PRIVATE EQUITY IN THE DEVELOPING WORLD

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1 PRIVATE EQUITY IN THE DEVELOPING WORLD Aditi Kapoor, Reed Smith LLP Type: Published: Last Updated: Keywords: Legal Guide June 2012 June 2012 Private Equity, Funds, Investors

2 This document provides general information and comments on the subject matter covered and is not a comprehensive treatment of the subject. It is not intended to provide legal advice. With respect to the subject matter, viewers should not rely on this information, but seek specific legal advice before taking any legal action Any opinions expressed in this document are those of the author and do not necessarily reflect the position and/or opinions of A4ID Advocates for International Development 2012

3 Introduction: Private Equity Private Equity (PE) is one of a number of sources of funds for a project, business or transaction. PE Funds are investment vehicles which primarily invest in unlisted securities which are not traded on a public exchange, as opposed to securities which are publicly traded. The objective of a PE fund is to achieve a return on investment over its life span, normally 10 years. Investors in PE funds are typically pension funds, corporations, insurance companies and high net worth individuals. PE funds generally acquire shares in privately-held companies and manage these investments in order to increase their value on exit. Exit may be achieved by way of initial public offering (IPO) of the investee company s shares on a stock exchange, or by selling the investment to a trade buyer or another fund. PE funds invest in businesses starting from scratch (start ups), and is also commonly referred to as venture capital in places such as the United States. Where funding is injected into an existing business to help it expand, this is known as development capital. A PE buyout involves a PE fund raising funds for the purchase of a business by a management team. The team will be involved in the management of the business with the aim of maximising the return on investment for the team itself and the PE fund. As PE has developed, funds have become more specialised and focused on industry sectors and geographic regions. There is great potential for PE investment in developing countries and, although the PE experience differs considerably between developing countries, this guide aims to provide a general overview of the activity in this area. Comparison with Foreign Direct Investment (FDI) PE can be compared to FDI, which is direct investment into production in one country by a company located in another. This is achieved either by acquiring control of a company or by expanding an existing business in the host country as opposed to acquiring a minority interest as is typically the case with PE. FDI is usually undertaken with a view to acquiring a long-term management interest in the target enterprise. FDI is usually only accessible to the larger, more established companies in emerging markets. Meanwhile, the ability of PE to cater equally to start ups and more established businesses means that it can be an effective tool in expanding the private sector in developing countries.

4 The role and the history of private equity in developing countries and likely future trends, particularly in sub- Saharan Africa Investors began to consider emerging markets when seeking new investment territories in the late 1990s. PE is generally associated with high returns on investment compared to other types of investment such as dividends from shareholdings or interest from loans, but there was concern that continued investment in developed countries would be incapable of sustaining such high returns. Alongside this, developing nations were becoming more attractive to investors owing to the transition of many of them to market economies. Tax, accounting and disclosure reforms, prompted by international organisations like the International Monetary Fund (IMF), were also a contributing factor. Conventional ways of raising finance, such as borrowing from banks, are often difficult for companies already burdened with debt, or those which are not sufficiently well-known to inspire confidence at an early stage. Likewise, international capital markets are not accessible to the great majority of companies. PE investment is attractive to developing economies because it can fill the gap between a company self-financing and obtaining funds from banks or through issuing debt securities or shares to investors. However, the attractiveness of emerging markets to PE investors cooled before the global financial crisis of 2008 as anticipated returns were not achieved, exits proved difficult and the challenges of doing business in these markets resulted in a general decrease in PE investment in the developing world. The PE approach is currently being re-assessed to improve the investment and exit conditions for investors by focusing on the training of local management teams and improving corporate governance in order to encourage investors to increase investment in the fastgrowing BRIC economies (Brazil, Russia, India, China). There is also growing interest amongst PE investor s in newer markets, such as Sub-Saharan African countries. South Africa has been and continues to be a major PE player, accounting for more than half of the PE investment into Sub-Saharan Africa. More recently, Nigeria, Kenya and Ghana, among others, have been receiving PE investment, principally in the fields of mining, energy and infrastructure. This focus, particularly on resources, is likely to continue, driven by the demand for raw materials in China.

5 Risks for PE investors in the developing world There are a number of obstacles to PE investment in developing countries. Often, internal corporate governance procedures are underdeveloped. Family run businesses are common throughout the developing world and are usually run by their promoters with a substantial degree of autonomy. This makes it difficult to achieve the accountability and transparency required by PE investors. Furthermore, PE funds need to be localised, with individuals operating on the ground who understand local business practices and culture. Limited availability of local management expertise can be a barrier, as can the difficulty in developing countries of accessing up to date and accurate financial information. This in turn impacts on the effectiveness of management and investor confidence. The lack of a thriving capital market is another issue, since the most successful PE exits tend to be achieved by IPOs. However, this is usually possible only for the largest firms in emerging markets. There is also the problem of enforcing contractual and intellectual property rights owing to unpredictable legal systems and ineffective dispute resolution and enforcement mechanisms, as well as weak minority shareholder rights, which act as deterrents to investors. The higher probability of civil unrest and political instability means that investors are not necessarily guaranteed a stable climate for investment, particularly where there may be a risk of political upheaval or regulatory overhaul by local governments. Environmental & Social (E&S) impact Businesses in developing countries may be wary that PE has traditionally been associated with being geared towards extracting short-term gains. Particularly in the more popular investment sectors in Africa i.e. mining and infrastructure, the E&S operating standards of businesses can be very low and fail to meet basic social and environmental objectives. However, development finance institutions (DFIs) are playing an increasingly significant role in ensuring that PE is used to enhance environmental and social performance. They encourage management teams to assess the main E&S liabilities of a business and set out action plans for compliance with standards. There are also E&S risk frameworks for particular industry sectors. For example, the Equator Principles have a project finance focus and provide guidance for financial institutions in the context of large-scale infrastructure projects. E&S objectives can also be aligned with wider positive impacts for businesses e.g. reducing energy consumption helps drive down running costs.by incentivising investors as well as encouraging the growing support for corporate social responsibility within businesses, it may be possible to foster real economic development through PE.

6 Tax, transparency and regulation Among the biggest challenges to successful PE investment in developing countries to benefit the host country are tax transparency and tax evasion. Many funds base some of their operations in tax havens to benefit from reduced levels of tax on capital and income. The lack of accountability, regulation and reporting obligations in these jurisdictions facilitates fraud and money laundering. Furthermore, tax evasion in developing countries weakens the effectiveness of the tax systems of these countries, resulting in very substantial untaxed outflows of funds every year. In the longer term, more transparent financial activity will require the narrowing of the scope for offshore structuring and tax evasion but, in the meantime, international financial institutions should scale back support for PE funds operating from offshore jurisdictions in line with the OECD standards on Transparency and Exchange of Information for Tax Purposes. These objectives, universally endorsed by the OECD countries, encourage jurisdictions to enter into agreements with one another for the exchange of tax related information. Similarly, the UN Principles of Responsible Investment provide further guidance for signatory institutions on assessing and monitoring the impact of their investment activity. If followed, such guidance will help ensure that PE investment can bring long-term benefits to host countries, not just short-term gains for foreign investors.