Beyond the talk of a “locusts’ plague”

Private equity funds (PEF) are companies which invest private equity capital in businesses, for the purpose of making a profit through the subsequent sale of their investment. These funds have been the subject of vivid debate in Germany. During the 2005 election campaign, Franz Müntefering, then leader of the governing Social Democratic Party (SPD), described PEFs as a “plague of locusts”. He has often been quoted since. PEFs are criticised on the grounds that they
– are focused on short-term results,
– generate excessive expectations of the rate of return,
– encumber businesses with excessive levels of debt, and
– ruthlessly destroy jobs.

This discussion is drawing international attention. The Chinese and South Koreans are considering how PEFs should be regulated – but also whether some of them even deserve support. Lacking access to equity capital presents an enormous obstacle for many businesses, particularly to small and medium-sized enterprises (SMEs). This is particularly true in developing countries with weak financial sectors.

Supporters of PEFs therefore regard them as a new form of financial intermediary. If they take a stake in a business, it can then increase its equity capital, make investments and obtain access to professional management know-how. PEFs can also help medium-sized enterprises if they have sucession problems. An example would be if the owner reaches retirement age, which could otherwise put the business’s continuation at risk. In short, the short-term involvement of a PEF can help businesses to overcome various types of bottleneck and to grow more quickly.

PEFs transfer considerable amounts to developing countries. In 2006, the amount transferred was 33 billion dollars, ten times more than in 2003. Not surprisingly, China and India are the main focus of interest, but last year commitments to Africa after all totalled 5.5 billion dollars.

PEF commitments are also becoming increasingly important for development finance institutions (DFIs), for example, the World Bank subsidiary IFC and the German Investment and Development Company (DEG), a subsidiary of the KfW banking group, or other institutions, whose specific mandate is to set up and develop the private sector. The SME target group is often served better by funds which are active locally, with relatively small sums and intensive management support, than by the DFIs themselves.

Empirical results

The question naturally arises whether PEFs should really be described as destructive “locusts”. The IFC, the European Bank for Reconstruction and Development and the Asian Development Bank have all had case studies prepared on this type of commitment. Their main finding is that the PEFs do make a positive contribution. DEG also reached a similar conclusion. It was the first institute to assess its entire PEF portfolio, in order to make a systematic and thorough review of the effects of its commitments.

In early 2007, DEG carried out an “ex post” portfolio analysis. It found that there had been positive contributions to measurable development effects. This was particularly so in the following areas:
– Employment: about 210,000 jobs were created or secured in the 300 or so companies in which PEFs invested with DEG involvement. This is substantial, given the usual two-digit unemployment rates in the target countries. In addition, 500 senior positions were created at management level in the PEFs themselves.
– Capital market / finance sector: PEFs often expand the supply on local capital markets. 66 per cent of the PEFs in DEG’s portfolio invested in SMEs which usually do not have access to long-term equity capital. Roughly two thirds of the PEFs funded innovative sectors, such as renewable energies, information technology and health. 59 per cent of the PEFs made available capital from local investors, and thus counteracted capital flight. They thereby contributed to the systematic development of the financial sector.
– Development of the enterprise sector: Corporate management, in the professional sense, was upgraded in 86 percent of the investee companies (see diagram). In two thirds of cases, for example, the accounting and reporting systems were brought up to international standards. Three quarters of the investments involved expansion and/or modernisation, including technology transfer. In one third of cases, environmental and social monitoring systems were introduced. This figure is considerable given the SME target group. Nevertheless these rates should certainly increase in future.

It should be noted that investment funds typically provide management know-how as well as equity capital. This fact is also reflected in the active role which DEG itself plays within the PEF. Not only did the Cologne-based institution make available equity capital but, in 71 per cent of the PEF commitments, it actively participated on supervisory boards or investment committees, which involves important advisory functions.

In addition, as promoter of environmental and social management systems, better corporate governance and extended assessment of developmental effects, DEG influenced standard setting within the PEF sector. The DFI’s role here as mediator received particular praise from the World Economic Forum’s Financing for Development initiative. A further important factor is that, in many cases, local investor capital was made available. DEG thus fulfils a signalling role, which is typical for DFIs.

DEG’s survey included 44 investments in PEFs with a total commitment volume of around 210 million Euro. The portfolio is broadly diversified by regions, with 35 percent of the commitments allocated to Eastern Europe, 30 per cent going to Africa, 25 per cent to Asia, and ten per cent to Latin America. Compared with other institutions in the market, DEG’s Africa’s share is considerable.

DEG reviewed its PEF portfolio using corporate-policy project rating (GPR), an internal assessment tool. It is an index point system, whereby a score is given according to the degree to which particular goals have been fulfilled (Koch, 2007). The factors mentioned above (employment, diversification of the finance sector and development of the enterprise sector) are included in the developmental assessment. Also important are aspects such as the relevance of women, institution building, as well as training and capacity building. DEG’s rating system has recently been adopted by eight other European DFIs. The GPR not only assesses development effects, but also evaluates other important factors. These include long-term PEF profitability, DEG’s active participation and DEG’s return on equity. The development score results showed a success rate of 71 per cent, while the score for fully successful projects is significantly lower yet, at 41 per cent.

However, this might be explained by the fact that PEF commitments are generally planned for eight to ten years. The returns are not reaped until, after successful growth, the investments are listed or onsold to strategic investors. Currently more than half of DEG’s portfolio is still in the set-up investment phase.

Conclusion

Investment funds can be a sensible instrument for development activities. The talk of “locusts” as a generalisation is true neither for industrial nations nor for developing countries. A more differentiated assessment is necessary. The criticism is aimed at hedge funds, which are intended for short-term speculation, and at investors which fund company and investment purchases with excessive levels of debt (aggressive leveraged buyout funds).

Meantime, experts are increasingly accepting that PEFs play a positive role in the systematic development of the financial sector (Patricof und Sunderland, 2006). The sector concept of the German Development Ministry (BMZ) on financial system development also refers to PEFs as a sensible instrument.

However, PEFs do not automatically produce the desired developmental effects. It is advisable that development finance institutions play an active role as stakeholders and that the developmental effects be regularly monitored.