The World Is Not Very Flat In Emerging Markets......

Raising Funds in Emerging Markets

The private equity industry in the emerging markets have been growing at astonishing speeds, however the bulk of capital has traditionally been sourced from North American and European institutional investors. There is serious change in progress. As economic stagnation continues in the developed nations, general partners are looking to institutional investors from many of the emerging markets.

To this end, general partners are realizing that traditional ‘unwritten rules and understandings’ between GP’s and LP’s, so strongly advocated by organizations such as ILPA, are being ‘re-written’. When approaching investors from emerging markets, one must first understand the business culture in an emerging market. At the risk of over-generalizing the facts, there are many similarities in how investors approach deals in any emerging market.

The first thing any general partner will notice is that many institutional investors from emerging markets will want to take part in the investment decision. The second thing any general partner will also notice is that institutional investors will want quicker exit times from portfolio companies and ultimately a shorter life-cycle for the fund itself.

So why do investors from emerging markets want these provisions before making a commitment?

We need to understand the dynamics of an emerging market before we can answer this. Tracking of an investment and a lack of world class (and... trustable) management has always been a point of concern in the emerging markets. One way to solve the problem was to have the investor take an active role in the company in order to protect its interests.

Wild economic swings are a common characteristic in any emerging market. The term ‘long term asset allocation’ has a different meaning to an investor from an emerging market than to an investor from a developed market. Traditionally, investors in emerging markets like to exit within two or three years from any deal.

Many traditional investment ‘rules’ have clearly been transferred to the private equity realm. The rules are changing and many general partners and industry organizations from developed markets must adapt if they wish stay in the business.

 

Evolution of the Chinese Private Equity Sector

Guo Guangchang, one of the most prominent investors in China, is betting big on the fast-growing domestic market.

via dealbook.nytimes.com

According the an article in the New York Times, some Chinese private equity firms are looking for deals to invest outside of the country. We can draw several conclusions from this event, of which the foremost should be the acknowledgement that that Chinese economy is rapidly transforming from an 'emerging market' to a 'developed market' (if you have to categorize).

This important act of diversification will prove well in an environment where many global investors are increasingly concerned with whether China will continue to keep its break-neck growth. It is a great way to mitigate any homegrown (domestic) risk. It is also a great investment strategy based on consolidation and international growth for local Chinese portfolio companies.

Obviously there are also several other conclusions we can draw from this: the high valuations in the Chinese market (which the article claims is one of the primary drivers for PE firms looking outward) is an indication that real incomes (and therefore real costs) are also on the rise in a country that relies on low cost manufacturing labor to keep its economy on the growth path. To this end, it is increasingly becoming clear that the Chinese economy must undergo significant transformation into an innovation/services based market.

 

Moving forward in EMEA with Private Equity

I am being asked about the social uprisings across the Middle East region on a daily basis and its effects on private equity so I thought to write some of my thoughts on the matter.

The first thing we should remember is that in the long run, what is happening in the Middle East emerging markets are akin to the fall of the Soviet Block in the 80's. They are socially, politically and economically a game changing phenomenon for the region... which is clearly long overdue. The shift, however gradual, of power from the hands of the few to the hands of the many is something we should all cheer for.

The second thing we should remember is that this transformation will not be an overnight event. Even if actual power changes hands, the effort required to transform the social, political and economic constitutions of these states will be difficult. I guess it all starts with the first step.

So, what does this mean for private equity?

Valuations are all over the map and there is a reason for this. It is critical for PE firms to put additional weight in determining the political exposure for each company in the region. There is a chance that those companies with strong state connections may be at high risk. There is also the risk of maneuvering through the liberalization of the economy. No one knows how it will unfold and transitions such as these have historically proven to be filled with a variety of risks for investors.

Having said this, beyond the immediate short-term, there is tremendous economic potential throughout the region. I predict it to be one of the highest growth areas in the world within the next three years... taking it's place next to the Asian and South American emerging economies.

It is time for private equity do its homework and mobilize.

 

SaaS: Do not confuse business model with pricing strategy!

The rapid proliferation and success of the SaaS (software as a service) business model over the past several years is astonishing. The business model has many advantages over conventional software or services firms and it owes its sudden expansion primarily to infrastructure advances in bandwidth and increasingly sophisticated development platforms.

However, investors (particularly angel investors) as well as entrepreneurs should not confuse "business model" with "pricing strategy". I come across several investors and entrepreneurs refer to SaaS businesses as a 'pay-as-you-use' business. This mix-up in terminology is not only misleading but will certainly lead to a bad investment.

SaaS is a business model that delivers a particular information or service via the internet, which in the past would require the end user to integrate/implement large amounts of software on it's own servers.  As is the case with any other business model, various pricing strategies can be applied to an SaaS business (pay-as-you-go, etc..).

VC and PE Investment Diversification

Over the past several weeks, I have been approached by at least three people asking me what it means for VC's and PE's to diversify their portfolio.

It depends what you mean by 'diversification'. In short, any 'diversification' criteria is often predetermined during the formation of the fund. Each investment a fund undertakes should (in theory) fit the investment strategy and objectives of the fund managers. 

Diversification in terms of capital allocation:
On the most part, the rule of thumb is (as James Law pointed out in his comment above) to have no more than 10-15% of your total capital allocated to a single portfolio company.

Diversification in terms of investment strategy:
An investment strategy ultimately determines the level of risk a fund will undertake. There are many types of investment strategies (consolidation, etc...) and most LP's will require a clear understanding of the general number/type/sector of investment a fund will undertake in order to mitigate risk.

Risk / Return Themes For Private Equity Investments

Our world is changing and in response, risk vs. return themes and profiles are also registering substantial shitfs. It is important to know exactly what these new themes are.

Current relevant RISK theme:

Credit Risk. Before the financial crisis hit, there were a large grouping of companies that relied on a steady flow of credit from banks to feed their OPEX in order to grow. These companies have always had good management and their markets were showing healthy signs of steady growth. Many private equity firms did not see much risk in their way of operation (or at the very least they did not put much weight on the potential risk these companies posed).

The risk profiles of these companies has changed dramatically. Without adequate credit, many of these firms have been forced to liquidate large portions of their operations. Within a single quarter, we saw these companies go from healthy to distressed due to a lack of OPEX capital.

Current relevant RETURN theme:

Stability. The primary return expectations have also changed dramatically over the past six months. Private equity and venture capital firms have consistently performed under par of what they originally promised to their limited partners. Expectations of grand returns during a severe downturn in overall global valuations is unrealistic and therefore most LP’s have opted for stability rather than growth.

At least for the time being, I believe LP’s are more concerned with ‘safety’ rather than ‘aggressive growth’. The problem here is that a private equity firm is not designed for ‘safety’  but rather tends to concentrate on aggressive risk taking.

In the new and transformed investment world of today, I believe private equity firms must be able to shift their focus rapidly between aggressive growth and stability as LP’s are now demanding more rights and flexibility from GP’s.

It will be very interesting to see the sea of change that is up against the private equity and venture capital worlds.

Co-invest or Not to Co-invest

Tough economic times often bring a heightened sense of risk aversion for private equity and venture capital players. This is the case in the most developed of economies and in those that are developing, i.e. Turkey and the Balkan region.

One way to reduce risk is to allow co-investors into your deals.

The benefits of co-investing into deals are obvious: sharing of due diligence work, resources, best-practices and know-how. The ultimate goal is to be able to share the risk of investment.

As appealing as it may seem, there are several other factors that I believe PE and VC firms must be mindful of when experimenting with co-investment opportunities. First and foremost, the identification of a potential co-investor will most probably divert more resources from your firm that what is often initially planned. Almost everyone in the PE and VC community has ample experience in trying to identify fresh funding for new companies. This is primarily an exercise in exactly that: identifying new sources of funding for your deal. It can be challenging to find the right investor for the right deal.

Size of the deal matters when considering co-investment partners. All private equity and venture capital firms have target investment sizes and other criteria that their deals must meet. It is often difficult to compress and balance all of the criteria of multiple investors into a successful deal. The chance of the deal falling apart also increases as the number of co-investors increase.

Beware of the ego. For some reason the ego problem is much more prevalent in private equity and venture capital firms in developing nations than they are in more developed economies. That is simply what I’ve noticed over the years – however other investors may certainly have different experiences with competing egos. After all, it is human nature to try to become the hero – it just becomes rather complicated when we are dealing with other people’s money!

All PE and VC firms have set agendas and strategies for when they enter deals. Co-investment may produce tremendous conflicts of interest from the moment of closing until the actual exit. Each investor will have varying ideas and demands on how to grow their portfolio companies (organic or inorganic), who will manage the growth, when to consider an exit, what the exit strategy will be, etc… A refined definition, understanding, and agreement of all voting rights is an absolute must when going into a co-investment deal.

Although co-investment may sound like a good idea at the outset, it can turn into an unproductive deal at the end of the exercise. This is especially the case when working in developing nations. Investors must be ready for a bumpy ride.

 

What can the Balkan Region Learn From the Western Markets?

It is often regarded that the Balkan Region must have to ‘learn’ from Western markets and not the other way around. I’ve now been living in Turkey since only last summer so it hasn’t even been one full year, however I can assure you that there is plenty of learning to do on both sides of the coin.

I do not believe in the fact that ‘best practices’ and ‘know-how’ are what the region can take from western markets. More often than not, many industry experts in this region have received their grooming in western companies in the first place. They automatically bring ‘most’ of the practical knowledge with them as they represent western funds/capital.

There are, however some general complaints I often hear from local private equity and venture capital players. These are:

1.     Lack of good deals

2.     Unreliable management

3.     Inadequate book-keeping and accounting practices

4.     Deal sizes often too small

5.     Lack of overall transparency and growth opportunities

Ironically, these have been the EXACT same complaints and arguments I hear from Californian investors. It seems private equity and venture capital must solve similar challenges in each region. After all, we are in the business of identifying the right deal and increasing its value before exit. This template is the same wherever you go.

So, what is it really that the Balkans region can learn from the West?

The answer is not what it can learn from the west, but what it can teach itself.

Most funds in the US are capitalized by actual US investors whereas a large majority of the funds in Turkey (and I’m assuming the Balkan region as well) is capitalized by foreigners – primarily US or European investors.

In my opinion, the critical lesson all Turkish investors must ‘teach themselves’ should be the ability to communicate the reasons why foreign investors should choose this region as opposed to any other. Turkish funds must realize that international investors do not have adequate knowledge about Turkey as they do on other places such as China, Brazil and Russia.

I have yet to see a compelling presentation as to why any investor should choose Turkey over other developing nations for their investments. I have not yet seen rates of return on private investments as compared with other nations across the globe (or even for that matter, with other European nations).

If Turkish funds want to capture more investors then they must be able to show them actual concrete evidence why choosing Turkey would be an advantage.

Which investors are interested in Turkey and the Immediate Region?

In light of the epic restructuring that is taking hold of the global financial markets, we have been witness to wild fluctuations in investor appetite for emerging markets – specifically for Turkey.

The question is not ‘which’ investors are interested in Turkey as we still see the usual suspects in the market for deals. The questions would be more appropriate as: ‘how has investment strategies changed throughout the region’?

It should come as no surprise that private equity and VC players tend to be some of the most flexible and diverse investment platforms available and to this end, they often have an uncanny ability to shift gear in times of uncertainty. This is why many players that I speak with have either altered their investment strategies or have consolidated their positions considerably.

In terms of investment strategies, I’ve mentioned in previous posts that private equity and venture capital has essentially taken up the void in the credit markets left by banks. Many of these institutions are now focusing on structured debt instruments as their primary offering to both private and public companies across the region. The days of buy-outs seem to (at least for the time being) have left us.

In addition to this new investment strategy, there is considerable consolidation of portfolio companies being realized. I heard from a good source that some private equity players are offloading their portfolios at an average discount rate of 75%.

We should be mindful that as the economy turns positive, many of these ‘new’ investment strategies will once again be shelved in exchange of ‘buy-outs’.

Why Taxing Private Equity Will Not Work

I’ve said this many times and I will say it again: The ongoing debate about taxing private equity and hedge funds is only a media campaign for those who want to take advantage of the public misunderstanding with regard to the workings of these two sectors.

There is an alternate way to look at this situation: Trying to tax the private equity and the hedge fund sectors (or bringing them under SEC control, as it is proposed in the United States) is no different than certain governments who are actively trying to block websites (youtube, blogs, etc…) from the reach of their citizens. It is absolutely impossible.

As difficult as it may be for regulators to admit, there are an infinite ways of stepping around any tax/regulatory barriers placed in front of financial institutions. Just think about how our current financial crisis came to be? It wasn’t that the SEC or other regulatory bodies were caught sleeping at the wheel, it was because the financial institutions (and their army of international tax lawyers) were able to circumvent them in order to provide new investment instruments to their ‘trillion dollar’ client lists. Consequently this is why throwing money at the problem will not solve anything, but that is another Pandora’s Box I will not open.

This is not about evading the law. This is about competition and it is about investor satisfaction… which inevitably boils down to maximizing returns and minimizing taxes. It is as natural an instinct as getting out of the way of an oncoming vehicle.

Many of the private equity and hedge funds in the United States are already registered in foreign countries through what are referred to as ‘feeder funds’: for the US it is generally the Cayman Islands and for Europeans, it is Guernsey. This sector is remarkably flexible and seems to be able to adapt to any challenge. It is driven principally by investors and therefore it is determined with the capital of the very people who are actually trying to obstruct the sectors operations.

Having said all this, I have to admit that I often see some companies take spectacular risks with investor capital. There is no law against risk (and without taking any, there would not be progress), however I do believe that the sector should be more transparent and responsive to its primary clients: pension funds, practically every government institution, municipalities and oh yes… the private sector investors as well. The sector needs to communicate the risks they are willing to take in order to make their clients make more money. If their clients are not comfortable with the levels of risk, they should be allowed to pull out.

Upon a continuous barrage of news on the topic on Bloomberg and President Obama this morning, I found myself in front of the blog trying to articulate my two cents.