VENTURE CAPITAL INVESTMENTS IN EMERGING ECONOMIES: AN EMPIRICAL ANALYSIS

1. Introduction

In recent years, a rising number of entrepreneurs have started ventures involving multiple countries and cross-border capital flows (McDougall et al., 1994; Brush, 1995; Kuemmerle, 1995,2002), yielding both micro-level financial rewards for entrepreneurs and venture capitalists and macro-level prosperity and improved economic conditions for certain countries. Regarded as the most successful example, the U.S. economy has benefited enormously from the growth of its venture capital funds and high-tech "Silicon Valley" entrepreneurs (Jeng and Wells, 2000; Belke et al. 2002). This is owed to a combination of long-term factors, including: first-rate educational institutions, supportive governmental policies, an attractive environment inducing immigration of scientists and entrepreneurs, protective patent laws, a sophisticated financial system, and a culture with a positive view towards monetary rewards for inventors and innovators (The Economist, 2001; Mueller and Thomas, 2000).

The next logical "group," with a potential to reap such benefits, is expected to be the emerging economies. The purpose of this study is to analyze the requisite economic and financial factors that contribute to the growth of venture capital investments - and in turn to overall economic improvements - in emerging nations. It is clear that many members of this group already have introduced government deregulation and market liberalization, and have taken the essential steps to further integrate their respective capital markets with industrialized nations. Our empirical analysis is aimed at identifying a set of specific contributing variables.

This research is organized as follows. In section 2 a literature review shows that a majority of prior studies have focused on advanced countries, in relation to which a number of determining factors for venture capital (VC) funds and investments have been identified. Analyzing emerging economies, however, can be quite challenging since (a) they differ from most industrial states in terms of economic and political conditions, and (b) there exist limitations on data availability for this group. Thus, in section 3 we establish the necessary theoretical and empirical support for an alternative set of independent variables aimed at explaining VC investments in emerging markets.

The empirical analysis, based on 1990-2003 data, is presented in section 4. The section contains a comprehensive set of statistics - heretofore not reported in the literature - on the dependent variable, VC investments in emerging nations. In addition, it shows the test results on the independent factors, confirming the significance of four of the five proposed variables: GDP per capita, long-term capital inflows, stock market listings, and a measure of stock market correlations in explaining VC investments. section 5 contains some concluding remarks.

2. Literature Review

2.1. General research

Venture capital is defined here as equity commitments - comprised of seed, startup, and expansion investments - by private entities (e.g., venture capital firms and banks), governments, and international organizations (e.g., World Bank's International Finance Corporation) in both private firms and public (listed) companies. A number of studies have looked at the general topic of VC investments and entrepreneurship: Bruyat and Julien (2000), Mueller and Thomas (2000), The Economist (2001), Erikson (2002), Kuemmerle (2002), Martell and Stulz (2003), and Gompers et al. (2003). Among the key conclusions:

* To understand or forecast the entrepreneurial act and its success or failure requires an analysis of the environmental conditions surrounding that act. Specifically, the entrepreneur must be viewed as an individual with the ability to create, learn from, and influence the environment. Also, entrepreneurial learning and networks are found to be among the critical factors contributing to the creation of VC-backed firms.

* Entrepreneurs do need political, social, and business backing. A nation's culture, though, is equally critical by fostering a business education system that - in addition to teaching the functional tools-encourages individuals to be creative, independent, and self-reliant.

* A society is more likely to have substantial growth in venture capital and entrepreneurship if it features high quality educational establishments, an independent and fully functioning legal system, well-diversified and highly liquid capital and financial markets, supportive governmental policies, and an environment that attracts educated and wealthy immigrants.

* For "entrepreneurial capital" to develop, it is essential that the key participants, namely prospective entrepreneurs, venture teams, and investors, possess competence and commitment in identifying and pursuing opportunities.

2.2. Country studies

Numerous authors have conducted country-specific studies. For example, Dossani and Kenney (2002) look at India, Harnao et al (2000) analyze Japan, Sullivan and Unite (2001) consider the Philippines, and Tsang (2002), Chi and Padgett (2002) and Chen and Shih (2003) examine the Chinese case. The main conclusions are:

* A government's bureaucratic tendencies and its degree of control over the economy are important contributing factors to the development of venture capital industry. Also, highly educated and successful nationals based overseas can play a critical role in the development of a country's venture capital markets and the funding of its indigenous entrepreneurs.

* Captive VC firms (i.e., subsidiaries of manufacturing and financial corporations), in contrast to those that are independent, tend to face conflicts of interest and may yield inferior long-run financial performance. Also, potential investors negatively view a family business group's affiliation/ownership of the unit being offered.

* For China's privatization of state-owned enterprises, the fact of government ownership along with the IPO size and the technology-level are found to be among the major determinants of long-run performance, with the latter negatively influenced by an EPO's underpricing. As for privately owned Chinese enterprises, many of which are "Chinese family businesses," their overseas venture activities are strongly shaped by family-based (less formal) approaches. There are potential implications for "outside" investors interested in buying into such family firms since ownership, management control, and the knowledge base are heavily concentrated in family hands.

2.3. Cross-country analyses

In order to identify and test the role played by specific economic and financial factors which lead to the growth of venture capital funds/investments, we continue our review by examining the empirical findings of Manigart et al. (2002) and Jeng and Wells (2000), among others.

Manigart et al. (2002) look into the determinants of the return required by venture capitalists. Their findings show that differences due to stage of investment, holding period, public vs. private status, and country of operation influence return requirements and thus the overall environment fostering the growth in venture capitalism and entrepreneurship (see Mayer et al., 2002, and Hellmann, 2002, for additional discussions on independent venture capitalists vs. other corporations as funding sources, variations in investment patterns, and potential conflicts of interest between entrepreneurs and investors). Clearly, these results have implications for VC firms, entrepreneurs seeking capital, and policy makers.

Jeng and Wells (2000) regress venture capital funds/investments on several independent variables. Among the factors examined, total market value of IPOs (divided by GDP) is found to be significant. This is logical since having a viable "exit" mechanism is imperative for all parties involved. For both investors and venture capitalists, IPOs, regarded as one of the most attractive alternatives (Laine and Torstila, 2003), imply a potential ending through which their original investments are regained. Similarly, entrepreneurs attach importance to IPOs since these offerings give equity-linked financial incentives/rewards to managers along with an eventual control of the firm.

Jeng and Wells (2000) also look at the growth in both GDP and market capitalization, finding neither variable to be significant in explaining VC investing. Next, they focus on a firm's consolidated statements: "with good accounting regulation, venture capitalists need to spend less time gathering information to monitor their investments." They fail, though, to get a correct regression sign in their empirical analysis.

Labor market rigidity - regarded by prior research (Sahlman, 1990) as an important measure of and a potential obstacle to VC funding - is also among the explanatory factors analyzed by Jeng and Wells (2000). Approached in the context of job tenure, the authors find partial support for the role played by inflexibilities in the labor force.1 Meantime, Belke et al. (2002) note that the "effect of venture capital investment on labor market performance should be more pronounced for qualified workers alone than for the total labor market." These results, along with the arguments presented by Krueger and Kumar (2002) on the differences in educational approaches undertaken by the U.S. and the EU, point to a number of advanced economies, especially euro-zone member states and Japan, where labor rigidities continue to be quite pervasive. Such rigidities have long been cited as major contributing factors to persistent high unemployment, and as causing relatively low growth rates observed in not only VC- and entrepreneurial-related activities, but long-term capital inflows as well.

The final variable examined by Jeng and Wells (2000) reflects the existence of private pension funds and the extent to which VC firms will tap into them in order to raise investment capital (Black and Gilson, 1998). Although Jeng and Wells (2000) postulate a positive impact, they find that "the coefficients on pension fund levels and growth rates are not statistically significant," attributing the results to the existence of varying pension fund regulatory systems across the sample countries.

In sum, prior research has primarily considered advanced nations in analyzing some of the major explanatory factors to venture capital investments and entrepreneurial activities. This paper, on the other hand, focuses on a group of emerging economies, which differs, in many respects, from that of industrial countries. Hence, previously identified determinants may not be applicable to the group under consideration here. This, combined with limitations posed by a lack of data availability for this group, demands the identification of and support for alternative independent variables.

3. Emerging Economies' Characteristics

The selected countries are: China, Hong Kong (SAR, China), India, Malaysia, Singapore, South Korea, Taiwan, Thailand, Argentina, Brazil, Chile, Mexico, Egypt, Israel, South Africa, Czech Republic, Hungary, Poland, Russia, and Turkey. This selection (and hence the exclusion of others) is partly based on data availability and partly a reflection of the selected economies being widely regarded as having the highest potential in terms of: rise in GDP per capita, market liberalization, social stability, growth in international trade, attracting foreign capital, and fostering VC investments and entrepreneurial activities.

The literature review presented in the previous section identified a number of determining factors. Unfortunately, for our selected emerging economies the lack of data availability on most of those factors will preclude us from undertaking any meaningful empirical analysis. Instead, it would be necessary to suggest and support alternative measures.

We start by considering several variables designed to capture the importance of the exit mechanism to VC investments. The first factor is a measure of long-term correlation between each emerging economy's stock market index and that of the U.S. S&P 500 index (see the Appendix for details on all the variables and data sources). The higher this measure, the more likely one should find, ceteris paribus, strong fundamental links between the two respective capital markets in terms of: cross-investments by multinational corporations, corporate governance, regulatory framework, and investor protection laws.2 These elements are expected to promote further growth in VC investments (Black and Gilson, 1998). In support, Claessens et al. (2002) state that "economies with higher income per capita, sounder macro policies, more efficient legal systems with better shareholder protection, and more open financial markets have larger and more liquid markets," and Henry (2003) argues that "when emerging economies open their stock markets to foreign investors ... investment booms." Moreover, Salehizadeh (2003) finds the S&P 500 index to have the strongest correlations and long-term cointegration with stock market indices from other advanced economies. Table 1 presents the correlation figures for the S&P 500 index measured against a series of regional (shown in Panel A) as well as individual country (Panel B) indices.

A second measure consists of the number of listed stocks, both domestically and overseas (with the latter proxied by American Depository Receipts, ADRs). The combined figure is anticipated to be a strong indicator of how actively long-established private firms (a norm in many emerging countries) as well as newly-founded entities - some with VC funding, others based on family support - have opted for public-listing. For stock market listings initiated outside each country, data consist of end-year active ADRs. ADR, or cross-listing in the U.S., allows public (private) foreign entities to seek a broader shareholder base and to raise additional (new) capital (Baker et al., 2002; Lang et al., 2003; Foerster and Karolyi, 1999; Miller, 1999; Doidge et al., 2004; Reese and Weisbach, 2002; Lee, 2003). A combined variable representing these two alternative measures will proxy the number - rather than the amount - of IPOs,3 and is intended to provide for a potential "exit" mechanism previously identified as being critical to both venture capital firms and entrepreneurs.

The use of ADRs will have a secondary-contributing role as well. Such cross-listings compel foreign firms to adhere to the more strict rules and standards imposed on business firms by the sec and other U.S. agencies. Moreover, U.S. capital markets and its better-informed institutional as well as individual investors demand more information and accounting disclosures than is common practice in most, if not all, the emerging economies being analyzed here. Indeed, as Lang et al (2003) conclude, "... firms that cross-list on U.S. exchanges have greater analyst coverage and increased forecast accuracy relative to firms that are not cross listed," and that "cross-listed firms have better information environments, which are associated with higher market valuations." It is expected that increased ADR activities lead to a better financial reporting system and an accounting practice more closely aligned with the U.S. standards, fostering further growth in the levels of VC investments. (Due to space limitations, tables containing the data on the remaining independent variables are not included here, but are available from the author.)

For a macro economic variable, the model here utilizes nominal GDP per capita measured in U.S. dollar terms. The related figures being expressed in U.S. dollars provide comparability across such a varied sample and also give an indication of international confidence in each country's economic/political conditions. This variable, having received extensive support in the literature (Bruyat and Julien, 2000; Mueller and Thomas, 2000; The Economist, 2001; Erikson, 2002; Kuemmerle, 2002), is expected to represent the progressive advancements in the level of income and wealth, the combination of which is posited here to be a proxy for the increasing likelihood of commitments to VC investments on the part of an economy's wealthy individuals and institutions.

Host nations receive foreign capital (as a potential contributor to VC investments) through a number of channels, one of the most prominent of which is foreign direct investment, FDI. It is posited here that an increase in this explanatory variable should lead to: higher overall economic growth rate; higher amounts and level of technology transfer; a rise in the wages for FDI-employed labor; and a reduction in the level of labor market rigidities and barriers applicable, primarily, to foreign-owned projects and, secondarily through FDI spillover effects, to the more-skilled segment of the entire labor force. All of these developments are anticipated to have a positive impact on VC investments. In support, the following theoretical arguments and empirical evidence are offered.

By focusing on existing wage differentials between host and source countries, multinational corporations (MNCs) exploit such differences, with potential wage-increase benefits accruing to host-country labor force (Glass and Saggi, 1999; Lipsey, 2002). Also, Borensztein et al. (1998) report that "FDI is an important vehicle for the transfer of technology, contributing relatively more to growth than domestic investment," and Alfaro et al. (2002) observe that FDI brings benefits to a host country in terms of "the introduction of new processes to the domestic market, learning-by-observing, networks, training of the labor force, and other spillovers and externalities," but that the "level of development of local financial markets is crucial for these positive effects to be realized."

Further support for the inclusion of FDI as an independent variable rest on: the role of FDI in leading to more domestic investment (Mody and Murshid, 2002); the importance of strong leadership, sound macro-economic policies, institutional reforms, etc., to attracting FDI (Basu and Srinivasan, 2002; Lim, 2002); and that for developing economies "FDI liabilities seem to be safer than debt or other forms of non-FDI obligations, irrespective of country risk factors such as income level and degree of openness" (Fernandez-Arias and Hausmann, 2001). Overall, long-term capital investments by foreign MNCs - committed in the form of wholly-owned subsidiaries/affiliates as well as mergers and acquisitions visa-vis both existing firms and IPOs - signal that a host country is deemed to have achieved a certain economic and political status, including improvements in labor laws, financial markets and institutions. These conditions are expected to attract more FDI inflows, thus contributing to additional growth in domestic investment and economic output, which in turn, should promote further growth in VC investments.

A final variable being proposed here consists of short-term capital inflows. Such inflows, comprised of equity and debt, are expected to not only capture foreign investors' favorable sentiment towards a host country's capital markets/firms but act as a substitute for domestic funds by providing much-needed investment capital to both existing and start-up companies. Short-term capital flows, unlike FDI, involve substantially higher risk of "reversal" at times of currency and financial crises (as best illustrated by the Asian and Latin American economic events of the last ten years). Nonetheless, the positive aspects of both portfolio and debt inflows are highlighted in a study by the World Bank (1997), with additional support for the link between portfolio inflows and domestic market reforms found in Garibaldi et al. (2002) covering the transition economies of Europe and the former Soviet Union over the 1991-1999 period. Also, Froot et al. (1999) conclude that portfolio "inflows have positive forecasting power for future emerging-market returns," attributing this to the premise that "current inflows predict future inflows, and future inflows drive up prices." During the period under observation here, significant growth has been recorded in financial flows to emerging/developing economies.

In sum, a number of explanatory variables have been proposed. Next, we will examine various aspects of VC investments for our group of emerging economies and then proceed to analyze the role played by the independent factors in explaining such investments.

4. Data Analysis

Annual U.S. dollar figures for V are tabulated based on 1990-2003 data obtained from VentureXpert (see the Appendix). With no data available for Egypt, this country is eliminated from further consideration. The main findings for V are depicted in Tables 2 and 3. It is important to note that an intensive search through the pertinent literature points to our research as being among the first in tabulating and analyzing VC investment data for a group of emerging economies.

Table 2 presents the annual VC investments for each country. Clearly, there are wide variations in the pattern of data, both over time and across countries. In general, though, higher absolute levels appear to be associated with those nations that have achieved higher GDP per capita (including Hong Kong, Israel, Singapore, South Korea, and Taiwan). This conclusion receives further support when VC investments are measured relative to each country's nominal US$ GDP (a dataset not shown in the table but used in the regression tests reported later in this section).

Next, individual country-data containing a number of important statistics are summarized in Table 3.4

Noteworthy are the following points:

* The U.S. is the most active provider of VC investments across all the countries, but its "percentage" position declines as a country becomes more entrepreneurial-oriented (such as South Korea, Israel, and India, each of which has been a "home" to both a large number of indigenous VC funds and correspondingly a substantial amount of VC investments).

* The most common investment stage is expansion, an expected outcome since foreignbased VC funds/firms may not wish to become involved in "risky" ventures located in even riskier emerging economies until the target firms have established proven-records in terms of financial results, products, market shares, etc. The notable exception is that of India where startup/seed is more prominent (owing to a rather large number of entrepreneurial Indians living overseas who have made significant commitments to startup ventures back home).

* "Privately held" is the most frequently observed end-status across all the countries, with the exception of Taiwan where "public" (i.e., IPO) is the norm. Interestingly, and in line with our prior discussions regarding the lack of stock market and financial developments in emerging economies, it turns out that a small percentage of all the VC investments in each country actually went public. Hence, even if the necessary data on IPO amounts and numbers were available for this group of countries, it is unclear that IPO as an independent variable would have received any significant empirical support. Of course, its "proxy" variable, namely A (representing the total of all the domestically listed companies and ADRs, divided by GDP), is in fact found to be a significant factor, as highlighted below. Therefore, it is imperative that emerging economies continue to take the necessary steps for establishing and maintaining a well-functioning stock market regarded by both VC firms and entrepreneurs as a critical "exit" mechanism.

In order to maintain consistency and comparability across both time and counties, the figures used for the dependent variable in Equation (4.1) represent annual VC investments measured as a proportion of each country's nominal US$ GDP. A program called EViews is utilized, and regression tests are carried out based on a "pooled estimation" method whereby Equation (4.1) is estimated with a common intercept, cross-section weights, and "unbalanced" data observations.

Table 4 presents the main regression findings. Test results that rely on the most appropriate estimation technique yield the outcome most consistent with a priori expectations. Other than the variable representing short-term capital inflows - which was previously identified as being highly volatile - all the other independent factors are found to be significant. Indeed, even with the alternative (less-suitable) estimation methods, the findings appear to lend varying degrees of support to the critical roles that G (GDP per capita) and S (stock market correlations) play in explaining VC investments across a varied sample of emerging economies.

It seems that other nations can learn best from the U.S. VC-related successes by adopting economic and political reforms with the aim of raising income, establishing a wellfunctioning stock market, enhancing corporate governance and transparency, and removing impediments (such as labor market rigidities) to attracting long-term capital inflows.

5. Summary and Discussion

Over the last two decades, a confluence of educational, cultural, financial, legal, and governmental policies and conditions has contributed to a significant growth in venture capital funds and entrepreneurial activities in the U.S. This study has looked at a group of emerging nations and proceeded to answer the following question: What specific sets of economic and financial factors explain venture capital investments in emerging markets? It is important to note that no other country has been able to duplicate the U.S. accomplishments, and that potential benefits for emerging economies will take time and yield gains of varying magnitudes.

Prior studies have identified certain key contributing factors to VC-related funds and investments for advanced countries. This research, however, contributes to the literature by being among the first studies to propose and support alternative explanatory factors for emerging states. Additionally, a relatively large number of data points have been tabulated on various aspects of VC investments in the selected countries, resulting in a heretofore unpublished highly informative and somewhat unique set of statistics on international venture capital activities.

Regression findings reveal that a country's GDP per capita plays a positive role. Undoubtedly, as a nation undertakes the requisite changes related to economic and political systems, the ensuing rise in the level of income can be expected to lead to an increasing likelihood of commitments to VC investments on the part of not only indigenous individuals and institutions, but foreign firms as well. Next, a measure of long-term correlation between each country's stock market index and that of the S&P 500 proves significant. Higher correlation links should be associated with rising levels of cross-investments by multinational corporations, adoption of corporate governance, an established regulatory framework, and better investor protection laws.

The total number of indigenous stock market listings and ADRs - as a proxy for IPOs - is found to be significant. Both VC firms and entrepreneurs rely on a potential "exit" mechanism, thus requiring an economy to have a well established and fully functioning stock market system in place. Likewise, it is important for VC firms and entrepreneurs to have access to listing on foreign stock markets (such as ADRs). Finally, a factor representing longterm capital inflows is shown to be influential. Comparing the 1990-2003 VC investment figures for China and Russia as depicted in Table 3 can highlight its relevance. China recorded 334 deals worth close to US$4 billions, while Russia had 51 investments valued at US$155 million. Meanwhile, their total cumulative FDI inflows over this period were US$472 billion and US$34 billion, respectively. Clearly, FDI has a positive association with VC investments.

The results reported here are subject to certain limitations. First, statistical significance does not imply any cause and effect. Second, the relatively small number of economies for which a complete dataset is available may constrain any wider interpretation/implication. Third, in light of short-term capital inflows not receiving any empirical support, other explanatory variables need to be identified and examined. Finally, comparisons of various characteristics of VC investments in advanced and emerging states should allow the latter group to achieve more benefits from VC- and entrepreneurial-related activities. With more complete datasets becoming available over time, these and related topics remain for future research to explore.

In conclusion, it is hoped that this study and its results, by presenting a unique set of statistics and analysis for a group of emerging nations, will be of help to policy makers, VC firms, and entrepreneurs in creating a right combination of economic and political environment, enabling other economies to emulate the U.S. success in venture capitalism and entrepreneurship.