Institutional capital’s growing comfort with emerging market private equity
September 2015 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
As of this year, the 10-year average emerging market private equity returns are roughly comparable with developed market PE returns. To which developed market LPs can be quick to point out, ‘but you don’t get paid for the risk’. It’s time to think twice about this.
Private equity buy-in multiples are currently trading at their 2007 pre-crash peak. Developed market LPA terms have swung well back in favour of GPs. Leverage remains a critical driver of returns in developed markets, yet interest rates are on the move.
Emerging market risks are different from developed market risks – that much is clear. And many traditional PE investors are simply not equipped to identify, let alone evaluate, emerging market risks. How do you align existing structures with unique risks in emerging market currency, political climate, regulatory framework, and market maturity, to name just a few? As emerging markets grow, and in some cases shed their ‘emerging’ status, it may be to time take another look at who is investing capital there, and why.
Quality of managers
One of the welcome developments since 2008 is that today’s emerging market private equity manager is being held to the same diligence standard as any other global manager, and many of them are meeting the standard. Managers must show pipeline, track record, investment discipline, value creation capability, conflict free governance and exit vision.
Today’s successful first, second and third time fund managers are modest, diligent, realistic and very close to their markets. They are focused on capital preservation and entry pricing, and adept at managing a wide range of risks using a much deeper toolbox. They recognise that some volatility drivers are outside of everyone’s control, but that managing the consequences is still their obligation to investors.
Quality of LPs
Another welcome development is that local capital is flowing into these funds. Local pensions are being authorised to invest in alternatives. The local entrepreneurial class and the industrial families are committing to blind pools. Multinationals with emerging market roots and operations are making commitments to local funds much the same way the Fortune 500 have done in the US and Europe.
Smart local money is participating, and it has a more uniquely informed perspective than the ‘fly in’ money. Just as the average US LP may feel relatively comfortable pricing an investment they know well, there are local investors in places like Abidjian, Chennai or Lima who are adept at pricing their specific analogue to that same investment, one which the US LP would struggle to evaluate. Today’s emerging market LPs are still a very eclectic group, but they are bringing wisdom as well as conviction.
Quality of governance
The governance of funds, managers and portfolio companies today is an area of intense scrutiny, and in many regards, outperformance relative to developed market funds. While key man clauses in developed market funds have developed some shocking loopholes (for example, ‘any partner can elect to become a part-time senior advisor’ with no consequences) emerging market managers understand that LPs expect them to keep their shoulder at the wheel for the entire fund duration. LPA terms in emerging markets must reflect this unequivocally.
Emerging market managers themselves are more readily transparent in sharing with LPs the governance of their firm, their investment committee processes, the carry allocations and the budget projections. Of course an over-subscribed fund is less forthcoming on these issues, but as long as LP capital is scarce in these markets, the ability of LPs to truly understand their managers will be advantaged.
In Europe and in the United States, portfolio companies are expected to comply with local environmental and labour laws. People take for granted both the standard and the obligation. In emerging markets, however, regardless of whether there are environmental and related laws on the books or whether they are enforced, most of the private equity managers must ensure that the portfolio companies comply with the IFC’s ESG performance standards. In many regards the IFC standards – such as those on community engagement, labour rights and monitoring – reflect a higher standard than the developed markets’ equivalent.
Building a portfolio
Notwithstanding some of these advantages, building a PE portfolio in emerging markets is difficult, expensive, time consuming and travel intensive. Local knowledge is hard to acquire and local conditions can appear to change quickly. Complicating this process is the ‘tuition capital’ of LPs who chase the latest regional trend. Even though private equity should be aligned to a 10-year vision, LP money can slosh from China to India to Brazil to Turkey to Africa – all over a brief five-year period. In each case, certain markets get distorted.
That said, there are several institutions that have emerging market portfolios with current and historic commitments to more than 50 different funds. These investors have a wealth of experience – both in shaping the market to where it is today, and in having a vision for where the market is heading in the future.
Catalysing institutional capital
There is real opportunity for the private sector in addressing global development challenges like power access, clean water delivery, healthcare, education and agriculture modernisation. This is particularly true in emerging markets that have a middle class that is today comparable in size to a number of European countries.
Many of the most experienced emerging market investors are development finance institutions (DFIs). Part of the role of these banks, in addition to making money and financing development, is to catalyse the deployment of commercial capital into capital-starved markets. As was the case in developed market private equity and venture capital in the middle of the last century, the early investors took risks which ultimately led to the PE and VC industry that we have today. Through DFI leadership, that same process is unfolding today in more than 100 emerging markets.
The Overseas Private Investment Corporation (OPIC) is the US government’s DFI. OPIC focuses on finding managers that fit within the parameters of OPIC’s mission: supporting US investment in economic development, serving as a tool of US foreign policy and national security, generating positive returns for the institution and the US taxpayer, and of course catalysing the entry of private capital into emerging markets.
On the ground presence is important, and OPIC is the only private equity investor with an affiliated office in every market in which it invests: US government embassies and consulates. OPIC’s foreign policy role allows it to access these relationships in support of the development investments of fund managers and co-investing LPs.
An area where OPIC can also benefit LPs is in diligence. In addition to retaining third party gatekeepers to provide an independent view on each manager, OPIC can leverage the breadth of US government databases to check on potential reputational risks of key personnel associated with the fund and with the portfolio companies.
In addition to providing high quality oversight of managers and acquisitions, OPIC’s team also dedicates substantial resources to monitoring. If a company promised to put a fire alarm in the stairwell, treat effluent prior to discharging it into a river, or pay living wages to its employees, OPIC has the right to visit to ensure full compliance.
Much of the capital base in the developed world relies on a view of emerging markets informed largely by the drama of the evening news. Even though emerging markets generate more than 50 percent of GDP, it will probably be many more years before emerging markets capture 50 percent of the private equity LP purse. In the meantime, a growing number of emerging market pioneers will be laying the groundwork, managing the risks and encouraging the returns of private equity opportunities in the high growth economies of a dynamic world.
Brooks Preston is vice president for investment funds at Overseas Private Investment Corporation (OPIC). He can be contacted on +1 (202) 336 8400 or by email: email@example.com.
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Overseas Private Investment Corporation (OPIC)