64 TRANSITION REPORT 2015-16 REBALANCING FINANCE

PRIVATE EQUITY AS A SOURCE OF GROWTH

THE TOTAL VOLUME OF ADDITIONAL ON AVERAGE CAPITAL THAT THE EBRD REGION COULD POTENTIALLY ATTRACT IS 30 ADDITIONAL JOBS ARE CREATED US$30.5 BILLION BY EACH COMPANY IN THE EBRD REGION THAT RECEIVES PRIVATE EQUITY INVESTMENT CHAPTER 4: PRIVATE EQUITY AS A SOURCE OF GROWTH 65

Private equity funds in the transition region not only target companies with high growth rates but also assist their growth by implementing operational improvements. They also relax companies’ credit constraints and increase both employment and physical investment. The transition region is home to a sizeable pool of companies that could potentially benefit from these positive growth effects associated with private equity investment. However, in order for a larger segment of the economy to reap the benefits of private equity investment, policy-makers need to address a number of institutional constraints.

Introduction

Private equity investment has played an important role in stimulating company growth and innovation in the advanced market economies of North America, western Europe and Asia. However, such growth has, at times, been achieved by shedding employment, cutting costs and/or limiting capital expenditure.1 Such investment may generate short-term financial returns for shareholders, but its long-term implications for the economy as a whole are less clear. It is therefore important to differentiate between the social and financial returns on private equity investment and to have a good understanding of how economic 18 % productivity and output respond to private equity financing. AVERAGE ANNUAL REVENUE GROWTH OF INVESTEE 1 See Kaplan and Strömberg (2009). COMPANIES IN THE EBRD REGION PRIOR TO RECEIVING PRIVATE EQUITY FINANCING 66 TRANSITION REPORT CHAPTER 4: PRIVATE EQUITY AS A SOURCE OF GROWTH 2015-16 REBALANCING FINANCE

Chapter 3 demonstrated that private equity funds in the Private equity and economic outcomes transition region often rely on operational improvements to achieve financial returns for their . This chapter asks Evidence from advanced economies a different question: how do these operational improvements Evidence suggests that private equity investment is associated contribute to economic development – specifically, employment, with significant operational improvements and rising profitability productivity, profitability and physical investment – in the in investee companies.2 These findings have primarily been companies that private equity funds invest in? documented in developed economies. For instance, private equity Analysis shows that private equity funds in the transition activity in the United States and the United Kingdom has a positive region have a positive impact on both profitability and impact on total factor productivity and innovation as measured employment levels. The estimated impact on revenue and by patent counts and citations.3 Similarly, companies that have employment in the region is stronger than that reported for received private equity financing in France and Sweden have advanced economies. This is achieved via a combination of experienced increases in operational efficiency and earnings.4 scaling up operations, increasing capital expenditure with the How private equity funds improve the operational performance aim of improving labour productivity and introducing leaner of investee companies remains a matter of debate. Three issues production methods associated with better inventory and cash dominate this debate. The first contentious issue is whether management. Furthermore, private equity financing enables private equity funds do indeed improve companies’ efficiency companies to access credit markets and fund some of their or simply invest in more efficient companies that would have physical investment and operational improvements through bank performed better subsequently in any case. Evidence suggests finance. This effect has gained in prominence since the global that both effects exist. A recent study found, for instance, that financial crisis and is of particular benefit to smaller companies. companies invested in by US funds were an There is a sizeable pool of companies in the EBRD region average of 7 per cent more productive than other firms. However, similar to those that have already attracted private equity these investee companies also experienced, on average, a 12 financing. These companies have typically sustained high per cent increase in productivity after receiving the investment.5 levels of revenue growth over a number of years, they have funds, in contrast, tend to invest in underpriced companies room for the operational improvements that private equity and may contribute little in the way of operational improvements.6 funds can deliver, and they are not overvalued. Many of these A second contentious issue is the impact that private equity companies could potentially benefit from private equity injections. has on employment. On the one hand, evidence from the United Indeed, it is thought that they have the potential to attract an States and the United Kingdom shows that employment and estimated US$ 30.5 billion of private equity financing. However, wages grow more slowly in companies that receive private equity private equity funds in the region have invested a total of just financing relative to the rest of the economy. This is consistent US$ 9.2 billion since 2010. This disparity reinforces the with the idea that private equity funds focus on reducing labour observation in the previous chapter that private equity is an costs in order to improve operational efficiency. On the other underutilised source of external finance in the region. More hand, evidence from France shows that investee companies importantly, it means that the positive impact that private experience stronger growth in both jobs and wages than similar equity has on companies and workers remains limited to companies that have not received such investment.7 In other small sections of the economy. words, it does not seem possible to generalise the impact private There are two ways in which policy-makers can help ensure equity has on employment. that more companies in the region benefit from private equity A third contentious issue is whether private equity funds financing. First, shareholder protection and the enforcement of sacrifice long-term investment and focus on generating short- corporate governance legislation are essential to increase the term cash flows. In the 1980s investee companies in the United effectiveness of private equity in the region and make companies States experienced reductions in capital expenditure following more attractive to potential investors. Given the long-term and .8 However, subsequent studies have documented illiquid nature of private equity as an asset class, investors need a positive impact on capital expenditure and investment in to be given a transparent and reliable legal framework, especially innovative activity in the United States and France.9 On balance, as regards the rights of minority shareholders. Second, the private equity funds do not appear to sacrifice long-term development of public equity markets and the establishment of productivity in return for short-term gains. stock exchanges tailored to small and medium-sized enterprises In part, these conflicting findings reflect differences in the (SMEs) can provide private equity funds with more opportunities focus of private equity in different countries. For instance, buyout to exit investments. In addition, the development of credit funds in the United States and the United Kingdom tend to markets can support the development of private equity, as high- target large, mature firms, where they focus on reducing capital growth companies typically rely on both bank loans and private expenditure, restructuring labour and financial engineering in equity financing to fund their expansion. order to increase profitability. In contrast, private equity funds in France, where credit markets are less developed, typically target credit-constrained companies with growth opportunities and help these companies to access alternative sources of finance.10

2 See Kaplan and Strömberg (2009) for a review of academic studies on this subject. 6 See Kaplan and Strömberg (2009). 3 See Chemmanur et al. (2011), Lerner et al. (2011) and Davis et al. (2014) for evidence on the United 7 Furthermore, investee companies in Sweden do not experience wage reductions or the restructuring of States. See Harris et al. (2005) and Amess et al. (2015) for evidence on the United Kingdom. labour. See Bergström et al. (2007) and Boucly et al. (2011). 4 See Bergström et al. (2007) for evidence on Sweden and Boucly et al. (2011) for evidence on France. 8 See Kaplan and Strömberg (2009). 5 See Chemmanur et al. (2011). 9 See Boucly et al. (2011) and Lerner et al. (2011). 10 See Boucly et al. (2011). 67

With this in mind, this chapter examines the impact that private equity investment has on companies’ performance in TABLE 4.1. Impact of private equity investment on growth and productivity the EBRD’s countries of operations. It begins by discussing (1) (2) (3) (4) Operating Operating Labour the screening of companies by private equity funds, before Dependent variable: revenue profits Employment productivity documenting the impact that private equity investment has on Average impact of 0.3504*** 0.1973** 0.1946*** 0.3011** revenue, profitability, employment and productivity in investee private equity investment (0.1066) (0.0821) (0.0659) (0.1177) companies, taking into account the restructuring of labour and Observations 10,210 10,210 10,210 10,210 credit constraints. R2 0.3207 0.0815 0.2623 0.1528

Methodology Source: EBRD, Orbis and authors’ calculations. This analysis uses the EBRD’s proprietary dataset, which covers Note: This table reports the results of a difference-in-differences regression estimating the impact of private equity financing on company-level outcomes. The estimation sample comprises private equity and control the investments of more than 100 private equity funds across the group companies. Dependent variables are measured in logs. The results indicate the average impact of private equity investment on the log change (that is to say, change in per cent) in the dependent variable. EBRD region between 1992 and 2013. The data cover a variety Standard errors are clustered at the company level and shown in parentheses. *, ** and *** indicate of different types of private equity fund, including buyout, growth statistical significance at the 10, 5 and 1 per cent levels respectively. capital and venture capital funds (see Chapter 3 for further details). CHART 4.1. Impact of private equity on companies’ revenue Simply comparing the performance of companies with and 40 without private equity investment may produce misleading results. This is because private equity investors may be good at choosing companies that have good growth potential. The 30 superior performance of such companies following private equity investment would then reflect the funds’ successful screening of potential investment targets, rather than efforts to improve 20 companies’ performance. To address these concerns, changes in a company’s performance after it receives private equity financing are

compared with changes in the performance of similar companies revenue (US$ millions; log) Average operating 10 without private equity involvement (by means of a “difference- -3 -2 -1 0 1 2 3 4 5 in-differences analysis”). It is important to ensure that the Years since private equity investment companies that receive private equity investment are similar Private equity sample Control group sample to those that do not (the “control group” in the analysis). The Source: EBRD, Orbis and authors’ calculations. control group for each investee company comprises five similar Note: Shaded areas indicate standard errors. The green vertical line indicates the year of the private equity firms drawn from the Orbis database of companies in the EBRD investment, so points to the left show the evolution of revenue in the run-up to the investment and points to the right show its subsequent evolution. region. These firms are selected from the same country, industry and year as the investee company and are similar to it not only in terms of age, average sales and investment growth, but also in Employment terms of their revenue, assets and fixed assets over the three- Private equity financing also has a positive effect on employment. year period preceding the investment.11 On average, investee companies see their labour force grow by a fifth more relative to other companies. This corresponds to The impact of private equity on firms in the transition region approximately 30 additional jobs per investment. The impact Revenue on employment appears to be stronger in the EBRD region than These comparisons reveal that, on average, increases in it is in advanced economies (with a rate of 12 per cent being operating revenue are 35 per cent stronger for companies that observed in France, for example),12 as private equity funds in the receive private equity investment relative to their peers (see EBRD region focus primarily on companies with strong growth Table 4.1). This increase is achieved over a period of three to five potential, rather than mature companies that are in need of years following the initial private equity injection. This is a large restructuring (as discussed in Chapter 3). effect, given that for most companies in the region revenue grows by less than 10 per cent in a given year. Crucially, this positive Labour productivity impact is not driven by the targeting of high-growth companies. As sales in investee companies grow faster than employment, As Chart 4.1 shows, companies that are similar to those in the sales per employee also increase – by nearly a third more than in private equity sample also experience rapid growth in the years other companies. Thus, companies with private equity investment prior to the investment, but they fail to maintain that performance are able not only to increase the number of people they employ, in the absence of private equity. The consistent growth in revenue but also to employ these people more efficiently (for instance by of companies that receive private equity financing also translates adopting leaner production techniques). This runs counter to the into a 20 per cent stronger increase in operating profits relative widely held view that private equity investment normally entails to their peers. the shedding of labour.

11 The Orbis database, which is maintained by Bureau van Dijk, contains detailed data on firms’ ownership 12 See Boucly et al. (2011). and financial situations. 68 TRANSITION REPORT CHAPTER 4: PRIVATE EQUITY AS A SOURCE OF GROWTH 2015-16 REBALANCING FINANCE

CHART 4.2. Impact of private equity on labour productivity CHART 4.3. Impact of private equity on fixed capital investment

140 10 9 130 8 7 120 6 5 110 4 100 3 90 (US$ thousands; log) (US$ millions; log) 2

Average labour productivity 80 Average tangible fixed assets Average tangible

70 -3 -2 -1 0 1 2 3 4 5 1 -3 -2 -1 0 1 2 3 4 5 Years since private equity investment Years since private equity investment Private equity sample Control group sample Private equity sample Control group sample

Source: EBRD, Orbis and authors’ calculations. Source: EBRD, Orbis and authors’ calculations. Note: Shaded areas indicate standard errors. The green vertical line indicates the year of the private Note: Shaded areas indicate standard errors. The green vertical line indicates the year of the private equity investment. equity investment.

TABLE 4.2. Impact of private equity on investment and the accumulation of CHART 4.4. Impact of private equity on debt-to-asset ratio (1) (2) (3) (4) (5) Inventory 32 Tangible fixed Capital and cash assets intensity Stock of debt Leverage management 30 Average impact of 0.4126*** 0.4642*** 0.8731*** 0.0263 0.0527*** 28 private equity investment (0.1391) (0.1095) (0.2865) (0.0173) (0.0195) 26

Observations 10,210 10,210 10,210 10,210 10,210 24 2 R 0.2387 0.2378 0.0448 0.0193 0.0124 22

Source: EBRD, Orbis and authors’ calculations. 20 Note: This table reports the results of a difference-in-differences regression estimating the impact of private 18 equity financing on company-level outcomes. The estimation sample comprises private equity and control group companies. Tangible fixed assets and the stock of debt are measured in logs. Columns (1) and (3) Average debt-to-asset ratio (per cent) 16 indicate the average impact of private equity investment on the log change (that is to say, change in per 14 cent) in the dependent variable. Capital intensity is measured as fixed assets per employee. Leverage is the -3 -2 -1 0 1 2 3 4 5 ratio of debt to total assets. Inventory and cash management is measured as the ratio of working capital to Years since private equity investment total capital employed. Columns (2), (4) and (5) indicate the average impact of private equity investment on the percentage change in the dependent variable. Standard errors are clustered at the company level Private equity sample Control group sample and shown in parentheses. *, ** and *** indicate statistical significance at the 10, 5 and 1 per cent levels Source: EBRD, Orbis and authors’ calculations. respectively. Note: Shaded areas indicate standard errors. The green vertical line indicates the year of the private equity investment.

Improvements in labour productivity may take several years to realise (see Chart 4.2). Initially, investee companies have similar levels of efficiency to their peers, but they then experience stronger improvements in efficiency after a few years of private equity involvement.

Investment Another widely held view is that private equity funds tend REVENUE GROWTH IS to engage in far-reaching reductions in company assets. In ON AVERAGE particular, they may limit capital investment and research and development expenditure, which frees up cash in the short term but hurts the future profitability of the company. If financial 35% returns are primarily achieved in this way, the improvement in STRONGER IN COMPANIES operational efficiency may be short-lived. RECEIVING PRIVATE In fact, contrary to this view, private equity funds in the EQUITY INVESTMENT IN EBRD region substantially increase capital expenditure in order THE EBRD REGION to improve operational efficiency. The analysis reveals that become more creditworthy borrowers in other ways. in other borrowers creditworthy more become to companies help investee can also financing equity private outcomes for companies that are more credit-constrained and and are credit-constrained more that for companies outcomes stronger expect would one equity, private of impact economic are key the to improvements operational and credit to access If Table (see 4.2). peers their to relative capital total to capital working of ratio in the improvement point 5 percentage a experience region EBRD in the companies investee that show data the Indeed, use. effective more to put be to cash company. allows retained bythe This needed capital working the reduce to combine which bycustomers, payments faster inventoryintroduce management better and systems ensure can they For instance, cash. and inventories of management better through companies their investee of efficiency operational improve to the seek also funds equity Private management flow Cash years. in later debt down pay to used revenue are then of levels higher The ratio. debt-to-asset companies’ in investee increase significant no is there that revenue, and such productivity of levels expenditure. capital their of part finance to debt additional issue companies investee that suggests analysis 4.4). In fact, Chart (see period investment the of years early in the place takes borrowing expenditure, Table (see capital with investment 4.2). As equity private receive not do that companies to relative doubles almost professionals. equity by private monitoring close to subject will and be fund equity private by the approved been has that plan business apromising has company the that indicating market, credit the to signal astrong sends this place, takes transaction However, equity aprivate when prospects. unpredictable with companies entrepreneurial by submitted plans unwilling investment finance to are often 14 13 against. borrow to assets more has company the as increase comfortably also –can assets total to debt of ratio the as –defined leverage then assets, collateralisable increase to used is equity the of some if hand, other the On capital. physical in invest to funds equity private from equity raised freshly the of some use can companies hand, one the On expenditure? capital surge in the finance companies investee do How Debt years. in later are realised productivity in labour improvements why explains which stabilises, then capital physical of stock The 4.3). Chart (see investment initial funds’ equity private of years employee. per in capital increase stronger cent per a46 into translates investment in fixed-asset Table increase remarkable 4.2). This financing (see equity private receive not do that companies to and computers) following investment relative private equity machinery buildings, (which includes stock capital in their increase stronger a41 cent per experience companies investee   See Boucly et al. (2011). al. et Boucly See a buyout transaction and borne by a holding company, which in turn owns the investee company, is not not is company, captured. investee the owns turn in which company, aholding by borne and finance to fund transaction equity a buyout aprivate by on taken is which Debt companies. and holding by on taken accounts debt company excludes unconsolidated from derived is analysis this in used debt of measure The The resulting increase in capital intensity translates into higher higher into translates intensity in capital increase resulting The debt of stock companies’ investee that reveals analysis The Increases in physical investment typically take place within two two within place take typically investment in physical Increases 13 14 Thus, Thus, Banks Banks

significance at the 10, 5 and 1 per cent levels respectively. respectively. levels cent per 1 and 10, 5 the at statistical *, *** ** indicate significance and median. the than older are companies mature while private to a prior investment, median equity sample the than younger being as defined are companies Young companies. group financing andequity equity control sample private on Thecomprises company-levelestimation outcomes. Note: Source: per 1 and 10, 5 the at cent levels respectively. significance statistical *, *** ** indicate and employ median. have the above are companies that large while levels ment investment, equity aprivate to prior the years below three are the in that median levels sample employment average having as defined are companies Small companies. group financing andequity equity control sample private on Thecomprises company-levelestimation outcomes. Note: Source: Transition Report year’s in last documented as productive, less therefore and innovative less are also companies These against. borrow to flows cash stable and assets have not do physical often which firms, younger and smaller are typically companies such region, the EBRD In investment. equity private that to prior inefficient mature companies (see Charts 4.5 and 4.6). A similar pattern 4.6). and 4.5 Asimilar pattern Charts (see companies mature and large for is it as companies young and small for large as twice around is investment equity by private revenue caused in growth additional The companies. mature and large benefits it than more companies young small and benefit indeed 4.6. CHART 4.5. CHART Per cent Per cent 100 120 100 120 140 20 40 60 80 20 40 60 80 This chart shows the results of a difference-in-differences regression estimating the impact of private private of impact the estimating regression adifference-in-differences of results the shows chart This private of impact the estimating regression adifference-in-differences of results the shows chart This 0 The analysis suggests that private equity financing does does financing equity private that suggests analysis The 0 EBRD, Orbis and authors’ calculations. calculations. authors’ and Orbis EBRD, calculations. authors’ and Orbis EBRD, Operating Operating revenue revenue Impact of private equity investment on firms’ performance by firm age firm by performance firms’ on investment equity private of Impact Impact of private equity investment on firms’ performance by firm size size firm by performance firms’ on investment equity private of Impact Operating Operating profits profits . Employment Employment productivity productivity Labour Labour Small firms Young firms fixed assets fixed assets Tangible Tangible Large firms Mature firms intensity intensity Capital Capital Stock ofdebt Stock ofdebt Leverage Leverage cash management cash management Inventory and Inventory and 69

10 12

0 2 4 6 8

0 1 2 3 4 5 6 7

Percentage points Percentage - points Percentage control group companies. *, ** and *** indicate statistical significance at the 10, 5 and 1 per cent levels levels cent per 1 and 10, 5 the at respectively. significance statistical *, *** ** indicate and companies. group control financing equity and equity private sample private on Thecomprises company-levelestimation outcomes. Note: Source: doubled since the global financial global the doubled since crisis. of employment and profitability. levels higher about brings which expenditure, capital increase to used then is source funding additional This constraints. financial in relaxing role equity’s private in line with debt of stock in the increases largest the see assets, collateralisable lack often which sectors, services and trade wholesale retail, in the Companies 4.7). Chart (see jobs additional create to seem not does investment this but improve to productivity, investment capital large-scale funds undertake private equity sectors, technology In high- sector. to sector from vary performance companies’ management. flow cash improving primarily and on eliminating focused be inefficiencies operational to appear efforts companies, In these investment. equity private following employment or profitability their in growth additional limited only experience companies investee mature and large words, other In firms. young and small for observed primarily is employment and profitability on impact the Furthermore, management. flow cash and capital in physical investment including performance, of measures other for observed be can revenue growth. revenue on impact astronger into translating ultimately increased, also has productivity in labour improvements associated and growth expenditure capital of in terms equity private of impact the result, As a conditions. credit tighter much faced have firms approval) of seal funds’ equity private of absence (in the that 15 70 CHART 4.7. CHART  following the private equity investment. investment. equity on taken private debt the any of following percentage asignificant recent, repay to time had relatively yet not are have 2008 since companies conducted investee so transactions equity private that fact the reflect also may This Per cent 140 100 120 20 40 60 80 This chart shows the results of a difference-in-differences regression estimating the impact of impact the estimating regression adifference-in-differences of results the shows chart This 0 Strikingly, the impact of private equity on access to credit has has credit to access on equity private of impact the Strikingly, improve investee funds equity private in which ways The EBRD, Orbis and authors’ calculations. calculations. authors’ and Orbis EBRD, Operating revenue Impact of private equity investment on firms’ performance by sector by performance firms’ on investment equity private of Impact Operating profits Employment Manufacturing productivity Labour High technology fixed assets Tangible intensity Capital 15 This reflects the fact fact the reflects This Stock ofdebt Trade andservices FINANCE REBALANCING 2015-16 TRANSITION REPORT Leverage cash management Inventory and

0 2 4 6 8 10 12 14

Percentage points Percentage 28 per cent in Russia. cent 28 per (CEB), but states Baltic the and Europe in central cent per 18 least at of rates growth display to are required targets potential this analysis, of purposes the for For instance, region-specific. are companies target to applied criteria the reasons, For these regions. in these investing of risks higher perceived the for histories – perhaps to strong growth particularly compensate with companies target to appear Asia (EEC), Central and Russia Caucasus the and Europe in eastern investing funds equity Private 4.8). 2011 Chart (see since region EBRD in the company typical the of rate growth the times three figure This is around financing. equity private receiving to prior cent per 18 than more of annual average revenue growth display typically sample equity private in the Companies investment. to prior region same the from company investee average the than faster grow to required are targets potential growth: strong is first The investment. equity private for target apotential as qualify to in order criteria four meet must companies that suggests above analysis The targets Potential financing. equity private receiving companies investee the to them compares and companies”) of universe (“the region transition in the companies all of active database a uses section this this financing? question, To answer equity private attract potentially could that region in transition the there are companies But manyhow more financing. such of benefits the reap to companies of set alarger enable could region EBRD in the investment equity private of penetration the Increasing region in transition the equity Scaling up private CHAPTER 4: PRIVATE EQUITY A OF SOURCE GROWTH AS Source: of the economy of the economy CHART 4.8. 4.8. CHART Per cent 10 15 20 25 30 35 40 0 5 EBRD, Orbis and authors’ calculations. calculations. authors’ and Orbis EBRD, CEB Average growth rates of investee companies and the rest rest the and companies investee of rates growth Average Turkey Private equitysample(threeyears priortoinvestment) Universe ofcompaniesintheregion(2011-13) SEE Russia EEC

Central Asia

and taxes). and interest (before earnings its value to book acompany’s of ratio valuations by region. company and margins sales assets, on returns for applied criteria Table the shows 4.3 companies. investee of sample in the ratios these of distribution the of 70th percentile the exceed cannot invested in the EBRD region since 2010. since region EBRD in the invested been has capital equity billion private of 9.2 US$ just of total a Indeed, cent). 0.1 than per less at stands (which currently penetration region’sthe equity GDP, in private increase asteep of cent 0.5 around per to correspond would –it ownership direct of forms other or investment direct (IPOs), foreign offerings public initial through raised being than –rather funds equity private from come to were amount all this If of investors. byequity region in the deployed be billion could 30.5 US$ of atotal investors, potential to shares companies’ their of half willing sell be would to Table owners see that 4.4). in(measured 2013 Assuming prices; 61 US$ value of billion book have atotal region EBRD in the investment. an choosing to comes it when factors important most the of one is this that report funds equity Private high. prohibitively not is that valuation improvement. for scope leaving sample, equity private in the company investee average the of that than higher no but positive, be to required limited. appear may improvements operational further for scope the as targets, attractive be not may have ratios high already that company. Companies investee average the of that than higher no be must ratios Thus, earnings. to generate capital its uses company a how efficiently captures – assets total to income net of ratio the as –defined assets on return The improvement. operational for room but assets, their on target companies being underestimated in these countries. in these underestimated being companies target potential of pool the to led probably has region CIS the and Russia of prospects economic in the downturn recent the instance, calculations and are are not precise purelythese indicative. For Turkey of 4.9). true Furthermore, Chart (see particularly is This small. in 4.4 relatively identified are Table targets investment of potential majority vast the whereas companies, investee will investors equity continue looking for large relatively 18 17 16 19 the region. the in 42,000 jobs 700 (since 2010), an estimated create could ajump 2,100 around mean would to which from investment, GDP.of cent per figure 1 is around corresponding the where Kingdom, United the as such markets in advanced activity equity private of level the of short falls amount increased   This is based on investment in Russia, Turkey and the CEB, EEC and SEE regions. regions. SEE and EEC CEB, the and Turkey Russia, in investment on based is This

As target companies are typically unlisted, their book values are assumed to be strongly correlated with with correlated strongly be to values. market their assumed are values book their unlisted, typically are companies target As mentioned growth in the value of the underlying business as a driver of returns. returns. of adriver as business underlying the of value the in investors all growth States, mentioned United the in funds equity private of survey their In (2015). al. et Gompers See These data are not available for companies in Central Asia, which are dropped from the subsequent analysis. subsequent the from dropped are which Asia, Central in companies for available not are data These On the basis of these criteria, potential target companies companies target potential criteria, these of basis the On have to a are required companies target potential Lastly, is It margin. sales the to relates Similarly, criterion third the return have to apositive are required targets potential Second, Tripling the number of companies receiving private equity equity private Tripling receiving companies of number the 20 17 However, private that this assumes calculation It is assumed that a potential target company’s ratio ratio company’s target apotential that assumed is It 18 16 The proxy for valuation used here is the the is here used valuation for proxy The 19 However, the even

EMERGING COMPANIES MARKET İSTANBUL’S BORSA ON LISTED CURRENTLY ARE COMPANIES Source: 22 Source: taxes. and interest as before measured is earnings to valuation value book of Acompany’s ratio the revenue. operating to taxes as and measured is interest margin before sales The earnings of ratio assets. the total to income net of ratio the as measured is assets on return The Note: Source: 20 Note: TABLE 4.4. TABLE 4.3. TABLE of companies of companies CHART 4.9. 4.9. CHART Turkey South-eastern Europe Russia Eastern EuropeandtheCaucasus Central EuropeandtheBalticstates Central EuropeandtheBalticstates Turkey South-eastern Europe Russia Eastern EuropeandtheCaucasus  estimate of 30 new jobs per private equity investment. investment. equity private the per 2010and jobs since new 30 of financing estimate equity private received have that companies of number the on based is This Per cent 10 12 This table reports the criteria applied to potential targets from the universe of companies in the region. region. the in companies of universe the from targets potential to applied criteria the reports table This Company values are calculated using companies’ book values and measured in 2013 prices. prices. 2013 in measured and values book companies’ using calculated are values Company 0 2 4 6 8 EBRD, Orbis and authors’ calculations. calculations. authors’ and Orbis EBRD, Orbis. Orbis. sample. equity private EBRD

Turkey Potential private equity investment in the EBRD region region EBRD the in investment equity private Potential Criteria for identifying potential targets for private equity investment investment equity private for targets potential identifying for Criteria Shares of potential targets for private equity funds in the universe universe the in funds equity private for targets potential of Shares Small companies Very largecompanies Russia

Return onassets Number ofpotentialtargets All companies Large andmedium-sizedcompanies 0.08 0.11 0.15 0.10 0.12 CEB 13,052 16,946 6,014 3,145 505 Sales margin 0.10 0.11 0.13 0.05 0.07 SEE Total value ofcompanies (US$ billions) 34.78 16.84 5.06 2.18 2.01 Valuation EEC 71 9.17 7.85 5.25 9.33 8.33

72 TRANSITION REPORT CHAPTER 4: PRIVATE EQUITY AS A SOURCE OF GROWTH 2015-16 REBALANCING FINANCE

What can policy-makers do? Moreover, in some cases, boards may have little say in Given the significant benefits that private equity involvement decision-making. Companies across the region tend to be entails in terms of investment, job creation and company growth, organised under a two-tier system, with separate supervisory encouraging more private equity investment in the region could and executive boards. In an ideal world, the general meeting of help to scale up investment and stimulate more growth. There are shareholders would appoint the supervisory board which would a sizeable number of potential private equity targets in the region. then appoint and remove the company’s executives. However, the However, levels of private equity investment in the region have EBRD’s assessment has found that in a number of countries the remained relatively low compared with advanced markets, as default legal rule enables the general meeting of shareholders to documented in Chapter 3. What could policy-makers do to make appoint both the supervisory board and the management (unless the region more attractive to private equity investors? the company’s by-laws provide otherwise). This mechanism, coupled with the absence of cumulative voting, allows a protection and corporate governance controlling shareholder to appoint both the supervisory board and There is a significant degree of heterogeneity across the EBRD the company’s executives, depriving the board of any leverage region in terms of corporate transparency, investor protection over these executives. This discourages private equity funds and corporate governance. Weak shareholder protection may from acquiring minority positions and prevents private equity discourage investors from engaging in relatively risky, illiquid funds that do hold minority stakes from carrying out operational and long-term projects such as private equity investments. improvements. Furthermore, in countries with civil law or socialist legal Another key aspect of governance from the perspective backgrounds and countries where legal enforcement is difficult, of potential investors is the level of non-financial disclosure. private equity funds are more reliant on obtaining majority control Although financial reporting in the region has reached a and having more representation on the board.21 This significantly good standard, previous instances of corporate fraud have reduces the number of potential private equity deals, as many underscored the importance of validation procedures for financial entrepreneurs may be reluctant to hand over majority control at reports. In this respect, a key role is played by audit committees. an early stage when the valuations of their companies are still Members of a company’s audit committee need to be qualified low.22 It also makes it difficult for funds to diversify their portfolios and independent if they are to recommend best practices in the by targeting a large number of companies. area of reporting and provide stakeholders with a clear picture In order to determine the quality of corporate governance of key developments in the company. The EBRD’s assessment legislation and its implementation in the region, the EBRD suggests that this may not be the case except for a very small launched a new corporate governance assessment in 2014.23 number of countries (such as Poland and Turkey). A lack of This assessment sought to ascertain whether minority independence and expertise on company boards makes it more shareholders that want to play an active role in the company, difficult for private equity funds (which have limited resources) to such as private equity funds, (i) can conclude shareholder ensure adequate monitoring of their investee companies. agreements and rely on their enforceability, (ii) have the option to appoint a board member and (iii) can rely on the disclosure Development of equity markets offered by companies. Private equity funds aim to exit their investee companies within a Shareholder agreements can be an effective tool enabling limited period of time and achieve the highest possible valuation. investors such as private equity funds to protect their Exiting an investment via an IPO is an attractive option in both investments. However, the EBRD’s assessment has revealed regards. However, exiting investments via IPOs is harder in the limitations in the use of this tool in the transition region. In most EBRD region than it is in more advanced economies owing to the countries, shareholder agreements do not need to be disclosed. lower average level of capital market development. Furthermore, Furthermore, in most countries it is not clear whether they are less developed and less liquid capital markets may also enforceable. They seem to be fairly rare in practice, and little or no reduce the expected returns from an investment. Both factors case law exists on this matter.24 discourage private equity activity in the region. Furthermore, while many countries in the region have Although there is significant variation across countries (see legislation enabling minority shareholders to appoint board Box 4.1), capital market development tends to be the area members, it often does not apply automatically. In other words, where the EBRD region lags furthest behind western Europe minority shareholders have to formally request that such and the United States when it comes to attracting venture provisions be applied. For instance, existing legislation in many capital and private equity. According to the index compiled by countries allows cumulative voting on the appointment of board the IESE Business School, the region scores a lowly 40 out of members to be requested. This would prevent the majority 100 in this area, where 100 indicates the level of capital market shareholder from appointing all board members.25 For cumulative development in the United States (see Chart 4.10), while in other voting to work effectively, however, the company’s shareholders areas (such as investor protection and corporate governance) need to know who the other shareholders are in order to be the region’s scores are substantially higher. This shows that able to organise themselves, form an alliance and nominate a increasing the depth of capital markets should be a clear priority candidate to elect. Unfortunately, lists of shareholders are not when it comes to attracting more private equity investment to easily available in many cases. the region.

21 See Lerner and Schoar (2005). 10 largest listed companies in each country. 22 See Lerner and Schoar (2005). 24 In a few countries – such as Estonia, Latvia and Poland – they are considered enforceable, but this is 23 This assessment is based on research carried out by the EBRD’s Legal Transition Team. These often subject to strict legal conditions. The assessment has also found that shareholders rarely seek questionnaires are based on internationally recognised best practices and cover both relevant legislation redress on behalf of the company (by means of a “derivative suit”) where they feel that their rights have and “soft law” governance norms such as corporate governance codes. The EBRD team validates been breached. responses to the questionnaire by looking at the applicable framework and the disclosure offered by the 73

A number of policy options are available to facilitate the development of public equity markets. First, policy-makers can CHART 4.10. Attractiveness of eastern Europe in terms of private equity (2015) support the establishment of exchanges designed specifically Economic activity for SMEs (see Box 4.2). Many of the companies in the EBRD 120 100 region that attract private equity financing are SMEs and more 80 SMEs may be able to attract such funding if they can list their Entrepreneurial culture 60 Depth of capital market and deal opportunities shares on an exchange with relative ease at the time of exit. In 40 contrast with a national stock exchange which typically caters 20 for large conglomerates, an “SME growth market” allows smaller 0 companies to float shares under a more flexible regulatory system at a lower cost. A very successful example of such an exchange is the AIM in the United Kingdom, while Poland, Romania and Turkey Human and social Taxation all have fledgling SME growth markets. Stricter enforcement environment of insider trading rules is also instrumental in supporting the development of equity markets (see Box 4.1). Investor protection and Second, channelling more savings from households and corporate governance institutional investors into equity markets is crucial. EU member Eastern Europe Western Europe United States states’ efforts to establish a capital markets union should help to Source: 2015 Venture Capital and Private Equity Country Attractiveness Index (http://blog.iese.edu/ match institutional investors with productive companies across vcpeindex). the EU (including SMEs and start-ups, which are most in need of long-term capital). In particular, the European Commission’s green paper on this issue26 recommends measures to reduce transaction costs and cross-border marketing costs, which should increase competition and attract new players. Harmonising regulations in the areas of insolvency legislation and tax regimes should also encourage institutional investors to invest larger amounts in the region’s capital markets. This could help EU member states in the EBRD region to attract foreign capital and make up for their relatively low levels of domestic savings. A third and related policy option concerns pension systems in the region. Since the global financial crisis, there have been setbacks in a number of countries in terms of the development of mandatory funded pension systems, which have placed private pension funds under intense pressure. When funded pension schemes are cut back as a result of regulatory changes, the liquidity and efficiency of local capital markets suffer. As a result, less funding is available for the region’s companies and the prospects of a successful IPO become less certain. This COMPANIES IN THE EBRD has a particular impact on capital directed towards long-term REGION RECEIVING PRIVATE “alternative” investments such as private equity. EQUITY INVESTMENT HAVE ON AVERAGE 150 EMPLOYEES 700 COMPANIES IN THE EBRD REGION HAVE RECEIVED PRIVATE EQUITY INVESTMENT SINCE 2010

25 Under the cumulative voting system, each shareholder has one vote per share for each of the directors to be elected, but can use all of those votes on a single director. Cumulative voting is not provided for by law in Azerbaijan, Bosnia and Herzegovina, Bulgaria, Cyprus, Estonia, FYR Macedonia, Hungary, Jordan, Morocco, the Slovak Republic, Slovenia or Tunisia. 26 See European Commission (2015). 74 TRANSITION REPORT CHAPTER 4: PRIVATE EQUITY AS A SOURCE OF GROWTH 2015-16 REBALANCING FINANCE

Conclusion This chapter has shown that private equity investment can BOX 4.1. AN ANATOMY OF STOCK MARKETS IN help to transform companies, ultimately boosting investment, EMERGING EUROPE27 employment and growth in the EBRD region. Private equity funds help companies to gain better access to credit and increase Emerging market stocks have become an integral part of global stock physical investment. These funds constantly monitor companies’ portfolios following the wave of financial liberalisation in the late 1980s operations to ensure that investment in capital helps to make and early 1990s. While most emerging stock markets have been studied employees more productive rather than merely replacing them. in detail, relatively little is known about stock markets in emerging As a result, a company that attracts private equity financing will Europe, which have tended to be liberalised later than those of other enjoy stronger growth in revenue and employment than similar emerging markets.28 This box provides an overview of the development companies that do not have access to such risk capital. of stock markets in central and eastern Europe, Kazakhstan, Russia and The positive effect private equity has on employment Turkey since the mid-1990s. It uses firm-level data to construct stock and physical investment is striking, particularly as negative market indices and market development indicators that help to assess effects have sometimes been found in advanced economies the current state of development of the region’s stock markets, as well as where private equity funds tend to focus on cutting costs and looking at the benefits of diversification for global investors. restructuring in mature companies. In the EBRD region, in contrast, private equity funds typically invest in credit-constrained Indicators of stock market development companies with considerable growth potential, adopting Stock market development can be tracked using five key indicators. The strategies that generate investment and jobs. first indicator, the ratio of total market capitalisation to GDP, measures The number of companies in the region that have strong the size of the stock market relative to the size of the economy. Two growth prospects and could potentially attract private equity liquidity indicators, stock market turnover and the average percentage funding is estimated at around 40,000 – more than 50 times of non-zero daily returns, track the evolution of market liquidity. And the actual number of companies that have received such the last two indicators track stock market concentration at firm and financing in recent years. Extending equity financing to just a industry level respectively, using Herfindahl-Hirschman Indices (HHIs). fraction of these companies would create a significant number Investors prefer unconcentrated stock markets with more opportunities of jobs and boost investment. for diversification. In order to increase the presence of private equity firms in the These indicators suggest that Russia and Turkey have the most highly region, policy-makers can help to strengthen the protection of developed stock markets thanks to the large market capitalisations of minority shareholders and support the development of private their domestic listed companies and their high levels of trading activity equity markets. As they are often minority shareholders, private (see Table 4.1.1, where darker shading indicates a higher level of equity firms stand to benefit from improved enforcement of development). They are similar to Germany in these respects, but they regulations designed to protect minority shareholders and the lag some way behind the United States. However, stock market activity application of industry best practices in terms of information in these countries continues to be dominated by a few industries, as disclosure rules. Furthermore, the establishment of stock reflected in their high concentration indices. The same is true of the rest exchanges that are specifically designed for smaller companies of the region. can help to enhance SMEs’ access to equity financing and improve private equity funds’ exit opportunities, making Drivers of stock market development investment in SMEs more attractive. Stricter enforcement of After the fall of the Iron Curtain, many countries in the region liberalised insider trading laws is another crucial driver of stock market their stock markets by allowing foreign investors to invest in domestic development and an area where significant work remains to be stocks, introducing insider trading laws and – at a somewhat later stage done across the region. Last but not least, it is also important to – establishing electronic trading systems. Countries implemented these revitalise bank lending in the region, as private equity firms and policies at different times, and the reform process remains incomplete other equity investors rely on complementary debt financing to across the region. Knowing which reforms are most strongly associated fund investment underpinning the growth and modernisation with the development of stock markets can help policy-makers to of firms. determine their priorities in this area.

27 This box is based on Baele et al. (2015). 28 See Bekaert and Harvey (2014). market capitalisation is distributed across listed companies and industries. industries. and companies listed across stock distributed total is how captures and capitalisation Index market Herfindahl-Hirschman price the daily non-zero indicates of HHI currency. percentage local in average returns value-weighted the is returns Non-zero capitalisation. market Note: Source: TABLE 4.1.1. 4.1.1. TABLE Source: CHART 4.1.1. 4.1.1. CHART western Europe Europe western Russia Turkey Hungary Poland Slovenia Czech Rep. Lithuania Ukraine Bulgaria Estonia Croatia Romania Serbia Latvia Slovak Rep. Kazakhstan Germany Correlation United States -0.2 0.0 0.2 0.4 0.6 0.8 1.0 Turnover is defined as the ratio of the total dollar trading volume per year over the end-of-year end-of-year the over year per volume trading dollar total the of ratio the as defined is Turnover Baele et al. (2015). (2015). al. et Baele Baele et al. (2015). (2015). al. et Baele 1995

1996 Equity market Indicators of stock market development development market of stock Indicators development Correlation between stock market returns in emerging and and emerging in returns market stock between Correlation

1997 ranking 10 11 12 13 14 15 16 1 2 3 4 5 6 7 8 9 - -

1998

1999 capitalisation Ratio of to GDP market 0.59 0.39 0.22 0.32 0.19 0.21 0.12 0.09 0.08 0.09 0.14 0.08 0.05 0.04 0.03 0.06 0.43 1.18 2000

2001 Turnover 0.81 1.37 1.07 0.37 0.09 0.49 0.07 0.10 0.06 0.31 0.06 0.14 0.08 0.03 0.28 0.01 1.14 2002 1.76

2003 Non-zero returns 0.91 0.83 0.95 0.81 0.85 0.97 0.90 0.78 0.66 0.81 0.90 0.82 0.70 0.62 0.24 2004 0.65 - -

2005

2006 Firm-level 0.05 0.03 0.20 0.04 0.12 0.27 0.06 0.10 0.03 0.10 0.30 0.21 0.07 0.14 0.59 0.25 HHI - - 2007

2008 Industry- level HHI 0.20 0.22 0.16 0.22 0.11 0.31 0.18 0.21 0.15 0.35 0.29 0.33 0.31 0.34 0.67 0.39 0.14 0.13

2009

2010 with world markets when the global financial crisis struck. crisis financial global the when markets world with integrated poorly relatively still were and others than later liberalised were region EBRD the in markets stock time, same the At clear. less become have markets emerging in investing of benefits diversification the aresult, As correlated. strongly more much become have two the and those in developed markets. developed in those and markets these in returns between correlation little was there as benefits, diversification great and potential growth offering opportunities, investment ideal the as regarded were Asia south-east and America Latin 1990s early the In investors? for opportunities diversification additional offer Europe emerging in markets stock do So, investments. of portfolio adiverse hold to keen are investors market Stock benefits Diversification countries. many in capitalisation market in increases to contributed also has trading electronic of introduction The market. stock the to companies more attracts and activity trading fosters laws trading insider of enforcement stronger stock, of cost the reducing by Thus, stock. issuing of cost the and costs transaction increasing thereby price, buy their lowering and price sell their increasing by themselves protect market-makers enforcement, weak with countries In exchange. stock the on listed be to tend industries) more in (and companies companies of numbers larger and higher, be to tend levels liquidity and capitalisation market enforcement, stronger with countries In analysis. regression unreported an to according markets, stock of development the fosters –systematically prosecutions 31 30 29 diversification benefits to global investors. global to benefits diversification many offer to unable be may region the years, coming the in persists correlation strong this If Europe. western in prevailing those with aligned closely been have region EBRD the in companies of profitability future index comes from MSCI). from comes index market stock European Table 4.1.1; in listed western the markets stock the from stocks individual 2,000 than more on based is index Europe emerging 4.1.1, custom-made the Chart (see which in markets stock European western in those to similar very been have markets stock    as well as careful checks on return data. These custom-made value-weighted indices aim to account for for capitalisation. account to market aim total of indices cent per 85 around value-weighted custom-made These data. return liquidity, on and checks availability careful as data at well as looking tests inclusion of aseries passed 4.1.1 have Chart in stocks The See Harvey (1995). (1995). Harvey See See Bekaert and Harvey (2014). Harvey and Bekaert See The enforcement of insider trading laws – as evidenced by by evidenced –as laws trading insider of enforcement The Since the financial crisis, however, returns in emerging Europe’s Europe’s emerging in returns however, crisis, financial the Since 31 This indicates that the factors affecting the the affecting factors the that indicates This 29 Over the last two decades, however, decades, two last the Over 30

75 76 TRANSITION REPORT CHAPTER 4: PRIVATE EQUITY AS A SOURCE OF GROWTH 2015-16 REBALANCING FINANCE

BOX 4.2. EXCHANGES AS COMPANY FINANCING HUBS CHART 4.2.1. Percentage of overall market capitalisation accounted for by small and mid-caps Small and medium-sized enterprises (SMEs) are a major driver of economic growth and employment in the EBRD region. However, it 100 has become harder for SMEs to obtain bank financing since the global financial crisis (see Chapter 2). Equity markets could help to alleviate 80 constraints in terms of SMEs’ access to finance, as regards both equity 60 (via the listing of companies) and debt (via the issuance of corporate bonds). However, much remains to be done if exchanges are to become 40 effective providers of financing to SMEs.

In terms of market capitalisation, SMEs already make up the 20 majority of most exchanges’ clients in the EBRD region (see Chart

4.2.1). However, SMEs typically face the same listing requirements and 0 Cyprus Kazakhstan Jordan Slovenia Greece Egypt Hungary Turkey EMEA Morocco regulatory regimes as large companies. Brokerage and initial public average offering (IPO) consultancy fees can be particularly high for SMEs as a Source: World Federation of Exchanges 2013 Market Segmentation Survey. percentage of sales or profits. For instance, the average cost of an IPO Note: Small and mid-caps are companies with market capitalisation of up to US$ 1.3 billion. for SMEs in Turkey is 7 per cent of the capital raised, compared with only EMEA stands for Europe, Middle East and Africa. 4 per cent for larger companies. A few stock exchanges in the EBRD region already have designated while at the same time specific investment restrictions apply for retail SME market segments, such as the Emerging Companies Market investors in this segment. operated by Borsa İstanbul, the NewConnect market at the Warsaw In the EU, MiFID II creates new tailor-made markets for SMEs in Stock Exchange or the Aero market recently established by the the form of multilateral trading facilities (MTFs).32 MiFID II maintains Bucharest Stock Exchange. These segments remain relatively small. For high levels of protection for investors, while reducing unnecessary instance, 22 companies are currently listed on the Emerging Companies administrative burdens for issuers in these markets. Existing growth Market, which had a trading volume of US$ 890 million in 2014. SMEs markets can voluntarily choose to register as SME growth markets, as listed there benefit from a special subsidy of approximately US$ 35,000 long as at least 50 per cent of issuers are SMEs. from Turkey’s SME Development Center, which helps to bring down the Exchanges with a multi-level equity market structure covering issuers costs faced by smaller firms. Special incentives encouraging brokers, of various sizes that are at different stages of development are in a very investment banks, analysts and accounting firms to specialise in small good position to offer SMEs access to capital markets (see Chart 4.2.2). companies also reduce the cost of listing for SMEs. Shares in SMEs For example, the TMX Group in Canada operates a tiered equity market tend to be traded less frequently than blue-chip stocks, so the design of consisting of three markets: (i) the Toronto Stock Exchange (TSX), the SME markets and their legal and regulatory environments needs to take main market targeting large and medium-sized companies; (ii) the TSX account of the lower levels of liquidity in these segments. Venture Exchange, a junior equity market focusing on SMEs; and (iii) The US Jumpstart Our Business Startups (JOBS) Act, the new EU the NEX market segment, which is for companies which do not fulfil the Markets in Financial Instruments Directive (MiFID II) and Canada’s TMX criteria for listing on the TSX or the TSX Venture Exchange. The multi-level Group provide some guidance in this respect. In the United States, the market structure provides companies with simplified listing procedures, JOBS Act focuses on what it calls “emerging growth companies” (EGCs), helping them to graduate to higher market segments. providing a legal framework for EGCs with audited accounts that plan The development of such specialist SME exchanges and simplified to raise up to US$ 1 million of capital annually and unaudited EGCs regulatory and listing requirements for SMEs can greatly improve SMEs’ planning to raise up to US$ 500,000 per year. SMEs are subject to less access to finance across the EBRD region and diversify the funding onerous registration procedures and reporting/disclosure requirements, options available to SMEs.

CHART 4.2.2. A company financing hub with a multi-level structure

Exchange’s Equity/debt Private company SME growth Exchange’s standard prime market market market market platform

Level 1 Level 2 Level 3 Level 4 Level 5

Source: EBRD.

32 An MTF is a trading platform operated by an approved market operator (such as an exchange or an investment bank). The US equivalent is the alternative trading system (ATS). MTFs were introduced by the first Markets in Financial Instruments Directive (MiFID) with the primary aim of enhancing competition, encouraging trading and offering competitive prices. MTFs are subject to more relaxed regulatory requirements compared with regulated markets operated by exchanges. 77

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