Why private equity boosts developing economies

Inclusive Economy10 Nov 2014Matthijs de Bruijn, Som Toohey

Despite deep-rooted criticism of the private equity industry, the private equity model is increasingly being used as an instrument for sustainable growth of the private sector in developing countries. SMEs are no exception.

The private equity industry does not generally have a good image. In the media, it is often portrayed stripping companies of assets, loading them up with high amounts of debt, reducing employment or dodging taxes. There is no doubt that there is sometimes validity in these claims.Yet there is also an underexposed side of the industry where it is an effective model for sustainable development and an important source of risk capital in countries with shallow capital markets and underserved SMEs. Private equity, through a long-term horizon, a focus on value creation, a fexible investment approach and a strong position of influence to improve Environmental, Social and governance (ESG) standards can provide a sustainable solution.

Private equity in developing countries

PE investing has been utilized for well over two decades by development finance institutions (DFIs) and by commercial PE firms as a method to invest in developing countries. Most of these firms envisage realising economic and social change as a critical a part of their success. The International Finance Corporation (IFC) has also pointed out that the vast majority of private equity capital flows to emerging markets is in the form of growth capital using relatively little leverage. The most recent development is the adoption of the model by ‘impact investors’, who specifically aim to realise a beneficial social or environmental impact alongside a financial return. We have identified four main characteristics of the PE model which could explain why it can be appropriate for developing and enhancing the private sector of emerging economies.

1. Long-term investment horizon

PE fund managers have a long-term investment horizon, with the regular lifespan of a closed-end PE fund being ten years and the average holding period of an investee company being five years. The long-term commitment and involvement of a private equity investor ensures that there is sufficient time and a stable environment to put an expansion or professionalization plan to work. This is a prerequisite for successfully growing a business in developing markets, as constraints in the business environment – such as bureaucracy, access to energy or unreliable tax regimes – call for patience.

2. Value creation

A strong focus on improving a company through active management such as through board seats is key to the PE model. Fund manager team members often have previous boardroom experience, a good business network and specific sector or technological expertise. Companies can tap this expertise and use the network of its investor. This focus on growth and knowledge transfer is unique to the PE model and is in great demand in developing countries.

3. Flexible investment approach to fill the financing gap

PE can be flexible, allowing the provision of tailor-made financing solutions appropriate for the individual company’s cash flows. It can target companies in all stages and sectors, including SMEs. The World Economic Forum has coined SMEs in emerging markets the ‘missing middle’ – enterprises that are too large to receive finance from microfinance institutions and too small for bank finance. Yet at the same time SMEs are the engine of social and economic development, being the primary source of new job creation and a key contributor to GDP growth. An example in SOVEC’s portfolio is the case of a growing housing company taking informal contractors onto its formal payroll. This helped the company retain knowledge, provided employees with regular steady income and promoted financial inclusion by opening bank accounts for these previously unbanked people.

However, SMEs in emerging markets are often constrained due to inadequate access to capital. In fact, according to IFC data up to 68% of formal SMEs in developing countries are unserved or underserved financially. The fundamental problem is that banks are wary to give out loans to SMEs, as they often lack fixed assets and have low cash reserves, or charge excessively high interest rates. PE offers an alternative: it can provide capital without these high interest rates, by participating in a share of the profits and sharing in capital gains instead. In addition, PE has the ability to target and boost all sectors of a developing economy, creating a diversified portfolio, unlike stock market investments in these countries.

4. Opportunity to improve ESG

PE investors are well-positioned to improve the environmental, social and governance (ESG) management of a business, mainly for two reasons. Firstly, due to a general lack of knowledge of the business case for sustainability in developing markets, PE fund managers can play a crucial role in introducing or improving ESG management. Secondly, PE’s long-term horizon provides the prerequisite for ESG improvements to really materialise. Patience and time are needed, as improvements in this field are not usually quick fixes. They may even require a change of culture among employees, such as in the case of enhanced health & safety procedures.

Awareness among fund managers that ESG can mitigate risks and offer opportunities to add value only notably appeared over the last few years, but is gaining recognition rapidly. According to research by PwC, 71% of private equity firms currently include ESG aspects in their due diligence processes. Apart from managing risks, ESG management also provides opportunities for fund managers to generate more value. There is often potential for substantial cost savings through energy efficiencies, reduced use of resources or improved waste management. These are environmental issues but also clear business concerns. In addition, there are opportunities to improve governance. This is particularly important in Sub Saharan Africa and South Asia, where businesses are frequently still operated informally or based on family structures. Companies can receive a major boost by seemingly basic measures, such as setting up board committees, establishing performance indicators or improving auditing. Therefore ESG management can mitigate risks, improve the value of a business and benefit society.

Effective private sector development

A shortage of capital is still considered as one of the major constraints to private sector development in developing countries. As this article shows, PE can be a highly effective model for providing capital and growing businesses sustainably in developing economies. It can particularly be suitable for realising inclusive growth of SMEs, as it can create several characteristics of an enabling environment for SMEs that were discussed previously on the Broker.

Government agencies, impact investors and institutional investors such as family offices and pension funds should therefore not be deterred by the image of the industry in Western markets, but should consider committing to specialised emerging markets fund managers. It could provide an opportunity to not only generate attractive returns by tapping rapidly growing economies with a diversified portfolio, but also to effectively contribute to private sector development.