Demystifying private equity: A cause and effect of development

How can private equity fill a unique and meaningful role in the world of development finance? Photo by: Kent Wang / CC BY-SA

The notion of private equity typically calls to mind certain images — financial district skyscrapers, boardroom negotiations or billion dollar transactions closed over five-star lunches. It is indeed a high-stakes industry that mobilizes vast sums of capital — the kind that can deliver meaningful results for large-scale development initiatives.

Private investment of all forms is needed to fund the 2030 Sustainable Development Goals, whose price tag is estimated to be in the trillions. For a business, investment can involve new models to capture base of the pyramid markets. For banks, innovative instruments to finance those operations. Where, then, does private equity fit into development finance? Devex spoke with several private equity investment managers to get their take on the nexus.

An indirect alliance

The two often overlap but may not directly intertwine. By definition, the private equity industry exists to grow businesses and commercialize innovations that, in turn, can allow economies to flourish. That often leads return-seeking investors to the same emerging economies where growth potential is high and development work is most needed. According to the Emerging Markets Private Equity Association, private equity flows to emerging economies totaled $14 billion in the first half of 2015 — a number that dwarfs the gross domestic product of a handful of sub-Saharan African economies.  

But the commercial aims of traditional private equity funds disconnects with those of traditional development. A successful investment — technologies in renewable energy, transportation or waste management, for example — can generate thousands of jobs and make huge inroads for sustainable development, but those outcomes are not the principal aim.

“We invest in business models, not development,” Jeffrey Leonard, chief executive of Global Environment Fund, an energy-focused private equity group that manages $1 billion in assets, matter of factly told Devex.

And though private equity investments can spur industries and enable growth, the decision to invest in emerging markets hinges on the presence of various development conditions.

“It’s about managing risks and achieving outsized rewards,” Leonard explained. The size of the potential investments at stake can make private equity both a catalyst for and beneficiary of development.  

To be sure, there are private equity groups that focus primarily on development. The most notable example is perhaps the International Finance Corp., the private sector investment arm of the World Bank, which invests $500 million annually in private equity funds. Unlike other private equity firms, the IFC’s mandate with any investment is to promote development, which often means it is the first equity investor in developing countries with nascent infrastructure.

The art of evaluation

Private equity groups evaluate their risks using a host of criteria. They are specific to the company being invested in and can range from its valuation price to the strength of the management team, its ability to deploy growth capital, how the company uses proceeds and its compatibility to other business models that the private equity fund invests in.

But equally critical are the broader political and economic conditions that build an enabling environment for private equity investments. They are closely aligned policies and conditions that promote economic stability in order to boost development and serve as useful guidelines for governments wanting to attract private equity.

First, private equity is about scale. The sums of capital pooled together are large and in search of high returns. Expected returns in a mature market such as the U.S. are around 12 percent, but in developing countries investors typically seek a 5 percent premium, according to Sergio Pombo, founder of the Latin America-focused group Berkana Private Equity.

High returns often require large markets, which in turn, may require regional integration. “If your business is manufacturing and selling products, you need to have a market that’s big enough,” said Leonard. It is a factor that makes emerging markets such as a Brazil and India attractive for private equity and can potentially draw similar interest in Africa as the African Development Bank promotes regional integration as one if its core development priorities.

Related to the issue of scale is the question of size. Size generally matters in private equity and the notion of “too small” to invest does exist. Private equity is not typically in the business of funding startup social enterprises, for example. But while those ventures are not the main targets for private equity groups, fund managers point out that more can be done by governments and grant-giving agencies to scale up social enterprises to the level of interest for private equity groups.

A private equity dilemma in Africa, one manager noted, is not the lack of companies, but a gap in technology, environmental standards, accounting procedures or other management systems that can boost start-up companies to the level of a fund’s interest.

Private equity funds tend to be large and are selective and patient in their investments. Funds typically have a horizon of between eight and 10 years and average less than 10 investments over that span. As a result, private equity funds need stability.

Fiscal responsibility by governments is a key component of stability. Large deficits or wasteful spending that erodes local currencies pose foreign exchange risks for investors repatriating their returns.

It can also mean eliminating policies that create distortions in local economies such as subsidies.

“All they do is drive overconsumption and breed single solutions,” said one fund manager.

Conversely, clear and transparent pricing — even in the form of taxes on a business and its operations — can promote the type of stability that investors desire. The growing support among the business community for a price on carbon, for example, reflects this trend. “If you price carbon, the investment landscape shifts towards other options,” Leonard noted. “Perhaps the solution is energy efficiency.”

But ultimately, private equity is all about an exit strategy and the ease in which an investor can liquidate an asset — with favorable returns — at the end of a horizon. Much of that depends on the conditions of local industry and commerce. Financial markets need to be well-established to support a public offering. Or multinationals should be present to serve as potential buyers. A common strategy for investors in developing countries with nascent capital markets, for example, is to purchase a middle-tier company with the hopes of eventually selling it off to the largest player in that industry.

Private equity can fill a unique and meaningful role in the world of development finance. As a vehicle for massive volumes of capital, the business models that it invests in naturally target high-impact innovation and large-scale growth — a mission that aligns with many development initiatives. But as with any private entity, those commercial objectives can only catalyzed by a framework of policies by government that promote financial stability and incentives.

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About the author

  • Naki B. Mendoza

    Naki is a former reporter, he covered the intersection of business and international development. Prior to Devex he was a Latin America reporter for Energy Intelligence covering corporate investments and political risks in the region’s energy sector. His previous assignments abroad have posted him throughout Europe, South America, and Australia.