Ignore the Noise: Emerging Markets Remain Attractive
Following the Federal Reserve’s suggestion that it might taper asset purchases this past May, emerging markets experienced a bout of volatility across all asset classes. As the OECD pronounced that global economic growth was shifting away from emerging markets and toward developed markets, newspapers became filled with commentary questioning the rationale for investing in emerging markets. In this Views from EMPEA, Mike Casey, a Director with EMPEA’s Consulting Services team, asserts that four key drivers of the emerging markets private equity thesis remain intact, teeing up opportunities for investors to achieve outsized returns.
Have emerging markets truly lost their allure? Following the Federal Reserve’s suggestion that it might taper asset purchases this past May, emerging markets experienced a bout of volatility across fixed income, currencies and equities, only to be treated to news in September that the Organisation for Economic Cooperation and Development now believes that global economic momentum is shifting away from the once-vaunted “growth markets” to developed markets.
Seemingly gone are the days of linear extrapolations of emerging market GDP growth, with their insinuations of guaranteed returns. And how quickly sentiment changed! Not more than six months ago, appetite for emerging markets was insatiable: Brazil’s state-owned oil company, Petrobras, set a record for the largest emerging market corporate debt sale ever at US$11 billion; frontier markets such as Tanzania and Rwanda issued international bonds for the first time ever; and stock markets across non-BRIC economies— from Mexico to Indonesia—were rocketing to all-time highs.
Amidst the liquidity-induced euphoria, one might surmise that long-term investors in private markets opportunities had been a bit more circumspect. According to EMPEA data, through June 2013, only US$10.8 billion had been raised by 31 emerging market-dedicated private equity funds. This constituted a 52% decrease in capital committed to EM funds from the first half of 2012, and the lowest six-month fundraising figure since the depths of the global financial crisis in 1H 2009 (US$8.8 billion).
However, the figures belie global institutional investors’ continued commitment to the asset class, as EMPEA’s newly released Q3 data show US$10.4 billion was raised for emerging market funds between July and September. Moreover, EMPEA’s 2013 Global Limited Partner Survey finds that nearly 60% of institutional investors expect the dollar value of their new commitments to emerging market private equity funds to increase over the next two years, while one-third anticipate that emerging market-dedicated funds will increase as a share of their total private equity commitments.
Despite murmurs of crisis on the tips of reporters’ pens, long-term investors continue to believe in the underlying fundamentals in emerging markets. Indeed, they have little reason not to, as four key drivers of the emerging market private equity thesis—the financing gap, diversification, information asymmetries and active management—continue to create conditions for outsized returns.
1. The Financing Gap
One of the most pernicious obstacles holding back private sector development in emerging economies is the inability of businesses to secure medium- to long-term growth capital. In many countries, capital markets are in a relatively nascent stage of development: credit and equity markets are shallow, liquidity is sparse and the local institutional investor base is incipient. In countries where capital markets are more developed, small- and medium-sized enterprises often remain locked out of them. Even securing bank loans can be a challenge. McKinsey & Company and the International Finance Corporation estimate that 200-250 million micro-, small- and medium-sized enterprises in emerging markets are either under-served or completely unserved by banking institutions. Moreover, in some countries, banks remain focused on directing capital to state-supported projects and enterprises, not necessarily to profitable businesses. The financing gap creates opportunities for investors in emerging markets private equity to arbitrage their capital, from assets and regions where it is abundant, to companies in countries where capital is a scarce factor of production.
Many investors dip their toes into emerging markets initially through public equities, which have traditionally offered exposures that were reasonably uncorrelated with developed market equities. Over time, however, returns from publicly traded emerging market securities have become more correlated with those of developed markets. Bain & Company finds that cross-asset correlations between emerging market and developed market equities increased from 38% between 1990 and 1995 to 74% between 2005 and 2010.
Concentration within public equity markets presents an additional challenge. In many emerging markets, the largest companies account for the majority of the float. For example, in Russia, Brazil, Mexico and Indonesia, the five largest companies constitute 45%, 40%, 36% and 26% of the total market cap, respectively, compared to just 8% in the United States. Beyond market concentration, emerging market exchanges also suffer from sector concentration; the materials, energy and financial sectors—which essentially are a play on the commodity super-cycle and expansionary monetary policies—account for approximately 44% of the MSCI EM Index.
Private equity, on the other hand, offers greater diversification through access to the consumer, healthcare, industrial and IT sectors. Whereas these four sectors account for approximately 42% of the MSCI EM Index, they account for roughly 62% of emerging market private equity deals completed in 2012. Through investments in private equity funds, global investors can achieve uncorrelated returns while accessing more pure exposure to the growing middle class within emerging economies.
3. Information Asymmetries
Unlike developed markets, emerging markets lack an established landscape of investment banks and advisory firms intermediating deals. Fund managers with a local presence and a well-developed network of relationships are thus positioned to generate proprietary deal flow. Moreover, because of the lack of intermediation, there are opportunities for private equity firms to identify promising companies and to structure deals at favorable prices, while avoiding the bidding processes frequently seen in developed markets. When conducted well, deals exploiting these information asymmetries can provide investors with a margin of safety, while setting up opportunities for robust value creation.
4. Active Management
Many—if not most—emerging market companies suffer from an array of inefficiencies and stillborn growth initiatives. Using active management, private equity firms can professionalize and create value in their portfolio companies: implementing financial controls, strengthening corporate governance, driving revenue growth and optimizing working capital. These initiatives can free up cash for capital expenditures, and facilitate a firm’s ability to acquire follow-on financing, either from banks or through public markets. A recent EMPEA study undertaken with EY discovered that organic revenue growth drove 80% of EBITDA growth in Latin American portfolio companies, compared to 44% in the United States and Europe. When done well, these enhancements can deliver alpha for global investors.
Ultimately, these four dynamics boil down to bottlenecks in the flow of capital to its most productive uses, in the flow of information to investors, and in the availability of human capital in emerging market businesses. Private equity firms can exploit these bottlenecks both to finance capital-hungry companies and to provide needed business expertise to management teams in developing economies.
I worry that the recent questions surrounding emerging markets’ future growth prospects could scare investors away from private equity in these countries. That would be a shame. I believe the naysayers are underestimating the degree to which private equity investors are already sparking a virtuous cycle of corporate growth, with positive externalities not only on investors’ portfolios, but also on emerging economies more broadly.
Are there risks in emerging markets? Undoubtedly. Are greater reforms necessary? Absolutely. But at the end of the day, investors should seek to deploy their capital into cash-generative enterprises that are likely to deliver favorable risk-adjusted returns. Despite the volatility in sentiment and gyrations we’ve seen since May, the emerging market private capital opportunities remain too large to be ignored.