Friday Letter Don't just buy IBM

In today's extraordinarily tough global fundraising environment in which LPs ‘hold all the cards’, managers of emerging market private equity funds are having to fight a rising trend amongst investors to buy conservatively. 

PEO was in Dubai this week for our annual Middle East Forum where more than 300 investors and fund managers from across the Middle East, North Africa and South Asia (MENASA) had a chance to share notes about the road they have travelled – and the journey ahead. The mood was notably sanguine in terms of investment opportunities, but for fundraising much less so.

The MENASA region has not been as badly affected by the credit crisis as more mature private equity markets whose business models relied much more heavily on leverage and smart deal engineering. That said, it is regions like MENASA that are finding it hard to counter the assumption that they are more fragile – and hence riskier – than those mature markets. 

“We have to think very rationally and calmly about where the world finds itself, because don’t forget, when we looked at risk many years ago – even two years ago – everybody had a very clear model in their heads: risk, when it came to being priced for emerging markets, was generally priced at a premium,” said Arif Naqvi, founder and chief executive of Abraaj Capital. “But ladies and gentlemen, when risk came, it came from the West.”

As with other less mature markets, the provision of growth capital defines most private equity investment activity in MENASA. The acquiring of minority positions in sector-leading companies that are ready for the next stage in their development (for example, becoming regional players) is the hallmark of many groups' investment strategies. And for those who have weathered the storms of 2008 and 2009, this year looks set to offer some compelling opportunities. 

Despite this, managers in the region are having a tough time on the fundraising trail. Via a series of anonymous audience polls, it became clear that many GP groups attending were in fundraising mode or planned to be in the next 12 months. They also revealed a wish to expand their LP base to become less regionally-dependent. Most also confirmed that the fundraising process was slow-going and that their pitches were not being terribly well received.

The biggest problem MENASA managers are facing is one that most all emerging markets managers bemoan: the “up to” allocation model many LPs employ which essentially make emerging markets commitments “nice to have” as opposed to “must have”. For example, an LP that has a 10 percent allocation to private equity might carve that up into 4 percent for US managers, 4 percent for European managers and up to 2 percent for emerging markets managers. An LP that’s facing its own portfolio and liquidity issues will most likely axe the emerging market allocation first, said the head of investor relations for one emerging markets private equity firm.

“It’s like cutting training from the operating budget: we’re always the first to go,” agreed the head of one GCC-focused private equity firm.

Such a knee-jerk reaction is in part an indication of an LP’s capacity to evaluate emerging market private equity effectively – and accurately. As Sasha van de Water of investment adviser and fund of funds manager Keyhaven Capital pointed out, many investors have insufficient time and personnel to proactively assess new markets and their managers. To this end, it's down to the emerging market GP to take the conversation to the LP.

That conversation will need to address at times thorny issues head on, too. In the Middle East for example managers can't ignore Dubai’s debt problems and their implications – or lack thereof – on the regional private equity industry. It's not as if such issues are unique to the region though.

Stewart Hay, partner with SL Capital Partners, told delegates. “We’ve got [the same issue] in Europe: the first question people say to me is ‘What about Greece?’ And they’ll say, ‘Alright what about the PIGS [Portugal, Ireland, Greece and Spain]?’ … Let’s keep it in context: Greece is the size of Alabama and Ireland’s got the same population as Kentucky. The biggest GDP deficit anyone’s got right now is California, and nobody seems to worry too much about that.”

The head of one regionally-focused private equity firm agreed. “People do ask, but they must keep in mind that [while] Dubai has been a focal point, it’s a very tiny piece of the regional economy.”

Communicating the appeal of investing in their respective regions is a challenge most emerging market managers are ready and able to meet. Dealing with investors' (and trustees') post-crisis inclination to buy brand name private equity is a tougher ask. Perhaps some would recognise the irony in that old adage that “you don't get fired for buying IBM.” Just ask Lenovo.

PS – PEI’s forthcoming April issue will explore the complex challenges present in today’s global fundraising market, in which, as one placement agent tells us, “LPs hold all the cards”.