Emerging market private equity: Why the angel is in the details
When OPIC hosted some clients this spring for a discussion about private equity, we conducted a highly informal survey about the climate for fundraising today and the outlook for tomorrow.
The results were realistic but sobering. On a scale of one to five with one being “great” and five being “dismal,” half of the 10 guests who completed the survey ranked the current fundraising environment a four. More than one asked if they could write in six. When asked about their outlook for the fundraising environment with one being “very optimistic” and five being “very pessimistic,” no one answered one, while half of those surveyed answered either four or five.
The fill-in-the-blank question, “When do you anticipate the fundraising environment to improve?” produced 10 different responses, from 2013 to “gradually over 5 years” and the open-ended “once the European crisis is over.”
While there is a strong consensus that the investing environment is tough, investors also recognize that the climate varies significantly from region to region, especially in the developing world. OPIC’s meeting was held the same week as the annual conference of the Emerging Markets Private Equity Association (EMPEA) in Washington DC, where Jay Koh, OPIC’s Head of Investment Funds and Chief Investment Strategist, moderated a panel with other investors who shed some more light on the current constrained climate and how that was playing out in different industry sectors and different geographic regions, and identified pockets of strength from Latin America to Sub-Saharan Africa and Southeast Asia.
Koh, whose Investment Funds Department provides one of the largest single sources of capital in emerging market private equity, has a highly detailed appreciation of investment trends across the developing world. He shared some of those insights – along with a lot of raw data –during a speech in April of this year at the Thunderbird Private Equity Conference in Glendale, Arizona, where he outlined why investors are increasingly looking to emerging markets.
Koh’s speech is excerpted below:
Keynote Address to the Thunderbird Private Equity Conference
OPIC has been involved in emerging markets private equity since 1987, and currently runs an active portfolio of $2.5 billion across 36 active funds, making us one of the largest and longest standing single sources of capital in emerging markets private equity. As the United States’s development finance institution, OPIC has been supporting development and U.S. foreign policy across emerging markets since 1971 on a self-sustaining basis, generating positive returns for the U.S. taxpayer.
Our perspective comes from watching emerging markets private equity expand from Latin America, Russia, and CEE (Central and Eastern Europe) in the mid-late 1990s, Asia and the BRICs in the late 1990s and early 2000s, Africa and Southeast Asia in the early 2000s, and MENA (Middle East and North Africa) in the 2010s.
Although it is clearly an oversimplification to discuss emerging markets as if it were one market – there are 54 countries in Africa alone, 20 in Latin America, and 48 in Asia – I thought I would start by making three observations of the current state of emerging markets private equity:
1. Capital is Coming – but it’s concentrated and lumpy.
When hockey legend Wayne Gretzky was asked the secret to his success, he answered, “skate to where the puck is going, not where it has been.” Applying Gretzky’s rule to private equity, the puck is going to emerging markets, but not smoothly or all at once.
The demand for absolute return in a low interest rate, high volatility environment is driving investors to consider alternative investments and emerging markets in particular.
The math here is simple:
Many defined benefit plans (and other institutional investors) still have an 8-8.5 percent return hurdle.
This was possible to meet when historical risk free rates ranged about 4-5 percent, listed U.S. equities outperformed roughly 3-4 percent above that, and fixed income similarly provided additional return. With the risk free rate at 2 percent or less, listed equities returning 1-2 percent above that, and fixed income in the 1percent range, the math simply doesn’t work and pushes investors into looking for return in alternatives.
This is not fear vs. greed, it’s fear vs. fear; that is, fear of losing money versus fear of not making return hurdles.
Emerging markets private equity is a beneficiary.
The Emerging Markets Private Equity Association (EMPEA) reports that emerging markets private equity funds raised $38.5 billion in 2011 vs. $23.5 billion in 2010, a 64% increase, and a record 15% of total global PE fundraising.
But capital is flowing into emerging markets private equity in focused markets and concentrated amounts. China and Brazil dominated emerging markets private equity fundraising in 2011, with $16.6 billion versus $14.5 billion (2008) for China, and $7.1 billion vs. $3.6 billion (2008) for Brazil. Brazil demonstrates how lumpy that capital was committed: 95% of the record $3.6 billion went to 5 funds (EMPEA).
Limited partners are clearly increasing their interest in and exposure to emerging markets. At the Institutional Limited Partners Association (ILPA) conference last fall in Vancouver, I polled the audience of institutional investors and a full 72% said that they had emerging markets private equity exposure.
But the fundraising environment is still extremely challenging: Preqin reports 20.9 months to close funds in Q1 2012, up from 18.5 months in 2011, and 16.1 months in 2010 (vs. about 10-11 months in 2006-2008).
2. Change Changes.
A major draw to emerging markets generally has been the growth differential between developed and developing markets. From 2002 to 2011, BRICs (Brazil, Russia, India, China) have had 3-6 percent greater GDP growth than the U.S. or Europe. The gap appears to be narrowing as the US starts to recover and the BRICs begin to slow, with Europe remaining challenging.
Change is changing: unlike the pre-2007 trend, each of the BRICs is also slowing, while the U.S. stabilizes and begins to show signs of accelerating and the Eurozone experiences a jagged down/sideways growth trend.
This begs the question: What happens when the “growth gap” narrows?
New investment opportunities become attractive, and capital flows begin to shift. For example, Preqin reports that $50.1 billion is being raised across 66 distressed private equity funds, 70% in North America.
In addition, markets “beyond BRICs” – we might call them “inflection markets” – are also beginning to attract attention. These are markets with substantial populations and substantially higher growth, such as Indonesia, Nigeria, Turkey, Colombia. The average growth rates in these Inflection Markets are beginning to converge with those in the BRICs:
As change changes, attractive investment opportunities – and the capital flows that chase them – should and will also change. When considering which emerging markets to invest in, investors must expect opportunities to shift as markets change and develop – and account for those changes in their long term investment strategies.
3. The Angel is in the Details.
As with any type of investing, while the macro environment sets a tone for deploying capital, the specifics of investible opportunity matter. Although emerging markets offer a rich complexity of less familiar operating conditions for many institutional investors, hard work to understand the specifics of individual investments can yield great returns.
In other words, the Angel is in the details.
In thinking about the specifics, here are a few things to remember:
Emerging markets private equity is evolving differently than developed markets private equity.
- Emerging markets private equity is largely growth equity, with low if any leverage; it is primarily acceleration/expansion capital. The exceptions are in a few markets like South Africa, and in some of the megabuyout funds in Asia and Brazil.
- There is a widespread and continually growing recognition in emerging markets that best practices include ESG – environmental, social, and governance standards – and that those best practices can enhance financial as well as societal value.
Emerging markets private equity funds invest in an evolving set of sectors as the markets they are in change and develop.
- Initially, many funds invest in telecom, financial services, consumer (FMCG)
- In selected markets, funds invest in extractive industries and related sectors
- Private capital then begins to invest into business services and infrastructure related opportunities.
Even though there are common themes to emerging markets private equity fund strategies, their specifics depend on local market conditions. For example, funds in Brazil and Indonesia are focusing on similar sectors of consumer products and natural resources. In Brazil, the focus is on goods and services that serve the 50 million Brazilians moving into the middle class, with natural resource investments ranging from oil and gas to agribusiness and ethanol. Meanwhile, in Indonesia, the consumer story is more focused on the emergence of new basic consumer products and services aimed at a lower income population, and natural resources related to the vast concentrations of natural resources in coal and palm oil, for example.
Investible opportunities exist – emerging markets fund managers are increasing and maturing:
OPIC recently launched a Global Engagement Call, which solicited applications for investment funds operating in any of the over 150 countries where OPIC is open for business, across sectors and fund types, including private equity and growth equity, coinvestment, fund of funds, and mezzanine/expansion financing funds. We are pleased to report that we received 158 full applications to the Call, a record number for the agency, that ranged across geographies, sectors and investment styles.
We will be releasing additional information about those applications in a set of research reports we call Project 158, but suffice it to say that unlike a decade ago, emerging markets private equity now presents a range of fund types and managers that are targets for private capital.
Finally, if in real estate the three most important factors in investing are location, location, location, the three most important factors in emerging markets private equity to us are active, active, active: Active asset allocation, active fund selection, and active asset management.
The limited information, challenging and changing investment environment, and relative newness of the asset class require investors to take a more active approach to allocating capital, selecting managers, and monitoring their portfolios.
In conclusion, emerging markets are becoming an increasingly interesting destination for private equity investment – but the conditions continue to evolve and attention to the details will make a real difference.
At OPIC, we have supported private investment – and private investors –across emerging markets and transitional economies successfully and profitably for the U.S. taxpayer for the past forty years. We’re looking forward to seeing what the next 25 years bring.
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