Braving Africa

As KKR makes its first African deal, a new paper suggests that LPs are overestimating the kind of returns emerging markets are likely to deliver.

Is investing in emerging markets worth the risk? It’s a question that seems timely at the end of a week in which Kohlberg Kravis Roberts became the latest big firm to signal its growing interest in Africa: its $200 million investment in Ethiopian rose business Afriflora marked its first ever deal on the continent.

The macro story behind Africa (and indeed other leading emerging markets) is certainly an appealing one: in today’s environment, where else is likely to see the sort of growth predicted for Africa in the next decade? And it certainly seems to be attracting a lot of attention as a result; it’s rare to meet a private equity LP these days who isn’t considering a new Africa fund. One told us this week that he was looking at “between 40 and 50” managers there (this was at the lower end of the size spectrum).

But will this macro story translate into compelling private equity returns? One way of answering this question is to look at how successfully the industry has managed it in the past.

Of course, trying to draw sensible conclusions about private equity performance is tricky enough at the best of times, and particularly so in emerging markets. The data can be patchy or inconsistent, and in some cases, there’s just not enough of it. However, that doesn’t seem to stop LPs having a certain expectation about the returns they’re going to get. According to a recent survey by EMPEA, 57 percent expected an average return of 16 percent, which is about 400 bps more than they typically expect to get from developed markets.

So are they actually getting this sort of premium? Cyril Demaria, a Switzerland-based asset manager and academic, sets out to answer this question in a new paper (for eFront's PEVARA database). And his short answer is no: according to the information available, there’s no indication that LPs earn the sort of upside that most of them expect from markets that are higher-growth and higher-risk.

It’s worth pointing out that LPs tend to overestimate their returns from developed markets too: according to Demaria, the only way for investors to have beaten that 12 percent benchmark consistently would have been to invest only in the top-performing 5 percent of funds, which is a big ask over an extended period. Even the top quartile funds only beat the benchmark in four of the nine years Demaria considered, while the median returns (arguably the best proxy for the returns of LPs as a whole), never exceeded nine percent.

But the underperformance was even worse in emerging markets: even the top 5 percent of performers only beat the 16 percent expectation in six of the nine years, and the top quartile only beat it twice. What’s more, pooled emerging market returns delivered that 400bps premium to developed markets in just one of the nine years; in seven of the years, they actually lagged developed market returns. So investors weren’t just getting a smaller than expected premium; they were actually getting a discount. (Demaria suggests this may be due to a surfeit of capital, plus price contagion from developed markets.)

And even if you were to argue that past performance is not necessarily an accurate indicator of future performance, there are other data points that ought to give prospective emerging market investors pause for thought. According to figures produced at the end of last year by Goldman Sachs and Capital IQ, FX volatility in emerging markets has been rising while revenue growth from emerging markets has been falling – to the extent that since 2012, the former has actually been higher than the latter. When that happens, investors ought to be getting nervous (Goldman certainly thinks so: in December, it predicted “the strong possibility of significant underperformance and heightened volatility [in emerging markets] over the next five to 10 years.”)

So does all of this mean that investors should shun Africa and other emerging markets? Not necessarily: as Demaria points out, they can still serve a valuable diversification purpose, and some of the top funds are still likely to outperform. And again, interpreting the numbers available isn’t straightforward: given where the bulk of the action has happened in recent years, any pooled emerging market data set is likely to be skewed towards the BRIC countries, rather than those regions such as Africa that are now tipped to grow more strongly. It could be different this time. Still, this data does suggest that the most bullish investors need to re-evaluate the inherent risks of these markets – and, arguably, lower their return expectations accordingly.