Market Conditions and the Exit Rate of Private Equity Investments in an Emerging Economy.
| Autor | Minardi, Andrea Maria Accioly Fonseca |
Introduction
Private Equity (PE) investment has been increasing globally, reaching US$582 billion in 2018. In December 2018, there was US$2 trillion available for new PE investments (Bain and Co., 2019). Those funds are active investors, which buy equity or quasi-equity stake in potentially high-growth companies, which are usually private and with many operational inefficiencies (Muscarella & Vetsuypens, 1990). Besides providing capital, PE funds help the growth of the investee companies by hiring talented board members and managers, improving governance and managerial processes, participating actively in the board of directors, forcing the adoption of budget and pay-for-performance compensation, giving access to the investors' networks and to extra funding sources, thus requiring periodically audited information (Latini, Fontes-Filho, & Chambers, 2014; Masulis & Thomas, 2009).
Before investing in a company, PE funds often negotiate a value creation plan with the business owner(s) and management, and they require covenants in the shareholder agreement regarding control rights (Kaplan, Martel, & Stromberg, 2007). PEs do not get involved in daily operations. Instead, they participate actively in the board by creating sub-committees for the key processes to implement the negotiated plan, determining accountability for the processes and appointing and firing C-level executives if necessary (Latini et al, 2014; Lerner, Leamon, & Hardymon, 2012). PE funds provide smart money to companies. Besides financial resources, they bring efficiency gains, managerial processes, better corporate governance practices, and innovation to their investees. However, the model has limitations, and a major one is the potential misalignment between fund managers and company owners regarding exit timing.
PE funds usually have a finite life (ten years), and raise capital from institutional investors and wealthy individuals. During their lives, PE funds have to find interesting companies, invest in them, create value and exit the investments by selling their equity stake. If PE funds return the capital to their investors with a profit, they are eligible for a performance fee, called carry. Therefore, the exit is crucial for PE funds. Investors will only get a return on their capital after the investments have been liquidated, hopefully with a profit, and if this is the case, the fund will receive the performance fee and generate a track record (Lerner et al., 2012). PE firms need good track records to raise new funds and perpetuate themselves. There is performance persistence in the PE industry, and investors interpret past performance as a skill (Kaplan & Schoar, 2005). The pressure to exit may create misalignments between the private equity fund and the investee company's owner. The optimal horizon to implement the value creation plan in the company may differ from the PE fund's ideal investment holding period.
There are basically 5 exit alternatives: sale to another company (trade sale); IPO (capital market); sale to another PE fund (secondary sale); sale to the owner; and write-off (bankruptcy and sale to owners for an insignificant value). The first two alternatives, trade sale and IPO, are considered the most successful, with higher returns (Giot & Schwienbacher, 2007; Johan & Zhang, 2016; Zarutskie, 2010). Market conditions significantly influence the number of deals and the return of Merger and Acquisition (M&A) and IPO activities. PE fund managers time the market to sell their investments in higher valuation periods (Cao, 2011), and this may create situations in which PE funds exit before accomplishing the value creation plan or fully exploring the value creation opportunity. If the company is sold to another company, the owner will usually be forced to sell her or his stake to the PE fund, and if the sale is premature, the value creation plan will generally not be fully accomplished. In this case, the owner will receive a lower valuation for her or his stake. In the case of IPOs, the pressure to exit may prematurely push a company to an IPO, thus increasing the risk of failure and underpricing (Gompers, 1996).
In emerging economies, hot market windows are shorter and less frequent than in developed countries, and therefore fund managers have an even higher incentive to time the market. Brazil, for instance, had an IPO boom between 2004 and 2008, and 39% of the IPOs were backed by PEs (Minardi, Ferrari, & Tavares, 2013). PE funds benefit from hot market windows to achieve more profitable exits. The majority of the PE investors in emerging economies are international, and therefore the exchange rate should also have an impact on the exit rate.
Understanding the dynamics of exits is an important issue in PE investments. The exit rate is dependent on the time that the company has been part of the fund's portfolio. If the fund has recently acquired the company, it will need more time to implement the value creation plan, and the chances of exiting the company are little. As time goes by, the exit rate should increase with the implementation of the value creation plan. Therefore, we cannot analyze exit timing without taking into account the period that the PE fund has held the company in its portfolio. According to Cao (2011), investment return increases with the holding period, but with a concave function. The holding period must be long enough for the fund to implement the value creation plan. However, a holding period that is too long has a negative effect on the IRR (internal rate of return), and, consequently, on performance fees and track records. Besides this, PE funds have a finite life, usually around 10 years, and the longer the investment stays in the portfolio, the closer it comes to the end of a fund's life. Extremely long holding periods may indicate difficulties in selling (Giot & Schwienbacher, 2007). Therefore, we should expect low exit rates for short holding periods, and high exit rates for long holding periods. As private equity funds intend to exit at some point in time, even proprietary funds, which does not raise capital with investors and does not have a finite life, will eventually sell their stake in the portfolio company.
Private equity is a fairly recent industry in Brazil, and Brazilian PE organizations need to prove that they can generate good returns in the country. Therefore, the pressure to exit in hot market windows is strong, and fund managers may liquidate their stake in the company even before implementing the value creation or restructuring plans. This is not optimal for the investee company, and it may create conflicts between the PE fund's manager and the business owner. The objective of this article is to investigate how market conditions impact PE exit rates in Brazil, and if this significantly increases the chances of quick flips; that is, exit investments with holding periods shorter than two years. In a horizon shorter than two years, it is very probable that a PE fund has not had enough time to prepare the company well for growth and has not accomplished the value creation plan yet.
We use the hazard model to estimate the market condition effect on the exit rate. This methodology allows us to adequately control for the investment holding period. We adopt four variables related to market conditions: the price-earnings ratio, the number of IPOs, the Brazilian real appreciation against the US dollar, and the Brazilian interest rate. We also control our analysis for deal size, fund manager experience, fund strategy (buyout or growth), the time of the investment in relation to the fund-raising date, sector, and the year of investment.
This analysis, which takes the exit dynamic into accounting, is a pioneering one in Brazil and it contributes to the emerging market literature of Private Equity. As part of the BRICS block, Brazil is one of the emerging economies that has raised the most private equity capital in the last decade. It is also the largest capital market in Latin America. This article also contributes to a better understanding of the exit dynamics, an important tool for liquidity analyses for private equity investors. By incorporating these relevant factors into simulation models, investors can better predict cash flow patterns and liquidity issues. Business owners can also better estimate the risk of an anticipated exit by a PE fund.
Our results indicate that PE fund managers in Brazil time the market significantly. The exit rate increases by around two times in moments of high market price-earnings ratio, with high numbers of IPOs, and moments of Brazilian currency appreciation against the US dollar. This is also true for holding periods less than two years. A higher interest rate decreases the exit rate by roughly 60%. Our findings are in accordance with the hypotheses of market timing and grandstanding. Fund managers may exit before an optimal holding period in order to generate good track records.
Literature Review and Hypothesis Formulation Private equity in Brazil
The dominant target for PE funds in such emerging markets as Brazil are family-owned companies, managed by the first or second generation of the founding families (Zeisberger, Prahl, & White, 2017). These companies are often less formal, facing financial capital constraints, underdeveloped capital markets and a weak institutional environment (Latini et al., 2014; Wright, Amess, Weir, & Girma, 2009). Family-owned companies in emerging markets can benefit substantially from Private Equity investment. Besides providing funding, PEs can increase their efficiency. There is international evidence that PE funds contribute substantially to the improvement of corporate governance and to the operational performance of the investee companies (Helman & Puri, 2002; Masulis & Thomas, 2009; Muscarella & Vetsuypens, 1990).
The PE industry is fairly recent in Brazil. Although the first PE firm was founded in the early...
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