Private Equity in Emerging Markets

Private Equity (henceforth PE) is a vital component of any economy. PE has been integral to the growth of some very famous companies in recent decades; these companies include Federal Express (now FedEx), Oracle, Intel, Apple Computer (now Apple). The asset class provides the opportunity for entrepreneurs the asses to capital, and in return PE firms can make significant returns for shareholders of their investment fund.

Private Equity Overview

PE firms create a fund, with investors contributing their capital to the fund of the PE firms that they believe have good plans and prospects for growth and profitable investment returns. These outside investors are called “Limited Partners” and usually contribute around 99% of the fund’s capital. In addition to this the General Partners of the PE firm – the owners and decision makers within the firm, will put their capital into the same fund (usually around 1%). Using this capital from the fund, the PE firm will invest into privately held companies; in the sectors, industries and regions they feel most appropriately suit their investment strategy.

Sometimes investments are made into small companies, $1m – $50m, medium companies, $50m – $1bn, or large companies, $1bn+; it depends on the size of the fund, the potential for return on investment, and sometimes on existing experience/held companies – as potential synergies/competencies can be leveraged.

As ownership of the acquired companies is in privately held companies, the ownership stake taken by the PE firms is usually large. The average percentage ownership stake is around the 70% mark. This marks this type of ownership out clearly form, say, acquiring a very small minority shareholding on a publicly traded company, listed on a stock exchange. Thereafter, the primary method by which Private Equity firms extract/enhance value from the businesses they invested into is through:

1)    Leverage
2)    Multiple Expansion
3)    Growth
4)    Efficiency

In Emerging Market’s (henceforth EM’s), Growth and Efficiency improvement are the two primary methods by which value is enhanced, and so, returns are generated. However, generally speaking, many, if not most, firms use a blend of the four.

The premise of a PE company, using the capital in the fund is has available to it buys up a privately held companies – PE firms both seek acquisition targets and are approached by companies. Usually, a corporate restructuring is then implemented; debt it restructured, the organisational structure is sometimes restructured (resulting in job losses), other costs are cut, including the selling of business units, divisions, assets etc ; and sometimes the whole corporate strategy is restructured/overthrown and rebuilt.

There has been controversy surrounding PE in the past; much of this comes from: job cuts, the selling assets quickly in an “Asset-stripper” fashion immediately after acquisition, and the payment of very large dividends to shareholders (largely themselves) from cost reductions immediately after acquisition. Responsible for developing business internationally, there are factors that PE firms should consider in the emerging markets, such as: the development of the local community, environmental considerations and development, social contribution from businesses, ethical issues etc – thus, the objective should not be to “make a short-term perspective quick buck” from EM investment.

However, the fact remains that PE is an excellent way for the investors in the PE firms; both general partners and limited partners, to benefit enormously from the return on investment; and the businesses which they invest into are able to gain access to capital, (which they may not have been able to have access to all before, or at least, not at such a favourable rate of interest).   What is more, the PE firm will often have many contacts in the field they are investing into, or the employees may be experts themselves, allowing the company to grow more rapidly and with a greater chance of success. There are also considerable benefits to the overall economies of nations with an efficcent market set up for Risk Capital.

The controversial issue are not the focus of this article, so henceforth, I will look at PE in a relatively win-win situation for both the PE firm and the companies they invest into; bearing in mind, many entrepreneurs set up companies with the exit strategy of selling to PE firms. Above all, it is an important part of a capitalist economy and keeps investment capital flowing.

The Case For Private Equity in Emerging Economies

For successful PE firms to exist there must first and foremost be good businesses for them to invest in, and also good economic trading conditions for the business to flourish. As is shows, the two largest markets for Private Equity are in the US and UK; whereas in comparison the BRIC countries represent a low saturation level of PE firms. This could potentially be a chance for foreign firms to penetrate these markets, or for local PE firms to spring up and invest in businesses in their respective flourishing economies.  It would seem a logical move to look for investment opportunities in the emerging markets; yes risks are higher, and factors such as political instability, a degree of economic uncertainty, and the desperate need for social development and infrastructural reform, are not the primary concern factors of many of “The West’s” investment considerations. However, resultantly, the returns offered have the potential to be extremely high.

Recent years have shown the resilience of these emerging economies in light of the Global Financial Crisis (GFC), and this developmental change looks set to continue. Thus, expanding a company portfolio represents a healthy diversification away from Western European and US businesses that are tied in to the stagnated economies of these regions; companies is these emerging economies can provide a much needed driver for portfolio growth, and, so long at good quality businesses are invested in, may even represent a risk-reducing diversification strategy away from saturated, highly competitive and slowly growing market in The West.

From the countries perspective, having PE firms in the marketplace infuses capital into the system and greases the wheels of the economy in which the PE firm operates. The International Finance Corporation is the private investment arm of the World Bank Group, and currently has $3bn of committed capital through 180 funds in emerging market private equity, representing 10% of total investment  . Since 2000, this company has created 200, 000 jobs throughout EM’s and the average level of job growth stands at 22.3%. Moreover, as EM’s increasingly deregulate their markets and the wealth of the population continues to increase, the businesses invested into by PE firms, are able to find high consumer demand for their products. So, as more capital is then invested into the economy this cycle perpetuates and the wealth creation process continues.

The average exit for an EM PE firm is 4.9 years demonstrating that a healthy return on investment can be generated in a relatively short period of time. Moreover, as the IFC indicates good Exit opportunities DO exist in emerging markets. Exit opportunities are a key factor in PE as firms don’t want to hold on to investments longer than they can extract value from/or add value to, so the existence of other PE firms sell to, or, the stock market structure for and IPO, or, the a access to capital to senior management for an MBO, further increases the attractiveness of the EM proposition, and reduces the risk factors of investing there.

Finally, the IFC proposes that small companies invested into can still generate significant returns; of course, the GDP growth of the BRIC countries make the headlines and the very big industries such as Steel, Oil, Gas etc make the headlines too; but this does not mean that smaller businesses will necessarily follow this trend, and funds mangers should be wary before investing blindly into what looks seems a sure thing, based on overall GDP figures. Needless to say not all businesses will succeed. However, smaller there do exist very good companies in the EM’s, and the IFC has indicated that companies valued as low as $2m can be very successful and thus, represent a good return on investment for PE funds.

The Case Against Private Equity in Emerging Economies

However, the case against emerging market private equity must also be considered, and is an important consideration for any firm looking to invest any percentage of its funds in EM’s, or for any entrepreneurs looking to set up their of PE firms in EM’s.

As previously eluded to, many of the factors that lead to the development and indeed prevalence of Private Equity in the US and other developed economies are lacking, to some extent, in the emerging economies. Factors such as ‘low standards corporate governance terms of the quantity of information required to make investment decisions and monitor performance once investments have been made; the weakness of legal systems in enforcing contracts and protecting classes of investors; and the inability of domestic equity markets to offer a reasonable prospect of exit through the IPO market’  are all significant factors to be considered prior to investment. However, the extent to which investors place the credibility of these factors is subjective and should be seen as on a market by market basis. Indeed, the final consideration regarding IPO exit, (or a lack of possibility for it) directly contrasts with the IFC assessment of the established exit infrastructure. Nevertheless, without beginning to divulge too far into this, it is suffice to say that there is ambiguity over the risk factors and the manner in which the EM PE market will take shape.

A key aspect that should be considered in assessment of EM PE is the level of returns offered. If the risk/return ratio is unjustifiable it can be hard to justify to the PE firm’s shareholders why they continue to invest in EM’s with little return, or even losses. Leeds et al has identified that by the late 1990’s/early 2000’s emerging market private equity investment funds had ‘performed poorly both in absolute and relative terms.’  Neither the dollar’s appreciation, nor the comparison to a booming US venture capital industry was enough to justify the poor returns in EM’s. It would seem that extraction of the value of companies in emerging market was harder than first thought. One very dismayed fund manager felt returns had been poor in Asia, Latin America and Russia and would continue to do so as investors had no ‘high profile role models of consistently successful funds to demonstrate that this type of investing works well’ , and the enthusiasm for the asset class declined away during the early 2000’s.

Finally, for good investments to be made, above all, there must be good businesses to be invested into. This is the demand side of risk capital; without an entrepreneurially nurturing societal culture, and without significant threat of corruption, bribery and undue socio-political unrest, businesses cannot be set up or run effectively and so cannot warrant the developing need for risk capital, thus arresting PE funds from flourishing in these particular EM’s.

The Future

The theoretical concept of Private Equity funds investing in Emerging Markets, and even the prospect of local PE funds emerging to compete in the local EM market place, is a tantalising idea. Certainly, the GDP growth figures are incredibly strong, PPP in growing in Latin America, SE Asia, the BRIC countries and the development of both B2B and B2C markets associated with this, suggests start-ups, mid-market and even larger firms can benefit from PE capital investments into their businesses. What is more, governments and economies stand to benefit from the development of risk capital markets, and should work to enhance further migration of this asset class to their economies. Therefore, it is in the government’s interest to address the key issues that deter risk capital investment: corporate governance issues, and investor protection. These issues are paramount to nurturing the development of the industry and start with addressing corruption, bribery and ensuring financial law is enforced more effectively. It has been noted, by Djankov et al (2005) that the legal environment strongly determines the ‘size and liquidity of a country’s capital market ‘ . Thus, it is important for the government to tackle these key issues that affect the “supply” side of private equity. Conversely, on the “Demand” side, what truly drives business development is entrepreneurial prevalence and dynamism to identify and exploit opportunities. Black and Gilson (1998)  has suggested that this is a bit of a ‘chicken-and-egg problem’; however, as can be seen, the development of entrepreneurial ventures is forthcoming in emerging economies as inhabitants are being economically, socially and politically empowered and this trend is set to continue. The development of further financial infrastructure can significantly increase the likelihood of profitably benefitting from these developments and allowing Private Equity funds to gather momentum in this space and even for local PE funds to be established and grown. Thus, generating returns from PE in EM’s is not as easy as was first anticipated; but the key players appear to have learnt from many of their mistakes and will, for example, ensure their they have “eyes and ears on the ground”, if not an office, certainly a few employees to manage investments are needed. Above all, entrepreneurial spirit will overcome adversity and challenges in front of it, so long as the right infrastructure is in place, funds are managed more carefully and businesses are nurtured as is appropriate, the Private Equity industry with flourish and has the potential to be very profitable in Emerging Economies.

One thought on “Private Equity in Emerging Markets

  1. The analysis clearly shows the potential of PE Funds wisely used not only for startups in 1st world economies, but even more in developing countries.

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