Special Evaluation Study on Private Equity Fund Operations

Evaluation Study Reference Number: SST: REG 2008-17 Special Evaluation Study July 2008 Private Equity Fund Operations Operations Evaluation Department ABBREVIATIONS ADB – Asian Development Bank AIG – American International Group AISF – AIG Indian Sectoral Fund APVL – Asia Pacific Ventures Limited ASEAN – Association of Southeast Asian Nations CAGR – compound annual growth rate CalPERS – California Public Employees Retirement System CAPE – country assistance program evaluation CAPM – capital asset pricing model CLASS – comprehensive loan administration and servicing system CPS – country partnership strategy CSP – country strategy and program CTL – Controller’s Department DMC – developing member country EBRD – European Bank for Reconstruction and Development EMPEA – Emerging Markets Private Equity Association ESHS – environmental, social, health, and safety FDI – foreign direct investment FIRR – financial internal rate of return GDP – gross domestic product HQPV – H&Q Philippine Ventures Incorporated ICICI – Industrial Credit and Investment Corporation of India ICT – information and communication technology IFC – International Finance Corporation IL&FS – Infrastructure Leasing & Financial Services Limited IVCL – IL&FS Venture Capital Limited LAPIC – Lombard Asian Private Investment Company LNWCEI – Liberty New World China Enterprises Investments MDB – multilateral development bank NPL – nonperforming loan OED – Operations Evaluation Department OGC – Office of the General Counsel OIST – Office of Information Systems and Technology PAU – Project Administration Unit PCR – project completion report PEF – private equity fund PPER – project performance evaluation report PPP – public–private partnership PRC – People’s Republic of China PRISMS – private investment securities management system PSCM – Capital Markets and Financial Sectors Division PSDS – private sector development strategy PSIM – private sector investment management PSOD – Private Sector Operations Department RMU – Risk Management Unit RRP – report and recommendation of the President RSDD – Regional and Sustainable Development Department SMEs – small and medium-sized enterprises SOE – state-owned enterprise WAAVC – Walden AB Ayala Ventures Company WACC – weighted average cost of capital GLOSSARY Additionality – This evaluation parameter consists of two components: (i) the extent to which ADB finance was a necessary condition for the timely realization of the project, directly through mobilization of funds and/or indirectly by providing comfort to other financiers; and (ii) ADB’s contribution to the design and functioning of the project to improve development impact. Carried interest – A fund manager’s share (typically about 20%) of capital gains on investments returned to investors, net of the hurdle rate. Fund – Entity in which investor’s funds are held Hurdle rate – Preferred return on investment paid first to fund investors before calculation of the fund managers’ carried interest (typically about 8% per year) Management fee – Annual fee for investment funds calculated on committed or invested capital (typically 2.0%–2.5% per year) Frontier Countries – Developing Member Countries other than India and the People’s Republic of China Fund manager – Entity that manages the fund NOTES (i) In this report, "$" refers to US dollars. (ii) For an explanation of rating descriptions used in this evaluation report, see: ADB. 2007. Guidelines for Preparing Performance Evaluation Reports on Nonsovereign Operations. Manila. Key Words additionality, asian development bank, business success, country strategy, development impact, financial sector, asia, pacific, investment fund, performance evaluation, private sector operations department, private equity, infrastructure, venture capital, small and medium-sized enterprises, pensions, capital markets, institutional investors, work quality Director General H. S. Rao, Operations Evaluation Department (OED) Director R. B. Adhikari, Operations Evaluation Division 2, OED Team leader B. A. Finlayson, Senior Evaluation Specialist, Operations Evaluation Division 2, OED Team members J. Dimayuga, Evaluation Officer, Operations Evaluation Division 2, OED M. Tagud, Senior Evaluation Assistant, Operations Evaluation Division 2, OED Operations Evaluation Department, SS-91 CONTENTS Page EXECUTIVE SUMMARY i I. INTRODUCTION 1 A. Background 1 B. Study Objectives, Methodology, Scope, and Sources of Data 1 C. Organization of the Report 4 II. RATIONALE FOR PROMOTING PRIVATE EQUITY FUNDS 4 A. Overview of Market Trends 4 B. Good Practices 5 III. ADB’S STRATEGIES AND ASSISTANCE PROGRAMS 8 A. Strategic Objectives and Scope of Operations 8 B. Public Sector Operations 9 C. Private Sector Operations 10 IV. PRIVATE EQUITY FUND EVALUATION 19 A. Overview 19 B. Rationale and Objectives 20 C. Development Impacts and Outcomes 20 D. ADB Investment Profitability 29 E. ADB Work Quality 33 F. ADB Additionality 39 G. Overall Assessment 39 H. Conclusions 40 V. ISSUES, LESSONS, AND RECOMMENDATIONS 40 A. Issues 40 B. Lessons 50 C. Recommendations 51 APPENDIXES 53 1. ADB’s Private Equity Portfolio 53 2. Overview of Trends in Investment Funds in the Asia and Pacific Region 55 3. A Literature Review of Good Practices 67 4. Performance Evaluation Reports 79 5. Review of ADB’s Private Equity Fund Management Operation 88 6. Evaluation of Financial Internal Rate of Return and Weighted Average 98 Cost of Capital The guidelines formally adopted by the Operations Evaluation Department (OED) on avoiding conflict of interest in its independent evaluations were observed in the preparation of this report. Joseph C.F. Lufkin was the consultant. To the knowledge of the management of OED, there were no conflicts of interest of the persons preparing, reviewing, or approving this report. EXECUTIVE SUMMARY A. Introduction and Background Investments in private equity funds (PEFs) are a core activity for the Private Sector Operations Department (PSOD). The Asian Development Bank (ADB) made its first PEF equity investment in 1983. Between 1983 and 31 December 2007, investments in a total of 75 PEFs were approved with a combined value of $900 million. At 31 December 2007, PSOD had 40 active funds with a total approved value of $676.4 million. The increase in the level of investment in PEFs within ADB’s operations since the last Operations Evaluation Department (OED) evaluation five years ago, the significant size of the PEF portfolio in relative terms compared to other peer development agencies, and a forecast increase in PEF approvals in 2008, indicate that it is an opportune time to independently reevaluate the PEF portfolio. The objective of this special evaluation study is to independently evaluate PEF operations, draw lessons, and identify ways in which its contribution to supporting private sector development through the use of PEF instruments can be enhanced. The special evaluation study follows OED’s Guidelines for Preparing Performance Evaluation Reports on Nonsovereign Operations. Private equity in emerging economies has grown rapidly over the last five years into a multibillion dollar industry. Asia is the dominant destination for private equity among emerging economic regions, and annual fundraising has risen from $2.2 billion in 2003 to an estimated $23.1 billion in 2007. While these private capital flows are substantial and growing rapidly, allocation is quite narrow across countries and sectors. In Asia, investment is concentrated in India and the People’s Republic of China (PRC). The fostering of high-growth small and medium-sized enterprises (SMEs) and catalyzing productivity improvements in existing businesses are seen by governments and development agencies as important policy objectives in many developing member countries. Virtually all multilateral development banks and bilateral development finance institutions invest in PEFs as part of their efforts to promote SMEs. PEFs provide a means of improving SME access to technology and equity capital. By the mid-1990s, multilateral development banks such as ADB had become important participants in the PEF market in Asia, to help catalyze third-party private equity in the region. Despite the high level of sophistication of the financial structures used in the private equity industry, financial performance has been low and highly skewed. Unless investors in PEFs were with a top performing manager, evidence indicates that better returns would have been achieved investing in bonds. PEFs have formed an important component of ADB's Private Sector Development Strategy approved in 2000. Within this framework, ADB’s public sector regional departments are responsible for developing the enabling environment, whereas PSOD takes the lead in directly catalyzing investment. A review of ADB’s country strategy and programs indicates regional departments have been most active supporting PEFs in the large, relatively advanced, rapidly transforming economies such as India and the PRC. Regional departments have been creating enabling conditions for SMEs (and indirectly PEFs) in these countries by pursuing reforms in areas such as strengthening local equity markets and helping remove investment restrictions on pension funds. Reforms of the enabling environment that is directly beneficial for private equity has been limited in countries such as Indonesia, Pakistan, the Philippines, and Thailand, where PSOD was active investing in PEFs in the past. ii PSOD has targeted medium-sized funds in developing member countries, with a particular focus on SMEs in

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