Friday Letter: It's where the world of investment is going

Making good, consistent returns in emerging markets is still hugely challenging. But with developed markets stagnating, these fast-growing economies are becoming increasingly difficult for private equity investors to ignore.  

In a week when the headlines have been dominated by Europe’s ongoing macroeconomic woes, delegates at PEI’s Emerging Markets Forum in London were focused on an altogether less gloomy subject: the opportunity for private equity to generate out-sized returns in developing economies.

The thesis is very straightforward. Private equity likes growth, and emerging markets deliver it. AlpInvest’s Peter Cornelius flagged IMF figures showing that since 2007, GDP growth in emerging economies has remained steadfastly positive, despite the global downturn. During the same period, growth in the so-called “advanced economies” has been anaemic at best.

The IMF believes that real GDP growth in emerging markets will continue to outstrip growth in the developed world. In fact, Standard Chartered predicts that by 2030, four of the world’s five biggest economies will be from the list of those currently labelled ‘emerging’: China in first, India in third, Brazil in fourth and Indonesia in fifth (the US, in second place, is the only exception).

Making money in emerging markets isn’t easy, of course. Political risk is invariably an issue, as the example of Egypt proves: a year ago it seemed to be one of the industry’s most promising new frontiers, but now, thanks to the political unrest sparked by the Arab Spring, most investors will be giving it a wide berth. And unless you’re one of those optimists who believe in the concept of decoupling, it’s hard to believe that those fast-growing economies that rely on exports won’t be impacted hugely by a major slowdown in the Western world.

Practical barriers to entry are still high, too. Building a local team with the necessary expertise (and managing their relationship with the rest of the firm afterwards, as James Seymour, a managing partner at Pontefract Global Strategies, pointed out at the conference) is often a difficult and expensive process. Legal and regulatory protections can be confusing, inadequate or even non-existent.

However, the opportunities remain tantalising. In addition to the general growth story in some of these emerging economies, managers are attracted by the prospect of doing deals using tiny amounts of leverage; and of buying quality family-owned  businesses that just need a bit of tweaking to get “to the next level”.

And regardless of the challenges, the salient question today is: do investors have a choice? With growth likely to be sluggish at best in developed markets for the foreseeable future, emerging markets are looking like an increasingly good bet. In an era where Brazil is, on some measures, considered to be substantially safer place to invest than Spain, Italy and Portugal, the risk/ return profile of investing in emerging markets is evolving all the time.

In fact, you might even go so far as to say that emerging markets are the future of the asset class. Our closing keynote interview at the Forum was with Georges Sudarskis, the man who set up the Abu Dhabi Investment Authority in 1998; in his view: “This is where the world of investment is going.” Ignoring emerging markets looks increasingly like a recipe for missing out on the best returns.