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EBRD Transition Report 2014 – Box 4.1. Private equity and venture capital

TRANSITION REPORT 2014 Innovation in Transition

Box 4.1. Private equity and venture capital

Most innovative technologies and products have two things in common. First, they take many years to develop and have unpredictable returns, making them risky investments. Second, they are often introduced by start-ups and younger companies.19 These characteristics mean that bank credit – and debt more generally – is not an ideal funding instrument for R&D, as this chapter demonstrates.

Instead, advanced economies have traditionally used equity to finance innovative companies. Private equity (PE) and venture capital (VC) funds provide equity to a diverse portfolio of companies, as well as offering know-how and incentives to help them realise their potential.

There is now growing evidence from both Europe and the United States that companies backed by PE or VC carry out more patented innovations and have their patents cited more often (an indication of the quality of these innovations).20 This is not simply because PE/VC funds are good at picking the most promising companies and sectors. It also reflects the fact that these funds add economic value to companies in their portfolios through improvements in corporate governance, better monitoring of managers and superior access to human capital.21

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While smaller and younger companies stand to gain the most from such professional expertise, equity financing can also benefit more established businesses. Without adequate modernisation or R&D, older and larger companies may find it hard to maintain brand names or introduce new products or processes. As a result, their growth may stagnate.

This is especially relevant for larger and older firms in the transition region that need to catch up with the technological frontier in terms of corporate governance and the sophistication of products. For these more established companies, equity financing may not only boost R&D, but also help them to catch up by adopting products and processes from elsewhere.

Unfortunately, over the past decade the transition region has seen only modest levels of PE/VC financing, which has tended to remain focused on the United States and western Europe. While equity funding is increasingly being directed towards emerging markets, the region has also lagged behind Brazil, China, India and South Africa when it comes to securing such funding.

Chart 4.1.1 shows, on the left-hand axis, the average number of private equity deals in each EBRD subregion (4.1.1a), comparing those figures with other emerging economies and the United Kingdom (4.1.1b). The CEB region and Russia stand out as having the highest number of deals in the transition region, which secures investment in a total of around 190 companies a year on average. However, this figure pales in comparison with Brazil, China, India and South Africa. The transition region also lags far behind the United Kingdom, where upwards of 600 companies typically attract equity investment in any given year.

Emerging markets have become more attractive for private equity investors over the past decade, but the impact of the global recession of 2009 has varied from country to country. The average number of private equity deals has risen considerably in Russia and Turkey, while the CEB, SEMED and SEE regions have all seen declines in the post-crisis period. This partly reflects the impact of bank deleveraging in Europe, with the United Kingdom also seeing fewer deals in this period. However, Brazil, China, India and South Africa are continuing to see strong growth in such deals.

Chart 4.1.1 also shows, on the right-hand axis, the penetration ratio for private-equity investment in the various EBRD regions (4.1.1a) and the same group of comparator countries (4.1.1b). The chart shows that in some of the largest transition countries, such as Russia and Turkey, PE/VC flows barely constitute 0.05 per cent of GDP, while that penetration ratio is typically upwards of 0.25 per cent in more mature markets. PE/VC penetration in the CEB region compares favourably with mature markets, despite a sizeable decline since 2008. The SEE region has also suffered a particularly strong decline in PE/VC penetration. Overall, then, the contribution that PE/VC investment makes to innovative activity may well remain limited in most of the EBRD region.

Why has private equity financing been so lacklustre in the region? Table 4.1.1 offers a few clues using an index that measures countries’ attractiveness for venture capital and private equity.22 The table contains details of six different indicators measuring how far each country is from the United States in terms of its attractiveness for equity financing.

Panel A shows the transition region and Panel B shows a set of comparator countries. The table shows that the development of capital markets is a significant area in this regard – one in which the transition region is a long way from catching up with the major emerging economies and more developed economies. The lack of developed stock markets, the paucity of opportunities for initial public offerings and mergers and acquisitions, and the immature credit markets all serve to discourage PE/VC funds, for which viable exit strategies are crucial in order to realise financial returns. The region also scores less favourably in terms of its human and social environment, indicating that it does not have sufficient human capital to attract PE/VC investors. In addition, there is room for improvement both in terms of the ease of doing business and corporate R&D spending (in order to boost entrepreneurial opportunities) and in terms of investor protection and corporate governance rules. On a more positive note, the region’s taxation system compares favourably with developed economies.

CHART 4.1.1
  CEB SEE Turkey EEC Russia Central Asia SEMED  
  • Average number of private equity deals per year (left-hand axis)
  • Average annual private equity investment as a % of GDP (right-hand axis)

  Brazil, China, India and South Africa   United Kingdom  
  • Average number of private equity deals per year (left-hand axis)
  • Average annual private equity investment as a % of GDP (right-hand axis)

Source: Thomson Reuters VentureXpert, July 2014.
Note: The left-hand axis measures the average number of portfolio companies receiving private equity financing per year. The right-hand axis measures the average private equity penetration rate – that is to say, average annual private equity investment as a percentage of current GDP.

TABLE 4.1.1

Distance to developed venture capital and private equity markets

Panel A

Country Ranking Index Economic
activity
Capital
markets
Taxation Investor protection
and corporate governance
Human and
social environment
Entrepreneurial
opportunities

Poland

29

69.9

81.2

70.0

101.3

69.5

61.5

64.0

Turkey

30

69.7

90.2

75.2

109.4

67.4

51.0

60.5

Russia

41

63.0

91.7

72.1

100.7

46.5

33.6

66.5

Lithuania

43

61.0

68.9

47.1

103.2

74.5

65.2

62.7

Hungary

45

58.8

72.8

45.6

96.5

63.6

64.3

60.5

Slovak Rep.

48

56.8

66.6

48.7

94.2

59.3

54.2

57.7

Morocco

49

55.2

81.1

51.3

108.2

60.3

38.5

50.1

Slovenia

50

54.5

59.5

33.3

112.1

68.0

70.4

66.8

Estonia

51

54.2

62.1

31.4

109.2

85.2

61.6

65.9

Romania

52

53.9

83.2

42.4

83.1

58.7

42.4

58.6

Jordan

53

53.5

66.4

45.9

95.4

47.9

58.6

52.4

Latvia

55

53.2

68.3

32.0

107.2

77.7

58.7

61.1

Bulgaria

56

53.2

63.5

40.6

89.1

55.4

62.1

55.9

Tunisia

60

50.3

64.1

44.1

109.2

63.7

50.9

38.6

Ukraine

63

48.0

72.8

49.2

82.7

43.3

27.0

48.7

Croatia

64

47.6

60.3

34.1

108.1

53.6

41.3

56.8

Egypt

69

46.4

76.6

49.3

83.0

46.6

19.8

46.7

Kazakhstan

70

45.9

90.4

23.9

98.2

64.5

42.1

56.5

Georgia

71

45.9

57.5

27.3

104.7

61.7

58.8

50.7

Bosnia and Herz.

75

43.6

42.5

31.0

74.5

52.6

53.0

50.7

FYR Macedonia

78

42.9

36.6

25.3

93.8

67.0

59.9

53.2

Serbia

79

42.8

55.9

26.7

44.8

47.7

57.8

55.0

Montenegro

84

38.8

35.1

20.5

86.6

71.0

74.9

40.2

Armenia

86

38.6

52.0

16.8

94.4

66.8

46.0

55.8

Mongolia

87

38.3

72.3

18.7

73.6

55.8

40.6

48.5

Belarus

92

33.1

78.5

12.0

93.8

35.2

44.2

53.6

Moldova

96

29.0

56.1

11.4

93.2

54.1

26.2

41.4

Kyrgyz Rep.

101

25.4

58.2

10.5

66.5

45.0

23.2

33.1

Albania

106

23.4

54.5

5.0

74.9

57.7

37.6

42.7

Panel B

Country Ranking Index Economic activity Capital markets Taxation Investor protection
and corporate governance
Human and
social environment
Entrepreneurial
opportunities

United States

1

100.0

100.0

100.0

100.0

100.0

100.0

100.0

United Kingdom

4

95.3

92.2

87.2

122.6

107.9

103.4

92.4

China

22

78.4

116.5

86.0

109.6

62.6

53.1

73.4

India

28

70.7

94.5

81.4

84.7

66.0

49.2

60.8

South Africa

32

69.4

62.3

76.8

111.3

87.1

43.6

67.4

Brazil

40

64.0

94.7

77.3

23.0

58.0

55.1

55.5

Source: 2014 Venture Capital and Private Equity Country Attractiveness Index.
Note: The Venture Capital and Private Equity Country Attractiveness Index measures the attractiveness of a country for investors in limited partnerships on the basis of six key drivers: economic activity (size of the economy, GDP growth and unemployment); capital markets (size and liquidity of stock markets, IPO and M&A activity, credit markets and sophistication of financial markets); taxation (entrepreneurial tax incentives and administrative burdens); investor protection (quality of corporate governance, security of property rights and quality of legal enforcement); human and social environment (human capital, labour market policies and crime); and entrepreneurial opportunities (innovation capacity, ease of doing business and corporate R&D). The United States is used as a benchmark, with values equal to 100; lower values indicate lower levels of attractiveness. Azerbaijan, Kosovo, Tajikistan, Turkmenistan and Uzbekistan are not covered.