Buffalo Hunters

Salute it as zeitgeist, or damn it as hubris: raising private equity funds for emerging markets currently looks as simple as shooting fish in a barrel. One hundred and sixty-two funds managed it last year, according to data from the Emerging Markets Private Equity Association.

The aquatic analogy is apt in a world awash with liquidity looking for alternative investments for asset allocation.

Yet PE funds and their legal advisers face tough new challenges in emerging markets as controversies over private equity and its tax treatment fuel economic nationalism and regulatory uncertainty.

PE funds typically channel investments through tax efficient entities in offshore jurisdictions such as the Cayman Islands, British Virgin Isles, Jersey and Guernsey.

The choice depends on where investors are based, taxes in the country of the operating company being invested in and, in turn, that nation’s own tax treaties with the offshore jurisdiction.

For example: Baring Vostok Private Equity Fund IV LP, the recently closed US$1bn giant investing in Russia/CIS, is a limited partnership with a second limited partnership as general partner (GP), which in turn has a Guernsey Company as its GP.

Many China funds, dominated by large US players, use the Cayman Islands, British Virgin Islands, or Delaware, though sometimes they interpose another entity – for example, a Mauritius one between China and the Caymans – to deal with issues where a tax liability might otherwise arise for some investors.

Mauritius is a popular choice for India because of a highly favourable tax treaty between the two. It has also been chosen for the offshore vehicle for Aureos Capital’s now closed US$100m Central Asia Fund focused principally on Azerbaijan and Kazakhstan.

Such strategies are advantageous to PE funds and their private and institutional clients because paying zero, or minimal taxes helps to lift the IRR into the right range to make the case for investing in an inherently higher risk environment.

It also offers rights and protections that investors enjoy at home, but for which there may not be legal provision in emerging markets, particularly past and present communist states.

Such rights may include limited liability, share options, preference shares, co-sale rights for minority shareholders when a majority shareholder sells out, and shareholders with restricted rights being able to register shares for offer to the public.

The offshore route can also pave the way for a clean, tax efficient exit through a simple trade sale of the offshore parent shares, without incurring capital gains or other taxes or necessarily needing approval by regulators in the relevant EM.

Exiting through an IPO is not always straightforward in emerging markets. In China, India and Russia, there are considerable complications and obstacles to listing on the Shanghai, Hong Kong, Bombay or Moscow stock exchanges.

Variously, these may include requirements for a well established profitability record, which effectively disbars many young, fast growth companies; limits on dealing in non-publicly offered shares; burdensome bureaucracy that adds to time and costs; an insistence on part or wholly domestic ownership of companies for some flotations.

To get round this, and to insulate themselves somewhat from political risk, widespread corruption and inefficiency at home, many Chinese companies have listed in the USA, Russians in London.

And do not imagine that setting up a Global Business Company in Mauritius to invest in India is simple. Care must be taken over issues from the wiring of funds first to Mauritius, to board decisions being seen to be made there, and taking care that an operating company in India cannot be deemed to be permanently resident there.

In such regulatory minefields, private and institutional investors value being able to use experienced PE fund managers who know the language, customs, the right people, the letter of the law, but can also read the runes.

“Chinese regulations are not always a model of clarity,” explains Thomas Britt III, a Hong Kong based partner at the international law firm Debevoise & Plimpton LLP, and one of the world’s top capital markets lawyers.

“Trying to figure out what a regulation means is often a product of pure experience accumulated over time, working with regulators to understand what has become their common interpretation as opposed to a judicial interpretation.”

Judging which way the wind is blowing, and where the boundaries of acceptability are, is doubly important during the current controversy worldwide over the nature, methods and roles of PE in capital markets.

The industry was stunned in 2005 when Korea imposed a fine of some US$130m on five foreign funds investigated for allegedly evading tax through establishing entities in tax havens or jurisdictions that had tax treaties with the country. The Korean Government has since moved to erect barriers to so-called ‘treaty shopping’, thus raising the hurdle to foreign investment.

Attitudes vary between governments and within countries. China, for example, sees advantages in the PE funds approach, particularly when restructuring its state enterprises, usually through a partial sale of shares.

“They see so many stakeholders – ministry legacies, factory managers, communist party and local government officials, sometimes family interests,” explains John Kuzmik, a partner and leading China specialist with Baker Botts LLP – the American international law firm.

“Keeping them all happy about the kind of restructuring needed to present a viable, international standard company is really difficult to do. So there is some recognition that a PE-like function could actually be helpful.”

But, notes Kuzmik, China still bristles at the notion that much of the PE is going to come from abroad and that foreigners will cherry-pick the best of its industry.

Strategic industries such as broadcast, a huge opportunity in the world’s most populous nation, pointedly remained closed to foreign ownership after China’s accession to the World Trade Organisation in 2001.

Telecommunications, another plum, is still heavily restricted, and while in theory foreign entities may own up to 49% of most types of assets, in practice it rarely happens, and has never occurred in fixed line or mobile telephony.

Even Carlyle Group, a premier private equity group, with more than US$35bn under management, has been frustrated by economic nationalism after initially agreeing a US$375m deal for 85% of Xugong Group Construction Machinery Co. in October 2005.

A thwarted rival bidder from China delayed the sale, arguing that Xugong’s name was an icon of Chinese machinery making.

Nothing better underlines the dichotomy between enthusiasm and protectionism than China’s announcement in 2006 of a new regime for M&As, couched so vaguely that some of the best legal brains are still scratching their heads over likely implications.

The new rules allow regulators to block deals that ‘disrupt the social economic order or harm the social public interest’ or if factors other than market share could ‘seriously affect…the national economy, the people’s livelihood, and the economic security of the state’.

Seen as a move to dampen soaring inflation exacerbated in part by foreign capital flooding in, and to slow the sale of prime assets to outsiders, the wording is clearly a ‘catch-all’ provision. Maybe nothing has changed, but maybe everything has.

“The nature of the [optimal investment] structures hasn’t necessarily changed, but the steps that you have to go through in order to make use of those structures have,” advises Thomas Britt at Debevoise. “You now have to get approval.”

Uncertainty over economic policies is not the only constraint on further investment in emerging markets. In a 2006 survey, the Emerging Markets Private Equity Association identified concerns over governance at the national, local fund manager and company portfolio level.

Chief among these were issues of corporate governance, accounting, reporting, and valuation, liquidity, IPOs, and more reliable flotation windows in local stock markets.

In many emerging market cultures, companies are dominated by strong characters who like to demonstrate that they are in charge by making instinctive decisions, paying little attention to subordinates and, if they have any, independent directors.

Regulatory bodies also vary in quality, power and efficacy. Where guidelines are weak, vague or not applied reliably and consistently, company decision-making can become paralysed.

Accounting in EMs seldom conforms word for word to benchmark International Financial Reporting Standards (IFRS) or the USA’s domestic version of Generally Accepted Accounting Principles (US GAAP), and company, market and economic information is often harder to access or trust. In-depth country knowledge and experience is vital here too.

Such uncertainties create problems in pricing companies. Local entrepreneurs point to booming national economies and demand US or UK-level valuations, but fund managers need to factor in the risk inherent in the country.

Change is afoot. As of January 1, listed companies in China must use accounting standards that include all IFRS principles if not the exact wording. It is a fillip to investment prospects. India does not currently allow IFRS for domestic listed or unlisted companies.

Russia began harmonising its accounting standards with IFRS in 1998. Commercial banks came into line in 2004, and listed companies are phasing it in. Unlisted entities can choose to present IFRS financial statements as well as Russian GAAP reporting, but migration towards full adoption of IFRS is not expected until after 2010.

IFRS applies widely in Central and Eastern European states, particularly those that are now in the European Union, which has implemented IFRS with only a few minor, technical tweaks for certain banks and companies.

While local uncertainties and issues remain, progressive adoption of IFRS standards, and other developments, is driving the more mature emerging markets firmly towards mainstream markets for private equity.

“The fund market in Asia is beginning to look like the fund market anywhere else in the world,” says Andrew Ostrognai, Chair of Debevoise & Plimpton’s private equity practice in Asia, and who leads what Chambers Global recently hailed as the pre-eminent fund formation practice in Hong Kong.

“It’s not developing on a different trajectory, it’s just at a different stage of development. The investors are the same as in the USA and Europe. Granted the local issues are different, but the structures are the same.”

Some old hands sound a note of caution over the frenzy of fund raising and deal chasing.

“PE firms are like buffalo hunters,” warns John Kuzmik in Shanghai. “The minute you see a buffalo, all the other hunters go off after it. The number of good deals is really the problem. There aren’t as many opportunities here as the press would make out.”

Competition among funds could set things back in some ways: companies have more scope to kick against pressure to improve accounting and reporting and for better access for due diligence. Entrepreneurs may also hold out for higher valuations.

Andrew Ostrognai in China shrugs off some of the doubts. “Even though people are saying that valuations are getting out of whack, and that excess capital is flowing through the system, PE is still in the very nascent stages of evolution out here. It is significantly underemployed.”

He points out that, expressed as a percentage of GDP, private equity is still in the early stages of penetrating emerging markets compared with its presence in developed markets where it has been operating for more than three decades.

Certainly, PE funds are still flocking to the honey pots, and staying. “I’ve not heard of any player that’s consciously chosen to get out,” says Andrew Ostrognai in China. “Obviously not all of them are here, but frankly, the number that are not here dwindles every day. And we know for a fact that some that are not here, are looking with great interest.”

Buffalo hunters and other obstacles aside, there are compelling reasons to be in the larger emerging markets, stresses Ostrognai.

“When China is rich enough, the domestic Wal-Mart of China will be one of the major retailers of the world. Eventually, you will have companies that are on a global scale just off the back of Chinese domestic demand.”

Ditto India. If its high growth continues, incomes will nearly triple over two decades as it moves from the world’s twelfth to its fifth-largest consumer market by 2025, according to a study by McKinsey Global Institute.

With the rewards potentially so high, the prospect of shooting a buffalo, or even something bigger, will likely keep the hunters out on the range now matter how tough the going is.