Friday Letter: Fools rush in

The boom in Asia-focused fundraising is beginning to sound alarm bells as growth in China slows and inflation in India pushes up interest rates again. 

A glut of capital is finding its way to emerging market private equity managers. Half-way through the year and already more than 100 funds have raised $35 billion, a 68 percent increase over the amount raised during the same period in 2007, according to the latest numbers.

The data, from the Emerging Markets Private Equity Association (EMPEA) in Washington, shows the total value of private equity funds raised in the first two quarters of 2008 is greater than the $33 billion raised during all of 2006.

Interest in emerging markets private equity has turned into a mainstream allocation strategy as Western investors look further afield for returns. Economic conditions in the US and Europe appear to be having less impact on fundraising for private equity in the emerging regions compared to mature private equity markets.

According to EMPEA the dramatic growth during the first half of 2008 was driven by a surge in funds raised for investment in emerging Asia. They accounted for 75 percent of capital raised in the first half of 2008, compared with 55 percent during the same period in 2007. They raised a total of $26.3 billion, more than double the $11.6 billion raised in the first half of 2007.

Pan-Asian regional funds accounted for $11 billion of the total. Fundraising for China-dedicated funds boomed especially, with a watershed $11.2 billion raised to the end of June. And capital commitments for India-dedicated funds grew by 357 percent, raising a total of $3 billion in the first half of the year.

What then to make of the news that economic conditions across Asia are worsening?

China’s economy for instance, which has grown in excess of 10 percent annually for five years in a row, appears to be slowing. It may yet scrape through for a sixth year, but this is unlikely if official numbers reflect reality.

To be sure, as far as private equity investment is concerned, deteriorating fundamentals need not prove disastrous. Fixed asset investment, around half of China’s economic output, remains strong, and government spending – including reconstruction expenditure following the recent earthquake – should take up any slack from the corporate sector. And if China’s growth is abating it is far from grinding to a halt.

Perhaps more worrying for Asian private equity investors is the spectre of inflation looming large. This week’s news that India’s central bank has raised its benchmark interest rate by half a percentage point, to 9 percent, the third increase in less than two months, was welcome. The bank said it aimed to bring inflation down to a more “tolerable” level as soon as possible.

Taming inflation is now widely considered crucial. Richard Laing, chief executive of CDC, the emerging market investor, told PEO recently that inflation was on the agenda of every investment committee meeting, when 12 months ago it did not warrant a mention.

Laing also said that it is of course still possible to make money in an inflationary environment – but to do it you need grey hair and plenty of experience.

Unfortunately, these are at a premium in most emerging markets. Or as one investor told us this week: “There is not a lot of history, dollars or managers.”

In this light investors have to exercise extreme caution in selecting their emerging market relationships. Throwing money at Asian funds and expecting it to be thrown back in buckets is no longer a realistic strategy – if ever it was. As we are beginning to see from the US and European boom vintages of 2006 and 2007, a glut of capital pushed prices sky high and only greater fool theory kept the party rolling along. Now a lot of those assets are write-down candidates.

For the time being, the LP herd mentality seems certain to provide a steady supply of fools to Asia, which is of course still a long way off the recessionary climate prevailing in mature markets. The challenge to managers is to use the money wisely.