When it comes to pricing risk relative to return, the commonly held view is investors in illiquid assets are typically worse at it than those investing in liquid assets. This would seem plausible given that liquid investors are exposed to daily volatility and risk, whereas investors in illiquid assets represent patient capital less concerned about tomorrow’s risk and more about the likely macro-risk factors over the next decade. While I haven’t seen any empirical evidence to support this view, it is clear to me that private equity investors are typically more concerned with the nominal net return than any risk-adjusted return. When last did you hear a limited partner ask about the Sharpe ratio – ie, the return above the risk-free rate equivalent on a fund?
Nevertheless, a risk that LPs around the world are very aware of and price into their return expectations is emerging market risk, which manifests itself in the form of an EM return premium. Some of the root causes of this notional premium include the following:
Currency volatility – some assume a 5 percent erosion of returns annually;
Historically poor ‘index’ return for EM PE – the mean actual return has been relatively poor, hence the required return yardstick is set unrealistically high;
Team turnover – perception that this is markedly higher than developed markets given a significantly smaller talent pool;
Macro-political instability – ranging from unpredictable coups d’état or impeachments to unforeseen inflationary spikes;
Protracted illiquidity – exiting investments has historically been more difficult, resulting in extended fund terms and prompting further liquidity discounts at the outset;
NIMBY (Not In My Back Yard) – difficult to find and perform diligence on superstar managers while developing an enduring partnership given logistical challenges and unknowns of far-flung frontier markets.
Although the diversification benefits of investing in EM are attractive, the tendency is that market shocks affecting developed markets have also resulted in negative ripple effects in EM. It therefore typically boils down to evidence of tangible premium returns, which leads us to the obvious question – is there a sustainable and realistic risk premium that justifies the effort?
The reality is the required premium is meaninglessly reflected in any general partner’s pitchbook, unless it’s actually been generated in the past. Given the relative infancy of EM track records it becomes difficult to bet on a premium that’s notional and so LPs begin to ask, why bother? The flipside of all this is the scale of the intrinsic arbitrage between EM and DM businesses where EM opportunities, especially at the lower end of the market, are typically less leveraged – if they are at all; are priced at low, single digit multiples of EBITDA; are exposed to a significant and growing middle class; have immature business models with significant room for development in the right hands; significantly higher GDP growth levels; and so on. This is where everyone originally got very excited – so where’s the gold dust?
GOOD AS GOLD
The reality is you have to dig deeper to strike gold, but it’s incredibly rewarding when you do – not only financially, where we’ve seen stellar dollar fund returns in growth and buyout – but the depth of relationship you can build is significant because each dollar invested, each bit of advice imparted, is magnified 100 in value. The strategic partnership an LP can build, from co-investment to trusted mentor is something that most in developed markets yearn for, but battle to achieve in what have become more perfectly functioning markets in the West.
What is clear is emerging market investing is all about execution as opposed to ideas. Those GPs that benefit from best-in-class PE training and toolset, but with local street smarts and relationships have been able to consistently deliver a very strong return to their international LPs in dollars.
It’s early days for most, but the signs are promising as several strong franchises begin to emerge in specific sub-regions or countries across EM.