Majority and Minority Ownership in Global Growth Markets Josh Lerner, Andrew Speen, Chris Allen, and Ann Leamon
Series 3/5
Majority and Minority Ownership in Global Growth Markets Josh Lerner, Andrew Speen, Chris Allen, and Ann Leamon Table of Contents Executive Summary
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Introduction 10 Theoretical Evaluation
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Origination Risks
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Operational Risks
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Exit Risks
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Quantitative Assessment
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Returns 14 Length of Holding Period
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Route of Exit
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Conclusion 20
Table of Figures F1. Multiple of Capital Contributed (MoC) for 64 Abraaj Investments Since 2002
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F2. Median IRR of 312 IFC Private Equity Investments
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F3. Average IRR of 312 IFC Private Equity Investments
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F4. IRR of GGM Venture/Growth and Buyout Funds, Vintage Years, 1995-2012
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F5. Median Holding Period, in Months, of GGM Exits, January 1991-March 2015
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F6. Median Holding Period of GGM Investments Since 2003, by Exit Year
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F7. Median Holding Period of GGM Private Equity Exits, in Years
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F8. Median Holding Period of 527 GGM Private Equity Exits by Sector
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F9. Share of Exit Routes in GGM Private Equity Exits
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F10. Share of GGM Exits by Sector for Minority and Majority Deals
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Executive Summary
Private equity limited partners (LPs) raise several concerns about investing in global growth markets (GGMs). Will the local courts protect my rights? Can I profitably exit my investment? To what kind of exchange rate risks am I being exposed? Another equally important worry relates to the level of ownership investors take in the company. Minority stake purchases by private equity firms (spanning all investment stages) occur in about half of the deals in global growth markets (GGMs), but are much rarer in developed markets where they comprise only about 16% of deals.1 Minority investors often enjoy important rights on company boards, but the existing owners remain largely in control of company strategy and operations. Institutional investors with experience in U.S. and European private equity may therefore instinctively feel more comfortable investing in funds that plan to take majority ownership positions, as they may be concerned that limited control will lead to reduced investment returns. Such concerns, however, may be inconsistent with realities on the ground in GGMs, where majority ownership opportunities are rare, and often expensive. Concerns about the limited control afforded to minority investors are also not reflective of actual practice. Minority investors can obtain many of the privileges enjoyed by majority owners using covenant provisions that appear on virtually all private equity term sheets. These covenants, which often include a combination of reserved rights, separate service contracts for management, and up-front agreements on value creation plans, provide minority investors with de facto company control, and may provide better outcomes than majority positions. 5
Due to limited data, there has been little research done on the performance outcomes of minority versus majority investments in GGMs. This paper compiles the currently available GGM data in this area from three sources: summary data on the performance of GGM investments made by the International Finance Corporation (IFC), data from fully realized, exited investments made by The Abraaj Group, and data from a custom built database of GGM investments and exits, constructed by the Bella Research Group. By triangulating these three sets of data, we investigated the investment performance of minority and majority investments in GGMs. We proceeded in three steps: first, we discussed three major areas of investment risk: deal origination risk, operational risk, and exit risk. Next, we analyzed the relative strengths and weaknesses of majority and minority stakes in relation to each of these three risk categories. Finally, we analyzed the available empirical evidence on returns, holding periods, and exit routes to evaluate any performance differences between minority and majority private equity investments in GGMs. Our examination of deal origination risks centered on the motivations and incentives of the entrepreneur offering company equity. We highlight several worrisome reasons an entrepreneur would prefer to sell a majority interest of an underperforming enterprise, ranging from financial distress to outright fraud. We further cite academic research suggesting that more successful entrepreneurs in many cases are less likely to sell their ventures to venture capitalists. These origination risks are greatly mitigated in minority deals however, since the entrepreneur retains significant company 6
equity and is guided by many of the same incentives as the minority partner. A study of the operational risks facing majority and minority investors found that the main advantages of majority control, the ability to unilaterally make managerial changes, is to some extent negated in GGMs by the scarcity of highly qualified replacement managers.2 Additionally, we found that the value of experienced and well-motivated owners who can continue to leverage important, and difficult to replicate, business relationships, may outweigh many of the gains from switching to new management. We also highlight several deal covenants that protect minority investors by limiting managerial decisions that involve changing the business, buying or selling assets, issuing new debt or securities, or hiring new managers.3 Our analysis of the final risk factor, exit risk, found that while minority investors may have less control over exit decisions than majority owners, several covenants redress this imbalance. Carefully constructed deal terms and conditions, like “tag-along rights” and the “right of first offer”, are commonly used to equalize the rights of minority and majority investors. Additional conditions such as put options and performance-linked ownership awards or penalties can further align the interests of both majority and minority owners.4 We note, however, that enforcing such contractual rights requires a level of judicial effectiveness. While this level is not often reached in GGMs, PE firms will often domicile relevant documents (and equity stakes) in well-established jurisdictions to circumvent these problems.
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Our analysis of the risk profiles of majority and minority investments concludes that, contrary to the general preference for majority positions, holders of minority positions in GGM companies fare well in the three major categories of risk. The second half of this study presents empirical data underscoring the slight performance differences between minority and majority investments. Using three performance metrics—returns; holding period; and exit route—we generally found relatively small differences between the performance of majority and minority investments in GGMs. In most cases of notable differences, minority investments are favored. We compare GGM performance data from three sources: the International Finance Corporation (IFC); a database of GGM deals developed by the Bella Research Group; and proprietary data supplied by The Abraaj Group. The analyses failed to exhibit robust differences between the performance of minority and majority investments. Statistical tests confirmed (in most cases) the lack of any meaningful differences. Since majority investments are typically buyout deals, and minority deals are heavily concentrated in venture and growth capital investments, any effects attributed to minority or majority ownership status may simply be confounded by these characteristic deal types. For example, since GGM venture/ growth deals generate significantly higher returns than buyout deals (Figure 4), it may be the case that deal stage is more influential on investment performance than ownership type (minority or majority).
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The performance of a private equity investment relies on many critical factors. Highly skilled and motivated managers are essential, as is a cogent business plan, operational excellence, and a strategic vision. Risks abound, and success is difficult and rare. In general, however, the overall risks and rewards of an investment depend on the company as a whole and do not distinguish between minority or majority shareholders. Investment success or failure depends on a plethora of factors, but we find it is not determined by investor ownership stake.
1 Bella Research Group analysis based on data from the CapitalIQ database from Standard & Poor’s. Based on 35,572 completed private equity acquisition transactions from 1996 through March 2015. 2Finding executives “who have the ability to move easily between different cultures and have deep local roots as well as international operational experience in Brazil, China and India “‘is very challenging,’” as “‘the talent pool is very small,’” according to the former president of the Association of Executive Search Consultants. See Joann Lublin, “Finding Top Talent in China, India, Brazil,”
Wall Street Journal, April 11, 2011 (quoting Peter Felix). Academic research also suggests that firms in developing countries, such as Brazil, China, and India tend to be poorly managed. See Nicholas Bloom, Christos Genakos, Raffaella Sadun, and John Van Reenen, “Management Practices Across Firms and Countries,” Academy of Management Perspectives, Vol. 26, No. 1 (February 2012): 12-33. 3 Also see, Paul Gompers and Josh Lerner. “The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements,” Journal of Law & Economics, Vol. 39, No. 2
(1996); and Ola Bengtsson, “Covenants in Venture Capital Contracts,” Management Science, Vol. 57, No. 11 (2011): 1940. 4 Exit covenants often indicate a misalignment of interests and are viewed as options of last resort exercised in response to underperformance. Optimal exits will likely be initiated organically with a consensus from majority and minority shareholders.
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Introduction
The private equity model that evolved in developed markets over the past 25 years was built upon a few key principles, among these a preference for assuming majority control of investments. Buyouts assured control over the structure, development, and eventual exit of the investment. Unlike minority investors, majority owners are free to restructure both the finances (leverage) and operations (personnel) of the company, and enjoy unfettered control in piloting the investment to an exit. Minority deals remained an essential source of growth capital, but it was buyout deals that attracted the most attention and highest returns.
A
s private equity investors expanded into global growth markets (GGMs) in the 1990s, attractive investment opportunities of any type were difficult to find. Owners of established businesses in GGMs saw little need to sacrifice company equity in exchange for capital since they faced few competitive pressures in local markets. Strong traditions of family-run businesses in many GGMs also provided few openings for outside investors.
to raise capital for growth rather than to monetize their business, perhaps prematurely, through a sale. For these reasons, the bulk of private equity deals in GGMs are minority deals. Many global investors, accustomed to the more common majority investments in developed markets, are concerned that the different ownership stake assumed by PE firms in GGMs may fundamentally undermine the private equity model and lead to diminished investment performance. Although much anecdotal evidence abounds, very little research has been done in this area. To address these concerns, this paper gathers recent available evidence on the relative risks and rewards of minority and majority investments in GGMs. We begin with a definition and evaluation of the risk profile facing minority and majority investors, followed by a quantitative analysis of the rewards earned by these two types of investors.
Market reforms undertaken in many GGM countries since the late 1990s relaxed regulations and created more open, globalized economies. As competition grew and business opportunities developed, so did the demand for growth capital. Entrepreneurs in GGMs, anxious to capitalize on the growth of newly globalized GGM economies, became increasingly receptive to private equity partners.
Entrepreneurial appetite for private equity, however, has been selective: only half of the private equity deals in GGMs have been majority investments.5 The hesitation to enter majority deals has largely been driven by the reluctance of owners to part with a majority interest in promising companies. The preference for minority deals also reflects the basic motivation of company management
To explore whether minority or majority investments in GGMs typically produce different levels of returns, it is important to understand the different nature of the two types of transactions and the different risk profiles associated with them. The following section compares the risks of minority and majority investments across three major categories: origination risks, operational risks, and exit risks.
Theoretical Evaluation6
Bella Research Group analysis based on data from the CapitalIQ database from Standard & Poor’s, including 35,572 private equity transactions from 1996 through March 2015. Much of the theoretical framework presented here is extracted from: Wen Tan, “A Comparative Analysis of the Theoretical Risks of Minority Growth Capital Investing in Emerging Markets Relative to Traditional Control Leveraged Buyouts,” (Hong Kong, Squadron Capital, 2012). In particular, we explore three of the five categories the paper identified, namely, origination risks, operating risks, and exit risks. Tan additionally assessed structural risks (i.e., risks associated with the transaction structure) and business risks (i.e., the characteristics of the company’s sector). See also Josh Lerner and Antoinette Schoar, “Does Legal Enforcement Affect Financial Transactions?: The Contractual Channel in Private Equity,” Quarterly Journal of Economics, Vol. 120, No. 1 (February 2005): 223–246, and Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts,” Review of Economic Studies, Vol. 70, No.2 (2003): 281-315. 5 6
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Origination Risks The risks of private equity investing begin at the very outset of the deal, when the entrepreneur and the private equity firm negotiate over the amount of ownership that the company will exchange for private equity financing. Entrepreneurs willing to part with a majority interest in their company may be motivated by different factors than entrepreneurs willing to sell only a minority interest. There are of course many legitimate reasons for an entrepreneur to sell a majority interest in a promising company, including poor health, impending retirement, or just a lack of energy or interest to continue expanding the company. Very often, the owner will have grown a successful company, and simply attracted an offer that was difficult to resist. But the motivations may not be so straightforward and benign. By offering majority interest in the company the entrepreneur may be signaling poor future growth prospects or that the business is already in such a state that current shareholders are eager to exit. The willingness to sell the majority of the business to an outside firm may therefore indicate a “lemons problem”7—that is, the possibility that the entrepreneur has negative insider knowledge unknown to the potential acquirer, such as weakening demand, difficulties in introducing new products, or even hidden fraud. Assessing the seller’s motives is an essential component of due diligence, and especially critical for investors contemplating a majority investment. This type of origination risk, while smaller for minority investors, is not entirely eliminated. An entrepreneur selling a minority stake may also be driven by financial distress or poor growth prospects, and may simply be seeking to take some money “off the table.” It is important that the investors pursue sufficient due diligence to understand the sponsor’s motivations. Academics have studied the effects of the incentives driving private equity investment from the perspective of the firm. One study suggests that in many cases, information gaps lead high-quality entrepreneurs to resist private equity investments (specifically, venture capital) in order to capture the entire rewards from their enterprise. Less talented entrepreneurs, on the other hand, are more willing to sacrifice company equity and willingly endure the interference that accompanies these partnerships.8 As a result, the number of entrepreneurs offering to part with a majority stake of a potentially profitable and established business appears limited. Still (consistent with the study cited above), minority investments demand careful evaluation at the origination stage to assess the capabilities and attitude of the entrepreneur/owner. In contrast to the managerial autonomy enjoyed by majority investors, minority investors can generally select top management only during the origination stage of a deal. Prudent minority investors conduct very thorough due George Akerlof, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics, Vol. 84, No. 3 (August 1970): 488-500. 8 Raphael Amit, Lawrence Glosten, and Eitan Muller, “Entrepreneurial Ability, Venture Investments, and Risk 7
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diligence to minimize this origination risk. The thin GGM market for managerial talent underscores the critical nature of due diligence in deal origination, for both majority and minority investors. In exchange for capital, entrepreneurs pursuing minority investors explicitly agree to participate in a partnership. By accepting the terms of a private equity investment, the business owner shares in both the risks and rewards of the investment, and the active participation of a properly incentivized and engaged business owner improves the probability of success. Importantly, the entrepreneur should recognize the value of the private equity firm’s non-monetary benefits, and agree to work together with the investors in creating value in the operation. While ideal, these positive dynamics are rarely universal. A final origination consideration of minority positions relates to deal size. Minority investments make it possible to spread a given fund amount over a larger number of companies than possible with fewer, larger majority investments. The diversification benefits gained by holding a portfolio of a greater number of minority positions may further reduce origination risks.
Operational Risks In contrast to external market risks (which generally apply equally to both majority and minority investments, and are not explored in this paper), operational risks involve uncertainties caused by the internal governance and management of the company. The operational risks faced by minority investors are distinctly different from those encountered by majority owners. The majority interest gained in a buyout allows GPs to directly control the strategic direction of the company and exercise day-to-day oversight of operations. Majority owners are also free to make personnel changes in top management positions, which may include removing the previous owner—if that individual has remained with the company—and possibly even some of the management team. Yet this is not an unmitigated benefit. When a founder/ long-time owner is replaced after selling the entirety of a company, the operation loses years of valuable management expertise. Since a formal succession plan is rarely in place, the acquiring firm must recruit new managers and familiarize them both with the company’s operations and the planned value creation strategy. The newly hired management may have difficulty becoming familiar with company operations, and unlike the previous owner-manager, may not have as strong an incentive to succeed. This new team may also lack the business network that the previous management had built, which could seriously impair company growth. Of course, this assumes that management talent is available—which is often not the case in many GGMs.10
Sharing,” Management Science, Vol. 36, No. 18 (1990): 1232-45. 9 Ernst & Young, “Global Survey Reveals Talent Management Challenges for Rapid Growth Market Multinationals,” (Boston, MA: Ernst & Young, 2012), and Ernst & Young, “Paradigm Shift: Building a New
Talent Management Model to Boost Growth,” (Boston, MA: Ernst & Young, 2012). See also Nicholas Bloom, Christos Genakos, Raffaella Sadun, and John Van Reenen, “Management Practices Across Firms and Countries,” Academy of Management Perspectives, Vol. 26, No. 1 (February 2012): 12-33.
The absolute control of a majority owner contrasts with the more nuanced managerial relationship of an entrepreneur and a minority partner. As co-owner, the entrepreneur may have an even greater incentive to manage effectively and adopt the minority investors’ value creation plan. After all, he/she still owns the majority of the company, chose the investor, and has considerable reputation riding on the success of the transaction. The sizable ownership stake held by the entrepreneur aligns interests with minority investors and provides very effective motivation. In fact, a deal team member of a minority investment from a venture capital firm that specializes in GGMs noted that, “structuring the investment as the minority sharehold[er] was…the only thing that made sense in order to keep [the entrepreneur] motivated.”
“Assessing the seller’s motives is an essential component of due diligence, and especially critical for investors contemplating a majority investment” Lacking reliable courts and strong contract law, many global growth economies rely on relationships as a way of certifying a person’s trustworthiness. Minority investments assure continuity in the relationships established by the owner and provide private equity investors with a halo effect based on that individual’s reputation, just as the private equity firm, conversely, provides credibility to the CEO and the company. Minority stakes also imply that the sponsor has agreed to the imminent changes in governance and strategy stipulated as part of the pre-established value creation plan. The CEO can then rally support for these changes among the rest of the team. By integrating existing management, minority investors can create better working relationships with entrepreneurs, which can lead to more effective business transitions. This working relationship between the GP and the entrepreneur can often outweigh the benefits from strict control gained in majority deals. The direct control sacrificed by minority owners is typically recouped by including deal covenants that pertain specifically to managerial issues. Such covenants may include elements that prevent the management team from unilaterally (1) changing the business, (2) buying/
Ernst & Young, “Global Survey Reveals Talent Management Challenges for Rapid Growth Market Multinationals,” (Boston, MA: Ernst & Young, 2012), and Ernst & Young, “Paradigm Shift: Building a New Talent Management Model to Boost Growth,” (Boston, MA: Ernst & Young, 2012). See also Nicholas Bloom, Christos Genakos, Raffaella Sadun, and John Van Reenen, “Management Practices Across Firms and Countries,” Academy of Management Perspectives, Vol. 26, No. 1 (February 2012): 12-33. 11 See Ola Bengtsson, “Covenants in Venture Capital 10
selling assets, (3) issuing debt/junior securities, or (4) hiring management. The importance of these covenants is confirmed by academic research, which has found that when private investors do not control a majority of board seats, they rely more heavily on negative covenants to limit the ability of management to make operational decisions.11 The control gained by these covenants effectively limits many of the key problems that have beset minority owners of GGM companies—such as the “tunneling,” or appropriation, of profits by the controlling entrepreneur. Critically, however, the ability of investors to enter into such contracts with these provisions hinges largely on the effectiveness of the legal system. Lerner and Schoar (2005), for example, note substantial variation among 210 developing market private equity investments with respect to nations’ legal enforcement. They found that investments in countries marked by low legal enforcement and civil law (as opposed to common law) tended to rely on majority ownership and board dominance to alleviate legal enforcement problems.12 As mentioned previously, however, investors also tend to domicile their PE funds in more friendly jurisdictions (e.g., common law nations with a history of political stability) to enable reliable contracts, even when investing activity is focused in low-enforcement regions.
Exit Risks Majority investors tend to enjoy greater flexibility in exiting private equity investments than do minority investors. Exit considerations such as timing, route, valuation, and post-exit terms are primarily the concern of the majority owner, and minority investors generally have a limited voice in these decisions. Unlike minority investors, majority investors can, in certain circumstances, perform a leveraged re-cap, which allows equity investors to be given a one-time dividend by refinancing and increasing the portfolio company’s debt levels. In doing so, the equity investors are able to return invested capital without relinquishing control of the company.13 A variety of contractual provisions, however, can be used to protect minority interests. Often minority investors will negotiate “transaction protections” that prevent the majority owner from executing an exit, a major acquisition, or a dilution of existing equity without the approval of minority investors. Specific exit protections included in many minority deals grant so-called “tag-along” provisions that confer the option for minority investors to join the exit transaction on equal terms with majority owners. Minority investment contracts also typically stipulate the “right of first offer,” which gives minority investors the opportunity to purchase the company before it is offered to a third party.
Contracts,” Management Science, Vol. 57, No. 11 (Nov. 2011): 1926-1943. The author found that VCs lacking a majority of board seats negotiate more robust covenant protection, given a dataset of first-round contracts of U.S. VC-backed companies. The author reports that VC contracts lacking a VC board majority requirement include more covenant protection than do contracts that require a VC board majority. 12 Josh Lerner and Antoinette Schoar, “Does Legal Enforcement Affect Financial Transactions? The Contractual
Channel in Private Equity,” The Quarterly Journal of Economics 120, no. 1 (2005): 223-246. 13 We note, however, that re-caps generally increase company risk and can lead to misalignment of incentives if not done under the proper conditions. See, Josh Lerner, Ann Leamon, and Felda Hardymon. Venture Capital, Private Equity, and the Financing of Entrepreneurship, (New York: John Wiley & Sons, Inc., 2012), pp. 138-39.
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Furthermore, a “minority drag-along” provision can enable the minority shareholder to compel the majority shareholder to participate in a full exit arranged by the minority. Most importantly, minority investors can also be protected by put options that require the majority owner to buy the minority stake after a prescribed time period or upon reaching agreed-upon financial or performance milestones. 14 Put options effectively recast the PE investment as a loan, which can be repaid with a fixed interest rate. These provisions greatly mitigate the exit risks faced by minority investors. 15It is important to again note, however, that the force of such protections for minority shareholders is a function of legal and regulatory reliability. In other words, without strong judicial systems the benefits afforded to minority investors through contractual protections is limited, which makes the country of domicile particularly important for minority investors. Ideally, a minority investment allows the company to go public in an IPO. Few global growth markets currently have public equity markets with the scale to accommodate more than a handful of IPOs each year, but as we document later in this report, GGM minority investments exit via IPOs at a slightly higher rate than majority investments. Trade sales however, currently dominate exit markets, as illustrated in Figure 9. Some strategic buyers have traditionally viewed minority stakes as less desirable than majority stakes due to the diminished control they offered, but as we will see later in this report, statistical evidence indicates robust markets for trade sales of minority stakes.
Quantitative Assessment Having considered some of the relative risks of minority and majority investments, we next examine the available empirical evidence in order to quantify the performance of these two investment types. The following section evaluates minority and majority investments across three major metrics: returns; length of holding period; and exit route. Three different datasets, all specific to GGMs, are used to triangulate our findings. We use data on the GGM investments made by the International Finance Corporation (IFC), data from fully realized, exited investments made by The Abraaj Group, and data from a custom built database of PE investments and exits constructed by the Bella Research Group.
14 Historically, put options could not actually force the sale of the portfolio company, as the fund would instead “enjoy an increased ‘default’ rate of interest on its investment or an additional director if the company defaulted on the put obligation.” More recent funds, however, are establishing measures to force companies to follow through on such obligations by, for example, taking full control of the board. See Eva Davis, “Minority Investment by Private Equity Funds,” Law360, November 2009. 15 Minority investors can also protect themselves with myriad other deal terms and conditions not discussed here, including, among others cash penalties for missing performance targets and convertible preferred shares. 16 See, for example, Per Strömberg, “The New Demography of Private Equity,” in Globalization of Alternative Investments, Working Papers Volume 1, World Economic Forum, January
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The Bella Research Group database contains 527 successfully exited GGM PE deals from the Capital IQ database from Standard & Poor’s, during the period from January 1, 1991 to March 31, 2015, with the earliest matching investment date identified in November 1991. Our dataset excludes bankruptcies and only includes deals where it was possible to identify the nature of the initial investment (minority or majority), and where we could match the identity of the PE firm at investment and exit. Our dataset looks at PE activity in the broadest sense, including all PE/VC-style investments that qualify as M&A as defined by Capital IQ: leveraged buyouts (LBOs), venture capital investments, mezzanine investments, management buyouts (MBOs), recapitalizations, going private transactions, etc. Our analyses, however, do exclude private investments in public equity (PIPEs). Consistent with academic literature, we exclude private placement (PP) transactions from baseline analyses that use the Bella database.16 In unreported statistics, we rerun each of these analyses to include private placements (increasing the number of exits in our database to 1,258). To avoid misrepresenting name changes or other peculiarities as exits, we exclude all exits with holding periods under 100 days. We note that the Bella database uses only those events where we were able to determine that the original investor was also a seller at the exit event, which enables us to assess deal characteristics (such as holding period) from the investor’s perspective.17 Because only a fraction of the “entry events” in Capital IQ could be matched to their respective “exit events,” our dataset is not a comprehensive view of total exits in GGMs during our sample period. Nonetheless, this paper provides a useful first look at majority versus minority investments in the developing world.
Returns We looked at three major metrics in evaluating the performance of minority and majority investments. The first of these metrics is investment return, as measured by earnings multiples and internal rate of return (IRR). Data on IRR and return multiples is very difficult to obtain for private equity portfolio companies, but The Abraaj Group has provided us with returns for 9 majority (i.e., ownership stake > 50%) investments and 55 minority investments (i.e., ownership stake < 50%) made since 2002. This sample represents all of Abraaj’s fully realized, exited positions, with the exception of three deals in which Abraaj acquired a 50% stake (i.e., neither a minority nor majority position). The results of our analysis, summarized below in Figure
2008. Strömberg explained some of the peculiarities: “…a substantial number of the transactions by buyout funds are classified as ‘private placements’ rather than acquisitions. In most cases, these are not proper LBO transactions, but rather acquisitions of minority stakes or follow-on investments” (p. 6). A similar methodology was employed in many subsequent academic studies of the private equity industry. 17 It is important to note that if an “entry” investor was a consortium, then the deal was identified as a minority deal on the basis of the consortium’s ownership stake. In the cases where consortium investors exited at different times, we used the date of exit of the first investor—for which we were able to identify both entry and exit transactions—from the consortium. In addition, our dataset examines “first exits” and therefore does not represent fully exited deals
in all cases. Because our dataset only contains exits with an identifiable entry and exit date from at least one original buyer, the number of observations is limited and is best served for comparison purposes between majority and minority investments. 18 We test the statistical significance in two ways. First, we conduct a two sample t test (assuming unequal variances), which gives p=0.15. Median tests similarly give p > 0.05. We note that weighted average figures must be interpreted carefully, as the top two deals compose 93% of investment dollars for majority investments and 58% for minority investments. We also note that these results are robust to excluding (that is, do not change if we exclude) one anomalous majority deal that was done from Abraaj’s balance sheet instead of a fund.
1, suggest that majority deals outperformed minority deals. Adding an additional layer of statistical rigor, however, reveals that the differences are not statistically significant at the standard 5% level.18
Figure 1. Multiple of Capital Contributed (MoC) for 64 Abraaj Investments Since 2002. Weighted Average (Weighted on Amount Invested)
Median
Average
Majority (n=9)
2.3x
2.6x
3.4x
Minority (n=55)
2.1x
2.1x
2.2x
Another source of return data that segments GGM minority and majority investments is provided by the World Bank’s International Finance Corporation (IFC). The IFC breaks out minority and majority GGM investment returns in an analysis of the exit routes of the 312 IFC investments that were fully exited by the end of 2009. As shown below in Figure 2, the median IRRs from these deals also appear to show little difference in return when separated by exit type.
Source: Bella Research Group Analysis of Data Supplied by Abraaj Capital. Exit dates range from 2004 to 2014.
Figure 2. Median IRR of 312 IFC Private Equity Investments.
¢Majority
¢Minority
50%
IRR
40% 30% 20% 10% 0%
IPO
Trade Sale
The IFC does not break out this data by individual deal, but a look at the averages, in Figure 3 below, in comparison to the medians above, indicates sizable positive outliers for minority IFC investments, which highlights the strong “upside” potential of minority investments.
MBO
Structured Exit Source: IFC, “Emerging Market Equity: Private Equity, Public Equity, Risks & Opportunities” (Feb. 2012). Based on exits of 61 majrity positions; 251 minority positions.
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Figure 3. Average IRR of 312 IFC Private Equity Investments
¢Majority
¢Minority
60% 50%
IRR
40% 30% 20% 10% 0% IPO
Trade Sale
MBO
Figure 3 above should not be interpreted as demonstrating a correlation between minority investments and higher returns. A more likely explanation is the strong correlation of minority investments with venture and growth stage deals. As shown in Figure 4 below, GGM venture/growth deals generate significantly higher returns, on average, than do buyout deals. The greater returns of minority investments seen in Figure 3 are most likely a reflection of the higher concentration of growth deals in minority investments.
Structured Exit Source: IFC, “Emerging Market Equity: Private Equity, Public Equity, Risks & Opportunities” (Feb. 2012). Based on exits of 61 majrity positions; 251 minority positions.
Figure 4. IRR of GGM Venture/Growth and Buyout Funds, Vintage Years, 1995-2012 Average
Average Weighted by fund size
Venture/Growth (n=181)
14.50
12.65
Buyout (n=89)
9.23
7.13
Length of Holding Period Other than the Abraaj and IFC data shown in the exhibits above, data on multiples and IRRs are generally unavailable at the portfolio company level. We can, however, infer some performance characteristics from the length of the investment holding period—the period between the original private equity investment, and the exit. This data provide a rough indication of the difficulty of exiting each investment. Each investment is different and a longer holding period is sometimes due to a private equity firm awaiting a more lucrative exit opportunity. In general, however, a quick exit frees up LP cash more quickly and, due to the time-value of money, leads to a greater IRR. The Bella Research Group database of private equity exits contains holding period data for 527 GGM exits. We emphasize that because our database captures the earliest exit from an investor in the original deal—and thus not 16
Source: Preqin database, accessed April 28, 2015. Based on 181 Growth and Venture Funds and 89 Buyout Funds that (a) invest in emerging markets (as defined by Preqin), (b) do not have a U.S. region focus; and (c) include performance figures.
necessarily a full exit in all cases—our figures likely are biased downward. Still, the data reveal little difference between the outcomes of majority and minority private equity investments. Figure 5 below breaks out the minority and majority holding period medians of the GGM exit deals in the Bella Research Group database. We do note, however, that these differences are statistically significant at the 5% level, which implies that the longer holding periods among majority deals are unlikely to be a result of random variation.19
Figure 5. IRR of GGM Venture/Growth and Buyout Funds, Vintage Years, 1995-2012 Majority (n=330)
Minority (n=197)
Median Holding Period, Months
45.4
35.3
Average Holding Period, Months
49.3
42.3
Exit markets are cyclical, and minority and majority investments may experience these effects differently. To explore this, we looked at the data by exit year, to see if there was a difference in holding period between majority and minority investments that exited during the same year. As illustrated in Figure 6 below, the holding period is generally shorter for minority investments, even when examined annually over time.20
Source: Bella Research Group analysis of data from the CapitalIQ database from Standard & Poor’s. We exclude all holding periods under 100 days, since these “exits” are likely only partial exits or the result of a portfolio company name change.
Figure 6.
Holding period (Years)
Median Holding Period of GGM Investments Since 2003, by Exit Year.
¢Majority
¢Minority
8 6 4 2 0
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Exit year Geography may make a difference in the performance of minority and majority investments, so we also explored the GGM data by region to see if the median holding period might be longer in one region than another. Figure 7 below shows that median holding periods are shorter for minority deals. In all regions except Europe, these differences are statistically significant at the 5% level.21
19 A two sample t test (assuming unequal variances) gives p=0.018. Median tests similarly give p < 0.05. When the sample size is expanded to include private placements (n=1,258), differences in mean and average holding periods no longer exhibit statistically significant differences. 20 In our sample that includes private placements, minority
investment holding period were shorter in eight of the 12 years from 2003-2014. Across these years, the average holding period was 0.40 years longer for majority investments. 21 Median tests show that with the exception of Europe, the results are statistically significant (i.e., p < 0.05). While
Source: Bella Research Group analysis of S&P, CapitalIQ data. Accessed April 28, 2015.
minority holding periods are still shorter in Europe, Latin America, and Middle East & Africa when private placements are included (n=1250), no differences in medians are statistically significant at the 5% threshold.
17
Figure 7. Median Holding Period of GGM Private Equity Exits, in Years. By Portfolio Country Region
Majority
Minority
Asia
4.0 (n=71)
3.0 (n=60)
Europe
3.3 (n=139)
2.9 (n=63)
Latin America
4.0 (n=63)
2.0 (n=12)
Middle East & Africa
4.6 (n=72)
3.2 (n=62)
Each industry sector presents unique market risks, and it is possible that these risks can have different impacts on the holding periods of minority and majority investments. Analysis of holding periods and exit routes by sector, however, continues to show little difference between these two ownership positions. Figure 8 below shows the median holding period for the 527 GGM exits in our database by sector. The differences generally favor minority deals, with the most sizable differences in utilities (2.62 years), energy (2.09 years) and industrials (1.36 years).
Source: Bella Research Group analysis of data from the CapitalIQ database from Standard & Poor’s. Based on 527 GGM deals with holding periods of at least 100 days.
It is important to consider the relatively small sample sizes here, however. Only the healthcare sector shows statistically significant differences in holding periods.22
Figure 8. Median Holding Period of 527 GGM Private Equity Exits by Sector
¢Majority
¢Minority
Holding Period (Years)
6 4.90
5 4 3
4.03
3.79 3.38 2.93 2.16
4.57
4.48
4.25
3.87
410
3.52 3.12 2.62
2.32
2.27
2
1.63
1.95
1 0
Consumer (54/104)
Energy (7/6)
Financials (28/34)
Healthcare Industrials (19/21) (24/59)
Info Tech (35/42)
Route of Exit The exit route taken by private equity investments provides another indication of the relative success of minority and majority private equity investments. Initial public offerings typically generate the highest returns, and are often the 18
Materials (15/33)
Telecoms (10/24)
Utilities (5/7)
Souce: Bella Research Group Analysis of Data from S&P, CapitalIQ. Accessed April 28, 2015. Figures in parenthesis indicate the number of observations for each sector: Minority/Majority.
preferred exit route, followed by trade sales and then by sponsor-to-sponsor deals.23 We examined the relationship of ownership position and exit route of the 527 GGM investments in the Bella Research Group database. We found a greater percentage of GGM minority investments were exited through IPOs than were majority investments. Minority positions also had slightly lower rates of trade and sponsor sales than majority investments, as shown in Figure 9, below. We note, however, that these figures must be interpreted with caution due to the small sample size, as none of these differences is statistically significant at the 5% level.24 Although the sample size is small, we suggest that the data give no indication that minority deals lead to less favorable exit routes.
Figure 9. Share of Exit Routes in GGM Private Equity Exits. Majority
Minority
IPO
6% (n=20)
19% (n=38
Trade Sale
71% (n=235)
64% (n=126)
Sold to GP
23% (n=75)
17% (n=33)
No. Observations
330 (100%)
197 (100%)
The large discrepancy between the number of minority and majority deals that lead to IPOs seen in Figure 9 above, can be explained by the motivations of the entrepreneur/CEO who has been retained as part of a minority deal. An IPO exit is most likely to preserve this entrepreneur’s position as CEO, since the highly dispersed post-IPO ownership is unlikely to unite on a replacement. There is a higher possibility of the entrepreneur being replaced following a trade sale. Another factor causing an imbalance in IPO frequency is the preference of many private equity majority owners for trade sales. Unlike the partnership formed by an entrepreneur and minority owner, a majority owner can exercise greater control over exit terms and timing. Trade sales have a higher degree of certainty in pricing and timing than IPO exits, where the fluctuations of public markets make timing and pricing less predictable. Trade sales therefore allow majority owners to best leverage their control positions in orchestrating an exit. Finally, we examined exit route differences by industry sector, and present the results in Figure 10, below. Since the sample size is small, we only show the four sectors with more than 60 observations (the number of observations for each sector are in parenthesis in the column heading). It appears that sponsorto-sponsor exits are relatively consistent across sectors. We find a relatively high difference in exits via trade sale and IPO in financials and industrials, however, with a relatively larger proportion of IPOs in these sectors coming from minority deals.25 Since IPO exits typically generate higher returns, the larger share of IPO exits underscores the overall exit strength of minority positions in these promising sectors.
Source: Bella Research Group analysis of data from the CapitalIQ database from Standard & Poor’s. Based on 527 GGM deals with holding periods of at least 100 days.
Median tests reveal p > 0.05 with the exception of healthcare. Median tests give p > 0.05 for all industries when including private placements (n=1,253). 23 For relevant discussions, see James C. Brau, Bill Francis, and Ninon Kohers, “The Choice of IPO versus Takeover: Empirical Evidence,” The Journal of Business, Vol. 76, No.
p > 0.05 for each exit route. Including private placements, however, differences in trade sales become statistically significant (p < 0.05), with 89% of majority investments exiting via trade sale versus 69% for minority investments.
22
4 (October 2003), pp. 583-612; Onur Bayar and Thomas J. Chemmanur, “IPOs versus Acquisitions and the Valuation Premium Puzzle: A Theory of Exit Choice by Entrepreneurs and Venture Capitalists,” Journal of Financial and Quantitative Analysis, Vol. 46, No. 6 (2011): 1755-1793. 24 We performed a two-sample test of proportions and found
19
Figure 10. Share of Exit Routes in GGM Private Equity Exits.26 Consumer (158)
Financials (62)
Info Tech (77)
Industrials (83)
Majority
Minority
Majority
Minority
Majority
Minority
Majority
Minority
IPO
5%
19%
0%
21%
10%
14%
10%
29%
Trade Sale
68%
65%
79%
61%
74%
77%
63%
46%
Sponsor-toSponsor
27%
17%
21%
18%
17%
9%
27%
25%
Total
100% (n=104)
100% (n=54)
100% (n=34)
100% (n=28)
100% (n=42)
100% (n=35)
100% (n=59)
100% (n=24)
In summary, our quantitative analysis finds few substantive differences in multiples, IRRs, holding periods and exit routes between GGM majority and minority investments. The slight variations that were found do not indicate any underperformance from minority investments, and possibly suggest a slight performance advantage.
Source: Bella Research Group analysis of data from the CapitalIQ database from Standard & Poor’s. Based on 380 GGM deals with holding periods of at least 100 days.
Conclusion Prudent investors carefully weigh risks and rewards, and this paper has followed a similar course. We began with risks, and a comparative assessment of how three important risk factors affect minority and majority investors. We pointed out the motivational dynamics that make the risks associated with the origination of a deal relatively smaller for minority investors. Operational risks were also evaluated and we demonstrated how the main advantage of majority control, the authority to make personnel changes, is largely nullified in GGMs due to the relative shortage of available managers and the many covenants that give both minority and majority investors de facto control. Several governance and incentive issues were also raised, suggesting that entrepreneurs working in tandem with minority investors pose fewer operational risks than in majority investments where the fund manager has operational control. Finally, exit risks were evaluated, and minority risks were found to be equivalent to those of majority investors due to the extensive application of covenants like put options and tag-along rights. We do note, however, that the reliability of such covenants is largely dependent on a well-established system of contract rights. Following our discussion of risks, we looked at rewards. A detailed quantitative assessment compared minority and majority investments across three important performance metrics: returns; length of holding period; and exit route. Designed to find performance differences between minority and majority investments in GGMs, our tests failed to find any consistent, discernible variation. Our sample size is small, but three separate datasets (Abraaj, IFC, and the Bella database) do provide some evidence to suggest that minority investment fare slightly better in GGMs. Using statistical tests, we don’t find these differences to be consistently statistically significant. In total, while performance metrics are generally tilted in favor of minority investments, we find that minority and majority investors share fairly equally in the risk and rewards of global growth market investments.
Even when including private placements (n=1,002 in these four industries), minority investments exhibit IPO at a higher rate for each industry. 26 This exhibit is intended to illustrate the relative importance 25
20
of each exit route by sector. The small sample size somewhat exaggerates the importance of the six minority IPOs in the financial sector, and the seven minority IPOs in the industrial sector. Due to small sample sizes in
many categories, we did not test to see if differences are statistically significant across for minority/majority investments across exit route-sector pairs.
Funding for this project was provided by The Abraaj Group and is gratefully acknowledged.
