynamics of the private equity industry. Furthermore, it highlights the key challenges of each phase of the private equity cycle. In chapter 3 several strategies are proposed to succeed with these challenges. 17 Private Equity Dynamics To compare the future dynamics of the private equity industry in Spain, with those of the US, the five-forces model is used. Supply of funds. Three variables influence the supply of funds 13 : (1) investors belief that they will obtain higher returns than any other asset, (2) favorable regulatory climate and (3) experienced private equity partners. For the case of Spain, a stronger shift to an equity culture, together with an awareness of the private equity industry are also needed. The US private equity industry has been able to show sustainable high returns on venture capital and private equity investments; however Spain has shown returns for only the past 15 years. As in the US case, Spain needs an additional decade to show potential investors that private equity investments can yield high returns (exhibit 11). Spanish tax law creates incentives for national investors but not so many for foreign investors, and probably with this incipient level of development, foreign funds are strongly needed as private equities would need to show a strong track record so that they can attract Spanish funds. Finally, Spain needs more time to have a critical mass of experienced professionals in the sector. Demand of funds. Four conditions are required to create strong investment opportunities 14 : (1) favorable regulatory environment for new and mature firms, (2) sufficient infrastructure, technology and human capital, (3) entrepreneurial culture and (4) dynamic economy and strong IPO market. Compared with the US, starting a firm in Spain takes more time due to regulatory and bureaucratic procedures. Furthermore, Spanish corporate law is not debtor-friendly, having strong bankruptcy provisions that diminish the entrepreneur s ability to take risks. Spain has recently seen the development of technological areas around the so-called technology parks. These tech parks play the role of providing the infrastructure and talent flow required to build new businesses. However, these small tech parks cannot be compared with technology clusters such as those in Silicon Valley or in Boston: size matters, as it creates positive externalities in the flow of ideas, talent and demand of funds. Furthermore, Spain tends to be a country with a weak entrepreneurial culture with limited connection between scientific and business communities. Finally, though the Spanish economy has significantly grown during the last decade, it has not been able to develop a strong IPO market 15. However, a recent shift to an equity-driven culture, together with the globalization of the economy, has created a stronger demand of funds as companies have been forced to restructure and re-focus their efforts. Furthermore, many family- 12 Larger (smaller) investments per company in the past and now larger (smaller) investments per company. 13 Gompers, P. and Lerner, J. (2001). 14 Gompers, P. and Lerner, J. (2001). 15 It is worth mentioning the initiative of the Spanish New Market (Nuevo Mercado).

18 owned companies are facing succession issues, creating opportunities for private equities to play a role in the process. These two major drivers, restructuring and succession have led to optimism among Spanish buyout organizations and to the entry of new groups. EXHIBIT 11 INTERNAL RATE OF RETURN OF VENTURE INVESTMENTS US 140% 120% 100% IRR 80% 60% 40% 20% 0% Upper Quartile Average Lower Quartile Average Source: HBS case Current and potential competitors. There are currently 62 private equity players in the Spanish economy, compared with 41 players at the beginning of However, government-related institutions own many of them, 16, and only 26 manage over 30 million euro. Given the high returns during the last years, it could be argued that potential competitors would be likely to enter; however, the lack of strong deal flow and the increasing professionalism of entrepreneurs would put pressure on returns. Moreover, winner-takes all economies could limit the returns of new entrants to the lower quartile. Substitutes. It could seem that private equity is one of the best options for private companies to keep growing, however, there are other options that Spanish firms consider: Increasing financial leverage. Many Spanish owners believe that private equities only add expensive equity, preferring to increase their leverage and keep working on their own. Receiving equity from people with close relationships. If friends of the owner provide equity, the valuation will be more favorable. Reducing the pace of growth. The ambition of most of the Spanish owners/managers is not as high as that of the average US owner/manager and then they do not feel as eager to grow their companies. These three competitive substitutes are deeply embedded in the Spanish culture and if they do not change it would be very difficult to achieve significant growth onwards and partially close the gap with US relative investment levels. 18

19 Fundraising Spanish private equities face several fundraising challenges that can restrain future supply for private investment opportunities. The challenges are connatural with the level of development of the industry in the country. First-time fundraising challenge. As one US general partner put it fundraising is one of the biggest barriers to entry in this business. It requires stamina and relationships at the end of the day, a first-time fund is very hard to raise." In fact, in Spain it seems to be even harder for the three factors outlined before. To some extent, four strategies can mitigate the challenge 16 : Contribute more to the capital. It would be a signal of commitment and potential success. In fact, some new Spanish private equities have done this strategy. Identify investors who aren t motivated only by financial returns. GPs could address the investments office of Spanish wealthy entrepreneurs, corporations with an interest in developing new insights in the industry (for expansion, diversification, or for hedging technology risk) and other institutions with social interest. Establish an alliance with an existing institution. This alliance can be with a bank or another private equity group established in Europe or the US. However, there could be two different incentives and these could not be perceived well by all LPs. Recruit a lead investor. A brand name investor committed to a fund could signal a credibility that would help to raise additional funds. The lead investor should receive more attractive terms than the rest of the LPs. Access to capital. Though Spanish regulation allow investment firms to invest up to a 10% of their capital under management in private companies, many private equities face difficulties to access capital. Private equities have to overcome three main barriers to access capital easier: (1) develop a track record of high returns on past investments, (2) build a brand and (3) create awareness in the Spanish entrepreneurial, financial and business community. While the first two challenges have to be addressed individually by each firm in competition, the third challenge must be faced in coo-petition with other private equity firms. The third challenge should be addressed to attract investors to the Spanish market, and then the firms would compete to attract the capital. The first barrier is a matter of time and investment success and it will be addressed in the investing section. The third barrier should be overcome at an industry level with media and public relation strategies. The second barrier will be addressed in chapter three. Access to talent. As the private equity industry is a nascent one, there are not many professionals to build a solid industry. There are two major areas to address: (1) attract talent with a blend of consulting, finance and operations experience and (2) retain talent. Investing The major challenges Spanish private equities face in the investment phase are related to the ability to (1) generate and retain proprietary deal flow, (2) minimize price inflation in deal negotiation (3) maintain focus and scope, (4) develop a rigorous criteria to evaluate investments over time and (5) manage risk and rewards. Access to proprietary deal flow. Given the limited entrepreneurial talent, whether in early or later stage, and the partial awareness of many private equity firms in the business arena, it can be 16 Gompers, P. and Lerner, J. (2001). 19

20 difficult to develop a continuous, proprietary deal flow. Many investments come in an opportunistic way or through intermediaries, whether consultants, banks or law firms. Ability to retain deal flow. As well as developing a proprietary deal flow, private equity firms face the challenge of delivering a strong value proposition for entrepreneurs different from that of other competing firms. As many private equities have not developed a strong track record over time just because they were founded in recent years, retaining deal flow seems a considerable challenge. Too much money chasing few deals. As entrepreneurial talent is very scarce and many private equity firms are looking for this talent, good investments can be overpriced, reducing the attractiveness of returns to investors. This problem is more important when the market size is very limited. Ability to simultaneously maintain focus and scope. Given the limited market potential for private equity investments in Spain, private equities do not usually focus in one type of investment, whether early stage, later stage or a type of industry. In fact, a study made by the European Commission shows that generalist private equity firms in Europe have obtained higher returns than early or later stage funds. On average, a generalist fund obtains an annual return around 20% while an early stage fund obtains 6% and a later stage fund obtains 18%. However, generalist private equities must deliver with specific industry or functional skills. Ability to minimize downside and maximize upside. The most used financial instrument by Spanish private equities is common stock. This fact compares with the high use of preferred stock by US private equities. Though Spanish private equities protect themselves through covenants, vesting options and some super majority provisions, preferred stock is the only stock that minimizes the downside and captures the maximum upside through a loss of value of common stock. However, a trade-off exists: while preferred stocks give a preferential value in the liquidation of a firm, entrepreneurs, specially family-owned companies, which represent many of the transactions done by private equities in Spain, may see the rights of this type of security with suspicion. Ability to add value over time. In the first years of the private equity industry in Spain the easiest way to extract value from firms was through financial engineering. However, as companies and markets become more efficient, a shift in the way of adding value from financial engineering to strategy and operational involvement will happen. The challenges rely on whether the skills of Spanish private equity managers are adequate for this type of value and on whether they can devote enough time to each portfolio company (e.g. how many boards can serve each partner?). Exiting Exit options are probably the major constrain for the development of the private equity industry. If there are limited exits, investors will not be very interested in the market and the pool of talent of both, entrepreneurs and private equity managers, will decrease, then reducing even more overall industry returns. The Spanish industry is mainly characterized by a small IPO market and a limited number of Spanish based strategic buyers. These two features have to do with the economic size of Spain. Furthermore, the size of the Spanish economy makes more difficult to quickly grow and scale start-ups and mature companies. If high growth prospects want to be achieved, companies must expand into Europe and that implies dealing with different cultures and laws, then increasing to some extent the complexity of growth management. As it takes more 20

21 than the usual time (4 years) to grow firms and limited partners put strict exit deadlines, Spanish opportunities are not as attractive as those of the US. Small IPO market. The ability to exit investments, and the investment volume in previous years, has been identified as one of the major drivers for future fundraising 17. The Spanish IPO market for private-backed firms is quite limited compared to that of the US; for instance, only a few private equity firms have been able to IPO some companies and only one has been able to consistently IPO firms at an average rate of less than 1 firm per year. Some of the causes of the reduced capitalization of the Spanish IPO market have to do with the structure of the Spanish economy where a significant part of the economy is fragmented and governed by family businesses. These family businesses are reluctant to IPO their firms, thus making the market cap of the Spanish stock market concentrated in just a few large corporations. The size factor in Spain has two main implications: (1) mature firms are more attractive than young firms and (2) limited partners should expect larger maturity periods before exits or accept lower IRRs than those of their comparables in the US. 17 Marti, J., Balboa, M (2002). 21

22 Chapter 3. Winning strategies for private equities in Spain Competing for Industry Foresight As the Spanish public market is getting efficient, private equity is raising its profile as the next natural way to get abnormal positive returns. Given this trend, Spanish private equities must position in this winner-takes all industry. This smart money has the opportunity to exploit several discontinuities in technology, lifestyle, regulation, demographics, industry consolidation and globalization, serving as the financial and strategic fuel for growth in Spanish private markets. These are the trends that the US has been exploiting during the last decade. The key success factors have evolved too during the 90 s. The US private equity industry has passed through three different sets of skills: 1. Skills to raise funds. First, private equities obtained capital that was difficult to raise by managers and entrepreneurs. However, as information asymmetries have been reduced over time and markets have become more efficient, capital is not longer a distinctive source of competitive advantage. In fact, large amounts of hype-mobile pools of capital are in search of super-normal returns. 2. Skills to structure and exit a deal. The ability to structure a deal in a way that minimizes risks and maximizes returns in both the investment and exit area was a key value lever for great returns. However, as entrepreneurs and managers in the seller side are more sophisticated and the competition to get good deals in the buy side is higher, there is little room in deal structuring to get super-normal returns. 3. Skills to attract proprietary deal flow and create post-deal value. Several years ago, a significant part of the deal flow presented value creation opportunities as many firms were (1) under-performers, (2) under-leveraged, (3) without equity compensation for management 18. As there are less under-productive and under-leveraged firms, the opportunity for value creation is more limited. Private equities need to guarantee their high quality proprietary deal flow and then deliver through strategic and operational improvements. In Spain, there are still opportunities to capture value by developing skills to structure and exit deals. Private equities need to craft a robust strategic architecture so that they are able to exploit the highlighted discontinuities. It is important to note that these discontinuities are not only related to early-stage investments but also to later stage ones. There can be discontinuities such as an increased internationalization or national consolidation of a sector. Crafting Strategic Architecture: Building Gateways for the Future To successfully design a strategic architecture for a complex business, the thinking should not focus on the strategy but on the portfolio of strategies across the value chain of the business. The 18 Roberts, G. (1998). 22

23 portfolio of strategies is structured in four building blocks: big bets, real options, no-regrets moves and safety nets. Following the McKinsey definitions, big bets are major commitments to a course of action that may payoff handsomely in some situations but produce dismal results in others. Real options are investments that are made to learn more or create flexibility. No-regrets moves make sense no matter what eventually happens. Finally, safety nets are options specifically designed to protect a company against a big bet going bad. The strategic architecture is not a detailed plan but it identifies the major capabilities to be built. This framework is used to propose a portfolio strategy for private equities in Spain (exhibit 12). It defines a strategic matrix of areas to compete and strategies to use across the private equity cycle. Private equities must compete in three areas (fundraising, investing and exiting) with a different set of strategies and capabilities. EXHIBIT 12 PORTFOLIO STRATEGY FOR SPANISH PRIVATE EQUITY FIRMS Intangible Assets Big Bet Real Options Safety Nets & No- Regrets Moves Source: Author. Fundraising Investing Exiting Talent / Brand / Human networks Differentiate the private Simultaneously maintain Invest in larger private equity to limited focus and scope: companies partners through the - Small size development of industry - Family owned foresight - Restructurings Attract new types of investors: - Investments office of successful entrepreneurs - Universities - Pension funds Develop creative fund structures that align GPs and LPs incentives - Industries Capture the full value potential: - DCF - APV - Venture capital method - Real options Set a market-based corporate governance system Gear up for national and international listing Overcome the suspicion of public ownership Attract and Retain Talent Intangible Assets Talent is one of the main ways to maintain competitive advantage in the private equity business. Two major areas have to addressed in order to develop a critical mass of talent in Spain: Attract talent with a blend of consulting, finance and operations experience. Given the diverse tasks of a private equity job, professionals in the industry must have strategic and financial skills combined with some experience in operations. It does not mean that every professional must combine all these qualities, but the team as a whole should. This blend of skills would be more important for Spain as the industry matures, because the value added and returns will shift from doing and executing a transaction (financial skills) to the design and delivery of growth and operational improvement strategies (strategic and operational skills). 23

24 Retain talent. There are two ways by which US private equities have tried to retain talent and avoid that senior associates or principals leave the firm to fund another private equity. The first one is through an efficient recruiting process for non-partner positions. There are many potentially qualified candidates that prefer to stay in established careers such as investment banking and management consulting because private equity firms do not offer them partner-track positions. Potential candidates are demotivated when they see that every partner has been hired from the outside and that none of the associates has been promoted. The second one is related with the management of the intergenerational transition among partners. In private equities where the GPs founders and junior partners coexist, a typical situation of the Spanish industry, the discussion over the distribution of the carry interest is an issue. The controversy is between the day-to-day value added of junior principals and the franchise value 19 created by the GPs founders. This intergenerational dilemma can potentially blow up firms and increase the competition in Spain, with the consequential decrease in returns. David Mixer, managing director at Columbia Capital, a firm that experienced this problem, handled the issue: we knew that unless we created a situation where Phil and Jim and Harry (founders) felt justly rewarded, the company would self-destruct. We needed to have these guys feel that they re in control, and create a culture where they know that their turn will come. 20 Build a Brand It could seem that Spanish private equities could get abnormal returns because of their lack of publicity, information and distinctive way of making deals and management of their investments. However, as the industry grows, it is more difficult to attract and retain good deal flow. A powerful brand serves to create lock-in in each of the areas of the private equity cycle. First, it allows offering limited partners a brand of guarantee and disciplined investments. Second, it helps to attract best deals and intermediaries, creating a virtuous cycle in which best managers and entrepreneurs only want to work with best intermediaries and best intermediaries only want to serve well-respected private equity firms. Finally, it helps to market the divesture, whether in public or private markets, as a quality investment. For instance, the mission of The Carlyle Group is stated as to become the premier global private equity firm and to generate extraordinary returns while maintaining our good name and the good name of our partners 21. With the emphasis on the brand, The Carlyle Group grew from $5M and four investors in 1987 to $12.5 billion in capital committed in 17 funds. Another example can be found in Adams Capital Management, a small fund based in Pittsburgh, an area not featured as the hottest for venture capital and private equity. GPs, aware of this problem, recognize that branded funds outperform in a winner-takes-all economy. To differentiate their firm from others, they have developed two concepts. The first one, so called markets first strategy, is related to the markets they want to be; markets where they can exploit discontinuities. The second one is the so-called structure navigation, a set of five rules that are key to manage their investments. The ability to maintain these criteria over time, deliver on it and market these concepts to investors could provide an invaluable strategy to build premiere brands in Spanish private equities. 19 Gompers, P. and Lerner, J. (2001). 20 Lerner, J and Hardymon, F. (2002). 21 Website accessed March 4,