Options to Support Private Equity Investment in Georgia

P O L I C Y B R I E F I N G 0 5 | 2 0 2 0 G E O R G I A

Options to support private equity investment in Georgia

Dr Alexander Lehmann

Berlin/Tbilisi, September 2020

I. Policy challenges for Georgia II. Recent trends in private equity in emerging Europe and rationales for state support III. Types of state support to private equity in mature capital markets IV. Alternative models of equity support V. Recommendations for Georgia

Distribution of Net Debt to EBITDA by company size • In GET Georgia (2019) we found a 100% large share of firms at risk from 80% excess leverage. 38% of firms 60% showed a net Debt to EBITDA ratio 40%

20% >4, representing 40% of assets in

0% the entire sample or 52% of all debt complete large medium in the sample. >=4 <4 <3 <2 <1 • The interest coverage ratio, as a Sources: SARAS database and GET calculations. Distribution of the Interest coverage Ratio by company size measure of liquidity risk, was below

100% the threshold of one for 38% of

80% firms. 60% • The current recession (Sep-2020 40% IMF estimate: -5% contraction) will 20% impact small enterprises in the large 0% tourism and hospitality sector complete large medium

<1 <2 <3 >=3 particularly hard.

Sources: SARAS database and GET calculations. © Berlin Economics 4 Options to strengthen equity capital in Georgia

• There is limited scope to avert the impact of the current recession on corporate balance sheets, which arises from the adverse demand shock, an uncertain outlook for certain business models (retail, tourism, hospitality), and possibly disrupted financing. • Firms with significant debt distress will require a debt restructuring from their respective bank, which the NBG should encourage through supervisory dialogue and guidance; the new insolvency code (“On Rehabilitation and Collective Satisfaction of Creditors”) defines a good framework for a court-based process (and will inform private restructuring solutions). • For a more broad-based injection of equity into the corporate sector, there are basically only three options: 1. Private equity funds: in a young market such as Georgia, these will likely operate in partnership with an international financial institution (IFI), such as EBRD, IFC, or EU fund; foreign funds may find individual targets in Georgia, though cross-border activity is minimal, and even more unlikely in the present recession. A small number of investee companies (<10) in the next 2-3 years is realistic, though growth in and demonstration of sound governance by investee firms may benefit the corporate sector more broadly. 2. Bank-based equity business: potentially significant, benefitting a wider range of SMEs, though raises prudential concerns and governance problems. 3. Further capital market development, encouraging IPOs, or FDI: this is not a short-term solution, and will likely benefit only a small number of companies. ➢ We will focus on private equity funds in this presentation. © Berlin Economics 5 II. Recent trends in private equity in emerging Europe and rationales for state support

• Figures from Invest Europe show that fundraising by private equity fell to EUR 1.4 bn in 2019, a large part of which (38%) was derived from governments and multilateral institutions. Nearly half of that total was directed to venture capital funds. • By contrast, investment has risen to EUR 2.9 bn. This was directed to 464 companies, though total volumes and distribution across countries was to a large extent driven by a few large deals (e.g. in Estonia or Serbia). The total volume represents less than 0.2% of the region’s GDP (which is well below an already low EU average).

➢ Private equity remains a niche financial product in emerging Europe. ➢ The CEE region has not participated in the growth of private equity in Europe: total European PE investment was up by 10% to EUR 94 bn, and the sector has EUR 782 bn capital under management. ➢ Globally, the ‘search for yield’ has fuelled funding flows to PE funds, which are estimated to now manage USD 8 tr, of which a significant share is ‘dry powder’ of committed but not-yet-invested funds.

Fundraising Fundraising by fund type

4,500 EUR m 4,500 EUR m Venture capital Growth capital Buyout fund 4,000 4,000 Mezzanine fund Generalist fund 3,500 3,500 3,000 3,000 2,500 2,500 2,000 2,000 1,500 1,500 1,000 1,000 500 500

0 0

2014 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2015 2016 2017 2018 2019 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Investment value Investment value in key countries EUR m EUR m 4,000 1,2002,505 2016 3,500 2017 3,000 900 2,500 2018 600 2,000 2019 1,500 300 1,000 500 0

Other

Latvia

Serbia

Poland

Croatia

Estonia

Ukraine

Bulgaria

Slovakia

Slovenia

Hungary

Romania

Lithuania

2014 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2015 2016 2017 2018 2019 CzechRep. Source: Invest Europe © Berlin Economics 8 Typical obstacles in the regulatory framework of emerging markets

• Key targets for private equity investment are companies with a moderate valuation, a record of growth and with some potential that investor involvement in operational restructuring will bear fruit. • EBRD (2015) identified 40,000 firms in emerging Europe, which in terms of profitability, size and growth met the characteristics of their own (successful) PE portfolio. Only 2% of these firms had actually received PE investment. • In GET Georgia (2018) we reviewed empirical studies on the determinants of PE activity in emerging markets. These lie in the economic growth, and number of growth companies at appropriate size, innovation record, and the depth of the capital market as a potential ‘exit’ path. But regulatory factors also matter: – Taxation (level and ease of tax administration). – Corporate governance (including disclosure by companies), security of property rights and the quality of the legal enforcement. – Human and social environment, including the quality of education, and labour market rigidities.

• State support to equity finance is widespread. This is clearly the case for venture capital (given the inadequate track-record of start-ups), though also for the more mature growth companies funded by private equity. • All five forms of market failures are relevant in Georgia: – Information asymmetry: the private sector is unable to access information about the true quality of projects in investee companies (an argument used to justify VC support); – Barriers to entry for private equity investors (e.g. due to regulation) – Inadequate risk bearing capacity: the private sector is constrained in capital or diversification options. – Externalities. Private investors do not capture the full benefit of supporting a market infrastructure (e.g. when audit or legal services are established that subsequently benefit others), or from the growth in investee companies. Hence they under-supply risk capital. – Regulatory and tax distortions need to be redressed, e.g. corporate governance problems limit minority shareholder rights, or taxation raises the relative price of equity over debt. ➢ Pinpointing the nature of market failure is key to designing the right instrument, and limiting state support in terms of type and duration.

• In immature capital markets private equity funds are typically established with support of an IFI. In emerging Europe, EBRD is the lead agency, and the single largest investor. • Key aspects of the strategy are: – Portfolio companies are primarily SMEs, which confront greater obstacles in accessing equity capital, and in young markets typically a ‘generalist’ approach (as opposed to sector- themes). – Support to private equity firms with a track record; seek to attract other institutional investors into funds as limited partners (‘LPs’). Investment also in successor funds, with expectation that capacity and access to investor funds gradually make IFI role redundant. – In-depth integrity checks of fund management and portfolio companies. EBRD involvement seen as insurance against governance risks. – Where no private sector funding is available EBRD investment may account for the bulk (up to 90%) of fund capital. • Overall, superior outcomes (employment, sales growth) in investee firms, and good financial performance of supported funds (see EBRD Transition Report 2015), though the sector remains very shallow in the region (see above).

• In Sept. 2019 EBRD and the EU announced the EU-Armenia SME private equity fund, together contributing EUR 16 m. • Amber Capital was selected as fund manager through a competitive process, also in light of some existing capacity in Yerevan. • Further fundraising currently ongoing to meet the target of EUR 70 m; commitments have been secured from family offices and other development institutions (e.g. Dutch FMO). • Mandate is to establish a diversified SME portfolio covering all key sectors. • Fund investment will be combined with capacity building through the EBRD’s small business programme. This will seek to improve transparency, corporate governance and international orientation of investee companies. Early assessment ➢ EBRD backing likely attracts other LPs, and target fund volume is substantial. ➢ EU grant unlikely to be easily replicable. ➢ Capacity building in investee companies seems key.

• Various forms of state participation in private equity are aimed at growth companies: – The state participates in the holding structure of the investment company (as a ’general partner’): it owns the management company, and invests in the fund, and earns a management fee. It is engaged in the management of the fund and individual investment decisions. It bears unlimited liability. – The state is a limited partner (LP) in an individual fund, alongside other investors. It has limited liability, though only indirect control through a partnership agreement, and regular updates. – State sets up a ‘fund-of-funds’: it determines a general mandate and selects sub-funds (e.g. EIB’s Baltic innovation fund). These have little relevance in a young market such as Georgia, where capacity in the fund management sector is very limited. • Tax preferences. e.g. Venture Capital Trusts in the UK, with tax benefits to investors on dividends and capital gains. Given distant and uncertain exit (typically after >5 years) and already low rates in Georgia, these will have limited value. • State guarantees are not normally used. This would make the state liable for selection and performance of investments without being able to participate in the governance of the fund.

• Several European development banks run equity funds or offer direct equity participations (see overview here), e.g.: – Swedish Almi Fund (aimed at growth companies at all stages of development), – Latvia’s Altum, – Hungary’s MFB, – BpiFrance. • However, typically public institutions seek to mobilize private investors and their expertise through the funds-of-funds model, e.g.: – German KfW Capital (invests in VC funds). – Baltic Innovation Fund. Launched by the EIB/EIF and seeks to promote the development of high-growth firms in the region. EIB capital commitment of up to EUR 100 m, to be invested alongside the national promotional banks, and private local institutional investors and family offices. So far, five funds have been supported. The fund-of-funds model utilizes private sector fund management expertise, though depends on sufficient private sector capacity and competition. Additional costs and monitoring requirements through layered structure but state participation can be in the background, without active involvement.

• The business model of PE firms is aimed at companies with an established growth record and profitability, and moderate valuation. Typically a controlling stake and a holding period of approx. 5 years. • A number of factors result in a high IRR threshold: costs and duration of due diligence process, operational engagement during the investment phase, and uncertainty over exit options etc. • In the developed EU markets there is the added concern that PE investors ‘leverage up’ investee firms through additional lending or own debt type instruments (e.g. ECB, 2020), rendering them more vulnerable in the future. In emerging Europe this could not be verified (EBRD, 2015).

➢ PE investment may be suitable for resilient high-growth firms, though less so to address widespread solvency problems among SMEs following the current recession. PE funds focused on distressed firms, and ‘special situations’ are rare in emerging Europe. ➢ PE cannot be an instrument to address a broad under-capitalisation in Georgian enterprises. For this latter objective of broader equity support, alternative models need to be considered.

The UK Business Growth Fund • Set up after the 2011 crisis, as outcome of the government sponsored review of business finance • Owned by five major UK banks. Has become one of the largest PE investors in Europe with about 50 transactions a year. Current portfolio about GBP 2 bn in about 300 portfolio investee companies in the UK and Ireland. • Mainly companies in the ‘growth’ stage, though also allocations to quoted and venture stages. • Canada and Australia have copied this model. Attractions of this bank-led equity participation: – As BGF takes only minority stakes (without operational control) in investee companies there are fewer concerns of dilution of ownership rights than in the case of private equity – Scale and coverage across regions offers diversification benefits – Bank ownership and local offices support ‘deal generation’.

➢ Allows to target portfolio companies with a lower IRR and in smaller transactions, with less control on disposal and longer holding periods ➢ Unlike for PE investment there is no additional leverage within the investee company. Returns are supported through leverage within the banks ➢ There needs to be an operational and financial segmentation of banks’ loans and equity business, but there is not necessarily a conflict of interest ➢ Viability of this model depends on treatment of banks’ unlisted equity exposures under Basel III (there is flexibility, though it could become more onerous).

• In Europe the current assistance programmes to the corporate sector rely on a combination of debt financing, guarantees or debt service holidays. Rising leverage will have an impact on default probability, and will impede investment activity. Equity is needed as a loss-absorbing form of finance. • Most SMEs do not have access to the capital market. Established owners are resistant to new equity participations. • Boot et al. (2020) propose that all SMEs that meet a basic viability test are given cash injections, which would be recouped from future tax payments, including of income tax paid by sole proprietors. Problems around ‘moral hazard’ (in repayment) or disciplining actions that undermine profitability could be addressed. • A similar scheme was proposed by The City UK (2020), which estimates that GBP 100 bn corporate debt in the UK will be unsustainable once current loan holidays come to an end. Existing loan obligations would be converted into tax obligations, to be administered by single new agency, and reducing the borrower’s debt burden; loan guarantees into subordinated debt. Business owner control would be unaffected. ➢ Both proposals aim at avoiding a balance sheet recession by converting debt into equity-type instruments. Key is a ‘triage’ of viable companies, and addressing compliance problems in the repayment to the tax authorities.

➢ The majority of PE firms focus on mid-sized and mature companies with solid growth prospects. They typically take a controlling, not a minority, stake. An active role in management allows to create value over the typical five year investment horizon, though also sets a high return requirement. The attractiveness of Georgia to PE investors will lie in the availability of such growth firms, and to a lesser extent of start ups. ➢ Only few of the regulatory determinants could be changed in the short term: – Investor protection and corporate governance, including indicators of corporate governance, security of property rights, and the quality of the legal enforcement – Taxation, crucially also ease of tax administration ➢ Structural factors identified as determinants for PE activity are even less amenable are policy measures: – Entrepreneurial culture and ‘deal opportunities’, including innovation, R&D, and low obstacles to running a business. – Depth of the capital market as a potential ‘exit’ option.

Score (US=100) Overall Economic Depth of Taxation Investor Protection Human and Entrepreneurial rank out Activity Capital and corp. Social Culture and deal of 125 Market governance environment opportunities

Georgia 61 61 43 104 73 53 50

Czech Republic 33 85 48 102 71 73 73 Turkey 35 94 72 107 59 43 56 Poland 26 89 76 108 63 61 67 Ukraine 83 72 31 100 49 33 52

Source: VC and PE country attractiveness index 2018.

➢ There has been very limited cross-border activity of PE funds in emerging Europe. Actively seeking to attract a PE fund into Georgia is unlikely to yield a sustainable investment activity in the current recessionary climate, as this would likely require distortionary preferences, and questionable access to equity participations. ➢ The priority should be to work with IFI partners, such as EBRD, as these would safeguard integrity at fund and investee level, build capacity and skills, and attract other investors or IFIs as limited partners or through grants, as in Armenia. ➢ With four investment firms, Georgia has already has some capacity to mobilize equity capital, and as of this year the new Investment Funds Law will set a clearer regulatory framework.

Alternative forms of equity capital should also be considered: ➢ In Europe very few PE funds target distressed firms and ‘special situations’ (where a capital shortfall needs to be addressed), and it is unlikely this type of private investment funds business can be mobilized in the short term in Georgia. Equity participation funds aimed at SMEs are now considered in several EMs, though of course throw up governance problems. ➢ To mobilize equity in a broader set of companies, bank-based or bank- affiliated equity businesses could also be expanded. Equity investment businesses are already run by the two major banks but could also be run jointly by the largest banks. Governance and incentive problems need to be addressed through a clear separation from the credit business. ➢ This would however utilize the established due diligence capacity banks’ networks. If investments are within the core bank balance sheet, prudential regulation should encourage minority participations, as Basel III allows some flexibility.

The German Economic Team (GET) advises the governments of Ukraine, Belarus, Moldova, Georgia and Uzbekistan regarding the design of economic policy reform processes and a sustainable development of the economic framework. As part of the project we also work in other countries on selected topics. In a continuous dialogue with high-level decision makers of the project countries, we identify current problems in economic policy and then provide concrete policy recommendations based on independent analysis. In addition, GET supports German institutions in the political, administrative and business sectors with its know-how and detailed knowledge of the region’s economies. The German Economic Team is financed by the Federal Ministry of Economics and Energy. The consulting firm Berlin Economics has been commissioned with the implementation of the project.

C O N T A C T Sebastian Staske, Project Manager Georgia [email protected] German Economic Team Tel: +49 30 / 20 61 34 64 0 c/o BE Berlin Economics GmbH [email protected] Schillerstraße 59 www.german-economic-team.com 10627 Berlin