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By Veronica L. John
CEO, IDFC Capital in Singapore and President of IDFC Global Alternatives


Opportunities For Private Equity In Emerging Markets

The current outlook for the world economy remains bleak. The financial and economic dislocations experienced by global markets, but more significantly by the developed economies, are unprecedented even for the most seasoned investors. In this context, I have been asked to provide my views on private equity in emerging markets and the future of the asset class. I will summarize my conclusion at the beginning of this article. I believe that the future is bright and that the secular growth story for the emerging markets remains intact.

Emerging markets have not benefited from any sort of decoupling vis-à-vis its developed market counterparts albeit the degree of relative severity is significantly less. Yet amid these tumultuous times emerging markets continued to achieve new records in fundraising. According to the Emerging Markets Private Equity Association (EMPEA), $66.5 billion in fresh capital was raised for emerging markets in 2008, an increase of 10.0% over the $59.2 billion raised in 2007. Still the rate of growth was down from the 44% growth recorded in 2007, which is the slowest growth recorded since 2003. It is highly likely that 2009 fundraising will experience significant negative growth even as investors continue to look for higher returns in the emerging markets with higher allocations planned.

Fundraising statistics for emerging markets barely allow us to read into the ramifications of the recent financial turmoil. The capital returned in 2008, however, provides a stark contrast to previous years, and a look into what the near to medium term holds in store. According to the February 2009 version of the Asia Private Equity Review (APER), just over $8.6 billion is known to have been returned to investors in 2008 from Asian private equity investments. This is a 57% decline from the $20 billion returned to investors in 2007. Returns, however, were only slightly down with 2.77 times returned on the entry value in 2008 compared to 2.94 in 2007. Although APER’s numbers include developed markets such as Japan and Australia, the Review provides a decent indication of what the industry is to going to look like and experience in the global emerging markets in the near term. Capital returned to limited partners over the next couple of years will remain modest until such time that we start to see a recovery in the world’s financial markets. For emerging markets, this is not necessarily a bad thing, provided that portfolio companies into which fund managers invested over the last several years are fundamentally sound. Nonetheless, the stability of these portfolio companies will put slight downward pressure on IRRs. As a result, managers must continue to add value to their portfolio companies and prepare them for the eminent economic recovery.

What is quite notable about this downturn is the extent to which emerging markets were less adversely affected compared to the developed markets. Lack of leverage and sophistication in financial structuring has proven to be a godsend. I have seen a number of conference banners featuring topics focused on what the “new” private equity model will be post-crisis. I am of the opinion that nothing will change, or perhaps nothing should change. The world’s emerging markets, along with the developed markets, are undergoing an evolutionary process. As far as emerging markets private equity is concerned, it still in the early stages of its development as an asset class. It took the United States and Europe between 30-40 years to develop their private equity industries, and they continue to change their focus, priorities, and strategies. That is what is fascinating about private equity as an asset class is its chameleon-like nature and ability to adapt to the circumstances at hand.

The role of private equity remains quite small in emerging markets relative to developed markets. This implies room for further growth and development of the asset class. Recent statistics illustrate that private equity as a percentage of GDP in emerging markets is a fraction of what it is Europe and the United States:

PE Penetration in Emerging vs. Developed Markets

As the financial sectors and the economies in the emerging markets continue to develop, so will the PE industries in those markets. However, it is two sets of perfectly juxtaposed underlying factors that will keep emerging markets private equity at the forefront of investors thinking as they reconsider asset allocations strategies going forward. Overall solid structural fundamentals including rapid economic development (growing middle class, growth in domestic consumption, and significant investment in infrastructure), reduced reliance on foreign debt, responsible public finances and massive improvements in the monetary and fiscal management of the emerging markets economies since the 1997-98 Asian crisis coupled with inherent political and economic risks, information asymmetry, financial markets volatility, serious corporate governance transparency concerns, and government corruption creates an environment ripe for skilled PE fund managers and investors to generate above average returns for their investors.

It is important, however, to not lose sight of the fact that private equity investing is a personal and relationship driven business. In emerging markets, such relationships are the most important source of risk mitigation. If you do not lose sight of this important reality, then you are likely to do well as an investor in emerging markets. For investors that have access to liquidity that can be invested in emerging markets private equity over the long term, the same opportunity will exist over the next several years that was available during the economic crises in the late 1990’s. Resultant capital shortages forced valuations down, and created unique buying opportunities that have benefitted investors with the fortitude and the stomach to invest.

This is why I say that the model for PE investing in emerging markets has not changed. Investors with the inherent talent and skill to choose performing managers or invest directly have learned how to quickly identify the following attributes and characteristics of a successful PE investor:

  • Go local - Stick with predominantly local teams that have honed their PE investment skills through at least one fund cycle. Avoid fly-in and me-too funds or investors as they will almost never make you money, and are most likely to lose a decent amount.
  • Value addition – stick with managers that have proven their propensity for adding an exceptional amount of value to their portfolio companies including taking on the tasks of strengthening corporate governance practices, restructuring management, and positioning the company for a profitable exit given the extraordinary challenges with creating a viable exit opportunity.
  • Exits – Fund managers and direct investors have to demonstrate their ability to put incredible rigor into the exercise of mapping out a viable exit at the outset of their investment in a portfolio company.
  • Integrity, Honesty, and Honor – without this you might as well pack your bags and go home.

So these are the basics that have to be taken into consideration when selecting a fund manager to support or choosing to invest directly. This model or approach for successfully investing in emerging markets remains the same and will not change.

Emerging markets private equity has a bright future that is ensured partly due to the rebalancing of economic power that we are witnessing, albeit it will be a long time in the making. We are dealing with a changing paradigm that we cannot quite nail down at this time, but we can identify key trends.

While emerging markets will remain characterized by volatility and a fair amount of unpredictability, there are strong fundamentals in emerging markets economies that are supporting higher economic growth rates and domestic consumption, the opening of stock markets, greater economic diversification, less dependency on the developed markets for their survival, and the financial resources to support their markets when the inevitable economic downturns reoccur.

It will be important for investors to take a long-term view to investing in emerging markets, and to select the most qualified partners. Prudent but relevant allocations to private equity or “patient capital” in emerging markets should yield above average returns particularly in emerging Asia. You will have to remain focused on the long-term in emerging markets in order to survive occasional social upheavals due to growing inequality (“social incidents” in China increased from 10,000 in 1994 to 80,000 in 2004), environmental implications including the ramifications of regulation in connection with air and water pollution, weaknesses in regulatory frameworks and corporate governance, and global risks related to terrorism or health. There will be plenty of black swans along the way, but private equity capital gives skilled investors the time to recover and benefit from economic downturns as much as from upturns.

Until the fog clears and there is more clarity in the global picture, emerging markets private equity will suffer short term setbacks due to lack of capital in an environment that is bound to yield some rather extraordinary investment opportunities. Investors with fortitude and foresight, however, that return before there is clarity will have the benefit of experiencing exceptional returns like those that rose from the aftermath of the Russian and Asian Financial crises – not for the faint of heart but an opportunity that should not be overlooked due to a preoccupation with the next year on the investment horizon.

There is a plethora of discussion on going back to basics. Emerging markets private equity represents the back to basics investing that investors in today’s tumultuous times crave.

About the Author

Veronica L. John

VERONICA L. JOHN
CEO of IDFC Capital in Singapore and President of IDFC Global Alternatives

Veronica L. John is CEO of IDFC Capital in Singapore and President of IDFC Global Alternatives and is in the process of setting up a global emerging markets fund of funds business. This represents the IDFC’s first initiative outside of India.

Ms. John is a longstanding investor in emerging markets private equity funds in Asia. She has over 20 years of experience in international business and finance including fund management, project management, privatization, and investment banking with a regional emphasis on Asia, Russia, Central Asia and Central Europe.

Previously, Veronica was a Portfolio Director responsible for the Asia fund of funds portfolio of CDC Group based in London. Prior to joining CDC, Veronica was a Principal Investment Officer at the Asian Development Bank (ADB). She was responsible for its private equity investment funds operations.

Veronica lived in Kazakhstan and worked in Central Asia from 1994-2002. During this time, she was a Vice President at Central Asian American Enterprise Fund and managed the Fund’s Kazakhstan and Kyrgyzstan equity and loan portfolios. Prior to that, she was a Project Director with Carana Corporation and responsible for the USAID project for small-scale privatization and post-privatization enterprise support.

Other positions held were in international corporate finance with American Management Systems, investment banking with Central Europe Capital and Graham Rogers & Hamilton, and investment promotion and consulting with the Arnold & Porter Consulting Company in connection with its joint venture with most in Russia.

Ms. John holds a master of business administration from the George Washington University, and a bachelor’s degree in international studies and political science from Elmira College, United States.