How to get an emerging markets deal done during a downturn

When coronavirus cases began to increase sharply in China and across Asia in March, GPs in emerging markets faced a new challenge: the pandemic would only exacerbate the risk many investors already associated with developing economies.

Data from EMPEA’s global LP survey, taken between February and April, found fewer LPs were willing to make new commitments to emerging markets-focused private capital funds over the following two years. The economic impact of the pandemic, political developments and institutional risk aversion were among the constraints cited by institutional investors in the survey.

Private Equity International’s own fundraising figures, however, show a slightly different picture. By the end of the third quarter, funds focused on Asia-Pacific had raised a total of $36.6 billion – $2.4 billion more than the equivalent period in 2019.

Funds focused on the Middle East, Africa and Latin America also raised more capital – $4.6 billion during Q3 compared with $3.8 billion during the third quarter of 2019.

According to data from EMPEA, capital invested in South-East Asia jumped by 86 percent year-on-year from $2 billion in H1 2019 to $3.8 billion in the first half of this year.

China, despite being the epicentre of the virus during the early months of 2020, suffered only a limited impact: private capital investment in the country increased to $21.3 billion in H1, from $18.8 billion during the first half of 2019.

Due diligence gets tougher

So, to what extent has the coronavirus affected GPs’ ability to get deals done in emerging markets?

Vivek Pandit, a senior partner who leads McKinsey’s private equity practice across Asia-Pacific, says the inability to visit sites and interview people on the ground means “there could be a bit of a gap or surprise between what investors believe they’ve underwritten and what they may end up seeing”.

“In emerging markets, what you see is as important as what you hear and read,” he says. “How people maintain their workspaces can speak to culture. It’s one thing to talk about the quality and safety record at a plant, it’s something else to see it. It’s one thing to talk about organisation around how you apply operating principles to your business, or how you might apply digital to your environment, and it’s something else to see it in action.”

Without in-person meetings, resolving issues discovered during due diligence becomes more challenging, says Jack Clode, co-founder of investigative research and diligence company Blackpeak.

“If you come across concerns that the management of the company is untrustworthy or you come across allegations of undisclosed relationships with suppliers or customers, it is a little bit more difficult than it used to be,” he says.

Clode’s team – and consequently its PE clients – have also had to factor in a slightly longer timeframe for due diligence work. What would have normally been a six-week job could stretch to a couple of months in the new environment. No one has been pushing back on that, Clode says: “Sometimes the deals take a bit longer to close than they would have done originally, but they are still closing. They are still being done.”

He notes that the covid-related documentation has added another 10-15 percent to the overall workload. This includes questions around how the business has been affected, how it is rethinking supply chains or bringing them closer to home, as well as health and safety.

“Countries everywhere are having shutdowns in waves,” he says. “Even for business owners themselves, it’s unpredictable. For someone looking to buy them and forecast how this business is going to do, it’s very difficult.”

Especially in emerging markets, the second and third-order effects of the pandemic are not that easy to predict, Pandit says: “This means when a GP diligences record versus projections, it will be harder to understand how aspects of a supply chain have been impacted, or how much of that is temporary versus permanent in structure, or how much of consumer demand has been replaced by either an alternative product or austerity.”

He adds that the level of detail required to underwrite a few critical areas about which GPs need to be more certain had been increasing even before covid. Now, a wider set of unknowns has emerged: understanding the interplay of the virus’s impact on elements including digitisation and changing government policies is playing into the due diligence process.

“The depth and complexity of questions have therefore increased significantly,” he says.

On the ground is key

For Northstar Group, having an office in its key market of Indonesia has been a boon during the pandemic.

The South-East Asia-focused firm is working on its last deal of the year: a buyout transaction in Indonesia alongside another large buyout fund. Managing director Choon Hong Tan tells PEI that, as a result of covid, strategic buyers and PE firms that do not have a local presence in Indonesia could not make much progress on the deal and could not get comfortable, so they had to drop out.

“Our local experience and presence make us a solid partner for this deal,” he says. “The fund we are working with has an existing relationship with the management team, but they are unable to send anyone to Indonesia at this time due to travel restrictions.”

He adds that Northstar is providing local support through meetings with the management team, as well as market references and interviews.

The firm is also in the process of exiting a portfolio company to a US-based investor via a fully virtual due diligence process. This is an exception rather than the norm, says Tan, but the US buyer is prepared to do it for several reasons.

“First, it is a sector in which they have significant experience,” he says. “Second, the company has reached a reasonable size, has a professional management team, and has been owned by a PE shop for the past eight years. This all helps provide a level of comfort which facilitates fully virtual diligence.”

Investing in emerging markets during a pandemic may come with a few benefits.

“Because there hasn’t been as much fiscal and direct cash stimulus from governments, what you see is what you get,” says Pandit. “Results reflect the real economy – the good, bad and ugly is all out there.”

Threefold shift

He adds that three recent shifts make investing in emerging markets more favourable: gross domestic product is down, debt levels are up and there are fewer alternatives to private capital.

“Lower GDP in emerging markets tends to give rise to buyout opportunities where owners and families are willing to sell control,” Pandit says. “Debt is up and priced higher. This means that opportunities for alternative private credit funds have emerged, especially as state and national banks supported by the central banking are under increasing public performance pressure.”

Clode says he has seen a real impetus from GPs to deploy capital this year.

“First, a lot of the funds have dry powder and want to put it to work in an economy they expect will offer good valuations,” he says. “Second, there’s an expectation that economies will bounce back next year and that Asian emerging economies will recover fastest. That’s been borne out by China: first into covid-19, and first out.”