Investment Funds in Emerging Markets (Ifc Lessons of Experience Series, 2)

Investment Funds in Emerging Markets Investment Funds in Emerging Markets Lessons of Experience Series THE WORLD BANK ...

Author: Laurence Carter | Irving Kuczynski | Teresa Barger

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Investment Funds in Emerging Markets


Lessons of Experience Series THE WORLD BANK WASHINGTON, D.C. Copyright  1996 The World Bank and International Finance Corporation 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing July 1996 The International Finance Corporation (IFC), an affiliate of the World Bank, promotes the economic development of its member countries through investment in the private sector. It is the world's largest multilateral organization providing financial assistance directly in the form of loan and equity to private enterprises in developing countries. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and should not be attributed in any manner to the IFC or the World Bank or to members of their Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. Some sources cited in this paper may be informal documents that are not readily available. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to Director, Corporate Planning Department, IFC, at the address shown in the copyright notice above. The IFC encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. The complete backlist of publications from the World Bank, including those of the IFC, is shown in the annual Index of Publications, which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66 Avenue d'Iena, 75116 Paris, France. Laurence W. Carter is a senior policy analyst in the Corporate Planning Department of IFC. Teresa Barger is a Delivered by The World Bank e-library to: manager in IFC's Office of the Vice President aaaaaa for Operations, and Irving Kuczynski is Director of Financial University IP : 111.111.11.11 Sector Issues in the same office. Wed, 11 Jan 1111 11:11:11

Investment Funds in Emerging Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets This serial publication has been cataloged by the Library of Congress as follows: Library of Congress Cataloging−in−Publication Data Carter, Laurence W., 1960− IFC's experience in promoting emerging market investment funds, 19771995 / Laurence W. Carter p. cm. — (IFC lessons of experience series; 3) ISBN 0−8213−3676−2 1. International Finance Corporation 2. Capital markets—Developing countries I. Title. II. Series. HG3881.5.I56C368 1996 332.6'73—dc20 96−28502 CIP

In 1984 one of the first country funds for emerging markets was structured in Korea. Today the emerging market funds industry has more than US$100 billion under now targeting developing countries. Larger private equity funds have emerged, stimulated by privatization and private participation in infrastructure. And increased stock market size has encouraged development of domestic mutual funds in many emerging markets. The International Finance Corporation (IFC)—working with institutional investors, investment banks, fund managers and government regulators—has been uniquely involved with promoting the funds industry in emerging markets. Through a mix of providing technical assistance to governments, investing directly, underwriting and placing privately, identifying managers and core investors, and sitting on fund boards, IFC has helped pioneer numerous fund vehicles in emerging markets. These include country funds, debt−equity funds, index funds, venture capital funds, private equity funds, local mutual funds and private pension funds. Investment Funds in Emerging Markets describes IFC's lessons of experience arising from this work.

Preface The role of capital markets in economic development is becoming increasingly evident. It is now widely recognized that there is a direct correlation between economic growth and development of the financial sector. A well−functioning financial intermediation system helps to facilitate a virtuous circle of productivity increases, economic growth, and domestic savings. IFC has been involved with the capital markets sector for over 25 years, reflecting its focus on assisting developing countries in building their physical and financial infrastructure. It has helped supplement domestic resources by mobilizing external savings flows to emerging markets, and focused on developing domestic financial institutions and capital markets. This approach to "deepening" and "broadening" domestic markets has been critical to IFC's strategy of promoting the growth of local savings. IFC has pursued its capital markets objectives by: providing technical assistance to help create or change laws and establish regulatory agencies; creating new institutions. IFC has first of their kind in a country;

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to create new institutions, often the

Preface

2 (c) The International Bank for Reconstruction and Development / The World Bank

Investment Funds in Emerging Markets supporting existing financial institutions. IFC has helped domestic financial institutions expand their access to local and foreign financing sources (through provision of credit and agency lines, commercial paper programs, bond guarantees, etc.) and to strengthen their balance sheets (e.g., through swaps, the second tier capital and securitization of assets); and encouraging financial institutions to reach under−served business segments —especially small−and medium−sized enterprises (SMEs). IFC has used credit lines and promoted SME−focused institutions to improve the access of new, small−and medium−sized firms to financing. Since 1971, IFC has invested and made available through financial intermediaries some $3.5 billion in the financial and capital markets sector, covering more than 560 separate transactions to clients in over 50 countries. In addition, it has provided technical assistance through nearly 800 projects in over 90 countries. The scale of IFC's capital markets operations has increased dramatically since the beginning of the 1990s, during which time capital markets have come to the forefront of the development agenda worldwide. During 19911995, investments in the financial sector accounted on average for 22% of the Corporation's aggregate investment commitments, and for nearly 35% of its total number of transactions. Another objective of IFC's capital markets work has been to integrate domestic capital markets with international capital markets through the promotion of portfolio investment. Through a combination of measure—including technical assistance to governments, direct investments, underwriting and private placements, and identification of managers and core investors—IFC has helped pioneer a variety of investment funds in emerging markets. IFC today promotes country, regional, and global funds investing in listed securities in emerging markets, private equity and venture capital funds, and index and emerging market corporate debt funds. It provides the investment community with data on the performance of emerging stock markets through the Emerging Markets Data Base, which now covers 27 emerging markets on a daily basis and is the most comprehensive database available on these markets. Between 1972 and 1995, IFC's Board approved financing of 122 funds worldwide, involving a total capitalization of nearly US$7

billion. Many of these funds were the first of their kind in the countries concerned. The impact has been substantial. IFC's initiative in promoting "country funds" in emerging markets, for instance, proved seminal to the creation of a global industry, which in turn has helped bring about more open and efficient equity markets in developing countries. This paper, covering IFC's promotion of investment funds in developing countries, is part of the Corporation's strategy to further extend its development impact by disseminating the lessons of its experience in key sectors and activities to external audiences. The paper is one of a series of reports dealing with capital markets issues, all to be released as part of IFC's Lessons of Experience series. The work on these reports was carried out by a team of IFC staff under the coordination of Dileep Wagle and Teresa Barger. This paper was prepared by Laurence Carter, Teresa Barger, and Irving Kuczynski, with research support from Lory Camba−Opem and Tracy Rahn. Consistent with the fundamental basis of the series, the paper draws upon a full range of operational experience from across the Corporation. Data on IFC transactions reflect IFC's operational position as of end−June 1995.

JANNIK LINDBAEK EXECUTIVE VICE PRESIDENT

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Preface


Investment Funds in Emerging Markets INTERNATIONAL FINANCE CORPORATION JULY1996

Contents Executive Summary

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Expanded Opportunities

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Measuring the Change

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Why Did it Happen So Quickly?

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The Virtuous Circle of Funds

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IFC's Experience and Role

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The Lessons of IFC's Experience

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International Portfolio Equity Funds

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Venture Capital Funds

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Private Equity Funds

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Domestic Mutual Funds and Pension Funds

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Future Directions

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1 Investment Funds: An Explosion of Activity

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What Exactly Are Funds?

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A Large, Diverse Family

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Funds in Emerging Markets

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Why Have Funds Invested in Emerging Markets?

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Investors

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Firms

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Host Governments

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Legal and Regulatory Environment for Funds

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2 IFC's Experience Base

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Many Funds, Mostly Recently

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Early Years: FY77FY86

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Acceleration: FY87FY92

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Explosion of Activity: FY93FY95

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Fund Approvals. . . . . .and Actual Commitments Regional Distribution

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Investment Funds in Emerging Markets Asia

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Latin America

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Eastern Europe and the FSU

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Sub−Saharan Africa

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Middle East and North Africa

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Successful Mobilization

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Mostly Foreign, but More Local Investors Emerging

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More Funds in Riskier Countries

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A Growing Funds Portfolio

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Financial Performance of IFC's Funds Portfolio

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Returns on Portfolio Funds

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Returns on Venture Capital Funds

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Why Persevere?

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Two Caveats to the VC Return Figures

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Fund Managers

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Private Equity Funds: Rates of Investment

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3 IFC's Role in Promoting Funds

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A Proactive Approach

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Pushing the Edge of the Envelope

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Sequencing Fund Promotion Within Countries: No Single Pattern link IFC's Specific Roles in Promoting Funds

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International Portfolio Funds

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Rolling Out the Concept

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Reaching More Investors

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Underwriting and Placement

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Building Fund Management Capability

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Fund Governance

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Advice

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Assessing the Market

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Identifying Key Investors and Managers

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Structuring Mobilizing Capital

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Investment Funds in Emerging Markets Governance

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Private Equity Funds

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Mobilization

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Governance

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Environmental Risk Management

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Local Financing: Mutual Funds and Pension Fund Managers

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Mutual Funds

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Pension Funds

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4 Assessing the Impact

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An Overview

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The Catalytic Effect of Portfolio Funds

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Successful New Products Are Disseminated Fast

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Unlisted Firms Also Gain from More Developed Listed Markets

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VC Funds Can Finance Small−to Medium−Sized Firms

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Venture Capital Funds Provide More Than Just Capital

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Building Fund Managers

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Future IFC Work to Promote Funds

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Appendix Tables

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Table A1: Portfolio Equity and Financing Flows to Developing Countries

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Table A2: Number of International Emerging Market Equity Funds, 19811994

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Table A3: Net Assets of International Emerging Market Equity Funds, 19811994

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Tables A4: IFC Fund Approvals and Commitments, 1972−June 1995

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Box A1: Ingredients of Success in Developing and Structuring Venture Capital Funds

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Box A2: Fund Structures

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Bibliography

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Text Boxes Box 1.1: Defining and Categorizing Funds

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Investment Funds in Emerging Markets Box 1.4: Growing Firms Benefit from Equity Markets

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Box 2.1: Debt−Equity Conversion Funds: Responding to Market Needs

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Box 2.2: Helping to Build Chile's Equity Markets

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Box 2.3: Stimulating Portfolio Investment in Africa

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Box 2.4: Mobilizing US$2.6 Billion with Under US$10 Million

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Box 2.5: Some Improvement: IFC's Second Round of VC Funds

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Box 2.6: Pitfalls Aplenty in Venture Capital: Some Examples

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Box 2.7: Competing in Turbulent Markets: Investing in the Gold Fund

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Box 3.1: Building Domestic and Foreign Participation in Funds: Thailand

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Box 3.2: Informing Investors

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Box 3.3: Why Closed−End Country Funds?

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Box 3.4: Targeting Japanese Investors. . . and Introducing Them to Latin America

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Box 3.5: VC Fund Size: Is There Enough Demand?

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Box 3.6: Structuring to Meet Investor Preferences

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Box 3.7: Privatization Generates Deal Flow in Morocco

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Box 3.8: Enhancing Value Through Environmental Assessments

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Box 3.9: Chile's Bold Pension Reform Delivered Results

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Box 4.1: Financing Developing Country Firms

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Box 4.2: Foreign Portfolio Investment Catalyzes the Mauritian Stock Market

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Box 4.3: New Product Expands Dramatically: Global Index Fund link Box 4.4: Venture Capital in an Uncertain Environment

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Box 4.5: Spotting Opportunities and Adding Value to a Philippines Cable Company

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Box 4.6: Building Local Fund Managers

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Text Figures Figure 1.1: Many Investors Reaching Many Firms

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Figure 1.2: Net Private Capital Flows to Developing Countries, 19871994

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Figure 2.1: Cornerstones of a Funds Industry

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Investment Funds in Emerging Markets Figure 2.4: More Funds in Riskier Countries

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Figure 2.5: IFC's Funds Portfolio, 19921995

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Figure 2.6: VC Funds: Positive Returns Take Time

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Figure 3.1: Intermediating Savings to Investing Firms

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Figure 3.2: IFC's Specific Roles in Promoting Funds

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Figure 4.1: Local Investors Own 90% of Emerging Stock Markets link Figure 4.2: Demanding Fund Managers Drive Institutional Development

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Figure 4.3: How Foreign Funds Catalyze a Virtuous Circle of Market Deepening and Broadening

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Figure 4.4: Exit Possibilities Encourage More Entry

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Text Tables Table 1.1: Portfolio Equity Flows, 19891994

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Table 1.2: Welcoming Foreign Investors

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Table 2.1: Evolution of IFC's Funds Activities

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Table 2.2: IFC's Fund Approvals by Vehicle Type, 19721995

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Table 2.3: IFC's Commitments to Funds by Date, June 1995

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Table 2.4: Fund Approvals by Region, FY73FY95

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Table 2.5: Mobilization Rates, 1972June 1995

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Table 2.6: IFC's Funds Portfolio by Type, 19921995

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Table 2.7: IFC's Funds Portfolio by Region, 19921995

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Table 2.8: Financial Rates of Return on IFC's Fund Investments, as of June 1995

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Table 2.9: Financial Performance of Portfolio Funds Which IFC Underwrote

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Table 2.10: Disaggregating Returns on IFC's Venture Capital Investments, FY78FY90

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Table 2.11: Reaching Hundreds of Small Companies

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Table 2.12: Typical Ranges of Management Fees in IFC's Funds

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Table 3.1: Helping to Push the Edge of the Envelope

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Table 3.2: Opening Markets to Foreign Portfolio Investors

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Table 3.3: Examples of Portfolio Fund Technical Partners and Managers

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Table 3.4: Early VC Funds, by Country

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Table 3.5: Table 3.6:

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Investment Funds in Emerging Markets Funds Table 3.7: IFC's Investments in Mutual Funds and Pension Fund Managers

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Table 4.1: Indicators of Stock Market Development and the Funds link Industry, 19851994 Table 4.2: Sample Indicators of Stock Market Development, 1986 link Table 4.3: Stock Market Development After the Entry of Country link Funds Table 4.4: Rising P/E Ratios in Chile

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Appendix Tables and Text Boxes Table A1: Portfolio Equity and Financing Flows to Developing Countries

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Table A2: Number of International Emerging Market Equity Funds, 19811994

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Table A3: Net Assets of International Emerging Market Equity Funds, 19811994

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Tables A4: IFC Fund Approvals and Commitments, 1972−June 1995

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Box A1: Ingredients of Success in Developing and Structuring Venture Capital Funds

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Box A2: Fund Structures

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Glossary ADR

American Depository Receipt

AIF

Asia Infrastructure Fund

AEMF

Africa Emerging Markets Fund

CAMENA

Central Asia, Middle East and North Africa

EMDB

IFC's Emerging Markets Data Base

EMGF

Emerging Markets Growth Fund

EMIF

Emerging Markets Investment Fund

FDI

Foreign direct investment

FSU

Former Soviet Union

FY

Fiscal Year


Glossary



IFC

International Finance Corporation

IFCG Index

IFC Global Index

IFCI Index

IFC Investable Index

IMF

International Monetary Fund

IPO

Initial public offering

LAC

Latin America and the Caribbean

NYSE

New York Stock Exchange

OECD

Organization for Economic Cooperation and Development

P/E Ratio

Price/earnings ratio

PHP

Philippine pesos

SEAVI

Southeast Asia Venture Investment Program

SEC

Securities and Exchange Commission

US$m

US$millions

US$bn

US$billions (where billion=1.000 million)

VC Funds


Executive Summary Expanded Opportunities Throughout the developing world, professionally managed investment funds are growing rapidly. To illustrate the nature of this growth, picture five people making financial choices: 1) The portfolio manager of a large US−based pension fund would like to increase her holdings of emerging market stocks in order to diversify risks and benefit from higher returns. She decides to invest US$50 million in a country fund that buys listed securities in Latin American stock markets, US$25 million in a private equity fund targeting private infrastructure investments in Asia and, as something of a gamble, US$5 million in a venture capital fund being set up to invest in Russian companies. 2) The owner of a privately held, medium−sized textiles firm in Zimbabwe wants to expand. Local banks—concerned about market uncertainty—have indicated that they can only provide loans covering two−thirds of the expansion costs, and that the balance should come from the owner in the form of increased equity. In addition, the banks are requesting a marketing strategy as a precondition for approving the loan. The Delivered by The World Bank e-library to: owner turns to the managers of a local ventureaaaaaa capital fund, who agree to buy a 20% stake in the firm and help University IP : 111.111.11.11 develop a marketing plan. Wed, 11 Jan 1111 11:11:11

Executive Summary


Investment Funds in Emerging Markets 3) An office worker in Peru is considering switching from the state−operated pension fund to the newly instituted private pension scheme. She has seen several advertisements from competing pension managers. And she has read how Chilean workers have achieved annual real returns of 1314% since their scheme was instituted in the early 1980s. This is much more than the state system can offer, but how safe will her savings be? She looks at the regulations and concludes that the private managers have strict investment guidelines and are closely supervised. She switches to the new scheme. 4) A Sri Lankan man has inherited US$1,000 and wants to put it aside for a few years for his children's education. He puts half into a bank savings account. Knowing, however, that equity investments yield higher long run returns than bank deposits, he invests the other US$500 in a local mutual fund which buys shares traded on the Colombo exchange. 5) The treasurer of a firm in Mauritius is considering an initial public offering (IPO) on the local stock market. He has watched the market rise sharply since foreign portfolio investors were allowed to invest in the country. He has also noticed that local investors are more active in the market. This is partly because the government has used public offerings as part of its privatization strategy, but also due to the increased size and liquidity of the market. He decides to seek a public listing. None of these choices would have been possible 10 years ago. Even as recently as five years ago, the options would have been much more limited. What is the common theme? These people are benefiting from the spectacular growth in the number and variety of professionally managed investment funds operating in developing countries. Working closely with institutional investors, banks, fund managers and government regulators, IFC has been intimately involved in developing this new funds industry in emerging markets. Through a mix of technical assistance to governments, investing directly,

underwriting, private placements with investors, identifying managers and core investors, and sitting on Boards, IFC has pioneered and supported numerous fund vehicles in emerging markets: country funds, debt−equity funds, index funds, venture capital funds, private equity funds, local mutual funds and private pension funds. This paper describes the lessons from IFC's experience and the developmental impact of funds in these markets. Measuring the Change Simple numbers do not do justice to this explosion in opportunities for investors and firms. But they can help indicate its magnitude. Today over 60 developing countries have stock markets, compared with half that number in 1985. Their capitalization has increased more then ten−fold over the past decade, from US$171 billion in 1985 to US$1.9 trillion in 1995. Liquidity has increased even faster; turnover rose from 26% to 85% of emerging market capitalization between 1985 and 1994. And the number of domestic companies listed on emerging markets more than doubled from 8,916 in 1985 to 19,397 in 1995. Professionally managed investment funds have helped foster these dramatic changes. In 1984, only a handful of small funds invested in listed securities in emerging markets. The total capitalization of these funds was US$700 million. Ten years later over US$100 billion was being managed in about a thousand international emerging market funds. The largest of these started as a US$50 million fund in 1986; by August 1994 its assets amounted to US$5.5 billion. Delivered by The World Bank e-library to: aaaaaa University Venture capital and private equity funds have grown rapidly too. For example, by early 1995, just six years after IP : 111.111.11.11 11:11:11 there were over 80 ventute funds managing the first venture fund in Eastern Europe wasWed, set11upJanin1111 Hungary, US$4.4 billion targeting that region alone. Several private equity funds investing in private infrastructure or newly

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Investment Funds in Emerging Markets privatized companies have spurung up in the last three years. Some have had initial capitalizations of a much as US$500 million. Options for domestic investors are being widened as more countries switch to privately managed pension funds (e.g., Peru and Argentina), following Chile's highly successful experience. And as local stock markets develop, domestic mutual funds (also called unit trusts) are beginning to emerge in more countries. Why did it Happen so Quickly?

This revolution was waiting to happen. But few observers expected the pace to be so dramatic. Several trends seem to have coincided: Policy and market changes improved investor confidence. Macroeconomic stabilization, financial market liberalization (particularly the relaxation of rules constraining foreign investors), the resolution of the 1980s debt crisis, rapid economic growth and high rates of return from early funds have all improved investors' perceptions of emerging markets. Privatization has increased the supply of assets for investors to buy. This has been supplemented by the recent trend toward increased private financing of infrastructure. There are more investors. Institutional investors such as pension funds and life insurance companies, which have been the main investors in funds, have been growing rapidly. Between 1988 and 1993 the assets managed by institutional investors in OECD countries rose from US$7.5 trillion to US$13 trillion. This, combined with regulatory changes in OECD countries reducing restrictions on foreign investment and a period of low interest rates in the US in the early 1990s, encouraged investors to look at emerging markets. Demand for capital has risen in transition economies. The combination of new, growing private firms, a distressed banking sector and voucher privatization in the transition economies has led to heavy demand (and opportunities) for equity financing from both portfolio funds and private equity/venture capital funds. Better information has encouraged these trends. Sources such as IFC's Emerging Market Database have helped investors to assess risks and returns. Indeed, the fastest growing part of the international funds industry uses indexes such as these to allocate investment weights within portfolios. Improved telecommunications and financial innovations have made it easier to buy into emerging markets. The Mexican peso crisis has highlighted the value of timely information to both governments and investors.

The Virtuous Circle of Funds While these driving forces have been important, it has also become increasingly apparent to investors, firms and governments that professionally managed investment funds offer large benefits. This has created its own dynamic. Successful funds have attracted more investors. With the influx of investors, more fund managers have entered the market, increasing competition. As fund managers have gained experience, they have offered better service to investors extending into new markets. and as domestic firms see local equity markets become more liquid and accessible because of funds, these firms are listing or opening up to outside private equity, further expanding the market. Investors appreciate the advantages ofDelivered professional management of their monies, portfolio diversification, access by The World Bank e-library to: aaaaaa University to emerging markets and reduced transaction costs that funds can offer. Investors with higher risk−return profiles IP : 111.111.11.11 value the opportunity to invest in private equity venture capital funds. Domestic retail investors, who prefer to Wed, 11orJan 1111 11:11:11 invest in liquid, relatively low risk instruments, value the advantages offered by mutual funds. Why did it Happen so Quickly? (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets Domestic firms benefit from: 1) improved access to equity capital; and 2) in the case of venture captial funds, management input (strategic/financial planning, marketing, and so on). Spurred by their investors, portfolio fund managers have demanded improvements in the ''institutional infrastructure" of emerging stock markets (settlement, custodyu, registration, disclosure). Regulators and market participants have responded positively.The infusion of foreign capital into local equities markets has improved liquidity and raised price to earnings (P/E) ratios, thus reducing the cost to firms of issuing new capital. A virtuous circle has developed: existing firms issue more stock, new firms list, more investors are attracted by improved liquidity, and so on. Equally important, improved liquidity on traded equity markets provides better opportunities for public listing, thus offering exit opportunities for investors in privately held firms. This encourages venture capitalists to invest private equity in firms, in the expectation of a profitable flotation onto public markets. It also encourages entrepreneurs to start firms—the so−called "Netscape effect." Governments have recognized that professionally managed funds can transform savings into productive investment with improved efficiency. And funds can help to mobilize extra savings. International country funds enable countries to access international savings. Private pension fund managers have proven very successful in mobilizing local savings. IFC's Experience and Role Between 1972 and June 1995, IFC invested in or underwrote US$786 million in 99 funds that raised US$6.2 billion at inception. The Corporation also invested in 33 fund management companies. Over half of these commitments were made in the last five years, with a large expansion in the volume of venture capital and private equity funds in particular. Working closely with investors, investment banks, fund managers and regulators, IFC helped sponsor and often underwrite numerous path−breaking funds, including: the 1984 Korea Fund, which catalyzed the whole emerging markets protfolio industry; the first global portfolio investment fund for emerging markets, in 1986; the first debt−equity fund, in Chile, in 1987; the first fund to invest in emerging market private corporate debt in 1992; several early private equity funds investing in infrastructure and privatization; one of the earliest emerging market index funds, in 1993; the first venture capital funds in many developing countries; early domestic mutual funds in some countries, and private pension fund managers in Peru and Argentina. IFC's two broad objectives in promoting funds have been to: provide international and domestic investors with opportunities to invest through professionally managed vehicles; Delivered by The World Bank e-library to: provide domestic firms with better access

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management advice.

IFC's Experience and Role (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets Five kinds of fund vehicles have helped achieve these aims: (1) International portfolio equity funds (country funds) have mobilized large volumes of international private savings and stimulated the development of emerging stock markets. As international investment banks have moved into many emerging markets,IFC has shifted toward pre−emerging markets and promotion of new types of funds, such as index funds. (2) Private equity funds have also mobilized large sums from international investors, but for less liquid investment in unlisted firms. (3) Venture capital funds and managers have invested equity and provided management support to smaller, newer firms in a very wide range of developing countries. (4) Domestic mutual funds have mobilized funds from local investors and helped to develop local stock markets. (5) Pension funds have helped mobilize long term domestic savings from individuals. IFC's specific roles at the fund level includes: Diagnosis. Responding to government or sponsor requests, or sometimes at its own initiative, IFC analyzes the need for funds in a market, what kind of fund might be appropriate and assesses what fund size might be feasible. Assesing feasibility. If a niche exists and there is interest from government regulators and potential investors in developing a fund, IFC may undertake a more detailed feasibility study and sound out investors on a preliminary basis. Identifying and assessing sponsors/managers. Turning concept into reality requires identifying core investors and a fund manager. The two are related; a well known fund manager encourages investors, and a critical mass of committed investors may attract a fund manager. IFC may persuade a reputable investment management firm to research and analyze a hitherto unknown market. Or IFC might use its contacts with investors in previously sponsored funds to arouse interest in new vehicle. Together with the sponsors, structuring the fund. IFC plays the "honest broker" role in discussions with local regulators and assists with defining the fund's legal form and investment guidelines. IFC also tries to ensure that a local fund management capability is fostered, often by partnering a local manager with an international technical partner. Mobilizing funding. IFC has underwritten 12 of the 36 portfolio funds it has sponsored, and helped place most of the rest among institutional inverstors. On average IFC has invested in 16% of a fund's initial capitalization. Advising, monitoring and governing. Helping to build fund management capabilities is a critical role for IFC. The development impact of such institution building extents well beyond the monies raised within a particular fund. IFC staff sit on the boards of many funds and managers. IFC also trains fund managers in assessing and mitgating the environmental risks of the projects in which they invest. The Lessons of IFC's Experience International Portfolio Equity Funds

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These have been both financially returns to IFC investments in these funds have averaged 24% per annum. The funds have helped to raise the liquidity and quality of institutional The Lessons of IFC's Experience (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets infrastructure of emerging stock markets. Through these funds huge volumes of money have been raised and a professional emerging market fund management industry has evolved. Recently IFC has helped extend these benefits to stock markets in Africa, North Africa and the Middle East. Although international funds have helped catalyze more liquid, larger, better regulated stock markets, the main beneficiaries are local firms and investors. Local owners hold about 90% of emerging market capitalization.

Unlisted firms also benefit, as more investors and entrereneures are attracted by the better exit possibilities from a liquid stock market. Venture Capital Funds

Because of the nature of venture captial (VC) fund—long term, illiquid investments, with returns mainly realized at fund closure—their financial perfomance emerges slowly. The VC funds that IFC sponsored in the 1980s have performed relatively poorly: nominal returns averaged between −1% amd +5% per year. IFC has learned four important lessons from this: Management is the most important determinant of fund perfomance, However, identifying experienced, highly qualified VC fund managers willing to manage relatively small funds in difficult envirnonments has proved a major task. IFC has developed several methods to identify and build such VC management capability, but in the early funds it often had to accept relatively inexperienced managers. Fund structure helps define incentives for managers to perform and for fund shareholders to remain interested, but not interfere too much. Important structural elements include minimum fund size, a two−tier structure to separate the fund from the management comapny, a limited fund life (to give managers the incentive to divest), a common goal for shareholders, and mechanisms to prevent conflict of interest between fund managers and the fund (for instance, disclosure and review procedures). Deal flow. Many funds invested less and more slowly than expected. In some countries venture captital conflicted with local cutural norms: small, closely held firms were not used to sharing project ideas with outsiders, or ceding some ownership and control. In experienced fund managers needed a long time to build up an investment pipeline. And macroeconomic instability in some countries reduced firms' investment plans. Exit difficulties. Selling VC investments is often difficult. Liquidating a VC fund fully may take longer than anticipated, depending on the size and liquidity of the local stock market, and the atitutde of the owners of local firms. Despite the poor financial performance with its early VC funds,IFC expanded its VC investments sharply in the 1990s, for three developmental reasons: Needs of transition economies. Over half of IFC's VC funds since 1990 have been in transition economies, with several funds in both Russia and China. In countries such as Bulgaria and the Ukraine, where there have been limited financing opportunities at IFC's normal operational scale, IFC's first investment has been a VC fund. Accessing small and medium firms. VC funds remain the most cost−effective way for IFC to invest equity in small and medium firms. By mid−1995, 39 of the VC funds that IFC financed had invested in 679 companies, with an avarage investment of US$0.7Delivered millionbyper company. In low−income countries the sub−investments were The World Bank e-library to: aaaaaa University smaller yet: four Sub−Saharan African funds invested an average of US$100,000 per company in 81 firms. IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Venture Capital Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets Building VC management capacity. Good VC managers provide more than equity to firms: they supply advice on marketing, management and industrial contacts. allthe important components of building successful private firms. But VC management skills are scares in developing countries, so IFC has made it a priority to help develop local VC fund management capacity, often through partnerships with international managers. By incorporating the lessons of its early VC experiences, IFC has improved the prospects for better financial returns from its more recent VC investments. Other private investors also seem bullish: IFC's US$272 million investment in 45 new VC funds between FY91 and FY95 was matched by US$1.4 billion from private investors. Private Equity Funds

Private equity fund in emerging markets are too new to evaluate their financial performance. Lessons emerging from their rates of investment include these: continued government reforms and privatization are needed to supply a pipeline of investments; competition is increasing as moe financiers enter the market; and again, good managers are critical, to bring both financial and industry contacts and to adapt to changes in underlying markets.

Domestic Mutual Funds and Pension Funds

It is too early to assess the financial performance of domestic mutual funds and pension funds in emerging markets. It is clear, however, that pension fund managers need significant capital to service the needs of large numbers of retial investors. Similarly, because they draw investments from individuals, domestic mutual funds need a sound regulatory environment, supervisory capability, a supply of liquid and diverse securities in which to invest and supporting institutional infrastructure (settlement and transfer procedures, valuation systems, brokers, and so on). This combination of requirements makes the task of developing domestic mutual funds praricularly challenging. Future Directions The focus of IFC's future work in funds promotion will continues to shift in directions that have become evident from the Corporation's work over the past two years. IFC will focus on: vehicles that mobilize domestic savings, including pension funds, domestic mutual funds and local pools for venture capital funds. IFC will work closely with the World Bank to support pension reform efforts. private equity and verture captial funds, particularly in new sectors and countries. portfolio funds inthe so−called pre−emerging stock markets which have not yet benefited form groeign protolio investment. index funds. Sophisticated inverstors are using both actively managed country funds and, increasingly, index funds to invest in emerging markets. IFC will help to roll out index funds to more regions. As well as promoting specific funds, this work will involve adding new markets to its Emerging Markets Database (EMDB); indeed several countries are asking IFC to include them in EMDM's coverage, as this ensures automatic foreign portfolio investment from index funds. debt funds. As bond markets in developing countries deepen, IFC will promote more funds to invest in private corporate debt. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 undertaken by IFC to support these efforts Wed, 11 Jan 1111 11:11:11

The volume of advisory work will probably remain high and possibly remain high and possibly increase. As in the past, a significant share of this work will be undertaken as part of a Private Equity Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets World Bank Group team. Within this broad strategy, however, the volume, location and form of IFC's funds promotion work will depend to a significant extent on liberalization efforts by governments (including those not directly related to funds, such as privatization and private participation in infrastructure) and investor perceptions.

1— Investment Funds: An Explosion of Activity Fifteen years ago, few people had heard of the term "emerging markets." International investors, whether individuals or pension fund managers, could not readily buy listed securities in most developing countries. In 1985 only about 30 developing countries had stock markets, and most had relatively little trading. Few firms in developing countries—including large companies—raised capital from stock markets. And formal sources of private equity for firms, such as venture capital funds, were unheard of in nearly all developing countries. The change since then has been spectacular. Today over 60 developing countries have stock markets. Their capitalization has increased more than ten−fold over the past decade, from US$171 billion in 1985 to US$1.9 trillion in 1995. Liquidity has increased even faster: turnover rose from 26% to 85% of emerging market capitalization between 1985 and 1994. This compares with turnover rates of over 70% in the US and UK markets. And the number of domestic companies listed on emerging markets more than doubled from 8,916 in 1985 to 19,397 in 1995, pulling even with the 19,467 companies listed on the stock exchanges of developed markets.1 The venture capital industry has grown rapidly too. For example, by early 1995, just six years after the first venture fund in Eastern Europe was set up in Hungary, there were over 80 venture funds managing US$4.4 billion targeting that region alone. Professionally managed investment funds have played a key role in fostering these dramatic changes. The numbers are spectacular. In 1984 there were a handful of small funds totaling US$700 million which were investing in listed securities in emerging markets. Ten years later over US$100 billion in about a thousand funds was targeted at emerging markets. The entry of international funds has catalyzed many emerging stock markets by improving liquidity and supporting market infrastructure—in response to the demands of international fund managers. Despite this extraordinary growth, however, about 90% of listed securities in emerging stock markets remains owned by locals. In other words, the benefits of larger, more liquid, betterregulated markets have accrued overwhelmingly to local investors and firms. Institutional investors, such as pension funds and life insurance companies, have driven the expansion of the professionally managed funds industry. Households have been channelling more of their savings to pension funds and life insurance companies: in 1994 nearly 40% of household wealth in the United States was managed by institutional investors, up from 20% in 1980. Institutional investors have in turn sought to diversify risks and improve returns by using professional fund managers. Today a US−based pension fund manager can invest in, for example, a country fund targeting the Thailand stock market, a Ukraine venture capital fund, or a private equity fund investing in Asian infrastructure projects. Baring Securities estimates that UK pension funds now invest 5% of their portfolios in Asian markets other than Japan. Over the past 20 years, IFC has promoted the funds industry in emerging markets by working closely with institutional investors, investment banks, fund managers and government regulators. Funds are IFC's premier Delivered by The World Bank e-library to: aaaaaacapital University vehicle for 1) mobilizing large volumes of private for equity investment in emerging markets; 2) IP : 111.111.11.11 stimulating the growth of securities marketsWed, in 11 Jan 1111 11:11:11

1— Investment Funds: An Explosion of Activity (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets developing countries;2 and 3) improving small and medium−sized firms' access to outside equity and management advice. This paper reviews that experience, describes the lessons that have been learned in the process and assesses the developmental impact of funds. What Exactly are Funds? Funds—also known as collective investment vehicles — are financial structures for pooling and managing the monies of multiple investors. Investors cede significant control over their money to professional managers, who in turn buy either listed securities or private equity stakes in firms (see Figure 1.1). All parties gain. Investors can buy securities of companies that they could not otherwise hold due to transaction costs, legal restrictions or lack of expertise. They can diversify assets, achieve better liquidity and obtain the benefits of professional management and research. Specialized funds can meet the different risk−reward preferences of investors. For example, relatively low−risk mutual funds purchase equities on well−regulated, liquid stock markets while a venture capital fund operating in transition economies is a high−risk, illiquid investment. Firms needing equity also benefit from funds. Once they have grown beyond the stage of financing themselves from family, friends and other informal sources, firms need external debt and equity financing to grow and invest. The smaller the firm, or the more risky the proposed investment, or the more uncertain the environment, the greater the need to use equity financing. The existence of funds improves firms' access to equity, whether private or listed. In addition, most venture capital fund managers also provide firms with advice and specialized expertise in areas such as marketing and financial planning. In short, funds help to mobilize domestic and international capital and intermediate them efficiently. A Large, Diverse Family The sectoral, geographical and structural diversity of funds is extensive and growing. Box 1.1 describes how funds differ in their structure and how they are placed with investors. Four broad categories of investment purpose can also be identified: 1) International portfolio investment funds (also called country funds ) mainly buy securities listed on local stock exchanges. They may also buy shares of emerging market companies listed in international money centers, such as American Depository Receipts (ADRs). "Securities" include equities, quasi−equities, corporate debt and government debt. The fund managers place a premium on diversification, tradeability and liquidity. They buy minority stakes in companies and do not seek a management role. These funds may be quite large, with initial capitalizations often in the US$50US$200 million range.


What Exactly are Funds? (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets Figure 1.1: Many Investors Reaching Many Firms

2) Private equity funds (also called direct investment funds) buy significant minority equity stakes in unlisted companies. Investors aim for high capital gains, especially if a firm becomes listed. The funds can be large: IFC has sponsored two private equity funds focusing on infrastructure which each raised US$500 million at inception. Fund managers may sit on the boards of investee firms. Often the investing focus of private equity funds requires a joint effort between the fund's management (which possesses financial and general management expertise) and professionals with specific industry expertise. 3) Venture capital funds 3 mostly buy private equity stakes in smaller and newer enterprises. Venture capital (VC) funds historically have been quite small. The average VC fund sponsored by IFC has been US$30 million, although some recent funds have ranged up to US$100 million. VC funds buy significant minority stakes (sometimes majority stakes) in companies and often provide management input. Box 1.1: Defining and Categorizing Funds Structure. Most fund structures fall into two types. In a closed−end fund a given sum is raised and then the shareholder group is closed. Subsequently shares in the fund can be traded at a price which may reflect a premium or discount to its underlying net asset value (Nav). The funds can have a finite or an indefinite life. They can be listed on international stock exchanges or remain unlisted. In an open−end fund (e.g., most of the mutual funds in the US retail market) the manager agrees to buy back any shares at the published daily net asset value. Such funds grows or shrink as investors invest or divest. A few funds are structured as semi−open. typically, a fund manager agrees to buy shares from shareholders at net asset value at prearranged times. Investor placement. There are two main approaches. Funds can raise their capital through private placements to a small, perhaps pre−selected, group of investors, or to a worldwide universe of large investors. Alternatively, funds can be publicly listed and sold through underwriters to retail or institutional investors. Fund arrangers may list the fund on an exchange which will attract active trading (such as the NYSE) or inactive trading. The latter is chosen when regulatory or other conditions oblige investors to have their investment listed, but they do not want active trading, which might, at times, send the market price to a discount to NAV. Investor types. Institutional investors invest relatively large sums and demand high standards of management in return. They are often prepared to accept less liquidity than retail investors, and thus dominate investment in venture capital and private equity funds. Retail investors mostly invest in funds that buy traded securities: international funds or domestic mutual funds. Fund manager control. Venture capital and private equity fund managers usually seek some control over investee firms. This may include taking board seats, providing advice and seeking to influence the managers of investee firms. In constrast, international portfolio and local mutual fund managers seek no direct control over investee firms and typically limit their exposure to any single firm. Delivered by The World Bank e-library to: aaaaaa University

Thus, funds may be defined in terms of combinations of IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Characteristic

From . . .

. . . To

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Investment Funds in Emerging Markets Structure

Closed

Open

Placement

Private

Public

Investment

Private

Listed

Investor

Institutional

Retail

Fund manager control Some

None

Usual combinations. Some combinations of fund structure, placement and investment type occur frequently. Venture capital funds are usually structured as closed−end funds, placed privately with institutional investors, and are rarely traded on listed exchanges. Private equity funds are usually structured similarly, although they may sometimes be listed on "exchanges of convenience" where trading is light. Portfolio funds, however, can be either closed−ended or open−ended and may mobilze funds from institutional or retail investors. Domestic mutual funds often target retail investors, are ususally open−ended and invest mainly in actively−traded, listed securities.

4) Domestic mutual funds (also called unit trusts) raise money from local investors and buy securities listed on the domestic stock market. Often IFC also invests in separate management companies that manage these funds. Occasionally, IFC has invested only in the fund manager—pension fund managers are the best example. Three examples illustrate the variety. The China Dynamic Growth Fund is an unlisted, closed−end, venture capital fund. It was privately placed with institutional investors and invests in established, unlisted, majority−private−owned companies in China that require capital to grow. The Emerging Middle East Fund is a closed−end, portfolio investment fund listed on the New York Stock Exchange. It invests mainly in securities listed on stock exchanges in Egypt, Jordan, Morocco, Oman and Tunisia. The Pyramid Unit Trust in Sri Lanka is a domestic, open−end equity fund that invests in equity and fixed income securities listed on the Colombo Stock Exchange. Shares in the fund were placed privately with institutional investors when it was launched in January 1992 and were later marketed to the general public. In industrialized economies, venture capital (VC) financing has been closely associated with high technology firms. In many developing countries, where the concept of private equity financing is novel, VC funds reduce risks by financing a wide variety of firms and at different stages of their financing cycles. Box 1.2 describes the three basic stages of VC funds' investment activity: entry, operation and exit. Funds in Emerging Markets The flow of international portfolio investment to developing countries grew from nothing in the early Box 1.2: Venture Capital: Entering, Managing and Exiting Investments (1) Screening and entry. Venture capital (VC) fund managers screen investment proposals by assessing a)expected return and when it might be realized; b) investment size (too many small investments are expensive to manage); c) technology and market Delivered by The World Bank e-library to: sector; and d) stage of development. Firms may need outside equity at two main stage: aaaaaa University IP : 111.111.11.11 11 Jan 1111 11:11:11 "early stage ": second financing to prove aWed, concept, startup financing to develop a

Funds in Emerging Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets product, and other early stage financing to initiate commercial manufacture; and "expansion state ": second stage financing provides working capital for a company which is producing but may not be making a profit; later stage financing may be used for plant expansion or marketing; and bridge/mezzanine financing is for companies that expect to go public within a year—or raise term debt. If a prospective deal passes initial screening, more detailed due diligence takes place. VC funds typically give the investee firms' management quality and commitment the highest weight in evaluation. If it passes, the deal will be structured, priced and negotiated. (2) Value enhancement and operations. VC funds provide funding and management guidance to their investee companies. This is often through board participation and direct assistance with financial planning and marketing. VC managers usually have contacts with other financial institutions, and so can help firms raise additional captial. They may also have contacts with other industrial companies, which can provide technical advice or even act as jointventure partners. The need for close monitoring means that a) VC firms tend to be physically near to their clients; and b) each VC manager typically looks after less than 10 investee firms. (3) Divestment. Given the illiquidity of VC investments, equity exit stategies are essential: initial public offering (IPO), where shares are sold to the public. This is usually the most profitable and soughtafter exit route; acquisition of the investee firm by another company. This has been a common exit mechanism in developed countries; repurchase of the VC's shares by the investee firm or founder; and secondary purchase of the VC's share by a third party.

Figure 1.2: Net Private Capital Flows to Developing Countries, 19871994 1980s to US$47 billion in 1993, before falling slightly in 1994. Other sources of private financing to developing countries—bank lending, bond issues Delivered and foreign investment—have also grown rapidly (see Figure 1.2), by Thedirect World Bank e-library to: aaaaaaofficial Universityflows by 1994 (see Appendix Table A1). Portfolio such that total private flows were over three times IP : 111.111.11.11 flows accelerated sharply in the early 1990s, rising 3.7% of total flows to developing countries in 1990 to Wed, 11 Janfrom 1111 11:11:11 17.4% in 1994. Funds in Emerging Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets Closed−end funds opened the door into emerging markets for portfolio investors. Restrictions on direct equity purchases by foreigners, limited knowledge, high transaction costs and the narrow range of internationally quoted emerging market stocks meant that funds were often the only practical vehicle for investors seeking exposure to emerging markets. Some countries restricted entry solely to funds: for example, until 1992 foreigners could only buy Korean equities through country funds. Although preceded by the 1981 Mexico Fund, the successful launch of the Korea Fund in 1984 really catalyzed the emerging−market closed−end fund industry (see Box 1.3). By December 1994 about a thousand funds were managing US$105 billion in emerging markets. The list includes a fund targeted at Bangladesh, nine funds with nearly US$500 million to invest in African countries and 37 funds investing US$1.5 billion in Eastern Europe (Appendix Tables A2 and A3 show the details). Since the early 1990s, however, international equity issues (including ADRs) and direct equity purchases have accounted for much of the growth in portfolio equity flows. Thus, while in 1989 closed−end funds Box 1.3: The Korea Fund: Catalyzing a US$100 Billion Industry King William I of the Netherlands is credited with forming the first closed−end fund in Belgium in 1822, a type of fund that found popularity with British investors in the late 1800s. The Japan Fund, introduced in 1962, was the first modern country fund. Despite its success, the next country fund was the 1981 Mexico Fund. IFC advised on its structure but did not underwrite it because of concerns about the management arrangements. The timing was unfortunate: Mexico defaulted on its foreign debt in 1982, and the fund fell 75% from its offering price. Not long after, the US$60 million issue of the Korea fund in August 1984 ignited spectacular growth in the closed−end country fund industry. The public offering on the New York Stock Exchange followed several years of preparation by both the Korean Government and IFC. In 1981 two small investment trusts were privately placed among UK investors, to serve as pilot projects. For over two years prior to the 1984 public issue, IFC worked with Korean officials, introducing them to the international investment community and advising on the structure and launching of the fund. A well−known US investment manager—Scudder, Stevens & Clark—was selected to manage the fund. The underwriting syndicate considered of The First Boston Group (lead manager), and IFC and Shearson Lehman (co−lead managers). A second public offering in the Korea Fund was launched in 1986, with IFC playing a similar role. In the same year, IFC helped launch the first global fund targeted at emerging markets, the Emerging Markets Growth Fund (EMGF). The US$50 million fund was placed with 13 institutional investors. By August 1994 EMGF had net assets of US$5.5 billion, making it the world's largest emerging markets fund. These early successes kindled the interest—and money—of investors worldwide. Between 1986 and 1994. IFC underwrote or invested in over 30 other portfolio investment funds.

accounted for two−thirds of the US$3.5 billion of portfolio equity flows to developing countries, in 1993 the US$3.9 billion of new closed−end fund investment represented less than 10% of portfolio equity flows (see Table 1.1). All regions have benefited, although East Asian and Latin American countries have absorbed a larger share of the flows—mirroring the pattern seen for foreign direct investment Delivered by The World Bank e-library to: and private lending. These two regions still University accounted for about 70% of all portfolio equityaaaaaa in 1994, a year when net flows to Latin America fell sharply. IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

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Investment Funds in Emerging Markets More generally, all types of funds have grown in emerging markets, albeit often from a low base. The venture capital pool under management in Southeast Asia rose from under US$100 million in 1985 to about US$3 billion by 1992. Voucher−based investment funds have developed in some transition countries following mass privatization. Domestic mutual funds are emerging in many countries as local stock markets become more liquid and better regulated. And several countries, including Peru and Argentina, have recently set up a private pension fund industry. Why have Funds Invested in Emerging Markets? Why have fund managers turned to emerging markets, and why have many governments welcomed them? Both "pull" and "push" forces have been at work: "Pull" forces include macroeconomic stabilization, liberalization of financial markets (particularly the relaxation of rules constraining foreign investors—see Table 1.2), the resolution of the 1980s debt crisis, rapid economic growth and high rates of return in many countries. These have all improved investors' perceptions of emerging markets.4 Privatization—particularly of large infrastructure utilities—has increased the supply of assets for investors to buy. "Push" factors include regulatory changes in OECD countries reducing restrictions on foreign investment and, in the period to early 1994, declining interest rates, which made the possibility of higher rates of return in emerging markets attractive. These forces have been encouraged by better information about emerging securities markets. Sources such as IFC's Emerging Market Database have helped investors assess risks and returns. Technological advances and innovations in financial instruments have also made it easier to buy into emerging markets. These trends seem likely to persist, despite market turbulence in the wake of the 1994 Mexican peso crisis. Emerging markets still account for a lower proportion of institutional assets than portfolio diversification theory would suggest. For example, it is estimated that US institutional portfolios amount to US$9 trillion, of which Table 1.1: Portfolio Equity Flows, 19891994 (US$ billion) 1989

1990

1991

1992

1993

1994p

Int'l equity issues (ADRs and others)

0

0.1

4.9

5.9

11.5

20.5

Direct equity investment

1.3

0.8

1.5

6.9

31.5

12.0

Closed−end funds

2.2

2.9

1.2

1.3

3.9

7.0

Total

3.5

3.8

7.6

14.2

46.9

39.5

Sub−Saharan Africa

0

0

0

0.1

0.4

0.8

East Asia & Pacific

2.6

2.3

1.0

5.1

18.1

17.6

By type

By region

South Asia

0.2

Europe & Central Asia

0.2

Delivered by The World Bank e-library to: 0.1 0 University 0.4 2.0 aaaaaa IP : 111.111.11.11 0.3 Wed, 11 0 Jan 1111 11:11:11 0.2 1.3

7.7 2.5

Why have Funds Invested in Emerging Markets? (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets Latin America & Caribbean

0.4

1.1

6.2

8.2

25.1

10.1

Middle East & North Africa

0

0

0

0

0

0.4

Global funds

0.1

0

0.3

0.1

2.9

1.8

Source: World Bank.

Table 1.2: Welcoming Foreign Investors Percent of emerging stock markets ∗ Market status

Feb 1991 Dec 1994

Free entry

26

58

Relatively free entry

48

24

Restricted

15

16

Closed

11

2

Source: IFC Emerging Stock Market Factbooks. Note: Percentages are based on the number of markets responding to this question in EMDB's Annual Global Survey of Stock Exchanges—27 markets in 1991, and 45 in 1995. US$2.6 trillion is in stocks. Only 1% of that is invested in emerging markets. Yet emerging markets accounted for 13% of world stock market capitalization at the end of 1994. Emerging markets funds offer significant benefits to three key groups: investors, the firms they invest in and host governments. Investors

Emerging market funds benefit investors through: Portfolio diversification. Emerging markets offer different risks and returns than markets in industrial countries.5 However, historically returns have not been correlated closely with developed markets. Several studies have shown that adding emerging markets exposure to a portfolio both increases returns and reduces risks. Delivered by The World Bank e-library to:

Professional management. Fund managers provide management and market research in environments that aaaaaa University IP :information 111.111.11.11 may be prohibitively expensive for a single investor. investors often do not know well. ObtainingWed, this 11 Jan 1111 11:11:11

Investors


Investment Funds in Emerging Markets Economies of scale in management and administrative costs. Legal, fiscal and reporting costs that may be prohibitive for a single investment fall when handled centrally for several investments. Easy divestment —at least for investors in openended mutual funds. Occasionally, privileged access. Funds may enjoy privileged access to stock markets (for instance, Korea in the late 1980s, Mauritius when its market opened to foreign investment in 1993, and India until 1994). This is less usual today, with countries actively competing for foreign capital. Firms

Emerging market funds benefit firms through: Improved access to capital (see Box 1.4). This includes outside private equity sources, such as venture capital and more liquid traded equity markets. Managerial, marketing and financial advice. Venture capital firms provide more than just financing to the firms in which they invest. These benefits may be particularly valued by new, small−and medium−sized firms, and enterprises in transition economies. Better information, improving access to financing. Fund managers demand high standards of financial reporting. Better, more widely held information about firms' financial performance may lower appraisal costs by other financiers. Access to longer term financing. The combination of fund vehicles and broader, more liquid capital markets encourages the entry of investors with long−term horizons, such as life insurance companies. These institutions may be willing to provide long−term financing. The development of funds buying corporate debt has broadened this market. Host Governments

Emerging market funds benefit host governments through: Augmentation of domestic savings. If an investor in an open−end fund sells shares, the fund manager has to sell the underlying assets of the fund to repay the investor. In contrast, even if a closed−end fund is listed and actively traded (this applies only to some portfolio funds, not private equity or venture capital funds) a sale of shares in the fund may depress the fund's share price but will not require the fund to divest.

Box 1.4: Growing Firms Benefit from Equity Markets Without an equity market, a firm has limited financing choices. It can finance itself by ''inside" equity (retained profits or equity from family and friends), trade credit and bank borrowing. But then it is unlikely to grow as fast as it might. Why? First, without access to outside equity the firm's owner might consider the risk of expansion too concentrated. Second, investments that need equity financing, such as those with uncertain cash flows, may not be financeable with debt. Even if a firm can borrow, its high debt−equity ratio would leave it vulnerable to changes in cash flows. Delivered by The World Bank e-library to: aaaaaa University Outside private equity sources, such as venture capital allow firms to share expansion IP : 111.111.11.11 risks with other investors. And fund managers often complement their equity with Wed, 11 Jan 1111 11:11:11 advice on financial planning, marketing and contacts with other financiers and fims.

Firms


Investment Funds in Emerging Markets A public equity market offers benefits beyond a wider market for the firm's equity markets aggregate information that investors possess about firms, making it less costly for all external financiers—whether investors or lenders—to monitor firms. An influx of capital from a new country fund raises demand for shares and thus P/E ratios. This reduces the cost of raising equity. Firms with existing shares may issue more stock, and new firms may list on the market. These improvements in liquidity in turn attract new investors and intermediaries such as brokers. A more liquid market for traded securities provides an important and potentially profiabtle exit route, through a flotation, for holders of private equity stakes in firms. This in turn attracts more investors into private equity funds, thereby further improving access to equity for private firms. Reduced reliance on volatile financing sources. The long−term commitment of capital represented by closed−end funds reduces reliance on more volatile sources of private external finance, such as short−term bank credit. Diversification of ownership. Funds are attractive to governments that are concerned about concentrated foreign ownership of domestic enterprises. This explains why funds were allowed to invest in several countries before markets were opened to direct investors. Skills that develop local capital markets. Fund managers bring investment valuation and operational skills to local markets. Responding to the concerns of their investors, fund managers often demand high standards of custody, clearing and settlement, information disclosure and regulatory oversight. Higher stock prices. An influx of new, external capital to a securities market usually results in higher equilibrium stock prices, and thus a lower cost of equity to local firms. Growth stimulus for domestic firms. VC funds bring in high−risk capital and management expertise that enables small−to−medium domestic firms to grow. Legal and Regulatory Environment for Funds Governments influence funds in two ways. Most directly, they define the legal and fiscal regulation of funds and capital markets. Second, governments determine the macroeconomic and regulatory environment for private activity in the economy generally. In developed economies funds are encouraged by an atmosphere which supports investment in multiple ways. Regulations and legal processes are open and allow for rapid resolution of conflicts. Clearly defined investors' rights facilitate investment. Well−regulated and efficient capital markets, with unfettered execution and clearing, enhance investor confidence. All contribute to an environment where funds can define their investment objective, identify opportunities, openly and fairly negotiate a competitive value, quickly obtain legal ownership, liquidate the investment solely upon their decision, and freely convert and transfer the proceeds. In emerging economies, legal and regulatory environments vary from rigorous to relaxed. IFC's experience has identified the following desirable aspects among the many components that create an enabling legal and regulatory environment: legal status of equity ownership allowing fund to own portions of private enterprises;

legal regulations providing for rapid and transparent handling of conflicts between majority enterprise owners, Delivered by The World Bank e-library to: minority owners, creditors and other interested parties; aaaaaa University IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

establishment of minority shareholders' rights and system for redress; Legal and Regulatory Environment for Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets fund industry regulations (for both open and closed funds and their management companies) are open and allow for free competition; tax system that allows funds to be structured as pass−through vehicles that are tax neutral; reasonable dividend tax regulations; favorable foreign investment laws (that is, no penalty on currency conversion or capital repatriation, no restriction on foreign equity ownership); free and equal access to investment opportunity for local and foreign investors; international standards regulated for accounting practices; user−friendly regulations governing establishment of corporate entities or partnerships (including foreign participation). Although these conditions are desirable to help foster a healthy investment funds industry, few developing countries actually offer all of them. IFC's experience has shown that in many cases progress toward a freer, more transparent and well regulated environment can yield a significant response from fund investors and managers. IFC's experience has also shown that a larger funds industry in turn often encourages more reforms to improve the legal and regulatory environment for funds.

1. Data from 1995 Emerging Stock Markets Factbook (IFC), and based on EMDB's Annual Global Survey of Stock Exchanges. In 1995, IFC and other members of the World Bank Group defined emerging markets as those with GNPs per capita of less than US$8,956 in 1994.

2. Funds complement work undertaken via IFC's technical assistance program to develop securities markets.

3. Technically venture capital funds are a subset of private equity funds. But because they are much smaller than the large private equity funds that IFC has financed, and because IFC has invested in so many VC funds, they are treated separately here.

4. for example, the average credit rating for 24 Latin American countries published by Institutional Investor improved significantly form 20.3 in March 1989 to 27.6 in March 1995 (0 is least creditworthy and 100 the most). Some turnarounds were truly dramatic: Argentina improved from a rating of 22.3 in March 1989 to 38.9 in March 1995.

5. In December 1994, even after a roller−coaster year, the IFCG Total Return Index for emerging markets stood at 552.2 (on a base of end−1984=100), compared with 381.8 for the S&P 500.

2— IFC's Experience Base


2— IFC's Experience Base (c) The International Bank for Reconstruction and Development / The World Bank

27

Investment Funds in Emerging Markets What helps a funds industry develop? An adequate regulatory and legal environment, willing investors, capable managers with performance incentives and investment opportunities are all important elements (see Figure 2.1). IFC provides advice, information and financing to develop each component. Many Funds, Mostly Recently Between its first fund project in 1972 and June 1995, IFC's Board approved 175 transactions totaling US$1,081 million for investment in funds and their management companies. These funds covered 34 developing countries, as well as numerous regional and global funds. After netting out repeat approvals to the same fund or management company, IFC has approved investments in 122 funds and 40 management companies, mostly during the last 10 years. Indeed, during the last three years alone—FY93FY95—IFC's Board approved 94 fundrelated investments totaling US$671 million (see Figure 2.2 and Appendix Tables A4) Four broad areas of activity have emerged in the course of IFC's fund promotion work: 1) Mobilizing international savings to invest in listed securities in emerging markets; 2) Tapping foreign investment capital to invest in venture capital funds which in turn invest in small and medium−sized firms; 3) Mobilizing international savings to invest in private equity funds in developing countries; 4) Mobilizing and promoting the management of domestic savings to invest locally in listed securities and private equity.

Figure 2.1: Cornerstones of a Funds Industry


Many Funds, Mostly Recently (c) The International Bank for Reconstruction and Development / The World Bank

28


Figure 2.2: IFC's Fund Approvals, 19771995 Source: World Bank Note: There was one transaction in FY73. These activities have evolved unevenly across regions, over time and by product. They have responded to changing external circumstances and as IFC has learned from its own experience. Grouping IFC's activities into three time periods illustrates this evolution: the first 10 years, from FY77 to FY86; six years from FY87 to FY92; the most recent three years, from FY93 to FY95. Table 2.1 summarizes IFC's objectives, instruments and transactions in each period. Early Years: FY77FY86

In the 1960s and 1970s many governments were wary of foreign investors. Equally, investors showed little interest in developing country stock markets. In the late 1970s, after identifying regulatory barriers in developing countries as the key constraint, IFC staff began working with a few interested governments to amend regulations and identify potential investors and fund managers. After several years work IFC helped to structure the 1981 Mexico Fund, but withdrew from underwriting it because of concerns about the management arrangements. However, the successful 1984 launch of the Korea Fund (see Box 1.3) kindled the interest of international investors and government policymakers. IFC responded by approving a further 17 country or regional funds during the remainder of the 1980s. Meanwhile, starting in 1978 and over the following few years, IFC promoted "first" VC funds in several countries, including Spain, the Philippines, Brazil, Korea and Kenya. These investments were small: six IFC approvals between FY78 and FY83 totaled under US$6 million, and all of the funds together raised US$37 million. Acceleration: FY87FY92 Delivered by The Worldand BankFY92 e-library to: two approvals totaling US$5 million IFC's fund approvals increased sharply between FY87 from aaaaaa University annually to 10 approvals for US$60 million each Much of this expansion reflected the rolling out of the IP : year. 111.111.11.11 Wed, 11 Jan 1111 11:11:11 country fund concept to other countries, particularly in Southeast Asia and Latin America. But there were other important innovations, such as the world's first debt−equity conversion fund in 1987 in Chile (see Box 2.1). And

Early Years: FY77FY86 (c) The International Bank for Reconstruction and Development / The World Bank

29

Investment Funds in Emerging Markets IFC continued to promote venture capital in more countries, including the first fund in Eastern Europe (in Hungary), India, Portugal, Côte d'Ivoire, Madagascar, Zimbabwe and an early fund in China. Explosion of Activity: FY93FY95

Between FY93 and FY95, four developments fueled a near quadrupling of IFC's annual investment in funds to US$220 million in about 30 projects per annum: Privatization in developing countries stimulated listed markets. And private financing of infrastructure increased investment opportunities for financiers offering private equity. As private firms in the transition countries began growing, their demand for equity increased. IFC invested in over 20 funds in transition countries during these three years. Deeper, more liquid stock markets in many countries encouraged more firms to access equity from outside sources. Several governments promoted private pension funds and domestic mutual funds as policymakers saw the beneficial effects on domestic savings mobilization. IFC advised on

Table 2.1: Evolution of IFC's Funds Activities IFC approvals Period

Number US$m

Objectives

FY77FY86

18

51

Country and regional Mobilize funds international portfolio investment and improve liquidity of emerging markets

(10 years)

(2 per annum)

(US$5m Provide equity to Venture capital funds per annum) small−and medium−sized firms

FY87FY92

62

354

(6 years)

(10 per annum)

(US$59m Address debt per annum) overhang via debt conversion funds

Broaden/deepen listed markets

Vehicles

More country/regional funds Debt−equity conversion funds

Expand venture VC funds in new capital, especially in areas, including E. transition countries Europe and S. Asia FY93FY95

94

671

Expand investor Index funds, bond base for portfolio funds Delivered by The World Bank e-library to: funds aaaaaa University

(3 years)

(31 per annum)

(US$224m Mobilize Wed, 11 Jan 1111 11:11:11Infrastructure, per annum) international savings industry−directed and

IP : 111.111.11.11

Explosion of Activity: FY93FY95 (c) The International Bank for Reconstruction and Development / The World Bank

30


TOTAL [1] 175

for private equity investment

privatization funds

Promote VC funds in new markets

VC funds in Africa and transition countries

Mobilized local savings

Mutual and pension funds, local pools for private equity / VC funds

1,081

Note: [1] One approval in FY73 is also included in the total. regulatory frameworks or invested in funds and managers in countries such as Peru, Argentina, Sri Lanka, India, Pakistan, Zimbabwe and Kenya. IFC approvals included several private equity funds (mostly infrastructure−related), index funds, a corporate bond fund to attract portfolio investors to emerging market corporate debt, domestic mutual funds, private pension fund managers and VC funds in difficult countries. Fund Approvals . . . For the 122 funds which IFC's Board has approved, the average starting size was US$57 million, of which IFC's investment averaged US$8.7 million. Individual funds ranged from a US$600,000 unit trust in Kenya to two US$500 million private equity funds. But a look at fund type is more telling (see Table 2.2). The 36 portfolio funds averaged US$66 million at inception (US$13 million average IFC investment), although most have grown larger since. The 64 VC funds were much smaller

Box 2.1: Debt−Equity Conversion Funds: Responding to Market Needs By, 1987, five years after the onset of the 1980s debt crisis, several heavily indebted countries in Latin America and Asia were starting to develop programs to swap external debt obligations into domestic equity. Debtor countries obtained relief from debt service, re−awakened the interest of potential foreign investors and improved the potential for the return of flight capital. Creditors benefited from upside prospects in their new equity investment and the possibility that restructing would enable the remaining debt to be serviced. Responding to government requests, IFC advised on legal frameworks and developed vehicles that extended the debt conversion concept to portfolio investment in listed securities and, later, into private equity stakes. IFC helped develop, structure, and market debt−equity funds in Chile, the Philippines, Argentia, Brazil and Egypt. The two Chilean funds were highly successful, yielding returns of nearly 40% per annum by the time they were liquidated in 1994. Furthermore they opened the country to foreign portfolio investment for the first time. Although for various reasons IFC did not ultimately invest in some of the debt−equity funds for which it received board approval, Corporation playedto:a major role in Deliveredthe by The World Bank e-library aaaaaa University encouraging policymakers in both industrial and developing IP : 111.111.11.11 countries to recognize the Wed, Jan 1111 11:11:11 through equity importance of reducing the developing country11debt overhang

Fund Approvals . . .


Investment Funds in Emerging Markets conversion mechanisms. at US$31 million each (IFC investment of US$5 million), while the 15 private equity funds averaged over US$150 million—although there was very wide dispersion in fund size. In contrast, most fund management companies required very small capitalization, with the exception of pension fund managers, which need large capital bases to service very large numbers of small, retail investors. . . .and Actual Commitments Not all of IFC's fund approvals have been committed into investments. A few funds did not go ahead because of changes in market conditions. Several other approvals had not reached financial closure by June 1995, the cutoff date for these figures. Delays can be significant, particularly where investors are unfamiliar with a region or sector. Thus a private equity fund targeted at the West African franc zone countries, initiated by IFC after the 1994 CFA devaluation, took 18 months to close. And Table 2.2: IFC's Fund Approvals by Vehicle Type, 19721995

Number of Number approvals of funds

Total size at inception US$m

Avg size at IFC Avg IFC inception approvals approval US$m US$m US$m

Portfolio funds

39

36

2,423

67

460

13

Private equity funds [1]

15

15

2,382

159

280

19

Venture capital funds [1]

68

64

1,983

31

307

5

Unit trusts

7

7

136

19

14

2

Pension fund managers

4

2

111

56

15

4

Other fund managers

42

38

47

1

7

0.2

Total

175

162

7,083

—

1,081

—

o/w funds only

129

122

6,925

57

1,059

8.7

Funds:

Fund managers:

Source: IFC Note: [1] The distinction drawn here between venture capital and private equity funds is somewhat arbitrary. Funds in the private equity group (Appendix Tables A4 show the list) are mostly large and sectorally focused, or targeted at later stage investments. However the venture capital group also includes some large funds targeted at transition countries. Delivered by The World Bank e-library to:

aaaaaa University IFC's investments in some private equity and VC funds were only partly committed by June 1995 as the 24 year IP : 111.111.11.11 investment phase had not been completed. Wed, Some have found it difficult to make investments at the rate 11 managers Jan 1111 11:11:11 originally estimated, citing reasons such as:

. . .and Actual Commitments (c) The International Bank for Reconstruction and Development / The World Bank

32

Investment Funds in Emerging Markets political changes slowing the rate of reforms and privatizations; macroeconomic changes reducing firms' investment plans; misjudgment of the market for private equity investments; competition with other funds; and shortages of complementary financing, particularly local currency debt. Although slow investment rates can reduce returns, so can poor investments made in haste. Recognizing the importance of careful selection and structuring, IFC has supported fund managers who have resisted pressures to invest in the absence of high−quality deal flow. In addition, IFC only disburses its investments to fund managers as money is needed, to minimize idle cash balances. By June 1995 IFC had committed US$806 million to 99 funds and 33 fund managers, with a total initial capitalization of US$6.3 billion (see Table 2.3). Just under half of the US$318 million of IFC financing in portfolio funds was provided in the form of underwriting. Regional Distribution Appendix Tables A4 list IFC's fund approvals and commitments. In some countries IFC, together with other investors, has repeatedly sponsored fund vehicles as: 1) investors have become more familiar with the country; 2) regulations have evolved; 3) fund managers have gained experience; and 4) firms' owners have recognized the benefits of outside equity participation and public flotations (see Box 2.2). Asia

Asia has accounted for about a third of IFC's fund approvals in both volume and transaction numbers (see Figure 2.3 and Table 2.4). IFC has financed country funds and VC funds in several Asian countries; five or more funds of different varieties have been financed in India, the Philippines and Thailand. Latin America

Strong investor interest and reforms made over the past decade enabled IFC to help promote numerous fund vehicles in Latin America. The debt−equity conversion funds in Chile, pension fund managers in Argentina and Peru, the Scudder Latin American Power Fund and the Latin America Corporate Debt Fund were all landmark transactions. IFC introduced venture capital to Argentina and Brazil in the early 1980s. More recently, IFC, ING Bank and Chemical Venture Partners cosponsored the first Latin American regional private equity fund just a few months after the Mexican peso crisis. Eastern Europe and the FSU

Early in the transition of the former communist states, IFC identified new enterprise growth, rather than simply privatization, as a key driving force behind private sector development. Accordingly, it has made a special effort to support private firms' need for equity at all stages. Since cosponsoring the region's first VC fund—the First Hungary Fund—in 1989, IFC has invested in over 15 VC funds targeting most countries in the region, as well as the first fund providing private equity for telecommunications companies. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Regional Distribution (c) The International Bank for Reconstruction and Development / The World Bank

33

Investment Funds in Emerging Markets Table 2.3: IFC's Commitments to Funds by Date, June 1995 Total size at Number inception of funds US$m

IFC com− mitted funds US$m

Portfolio funds

31

2,133

318

(o/w underwritten)

(12)

(914)

(143)

Private equity funds

15

2,382

261

Venture capital funds

49

1,533

196

Unit trusts

4

116

11

Pension fund managers

2

111

15

Other fund managers

31

40

5

Total

132

6,316

806

o/w funds only

99

6,165

786

Funds:

Fund managers:

Source: IFC.

Figure 2.3: Regional Distribution of IFC's Fund Approvals, FY73FY95 Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Regional Distribution (c) The International Bank for Reconstruction and Development / The World Bank

34

Investment Funds in Emerging Markets Table 2.4: Fund Approvals by Region, FY73FY95

Region

Number of funds [1]

IFC approved US$m

Total fund cap US$m

LAC

29

287

2,018

70

Asia

37

338

2,071

56

Africa

13

57

268

21

CAMENA 11

51

265

24

Europe

24

182

1,084

45

World

8

145

1,218

152

Total

122

1,060

6,924

57

Avg fund cap US$m

Source: IFC. Note: [1] Excludes management companies and repeat approvals. Sub−Saharan Africa

The lower volume of approvals and the smaller average fund size at inception reflects the limited absorptive capacity of the smaller, more fragmented Sub−Saharan Africa market. Nevertheless, nearly all of the funds have been "firsts" for the region (see Box 2.3) or specific countries. For example, IFC invested in the first VC funds in Côte d'Ivoire, Kenya, Madagascar, Mauritius, Zimbabwe and South Africa, as well as the Mauritius country fund. IFC also cosponsored the first unit trust in Kenya. A fund in South Africa will invest in franchises, such as fast food and office supplies. The low entry costs of franchising mean that it is an effective vehicle for encouraging entrepreneurs. Infusions of capital from the fund, and management expertise from both the franchisor and the fund's managers, should help new franchisees to grow. Box 2.2: Helping to Build Chile's Equity Markets IFC has helped introduced new investors to Chile's markets and to devlop local fund management capacity through participating in several funds. 1988: Debt−equity conversion fund. This was Chile's first vehicle for foreign portfolio investment. IFC draft the regulations and invested in the fund and manager. 1989: Five Arrows Chile Fund. Cosponsored by IFC with N.M Rothschild, this was the third country fund for Chile (the others were launched a few months earlier), and the first with a regularly quoted London market price. 1994: Small−cap fund. IFC invested in the country's first fund (and manager) targeting listed small and medium capitalization companies, Local pension funds accounted for three−quarters of the fund's investors. In March 1995, a year after its inception, the fund was the best performer in the local market. 1995: Private equity fund. Building on the fund management expertise from the Delivered by The World Bank e-library to: small−cap fund, IFC invested in a new privateaaaaaa equity fund. The fund was designed to University IP : 111.111.11.11 attract investment from the local pension funds, which recently been given more Wed, 11 Jan 1111had 11:11:11 freedom under government regulations to invest in private equity. Sub−Saharan Africa


Investment Funds in Emerging Markets Boosted by rapid economic growth, privatization and demand from the private pension funds and international investmentors, Chile's stock market has grown spectacularly over the past decade. Between 1985 and 1994 turnover increased nearly a hundred−hold, from US$5.3 billion. Today the market's capitalization exceeds 100% of GDP, compared to 13% in 1985. And P/E ratios have increased from about 5 to over 20 in the same period.

Box 2.3: Stimulating Portfolio Investment in Africa In November 1993, IFC and Emerging Markets Management launched the US$30 million Africa Emerging Markets Fund (AEMF), the first investment fund targeted at securities listed on Africa's stock markets. The aim was to provide institutional investors with a "window" to invest in well−managed private African firms. In addition to investing US$7.5 million, IFC helped develop the fund's concept, select the manager, structure the fund, and promote it among potential investors. IFC also took the opportunity to suggest improvements to foreign investment laws for several countries. Partly in response to these efforts, Zimbabwe and Ghana legalized foreign portfolio investment in their stock markets, and several countries liberalized exchange controls to allow investors to repatriate their investment earnings more freely. By April 1996, AEMF was invested in 86 stocks in Botswana, Côte d'Ivoire, Egypt, Ghana, Kenya, Mauritius, Morocco, Namibia, Niger, Senegal, Swaziland, Tunisia, Zambia and Zimbabwe. The fund's net asset value per share increased by 20.7% between inception and December 1995. AEMF has increased turnover in several thinly traded markets. In Swaziland, for example, the fund's investment accounted for 99% of value traded in July 1994. Additionally, as the first institutional fund to enter many of the markets, AEMF has spurred the development of adequately−capitalized local custodians. More generally, African stock markets have grown rapidly. Between 1993 and 1995 their turnover (excluding South Africa) increased from US$772 million to US$4.1 billion. Middle East and North Africa

IFC invested in the first publicly offered, New York−listed portfolio investment fund dedicated to the Middle East and North Africa, the first mutual fund in Pakistan, a privatization fund and a debt−equity fund in Egypt, and several funds in Morocco and Tunisia. Successful Mobilization For each dollar that IFC has invested in funds, other investors have provided an average of US$6.80. The task of placing funds with investors has been shared with cosponsors and investment banks. Thus IFC's own commitments of US$806 million have been associated with US$6.3 billion at initial fund capitalization. Why did other investors raise proportionately more for private equity funds and unit trusts than for portfolio funds and VC funds (see Table 2.5)? Investors were particularly attracted by the private equity funds targeting infrastructure. The unit trusts are a special case: only a few have been financed, and IFC's foreign financing plays a relatively small part in what are primarily local investor vehicles. The lower mobilization for VC funds is Delivered The World often Bank e-library to: understandable: many involve small clubs of by investors, in untested environments. And many of the portfolio aaaaaa University funds were sponsored when investors were wary emerging markets. IP : of 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Furthermore, Table 2.5 understates the real mobilization achievement: Middle East and North Africa (c) The International Bank for Reconstruction and Development / The World Bank

36

Investment Funds in Emerging Markets Successful funds often have multiple closings as investors subscribe more cash (see Box 2.4), while Table 2.5 shows monies raised at the initial closing. For example the Emerging Markets Index Fund was launched in January 1994 with US$45 million; by October 1995 it had raised US$1.5 billion, over 30 times its original size. Private equity and VC funds invest minority stakes in growing businesses. Their investments often enable firms to raise complementary debt financing, thus facilitating expansions which otherwise might not have happened. Mostly Foreign, but More Local Investors Emerging By definition, most investors in foreign portfolio investment funds are foreign—although sometimes the foreign exchange is owned by nationals of the recipient country. Some funds probably acted as conduits for returning flight capital, particularly in Latin America. Most of the large private equity funds are also foreignfinanced. Although many investors in VC funds are also foreign, some have domestic investors. For example, a VC fund in Indonesia has an offshore fund, a local fund and a single management company to operate the two

Box 2.4: Mobilizing US$2.6 Billion with Under US$10 Million The nine−year long gestation of the first targeting developing countries—the Emerging Markets Growth Fund (EMGF)—finally came to an end in May 1986 when the fund closed with US$50 million in commitments. IFC had been developing the concept and promoting it among institutional investors since being given a mandate by the Development Committee of the World Bank and IMF in 1977. The birth of EMGF was not easy. IFC's Board had approved a US$7.5 million investment in the fund, but due to difficulties in finding other investors, IFC had to request authorization to invest a further US$2.2 million to reach the US$50 million minimum size. IFC started with a 17.4% share of the fund, along with 12 private institutional investors. The fund's early performance exceeded expectations, which attracted other investors. A rights offering in 1987, two private placements in 1988 and 1989, and several USSEC−registered public offerings in the early 1990s raised a total of US$2.2 billion. Including shares issued through reinvested dividends, total funds raised through June 1994 were US$2.6 billion. In August 1994 the fund was US$5.5 billion, 110 times its original size. When IFC sold its remaining holdings in September 1994 it realized a rate of return of 36% per annum on its investment. EMGF's manager, The Capital Group, played a key role in this success story. Capital introduced the concept of company visits to emerging market companies, which helped it obtain detailed, reliable information. During the fund's first year, Capital visited over 150 companies; by 1994 this had risen to over 500 firms per yeat. pools. A Tunisian fund is structured similarly: the locaTunisian Dinars pool was partly funded through a public offering. Finally, domestic unit trusts and pension funds mobilize almost entirely local savings. In Argentina, for example, by early 1995 over three million people were contributing over US$150 million per month to the private pension system set up in late 1993. Local investors are playing a larger part in the funds IFC is sponsoring. On average, the local financing share increased from 26% between FY77 and FY92, to 39% between FY93 and FY95. These are unweighted averages The domestic World Bank e-library and so overstate the volume of moneyDelivered raised by from sourcesto:(the large private equity and portfolio funds aaaaaa University : 111.111.11.11 are overwhelmingly foreign−financed). But theIPtrend is indicative. Follow−on funds often have increased local Wed, 11 Jan 1111 11:11:11 financing. For example, IFC has invested in two Philippines VC funds with the same manager. The first had 38% Mostly Foreign, but More Local Investors Emerging (c) The International Bank for Reconstruction and Development / The World Bank

37

Investment Funds in Emerging Markets local funding, while local investors in the second accounted for 53% of commitments. More Funds in Riskier Countries IFC's fund investments have become increasingly targeted toward poorer, riskier countries. This partly reflects changes in product mix. In the late 1980s IFC was promoting country funds in newly emerging markets such as Malaysia and Thailand, whereas in the 1990s IFC has invested more in private equity and VC funds in riskier countries. The Institutional Investor country risk scores shown in Figure 2.4 illustrate the trend—a lower score indicates that a country is regarded as riskier by foreign lenders. In the seven years from FY83 to FY89, IFC financed 29 funds with an average score of 41.5. This compares with 50 funds scoring an average of 34.7 in the last two years, FY94FY95. Out of 10 transactions in countries with ratings below 20 (very limited access to international private capital), nine were approved during the last three years, including projects in Russia, the Ukraine, Bulgaria, Peru and West Africa.1 Table 2.5: Mobilization Rates, 1972−June 1995 Mobilization rate [1] Region

Regional mobilization rate [1]

Portfolio funds

5.7

Asia

6.4

Private equity

8.1

LAC

7.2

Venture capital

6.8

Europe

7.3

Unit trusts

9.5

CAMENA 4.2

Fund managers

6.6

Africa

3.9

Global

7.8

All funds

6.8

Fund type

All funds

6.8

Source: IFC. Note: [1] Excludes management companies and repeat approvals.


More Funds in Riskier Countries (c) The International Bank for Reconstruction and Development / The World Bank

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Figure 2.4: More Funds in Riskier Countries Source:Institutional Investor A Growing Funds Portfolio IFC's fund portfolio rose nearly five−fold between June 1992 and June 1995, from US$108 million to US$530 million (see Figure 2.5 and Table 2.6). By 1995 just over a quarter of IFC's total equity portfolio was committed to funds. The number of funds in IFC's portfolio more than doubled in the three years to June 1995, from 31 to 69. Thirteen private equity funds accounted for nearly half of the volume of IFC's funds portfolio at June 1995. Three years earlier there were just two private equity funds, comprising under 4% of the funds portfolio.

Figure 2.5: IFC's Funds Portfolio, 19921995 Source:IFC The other major change has been the sharp increase in the number and dollar exposure of VC funds. Forty−one funds accounted for 31 % of IFC's funds portfolio by June 1995, up from 17 funds and 26% of the portfolio in June 1992. The regional split has also changed. Increases in the share of the portfolio in Asia, Europe and CAMENA have Delivered by Theand World e-library to: Nevertheless, in absolute terms exposure been offset by relative declines in Latin America in Bank global funds. aaaaaa University IP : 111.111.11.11 has increased sharply everywhere (see Table 2.7). For example, in June 1992 the only fund in the Middle East and Wed, 11 Jan 1111 11:11:11 North Africa region was a debt−equity conversion fund for Egypt investing in tourism projects. Three years later A Growing Funds Portfolio (c) The International Bank for Reconstruction and Development / The World Bank

39

Investment Funds in Emerging Markets there were VC funds in Egypt, Morocco and Pakistan, a regional VC fund targeting Morocco and Tunisia, a Moroccan privatization fund, a regional portfolio fund investing in Middle Eastern and North African stock markets and a mutual fund management company in Pakistan. The sharp increase in IFC's share of its portfolio in Asia was driven mainly by investments in the large regional Asia Infrastructure Fund, a regional VC fund, and several large venture capital funds in China, Indonesia and the Philippines. Financial Performance of IFC's Funds Portfolio Despite the large number of transactions, the bunching of approvals in recent years and evolution in fund types means that IFC's experience base is still very much evolving. An average age of just 3.7 years per fund makes it difficult to draw strong conclusions about ultimate investment performance. This is especially true of private equity and VC funds, where returns are realized mostly late in the fund's life or at final liquidation. Nevertheless, by June 1995 IFC was able to assess the financial returns for 48 funds and management companies, of which 14 had been sold and the remainder were still in the portfolio. IFC had invested US$175 million in these 48

Table 2.6: IFC's Funds Portfolio by Type, 19921995 Portfolio (US$m)

Number of funds

June 1992

June 1995

June 1992

June 1995

Portfolio funds

75

90

11

12

Private equity

4

247

2

13

Venture capital

28

164

17

41

Unit trusts

0

10

1

3

Fund managers

1

20

9

28

Total

108

530

40

97

o/w funds only

107

510

31

69

Source: IFC. Note: IFC's held portfolio, comprising disbursed and undisbursed equity. funds and management companies, and their average life in IFC's portfolio was six years (see Table 2.8). The financial return in nominal dollar terms for IFC's funds investments to June 1995 was 22.9% in unweighted terms and 21.1% when weighted by investment size. This is well above the 13.2% weighted return on IFC's overall equity portfolio. However, it is more meaningful to examine the returns of portfolio funds and VC funds separately. Returns on Portfolio Funds Delivered by The World Bank e-library to: aaaaaa University account the number of funds, investment IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

A reasonable sample, taking into volume, and years of experience, suggests that the average 24.3% nominal rate of return achieved on IFC's investments in portfolio funds is Financial Performance of IFC's Funds Portfolio (c) The International Bank for Reconstruction and Development / The World Bank

40

Investment Funds in Emerging Markets indicative of the asset class's consistently good perfor− Table 2.7: IFC's Funds Portfolio by Region, 19921995 Portfolio (US$m)

Number of funds

June 1992

June 1995

June 1992

June 1995

LAC

46

168

13

22

Asia

21

145

14

35

Africa

3

18

4

7

CAMENA

2

32

1

12

Europe

14

85

5

16

Global

22

81

3

5

Total

108

530

40

97

Source: IFC. mance. These are the funds in which IFC invested directly. The financial performance of funds which IFC underwrote is also broadly comparable (see Table 2.9). These high returns reflect the benefits of early entry into markets that had low capitalizations and values because they suffered from low liquidity. As Chapter 4 will show, following the entry of foreign investors most markets see increased liquidity, higher price to earnings (P/E) ratios, and new issues and listings. The earliest funds have captured more of the upward revaluation of each emerging market as liquidity improved. For example, IFC's return on its 1986−87 investments in the Emerging Markets Growth Fund was 36.5% per annum when the last portion was sold in 1994. By comparison, the annualized return on US Treasury securities during the same period was 8% and the return on the IFC Global Composite index was 15% (this index tracks 25 emerging markets). Table 2.8: Financial Rates of Return on IFC's Fund Investments, as of June 1995 IFC disburse− Number ments of funds (US$m)

Years in portfolio at 6/95

Unweighted Weighted returns at returns at 6/95 (%)[1] 6/95 (%)

Portfolio funds

16

133

4

24.3

26.2

Venture capital

21

36

7

−0.6

1.9

Private equity/unit trusts [2]

3

5

3

—

—

Fund managers

8

2

7

85.7

42.8

48

The World Bank e-library to: 176 Delivered byaaaaaa 6 University 22.9 IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Total Source: IFC.

21.1

Financial Performance of IFC's Funds Portfolio (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets Notes: [1] Nominal internal rate of return. Includes both sold and active projects. Fourteen fund projects had been sold by June 1995: 6 portfolio funds, 4 VC funds and 4 fund managers. Weighted returns are weighted by fund size. [2] Sample too small and recent to report the return figures.

Table 2.9: Financial Performance of Portfolio Funds which IFC Underwrote

Name of fund

Annual Inception return to date 7/95

Korea Fund

Q3, 1984

27.4

Thailand Fund

Q4, 1986

33.5

Malaysia Fund Inc

Q4, 1987

14.1

Thai Fund Inc

Q1, 1988

23.6

Thai Prime Fund

Q4, 1988

20.6

Manila Fund

Q4, 1989

19.9

First Phillippine Fund

Q4, 1989

26.8

Turkish Investment Fund

Q4, 1989

−9.3

Five Arrows Chile Fund

Q1, 1990

35.3

Portuguese Investment Fund

Q2, 1990

−1.4

Mexico Equity/Income Q3, 1990 Fund

11.2

Source: Micropal Emerging Market Fund Monitor. Note: Annual compound returns, net asset value to net asset value, with gross income reinvested. These returns reflect the performance of the funds' portfolio rather than their shares (which may trade at a premium or discount to net asset value). Returns on Venture Capital Funds Financial returns to date on IFC's VC funds have been poor. The unweighted nominal return on 21 VC funds at June 1995 was a negative 0.6 percent. Because some larger funds performed better, the weighted return was 1.9 percent. These figures slightly understate performance, because only four of the 21 funds were fully liquidated by June 1995, although several others were nearly fully divested. Because most of the returns to VC funds accrue as capital gains when they divest from investee firms, it is only at final liquidation that returns can properly be Delivered by The World Bank e-library to: assessed. Figure 2.6 shows how a VC fund typically has negative cash flow in the early years aaaaaa University IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Returns on Venture Capital Funds (c) The International Bank for Reconstruction and Development / The World Bank

42


Figure 2.6: VC Funds: Positive Returns Take Time as management fees and failed investments eat into capital, but cash flows turn positive as the fund sells profitable investments. Nevertheless, the financial returns on IFC's early VC funds are not expected to rise significantly, because few have portfolios with unrealized gains. Analysis of these poor financial results needs some context. In the early 1980s the venture capital industry was young even in many industrialized countries. The concept was completely new to developing economies. VC fund managers did not exist locally and few international managers were prepared to manage small funds in emerging markets. Reviews undertaken by IFC's Operations Evaluation Unit and Capital Markets Department identified lessons from VC funds which have been incorporated into the design of new projects.2 However, the product's nature (long−term, illiquid investments, exit difficulties) has meant that these lessons have emerged slowly. Table 2.10 disaggregates the figures for the first 15 VC funds in which IFC invested between FY78 and FY90 (IFC invested in six other funds after FY90). The unweighted average return for the 15 funds was 0.4% to June 1995. But three disaggregations yield some interesting results: The earliest funds performed more poorly. The nominal return on the first five VC funds in which IFC invested, between FY78 and FY83, was a negative 5.1 percent. As the lessons from these investments were gradually incorporated into subsequent funds, returns improved somewhat (see Box 2.5). But with one exception they were still below the return on IFC's overall equity portfolio. Funds with separate managers performed better. ''Single−tier" funds (where the fund and fund manager are incorporated in one entity) performed worse than those where the fund manager was separate. Single tier funds suffered from: high management costs: it was difficult to identify management costs separately;

Box 2.5: Some Improvement: IFC's Second Round of VC Funds Delivered The World Bank e-library Between FY84 and FY90 IFC invested in 10byventure capital fundsto:in Malaysia, a aaaaaa University regional South−East Asia fund, Argentia, China, Côte d'Ivoire, Portugal, the IP : 111.111.11.11 Wed,The 11 Janunweighted 1111 11:11:11 return at June 1995 was Philippines, Hungary, Madagascar and India.


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Investment Funds in Emerging Markets 3.2 percent. Two funds had been wound up by June 1995 and several were being liquidated. The philippines fund has a portfolio with large unrealized gains, which is not reflected in the figures above, This six year old fund had invested an average of US$580,000 in each of 23 firms. By June 1995 the fund's managers had divested profitably from one firm, while two others had been written off. If the fund divested itself of its entire portfolio at June 1995 valuations (based on market prices or reasonable P/E multiples) its managers estimated that it would achieve a 25% rate of return on invested capital. weak incentives for managers: it was more difficult to design performance incentives and to fire managers; and shareholder interference. A Brazilian fund's shareholders pressured the managers into violating exposure guidelines by investing nearly half its resources in a single computer firm that ultimately performed poorly. Funds need a minimum size. Funds under US$10 million performed worse than larger funds. Smaller funds were unable to attract good managers, focus sponsor attention, or invest enough to cover management costs or spread risks adequately. More generally, four lessons have emerged from IFC's experience: Management is the most important determinant of fund performance. Identifying experienced, highly qualified VC fund managers willing to manage relatively small funds in difficult environments has proved a major task for IFC. IFC has tried several methods to identify and build VC management capability (see Chapter 3), but in the early funds it often had to accept relatively inexperienced managers. Fund structure helps define incentives for managers to perform and for fund shareholders to remain interested without interfering too much. Important elements include minimum fund size, a two−tier structure, a limited fund life Table 2.10: Disaggregating Returns on IFC's Venture Capital Investments, FY78FY90

Number of funds

Average cap− italization (US$m)

Unweighted Weighted returns to returns to 6/95 (%) 6/95 (%)

All VC funds FY78FY90 [1]

15

18.6

0.4

3.1

of which FY78FY83

5

7.5

−5.1

−2.4

of which FY84FY90

10

24.1

3.2

4.4

Single−tier funds

7

5.4

−2.1

1.0

Separate management company

8

30.1

2.6

3.7

Under US$10m capitalization

7

4.2

−2.5

−1.0

Over US$10m capitalization

8

Delivered by The World Bank e-library to: aaaaaa University 31.1 Wed,IP11: 111.111.11.11 3.0 3.9 Jan 1111 11:11:11


44

Investment Funds in Emerging Markets Source: IFC. Note: [1] Excludes two funds structured as loans rather than equity investments. These two funds also performed poorly, and so would not change the results significantly. It also excludes a fund which invested in both private equity and listed equities—the JF Asia Fund. This fund performed relatively well, yielding a return of over 10% per annum between its establishment in 1989 and June 1995. But at no time has it invested more than a quarter of its assets in private equities, so it has been classified as a portfolio equity fund.

Box2.6: Pitfalls Aplenty in Venture Capital: Some Examples Inadequate regulatory framework. One fund's startup was delayed 18 months pending government action to amend venture capital regulations. Potential investors lost interest and the fund was not launched. Deal flow. At the time of IFC's entry into one fund it was projected that the fund would make 810 new investments per year for five years. In practice the fund invested in just 8 firms. Management inexperience. None of the first nine investments made by a fund's managers in its first two years proved successful, although three later investments performed better. The manager had no prior venture capital experience and no technical partner was involved. Government restrictions. The repatriation of divestment payments made by a fund manager to IFC was delayed by the government. Meanwhile substantial devaluation reduced IFC's returns. Government interference. One government—a partial shareholder—pressed the managers of a fund to borrow in order to one−lend to "deserving" projects, in contravention of the fund's articles. Conflicts of interest. In three of the first four investment proposals reviewed by the board of one company, an interested party from either the fund or management company owned equity in the firm, and stood to gain from the fund's investment. Complexity. One fund's structure was unusual. Instead of being pure equity, it issued a bond to local institutional investors and invested via unsecured subordinated loans. IFC bought part of the bond issue and guaranteed the bond's interest and principal. The strcture's complexity meant that only half of the estimated amount was raised, some investe companies were put off using the fund, and the managers and IFC found it difficult to monitor the fund. (to give managers the incentive to divest), a common goal for the shareholders (to maximize their returns), and mechanisms to prevent conflicts of interest between fund managers and the underlying fund (for instance, disclosure and review procedures). Deal flow. Many funds invested less and more slowly than expected. In several cases an expected two−year investment period became 35 years. InDelivered some countries the venture capital concept conflicted with local cultural by The World Bank e-library to: aaaaaa University norms: IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11


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Investment Funds in Emerging Markets Table 2.11: Reaching Hundreds of Small Companies Number of funds [1]

Avg per Investee company companies US$m

Private equity

9

56

9.7

Venture capital

39

679

0.7

o/w in Africa

(4)

(81)

(0.1)

Source: IFC. Note: [1] In June 1995 there were 54 VC and private equity funds in IFC's portfolio, but several were too new to report data on their sub−investments. small, closely−held firms were not used to sharing project ideas and business plans with outsiders, let alone ceding some ownership and control. Inexperienced fund managers took time to build up an investment pipeline. And macroeconomic instability in some countries reduced firms' investment plans (one fund did not start at all because of the onset of high inflation). Exit difficulties. Selling VC investments is often difficult. Liquidating a VC fund fully may take longer than anticipated, depending on the size and liquidity of the local stock market, and the attitude of the owners of local firms. Put agreements may not suffice: in one fund, three out of five put agreements negotiated at entry proved unenforceable. Notably, the two best performing funds from IFC's second round of VC investments had international partners, a two−tier management structure, limited lives and were located in growing economies where stock markets have developed rapidly. Appendix Box Al gives a more detailed list of some ingredients of success for VC funds in developing

countries. Nevertheless, as Box 2.6 shows, VC funds remain vulnerable to many risks: poor macroeconomic policies, inappropriate government regulation, cultural resistance to using outside equity, poor fund management and limited exit options.3 Why Persevere? Given this poor financial performance, why did IFC expand its VC investments dramatically in the 1990s? In the 12 years to FY90, IFC's Board approved US$35 million in 21 VC−related investments; in the following five years it approved US$272 million in 45 funds. There are three main reasons: Delivered by The World Banksmall e-library to: medium−sized private firms have emerged Needs of the transition economies. Large numbers of new and aaaaaa University IP : 111.111.11.11 in transition economies, many which need equity to finance expansion in uncertain macroeconomic and Wed, 11 Jan 1111 11:11:11 regulatory environments. Over half of IFC's VC fund approvals since 1990 have targeted transition economies,

Why Persevere?


Investment Funds in Emerging Markets with several funds each in both Russia and China. In countries such as Bulgaria and the Ukraine, where there have been limited financing opportunities at IFC's normal scale of operations, VC funds have represented IFC's first investment. Meeting the equity needs of small and medium firms. VC funds remain the most effective vehicle for IFC to invest equity in small and medium firms. By mid−1995, 39 of the VC funds which IFC had financed had in turn invested in 679 companies, with an average investment of US$0.7 million per company, typically for a 5% to 20% stake (see Table 2.11). The average VC fund had invested in 17 companies. In lowincome countries the sub−investments were smaller yet: four funds in Sub−Saharan Africa had invested an average of US$100,000 per company in 81 firms. Building VC management capacity. Good VC managers provide more than equity to firms: they supply advice on marketing, management and industrial contacts. All are important components of building successful private firms. But VC management skills are scarce in developing countries, so IFC has made it a priority to help develop local VC fund management capacity, often through partnerships with international managers. It is too early to assess the performance of the many VC funds promoted by IFC since 1991. However, preliminary indications suggest continued improvement— perhaps reflecting better structuring, more experienced managers and firms' owners accepting the concept of third party equity. (And IFC has made efforts to ensure that the lessons from its experience are applied to new funds consistently.) A 1989 Indian fund, for example, had invested in 16 companies by 1995, with large unrealized gains in its portfolio. Four companies had already listed. Several funds have become fully invested and follow−up funds are being planned (for instance, the Ukraine Fund, and the Indus Fund in India). Furthermore, private investors seem bullish. IFC's US$272 million investment in 45 new VC funds between FY91 and FY95 was matched by US$1.4 billion from private investors. Two Caveats to the VC Return Figures This analysis ignores the processing costs to IFC of putting small VC fund investments onto its portfolio, and monitoring costs such as sitting on Boards. These costs can be significant. For example, a US$0.88 million investment in a Pakistan fund cost IFC over US$100,000 to put on the books. Second, returns to VC fund investors may not fully reflect the performance of underlying companies. For example, high management costs might absorb much of a fund's surplus from investments. Noncore activities may also detract from financial performance: one fund made a 25% return on its equity investments, but losses on lending to the same companies reduced this to single figures. Fund Managers IFC learned early that funds should be structured with separate management companies, with contractually defined fees and incentives. Management fees are lowest for passively managed index funds, increase for actively managed portfolio funds, and are highest for private equity and VC funds where managers do significant appraisal, structuring and monitoring work (see Table 2.12). Managers of funds which invest in liquid, traded securities usually relate their fees to the fund's net asset value. Because their underlying investments are illiquid (and thus cannot be valued by the market) private equity and VC fund management fees usually relate to net committed capital. Furthermore, to encourage managers to invest in good projects and divest at the appropriate

Box2.7: Competing in Turbulent Markets: Investing in the Gold Fund Delivered by The World Bank e-library to:

In 1993 IFC helped to sponsor the first fund targeted to invest private equity in early aaaaaa University IP : 111.111.11.11 stage or expanding gold mine projects in developing countries. Wed, 11 Jan 1111 11:11:11 At its closing in January 1994, the Gold Fund's managers faced a positive investment environment: there were a Two Caveats to the VC Return Figures (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets large number of potential ventures in emerging markets and a scarcity of third party equity. By mid−1994, however, equity markets in developing countries were booming, and several investment opportunities which were being reviewed by the fund were financed instead by new equity issues. Just a few months later, however, financing opportunities for the fund improved, as global equity markets slowed in the face of rising US interest rates and the Mexican peso crisis. By May 1995 the fund had invested in five companies with gold mining projects in Ghana, Kazakhstan, Brazil, Indonesia and Central America. In the second half of 1995, the fund made two more investments in companies with gold mining projects in southern Africa and Indonesia. time, private equity/VC fund managers are typically offered an incentive payment (called "carried interest"). This is split between the management company, individual managers (often through shares in the management company) and investors, if the fund has achieved a hurdle rate of return when the investments are liquidated. In about half of its VC and private equity funds (36 funds) IFC has invested in both the management company and the fund. This enables IFC to participate in fund governance and share in the fund's profit. The average return on the few fund manager investments that have been would up has been high, although the absolute sums are small. However, the high returns are unrepresentative of IFC's broader fund manager portfolio, as the figures are dominated by two highly successful managers of funds investing in listed securities. Private Equity Funds: Rates of Investment Most of the private equity funds which IFC has sponsored are still investing, so it is too early to assess their financial performance. (By June 1995, nine private equity funds in IFC's portfolio had invested an average of US$9.7 million per firm in 56 companies.) Three lessons are emerging from the experience of these funds with rates of investment: Continued government privatization and reforms, as well as macroeconomic stability, are important to deliver a pipeline of potential investments. This particularly affects country−specific private equity funds. Funds in Argentina, Brazil and Morocco have all been investing at their expected rate, whereas those in Egypt and Peru have invested more slowly, partly because of delays in privatizations and government reforms. The market is rapidly becoming more competitive. Perceiving increased demand, more financiers are entering the market to supply equity and/or debt to sponsors of private infrastructure projects or buyers of privatized assets. Sponsors of good projects may have several financing options. Local or international stock market flotations have become feasible for some

Table 2.12: Typical Ranges of Management Fees in IFC's Funds Fund type

Typical management charges

Passive "index" portfolio funds

Under 0.5% of net asset value (NAV)

Actively managed portfolio funds

0.9%2% of NAV

Private equity and venture capital funds

2%3.5% of committed capital (less repayments to investors and deductions) Delivered by The World Bank e-library to: plus a share in distributed profits over a aaaaaa University IP : 111.111.11.11 stipulated hurdle (for instance, 20% of Wed, 11 Jan 1111 11:11:11 the surplus after the return of the

Private Equity Funds: Rates of Investment (c) The International Bank for Reconstruction and Development / The World Bank

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original capital plus an 8% compounded return to investors) Note: Managers of many actively managed funds—both portfolio and private equity—are paid scaled charges, which fall as the fund increases in size.

projects. International private banks, national export−import banks and official development financiers have been setting up project financing units. Private equity fund managers have sometimes found themselves at a disadvantage where sponsors seeking to finance a project with as few financing sources as possible, to reduce pre−financing complexity and time. Some lenders demand equity as part of their price for supplying long term debt, thus squeezing out opportunities for private equity funds. Box 2.7 describes how fluctuations in the availability of financing sources affected one fund. Good managers can overcome these problems. Experienced managers have proven able to adapt to changes in external circumstances. For example, the Central European Telecoms Fund was originally expected to invest heavily in local telephone concessions in Hungary. In the event, the concession winners demanded very high premia for outside equity investors, so the fund focused instead on investing in other telecoms companies in Hungary and Poland. Good contacts—to complement financial contacts—are also important. The managers of the Asia Infrastructure Fund, for example, are technical experts drawn from the different infrastructure sectors that the fund targets.

1. Twice a year Institutional Investor polls 75100 international banks to grade countries on a scale of 0 to 100, with 100 representing the least chance of default. The responses are weighted to give more importance to responses from banks with greater worldwide exposure and more sophisticated country analysis systems.

2. IFC's Operations Evaluation Unit (OEU) Reports: Support for SMEs Through Financial Intermediaries (August 1995), and An Evaluation of IFC's Experience with Financial Institutions That Assist Private Enterprise (June 1992). IFC's lead venture capital specialist also reviewed the Corporation's experience in Venture Capital Experience within the IFC: A Strategy for Future Implementation, J.T. Griffin (1991).

3. Returns to VC funds have fluctuated significantly in developed markets, too. Over the last 20 years mature funds in the US have returned an average of 11.5% per annum, although this rose to 18% between 1991 and 1994, due to the stock market's strength. Source: Venture Capital Journal, based on 504 limited investment partnerships formed since 1969.

3— IFC's Role in Promoting Funds A Proactive Approach With most of its investment activities,Delivered IFC responds to financing requests from private investors. In much of its by The World Bank e-library to: aaaaaa University capital markets work, however, IFC takes the initiative. The Corporation initiates concepts, undertakes feasibility IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11 studies, sounds out potential investors, and identifies technical partners for new institutions. IFC moves in advance of private initiatives because markets barely exist, or are hesitant, or because there is no local player to 3— IFC's Role in Promoting Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets introduce new products. Funds are a good example of IFC initiatives to strengthen capital markets (see Figure 3.1). In promoting funds, IFC aims to: Provide international and domestic investors with opportunities to invest their savings in professionally managed vehicles that offer a range of risk−reward options. Provide domestic firms with better access to equity capital. This ranges from venture capital for small and/or new firms, to private equity for larger private companies, through to traded equity for listed firms.

Figure 3.1: Intermediating Savings to Investing Firms

Table 3.1: Helping to Push the Edge of the Envelope Date

Vehicle / IFC Involvement

1977

IMF/World Bank Development Committee asks IFC to review constraints to private portfolio equity flows to developing countries

1978

Early VC funds in developing countries

1981

Early emerging

Fund / Country

Seffinova (Spain)

in 1979 Delivered by The World Philippines Bank e-library to: aaaaaa University : 111.111.11.11 market countryIPfund IFC helped structure Wed, 11 Jan 1111 11:11:11 Mexico Fund

3— IFC's Role in Promoting Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets 1982

Advised on design of private pension fund system in Chile

1983

First regional venture capital fund

SEAVI (South East Asia)

1984

Country fund which catalyzed international investor interest in emerging markets

Korea Fund

1986

First global portfolio investment fund


1987

First debt−equity conversion fund

Chile Investment Company

1991

Early domestic private mutual fund

Pyramid Fund (Sri Lanka)

1992

First corporate debt fund

Latin America Corporate Debt Fund

1993

Early sector−specific private equity funds

Gold Fund; Latin America Power Fund

1993

Early passively managed index fund

Emerging Markets Index Fund

1993 Priv:Private pension fund manager Pushing the Edge of the Envelope

Peru

Initially, in the 1980s, IFC worked to persuade governments that efficient capital markets are important and that foreign investors can help develop them. However, as investors, managers and firms in different markets have gained experience with funds, and more governments sought to develop their equity markets, IFC's role has broadened. In conjunction with fund managers, investment banks and regulators, the Corporation has helped develop new fund vehicles and promote funds in more countries (see Table 3.1). Sequencing Fund Promotion within Countries: No Single Pattern The variety of domestic financial markets, regulatory frameworks, government reform initiatives and investor interest means that IFC's fund promotion efforts have evolved differently in different countries. In Thailand, IFC's 1978 investment in a domestic mutual fund manager was followed by sponsoring several country funds (see Box 3.1). In Mauritius, IFC invested in a country fund in 1993, followed in 1995 by a venture capital (VC) fund. In Argentina, IFC helped introduce venture capital in 1984, promoted the first debt−equity fund in 1988, and invested in a private pension fund manager in 1994. IFC's Specific Roles in Promoting Funds

IFC follows several steps to promote funds (see Figure 3.2): Diagnosis. Responding to government or sponsor requests, or sometimes at its own initiative, IFC analyzes the need for funds in a market, identifies regulatory impediments, assesses what fund might be appropriate and Delivered by The World Bank e-library to: gauges what fund size might be feasible. aaaaaa University IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Pushing the Edge of the Envelope (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets Assessing feasibility. If a niche exists and there is interest from government regulators and potential investors in developing a fund, IFC may

Box 3.1: Building Domestic and Foreign Participation in Funds: Thailand IFC's involvement began in 1975 with help designing the regulatory framework for Thailand's domestic mutual fund industry. Three years later IFC subscribed to 15% of the capital of the country's first mutual fund management company (MFC). The timing was fortuitous: the stock market was just starting to develop. In December 1986 the country's first for foreign portfolio investors was launched. IFC and Morgan Stanley placed the US$31 million Thailand Fund with institutional investors, and it was listed on stock exchanges in London and Thailand. Ten months later IFC and Morgan Stanley followed this initial success by structuring and placing the US$155 million Thai Fund Inc., via a public offering on the New York Stock Exchange. Finally, jointly with Normura, IFC underwrote 10% of the US$155 million Thai Prime Fund, which was launched in September 1988, targeted at Japanese investors. MFC acted as the local manager on all of these funds, with technical assistance provided by Morgan Stanley and Nomura respectively. Investors have done well, with returns from inception to July 1995 exceeding 20% per annum in all of the funds. Stimulated by the influx of foreign funds, Thailand's domestic fund management capability developed rapidly. By 1990, MFC was managing seven domestic mutual funds totaling US$416 million, 10 international onshore funds worth US$855 million, and acting as registrar, transfer and payment agent for bond issues worth US$294 million. Seeking more competition, in 1992 the Thai authorities began licensing new mutual fund managers. By June 1995, eight management companies had 96 funds with US$9.4 billion under management. In 1991 IFC invested US$1.5 million for a 29% share in one of the first venture capital funds in Thailand. This investment was part of a wider regional VC promotion program orginally initiated by IFC in 1983, which has so far involved the creation of a regional VC fund and manager, and VC funds in Malaysia, Indonesia and Singapore. By March 1995 the Thailand VC fund had invested 91% of its committed capital in 12 companies. Although it is too early to assess expected returns, the portfolio is judged to be performing well. undertake a more detailed feasibility study and sound out investors on a preliminary basis. Identifying and assessing sponsors/managers. Turning concept into reality requires identifying core investors and a fund manager. The two are related: a well known fund manager encourages investors, and a critical mass of committed investors may attract a fund manager. IFC may persuade a reputable investment management



52


Figure 3.2: IFC's Specific Roles in Promoting Funds

Box 3.2: Informing Investors In the early 1980s information on emerging stock markets was poor. It was difficult to compare markets because indexes were calculated using different methodologies and were available only in local currency terms. In response to a growing number of inliquiries from international investors, IFC established the Merging Market Data Base (EMDB) in 1981. The original IFC indexes were based on the 1020 most active stocks in 10 emerging markets. By 1995 the EMDB was compling data on over 1,650 stocks in 27 markets, calculating 230 Global, Investable and Tradeable indexes each days, providing an on−lines service, and issuing four printed publications regularly. firm to devote resources to research and analyze an as yet unresearched market. Or IFC might use its contacts with investors in previously sponsored funds to arouse interest in a new vehicle. Together with the sponsors, structuring the fund includes determining the fund's legal form and domicile, defining the management structure and contractual arrangements, and clarifying the fund's investment strategy and its prudential guidelines. IFC plays the "honest broker" role in discussions with local regulators and helps define the fund's legal form and investment guidelines. IFC also tries to foster local fund management capabilities, often by partnering a local manager with an international technical partner. Mobilizing funding. IFC invests in, underwrites and/or often privately places the funds it sponsors. On average IFC has invested 16% of each fund's initial capitalization. Advising, monitoring and governing. Building fund management capabilities is a critical IFC role. The development impact of such institutionbuilding extends well beyond the monies raised by a particular fund. Accordingly, IFC staff sit on the boards of many funds and managers. IFC also trains fund managers in environmental risk management. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11


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Investment Funds in Emerging Markets International Portfolio Funds In 1976 Henry Kissinger, then US Secretary of State, proposed a US$500 million "International Investment Fund" to attract portfolio equity investment to developing countries. In 1977 the IMF/World Bank Development Committee asked IFC to review constraints to private portfolio equity flows to developing countries. The review identified restrictions imposed by developing countries as the main constraint, rather than regulatory limits imposed by capital exporting countries. Accordingly, IFC began working with governments willing to remove restrictions, and among market players—managers, underwriters and investors—who were interested in obtaining some exposure to emerging markets. IFC staff spent several years persuading governments and institutional investors of the potential benefits of foreign portfolio investment—through advisory work, papers, speeches, and meeting investors and regulatory authorities. For the first time investors were given a comparative picture of the investment environment in different countries. The formation of the Emerging Markets Database was an important part of this process (see Box 3.2). Equally important, governments with emerging markets realized that they could position themselves to benefit from international portfolio capital. Many developing country governments were concerned both about foreign investors taking control of domestic firms and about potentially destabilizing hot money flows. The closedend country fund model helped address these concerns (see Box 3.3), with the Mexico and Korea Funds representing the beginning of the emerging markets portfolio equity industry. (Given the debate over the advantages and disadvantages of foreign portfolio investment engendered by the 1994 Mexican peso crisis, it is worth distinguishing between different kinds of portfolio flows. From the host country's perspective, closed−end equity funds provide a more stable source of capital than direct portfolio equity investment, and investment in equities is more stable than that in shortterm debt instruments.) Rolling Out the Concept

At this nascent stage of the industry's development, IFC's imprimatur and promotional efforts were regarded as indispensable in many markets. In partnership with international investment banks and asset managers, IFC helped to roll out the country and regional fund concept

Box 3.3: Why Closed−End Country Funds? Country funds helped open up previously restricted markets to foreign investment because they addressed two concerns help by developing country governments in the 1980s. Foreign control of domestic firms. Structured as pools owned by multiple investors and amining for diverse portfolios (most funds limit their holdings to on more 10% of a single firm's equity), portfolio country funds posed on threat to the control of domestically owned private firms. Portfolio fund managers seek financial returns rather than control. Destabilizing hot money flows. Investors in closed−end country funds can only redeem their shares if they can find another buyer. Thus redemption by one investor is replaced by another, with no net impact on fund size or the host country. Most of the Early funds had an initial fixed life of 510 years and agreed to hold a high percentage of their assets by The World Bank e-library to: in local stocks rather than more liquidDelivered government securities. Furthermore, the fact that aaaaaa University IP : 111.111.11.11 their investors were institutions and were purchasing equities in liquid stock markets Wed, 11 Jan 1111 11:11:11 (where it is difficult to sell large amounts quickly), made it evident to policymakers International Portfolio Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Investment Funds in Emerging Markets that these funds were bringing monies that were committed to the domestic market. By the 1990s attitudes had changed policymarkers in developing countries without foreign portfolio capital were keen to attract it. Funds such as the Africa Fund provided large institutional investors with cost−effective, diversified access to several underdeveloped, illiquid stock markets, with prospect of prospect of significant gains as these markets opened. to new markets (see Table 3.2). In many countries the initial fund was quickly followed by others. For example, two years after the Malaysia Fund's launch in 1987, the country attracted eight other funds which raised US$600 million. By the end of 1991, just seven years after the launch of the Korea Fund, there were nearly 300 funds managing US$20 billion targeting emerging markets (see Appendix Tables A2 and A3). IFC's attention shifted progressively to promoting funds targeting stock markets which had remained untouched by foreign portfolio investment. The Africa Fund and Mauritius Fund were approved in 1993. And in October 1994 IFC's Board approved an investment in the Emerging Middle East Fund, the first publicly−offered, New York−listed investment fund covering markets in the region (the fund's initial focus has been on Egypt, Israel, Jordan, Morocco, Oman and Tunisia). The US$40 million fund represented the culmination of an IFC advisory and structuring initiative, and followed an IFC−led technical assistance program to establish or revive stock exchanges in these countries. IFC initiated the fund's concept, structured it, selected the managers, defined its policies and investment focus, Table 3.2: Opening Markets to Foreign Portfolio Investors Capitalization (US$m) IFC approval

Country

Fund

Initial

June 1995

1984

Korea

Korea Fund

60

734

1986

Global


50

5,570

1986

Thailand

Thai Fund

30

—

1987

Malaysia

Malaysia Fund Inc

84

204

1987

Brazil

Equity Fund of Brazil

87

94

1989

Latin America

New World Investment 62 Fund

242

1989

Philippines

Manila Fund Inc

50

61

1989

Turkey

Turkish Investment Fund Inc

24

48

1990

Chile

Five Arrows Chile Fund

75

394

1990

Portugal


30

28

1992

Mauritius

Mauritius Fund

1993

Africa

Delivered by The World Bank e-library to: aaaaaa University 17 31 IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

30

60

International Portfolio Funds (c) The International Bank for Reconstruction and Development / The World Bank

55

Investment Funds in Emerging Markets Africa Emerging Markets Fund 1994

Middle East

Emerging Middle East Fund

40

39

and mobilized a world−class underwriting group. The fund is the first vehicle to cover markets in both Arab countries and Israel. It is also the first in the region to be listed on a major international market. By the end of 1994 there were 953 funds managing US$106 billion investing in emerging markets. Preliminary indications suggest that the Mexican peso crisis slowed the pace of expansion during 1995, but the total number and volume of funds continued to increase. Reaching More Investors

At the same time IFC was promoting funds in more countries, the Corporation was also targeting a broader investor base. IFC targeted institutional investors through its underwriting and placement efforts, and structured funds to be attractive to new categories of investors (see Box 3.4). Underwriting and Placement

IFC—in conjunction with international investment banks—has underwritten 12 of the 36 portfolio funds which it has sponsored, and helped to place most of the rest among institutional investors.1 IFC never lead manages an issue alone: it has acted as joint leadmanager with over 25 investment banks to date. IFC's fundraising efforts are limited to the initial placement. The Corporation does not engage in any secondary market making, broking or trading activities. IFC uses its underwriting and placement capacity to generate demonstration effects which go beyond the monies raised for a particular fund. Persuading investors to subscribe to a new asset class is a good example. In 1992 IFC began marketing the Latin American Corporate Bond Fund, which would be the first emerging markets debt fund to invest mainly in US dollar−denominated debt issues of private Latin American companies. At the time a few debt funds existed, but they focused on sovereign debt. IFC, together with SG Warburg, spent over a year persuading major international institutional investors of the fund's merits. In early 1994 US$79 million was subscribed to the fund by six investors, including US$15 million from IFC. Building Fund Management Capability

Good fund managers improve fund performance but can also help develop domestic capital markets by demanding high standards of research, settlement and accounting procedures (see Chapter 4). IFC promotes good fund managers by: Combining experienced international managers with local managers. This helps build domestic fund management capabilities and provides the international fund manager with access to local market knowledge. Endowing funds with clear investment objectives and exposure guidelines. Although portfolio Box 3.4: Targeting Japanese Investors. . . and Introducing Them to Latin America Delivered by The World Bank e-library to: aaaaaa University Following the successful 1986 launch of the Emerging Markets Growth Fund, IFC IP : 111.111.11.11 11 Jan 1111 11:11:11 promoted a sister fund targeted at JapaneseWed, institutional investors, the Emerging

Reaching More Investors (c) The International Bank for Reconstruction and Development / The World Bank

56

Investment Funds in Emerging Markets Markets Investment Fund (EMIF). IFC began structuring the fund after a request from the Japanese government to increase Japanese private portfolio capital flows to developing countries. EMIF was incorporated in Luxembourg because of taxation and regulatory advantages for the investors. Reflecting investor preferences, the fund was initially targeted at five Southeast Asian markets: Malaysia, the Philippines, South Korea, Taiwan (China), and Thailand. Volatility in international markets at its launch in early 1988 meant that the fund closed with lower than expected commitments: US$43 million, versus a targeted US$100 million. IFC acted as placement agent and invested US$5 million. The fund's directors approved its first capital increase just nine months later, and four further placements during the next three years raised over US$150 million. Through its membership on the fund's advisory council, IFC helped to persuade the Japanese con−investors to allow the fund invest in Latin America. By 1995 the fund was invested in 16 markets with a wide geographic spread. EMF is the only emerging markets protfolio fund primarily subscribed to by Japanese institutional which invests beyond Asian markets. The ''broadening" stratedy has paid off, at least in US dollar terms: between its launch in February 1988 and August 1994 the fund's returns were 23.9% per annum, compared with 19.2% for the IFCG index as a whole. In Agust 1995 the fund's net asset value stood at US$239 million.

funds face prudential regulations set by the country in which they are incorporated, and the exchanges on which they purchase equities,2 internal guidelines are also important. To illustrate, the Brazilian Investment Fund faces portfolio diversification requirements under Brazilian regulations (for instance, investments in a single company should not exceed 5% of the voting capital or 20% of the total capital of that company), but the fund also has its own, selfimposed restrictions (for instance, it may not invest more than 25% of its assets in a single industry). Participating on the boards of directors of funds in which IFC has invested. Managers such as the Capital Group, who gained emerging market experience through managing the Emerging Market Growth Fund, were selected by IFC and other sponsors to manage several early funds. Fund manager reputation is as important for mobilizing investors as for subsequent management of the monies, so IFC helped to select well−known managers for several funds (see Table 3.3). Often, international managers are supported by a local partner. A local investment bank, Unibanco, advises the Brazil Investment Fund's manager on investments, researches Brazilian companies and is the fund's custodian and local administrator. Fund Governance

Senior IFC staff sit on the boards of several portfolio funds. Occasionally IFC has nominated an outside director instead of taking a seat itself. Nevertheless, despite being on the board there has been the odd instance where IFC has disagreed with the strategies being pursued by managers or other investors. For example, one fund that was formed in 1990 to invest in smaller emerging markets had 95% of its assets invested three years later in the large markets of India, Malaysia, Pakistan, and Sri Lanka. IFC considered that the fund was not being aggressive enough in investing in smaller markets and divested in 1994. Venture Capital Funds Delivered by The World Bank e-library to: aaaaaa University development of stock in many countries IP :markets 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Notwithstanding the rapid characteristics still hold true in most developing economies:

over the past 10 years, two

Fund Governance


Investment Funds in Emerging Markets Even where they exist, many stock markets remain relatively illiquid, with relatively few market participants and weak supporting infrastructure. Stock markets serve as financing sources mainly for larger companies with a history of audited accounts. Table 3.3: Examples of Portfolio Fund Technical Partners and Managers Manager / technical partner

Country of fund

Capital Group

Morgan Stanley Asset Management

Batterymarch

Foreign & Colonial

Type of fund

Fund

Global

Global/regional fund


Global


Emerging Markets Investment Fund

Latin America


New World Investment Fund

Thailand

Country fund

Thailand Fund

Thailand

Country fund

Thai Fund

Malaysia

Country fund

Malaysia Fund Inc.

Turkey

Country fund

Turkish Investment Fund

Portugal

Country fund


Brazil

Country fund

Brazil Investment Fund Inc.

Brazil

Country fund

Equity Fund of Brazil

Various

Regional fund

Commonwealth Equity Fund

Latin America

Regional debt fund Latin America Corporate Debt Fund

Middle East

Regional fund

Emerging Middle East fund

Source: IFC.

Table 3.4: Early VC Funds, by Country Date

Country

Project Name

Jan 1978

Spain

SEFINNOVAI

Sep 1979

Philippines

VIBES

Nov 1980

Brazil

Brasilpar

Jan 1982

Kenya [1]

Delivered by The World Bank e-library to: IPS (Kenya) aaaaaa University

May 1983

Korea

KIDC

IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Fund Governance


Investment Funds in Emerging Markets Nov 1983

Malaysia

Malaysia Ventures

Nov 1983

Asia Regional

SEAVIC

Oct 1984

Argentina

SADICAR

Jun 1987

China

JF China

Nov 1987

Côte d'Ivoire [1]

IPS (Cote d'Ivoire)

May 1988

Portugal

Inter−Risco

Jul 1989

Hungary

First Hungary Fund

Dec 1989

Madagascar

AEF−FIARO

Apr 1990

India

TDICI−VECAUS II

Dec 1990

Thailand

SEAVI Thailand

Dec 1990

Indonesia

SEAVI Indonesia

May 1991

Zimbabawe

VC of Zimbabawe

Dec 1992

E. Europe

Advent PEF: Europe

Dec 1993

Russia

Framington Russian Investment Fund

Dec 1993

Ukraine

Ukraine VC Fund

May 1994

Bulgaria

Balkan Fund

Jun 1994

Mauritius

Mauritius VC Fund

Notes: [1] Holding company transformed into VC fund. Yet access to outside equity is important for growing firms—many of which are new and/or small. Venture capital (VC) funds enable IFC to reach firms which may be too small for it to finance directly. Accordingly, IFC has introduced the VC fund concept to many countries. Table 3.4 lists those where IFC−sponsored VC funds were the first or among the early entrants. IFC has also sponsored follow−on VC funds to stimulate competition, or to invest in a particular sector. In India IFC sponsored four funds between 1990 and 1995, including an information technology fund and a "fund of funds" to invest in several state−level sub−funds. Advice

In South Africa, IFC identified an opportunity for a fund to invest in franchising. The Turkish government asked IFC to help draft legislation to govern the venture capital industry; the legislation was adopted in 1994. IFC has by The World Bank e-library to: In India, for example, only government also helped to create new methods of Delivered addressing market impediments. aaaaaa University : 111.111.11.11 institutions could sponsor trusts, which are theIPpreferred structure for VC funds in many countries to allow profits Wed, 11 Jan 1111 11:11:11 to pass to shareholders without being taxed. IFC used a rather obscure legal entity (a "determinate trust") to Advice


Investment Funds in Emerging Markets achieve the tax pass−through effect of a unit trust. This served as a prototype for the development of the privately−sponsored VC industry. Assessing the Market

IFC's experience has shown that expectations of demand for venture capital in a new market are often too high. Deal flow is affected by macroeconomic uncertainty, the small size of private firms and competing sources of capital from official aid or government sources (particularly in some African and transition economies). While entrepreneurs often tell survey−takers that they want outside equity, few are aware that venture capital is expensive. VC investors demand returns commensurate with risks and, understandably, attach conditions to their money: VC fund managers may replace firm managers or Box 3.5: VC Fund Size: Is There Enough Demand? Fund size depends on how much investors will commit, how much is necessary to sustain a good manager and what the market can absorb within a reasonable period. A back−of−the−envelope calculation for a small prospective VC fund might look like this: Management fees of US$0.25 million per annum might cover the costs of an office and 12 professionals. Assuming management fees of 2.5% of commitments, the fund would need to be at least US$10 million. The manager might expect to target investments in, say, 20 companies over 34 year investment period—about average for a 10−year fund. As a rule of thumb the managers might expect to invest in 5%10% of all potential deals that they screen. So, in order to invest in 20 companies in four years, the managers would need to screen 200400 potential deals, or 50100 per year during the investment period. The fund's average investment of US$0.5 million might equate to taking a 25% stake in each company. Does the economy have enough companies of that size interested in using outside equity? As can be seen from this simple example the creation of a VC fun can be fairly daunting task.

veto investments. Government equity programs rarely carry these disciplinary costs and are therefore "priced" below market rates. Accordingly, IFC assesses the VC market carefully, focusing on whether a fund large enough to support a capable management team can be invested (see Box 3.5). Sometimes IFC finances studies of market demand (as with the South Africa Capital Growth Fund). Identifying Key Investors and Managers

VC managers need to be close to their investee companies. This has presented IFC with a dilemma: how to attract experienced managers to manage relatively modest funds in often small or difficult countries. Several approaches have been used: Delivered by The World Bank e-library to:

Establish a regional management company and fund to provide international management input to several aaaaaa University IP : 111.111.11.11 country funds in a region—which each have their own manager as well. This structure achieves critical mass for Wed, 11 Jan 1111 11:11:11 the international manager, but also develops local expertise. It has been promoted successfully by IFC in Assessing the Market (c) The International Bank for Reconstruction and Development / The World Bank

60

Investment Funds in Emerging Markets Southeast Asia (the SEAVI program) and in Eastern Europe. Ensure that the fund is large enough to attract an international partner —where the market permits. The average size of the VC funds financed by IFC between FY91 and FY95 was US$37 million, compared to US$17 million for funds approved between FY80 and FY90. The five VC funds in Russia approved by IFC's Board by June 1995 averaged US$70 million. All had foreign technical partners for the management companies. Help local fund managers to expand by introducing a foreign technical partner and new capital. In India, IFC supported the expansion of the Creditcapital Venture Fund by negotiating a technical training and oversight agreement with an experienced international management company. The technical partner is SEAVI, the regional fund manager created in 1983 with IFC's assistance to manage a series of funds in Southeast Asia. Identify excellent individual managers. For example, the manager of the South Africa Capital Growth Fund had previously managed four funds in which IFC had invested, in Korea, the Philippines, Portugal and Argentina. Where a fund is too small to attract an experienced manager, IFC has sometimes sought partial donor financing of management costs. For example, French aid is paying the expatriate manager's salary of the US$9 million Mauritius VC Fund for the first 20 months. Despite seeking highly qualified managers, country realities have meant that in practice IFC has sometimes accepted relatively inexperienced managers, hoping that tight structuring and monitoring would yield good performance. Structuring

IFC works with sponsors and managers to structure funds. Issues typically include: tax efficiency; the fund's legal form and domicile; legal status of the fund's investors; separation of the fund from management and management incentives; and the fund's investment strategy and exposure guidelines. Appendix Box A2 describes the corporate structures used for funds—stock corporations, partnerships, trusts and limited liability stock corporations. Structuring a fund to meet investor preferences (see Box 3.6) and government requirements is often complex. For example, a potential US$50 million VC fund in Indonesia faced two difficulties: 1) foreign investors needed government permission each time they invested in an Box 3.6: Structuring to Meet Investor Preferences While a VC fund needs to be structured to meet host country regulatory requirements, attention also needs to be paid to foreign investiors' needs. In 1993 IFC subscribed US$5 million to a US$39 million VC fund targeting Eastern Europe. the fund was structured as two parrallel investment pools in the legal form of limited partnerships, with one for US investors under US law, and another for European investors incorporated under Dutch law, linked by a co−investment agreement. the limited partnership structure was required by certain tax free US insitutions (pension and endowment sources) Delivered by The World Bank e-library to: because the structure protects their non−tax status. aaaaaa University IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Structuring


Investment Funds in Emerging Markets Box 3.7: Privatization Generates Deal Flow in Morocco Interfina, a US$24 million fund set up in December 1992 to purchase the equity in companies being privatized by the Moroccan Government, has had a promising start. By may 1995 the fund had invested in five companies. One was subsequently divested, yielding a 25% per annum return. The fund has been helped by good deal flow: between 1992 and 1994 the Government privatized 27 companies and hotels, yielding US$695 million. During 1994 alone the Casablanca Stock Exchange's capitalization increased by 53% and turnover almost doubled. Funds such as Interfina have helped maintain demand for privatized assets. unlisted company; and 2) the tax treatment resulting from selling stakes in locally−incorporated companies was unclear. The solution was to structure the fund as two investment pools, one incorporated with local investors and the other offshore, with both pools managed jointly by an offshore manager. The local fund acquires a small amount of equity in a company, with most of the financing placed as convertible bonds from the offshore pool. This obviates the need to ask for government permission at the investment stage and reduces the potential tax problem at liquidation. Mobilizing Capital

As well as investing directly, IFC helps raise capital from other investors. In 1994 IFC placed with institutional investors nearly half of the largest fund targeting the former Soviet republics, the US$180 million First NIS Fund. Another high profile placement was for the first VC fund in Eastern Europe, the US$80 million First Hungary Fund, which was placed in 1989 before the fall of the Berlin Wall. Governance

IFC does not micromanage VC funds or generally seek a veto over prospective investments. There are practical reasons: it is not efficient for IFC to vet the large number of small investments made by most VC funds. Nevertheless, IFC sits on the boards of about three−quarters of its VC funds and in most of the rest is represented on the investment committee or advisory committee. IFC also invests in fund managers (for 30 of the 68 VC funds approved by IFC's Board), which usually gives IFC a seat on the board of the management company. Although IFC's representatives rarely have veto power, they have considerable de facto influence because most boards operate consensually. IFC's Board nominees tend to be more active in newer funds operating in difficult environments or where the fund manager is inexperienced. For example, in an Eastern European VC fund where technical assistance was not being provided to the fund's investee firms (as promised in the investment memorandum), IFC advised fund shareholders and management on the necessary reorganization steps to bring in competent support. Private Equity Funds Starting in the early 1990s, IFC expanded its efforts to promote private equity funds. The market for such funds had developed in response to: 1) privatization (see Box 3.7); 2) increased private financing of infrastructure; and 3) improvements in the liquidity and size of stock markets—which increased opportunities for private equity funds to sell otherwise illiquid stakes through initial public offerings. Mobilization

Large volumes of capital have been raised. The five largest private equity funds in which IFC has invested have Delivered byand The at World Bank e-library to: raised US$1.65 billion at initial capitalization least one has raised extra monies since. Most of these funds aaaaaa University IP : 111.111.11.11 have targeted infrastructure and/or the Asian or Latin American regions (see Table 3.5). Wed, 11 Jan 1111 11:11:11

Mobilizing Capital


Investment Funds in Emerging Markets Three examples illustrate IFC's funds mobilization function: In 1994 IFC invested US$50 million in the Asian Infrastructure Fund, one of the first funds established to target Asian infrastructure. IFC helped structure the fund and define its investment policies and exposure guidelines. IFC's presence as an initial investor and its shareholding in the fund's manager increased the fund's marketability, helping it mobilize US$500 million from major institutional investors at its first closing. By June 1995, seven investments totaling US$275 million had been approved in power, transportation and telecommunications projects. An additional US$280 million was raised in early 1996.

Table 3.5: Examples of IFC−Sponsored Private Equity Funds Initial cap. (US$m)

Board approval date

Name of fund

IFC % Regional share /sectoral focus

500

Mar 94


10

Asia, infrastructure

500

Apr 94

Global Power Investment

10

Global, power

500

Jan 94

GP Capital Partners Brazil

5

Brazil, any

150

Jun 95

Latin American Enterprises Fund

13

Latin America, any

100

Jan 93

Scudder Latin American Trust 25 for Power

Latin America, power

78

May 94

Peru Privatization Fund

12

Peru, privatization

75

Jan 93

Gold Fund

25

Global, gold mining

68

Dec 94

Argentina Investment Capital 20 Argentina, any Fund Five months after the onset of the Mexican pesocrisis, with investor confidence still very low in the whole Latin America region, IFC invested in one of the region's first private equity funds, the Latin America Enterprise Fund. The fund had an initial closing of US$145 million. The fund will invest substantial minority stakes in private firms, with the intent of exiting mainly through stock market flotations. In 1994, with two other major investors, IFC invested US$50 million in the US$500 million Global Power Investments Fund, and US$1.1 million in the fund's management company. IFC's initial mobilization multiple of nine times is expected to increase as the fund intends to mobilize funds from other institutional investors and possibly to raise debt. Governance

The high profile of many private equity funds and their large sub−investments (averaging US$9.7 million by June 1995) makes IFC's active participation in fund governance important, prudent and cost−effective. IFC has Delivered by The World Bankseats e-library appointed senior staff to its board or investment committee onto:funds. Although IFC has a formal veto on aaaaaa University prospective investments in relatively few fundsIP(for instance, the Gold Fund, and Global Power Investments : 111.111.11.11 Wed, 11 Jan 1111 11:11:11 Fund), in practice its nominees have considerable influence on the funds' investment decisions (see Table 3.6).

Governance



Table 3.6: IFC's Governance Role in a Sample of Private Equity Funds Name of fund

IFC % in fund mgr

IFC participation in fund management arrangement

Gold Fund

30%

IFC is represented on the fund's board and fund manager's board. Investments require a unanimous vote of the manager's board.

Global Power Investments

10%

IFC is represented on the general partnership board (where investments require unanimous approval) and the limited partnership board.

Scudder Latin American Power Fund

none

IFC is represented on the board of the managing trustees, and on the project review board (PRB). At least three of the four PRB members are required to approve an investment.

Peru Privatization Fund

11.8%

IFC is represented on the board of the fund and that of the management company. Investment decisions are made by consensus but formally require a two−thirds majority.


9.5%

IFC is represented on the board of the fund, the board of the management company and on the fund manager's investment committee. Investment are made by consensus.

GP capital Partners Brazil

none

IFC is represented on the fund's advisory board, which advises on conflicts of interest, and has veto power on certain exposure guidelines (for instance, a 25% limit in any one company).

Environmental Risk Management

Part of IFC's governance input to funds (all funds, but especially to private equity funds) involves advising managers on how to meet World Bank Group policies and guidelines. IFC goes further, however: it has identified all financial institutions—including fund managers—as a key target group for promoting awareness of environmental risk management. There are two reasons for this: Investor comfort. Financial institutions that abide by environmental guidelines and know how to manage environmental risks are likely to be more attractive to potential investors. Demonstration effect. Competing financial institutions are likely to emulate financiers which have improved their risk management techniques and, thus, profitability. IFC treats environmental risks as business risks requiring proper management to protect the value of assets. Fund by The World Bank as e-library to: managers are encouraged to approachDelivered environmental issues opportunities for adding value to an investment. aaaaaa University IFC inculcates this awareness and diligence through: IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Environmental Risk Management (c) The International Bank for Reconstruction and Development / The World Bank

64

Investment Funds in Emerging Markets Fund guidelines. IFC only invests in a fund if it adheres to local or international environmental guidelines. Thus the Asia Infrastructure Fund's articles of association and its placing memorandum state the fund will adhere to the environmental policies and guidelines of the World Bank in its sub−investments. Training. IFC has conducted workshops on environmental risk management for fund managers. Many fund managers have adopted environmental compliance checklists as a screening mechanism and are using environmental consultants to assess investments (see Box 3.8). IFC has also had requests from other fund managers for similar training. Project−specific environmental reviews. For a few large funds (for instance, the Global Power Fund), IFC has provided a check on the environmental review procedures used for the initial investments. Also, fund managers have sometimes piggybacked on IFC's internal environmental reviews where IFC has invested in a project itself. For example, the Scudder Latin America Power Fund used IFC's environmental review when considering a power investment in Jamaica. Furthermore, in conjunction with other investors, IFC is preparing to sponsor several funds that will explicitly target investments in the environmental field. Local Financing: Mutual Funds and Pension Fund Managers IFC has become increasingly involved in promoting domestic mutual funds and pension fund managers, which mobilize local savings directly. Open−ended mutual funds and pension funds mobilize savings from individuals and are thus closely regulated. Open−ended mutual funds (that is, the mutual fund manager offers a continuous market to buyers and sellers in the fund's units) require a supply of diversified and liquid securities—equity and government/corporate bonds—in which to invest, as well as relatively sophisticated supporting institutional infrastructure (for instance, settlement and transfer procedures, valuation systems, brokers, custodians and registries). This combination of requirements— for a sound regulatory environment, adequate supervisory capability, a reasonably liquid and diversified Box 3.8: Enhancing Value Through Envornmental Assessments When considering a potential investment in a port in China, the managers of the Asian Infrastructure Fund commissioned an environmental audit of the port. The audit identified several changes that needed to be made. AIF management proceeded with the investment, along with an investment program to bring the port into compliance with the regulations. Similarly, when considering an investment in a Chinese power company, the fund's managers commissioned a study to assess whether the plant was in compliance with World Bank standards. The AIF managers recognized that the company would need to access international debt markets to finance its investment program, and that most international lenders require compliance with the World Bank's environmental standards.


Local Financing: Mutual Funds and Pension Fund Managers (c) The International Bank for Reconstruction and Development / The World Bank

65

Investment Funds in Emerging Markets Table 3.7: IFC's Investments in Mutual Funds and Pensoin Fund Managers Board approval date

Country

Fund / manager

Initial cap. (US$m)

IFC IFC share share in in fund (%) manager (%)

Mutual funds Apr 77

Thailand

Mutual Fund Company

—

—

15

Sep 91

Sri Lanka

Pyramid Unit Trust

9.0

3

10

Jul 93

India

Taurus Starshare

67.0

11

20

Jan 94

India

Centurion Growth

25.6

9

10

Sep 94

Pakistan [1]

Unit Trust of Pakistan

10.0(e)

20

20

Dec 94

Kenya [1]

Kenfunds Unit Trust 0.6(e)

25

20

Pension fund management companies Sep 93

Peru

AFP Horizonte

—

—

7

Apr 94

Argentina

Maxima

—

—

14

Note: [1] The proposed funds in Pakistan and Kenya had not been launched by June 1995. supply of securities in which to invest and for adequate supporting institutional infrastructure—makes a challenge of developing domestic industries in mutual funds and pension fund management. By June 1995, IFC's Board had approved investments in mutual funds and their managers in five countries3 and in pension fund managers in Peru and Argentina (see Table 3.7). In each case IFC invested in one of the country's first funds/managers. One important role has been to help new domestic funds to reach a critical mass for startup, and to ensure that they are managed to high standards, thus setting a precedent for competitors. IFC is also providing advice in other countries. For example, during 1995 IFC advised the Government of Zimbabwe on regulatory changes needed to set up a domestic mutual fund industry. Mutual Funds

IFC's role in developing Pakistan's mutual fund industry illustrates the range of tasks involved. Prior to the early 1990s all open−ended mutual funds were governmentowned. They were conservatively operated and had grown sluggishly. As part of a strategy to develop the local market and mobilize more domestic savings, the government decided to encourage the formation of private mutual fund managers. IFC helped draft regulations governing the operation of private asset management companies; the law was passed in May 1995. IFC then identified a foreign technical partner for the local sponsor of a new mutual fund manager and fund. IFC also helped identify a local bank to be the fund's transfer agent, and which will market the fund through its nationwide branch network. The fund manager proposes Box 3.9: Chile's Bold Pension Reform Delivered Results Delivered by The World Bank e-library to:

aaaaaa University In 1981 Chile's old pay−as−you−go, government−run pension system was bankrupt, IP : 111.111.11.11 with over half of the money from contributions spent on administration. In a Wed, 11being Jan 1111 11:11:11 bold, unprecedented reform, the government instituted a strictly regulated

Mutual Funds


Investment Funds in Emerging Markets privately−managed contributory system, whereby employees contribute 10% of earnings to one of 18 fund management companies. IFC provided some advice on the system in its early years, specifically by recommending that pension funds should be allowed to invest in equities, rather than just government paper and bank deposits. By 1995, after 14 years of operation, the funds were paying pensions 50%100% higher in real terms than the state system paid. The pool of private pension funds had grown to US$23 billion by 1995 (46% of GDP). The annual US$3 billion increase is higher than the rate of GDP growth because more contributors continue to enter the system and contributor's incomes are rising. Chile's savings rate of 27% of GDP of 10% above the average for the region. The deep pool of domestic capital the country weather the fallout from the Mexico peso crisis almost unscathed: the 7% GDP growth rate predicted for 1995 is just above the average for the past decade.

to set up an open−end fund aimed at retail investors preferring low−risk, liquid investments, and a closed−end fund for more sophisticated investors with a higher risk−reward profile. Pension Funds

Setting up a system of privately−managed, contributory pension funds to replace pay−as−you−go government schemes is perhaps the most important change a government can make to encourage higher domestic savings rates and develop local capital markets. Chile's early switch to private pension management (see Box 3.9) has encouraged other Latin American governments to follow suit. With the aim of helping establish credible, efficient and financially sound pension fund management companies, IFC has invested in fund managers in both Argentina and Peru. In December 1992, Peru approved a new private pension system modeled on that of Chile. It offered workers a voluntary option to opt out of the state−run pension system and into a privately managed contribution−determined system. In September 1993, IFC invested US$0.7 million for a 7% share in one of the new pension management companies. Two years later this company, Horizonte, had over 250,000 contributors, equivalent to nearly a quarter of the 1.1 million subscribers to the new system. Horizonte had achieved a real annual return of 8.3% and had US$130 million under management. The overall system is well established, with over US$500 million under management and continuing growth in terms of number of contributors. In July 1994, Argentina instituted an integrated pension system that combines state provision with a new private system. By late 1995 about 4 million people had subscribed to the new private system, equivalent to about two−thirds of the total number in both systems. Total funds under management had reached US$2.2 billion. IFC has helped promote one of the leading private pension managers. Maxima, and two related companies which provide life and disability coverage and annuities to contributors to the private pension system. In addition to a US$19 million investment, IFC provided technical assistance for the projects' feasibility studies. By the year 2004, Maxima expects to be managing nearly US$5 billion in pension funds.

1. Regulations on major traded stock markets such as New York or London prohibit underwriters from being primary investors in funds they underwrite. These rules do not apply to funds listed on stock markets with little by The World Bank e-library to: markets. trading so IFC has invested directly inDelivered funds which are listed on these aaaaaa University IP : 111.111.11.11 Wed, 11 Jan 1111 11:11:11

Pension Funds


Investment Funds in Emerging Markets 2. IFC has also been active in advising stock market regulators in this area.

3. The two funds in India were both closed−end.

4— Assessing the Impact How much has changed for investors and firms in developing countries over the past decade? Do firms have a wider choice of financing options, including raising private equity or floating shares on a domestic exchange? Are stock markets more developed—larger, more liquid, more participants, more transparent, better regulated? Have small firms benefited from these changes? Do foreign and domestic investors in developing countries have a wider range of vehicles through which to invest their assets, to match differing risk−reward preferences? Are they able to benefit from professional fund managers and good information on domestic firms? This chapter suggests that the answer to these questions is "yes." It documents the improvements in the breadth, depth and quality of public and private equity markets, and how firms and investors have responded to these changes. Furthermore, it illustrates the catalytic role played by investment funds in stimulating many of these changes. It emphasizes the links between developed and listed markets, and access to private equity. Despite these changes, however, much remains to be done to extend the benefits offered by funds to more investors, firms and countries. This chapter concludes with a synopsis of ways in which IFC is continuing to promote funds. An Overview Large firms in developing countries finance more of their investment from "external" sources (that is, borrowing, private equity, or new equity issues) than enterprises in industrialized economies (see Box 4.1). 1 Under these circumstances, any improvement in the efficiency with which financial savings are channeled to investing firms is likely to yield significant benefits. All measures of stock market development in emerging markets have grown spectacularly. The number of stock markets, the number of listed firms, market capitalization, and turnover have all grown dramatically over the past decade and particularly since 1990 (see Table 4.1). Countries such as Ecuador, Namibia, Bangladesh, Swaziland, Zambia and numerous transition economies have set up stock markets during the past five years. Markets as varied as China, Colombia, the Philippines and Zimbabwe posted triple−digit increases in annual value traded in 1994 alone. Given this positive backdrop, it is not surprising that new issues also increased dramatically: in 1994 some 2,700 firms in developing countries raised US$58 billion through new stock flotations. Although these trends have been strong and widespread, emerging markets as a whole remain more volatile than developed markets, as illustrated by the downturn suffered by many emerging markets in 1995. This higher risk is the price for higher rewards. Sophisticated international investors (primarily institutions) recognize this and seem likely to continue rebalancing their portfolios to include more exposure to emerging markets. Arguably, the contrast in 1995 between the strong performance of several OECD markets and the falls in emerging markets supports the observation that the two do not move in tandem—thus reinforcing the case for spreading risk through portfolio diversification. Delivered by The World Bank e-library to:

aaaaaa University Box 4.1: Financing Developing Country Firms

IP : 111.111.11.11

Wed, 11 Jan 1111 11:11:11 An IFC sponsored survey examined how the 100 largest listed firms in 10 developing

4— Assessing the Impact (c) The International Bank for Reconstruction and Development / The World Bank

68

Investment Funds in Emerging Markets countries (Brazil, India, Jordan, Korea, Malaysia, Mexico, Pakistan, Thailand, Turkey and Zimbabwe) financed corporate growth over the period 19801990. It found that large developing−country firms rely significantly more than their industrialized country counterparts on 1) external financing, and ii) equity financing in particular. For example, in seven of the countries over half of the growth in corporate assets was financed externally. And in five countries over 40% of the growth in assets was financed by new share issues. The findings seem counter−intuitive, given the less developed financial sectors and stock markets in emerging markets. Several explanations have been advanced: Rapidly growing firms—the case for much of the sample—rely heavily on external finance. The rapid development of stock markets (and a consequent fall in the relative cost of equity capital) in several countries during the mid to late 1980s enabled firms to tap equity sources. Country−specific factors could create greater reliance on external finance. For example, government−imposed debt−equity ceilings in Korea might have encouraged firms to seek stock market financing. Despite explosive growth by the international portfolio fund industry in emerging markets, local owners dominate the markets. The emerging markets portfolio funds industry is only about 10 years old. By 1994 over US$100 billion was being managed through a thousand funds. Despite this dramatic growth, however, international portfolio equity accounts for only about 5% of stock market capitalization in emerging markets.2 Adding in other portfolio capital invested in emerging markets (for example direct equity holdings—rather than through funds) brings the estimated total foreign portfolio capital invested in emerging markets to about US$200 billion at end−1994. This is still only about 10% of the total capitalization of emerging markets. In short, local owners hold about 90% of emerging market capitalization. Stock markets remain places where local firms raise equity overwhelmingly from local investors. However, as illustrated below, foreign funds have played a disproportionately large role in improving the functioning of emerging markets. Although statistics are incomplete, the venture capital industry in emerging markets has also grown rapidly during the past five years, particularly in Southeast Asia, Latin America, and the transition economies. Table 4.1: Indicators of Stock Market Development and the Funds Industry, 19851994 Indicator

1985

1990

1994

Stock markets in developing countries Countries with functioning stock markets

31

36

48

Number of listed domestic companies

8,916

12,541

17,115

Capitalization US$bn

171

612

1,929

Capitalization as % of developed markets

3.8

6.9

14.6

Value traded as % of capitalization [1]

25

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 35.1 55.2 Wed, 11 Jan 1111 11:11:11

4— Assessing the Impact (c) The International Bank for Reconstruction and Development / The World Bank

69

Investment Funds in Emerging Markets Number of new issues [1]

—

Value of new issues US$bn [1] —

1,112

2,714

12.7

58.1

Internation equity funds targeting emerging markets Number of funds

17

232

953

Assets under management US$bn

1.3

13.7

105.8

As % of stock market capitalization

0.8

2.2

5.5

Number of funds

1

—

123

Capital under management US$m

28

—

2,956

Number of funds

—

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