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Viewpoint
The World Bank Group                                                                     September 1996
Note No.90   Venture Capital Funds in Emerging Markets
-Lessons from IFC's Investments
Teresa Barger,   Venture capital funds pool and manage money   some control over the enterprise by, for ex-
Laurence Carter,  from investors seeking private equity stakes in   ample, taking an equity stake large enough to
and Irving        small and medium-size enterprises with strong   enable them to sit on the board of directors or
Kuczynski         growth potential. These funds provide firms   reserve the right to replace management. This
with not only equity finance; their managers   sets venture capital funds apart from, say, port-
add value through participation in the firms'  folio funds, which tend to buy passive minor-
management. Fund managers usually seek   ity stakes and seek no management role.
Ultimately, fund managers aim for high capital
TABLE 1   NEW ENTRY FUNDS WiTH IFC FINANCING        .    gains. But a venture capital fund typically has
a negative cash flow in the early years as man-
agement fees and some failed investments eat
Date of inception    Country or region   Project name     into capital cash flows turn positive as the fund
;~~~~~~~~~it caia;cs lw  unpstv  stefn
sells profitable investments. As a result, ven-
Jlanuary 1978    Spain           SEFlffllOVA I
January -9'78    Spain          SEFINNOVA I               ture capital investment tends to be long term
November1980     Brazil          Brasilpar                and relatively illiquid.
June 1982        Kena            IPS (Kenya)
May1983          Korea,Rep.o1   KDIC.                     IFC's portfolio
November 1983    Malaysia       Malaysia Ventures
November1983     AsiaRtegional  SEAVIC                    For the past two decades, the International
Finance Corporation (IFC) has promoted ven-
-oe1  Ature capital funds in developing economies in
June1987         China          JF China                  an effort to improve small and medium-size
November1987     C6tv divoire   IS (Okte d'lvoire)        firms' access to equity finance and manage-
July1989         HuIngary        First Hungary Fund       ment expertise. Working with institutional in-
April 1990       India          TDICIVECAUS I             vestors, investment banks, fund managers, and
December 1990    Thailand       SEAVI Thlailand           government regulators, IFC has undertaken
activities ranging from advising governments,
to structuring, investing in, underwriting, and
May1991          Zimababwe      VC of Zimbabwe            placing funds, to identifying fund managers,
December1992     Eastern Europe    Advent PEF            to sitting on boards. Its investments in funds
December1993     Russia         Framlington Russian       have been substantial. Between 1978 and June
Investment Fund         1995, IFC invested US$196 million in forty-nine
December1993     Ukraine        Ukraine VC Fund           venture capital funds whose total size at in-
ception was US$1.5 billion. (See table 1 for
May1994          Bulgaria       BalkanFund                IFC-sponsored funds that introduced the ven-
June 199         Mauritis       Mauritius VC Fund         ture capital industry in new markets.) The av-
erage fund size has been US$30 million,
Akto;VCisvenceapitaI;PEFisprivaieequ4ftiumd            although recent funds have ranged up to
US$100 million.
WM                International Finance Corporation * Vice Presidency for Finance and Private Sector Development



Venture Capital Funds in Emerging Markets-Lessons from IFC's Investments
funds were still in the early stages of their in-
Venture capitaifuhds mos4y by private equty stsRes insmallotervestment life cycle. Many countries had high
priseThes4ntwrisesend o net riidet~y*s6nIsiges~levels of macroeconomiic instability in the 1980s.
The venture capitalindustry wase ill young even
QonceJltorprQductdeslRn                        ~~~~~in many industrial countries and was an entirely
new  concept in emerging market economies.
There were no local venture capital fund man-
; Expansion stage ox second stap financing tbptevi4ewotl~ing       agers in emerging markets, and few international
tamanagers prepared to manage the small funds
in these markets. And until recently, the under-
developed stock markets in most countries made
FtnelThcreeninvestmentproposats byassessing the    it difficult for funds to sell their investments.
ebected  4en mixed.he early fundsperforme    y     just as the industry has taken hold and evolved,
ithelmd i manternmal ranvofrturn for&twentp-onS the   Jte padFC too has been on a learning curve. Perhaps
zettiioloy ofthe ot#irite#d thhia$d~as~~ofreflecting more experienced managers, better
development faprospeetMe~ passost ~stmucturing, and broader acceptance among lo-
rnan~lijiidrt~k  mert dtalldAle4iiiueno. ypicllyCal owners of the concept of third-party equity,
givig te goatstwighto te qatiyndcommnntif he      -- recent results show improved perfor-mance. And
funda  by Jue  98    as-50pecet Svea               by important new  opportunities in the transi-
and egutiate   factors playedwfarole.heresutsI c b t tion economies, where large numbers of small
utpr ed ien part to earlyexperimentation.Many      smand medium-size private firms have started up.
~~~~~~~~~ ~~~~~~~Many of these firms need equity to finance ex-
nies vetur caitamndmanget lbou* cetmn wih oherpansion in uncertain macroeconomic and regu-
fiacaistttos  anep m                i4 ~4je                           atory environments-conditions in which
mastalsohav conact wit iiiustialoinpie~tiatn  ~venture capital can be most effective.
teonrcladacer~ent eutre<aflersips Th nedle clseAs prospects have improved in the 1990s and
maoitongieanthaventpr caiial undteul t li ne thirthe demand for private capital has increased,
clintsaudachanaertphaly ookiftrsiie ig'tPdtfoIe~K-' IFC has expanded its venture capital investments
companies                                        ~~~~~~~~~~~dramatically-approving US$272 mnillion in yen-
VenurecapattndsulimaelyabaItibig apitlgaca rea  - ture capital investments between 1990 and 1995
(compared with US$35 million in the previous
~~---'--~~~~--~~                twelve years), matched by, US$1.4 billion from
may include                                      ~~~~~~~~~~~private investors. IFC has been especially active
An nital ublc oferegl whchshaes re ellto hapbIi-~in Eastern Europe. Between 1989, when it spon-
usuallytb mospmtbbie&tsougt-aferrate.    ---     ored the first Eastern European fund, in Hun-
Acqusitin baneter cmpay-a-emrail  ames-nisin     ary, and June 1995, IFC invested in eighteen
. k4trMcount~~~~~~~~~et ~funds in the region (five in Russia alone). The
ptrtthasabythe hwest~~~0Irmor                 economies is shared by the private sector: over
Secondartpurphasabta thlr&i*nrtt:               the same period, the private venture capital in-
dustry in the region grew to seventy-two funds,
with committed capital of about US$4.5 billion.
Tefinancial results from these investments have
been mixed. The early funds performed poorly:   As the industry has gained acceptance and ex-
the internal rate of return for twenty-one of these    panded, it has become increasingly clear that
funds by June 1983 was -5.0 percent. Several   venture capital funds are an effective way for
factors played a role. The results can be attrib-    IFC to invest in a large number of firms too
uted in part to early experimentation. Many    small for it to invest in directly. IFC-sponsored



venture capital funds invest in 150 to 300 com-   * Identifying and retaining excellent interna-
panies a year. By mid-1995, thirty-nine of the    tional managers. For example, the manager
venture capital funds that IFC had financed had  of the South Africa Capital Growth Fund had
invested in a total of 679 companies, with an  previously managed four funds in which IFC
average investment of US$0.7 million per com-  had invested, in the Republic of Korea, the
pany, typically for a 5 to 20 percent stake. In  Philippines, Portugal, and Argentina.
low-income countries, such investments were   * Helping local fund managers to expand by
smaller yet: four funds in Sub-Saharan Africa    introducing a foreign technical partner and
invested an average of US$100,000 in eighty-  new capital.
one firms. A few funds reach a particularly large  Ensuring that the fund is large enough to at-
number of companies. VECAUS-I1, a US$32 mil-   tract an international partner-where the mar-
lion venture capital fund launched in India in    ket permits. The average size of the venture
1990, had invested in 121 companies by De-    capital funds financed by IFC between 1991
cember 1994 (an average of US$260,000 per    and 1995 was US$37 million, compared with
firm). (The market value of the portfolio in De-  US$17 million for 1980-90. The five venture
cember 1994 was 85 percent above cost, and   capital funds in Russia approved by IFC's
42 of the 121 companies were already listed.)    board by June 1995 averaged US$70 million.
Moreover, in countries where the private sec-    All had a foreign technical partner in their
tor is still nascent and stock markets have yet    management company.
to develop, venture capital funds may be the  Seeking partial donor financing of manage-
only vehicle foreign investors can use to fi-    ment costs for funds too small to attract an
nance a portfolio of small to medium-size pri-    experienced manager. For example, the
vate firms. The venture capital funds in Bulgaria    French government is paying the salary of
and Ukraine, for example, were the first IFC  the expatriate manager of the US$9 million
investment projects in both countries.       Mauritius venture capital fund for the first
twenty months.
Lessons
Size and structure
Several important lessons emerge from IFC's
experience.                                The structure of a fund helps define the incen-
tives for managers to perform and for fund
Management                                 shareholders to remain interested-but not to
interfere too much. The size of funds has been
The quality of fund management is the most   one important factor. Funds under US$10 mil-
important factor in a fund's performance. Ven-  lion have performed worse than larger funds.
ture capital fund managers need to be close to   These smaller funds have generally been un-
the companies they invest in, but finding expe-   able to attract or hold onto good managers,
rienced, high-quality venture capital fund man-   keep their sponsor's attention, or invest enough
agers willing to manage relatively small funds   to cover management costs or to spread risks
in difficult environments has proved a major   adequately. A two-tier structure separating fund
challenge. IFC has used several approaches:  managers from the fund is preferable. For
Establishing a regional management company   single-tier funds, in which the fund and fund
and fund to provide international manage-   manager are incorporated in one entity, per-
ment expertise to several country funds in a   formance has been worse, for several reasons:
region-each of which also has its own lo-   costs are difficult to control because it is hard
cal advisers or managers. This structure  to isolate management costs, it is more diffi-
achieves critical mass for the international   cult to design performance incentives and to
manager, but also develops local expertise.  fire managers, and shareholders interfere too
It has been successfully promoted by IFC in  readily, leading, for example, to violations of
Southeast Asia (the SEAVI program) and East-  exposure guidelines. Funds also should have
ern Europe (Advent Private Equity Fund).  a limited life-say, eight to ten years-to give



Venture Capital Funds in Emerging Markets-Lessons from IFC's Investments
If wieagmehfoesareassuedibeZ5erugtsfommtmens ~with local cultural norms. Small, closely held
fund  mddndto e IJ$10mion.Its anagr stbt~pcttofirms were not used to sharing project ideas and
targtinestnntsn,saAwetjuompaiesverahre-twfur earbusiness plans with outsiders, let alone ceding
some ownership and controt. Inexperienced
fund managers took time to build up an invest-
ment pipeline. And macroeconomic instability
screened, SO,tOlJWestlNtWenty                      ~in some countries caused firms to cut hack on
woul uedtoscren 00 a40potetia dels.or5tolllaearinvestment plans. Deal flow also has been af-
tar nt~  nvetmeitperioT  ag~iive~tnentnUS$O5fected by competing sources of capital, such as
-milionmigit aua!a~5erpntsh~ei*ael cmpan. Tus,theofficial aid or government sources (particularly
a4era   ninveteeW&idbe U$2 inhbit. oe#iiiitpnyin some Mfrican and transition econom-ies). While
.ave-enough companies tithis sizeinterested iouutsidaequity?          entrepreneurs often tell market surveyors that
they want outside equity, few are aware that
venture capital is expensive. Venture capital in-
vestors demand retums commensurate with risks
managers the incentive to divest, a common    and, understandably, attach conditions to their
shareholder goal of maximizing returns, and    money: venture capital fund managers may re-
mechanisms to prevent conflicts of interest be-    place a firm's managers or veto questionable
tween fund managers and the fund, such as    capital expenditures. Government equity pro-
disclosure and review procedures.                    grams rarely carry these disciplinary costs and
are therefore "priced" below market rates.
Other important issues in structuring a fund typi-
cally include tax efficiency, legal form and do-    Exit difficulties
micile, the legal status of investors, management
incentives, and the investment strategy and ex-    Selling venture capital fund investments is of-
The Note sernes Is an   
open forum intended to    posure guidelines. Structuring is often complex,    ten difficult. And liquidating a venture capital
encourage dissemina-  as in the case of a potential US850 million ven-    fund may take longer than expected, depend-
tion of and debate on  ture capital fund in Indonesia. The proposed    ing on the size and liquidity of the local stock
ideas, innovetionno, and
beas practices for   fund faced two difficulties: foreign investors    market and the attitude of the owners of local
expanding the private  needed government permission each time they    firms. In some developing countries, however,
sector. The views    invested in an unlisted company, and the tax    recent stock market growth is easing the exit
published are those of
the authors and should    treatment of sales of stakes in locally incorpo-    problem and, in fact, having a multiplier effect
not be attributed to the    rated companies was unclear. In the end, the    on the exit valuation through higher average
World Bank or any of its   solution was to structure the fund as two in-    price-earnings ratios when sales are made on
affiliated irganizanions.
Nor do any of the con-  vestment pools-one incorporated with local in-    the stock exchanges. And the rapid growth of
clusions represent   vestors and the other offshore-managed jointly   the venture capital industry in the Eastern Eu-
official policy of the  by an offshore manager under a twinning agree-    ropean transition economies shows that venture
World Banik or of its
Executive Directors  ment. The local fund acquires a small amount    capital investors may be prepared to invest in
orthe countries they  of equity in a company, with most of the fi-   anticipation of improved exit opportunities as
represent.           nancing from convertible bonds placed by the    domestic stock markets develop.
Comments are welcome,   offshore pool. This obviates the need to seek
Please call the FPD  government permission for investments and re-    This Note is based on a paper by the International Finance Corpora-
Note line to leave a  duces potential tax problems at liquidation.         ton, InvestmentFundsinEmerging-Markets(Waslbington, D.C., 1996).
message (202-458-1111)
or contact Suzanne
Smith, editor, Room  Deal flow                                             Teresa Barger, Division Manager, Capital
G81D5, The World Bank,                                                     Markets, Laurence Catter, Corporate Planning
igig H Street, NW,
Washington, D.C. 20433,   Many funds invested less capital and more slowly    Department (email: lcarter@ifc.org), and
or Internet address  than expected. In several cases, an expected    Irving Kuczynski, Director Financial Sector
ssmith7@worldbank.org.   two-year investment period stretched to three    Issues, International Finance Corporation
ePrinted on recycled  to five years. The problem  in some countries    (another contact isJeffrey Griffen, Venture
paper.               was that the venture capital concept conflicted    Capital Specialist, IFC, 202-473-5347).