Chapter 4

Private equity investing in emerging marketsa

4.1 INTRODUCTION

4.1.1 Overview

Emerging economies represent over 80% of the world’s population and landmass, yet their financial markets are currently much smaller relative to GDP than those in mature markets. The total value of all emerging market financial assets is equal to just 165% of GDP, well below the 403% financial depth of developed economies (Roxburgh and Lund, 2009). While the share of emerging economies in the global capital market has grown fast, this has been from a relatively small base. Emerging economic regions, which do not yet have well-developed markets for finance, continue to have a considerable need for capital to finance infrastructure and communication investments. Consequently, private equity (PE) investors are increasingly being attracted by this need for financing, especially from non-quoted corporations.

A discussion of the PE landscape in emerging economies is inherently difficult due to the very large variation in their characteristics. As a result, any sweeping generalizations that we make on the causes and consequences of the PE investment activity in these countries are disputable. Nevertheless, we make an attempt to provide a basic framework that describes what we think are the most important issues associated with PE investing in emerging markets.

Emerging markets appeal to PE investors for many reasons. Strong economic growth, improving macroeconomic conditions, better physical and legal infrastructures, increased receptivity of governments to foreign investors, and the prospects of earning high returns encourage PE investors to allocate more capital to these markets. In addition, geographically dispersed investments potentially reduce the risk of capital supply–demand imbalances, with their adverse consequences for PE investment returns. Recently, however, emerging markets started to become increasingly integrated with developed markets, both in absorbing foreign PE capital and as global suppliers of PE capital. Such developments have potentially negative implications for the future performance of the PE asset class and the volatility of its returns.

Emerging countries are a heterogeneous group and PE investors must take into account important differences across these countries. The pace of political change and the size of economic gains have not been uniform. Some countries managed to achieve macroeconomic stabilization while others are still working on it. Also, development of market institutions, such as legal infrastructures that provide the basis for effective corporate governance, has been slower and difficult to achieve in many emerging economies. The lack of well-defined property rights and strong legal frameworks in some countries provide additional hurdles. However, domestic policies are becoming more market oriented and governments are opening their countries to foreign markets and joining regional trading associations. Most importantly, emerging economies have enormous growth potential.

Although emerging economies need a significant influx of PE investment to enhance growth, competitiveness, and entrepreneurial activities, investment biases and risk perceptions limit the PE investment supply which is still small compared with that in developed economies:1

4.1.2 What are emerging countries?

It is important to define what we mean by “emerging countries” because economic indicators alone are not always sufficient. An emerging country can be defined as a country that satisfies two criteria: (1) it is in a transitional stage, typically moving from a closed to an open economy and having embarked on a reform path, and (2) it faces a rapid pace of economic development, undertaking significant efforts to improve its economic performance to catch up with the economies of more advanced nations. The term was coined by the International Finance Corporation in the early 1980s to describe nine specific developing countries. Since then international investors and the media have broadened the term to refer to all developing countries, not just the few with relatively well-developed domestic equity markets.

In this book, emerging countries PE refers to the PE industry in the emerging economies of Asia, Central and Eastern Europe, the Middle East, Latin America, and Sub-Saharan Africa, as defined below:

• Asia—all Asia, except PE funds whose primary mandate is investments in Japan, Australia, or New Zealand
• Central and Eastern Europe (CEE)—European Union accession countries, Turkey, the Baltics and Balkans, as well as the Commonwealth of Independent States (CIS) countries, including Russia
• Middle East and North Africa (MENA)—Gulf Cooperation Council (GCC), Afghanistan, Iran, Iraq, Jordan, Lebanon, Palestinian Territories, Syria, and Yemen, as well as Algeria, Egypt, Libya, Morocco, Sudan, and Tunisia
• Latin America and Caribbean—Central and South America and the Caribbean region, excluding Puerto Rico
• Sub-Saharan Africa—All Africa, excluding funds whose primary mandate is investments in North Africa (Algeria, Egypt, Libya, Morocco, Sudan, and Tunisia).

This list is consistent with the definitions used by the Emerging Markets Private Equity Association (EMPEA). Among all emerging markets, the economies of Brazil, Russia, India, and China, commonly termed as the BRIC countries, are particularly relevant, mainly because of their significant size and consistent annual growth since the 1980s. China has grown at an average rate of 9.8%, followed by India and Russia at around 5.8% and Brazil at a relatively slower rate of 2.4%. By contrast, the large industrialized nations (Group of Seven or G7) have shown an average growth of just 2.7% before the financial crisis. During the crisis, the economies of these countries have contracted while emerging economies have continued to grow.

4.2 INVESTMENT LANDSCAPE

4.2.1 Investment and fundraising activities

PE investment activity in emerging economies has risen steadily in recent years. Fundraising for emerging market–dedicated PE funds slowed in 2009, but investment activity was comparatively strong. Overall, emerging markets captured 9% of the global private equity fundraising and 26% of global private equity investment, with deal activity by transaction volume down by only 11% (EMPEA, 2010b). By comparison, in 2004 the emerging markets had only a 4% share of global PE investment. This jump is broadly in line with the growth of emerging economies (see Exhibit 4.1).

Of the 26 largest funds raised until 2009 dedicated to PE investments in emerging markets, half were USD1bn or greater. Emerging Asia boasted the largest funds of all: the largest five raised as of December 2009 all topped the USD2bn mark. Fundraising in Sub-Saharan Africa has yet to breach the USD1bn threshold, but in the early months of 2010 a few African funds were poised to break fundraising records. The trend towards USD1bn+ funds in emerging markets began to slow in the latter half of 2008. The smaller size of funds being raised for emerging markets reflects an adaptation to lower entry valuations caused by the credit crisis, and also existing underinvested funds already sitting idle. Funds under USD250mn (i.e., equity investments ranging from USD10mn to USD30mn) represented 81% of the sample in 2009, compared with only 54% of the sample in 2007.

During 2009, which was particularly difficult for the industry, PE activity was more robust than in the developed markets. Overall transaction volumes in emerging markets were only slightly depressed, with 674 deals totaling approximately USD22bn, a 54% fall in value.

Expansion deals and private investments in public equity (PIPE) dominate, compared with buyouts in the more mature economies (Rajan and Deshmukh, 2009). Venture capital (VC) funds still constitute a significant portion of the market, accounting for 29% of funds with final closes, but only 11% of capital raised (EMPEA, 2010a). Recently, several multiregion and Asian funds focused on buyout transactions have emerged but, even so, funds with a buyout focus accounted for only 11% of final closes in 2009 (EMPEA, 2010a).

Asia

Emerging Asia’s fast growth in PE commitments continued in 2009. It drew 71% of capital raised by emerging markets, up from 48% in 2007 and only 34% in 2004. This growing share can be attributed to the larger sizes of many pan-Asian and China-dedicated or India-dedicated funds relative to other markets, and to the continued proliferation of new funds. China-dedicated funds accounted for USD6.6bn of the USD15.9bn raised for emerging Asia. China funds’ share of fundraising grew from 22% of the emerging markets total in 2004 to 29% in 2009. India-dedicated funds raised USD4bn in 2009, or 18% of the total.

CEE and CIS

The share of new commitments raised by funds focused on the Central and Eastern European and CIS markets declined over the same period, falling from 27% of capital raised in 2004 to only 7% in 2009 (EMPEA, 2010a).

MENA

Funds dedicated to MENA raised a total of USD1.1bn in 2009 or 5% of all emerging market fundraising, a steep decline from the USD6.9bn raised in 2008 or from the USD5.3bn raised in 2007. Even in 2005 the amount of funds dedicated to MENA was larger at USD2.7bn. While only few PE funds are deploying capital in more nascent markets such as Pakistan or Iraq, the majority of funds are focused on opportunities in the GCC and North Africa. Investments were similarly sluggish in 2009, although falling less steeply, at USD2.2bn (34 deals) from USD3.4bn in 2008 (67 deals). About USD19.2bn has been raised between 2005 and 2009 and only USD11.4bn invested during the same time period (EMPEA, 2010b). As a result the MENA region is home to funds that have ample dry powder.

Latin America

Funds raised in Latin America declined to USD2.2bn in 2009, following USD4.4bn raised in 2007 and USD4.5bn in 2008 (EMPEA Insight, 2010a). Among emerging markets, Latin America has been the second most active market for PE investment, behind emerging Asia, with over USD7.5bn deployed from January 2008 to September 2009. Brazil continues to be the largest PE market in Latin America while Mexico has historically led the region behind Brazil. A new tier of countries such as Colombia, Peru, Chile, and Argentina is emerging.

Sub-Saharan Africa

Between the boom years of 2006 and 2008, Sub-Saharan Africa accounted for approximately USD6.2bn in private equity funds raised and USD7.7bn invested which is a fraction of other emerging markets during the same period (EMPEA Insight, 2010c). Private equity fundraising for Sub-Saharan Africa slumped in 2009, total funds raised for the region reached USD933mn in 2009, a sharp decrease (64%) from the peak of USD2.6bn raised in the prior year. South Africa continues to lead both as a fundraising hub and as an investment destination, accounting for nearly 50% of capital deployed from January 2009 through July 2010.2 Development finance institutions (DFIs) have historically played a leading role in developing the region’s private equity industry and have not only kept established fund managers afloat throughout the global financial downturn, but have also continued to back first-time funds. Over 2009, DFIs have funded well-established GPs in the region by committing to their third or fourth vehicles.

4.2.2 Alternative funding sources

In addition to the traditional private capital provided by institutional PE investors, PE capital in emerging markets is further increased by two important sets of investors: sovereign wealth funds and development finance institutions.

Sovereign wealth funds (SWFs)

Sovereign wealth funds (SWFs) are state-owned funds which invest abroad as well as domestically and, unlike central bank reserves, are free to invest in less liquid and more risky assets to seek better returns. Most SWFs have been created through commodity exports (mainly oil), either taxed or owned by the government but there are many SWFs that have been created through transfers of assets from official foreign exchange reserves or from national budget surpluses (e.g., in China and Singapore). The largest SWFs in the world are Abu Dhabi Investment Authority (ADIA) in the U.A.E., the Government Pension Fund in Norway, SAMA Foreign Holdings in Saudi Arabia, and China Investment Corporation (CIC) in China. Other very large SWFs are in Singapore, Kuwait, Russia, Qatar, and Libya. Sovereign wealth funds based in Asia control 40% of the aggregate total assets of all sovereign wealth funds. Those based in MENA control 35% and Europe-based sovereign wealth funds manage 19% (Perryman, 2010).

Industry estimates of SWF commitments to private equity are about 10% of all global capital available to the sector. About 90% of SWFs have made some kind of private equity investments in the past (SEIU, 2008). SWFs are relatively new to private equity, but they are expected to become increasingly important providers of capital not least because many SWFs have little exposure to the PE asset class. These low levels of capital allocation to PE will increase their commitments in the pursuit of greater diversification of their asset base and greater long-term returns.

Development finance institutions (DFIs)

Development finance institutions (DFIs) are specialized financial institutions backed by states with developed economies that invest in developing countries or domestically. In Europe there are 15 national DFIs, which serve to implement their government’s international development and cooperation policies. There are also multilateral DFIs, such as the World Bank’s International Finance Corporation and the private sector arms of the regional development banks. The mandate of DFIs is to provide financing for projects that promote development, and especially those projects that fail to attract private investment.

In Europe, the advent of development banking can be traced back to the mid-19th century, and was established to meet the demand for medium to long-term capital by new and emerging enterprises during the Industrial Revolution. The years following the Second World War saw the establishment of DFIs in many developing countries to provide medium and long-term financing which is critical in supporting the economic development agenda of these countries.

The aim of DFIs is not only to generate a development impact but also to deliver a financial return. DFIs have emerged as an additional source of funds for the PE asset class in emerging economies, particularly for end-investments in the SME sector, which is typically underserved, and where the development impact potential is high. In the past, DFIs encouraged investors to support identical PE fund structures and investment approaches even though sometimes the regulatory and legal frameworks in emerging countries did not provide adequate investor protection. Fund managers used similar processes for identifying, analyzing, and valuing target companies as well as for structuring deals, despite large differences in accounting standards, corporate governance practices, and exit possibilities across different emerging countries. Nowadays, PE funds have become less foreign and more local and DFIs have started to assist governments to strengthen regulatory environments.

In recent years, SME financing has been a priority in development policy. DFIs invest directly via intermediaries, through PE funds and through other types of financial institutions, which then provide access to finance for SMEs in all types of sectors. DFIs also invest indirectly in financial institutions that are expected to support SME financing.

4.2.3 Outlook and prospects

Economic forecasts suggest that the emerging markets will continue to grow for the foreseeable future, supporting growth-based PE investments. While the PE industry is fundamentally about value creation through improving companies, the emerging markets have been dominated by PE growth capital.

Recent studies by leading industry associations such as EMPEA have highlighted some key trends relating to LP interest in emerging markets. LPs have started to view emerging market PE opportunities as attractive, both in their own right and relative to PE opportunities in developed markets. The emerging market share of new PE commitments is therefore expected to continue to grow. In terms of performance, most LPs now expect emerging market PE funds to outperform the PE industry as a whole.

Geographically, most studies rank China, India, and Central and Eastern Europe as the most attractive, followed by South East Asia, Latin America, the CIS, and MENA. Africa is ranked lowest. A recent survey found that, over 2011 and 2012, the greatest expected expansion in commitments from existing investors will be in Asia: 44% of investors plan increased exposure in China, 28% in India, and 26% in other Asian emerging PE markets (EMPEA/Coller Capital, 2010). However, things are changing rapidly and it is difficult to predict which regions will provide the best investment opportunities in the future.

4.3 DRIVERS FOR PE INVESTMENTS IN EMERGING ECONOMIES

Successful PE investments require interesting businesses in which to invest, combined with access to equity stakes with influence over those businesses. Both the breadth and the quality of emerging market PE opportunities have improved markedly over the last few years. An adequate flow of good opportunities can support the setup of local investment teams that can significantly improve the quality of PE transactions. Deal origination and structuring, and advice to the investee companies, can be done more effectively in close proximity and in real time by PE professionals embedded in the local market.

Favorable growth drivers (which we discuss below) have partly sustained the increase in PE activity, but three main macrotrends have amplified both the number of good PE investment opportunities, and the PE funds’ ability to acquire control in emerging countries:

• Economic liberalization policies and the movement to market-based economies since the 1990s have increased entrepreneurial and new business activity and, thereby, have increased the potential for PE investments.
• The opening up of economies has increased both the business opportunities to expand and the competitive pressure, leading to more business owners seeking private capital.
• The close identification of family status and wealth with direct ownership of a company has reduced. This in turn has generated less reluctance to engage in third-party equity financing. The last decade has seen a gradual shift in the appetite for PE capital, even by family-owned businesses.

Emerging markets have been attractive to risk capital investors, and increasingly so in recent years, mainly for the higher growth rates and consequently the higher expected financial returns. However, expected growth is not the only thing that matters to investors in the PE asset class. Many criteria affect PE funding. We list below the main macrofactors that likely affect the flow of PE investments to and across these economies:

• Expected growth rates and market size—most PE investors look at the size and growth rates of their domestic markets when investing in emerging economies. The growth rates seen in developing economies are often higher than in mature developed economies—sometimes more than double. This is a significant driver for investing in businesses positioned to cater for these markets. Market size is also a critical determinant for most PE investors. Much attention has therefore been focused on the so-called BRIC countries of Brazil, Russia, India, and China, whose combined population constitutes more than 40% of the world’s inhabitants. This huge population implies a large—and fast-growing—consumer pool, which should provide economies of scale as well as high and continuous growth rates for businesses that exploit this potential.
• Political stability—PE investing patterns show that democracy is important, but political stability is even more so. China and India, for example, receive by far the largest volume of PE investments. They are polar opposites on the political spectrum, but both have excellent track records of stable government and peaceful transitions of power. By contrast, emerging regions that are inherently politically unstable receive a lower level of interest from PE investors.
• Legal environment, investor protection, and corporate governance—company and investment protection laws have undergone revision, and codes of corporate governance practice have been introduced in many emerging markets, in part supported by assistance from multilateral development banks. Transparency and disclosure have also improved and international accounting standards (IFRS) are increasingly adopted. The legal environment as well as accounting and corporate governance practices have a natural impact on the success of any external investor. In particular, large PE investors have a wide choice of investment options, hence they are naturally drawn to environments that are better structured and supportive for foreign investors. Funds that operate in common law countries may find it easier to enforce their rights in commercial contracts.3 On the one hand, better laws facilitate deal screening and origination but also investors’ board representations and the use of desired types of securities. The choice of securities in emerging market PE deals is driven by the legal and economic circumstances of the nation and of the investing PE fund (Lerner and Schoar, 2004). On the other hand, weak property rights and investor protection are likely to limit PE investors’ ability to run efficiently the businesses in which they invest. Further, rigid labor market policies might make a PE market less attractive. Institutional investors might hesitate to invest in countries with exaggerated labor market protection and immobility.
• Receptivity to private investments—sometimes certain industries are off limits to foreign investors but, on the whole, most emerging countries are clearly receptive to private investments in all industries. Since PE is a relatively long-term asset class and needs a favorable environment for new businesses to succeed, regulatory policies and entry barriers often have a significant impact on PE investment flows. The sectors that are high growth and are accompanied by favorable policies for investment naturally attract more PE investment.
• Stage of development of the capital markets—there is a strong relation between PE activity and the development of public local stock markets. The ability to exit PE investments via listings on local stock exchanges is the strongest driving force for PE investing. As a result, PE capital flourishes in countries with deep and liquid stock markets (Gompers and Lerner, 2000). There is a growing list of highly profitable exits by selling to strategic and financial investors, which suggests that experienced PE firms are adapting successfully, but this element of risk will continue to differentiate emerging markets from developed markets. Finally, the availability of debt financing, a key source of capital, is an important determinant of the success of PE investments that focus on capital-intensive businesses.
• Maturity of the local PE market—the maturity of the local PE is reflected by the number of players and supporting institutions, such as law firms, investment banks, M&A boutiques, auditors, consultants, and other advisors. If investors have confidence in the efficiency of the local PE market and the PE market has an established track record, they will continue to invest in follow-on funds. Annual PE fundraising volume depends on the previous year’s market liquidity (Balboa and Marti, 2007). In addition, there is a positive relationship between the size of the economy and the level of PE activity. If an economy is too small, it falls outside the scope of internationally acting institutional investors, the main source of PE funds.
• Availability of skilled human capital—countries with a relatively deep pool of skilled human capital are more attractive than those with low-wage labour alone. Many emerging countries have well-regarded systems of higher education in technical disciplines, and therefore rank highly on the list of PE investments. If university systems are severely deficient, it makes it difficult to recruit competent local managerial and technical personnel. This, in turn, acts to deter PE investors, who tend to prefer economies with a more efficient and developed pools of human capital.

Which of these factors is the most important? There is no clear agreement on this. Groh and Liechtenstein (2009) survey the relevance of some of these issues to institutional investors when allocating PE capital to emerging markets. They find that investors perceived protection of property rights and corporate governance as very important for international PE allocation decisions. These were followed by the assessment of the management quality of local GPs and entrepreneurs according to Western management standards, by expected deal flow, and by the amount of bribery and corruption. Institutional investors in PE are not particularly swayed by government programs to stimulate local risk capital markets. They rely on the quality of the GPs they invest in. The GPs in turn rely on the managers of the corporations they back. If investors’ claims are poorly protected, or if they doubt the quality of their investees, or integrity in a host country, then they are likely to refrain from investing.

For these reasons PE investors favor India, Central Eastern Europe, China, and now increasingly Latin America. They are less attracted by South East Asia, the Commonwealth of Independent States, and Africa. We discuss investment risks in the following section.

4.4 RISKS OF INVESTING IN EMERGING ECONOMIES

Although institutional investors are attracted by the expected growth and entrepreneurial opportunities in emerging economies, they need to be aware of the potential risks. Emerging markets can indeed provide a significant financial return on PE investments, but much of this is driven by inherent risks. PE investors are expected to weigh up the risk–return tradeoff before they commit funds to the various emerging markets.

PE investors face risks in emerging markets both at a country and at an individual company level. At the country level, these risks tend to reflect political risks, economic volatility, and regulatory risks, while for individual companies they often relate to gaps in corporate governance, management quality, and information disclosure. We start with a discussion of the main risks at the country level (macrolevel risks) and then continue with a discussion of risks at the company level (microlevel risks).

4.4.1 Macrolevel risks

While the long-term growth potential of the emerging markets remains significant, the path of growth is likely to be volatile. Moreover, emerging markets comprise a very heterogeneous group of countries: some will show steady long-term improvements and some will languish behind. At the same time, high economic growth in emerging markets exerts pressures on the prices of food and mineral resources which have contributed to mounting inflation in emerging markets. Rising inflation levels coupled with a recessionary environment can create short and medium-term uncertainty for PE investors whose investment horizon is usually medium term.

Political risks

Until the 1990s, PE investment in emerging markets was difficult, because of multiple restrictions on foreign direct investments. Most PE investments were provided by state-backed development finance institutions. From 1990 onwards, a series of reforms in emerging countries, which resulted from significant political changes, have made access easier for private providers of risk capital. After years of instability, the political risks in most emerging countries have been diminishing very fast. However, PE investors still need to be alert to political conflicts, which can generate wars, or riots, or just unpredictable changes in regulations. These have direct negative effects on PE investments. They are also associated with macroeconomic instability, which can quickly erode companies’ attractiveness because of inflation, a poorly functioning financial system, high unemployment rates, or negative growth rates. One of the top priorities for PE investors should be an effective political analysis and a continuous monitoring of the political landscape in emerging countries.

Political risks not only indirectly affect an emerging market investment through their impact on the macroeconomic environment, they can also have direct effects. Some governments may protect local industries that create jobs and ignore international laws for political gains. What seems right for the local emergent economy may trump foreign investors’ rights in courts, so they have to protect themselves at the front end by buying stakes in companies with other defenses. Lawsuits are an option, but may be expensive and ineffective, especially if the legal system is different. Therefore, PE investors from developed countries often emphasize good relations with the local government. This can speed up permit approvals and other government processes significantly and, sometimes, can provide a competitive advantage.

Currency risks

Most emerging countries’ currencies fluctuate significantly, although some are tied directly to the U.S. dollar (China’s yuan is a notable example). The PE investor should try to form a 3-to-5-year view of local currency depreciation relative to the currency in which the PE fund has been raised in the country of domicile. It is difficult to make currency forecasts, but they can be extremely informative when investing, because devaluations can easily “eat” the returns in, say, USD or EUR at the time of exit. Forecasts can be obtained from large financial institutions or commissioned from specialist advisors.

One way to deal with this particular risk is to allocate PE funds across different emerging markets, in the hope that such diversification will limit the potential losses due to currency movements. An alternative is to hedge investments denominated in foreign currency by using derivatives that are traded in currency markets.

Regulatory risk

Successful investing in emerging markets requires PE investors to master complex regulatory environments for competitive advantage. The legal and regulatory environment in many emerging countries is constantly changing (e.g., allowing certain businesses or activities and then disabling them). In addition, complex regulations and licencing requirements can vary across national, provincial, and city levels. These changes can be driven in part by economics but also by politics. Although sudden regulatory changes can be costly to PE investors, they can also provide good opportunities (e.g., licencing requirements can be leveraged as a barrier to competitive entry). Turning regulations to advantage should be a key skill of many PE investors in these markets. They need to have an inside track on regulatory changes that allows them to anticipate coming opportunities as well as pull out of disfavored sectors.

The problems of implementing legal frameworks and enforcement are accentuated in emerging markets, because local business owners tend to be adept at navigating the legal system. This puts outside PE investors at a disadvantage, particularly when they need to resort to the law to resolve contractual disputes. The best way to mitigate this problem is to partner with carefully selected local agents and intermediaries as a common modus operandi at some or all stages of the deal execution.

PE investors should also try to fund firms that are concentrated in one region and seek to build relationships with local authorities in order to be able to understand and manage the local regulatory regime that their funded firms face. Understanding and controlling the risk from regulatory institutions can become difficult and very costly if the PE firm’s investments are geographically diverse.

Finally, PE investors can create innovative financial and legal structures that are a mix of local and Western structures. Offshore Western financial and legal structures, such as in the Cayman Islands or British Virgin Islands, provide a legal oasis where emerging market PE investors can still meet the objectives of investment protection and access to liquidity while adhering to local laws. The investor’s limited partnership may be a permissible U.S. or U.K. entity but its portfolio company may be incorporated somewhere else. Simplistically, incorporating in efficient jurisdictions with strong legal frameworks permits instruments such as both preferred and common stock, employee stock options, and the ability to list on stock exchanges in developed markets, thus solving the lack of access to local capital markets.

4.4.2 Microlevel risks

Particularly in emerging markets where there is weak protection of investors’ rights and the enforcement is poor, investors must be alert to the quality of the management in charge of the portfolio company and the corporate governance. When the broader macroeconomic environment is stable or positive, many corporate level risk factors may not come to the surface. However, in more challenging environments, the management and governance quality as well as the accuracy of the information reported by the company are likely to be key factors that differentiate successful PE investments.

Management risks

Managerial risk is one of the main drivers of poor investment performance, and it needs to be thoroughly assessed by the PE investor. Ineffective management, lack of focus, or failure to implement strategies properly can easily transform a good PE deal into a loss-making investment. Other managerial issues, such as corruption or lack of integrity, may also play a role.

Emerging countries may have many talented entrepreneurs and managers, but there is a perceived lack of professional managerial skills, particularly in sectors that require specialized knowledge. Good and experienced new managers are usually a scarce resource. Management turnover rates in some fast-growing emerging markets are high and the pool of world-class talent can be shallow, particularly for CFOs. However, there is talk of a reverse braindrain, especially due to the recent financial crisis and the improvement of professional education in these countries. Many educated professionals who worked abroad bring their experience back home. This phenomenon positively impacts the quality of the management teams put in place by the PE funds.

PE investors must always be mindful of their relationship with key managers in emerging markets. Replacing management, while possible, may become much more complicated in emerging markets as the loyalty of employees and possibly of customers is to key managers—not to the company as such. Replacing these managers may trigger replacing an entire management team.

Management risk can be minimized by using a selective recruiting process with detailed reference checks. The PE investor also needs to be aware of the changing environment and to provide competitive and timely incentives for very talented managers, in order to discourage them from leaving. Rapidly improving economic conditions and the limited pool of candidates combine to increase the competition for managerial talent. Aligning managerial, employee, and shareholder interests may require innovative approaches since employee stock options, a key instrument to incentivize employees in developed markets, may be simply unavailable as a financial instrument in emerging markets.

Corporate governance risks

In terms of corporate governance, the PE investor should put in place effective management information systems that can provide timely feedback on managerial performance and protect the invested capital. Installing and maintaining financial controls becomes critical as the company’s capital must be viewed as separate from the local entrepreneur’s personal finances. Hence, PE investors should install tight restrictions such as forbidding the purchase of speculative assets and unnecessary expenditures. In addition, good financial controls and receivables management can reduce the investment capital required to run the company.

PE investors should require board seats for the firms they fund. However, they need to be aware that the power and information provided to board members is sometimes less than in developed markets. Information can often be withheld from the board, and the influence of outside directors may be weak. In addition, the market for corporate control might be virtually non-existent. In part, this reflects the fact that in the regulatory environment of many emerging countries a board of directors is not required for a firm. Thus, it is more important to remain close to their invested firms to obtain the desired information and ensure its accuracy than to depend on a board seat for it.

Another way to minimize corporate governance risks is to use two classes of stock to guarantee that the investment has a preferential return—especially in cases of liquidation. The most commonly used instrument that guarantees this return is preferred stock, which is the class of stock that PE investors should hold. All other shareholders should receive common shares which may not have these special preferential rights. However, some emerging countries might not allow preferred shares (e.g., the most notable example is China). Other protection instruments are antidilution clauses or penalties for non-performance.

Information risk

PE investors always have to make investment decisions based on incomplete information that is controlled by management. This information asymmetry tends to be far more serious in emerging economies. Regulations in emerging markets do not require the same level of public information to be provided to the government or other regulatory bodies as in developed countries. Further, owners of private companies in these countries are used to retaining complete control of information and of its visibility. In addition, some countries have accounting and legal rules that leave considerable room for interpretation.

Valuation is more art than science in the best of circumstances, but this is particularly true in emerging markets. Forecasting future company performance is complicated by the dearth of reliable data on markets, competitors, and product pricing, and by the volatility that characterizes developing economies. It can also be hard to value a business at the time of acquisition or exit, because of thin domestic equity markets, which provide minimal guidance on comparable company values. Since the ability to accurately obtain full information on a firm is so constrained, due diligence in emerging markets commonly focuses on the entrepreneur’s background and his or her contracts.

Very often PE investors face local managers who are not educated on international business and reporting standards. This could mean that a portfolio company could have one accounting book filled out according to international GAAP and one book completed according to local standards. And they do not have the same numbers. Even three sets of financial accounts are not uncommon, which makes processing the information and pricing a business appropriately a daunting challenge. Therefore, it is important that PE investors take the time to educate the owners and managers of local companies when investing.

In addition, to mitigate the information risks, PE investors should ask firms to produce financial reports in a form that is interpretable and can be verified. This usually requires that an international accounting firm is hired to help with the financials and audit of the firm.

Intellectual property risks

An important aspect relating to PE investments in emerging markets is the management of intellectual property rights. Protecting intellectual property can involve a change in thinking for most emerging market entrepreneurs. Many of them think of intellectual property quite differently from their foreign counterparts. In particular, they might not consider copying a crime. Different risks about intellectual property rights can arise. For instance, an entrepreneur or employee might want to split off another, independent enterprise even though it may be based on the intellectual property of the entity in which a PE fund invests. Also, some employees might come to the organization and use the proprietary intellectual property of their former employers. In yet another example, competitors may counterfeit a venture’s products creating economic and reputation risks, especially as the costs of advertising escalates and the venture is approaching an exit.

To mitigate these risks PE investors have to instill the very concept of intellectual property and an understanding of the company’s intellectual property rights in both the entrepreneur and the employees of the company.

4.5 MARKET STRUCTURE AND INVESTMENT CHARACTERISTICS

4.5.1 The role of local knowledge

PE investors going into emerging markets need to commit to these markets for the long term. If they cannot, then they are likely to have a difficult time competing with local PE firms and foreign groups who have gone local. Given the current crowded nature of the PE market, PE money has become more of a commodity than ever, so investment managers need to distinguish themselves. They need to build up a reputation for success and trust and the only way to achieve this is by spending time in emerging markets. This will also allow them to cultivate strong relationships with local partners who can help navigate and source deals and to collect local knowledge that puts them in a better position to assess the best deals.

The home offices of PE firms are not always able to bridge the culture and knowledge gap to understand why a certain emerging market branch is pushing certain deals. In fact, successful PE firms, who have local offices or have partnered with local PE firms, usually keep the final decision-making authority with the local fund managers. If the investment decisions are vetted at home, then many relationships may not work. If the ideas of the local representatives are constantly disregarded, they can become frustrated and leave. Such outcomes can be problematic given that good local representatives may be irreplaceable. Their knowledge and relationships may not be easily duplicated.

Therefore, a key feature of PE investing in emerging economies is that, even if most funding comes from investors based in the developed economies, the development of local knowledge is critical. The solution is not only to hire local partners, but also to come to the emerging market to learn and build trust with these local partners.

4.5.2 Deal dynamics in emerging markets

Screening and selection

PE funds in emerging markets are typically proactive in deal selection. Rather than wait for business proposals to land on their desks, or for investment bankers to make a pitch on behalf of a client, PE professionals typically approach companies they find attractive. This also avoids getting involved in a bidding auction.

Most funds still approach emerging markets with a generalist strategy, focusing on a basket of the most promising sectors, based on the size of transactions they seek. Funds with a single-sector focus, such as infrastructure, natural resources, or financial services, were slightly less prominent in 2009 than in 2008 or 2007. Each PE fund’s strategy is tailored to the investment environment in each emerging market (e.g., funds recently focused more on consumer opportunities in China, agribusiness in Brazil, or telecommunications and financial services in Sub-Saharan Africa).

As a result of recent trends in deregulation and openness, most PE deals in emerging markets comprise companies targeting growth: two thirds (67%) of transactions fell into this category in 2009 (EMPEA Insight, 2010a).

Structuring and monitoring

Typically, once a firm has passed its initial screening, PE investors proceed with due diligence, which includes confirmation of the nature and status of the firm’s product, production capability, market demand, and status of key relationships with other organizations. In emerging markets this process is complicated given the limited availability of accurate information. Local bureaucrats and business owners have significant control over information crucial to understanding the market and the regulatory environment providing a serious disadvantage to outside PE investors.

In addition, business owners in emerging markets may be reluctant in dealing with foreign PE investors. Building up a comfort level that would enable these individuals to judge the PE funds, and the PE funds to judge them is crucial, and takes some time. Learning about the founder, his colleagues, and even family is important in the due diligence process.

Once an investment is made, PE funds typically monitor their investments through memberships on boards of directors or via reporting mechanisms they set in place. They can also seek to protect themselves from abuses by having extensive minority protection clauses in the investment agreements. It is, however, difficult to anticipate all the potential problems, and the enforcement of the agreements is often problematic due to underdeveloped regulatory institutions like the court system and the commercial code.

PE investors’ main goal is profit maximization. However, when monitoring their investment, they might need to recognize that the local entrepreneur or the local government departments with influence over the firm might have different goals. For instance, maximization of employment and/or production might be more important for these parties. Without careful oversight, firms can end up with extra employees and overproduction of goods that will result in unsalable inventory.

Investments in emerging markets are typically structured with the following common characteristics (see Schoar and Lerner, 2004 for a more extensive discussion):

• Minority positions are quite common and have proved not “too” risky. They have performed well in all forms of exit, indicating that the risks associated with minority positions can be managed effectively.
• Unlike developed markets, where the use of convertible preferred securities is common, in emerging markets more than one half of the transactions involve common stock while a significant subset employ instruments that are essentially debt. When preferred securities are not used, PE funds are more likely to obtain a majority of the firm’s equity and to make the size of their equity stakes contingent on the performance of the company.
• Antidilution provisions which are common in developed markets are encountered far less frequently in emerging markets.
• Larger financings and transaction values are seen in emerging markets with a common law tradition. Also, transactions in these countries are generally associated with more contractual protections.

Exit strategies

PE investors in emerging markets should assess exit strategies rigorously before deciding on an investment. Despite the uncertainties of an event that will not occur for 3 or 5 years hence, it is important to ensure that the company’s management understands and commits to the strategy.

The goal is to ultimately exit investments in emerging markets before the PE partnership is terminated. Exits through IPOs are very common. However, they may be problematic, even for successful investments. There are several reasons that contribute to this outcome:

• A host of laws on securities markets, disclosure, and accounting standards that should facilitate such IPOs are not yet in place in many emerging markets.
• The selection of which firms may list on the local stock exchange might be principally a state decision (especially in China).
• Local exchanges are very small and illiquid.

Consequently, many PE funds do not consider listing their investments locally but instead choose foreign exchanges. They also prefer to look for strategic buyers. This is typically the only major exit strategy readily available in many emerging markets.

Some PE investors in emerging markets are willing to experiment with new, more creative approaches to exit. For example, one Latin American fund has launched a mezzanine fund that offers debt financing with many of the same characteristics as equity, but provides investors with greater assurance of a steady income stream. Another has begun to recapitalize some successful portfolio companies, which allows the fund to realize capital gains while waiting for an opportune time to exit.

4.6 COMPARATIVE LANDSCAPE OF EMERGING MARKETS

Emerging markets have heterogeneous characteristics and can differ widely in many respects, but they have some common features that seem to attract PE investors across all these economies such as high growth rates and improving legal environments. Geographically, the main emerging regions are competing with each other to attract funding from institutional investors.

We shall now look at some of the highlights of a few key emerging market areas. China, India, and Brazil remain the most attractive emerging markets for GP investment. We start with a discussion of these three markets and then continue with short discussions about Central Eastern European (CEE), Sub-Saharan Africa, and Middle East and North Africa (MENA) markets.

4.6.1 China

China is the only emerging market that compares in size with the U.S. and European PE markets. Within Asia it is on track to displace the more developed PE markets such as Japan and Australia for both volume and investor attention. Investors continue to be extremely optimistic about China.

Investments in China held steady at USD9bn in 2008, down only slightly from USD9.5bn in 2007, making China home to the greatest amount of PE investment dollars across the emerging markets to date. The main reason for the small dip in investments is China’s stimulus plan which has flooded the market with inexpensive debt, making PE less attractive to companies seeking financing.

PE funds were unknown in China until the late 1990s. They initially were popular with Chinese companies short of capital and knowhow. Before 1992, the principal vehicles for private equity entry were China Direct Investment Funds (CDIFs). These funds were typically listed on the Dublin, London, or Hong Kong stock exchanges in order to attract money from institutional investors.4 Today, most PE investment funds raised are not listed as investment funds on stock exchanges. Rather, they are organized as limited partnerships in a manner similar to U.S. PE funds or are units of large international financial institutions. Most funds first create an offshore corporation for the joint venture with the local Chinese firm.

China has traditionally been a difficult place for deals. It is still difficult to execute large, foreign-sponsored investment in strategically sensitive domestic sectors such as media and defense, and some sectors remain off limits to foreign investors altogether. The challenging regulatory environment in China, which includes unclear rules and regulations for foreign investors regarding procedures and taxation, has meant that, historically, the location of the PE investment process has been offshore.

However, the landscape is changing. The Chinese regulatory authorities seem committed to establishing a framework that recognizes and promotes PE as a distinct asset class. For instance, various local and provincial government initiatives that have been launched across the country introduce incentives for foreign firms to establish wholly foreign-owned or foreign-invested fund managers based in China, and the national government has signaled its intention to allow foreign firms to establish local currency–denominated funds via onshore vehicles.

Social capital in the form of “guanxi” is essential as a source of relevant information and as a basis for influencing business behavior in every part of a PE deal in China: from sourcing and developing, to its management and exit (Deloitte, 2005). Guanxi is a network of social and business relations that enable preferential favors based upon trust or mutual benefit. While in America or Europe, business can easily be conducted among strangers based on the trust placed in institutional and legal recourse, this is not the case in China. Guanxi can overcome the inefficiency of information markets and the trust gap among business people in China during the due diligence process. Since there is much less reliance on contracts and institutions and far greater emphasis on personal relationships, this mutual due diligence can be a significant and critical stage of deal making in China.

China is poised to continue to lead the emerging markets as the foremost destination for both fundraising and investment. Going forward, the expected shift in focus to onshore firms and capital will be crucial for the PE industry in China. Foreign fund managers may have longer track records, but domestic players have a large role to play in the industry’s development, because they are not restricted to particular sectors, are subject to far fewer approvals, and have a distinct advantage in their ability to take advantage of local relationships and knowledge. In fact, funds denominated in renminbi (RMB) constitute an increasing share of the capital being raised by both local and foreign players.5 These funds were born under China’s amended Partnership Law passed in 2007 and accounted for almost half of all capital raised in the first half of 2009.

4.6.2 India

India’s PE industry has been developing rapidly over the last 5 years. The Indian economy has grown at an average annual rate of more than 8% over the last 5 years, and other macroeconomic factors and policies have complemented this growth. As a result, India has emerged as an attractive PE investment destination. Rivaling China, India saw USD7.7bn in funds raised and USD7.5bn in capital deployed in 2008 as PE investors were enticed by its growing status as an economic powerhouse, its strong entrepreneurial spirit, and its highly skilled, English-speaking workforce. In addition, another driving factor is India’s size as the world’s largest democracy with the second highest population in the world and a huge pool of intellectual talent and varied skills.

Since its economy opened up in the early 1990s, India has encouraged the growth of this asset class, taking steps towards relaxing restrictions on PE investments to encourage greater capital flows into the country, including allowing government-owned banks to invest in PE directly. In sharp contrast to the time when PE funds were invested in India from an overseas base such as Singapore, many PE firms have now established their presence in the country. But significant barriers to investment remain. The primary deterrent to entry is India’s complex regulatory framework.

Small family-owned and family-managed businesses in India account for a high proportion of the investment opportunities pursued by PE funds. Typically, deal sizes are smaller in India than in other major emerging economies, but this is mainly due to the robust VC industry in the country. However, several recent investments, mostly at late stage in industries such as telecommunications and financial services, have seen deal sizes unprecedented in the Indian PE arena.6

Most of these PE funds investing in India are sector agnostic, but specialized funds are becoming more common. Infrastructure and technology are the leading industries attracting sector-specific PE funds in India. Real estate and infrastructure have gained prominence over the last 5 years as magnets for PE investments, driven by the gap in India’s infrastructure needs, and by the government’s drive to launch large-scale projects to meet the economy’s growing needs. However, dedicated vehicles targeting the agribusiness and clean technology sectors are also beginning to emerge. Some of India’s most recent entrants are focusing on niche sectors such as healthcare and education.

Large Indian corporations (e.g., Tata Group, Aditya Birla Group, Mahindra & Mahindra, or Reliance Industries) and financial institutions started to see PE as a critical part of their growth strategy. These companies have either recently begun PE operations or intend to raise third-party capital in order to do so. They have the advantage that they can operate under a unique platform, with a local presence and significant capital resources.

As India continues to build its PE industry, critical drivers for success will be the growth of domestic sources of capital and the relaxation of investment restrictions for foreign investors. Despite its internal challenges, India offers long-term economic growth and a large and growing middle class focused on domestic consumption. The country’s strong fundamentals will continue to make India an attractive destination for PE investors.

4.6.3 Brazil

Brazil’s appeal as an investment destination rests on stable government policies and a rapidly growing middle class, which has grown from 38% of the population in 2003 to 49% in 2010 (EMPEA, 2010a). Brazil is intensifying its investments in infrastructure through government-backed initiatives and private investment. PE investors are playing an increasing role in financing the growth and development of Brazil’s infrastructure.

Brazil continues to tap its massive natural resources, both biofuels and hydrocarbon, to meet its rapidly growing energy demands. The country has made major investments in the renewable energy sector over the last four decades, helping to make the country the world’s most cost-efficient producer of ethanol fuel. PE firms continue to play a pivotal role in financing the growth of the ethanol fuel industry and are also targeting other renewable energy sectors.

Brazil leads Latin American fundraising efforts.7 Although the number of active fund managers continues to increase, PE investment as a percentage of Brazil’s GDP remains low (typically less than 0.5%), compared with the penetration rate in the U.S., which typically is between 1% and 2%. In this environment, competition for deals is still minimal, and auctions are rare, but PE firms do face competition in the demand for capital from the soaring public markets. The participation of pension funds has unlocked a massive source of domestic capital for local fund managers, but some PE firms continue to target foreign LPs, citing the lack of an established LP culture among domestic institutions as a deterrent.

PE firms that raise capital abroad to invest in Brazil typically establish their funds offshore as limited partnerships although a growing number of funds are being established in Brazil. Still, more than two thirds of capital is raised by offshore funds, as international investors are the main source of capital raised and are more familiar with offshore jurisdictions.

4.6.4 Central and Eastern Europe (CEE)8

The CEE countries offer institutional investors a wide range of opportunities. Expectations for economic growth for the coming decades are promising, and the legal system is favorable to investments given the membership of many of countries in the European Union. The accession to European Union (EU) membership resulted in stability and a reduced country risk. CEE countries have good long-term growth potential. Most recently witnessed booming economies, high GDP growth rates, rising income levels, and profitable companies; however, the credit crisis has significantly negatively affected these economies.

The supply of risk capital is relatively poor in relation to the opportunities in this region and compared with other countries.9 Although raised and invested PE funds have been gradually increasing over the years, the lack of liquidity and access to debt remains a concern, as it impacts exit opportunities. The insufficient size and liquidity of the CEE capital markets is another obstacle.

While a significant source of deal flow in the 1990s, privatization has since diminished in importance in the CEE countries. A majority of the investments are made in the infrastructure, financial services, and real estate sectors. PE investors are also responding to a surging middle class across the CEE markets by channeling investments into consumer goods, retail, communications, and healthcare sectors.

Trade sales continue to play a central role in CEE. According to a report issued by EVCA in 2008, 41% of the total number and 60% of the total value of CEE PE-backed exits in 2007 were trade sales. Strengthening capital markets have made IPOs an increasingly attractive exit path, with the capital markets in Poland being the largest.

4.6.5 Sub-Saharan Africa

From a meager annual average GDP growth rate of approximately 2% throughout the 1980s and 1990s, growth in Sub-Saharan Africa peaked at 6.5% in 2007, according to the World Bank. The World Bank estimates that GDP growth in Sub-Saharan Africa will average 5.1% in 2011, significantly trumping the anticipated average of 2.3% for OECD countries.

The region’s growing macroeconomic stability has been complemented and enhanced by political reforms. Another significant factor contributing to the region’s rebound has been the strong and rising global demand for the continent’s vast resources, particularly from other emerging markets. Sub-Saharan Africa is home to 90% of the world’s platinum and chromium, 67% of phosphates, and over 40% of gold (EMPEA Insight, 2010c). China is the biggest single driver of growth on the continent, and increasingly a huge indirect competitor to PE firms in Sub-Saharan Africa.

As a result, capital flows to Sub-Saharan Africa have been growing at a rapid pace. Significant developments are currently taking place, in particular expanding the scale of investment opportunities (particularly beyond South Africa) and an improving exit environment. At the behest of local governments, and with some donor encouragement, Africa has increased the number of its domestic stock exchanges from five in the late 1980s to 15 today. Despite this modest headway, Africa’s “frontier markets”, outside South Africa, still receive a small fraction of investments. Overall, Sub-Saharan Africa still lags the PE volumes in China or India.

Investors continue to command a high risk premium for Africa which remains a complicated place to do business. The EMPEA/Coller Capital Emerging Markets Private Equity Survey (EMPEA/Coller Capital, 2010) asked institutional investors what they considered to be the primary factors deterring them from beginning to invest in Africa, inclusive of North Africa. A “shortage of experienced GPs” ranked first as the greatest barrier to first-time PE investment in the region (60% of LPs), followed closely by political risk (58%), and a weak exit environment (34%). Anecdotally, many investors also cite fragmented markets, lack of infrastructure, and health concerns, including persistently high rates of HIV infections, as key factors limiting their willingness to invest in the region. There are also concerns about whether international investors receive the same terms as local investors or, in some countries, whether a government concession might be withdrawn on a change of government. In many African countries, rules are not transparent around certain sectors such as mining and energy.

In addition to the concerns above, the currency risk presents another hurdle for PE investors. The South African rand tends to be quite volatile, as can be the Nigerian naira, which devalued by 15% amidst a banking crisis in early 2009. Investor interest in Zimbabwe spiked in the same year, when the new unity government gave up on trying to tame runaway inflation and switched to the U.S. dollar and South African rand. Some PE investors say it is too costly to hedge their investments in Sub-Saharan Africa, and some factor in large devaluations for worst case currency scenarios.

Nevertheless, Africa has made significant progress in developing its domestic capital markets. Information on African markets is improving, regulatory and financial sector reforms have been implemented, and countries are beginning to adopt modern technologies such as automated trading and central depository systems. South Africa has successfully risen to the ranks of the leading emerging market destinations.

4.6.6 Middle East and North Africa (MENA)

The PE industry has expanded rapidly in MENA, particularly in the Gulf Cooperation Council (GCC) states over recent years. Buoyed by petrodollar-fueled economic growth since 2001, local wealth has exploded, and GCC-based investors have increasingly looked at investment opportunities at home. In addition to a unified language, the GCC economies benefit from a unified economic agreement. The GCC common market, launched in January 2008, removed numerous barriers to cross-country investment. Further, GCC has one of the fastest growing populations in the world. As a result, most MENA-focused funds put GCC markets at the core of their strategies and international PE investors starting new operations in the MENA region often enter via the GCC.

Government expenditures across MENA, in areas such as infrastructure and healthcare, reached approximately USD550bn (EMPEA Insight, 2010b). In response, several sector-focused funds have formed; and, with one of the fastest growing travel industries in the world, MENA has also become the focus of several hospitality funds. The pace of PE investment has slowed recently in MENA economies, with total known investments valued at USD2.2bn in 2009 compared with USD3.4bn in 2008. With USD19.2bn raised between 2005 and 2009, and only USD11.4bn invested during the same time period, the MENA region is home to large amounts of money committed but not invested yet (EMPEA Insight, 2010b).

MENA fund managers have traditionally targeted local investors as sources of capital. The region’s sovereign wealth funds, family offices, and high-net-worth individuals have, to date, formed the core of MENA’s PE investors.

According to a recent survey of MENA, there is long-term confidence in the MENA market: 78% of surveyed firms anticipate increased investment in the near term (Deloitte, 2009). Most investments to date have represented minority stakes in family-owned enterprises, but control/buyout opportunities are likely to emerge, as many local firms face the pressures of operating in difficult economic times, as well as transitioning to third and subsequent generations of family control.

4.7 SUMMARY

The long-term appeal of the emerging markets to PE investors is undisputed. There is little doubt that these economies will become increasingly integrated into the global capital markets, and attract an increasing share of PE capital commitments, but in the short to medium term investors still face important challenges. Depending on how individual PE fund managers deal with these challenges, we would expect a greater dispersion of PE returns than in more mature markets. In addition, fundraising and investing in emerging markets, relative to developed markets, are likely to remain more cyclical. A gradual upward trend of PE capital inflows will likely make these cycles less pronounced over time.

4.8 REFERENCES

BALBOA, M., AND MARTI, J. (2007) “Factors that determine the reputation of private equity managers in developing markets,” Journal of Business Venturing, 22(4), July, 453–480.

BERNOTH, K., COLAVECCHIO, R., AND SASS, M. (2010) “Drivers of private equity investment in CEE and Western European countries,” working paper, DIW Berlin, German Institute for Economic Research.

DELOITTE (2005) Seven Disciplines for Venturing in China, Research Study, Deloitte Research.

DELOITTE (2009) Shaping Up for 2010: MENA Private Equity Confidence Survey, Deloitte Corporate Finance.

EMPEA (2010a) Fundraising and Investment Review, Emerging Markets Private Equity Association, April 2010 report.

EMPEA (2010b) Quarterly Review, VI(1), Emerging Markets Private Equity Association.

EMPEA/COLLER CAPITAL (2010) Emerging Markets Private Equity Survey.

EMPEA INSIGHT (2008) CEE/CIS: An Overview of Trends in Select Sectors and Markets, Emerging Markets Private Equity Association, July 2008 report.

EMPEA INSIGHT (2009) India: An Overview of Trends in Select Sectors and Markets, Emerging Markets Private Equity Association, July/August 2009 report.

EMPEA INSIGHT (2010a) Brazil: An Overview of Trends in Select Sectors and Markets, Emerging Markets Private Equity Association, May 2010 report.

EMPEA INSIGHT (2010b) MENA: An Overview of Trends in Select Sectors and Markets, Emerging Markets Private Equity Association, March 2010 report.

EMPEA INSIGHT (2010c) Special Edition: Private Equity in Sub-Saharan Africa, Emerging Markets Private Equity Association, November 2010 report.

FURTADO, C. (2010) “Overview of the Brazilian private equity and venture capital industry,” ABVCAP Conference, Rio De Janeiro.

GOMPERS, P., AND LERNER, J. (2000) “Money chasing deals? The impact of fund inflows on private equity valuation,” Journal of Financial Economics, 55(2), February, 281–325.

GROH A., AND VON LIECHTENSTEIN, H. (2009) International Allocation Determinants of Institutional Investments in Venture Capital and Private Equity Limited Partnerships, Financial Management Association (FMA), Reno, NV.

LERNER, J., AND SCHOAR, A. (2004) “The illiquidity puzzle: Evidence from private equity partnerships,” Journal of Financial Economics, 72(2), 3–40.

PERRYMAN, E. (2010) Sovereign Wealth Funds Assets Grow to USD 3.51trn, Private Equity Wire, Hedgemedia.

RAJAN, T., AND DESHMUKH, A. (2009) “On top of the world; still miles to soar: An analysis of venture capital and private equity investments and exits during 2004–08,” working paper, Indian Institute of Technology.

ROXBURGH, C., AND LUND, S. (2009) “Look to emerging economies,” Forbes.com

SCHOAR, A., AND LERNER, J. (2004) “Transaction structures in the developing world: Evidence from private equity,” MIT Sloan Working Paper No. 4468-04.

SEIU (2008) Sovereign Wealth Funds and Private Equity: Increased Access, Decreased Transparency, Service Employees International Union.

a This chapter has been co-authored with Sonia Katyal.

1. It is worth noting that more than two thirds of the LPs surveyed recently plan to increase their exposure to emerging countries in the future (EMPEA/Coller Capital, 2010).

2. Together with South Africa–focused funds expanding in other African countries, new funds started to focus exclusively on fast-growing markets such as Nigeria and Kenya or on less competitive markets, including Angola and Zimbabwe.

3. Judges develop common law through the decisions of courts and similar tribunals, rather than through legislative statutes or the actions of states’ executive branches. That is, common law is based on precedent. Common law systems are usually found in emerging countries that trace their legal heritage to England as former colonies, such as Malaysia, Pakistan, India, and South Africa. Most Latin American countries as well as Russia and China, have legal systems based on the civil code, which relies on state-initiated legislation.

4. Stock exchanges recognized these funds as investment companies and, thus, restricted their investments. For example, the London Stock Exchange (the most common listing for CDIFs) required that such funds invest only as a minority investor, taking less than 49% of stock of the target investee firm. Typical additional listing regulations required CDIFs not to play a significant role in management of the firm or place more than 20% of the fund in any one investment.

5. RMB-denominated funds can be domestic or foreign-invested funds. Domestic funds are raised from Chinese investors and governed by laws relating to domestic commerce. Foreign-invested funds are either fully or partially owned by foreign investors. Hence, they are subject to laws governing foreign investments in China.

6. Nearly 70% of PE–VC investment deals in India are valued below USD20mn. This is similar to PE investments in the U.K., where 77% of deals are below GBP10mn. Also, only 5% of deals in India have been above USD100mn in size (EMPEA Insight, 2009).

7. As of December 2009 approximately USD39bn of funds were available for PE investments in Brazil, a large increase from the USD5bn available in 2000 (Furtado, 2010).

8. CEE comprises the countries of Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia.

9. The ratio of private equity investments measured as a percent of GDP of the CEE region was 0.21% in 2008, much lower than the ratio in the European Union (0.40%) (Bernoth et al., 2010).