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 © Berlin Economics Outline 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 © Berlin Economics 2 I. Policy challenges for Georgia © Berlin Economics 3 Georgia’s pre-existing vulnerability from corporate debt 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 © Berlin Economics 6 I. Private equity in emerging Europe: recent trends • 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. © Berlin Economics 7 © EconomicsBerlin 1,000 1,500 2,000 2,500 3,000 3,500 4,000 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 Source: Invest EuropeInvest Source: 500 500 0 0 EUR m EUR EUR m EUR 2003 2003 2004 2004 2005 2005 2006 2006 2007 value Investment 2007 Private equity activity in the CEE region CEE the in activity equity Private 2008 2008 Fundraising 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016 2017 2017 2018 2018 2019 2019 1,200 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 2,505 300 600 900 500 0 0 EUR m EUR m EUR Estonia 2007 Poland 2008 Investment value in key countries key in value Investment Romania Mezzaninefund Venture capital 2009 type fund by Fundraising Serbia 2010 Lithuania 2011 Hungary 2012 Croatia 2013 Generalist fund Growth capital Czech Rep. 2014 Ukraine 2015 Slovakia 2016 Bulgaria Buyoutfund Latvia 2017 Slovenia 2018 2019 2018 2017 2016 8 Other 2019 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. © Berlin Economics 9 Market failures as a rationale for state support? • 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. © Berlin Economics 10 IFI and EBRD support to private equity funds • 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). © Berlin Economics 11 The example of the EU-EBRD Armenia equity fund • 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. © Berlin Economics 12 III. Types of state support to private equity in mature capital markets © Berlin Economics 13 Types of state support to private equity funds • 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.