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Emerging Market Venture Capital Funds

International venture capital (defined broadly to include investment in non-publicly traded companies, including (1) seed or initial capital, (11) startup capital, and (m) expansion or growth capital) with a focus on the emerging markets has grown considerably over the past fifteen to twenty years. Beginning in the late 1980s, emerging markets have increasingly become the target for direct foreign investment. Initially, strategic investors and investors in publicly traded securities were the principal players in these markets. International venture capital investors, however, have followed in their tracks and today are important sources of foreign investment in these markets.

U.S. institutional investors have been on the forefront of the growth in international venture capital in emerging markets. These investors are attracted to this sector because of the perceived high growth/return opportunities in these markets, as well as the perceived need to diversify their holdings internationally. This interest by institutional investors has led to the formation of many pnvate equity funds focused on investments in the emerging markets. As more and more investors and fund managers become involved in international venture capital, there is a growing need for attorneys to focus on this area. Attorneys specializing in international venture capital participate in these projects both during the formation of the investment fund and through participation in the investments made by these funds.

Attorney Roles in International Venture Capital in Emerging Markets

Many attorneys focus on the representation of fund managers and/or institutional investors during the process of formation of the fund. These attorneys generally must be sensitive to the many tax and regulatory issues associated with the establishment of cross-border investment funds.

Representation of the venture capital funds in the implementation of their investment programs is the second arena where attorneys are generally very active. These attorneys generally have expertise in the acquisition and sale of emerging market companies and, frequently, expertise with respect to the sector in which the investment is being made.

Challenges of Emerging International Markets

The initial wave of international venture capital investing in the emerging markets typically involved fund managers with (1) extensive knowledge and contact with the target region but little private equity experience or (11) extensive private equity experience (usually in the United States) but only marginal experience in the target region itself. In addition, there was no generally accepted framework for private equity investing in emerging markets. Rather, the approach was one of trial and error.

For example, based on the successful model developed in the United States where venture capital investors frequently have been able to exit investments through the public securities markets, many of the initial private equity funds structured their investments with the aim of exiting through the local secunties market or through an international placement of the target company's secunties. Unfortunately, the public secunties markets (locally or internationally) have not proven to be an effective means to exit most pnvate equity investments in the emerging markets. As a result, many emerging market funds have encountered difficulty in exiting their investments.

Fortunately, the expenences of the last fifteen to twenty years have helped to shape a model for emerging market pnvate equity investing. This emerging model retains the basic structure developed in the United States but has adjusted such model to meet the requirements of the local market. For example, this evolving model utilizes techniques designed to mitigate nsks associated with a less than fully transparent and effective judicial system and with thinly capitalized public secunties markets.

Addressing These Challenges

Expenenced attorneys are essential to the implementation of this new model. For example, the new model emphasizes the need to focus on developing an exit strategy for an investment pnor to making the investment. Moreover, such strategy will require looking at a variety of options, including making a quasi-equity investment rather than the traditional equity investment, negotiating put nghts with respect to an investment, and obtaining a drag-along nght or a forced sale nght (e.g., the nght to require that the target company be put up for sale itself if an exit is not completed by a certain date).

Legal Documentation to Establish Venture Capital Funds

^Agreement Establishing the Fund

Creating a venture capital fund requires extensive legal documentation. The principal document establishes the fund itself, typically through a limited partnership agreement. It should be noted that funds are generally established, for tax purposes, as limited partnerships or other forms of "pass-through" vehicles. The agreement establishing the fund will provide for the investors to make cash contributions to the fund so the fund may then make portfolio investments. The investors generally are entitled to limited liability, which means they are responsible and liable only for the money they have agreed to put into the fund. This document generally provides the investors with only limited control rights with respect to the fund; they are passive investors. Control of the fund is generally assigned to a general partner. The general partner is under law jointly and severally liable for the obligations of the limited partnership. For that reason, the general partner is frequently a special purpose vehicle that has no assets beyond those of participating in the limited partnership.

The agreement establishing the fund generally establishes the conditions that must be met in order to have the investors provide the fund with the cash to make the fund's investments and pay its ongoing obligations (including the management fee described below). This agreement also contains reporting obligations on the part of the general partner, restrictions on the transfer of ownership interests by the general partner and the investors, mechanisms to handle conflicts of interest, and a mechanism to terminate the fund and/or the general partner.

The fund agreement also specifies how the proceeds of the fund's investments are to be distributed among the partners (limited and general). Generally, the proceeds of the fund's investments are distributed in accordance with a "waterfall." The waterfall will provide the investors with priority with respect to a return of their invested capital and a pre-established profit, with the general partner and the investors sharing in the profits beyond such amounts.

Management ^Agreements

A second contractual arrangement common for international venture capital funds is the management agreement. This is an agreement under which a management company agrees to provide management and administrative services to the limited partnership and/or the general partner. The management company frequently is closely affiliated with the general partner. Under the management agreement, the management company generally agrees to seek investment opportunities, monitor the performance of portfolio investments, help portfolio companies grow and prosper, and ultimately assist in exiting the investment. The management company is paid a management fee for these services, which is generally a percentage of the size of the fund.

Important Consideration in Legal Documents

Legal documents to establish venture capital entities attempt to set in place appropriate incentives for implementing the investment strategy. They should also address potential conflict issues, help negotiate circumstances regarding a questionable decision, and protect against changes that could ultimately impact return on the investment. Attorneys representing fund managers should structure legal documents so the fund manager is compensated for the value it has added.

The Impact of Evolving Market Conditions

As noted above, over the past fifteen to twenty years, there has been increasing interest on the part of international institutional investors in making private portfolio investments in emerging markets. This strong interest provided fund managers with considerable leverage in negotiating the terms and conditions of the fund formation documents. As funds organized in the 1990s failed to obtain the anticipated results, the climate has changed. Today, it is much more difficult to raise new emerging market venture capital funds (excluding funds focused on India and China). Investors generally have more leverage with respect to the specific terms of the fund document. However, the basic structure remains in place and has become a market standard.

Working with Venture Fund Clients

As with other practice specialties, it is important for attorneys active in the representation of international venture capital funds in the implementation investment program to "know the client and the client's needs." First, the attorney must develop an understanding of the requirements imposed on a fund manager by its investors. For example, is the fund allowed to make debt investments? Second, the attorney must understand the client's investment strategy, with the objective of assisting the client in identifying other professionals who may assist the client in the identification and review of investment opportunities. Third, once the client has identified an opportunity for the fund, the attorney must help the client understand the risks and opportunities associated with an investment.

Keeping Up to Date

International venture capital lawyers working with an emerging market fund must keep in close contact with local professionals in all the jurisdictions where the fund is contemplating making investments. These local professionals can help identify issues and resolve any problems associated with such issues. In essence, the approach should be interdisciplinary.

Ultimately, the goal of the lawyer is the client's success. Even if an investment is appropriately structured from a legal standpoint, a lawyer will only be truly successful if the investment is a success for the client.

Jorge A.lers's practice primarily consists of providing legal advice in the areas of mergers and acquisitions, project financings, privatisations, and direct investment transactions Mr. A.lers has participated in numerous project financings in Latin ^America and other emerging markets. He has represented both lenders and developers! borrowers in project financings in, among others, the energy, mining, telecommunications, tourism, and transportation sectors. Many of these financings have involved financial support by multilateral or bilateral financing institutions, such as the Inter-^American Development Bank, the International Finance Corporation, and the Overseas Private Investment Corporation.

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