FORUM: Managing risk and creating value in emerging market investments
December 2015 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
FW moderates a discussion on managing risk and creating value in emerging market investments between Sam Robinson at Aberdeen Private Equity, Daniel Schmidt at CEPRES GmbH, and Luz María Pineda Lucy at Fondo de Fondos.
FW: How would you describe the current emerging markets landscape? With Western markets becoming saturated, has this led to less mature economies experiencing stronger deal flow in recent years?
Lucy: Without doubt, the world economy has experienced changes that may lead investors to turn to emerging markets as potential generators of investment. Of course, it depends on the economic industry and on the region of the emerging market in which you want to invest – therefore, taking into account valuable statistical information for this decision-making process, it is undeniable that emerging countries require investments that strengthen and grow these markets, with the consequent effect on global development. Emerging markets have experienced a higher growth in certain industries. In the case of Latin America, private capital has a growing future that will impact favourably upon the development of both society and the economy.
Robinson: The emerging markets landscape continues to evolve, with investor interest in these markets having waned over the last three to four years. We think the reason for this is that as the West has recovered from the global financial crisis it has facilitated a number of strong private equity backed exits within these regions, which has diverted interest away from Asia. The recent destabilisation of China’s currency and its slowing growth, along with sometimes poorly regulated markets, has also deterred investors from emerging markets. With regard to deal flow within emerging markets, we believe this has remained constant over the last few years. Whilst PE has become a more mainstream asset class with family businesses becoming more open to the idea of outside involvement, there is still some resistance with potential vendors often opting to retain control of their business.
Schmidt: The emerging markets landscape is as competitive now as it ever has been. With strong capital inflows from funds raised over the past five years after the financial crisis and an extremely low interest environment in the West, LPs are looking to the East for returns. Having said that, deal flow has not necessarily increased in tandem with the number of new funds and GPs entering the market, resulting in more capital chasing after deals. Furthermore, entrepreneurs in Asia are generally more reluctant than their Western peers when it comes to sacrificing equity and control for raising external financing. Finding the right high quality asset at a reasonable valuation is an increasing challenge in the near to midterm.
FW: Which emerging markets seem to be offering solid investment opportunities? What factors are driving this activity?
Robinson: When considering returns from emerging markets it is vital to look at this over the medium to long term. Whilst current instabilities may encourage short term opportunistic investing, returns would not be certain. When looking at expected returns from emerging markets over the medium term, say three to five years, we are more positive than a few years ago due to improved fundamentals and more reasonable deal pricing. It’s difficult to pinpoint one particular region which offers strong investment opportunities as each one also faces a number of unique challenges. India may be one to watch given its relatively new government which is focused on implementing necessary reforms on governance, price rises, employment and capital markets, to rebuild confidence in India, both domestically and within the international community. Alongside this, technology developments including greater access to the internet and mobile devices should encourage business growth, with greater levels of ecommerce and more efficient business processes.
Schmidt: Two years ago, ‘BRIC’ was the acronym used when it came to the emerging markets. Now we see that each of the BRIC countries has its own specific – and sizable – challenges, some of which are so daunting that they are now no longer even considered as an investment destination for LPs. India and China are still the leading destinations in Asia simply as a result of the size of their respective markets and growth potential. Both have the strong underlying demographics and economic transformation potential to support solid investment opportunities. In India we have seen a few larger investments driving returns. As demonstrated by recent market events over the past four months, Chinese valuations have dropped. China will likely increase the pace of the country’s economic shift from a low-value manufacturing and export model into an innovation-driven, domestic consumption model. And the Chinese government will have to continue to divest from its state-owned enterprises (SOEs). This transformation will take time but it will present good investment opportunities. Other solid investment opportunities can be found in the ASEAN region where there is also a large, young and vibrant demographic, and room in the market for innovation and growth. These can be pan-ASEAN companies that operate across the region, but are officially domiciled in Singapore.
Lucy: Investors have been cautious to invest in emerging markets. Statistics show that there was a greater acceleration during 2012 and 2013, and a slight slowdown in 2014. In Latin America, the region has shown an increased growth and attractiveness for investors, including countries such as Colombia and Peru, due to their individual advantages which attract more investors. With respect to Mexico in particular, the perception of investors has improved since structural reforms have been carried out, particularly in the energy sector; however, the environment for operating a businesses can be perceived as complex. In the region, the process to raise capital continues to be an arduous process, so investors are less interested in first-time funds.
FW: What is the lure for investors in terms of investing in up-and-coming markets? To what extent are emerging markets funds considered an essential part of a balanced investment portfolio?
Lucy: The attractiveness of emerging markets may lie in the extension of economies insofar as investments are focused on the base of the pyramid. However, it is necessary to maintain a balance of investments across portfolios in order to attract more capital. Today, having investments in emerging markets can be perceived as part of a comprehensive portfolio. The performance of investments will have a bearing, of course, but both companies and their shareholders need to prove that they have implemented high ethical and compliance standards. Moreover, participation in the stock market also contributes to these attractive markets, as recently seen in Mexico with the placement of private equity funds made through development capital certificates (CKDs).
Schmidt: One of the biggest attractions for investors is the idea of investing in an emerging market and riding the growth wave up the ‘hockey-stick’ without necessarily investing in a risky VC tech deal. Equally, the notion of capturing that potentially huge return without having too much leverage risk is a big attraction. A ‘balanced’ investment portfolio, by definition, should certainly include an allocation to the emerging markets, which raises a number of questions. How large should that allocation be? To which countries and sub-regions within the emerging markets should the investments be made? Ultimately, the answers to these will be based on the portfolio’s target risk/return profile, the structure of the existing developed markets portfolio, and the investor’s understanding and appetite for risks within the sub-regional markets. There are encouraging signs for investing into some emerging markets due to better entry valuations in China – especially when capital inflow is significantly reducing due to the shock investors got during the recent crash – and an improved sentiment in India.
Robinson: Emerging markets display several attractive investment characteristics, most notably the possibility of higher returns than those from more developed markets. These tend to be driven by the economic development which emerging markets are experiencing, with demographics suggesting continued growth is likely in these regions going forward. That said, associated risks tend to be greater, so emerging markets are a good complement to more risk-averse investments when looking to create a balanced investment portfolio.
FW: How would you characterise the risks associated with investing in emerging markets? How should a fund manager go about identifying then mitigating extant risks, such as potential corruption?
Schmidt: We would describe the emerging markets as having an additional layer of ‘fundamental emerging risk’ on top of the existing macroeconomic risk one encounters when investing in any market. Fundamental emerging risks are the inherent risks associated with developing countries that can include things such as political turmoil, corruption or lack of governance, underdeveloped regulatory frameworks for the private equity asset class, and government-controlled capital markets including currency peg policies. The key for GPs is to have local teams consisting of local investment professionals who have a deep understanding of the operating environment, develop personal relationships with entrepreneurs and management teams, and put into place investment transaction covenants that protect the interests of the fund – and ultimately, the LPs – in case things do turn south.
Robinson: Risks associated with emerging market investments most notably focus on regulation, political leadership and currency volatility. Often there is little or no regulation in place, and in the instances where there is, it is often underdeveloped. The political leadership of many emerging markets is changing, and is often uncertain, with the introduction of new regimes having huge potential to impact the operating environment and thus investment returns. Firms also tend to be smaller, which brings with it another set of risks including volatile performance, increased susceptibility to the impact of macro trends and heightened key man risk owing to the dominance of individuals. All of this means that when looking to invest in emerging markets you really need to be present on the ground and know the local market. When conducting deals it is prudent to only do so with business professionals with whom you have built relationships over a period of time, where you really know the business and have carried out extremely thorough due diligence.
Lucy: In emerging markets, is important to practice due diligence in greater depth, supplemented with a detailed elaboration of risk questionnaires in order to identify issues of concern arising in portfolio companies, and conduct interviews at different levels of organisations that can help to identify potential risks. It is necessary to conduct an assessment in order to have better tools to establish the evolution and assessment of a portfolio. Deep local research is recommended, supplemented by specialised databases and public sources, as well as conducting a basic internet search, which can trigger alerts that lead to even deeper research. The news within a country may not always be encouraging, but this should not be the sole deciding factor for making an investment. If it were, the categorisation of ‘corrupt’ countries would make investment flows impossible.
FW: With emerging markets funds often spread across a variety of countries and continents, what can fund managers do to guard against the knock-on effects of political instability and potential changes to government policy?
Robinson: Diversification is key to investing in emerging markets. Committing to a number of GPs, for example, can achieve exposure across a region and thus counter the risks inherent in investing in developing countries. Investing in consumer businesses can generally be seen as a safer choice as they tend to be free from government interference. Whilst sectors such as education and healthcare are more exposed to political intervention, there is likely to be reluctance for politics to interfere given the inherent demand for their services. Fund managers should only invest in managers or companies they really know and on whom they have undertaken extensive due diligence. There tends to be a preference for GPs who are macro savvy and cognisant of political risk rather than those who are wildly optimistic.
Lucy: Portfolio diversification is always a relevant topic. In multiregional funds, the identification of risk is broader, so that each country is categorised according to risk level. Such funds have, within their structure, areas of market research and analysis which allow them to select the best investment countries and minimise the risk of political instability. Considering the phrase ‘information is power’, one might think that as more information can be identified, more alerts will be generated to measure and monitor the risk. It is undeniable that financial experts have identified the possible potential of each country in which to make investments in order to foresee their expansion and future returns.
Schmidt: First, it is critical for GPs to have professionals embedded in the local countries and local operating environments. Investing in and managing assets remotely by flying in and out is insufficient, especially in a scenario when the operating environment changes for the worse. Second, the GP must invest in strong and sound business models that firstly focus on the key fundamentals instead of short-lived hype, and secondly, can withstand macro changes that are out of your control – that means avoiding single product, service, client or strategy businesses.
FW: What advice can you offer to fund managers deploying capital into emerging markets, in terms of creating value from their investments? How important is local knowledge, for example?
Schmidt: This comes back to the fundamentals of PE investing. GPs should be providing the guidance and strategic advice to management teams, without micromanaging the businesses. They can help create value by opening doors to new markets, new clients, new suppliers and vendors, finding and exploiting synergies with other business partners, removing excess cost and improving operating efficiencies. Doing all of these things effectively in a very heterogeneous region such as Asia certainly requires local expertise. But, importing an Ivy League MBA ex-consultant who is fresh to Asia to work with management teams across the region is a recipe for disaster. A local operator with 20 years of first-hand industry experience and a deep personal network in the market, but speaks less than perfect English, could be the perfect person to help a management team navigate and solve problems, and ultimately create value.
Lucy: Local knowledge is essential in all transactions but particularly in financial transactions. Not only for business purposes, but also with respect to the perception among stakeholders of a potential investment, local knowledge is an important step toward institutionalisation and a growth that will promote the longevity of a business. The right approach to creating value is aligning interests, which can be achieved with the experience of fund managers and company executives working together to generate long-term value. Large international funds have contributed to jobs creation in emerging countries, which gives them added value in the eyes of society. Furthermore, investments that have a balance in sustainable terms also add long-term value.
Robinson: Local knowledge is absolutely essential when it comes to investing in emerging markets. Without it, you will not understand the native business cultures. Fund managers need to have a local presence on the ground and also knowledge and experience of wider, more international markets. Their local presence will be advantageous in terms of improving communication and thus speeding up processes, whereas having an international presence and experiences will mean they are better placed to grow the company and enter it into new geographies given their understanding of practices in these areas. The real difficulty is in achieving a team balance whereby you are local enough to understand and help investee companies, but also broad enough to understand international competition.
FW: Going forward, what trends and developments do you expect to see in the emerging markets arena in the coming year? Are fund managers coming under increasing pressure to generate returns in these regions? And do emerging markets still constitute a good, long-term bet?
Lucy: The trend in emerging markets points toward new forms of business due to demographic changes, and even roles in terms of income generation, particularly with reference to women. These kinds of dynamics, in terms of business and consumer habits, certainly improve developments in emerging markets. It is not the pressure to generate returns in these regions, but rather a question of making a difference in the world by generating a chain of value. Emerging markets remain a good bet to achieve long-term investments, partly because private equity funds are looking for investments in markets with fewer players.
Robinson: Emerging markets will continue to be volatile over the course of the next year owing to a number of factors including the bedding down of China’s new administration and repercussions of the impending US interest rate hikes. Off the back of this, PE backed exits, particularly through the IPO route, will be limited as vendors will be put off by the volatile markets. Over the longer term we will see more efforts to improve regulation in order to help attract more foreign capital. Fund managers that invest in emerging markets are not generally under more pressure to generate returns from these regions than those who invest elsewhere. We still firmly believe that emerging markets are a good long term investment, provided that you invest through a reputable manager who has a local presence on the ground, with the support of a wider network and who has a proven due diligence process.
Schmidt: There will be pressure coming from LPs for exits and liquidity as funds raised after the global financial crisis start to become ripe for harvesting. TVPIs and IRRs may have looked fine for LPs over the last few years, but now they will expect their DPIs to catch up. However, whether the public markets are conducive for exits is uncertain. Secondary and trade sales will be the preferable exit channels, and that will be just fine for LPs in existing funds raised years ago – but what about new funds, and their LPs – buying into these deals as a secondary? Going forward, the biggest 12-month trends in the emerging markets will be the longer holding periods, increasing entry valuations as more capital chases deals and consequently, the capital overhang as money raised is sitting on the sidelines waiting to be deployed in quality assets at reasonable valuations. Emerging markets are still an attractive long-term proposition, but the approach towards making an allocation to the emerging markets should be based on a solid understanding of the current condition of the existing investment portfolio, and the target risk/return profile of the portfolio, and also on a systematic approach toward fund manager selection that is based on fundamentals, and not simply a ‘follow the herd’ or ‘brand names rule’ mentality.
Sam Robinson is a Senior Investment Manager at Aberdeen Private Equity. Mr Robinson has played a significant role in the creation, investment and portfolio management of a number of fund of funds managed by the team. He has over 17 years’ experience in the private equity industry and has been involved with both primary and secondary investments. Mr Robinson has a degree in Politics, Philosophy and Economics from Oxford University and is a Chartered Accountant. He can be contacted on +44 (0)20 3680 0169 or by email: email@example.com.
Dr Daniel Schmidt is the founder & chief executive officer of CEPRES, the investment decision platform. Prior to CEPRES, Dr Schmidt worked as managing director for Deutsche Bank Private Equity and other investment firms and gained more than 15 years experience in investment management and portfolio management. He holds a PhD with honours in the field of private equity risk management. He can be contacted on +49 89 2324956 10 or by email: firstname.lastname@example.org.
Luz María Pineda Lucy has been the compliance and risk director of Corporación Mexicana de Inversiones de Capital, S.A. de C.V., Fondo de Fondos since 2009. She has been in charge of overseeing and managing legal and compliance issues, regulatory requirements, policies and procedures, code of ethics and conduct, risk management, corporate governance and coordinating internal committees. Ms Lucy has pioneered the development of a compliance officer’s activities in this industry in Mexico. She can be contacted on +52 55 4433 4500 or by email: email@example.com.
© Financier Worldwide