PRIVATE EQUITY AS A SOURCE OF GROWTH

Chapter 3 demonstrated that private equity funds in the transition region often rely on operational improvements to achieve financial returns for their investors. This chapter asks a different question: how do these operational improvements contribute to economic development – specifically, employment, productivity, profitability and physical investment – in the companies that private equity funds invest in?

Analysis shows that private equity funds in the transition region have a positive impact on both profitability and employment levels. The estimated impact on revenue and employment in the region is stronger than that reported for advanced economies. This is achieved via a combination of scaling up operations, increasing capital expenditure with the aim of improving labour productivity and introducing leaner production methods associated with better inventory and cash management. Furthermore, private equity financing enables companies to access credit markets and fund some of their physical investment and operational improvements through bank finance. This effect has gained in prominence since the global financial crisis and is of particular benefit to smaller companies.

There is a sizeable pool of companies in the EBRD region similar to those that have already attracted private equity financing. These companies have typically sustained high levels of revenue growth over a number of years, they have room for the operational improvements that private equity funds can deliver, and they are not overvalued. Many of these companies could potentially benefit from private equity injections. Indeed, it is thought that they have the potential to attract an estimated US$ 30.5 billion of private equity financing. However, private equity funds in the region have invested a total of just US$ 9.2 billion since 2010. This disparity reinforces the observation in the previous chapter that private equity is an underutilised source of external finance in the region. More importantly, it means that the positive impact that private equity has on companies and workers remains limited to small sections of the economy.

There are two ways in which policy-makers can help ensure that more companies in the region benefit from private equity financing. First, shareholder protection and the enforcement of corporate governance legislation are essential to increase the effectiveness of private equity in the region and make companies more attractive to potential investors. Given the long-term and illiquid nature of private equity as an asset class, investors need to be given a transparent and reliable legal framework, especially as regards the rights of minority shareholders. Second, the development of public equity markets and the establishment of stock exchanges tailored to small and medium-sized enterprises (SMEs) can provide private equity funds with more opportunities to exit investments. In addition, the development of credit markets can support the development of private equity, as high-growth companies typically rely on both bank loans and private equity financing to fund their expansion.

How private equity funds improve the operational performance of investee companies remains a matter of debate. Three issues dominate this debate. The first contentious issue is whether private equity funds do indeed improve companies’ efficiency or simply invest in more efficient companies that would have performed better subsequently in any case. Evidence suggests that both effects exist. A recent study found, for instance, that companies invested in by US venture capital funds were an average of 7 per cent more productive than other firms. However, these investee companies also experienced, on average, a 12 per cent increase in productivity after receiving the investment.5 Buyout funds, in contrast, tend to invest in underpriced companies and may contribute little in the way of operational improvements.6

A second contentious issue is the impact that private equity has on employment. On the one hand, evidence from the United States and the United Kingdom shows that employment and wages grow more slowly in companies that receive private equity financing relative to the rest of the economy. This is consistent with the idea that private equity funds focus on reducing labour costs in order to improve operational efficiency. On the other hand, evidence from France shows that investee companies experience stronger growth in both jobs and wages than similar companies that have not received such investment.7 In other words, it does not seem possible to generalise the impact private equity has on employment.

A third contentious issue is whether private equity funds sacrifice long-term investment and focus on generating short-term cash flows. In the 1980s investee companies in the United States experienced reductions in capital expenditure following buyouts.8 However, subsequent studies have documented a positive impact on capital expenditure and investment in innovative activity in the United States and France.9 On balance, private equity funds do not appear to sacrifice long-term productivity in return for short-term gains.

In part, these conflicting findings reflect differences in the focus of private equity in different countries. For instance, buyout funds in the United States and the United Kingdom tend to target large, mature firms, where they focus on reducing capital expenditure, restructuring labour and financial engineering in 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

With this in mind, this chapter examines the impact that private equity investment has on companies’ performance in the EBRD’s countries of operations. It begins by discussing the screening of companies by private equity funds, before documenting the impact that private equity investment has on revenue, profitability, employment and productivity in investee companies, taking into account the restructuring of labour and credit constraints.

Simply comparing the performance of companies with and 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 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 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 without private equity involvement (by means of a “difference-in-differences analysis”). It is important to ensure that the companies that receive private equity investment are similar to those that do not (the “control group” in the analysis). The control group for each investee company comprises five similar firms drawn from the Orbis database of companies in the EBRD 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 terms of their revenue, assets and fixed assets over the three-year period preceding the investment.11

The analysis reveals that investee companies’ stock of debt almost doubles relative to companies that do not receive private equity investment (see Table 4.2). As with capital expenditure, borrowing takes place in the early years of the investment period (see Chart 4.4). In fact, analysis suggests that investee companies issue additional debt to finance part of their capital expenditure.

The resulting increase in capital intensity translates into higher levels of productivity and revenue, such that there is no significant increase in investee companies’ debt-to-asset ratio. The higher levels of revenue are then used to pay down debt in later years.

If access to credit and operational improvements are key to the economic impact of private equity, one would expect stronger outcomes for companies that are more credit-constrained and inefficient prior to that private equity investment. In the EBRD region, such companies are typically smaller and younger firms, which often do not have physical assets and stable cash flows to borrow against. These companies are also less innovative and therefore less productive, as documented in last year’s Transition Report.

The analysis suggests that private equity financing does indeed benefit small and young companies more than it benefits large and mature companies. The additional growth in revenue caused by private equity investment is around twice as large for small and young companies as it is for large and mature companies (see Charts 4.5 and 4.6). A similar pattern can be observed for other measures of performance, including investment in physical capital and cash flow management. Furthermore, the impact on profitability and employment is primarily observed for small and young firms. In other words, large and mature investee companies experience only limited additional growth in their profitability or employment following private equity investment. In these companies, efforts appear to be focused primarily on eliminating operational inefficiencies and improving cash flow management.

The ways in which private equity funds improve investee companies’ performance vary from sector to sector. In high-technology sectors, private equity funds undertake large-scale capital investment to improve productivity, but this investment does not seem to create additional jobs (see Chart 4.7). Companies in the retail, wholesale trade and services sectors, which often lack collateralisable assets, see the largest increases in the stock of debt in line with private equity’s role in relaxing financial constraints. This additional funding source is then used to increase capital expenditure, which brings about higher levels of employment and profitability.

Strikingly, the impact of private equity on access to credit has doubled since the global financial crisis.15 This reflects the fact that (in the absence of private equity funds’ seal of approval) firms have faced much tighter credit conditions. As a result, the impact of private equity in terms of capital expenditure growth and associated improvements in labour productivity has also increased, ultimately translating into a stronger impact on revenue growth.

Second, potential targets are required to have a positive return on their assets, but room for operational improvement. The return on assets – defined as the ratio of net income to total assets – captures how efficiently a company uses its capital to generate earnings. Thus, ratios must be no higher than that of the average investee company. Companies that already have high ratios may not be attractive targets, as the scope for further operational improvements may appear limited.

Similarly, the third criterion relates to the sales margin. It is required to be positive, but no higher than that of the average investee company in the private equity sample, leaving scope  for improvement.

Lastly, potential target companies are required to have a valuation that is not prohibitively high. Private equity funds report that this is one of the most important factors when it comes to choosing an investment.16 The proxy for valuation used here is the ratio of a company’s book value to its earnings (before interest and taxes).17 It is assumed that a potential target company’s ratio cannot exceed the 70th percentile of the distribution of these ratios in the sample of investee companies. Table 4.3 shows the criteria applied for returns on assets, sales margins and company valuations by region.18

On the basis of these criteria, potential target companies in the EBRD region have a total book value of US$ 61 billion (measured in 2013 prices; see Table 4.4). Assuming that owners would be willing to sell half of their companies’ shares to potential investors, a total of US$ 30.5 billion could be deployed in the region by equity investors. If all of this amount were to come from private equity funds – rather than being raised through initial public offerings (IPOs), foreign direct investment or other forms of direct ownership – it would correspond to around 0.5 per cent of the region’s GDP, a steep increase in private equity penetration (which currently stands at less than 0.1 per cent). Indeed, a total of just US$ 9.2 billion of private equity capital has been invested in the EBRD region since 2010.19 However, even the increased amount falls short of the level of private equity activity in advanced markets such as the United Kingdom, where the corresponding figure is around 1 per cent of GDP.

Tripling the number of companies receiving private equity investment, which would mean a jump to 2,100 from around 700 (since 2010), could create an estimated 42,000 jobs in the region.20 However, this calculation assumes that private equity investors will continue looking for relatively large investee companies, whereas the vast majority of potential investment targets identified in Table 4.4 are relatively small. This is particularly true of Turkey (see Chart 4.9). Furthermore, these calculations are not precise and are purely indicative. For instance, the recent downturn in the economic prospects of Russia and the CIS region has probably led to the pool of potential target companies being underestimated in these countries.

In order to determine the quality of corporate governance legislation and its implementation in the region, the EBRD launched a new corporate governance assessment in 2014.23 This assessment sought to ascertain whether minority shareholders that want to play an active role in the company,  such as private equity funds, (i) can conclude shareholder agreements and rely on their enforceability, (ii) have the option to appoint a board member and (iii) can rely on the disclosure offered by companies.

Shareholder agreements can be an effective tool enabling investors such as private equity funds to protect their investments. However, the EBRD’s assessment has revealed limitations in the use of this tool in the transition region. In most countries, shareholder agreements do not need to be disclosed. Furthermore, in most countries it is not clear whether they are enforceable. They seem to be fairly rare in practice, and little or no case law exists on this matter.24

Furthermore, while many countries in the region have legislation enabling minority shareholders to appoint board members, it often does not apply automatically. In other words, minority shareholders have to formally request that such provisions be applied. For instance, existing legislation in many countries allows cumulative voting on the appointment of board members to be requested. This would prevent the majority shareholder from appointing all board members.25 For cumulative voting to work effectively, however, the company’s shareholders need to know who the other shareholders are in order to be able to organise themselves, form an alliance and nominate a candidate to elect. Unfortunately, lists of shareholders are not easily available in many cases.

Moreover, in some cases, boards may have little say in decision-making. Companies across the region tend to be organised under a two-tier system, with separate supervisory and executive boards. In an ideal world, the general meeting of shareholders would appoint the supervisory board which would then appoint and remove the company’s executives. However, the EBRD’s assessment has found that in a number of countries the default legal rule enables the general meeting of shareholders to appoint both the supervisory board and the management (unless the company’s by-laws provide otherwise). This mechanism, coupled with the absence of cumulative voting, allows a controlling shareholder to appoint both the supervisory board and the company’s executives, depriving the board of any leverage over these executives. This discourages private equity funds from acquiring minority positions and prevents private equity funds that do hold minority stakes from carrying out operational improvements.

Another key aspect of governance from the perspective of potential investors is the level of non-financial disclosure. Although financial reporting in the region has reached a good standard, previous instances of corporate fraud have underscored the importance of validation procedures for financial reports. In this respect, a key role is played by audit committees. Members of a company’s audit committee need to be qualified and independent if they are to recommend best practices in the area of reporting and provide stakeholders with a clear picture of key developments in the company. The EBRD’s assessment suggests that this may not be the case except for a very small number of countries (such as Poland and Turkey). A lack of independence and expertise on company boards makes it more difficult for private equity funds (which have limited resources) to ensure adequate monitoring of their investee companies.

Although there is significant variation across countries (see Box 4.1), capital market development tends to be the area where the EBRD region lags furthest behind western Europe and the United States when it comes to attracting venture capital and private equity. According to the index compiled by the IESE Business School, the region scores a lowly 40 out of 100 in this area, where 100 indicates the level of capital market development in the United States (see Chart 4.10), while in other areas (such as investor protection and corporate governance) the region’s scores are substantially higher. This shows that increasing the depth of capital markets should be a clear priority when it comes to attracting more private equity investment to  the region.

A number of policy options are available to facilitate the development of public equity markets. First, policy-makers can support the establishment of exchanges designed specifically for SMEs (see Box 4.2). Many of the companies in the EBRD region that attract private equity financing are SMEs and more SMEs may be able to attract such funding if they can list their shares on an exchange with relative ease at the time of exit. In contrast with a national stock exchange which typically caters for large conglomerates, an “SME growth market” allows smaller 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 all have fledgling SME growth markets. Stricter enforcement of insider trading rules is also instrumental in supporting the development of equity markets (see Box 4.1).

Second, channelling more savings from households and institutional investors into equity markets is crucial. EU member states’ efforts to establish a capital markets union should help to match institutional investors with productive companies across 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 has a particular impact on capital directed towards long-term “alternative” investments such as private equity.

In terms of market capitalisation, SMEs already make up the majority of most exchanges’ clients in the EBRD region (see Chart 4.2.1). However, SMEs typically face the same listing requirements and regulatory regimes as large companies. Brokerage and initial public offering (IPO) consultancy fees can be particularly high for SMEs as a percentage of sales or profits. For instance, the average cost of an IPO for SMEs in Turkey is 7 per cent of the capital raised, compared with only 4 per cent for larger companies.

A few stock exchanges in the EBRD region already have designated SME market segments, such as the Emerging Companies Market operated by Borsa İstanbul, the NewConnect market at the Warsaw Stock Exchange or the Aero market recently established by the Bucharest Stock Exchange. These segments remain relatively small. For instance, 22 companies are currently listed on the Emerging Companies Market, which had a trading volume of US$ 890 million in 2014. SMEs listed there benefit from a special subsidy of approximately US$ 35,000 from Turkey’s SME Development Center, which helps to bring down the costs faced by smaller firms. Special incentives encouraging brokers, investment banks, analysts and accounting firms to specialise in small companies also reduce the cost of listing for SMEs. Shares in SMEs tend to be traded less frequently than blue-chip stocks, so the design of SME markets and their legal and regulatory environments needs to take account of the lower levels of liquidity in these segments.

The US Jumpstart Our Business Startups (JOBS) Act, the new EU Markets in Financial Instruments Directive (MiFID II) and Canada’s TMX Group provide some guidance in this respect. In the United States, the JOBS Act focuses on what it calls “emerging growth companies” (EGCs), providing a legal framework for EGCs with audited accounts that plan to raise up to US$ 1 million of capital annually and unaudited EGCs planning to raise up to US$ 500,000 per year. SMEs are subject to less onerous registration procedures and reporting/disclosure requirements, while at the same time specific investment restrictions apply for retail investors in this segment.

In the EU, MiFID II creates new tailor-made markets for SMEs in the form of multilateral trading facilities (MTFs).32 MiFID II maintains high levels of protection for investors, while reducing unnecessary administrative burdens for issuers in these markets. Existing growth markets can voluntarily choose to register as SME growth markets, as long as at least 50 per cent of issuers are SMEs.

Exchanges with a multi-level equity market structure covering issuers of various sizes that are at different stages of development are in a very good position to offer SMEs access to capital markets (see Chart 4.2.2). For example, the TMX Group in Canada operates a tiered equity market consisting of three markets: (i) the Toronto Stock Exchange (TSX), the main market targeting large and medium-sized companies; (ii) the TSX Venture Exchange, a junior equity market focusing on SMEs; and (iii) the NEX market segment, which is for companies which do not fulfil the criteria for listing on the TSX or the TSX Venture Exchange. The multi-level market structure provides companies with simplified listing procedures, helping them to graduate to higher market segments.

The development of such specialist SME exchanges and simplified regulatory and listing requirements for SMEs can greatly improve SMEs’ access to finance across the EBRD region and diversify the funding options available to SMEs.