Private equity, including venture capital

On ly Private Equity Investing in the Philippines: Business Angels vs. Venture Capitalists EDMUNDO S. ISIDRO Au th or Dr af tF is a president...
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On ly

Private Equity Investing in the Philippines: Business Angels vs. Venture Capitalists

EDMUNDO S. ISIDRO

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is a president at Philippine Venture Capital Investment Group in Makati City, Philippines. [email protected]

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rivate equity, including venture capital and business angel investing, is a recent but rapidly increasing trend in Asia (Deloitte & Touche [2007]; Lockett and Wright [2002]) that has not been adequately researched in comparison to private equity research in the U.S. and Europe (Gompers and Lerner [2001]; Harrison and Mason [1992]). The lack of research is especially problematic in terms of business angel investing in Asia, as we could only find four published studies specifically focusing on this phenomenon (Hindle and Lee [2002]; Katsuna and Harada [2004]; Tashiro [1999], and Wong and Ho [2007]). These studies focused exclusively on developed Asian countries, including Japan and Singapore. Venture capitalists make equity investments in high-growth, small and mediumsized privately held companies (Scheela [2006]). Venture capitalists raise and manage a venture capital fund, which is sourced primarily from institutional investors, and the goal is to generate significant returns for these investors and also the venture capitalists. Business angels are high-net-worth individuals, typically with considerable business experience, who invest both their personal funds and managerial experiences in early-stage ventures (Freear, Sohl, and Wetzel [1995, 2002]; Morrissette [2007], and Roberts, Stevenson, and Morse [2000]). While venture capital has played a significant

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role in funding high-tech SMEs in the U.S. over the last three decades (Gompers and Lerner [2001]), business angels are playing an increasingly significant role in the U.S. by providing equity investments for earlystage ventures, which venture capitalists increasingly perceive as being too risky and too small for investing (Morrissette [2007], and Sohl [2003a, 2003b]). It is unclear if this investment strategy dichotomy exists in Asia, whereby venture capitalists are increasingly funding later-stage SMEs while business angels are funding more early-stage SMEs. There have been recent calls by researchers to expand business angel research beyond Western countries to include emerging countries, including Asia (Harrison and Mason [1992], and Gompers and Lerner [2001]). It is important to recognize that Asia is not a homogenous region on many continuums, including the development of a private equity industry (Bruton, Fried, and Manigart [2005], and Lockett and Wright [2002]). This article compars the results of two earlier studies where we focused independently on venture capitalists (Scheela [2006]) and business angels (Scheela and Isidro [2005]), operating in the Philippines, which is a developing country. We use institutional theory as our theoretical framework in both studies in order to better understand the challenges facing private equity investors

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is a professor at Bemidji State University in Bemidji, USA. [email protected]

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WILLIAM SCHEELA

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WILLIAM SCHEELA AND EDMUNDO S. ISIDRO

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operating in a developing Asian economy characterized by a lack of fully developed institutions.

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Institutional theory attempts to explain the impact contextual systems have on organizational behavior and economic performance (Hoskisson, Eden, Chung, and Wright [2000], and North [1990]). North [1990, p. 3] defines institutions as providing the “…rules of the game in a society or, more formally, the humanly devised constraints that shape human interaction.” Scott [1995] posits that institutional theory is comprised of three categories of institutions: normative, regulatory, and cognitive. Scott [1995] defines normative as the acceptable behavior and values of individuals and organizations. The regulatory category consists of the laws and political power that regulates individuals and organizations and cognitive represents the inf luences that develop through social interaction. Institutions, especially legal and financial institutions (regulatory), tend be more fully developed and effective in developed countries, especially in comparison to developing countries (Peng [2003], and Ramamurti [2000]). A major impact of the lack of institutional support in developing countries is a higher cost of doing business (North [1990], World Development Report [2002]). Bruton, Fried, and Manigart [2005] propose that all three categories of institutional theory can be used to study the development of venture capital worldwide. More specifically, Ahlstrom and Bruton [2006] applied Scott’s framework in their analysis of East Asian venture capital firms. They determined that regulatory institutions are generally weak; that normative institutions are only developing, primarily in the form of venture capital associations; and that cognitive institutions are significantly impacted by the Overseas Chinese commercial and entrepreneurial cultures in many East Asian countries. Regulatory institutions provide legal protection for investors and support the development of effective capital markets. Private equity investors require fully developed legal and financial institutions, robust IPO markets, a strong entrepreneurial culture (cognitive institution), and developed physical infrastructures (Gompers and Lerner [2001], and La Porta, Lopez-de-Silanes, Shleifer, and Vishny [1997, 1998]). In terms of normative institutions, some of the larger developing Asian countries

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INSTITUTIONAL THEORY

do not have formal venture capital associations (e.g., the Philippines and Vietnam), and we found only one formal business angel association in East and Southeast Asia (Singapore). Bruton, Fried, and Manigart [2005, p. 743] characterize Asia’s regulatory institutions as “generally poorly developed [and] not enforcing laws and regulations.” However, Asia is not a homogeneous economic region, but a continuum of economic development, ranging from developed economies and institutions such as Japan and Australia to emerging economies with relatively undeveloped institutions that include China, India, Malaysia, and Vietnam (Lockett and Wright [2002]). Regulatory institutions have been shown to play a significantly positive role in the development of venture capital in Singapore, a country with fully developed regulatory institutions and a vibrant venture capital industry (Bruton, Ahlstrom, and Singh [2002]). While improving institutions have been shown to generally provide added support to facilitate the birth of new ventures in China (Sebora and Li [2006]), very little research has specifically analyzed the development of venture capital in the emerging Asian economies, whose regulatory institutions would better fit the above description as “generally poorly developed” (Bruton and Ahlstrom [2003], and Scheela and Nguyen [2004]). Based on our literature review, even less research has focused on the impact of undeveloped institutions on the investment strategies of business angels operating in emerging Asian economies (Scheela and Isidro [2005]). The Philippines, an emerging Asian economy, is characterized by low scores in a large number of competitiveness factors, such as financial disclosure and regulation, stock market effectiveness, property rights protection, and venture capital, and a high score in corruption occurrence (Porter, Sachs, Warner, Cornelius, Levinson, and Schwab [2000]). Basically, the Philippines lacks the required fully developed regulatory institutions to support an effectively functioning private equity industry. However, venture capital firms have been active in the Philippines since 1988 (The 2003 Guide to Venture Capital in Asia [2002]). Normative institutions are also lacking, as there is neither a venture capital association nor a business angel club. Only cognitive institutions appear to have a presence because there is an active Overseas Chinese business community (Yueng [2006]).

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We are interested to study the investment and operating strategies developed by venture capitalists and business angels in response to the lack of fully developed institutions in the Philippines. Our research question is: What is the impact of the lack of fully developed institutions on venture capital and business angel investing in an emerging Asian economy?

the Philippines and investment performance. The frequency distributions are shown in Exhibits 1–6 for comparative purposes. RESULTS

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Characteristics and Challenges of Investing in the Philippines

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We used the same research methodology for both studies in order “to establish equivalence in sampling, instrumentation and data collection procedures” (Coviello and Jones [2004, p. 501]). We used a structured, face-to-face format to interview both business angels and venture capitalists. All interviews took place in the Philippines and averaged about 90 minutes. Because business angels are diff icult to f ind (Harrison and Mason [1992]; Mason and Harrison [2002], and Paul, Whittman, and Johnson [2003]), we developed a judgment sample of potential business angels from a list of members who attended monthly meetings of investors and entrepreneurs in the Philippines (Scheela and Isidro [2005]). From this list we identified individuals who had a history of actively investing in small and medium enterprises (SMEs). In November 2003 and 2004, we interviewed 29 individual investors who live in the Philippines and met the criteria of being categorized as a business angel investor. These are investors who have significant business experience and net worth and make substantial investments of their own money in privately held, early-stage companies (Freear et al. [1995, 2002], and Roberts et al. [2000]). For more detail on the business angels in this study, see Scheela and Isidro [2005]. We also developed a judgment sample of venture capitalists in the Philippines from The Guide to Venture Capital in Asia [2000, 2002]. In January of 2002 and 2003 we interviewed eight venture capitalists from the top five venture capital firms in the Philippines. These firms were identified as the most active long-term investors in the Philippines. For more detail on the venture capitalists in this study and the venture capital industry in the Philippines, see Scheela [2006]. Both studies used frequency distributions for data analysis (Yin [1989]). We coded the data in three categories for both venture capitalists and business angels: characteristics and challenges of investing in

As shown in Exhibit 1, business angels characterize the investment climate in the Philippines as being poor because of the lack of both good investments and quality foreign investors, which have resulted from high levels of currency and economic, legal, and political risk. Government corruption is a significant problem that further damages the investment climate. The combination of these two characteristics (poor climate and corruption) may have resulted in a lack of ethical and professional behavior (normative institution) of both investors and entrepreneurs. Because of the lack of fully developed regulatory and normative institutions to support a transparent investment climate, informal networking among investors is the primary method of investing. Not surprisingly, difficulty in completing deals in this type of investment climate is also a characteristic of business angel investing. Venture capitalists characterize the venture capital industry as small in both fund size and the size of average deals (see Exhibit 2). Initially, investments were made primarily in family businesses, but more recently nonfamily businesses are receiving equity investments as entrepreneurs become more knowledgeable about, and open to, venture capital investments. Venture capitalists are forced to play a fairly active role with their investee companies because of the lack of financial transparency (lack of regulatory institutions) and a low level of technical expertise for most entrepreneurs (low cognitive institution). Because of the lack of fully developed regulatory institutions, venture capitalists from the Top Five firms work closely together and prefer to invest in later-stage companies that have developed a regionally focused (primarily Southeast Asian) business strategy. The challenges faced by business angels, shown in Exhibit 3, ref lect the characteristics analyzed from Exhibit 1. Because of a very poor investment climate and lack of transparency in the Philippines, business angels have difficulties in finding the right people (entrepreneurs, co-investors, and managers) in order to do deals. This challenge is exacerbated by the decreasing number

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RESEARCH METHODOLOGY

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EXHIBIT 1

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Characteristics of Angel Investing in the Philippines

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Source: Scheela & Isidro [2005, pp. 20–21].

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of foreign investors entering the Philippines because of the small country market, currency risk of the peso, political instability, and government red tape and corruption. Consequently, it is important for business angels to be patient investors, conduct in-depth due diligence for each potential investment, and focus geographically primarily in the Philippines (invest close to home). Some business angels believe there is a low entrepreneurial propensity exhibited by young people in the Philippines, which ref lects negatively on the development of 4

cognitive institutions needed to support a culture of entrepreneurship. Similar to business angels’ responses, the challenges identified by venture capitalists (Exhibit 4) ref lect the industry characteristics from Exhibit 2. The major challenge is maintaining a presence in the Philippines, given institutional investors’ negative perceptions about the “investment climate, increasing currency and country risks (political instability), capital f light, and the ongoing problem of government corruption…” (Scheela

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EXHIBIT 2

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Characteristics of Venture Capital Investing in the Philippines

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Source: Scheela [2006, p. 83].

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[2006, p. 85]). The combination of these investment concerns makes an exit strategy via an IPO very problematic in the Philippines. The lack of competent entrepreneurs, who have both high-technology experience (identified as a characteristic) and an understanding of how to financially value a company, makes doing deals very challenging, which further supports the lack of significant cognitive institutions. Venture capitalists in the Philippines are increasingly forced to develop a regional (Southeast Asian) investment focus because of the limited investment opportunities in the Philippines. The lack of fully developed regulatory, normative and cognitive institutions makes venture capital investing in the Philippines very difficult and requires significant due diligence.

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Investment Performance

We asked each business angel and venture capitalist to evaluate investment performance (actual vs. expected) on two levels (Scheela and Isidro [2005], and Scheela [2006]): Investee company performance and investment fund performance. The results are summarized in Exhibits 5 and 6. Investment performance on both levels is generally positive for business angels and generally negative for venture capitalists. According to the business angels, 63% of their investee companies are meeting or exceeding expectations, while only 45% meet or exceed the expectations of venture capitalists. For venture capitalists, 55% of investee companies have

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EXHIBIT 3

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Challenges of Business Angel Investing in the Philippines

Source: Scheela & Isidro [2005, p. 22].

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EXHIBIT 4

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Challenges of Venture Capital Investing in the Philippines

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Source: Scheela [2006, p. 84].

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not met expectations, while only 37% have performed poorly for business angels. Business angels report that their investment funds are performing very well, with almost 80% evaluating their overall investment performance as meeting or exceeding expectations. Contrastingly, six of the eight (75%) venture capitalists evaluate investment fund performance as below average, and only one (12.5%) evaluates performance as above average, while over 40% of the business angels evaluate their fund performance as above average. The 29 business angels invested in 238 companies and the eight venture capitalists invested in 52 companies. On average, each business angel invested in 8.2 companies, while each venture capitalist invested in 6.5 companies, resulting in an average of 10.4 investee companies per venture capital firm. Summary of Results

These two studies have documented that the Philippines is a difficult country for both business angel SPRING 2008

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and venture capital investing, primarily because of the difficult investment climate due to the absence of effective institutions. This finding directly addresses our research question: “What is the impact of the lack of fully developed institutions on venture capital and business angel investing in an emerging Asian economy?” More specifically, the lack of fully developed institutions makes it very challenging for private equity investors to both find and make investments and also to monitor their investee companies. Both business angels and venture capitalists use a networking investment strategy to minimize investment risk (adverse selection) and a hands-on monitoring strategy to minimize operating risks (moral hazard). It appears that business angels’ investment strategies have been more successful than venture capitalists operating in an emerging economy, lacking developed institutions on all three levels: regulatory, normative, and cognitive. In stark contrast to venture capitalists’ regional investment strategy, most of the business angels in our study (Scheela and Isidro [2005]) have focused their investments primarily in Manila and Cebu, which have resulted in generally positive investment returns in spite THE JOURNAL OF P RIVATE EQUITY

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EXHIBIT 5

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Business Angel Investment Performance Summary

increasingly developing regional funds that focus on Southeast Asia at the expense of a Philippine country fund. Second, venture capitalists are also increasingly investing in growth-stage and mature Philippines’ companies that have a Southeast Asia business model. Consequently, venture capitalists are investing less in the Philippines, resulting in one of the top five firms closing its Manila office (interview [2004]). These two trends collectively have decreased the equity funds available for early-stage companies. It is unclear how large this venture capital gap is and what impact business angel investing will have or is having on filling this gap. The median investment range/deal by the business angels in our study is US$100,000–250,000 with a median investment fund/ business angel of US$1.8 million (Scheela and Isidro [2005]). The average size of venture capital funds in the Philippines is US$21 million (Scheela [2006]); while small by international standards, that is still considerably larger (by over 10 times) than business angel investment funds. Business angels in the Philippines, in our study, overwhelmingly invested in early-stage ventures, which have been increasingly ignored by venture capitalists (Scheela and Isidro [2005]). So while business angels may be partially filling the early-stage investment gap, growth-stage, domestically focused SMEs needing sizable expansion equity financing (in excess of US$250,000) are not getting funded by either venture capitalists, who are leaving, or business angels, who lack large investment funds. Business angels are interested in forming business angel clubs in order to do bigger deals (Scheela & Isidro [2005]), which could begin to fill this growth-stage investment gap in the Philippines as it has in the U.S. (Freear et al. [2002], and San Jose, Roure, and Aernoudt [2005]). Further research is needed to determine if the venture capital gaps are an increasing problem throughout Asia (especially in emerging and transition economies) and to examine the impact that business angels and angel alliances may or do have on filling these gaps. Both business angels and venture capitalists use networking as an investment strategy. This appears to be more significant for business angels, as venture capitalists make significant individual investments without partners (Scheela [2006]), but business angels do so very rarely (Scheela and Isidro [2005]). Peng and Heath [1996] support the effectiveness of using a networking strategy as a way to build competitive advantage in emerging econ-

*43 companies are not included (exits or very recent investments). Source: Scheela & Isidro [2005, p. 18].

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Venture Capital Investment Performance Summary

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EXHIBIT 6

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*8 venture capitalists, from 5 VC firms, evaluated 52 investee companies, 2002 and 2003. Source: Scheela [2006, p. 86].

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of the challenging investment climate. Because of disappointing investment performance in the Philippines, venture capitalists have broadened their investment focus from a country fund strategy to a regional fund strategy. In essence, venture capital investments in the Philippines have done poorly, resulting in a lack of new funds being dedicated solely for investing in the Philippines (Scheela [2006], and The 2003 Guide to Venture Capital in Asia [2002]). DISCUSSION AND FUTURE RESEARCH

A venture capital gap is being created in the Philippines for two reasons. First, venture capitalists are 8

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Hindle, K., and L. Lee. “An Exploratory Investigation of Informal Venture Capitalists in Singapore.” Venture Capital, 4 (2002), pp. 169–181. Hoskisson, R.E., L. Eden, M.L. Chung, and M. Wright. “Strategy in Emerging Economies.” Academy of Management Journal, 43 (2000), pp. 249–267.

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Ahlstrom, D., and G.D. Bruton. “Venture Capital in Emerging Economies: Networks and Institutional Change.” Entrepreneurship Theory and Practice (Summer 2006), pp. 299–320.

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Bruton, G.D., D. Ahlstrom, and K. Singh. “The Impact of the Institutional Environment on the Venture Capital industry in Singapore.” Venture Capital, 4 (2002), pp. 197–218.

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Bruton, G.D., and D. Ahlstrom. “An Institutional View of China’s Venture Capital Industry: Explaining the Differences between China and the West.” Journal of Business Venturing, 18 (2003), pp. 233–259.

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Bruton, G.D., V.H. Frie, and S. Manigart. “Institutional Inf luences on the Worldwide Expansion of Venture Capital.” Entrepreneurship Theory and Practice (November 2005), pp. 737–760. Deloitte & Touche LLP. Global Trends in Venture Capital 2007 Survey, 2007. Freear, J., J. Sohl, and W.E. Wetzel. “Angels: Personal Investors in the Venture Capital Market.” Entrepreneurship & Regional Development, 7 (1995), pp. 85–94.

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Kutsuna, K., and N. Harada. “Small Business OwnerManagers as Latent Informal Investors in Japan: Evidence from a Country with a Bank-Based Financial System.” Venture Capital, 6 (2004), pp. 283–311.

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omies that are lacking in fully developed institutions. More specifically, Bruton and Ahlstrom [2003] found that Chinese venture capitalists networked with local government officials. Contrastingly, in the Philippines, private equity investors tend to network with each other in deal making and avoid government contacts, because of fear of government corruption. Further research is needed to better understand the impact of networking by private investors in emerging Asian economies and the specific differences between business angels and venture capitalists. Private equity investors in the Philippines are very hands-on in terms of their relationship with their investee companies, and especially so for business angels. This is also true in China (Bruton and Ahlstrom [2003]) and Vietnam (Scheela and Nguyen [2004]). It appears that close monitoring of investments may be a homogeneous characteristic of private equity investors operating in Asian emerging countries. Further research is needed to determine if this is a common occurrence for private investors in emerging economies.

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To order reprints of this article, please contact Dewey Palmieri at dpalmieri@ iijournals.com or 212-224-3675

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