Since the 1990s, global investment in private equity has increased from nearly $10 billion to well over $100 billion per year. Concurrently, there has also been a shift away from public markets in major economies like the U.S. and U.K. These two developments are likely connected by the trend of small and mid-sized companies staying private longer due to increased supply of private funding.
Another notable change during that same time period has been the trend toward more private equity investment outside the U.S. and U.K. despite concentrated fundraising activity. In fact, while in the mid-1990s, the share of U.S. and U.K. private equity investment was over 90% of the total global investment, this share declined to about 70% by 2017. The increase in global private equity investments, coupled with the recent levelling off and slight downturn in global public company listings raises important questions about the development of capital markets globally. Are changes in the preference for private versus public ownership in the U.S. and U.K. part of a larger global trend? If so, what factors have driven growth in private equity historically and why?
Our empirical study and conclusions
In an attempt to answer these questions and to better understand current and future trends in capital formation through private equity, we studied the determinants of buyout investments across 61 countries over the period of 1990 – 2017 using comprehensive country-industry-level data on international private equity activity. Our main results showed that macroeconomic conditions, financial development, and regulatory environment all play some role in determining the level of buyout activity at the country level.
1. Macroeconomic conditions and financial market development
For macroeconomic conditions, we found that country-level buyout activity increased more during economic expansions, measured by a declining unemployment rate. We found a similar result at the industry-level: industries received more buyout investment following expansions in industry-wide employment. These were likely due to higher demand for capital in a growing economy indicating that private equity may provide capital for companies in need. Given this, private equity might be a substitute for public equity and play a role in providing growth capital in economies where public markets are not as active. Nevertheless, we found evidence for the opposite: countries with more stock trading experienced more buyout activity. This suggests that instead of being a substitute, private equity activity is complementary to public market activity. Overall, these results indicate that financial market development goes hand in hand with private equity market development.
2. Regulatory environment
Next, we explored how the institutional and regulatory environment in a country impacts the extent of buyout activity. The law and finance literature has shown the importance of legal factors for the development of financial markets across countries. We expected the legal regulations to play a role in private equity market development as well. As private equity transactions typically involve a large transfer of ownership and private contracting, we explored reforms our sample of countries have adopted over the sample period on investor protection and contract enforcement. We compared buyout activity pre- versus post-regulatory reform across countries that adopted a reform versus those that did not. We found that countries received more buyout investment following investor protection and contract enforcement reforms.
Furthermore, we also studied whether the positive effect of the regulatory reforms differed across countries based on their existing legal conditions. On the one hand, a country with weaker governance may benefit more from the implementation of regulatory reforms; on the other hand, to make the reform effective in attracting more buyout capital, a country may need a strong country governance structure. As expected, we found that investor protection and contract enforcement reforms were more effective in attracting more buyout capital in countries with better regulatory quality, rule of law, and lower corruption. Additionally, we also found the positive association between regulatory reforms and buyout investments to be more pronounced in countries with higher level of education, suggesting that reforms need to be backed not only by a strong regulatory environment but also high-quality human capital.
We also considered whether the factors we identified were specific to private equity: i.e. do these factors similarly impact other traditional forms of investment such as foreign direct investment or gross capital formation in a country? Our analysis indicated that, compared with other traditional forms of investment, private equity investment was more responsive to macro-economic conditions, financial development, and institutional factors. Finally, we performed comparative statistics using our main model on the determinants of buyout activity to better understand where our sample countries stand in terms of realized versus predicted buyout capital investment. Based on our predictions, we found countries like China, Argentina, New Zealand, and Indonesia to be below predicted levels of buyout activity and hence expect them to receive more buyout investment in coming years. We find other countries like Poland, Hong Kong, and Qatar to be above predicted levels, suggesting that they are likely saturated with buyout investment as of the end of 2017.
Despite the tremendous increase in global buyout investments over the last two decades, there is a significant lack of systematic studies exploring the country-level drivers of buyout investments. Our study fills that gap by providing the first large sample evidence on the determinants of global private equity investments. Our findings help understand how capital markets will evolve in developed and developing economies. Our study also has policy implications, which suggest that policy makers, especially those in developing economies, should focus on improving the institutional and regulatory environment in addition to providing growth potential to attract private capital. Such reforms would attract private equity, which would help local companies realize growth opportunities by providing them needed capital along with significant management expertise.
Serdar Aldatmaz is an assistant professor of finance at George Mason University’s School of Business.
Gregory W. Brown is a professor of finance at Kenan-Flagler Business School of University of North Carolina at Chapel Hill.
Asli Demirgüç-Kunt is is the Chief Economist of the Europe and Central Asia Region of the World Bank.
This post is adapted from their paper, “Determinants of International Buyout Investments,” available on SSRN.