Friday Letter Emerging concerns

As emerging markets heat up and rebound more quickly than advanced economies, GPs must maintain investment discipline to win LP support.  

The boxes emerging markets fund managers must tick to gain institutional capital are roughly similar to those applied to GPs operating in OECD territories. It’s no surprise, for example, that LPs expect to see signs of aligned interests in terms and conditions and the GP commitment to a fund. That’s crucial no matter if the fund invests in the US or Uganda.

But LPs also have concerns specific to private equity funds focused on developing economies, where GDP growth is expected to hit 6 percent this year as opposed to the 2 percent the IMF projects for advanced economies.

Investment discipline was the number one worry LPs voiced repeatedly this week at PEI’s Emerging Markets Investor Forum in New York. Institutional investors looking to commit money to emerging markets funds want GPs to have the restraint and patience to stick with a certain strategy, which means resisting the temptation to drastically upsize subsequent funds and do increasingly larger deals.

Huge amounts of capital pouring into a certain region can temp GPs into rapidly deploying their funds so they can start raising its successor. LPs worry that firms aren’t properly evaluating investments opportunities, but simply looking to spend as fast as they can.

Some private equity firms that sprang up during the pre-crisis boom years in India, for example, raised multiple funds within a short period, according to one India-focused investor. He gave an example of one firm that raised three funds within five years. This resulted in the firm asking LPs for fresh commitments before it had even sealed any exits (and distributed cash to LPs) from prior funds – not an ideal situation, and apparently not one that is unique to India, either. LPs also complain about this quick turnaround of capital in regions including Asia and the Middle East. The phenomenon, they say, will play a part in deciding which firms ultimately survive in the coming years, and which will fade into oblivion.

As emerging market growth prospects increasingly capture the hearts and minds of LPs, there is also the worry that GPs will be tempted to significantly ramp up their fund and deal sizes. Fund managers that have excelled at investing in smaller companies may not find the same success when applying the same skill set to a multibillion fund investing in larger companies or different industries. As such emerging markets GPs will have to work harder to demonstrate their revamped strategies are best placed to bring LPs lucrative exposure to developing and frontier markets.

The anxieties LPs voiced at this week’s Emerging Markets Investor Forum are important, but should not overshadow one of the other main messages from the conference’s speakers and delegates: emerging markets are indeed where limited partners want to be. They see the wild potential for growth, but they will be much more careful than perhaps they have been in the past in deciding who will bring them exposure to these territories.