Convergence of Venture Capital and Private Equity in Islamic Finance

Islamic finance is trending towards a convergence with private equity and venture because of the general ability of these forms of investments to provide the capital necessary for firms under the requirements of Sharia law. Islamic finance is theoretically based on the principles of Sharia law, which prohibits certain types of investing activity commonly found in non-Islamic capitalization transactions such as the use of debt instruments or use of preferred shares providing higher return than common shares. The venture capitalist or private equity provider must not only evaluate the financial merits of an investment opportunity, but must also structure the investment to remain compliant with Islamic financial requirements. Sharia law prohibits lending funds at interest for business investments. Because of this restriction, the venture capital and private equity approach supports economic growth with the provider of capital becoming a shareholder in the organization. The convergence of venture capital and private equity with Islamic finance is because of the attributes of the private equity financing approach that create inherent compatibilities with the principles of Islamic finance.

Under Sharia law, the provider of capital for a business venture is viewed as involved in a partnership with the operator of the business. Venture capital and private equity are very compatible with the fundamental principles of Islamic finance because the provider of capital holds an equity interest in the firm and becomes involved in its success or failure at a relatively early point in the company’s life. Venture capital and private equity involve investments in companies providing real goods and services that have a beneficial influence on the economy. Both the company and the private equity provider share the same risks for profit and loss as the company grows. In addition, the private equity stake in a firm in most cases is sufficient to influence the firm’s governance to ensure operations are conducted in an ethical manner. The private equity stake can also be sufficient to alter the capital structure of the firm to minimize or eliminate its debt related activities. At the same time, venture capital and private equity support economic growth by providing necessary capital for a firm’s expansion compliant with the Sharia prohibition against the use of borrowed capital.

Investing under the principles of Sharia law imposes an obligation on the individual or organization making the investment to ensure the funding is used only for moral purposes. The business activities of the firm in which the investment is made cannot be immoral, and the business cannot conduct its operations in an immoral manner. Because of this requirement, the venture capitalist in Islamic finance not only has to determine whether the purpose of the business is moral, but also has to ensure the actions of management are moral. While this requirement does not impose an obligation on the investor to continuously monitor the activities of management, it does create a requirement to thoroughly investigate the activities of the business prior to making an investment. The requirement, however, does preclude investing in firms involved with alcohol production, defense, the production of pork products, gambling, or pornography as defined under Sharia interpretations.

Sharia law also requires the investor to share in both the risks and the rewards from an investment, envisioning the relationship between the supplier of capital and the operator of a business as a partnership. This amounts to a prohibition against lending funds to a firm without an equity stake because the lender may have a reduced risk because the loan claim would have a higher priority than an equity claim. Because of this requirement under Sharia law, all funding for businesses in Islamic finance take the form of either mudarbah or musharaka financing. Mudarbah financing can be viewed as a traditional venture capital arrangement in which the owner of a business provides the knowledge and expertise to operate the business while the financing organization provides the necessary capital. If the venture operates at a loss, the venture capitalist receives no return on investment or may experience a loss. In the event the business prospers, the venture capitalist profits according to pre-negotiated percentages. The musharaka arrangement can be characterized as a joint venture in which the business operator and the venture capitalists jointly supply capital, with profits and losses divided according to the capital contributions. In both approaches, the investor provides capital to a firm in exchange for a portion of ownership, with the right of control over the firm remaining vested with existing management. The provider of capital can subsequently sell the equity ownership for a profit or can continue to hold the equity stake in the firm and receive a portion of the profits. Both the lender and the business operators divide the profits of the venture according to an agreed ratio. Most private equity arrangements in Islamic financing involve the mudarbah approach in which the firm’s managers continue to control operations although the private equity investor will oversee operations through the corporate governance structure.

One of the private equity approaches sometimes used in Islamic finance for some industries is the use of capital leasing, which is compliant with Sharia requirements and is known as murabaha. For firms requiring large capital assets such as airlines or manufacturing firms requiring capital equipment, the private equity firm purchases the equipment and enters into a long-term lease with the user of the asset. The lessee pays a fee for the use of the asset enabling the private equity firm to obtain a significant return on investment. The lessee has use of the asset during the term of the lease, but title remains with the lessor. This approach enables the private equity firm to fund asset-intensive industries such as an airline while remaining compliant with Sharia law by retaining title to the asset leased by a company. While this approach, constructive ownership remains with the private equity firm, while the company can use the asset to produce value. This approach, however, often has fixed terms for the use of the leased asset and does not allow the lessor to participate in the growth of the firm using the asset. A variation of this type of capital lease is a situation occurs when the owner of the asset such as a building agrees to transfer title to the lessee after a fixed number of payments have been made. In practice, the payments are equivalent to the cost to the lessor of the purchase of the building plus an amount equivalent to interest. Title to the asset, however, remains with the lessor until the stipulated number of payments has been made. While some private equity firms engage in capital leasing for major assets such as aircraft or property, the majority of the private equity firms provide capital through an ownership stake in target firms.

Sharia law regarding financial matters has supported the development of both venture capitalism and private equity funds in Islamic nations because both investment approaches emphasize ownership stakes in the investment, sharing the risk, and exiting the equity position at a future time with profit contingent on the success of the venture. The venture capital approach is the traditional method for raising capital in Islamic nations, with the venture capitalist providing the seed or startup capital necessary for a firm but not adopting a management role. The private equity approach is used for the second stage of funding for a business after it is established, and is intended to take a long term perspective in which the investor becomes involved with a firm early in its growth and prospers along with the firm over the long term. Because of the increased inflow of wealth into many of the Islamic nations involved with oil production, the private equity firms and funds that have emerged over the past several years are one of the primary vehicles for investing in accordance with Islamic principles. An additional factor supporting the growth of private equity in Islamic nations is the traditional reliance on smaller family owned firms, which require additional capitalization and restructuring to expand operations. Banks in Islamic nations are also becoming involved in private equity financing, considering private equity funds as an opportunity to increase revenues from management fees while providing investors with professional management of the fund.

Because relatively few firms are fully compliant with the Sharia requirements to avoid issuing or using debt, the general approach taken by Islamic jurists in determining the criteria for investing in a firm is to use the rule of necessity. Under this rule, the use of debt should be minimal and only if it is necessary. As a result, a venture capital or private equity investment in a firm is permissible under Sharia law if its accounts receivable are less than 45% of its assets, interest income constitutes only a small portion of its income, and whose debt to moving average of market capitalization is less than 33%. In general, Islamic private equity firms use these criteria as an initial screen to identify firms eligible for investment, and are therefore able to take positions in firms outside of Islamic nations. In some cases, an Islamic private equity fund will also take a position in a firm contingent on the restructuring of debt and receivables to fall within the specified criteria. The restructuring may take the form of leased-based buy-outs of secured loans, which restructures the debt obligation to a lease obligation. The use of the criteria enables Islamic private equity firms to acquire positions in a variety of firms in non-Islamic nations while remaining compliant with Sharia law. As a result, the larger Islamic venture capital and private equity firms have globalized their operations, with major investments in Europe, North America and Asia.

One of the difficulties faced by a venture capitalist in Islamic finance is liquidity of the investment at the time for exiting the investment. While it is possible for smaller firms in Islamic nations to grow to the point where they have an initial public offering of stock to support liquidity and to raise additional capital, many firms in the region remain privately held. As a result, the venture capitalist with stakes in a few firms may not be able to find a buyer for the equity stake. The problem of liquidity may be even greater if the firm has not prospered and the value of the equity position has decreased. Islamic private equity funds provide some solution to the liquidity problem by creating a relatively large market for the purchase of equity positions in firms. To some degree, the private equity approach reduces the difficulties faced by the venture capitalist desiring to exit a position after a firm has developed, with the possibility a private equity fund will purchase the equity stake from the venture capitalist. In addition, many private equity investments have a very long-term horizon, intending to hold the ownership stake for an indefinite period.

The private equity funds following Sharia principles invest only in firms who agree to follow Sharia law, which eliminates firms borrowing funds for operations, and firms engaged in morally questionable practices. Because the amount of private equity funds available for investment is so large, some funds have adopted the approach of purchasing majority positions in firms with the intention of altering the practices of the firm to achieve compliance with Sharia requirements. In cases where the firm is not already compliant with Sharia law, the private equity placement should obtain a majority interest in the firm to bring it into compliance. An example of this type of approach is Qatar-based Corecap, which has assets of $150 million to invest specifically in the information and telecommunication sector. After acquiring a majority stake in firms, the fund intends to alter the capital structures and practices of firms to ensure they are compliant with Sharia law and principles. In practice, this will require the gradual change to the capital structure of target firms by divesting debt and if necessary replacing the debt with equity capital. It may also require some changes to the types of products and services offered by the firms.

Despite the trend towards convergence between private equity and Islamic finance, private equity firms face several challenges to sustaining growth over the long term. Because of the need to select only Sharia compliant investments, the screening and research costs may be relatively high because it involves very close scrutiny of the firm and its practices. Obtaining adequate and trustworthy information about firms eligible for private equity investments under Sharia law is difficult in some developing nations because of the lack of transparency in financial reporting. Another type of challenge occurs in the use of private equity to support a merger or acquisitions between a Sharia compliant firm and a non-Sharia complaint firm. The merger or acquisition may be permissible only if there is a reasonable expectation the combined business entity will be Sharia compliant. 4There is also a lack of uniform accounting standards and interpretation as to whether the firm meets the Sharia requirements. Each private equity fund should establish a Sharia board to ensure a contemplated investment is compliant, but may have difficulty with finding a sufficient number of Sharia scholars with the necessary financial expertise.

The main opportunities for the use of private equity in the Islamic financing system is the possibility of generating greater gains over the long term for investors because of direct participation in the growth of the firm. The private equity approach has advantages for the investor because it can provide a very high return on investment if the firm prospers. Because the private investment firms become directly involved in the governance of firms, they can ensure management behaves in an ethical and responsible manner to increase the value of the firm over the long term. In many Islamic nations such as Saudi Arabia, there is also a growing demand for capital supplied by investors to help transform smaller family-owned enterprises into multinational firms capable of competing in global markets. As a result, there are an increasing number of opportunities for investment in the Middle East in Sharia-compliant firms. At the same time, there the amount of capital controlled by venture capital and private equity funds in Islamic nations has increased substantially, leading to a global search for opportunities meeting the Sharia investment criteria. In the future, the venture capital and private equity approach is likely to become the primary component of Islamic finance.

article by: arjun sethi

Valuation of Social Networking

Introduction
The purpose of this paper is to explore the topic of social networking sites from the vantage point of private equity and venture capital. This report will examine the trends of social networking sites, as well as whether the future of these sites shows potential increases in the number of users and the financial returns that can be made for investors. In addition, a discussion will be provided about the ways in which private equity and venture capital valuations of companies are made and the possible valuations of the top 10 social networking sites today. Possible valuations using both types of models will also be provided. In the end, this paper will use all of the data and information to determine if social networking sites are better for investment purposes from the standpoint of venture capital and private equity. In addition, using the valuations, a discussion will be provided as to whether it makes sense for a private equity firm to try and take over a social networking site that may not be performing as well as would be liked.

Social Networking Sites
The information on the popularity of social networking web sites, such as Myspace and Facebook provide both joy and concern for those seeking to invest in these types of ventures. At the end of 2007, it was estimated that the total number of users of all social networking sites around the world was more than 230 million. What is even more impressive is that this number is expected to continue to grow until 2012. The problem, however, is that within the next 4 to 5 years, the actual growth of social networking sites is expected to level off as the number of people that are available to become new members becomes smaller (DataMonitor 2007, 7).

At least at the present time, there is clearly a draw among people to visit social networking sites. A recent poll reported that about 37% reported that they checked Facebook once to twice day. Even more, 8% of those in the poll actually reported checking the site as many as 10 times per day. In addition, nearly 15% reported being logged onto the site through the day to check for messages and updates from friends (DataMonitor 2008, 234). This suggests that social networking sites are clearly very popular and are being used as a way to keep in touch with friends and even strangers.

While these numbers do show the popularity of these types of web sites, the purpose of this paper is to explore this phenomenon from the perspective of investors from the world of private equity and venture capital. When this perspective is used, the trends and future potential for social networking sites becomes a little more difficult to understand. In total, revenues generated by social networking sites are about $965 million. This number is actually expected to increase to $2.4 billion by 2012. However, as has already been stated, the problem is that this number is expected to level off after 2012. From there it is much harder to predict what will happen with these types of sites in terms of their revenue-generating abilities (Social Networking’s Explosive Growth 2007).

What is also problematic is that not all social networking sites are seeing growth year after year. In fact, the current top 10 social networking sites in terms of membership have not seen increases in users from 2006 to 2007. Popular sites such as Myspace and Facebook have seen nice growth in terms of members. Others, however, such as AOL Hometown and Reunion.com have seen decreases in the number of members (Nielson Online 2007). This only adds to the confusion about the potential future value from any investments in these web sites. Figure 1 shows the membership numbers for the top 10 social networking sites from 2006 to 2007.

There is also the problem of actually generating steady revenues for these sites. Social networking sites rely on advertisements as the primary source of revenue. The actual services are provided to users for free. This means that many sites spend a great deal of time trying to increase membership numbers as a way to becoming more attractive to advertisers. What also makes the future of these sites difficult to predict is that technology is likely to change in the next five years. This may mean that interest in social networking sites will wane as new means of communicating and connecting with friends, such as virtual worlds, come into play (Ranger 2008, 46).

What is also problematic is that the actual market share of the top 10 social networking sites from 2006 to 2007 when compared only with each other, and not with all of the social networking sites that are available, has changed differently than the level of membership. For example, Myspace has grown from 55 million members in 2006 to 60 million in 2007. However, as a percentage of the market share among the top 10 sites, it has decreased from 49% to 45% (Nielson Online 2007). Depending on how to evaluate growth, or the lack thereof, a specific site may be growing or it may be declining in terms of users and market share. Figure 2 shows the membership percentages in terms of comparison among just the top 10 sites.

From the standpoint of valuation, all of this means that it is very difficult to put a value on social networking sites using traditional valuation models. The lack of real data about revenues and growth means that determining the current value based on a future rate of return lacks the same level of specificity that might be found in other industries (Knowledge@Wharton 2006). Instead, putting a value on these sites depends on how other similar sites have received funding, either from venture capital or private equity, as well as the technology and services that are offered. Many social networking sites only offer a way to communicate and stay in touch. This is a service that can easily be provided by anyone and is not something that is proprietary to one company over another.

Valuation Information
Some data is available that can help to provide a basis for putting a value on social networking sites. Some of this information is based on what other companies have invested in these sites, as well as the little information that is public about the generation of advertising revenues. For example, takes in about $180 million a year in advertising revenue (Davis 2006). However, it must be remembered that Myspace is the largest social networking site in the world. It has the most members and advertisers realize that Myspace can provide a lot of potential viewers of their marketing efforts.

Some of the current list of top 10 social networking sites have also received funds from venture capitalists. Facebook has received a total of $13 million in venture capital. LinkedIn, however, has received nearly $17 million in venture capital. Friendster falls right in the middle of these two sites with a little over $15 million in venture capital funding (Loizos 2005, 5). The problem arises when you try to compare the amount of funding with actual information about membership. It is easy to determine that the level of funding is not always based on the actual membership numbers at the time of investment.

In terms of private equity investments, Myspace has been valued at around $15 billion based on a $580 million offer made by News Corp. for a stake in the company. However, some have argued that this valuation is a little inflated considering that Myspace would need to take in $270 million a year in advertising revenues to actually hit the $15 billion valuation. The fact that the company does not take in $270 million in revenues means that the valuation provided with the News Corp. offer was too high (Knowledge@Wharton 2006).

Methods of Valuation
Private Equity
Before actually trying to decipher the valuation of social networking sites and create concrete values, at least in theory, it is important to understand how private equity and venture capital places values on potential investments. From the standpoint of private equity, the valuation process can be difficult to understand because there is really no specific standard that is used (Harrington 2004, 44). Instead, there are guidelines and procedures, and even precedents that come into play. For the most part, however, most private equity firms use a net present value based on a discounted cash flow to determine the value of a potential investment (Yescombe 2007, 286).

The discounted cash flows are usually discounted based on the perceived rate of return that could be obtained for selling the investment (Yescombe 2007, 286). In other words, if a private equity firm believed that selling an investment in a social networking site would yield a rate of return of 20% in the future, then the firm would use a discounted rate of return to value the investment of 20%. The discount rate can be set to whatever a private equity firm thinks it can obtain in the future. However, private equity firms also operate under pressure to use a fair value and not to try and take advantage of small companies that may be desperate to receive any funding possible (Harrington 2004, 44).

This takes us back, however, to the problem about actually determining a value for companies for which a history of revenues is not really available. When a history of revenues, or a history of stable revenues, is not present, then private equity firms have to determine how to provide a valuation, or even if the valuation and the eventual investment is worthwhile. Not being able to put a value on an investment can make it very difficult to determine a fair value or really any value at all.

What this means is that putting a value on social networking sites really depends on looking at comparable companies and determining, based on such factors as expected revenues, what a company is worth. While this is certainly not the desired method for private equity that likes to be able to look at the revenues and determine a book value based on price and equity (Draho 2004, 161). Of course, the inability to do this in a scientific manner may mean that investing in social networking sites is really not appropriate for private equity.

Venture Capital
The most common method for venture capital to value a company is known as the comparable method. This method is simply how it sounds: a venture capital firm will research what other firms have invested in similar types of companies and base their valuations on those numbers along with how the current potential investment performs in relation to the comparable information (Camp 2002, 222). What this means is that another venture capital firm may have given $10 million to a company that is twice the size of the one in question. If both companies appear to have similar prospects for growth, then the venture capital firm might value the investment in the current company at $5 million.

In some respects, the method of valuation that is used for venture capital seems much easier than the method that is used by private equity for firms that really lack a long history of performance. Rather than trying to predict what a company may do in the future in terms of financial performance, a venture capital firm can determine what others have invested in similar companies and what they have believed is a sufficient investment to see a return.

Valuation
Based on the information about the way in which private equity and venture capital use to value investments and the value of companies, it is possible to use those methods to create values for the top 10 social networking sites. First, it is necessary to determine the expected revenues for these companies. Since not all companies have accurate revenue information available to the public, the method that will be used is to use the revenues from Myspace and estimate revenues for the other companies based on the revenues per member. In the case of Myspace, the revenues per member come out to $2.99. This is used to determine the estimated revenues for the other social networking sites. Table 1 shows the estimated revenues for each site.

As the table shows, the estimated revenues range from $180 million, which is the actual reported revenues for the company, to an estimated low of just over $9 million for Flixter. It is important to explain that this method of creating revenue valuations is not entirely inappropriate. The cost that advertisers pay to display their ads on these sites is paid per 1,000 thousand impressions. The rate for this is determined based on the number of people who are actually members of these sites (Davis 2006).

Based on these revenues, and using the investment from News Corp of $580 million in Myspace, which resulted in a total valuation of the company at $15 billion, it is possible to determine a valuation for the other nine social networking sites. This is done by using the $15 billion total value of Myspace and taking into account the advertising revenues in relation to the valuation. Using this ratio, the valuation of the other companies based on their advertising revenues is created. Table 2 shows the valuations that have been created for the social networking sites.

It is easy to see the problems that this can create. Using this method of valuation for private equity means that Facebook is worth about $5.5 billion. However, a site like Flixster is worth nearly $773 million. It has to be remembered, however, that this is based on an investment of $580 million. In other words, many of these social networking sites would not be a good investment for private equity because a large part of their value would actually come from the money invested by the private equity firm. Even more, the fact that many of these sites have shown decreases in member over the past year means that advertising revenues will likely decrease.

From the standpoint of venture capital, the information that is available has shown that venture capital firms have invested between $13 and $15 million in these types of sites regardless of the actual level of membership. For Facebook, the $13 million in venture capital funding translates into about $0.57 per current member. However, the $14.9 million venture capital funding of LinkIn translates into about $3.10 per member. It is likely, however, that the differences are based on perceived level of growth in the short-term. LinkIn has more than doubled its membership from 2006 to 2007. Facebook has also nearly doubled its membership numbers, but it already had more than 10 million members when the investments were made. This would likely mean that there is more potential for growth from LinkIn than Facebook in the short-term.

If this method is used, then it would suggest that a company with less than 10 million users should receive a valuation of $3.10 per current member. Social networking sites with over 10 million members should receive a valuation per member of $0.57. Table 3 provides the estimated valuation of investments using the venture capital method of pricing. The values for Facebook and LinkIn are not present because they were used as the comparables for creating the valuations of the other companies.

What can be seen from this method of determining an appropriate investment is that the numbers seem much more in line with the actual projections about revenues. The investments range from around $10 million for Flixster to about $27 million for Windows Live Spaces. However, if you were to take into account changes in actual members from 2006 to 2007, then all of the numbers would likely hover around $10 to $15 million to take into account declining memberships for some of these sites. If you were to reduce the valuations based on the percentage decreases in membership over the past year for those sites that have lost members, the new and final valuations would be as they appear in table 4.

The new values for those sites that lost memberships from 2006 to 2007 provide even further evidence that the venture capital model is more appropriate for these companies. All of the investments lie within the range of $5 million to about $25 million. What is also important, however, is that all of these values are relatively in line with previous venture capital investments in Facebook and LinkIn. The only major outlier in the group is Myspace. This is not surprising considering the much larger popularity of the site and its overall revenues.

Private Equity and Social Networking Sites
The analysis of the valuation models suggests that private equity is not well suited to make investments in social networking sites. The method of pricing such investments is simply not suited to companies that may not have long-term histories of generating revenues year-after-year. Even more, the data and information available indicate that even when valuations are made by private equity, they may be inflated in terms of the actual value of the company and the actual ability to generate the required return on the investment.

This would also seem to suggest that private equity firms are also not well suited to take over a social networking site that is under performing. The reason is that a site that is already in trouble will be hard to value in terms of future potential revenues. Even more, the ability of the private equity firm to be able to produced a return by selling its investment on a secondary market may not be that great. In the end, the nature of private equity and the desire to be able to sell investments in the future for a specific rate of return is not appropriate for social networking web sites. The future of revenue generation, as well as the future of the industry in general, makes these types of investments too risky for private equity.

Discussion and Conclusion
The purpose of this paper has been to examine the value of social networking sites from the standpoint of private equity and venture capital. In addition, this paper sought to determine if it appeared that one form of investment might be better suited than another for these types of companies. The analysis of this issue showed that trying to put a value on social networking sites using the private equity valuation method is really not very accurate and requires too many assumptions for some of these companies. The lack of revenue data for some of these companies, either because of the lack of information or simply the lack of a revenue-generating history, makes the investment too risk for private equity.

Even more, there is also the concern that these sites are simply overvalued based on the potential for future returns by selling these investments on secondary markets. It has been shown that some believe that even for a sight like Myspace, a valuation of $15 billion in the private equity world is too high for the level of revenues that are generated by the site. If a site like Myspace that is very popular and is the top rated social networking site in terms of membership is hard to accurately value, then it is not difficult to understand the troubles that are possible in attempting to place a value on other companies with fewer members and less market share.

Venture capital is best suited for investment in these types of sites because they can provide an investment that can likely be returned within a specified amount of time without having to worry about the future of trying to sell the investment on other markets. This may be especially true for shorter-term investments that are made for a period of two to four years. The reason for this is that the overall market for social networking sites and for revenue generation on these sites is expected to level off by 2010. This does not necessarily mean that they will stop generating revenue. Instead, it means that growth may level off and these sites may become stagnant in their ability to generate growth year-after year.

Venture capital firms have more freedom to focus on the short-term to move in and provide a company with necessary capital and then seek repayment of the investment in one way or another. In addition, venture capital firms, by their very nature, are in a position to give smaller amount of money to companies in order to provide a source of capital for future growth. Rather than being determined about book values, equity, and changes in revenue, they can be more concerned about helping a company get off the ground or grow through a period of transition.

This evaluation also shows that there is a reason why there are private equity firms and venture capital firms. Both types of investments are not right in all situations. Even for companies and industries that, at least on the surface, seem like a strong growth area, both types of firms may not have the methods to ensure that their investments and the desired outcome from these investments will be safe and secure. Even more, there is the possibility, especially for private equity, that the investment may be larger than can really be supported by the growth potential for the company in question to see the desired return on investment.

Finally, the question was raised as to whether a private equity firm could take over a social networking site that is not performing well and turn it around. It would appear from the analysis in this report that venture capital might actually be a better method for this than private equity. A site that is already underperforming may simply present too much of a risk for private equity investors. However, a venture capital firm may be able to provide enough cash to a social networking site with a good idea that simply lacks the capital to advertise their idea and effectively manage the business. Then, once the site becomes more profitable, the venture capital firm can see a return on their investment without the concern about long-term growth and the ability to sell the investment.

The importance of this research is that it truly shows that dangers that are present in assuming that the latest trends in an industry can be a good investment. Instead, proper due diligence and a proper understanding of how to determine the value of investment are necessary. Without these things, it is quite possible for a firm, either venture capital or private equity, to invest money in a way that may result in a lack of return on an investment. It could also mean a major risk for a private equity firm that is looking for its own growth in the future.

article by: avi schwartz & arjun sethi
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India's Outsourcing - Is the end near?

As we had predicted earlier in our article. (China vs. India). Forbes recently published an article about wage inflation in India. Salaries rose 15.1% in 2007, up from 14.4% the previous year. The 2008 forecast: 15.2%. This would be the fifth consecutive year of salary growth above 10% and the appreciation of the rupee against the weakening dollar (11.5% in 2007).

I am not sure how the outsourcing market will survive this. Assuming a 15% year-to-year salary hike rate, and a 2007 cost advantage of 1:3 in favor of India, if U.S. wages remain constant, India’s cost advantage disappears by 2015 or sooner.

article by forbes: click here
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Canadian Capital and Equity: An Overview

Introduction
The purpose of this paper is to examine what Canada has to offer to the private equity market. What is meant by this is that this paper will examine the characteristics of Canada that make the country so inviting for private equity firms from around the world. In performing this analysis, a variety of economic indicators will be provided to show how Canada has a strong economy and innovative industries that are a good source of investment for individuals in the private equity market and for venture capitalists. At the same time, comparisons will be made to economic factors in the United States to show the relative strength of Canada.

Besides the actual strength of the Canadian economy, this paper will also examine the ability of companies that have been funded by private equity and venture capital togo public in the country. This examination will discuss the ease and reduced cost of going public in the country, as well as the strength of going public on the Toronto Stock Exchange because of its rules governing smaller companies. Comparisons will also be made between the rules and financials of going public in the United States as compared with going public on the Toronto Stock Exchange.

It should be noted at the outset that this report will contact several charts and graphs showing economic indicators and making comparisons with the United States. One reason for this is to show the strength of Canada against the United States. The other reason is to show the general strength of the Canadian economy. As an economy grows, the amount of venture capital and private equity that is invested in that economy typically increases (Vance 2005, 142). This information will be important to explain what Canada has to offer those looking to invest in private firms, and especially those who hope to take their investments public in the future.

Foreign Investment in Canada
An important cliché in the world of venture capital is that success breeds success, or perhaps more accurately: money brings money. People who are looking to make investments in private companies will often go where others are making investments because this is seen as a sign of strength at the present time, and growth for the future (Bartzokas & Mani 2004, 222). In the past few years, the amount of foreign investment in Canada as a percentage of the total venture capital in the country has risen from 3% in 1998 to 23% in 2005 (Sheahan 2005, 50). Figure 1 shows the yearly investments from venture capital in the country and the amount of foreign investments in venture capital.


What is also interesting is that the venture capital market in Canada has not grown much in the past few years. There have been years when the amount of venture capital invested was higher, but overall the market has remained fairly stable. However, the amount of foreign venture capital into the country has increased. What this indicates that is foreign investors are looking to Canada and its private companies as a way to grow their money.

One of the reasons for this interest by foreign investors in Canada is that the country offers prospects for growth that are not necessarily available in countries like the United States or European nations (Johnson 2007, 24). Investors looking to make money have largely tapped out industries in the United States and Europe. Those countries have markets that are saturated with investors who are looking for places to invest their money. Canada, on the other hand, until recently has largely been ignored by the private equity and venture capital markets. This surge in equity investing in Canada will likely continue as there is currently around $600 billion worth of venture capital available in North America. Put another way, there is $600 billion worth of funding that could potentially go to Canada. Obviously, all of it will not go to Canada, but the country does offer companies that are strong and have not yet been discovered by other venture capitalists.

While some might argue that simply having the attention of other venture capitalist and private equity investors does not make Canada a strong market, it is clear that people often want to go where the money is. In this case, more and more private equity is flowing into Canada. If nothing else, this will spark even more curiosity to the possibilities of investing in Canada. This can be a good way to at least catch the attention of the world. However, what will keep their attention and create a situation where they will want to invest in Canada is the strong economy of the country.

Canadian Economy
A recent survey of investment fund managers in Canada found that many fund managers believe that foreign investments are coming into Canada because of the relative strength of the Canadian economy as compared with that of the United States (Lee 2006, 43). Canada is the third fastest growing economy in the world behind Russia and the United States. Between 2002 and 2006, Canada saw an average rate of growth in gross domestic product of 2.7%. This is not far behind the United States that had a rate of real growth in GDP of 3.2% in that same time period (McKinsey & Company 2007, 6). Figure 2 shows the rate of real GDP growth for Canada and the United States over the last nearly 3o Years.


Even more, the year-to-year rate of growth in real gross domestic product has been slightly higher for Canada than the United States at times over the past five to ten years. Within the past two years, Canada’s yearly rate of GDP growth has actually been slightly higher than that of the United States. Overall for the past 25 years, the rate of growth in gross domestic product for Canada was right in line with that of the United States.

With Canada’s economy growing every year in line with that of the United States, there are other economic indicators that are inviting to venture capitalists and private equity investors. One of them is the growing strength of the Canadian Dollar versus the U.S. Dollar. In the late 1990s, the Canadian Dollar was only worth about three-quarters of the U.S. Dollar (Canadian Economy Online 2008). This difference in value meant that the cost of doing business in Canada as compared to the United States was greater. Even worth, any money made in Canada by someone living in the United States was worth much less than if that money had been made in the United States. Overall, the costs of making investments in Canada were greater and the rewards were less. Figure 3 shows the value of the Canadian Dollar compared to the U.S. Dollar since 1997.


However, in the past few years all of that has changed. In recent years, the value of the Canadian Dollar has increased sharply in relation to the U.S. Dollar. At the present time, the values of the Canadian Dollar and the U.S. Dollar are nearly equal. For private equity investors and venture capitalists, this equalization of the exchange rate between the Canadian Dollar and the U.S. Dollar takes away some of the uncertainty in making investments in that country. Even more, this equalization in the exchange rate takes away the costs and potential downfalls of investing in Canadian firms.

Finally, one other concern for potential investors in Canadian firms is the cost of debt. Many smaller and even medium-sized firms rely on debt to allow the companies the capital needed for expansion. In 2006, the average central bank interest rate in Canada was 4.5%. This is in relation to the average central bank interest rate in the United States of 5.25% at the same time (McKinsey & Company 2007, 6).

While this difference might not seem that important, it can add up to a lot of savings or cost for a company. For example, a 5-year loan of $1 million at 4.5% results in total interest payments of $118,581.15. However, a 5-year loan of $ 1 million at 5.25% results in interest payments totally $139,159.03. The savings to a company for this type of loan between the Canadian interest rate and the U.S. interest rate would be $20,577.88. This is money that could be used for expenses incurred by the company rather than paying back a loan (Financial Loan Calculator 2008).

The end result in all of this is that the Canadian economy offers several incentives that are not available to private equity investors in the United States. It is cheaper for companies in Canada to borrow money. At the same time, the stronger Canadian Dollar is not a potential hazard for a person or company that would wish to invest in a Canadian firm. What Canada offers to the private equity world is a strong economy where the cost of debt is cheaper than other major nations. At the same time, Canada’s economic growth is equal or even slightly above nation of the United States.

Another economic aspect that is worth mentioning is that Canada offers reduced corporate taxes and capital taxes. Canada has gone through a period of reducing corporate income taxes from a high of 28% in 2000 to a low of 23% in 2003. For the private equity world, this means that the companies in which they invest pay less in corporate taxes than their American counterparts. Even within Canada, there has been a reduction in corporate income taxes to encourage growth and investment (Department of Finance Canada 2003).

Another rule in Canada that might be of particular interest to private equity and venture capital is the elimination of the tax on excess capital that had previously been in place in the country. In 2003, the government called for the elimination of the federal capital tax over a five-year period for firms that held less than $50 million in capital. The government also began work in that year to completely eliminate the capital tax indefinitely.

Canada is offering investors the opportunity to allow more of their investments to work for the growth of their companies rather than paying the money in taxes. These more lenient tax rules that are currently in place over previous years means that companies in Canada truly do save money for themselves. This is especially true with the elimination of the capital tax. Companies can feel more free to hold on to access capital at the present for future uses rather than feeling the need to use the money for fear of paying out excess taxes.

Expanding Industries in Canada
One of the aspects of Canada that makes it so ripe for foreign investment in the form of private equity and venture capital is the growing industries in that country in innovative sectors. One such sector that is growing in Canada is the environmental technologies industry. Canada is a country that is rich with nature resources. However, in recent years, companies have begun to focus just as much as the development of renewable energies and technologies in the field of renewable energy. This has led to the creation of many companies in the Western portion of Canada that are developing new technologies in the energy sector that are being exported to countries around the world (Affleck & Dunn 2008).

This industry in Canada is focusing not only on the creation of new technologies, but also the design of environmental services and analysis of plans and projects for more environmentally friendly organizations. This industry is also working with other industries inside and outside of Canada to educate citizens about renewable and cleaner energies. The companies in this industry are also building partnerships with other companies to increase the importance and knowledge of renewable technologies (Affleck & Dunn 2008).

For venture capitalists and private equity, the industry of renewable energy is an untapped and potentially profitable industry in Canada. The reason for noting this is that Canada is not only a country with nature resources. Instead, it is also a country where companies are working to create new technologies to preserve nature resources and to create a cleaner environment. The future of this industry is likely to grow as more and more people become concerned about the state of the environment and the ways in which it can be cleaned up for future generations.

Business Regulations and Going Public in Canada
One of the concerns of private investors when they step outside of their home country is that the regulations that government corporations will make growth more difficult. This is especially true for private companies where there can be a lot of regulations that have to be followed in order for private equity or venture capitalists to make investments. In many of the provinces of Canada, the rules regarding private investors allows a company to have around 25 investors and to raise less than $3 million in funds before having to register with provincial governments. The registration rules change based on certain characteristics of the companies and the investors seeking to infuse capital into companies (Carpentier, L’Her & Suret 2000, 61).

The concern, however, is that the registration rules and other compliance regulations in Canada might cause undue burden upon smaller companies which would prevent their growth. Carpentier, L’Her & Suret (2000, 61) investigated this particular issue. What the researchers found was that various rules in Ontario about financial registration with the Ontario Securities Commission did not cause unnecessary burden on small companies in the province. In the end, it would appear that the rules governing company registration, at least in Ontario, do not prevent companies from raising capital and growing in size.

While this one particular study may not provide sufficient evidence to make inferences about business regulations across the country, it does indicate that in Ontario companies have not significantly suffered because of various reporting or registration requirements. This information is important because most private equity investors and venture capitalists invest in companies in any country with the eventual exit strategy of taking a company public (Johnson 2007, 25). If the ability to take a company public is not available, or if the costs are too high, then this is likely to dissuade some investors and venture capitalists from even making investments in the first place.

For Canada, the ability for small firms to go public is another strength that is offered to the venture capital and private equity worlds. In the United States, it is difficult for a company valued at under $100 million to issue an IPO. The reason for this is that American stock exchanges have very rigid listing requirements. A company cannot simply expect to offer stock and have that stock listed on a major stock exchange in the United States. Even more companies that are valued between $200 and $300 million, the requirements can be tough to navigate (Panio 2007).

The Toronto Stock Exchange has realized the need for easier listing requirements for smaller firms. Rather than having a set of listing requirements that are rigid and must be met, the Toronto Stock Exchange has no listing requirements at all. Instead, the stock exchange uses a system of nominated advisors who are used to determine if a public company should be listed (Panio 2007). The result in this is that smaller firms that show great potential and a solid management team and business plan can compete on an equal level with large firms that are worth billions of dollars.

Even more, the Toronto Stock Exchange has a sub-unit known as the TSX Venture Exchange. This is an exchange where smaller companies are able to trade. In offering this variation, the Toronto Stock Exchange provides a place for Canadian companies to go public where equal size American companies would never be able to get listed by a major exchange in the United States. In fact, the average value of companies listed on the Toronto Stock Exchange is $1.35 billion. However, the average value of companies listed on the TSX Venture Exchange is only $29.1 million (Panio 2007).

Even for larger companies that wish to go public and get listed on the main Toronto Stock Exchange, there is an advantage over listing on the New York Stock Exchange in terms of cost. The average IPO on the New York Stock Exchange is $470.6 million. This is almost five times the average size of an IPO on the Toronto Stock Exchange of $99.6 million (Shutt & Williams 2000, 2). Again, it is easy to see that even for large firms that wish to go public, there is a distinct size disadvantage of trying to go public in the United States. Only the largest firms are able to meet the listing requirements and compete to be listed on the New York Stock Exchange.

Another concern that is present for venture capitalists and private equity investors is the actual cost of going public at all. The cost of going public is typically listed as a percentage of the total proceeds that are raised in an IPO. Because of this, the total percentage costs of an IPO are usually lower for a firm with a larger IPO size. For a firm with an IPO valued at between $10 million and $50 million, the percentage costs of going public on the Toronto Stock Exchange is around 10%. This is less than the 14% costs of going public for the same size firm on the New York Stock Exchange. Even more, the percentage cost of a firm with an IPO of less than $10 million is 12% on the Toronto Stock Exchange and nearly 18% on the Nasdaq (Shutt & Williams 2000, 2). There is no cost available for a firm this sized on the New York Stock Exchange because a firm of this size could not get listed on the NYSE. Figure 4 shows the direct percentage costs of going public for the Toronto Stock Exchange, Nasdaq and New York Stock Exchange.

Finally, investors who are seeking an IPO as an exit strategy for their investments want to have some type of idea of the performance of the larger market upon which the IPO will exist. It must be remembered than an IPO is not merely a short-term exist strategy for a private equity investor or venture capitalist. Instead, an IPO can also be a long-term investment in the company in which the initial investment was made. However, part of this is not only based on the growth and strength of the company that is taken public. Instead, part of the ability to see an IPO grow is based on the relative strength of the larger market on which the company is listed.

One of the ways to determine the relative strength of a stock market is to look at the level of volatility and growth over a period of time. Figure 5 shows the level of change in the Toronto Stock Exchange, the Nasdaq, and the New York Stock Exchange. As the figure indicates, all three of the markets have moved with some relation based on larger economic conditions. However, the past three or four years, it does appear that the Toronto Stock Exchange has seen a sharper increase in value over the Nasdaq or New York Stock Exchange.


However, simply looking at straight performance is not enough to determine which market has had stronger growth through various periods over the past 10 years. The reason is that the values of the stock market indices are not standardized. By standardizing the values of the indices, a direct comparison can be made based on the actual levels of growth of each.

Figure 6 shows the standardized performance of each of the three stock market indices. It should be noted that each market index was standardized to start at a value of 100 for the month of January 1997.

As the figure shows, the Nasdaq experienced much greater growth around the turn of the century. However, those gains quickly fell in 2001. The Toronto Stock Exchange and the New York Stock Exchange have moved nearly in line with each other for the past 10 years. Specifically, from January 1997 through December 2007, the Toronto Stock Exchange had a 124% increase in its value. During that same period, the Nasdaq had an 92.8% increase in value and the New York Stock Exchange experienced a 123.6% increase in value (Yahoo Finance 2008).

The Toronto Stock Exchange was technically the strongest performing stock exchange in terms of returns of all three. However, the difference between the returns for the Toronto Stock Exchange and the New York Stock Exchange were negligible. What is important for the private equity world is that they can invest in Canadian companies and then take them public on the Toronto Stock Exchange for less cost and still expect to see the same rate of growth or even greater rate of growth as the Nasdaq or New York Stock Exchange.

Conclusions
The purpose of this paper was to show what Canada has to offer the world of private equity and venture capital. What should have been gained from this report is that Canada has a lot to offer private equity and venture capital in the form of a strong economy, increases in the amount of foreign investment coming into the country, a strong currency, and IPO opportunities that are easier and less costly than in the United States. On the surface, it might seem like Canada is merely a smaller economy that must compete with its larger neighbor to the south. However, the information that is available shows that the Canadian economy is as strong, if not stronger in some ways, than the economy of the United States. This means that the potential for growth for small companies is strong. Even more, the ability to take a company public in Canada on the Toronto Stock Exchange is easier for small firms, and is less costly for firms of all sizes as compared to the United States.

In the end, Canada can offer private equity and venture capital the ability to know that investing in companies in the country offers the ability to see real growth with reduced taxes, fewer restrictions on small companies being listed on a major stock exchange, and the ability to invest in untapped and unnoticed industries. In essence, what is available form Canada is the ability to invest in industries and companies that have been largely ignored in the past. Rather than investors competing in a country like the United States that is saturated with private equity, these people can look for the best opportunities and the highest potentials for growth in a country where companies have largely grown and expanded on their own until just a few years ago.

article by: simon beckel and arjun sethi
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Due Diligence Investment Of India's Businesses

The purpose of this paper is to examine what should be the due diligence for firms and investors that are seeking to invest in small and mid size companies in India. In the period from August 1991 through August 2007, foreign investors pumped some $56 billion worth of capital into the country. Within just the past year, the amount of capital invested in India from foreign entities and investors has totaled nearly $6.5 billion (Ministry of Commerce and Industry 2007, 1). It is quite clear that venture capitalists and private equity firms see strength in the future potential of the Indian economy and people. However, making any investment, even in a country where so many others are investing their resources, still requires due diligence to determine the appropriateness of the investment.

In order to examine what should be the due diligence process for firms seeking to invest in small and mid size firms in India, this paper will begin by looking at the proper due diligence process from a theoretical process. The information presented will examine the process that should be followed and why these processes of due diligence are so important. Following this discussion, information will be presented as to the actual due diligence process that is being used by venture capital and private equity investors in India. A comparison of the similarities and differences will also be presented to determine where these firms are following the entire due diligence process, as well as where they may be cutting corners in the name of making money.

The Theoretical Due Diligence Process

The first step in determining the appropriateness of a small or even mid sized company in India for investment purposes is to actually determine if a company or entity is a rogue. This may seem odd, but Davies (2004, 157) notes that most small and mid sized companies in India are run by well-intentioned individuals who are seeking to be able to fund growth through the acquisition of venture capital or private equity. However, there are those individuals who have other motives for finding investment dollars from outsiders. These individuals may set up a business entity and have the appearance of running a typical company. However, the reality is that these rogues are simply seeking to take money from others with no real intent to run the business properly.

Davies (2004, 158) notes that part of this step in the due diligence process calls for overcoming any initial charm that may be presented by a potential recipient of investment resources. Instead, the investor must investigate the people who are running the company, as well as the company itself. In order to overcome cultural differences between Western companies and those in India, this may require doing some cultural homework about how small and mid sized businesses and business owners operate. This might even require gaining help from others who are more skilled in Indian business practices.

The next step in the due diligence process is really the beginning of the screening process to determine if further due diligence is necessary. Once potential investors have determined that a potential investment company is real and is in business for serious matters, it is time to actually assemble some basic information to determine if further due diligence is worth the time and effort. This initial screening process is really about quantitative data to make a decision about whether the potential investment shows any potential value based on what the investors desire in an investment (Dewan 2001, 90).

For example, investors might determine that they want a small company that has annual revenue of at least $2 million. If a company that is being considered for investment is found to have annual revenues of less than $2 million, then continuing with an in-depth due diligence process is not necessary. In addition, investors might want a potential investment to have been in business for a specific number of years or to have a certain level of sustain customers. Again, not meeting or exceeding these quantitative criteria would render further due diligence to be unimportant (Dewan 2001, 90).

Once the initial screening process has been completed and a potential investment has passed this process, then the true due diligence work begins. Whereas the initial screen process involved the collection of a small amount of quantitative data, the full due diligence process requires the collection of a large amount of data about the potential investment. First, investors should acquire a complete picture of the affairs of the company in terms of how the company has been run from its inception to the present (Committee on Negotiated Acquisitions 2005, 1.1).

It is important to realize that having a picture of the assets and liabilities of the potential investment is not enough. It is also necessary to know the location of the assets that are held by the company. Even more, it is important to completely understand the liabilities of the company. This means understanding the different type of liabilities that are present, such as loans or even legal actions. It also means understanding how much of the potential investment company’s budget goes to paying for and handling liabilities, especially legal liabilities (Committee On Negotiated Acquisitions 2005, 1.1).

Aside from the information that might be found on a balance sheet or in legal documents, the due diligence process also requires the acquisition and investigation of public perceptions about the company in question. An understanding of how the company is viewed by the public, as well as the level of respect that is present for the company’s products or services should be put together. At the same time, any existing relationships between the potential investment company and other entities or companies should be known. All of this information really points to potential future growth or operations that might be built off of existing operations and the background of the company in question (Committee on Negotiated Acquisitions 2005, 1.1).

The next step in the due diligence process is to use the information that has been obtained about the company and its products or services to determine if there is room for future growth. This part of the due diligence process requires both information about the existing technologies or services that are present and putting that together with a plan that would hopefully result in growth (Dutz 2007 177). This is where investors and company leaders must come together and make decisions about where the company is headed in the future. In addition, discussions and decisions about possible research and development into improving existing technology or services, or creating new technologies and services, must take place.

This is the point of the due diligence process where investors have to really take what they know about the company and its technologies or services and determine if they think that future growth is possible. Now, this part of the process requires listening to the goals and ideas of the business owner or owners. However, it also requires that the investors think about their positions within the company if they decide to invest financial resources. This is the part of the due diligence process where investors have to determine the level of commitment that is present on the part of the company’s owners or operators to work with them if an investment deal goes forward (Millar & Chandramouli 1999, 327).

Investors should realize that a potential investment may pass all the steps of the due diligence process. However, if the current owners of the company do not have the proper attitude or desire to work with investors, then the potential value of the investment may be in jeopardy. The purpose of investing money in a company through venture capital or private equity is to reap returns on those investments. The owners of a company may not have the proper desire or attitude that is necessary to work with investors to create the largest potential growth for all parties involved. If this is the case, then the level of risk might actually increase because investing in the company in question might mean years of fighting and disagreements that could actually hurt any changes of growth.

Another part of this final step in the due diligence process is to make decisions if the structure of a potential investment is conducive for a potential investment. It is likely that many small businesses in India are going to be run by the individuals or families that started them. However, mid sized companies might actually be at a stage where they have become decentralized from the original founders. This decentralization of power and authority in the company might make the transition from private ownership to having investors more difficult. At the same time, this decentralization of power could also mean differences in how the company attracts talented workers and the type of benefits or working environment that is present. All of these variables can play a factor in the potential future value of an investment (Millar 2006, 66).

In total, the theoretical discussion of how the due diligence process should work indicates that a lot of time and work goes into the investigation of a possible company in which to invest. While the discussion that has been presented might make it seem like the information that is needed for a full due diligence to take place can be acquired relatively fast and easily, this is not the case at all. It could actually take months to fully investigate a company and its products and structure. This might be especially true for a small company that may not have the same type of formal record keeping system as a larger company.

The entire process of due diligence is really about obtaining as much information as possible so that investors can make a decision about whether they believe a company’s growth potential is large enough so that they reap the type of dividends desired from their investment. In this regard, due diligence is somewhat subjective in nature. While information and data are used to make the final investment decision, investors also have to determine if the conditions are such that they feel comfortable taking the risk of lending a small or midsized company in India what might be millions of dollars over a several year period.

The Practical Application of Due Diligence

As with so many things, there is a great difference between theory and practical application. This is true for the due diligence of investing in small and mid sized companies in India. The previous section of this paper presented how the due diligence process should work and all of the steps that are involved. This section of the paper is going to present how venture capital firms and other private equity investors actually complete the due diligence process. Information from people in the industry, as well as actual due diligence guidelines from banks, legal advisors, and venture capital firms will be discussed.

One of the first steps that was mentioned in the theoretical discussion of the due diligence process was that an initial screening process takes place before the full due diligence occurs. Key Bank, which is a full service bank and financial company based in Cleveland, Ohio, states that their first step in the due diligence process is the initial screening of a potential investment (2008). The bank explains that the initial screening may occur in order to limit potential investments to certain areas, such as companies in the technology or construction sector. In addition, the screening process is to limit investments to companies that meet certain size or revenue criteria.

While the initial screening process is the same in practical application for a company like Key Bank, the actual due diligence differs. First, the bank explains that the actual gathering of in-depth information about a small or mid sized company is often not possible. The reason for this, especially for a small company in India, is that there is simply not enough information for a true formal evaluation to take place. In addition, the bank states that the lack of formal information may actually make the formal evaluation of the potential investment not desirable (2008).

Key Bank does state that much of the due diligence evaluation is based on the actual owner or entrepreneur of the company in which an investment is being considered (2008). They look to see if they like the qualities of that person, such as leadership ability, ideas about the product or service, and certainly the business plan that the individual has put together for the future of the company. In this regard, the due diligence process is somewhat more subjective about how the investors feel about the person running the company and how they view his or her plans for the future and his or her ability to see those plans through to fruition.

As this explanation of the investment process shows, the reality of investing in a small business in India is that the decision of whether or not to invest is based much more on subjectivity than analyzing actual data. This is due to the fact that there may not be a lot of data to analyze. Instead, potential investors have to listen to the owner of the company and get to know his or her leadership and business skills. It is from these qualities that investors can truly determine if they feel comfortable making an investment in the company and if they think they will see a return on that investment.

Fenwick & West, LLP, a law firm providing legal services to investors and companies based in California, provides another means of seeing the differences between the theory and practical application of due diligence. They state that one of the criteria of determining if an investment in a small or mid sized firm in India is appropriate is the ease of taking a company public as an exit strategy (2007, 1). What is being explained here is that the firm is concerned with their ability to exit as investors and to reap financial rewards in the form of an IPO for the company in which they have invested. If they think that an IPO is not going to be likely, then this is an important consideration that is potentially going to prevent an investment from taking place.

In fact, Fenwick & West state directly on their 2006 Update to Structuring Venture Capital and Other Investments in India that “exit valuation and ease of exit for investors are the most important considerations” (2006, 1). They are more concerned and advise their clients to look more closely as the ability to get out of the investment, as well as the value of the exit. In reality, this is not that surprising because venture capital and private equity investments, regardless of where they are made, are about obtaining returns for investors. In this regard, investors are likely to be more concerned with the returns they are going to see than with the actual product or service that is offered by the company.

Fenwick & West also states that another consideration for venture capital investments in India is the level of comfort that the investors have with the laws governing stock and shareholder rights in India (2007, 1). If a company is to go public in India, the investors must be comfortable with the laws that exist in that country and how they differ from laws in the United States. Specifically, they must be comfortable with how the Indian laws treat preference shares, or shares of stock that entitle the holder to a fixed rate of dividend payments that are made before payments to other stockholders (Marsh & Soulsby 2002, 255). Again, the idea is for investors to be comfortable with their ability to reap financial rewards from their investments in an Indian company.

Murali (2007) also explains that venture capitalists are often looking for higher rates of return because they are taking on riskier investments. With this in mind, it is explained that venture capitalists are usually seeking a product or service that has growth potential, not only in the product or service but also that it is targeted toward a growing sector of the country’s economy. This might be an expanding area of consumer demand or an untapped market where there is very little competition. In either case, the idea is to find a company that is directing its product or service toward those consumers where a demand exists or is likely to exist.

At the same time, Murali (2007) does state that venture capitalists are also concerned about the leadership qualities of the owner, as well as the type of structure that is present in the company. The investors are interested in how the company functions as a team and how it brings innovation to the market. This does parallel with the theoretical side of due diligence because of the discussion of the importance of understanding whether a company is centralized or decentralized in leadership, as well as whether there is strong leadership to oversee the various internal functions of the organization.

The construction sector in India is one area in which the desire for strong growth can be seen. The real estate industry in India has received about $10 billion in investments from private equity firms within just the past year. Wachovia Bank, a bank and financial company in the United States, made a $57 million investment in a mid sized real estate company in India within the past year. Part of the reason for this rush to invest in Indian real estate has to do with the 30% increase in real estate values within the past year (Hussain 2007). Investors from the private equity sector are seeing the potential for double-digit gains in a very short amount of time. Rather than seeking to invest in companies that might be in sectors that lack the current growth of the real estate market, investors are seeking to put their money in an area where growth is taking place at the present time.

Differences and Similarities in the Due Diligence Process

The discussion of how the due diligence process is carried out in practical application reveals both similarities and differences to how the process should work. First, there is very much a similarity to theory in the initial screening process of seeking out potential investments. Venture capital firms and private equity investors seek out companies in which to invest that meet certain criteria. These investors may only want companies that operate in the real estate and construction industries or the information technology industry. In addition, they may only want companies that have shown a certain level of revenue growth. Whatever the case may be, it does appear that most investors do take part in this initial screening to make choosing a potential investment easier and within their own comfort zones for investments.

Another similarity that exists between theory and practical application is the examination, at least in some part, of the qualities of leadership and innovation of the owner or entrepreneur that would be receiving the investment. It appears that investors want to know that the owner of the company has the skills and qualities that they feel are necessary for a company to grow and prosper. They also spend at least some time examining the internal structure of the organization and how the business is run and how innovation takes place.

However, there are several differences that exist between theory and practical application of the due diligence process. First, there appears to be less of a formal review of the financial data of companies that is suggested in theory. From a practical standpoint, many small businesses and even some midsized businesses in India simply do not have the background for a full and complete investigation of financial records to take place. Because of this, some investors do not take the time to search for information that may not be present or might not be completely accurate even if available.

Instead, they look more toward the potential financial outcomes of their investments in small and mid sized companies in India. They plan for the ease at which they can exit an investment by helping to take a company public on the stock market in India. In addition, they also examine how their ownership in the company will transfer to the stock available in the publicly traded company, and how much preference they will have over other shareholders based on the financial laws of India.

In the end, the real difference between the theory of due diligence and the actual application really appears to lie in the importance of the rewards that are to be gained. The theory of the due diligence process seems to focus on finding a company with strong ideas and strong leadership. The reality of the process, however, is that investors are looking for companies that can grow in a relatively short amount of time and reap huge dividends. Investors are also looking for companies in which they will have a certain level of control and be able to exit as easily and hopefully efficiently as they entered the investment. They are looking more for a way to make money by taking advantage of a hot sector of the Indian economy or an untapped market much more than they are looking to see an innovate idea grow. Unless, of course, that innovate idea happens to be in the hot sector of the economy or be targeted toward those consumers in India with the financial means the desire to purchase the product or service in question.

article by: arjun sethi
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The Private Equity Value of LinkedIn.com to News Corp and the Wall Street Journal

LinkedIn.com is a private firm operating an internet web portal to foster the development of social networking for professional development and career enhancement in the business community. LinkedIn has attracted an increasingly large number of visitors and registered members, and currently has approximately 3.2 million visitors per month and an annual growth rate in visitors of about 485%. As a social networking platform, LinkedIn has the potential for use as a medium for classified advertising for businesses and professionals in areas such as job openings, professional services, and goods aimed specifically at the business community. At the same time, traditional print media including the Wall Street Journal is experience a downward trend in classified advertising because of the increased trend towards use of online resources by the business community. An acquisition of LinkedIn by News Corp, the parent firm of the Wall Street Journal, would provide an alternative venue for the newspaper to present classified advertising t to the public, increasing the newspaper’s revenues despite the shift in the habits and preferences of the public. Such an acquisition would also provide greater legitimacy for LinkedIn as a source of business networking and information, and increase the total number of visitors as well as its revenue per visitor.

LinkedIn is a social networking website and portal, which allows individual users to establish networks among individuals with similar ideas and interests. Each member of a network can be considered a node that is linked directly with other primary nodes and indirectly with secondary nodes linked to their primary nodes. The online social network service was originally developed in the 1990s with various types of registration or search services. The use of more advanced business models and technologies and business models now allows users to place an extensive amount of information in a posting and to establish complex networks. The social network services on the internet pursue business models intended to attract different demographic and psychographic segments of the internet market. The social networking approach on the internet is effective in attracting users because it provides an automated and scalable method for individuals to expand the scope of their social networks based on their personal interests and perceived needs.

LinkedIn is specifically targeted at business professionals in an age demographic between 30 and 60. Firms use LinkedIn for various purposes such as keeping internal and remote employees connected with each other and to allow employees to share information on best practices. In addition, firms can use the networks to monitor competitive intelligence by examining the postings by individuals in other firms. Employees can also use the social network to identify new job opportunities in other firms through their connections with peers in their network. In many respects, LinkedIn functions as a public knowledge management. At the current time, LinkedIn is the fourth most popular networking service website, behind Yahoo 360, MySpace and FaceBook. At the current time, MySpace is owned by News Corp and targets a general age group. FaceBook is a privately held firm targeted an adolescent and young adult age group.

In the past year, LinkedIn has experienced a very rapid rate of increase in the number of visitors to the site from approximately 500,000 per month to approximately 3.2 million, which is an annual increase of 485%. In addition, a survey conducted by the Institute for Corporate Productivity found that 65% of businesses are connected to a social network such as LinkedIn for personal and professional purposes. Figure 1 shows the number of monthly visitors for LinkedIn for the past year


In contrast to LinkedIn, the rate of growth in other social network service websites such as MySpace and FaceBook are substantially lower, with the rate of growth related to the length of time the specific service has been available in the marketplace. MySpace was founded in 2003 and is one of the older social networking sites on the internet. The business model was aimed at a broad demographic and psychographic segment of market by emphasizing the ability to create social networks based on a variety of personal interests and topics. The website offers all features at no charge, deriving its revenues from advertising. MySpace is considering adding premium features in the future. The advertising revenue model has been successful because of the large number of members and visitors to the site, attracting 65.5 million visitors in the past month (see Table 1). The rate of growth of the website based on the number of users, however, is flattening and has fallen from a peak of 70 million visitors in June 2007. The user data suggests that the business model used by MySpace is approaching maturity in the social networking market. FaceBook uses a business model substantially similar to that of MySpace, but targets an adolescent and young adult demographic. The social networking use of FaceBook is often more informal than on MySpace and involves interests and subjects related to the young age demographic. FaceBook was launched in 2004, approximately one year after MySpace. FaceBook has approximately 30 million users and is still in a strong growth phase with the number of users increasing by 126% in the past year. The general pattern of development of the social networking websites suggests they undergo a period of very rapid growth for about four years after their launch, following by tapering of the growth rates.

Figure 2 shows the comparative number of visitors between the three sites over the past year. The data suggests that LinkedIn is in the rapid growth phase of market penetration, which is likely to continue for another two to three years. FaceBook is also likely to continue to experience substantial growth. MySpace, however, has entered the maturity phase of growth with its present business model. The growth rates, however, are subject to technological change and innovation, with the firms in the social network website industry potentially resuming growth if they develop additional services to attract a wider market and more extensive customer usage of the website.

One of the difficulties with valuing the firms in the online social networking industry is the absence of a business model producing consistent and predictable revenues. Because MySpace and FaceBook depend on advertising revenue for income in their present business model, revenues are dependent on the number of visitors rather than the services used by the visitors. In contrast, LinkedIn derives revenues from premium services sold to personal and business users. While revenues depend on the number of users visiting the site, they also depend on the amount and type of services used by the visitors. This provides LinkedIn with a revenue advantage over its competitors, which is due primarily to the targeting of the business community that is willing to pay for social networking.

LinkedIn currently has 6.4 million registered users, with only 3.2 million visits each month. This suggests that many of the registered users do not visit the website regularly. With the revenue approach of the firm, however, the frequency of visits of registered members does not affect income. The estimated income for the firm in 2007 is $25 million, which is based on the amount reported in 2006 and the growth rate in the number of registered members and users. The value of the firm as a stand-alone entity can be estimated from the current revenues of the firm extended the number of registered members using a discounted cash flow model and assumptions about the ability of the website to increase revenues per visit. Various types of sensitivity analyses can be used to determine the value of the firm in different scenarios.

In the first valuation approach, the revenue per member can be determined by dividing the number of registered members by the total revenues of the firm. The firm is forecasted to earn $25 million in 2007 with 6.4 million members, or $3.91 per member. If the rate of growth follows the same pattern as with other social networking websites, LinkedIn has the potential to attract 85 million members by 2012. This valuation model assumes that the rate of growth will taper off dramatically in the next several years following the same pattern as the other social networking websites. This approach assumes that the rate of growth for LinkedIn will be 300% in 2008, 150% in 2009 and decline to 10% in 2010, the fifth year of the websites operation. Another assumption in this valuation approach is that the cost of operations is scalable as the fixed overhead is distributed among a larger number of members and users. As a result, the free cash flow per member is estimated at 60% of the total revenue per member or $3.91*60% = $2.34 per member. The analysis also assumes that the cost of capital for discounting estimated cash flows is 10% and that LinkedIn will not add any additional revenue producing services over the next five years. Table 2 shows the net present value of the anticipated cash flow from LinkedIn at $550 million using these growth and revenue assumptions. The acquisition of the firm at a cost less than $550 million would produce value for the combined business entity.

The optimal growth estimate is also based on qualitative assumptions about the effectiveness of various initiatives at LinkedIn to increase relevancy and accessibility for its target business user market. One of these initiatives is to allow users to post business-style photographs that are intended to assist individuals in a network recalling the identity of other members. Other initiatives are the development of industry conference websites within the LinkedIn platform for the open exchange of ideas and a classified job board where employment openings can be posted.

To determine the value of LinkedIn under the most pessimistic scenario, the growth assumptions are modified to a growth rate of 225% in 2008 and 100% in 2009. At the current time, LinkedIn is adding about 36,000 new members a day, which corresponds to the estimated growth rate of 225% in 2008. These assumptions are based on the limited target market segment of LinkedIn focusing on the business community, which is likely to represent a smaller market than the more general MySpace and FaceBook markets. In addition, competition is intensifying for the social networking among business users, with the major competitor websites offering some business services. Table 3 shows the net present value of the anticipated cash flow under these growth conditions and a 10% cost of capital at $366.6 million.

The estimates of the stand-along value of Linked-In with no changes to the service offerings or synergies to reduce costs and develop cross-selling indicate that the firm has a market value between $366 million and $550 million. If the firm can develop synergies through an acquisition by News Corp, it is likely that the firm can enhance its revenues per member. One of the key synergies for revenue enhancement would be the use of LinkedIn as a portal for classified advertising aimed at the business community, with a direct association between LinkedIn and the News Corp subsidiary, the Wall Street Journal.

There is a trend among traditional print newspapers to extend classified advertising to online venues. Revenues from classified advertising for employment have fallen by 42 nationally since reaching a peak in 2000. The decline in classified advertising revenues is because of the decrease in the number of readers of newspapers and the substantially lower cost structure for advertisers from online advertising. At the same time revenues on websites specializing in employment have been increasing. Monster.com is the leading online firm offering classified employment listings, and had $650 million in revenues in 2006 with a 15% rate of growth in classified advertising sales. This trend creates the possibility that an acquisition by News Corp and an association between the Wall Street Journal and LinkedIn could obtain a portion of the online classified advertising market to increase revenues above the level the firm would obtain as a stand-alone entity. It may be possible for News Corp to develop cross-selling or dual membership options between MySpace and LinkedIn to accelerate growth of LinkedIn memberships and use of premium services. In addition, the association of LinkedIn with the Wall Street Journal could confer greater legitimacy on LinkedIn in the business community and the use of an online classified section, which could accelerate membership growth.

The valuation of LinkedIn as a firm controlled by News Corp requires an assessment of the additional revenues the website can generate from classified advertising. The fundamental assumption in this analysis is the ability of LinkedIn to obtain 2% of the revenues obtained by Monster.com in its first year of operation and a 10% annual rate of growth in revenues over a five-year period. In addition, the analysis is based on the most pessimistic estimate of the rate of growth of the number of members of LinkedIn and the revenues generated by the members. The valuation also assumes that there is no increase in overhead for LinkedIn from the classified advertising because of synergies from and other units of News Corp such as MySpace. Table 4 shows the five year cash flow and net present value of LinkedIn using the slow growth rate and additional classified advertising revenues.

This analysis suggests that the value of LinkedIn when the synergies with the Wall Street Journal and other News Corp holdings is approximately $425 million, which is near the mid point between the optimistic and pessimistic estimates of the value of the firm as a stand-alone business. This value also represents a revenue multiplier of 17 using the forecasted revenues for 2007, which is a realistic valuation based on the income potential for the firm in the short-to-medium run. It is possible that News Corp could acquire the firm at a price substantially below this valuation because of the relatively low amount of capital provided by the firm’s investors. At the same time, it is possible that a bidding war could occur following an offer by News Corp for LinkedIn because of the extremely positive market sentiment for firms involved in the online social networking business. If a bidding war should occur, News Corp should consider the stand-alone net present value of LinkedIn under the most optimistic growth scenario as the upper limit for a bid.

article by: simon beckel & arjun sethi
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Private Equity in Pakistan, Israel, and Egypt

Abstract: The nations in the Middle East represent an emerging opportunity for global private equity investments because of the rapid rate of economic growth in the region. Israel has received a substantial amount of private equity investment, but it has been focused primarily in the high technology sector in which the nation enjoys a competitive advantage. Pakistan and Egypt, however, have a larger number of private equity opportunities than Israel in a variety of industry segments. Both Pakistan and Egypt have implemented structural reforms to foster economic growth, and have well developed stock exchanges to support various exit strategies for private equity investments. Since 2004, Pakistan has increasingly attracted private equity investments and is ranked at 20 in the world based on volume of investment. Egypt, however, has not attracted a significant amount of private equity investment. The political risk in Egypt is relatively low while the political risk in Pakistan has increased resulting in the imposition of a state of emergency. The analysis of the risk and reward factors indicates that Egypt represents an excellent opportunity for private equity investments. Pakistan remains a good opportunity for private equity investments, although commitments should be postponed until there is a resolution to current political issues. While Israel continues to offer good opportunities for private equity investment, the range of opportunities is limited.

Introduction
The trend towards global convergence of financial services and infrastructure has also impacted the private equity industry, with private equity and venture capital examining opportunities in all nations. Global private equity investments have increased steadily over the past five years following a dramatic decline during the global recession in 2001. In 2005, global private equity investments were approximately $131 billion. Europe and North American is the largest source of private equity capital. The placement of private equity has traditionally focused on firms in the industrialized nations, with Europe and North America accounting for 80% of the private equity investment in 2005. The Asia Pacific Region received 16% of the global private equity and the Middle East received 3% with the Middle East broadly defined as the Middle Eastern and North African nations. The remaining 2% of the global private equity was placed with firms in Latin America and Africa.

One of the outcomes of financial globalization is greater efficiency in the movement of capital across national borders, which theoretically results in greater resource allocation efficiency. With private equity, globalization theoretically allows the private equity overhang, or excess supply of private equity capital, to flow to geographic regions where there is no overhang. In the United States and Europe, there is a substantial private equity overhang, which had a cumulative total of $471 billion between 1998 and 2004. This large overhand indicates the private equity industry could not find sufficient opportunities in the American and European regional markets to absorb the full amount of available private equity investment. During this period, however, the Middle East had a negative private equity overhand of $3.11 billion. The differential in overhands suggests that there is a high demand for private equity in the Middle East, which represents an opportunity for private equity placement form sources in the United States and Europe unable to find suitable domestic opportunities.

Risk Factors
Although financial globalization has created the means to support the capital flows, global private equity placement decisions are based on the assessment of the risks associated with the nation where the business will be located, which is a risk factor in addition to any specific risks associated with a firm or industry. Some of the considerations contributing to the country risk of each nation are political stability, the amount of corruption, and the extent of development of the financial infrastructure such as stock markets and regulatory structures. The degree of the risk when investing in developing nations is dependent on the stage of transition in the process of developing property protections under law and mechanisms for smaller and rapidly growing firms to access sufficient capital. Political risk factors can include the threat of expropriation, the threat of civil unrest and the effect of governmental monetary and fiscal policies on the economy.

The Middle East represents an opportunity for private equity placement because of the increasing trend in the region towards institutional development and political stability, and the negative private equity overhand in the region. Small and medium enterprises (SMEs) have traditionally had difficulty raising venture capital and mezzanine capital from the existing debt and equity structures in these nations, which have given preference to larger more established firms. Larger firms may also have difficulty raising capital for mergers and acquisitions in local markets. At the same time, the governments in the region are developing policies to attract foreign private equity investments by improving liquidity in equity and debt markets. The opportunity for private equity investment in the Middle East is also based on the accelerating rate of development of the markets and the growth of the economies in the region. An additional factor increasing the attractiveness of private equity investment in the Middle East is the lower cost of the labor input for production, which increases the competitiveness of firms in labor-intensive industries. Because of political and religious factors, Israeli firms cannot easily access markets in other Middle Eastern markets. As a result a private equity investment in an Israeli firm is not functionally an investment in the Middle East, but rather an investment in the domestic Israeli market and possibly in export to global trading partners. In contrast, a private equity investment in a nation such as Egypt or Pakistan supports the ability of the firm to access markets throughout the Middle East as well as global trading partners.

Purpose of This Study
The purpose of this study is to examine the viability of Pakistan and Egypt as an alternative to Israel for private equity investment in the Middle East. In the past, the nations in the Middle East have had a slow rate of productivity growth because of low investment in education, poor governance, and laws restricting commerce and free trade. At the same time, Israel has attracted a large amount of private equity because of its use of transparent laws and regulations for financial transactions, a well developed financial market, and protections for property rights. Many Middle Eastern nations such as Pakistan and Egypt are in the process of developing an infrastructure changes to establish the conditions necessary to achieve higher productivity and a more rapid rate of economic growth. The analysis examines the state of development of Pakistan and Egypt to determine if they represent a more attractive venue for private equity investment in the Middle East than Israel.

Private Equity
Private equity is the term applied to a direct investment in a firm by private parties without the use of a traditional banking or equity exchange intermediary. Private equity can include the initial capital necessary to start a business, which is referred to as a venture capital. It can also include the capital to expand the operations of an existing firm, which is referred to as mezzanine capital. Private equity can also be used to finance mergers and acquisitions or to provide capital for distressed firms unable to obtain financing from banks or equity markets because of the high risk to the investment. In some cases, a well-established and profitable firm may seek private equity as an alternative to equity or debt issue in the public market because it has lower transaction costs. The process is usually managed by private equity funds, which obtain commitments form investors and draw on the commitment when it finds a suitable investment opportunity. The private equity funds function as the intermediary between the investor and the firm seeking funding from private equity sources. Private equity overhang occurs when there are more investment commitments than available opportunities. Individual investors seeking private equity opportunities generally consist of high net worth individuals with a high tolerance for risk when there is a high potential for reward. Institutional investors also seek private equity opportunities as a means increasing their return on assets through more profitable long-term investments. The major investment banks have private equity units focusing on global private equity opportunities and some financial services firms have been formed with the express purpose of operating in the private equity market.

Private equity functions at the periphery of the global financial markets because of the low liquidity and high information asymmetry associated with private equity investments. There is no ready secondary market for a private equity investment. Once the investment is made, it can be liquidated only by finding another private equity investor willing to make the same investment. In the case of venture capital, an initial public offering (IPO) could also lead to liquidity for the investment. As a result, private equity represents a long-term commitment to the business venture, with a high risk that no portion of the investment can be recovered if the firm performs poorly. The private equity investment is also characterized by a high degree of information asymmetry, with the investor often unable to obtain sufficient information to make an informed decision about the firm and its prospects. This issue with private equity is most apparent with venture capital for firms in the start-up phase of operations because of uncertainty about the viability of the business model and the capabilities of management.

Factors Influencing Investment Selection
The assessment of investments for suitability for private equity uses risk assessment and management techniques common in the financial services industry, but modified for the information asymmetry encountered in private equity investing. The risk management approach assesses the possibility that an adverse event will occur reducing the value of the investment and the likelihood of the occurrence. In many private equity situations, there is insufficient information to quantify the risks of factors such as earnings volatility for an individual firm. In global private equity investing there are also political risks that are difficult to measure and quantify. As a result, many private equity investors use a value at risk approach, which limits the amount of assets invested in specific firm, industry or nation. By distributing the risk over a number of different sectors, the investor becomes less vulnerable to an unexpected event. Certain industries such as high technology, communications and consumer services have attracted a higher amount of global private equity because of the greater potential for a high return on the investment if the firm is successful. While these industries may represent higher risk than other industry segments, the risk is offset by the greater potential for gain. Similarly, global private equity placements focus on investment in regions where there is lower political risk to reduce the overall risks the investments in a portfolio. An assessment that a nation or a region involves high political risk does not preclude investment in the nation or region if the private equity fund has sufficient diversification in more stable nations to establish the overall risk for the portfolio of investments at the desired level.

Private Equity Investment in Israel
Israel is considered an attractive nation for the placement of private equity, and is ranked number 16 in the world based on the amount of private equity entering the nation from external sources. It also has the highest growth rate in the amount of private equity invested in nation with a 13% increase per year. Israel has a population of about 6.4 million, which includes a large number of émigrés. About 23% of the population is Arab. Israel has developed a technology-driven market economy with the government closely involved with regulating and supervising commercial activity. In 2006, the nation had a rate of growth of 5.1% in its GDP, and a per-capita income of about $26,000. A substantial portion of the industry in Israel is in the high technology, communications and chemical production sectors. The nation does not have extensive natural resources and must rely on imports for critical commodities such as oil, food, and coal. To maintain a positive balance of trade, Israel has to ensure that its exports are approximately equal to its imports.

Because of the small size of the population in Israel, it is unable to support a large number of rapidly growing businesses aimed solely at the domestic market. To compensate for this shortcoming, Israel has developed a global focus for its industries to leverage its significant competencies in knowledge assets. More engineers and scientists reside in Israel on a per capita basis than in any other nation. As a result, Israeli industry has emphasized research and development for the export market. In practical applications, this approach often consists of SMEs engaging in research and development of new products and technologies that will ultimately be used larger multinational enterprises (MNE) to produce goods and services for distribution in global markets. The research and development focus is generally on fundamental technologies with a wide range of potential applications. Because of the high success rate of Israeli firms in the execution of this research and development strategy, the nation has attracted interest from private equity sources.

Impact of Historical Factors
The historical development of Israel since the nation’s founding in 1948 has influenced the type of general economic strategy adopted by the nation. Because Israel was created by a United Nations mandate and has a predominately Jewish population, there has been continuing conflict between Israel and its Arab neighbors. Israel has fought four wars against various coalitions of neighboring states in 1948, 1956, 1967, and 1973. In addition, there have been ongoing military conflicts with various nongovernmental organizations operating from Lebanese territory. Israel has also occupied the West Bank of the Jordan River and the Gaza Strip since the Six Day War in 1969. A large Palestinian population resides in this territory that is extremely hostile to Jews and the Israeli government. As a result of its external and internal conflicts, terrorists frequently attack Israeli interests. At the current time, the greatest threat to commerce in Israel is the potential disruption caused to business by terrorist attacks or civil unrest in the Palestinian areas.

The historical development of Israel has resulted in the nation forming trade and military alliances with nations committed to supporting Israeli interests such as the United States and the United Kingdom. It cannot engage in a large amount of regional trade with its neighbors because of political and religious differences. In addition, Israeli trade with some nations outside the region friendly to Arab interests remains limited. As a result, Israel remains highly dependent on American and European trade, military support and financing.

Domestic Political Considerations
Israel is a parliamentary democracy with the centrist Kadima Party currently holding the majority in the Knesset. One of the policy objectives at the current time is unilateral disengagement of Israel form the occupied territory on the West Bank. While the outcome of the policy is uncertain, it has the potential to increase internal stability in the nation. Another political issue affecting the economy is the pace of privatization. The Israeli government has owned and operated some firms critical to national infrastructure such as the airlines and electric power company. The government has been gradually privatizing these industries. The employees of the industries and the unions, however, oppose privatization, which has resulted in substantial political resistance. As a result, the cost of many infrastructure services in Israel remains high due to the inefficiency of the government-operated industries. There is also substantial political pressure on the government to increase social services and transfer payments, which has had an inflationary effect in the past. A high rate of inflation could erode the value of private equity investments repatriated to other nations at some point in the future. The Bank of Israel, which is a quasi-independent body, develops monetary policy independent of political considerations and is likely to keep inflation at moderate levels.

Infrastructure
Israel has a well-developed banking system and stock market with the government providing a strong regulatory structure supervised by the Israel Securities Authority. The Tel Aviv Stock Exchange (TASE) is the only stock exchange in the nation. The TASE allows companies listed in the United States or the London Stock Exchange to also list in Israel without any additional regulatory burden. In addition, the TASE has a large government and domestic bond segment, which allows Israeli firms to use the exchange as a means to access both debt and equity capital. Derivatives are also traded on the TASE. The exchange has a fully automated trading and settlement system to facilitate transactions. The TASE is suitable for IPOs by domestic firms following sufficient growth of the firm through private equity venture capital. It is also common for Israeli firms to use the stock markets in the United States and the United Kingdom for IPOs. The legal system also provides strong protections for property rights and intellectual property, with very low risk of government expropriation of foreign assets or investments,

Implications of Private Equity Investments in the Israeli Economy
The high rate of private equity investments in the high technology sector in Israel is the outcome of the nation’s efficiency in managing human capital and knowledge assets in this sector. Other sectors of the economy, however, are not characterized by entrepreneurial activity or growth that is attractive for private equity. As a result, the opportunities for future private equity investment in Israel are limited to the technology sector with the return on investment contingent on the ability of firms to produce a steady stream of new research and products. The ability of Israel to attract such a high percentage of global private equity, however, is due to the strong financial and legal infrastructure of the nation.

Private Equity Investment in Pakistan
Pakistan is attracting an increasingly large amount of private equity and was the ranked as number 20 in the world based on the amount of private equity entering the nation. Pakistan has had an annual rate of GDP growth of approximately 8%, with fluctuations between 6% and 9% over the past several years. The nation has a population of about 164 million, and a per capita income of about $2,600. The major industry in the nation is agriculture, followed by the service sector. The unemployment rate is moderate at about 6.5%, but there is substantial underemployment with workers able to obtain only part-time employment. One of the competitive advantages in Pakistan in the global market is the comparatively low cost of labor, which provides an advantage for MNEs in labor-intensive industries. Because of government fiscal and monetary policy reforms, the exchange rate has remained relatively stable for the Pakistani rupee.

Pakistan has been able to attract a large portion of the global private equity investments because of economic reforms initiated in 2003 that have provided foreign investors with greater assurances for the stability of the nation and their ability to repatriate invested funds in the future. The sectors attracting the largest amount of private equity funds are telecommunications, financial services, petrochemical exploration and development, and retail. Pakistan also has an indigenous private equity fund managed by BMA Capital from Karachi and Abraaj Capital from Dubai. Private equity investments in Pakistan have been in a large number of industry sectors, which are attractive because of the large population base and the good rate of GDP growth. In effect, there are both rapidly developing internal markets for goods and services as well as significant labor cost advantages for firms in the export trade. There is also a basic structure in place to support a private equity exit strategy such as an IPO or the acquisition by a larger firm. A number of MNEs have been successful in finding buyers for firms following private equity investments in startup ventures in Pakistan, including Evian’s sale of its oil and fats operations and Unilever’s sale of a cooking oil processing business.

Impact of Historical Factors
Pakistan was formed in 1947 after more than a century of British rule when a regional Muslim majority separated from the Hindus in India. Pakistan has had a continuous border dispute with India regarding Kashmir, with a border war occurring in 1999. A cease fire is currently in place, but there has been no progress towards a permanent resolution of the dispute. There has been a strong element of Islamic fundamentalism in Pakistan since the nation’s founding. In 1977, General Zia ul-Haq overthrew the democratic government and introduced gradual changes intended to create an Islamic republic. The process, however, has met with substantial resistance from the more secular elements in Pakistan located in the urban centers. The defeat of the Taliban in Afghanistan by a coalition of international forces in 2002 led to an influx of Taliban refugees into Pakistan, which produced an increase in Islamic fundamentalism in the nation. The objective of the fundamentalists is the creation of an Islamic republic in Pakistan.

Domestic Political Considerations
Pakistan has a bi-cameral parliamentary system, although the nation functions as a presidential dictatorship under President General Musharraf. After a military coup in 1999 placing Musharraf in power, he suspended the constitution and called for a referendum which gave him both executive and legislative authority until 2007. Musharraf has the support of the military, small merchants and industrialists. He is opposed by Islamic fundamentalists because of his pro-Western and pro-development policies. Musharraf has had difficulty controlling the fundamentalist elements in Pakistan and has recently declared a state of emergency, which is equivalent to martial law. As a result, the political risk in Pakistan has increased dramatically. In the event that Musharraf is replaced as the head of the government, there is no certainty that Pakistan will establish a democratic government under its constitution. The state of emergency also appears to have intensified opposition to Musharraf from all segments of society. Although the government’s policies have created a favorable climate for private equity investment, they have also produced some instability that can be a deterrent to investment in the nation.

Pakistan is engaged in the privatization of most of the industries that have been historically operated by the government including telecommunications, chemical and petroleum production, and electricity. Because Pakistan has a high unemployment rate, the privatization initiative has encountered strong domestic resistance because of the concerns of workers and unions about the loss of jobs. The economic reforms initiated by the government also include measures to improve the balance of trade and the development of methods to improve tax compliance. These reforms have contributed to government opposition despite the long-term benefits they can bring to the economy,

Infrastructure
Pakistan has a good transportation and communications infrastructure in its urban centers, particularly in the southern part of the nation that is geared for export. The nation also has a moderately well developed banking and financial system, although it has some deficiencies in its regulatory and supervisory structures. The Karachi Stock Exchange (KSE). Under the KSE rules, a company cannot seek a public listing until it has been in business for more than one year and has a demonstrable history of revenues and expenditures. As a result, startup firms depend heavily on venture capital for early capitalization. This system increases the risk for private equity investment for startup firms with the possibility that the firm will require additional capital before it can meet the qualifications of the KSE. While government and corporate debt also trade on the KSE, the market is very thin because of the historic involvement of the banking sector in corporate debt. The banking deregulation initiatives of the government now allow firms to access debt in public markets, but relatively few firms have used this option.

One of the difficulties for private equity investment in Pakistan is the lack of sufficient enforcement of accounting and reporting standards for businesses. Businesses chronically understate income and overstate expenses as a means of tax avoidance. As a result, it is very difficult to determine the actual condition of a firm seeking private equity financing solely from financial statements. A substantial private equity placement essentially requires an investigation of the firm to determine its actual financial position, which increases the transaction costs for the private equity investor. The government has implemented tax collection reforms, which can lead to improvements in accounting transparency.

Pakistan has a legal system based on English common law as legacy from the period when it was under British rule. The legal code also includes principles of Muslim Sha’ria law. Financial institutions make claims against borrowers in defaults in special summary courts, with special procedures developed to foster the rapid execution of any judgment against a debtor. The legal system and strong property protections provide a benefit for private equity placement by creating a more stable

Analysis and Implications for Private Equity Investments in Pakistan
Until recently, Pakistan has been largely ignored by the global private equity industry. As a result, there are a large number of opportunities for private equity placement in Pakistan with the potential to provide investors with a high rate of return. One of the advantages of Pakistan as a location for private equity placement is the large number of industries enjoying a rapid rate of growth. In addition, Pakistan has established an infrastructure that is generally favorable for private equity investments, with a well-regulated stock exchange and a legal system providing property protection for property rights. The nation is particularly suitable for private equity ventures in labor intensive industries because of its large and underemployed labor force.

Private Equity Investment in Egypt
Private equity has not been widely used in Egypt in the past as a source of funding for businesses. The government, however, has instituted a number of policy changes and reforms specifically intended to develop internal private equity funds and to attract private equity funding from international sources. Egypt has a population of about 90 million, with the population concentrated to a region within 20 miles on either side of the Nile River. The nation has a GDP growth rate and a per capita income of about $4,200. The inflation rate is moderately high at 7.7%. The majority of the population is employed in the services sector, followed by agriculture and industrial production. The major industries include textiles, hydrocarbon and chemical production, and generic pharmaceutical production. Unemployment is high at about 10.5%.

While there are a several private equity funds in existence in Egypt such as EFG and Turncorp, the use of private equity as a source of funding is not well understood in the Egyptian market. While the owners of these businesses desire access to capital, the private equity transaction must be structured in a way that allows the owners of the business to retain full control of the business and its operations. As a result, smaller firms continue to use debt capital from banks as the primary source of financing. Larger firms that have capital needs for expansion or mergers and acquisition rely on public equity financing and bank loans. One of the issues affecting the use of private equity in Egypt is the prevalence of family-owned SMEs, which is common in many Middle Eastern nations.

Impact of Historical Factors
Egypt was under British colonial rule between 1888 and 1922, which influenced the development of governmental and social institutions. Until 1952, Egypt was governed by a monarchy and retained close ties with the United Kingdom. The new government adopted socialist policies to foster economic development, with government owning and operating a large number of commercial industries. These policies included the confiscation of private property, which had a chilling effect on investment and economic development. In 1958 Egypt and Syria formed a single state known as the United Arab Republic with the objective of encircling and eliminating the state of Israel. Syria, however, seceded in 1961. Between 1948 and 1972, Egypt was involved in four wars against Israel, and suffered several humiliating defeats by Israeli forces.

The current head of the government is Hosni Mubarak who became President in 1981 following the assassination of Anwar Sadat by an Islamic fundamentalist group. Mubarak initially followed the socialist policies of his predecessors. By 1990, however, the economic policies had produced a very slow rate of growth and a high level of external debt. In addition, poverty and unemployment fostered the development of fundamental Islamic movements within the nation. The government gradually adopted a number of structural reforms in the banking and financial services sector intended to stimulate the development of equity markets and to increase the availability of capital for private enterprise. Included in these reforms was the gradual privatization of state-owned enterprises. The economic reforms initiated by Mubarak in 1990 have been generally well received, and have led to the gradual growth of the Egyptian economy.

Domestic Political Considerations
Egypt is nominally a parliamentary democracy, but the National Democratic Party (NDP) has completely dominated the People’s Assembly for more than 25 years. In addition, Mubarak and the NDP have suppressed the growth of some opposition political parties embracing radical Islamic fundamentalism. At the current time, the political situation in Egypt is relatively stable, with the Mubarak’s son likely to succeed him as President in an orderly process. Although Islamic fundamentalist groups operate in Egypt, the government takes active steps to ensure these groups do not become a threat to the government or undermine the economic development of the nation. High profile attacks on tourists in Egypt by fundamentalists groups suggest that terrorists remain a risk to private equity investments in certain sectors of the economy. The privatization of the state-owned enterprises has produced some resistance among the employees and unions concerned about the loss of jobs. In response to the political resistance, the government has proceeded very slowly with the privatization program and retains a controlling stake in many industries.

Infrastructure
Egypt has a very well developed transportation infrastructure, with transportation based on rail and the Nile River. The communication infrastructure uses satellite technology for voice and internet access, with all the system extending to all parts of the nation. The Cairo and Alexandria Stock Exchange (CASE) was established in 1908 and has a good clearance and settlement system with strong oversight of the market and intermediaries. The CASE had relatively slow growth in capitalization and listings until the government enacted a number of reforms in 2004 regarding regulations for the repatriation of foreign capital and a shift in monetary policy to a free-floating exchange rate. Although these reforms primarily affected the banking sector, they also allowed the CASE to implement cross-listings in many European exchanges including Dublin and London. The bond market in Egypt is also growing steadily, although it is not widely used as a source of debt capital by firms. The CASE and the financial services industry is regulated by the Capital Markets Authority, which is a quasi-governmental entity. As a result, the CASE represents a viable vehicle to support an exit strategy for private equity investments in Egypt.

Analysis and Implications for Private Equity Investment in Egypt
Because of the relatively infrequent use of private equity in Egypt, it represents a market with a low level of competition among private equity investors. The reforms that have been gradually implemented in the market now fully support the international mobility of capital and the monetary policy has resulted in a relatively stable currency. In addition, the well-developed infrastructure of the CASE and its cross-listing capabilities with major international exchanges provides the means to implement an exit strategy from a venture capital investment. Egypt is also a diversified economy with private equity opportunities in a large number of diverse industries providing goods and services to both the domestic and export markets. The risk of political instability is low, although there is an ongoing threat from Islamic fundamentalist groups. The primary difficulty for private equity investments in the Egyptian market is the understanding of the managers of SMEs of the role and purpose of private equity.

Conclusion
The analysis suggests that private equity investments in Pakistan and Egypt may be more attractive than private equity investments in Israel. This is an unexpected finding of the analysis because of the concerns about political stability in many of the nations in the Middle East such as Pakistan and Egypt. The evidence indicates, however, that the risk of political instability or civil unrest may be lower in Pakistan and Egypt than in Israel. The crisis in Pakistan is likely to be resolved in the short tern, with the government regaining its ability to maintain order and promote economic development. Nonetheless, private equity investors should postpone committing to an investment until there is greater certainty about the political stability of the nation. Although there is some radical opposition to the government in Egypt, radical groups do not pose a significant threat to political stability.

One of the main advantages for private equity investment in Pakistan and Egypt is the diversity of opportunities in different industry sectors. Pakistan has competitive advantages in all labor intensive industries regardless of the sector. In addition, it has a large domestic market to support growth of retail and service firms and good infrastructure to support growth of firms engaged in the export of goods and services. Egypt is similarly situated with a large number of industry sectors experiencing strong growth. Because of the rapid rate of growth of the economy in these nations, there are also opportunities in firms specializing in infrastructure development such as construction or telecommunications. In comparison, Israel’s opportunities are limited to a few industrial sectors such as high technology, which narrows the range of potential opportunities.

Another advantage of Pakistan and Egypt is the absence of significant competition in the private equity market, although Pakistan is becoming increasingly important as a destination for global private equity investment. The lack of competition creates a situation in which a private equity investor can carefully select the best opportunities in the market without competitive pressure from other private equity investors. As a result, a firm entering these markets early can establish a strong position in growth industries that can bring significant returns over the long term. In contrast, the Israeli private equity market attracts a substantial number of investors seeking the most advantageous opportunities in the market.

The general trend in both Pakistan and Egypt is towards strong economic growth, continued deregulation of markets, and ongoing enhancements to the financial and commercial infrastructure. Baring a change in government leading to a full reversal of past policies, these trends are likely to continue in the future. The increased liberalization of markets is likely to continue to foster GDP growth above 5% a year in the foreseeable future, which will benefit all firms in these nations. Increased liberalization will also expand export opportunities for goods and services originating in Pakistan and Egypt. The reforms to the equity markets and banking sectors further support the use of various exit strategies such as an IPO for venture capital investments or a leveraged buyout for an expansion capital investment.


Final Evaluation
At the current time, Egypt represents the best opportunity to achieve the highest reward for a private equity investment with the lowest level of risk. There are a large number of opportunities in the market in different industry segments, with no significant competition in the private equity market. Egypt enjoys political stability and has been successful for the past 17 years in gradually implementing reforms to liberalize the market and improve its financial systems. Pakistan also represents an opportunity to obtain a high reward from private equity investments, but has a higher risk than Egypt at the current time because of potential political instability. The structural reforms in Pakistan have only been in place for five years with the possibility that a new government would curtail the reform process. As a result, private equity investors should postpone investment commitments in Pakistan until the political situation becomes more certain. Israel represents the lowest potential reward for private equity investments because of the narrow range of opportunities in the nation. At the same time, Israel remains subject to political risk from the actions of various groups committed to the destruction of the Israeli state.

article by: arjun sethi
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Will China Pacific Be Carlyle's Big Jackpot?

HONG KONG -- A stepped-up initial public offering of shares by China Pacific Insurance (Group) Co. would make Carlyle Group's investment one of its most profitable deals ever.

China Pacific is increasing the amount of capital it plans to raise in offerings in Shanghai and Hong Kong in the next few months, hoping for between US$4 billion and US$6 billion, people familiar with the offering say. Originally intending to pull in around US$4 billion in the combined offerings, China Pacific has raised those expectations amid a boom in domestically listed Chinese shares, the people say.

The IPO furnishes the Washington private-equity firm with a way to cash out of its nearly 20% stake in the Shanghai insurer, which it owns with co-investor Prudential Financial Inc. Carlyle and Prudential acquired about 25% of the Chinese company's life-insurance unit in 2005 and early this year transferred the stake to the parent company in preparation for the listing.

China Pacific expects to sell domestic A-shares in Shanghai sometime before year end, launching an IPO in Hong Kong in the first quarter of next year. Despite recent selloffs in Chinese shares, the Shanghai Composite index is up 99% this year as mainland investors, restricted by capital controls in investing abroad, pump savings into the local stock exchange. Meanwhile, Hong Kong's Hang Seng index, consisting largely of Chinese companies, has rocketed 38% this year, despite a loss of about 6% over the past month on economic and credit jitters and delays to a program to let mainland investors trade directly in shares listed in Hong Kong.

A share sale of this size would be a bonanza for Carlyle. With Prudential, the firm two years ago paid about US$410 million for its initial stake in the life insurer. Since then, the investors have installed new management and pushed China Pacific, China's third-biggest life insurer by premiums, to position itself with new products appealing to growing numbers of Chinese seeking insurance.

Private-equity firms have hit regulatory hurdles in China and struggled to score transactions bigger than US$500 million. Carlyle saw a deal rejected for a minority shareholding in a bank and has faced delays in a plan to buy a big stake in a machinery maker, Xugong Group Construction Machinery Co.

Credit Suisse Group and UBS AG are among those underwriting the China Pacific offerings.

By LAURA SANTINI
November 19, 2007; Page C6
Wall Street Journal
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Risk and Return in the Field of Global Private Equity and Venture Capital

The Private Equity/Venture Capital market has been amongst the most explosive and unpredictable of the free trade era’s deregulatory byproducts. With the relaxation of global standards for economic and corporate interaction across international borders, the entrance of private equity investment into developing or emergent markets has been nothing short of precedent setting, creating a mold for the way that many investment firms have trended. However, the private equity market remains in many ways not yet fully explored, with its relative growth far outstripping the relatively absent maturity of this market. Such is to say that while expectations and legal parameters seem to anticipate a tremendous return on the investment for private equity firms, there are nonetheless myriad unforeseen or underestimated risks in this global approach, both to individual firms and to national governments.

Our discussion will note that as a concept for examination, private equity is somewhat diverse, but concisely speaking, concerns a private firm’s purchase of a major stake in a company or firm that does not avail stakes for public trade. The result is that the privately investing firm will have a controlling interest in the firm and its responsibilities, and additionally, that the investing firm will be in a position to offer stock for this company through public channels at such time when its investment has produced appealing growth in the asset. This is an approach to business which has seen a demonstrable rise in relevance over the last two decades, given the deregulatory modes of globalization, the proliferation of global communication technologies and the greater intimacy between economies beyond national boundaries. All of these have given incentive for investment firms in developed nations to increasingly look abroad for suitable investment opportunity. To this end, “investment strategies in private equity are becoming more and more global, increasingly involving emerging markets.” (Cornelius, 111)

Of course, the capacity of a firm to achieve a return on an investment which, in this context will typically involve sums well in excess of multiple millions of dollars, will depend on a wide range of factors. The initial terms of an investment, wherein an invested upon asset may be in declining health but prospective for inevitable recovery, will play a role in the prospect of a positive return. Additionally, though, there are myriad risks that cannot be as sufficiently gauged, concerning the stability of a sector or nation receiving the investment, concerning the veracity of economic indicators emerging from organizations which are not yet publicly traded or concerning the overarching impact which private equity investment en masse in the emerging sphere is having of the geo-economic outlook.

Though historically, private equity has been an exclusive investment mode reserved only for the wealthiest of corporate investors—made especially so by the enormity of many of the public or governmental services represented by investment recipient firms—today it has become a central part of the strategic push of globalization. The continued interest in the elevation of the developing or emergent sphere, which includes such crucial world players as China and India, has resulted in a great international rush to invest government contract work. Modernization and infrastructural growth efforts in the developing sphere have helped make private equity the desirable way to enter foreign markets.

To this point, the Bloomberg Financial Firm calculates that in 2005, the equity market produced $255.3bn in buyouts, which was projected to be eclipsed three-fold by the following year. (Cheung, 1) The context into which we enter this discussion is one which capital-investment firms have been drawn to the places in the globe where the demand is highest for development and where, therefore, legal and economic conditions are ideal for the development and monetary infusion of companies which, for one strategic cause or another, do not wish to become publicly traded.

A story this month, for example, drawn from CNN.com, reports the purchase of a significant stake by the Paris-based Global Private Equity Funds of the Indian surface transport company, REACH. The purchase of a $5 million portion of the companies privately held shares places Global in a positive place to reap the benefits of India’s infrastructural needs. (Manibo, 1) Due to the enormous developmental tasks facing the economically beleaguered public service community as well as the enormous developmental opportunity thrust before its various technological and service sector aspects, India’s infrastructurally relevant agencies have become optimal for investment consideration. Thus, for private equity investors, the relationship between public need and corporate opportunity are somewhat inevitable as well as instigative of a strategy for “acquiring assets in the logistic sector in India, which is one of the fastest growing segments in the country's economy.” (Manibo, 1)

This characterizes a significant part of the form that private equity investment has taken. This is something which we will explore in this discussion with more specific reference to the risk and return of this strategy for nations such as China and India. But there is another global consequence to the emphasis on private equity investment that speaks to the transition experienced by these ascending nations. Certainly, the biggest transition which is occurring is a condition which is even more pervasive than simply the advancement of conditions for developing nations. More than that, the new age in private equity and venture capital investment is giving private firms greater influence than ever over the implementation of public programs, services and policy initiatives. Both in terms of their oversight of such programs and their capacity to influence the conditions of program execution, corporations who have invested a sizeable enough stake into the advancement of groups generally designed to animate government contracts are finding themselves economically and politically in a place of great determinant strength.

As the British department of Financial Services Authority reported in 2006, the scale to which company’s have been able to invest in such organizations has steadily risen. This pattern “has enabled far larger transactions to take place, including taking significant public companies private A potential new global record has been set with the proposed $33bn acquisition of US based health care services company HCA. A new European record was set by the €12.9bn acquisition of TDC.” (Jones, 4) This means that absent of national modes of protecting domestic assets, these enormous sums of money are being shifted into positions of influence and economic value with governments away from home.

One aspect of this circumstance to consider is that beyond the economic ramifications of private equity, there are a great many political implications to the power affording investing firms. Such is to say that private equity firms often will aim—due to their scale and feasibility—at funds related to significant service concerns or utilities that can have a direct effect on public living standards, popular access to needed public resources or, as a consequence of these and other factors, the way that public relates to or perceives its government. This is to indicate that a genuine risk for the government enabling this mode of investment exist in that the investment can be a direct route for a firm taking such an interest to levy its influence on an entity which itself can have a genuine influence on overall public policy. This is a risk which in many ways defies measurement, with the interest of a foreign government or firm in brokering such a deal will suggest that economic conditions demand this allowance. Such is to say that the relatively uncalculated risk of corporate impingement upon governmental policy, or the potential for public services to suffer as a result of a heightened interest in profitability, are often absorbed in the face of pressing economic conditions.

Thus, the idea that globalization should serve as a way of bringing into closer reflection of one another the collective standards of living, human rights and economic orientation in a global community is only seeing the light of day insofar as there is a more collective global interest in elevating corporate consolidation efforts and in removing the control of domestic governments of global trade behaviors. Herein, global private equity investment has experienced a great expansion over the course of more than a decade, with hostile buyouts, corporate mergers and monopolistic industry sweeps helping it on its path.

And with deregulation placing policy control with international economic alliances, this is also a circumstance which prevents many governments from applying the necessary regulations to restrain foreign investment or to channel it properly. As a result, many markets today suffer from investment saturation. Indeed, one of the great risks in private equity is inclined by the rapid expansion of the market. Such is to say that, while there may be reception to the support of such an expansion, it is not necessarily so that all participants are aware of the inherent perils of this approach to public sector growth. This is to note that “market participants have expressed concerns about a perceived lack of understanding amongst public policy makers, potential future investors and commentators with respect to the nature private equity business models and their inherent risk.” (Jones, 4) There is particularly a conception that governments such as those facing the monumental modernization tasks of India or China are unprepared for the future implications of the invasion of private interests into the forum of public policy.

Findings determining the extent to which private equity or venture capital investment through buyout methodology are appropriately gauged with regard to the risk-return ratio are mixed. A 2003 study sponsored by the U.S.-based National Bureau of Economic Research warns that for the private equity firm investing a sum of the quantity generally required to enter into this high-stakes investment field, the average wait time for a profitable return on an investment is 10 years. This means that an investment firm must be prepared not just to wait out the illiquidity of an investment but must also be prepared for the various climate changes which are likely to have occurred over that period of time in a regional economy, national economy or global trade sector. Thereafter, however, the same U.S. think-tank determines that “private equity generates excess returns on the order of five plus percent per annum relative to the aggregate public equity market.” (Ljungqvist et al, 1) This is to indicate that for those organizations with the means and stability to weather the incubation period, the rate of return does endorse the internal investment approach.

As noted though, there is no consensus on the veracity of this return promise. Particularly, some studies show, this is a distortion tended toward by some of the distinctions in private equity investment versus public stock trading. This is to indicate that some of the positive perceptions regarding the return on risk for private equity “seem to result from the low correlation between reported fund quarterly returns with quarterly returns on stock market indicates. The fund quarterly returns, reported by general partners, come from a mix of current and stale company valuations.” (Woodward, 1) The study in question here, published in 2004 by Sand Hill Econometrics, contends that the lower standards required the reporting of facts for companies that are not public traded means that many of the economic measures available to private equity investors do not reflect the most accurate or recent data on specific investments. This, of course, stimulates both an inflated perception of the return on a risk as well as an underestimation of the risk inherent to a chosen investment.

This demonstrates the importance of the consideration of legal elements of the question of private equity’s investment value. In the United States, for example, firms interest in investing in private equity at home or abroad are benefited by tax laws which had been legislated prior to the modern boom in private equity interests. There appears a distinct interest in encouraging this type of privatization, rather it be through the investment of domestic or foreign firms, or through the investment of an American firm in foreign markets. In any sense, legal standards allow primary equity investments to be counted as revenue with a modesty that contradicts their status in today’s marketplace. Under these parameters, “Partners in private equity ventures treat their performance fees as capital gains — in other words, like profits on the sale of a stock — and thus pay tax on the fees at a rate of 15 percent, about the lowest in the tax code.” (NYT Editorial, 1) Naturally, this is a considerable return on the risk, and some within the venture capital community might parrot the sentiment that this is the reward for possessing the initial capacity to take on such substantial investment needs within the market. This is a conflict of perception which predominates the uncertainty present today concerning the sustainable value of private equity, especially given the market’s competitive saturation.

In this regard, we are beginning to address a risk that is substantially greater than that noted to pertain to organization. We have already spoken to the risk undertaken by developing nations such as India and China, who may run the danger of wresting authority over public services to firms with distinctly private interests. However, for such developed nations as the United States, the risk concerns the consequences of tax inequality on market elasticity. The editorial references from the New York Times argues in reference to the capital gains exemption that “excessively favoring one form of income over another encourages wasteful gamesmanship, creates inequity and crowds out other ways to foster risk-taking.” (NYT Editorial, 1)

There is a risk of producing an economic outlook in the developed sphere which does not favor growth, but instead helps its corporations to shelter their earnings outside the boundaries of a national revenue structure. This is a condition which has been promoting as a way to induce a greater long-term availability of parties interest in investing where such considerable need existed. Such “strategies are designed to expand the boundaries of the universe of attractive targets, thus mitigating the risk of possible supply-demand imbalances that could have adverse consequences for returns.” (Cornelius, 112) However, the changing nature of the market should suggest no further need for incentive for potential investors.

This is especially true for the administrators of developed markets considering perhaps the most surprising of findings to emerge from this portrait. Indeed, it is one that could have expansive effects on the global economy and its related power structure. To this point, we have addressed primarily the manner in which developed nations provide the funding source—typically through a domestic corporation or firm—to organizations in emergent economic settings. However, there is today an indication that many of those emergent economic settings have become demonstrative of a transfer of wealth which has in many ways been carried out through the swing toward private equity, hedge funding, venture capital and a whole host of unidirectional activities removing money from national economies and relocating them to globally operating private firms. The result is that, today, emergent economies are actually becoming a source for equity funding as well as receipt. Even as infrastructural growth remains a central activity in the developing sphere, the nations of Asia and Southeast Asia have achieved a certain degree of corporate relevance that is shifting the table. Today, analysts note it to be “significantly more likely that emerging markets will be large net capital exporters of private equity, fueling rather than containing what has become known as the money-chasing-deals phenomenon.” (Cornelius, 113)

The evidence of this transfer of wealth is demonstrable in India, which must be characterized as recent history’s most prominent recipient of global private equity investment. The correlation between the meteoric growth of the Indian capital market through its technology, telecommunication, bioengineering and service sectors has helped to stimulate a greater global investment interest both in India and in other nations which might be modeled by its successful template. However, conditions as favorable as those found in India may be difficult to come by, given India’s active courtship of outside investment. Due to its great need and its limited capacity for distribution, India has helped companies realize somewhat unobstructed investment returns by open its doors wide to foreign firms. As a consequence, India’s equity market has been remarkable, drawing three times as much in the first half of fiscal year 2005-2006 as in the year prior at that juncture. (Moniz, 2006)

Still, with China’s geo-economic ascent, expansive human resource potential and prospective interest in political liberalization, it may be difficult to continue to characterize India as the future’s brightest private equity investment spot. However, its reign in that position for the past decade has produced a new outlook for the nation, both in terms of its potential for levying domestic improvements and with regard to its shifting role as an economic power. As the 10th largest economy in the world, India has achieved a certain degree of economic self-determination that might not have been predicted of the long-colonized and disenfranchised ‘third-world’ nation. “ (Dickenson Associates, 2006) However, as the equity investment interests have poured into the nation for the benefits of its comparably low labor costs, low resource costs, high manpower capacity and infinite growth potential, India itself has become a broker of economic power. With $2.3bn invested through private equity in India just in the year 2005, “the windfall that has come India’s way from these investors in the three years between January 2003 and December 2005” has amounted to “$4.4 billion.” (Sengupta, 1) This still ranks it second to China in its region for global investment. In 2005, China attracted $6 billion in investment through foreign private equity firms with a return proportional to India’s. (Sengupta, 1) Given the expansion noted above to these markets in 2006, it remains to be seen to what extent the rate of return has continued its upward mobility. The implication is clear, that the primary avenues through which to realize private equity investment returns have been those inexorably rising nations in the eastern sphere. And the result is truly a larger pattern toward greater equilibrium on the worlds’ economic front, with western corporations driving an initial ascent of eastern governments, peoples and, inevitably, also corporations.

article by: avi schwartz
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Revisiting Private Equity in the Age of Globalization: China & India

Abstract: Private equity investment has become the object of increased interest among financial planners as a component of corporate growth strategy, a development incident to both the deregulation of international trade and to a period of unprecedented corporate consolidation. This investigation discusses the experiences of two of the fastest growing nations in the schemes of both globalization and increased interest in foreign direct private equity investment—India and China. After consideration of the economic, organizational, and political ramifications of private equity investment in either setting, this research finds that the isolated nature of India’s globalization-based growth makes it a less certain investment opportunity than China, where development of infrastructure and elevation of the middle class are likely to overshadow future political or social unrest.

The Cold War ended with a thump, rather than a bang. The Berlin Wall, so long a symbol of East-West division, was torn down by a reveling crowd rather than leveled in the course of battle. The Soviet Union, to all intents and purposes, voted itself out of existence. A chapter in human history ended.

The geopolitical stratagems, global power structures and economic interactions that marked the East-West struggle that dominated so much of international public life during twentieth century are now in transition. Most notably, this recalibration points to an increasingly intimate relationship amongst the remaining world powers. This upcoming increase in global trade openness will likely operate under the coloration of state-regulated capitalism. Nations such the United States, Japan and the Western European components of the European Union, having emerged from the fifty-year standoff, will function as the prime economic arbiters of the global future. A tangible result has been a level of corporate consolidation never before seen, spanning not just across companies and industries, but across borders and oceans. But those same ‘prime economic arbiters of the global future’ may have added company.

Underlying desiderata
Financial globalization presupposes a bringing into harmony of shared standards. This is being realized, at least to some extent, in the ongoing efforts at corporate consolidation and progress toward the elimination of existing global trade barriers. Discussion here is focused on one of the leading indicators implicating both of the above-mentioned developments. Private equity investment on a global scale has experienced an exponential growth over the last decade, growth that has been fueled by a rash of buyouts, mergers and consolidations (and, as it happens, that are functions of the two conditions noted above.) For private equity firms operating in the Western economy, the opportunity to enter such potentially expanding markets as those in China and India—both opened to unexampled internationalization since the start of the millennium—has been met with considerable enthusiasm. For these two nations, the focus of this discussion, private equity investment acts as a vehicle for domestic economic expansion, while at the same time allowing foreign investors to extend their consolidating interests into previously inaccessible or undesirable markets.

China and India as expanding international markets
With populations of roughly 1.3 billion and 1.1 billion, China and India are respectively the first and second most populous nations on the Earth. They share parallel interests—and face equally concomitant difficulties—in succeeding in their struggles to meet the needs, demands and ambitions of populations of such magnitude. Widespread poverty, inequality, social unrest and even political upheaval are conditions that persist both in remote rural regions and concentrated urban centers and represent genuine challenges to those nations’ prospective emergence as major players in the world community.

By the same token, the magnitude of potential inherent in such national labor forces, consumer interest and resource authority increasingly has coincided with a heightened openness toward internationalization of corporate and trade interactions. On both the global scale and within their domestic contexts, the Chinese and Indian political leadership have come to recognize that it is in their respective national interests to engage in economic activities that presuppose largely unencumbered economic interdependence. This new perception is affected by and shapes the behavior of worldwide investment strategies, with foreign direct investment taking the helm in many such settings. Through the foreign privatization of such major equities as those which are likely to play a key role in the evolution and resource distribution of such nations, we have witnessed a major shift in capital investment fund strategy, a development indicative of escalating interest on the part of western investment firms in insinuating themselves as participants in this grand to build toward and benefit from this historic turning point for the great Asian powers.

Focus of this analysis
The focus of this investigation is both the role that foreign private equity investment has played in the growth of China and India and the resulting private equity investment atmosphere currently manifesting itself in both venues. The intent is to determine which, if either, is a more appealing or meritorious market to potential private equity investors than the other. In addition, the investigation yields insights into the incentives and detractions present in each of these settings.

Private Equity
Private equity is broad in concept, referring generally to a specific mode of investment, one in which a party with the financial resources—most often a corporate investor—purchases a significant private stake in a company which is not publicly traded. Nonetheless, private equity is in fact a very broad term, used to define types of funds or investments. The term signifies the source of the money as opposed to the form that the money takes on. As the name suggests, private equity is private, i.e.: it is not reachable in public markets, such as the stock exchange.

It is important to grasp the purpose of private equity in order to understand the difference between private equity and venture capital. Private equity today mostly comes from private equity firms. These firms are not really known, yet hold huge companies and amass fortunes. They are commonly referred to as venture capitalists, although this is not accurate in many cases. Private equity companies buy an undervalued company, change the company, make it more valuable, and then sell it. Upon occasion, the private equity firm will purchase an undervalued firm listed in public offering and take it back to private status while they ‘work on it’. This provides the firm making this private equity investment with the opportunity to create its own Initial Public Offering (IPO) with the stake in its possession at a later date when the stock has appreciated in value, or “Investing in no-publicly held securities through a negotiated process,” (Bance, [2004]). This definition is fairly descriptive in that it becomes clear that the process is indeed negotiated; the return on the investment varies and the proportion of the company’s profits that the investor keeps is arranged between the investor and the firm.

Contingent factors
The success of an investment depends on a number of factors. Paramount among them is the ability of the firm to achieve favorable terms as a condition of its initial investment. These may be consequent to, inter alia, the declining fortunes of the equity being prospected, the vulnerability of the prospected company’s ownership to hostile takeover or the nascent state of the prospected company. Likewise, it may well have an interest in courting outside capital without directly becoming a publicly traded company. This is an investment circumstance that naturally favors the interests of corporate investment over the interests of pubic traders.

Still, even though private equity had typically been one of the least accessible of investment modes, usually reserved for only those select firms with sufficient capital means to undertake such an approach, its popularity is on a distinct upswing. Globalization has given it an enhanced strategic relevance as an investment tool. The relaxation of international standards regarding foreign investment in developing countries has generated a global flood of fund projects for which private equity investment is the preferred mode of resource acquisition. This, in turn, is a function of the nature of its benefits—ones that accrue to both the contracting government and the investing firm—and to the huge number of emerging projects in modernizing sectors of Asia and Africa. As a consequence, each year of the new millennium has witnessed an ever-higher number of international buyouts, pointing to the increasing private equity status of various companies. To this end, “there were $255.3 billion of announced buyouts globally last year according to data compiled by Bloomberg, a third more than in 2004.” (Cheung, [2007]) The atmosphere which serves as the backdrop in this current era in global economic activity is increasingly the interest of capital-investment firms in parts of the world where the demand is greatest and the conditions are most favorable for the development and monetary infusion of those companies that, for one strategic reason or purpose, do not wish to become publicly traded.

Underlying political considerations
Beyond the economic realities and investment principles that play directly into our understanding of the subject, there are myriad political considerations that likewise must be taken into account in any forum in which such vast sums of capital are traded or otherwise at work. Indeed, private equity firms are typically aimed at funds related to significant social service concerns or public utilities that can have a direct effect on public living standards, popular access to needed public resources or, as a consequence of these and other factors, the way that public relates to or perceives its government. In light of this, private equity investment can be direct route for a firm taking such an interest to leverage its influence on an entity which itself can have a genuine influence on overall public policy. (As is made clear in the discussion below, this is one of the core aspects of private equity investment that cannot necessarily be quantified, at least with any measure of confidence.) The determination of a government or firm to deposit multiple millions (or billions) of dollars into a foreign economy almost inherently dictates that either the conditions there have become more accommodating to such foreign investment or that it is the expectation of the foreign government or firm that political and/or social conditions will ultimately flow in the direction of such an accommodation.

Private equity investment in India
A nation conventionally (and correctly) regarded as one stricken by endemic poverty and a dysfunctional distribution of wealth, India, nonetheless, has “today become the tenth largest economy in the world with a GDP of over $166 billion.” (Dickenson Associates, [2006]) This rise in economic status should not have been unexpected. Certainly, it has been a long and difficult effort to overcome the disadvantages that have characterized its history as a deeply conflicted British colony. Nonetheless, India is today a veritable bastion of democracy in a part of the world otherwise resistant to many of the strains of political and economic modernity. And in accompaniment with this great expansion has been the increased level of interest that it has attracted from foreign investors, individuals and institutions confident in India’s potential to be the center of capitalist development in South Asia. Private equity investment in India has paralleled its rise in world economy ranking. According to the Bain & Company capital management firm, “the private equity market in India, which attracted $2.2 billion in investment capital in 2005, will reach nearly $7 billion in 2010.” (Krauss, [2006]) This relatively short term project parallels a belief by many that India is a top destination for investment funds, with its future growth likely translating into major profits.

Impact of colonialism
Ironically, it must be noted that India’s colonial history is as much responsible for its receptiveness to western investment as it is for its lengthy struggle to achieve a positive independent identity. Without a doubt, the longstanding history of English education and interaction with western economic systems today makes India a natural partner to western capitalist-derived globalization. This disposition also has roots in the all too evident need for development throughout the Subcontinent, as well as by India’s leading (an exponentially increasing) role as a provider of services and technical support to American firms. In both of these, we can see that India has been a key player in bridging the gulf separating Eastern and Western economies. As a globalization ‘node,’ India is proving itself capable of moving rapidly toward solutions to some of the problems impeding economic structural development.

While it is an intuitive observation, there appears to be a case to be made that one of the legacies of India’s colonial experience is its level (and abundance) of bureaucracy. “What does excessive bureaucracy consist of? … [The] cost of entering and exiting businesses in India is high. Compliance with health, safety, and environmental standards is costly, due to excessive inspections and documentation requirements, and there is a great deal of inter-state bureaucracy of questionable utility (for example, the ‘entry forms’ that some states require whenever goods are moved across state borders… There is no real logic to this practice…)” (KPMG, Manufacturing in India [2005], 19)

Domestic political considerations
The relationship between the rapid expansion of the Indian capital market and its heightened emphasis on a global investment strategy has given the Indian government as much incentive to open its doors to foreign firms as it has given these firms economic cause to enter an increasingly saturated field. The result has been an incredible boom to India’s equity market, where in the first half of fiscal year 2005-2006, India was the site of roughly U.S. $7.96 billion of foreign direct investment (FDI), which represented over three times as much of such investment as was reported during the comparable period of the prior year. (Moniz, [2006])

India’s hospitality toward foreign investment has taken the form of an increased willingness to permit foreign investment to attain majority interest in some of the nation’s largest industrial and service sectors (e.g., telecom and infrastructure). These major state-regulated concerns are increasingly receptive to what appears to be an endless flow of western capital into “development of new airports, laying of natural gas pipelines, petroleum infrastructure, captive mining of coal and lignite, mining of diamonds and precious stones, as well as the development of townships where complete foreign ownership is now welcome.” (Moniz, [2006]) This particular agenda characterizes the larger appeal of India. On a less favorable note, it also reflects disparate official attitudes at the state level. “The World Bank says that the six states and territories that have attracted most foreign direct investment were also rated as having the best investment climates on a broad range of measures. Investment is clearly flowing to locations that yield the best return, irrespective of government attempts to lure investors into some less attractive states.” (KPMG, Manufacturing in India [2005], 30)

Infrastructure deficiencies
The shortcomings of Indian infrastructure, while hardly the Achilles heel of the national economy, remain a troublesome reality for both Indian government planners and prospective investors. If pitted roads, decaying regional airport and seaport facilities, and, quite often, tainted water are readily apparent to the foreign visitor (and investor), it is the limitations imposed by underdeveloped sectors essential to production that are the more troubling. “Nowhere is India's weak infrastructure more obvious than in power. In cities and towns across the country, richer homes hum with the sounds of diesel generators during frequent brownouts. Poorer ones sit in darkness and silence. According to India's ministry of power, in the previous financial year up to March 31, peak demand exceeded supply by about 10,500 megawatts, or 11.6%.” (A tale of two sectors [2007]) It is not as though there has been insufficient effort to resolve the power delivery shortfall. Rather, a congeries of factors has placed impediments on adequate rates of expansion. “At the heart of India's power problem lie the government-owned State Electricity Boards or SEBs. Afraid of angering powerful farmer lobbies, state governments tend to heavily subsidize agriculture at the expense of industry. In states such as Punjab and Andhra Pradesh, the promise of free power to farmers has been an electoral campaign staple… Theft has played a major role, too: It's not uncommon for consumers to simply hook their homes and businesses illegally to the transmission grid, or to bribe corrupt board employees to look the other way. Between 1992 and 2002, 40% of the power generated in India was stolen.” (A tale of two sectors [2007]) Resolving the underlying problems means, essentially, addressing long-standing cultural factors—e.g., the ostensible right to ‘free’ electrical power—factors that are fostered, rather than impeded, by the processes of democratic government. To the extent that the would-be investor is required to work his way around these impediments (e.g., by installing private sources of power) he may be less sanguine about investing in the Indian economy.

Adopting a more friendly attitude toward foreign investment
The nation is advertising itself today as a prime venue for the investment or foreign capital, projecting itself as an avid participant in the push toward a free trade-based global strategy as a major component of the fight against endemic poverty. While it may not be entirely clear that foreign corporate investment does this—and certainly there are myriad arguments to suggest that this is an overly optimistic take on private equity investment—India has nonetheless incorporated into its growth strategy an anticipated dramatic increase in foreign firms’ control entitlement. To this end, in 2006, “during the World Economic Forum in Davos, India made an all-out push to promote itself as a business-friendly environment for investment. In a move that seemed timed to coincide with the forum, the government lifted limits on foreign direct investment. The most notable change was in the retail sector where outside firms selling a single brand, such as Nike, will be allowed to own a majority stake in Indian stores.” (Knowledge Wharton, [2006]) The operating principle is that expanded interest of western investors in all sectors of India’s economy will eventually result in an improvement in overall economic conditions as well as bring in capital necessary for construction and infrastructure development.

But there are larger, more amorphous—yet ultimately crucial—factors at work. “Liberalization is increasingly a function of state governments as much as for the central government… [Nonetheless,] the central government has succeeded in opening many sectors of the economy to foreign investment… For example, vehicles, consumer electronics, and white goods are fully liberalized, while insurance and media investments are restricted to minority partnerships…” (KPMG, Manufacturing in India [2005], 16) Investment, of course, does not operate in a vacuum. Certain—often unspoken—factors are expected to be at work. The investor likely anticipates a vehicle for redress if in-country counterparts fail to meet contracted requirements. India’s judiciary is considered well-nigh incorruptible. But justice in India proceeds only slowly, given procedural requirements and a reported backlog of 25 million cases, all told. By the same token, local officialdom occasionally has an unfortunate history of corruption. To at least some extent, foreign investors may be tempted to bypass time-consuming legal processes in favor of questionable assistance from venal officials.

Prospective negative outcomes incident to over-investment in a few sectors
This has been true so far, at least to the extent that the low cost of its labor force and the aptitude of its population toward technological sophistication have joined together to make India a top site for private equity investment in the infrastructure sector. But private equity investment here is somewhat different from our conventional understanding of the process, suggesting the influence of globalization on the selection of development strategy. Understood in these terms, “while the traditional route for private equity firms is to buy a controlling stake in struggling, mature corporations and then try to turn them around, in an emerging economy such as India these firms act more like venture capitalists. They look for promising companies in industries ranging from tech to textiles and seek to give them a boost, doing everything from injecting more capital for expansion to holding the hand of management and providing strategic guidance.” (Kripalani, [2005])

This suggests that foreign investment interest in India has its origins in an anticipation of broad-based growth. However, it is also indicative of the ways in which India’s development hinges on the still uncertain promises of globalization. A nation whose growth has to this point been founded entirely on the basis of its importance to the world as an affordable center for technological support and expertise, India has yet to prove itself a safe long term bet for the reach of its economic growth and actually achieved level of modernization.

Private equity investment in China
Today’s China enjoys a major—if not dominating—role in the global private equity scheme. China’s receptiveness to participation in the global trade explosion of the new millennium is surely among the biggest economic stories of the new era. Its seemingly inexorable rise in prosperity, its increasing influence in geopolitical affairs and its efforts at dominance in its economic interactions, even with fellow powers such as the United States, have multiplied the gross value of its assets, both publicly traded and exclusively held. The result has been an increasingly receptive global community, which has welcomed China’s surge with a seizing of opportunity. To this end, “private equity firms are looking to become a more important part of the Chinese economy as companies there are looking for experience in become global corporate players.” (AP, [2007])

Investor desiderata
Desiderata in decisions of private equity firms to participate in China’s current massive growth phase include the affordability of its resources, the vast potential for growth represented in its enormous population, and an asset field that is still a frontier for many western firms. In contrast, there are a spectrum of prospective deterrents to such an investment strategy, including increased competitive saturation, social conditions conducive to future instability, and a government that is regularly accused of widespread human rights violations. An additional consideration is the potential roles beyond the reach of strict personal investment which foreign private equity firms might play in future Chinese governmental, political and social developments.

Across-the-board investor opportunities
Certainly, there is more than sufficient cause to recognize that China is rife with the opportunity for large-scale speculation, as well as with an interest in allowing foreign investors to take part in further development of its infrastructure, resource and service capabilities. Projections leading into 2006 proved correct, with Bloomberg Financial projecting that China would “attract at least $6 billion in private-equity investments . . .as buyout firms raise[d] bets on economic growth.” (Cheung, [2007]) This projection would come on the heels of the previous year’s eightfold expansion to $3.9 market in 2005. And these figures parallel directly what have now been two solid years of unprecedented Chinese stock market growth, where conditions have been so favorable to investors that owners of private equity funds are finding this an environment especially hospitable.

Promising stocks appearing on the Chinese market are targeted by a buying public, one that has shown itself a sophisticated interpreter of the specifics of this particularly robust economic environment. As Katherine Ng, managing director of the Hong Kong Centre for Asia Private Equity Research Ltd. indicated in a 2005 discussion, “ Chinese stocks are in such a favorable position that you will find investors can dispose of their shares or holdings very quickly.” (Cheung, [2007]) This is particularly encouraging to companies seeking opportunities in a country which in 2005 surpassed both France and the UK to possess the fourth largest economy in the world, suggesting that the prospects for its future growth have really only begun to be apparent or, for that matter, even definable. Investors in China seem to be aware of a continued likelihood for growth and prosperity, posting a vote of confidence in sustained growth in accordance with the current pattern. If this perception is vindicated, so too will be the various western firms that have each year in the past four added yet more funds to the economy. As a nation that is only today beginning to learn of the consumer-revenue based benefits of generating what may well prove to be the world’s biggest middle-class, China is expanding so quickly and spectacularly that it has had to focus efforts on fiscal and monetary policies that facilitate, but not improperly exploit, this growth pattern.

Abandoning the self-imposed isolation of the past
Indeed, “China’s reserves are growing by about $20 billion a month as surging exports bring in a flood of foreign currency, forcing the central bank to drain billions of dollars a month from the economy by selling bonds to reduce pressure for prices to rise.” (AP, [2007]) Today, China represents by far the fastest growing contender to join in the global economic scheme that has to date has been largely restricted to the United States, Japan, and the European Union. Indeed, as of this spring, 2007, “China has agreed to acquire a $3 billion stake in U.S. private-equity firm Blackstone Group LPI, a deal that marks the country’s long-anticipated move to expand how it invests its massive foreign exchange service.” (AP, [2007]) China has shown itself to be increasingly less isolated than it had been in the years immediately following the end of the Cold War. However, it appears that today, China fully appreciates its role in the world and had facilitated its own growth within the framework of global systems initially sponsored by western powers. Its growth suggests that it has adapted to such a degree that it is now eclipsing many of its western counterparts.

China as a major player in the world currency market
The duality of China’s relationship with the U.S. economy is of particular interest. Its investment in the American dollar has effectively bound much of the country’s liquidity to its value. Nonetheless, the growth, which this policy has afforded the communist superpower, is now allowing it to reshape the basis of its economy. For China, investment in foreign private equity represents a mode through which it can today transfer its substantial holdings in the U.S. dollar into more robust (or at least less comatose) currencies. Referring back to its blockbuster deal with Blackstone, we can see an actualization of this strategy. The $3 billion invested in the American firm will ultimately be transferred at increased cost to the public buyer. This is a demonstration of one way in which “the Chinese government had been set to shift some of its foreign exchange reserves of more than $1 trillion into other world currencies because of the sluggishness of the dollar.” (AP, [2007]) In coming years, such private equity ventures will likely prove beneficial to the Chinese government, which, in turn, will encourage a favorable monetary expansion, one that is new and separate from any dependence upon the value of a once considerably more merited U.S. dollar. This one strategic investment mode illustrates a way that the Chinese likely will redistribute private equity fund purchases to members of the Chinese public, as well as investing citizens of Asia or the European Union, through an IPO.

Special appeal to American investors
American fund investors believe even greater fluidity will eventually prevail between American and Chinese corporate and capital investment. A factor that has made China so appealing a destination for foreign direct investors is that it remains a market that has not been competitively tapped by western firms. This resulted from heretofore extensive, government-enforced restrictions on offshore investment, a policy now muted as China increasingly opens its doors to outsiders. For private equity investors in America, there is the promise that the Blackstone deal will set a precedent for reciprocity in light of this openness policy, opening wider “the door for direct stakes in Chinese companies as that nation becomes more receptive to foreign investments.” (AP, [2007]) This is, of course, an extremely appealing prospect to the many companies in America, especially ones that find themselves priced into globalization strategies by the proportionally lower cost of investment. This has precipitated an impressive and growing rate of return for equity investors. In 2005, “private equity investors exited 48 China investments. . . raising $1.86 billion, compared with 46 exits valued at $1.05 billion in 2004, according to data complied by the Centre. A survey of 45 exits last year showed 44 percent of them had an internal rate of return of more than 200 percent.” (Cheung, [2007]) There is almost certainly no better metric pointing to the short-term success enjoyed by organizations seizing Chinese investment opportunities in recent years.

Prospective drawbacks
Still, the outlook in China is hardly without its causes for apprehension. In fact, if there is a primary drawback, it may well be that China has been too receptive to foreign investment. Problematic from the perspective of the private equity firm is the fact that “an oversupply of capital is placing more negotiating power in the hands of the target companies, possibly limiting potential investment returns.” (MQ, [2005]) This differs from the expectation and intent of private equity firms, which often operate by principle from a position of dominance. The notion of a buyout may well take the form of a hostile takeover, where the failing or immature nature of private equity holdings give them an appealing quality, while precipitating decisions of interested firms to swoop down and swallow such entities up at a low cost. While China has generally presented, and continues to present, positive opportunities for growth on an absolutely massive scale, its leaps and bounds of the last two years, capping an important decade-long expansionary period, have clearly not gone unnoticed. Indeed, coincident with the recent exponential growth of the Chinese market has been the interest of foreign firms in participating in the resolution of anticipated future national economic requirements, notably China’s massive—and likely increasing—infrastructure needs.

Some economists argue that a possible outcome of this sustained growth period is a coming leveling of the market, which has until now been in an early growth stage. For aspiring investors, China may be entering a period of balance, where conditions no longer overwhelmingly favor foreign investors but instead seem ready to project an economy now entering its prime. The private equity field has become particularly dense in China, where competition for favorable entry is now genuinely fierce. Any private equity investment strategy under such conditions would be inherently counter-intuitive.

Insufficient transparency
This also raises the issue of China’s questionable prospects of adherence to established principles of business ethics and practice that have shaped and fostered western capitalist structural growth. According to Richard Daniel Ewing of the China Business Review, who offered this insight in 2004, “despite the allure, a combination of developing legal systems, opaque regulations, and unpredictability makes the Chinese private equity market treacherous.” (Ewing, [2004]) Indeed, the Chinese market at this juncture is still relatively green, a condition coincident with shortcomings in its regulatory capacities, but one that nonetheless threatens to undermine likely future company investments, especially among those preferring investment environments in which due diligence is the norm.

Myriad opportunities exist for outsider firms to exploit the structural inexperience of the Chinese economy, with Ewing arguing that the prior exclusivity of such markets to state-sponsorship has left its banks ill-prepared to assess and levy appropriate charges upon would-be investors. To this day, “Chinese banks loan much of their money to state-owned enterprises (SOEs) and lack the tools to analyze the credit risk of new firms with unproven technology.” (Ewing, [2004]) To at least some extent, this structural inability is almost certainly related to the cultural tradition captured in the locution quanxi—the network of social relationships that often trump other considerations in business decision-making. The willingness of Americans to let an entrepreneur succeed, regardless of his or her social or political connections, has been the cornerstone of U.S. economic success, [Knowledge Wharton analyst Siegel] points out. ‘People with Chinese connections can do a lot, but I'm cautious about the whole question of whether the contracts written would be upheld with the wider amount of certainty that they would in India’.” (Knowledge Wharton, China or India: Which is the better long-term investment for private equity firms? [October 18, 2006]) This creates a dangerous environment for organizations that are actually prepared to make good on their committed investment promises, especially in the face of a competition driven by false claims. In short, as an investment frontier with a historically and, in many regards, continually secretive governmental/corporate culture, China’s private equities market is as rife with the potential for corruption and exploitation as it is with the potential for extraordinary profitability.

Analysis
On the surface, there appear to be a number of reasons to look to India as the site with a greater long term likelihood of economic growth and, therefore, a commensurately greater degree of appeal to the outside investor. There is the still extant and significant chasm separating growth rate and extension of material benefits promised to the general populace as the fruit of past investment in infrastructure development. This points to room for growth that will be interpreted as yet further exciting ground-floor projects for foreign private equity firms. One might go so far as to suggest that there is an apparent promise to the people of India for economic improvement based on the nation’s attachment to democratic norms that contrasts with the restrictive social and political atmosphere of communist China.

Cronyism in China
And certainly, the research herein demonstrates a variety of reasons why we might conclude this to be the case. Significantly, today’s China is a breeding ground for nepotism and corruption. The predilection of its government for crony-influenced decision-making suggests that any intent by western firms to gain influence in Chinese public policy must overcome a spectrum of institutional structural obstacles. Included among these is a government and corporate atmosphere highly susceptible to corruption.

Excessive government regulation in India
Research suggests that the Indian government is currently predisposed to business relationships that, to a significant extent, foster patronage of western corporations. India’s government has already demonstrated a greater interest in constraining restrictive regulatory oversight, to the extent that corporate growth has been almost totally centered on the value of foreign investment. This differs from a China, which is largely self-sufficient and yet deeply tied to the financial affairs of western investors. As a result, a key difference for the private equity firm, is that India’s greater dependence on foreign investment has encouraged adoption of a policy of stronger commitment to reliable, appealing and more likely to be honored private equity offerings, which are part and parcel of its growth strategy. The benefit here is shared by investment firms (that have found themselves welcome in India) and by the nation itself (which is generally attached of the kinds of reform fostered by capitalism, at least in its modern, western variant).

Fiscal considerations at prospective odds with western moral preferences
That notwithstanding, a more fiscally driven analysis suggests that these social and political conditions must take a back seat to the evaluation of a nation’s demonstration of growth potential. In understanding some of the core differences between China and India, we may come to understand the prime conditions required for the ideal private equity investment. Specifically, Mukund Krishnaswami, managing director of Krilacon Group, an investment firm based in New York and Philadelphia makes a point that is compelling in any discussion of private equity investment. He notes that one must “look for derivative areas of economic growth and take a 12- to 25-year horizon. Those who do will be fairly compensated for the risk they're taking.” (Knowledge Wharton, [2006]) He warns against using private equity as a vehicle for investing in temporary boom sectors, suggesting that such investments will ultimately prove ill-suited modes for achieving the type of profitability and success in gaining public equity buying interest, at least to the extent investors regularly anticipate. In this context, the case being made is that the relative singularity of the Indian market is problematic. While one might desire to invest in India for the inbuilt promise of its attachment to western values as well as reasonably transparent regulatory standards, it is nonetheless true, as we have established, that India is a nation which has experienced very promising, but also very specifically contained, growth.

Its economic boom can be properly characterized as occurring almost entirely within the technology and technology services sectors that, as the Knowledge Wharton article notes, are important but nonetheless limited. Though it would not be proper to describe these as isolated sectors, they are at a considerable remove from those sectors most likely to fuel any elevation of collective national living standards. This experience compares unfavorably with the cross-sector evolutions that have already swept through China. The implication here is that India’s markets have not, as a whole, matured to the extent that we might necessarily enjoy a long-term confidence in the receptiveness of its consumer population to investment opportunities.

Though both nations are today in the throes of fostering the expansion of heretofore virtually nonexistent middle class populations to primacy in shaping overall socioeconomic outlooks, it is suggested that China has already shown a great deal more promise than India in the likelihood of its consumer population reaching a level of investment power commensurate with a collective rise in living standards and structural soundness.

Conclusion
In sum, comparative research yields a surprising conclusion: irrespective notions that political stability and social openness should together be considered more favorable to the actualization of investment and growth strategies, it appears that it would be incorrect to conclude that India as the more stable of the two nations considered. If one is to examine the various factors limning future growth patterns, there is at present far more cause to view China as moving inexorably forward and upward. Investment in its growth, from a private equity standpoint, even if committed in the midst of great competition, is at least founded on the certainty that China’s growth will continue unabated well into the future. The extent to which its growth has spread across sectors and has even begun to elevate collective living standards and personal opportunities for economic mobility promises that China will ultimately boast a more able and numerous investing public than what might be anticipated in India.

Prospectively diminishing attractiveness of investment in India
In the coming decade, India will struggle to address the various issues considered here, especially with respect to its great infrastructure disinclinations and there is as yet no evidence that western firms interested in its technology sectors will necessarily extend that investment interest to further the advancement of India’s building and public health sectors, as well as the overwhelming demand for infrastructure/public works projects. Absent any evidence that these must inevitably arise from today’s focus on India’s provision of technological services to the world consumer community, we must understand India remains a nation with vast, but as yet unproven, potential.

Given this uncertain future, it is only fair to note that the patterns of free trade thus far realized do not suggest a prospective positive outcome. Foreign investors seeking a rapid return are not so much restricted to particular economic sectors as they are attracted to relative under-development, if only because it is in the earliest stages of sector development that short term, exponential growth is actually experienced. Understood in these terms, it may well be in the individual investor’s interest to abandon a maturing economy—e.g., India’s—in favor of less developed ones. Of course this would have the practical effect of leaving the Indian economy in the lurch, at least insofar as prospective investment for further development was concerned. Were this to occur in India, private equity firms would likely find themselves holding a rather worthless bag, absent a populace with the capability or confidence to help them unload it.

This prospect, however, presupposes an extrapolation from near-term experience, rather than taking a long-term view that incorporates difficult to assess intangibles. Mukund Krishnaswami, managing director of Krilacon Group, an investment firm based in New York and Philadelphia, points up this differentiation. "Long term, I'm a very big bull on India. India is a country where they've done so much wrong in the last 45 years. Yet despite all that there's so much that is good going on that if they just get it right, the opportunities [will be] fabulous in 25 years," he said. "In the short-term, I'm quite a bear. I think the risk premium just isn't there in most assets to be spending a lot of money [in India] today." (Quoted in Knowledge Wharton, China or India: Which is the better long-term investment for private equity firms? [October 2006])

Long-term attractiveness of the Chinese market
As such, this research must conclude that private equity in China is the more reliable for prospective investment. The self-sufficiency of China, combined with promises of future growth on the horizon, strengthened by findings here that China itself is showing a willingness to invest beyond its own borders and even in the United States, suggest that it may be worth weathering the hazards of its problematic shortcomings in governance and social order. These, market forces seem to suggest, will ultimately ameliorate in the face of collective social advancement incident to infrastructure development. Though today both China and India both present appealing conditions for investment, as well as clear and unmistakable causes for serious caution, China is the nation whose growth is a product of genuine market conditions and not simply those precipitated by globalization. This is largely attributable to the Chinese focus on manufacturing—a function of satisfying that nation’s enormous (and still growing) demand for consumer products—rather than replicating India’s emphasis on the service sector. Simply stated, the Chinese market has more prospective ‘staying power,’ even under unfavorable conditions, that its Indian counterpart. Therefore, from the perspective of a private equity firm, market conditions are a preferred desideratum over the still questioned prospective outcomes associated with globalization.

Final evaluation
While it is the hope of globalization advocates that India’s technology sector advancement will find comparable advancement in the nation’s consumer economy, there is already evidence that this is occurring today in China. From that perspective, the risk to gain index is that much better in China. Given the body of evidence that China’s growth is largely a function of its own domestic efforts, with resource allocation favoring multi-sector expansion, this research investigation finds that China is the better private equity investment market for the foreign investor at the present time.

article by: arjun sethi
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