Banks vs. PEFs: An Old Friend Better than Two New Ones?
It is no secret that domestic banks, which now accumulate money to pay their huge foreign debts, have drastically shrunk loans to the real sector. The deficit of debt instruments is first of all to the detriment of companies with medium and low capitalisation, whose strategic development plans may now be foiled. A realistic alternative for them could be to raise money from private equity funds (PEF) by selling a share in their capital stock.
Globally, sources of financing for business development divide into three main groups. The first group is banks and credit institutions who finance various projects through loans. The second one is institutional and private investors who invest their money in shares and bonds of well-known public companies listed on a stock exchange. And, finally, the third one is private equity funds and investment companies that take part in projects directly, i.e. through equity financing. While in developed countries all these elements supplement and balance each other, Kazakhstan in recent years leaned primarily to bank financing. According to some estimates, because of excess liquidity in second-tier banks some 97% of all investments in our country were made with the help of loan capital. This can be deemed one of the reasons for the Kazakh economy’s ‘hard landing’ in 2007. Without the support of the banking ‘purse’, domestic companies now feel an acute shortage of money even to stay afloat, not to speak of future growth. The government’s attempts to bolster the Kazakh stock market were apparently late (despite some progress in the market) and access still remains difficult for companies with low or medium capitalisation. The listing preparation process can take between six months and a year, whereas money is generally needed today.
Considering this, experts believe that the most flexible means to finance business development, one which remains available when other sources cannot be used, is direct investment. So it is no accident that the Kazakh business community is now actively discussing the development of PEFs.
What is a PEF?
As distinct from portfolio investors, PEFs invest money in shares of those companies that are not listed on an exchange. The conditions of each transaction are determined during direct negotiations and depend on the type of the fund and the share purchased. A PEF may be an outside investor or an active participant in the operating activities of a company. The business scheme of a PEF is as follows: finding a promising company with strong management and buying at least 25% of its shares; developing this company within an agreed timeframe and raising its market capitalisation to a significant extent; and, finally, selling its interest to a strategic investor or making an IPO. As a rule, PEFs enter a project for three to seven years and receive 30-40% p.a. on exit.
This profitability explains why the private equity industry is as popular with investors as public shares, treasury bonds or real estate and why PEFs have no problems in raising capital. Tim Russell, Deloitte’s Partner in the Caspian Region, says that in 2007 alone this industry attracted about €500bn globally. The main sources of funding for PEFs are corporate and private investors, government development institutions, banks, pension funds, insurance companies and even academic institutions.
In Kazakhstan, the first PEFs – Eagle Kazakhstan Fund, AIG Silk Road Fund and CAAEF – emerged as early as in 1994-1995. They were set up under intergovernmental agreements between Kazakhstan and the U.S. or with the help of international financial institutions such as EBRD. Yet, the private equity market in our country only began to develop in 2007 when local venture funds and PEFs were set up with the help of institutional and private foreign investors and some government development institutions. These funds include Tau Capital managed by Visor, Aureous Central Asia and Private Equity Fund, among others.
At the same time, the aggregate capitalisation of PEFs specialising in Kazakhstan does not exceed $1bn, which is surely a low figure when compared to the $100bn economy. For this reason, the government decided to take part in this process and set up Kazyna Capital Management within the Kazyna holding. Borisbai Jangurasov, the new company’s Deputy Chairman of the Board, said at the conference ‘International Corporate Finance 2008’ that Kazyna Capital Management will be the ‘fund of funds’, which will invest in PEFs together with private investors and PEFs, in their turn, will finance the real sector.
Given their relatively small size (an average Kazakh fund amounts to $100m), the primary focus of PEFs is non-primary small- and medium-sized businesses. According to Patrick Vosgimorukian, Head of Investment Banking, Central Asia at Renaissance Capital, the most attractive investees for PEFs in the region are small- and medium-sized banks, telecommunications, mass media, and producers of building materials. Other priority industries for management companies are tourism, healthcare and pharmaceuticals, retailing and consumer services, agriculture and power engineering.
For and against
Management companies believe that cooperation with PEFs can reduce the tension between banks and private businesses; this is beneficial for both sides. As a result of debt refinancing, a bank improves the quality of its credit portfolio, as well as its liquidity. Plus, the debt burden will no more prevent the borrower from growth as it becomes capable of paying its outstanding debts. Moreover, in the future the banks will have creditworthy and fast-growing companies as their clients.
As for the businesses themselves, they get an opportunity to finance their current and future projects in the long term and this financing is not burdened by the payment of interests or principal. The debt obligations of a company go down, its assets are released from pledges, and its capitalisation increases.
In addition, business owners receive a highly professional financial partner who is interested in the company’s growth. As a rule, when joining a project, funds offer active assistance in improving corporate governance, developing informational and reporting systems, and preparing strategies. They act as intermediaries to raise foreign loans, attract strategic investors, arrange listing, or search for experts.
Surely, all this is done for money. By investing in a project, a PEF finds itself in the same boat with business owners and share all their risks. In turn, the fund poses additional requirements for the company. To reduce risks, agreements are made to prevent capital dilution and PEFs acquire the right to receive information, leave the project, veto large transactions, etc.
The necessity to report to external shareholders can become a real obstacle to the successful development of this type of financing in Kazakhstan. A peculiarity of local business is that “the empire-building mentality prevails over the idea of raising the cost of equity,” says Tamerlan Khamidzade, Partner at Aureos Central Asia Fund. In small- and medium-sized companies, the interests of owners and business are usually the same and cash flows often mix with family money. Low transparency of companies can be explained by fear of raids and loss of control. However, the time of cheap bank loans in Kazakhstan has come to its end and there is hope that more owners and managers will accept the new rules of the game.
Among other factors that have an adverse impact on the development of private equity in the region, Mr Khamidzade names unfair competition on the part of political elites. “There are countries where if you make a transaction for, say, more than $1m you get on the radar of the political elite and simply cannot close this transaction,” he explained. “In Azerbaijan, for example, the limit is $10m.” For Kazakhstan this issue is less pressing: for a transaction to get ‘on the radar’ its value must be at least $500m. This situation is directly connected with the yet weak judicial system that sometimes cannot guarantee the right of ownership.
Outlook
On the whole, experts believe that despite certain systematic problems the time of PEFs in Kazakhstan has come. All is needed now is to earn positive history. Mr Khamidzade is sure that five to six years of successful transactions are needed to prove that business owners will truly benefit from cooperation with PEFs and that PEFs produce added value not only for themselves, but for their partners as well. It is also important that by that time the domestic stock market should be built up with the help of KASE and RFCA. For PEFs this means that, in the near future, the exit from a project – at least at companies with middle capitalisation – can be arranged through an IPO on the local floor.
Tim Russell says that the success of the private equity industry depends fundamentally on the quality of fund management teams. Kazakhstan’s experience in the open market is less than 20 years, which is why qualified personnel must become top priority for PEFs. Major foreign funds have already begun to approach our market and local management companies have faced competition with some very strong rivals. As the industry grows, funds also need to enhance their specialisation. Western PEFs are all diversified into industries and Kazakhstan will only benefit if it can boast a similar selection of PEFs.
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