Emerging market private equity assets surpass $500bn
September 2017 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
September 2017 Issue
The private equity industry – consisting of buyout, growth, venture capital and closely related fund types – has historically been focused on the developed markets of North America and Europe. These regions house the largest investors, fund managers and vehicles, and are typically the site of the largest deals and exits. However, the industry has been growing in both scale and prominence in global emerging markets, and as of September 2016 (the latest data available) private equity funds focusing on these regions held more than half a trillion dollars in assets under management (AUM).
Given that the global private equity industry holds around $2.5 trillion in AUM, this makes emerging markets-focused funds an integral component of the asset class, accounting for around a fifth of its size. This is a reflection of the rapid growth of the industry in these regions: emerging markets-focused private equity funds held $93bn in AUM as of December 2006 and have grown at an average annual rate of 21 percent to reach $564bn as of September 2016.
Emerging markets-focused funds have also started to return net positive cash flows to their investors in recent years. In 2010, net cash flow to investors reached a record low of -$34bn, as fund managers called up more capital than they returned through distributions. In 2015, however, annual net cash flows were positive for the first time, as distributions outstripped capital calls by $7bn, and the first three quarters of 2016 saw a further $13bn in net capital returned to investors.
However, this success does not seem to have spurred greater year-on-year fundraising for private equity investments in emerging markets. Fundraising peaked most recently in 2014, when 330 emerging markets-focused funds raised a combined $79bn. Since then, successive annual fundraising totals have fallen, and in the first five months of 2017 61 funds raised just $16bn. This runs counter to global trends, which have seen near-record levels of fundraising since 2015. As a result, emerging markets represent a declining portion of total fundraising activity: funds focused on these regions accounted for 22 percent of global capital raised in 2014, but just 10 percent of capital between January and May 2017.
There may be two key factors which explain this phenomenon: the comparative strength of private equity funds focusing on the developed markets of North America and Europe and the variability of fund performance across disparate emerging markets.
The former is due to the overall strength of the private equity asset class. Not only is fundraising at historic highs (2017 has seen the largest ever private equity fund closed, and seems set to surpass 2007 as the record year for the industry), but performance has remained strong. Private equity funds passed a record $488bn in distributions to investors in 2016, a net capital flow totalling almost a quarter of a trillion dollars. This was driven primarily by high performance in developed markets – North America-focused funds returned 11.1 percent in the year to December 2016, while Europe-focused funds returned 13.1 percent. By contrast, emerging markets-focused funds returned just 6.7 percent across the same period.
While returns for private equity in emerging markets are nonetheless robust, their relative underperformance compared to vehicles focused on developed markets may be in part due to the disparate nature of different emerging regions, and the impact their various circumstances have on funds focusing on these markets. As a whole, the standard deviation in the IRRs of emerging markets-focused funds is 15.4 percent, higher than for funds focused on North America (14.9 percent) or Europe (13 percent), despite both of these fund pools being significantly larger. This shows that funds in emerging markets show a wide variety in performance, reflecting the diverse natures of emerging economies.
For instance, emerging economies in Asia are becoming key drivers of activity not just among emerging markets, but globally. Booming growth in India and China has spawned increased opportunity for venture capital and growth funding, spawning expansion in these sectors across the region. Despite concerns in some quarters about the future pace of development, these industries nonetheless offer investors the potential for robust returns: Asia-focused private equity has returned an overall IRR of 10.1 percent annually in the three years to the end of 2016.
By contrast, circumstances in Latin America have deterred investment in the region in recent years. Several economies in Latin America are bolstered by the production of oil or minerals, so long-term falls in oil prices and the widespread slump in the global mining industry have seen the region come to be perceived less favourably. At the same time, political instability, government defaults and relatively restrictive capital controls have made foreign investors wary of committing capital to Latin American economies. As a result, fundraising for Latin America-focused private equity funds fell from $10bn for funds closed in 2010 to just $500m in the first five months of 2017.
However, this is not to say that emerging markets-focused funds are out of favour with investors: 20 percent of those we surveyed in December 2016 said they were looking to increase their allocation to emerging markets private equity in the next 12 months and a further three-quarters will look to maintain their current rate of investment. It may also be that coming years will see the balance of investor interest tilt further in favour of emerging markets. There are concerns in some quarters that traditional private equity markets are in danger of overheating: undeployed capital stands at $918bn at the mid-point of 2017, and fund managers report that competition and pricing for deal opportunities are producing distinct economic headwinds.
Despite this, investor appetite for private equity remains strong, and satisfaction with the asset class is high. It seems unlikely that investors will look to reduce their allocations immediately in these conditions, but it may prompt them to look for investment opportunities which face less competition. Emerging markets-focused investments could be a solution, and the fact that the largest global private equity firms are increasingly launching vehicles to focus on these regions suggests that attitudes are starting to change. If emerging markets-focused funds can keep returning capital to investors, and show their ability to make the most of opportunities offered in these regions, then we may see fundraising and investor activity return to or surpass its previous heights.
Christopher Elvin is head of private equity products at Preqin. He can be contacted on +44 (0)20 3207 0256 or by email: firstname.lastname@example.org.
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